India
Cutting 2009 Growth Estimates Again
November 11, 2008

By Chetan Ahya | Singapore & Tanvee Gupta | India

Summary

Sustained credit defaults in many parts of the developed world are paralyzing global financial institutions’ ability to deliver risk capital. Cost of capital continues to remain at higher levels even while GDP growth has decelerated sharply. The vicious loop of rising credit defaults, a shrinking risk capital pool, slowing growth and rising unemployment is unveiling. Our economics team has revised its global GDP growth forecast to 1.7% in 2009 from 2.5% previously (see Beyond a Deeper Recession: Tepid Recovery, November 10, 2008). In this environment, global capital inflows into emerging markets are unlikely to revive soon. While India is perceived to be relatively insulated in an environment where the global economy is slowing, investors have underestimated the dependence of its domestic demand on global capital inflows. Risk aversion in the global financial markets has resulted in a sharp reversal in capital flows into India. With the duration of risk-aversion in global financial markets likely to be longer than we had estimated earlier, we are cutting our India GDP growth estimate for 2009 to 5.8% from 6.4% previously. On a financial year basis, we are forecasting F2010 GDP of 5.7%, compared with our previous estimate of 6.5%.

Capital Inflows – Critical Macro Link

We believe that over the last few years, India’s GDP growth accelerated much faster than potential growth due to large capital inflows – an argument that we have belabored for a long time now. India’s GDP growth accelerated to an average of 9.3% during the three years ended March 2008 compared with an average of 6.6% and 6.0% in the preceding three and five years, respectively. Capital inflows have risen dramatically over the last five years. India received an average of US$10 billion per annum between 2000 and 2002. During 2003-05, capital inflows more than doubled to an average of US$21.3 billion, followed by an increase to US$38.5 billion in 2006 and US$98.3 billion in 2007. We believe that capital flows have been the anchor of the self-fulfilling virtuous cycle of higher capital flows – an appreciating exchange rate – lower interest rates – strong domestic demand growth.

Unfortunately, capital inflows into India have less to do with India’s long-term fundamentals, in our view. Capital inflows into India have trended in line with overall EM capital inflows. The trend for capital inflows into EMs has been dependent on global risk appetite which, in turn, has been driven by the liquidity and growth environment in the developed world. As per IIF estimates, capital inflows into EM increased to US$782 billion in 2007 from US$113 billion in 2002. The trend in India has been very similar. Indeed, during F2008 (12 months ended March 2008), India received US$108 billion in capital inflows. There are several key components to this capital inflow: US$29 billion were portfolio equity inflows, US$42 billion were debt borrowings, US$15.5 billion were net FDI, and the balance was other inflows. Over the last few months, with the reversal in global risk appetite, we are seeing a sharp fall in capital inflows into India and EMs. Our approximate estimates based on the FX reserves trend indicate that, over the last five months, India has actually seen net capital outflows of around US$5-10 billion.

FX Outflows and Tightening Domestic Liquidity

Capital outflows at a time when the country runs a current account deficit has meant a large balance of payments deficit. We estimate that India’s balance of payments deficit was US$35-40 billion over the last five months. With the domestic banking system already witnessing tight liquidity conditions, foreign exchange outflows at the same time have resulted in a disruptive spike in the cost of capital. A policy rate cut and liquidity measures cannot prevent a sharp growth slowdown in domestic demand. We believe that measures initiated by the central bank will likely help to keep the cost of borrowing for the consumers and corporate sector from rising further dramatically. However, these measures are unlikely to help bring down the cost of capital in a meaningful manner before domestic demand and underlying credit demand decelerate sharply.

We believe that the balance of payments deficit as reflected in the decline in foreign exchange reserves will continue to weigh on the RBI’s ability to bring down the cost of borrowing. Even as the RBI has announced liquidity measures, the three-month AAA commercial paper rate at 13-14% has continued to be about 400-500bp higher than its level during the quarter ended June 2008. Similarly, while public sector banks have recently announced 50-75bp reductions in lending rates for mortgage loans, they have tightened lending standards, reducing accessibility for borrowers. Private sector banks have not cut their lending rates so far and, even if they were to cut their prime lending rates, we do not expect the banking system to cut the effective borrowing costs for consumers and the corporate sector until credit demand decelerates sharply and/or capital inflows revive meaningfully.

Vicious Loop of Risk-Aversion Already Unveiled

India has had an unusually strong credit growth cycle over the last few years, premised on large capital inflows. The outstanding bank credit stock increased from just US$186 billion as of March 2003 to US$638 billion by end-F2008 (Y/E March). The RBI has constantly been initiating prudent measures to build protection in the banking system against a reversal in the growth cycle. However, we believe that a sudden dramatic reversal in capital inflows at a time when the banking system had been in one of the strongest credit cycles in history will make a major rise in non-performing loans (NPLs) in the banking sector inevitable. Industrial production has already decelerated sharply to an average of 4.7% during the three months ended August 2008 from the peak of 13.6% during the three months ended January 2007.

The risks are particularly high in real estate loans, unsecured personal loans and SME loans. Our conversations with real estate market players indicate that many developers are facing serious financial management challenges. Some are borrowing at 30%-plus to complete their projects. Private sector banks already face a significant rise in NPLs on their unsecured loan portfolio. Banks also have exposure to non-banking financial companies, which in turn are also likely to face higher NPLs.

One of the areas that concerns us the most is the performance of the SME sector. Its profitability has been hit badly. Hundreds of SMEs have raised external commercial borrowings over the past few years when the cost of borrowing in the international market was very low. Some had not hedged the foreign exchange risk or had hedged under ‘knock-in knock-out’ (KIKO) agreements. Many hedges made under these KIKO contracts are lapsing due to the sharp movement in the rupee in such a short time span. This has meant that many SMEs have seen foreign losses on external liabilities increase significantly. SMEs are also facing challenges on their export income due to the global demand slowdown, and the recent tight global liquidity has meant that trade credit has also become difficult to access. Lastly, the borrowing cost of the SME sector has risen sharply. With AAA rated companies borrowing in the commercial paper market at 13.4%, the SME sector is suffering even from higher borrowing costs for its short-term funding needs.

Cutting 2009 Growth Estimates Again

We believe that despite the measures initiated by the RBI, the cost of capital will remain relatively high even if growth has decelerated sharply. A vicious loop of a tight liquidity environment and rise in NPLs has been unveiled. We expect the fixed investment cycle to reverse sharply. Tight lending standards are likely to restrict consumer loan growth and private consumption spending. In addition, weaker global growth will also be reflected in the form of a slowdown in external demand. We expect export growth to decelerate to -1.8% in 2009 from an estimate of 15.9% in 2008. While lower oil prices should help to reduce the current account deficit, we believe that lower exports and remittances from non-residents should offset a large part of this gain. Moreover, as we have been arguing, capital inflows are more important for the balance of payments outlook than the current account balance. Building in weaker domestic as well as external demand, we are cutting our 2009 GDP growth forecast to 5.8% from 6.4% previously. On a financial year basis, for F2010, we are expecting GDP growth of 5.7%, down from 6.5% earlier.

Can the Government Initiate Aggressive Fiscal Policy Measures as in China?

The Indian government has been running pro-cyclical fiscal policies over the last few years. In F2009, we estimate that the fiscal deficit including off-budget liabilities will be 9.2% of GDP, one of the highest amongst large economies in the world. Public debt to GDP after including off-budget liabilities is estimated to increase to 95.1% as of March 2009. Moreover, with domestic liquidity conditions already tight, there may not be much room for further increases in public expenditure. Indeed, the RBI recently decided to redeem banks’ holding of government securities under the market stabilization scheme to provide room for the government to pursue its normal borrowing program without a tightening in domestic liquidity. However, we believe that the government could try to increase infrastructure spending through bilateral investment agreements with Japan and/or Middle East countries. Yet, we suspect that the implementation of such an investment program is unlikely to be quick enough to get the growth support in 2009.

