Government’s Stimulus Package
December 09, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai
The RBI’s Fresh Policy Measures
The Reserve Bank of India announced policy rate cuts and other liquidity measures on December 6 – the first part of the government’s stimulus package; the second part, in the form of fiscal measures, was announced the next day. The total amount of the new fiscal package is estimated to be about US$8-9 billion (0.7-0.8% of GDP). The key measures initiated by the RBI are as follows: 1) 100bp cut in policy rates: The RBI has reduced the repo rate (the rate at which it infuses liquidity) by 100bp to 6.5% and the reverse repo rate (the rate at which it absorbs excess liquidity) by 100bp to 5.0%, largely in line with market expectations. These policy rate cuts will be effective from December 8, 2008. While we expected the RBI to cut the repo rate to 6.0% by March 2009, this target is now likely to be achieved by end-January 2009. The RBI has been concerned about the weaker-than-expected growth outlook because of the global credit crunch. 2) Liquidity enhancement measures: As widely expected, the RBI also announced measures to enhance credit access to the small-scale sector and the housing sector. Accordingly, to increase the credit delivery to the employment-intensive micro and small enterprises (MSE) sector, refinance for Rs70 billion (US$1.4 billion) to the Small Industries Development Bank of India (SIDBI) is provided. The facility will be available at the prevailing repo rate for a period of 90 days. During this 90-day period, the amount can be flexibly drawn and repaid. At the end of the 90-day period, the drawing can also be rolled over. This refinance facility will be available up to March 31, 2010. The RBI has announced that it is working on a similar refinance facility for the National Housing Bank (NHB) of an amount of Rs40 billion (US$0.8 billion). As we highlighted before, the area most worrying to us is the performance of the SME sector. 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. (KIKO is the acronym for Knock-in Knock-out barrier options. A barrier option is like a plain vanilla option but with the exception of the presence of one or two trigger prices. If the trigger price is touched at any time before maturity, it causes an option with pre-determined characteristics to come into existence (in the case of a knock-in option) or it causes an existing option to cease to exist (in the case of a knock-out option).) This has meant that many SMEs have seen FX 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 13.5%, the SME sector is suffering from even higher borrowing costs for its short-term funding needs. 3) Buyback/prepayment of FCCBs made easier: In addition to the measures announced on November 15, 2008, the RBI now allows Authorized Dealers Category - I banks to prematurely buy back Foreign Currency Convertible Bonds (FCCBs) from their customers either out of their foreign currency resources held in India or abroad and/or fresh external commercial borrowings (ECB) raised in conformity with the current ECB norms, provided there is a minimum discount of 15% on the book value of the FCCB. In addition, the buyback of FCCBs out of rupee resources will be considered provided there is a minimum discount of 25% on the book value, the amount of the buyback is limited to US$50 million of the redemption value per company and the resources for buyback are drawn out of internal accruals of the company. 4) Loans given by banks to housing finance companies (HFCs) will be treated as priority sector lending, if they are to fund less than Rs2 million of housing dwelling units. However, the eligibility under this measure will be restricted to 5% of the individual bank’s total priority sector lending. This special dispensation will apply to loans granted by banks to HFCs up to March 31, 2010. 5) Relaxing NPL norms: The RBI has relaxed norms on classification of the NPLs in real estate loans and the corporate sector. Currently, RBI regulations do not allow the retaining of the asset classification of restructured standard accounts in the standard category. However, as the real estate sector is facing difficulties, the RBI has now allowed this exceptional/concessional treatment for commercial real estate exposures that are restructured up to June 30, 2009. Similarly, the RBI has relaxed norms for loans to “viable units facing temporary cash flow problems”. Currently, banks are allowed to restructure such loans only once. However, considering the increased stress in the corporate sector balance sheet, as a one-time measure, the RBI has decided that the second restructuring done by banks of such exposure (other than exposure to commercial real estate, capital market exposure and personal/consumer loans) up to June 30, 2009 will also be eligible for exceptional regulatory treatment. We believe that this change in norm will reduce the transparency of banks’ balance sheet. This will likely lower the market’s comfort in the asset quality of the banking system and dampen investor sentiment towards Indian banks. 