Colombia
Rate Cuts Coming
December 16, 2008

By Boris Segura | New York

Latin American central banks have not been cutting rates as quickly and aggressively as their counterparts in Asia and Emerging Europe. In view of recent struggles with high inflation and ‘fear of floating’, the region has been guarded about jumping onto the rate-cutting bandwagon this year. But we believe that this is about to change.

Colombia stands out as being on the brink of rate cuts. We are of the view that the central bank will be able to relax monetary policy in 1Q09, cutting its intervention rate by at least 200bp during the year.

Banco de la Republica (BanRep) has been one of the most proactive central banks in the region. It began hiking its intervention rate in April 2006, when inflation pressures still were not apparent, and only stopped its tightening campaign last July, with cumulative hikes of 400bp.

Still, inflation outcomes over the last two years have not been positive. A combination of strong domestic demand pressures and rising food and regulated prices put upward pressure on headline and core inflation, making the central bank miss its inflation target in both 2007 and 2008.      

Economic Deceleration: Faster than Expected

After growing by more than 7% in 2006-07, economic activity has decelerated sharply entering 2008. According to the central bank, the positive output gap that has characterized Colombia’s economy over the last two years is likely to dissipate by year-end.

A negative output gap is likely to be developing. Taking into account our below-consensus GDP growth forecast for 2009 (1.5%) and BanRep’s revised potential growth of GDP (around 5%), it is fair to say that domestic demand is likely to put downward pressure on inflation throughout 2009. As such, the central bank in principle can afford to loosen its monetary policy stance.

And the authorities don’t have the lever of running a counter-cyclical fiscal policy. We expect Colombia’s fiscal situation to deteriorate in 2009 (see “Colombia: Fiscal Pressure Points”, EM Economist, November 7, 2008). And with some pressure points arising in its financing plan, we doubt that fiscal authorities would be able to come up with a fiscal stimulus plan similar to the one just unveiled in Peru. Thus, monetary policy would be the only counter-cyclical tool at the disposal of the authorities.

But the credit channel is not particularly deep. With total domestic loans below 40% of GDP, monetary stimulus is not likely to save the day in Colombia, in our view (see “Latin America: Sliding in 2009”, EM Economist, December 12, 2008). As we envision shaky household and consumer confidence, more slack in the labor market, and some worsening in banks’ asset quality, it is going to be tough for monetary stimulus to translate into faster credit growth.

Inflation to Come Down in 2009

Unfavorable inflation readings have kept BanRep from cutting its intervention rate. Indeed, headline inflation has drifted away from the central bank’s 4% target. And even measures of core inflation have been fluctuating around the 5% level. But we do see some inflation relief arriving soon, for three reasons:

•           Slower domestic demand growth is likely to exert downward pressure on inflation, particularly non-tradable. A positive output gap is emerging, which is likely to put downward pressure on prices of goods and services, particularly non-tradable.

•           Food imports are also getting cheaper. The flip side of the commodity prices run-up that began in early 2006 was dearer imported food prices. With a lag, the bust in imported food prices is likely to be reflected in lower headline inflation, particularly after base effects roll over during 1H09. Two wildcards here: Adverse domestic weather conditions, such as those being experienced in Colombia lately, are putting upward pressure on locally produced foodstuff. And there is the effect on profit margins enjoyed by firms benefitting from these lower commodity prices.

•           Colombia is likely to face almost no inflation coming from the developed world. Our Global Economics team now expects CPI inflation in the developed world at a tame 0.5% next year, even with some negative month-over-month inflation prints in 1H09 (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008). For Colombia, this means that tradable inflation in particular is likely to remain well contained.

We look for headline inflation to ease noticeably in 2Q09. In fact, we believe it already peaked in October, and that a combination of the three forces mentioned above is likely to bring inflation lower still. Base effects are particularly challenging in 1Q09, but appear likely to ease afterwards, allowing for an overdue (headline) inflation relief by 2Q09.

The Pass-Through Wildcard

The main risk to our constructive 2009 inflation outlook is the possible pass-through from currency depreciation to inflation. Despite a major depreciation of the COP since last June, the pass-through to domestic inflation has been relatively contained, so far. Of course, there is no guarantee that this will be the case going forward.

