Global
A New Global Liquidity Cycle
January 16, 2009

By Joachim Fels | London

In a nutshell. As GDP downgrades abound and investors’ gloom thickens, our metrics indicate that a new global liquidity cycle is in the making. While still in its infancy, this new liquidity cycle will likely help support asset markets, end the recession later this year and prevent lasting deflation. As always, it is difficult to predict which asset classes will benefit most from the build-up of excess liquidity. However, our strategists favour credit and EM equities in 2009.

Focus on global excess liquidity... Our favourite metric for tracking the liquidity cycle remains the evolution of excess liquidity, which we define as the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K’). M1 is a narrow monetary aggregate comprising currency in circulation and overnight bank deposits held by non-banks. It is used for transactions in the real economy – when buying goods and services – and in the financial sphere – buying stocks, bonds or other financial assets. Simply speaking, if money grows by more (less) than nominal GDP, excess liquidity expands (contracts), and more (less) money is available for transactions in the financial sphere. We plot our measure of excess liquidity both for the G5 advanced economies and for the four BRICs as a proxy for the emerging world. With money highly mobile across borders, we prefer such ‘global’ measures of excess liquidity to national ones.

…as a driver of asset prices. As we have argued repeatedly over the years, the ups and downs in excess liquidity have been key drivers of past asset price booms and busts. The bond market rally of the early 1990s was led by a build-up of excess liquidity and gave way to a bond bear market in 1994 as excess liquidity evaporated. A renewed build-up of excess liquidity was also behind the equity bull market in the second half of the 1990s. It culminated in the dot.com bubble, which burst early this decade as excess liquidity turned down. And the mother of all credit and real estate bubbles up until 2006 was fuelled by the surge in excess liquidity that started in 2002 and lasted until early 2006, just as the downturn in excess liquidity from 2006 onwards foreshadowed the bursting of these bubbles in 2007/08. It is interesting to note that while G5 excess liquidity contracted already in 2006, the surge in excess liquidity in the BRICs at that time probably prolonged the surge in asset prices (mainly equities and commodities) into 2007. Only when BRIC excess liquidity also evaporated during the 2007 monetary tightening campaign did asset markets tank collectively.

Liquidity cycle has turned up. Importantly, in the most recent available quarter, G5 excess liquidity has started to rise again, for the first time in almost three years. In our view, this marks the beginning of a new global liquidity cycle. We illustrate this more clearly by showing the quarterly growth rate of excess liquidity (rather than the level). 

Excess liquidity is surging because M1 growth has started to rise at a time when (nominal) GDP growth is decelerating sharply. As we see it, excess liquidity is likely to accumulate further in the next few months and quarters, for several reasons:

•           With interest rates already close to zero in several countries and being cut further in others, the opportunity costs of holding cash and non-interest bearing deposits (M1) have declined.

•           By flooding banks with excess reserves (‘quantitative easing’), central banks have provided banks with plenty of wherewithal to create new deposits by lending to non-banks or buying securities. 

•           By targeting mortgage rates and other private sector lending rates directly through purchasing asset-backed securities (the Fed now prefers to call this ‘credit easing’ rather than ‘quantitative easing’ as per Chairman Bernanke’s speech last night), the Fed is supporting credit demand, which in turn supports deposit growth.

•           With real GDP shrinking across the industrialised world and consumer prices heading south, nominal GDP – the denominator in our definition of excess liquidity – will likely decline in the near term.

Thus, 2009 is likely to mark the beginning of a new liquidity cycle, driven by the unprecedented conventional and unconventional easing of monetary policy as well as a gradual healing of the impaired financial system. 

Surging excess liquidity is likely to have three consequences:

•           As in past episodes, excess liquidity will find its way into asset markets. To some extent, this has already started to happen, with government bond yields having been pushed to new lows across the yield curve, credit spreads coming in and equities having bounced off their lows from last autumn. Our excess liquidity metrics tell us nothing about which asset classes will benefit earlier and most. But our strategists favour credit over equities and government bonds, and EM equities over developed market equities.

•           By pushing interest rates lower and asset prices higher, excess liquidity should help to end the recession later this year. Despite their recent renewed growth downgrades, our economists in the various regions continue to envisage a recovery (though a muted one) during 2H09.