6) Reducing borrowing costs for exporters: India’s export growth (in dollar terms) declined 12.1%Y in October compared with 10.4% in September. This is the first time since November 2002 that export growth has slipped into negative territory and is the lowest year-on-year growth registered since May 1998. Moreover, foreign trade credit has become difficult in the current global environment. Currently, for overdue bills, banks have been permitted to charge the rates fixed for export for the period beyond the due date. It has now been decided that banks may charge a rate not exceeding banks’ prime lending rate minus 2.5 percentage points for overdue bills up to 180 days from the date of advance. Bottom line: The RBI’s proactive easing measures should help to reduce systemic risks from arising in the banking system. However, we believe that these measures are unlikely to revive business and consumer sentiment in the near term. The RBI’s policy statement also indicates that “a period of painful adjustment is inevitable”. Indeed, we believe that the real economy data for 1Q09 could be a major surprise for the market. We see risk of industrial production declining on a year-on-year basis for a few months in 1H09. We think that there could be greater risk of banking sector stress due to a sharp increase in NPLs. The vicious loop of rising credit defaults, a shrinking risk capital pool, slowing growth and rising unemployment is unveiling. Part II of the Government’s Stimulus Package The three most important measures in the second stimulus package, in our view, include 1) increase in government expenditure by US$4 billion; 2) reduction in central value added tax by 4%; and 3) effort to boost infrastructure spending by allowing the government-owned infrastructure finance company to raise US$2 billion through tax-free bonds. The total package of about US$8-9 billion is largely in line with our expectation of US$10-15 billion. Here is a summary of the fiscal measures announced: 1) Increase in government spending: The government has decided to seek authorisation for additional plan expenditure of up to Rs200 billion (US$4 billion) in the current fiscal year (YE March 2009). This will take the next four months’ government spending (both plan and non-plan expenditure) up to US$60 billion compared with budgeted US$56 billion. Note that the government’s budgeted total expenditure (excluding off-budget items) at the start of the financial year was Rs7.5 trillion. 2) Cenvat rate cut by 4%: An across-the-board cut of 4% in the ad valorem Cenvat (central value added tax) rate was announced that will be effective for the balance of F2009 on all products, other than petroleum and those where the current rate is less than 4%. This will result in a Rs87 billion (US$1.7 billion) revenue loss in indirect tax collections in F2009. 3) Exporters: The government has announced an interest rate subvention of 2% up to March 2009 on pre- and post-shipment export credit for labour-intensive exports, i.e., textiles (including handlooms, carpets and handicrafts), leather, gems & jewellery, marine products and the SME sector. In addition, the government has announced the following measures for exporters: a) allocation of a further Rs11 billion to ensure full refund of terminal excise duty/central sales tax; b) a further allocation for export incentive schemes of Rs3.5 billion; and c) providing a government back-up guarantee to ECGC (Export Credit Guarantee Corporation) to the extent of Rs3.5 billion to enable it to provide guarantees for exports to difficult markets/products. 4) Housing: On December 7, the RBI announced that it is working on a refinance facility for the NHB in an amount of Rs40 billion (US$0.8 billion). In addition, the government announced that it could increase the plan expenditure for the Indira Awas Yojana. There is no clarity on the amount to be spent by the government. The press release on the fiscal package mentioned that the public sector banks would shortly announce an incentive scheme for borrowers of home loans in two categories: a) up to Rs0.5 million; and b) Rs0.5-2 million. 5) Support for medium, small and micro enterprises (MSMEs): The RBI announced refinance for Rs70 billion (US$1.4 billion) to the SIDBI to increase the credit delivery to the MSME sector. In addition, the key measures announced include: a) the guarantee cover under the credit guarantee scheme for MSMEs on loans is doubled to Rs10 million from the existing Rs5 million with guarantee cover of 50% aimed at boosting collateral free lending; b) the lock-in period for loans covered under the existing credit guarantee scheme was reduced from 24 to 18 months, to encourage banks to cover more loans under the guarantee scheme; and c) requesting Central Public Sector Enterprises and State Public Sector Enterprises to ensure prompt payment of bills of MSMEs. 