Another risk is the evolution of regulated prices, which have risen sharply over the last 15 months. Even when the trigger for regulated price revisions is some predetermined increase in the consumer price index, the actual adjustment is based on the producer price index, which is more sensitive to exchange rate fluctuations. But the recent drop in domestic fuel prices is also likely to help hold down regulated prices.

When talking about the pass-through effect, we cannot ignore the business cycle. From that perspective, there is international evidence that the pass-through coefficient tends to be larger when the economy is growing strongly and vice versa. Colombia is no exception, so we should expect a smaller pass-through from currency depreciation to inflation now that economic activity is softer.

Perhaps more importantly, a COP depreciation is unlikely to have balance sheet effects, in our view. In a sense, recent currency trends have proven that there is no ‘fear to float’ in Colombia. Adept prudential macro-regulation minimized the currency and liquidity mismatches that were present in other countries in the region.

Rate Cuts: The Timing Is Tricky

We don’t expect to see the start of the rate-cutting campaign at the December 19 meeting. It seems to us that BanRep would probably like to make sure that upcoming wage negotiations do not validate unwarranted inflation expectations for 2009. It is useful to recall that the minimum wage has to be raised at least by the realized 2008 inflation, in accordance with a Constitutional Court’s ruling. However, minimum wage settlements have a major impact on the rest of the wage structure. Unions are already demanding raises of 14% in the minimum wage; our perception is that a final settlement closer to 7.5-8% would make the central bank more comfortable about the inflation outlook next year.

But we already got a ‘down payment’. At its latest meeting, BanRep decided to raise the midpoint of its inflation target in 2009 to 5%, from 4% in 2008, due to the persistent shock to food and regulated prices. Recall that a year ago, BanRep announced that the 2009 mid-point would be 3-3.5%. This large upward move suggests to us that more rate cuts than might otherwise happen in 2009 are likely in the offing.

We agree with the board’s majority that cutting rates now would be premature. Headline inflation has just peaked, and measures of core inflation sit uncomfortably above BanRep’s target. Even inflation expectations have dropped only marginally. We sense that the central bank would feel more comfortable cutting its intervention rate once headline inflation convincingly reverses course, and core inflation and inflation expectations begin to come in below the 2009 target. But we doubt that BanRep will wait that long and instead is likely to start cutting rates in 1Q09.

We expect 25bp rate cuts initially. The relaxation of monetary policy would be cautious, as authorities become more comfortable with the inflation outlook going forward. After that, we wouldn’t be surprised to see 50bp rate cuts, particularly as growth slows in line with our forecast of weakened economic activity in 2009.

And there is another wildcard in the rate-cutting pace – the upcoming replacement of two (hawkish) board members. The executive branch is to appoint two new members to the central bank’s board in the first months of 2009. Depending on who is appointed, the balance of the board might get tilted in the dovish direction, which could bring faster and deeper rate cuts into the picture.

Bottom Line

Make no mistake: rate cuts are likely. We think that weaker-than-expected economic activity is likely to reinforce an overdue inflation relief in 2009, giving way to at least 200bp of cuts by BanRep starting in 1Q09.

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Brazil
Zeroing in on Growth
December 16, 2008

By Marcelo Carvalho | Sao Paolo

Our 2009 below-consensus zero growth forecast may sound extremely bearish. But it does not require an abnormal quarterly growth path, in light of Brazil’s own history and the prospects for severe global recession. We look for negative sequential quarterly real GDP growth starting in 4Q08 and lasting through 1H09, with a gradual recovery in 2H09.

We are changing our interest rate forecast, in light of recent dovish policy signals. How does monetary policy respond to mounting evidence of growth weakness? The central bank seems increasingly worried about the growth downturn. Recent dovish signs in the wake of the December COPOM meeting lead us to revise our rate forecast. We now look for four consecutive rate cuts of 50bp each, starting at the January 2009 COPOM meeting. That is earlier and stronger than we had previously anticipated (a total of 100bp of rate cuts in 2H09). In turn, policy easing may cushion the blow and reduce the likelihood of worst case scenarios for growth. But it still seems unlikely to avoid recession, given powerful global headwinds. 

