Thailand
Range-Bound Growth Track Ahead
August 22, 2008

By Chetan Ahya & Deyi Tan (Singapore), Shweta Singh | India

Underperformer Over the Last Four Years

Thailand has lagged the ASEAN and emerging markets over the last four years due to political instability and the consequent impact on domestic demand. While we have seen GDP growth accelerating in almost all emerging markets in this period, Thailand’s growth has decelerated to an average of 4.9%Y over the last three years from an average of 6.7% in 2003-04. The stock market performance has followed a similar trend. MSCI Thailand has underperformed the MSCI EM by 25% over the last four years. Indeed, Thailand is one of the very few emerging markets that have not participated in the three common themes of increased household leverage for consumption and property investments, higher private corporate capex and government spending on infrastructure. Apart from political problems, the almost complete pass-through of higher international oil prices to domestic consumers (many other EMs have subsidized oil prices) has also affected domestic demand growth.

Worst Is Behind Us?

After prolonged below-trend performance, Thailand has witnessed a cyclical recovery in growth over the last six months (see Cyclical Recovery Underway, February 4, 2008). Domestic demand has recovered significantly over the last three quarters. The four key drivers for this recovery are: 1) increased pent-up demand; 2) a decline in real interest rates; 3) increased government spending; and 4) government measures to boost domestic demand, including tax incentives.

Some of the key indicators reflecting this recovery include:

Bank credit: Credit growth accelerated to 13.5%Y, 3MMA in June 2008 from 3.8%Y, 3MMA in December 2006, the highest number post the 1997-98 crisis.

Consumer goods imports: Consumer goods imports have shown improvement, supported by improved sentiment post the December 2007 elections. In USD terms, consumer goods imports have risen to 32.6%Y, 3MMA in June 2008 from a low of 5.7%Y, 3MMA in July 2007. Even in local currency terms, consumer goods improved to 20.7%Y, 3MMA (versus a decline of 3.8%Y, 3MMA in July 2007). Imports as a whole (in local currency terms) improved to 18.5%Y, 3MMA after having shown successive declines from January-September 2007.

Value-added tax collections: VAT revenue surged to 33%Y as of July 2008 from a low of -3%Y in May 2007, thus offering support to the domestic demand recovery story.

Indeed, domestic demand growth accelerated to a high of 6.4%Y during the March 2008 quarter from a low of -1.3%Y in 1Q06. We estimate that the domestic demand growth remained steady during the quarter ended June 2008.

Exports – the Bright Spot So Far

Despite the baht’s strong appreciation over the last two years, export growth has remained very strong. While on a real effective exchange rate (REER) basis, the baht has appreciated 16.0% over four years and export growth has outperformed the region. Thailand’s exports rose 27.4%Y in June 2008 as compared to the AXJ exports growth of 18.1%Y. External demand growth has averaged 8.0%Y over the last three years, compared with domestic demand growth of 2.2%Y. However, a further slowdown in the US, Europe and Japan over the next few months would likely cause some slowdown in export growth. Indeed, over the last nine months, one of the key reasons for total exports doing well was higher commodity exports (particularly food). With commodity prices peaking, overall export growth will likely slow.

Not Yet Ready to Run

We expect a slight moderation in domestic demand growth due to the adverse impact of higher oil prices, inflation, a weakening global outlook and continued political uncertainty.

High oil prices: Thailand imports a significant amount of its oil requirements and has one of the worst oil balances to GDP ratios (-9.0% of GDP as of 1H08 annualized) in the AXJ region. Further, there is an almost complete pass-through of high international oil prices to the domestic market.

Inflation: Higher commodity prices were reflected in inflation, which surged to a 10-year high of 9.2%Y in July 2008, the highest level post the 1997-98 crisis. In addition, producer prices jumped to an all-time high of 21.2%Y. The central bank has revised its inflation forecasts for 2008 and 2009 for the second time this year to 7.5-8.8% and 5.0-7.5%, respectively, from an earlier forecast of 4.0-5.0% and 2.8-4.3%.