•           Rising excess liquidity should also help to prevent a sustained period of consumer price deflation through its impact on asset prices, the real economy and inflation expectations.

Bottom line: Despite the massive growth downgrades, investors shouldn’t get too gloomy on markets in 2009, now that excess liquidity – a powerful driver of asset markets in the past – has started to turn up. It’s time to get ready for the new global liquidity cycle.

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ASEAN
2009 Growth Closer to Zero
January 16, 2009

By Chetan Ahya & Deyi Tan | Singapore & Shweta Singh | Mumbai

Summary

Sustained credit defaults in many parts of the developed world are hurting global financial institutions’ ability to deliver risk capital. Cost of capital remains 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 unfolding. The foreign trade and industrial production data for October and November across major economies in the world have surprised on the downside. G7 industrial production declined by 5.2% in October 2008, the lowest level post the 2001 tech bubble. Our US and Europe economics teams have again reduced their growth estimates for 2009. We expect the external demand support for the ASEAN region to be weaker than estimated earlier. Moreover, in this environment, capital flows into the region will also likely remain weak. We are cutting our ASEAN4 GDP growth estimate for 2009 to 0.4% from 1.3% previously.

Four Key Downside Risks

External demand support will weaken further as exports to developed and other emerging markets slow further. Trade linkages are significant as exports as a percentage of GDP for the ASEAN4 stand at 26-185%. In November 2008, ASEAN4 total exports declined 13.4% (USD terms). The trade credit freeze and inventory de-stocking might have overstated the downside for that period, but we do not expect a meaningful improvement in exports, considering that the underlying demand from the developed world is likely to be depressed in 2009. Indeed, the US ISM New Orders Index, which tends to lead the region’s exports by about six months, is also indicating further weakness in the near term.

The sharp decline in capital inflows over the last few months has already affected the cost of capital in the ASEAN economies, particularly for the small and medium enterprises. There has been no major international equity or debt issuance from the region recently. The investment cycle in the region has witnessed a sudden correction. Considering that the duration of the global financial market risk-aversion is likely to be extended at least through 1H09, we expect that business investment will decelerate/decline in 2009. Apart from this lack of access to low-cost risk capital, the corporate sector is also likely to be held back, considering the existing low capacity utilization levels due to a weak outlook for exports. Moreover, risk-aversion in the global financial markets is likely to take a toll on real estate and infrastructure investments in the region.

The decline in commodity surplus, demand and price is likely to hurt Indonesia and Malaysia’s growth trend. In 1H08, Indonesia (food, mineral fuels, crude materials and edible oils) and Malaysia (mineral fuels and edible oils) had commodity trade surpluses of 7.6% and 16.3% of GDP (quarterly, annualized), respectively. Both countries benefited from the positive terms-of-trade shock and a significant increase in business investment in mining and commodity-related manufacturing investment. Indeed, crude palm oil plantations-related investment also had the strong benefit of job creation in the rural economy. However, this will likely reverse with the commodity price outlook for 2009 trending down significantly.

The increase in NPLs and risk-aversion in the domestic banking system is another issue. The sudden and sharp deceleration in growth in ASEAN4 should lead to an increase in NPLs in the banking system. Banks are beginning to turn risk-averse. Indonesia and Singapore, which had the strongest credit cycles in the region, are likely to suffer the most from this trend, in our view. According to press reports, SMEs in these countries are already witnessing significant financial stress. We believe that the increase in NPLs will force the banking system to tighten lending standards further, restraining credit availability to households and companies.

Growth Outlook Uncertainty Due to Political Developments

Political conditions continue to be wildcards in the case of Thailand and Malaysia. Specifically in Thailand, political uncertainty could be a drag on macro momentum, particularly through the conduit of tourism and FDI. While the recent change in government has again increased hopes of kick-starting structural reforms, we believe that it remains to be seen if the full normalcy can return soon. In Malaysia, the transition process from a single-party government to a two-party government could also hinder momentum in the public sector economy. States under the control of opposition parties account for about 40-50% of GDP, and the uncertainty regarding co-ordination between the central government and the state governments will likely be increased.

Meanwhile, Indonesia is heading into elections in April 2009. Recent regulatory changes that raised the level of parliamentary seats and votes a party or coalition needs to have in order to nominate the presidential candidate (from 3% and 5% to 20% and 25%, respectively) introduce a degree of uncertainty, as President SBY’s Democratic Party won only 10% of the seats and 7.5% of the votes in the 2004 elections.

