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Russia All About Oil Global Credit Confusion South Africa Ushering in the New CPI Basket View GEF Archive

		The Global Economics Team

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Morgan Stanley Oil Forecast Suggests RUB Floor May Break in 2Q

Expectations of RUB devaluation have been highly disruptive of the real economy, and look likely to resume in the next few months.  The CBR’s new floor for the RUB at 41 on the 55% USD, 45% EUR reference basket is intended to hold at least until oil approaches US$30 for an ‘extended period’.  We still expect this floor to hold in 1Q, and would expect some near-term profit taking on long USD positions.  FX reserves are so far still adequate to deliver on the promise to defend the band, and we expect the CBR to deliver further administrative restrictions and liquidity squeezes, likely taking the overnight refinancing rate to at least 15% − still very modest in real terms.  The current account is seasonally strong in 1Q and still benefits from lagging high gas prices.  We are less confident that the floor can be sustained for longer, however.  Our own current account estimates suggest that, with Urals at $40 and trading partners outside the basket devaluing fast, equilibrium on the basket may already be around 44 – see Assessing RUB fair value below.  Morgan Stanley's Hussein Allidina sees Brent averaging US$35 in 2009 (see The Global Engine, Stalled and Flooded, February 2, 2009).  As oil demand continues to decline, he expects a dip to US$25 in 2Q before serious production cuts are triggered.  In this, our central case, the current basket floor is clearly unsustainable, with market participants likely to extrapolate the fall beyond US$25 and intensify speculation.  At US$40 on Urals, the implied current account deficit would be small and could potentially be absorbed by reserves.  However, given the lack of CBR independence and intense political pressure for easier RUB funding, it seems unlikely to us that the necessary monetary tightening can be sustained.  President Medvedev and Moscow Mayor Luzhkov among other senior officials have publicly pressed for lower interest rates.  Even Governor Ignatyev suggested when the RUB floor was set that rate cuts were not far off.  Much of the banking sector remains fragile, accustomed to exceptionally low rates over the past few years of surplus liquidity.  Sberbank’s current 10% rates on one-year fixed term RUB deposits remain far from compelling.  The Bank’s administrative controls on commercial banks’ use of funds may prove only temporarily effective if past experience is a guide.  We continue to see a free float as unlikely, the overshoot that it would imply being damaging both financially and politically.  However, if forced by reserve losses to widen the band, the CBR will have to set a significantly lower floor, potentially allowing an overshoot to around 44 on USDRUB in mid-year.  If we are correct in anticipating an oil price recovery driven by supply cuts in 2H, we would expect the RUB to appreciate within the band to around 43 to the basket, 36.6 on RUBUSD given EURUSD at 1.40, by end-2009. 

Assessing RUB Fair Value

Inevitably, RUB valuation involves a wide range of uncertainty.  Morgan Stanley’s Spyros Andreopolous has run a range of ten fair value models from PPP to real interest differentials, giving a range for RUBUSD of 20.85 to 38.91 (see FX Fair Values: Look to EM for Opportunities, January 30, 2009).  However, the price of econometric consistency is the use of 3Q08 data.  The CBR has been focused on finding a level that would balance the current account in 2009, currently assuming Urals at US$41.  The 4Q current account surplus was only US$8 billion, with December’s trade surplus the lowest since 1998 even before gas export prices have fully adjusted downwards.  We still estimate that at 2008’s average exchange rate, the current account would balance with Urals around US$65, with a US$10 fall in oil prices directly cutting around US$35 billion from export revenue.  However, the challenge of balancing this with import reductions becomes increasingly difficult as regional trading partners devalue their own currencies.  Russia’s range of trading partners differs significantly from the RUB reference basket – the CBR estimates a 9.8%Y RUB decline against the basket in December was equivalent to a 3.8% decline in the nominal effective exchange rate over the same period, even before Belarus and Kazakhstan’s devaluations.  30% of the trading basket has devalued sharply against the USD, on average by 45% since mid-2008.  Conservatively, we estimate a 10% depreciation against the basket is needed to keep the trade-weighted exchange rate stable.  Assuming a high price elasticity of imports (around 0.8), consistent with the sharp falls in imports already seen, and flat income, to compensate for the impact of a US$10 oil price fall on exports needs 15% RUB depreciation, from the 30.08 average in 2008.  At US$35, the fair value of the basket under these assumptions is around 46.6, at US$45 42.1, at US$25 51.1.  Risks to most of our assumptions here, particularly on import elasticity and on export volumes (which we assume flat), appear on the weak side for the RUB.  Our forecasts are slightly stronger than our fair value estimates on the assumption that CBR support continues. 