6) Textiles sector: It was announced that an additional allocation of Rs14 billion would be made to clear the entire backlog in the technology upgradation fund (TUF) scheme. 7) Infrastructure financing: In order to support financing of infrastructure projects in the Public Private Partnership mode that have been facing financial constraints, the government authorised the India Infrastructure Finance Co. Ltd (IIFCL) to raise Rs100 billion through tax-free bonds by March 2009. These funds will be used by IIFCL to refinance bank lending of longer maturity to eligible infrastructure projects, particularly in highway and port sectors. 8) Others: Besides the above, other measures announced include: a) letting government departments take up replacement of government vehicles within the allowed budget; b) eliminating import duty on naphtha for use in the power sector; and c) eliminating export duty on iron ore fines and reducing that on lumps to 5%. Bottom Line While these measures should help, the downtrend that is underway is unlikely to be reversed soon. Indeed, the recent economic data and rapidly deteriorating global growth trend have increased the downside risk to our estimated 5.7% GDP growth in F2010.
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Review and Preview
December 09, 2008
By Ted Wieseman | New York
A terrible run of economic data, which culminated in one of the worst employment reports ever after reports showing collapses in both ISM surveys and very weak consumer spending (that made clear the severe worsening of the downturn that began in October extended into November), combined with a rough week for risk markets that continued to feed a flight-to-safety bid, drove Treasuries to another week of big long end-led gains. The recession that has now officially been dated as having started a year ago appears to be descending into what will likely be the longest and possibly the most severe in the post-war era. At this point, we don’t expect the severity of this downturn to ultimately reach the depths of 1981-82, but there is little doubt that 4Q is going to be one of the worst on record. On top of the miserable run of early November figures, big downward revisions to already bad capital goods orders and shipments figures in the factory orders report indicated that capital spending is collapsing along with consumption, supporting our expectation coming into the week that 4Q real GDP will contract by at least a 5% annual rate. On top of the deteriorating economic environment, and partly in response to it (though more technical pressures and forced selling appeared to be much more important in some areas), renewed weakness in risk markets until a bounce Friday after what had been a decent rebound off the prior November 20 lows helped support Treasuries most of the week. Mortgages overall didn’t do a whole lot on the week. Origination pressures weighed as mortgage applications posted a record increase in response to the initial plunge in rates following the announcement of the Fed’s MBS and agency debt purchase plans. But with the prospect of US$500 billion in mortgage and US$100 billion in agency debt being bought out, the market also continued to support Treasuries as well, as the agency buying got underway Friday with a sizable US$5 billion operation, helping drive huge gains on the week by the 2-year part of the agency curve targeted by the Fed in the opening salvo of its new targeted quantitative easing policy. On the week, benchmark Treasury coupon yields fell 8-37bp, with the curve continuing to bull flatten. Since the end of October, yields have now plunged 64 to 133bp, with 2s-10s flattening 69bp and 2s-30s 63bp. In the latest week, the 2-year yield fell 8bp to 0.93%, 3-year 11bp to 1.18%, 5-year 29bp to 1.66%, 10-year 30bp to 2.65%, and 30-year 37bp to 3.11%. Though the 2-year lagged again, the very short end definitely didn’t. The 3-month bill yield ended the week at 0.02% and the 4-week at zero, while shorter-dated bills and coupons saw sporadic trading with negative yields Thursday and Friday. Extending for some tiny bit of yield in the bill sector sent the six-month bill’s yield down 19bp to 0.21% and the 1-year 38bp to 0.51% while also giving a very strong bid to agency money market debt. Even after giving up a lot of ground Friday, TIPS still had a strong week except at the very short end despite collapsing commodity prices – January oil plunged nearly 25% and the LME’s industrial metals composite index 10% – with the 5-year yield down 45bp to 1.76% and 10-year 35bp to 2.21%. Aside from moderate gains in low-coupon 4.5%s (which appeared to reflect a supply/demand imbalance for this small, but soon to be much bigger, part of the market), mortgage-backed securities traded off a bit for the week, as good investor buying was offset by heavy supply pressures. Still, most of the major gains seen in the days after the Fed’s initial announcement of its plan to buy US$500 billion in MBS have been sustained, and it seems likely that rates will resume moving substantially lower again when Fed purchases begin, if not before. It’s taking a bit more time for the Fed to prepare to start buying more complex MBS, but purchases of straight agency debt began Friday with a sizable US$5 billion operation in the 2-year part of the curve, starting its planned US$100 billion in total purchases, and the results for the agency market were huge. 2-year agencies moved to near flat versus swaps from around +35bp at the end of the prior week. The rest of the agency coupon market didn’t do quite as well, but probably stands to catch up as the Fed extends its purchases out the curve. Amid a broadly bad week for risk markets, though with a decent end at least on Friday, that added to the bid to Treasuries on top of the bad data, a collapse in the leveraged loan market stood out. Through midday Friday, the LCDX index was an astounding 730bp wider on the week at 1,969bp, blowing way through the previous all-time wide of 1,643bp hit on November 20 when most other markets were also hitting new lows. There was at least a strong recovery in the afternoon Friday that halted the collapse, but it was still on pace to end about 500bp wider on the week above 1,700bp. This index, after trading with low volatility around the 400bp level from mid-June to mid-September, has now gapped about 800bp wider in just three weeks after briefly staging a partial recovery off the prior November 20 lows. The latest week’s severe correction was particularly shocking when compared to high yield debt. The HY CDX index was a relative standout performer on the week amid the general risk market weakness, only widening 76bp through Thursday to 1,461bp and then holding about unchanged Friday. So the LCDX index, referencing secured loans, now trades much wider than the HY index, referencing unsecured bonds, despite substantial overlap between the components of the two indices. Who knows exactly what is driving this extraordinary disconnect, but it’s safe to say that it’s not any sort of careful reevaluation of the relative fundamentals of leveraged loans and high yield bonds as investments. Between the severe correction in leveraged loans and relative stability of high yield, other risk markets sold off to varying extents. The S&P 500 sold off only 2% after a good rebound Friday to stand 16% above the November 20 low. Investment grade credit has done worse, with the IG CDX index widening 36bp on the week to 272bp compared with an all-time worst close of 280bp November 20, though there was a strong intraday rebound Friday from much worse levels approaching 190bp. Interestingly, a terrible performance by municipal bond indices appeared to have a significant knock on effect on corporate credit, though the IG index managed its Friday recovery even as the 5-year MCDX index continued blowing out after already being more than 100bp wider on the week through Thursday’s close. November’s employment report was terrible across the board, one of the worst ever. Non-farm payrolls plummeted 533,000, the worst decline since 1974 and one of the worst in history even relative to the size of the growing labor force. Major job losses were seen across most industries, including construction, manufacturing, retail, wholesale, transportation, finance, information, business services and leisure. Healthcare remained the only pocket of strength. The unemployment rate rose to 6.7% from 6.5%, a 15-year high, and the rise would have been even bigger if not for a drop in the labor force. The average workweek fell to a record low 33.5 hours, which caused aggregate hours worked to fall 0.9%. Average hourly earnings were a bit elevated at +0.4%, but this likely just reflected a mix shift as relatively more low-paying workers were being fired. We see the unemployment rate rising to 9% over the next year, and increasing realization of how bad things have become in Washington is likely to increase urgency for major additional fiscal stimulus when the new Administration and Congress take office next month. Both ISM surveys in November were also dreadful. The manufacturing ISM composite index fell 2.7 points in November to 36.2, another new low since 1982. The key orders (27.9 versus 32.2), production (31.5 versus 34.1), and employment (34.2 versus 34.6) gauges all extended their recent collapses to fall deeply into recessionary territory. Orders have been particularly weak, with lower readings only recorded twice (both in 1980) in the survey’s 60-year history. The prices paid gauge fell to 25.5, the lowest reading since 1949 after as recently as June being at 91.5, a high since 1979. There has never before been such a massive collapse over such a short period that has come anywhere near what has occurred in this episode. Meanwhile, the non-manufacturing ISM composite index plunged 7.1 points in November to 37.3, easily setting a new all-time low in the survey’s 11-year history on its biggest one-month drop ever. The business activity (33.0 versus 44.2), orders (35.4 versus 44.0) and employment (31.3 versus 41.5) gauges all collapsed to all-time lows (none of them had ever even been below 40 before) and deeply in recessionary territory. Indeed, the composite gauge would have been even weaker, if not for an uptick in the less important supplier deliveries component. Only one industry (healthcare) reported growth in November and 17 contractions. After temporarily proving much stickier than the manufacturing version, the prices paid gauge tumbled to 36.6 from 53.4, also a new all-time low. Early indications for November consumer spending pointed to another sharp decline in retail sales on top of the near-record plunge recorded in October, though overall the results weren’t quite as bad as expected. Real consumption still appears on pace for another severe decline in 4Q on top of the 3.7% plunge, the worst since 1980, in 3Q, but probably not quite as bad as our -3.2% estimate coming into the week. Motor vehicle sales, though, were worse than expected again, falling to another new low since 1982 of 10.1 million units annualized after plunging to 10.5 million in October from the already dismal 12.5 million level hit in September. On the other hand, chain store sales, while simply terrible in any absolute sense, weren’t quite as bad as expected. Aggregate same-store sales posted one of their biggest drops on record in November, but coming against a tough comparison a year ago, and with the hindrance of a later Thanksgiving this year, the data pointed to significant weakness in key non-auto discretionary components of the retail sales report, but not as bad as our preliminary assumption. It’s clear that the recession the NBER officially dated as beginning in December 2007 has severely intensified in the current quarter, and even with the slightly less bad trajectory for consumption, weakness in construction spending, with overall October spending falling 1.2%, and especially capital goods orders and shipments revisions in the factory orders report added support to our expectation that real GDP will plunge by at least a 5% annual rate in 4Q, which would be one of the worst quarters in the post-war period. Non-defense capital goods ex-aircraft orders were revised down to -5.0% from -4.0% in the factory orders report and have now collapsed at a 36% annual rate over the past three months. Capital spending is clearly rolling over hard, and this should start to show up in a major way in 4Q. With non-defense capital goods ex-aircraft shipments revised down to -3.5% in October from -2.4%, and the freefall in orders pointing to more weakness in shipments in coming months, we now see real business investment in equipment and software plunging at a 22% annual rate in 4Q and overall business investment 18%. Consumption, capital spending and residential spending are all falling. With the US recession having gone global, the lengthy run of big positive boosts to growth from net exports is over. Inventories are starting to look increasingly bloated across a variety of metrics, and intensified production cutbacks will likely be needed to bring them back into line as demand rolls over, further dragging on growth. Often volatile federal government spending posted an unusually large surge in 3Q that will likely be largely reversed in 4Q, and major pressure on state and local government finances is weighing heavily on spending at the municipal level. This is likely to be the longest, and it increasingly appears possibly the most severe recession since the Great Depression. The economic calendar in the upcoming week is fairly quiet, with focus on Friday’s retail sales report. Earlier in the week, supply will be a focus, with the Treasury announcing a new 3-year and a reopening of the 10-year for auction Wednesday and Thursday. Before the market started ripping higher in November, the ongoing and upcoming flood of Treasury supply seemed to be substantially constraining the market. Clearly, such concerns have been set aside recently, but it’s possible that this becomes an issue again in the first part of the coming week. Other than the retail sales report, notable data releases include the Treasury budget Wednesday, trade balance Thursday and PPI and Michigan consumer confidence Friday.
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