The End Game Is That Earnings Suffer

Our equity strategist, Ridham Desai, believes that the BSE Sensex constituents, in aggregate, have grown earnings five-fold in five years from Rs247 billion to Rs1,215 billion – it is not incorrect to call this an earnings bubble, in our view. Broad market earnings have grown six-fold between F2003 and F2008. Corporate India is sitting on record margins, record financial income and a high base of earnings. To top this, financial leverage has risen, operating leverage is turning negative and asset turn is dropping. If earnings were to fall in the coming quarters, it should surprise nobody, in our view. We expect broad market earnings to fall 20% in F2010 and ROE to decline from 22% at its peak to 16% in the coming 18 months. The consensus is currently forecasting Sensex EPS growth at 13% for F2009 and 15% for F2010. We think that these numbers are likely to be significantly lower at around 9% and -7.5%, respectively. In our bear case, we believe that earnings for the Sensex constituents could fall 15% in F2010. Financials, materials and industrials should bear the brunt of the likely earnings weakness, in our view.

Gradual Recovery in 2010

We expect GDP growth to recover in 2010 in line with our global forecasts. Our economics team expects global GDP growth to accelerate to 3.6% in 2010. US and Europe GDP growth is expected to rise to 2.1% and 1.2%, respectively. We believe that the improvement in domestic demand in 2010 will be restrained by the fact that the banking sector will likely remain impaired due to large increases in NPLs in 2009. We expect a slight improvement in external demand as well as domestic demand. We forecast 2010 GDP growth to be at 6.5% (6.5% for F2011).

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Taiwan
Running Ahead in This Rate Cut Race
November 11, 2008

By Sharon Lam | Hong Kong

Summary and Conclusions

Although the Central Bank of the Republic of China (Taiwan)’s (CBC) next scheduled monetary policy meeting is not due until the second half of December, we have been stressing that the authorities look eager to stay ahead of the curve and so an inter-meeting would be highly likely.  Nevertheless, we are still surprised by the speed of the move.

In an emergency meeting over the weekend, the CBC cut interest rates again by 25bp, bringing the rediscount rate to 2.75% – the lowest level since 1Q07. The CBC has carried out four rate cuts, for a total of 87.5bp, since the cycle turned to easing in September.  As the country’s interest rate was relatively low to begin with, Taiwan is indeed ahead of other economies in the non-Japan Asia region in terms of the number of rate cuts and also the magnitude. Taiwan’s policy rate has come down from 3.625% to 2.75% (in four cuts), followed by Korea’s from 5.25% to 4% (in three cuts), India’s from 9% to 7.5% (in two cuts) and China’s from 7.47% to 6.66% (in three cuts).

Having the lowest inflation in the region, both headline and core, gives Taiwan room to be more aggressive than others in front-loading rate cuts. Although we do not think that rate cuts are what Taiwan needs most, we believe that the authorities will continue to strive to stay ahead of the curve. We project a further 100bp of additional cuts in the rediscount rate, with 50bp before the end of this year and another 50bp in 1Q09, which would bring the rate to 1.75%. Thereafter, we expect interest rates to remain stable since Taiwan also needs to maintain a respectable positive interest rate spread against USD rates to stop further capital outflows.

We do not expect that rate cuts alone can revive the Taiwanese economy, which is suffering more of a confidence issue than a liquidity issue. Yet, we estimate that the projected rate cuts could save at least 1% of GDP in interest burden.

We Expect 1% of GDP Savings in Interest Burden

In this easing cycle, the reduction in the lending rate could be less than policy rate changes since the former has not moved as much when the CBC was tightening. The drop in actual lending rates could be less than but close to 100bp, in our view. We lay out the sensitivity of savings in interest burden by the private sector based on the different magnitude of cuts in lending rates. If actual lending rates drop only 50bp, then total interest burden savings could be 0.6% of GDP annualized. If lending rates fall 100bp, then the savings would be 1.1% of GDP annualized. In other words, we expect a saving of around 1% of GDP in the interest burden from this easing cycle. The impact on domestic demand, however, will be less than 1% of GDP since the marginal propensity to consume/invest is less than one. Although rate cuts cannot turn around the economy, they would at least bring a meaningful reduction in debt obligations, which is crucial to keep sentiment from deteriorating much further from here. Also, monetary easing is only part of the government’s stimulus package, along with tax rate cuts and infrastructure spending.

Rate Cuts Will Not Stop NPLs from Rising

The non-performing loan (NPL) ratio is always a lagging indicator. As the latest data show, the NPL ratio for the Taiwanese domestic banks was only 1.53% in September, the lowest since this data series became available in 1997. The NPL ratio will most certainly rise in the coming months. We constructed our own Taiwan Credit Risk Index, which indicates that credit risk has indeed risen. Since we expect nominal income growth to fall to negative in the next two quarters, credit risk is still projected to rise despite factoring in our interest rate forecasts of another 100bp of cuts. However, the magnitude this time does not appear to be as bad as the corporate debt problem in 2001 or the credit card problem in 2005-06. This is because production overcapacity is less severe in this cycle than in 2001, while the property bubble, if any, that occurred this year was too short-lived to create any broad-based surge in household loans, in our view.

Corporate Loans Are at Bigger Risk than Consumer Loans

Although overall corporate loan growth in Taiwan has been timid in the past few years, corporates have not de-leveraged compared to the households. The noticeable contribution has been from the construction & real estate and electronic sectors, which account for 14% and 13% of total corporate loans, respectively, and have seen positive loan growth in the past three years. Metals, utilities and the chemical sectors also saw relatively higher loan growth in the past three years, though they have smaller weights in the loans outstanding. 

Having said this, we do not expect any full-blown credit turmoil in Taiwan this time. The ratio of short-term loans with maturity of less than one year has declined over the years (26% of total loans in 2008 versus 31% in 2001), thereby reducing the rollover risks. Most importantly, Taiwan’s banking system probably is among the most liquid in the region, as banks have liquid reserves of almost NT$6 trillion. The abundant liquidity condition is also reflected in interbank rates, which have declined further amid the current financial turmoil as the authorities have been injecting liquidity. Although banks will still be reluctant to lend at present, the abundant liquidity should at least allow the government guarantees to be more effective in restoring confidence to enable the credit market to function again.

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Ukraine
Flexible, but Not Yet
November 11, 2008

By Oliver Weeks | London

After formal approval of the IMF’s US$16.5 billion loan and disbursement of the first US$4.5 billion tranche, the outlook for growth and the UAH remains bleak and politicians’ readiness to comply fully with the IMF program remains questionable.  The program looks likely to provide effective support to the banking system, but the combined shock of a collapse in the terms of trade and capital inflows is likely eventually to require sharp FX adjustment.  We do not think that current FX support policy is sustainable and are further cutting our growth and exchange rate forecasts.  However, we think that government default remains unlikely and expect IMF disbursement to continue, even with only partial program compliance. 