Capital Account Pressure for Depreciation Still High

Even if RUB adjustment is sufficient to balance the current account in 2009, the CBR will continue to have to absorb outflows on the capital account.  We do not think that the recent pace of reserve loss is likely to be sustained. The US$130 billion of net private capital outflows in 4Q accounted for more than all previous total inflows.  Long USD positions are already substantial.  Presidential advisor Dvorkovich has suggested new measures will be introduced to retain FX; we think a return to compulsory export repatriation is conceivable in the near term.  Meanwhile, Rosneft has completed a US$1.35 billion 15-month secured pre-export loan, the first for a Russian company this year.  Yet outflows are still likely to be significant.  Private refinancing looks realistic mainly for energy exporters or those with state guarantees.  The CBR's own estimates suggest US$120 billion of FX debt comes due in 2009, but tend to underestimate short-term debt and that raised through offshore unlisted vehicles.  Covenant breaches and put options can also accelerate repayments.  Some unfavoured debtors look increasingly likely to be allowed to default, but the government still seems reluctant to risk domestic collateral falling into foreign hands.  Precautionary or speculative outflows can also continue − balance of payments data suggest only around US$50 billion of the 4Q outflow reflected debt repayment.  With property rights still weak and direct investment constrained, capital flight is likely to remain a problem, in our view.  November data show an 11% fall in RUB bank deposits, driven by a 20% decline in corporate RUB deposits.  Some of the corporate deposit outflow reflects FX debt repayment, but more bank failures are likely to test depositor confidence this year.  Overall, we continue to expect capital outflows of around US$200 billion in 2009.  FX reserves so far still look adequate to absorb this.  Including the oil funds, which we still see as available for RUB support, but excluding the FX correspondent accounts of commercial banks, FX reserves are around US$355 billion.  It still looks realistic to us that Russia can lose its sovereign investment grade rating this year − S&P raised Russia to investment grade in January 2005, when the fiscal surplus was at 4.1% of GDP, FX reserves were at US$120 billion, above total external debt, and on a rapidly improving trend.  In a bear case scenario, reserves could dip as low as US$100 billion, at which point we would expect the authorities to tolerate a free float, a RUB overshoot and explicit capital controls as a lesser evil than risking the humiliation of applying for international support.  Even in our oil bull case, upside for the RUB is likely to be constrained by pressure to rebuild reserves. 

Budget Fundable for Now but Little Stimulus

Lower oil prices have particularly extreme implications for the fiscal position, given both high dependence on oil taxes, and that revenue from these taxes falls more sharply than oil prices.  With Urals at US$35, we estimate oil tax revenue would fall around 75% from 2008 levels.  Clearly, the oil reserve funds still allow a degree of freedom on budget spending not available to some other emerging markets.  However, hopes for significant continuing fiscal stimulus and tax cuts seem misplaced to us.  The December 2008 federal budget deficit was an extraordinary 21% of monthly GDP, with federal revenue down 33%Y and spending up 54%Y − a clearly unsustainable divergence.  The 2009 federal budget, currently under revision, assumed a 3.7% of GDP surplus with Urals at US$95.  The Finance Ministry most recently estimates a 6.1% of GDP deficit, based on oil at US$41, real GDP down 0.7% and inflation around 13%.  This assumes spending at, RUB 9.025 trillion, the same level as originally planned, despite new spending commitments of around RUB 1.1 trillion and already announced tax cuts worth RUB 0.95 trillion.  The Ministry has so far cut RUB 0.48 trillion from federal investment spending and plans to cut another RUB 0.5 trillion, but the government shows few signs of being prepared for more serious cuts.  Net fiscal stimulus will be smaller than it seems, but risks to the deficit are also well on the upside.  Regional budgets look in an even more difficult situation, facing a revenue shortfall of at least RUB 1 trillion and having been even slower to adjust spending.  Federal subsidies to the regions will also have to rise to compensate.  Most recently the government has promised a further US$40 billion for bank recapitalisation and US$7.5 billion to support regional allies.  With oil at US$35, the RUB at 39 and a continuing lack of spending cuts, we estimate revenue could fall to RUB 6 billion and the budget deficit can reach RUB 4.5 trillion, 10.5% of GDP.  The Reserve and National Wealth Funds, currently at RUB 4.85 trillion and 2.99 trillion respectively, and also beneficiaries of RUB weakness, can fund this comfortably in 2009.  Limited domestic borrowing is also an option, at the expense of further crowding out credit to the real economy.  However, without a significant oil price recovery in 2H, the government will be forced into aggressive spending cuts and further devaluation, in our view. 