Weakening global outlook: With our economics team forecasting a technical recession in 4Q08 and 1Q09 for the US, broad economic stagnation in Europe and, in general, weaker global growth in 2009, we believe that this is likely to weigh on external demand. Falling food prices are also likely to have an adverse impact on Thailand’s export growth.

Political uncertainty: While the ruling coalition recently won a no-confidence motion in parliament and the PM has reshuffled the cabinet, the political environment is far from stable. The court cases against the party executives of the People’s Power Party (PPP, the leading party of the ruling coalition) and other members of the coalition could result in the dissolution of the concerned parties. Further, the PM himself is involved in a few cases that await a judgment. The Charter rewrite issue is another controversial area.

While the recent fall in commodity prices is likely to reduce the inflation pressure to some extent (as oil imports account for around 23-24% of total imports), we expect the central bank to hike policy rates by another 50bp before year-end as compared with our earlier forecast of a 75bp hike. We expect Thailand’s growth to remain within the 5-5.5% range over the next two quarters. The bottom line is that while the economy has recovered from the trough, it is not yet ready to reach its full potential, in our view. While the beta from the global macro will be negative, we are unlikely to see major support from domestic demand creating an exciting investment story in Thailand in the near term. 

Full Realization of Potential Growth Needs More Stable Political Environment

We believe that a fully fledged re-acceleration of GDP growth to the 6.5-7.0% achieved in 2003-04 would need a strong and stable government. The manner in which the PPP leadership manages some of the critical political issues over the next six months will determine how long the new government will last, in our view. 

Important Disclosure Information at the end of this Forum

Global
Rates Roundup: Less than Meets the Eye
August 22, 2008

By Joachim Fels | London

The global economy remains mired in a stagflationary situation, with the advanced economies broadly stagnating, growth in the emerging world slowing, and inflation uncomfortably high and exceeding central banks’ targets almost everywhere around the globe.  While stagflation creates a dilemma for central banks, most have opted for reacting to ‘flation’ rather than to ‘stag’ so far this year.  In fact, 23 of the 36 central banks in developed and emerging countries that our global economics team monitors and forecasts regularly have raised interest rates at least once this year.  By contrast, only five (the Fed, the Bank of England, the Bank of Canada, the Reserve Bank of New Zealand and the Czech National Bank) have lowered rates since the end of last year.

Major monetary easing ahead?  Not so... Over the past two months, however, financial market sentiment has swung from worrying about ‘flation’ to worrying more about ‘stag’ or even recession.  As a consequence, short rate expectations have come down significantly.  In mid-June, markets were pricing in central bank rate hikes for the remainder of this year for all developed country central banks except New Zealand.  Now, markets are pricing in cuts (or a probability of a cut) between now and year-end almost everywhere, except in the US, Sweden and Norway, where markets see some probability of a hike.  However, hopes that the global tide for rates is turning and many central banks will embark on a major easing path are greatly exaggerated, in our view. 

…except Down Under.   In fact, we expect only two central banks – the Reserve Banks of Australia (RBA) and New Zealand (RBNZ) – to cut interest rates in the remainder of this year.  The dovish RBA minutes released earlier this week confirmed Gerard Minack’s view that the RBA will start an easing cycle as early as September 2 (Gerard expects a 25bp cut, while the market is flirting with the idea of a bigger cut).  And Manoj Pradhan continues to expect the RBNZ to cut interest rates by 50bp on September 11, against market expectations of a 25bp move.  However, the RBA and the RBNZ are special cases rather than leading indicators for a great number of other central banks, in our view.  The main reason is that real rates are higher and monetary policy thus tighter than in most other countries, so that central banks have plenty of room to ease now that growth is slowing sharply. 