Policy Response to Be Disparate

In terms of policy response, Indonesia has been restrained in its monetary policy by the high level of inflation and increased currency volatility. In the case of Thailand and Malaysia, considering that the starting point for rate levels is not that high, there is not much scope for aggressive moves in monetary easing. Moreover, in the current environment of deleveraging and weakening business confidence, the private sector is unlikely to respond effectively to the cut in interest rates, even if the banks were to become liberal in providing credit.

In Indonesia, fiscal expansion is likely to be constrained by a higher cost of fiscal financing, particularly for sovereign borrowing. On the other hand, Thailand’s fiscal pump-priming could face execution difficulties if it is dependent on how political conditions pan out. For Malaysia, the already significant budget deficit suggests that room for additional delta in terms of discretionary stimulus could be more limited. Comparatively, the Singapore government has the most gunpowder, given its history of fiscal surpluses. Our ranking in terms of policy responses is Singapore (more effective), Malaysia, Thailand and then Indonesia (less effective).

Bottom Line

In view of these factors, and with incoming external and domestic demand indicators being weaker than originally penciled into our growth trajectory, we are downgrading our ASEAN4 GDP growth forecasts from 1.3%Y to 0.4%Y for 2009 and from 4.0%Y to 3.9%Y for 2010. Specifically, economies such as Singapore and Malaysia with higher external linkages and hence greater sensitivity to the global macro environment see more sizeable downgrades relative to Thailand and Indonesia. Overall, ASEAN4 growth for 2009 should be lower than the 2.1%Y growth we saw in 2001 but better than the -10.2%Y seen during the 1998 Asian Financial Crisis.

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Turkey
In the Absence of Growth
January 16, 2009

By Tevfik Aksoy | Istanbul

Downgrading Our GDP Growth Forecast

Almost all current and near-term growth indicators have been coming out significantly weak. In fact, both industrial production (IP) and capacity utilization (CU) data surprised the market heavily in recent months as the extent of the decline in production has been at near-record levels. In light of these developments, as well as the recent growth forecast downgrades by our US and European economics teams, we are lowering our real GDP growth rate forecast for 2009 to -0.5%Y from 1.0%Y. We are also downgrading our 2010 growth rate to 3.8%Y from 4.7%Y previously.

US and euro zone growth rate forecasts trimmed: Our global economics team lowered its growth rate forecast for the US by 0.5pp to -2.4%Y for 2009. The real growth rate for 2010 has been revised up marginally to 2.1%Y from 2.0%. Similarly, our European economics team downgraded its 2009 growth estimate to -1.6%Y from -1%Y previously. Clearly, these downgrades are likely to have a meaningful impact on Turkey’s growth prospects, mostly via the exports channel as well as through the possible limitations on investment originating from these regions.

Industrial production plummeted in November: Starting last August, the IP growth rate turned negative and has been so since then. However, the -13.8%Y figure in November, on top of an already weak figure posted in October, was reminiscent of the production picture of 2001. Especially in certain sectors such as automotive production, the cumulative production cuts reached some 43% since July 2008. Considering that this sector in particular had been a driving force of exports, the impact of this on growth and unemployment could be substantial. A dismal textile production picture has been lingering for quite some time and, despite a marginal improvement in currency competitiveness in recent months, there has been no visible improvement in production numbers. We suspect that the picture is likely to get worse on production, especially during 1Q09, before improving gradually in 2H.

Capacity utilization near all-time lows: At 65.2%, the private sector capacity utilization rate in December was the second-lowest print since 1999, only 3pp short of the level witnessed during the financial crisis of 2001.

In the past three months, both official and anecdotal evidence suggested that many production facilities had been shutting down for maintenance with the intention of lowering their inventory levels amid a lack of domestic and/or foreign demand. The practice seems to have been adopted by various companies and, while some production has resumed in January, a number of factories are still in recess. Hence, it would not be surprising to see weak CU data for most of 1Q09. Similar to the case in industrial production, we note that the drop in CU is fairly broad-based across various sectors.