Inflation a Lesser Risk for 2009

Very rapid spending of the reserve funds and rapid depreciation sound like a recipe for an inflation spike.  Finance Minister Kudrin has warned of upside risks to the official 13% forecast, even assuming the RUB floor at 41 holds.  Sberbank chief Gref has been reported by Interfax suggesting that the surge in liquidity around May implied by reserve fund spending could see inflation rising above 20%.  January inflation already accelerated to 13.4%Y.  We continue to see structural inflationary pressure in Russia as relatively high, reflecting weak support for competition and small businesses, and a lack of attractive savings options boosting consumption.  Yet, even given our expectation of further depreciation, we suspect inflation may surprise on the downside in 2009.  Wages in this cycle appear to be adjusting relatively quickly, already down 4.6% in real terms in December, and surveys suggest fears of job losses are very widespread.  Money supply has slowed sharply with FX outflows, M2 growth down to just 1.7%Y in December, and tends to feed inflation with a lag of around 12 months.  While oil has a negligible direct weight in the CPI, administered utility price growth is likely to be restrained both by lower global prices and the Kremlin’s heightened sensitivity to popular protest.  Most importantly, food prices, 39% of the basket, are likely to add significant downward pressure.  Wholesale food prices have been supported in the last month by government purchases, but grain stocks are high for the time of year and prices of wheat, grain and sunflower oil are still down 40-50%Y.  Food imports from Ukraine are unlikely to see price rises given the relative weakness of the UAH, while many other food imports are more likely to be replaced by domestic alternatives.  We see a reasonable chance that inflation dips into single-digits by year-end.  We suspect, however, that such relief will prove temporary.  Risks for 2010 look to the upside, as commodity prices pick up, the government proves slow to withdraw monetary stimulus into a recovery and growing state control further blunts productivity.  

A Devaluation-Driven Growth Rebound Looks Optimistic

While lower inflation would be positive, it is unlikely to imply lower interest rates given the pressure on the RUB, and the outlook for growth remains gloomy, in our view.  With oil at US$35, we cut our real GDP forecast to -3.5%.  With the GDP deflator likely close to flat, we see USD terms GDP contracting by around 18%.  The government’s preliminary 5.6% estimate for 2008 real GDP growth implies there was zero growth year on year in 4Q and a sharp contraction in December.  While it is clear that devaluation expectations have contributed to the drying up of credit and economic activity, we are skeptical of the view that once devaluation is completed, it will trigger a rapid growth rebound, as it did after 1998.  Not only is the external environment much weaker but spare capacity is so far lower, and corporate external debt and reliance on imported raw materials and equipment are higher.  We continue to see capital expenditure as the weakest link, with now even the government planning sharp cutbacks to investment spending.  Although private sector credit growth is still high by international standards, at 35%Y in November, official pressure to lend may prove increasingly ineffective.  The largest state banks (VTB, VEB, Sberbank and Gazprombank) have been ordered to raise lending to the real sector by 2% a month, but with NPLs rising, this may prove difficult for some, even with new capital injections.  Sberbank, relatively immune to pressure given its strong deposit base, earlier reported targeting credit growth only in line with inflation.  Government debt issuance may further crowd out credit.  The main strength of the Russian economy in the current environment is that aggregate leverage is relatively low – we estimate total local and foreign credit amounts to around 85% of GDP.  Household debt amounts to only 11% of GDP, and we continue to see consumption as a relative area of strength.  Rosstat estimates suggest savings rates are falling to smooth living standards.  Yet, even here we now see a 1% real contraction in 2009 as fears of job losses and wage arrears spread.  Surveys suggest downward revisions in household expectations in 4Q were sharp and sudden.  A perception that budget support is weakening may drive a further shift to pessimism. 