Still many hikers.  By contrast, we expect 16 central banks in our coverage universe to end the year with higher interest rates than the current levels.  Even in the first half of next year, when we see another seven central banks joining the RBA and RBNZ in the easing camp, rate hikers will still outnumber cutters on our forecasts.  There are two main reasons why we expect most central banks to be reluctant to ease policy even in the face of slowing growth or near-recession.

First, initial monetary conditions matter.  In most countries – even in many that have raised interest rates this year – the policy stance is fairly easy.  Real short-term interest rates (nominal policy rates minus current CPI inflation) are currently negative in no less than 20 of the 36 countries in our coverage universe.  Among others, these include the US, Japan, Canada, Switzerland, Russia, Ukraine, the Czech Republic, Korea, Taiwan, Singapore, Indonesia, the Philippines, Malaysia and Peru.  With policy easy to start with, there is thus little scope to cut rates aggressively.  By contrast, there are only a few countries that have relatively high real short rates and thus tight monetary polices.  Apart from Australia and New Zealand (where real short rates stand at 2.75% and 4%, respectively), these include Brazil and Turkey, where real rates stand at 6.6% and 4.65%, respectively. 

Global real policy rate still negative.  Aggregating across all countries in our coverage universe, the weighted global monetary policy rate currently stands at 4.5% in nominal terms.  However, current global (weighted) inflation is running at 5.3%, so the global real rate is -0.8%, the lowest in this decade.  Thus, global monetary conditions remain very expansionary, limiting the room for a major global monetary easing.

Second, despite the economic slowdown, inflation is likely to turn out stubbornly high in many countries.  Yes, the base effects from last year’s oil price increase together with the recent plunge in oil prices will help to bring down headline inflation from its recent multi-year peaks in many countries.  However, core inflation is rising and expected to continue to rise in many countries.  One reason is that the pass-through from higher non-core prices to core prices and wages is still in full swing.  For example, the higher-than-expected PPI numbers in the US and Germany reported yesterday showed broad-based pipeline pressures for a broad set of goods that will still have to show up in the core CPI.  Another reason why this slowdown should have a smaller disinflationary impact than usual is that potential growth is slowing, and also that the past energy price surge and the credit crisis have made productive capital obsolete (for more details, see “Potential Growth Is Slowing, Too!” The Global Monetary Analyst, July 30, 2008).  With demand AND supply decelerating, this slowdown will produce less spare capacity and thus less disinflationary pressures than usual, limiting the room for many central banks to ease policy.

Where we differ from the market consensus.   Finally, surveying our rate forecasts, it is worth highlighting where we differ from what the markets are pricing in right now.

•           In the US, where we think the worst for the real economy is still to come in the form of a technical recession around the turn of the year, we see the first Fed hike only around the middle of next year, against market expectations for a first hike during 1Q09.  If our downbeat economic outlook is right, markets may well swing to pricing in a decent chance of another cut in the meantime.

•           In Japan, our BoJ watchers expect the Bank of Japan to cut rates by 25bp during 1H09 in response to a standstill in economic growth over the next year or so.  While markets have recently started to attach some probability to such a move, it is not fully priced in.

•           Both in Australia and New Zealand, we see rates falling by more (by 200bp and 225bp, respectively) between now and the end of next year than markets are pricing in. 

•           In the euro area, our economists still think that the ECB has a tightening bias, despite President Trichet’s seemingly dovish comments at the last press conference.  One more hike later this year in order to quell the emerging wage pressures is still our main case.  But even if that hike doesn’t come, we think that the market has run ahead of itself in pricing in rate cuts for next year.

•           In the UK, our economists’ central case is for unchanged interest rates in the remainder of this year and next year, against market expectations for three to four cuts.  While some easing cannot be ruled out, we think that with inflation likely to remain above target for most of next year, the room for rate cuts is very limited.