Growth Faces a Sudden Stop

Brazil’s growth downturn will prove sharper than most observers are ready for. Our thesis is simple. First, Brazil is more sensitive to global developments than analysts often realize. Second, the global economy is falling into severe recession, facing the worst global crisis in decades. Third, as a logical conclusion, Brazil’s economy will suffer more than most are prepared for.

We have recently cut our 2009 Brazil growth forecast to zero, from a previous already below-consensus forecast of 2.0%, along with a generalized downward revision in Morgan Stanley’s 2009 global growth forecast, to 0.9%, from 1.7% before (see “Latin America: Sliding in 2009”, EM Economist, December 12, 2008, and “Brazil: Growth Pressure Points”, EM Economist, December 5, 2008).

Sharp as it may seem, the coming growth downturn is not unprecedented in Brazil’s recent history. The economy grew an impressive 6.3% on average during the four quarters through 3Q08. Our forecast sees a decline in that measure to zero by the end of 2009. The resulting decline of 6.3 percentage points is sudden – but not unprecedented. Brazil already saw comparable declines in previous growth downturns. The average peak-to-trough growth slowdown in the last three crises was about 5.8%. In fact, Brazil’s growth downturn in the wake of the 1995 Mexican crisis was even bigger. Back then, Brazil’s real GDP growth plunged from 8.5% to zero in the space of just four quarters.

In fact, the global backdrop suggests that Brazil’s growth downturn might prove worse than ever seen in Brazil’s quarterly data. Quarterly real GDP data for Brazil go back only as far as 1990. But the present global growth recession is proving worse than anything seen since the 1990s. In fact, observers now turn to the early 1980s recession to find a comparable global growth environment. True, many things changed since the 1980s – but one of them is precisely the increased importance of international linkages in a globalized economy. That is, Brazil’s growth performance might turn out to be weaker than anything seen before in its quarterly numbers, which are available only since the 1990s.

Brazil is at the start of a technical recession, judging by the popular rule-of-thumb that defines recession as two consecutive quarters of negative real GDP growth. We foresee Brazil’s sequential (quarter-on-quarter) real GDP growth in negative terrain during 4Q08, and then again in 1Q and 2Q09, before a gradual sequential growth recovery in 2H09.

Negative sequential growth seems a done deal in 4Q08, as the economy came to a sudden stop. Industrial production was already much weaker than expected in October, falling 1.7%M, or a sharp slowdown to just 0.8%Y. November looks set to bring an even larger sequential drop, judging by large declines in automobile production for instance. And December so far does not look much better either. In all, we see sequential real GDP growth of -1.0%Q in 4Q08, with risks currently biased to more negative numbers.

The sequential quarterly growth declines we foresee are not particularly rare by Brazil’s historical standards. In fact, on average, about one out of four quarters turns out in negative terrain, in sequential terms, judging by Brazil’s available quarterly history. That is, a negative sequential reading is more frequent than many seem to realize. The problem is that the last several years of global abundance seem to have distorted the perceptions of normalcy. Brazil has seen positive growth for many quarters in a row over the last years – historically, this is unusual.

The quarterly growth declines we forecast do not look particularly severe either. As for magnitude, available data show that Brazil’s average sequential growth decline is 1.5%, larger than the 1.0%Q decline we assume for 4Q08. In fact, when sequential quarterly real GDP growth falls into negative terrain, the drop is larger than the 1.0% mark about 55% of the time.

We assume a gradual sequential growth recovery only in 2H09. Amid depressed consumer and business confidence, high inventories, tight credit conditions, worsening labor market conditions and a tough global environment, Brazil’s economy looks unlikely to recover before 2H09. True, three consecutive quarters of contraction are not common in Brazil’s GDP data. But neither is the current global growth environment. Our global economics team does not see a global recovery before 2H09 – and global risks still seem biased to the downside.

Among GDP demand components, investment is likely to fall the most. In Brazil, as globally, investment is typically more volatile than the overall economy. Investment climbs the highest in the upswing, and sinks the lowest in the downturn. Brazil’s investment has indeed soared in recent years, jumping almost 20%Y in 3Q08. Ahead, as capex plans are cut back sharply, investment looks bound to plunge, all the way to negative terrain next year. Private sector consumption should slow too, but less dramatically so than investment, as consumption is typically less sensitive to the business cycle.