Debt Disputes, State Control to Slow Longer-Term Growth

As liquidity recedes, the underlying weakness of Russia’s institutions is also an increasingly evident constraint.  A long period of debt restructuring and related lobbying and uncertainty will hold back any recovery.  Budget and FX reserve limitations do finally seem to be limiting previously extravagant state bailout commitments.  PM Putin’s statements at Davos implied that for now the government plans to continue to refinance most of the foreign debts of corporates and oligarchs that are secured on Russian assets.  However, clearly pressure is growing to become more selective, and at the very least to encourage commercial restructuring talks by raising uncertainty about who can count on the state.  Deputy PM Shuvalov has suggested that the official refinancing programme through VEB may be cut short.  At the same time, Gazprombank’s latest loan to TMK, and generous state bank recapitalisation plans suggest responsibility may be extended to the other three major state banks, to the short-term detriment of the banks involved.  We still see FX liabilities of the state and related companies as well covered in all, but the most extreme oil price scenario and a complete failure of policymaking to respond with depreciation and spending cuts.  Total FX debt of the state and majority state-owned companies stood at US$189 billion at the end of 3Q, of which only US$25 billion was short term (less than one year) by original maturity.  Risks on the domestic debt market are higher, reflecting the difficulties of enforcing creditor rights, collateral and bankruptcy.  The closure of financial markets and reliance on state bailouts also has negative implications for corporate transparency and governance.  Most of any recent improvement was likely driven by capital raising requirements.  The government has indicated its collateral demands in return for its support will become increasingly demanding, leaving the state with large shareholdings.  While this may not prove a bad long-term trade, the temptation to hold on to such assets is likely to prove high and quality of management and capital allocation may deteriorate further. 

Fears of Political Unrest Look Exaggerated for Now

While political unrest is a serious risk now in much of eastern Europe, we do at least think reports of instability in Russia look exaggerated.  Budget cuts and the widespread realisation that recent improvements in living standards will at least be interrupted will undermine the government’s popularity, but its political capital remains relatively high.  Levada Institute polling data in January show a 16pp fall to 43% in the share of the population who think the country is ‘heading in the wrong direction’, but the government is not yet seeing much of the blame for this, and there is a widespread sense of little alternative.  Although the authorities show signs of nervousness, a serious challenge to the regime still looks unlikely to come from popular protest, unlike elsewhere in eastern Europe.  A more serious risk remains that from tensions within the ruling group.  Recent weeks have seen unusual overt signs of disagreement between PM Putin and President Medvedev on personnel, legal and economic policy, with the President notably appearing more flexible on the RUB.  The PM’s popularity is still higher than the President’s but has begun to fall more quickly, it being harder for a PM to pass on responsibility for policy mistakes.  Until now, Putin’s personal authority has been an important brake on overt struggles within the elite.  A significant weakening in that aura could begin to raise the risk that such struggles again begin to spill out of control.  With many of the most powerful of the elite also humbled by the financial turmoil, we are still some way from this becoming a major risk.  Clearly, the absence of a recovery in oil prices by late 2009, prompting a further wave of budget tightening and devaluation, will weaken the government, but regime change is still far from our central case.

Global
Credit Confusion
February 06, 2009

By Joachim Fels & Manoj Pradham | London

Does Money Matter?