Important Disclosure Information at the end of this Forum

Thailand
Range-Bound Growth Track Ahead
August 22, 2008

By Chetan Ahya & Deyi Tan | Singapore, Shweta Singh (India)

Underperformer Over the Last Four Years

Thailand has lagged the ASEAN and emerging markets over the last four years due to political instability and the consequent impact on domestic demand. While we have seen GDP growth accelerating in almost all emerging markets in this period, Thailand’s growth has decelerated to an average of 4.9%Y over the last three years from an average of 6.7% in 2003-04. The stock market performance has followed a similar trend. MSCI Thailand has underperformed the MSCI EM by 25% over the last four years. Indeed, Thailand is one of the very few emerging markets that have not participated in the three common themes of increased household leverage for consumption and property investments, higher private corporate capex and government spending on infrastructure. Apart from political problems, the almost complete pass-through of higher international oil prices to domestic consumers (many other EMs have subsidized oil prices) has also affected domestic demand growth.

Worst Is Behind Us?

After prolonged below-trend performance, Thailand has witnessed a cyclical recovery in growth over the last six months (see Cyclical Recovery Underway, February 4, 2008). Domestic demand has recovered significantly over the last three quarters. The four key drivers for this recovery are: 1) increased pent-up demand; 2) a decline in real interest rates; 3) increased government spending; and 4) government measures to boost domestic demand, including tax incentives.

Some of the key indicators reflecting this recovery include:

Bank credit: Credit growth accelerated to 13.5%Y, 3MMA in June 2008 from 3.8%Y, 3MMA in December 2006, the highest number post the 1997-98 crisis.

Consumer goods imports: Consumer goods imports have shown improvement, supported by improved sentiment post the December 2007 elections. In USD terms, consumer goods imports have risen to 32.6%Y, 3MMA in June 2008 from a low of 5.7%Y, 3MMA in July 2007. Even in local currency terms, consumer goods improved to 20.7%Y, 3MMA (versus a decline of 3.8%Y, 3MMA in July 2007). Imports as a whole (in local currency terms) improved to 18.5%Y, 3MMA after having shown successive declines from January-September 2007.

Value-added tax collections: VAT revenue surged to 33%Y as of July 2008 from a low of -3%Y in May 2007, thus offering support to the domestic demand recovery story.

Indeed, domestic demand growth accelerated to a high of 6.4%Y during the March 2008 quarter from a low of -1.3%Y in 1Q06. We estimate that the domestic demand growth remained steady during the quarter ended June 2008.

Exports – the Bright Spot So Far

Despite the baht’s strong appreciation over the last two years, export growth has remained very strong. While on a real effective exchange rate (REER) basis, the baht has appreciated 16.0% over four years and export growth has outperformed the region. Thailand’s exports rose 27.4%Y in June 2008 as compared to the AXJ exports growth of 18.1%Y. External demand growth has averaged 8.0%Y over the last three years, compared with domestic demand growth of 2.2%Y. However, a further slowdown in the US, Europe and Japan over the next few months would likely cause some slowdown in export growth. Indeed, over the last nine months, one of the key reasons for total exports doing well was higher commodity exports (particularly food). With commodity prices peaking, overall export growth will likely slow.

Not Yet Ready to Run

We expect a slight moderation in domestic demand growth due to the adverse impact of higher oil prices, inflation, a weakening global outlook and continued political uncertainty.

High oil prices: Thailand imports a significant amount of its oil requirements and has one of the worst oil balances to GDP ratios (-9.0% of GDP as of 1H08 annualized) in the AXJ region. Further, there is an almost complete pass-through of high international oil prices to the domestic market.

Inflation: Higher commodity prices were reflected in inflation, which surged to a 10-year high of 9.2%Y in July 2008, the highest level post the 1997-98 crisis. In addition, producer prices jumped to an all-time high of 21.2%Y. The central bank has revised its inflation forecasts for 2008 and 2009 for the second time this year to 7.5-8.8% and 5.0-7.5%, respectively, from an earlier forecast of 4.0-5.0% and 2.8-4.3%.