Help for banks, pain for consumers and importers: The IMF program stresses tighter fiscal and monetary policy, pre-emptive bank recapitalization and a flexible exchange rate.  The outlines have already been accepted in the anti-crisis law passed by the Rada, which sets out mechanisms for bank recapitalization and stricter supervision, triples the deposit insurance limit to UAH 150,000, and commits to a balanced budget in 2009.  (Less realistically, the law also establishes a Stabilization Fund, which so far lacks robust funding sources.)  Technically, the NBU has also lifted its exchange rate corridor and unified market and official exchange rates.  We believe that the plan will provide effective support for banking sector stability even given sharply rising defaults. The program assumes that UAH 10 billion is spent on bank recapitalization in 2008 and UAH 44 billion in 1H09, a huge sum in the context of the purely locally owned banks – equity of the largest ten of which amounts to around UAH 32 billion.  

Meanwhile, private bailouts of the two most vulnerable local banks have already been arranged.  For consumers and importers there will be little to soften the pain.  Household energy prices will have to rise sharply.  The Fund envisages a real GDP contraction of 3.0% in 2009 with a negative 14.3 percentage point contribution from domestic demand, real wages down 8.7% and real imports down 19.7%.  Such a contraction would be a massive test for an already fragile political system. 

Political resistance to FX adjustment seems unsustainable: Indeed, although early parliamentary elections appear to be receding from the agenda for now, political support for the program already appears weak.  The initial anti-crisis bill only achieved a narrow majority with the help of the small Litvin faction after a lengthy fight over election financing.  The Rada even took the risk of rejecting a commitment to delay hikes in the minimum wage requested by the IMF.  A senior BYT representative has questioned the need for the NBU’s new bank supervision powers.  A senior PR representative has rejected altogether the need for fiscal tightening and suggested that the turmoil was not serious enough to require IMF intervention.  Most significantly, both the president and prime minister have been determined to avoid the blame for FX depreciation, pressuring the NBU to engage in expensive and unsustainable intervention. The NBU’s draconian new exchange controls – forcing banks to sell cash USD at the official rate, to buy no more than 3% lower, to sell cash USD within a day or lower the rate and clients to use bought USD for approved purposes within five days – risk causing USD cash shortages and outflows of USD deposits. 

The IMF insists that controls will be phased out as confidence returns, but the hope of politicians to stabilize the UAH does not look compatible either with the program’s intention to conserve reserves at current levels or with the need for a sharp contraction in the current account deficit.  The NBU spent US$4.1 billion – 11% of its reserves or 25% of the IMF loan – defending the UAH in October.  Even with a modest 25% gas price hike in 2009, steel price falls could drive a terms-of-trade shock of as much as 15%, after a 25% improvement in the previous five years.  Even assuming full rollover of intra-bank FX debt and trade finance, no significant withdrawal of USD deposits and a halving of the current account deficit, the external financing requirement for 2009 is likely to be around US$15-20 billion, on our estimates.  Meanwhile, the program assumption of net inward FDI rising to 6.8% of GDP looks very much on the optimistic side. 

Cutting our forecasts further: In these circumstances, we are sharply raising our end-2009 USDUAH forecast from 6.2 to 9.0.  Contracting the current account deficit in the face of a large terms-of-trade shock is likely eventually to require significant depreciation.  Such a move is likely to come gradually, in the face of resistance from the government and NBU, and a greater spend-down of reserves than the program envisages.  It will also cause significant pain to both households and non-exporting corporates, in our view.  Household bank loans in FX exceed household FX deposits by US$9 billion, while corporate FX bank loans exceed FX deposits by US$22 billion.  We suspect that fiscal tightening will not prove to be as aggressive as the program requires, but that disbursement is likely to continue regardless.  We are cutting our real GDP growth forecast from +2.0% to -2.5%.  However, we think that CDS-implied risks of government default are still excessive – that the current Treasury balance already covers the likely 2008 deficit, that the government will be able to attract other resources to cover next year’s maturing Eurobond, and that gas price hikes will raise cost recovery at Naftogaz.  While the pain of next year will be intense and program implementation is likely to be far from perfect, we also think that Ukraine has enough strategic political significance to receive further support as it becomes necessary.

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Japan
Looking for Modest Healing in 2010
November 11, 2008

By Takehiro Sato | Tokyo

Pushing Back the Recovery Timing

As our colleagues lower forecasts for the global economy in 2008-09 and extend the forecasting range to 2010, we are making further cuts to our outlook for Japan in 2009 and pushing back the recovery timing to 2010.

The downward revisions for the US, European and Asian economies in 2009 trim about 0.3pp from the outlook for Japan, but we are assuming that fiscal stimulus will pull back more than 0.1pp, and have lowered our Japan forecast for next year by only a marginal 0.1pp. Positive growth should be restored in 2010, but we are more cautious on the momentum of recovery in Japan than in the US and Europe due to sluggish domestic demand.

Further Downside for Overseas Economies

The outlook is now for the global economy to experience a sharp retreat in demand due to liquidity constraints in both leading and emerging economies during the Oct-Dec and Jan-Mar quarters (see Global Economics: Beyond a Deeper Recession: Tepid Recovery by Joachim Fels, Richard Berner, November 10, 2008). Our teams have cut 2009 forecasts for each region by approximately 1pp as the launch pad for year-round growth drops. The recent pullback in energy prices is supportive, but not enough to shore up economies that face immediate liquidity constraints. Although policy efforts in the US and Europe to protect deposits and interbank lending using public money are paying off, and the money markets are gradually regaining their function, non-financial corporations still face a bleak financial environment.

We can hope that once December has been negotiated, the credit cycle globally will be restored to some extent as funding conditions ease. Yet even then, as Japan’s example shows, a full recovery would require massive fiscal stimulus as seen in 1998-99, and rapid moves to remove distressed debt from balance sheets in the private sector, as in 2003, with these divested assets then being priced in the market. If these conditions come together, asset prices could form a bottom and lead into a virtuous cycle as seen in Japan in 2003-05. During this period, monetary policy would play a painstaking central role in the healing process by supplying ample liquidity.

For now, however, we are at the stage of monitoring the effects of policy steps taken so far and even if new fiscal stimulus measures ward off a steeper trough for the economy in the near term, we now believe that it will be 2010 at the earliest before the global economy gets back on a recovery path. Under these conditions, we push back our forecast for the timing of Japan’s recovery from Jul-Sep 2009 into 2010.

Next Six Months Will Be the Toughest with the Downturn Deepening, Giving Way to a Flat Economy Even in Mid-2009

Economic conditions at home and abroad have deteriorated more sharply and more broadly since early October, when we last lowered our forecasts. Here in Japan, the current rate of decline in industrial production implied by the index projections for Oct-Nov is worse than the average since the 1970s, and comparable with cutbacks that followed the IT bubble.

Normally the downward trajectory of economic data is steepest in the four quarters or so following the economy’s peak. Assuming that Oct-Dec 2007 marked the peak, the climax of the downturn should be about now, and the pace of demand contraction can be expected to relent to some extent in Jan-Mar 2009. However, the earliest that the vector of the domestic economy would cease to point downward would be the Apr-Jun quarter, and thereafter we expect Japan’s economy to flat-line through Oct-Dec, with virtually no traces of a pick-up.

So, we are delaying the timing of Japan’s recovery by two quarters from our forecast as of October 7, and now anticipate the recovery finally getting underway in Jan-Mar 2010. Dating the last peak as October 2007, this would mark a 26-month recession, rivaling the 32-month downturn that followed Japan’s bubble in the early 1990s.

Downside Risk for Japan’s Economy

The risks for Japan’s economy in 2009 relate to a regulatory clampdown and liquidity constraints.

On the regulatory front, we highlight the revised Architect Registration Law due to be enacted next May and the revised Installment Sales Law slated for mid-2009, plus the Housing Defect Liability Law due in October. The revised Architect Registration Law risks creating bottlenecks for building approvals as the revised Building Standards Law did in 2007. The revised Installment Sales Law brings tougher assessment standards and may well dampen personal consumption, especially automobile sales. The Housing Defect Liability Law threatens to place new burdens on small- and mid-scale businesses.