We recently argued that the pick-up in money supply growth and the related nascent turnaround in our favorite excess liquidity measure should help to support asset markets, end the recession later this year and prevent lasting deflation (“A New Global Liquidity Cycle” The Global Monetary Analyst, January 14, 2009).  This view has met with much interest among our readers, but also with much disbelief. 

Many Think Credit Matters More

A frequent response has been that a pick-up in economic activity and asset prices not only requires rising money supply but also accelerating credit growth. But credit growth is unlikely to accelerate as banks are deleveraging, and hence the economy and asset markets are unlikely to recover, or so the story goes. This sounds intuitive, and it is unsurprising that after the bursting of the mother-of-all-credit bubbles, everybody is focused on the importance of credit.

The Evidence Suggests Otherwise

However, in our view, the story still gets the sequencing and the causality the wrong way round.  Banks, in their lending activities, have rarely ever been leaders in economic or market cycles, but are usually followers. Credit growth can be a powerful accelerator in economic expansions and usually kicks in strongly in later phases of the upswing, but it rarely leads markets or the real economy on the way up.  Put simply, the statement that there can be no recovery or pick-up in asset prices without a prior or coinciding pick-up in bank lending flies in the face of the available evidence.

Credit Crunches Last Longer Than Recessions

One way to underscore our point that credit growth lags in recoveries is to look (again) at the impressive work done by Stijn Claessens, M. Ayhan Kose and Marco E. Terrones on “What Happens During Recessions, Crunches, and Busts” (IMF Working Paper 08/274, December 2008).  The paper distills the empirical regularities of no less than 122 recessions,  112 credit contractions, 114 episodes of house price declines and 234 episodes of equity declines in their various overlaps for 21 OECD countries over the period 1960-2007.  The most relevant finding in our context is that the episodes of contracting credit usually last longer than the recessions that accompany them.  If a recession is associated with a credit crunch, it typically starts 4-5 quarters after the onset of a credit crunch.  Thus, credit crunches lead economic recessions.  However, recessions in the OECD countries typically end two quarters before their corresponding credit crunch.  As the IMF paper notes, this phenomenon of a “creditless recovery” is also evident from “sudden stop” episodes observed in emerging market economies.

The same conclusion emerges from our illustration, which shows US credit growth since 1947 and the recession period.  Credit growth usually peaks before the onset of recessions, but – at least since the mid-1970s – it troughs only after recessions have ended.

Money Leads Recovery, Recovery Leads Credit

We have also employed the statistical-econometric tool of impulse-response functions to shed more light on the empirical relationships between US money supply, credit and the real economy, where we use the ISM manufacturing purchasing managers survey.  Constructing an impulse response function is a two-step process. First, an estimate of how past values of money supply growth, credit growth and the state of the economy affect each other is generated (within a ‘vector autoregression’, in technical terms). Then, using the estimates, the model is able to show how a shock to any of the variables affects the others, i.e., how other variables in the system respond to an impulse/shock to one of the variables in the system.

In a nutshell, we find that while the ISM does not respond significantly to shocks to real credit growth, the latter does respond to shocks to the ISM.  So, again, we find that credit lags rather than leads the economic cycle.  Conversely, we find some evidence that real M1 growth leads rather than lags the ISM.  And, logically against this backdrop, we also find that money supply growth leads credit growth.  

Look at Money, Not Credit

Taken together, the empirical evidence is clear: if one is looking for a leading indicator of economic recovery, look at money, not credit.  Credit crunches tend to lead recessions, but they lag recoveries.  Right now, money supply growth is accelerating while credit is slowing.  We continue to believe that the acceleration in money supply growth and excess liquidity foreshadows an economic recovery later this year.  Eventually, the recovery in economic activity and asset prices, along with on-going balance sheet repair in the banking system would then end the credit crunch and lead to a pick-up in bank lending, in line with the typical sequencing.

To conclude, if one is waiting until credit growth resumes, one will miss both the pick-up in economic activity and the recovery of asset markets.