Weakening global outlook: With our economics team forecasting a technical recession in 4Q08 and 1Q09 for the US, broad economic stagnation in Europe and, in general, weaker global growth in 2009, we believe that this is likely to weigh on external demand. Falling food prices are also likely to have an adverse impact on Thailand’s export growth.

Political uncertainty: While the ruling coalition recently won a no-confidence motion in parliament and the PM has reshuffled the cabinet, the political environment is far from stable. The court cases against the party executives of the People’s Power Party (PPP, the leading party of the ruling coalition) and other members of the coalition could result in the dissolution of the concerned parties. Further, the PM himself is involved in a few cases that await a judgment. The Charter rewrite issue is another controversial area.

While the recent fall in commodity prices is likely to reduce the inflation pressure to some extent (as oil imports account for around 23-24% of total imports), we expect the central bank to hike policy rates by another 50bp before year-end as compared with our earlier forecast of a 75bp hike. We expect Thailand’s growth to remain within the 5-5.5% range over the next two quarters. The bottom line is that while the economy has recovered from the trough, it is not yet ready to reach its full potential, in our view. While the beta from the global macro will be negative, we are unlikely to see major support from domestic demand creating an exciting investment story in Thailand in the near term. 

Full Realization of Potential Growth Needs More Stable Political Environment

We believe that a fully fledged re-acceleration of GDP growth to the 6.5-7.0% achieved in 2003-04 would need a strong and stable government. The manner in which the PPP leadership manages some of the critical political issues over the next six months will determine how long the new government will last, in our view. 

Important Disclosure Information at the end of this Forum

Vietnam
Still Too Early for Meaningful Rate Cuts
August 22, 2008

By Deyi Tan & Chetan Ahya (Singapore), Shweta Singh | India

Initial Signs of Macro Stability Returning

The aggressive tightening undertaken by the State Bank of Vietnam (SBV), hiking the base rate from 8.75% in May to 14% in June, has had an effect on Vietnam’s macro environment. Coupled with declining commodity prices and administrative measures, indicators are showing signs of cooling off. This has increased the markets’ hopes for a meaningful cut in banks’ lending rates over the next 3-4 months. We review the following three key macro developments in the context of the monetary policy outlook:

1) Sequential inflation softening: July numbers show headline inflation still running at uncomfortable levels of 27.0%Y (versus 26.8%Y in Jun-08). The already high price level means that CPI is likely to stay closer to 30% on a %Y basis through year-end. We believe that sequential %M inflation is a better indication of what happens at the margin. On that count, price pressures (+1.1%M in Jul-08 versus a peak of 3.9%M in May-08) appeared to be subsiding on the back of macro corrective measures and declining commodity prices.

For August, we believe that sequential %M inflation could spike up due to the 14-37% retail fuel price hike implemented on July 21. However, Vietnam is the first country within the basket of Asian economies which subsidise fuel prices to reduce gasoline prices (by 5% on August 14). This should partially reverse the 14-37% retail fuel price hike implemented on July 21 and aid the softening %M trend which we expect to resume thereafter.

2) Balance of payments stress easing: As a result of the slowing domestic economy and reduced speculative demand, import momentum slowed to 35%Y in Jul-08 from a peak of 85% in Apr-08. Steel imports slowed to 1.5%Y in Jul-08 (versus the Jan-April average of 171%Y) as the real estate market cooled, and automobiles imports fell to 53.5%Y (versus the Jan-May average of 350%) amid auto tariff hikes. Gold demand volume rose 55% in 1H08 but the ban on gold imports since Jun-08 should reduce import pressures on this front. Consequently, the trade deficit (3M trailing sum, annualized, custom basis) has narrowed from a peak of 49.5% of GDP in Apr-08 (US$37.1 billion) to 17.7% in Jul-08 (US$13.8 billion). On a monthly basis, it has narrowed from a peak of US$3.3 billion in Mar-08 to US$0.8 billion in Jul-08. On the other hand, the FDI funding side has sustained. Investors still appear to believe in the long-term structural story of Vietnam, despite macro difficulties in 1H08. Data from the Ministry of Planning and Investment show that FDI commitments for Apr-Jul-08 were US$39 billion (versus US$5 billion for 1Q08). Similarly, FDI disbursements were US$4.3 billion, up from US$1.7 billion in 1Q08. 