The liquidity constraints take the form of a narrower pipeline for direct and indirect financing due to adverse feedback from overseas financial markets. Amid a tight environment for issuance of CP and corporate bonds, and with the banks becoming increasingly circumspect on lending as stock prices fall, companies are forced for now to prioritize maintenance of liquidity over capex. The financial authorities have responded to this risk with proposals that include easing capital adequacy standards for domestically licensed banks, and more far-reaching steps may be needed depending on the degree to which corporate financing is squeezed.

Route to Recovery for the Domestic Economy

It is tough to outline a convincing path of recovery at this point, but with weakness in overseas economies precluding expectations for exports and capex, for want of alternatives we must look to personal spending. The determining factors for a consumption recovery will be more settled price conditions as energy prices peak out, and pent-up demand emerging as consumers tire of economizing. For the former, we expect the core CPI to turn modestly negative towards 2H09, giving some fillip to real incomes. Yet nominal wages in 2006-07 moved down by the biggest margin since 2000, affected by the Old Age Employment Stabilization Law, depressing consumer spending. However, most companies had already implemented employment extension programs by 2007, so we do think that the downward pressure from the structural factor of nominal wage declines has now peaked out (see pages 11-12 of Investment Strategy/Economics: Japan in 2013: Winners, and Potential Winners, September 26, 2008 by Robert Feldman, Naoki Kamiyama, Takehiro Sato, Takeshi Yamaguchi for details).

Pent-up consumption demand was something we saw uncorked in the final phase of the 1997-98 recession, when Japan’s financial stability was in question. Nascent change was evident in the pick-up in sales of consumer durables from around Oct-Dec 1998, one year or so after the wave of domestic financial institution failures in November 1997. Since global turbulence in September has presumably chilled the consumer mindset further, we will probably have to wait about a year until the Oct-Dec quarter of 2009 for suppressed demand to filter through.

On corporate financing, we are hopeful that measures to fund SMEs, which were expanded to some JPY30 trillion in the second supplementary budget (using the credit guarantee system to backstop lending to SMEs) will function effectively and soon. These measures extend the range of industries under the purview of the emergency guarantee system and go beyond the shared-responsibility system (i.e., offer a 100% loan guarantee). For these reasons, we believe that these policies will go some way towards stabilizing funding for SMEs in general (see Towards Credit Crunch Relief, September 5, 2008 and Downturn to Climax in Oct-Dec Quarter, October 24, 2008 for details). 

Corporate Earnings: Looking for Profit Downturn to End in F3/2011

We only recently lowered our top-down forecasts for recurring profits in F3/09-3/10 (corporate statistics basis, companies with at least JPY1 billion in capital, excluding financials) in October to -25% for F3/09 and -10% for F3/10. Taking FX rate shifts into account as well, we have now made further cuts to -30% for F3/09 and a smaller margin of -5% for F3/10. Meanwhile, for F3/11, we are looking for the profit downturn to halt, partly due to an improvement in sales. Yet, such improvement may be offset by the worsening terms of trade.

Revised corporate guidance in the interim results season is finally narrowing the gap between bottom-up and top-down outlooks for F3/09 earnings, but for F3/10 there is still a yawning discrepancy between the micro (companies still project earnings growth) and macro forecasts. This does not augur well for a restoration of stock market confidence. However, demand will weaken further in 2H of F3/09, and we expect corporate earnings guidance to gradually become more realistic.

The profit impact of exchange rate and energy price fluctuation is about 3% for a 5% change in FX rates, and about 3% (inversely) for a 10% shift in energy prices.

A risk here is that Japan’s terms of trade in F3/11 might see renewed deterioration, pushing down the negative margin of the GDP deflator and depressing corporate earnings and employee incomes thereafter.

Policy Implications: Expecting Additional Measures

We believe that both fiscal and monetary authorities are likely to respond to a deepening economic slump with further policy action. On the fiscal side, for the time being the impact of the first and second supplementary budgets for F3/09 will be monitored, but with the economy likely to remain in the doldrums after F3/10 is underway, we would expect consideration of additional stimulus of about JPY5 trillion in terms of the real additional effective demand (‘mamizu’), principally via income tax cuts. We assume that the two budget supplements for F3/09 will add more than 0.1pp to GDP in F3/10. The impact of stimulus measures in F3/10 would depend on the content, but we are looking for a fairly potent effect from F3/11 on from broader steps to free up lending.

On the monetary side, we expect the BoJ to explore further policy options in the aftermath of its end-October rate cut. As the new reserve accumulation period gets underway on November 16, interest payments on surplus reserves will begin, and this will effectively allow the BoJ (like the Fed already) to conduct quantitative easing without ZIRP (zero interest rate policy). However, with the yen rising, we expect another rate cut and further progress towards restoration of ZIRP in the Apr-Jun quarter of 2009. As part of that process, the BoJ may also step up Rimban operations (outright JGB purchasing). We also see the possibility of direct support for corporate financing with a prudential policy involving non-traditional measures such as purchasing of CP, corporate bonds and equities.

We expect Japan to leave ZIRP behind in the Jul-Sep 2010 quarter, once the US economy has returned to cruising speed and has transitioned into stable growth. Our US team believes that the Fed will be tightening again soon after the start of 2010, but with Japan’s economy shackled by weak domestic demand and falling prices, the BoJ will be a long way behind overseas central banks.

Risks: Excess Liquidity Once Again?

The effects of policy actions overseas targeting financial stabilization are being tracked in the current phase, but a concern is that economic deterioration will generate new non-performing loans and refocus attention on shortages of capital at private-sector companies, prompting banks to become even more reluctant to lend, as happened in Japan in 2001-03. On the other hand, we expect economic stimulus from fiscal and monetary policy to gain momentum both in developed and emerging countries, helping the global economy avoid an even deeper trough and facilitating an early transition into the healing phase.

However, we do not share the view in some commentary that quantitative easing by the major central banks could lead to a return of excess liquidity. Japan’s quantitative easing in 2001-06 did not result in sufficient funds being channeled into the real economy, despite the BoJ’s massive liquidity provision, because the financial institutions’ function as credit intermediaries was hobbled by their capital shortages. In the same way, despite extensive provision of funding by central banks, the credit multiplier is likely to drop, and we cannot expect this to filter through to the real economy and asset markets in the near term.

On the political side, while a snap election in Japan is now off the agenda, it remains possible that economic and market changes, plus the issue of social inequality and demands of regional economies, will result ultimately in another alliance of conservative and leftist forces (as in the mid-1990s) – rather than a reform-oriented administration (center-right coalition) that the markets want to see. The enthusiasm of foreign investors for Japan could easily be dependent on the economic philosophy of the ruling administration.