Weak consumption, investment and net exports: Weak consumer sentiment, high interest rates, rising unemployment and the abundance of uncertainties associated with the duration of the ongoing challenges naturally lead consumers to save. In 2009, we expect private consumption to display a V-shaped behavior, with a rather sharp drop in 1H and some recovery in 2H, spurred by lower interest rates as well as a base year effect. Overall, we think that private consumption could post -0.5%Y growth for the year, after 1.7%Y growth in 2008. Despite the expected enactment of tougher fiscal spending rules as part of the anticipated IMF stand-by arrangement, we expect the government sector to contribute positively to overall growth in 2009, especially during 1H. We expect almost no positive developments on the investment front and anticipate a negative growth rate. Lastly, we envisage that both exports and imports will shrink in 2009, with only a marginal positive contribution to growth from net exports.

Monetary easing should help, but not enough to steer the economy away from recession: The negative growth rate in 2009 and the recession would be the first since 2001, when the economy contracted by 5.7%Y on the back of a banking sector crisis. Following a 6.8% annual average between 2002 and 2007, we expect growth to ease to our new forecast of 1.4% in 2008 (previously 2%Y). As a response to very weak domestic demand, the widening output gap and the lack of external demand (all factors which are likely to lead to a noticeable decline in inflation), the CBT has started to ease monetary policy.

We expect the monetary easing to continue in 1H09 such that the policy rate could decline to a record-low level of 12.5% and even less. However, given very weak consumer sentiment and the likely adverse impact of external demand weakness, we do not expect the economy to show significant signs of revival until later in the year.

Revising Down Our C/A Deficit Forecast

Balance of payments data for November pointed to a current account deficit of a mere US$559 million, which was not only half the consensus estimate but also the lowest monthly print in three years. Assuming that no major trend change had occurred in December, we would expect the 2008 current account deficit to have reached slightly less than US$42 billion – a figure nearly US$7 billion lower compared to our full year forecast. Based on the recent trends of exports and non-energy imports, as well as the decline in commodity prices, we are lowering our 2009 current account deficit forecast to US$17.9 billion, which is associated with around 2.5% of GDP. Compared to our most recent note on external financing, when we assumed a current account deficit of US$30 billion (see Turkey Economics: External Financing in 2009: How Much Is Needed? November 26, 2008), we are even more confident that Turkey will be able to close the financing gap in 2009 with a decent IMF package in place.

The adjustment has been sharper than expected: With lower commodity prices at hand and the anticipated slowdown in domestic demand, a contraction in the current account was expected, but the adjustment had been rather sharp in November. While exports eased below the US$10 billion mark, imports hit a 20-month low of US$11.4 billion. Not only the energy component but also the non-energy portion of the current account displayed a sharp improvement in November. On a 12-month rolling basis, the current account deficit declined to US$44 billion, while the current account excluding energy was in a surplus at around US$3 billion. This is yet another indication of the pace at which the economy has been responding to the global downturn, and unfortunately a reflection of the dismal picture on the manufacturing side.

There have been some interesting points regarding the financing of the current account: In November, foreign direct investment amounted to US$569 million and was one of the lowest figures of 2008, bringing the year-to date figure to some US$13.7 billion. We expect the full-year figure to hit around US$14.5 billion in 2008 but then decline to US$10 billion this year. Interestingly, foreigners’ real estate purchases seemed to have continued in November and brought the cumulative year-to-date figure to US$2.8 billion. Compared to an outflow of US$4.5 billion in October, portfolio investment posted an outflow of US$0.9 billion in November, bringing the year-to-date figure to US$4.9 billion. Finally, the non-bank private sector seemed to have continued to utilize credit from abroad, albeit a lower amount such that the net funding (net of debt redemptions) was nearly zero. In fact, the private sector external loan usage had been the lowest since January 2007.

Net errors and omissions to the rescue: In October, the net error term was a massive US$7.6 billion, which was inflated further by November’s US$2.2 billion, leading to nearly US$10 billion of unaccounted ‘inflow’ of foreign currency in just two months. While the size of this was quite large, on a 12-month rolling basis the figure was merely US$1.9 billion, which should not distort the data a whole lot. That said, the CBT had made comments indicating that it would be working further to explain the origin of the error, although the initial explanation was based on sharp currency movements, some inflow from residents’ deposits abroad and possibly some unrecorded FX transactions entering the system. At any rate, the error term helped the financing to a significant extent.

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