3) However, the banking sector’s balance sheet remains stretched: Easing inflation and the correction in BoP imbalances take stress off the currency, which saw significant depreciation pressures from macro overheating. 12M non-deliverable forwards are now pricing in 13.1% depreciation, down from a peak of 35% in Jun-08. However, with the tight monetary policy in place, the slowdown could be more intense than what the data are already suggesting, in our view. At the micro level, interest rate resets are under way. Borrowers are incrementally facing the pain of higher interest repayments as most loans are on floating rates.

Economic growth momentum had hinged on loose credit in the past, and now the intermediation system is facing stress, a part of it more so than others. Interbank rates have remained high at 19.8% after rising from 8-9% early this year, suggesting that liquidity conditions remain tight. This matters to joint stock banks and joint venture banks, which are more dependent on the interbank money market for funding. Although joint stock banks constitute only 29% of credit disbursed, this part of the intermediation system had helped to turbo-charge the economy, accounting for a significant share of incremental loan growth. Repayment stress on borrowers (both due to higher interest rates and their involvement in sectors that have been overextended), tight liquidity conditions and lower loan volumes could spell difficulties for these smaller players, in our view.

Also, while corporates shy away from taking loans due to the high rates, commercial banks themselves are also becoming more selective in terms of who they lend to. Indeed, credit growth has slowed from 6.3%M in Jan-08 to 0.7%M in Jul-08, taking YTD credit growth to 18.4% (versus 54%Y in 2007).

Still Too Early for Meaningful Rate Cuts

The SBV has kept the policy rate (i.e., base rate) on hold at 14%, but the reality of a deeper macro slowdown means that the possibility of monetary policy reversal remains.  In our view, there are three options for policy easing: 1) policy rate cut; (2) reserve requirement ratio cut and; (3) banks’ lending rate cuts. Specifically, with projects having ground to a halt, given the high cost of capital, state-owned banks might come under pressure from corporates to reduce lending rates.

Indeed, there have been some nominal lending rate cuts by commercial banks. However, we do not expect the SBV to undertake meaningful policy rate cuts this year, and meaningful banks’ lending rate cuts of 4-5% by year-end are also unlikely, in our view.

We believe that meaningful policy rate cuts are not sustainable in this environment. Liquidity conditions have been tight for several reasons. High inflation and negative real rates have made it more attractive to be a debtor than a depositor, leading to a funding/credit mismatch. Credit growth outpaced deposit growth when real interest rates turned negative in Dec-07 and the growth gap has persisted even after the latest SBV rate hike, with Jul-07 credit growth at 50%Y and deposit growth at 27%Y, according to our estimates. The liquidity tightness has also been accentuated by the fact that the SBV had also raised the compulsory reserve requirement to 11% for VND and foreign currency deposits under 12 months and 5% for VND and foreign currency deposits between 12 and 24 months in Feb-08, and part of the deposit base also likely went towards subscription of government bonds. Indeed, the incremental credit-to-deposit ratio (calculated as the 12M increase in credit stock divided by the 12M increase in deposit stock) has risen from 103% in Dec-07 to 161% in Jul-08. The credit-to-deposit ratio has also increased to 102% in Jul-08 from 95% in Dec-07.