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United States
Review and Preview
November 11, 2008

By Ted Wieseman | New York

Treasuries surged over the past week as the key initial run of October economic data was much worse than pessimistic expectations, and stocks traded off significantly.  That was the supportive fundamental backdrop, but in reality, as far as day-to-day trading went, the market was actually primarily driven by an early week surge in the mortgage market – with all of the week’s net gains made through Wednesday as mortgages ripped higher before giving gave back a bit of the rally Thursday and Friday – and then by supply concerns Friday as investors and dealers prepared for a deluge of coupon supply at the upcoming refunding auctions by selling into a brief post-employment report pop.  That employment report, which showed a larger-than-expected 240,000 drop in October non-farm payrolls on top of much bigger revised declines the prior two months and another surge in the unemployment rate to 6.5% – already exceeding the peak hit in the aftermath of the 2001 recession – capped a week of miserable economic news.  Both ISM surveys plunged way into recessionary territory in October, and early signs for October consumer spending were terrible, with auto sales plummeting to a more than 25-year low and chain store sales results taken as a whole the worst we’ve seen in the years we’ve been tracking these numbers.  It’s becoming increasingly clear that the contraction in the economy in 4Q is going to be the worst since the 1981-82 recession as, with a lag, the credit crunch is now hitting the real economy with full force and the prior support from exports is rapidly disappearing as the US recession goes global.  There were at least some positive signs amid the wreckage in the economic data and weak stocks.  The drop in mortgage rates, if it can be sustained (unlike a couple of similar rallies in October), would obviously be helpful. Term interbank rates continued to plunge, and investment grade corporate credit actually had a decent week, far outperforming equities. 

On the week, benchmark Treasury yields fell 14-26bp, with the intermediate part of the curve performing relatively quite well as it benefited the most from the mortgage-driven rally through the first part of the week.  The 2-year yield fell 23bp to 1.34%, 5-year 26bp to 2.56%, 10-year 20bp to 3.78%, and 30-year 14bp to 4.24%.  The MBS market surged higher early in the week, with a particularly powerful rally Tuesday, and carried Treasuries and swaps along with it.  MBS yields stabilized Thursday and then rose somewhat Friday, closely tracking the sell-off in Treasuries.  Still, by week-end, current coupon yields remained near 5.5%, down from around 6% the prior Friday, which should send average 30-year mortgage rates down to near 6% after the initial part of the rally was picked up in a drop to 6.20% national average in the latest week.  Mortgage rates swung up and down several times in October, tracking MBS volatility – 30-year rates averaged 5.94% the week of October 10, 6.46% October 17, 6.04% October 24, 6.46% October 31, and then 6.20% this past week – so it remains to be seen if we’ll witness another retracement of this latest rally in coming days or if it proves more lasting this time.  Meanwhile, even with oil prices tanking to their lowest levels since March 2007, TIPS did very well over the past week, particularly the longer end.  The 5-year TIPS yield fell 20bp to 2.65%, 10-year 29bp to 2.83%, and 20-year 39bp to 2.94%. 

Term interbank rates showed dramatic further improvement over the past week, so the Fed’s flooding of the financial system with overwhelming amounts of excess reserves in an effective quantitative easing policy seems to be having at least one major direct positive impact.  3-month Libor fell another 74bp in the latest week to 2.29%, having now fallen every day since peaking at 4.82% on October 10.  With so much excess cash in the banking system, effective fed funds was pinned right near 0.25% all week, not budging at all even after the Fed raised the interest rate paid on excess reserves to 1% from 0.65%.  As a result, the now low-rate Nov 08 fed funds contract rallied 24bp on the week to 0.43% and the Dec 08 contract 17bp to 0.47%, sending 3-month OIS (expected average fed funds over the next three months) to a series of record lows that reached 0.54% Friday and somewhat muting the impact of the drop in Libor on Libor/OIS spreads.  Still, the spot 3-month Libor/OIS spread dropped 64bp on the week to 175bp, within 100bp above pre-Lehman levels in the first part of September of around 80-85bp.  Forward spreads also improved, but much less than spot, and the market still thinks that it will take an entire year to undo the post-Lehman damage.  The forward Libor/OIS spread to December fell around 11bp to near 145bp, March 20bp to 115bp, June 25bp to 105bp, and September 17bp to 85bp. 

Meanwhile, in the money markets, all the cash sloshing around in the system and rock-bottom funding rates, with overnight Libor trading only slightly above the 0.25% fed funds effective, led to broadly based strength.  T-bill yields fell to their lows in a month, with the 4-week bill’s bond equivalent yield down 1bp to 0.11%, the 3-month 15bp to 0.30%, and the 6-month 10bp to 0.84%.  And while longer-dated agencies and munis continued to struggle to varying extents – 10-year agencies widened about 5bp versus swaps on the week to +70bp, and though the shorter end did better, the agencies have apparently decided that current spreads make coupon issuance uneconomical – money market debt in these sectors has done very well recently.  3-month agency yields dropped to near 0.90% and 6-month to 1.40% by midweek and held there through Friday, as the gap over Treasuries has come way down.  Muni money market yields also appear to have normalized to a major extent.  For example, the Vanguard New York Tax-Exempt Money Market Fund had an SEC 7-day yield of 1.58% on Thursday, down 30bp from the prior Friday and 443bp from the 6.01% peak hit September 30 to levels prevailing in the first part of September (though with T-bill yields far lower now than they were then, tax-adjusted muni money market yields still seem unusually high).  Trends in the CP market have been less encouraging.  The market has now grown for two straight weeks after a precipitous decline over the prior five.  But the increase has been more than accounted for by heavy Fed buying, while private sector investors have continued to leave the market.  The Fed now owns directly or indirectly more than 20% of the entire outstanding CP market, and its latest CP initiative, the Money Market Investor Funding Facility, hasn’t even gone into effect yet. 

It was a mixed week for risk markets.  Stocks were very volatile day to day, but eventually ended down 4% for the week.  Perhaps with the benefit of not having to worry about higher dividend and capital gains taxes, corporate credit did a lot better.   In late trading Friday, the investment grade CDX index was 14bp tighter on the week at 189bp, though high yield lagged, with the HY index 24bp wider through Thursday’s close at 1,124bp and only trading marginally better on the day Friday afternoon.  The leveraged loan LCDX index traded poorly compared to high yield, widening 65bp on the week through midday Friday.  As the Treasury continued to talk more about the possibility of creative uses of the TARP and less about the originally planned distressed asset purchases, the subprime ABX and commercial mortgage CMBX market suffered badly.  Every ABX index fell sharply to all-time lows at Friday’s close, with the AAA down 2.26 points to 39.70, AA 1.59 points to 9.41, and A 1.37 points to 6.91, while the BBB (4.74) and BBB- (4.82) both hit 4-handles for the first time late in the week.  Every CMBX index was also crushed, with only the AAA, which widened 39bp to 267bp, not quite at an all-time wide (the previous series AAA set the all-time wide close of 277bp during the Bear Stearns collapse in March).  The junior AAA index widened 204bp to 1,026bp and AA 243bp to 1,884bp, which are just astounding numbers for referenced debt with those ratings in a sector where defaults are certainly likely to rise substantially as the economy deteriorates but to this point haven’t been material.  CMBS delinquencies across all sectors were less than 1% in October and except for multi-family far below 1% (see Andy Day’s CMBS Analytics, November 6, 2008).

Expectations for the initial run of key economic data for October – employment, manufacturing and non-manufacturing ISM, motor vehicle sales and chain store sales – were quite pessimistic coming into the week.  And in each case, the actual outcome still turned out substantially worse than expected.

Non-farm payrolls dropped 240,000 in October, on top of much bigger revised drops in September (-284,000) and August (-127,000).  Job losses in October were broadly based, with big drops in manufacturing, construction, retail, temp help, financial services and wholesale.  Only healthcare and government showed growth.  Other details of the report were also weak.  The unemployment rate surged to 6.5% from 6.1%, having now risen a full point in four months.  The unemployment rate has already surpassed the last cycle peak of 6.3% in June 2003 and appears quite likely to exceed the prior cycle peak of 7.8% in June 1992 before this downturn is over.  At this point, we don’t expect the post-war high of 10.8% hit at the end of the 1981-82 recession to be exceeded.  The average workweek was steady at an all-time low of 33.6 hours, causing total hours worked to fall 0.3%.  Average hourly earnings only gained 0.2% for a second month, which combined with the drop in hours caused aggregate weekly payrolls, a proxy for total wage and salary income, to fall 0.1%; however, this would actually imply a decent gain in real terms, given the expected drop in inflation in October. 