Among the main sectors of the economy, industry probably suffers the hardest, although the slowdown is likely to prove broadly based across the economy. Services tend to be relatively less sensitive to swings in the broader economy. By contrast, industrial output looks set to fall into negative territory next year. Growth in the agribusiness is likely to suffer too, in part because the recent credit crunch has forced cash-strapped farmers to use fewer fertilizers and pesticides in the recent planting season. The reduced use of technology could entail smaller yields, even if the planted area does not shrink.

Interest Rate Cuts Are Underway

In turn, the economy’s downturn can trigger monetary easing soon, judging by recent signals from the central bank. The authorities seem increasingly concerned about a weakening economy. The central bank once again kept the policy rate unchanged at 13.75% on December 10, as widely expected. The decision was formally unanimous, after an unusually long meeting. But the short accompanying statement sounded remarkably dovish. Usually laconic and low-profile, the statement this time around explicitly said that a majority of board members discussed the possibility of cutting rates already at the December meeting. Such disclosure is unusual for the statement – this sort of detail normally is only revealed at the subsequent COPOM minutes, a week later. It seems that the COPOM wanted to already send an explicit, strong, early message this time.

That is, rates were still kept on hold – but just for now. Amid a very uncertain macroeconomic environment – the policy statement says – the board decided to “still keep rates unchanged, at the moment” (our italics). Overall, the statement sounds unusually explicit in suggesting that the COPOM is seriously considering cutting rates soon. All eyes now turn to the COPOM minutes, to come out on Thursday, December 18. In all, the COPOM statement substantially increases the odds that it will start cutting rates as soon as at the next meeting, on January 21.

The authorities seem increasingly concerned about the severity of the downturn, as additionally indicated by the joint (central bank and finance ministry) announcement the day after the recent COPOM meeting, with some fiscal easing through tax breaks as well as the central bank’s new decision to use part of its reserves in order to finance short-term corporate sector external debt obligations.

In light of these signs, we are changing our rate call. We now look for earlier and larger rate cuts. Before, we had assumed that rate cuts would materialize only in 2H09, although earlier cuts had remained a possibility. The policy rate would fall 100bp to 12.75% by end-2009. We had assumed that potential pass-through from currency depreciation into inflation would still keep the central bank on hold for a while. But recent signals suggest that this concern is no longer a main driver in the central bank’s thinking. That is either because the central bank feels sufficiently comfortable with the inflation outlook, or else because growing downside risks to growth outweigh upward risks to inflation in the central bank’s thinking.

We now assume total easing of 200bp next year, with four consecutive rate cuts of 50bp each, starting already at the January policy meeting. In the new forecast, the policy rate falls to 11.75% by mid-2009, and stays there through the rest of the year. By the January 21 meeting, signs of sharp growth weakening will have become even more evident than now, paving the way for the start of the easing cycle. We tentatively assume that the central bank would be done easing by mid-year, as growth recovers gradually in 2H09.

Adjusted inflation targets underway? It is interesting that the COPOM explicitly considered rate cuts at the December meeting, even though inflation is still running above the official target center of 4.5%. Current CPI inflation is above 6%, and market consensus expectations for 2009 inflation are above 5%. In such circumstances, a rate cut may mean one of two things. One possibility: in its balance-of-risks analysis, the central bank is concerned that inflation runs the risk of falling significantly below the target in the forecast horizon. Another possibility: despite above-target inflation, the inflation target itself is becoming less relevant as a driver for policy, given the unusual macroeconomic environment. If so, then it would not surprise us if the central bank eventually starts to work with some form of ‘adjusted’ inflation targets, partially accommodating the inflation-target overshooting. After all, the central bank has already worked with adjusted inflation targets in the past, as recently as in 2005.

Policy easing may cushion the blow, but will not avoid a growth recession. Monetary policy easing should help to avoid the worst case scenario of an even deeper growth downturn. But it is unlikely to avoid recession, for three reasons. First, room for policy easing in emerging market countries like Brazil still appears more limited than is the case in developed countries like the US, given relative track records on inflation fighting. Second, the credit channel in Brazil is narrower than in developed economies, and it may prove partially clogged with concerns about rising delinquency. That is, monetary policy might be ‘pushing on a string’. Third, policy easing seems unlikely to quickly or fully offset the very powerful global growth headwinds now at play.