Even in an optimistic scenario where sequential %M inflation were to gradually reduce to 0% by year-end, %Y inflation would still stay in the 25-30%Y range, on our estimates. Real deposit rates would likely stay negative, which means that while credit growth would be jump-started with rate cuts, poor deposit growth would present a practical liquidity constraint for credit reacceleration. Reducing reserve requirements might help to side-step this. However, re-accelerating the economy without having sufficiently eased capacity utilization constraints raises the risk of domestic inflation again flaring up and the trade deficit correction being truncated. A relapse of the macro difficulties Vietnam faced earlier this year could undermine its institutional credibility, in our view.

Bottom Line

We do not expect meaningful rate cuts this year.  Two goalposts are important in the interest rate decision, in our view: (1) Inflation has to fall to levels which restore a positive real interest rate, i.e., around 20%Y or 1.5%M for a quarter or so; and (2) Banking sector liquidity conditions have to improve, with the gap between credit growth and deposit growth narrowing and interbank rates normalizing.  We believe that this could happen in 1Q09 at the earliest.

Important Disclosure Information at the end of this Forum

Vietnam
Still Too Early for Meaningful Rate Cuts
August 22, 2008

By Deyi Tan & Chetan Ahya | Singapore, Shweta Singh (India)

Initial Signs of Macro Stability Returning

The aggressive tightening undertaken by the State Bank of Vietnam (SBV), hiking the base rate from 8.75% in May to 14% in June, has had an effect on Vietnam’s macro environment. Coupled with declining commodity prices and administrative measures, indicators are showing signs of cooling off. This has increased the markets’ hopes for a meaningful cut in banks’ lending rates over the next 3-4 months. We review the following three key macro developments in the context of the monetary policy outlook:

1) Sequential inflation softening: July numbers show headline inflation still running at uncomfortable levels of 27.0%Y (versus 26.8%Y in Jun-08). The already high price level means that CPI is likely to stay closer to 30% on a %Y basis through year-end. We believe that sequential %M inflation is a better indication of what happens at the margin. On that count, price pressures (+1.1%M in Jul-08 versus a peak of 3.9%M in May-08) appeared to be subsiding on the back of macro corrective measures and declining commodity prices.

For August, we believe that sequential %M inflation could spike up due to the 14-37% retail fuel price hike implemented on July 21. However, Vietnam is the first country within the basket of Asian economies which subsidise fuel prices to reduce gasoline prices (by 5% on August 14). This should partially reverse the 14-37% retail fuel price hike implemented on July 21 and aid the softening %M trend which we expect to resume thereafter.

2) Balance of payments stress easing: As a result of the slowing domestic economy and reduced speculative demand, import momentum slowed to 35%Y in Jul-08 from a peak of 85% in Apr-08. Steel imports slowed to 1.5%Y in Jul-08 (versus the Jan-April average of 171%Y) as the real estate market cooled, and automobiles imports fell to 53.5%Y (versus the Jan-May average of 350%) amid auto tariff hikes. Gold demand volume rose 55% in 1H08 but the ban on gold imports since Jun-08 should reduce import pressures on this front. Consequently, the trade deficit (3M trailing sum, annualized, custom basis) has narrowed from a peak of 49.5% of GDP in Apr-08 (US$37.1 billion) to 17.7% in Jul-08 (US$13.8 billion). On a monthly basis, it has narrowed from a peak of US$3.3 billion in Mar-08 to US$0.8 billion in Jul-08. On the other hand, the FDI funding side has sustained. Investors still appear to believe in the long-term structural story of Vietnam, despite macro difficulties in 1H08. Data from the Ministry of Planning and Investment show that FDI commitments for Apr-Jul-08 were US$39 billion (versus US$5 billion for 1Q08). Similarly, FDI disbursements were US$4.3 billion, up from US$1.7 billion in 1Q08. 

3) However, the banking sector’s balance sheet remains stretched: Easing inflation and the correction in BoP imbalances take stress off the currency, which saw significant depreciation pressures from macro overheating. 12M non-deliverable forwards are now pricing in 13.1% depreciation, down from a peak of 35% in Jun-08. However, with the tight monetary policy in place, the slowdown could be more intense than what the data are already suggesting, in our view. At the micro level, interest rate resets are under way. Borrowers are incrementally facing the pain of higher interest repayments as most loans are on floating rates.