Both ISM surveys collapsed well into recessionary territory in October.  The manufacturing ISM composite index fell another 4.5 points in October on top of September’s 6.4-point drop to 38.9, the lowest level since 1982.  The key orders (32.2 versus 38.8), production (34.1 versus 40.8), and employment (34.6 versus 41.8) gauges all fell to severely depressed levels.  Weakness across industries was broadly based, with only two of 18 industry groups reporting growth, down from six in September.  Meanwhile, the composite non-manufacturing ISM index fell to 44.4 in October from 50.2 in September, the lowest reading in the 11-year history of the survey.  The business activity (44.2 versus 52.1), orders (44.0 versus 50.8) and employment (41.5 versus 44.2) gauges all fell well into contractionary territory.  Only three sectors reported growth in October against 13 reporting declining activity.

Early indications for October retail sales were terrible, indicating that the 3.1% drop in consumption in 3Q, the biggest drop since 1980, extended into 4Q.  Motor vehicle sales plummeted to a 10.5 million unit annual rate in October, a low since 1983 and the lowest in the post-war period on a population-adjusted basis according to GM’s estimates, from the already awful 12.5 million hit in September.  If someone had wanted to bet me a year ago when sales were falling along at a more typical 16 million unit pace that I’d ever see a 10 handle on sales again in my lifetime I probably would have offered them 100 to 1 odds.  GM aptly described the situation across the US auto market as “carnage”.  Chain store sales weren’t quite as bad as auto sales but still recorded their worst overall month excluding Easter calendar distortions in many years, with our aggregate weighted composite of the biggest reporting companies showing same-store sales down 0.8%Y overall and down 1.3% excluding drug stores.  With what’s also likely to be a major price-driven drop in gas station sales, the motor vehicle and chain store sales declines point to one of the worst retail sales reports ever in October.  Indeed, we see ex-auto sales posting their biggest monthly decline in 40 years.

With another quarter of significant weakness in consumption likely along with intensified weakness in business investment, another drop in residential investment, a sharp fall in government as state and local spending turns down and the surge in federal defense spending in 3Q is partly reversed, and the absence of the big net exports boost in 3Q, 4Q GDP at this early point appears on track for a contraction in the mid-3% range, which would be the worst quarter since 1982.  And 3Q now looks to have been weaker than the advance estimate of -0.3%.  Based on factory and wholesale inventory numbers and revisions to state and local government employment released over the past week, we see 3Q being revised down to -0.8%.

Supply will be the major Treasury market focus for most of the short upcoming week.  With the Veterans Day holiday on Tuesday and an early close Monday, a lot of bond market investors will likely be out Monday for a four-day weekend, which could make for a rough debut for the revived three-year note.  With limited attendance, the market will have to try to take down a record US$25 billion for this maturity Monday morning.  This was never an issue that really ever found a particularly warm reception after previously being revived from 2003 to mid-2007, so we were certainly surprised to see the Treasury bring the issue back monthly instead of quarterly at such a big size.  It is probably not going to be easy to find a home for US$300 billion a year in three-year supply.  Judging from how poorly the recent unscheduled 10-year auctions went, though, it’s not clear that the US$20 billion 10-year auction on Wednesday or US$10 billion 30-year reopening on Thursday will go much more smoothly.  That’s a lot of duration for the deleveraging, balance sheet-constrained financial system to try to swallow.  The week’s key data release will be retail sales on Friday after the supply is out of the way.  Fed Chairman Bernanke will also participate in a panel discussion with ECB President Trichet and others Friday, preceding which he will give prepared remarks on ‘Policy Coordination Among Central Banks’.  Other reports due out include the trade balance and budget deficit Thursday and business inventories Friday:

* We look for the trade deficit to narrow another US$3 billion in September to US$56 billion, which would be the lowest level in nearly a year, on a second month of steep declines in both exports (-3.4%) and imports (-3.9%).  Most of the export weakness should be accounted for by a collapse in aircraft exports, as industry figures indicate that there were very few overseas deliveries as a result of strike disruptions.  Lower prices should also contribute to soft results for industrial materials.  On the import side, we expect the weakness to be about evenly divided between another sharp drop in petroleum products, with Energy Department figures pointing to major weakness in both prices and volumes, and a significant decline in other goods as inbound cargo shipments through the key ports slowed sharply.

* We expect the federal government’s budget deficit for October, the first month of the new fiscal year, to be US$115 billion, considerably larger than the US$57 billion deficit recorded in the same period a year earlier.  A small part of the swing (roughly US$10 billion) reflects calendar effects that accelerated some November payments into October, but lower receipts and higher spending across a broad range of programs appear to have been the main drivers.  Note that the October deficit would be considerably larger if TARP-related outlays of US$115 billion and estimated MBS purchases under the GSE support program of an estimated US$15 billion were being treated as on budget.

* We forecast a 2.2% drop in overall retail sales in October and 1.9% decline excluding autos, which is one of the worst months on record.  The weakness reflects both a price-related drop in gas station sales and widespread softness in discretionary categories.  In fact, chain store reports point to another decline in the general merchandise sector along with a very steep fall-off in activity at apparel shops.  We estimate that retail sales excluding auto dealers and gas stations declined about 1% in October. And we now see overall real consumer spending tracking at -2% in 4Q.

* Previously reported declines in stockpiles at both the manufacturing and wholesale stages – together with an expected dip at the retail level – point to a 0.4% pullback in overall business inventories in September.

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Brazil
Policy Pressure Points
November 11, 2008

By Marcelo Carvalho | Sao Paulo

Tighter global conditions have uncovered pressure points not only in Brazil’s economy and markets, but on the policy front as well. Don’t count on policy response to provide massive support for growth. Policy room for maneuver is limited. Brazil’s policy response could help to alleviate the blow from the global turmoil, but it is unlikely to be enough to avoid a sharp growth slowdown. We reaffirm our long-standing, below-consensus view that the economy’s downturn will likely prove more pronounced than most are ready for.

Monetary Policy: No Room for Rate Cuts Soon

The global shock is ‘stagflationary’ for Brazil. Many central banks around the globe have cut rates aggressively in recent times – particularly in the developed world. Why not Brazil? A key difference is that while the global turmoil is surely deflationary for the global economy, it is inflationary for Brazil. In fact, it is stagflationary: the global shock pulls Brazil’s growth down at the same time that it pushes inflation up. In economics jargon, think about it as an unfortunate outward shift of the so-called Phillips curve itself (which shows the trade-off between growth and inflation), as opposed to a move along the curve. That is, the trade-off itself has gotten worse.

The problem is currency devaluation and its negative effects on inflation expectations. Most estimates for the currency pass-through to inflation in Brazil tend to fall in the 5-10% range. To illustrate, a 30% currency devaluation (e.g., from 1.70 to 2.20) might add as much as three percentage points to consumer price inflation.

The pass-through coefficient may differ from previous episodes. True, the US dollar itself is appreciating against most other currencies too. So, the bilateral exercise alone might not be entirely fair. However, the bilateral exchange rate still probably matters more than any basket concept, as a visible reference for domestic price-setters. It is also true that there is international evidence supporting the notion that the pass-through from the currency to inflation should trend down over time, as the economy develops and monetary policy credibility consolidates. On the other hand, starting points matter: the pass-through tends to be higher when the level of resource utilization in the economy is high – as is still the case now. In all, while precise estimates can vary, there is little doubt that currency devaluation is not good news for inflation in Brazil.