As for the currency, our forecast assumes gradual devaluation through 2009, to the 2.5-3.0 R$/US$ range. Our end-2009 forecast is 2.7. After several years of steady currency appreciation amid soaring international commodity prices, strong global growth and steady capital inflows to emerging markets like Brazil, we foresee a weaker currency going ahead, amid tougher global market conditions. Our forecast assumes a gradual currency weakening path through 2009. That said, we are fully aware that floating currencies rarely follow a straight line. Volatility will not disappear overnight. The risks are that the currency undershoots (weakening) in the first part of 2009 amid global pressures, before it partially recovers ground, appreciating later in the year as external conditions improve.

Brazil’s balance of payments outlook is changing dramatically from recent years. Looking ahead, imports are likely to plunge on the heels of domestic recession and a weaker currency. But exports will fall fast too, despite help from a more competitive currency, on the double hit from falling international trade prices and volumes. In all, the net impact on the trade balance looks less clear now than the sharp trade improvement Brazil saw in previous cycles. As for the services accounts, the sharp increase in dollar outflows of profits and dividends seen during 2008 looks likely to subside in 2009, in light of shrinking domestic profitability and a weaker currency. But the wild card is the capital account. After unprecedented large inflows in 2007, the capital account looks set to be weak in 2009 as a whole. Its performance is set to play a key role on currency developments through the year.

Bottom Line

It does not take a highly abnormal quarterly path to achieve our below-consensus zero real GDP growth forecast for 2009, given Brazil’s own historical growth performance, and the outlook for a severe global growth recession. The central bank seems increasingly worried about the downturn too. Recent dovish signs lead us to revise our rate call. We now look for four consecutive rate cuts of 50bp each, starting in January 2009. In turn, monetary easing might cushion the blow, but shouldn’t be expected to help Brazil avoid a recession.

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Japan
No Clear Sign of Bottoming: December Tankan
December 16, 2008

By Takehiro Sato | Tokyo

Angle and Depth of Recession on Par with the Worst

The features of the Tankan differ entirely from the last report in September in that it reflects revisions in management plans due to the altered state of the global financial markets since mid-September, as well as earnings results for 1H of F3/09. The headline is down by two-digits, large companies’ capex plans have turned negative and recurring profit is seen down by 20%, a major downward revision as already suggested in guidelines when results were released. It already seemed clear from the October industrial production data that this recession would far surpass that of the IT bubble collapse in the early 2000s in terms of scale and breadth, and would more closely resemble that of the first oil shock in the early 1970s. What the Tankan has now done is confirm the angle and depth.

Results of the Key DIs

1) Business conditions DIs: The headline (current conditions, large manufacturers) slipped from -3 in September to -24 (-21 pp QoQ) and the DI for non-manufacturers fell by 10 pp QoQ to -9, ranking behind only the first oil crisis as the steepest falls on record. The 21 pp drop in the large manufacturers DI was second to the 26 pp decline between the June (+8) and September reports (-18) when the data were first released in 1974, and matched the decline between the December 1974 (-39) and March 1975 (-60) reports. That said, in terms of absolute levels, the outcome is not as bad as previous recessions that saw even sharper contraction: -38 between December 2001 and March 2002 at the time of the IT bubble deflation, -51 in December 1998 at the time of the Asian Financial Crisis, and -57 in June 1975 at the time of the first oil crisis. This implies potential for further declines in the headline going forward.

In fact, the outlook DI worsened significantly to -36 for large manufactures. The manufacturers’ outlook DI does tend to be worse than the current conditions DI, but this time there are no signs of production recovery even through January-March, so the deterioration of the outlook is more than a mere statistical tendency. The headline is bound to worsen significantly again in the next Tankan in March.

Looking at large manufacturers by industry, processing (-23 pp versus last report) fared worse than materials (-17 pp), with the autos industry (-46 pp) playing an obvious part.

The DIs for SMEs took on a similar track to the large corporations; autos (-48ppt) again struggled most among manufacturers.

2) Supply/demand DIs: In response to steep declines in both materials and processing industries, the domestic supply/demand DI for large manufacturers posted the biggest decline (-16 pp) since the 25 pp drop in September 1974.  The 22 pp fall in the overseas supply/demand DI was also unparalleled.