Economic growth momentum had hinged on loose credit in the past, and now the intermediation system is facing stress, a part of it more so than others. Interbank rates have remained high at 19.8% after rising from 8-9% early this year, suggesting that liquidity conditions remain tight. This matters to joint stock banks and joint venture banks, which are more dependent on the interbank money market for funding. Although joint stock banks constitute only 29% of credit disbursed, this part of the intermediation system had helped to turbo-charge the economy, accounting for a significant share of incremental loan growth. Repayment stress on borrowers (both due to higher interest rates and their involvement in sectors that have been overextended), tight liquidity conditions and lower loan volumes could spell difficulties for these smaller players, in our view.

Also, while corporates shy away from taking loans due to the high rates, commercial banks themselves are also becoming more selective in terms of who they lend to. Indeed, credit growth has slowed from 6.3%M in Jan-08 to 0.7%M in Jul-08, taking YTD credit growth to 18.4% (versus 54%Y in 2007).

Still Too Early for Meaningful Rate Cuts

The SBV has kept the policy rate (i.e., base rate) on hold at 14%, but the reality of a deeper macro slowdown means that the possibility of monetary policy reversal remains.  In our view, there are three options for policy easing: 1) policy rate cut; (2) reserve requirement ratio cut and; (3) banks’ lending rate cuts. Specifically, with projects having ground to a halt, given the high cost of capital, state-owned banks might come under pressure from corporates to reduce lending rates.

Indeed, there have been some nominal lending rate cuts by commercial banks. However, we do not expect the SBV to undertake meaningful policy rate cuts this year, and meaningful banks’ lending rate cuts of 4-5% by year-end are also unlikely, in our view.

We believe that meaningful policy rate cuts are not sustainable in this environment. Liquidity conditions have been tight for several reasons. High inflation and negative real rates have made it more attractive to be a debtor than a depositor, leading to a funding/credit mismatch. Credit growth outpaced deposit growth when real interest rates turned negative in Dec-07 and the growth gap has persisted even after the latest SBV rate hike, with Jul-07 credit growth at 50%Y and deposit growth at 27%Y, according to our estimates. The liquidity tightness has also been accentuated by the fact that the SBV had also raised the compulsory reserve requirement to 11% for VND and foreign currency deposits under 12 months and 5% for VND and foreign currency deposits between 12 and 24 months in Feb-08, and part of the deposit base also likely went towards subscription of government bonds. Indeed, the incremental credit-to-deposit ratio (calculated as the 12M increase in credit stock divided by the 12M increase in deposit stock) has risen from 103% in Dec-07 to 161% in Jul-08. The credit-to-deposit ratio has also increased to 102% in Jul-08 from 95% in Dec-07.

Even in an optimistic scenario where sequential %M inflation were to gradually reduce to 0% by year-end, %Y inflation would still stay in the 25-30%Y range, on our estimates. Real deposit rates would likely stay negative, which means that while credit growth would be jump-started with rate cuts, poor deposit growth would present a practical liquidity constraint for credit reacceleration. Reducing reserve requirements might help to side-step this. However, re-accelerating the economy without having sufficiently eased capacity utilization constraints raises the risk of domestic inflation again flaring up and the trade deficit correction being truncated. A relapse of the macro difficulties Vietnam faced earlier this year could undermine its institutional credibility, in our view.

Bottom Line

We do not expect meaningful rate cuts this year.  Two goalposts are important in the interest rate decision, in our view: (1) Inflation has to fall to levels which restore a positive real interest rate, i.e., around 20%Y or 1.5%M for a quarter or so; and (2) Banking sector liquidity conditions have to improve, with the gap between credit growth and deposit growth narrowing and interbank rates normalizing.  We believe that this could happen in 1Q09 at the earliest.

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