In fact, the latest news on the inflation front does not look bright. Headline annual IPCA inflation increased to 6.4% in October (from 6.2% in September). That is the highest reading since July 2005. It is also getting dangerously close to the 6.5% policy target ceiling for the calendar year. Looking ahead, recent currency weakening does not bode well for upcoming inflation releases.

Inflation expectations are worsening too. The central bank now releases a monthly frequency distribution of market expectations for IPCA inflation. This statistical material may seem a bit too technical – but it matters for the COPOM. The latest batch does not look good. The median consensus forecast for 2009 inflation had been coming down, from 5.0% at end-August to 4.85% at end-September. But it is now drifting up again, to 5.06% as of end-October, amid significant currency weakening. The frequency distribution now shows expectations clustering around three main benchmarks: 4.5%, 5.0% and 5.5%. Compared to a month ago, now many more economic agents see inflation at 5.5% next year, while few still believe in 4.5%. Also, the variance is larger, as the spectrum of possibilities widens. As the frequency distribution shifts to the right and uncertainty increases, the right-hand tail now encompasses figures close to the target ceiling of 6.5%. The official target center is 4.5%.

How should the central bank respond? Theoretically, a narrow-minded, inflation-targeting central bank that only cares about inflation should hike interest rates when inflation prospects are worsening away from the target. In practice, however, unusually high uncertainty can complicate matters for the central bank. 

Indeed, uncertainty seems to be the key reason for the central bank to have kept rates unchanged when it last met, on October 29, according to the latest COPOM minutes. The word “uncertainty” appears ten times in the minutes (versus seven times before), and in key paragraphs. Given uncertainty and time lags of monetary policy, let’s wait and see – COPOM seems to suggest.

There is food for hawks and doves alike in the minutes. For doves, the turmoil will slow the economy through the credit crunch and weaker consumer/business confidence. The credit crunch can magnify the impact of monetary tightening on demand and inflation, over time. For hawks, starting points matter – resource utilization has been very high. A weaker currency can push inflation up, especially in the short run, and rate moves come “not necessarily in continuous form”. That reads: rate hikes do not need to be back-to-back, as the COPOM can eventually resume hiking after a pause.

COPOM keeps its options open. It is interesting that the COPOM describes its latest policy decision simply as “leaving rates unchanged”. It does not talk about a ‘pause’, which could imply just a temporary interruption in the hiking cycle. Also, it does not talk about a ‘stop’ either, which could imply a final peak in rates.

The COPOM is in wait-and-see mode for now. In all, we don’t know how long the COPOM will stay on hold. We suspect that the COPOM may yet be forced to hike again, if currency weakening sufficiently damages the inflation outlook. Our forecast assumes a 50bp rate hike to 14.25% on December 10. The main risk to that forecast at this stage is that the central bank instead decides to stay on hold for longer.

We suspect that the central bank will eventually decide to explicitly accommodate the inflation shock. COPOM directors are serious about fighting inflation. Facing a major global shock, the authorities may eventually conclude that the cost of disinflation for the real economy is unnecessarily large. A pragmatic central bank might prefer to accommodate some of the shock. In other words, it would still aim to eventually bring inflation back to the target center – but over a longer time horizon. In that case, the central bank still hikes, but not by as much as needed to pull inflation immediately down to the very target center.

Brazil’s inflation targets have been altered before. In 2003, after major currency devaluation, the authorities decided to pursue a goal of 8.5%, instead of the original target of 4.0% for that year. Again in 2005, the central bank decided to pursue an ‘adjusted’ target of 5.1% that year, instead of the official 4.5% target center.

Policy accommodation means a lower peak in rates, but it does not mean aggressive rate cuts soon. We fear that cutting rates at the same time that the currency weakens and inflation expectations worsen could risk undermining market perceptions about the central bank’s commitment to fighting inflation. We continue to see rate cuts no sooner than late 2009.

Fiscal Policy: Limited Fiscal Space

There is little, if any, fiscal space for massive fiscal policy expansion. Our work suggests a strong relationship in recent years between real GDP growth and real tax revenues growth. The 2009 budget initially assumed real GDP growth of 4.5% next year. There is now talk of revising that assumption down to around 4.0%. The market consensus for 2009 growth has already fallen to about 3.0%. If our below-consensus 2.0% growth forecast is right, then expansion in real revenues could slow from the current double-digit pace to the low single-digits. This might imply a revenue shortfall to the tune of one to two percentage points of GDP, relative to current trends.

There are three things that the authorities can do in light of a downturn in tax revenues. First, the authorities could seek new revenue sources. Second, they could cut spending.  A third option is to do nothing, and simply let the fiscal balance deteriorate.

The actual outcome could prove to be a mix of the three options. Coming up with new tax revenue sources may prove politically difficult, given that Brazil’s tax burden is already too high by international standards. Well-thought-out spending cuts might prove a healthier solution. However, sadly, Brazil’s budget rigidities mean that quick cuts often end up concentrated on investment projects. As for allowing the fiscal balance to deteriorate, there are indications that the authorities would pursue a primary fiscal target of 3.8% of GDP next year, down from the 2008 expanded goal of 4.3%. As a reference, the primary surplus in the 12 months through September stood at 4.6% of GDP.

In all, some fiscal accommodation is possible, but outright aggressive stimulus is unlikely. After all, despite major improvements in debt dynamics over recent years, including the removal of dollar-linked domestic bills, Brazil’s debt still faces challenges. About a third of the domestic federal debt is floating-rate paper, linked to the overnight rate. Also, around a quarter of the federal domestic debt matures within 12 months.

Foreign Exchange Policy: No Line in the Sand

The central bank has plenty of ammunition in the form of a large stockpile of reserves. As of October, foreign reserves stood at US$204.4 billion, and this does not include the US$30 billion swap line from the US Fed. Brazil’s central bank has steadily accumulated international reserves in recent years, precisely as an insurance policy for times of need – like now. After years of buying dollars from the market, the central bank resumed selling dollars in the spot market in October. So far, it has sold US$5.1 billion in the currency spot market. That is a much larger figure than when it last sold dollars – although the very size of the market is now larger too. 

However, the central bank is unlikely to defend any particular currency level. The central bank seeks to smooth the currency path, by ironing out large swings in the currency through intervention in the spot market, to assure that markets function properly, with adequate liquidity. However, the central bank does not set any floor or ceiling for the currency. In other words, it may lean against the wind of currency moves and it can smooth the process, but it does not fight currency trends by defending any particular currency level.

Bottom Line

Despite rising pressure points, don’t count on massive policy easing to avoid a sharp growth downturn. Rate cuts are unlikely soon, in our view. There is little space for much fiscal stimulus. Though central bank intervention in the currency market may reduce exchange rate volatility, it is not likely to alter currency trends.

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Asia Pacific
Getting Ready for a Deeper Slowdown in 2009
November 11, 2008

By Chetan Ahya | Singapore & Sumeet Kariwala | India

Summary

Developments in the US and European credit markets are fast transmitting through to the rest of the world. Despite its relatively strong long-term fundamentals, the AXJ region is unlikely to emerge unscathed from this slowdown. Our US and European economics teams have revised their 2009 GDP growth estimates to -1.3% and -0.6% from -0.2% and 0.2% expected earlier (see Beyond a Deeper Recession: Tepid Recovery, November 10, 2008). The continued rise in credit market defaults will likely keep risk-aversion high. These developments are likely to hurt the AXJ region’s domestic as well as external demand. We are cutting our AXJ GDP growth estimates to 5.5% for 2009 from 6.4% estimated earlier. We are expecting a gradual recovery in 2010 to 6.9%.