The inventory DI rose by double-digits (+11 pp) for the first time since December 1980 (+15 pp). The prevailing view had been that shortening product cycles and development of improved inventory control processes would largely eliminate inventory cycles. However, recent supply/demand and inventory DIs suggest that production cutbacks have not been keeping pace with the unprecedented and rapid pullback in demand.

3) Price DI: The output and input price DIs tumbled in both manufacturing and non-manufacturing industries. Among large manufacturers, the output price DI (-15 pp) shed its most since March 1975, and the input price DI posted the sharpest decrease (-35 pp) since December 1980. The output price DI entered into a negative range (-4).

Meanwhile, with the decline in the input price expanding, the margin DI (output price DI minus input price DI) improved substantially. Processing industries showed the most obvious margin DI gains. SMEs did likewise.

Despite such margin improvement, i.e., better terms of trade, we expect profound deterioration going forward in sales volume, as the supply/demand DIs indicate.  Though we cannot merely assume renewed deflation based on a drop in sales prices, we do suspect that deflationary fears will eventually be fanned as corporate earnings look increasingly harsh. 

4) Employment and production capacity DIs: The employment and production capacity DIs jumped regardless of industry or size of the company, and the sense of surplus is rapidly increasing in both. Indeed, the employment DI showed its largest shift (large companies: +7 pp) since June 1992, which is congruent with the fast-changing employment landscape these days. With the sense of labor surplus expected to build further, employment trends are likely to worsen even more. The change in the production capacity DI (+6 pp for large companies) was also its largest since June 1975; this, in turn, casts a shadow over capex plans, to be discussed later.

The prevailing view has been that the three excesses in the Japanese economy after the collapse of the bubble (labor, capacity, debt) have already been removed. But the December Tankan indicates that the disappearance of such excesses is merely relative based on the performance of the real economy such as corporate earnings and so forth.

Overview of Management Plans

1) Revisions to F3/09 sales and profit plans: In the September Tankan, the target for F3/09 recurring profit at large corporations, all industries, was -9.4%Y, roughly a 10% decline. Reflecting revised corporate guidance after 1H earnings results, sales plans by large companies in all industries were revised down (by 1.4%), but at least they still expect year-on-year growth, at +3.1%. However, recurring profit plans envision a decline of 20.6%, having been revised down by 12.3%. Sales and recurring profit were both revised down in the December Tankan for the first time since 2003.

The assumed forex rate for F3/09 on average is JPY103.32/USD, revised up contrary to current forex market trends (September Tankan: JPY102.82/USD). This upward revision to forex reflects upward revisions to 1H earnings, but the 2H business climate is quite harsh, as we describe below.

Industrial production is currently running far below the average pattern for recessions since the 1970s, as well as the IT bubble collapse at the start of this decade, and instead is falling sharply in a way that closely resembles the pattern of output cuts at the time of the first oil shock in 1974, with the drop from the peak to the most recent bottom measuring over -15% based on the December forecast index. Assuming continued production cuts of around -5% in January-March, we think that curbs in the current phase of production pullbacks for industry as a whole could extend to around -25% or so from its peak to bottom.

Even at constant selling prices, we expect F3/09 manufacturing sales to fall by more than 10% on a year-on-year basis. We think it will be F3/10 at the earliest before the countering effects of recent falls in energy and raw materials prices start coming through as better terms of trade. Hence, for the time being, we expect gearing to be sharply negative. As a result, in the next and the next-but-one Tankan in March and June 2009, reflecting full-year earnings, we foresee steep downward revisions to management plans and believe that ultimately recurring profit at large corporations will subside to about -35%Y (MoF Corporate Statistics basis, excluding financials). We also expect F3/10 guidance to be exceedingly cautious when announced around April to May. For F3/10, we forecast a profit fall of -20% as the base case.

Our forecasts above assume a yen-dollar forex rate of JPY99.4/USD for F3/09 and JPY94.6/USD for F3/10, from which an average change of 5% upwards or downwards over the year would alter the profit outlook by about 3 pp in either direction.