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South Africa
Ushering in the New CPI Basket
February 06, 2009

By Michael Kafe & Andrea Masia | Johannesburg

Statistics South Africa published the long-awaited rebased and re-weighted CPI series on February 3. According to the new, rebased series, South Africa’s target inflation rate averaged some 7.7%Y in 2008. This was slightly lower than our estimate of 8%Y. The lower 2008 base, together with a higher-than-expected increase in the domestic regulated fuel price this month, has lifted our annual 2009 profile from 5.3%Y to 5.8%Y. Importantly, however, we still have CPI falling below the top end of the target band by June/July 2009, although it now bottoms out above the mid-point of the target band by the close of 3Q09. And, whereas we initially had a clear breach of the upper end of the 3-6% target band throughout 1Q10, we now have an average quarterly reading of 5.9%Y in 1Q10, comprising monthly readings of 6.0%Y, 5.8%Y and 5.8%Y for January-March, respectively. However, our end-2010 reading still comes in around 5.5%Y, which is higher than the SARB’s most recent forecast of 5.3%Y.

Despite the higher inflation trajectory, we note that most of the deterioration is at the front end of the inflation profile and is likely a result of technicalities associated with the re-weighting exercise. What’s more, although we still see inflation rising in 1Q10, we now believe it is unlikely to breach the upper end of the target band. This is particularly important, as it will be the first time since April 2006 that the inflation trajectory shows targeted inflation remaining within the target band throughout the policy horizon. We therefore stick to our view that the SARB is likely to front-load policy easing into 1H09, with interest rate cuts of 100bp at its February and April meetings, followed by 50bp in June.

Limitations of the New Index

The newly-published re-weighted and rebased series provide a good set of history from January 2008. But there are still a number of limitations with the new data set. First, although all the headline indices were provided, a number of sub-indices with a combined weight of 3.05% were omitted in the data release. These include cleaning products, take-away catering services, household appliances, glassware & gardening tools and other recreational items. Second, the fact that a longer history is not available makes it impossible to calculate a truly comparable annual inflation rate and also limits one’s ability to do any meaningful modeling of the new set of data.

Differences Between New and Old Sub-Indices

There are also a number of important differences between the new indices and previously published data. First are the differences in survey periods: for example, while the old series surveyed domestic worker costs in February and September, the new series carries out a quarterly survey in March, June, September and December. Also, while rentals were initially surveyed in the first month of the quarter, they will now be surveyed in the last month of the quarter. This may have significant implications for the annual inflation rates in the affected months, given that rentals have a high 3.5% weighting and are also quite volatile. It also appears that owner equivalent rent (12.21% of the index) will be surveyed in the first month of each quarter and not the last month of the quarter. Finally, the timing of the Medical Services survey has been moved from January to February. A second important difference is the changes in the monthly inflation rates: here, we note that the huge surge in vehicle prices earlier reported for the month of September has now disappeared, presumably because of the inclusion of used vehicles.

Also, the new public transport index now shows a 10.4%M jump in transport costs that was not reported in the old index. Finally, the momentum in food prices appears to be a little softer in the new index.

Looking Forward

Given the limitations (and the differences) in the new index, we acknowledge that there is significant forecast risk to our 2009 inflation estimates. To begin with, our January 2009 forecast of 7.5%Y is not much more than an educated guesstimate, as it is impossible to gauge the monthly momentum in the new index, given the absence of December 2007 data. And even though the latter limitation disappears during the remainder of the year, the fact that there is only one year’s worth of data makes it impossible to distinguish between permanently embedded seasonal movements and one-off anomalies in the monthly readings.

As far as policy action is concerned, however, we stick to our call for 100bp of easing in February and April, followed by a 50bp cut in June. It is important to note that, although our inflation profile is slightly higher than before, the trajectory still shows that a) thanks to the rebasing and re-weighting exercise, the targeted inflation index is likely to drop by as much as 280bp in January 2009; b) targeted inflation is likely to fall below the upper end of the 3-6% inflation target band by June/July; and c) inflation should still rise in 1Q10, but is now unlikely to breach the upper end of the target band. The final observation is particularly important, as this will be the first time since April 2006 that the inflation trajectory shows CPI within the target band throughout the forecast horizon. We believe that this will give the SARB enough comfort to accelerate the pace of rate cuts to 100bp.

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