Global Recession Could Be Deeper than Expected

Rising credit defaults in the developed world are paralyzing the global financial institutions’ ability to deliver risk capital. Cost of capital continues to remain at higher levels even while GDP growth has decelerated sharply. The vicious loop of rising credit defaults, shrinking risk capital pool, slowing growth and rising unemployment is unveiling the possibility of deeper-than-expected recession. While many central banks are cutting policy rates, the actual borrowing cost for the consumers and the corporate sector has continued to remain high even as the growth is slowing down. The ability of the global financial institutions to deliver risk capital to the real economy is unlikely to revive soon, implying that the duration of this global slowdown will be much longer than expected earlier. Our US and Europe economics teams have cut their GDP growth forecasts for 2009 to -1.3% and -0.6% from -0.2% and 0.2% expected earlier. Similarly, they are now expecting global GDP growth to be at 1.7% in 2009 compared with 2.5% estimated earlier.

Asia Is Unlikely to Emerge Unscathed

Reflecting the downside risks from global environment, we have cut our 2009 GDP growth to 5.5% from 6.4%. This takes our 2009 growth estimates very close to the trough reached in 2001 at 5.2%. We concede that the risks to our estimates are to the downside. We believe that the economies in the AXJ region are likely to be affected in two ways:

  (a) Risk-aversion in global financial markets transmitting in the form of higher cost of capital in the region: The sharp drop in capital inflows and increased contagion from the global financial markets has transmitted into most countries in the region in the form of rising cost of capital (cost of equity as well as cost of debt). While most countries have started cutting policy rates, the cost of borrowing for consumers and the corporate sector remains high. In order to analyze the adverse impact of rising risk-aversion in the global financial market, we group the region’s economies into three buckets based on their dependence on credit growth to drive their economic growth and the position of their current account balance.

The ‘Trouble Zone’, which includes India, Korea and Indonesia (accounting for 35% of the region’s GDP) has had a strong credit growth cycle and also current accounts in deficit. These economies are likely to suffer the most from the global financial markets contagion. A sharp decline in capital inflows at a time when their current accounts are in deficit has pushed their overall balance of payments suddenly into deficit. With their banking systems already suffering from tight liquidity, this balance-of-payments deficit and foreign exchange outflows have resulted in a disruptive rise in the cost of capital over the last three months.  We believe that these economies will face large dislocations in their financial systems, affecting their ability to revive the economies soon. These economies face the risk of a vicious loop of a rise in non-performing loans and a downswing in the growth cycle. While Singapore and Hong Kong are likely to be less affected compared with the Trouble Zone economies, we believe that they will still suffer from a deleveraging trend, as both have had a strong credit growth cycle. Singapore has also had a property cycle. China, Taiwan and Malaysia did not have a strong credit growth cycle and run current account surpluses. This group is likely to suffer much less than the other two groups.

Some of the region’s economies are also likely to face the added challenge of external debt refinancing risk. Total external debt in the region was US$1.47 trillion (20.8% of GDP) as of March 2008. Apart from currency depreciation loss on unhedged external liabilities, many countries are facing refinancing risks. The Korean won, Indian rupee and Indonesian rupiah have depreciated by 29%, 18%, 17%, respectively, from their peaks. The sharp move in currency has caused dislocations in the balance sheets of many companies and countries with external liabilities.

(b) External demand shock: AXJ’s exports have grown 20.6% YTD in 2008, driven by what we call the rest of the world, or ROW (world excluding US, Europe and Asia). The ROW group primarily includes emerging markets (Middle East, Emerging Europe, Latin America and Africa). Exports to the ROW have grown 30.7% YTD in 2008 compared with 6.1% and 18.0% in exports to the US and Europe, respectively.

However, a further slowdown in the US and Europe and a potential sharp slowdown in the ROW (largely emerging markets) could result in a sharp decline in the region’s export growth. Moreover, over the last five weeks, exports from the region have been affected by disruptions in the trade credit market and counterparty concerns. In the 2001 cycle, the region suffered from a 7%Y contraction in exports (in nominal US dollar terms). With the risk of the global economy going through a deeper recession, we expect the region’s exports to decline in 2009.

The follow-through impact on the region’s business capex cycle is likely to be severe. Many countries in the region have built large production capacities to feed global export demand. A sharp slowdown in exports can cause a major dislocation in the balance sheets of regional companies. Corporate investment demand will be hit significantly. While many countries in the region had the support from private sector construction and real estate investments in 2008, we believe that this spending is likely to witness a sharp deceleration in 2009, as domestic as well as international risk capital supply continues to shrink.

We believe that the external demand shock will hurt Singapore, Hong Kong, Malaysia, Taiwan and China the most, considering their high level of exports to GDP and large current account surpluses. Having said that, we do believe that these countries should suffer less dislocation in their financial systems as compared to countries with strong credit growth cycles and current account deficits.

Offsetting Benefit from Falling Commodity Prices

Continued strong global growth pushed commodity prices, particularly crude oil prices, to a new high by the middle of 2008. As a net importer of commodities, the AXJ region suffered from a negative terms-of-trade shock. The net commodities trade deficit shot up to 9.0% of GDP annualized during the three months ended June 2008 from 6.2% during the three months ended June 2007. However, with the sharp fall in commodity prices over the last three months, we expect the commodities trade deficit to narrow sharply. The fall in commodities prices has also helped the regional inflation rate to peak, removing the hesitation among the central banks in the region to respond with a loose monetary policy. Similarly, a reduced subsidy burden, particularly on food and energy, should also create some room for pursuing a loose fiscal policy.

How Strong Can the Monetary and Fiscal Policy Response Be?

While most central banks have already responded by cutting policy rates and/or initiating liquidity injection measures, we believe that these moves will be blunted to some extent due to the risk-aversion contagion from the global financial markets. These liquidity measures will likely be ineffective, particularly in countries like India, Korea and Indonesia.  Although countries with current account surpluses (Singapore, Hong Kong, China, Taiwan and Malaysia) should have better control of their domestic cost of capital, they are also likely to suffer partially from the contagion, reflected in the form of reduced access to risk capital from the global financial markets.

However, we believe that these current account surplus countries will likely get more bang for their buck from a strong fiscal policy response. On November 9, China announced an aggressive economic stimulus package of Rmb4 trillion (US$586 billion, about 16% of 2008 GDP) to boost domestic demand. About Rmb400 billion will be spent in 4Q08 and the balance by end-2010 (see Qing Wang’s China Economics: Quick Comment: An Aggressive Stimulus Package Announced, November 9, 2008). Even Taiwan, like China, with a relatively low public debt to GDP, has the ability to initiate a strong fiscal policy response. Our Taiwan economist, Sharon Lam, expects the Taiwanese government to spend 1.5-2% of GDP on infrastructure and tax cuts.

Looking for a Slow Recovery in 2010

Our US and Europe economics teams are expecting a tepid recovery in 2010 in those economies. They expect the US and Europe GDP growth to accelerate to 2.1% and 1.2%, respectively, in 2010. Similarly, our team estimates 2010 global growth to be at 3.6% compared with 1.7% in 2009. Reflecting these developments, we expect AXJ GDP growth to recover to 6.9% in 2010. This will be higher than 5.5% in 2009 but still lower than the 7.6% achieved in 2008. This recovery in the region assumes improvement in the availability of risk capital and bottoming out of external demand in 2010.

Bottom Line

Despite its strong long-term fundamentals, Asia is unlikely to emerge unscathed in an environment where the global economy is likely to see a deeper recession.

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