2) Revisions to F3/09 capex plans: For the same reasons as we discussed in relation to sales and profit plans, the December survey featured major overhauls of full-year capex plans. In a fragile economy where liquidity is suddenly constricted, companies’ stance on capex is noticeably weaker than the average pattern of the past five years. Non-manufacturers (electric power utilities) have a certain amount of replacement demand, but momentum is not strong enough to make up for falling spending on boosting capacity at manufacturers.

In particular, the revision rate for large companies was -1.8% (past 5-year average: +1.1%) and capex plans were down year on year (-0.2%; including land investment but excluding software investment), with manufacturers +2.4% (revision rate: -3.1%) and non-manufacturers -1.7% (revision rate: -1.0%); manufacturers thus revised down further. However, excluding land investment and including software investment (close approximation of nominal GDP-based figure), large corporations unexpectedly maintained year-on-year growth at +2.2% (revision rate: -3.0%). 

F3/09 plans of listed companies remain above year-earlier levels, at +2.4%Y, in the Nikkei capex survey of November 24, published in the aftermath of the turmoil in the global financial markets in September-October.

Yet, with macroeconomic conditions suddenly become even worse in December, we think it is quite likely that companies are now reviewing these plans further, and we think there is still room for downward revisions in future Tankan surveys in March and June 2009. Indeed, capex plans are normally revised down in the March and June Tankan surveys.

Keep a particularly close eye on the impact of tighter credit conditions, for both large firms and SMEs. We do not rule out the possibility of a situation that might reasonably be termed a ‘credit crunch’, even if small in scale, featuring for example a still-tighter bank stance on credit, and constricted liquidity. Conditions for large corporations to issue CP worsened suddenly, by 20 pp from +1 in September to -21 in December.

Revision of Land Purchasing Plans

In the September survey, large companies showed a 41.8% decline in land purchasing plans, but nonetheless did revise up plans. December saw much the same, with plans negative at -31.6%Y, though revised up.

Land purchasing plans, even at big firms, tend to be revised up gradually as the end of the fiscal year approaches.  However, the revision rate was somewhat weaker than the four-year historical average of +17.5%. It looks as if companies are shying away from aggressive property buying in anticipation of lower land prices and tighter funding.

Monetary Policy Outlook

With the further cuts in our economic outlook (as of December 10), we have brought forward our estimate of the timing of the ZIRP uptake by the BoJ to January-March 2009. However, in light of the December Tankan results, current employment trends and the market environment, we doubt that ‘no action’ would be accepted any more, politically, at the MPM on December 18-19. In other words, monetary easing policies will likely be ushered in with a rate cut at the December MPM.

Interest rates on term instruments continue to rise in the money markets as supply-demand conditions tightens towards the calendar and fiscal year-ends. With share prices falling, we also need to consider constraints on banks’ balance sheets. However, large corporations are reluctant to issue relatively costly CP and debentures, and instead are relying increasingly on drawing down commitment lines from banks. Consequently, even if growth in loans to large corporations pushes up overall bank lending, loans to SMEs might easily be restricted. The situation is now looking similar to 1998, when equity markets contracted as a result of share price falls, prompting banks to start clawing back loans as their assets shrank and posing a challenge for fund flows at even large corporations.

Projecting out to the end of the fiscal year (F3/09), given the circumstances, we expect further easing measures. We expect the BoJ to cut rates again relatively early in January-March, and ultimately expect it to shift back to quantitative easing with zero interest rates. We also expect policies aimed at improved financial health (prudence policies) to proceed along the lines of buying up CP and other private debt instruments. In general, we expect the menu for easing to feature such items as:

(1)        quantitative easing without ZIRP (+ unsterilized intervention);

(2)        rate cuts;

(3)        quantitative easing with ZIRP (+ unsterilized intervention);

(4)        increase in the value of rinban operations or repeated roll-over of the JGB held by the BoJ;

(5)        further broadening of eligible collateral (to include stocks, CMBS);

(6)        outright purchases of CP (ABS, ABCP) and CMBS;

(7)        outright purchasing of CMT and inflation-linked bonds; and

(8)        outright purchasing of stocks

Steps (1) and (3) could be the result of aggressive unsterilized intervention to counter the yen’s appreciation. If policies (6) to (8) were to materialize, we would expect monetary policy to be more similar to fiscal policy in place of fiscal stimulus measures that lack scope for further expansion of expenditure.

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