Growth Black Swan
February 19, 2009
By Marcelo Carvalho | Sao Paulo
Brazil’s recent growth collapse can be described as a statistical ‘black swan’, as it sits in the extreme left-hand side of Brazil’s historical frequency distribution. The plunge is so rare that it is unlikely to repeat. There are signs of some relief in early 2009, but beware of false dawns. Policy support should help to cushion the blow, but powerful headwinds will likely cap the eventual recovery. Three headwinds still threaten Brazil’s outlook: global recession, worsening labor markets and tight credit conditions.
Black Swan or Sitting Duck? The black swan theory refers to a large-impact and rare event beyond the realm of normal expectations. Rare events do occur, more than most dare to think. Human thinking is often limited in scope, and we make hypotheses based on what we see, know and assume from past experience. Reality, however, is much more complex and unpredictable than is often realized. The growth collapse in 4Q08 can be described as a black swan event. Many indicators in Brazil during the last quarter displayed the worst decline on record – ranging from paperboard sales and car production to heavy vehicle traffic and business confidence (see “Brazil: Growth Collapses”, EM Economist, January 23, 2009). Brazil’s industrial production in December fell the most ever, in 17 years of IBGE recordkeeping. Industrial production was down 12.4%M and 14.5%Y. In both comparisons, this was the worst decline on record. In fact, the 12.4% monthly decline stands more than five standard deviations away from the historical monthly average gain of 0.2%. Such extreme outcomes sit in the very far left tail of the statistical frequency distribution. It is thus no exaggeration to describe it as a black swan event. The second-worst monthly decline was an idiosyncratic one-off plunge in May 1995, when an oil workers’ strike temporarily pulled output down. There has been no shortage of crises in Brazil’s history, but the magnitude of the recent growth slump beats them all. December’s collapse in industrial production came on top of weakening in October (-1.4%M) and November (-7.2%M). The cumulative decline of 19.8% in those three months is also the worst ever in Brazil’s records. Brazil’s growth collapse is not unique among emerging markets, but the U-turn from previous recent expansion is striking, given Brazil’s strong growth performance until not long ago. Indeed, 4Q in general – and December in particular – was bad for growth across the globe. Several EM countries posted sharp declines in industrial production last December. Sharp as it is, Brazil’s December industrial production plunge was not the worst among emerging economies. What is striking, however, is the U-turn in Brazil’s growth performance. Brazil’s industrial production expansion through September last year had been one of the strongest across emerging markets, not far below China’s pace. The sudden turnaround in Brazil’s growth trend is impressive. Likewise, sequential real GDP growth likely took a sharp downturn during 4Q08. The number should be released on March 10 – just a day before the upcoming monetary policy meeting. After growing at an average sequential pace of 1.7%Q (not annualized) during the first three quarters of the year, Brazil’s real GDP growth looks set for a sequential decline in the range of 2-3%, or perhaps even weaker. We assume -2.5%Q in the last quarter. This is not annualized. The annualized rate of contraction would be around 10%, after average annualized expansion of 7% before. If it materializes, such a decline would stand more than two standard deviations away from the historical average sequential quarterly real GDP gain (of 0.9% not annualized, or 3.6% annualized). There are signs of some relief in early 2009. Brazil’s car output rebounded 92.7%M in January from extremely depressed levels in December, in part helped by seasonal factors. The annual comparison was still -27.1%Y. Sales also recovered 1.5%M but were off -8.1%Y. Despite a more competitive currency, global recession is pulling car exports down: -48.1%M, or -60.5%Y. But don’t get carried away. January’s domestic recovery reflects a tax break on domestic car sales, some normalization of credit conditions and payback from a strong effort to trim automobile inventories in December. However, the tax break on domestic sales expires at the end of March; while renewal seems probable, it is unlikely to provide much of an additional boost. The underlying outlook for demand fundamentals remains discouraging. Automobile inventory correction looks advanced, but not complete. Official data from Anfavea show that total vehicle inventories declined by 18,000 units in January, to 193,000 – after a peak of 305,000 in November. Carmakers have made a strong effort to cut back their excessive inventories. The inventory correction in the automobile sector now seems advanced, but not complete. Keep in mind that this sector is shifting to a much lower operating level in 2009. For 2009 as a whole, the automobile sector could easily see a downturn of about one-third from last year (see Autos & Auto Parts: Brazilian January Sales: Stimulus Spurt Won’t Last by Adam Jonas, February 10, 2009). Evidence from other sources suggests that the broader inventory adjustment in industry in general is far from over. For instance, a survey from Fundação Getulio Vargas shows that the share of companies reporting ‘excessive inventories’ has actually risen to a recent peak of 21.8% in January, from single-digit readings in recent years. Watch out for head fakes. False dawns are common in recessions. Don’t be fooled by the data, and don’t confuse temporary relief with a sustained growth recovery. Car data support the view of a sequential rebound in industrial production in January, possibly in the range of 5-10%M. But this comes after a record-large decline in December. The year-on-year comparison will remain in negative territory, probably still showing a double-digit decline. Sequential monthly recovery will not take industrial production back to the high levels seen before October anytime soon, in our view. Sequential real GDP growth will likely be negative again in 1Q09. Look at industrial production: even with sequential monthly recovery during 1Q, the average industrial production level in 1Q09 looks set to remain below the average level seen during 4Q08. Sequential quarterly growth thus will likely prove negative in 1Q, although less negative than in 4Q08. Going by the conventional definition of recession as two consecutive quarters of negative growth, we believe that Brazil is already in the middle of a technical recession. Our 2009 forecast assumes growth recovery in 2H09. Our quarterly sequential real GDP growth profile currently foresees outright declines in 4Q08 and 1Q09, a flat reading in 2Q09 and a return to positive figures in 2H09, supported by policy stimulus. The year-on-year growth comparison will plunge from a 6.8% peak in 3Q08 all the way to negative territory by mid-2009. We reaffirm our long-standing, below-consensus view on growth. Brazil’s downturn is proving much deeper than most have been ready for. We continue to look for zero growth in 2009 as a whole. We found very little sympathy when we slashed our already below-consensus 2% growth forecast all the way to zero last December. But the market consensus continues to move steadily, as the notion of zero growth gains increasing acceptance among competitors. Our zero growth forecast can soon start looking optimistic. The growth plunge in 4Q08 will easily erase any previous positive statistical ‘carryover’ for 2009. In fact, the carryover for 2009 will likely prove outright negative. Simple extrapolation of recent trends produces growth outcomes much worse than our zero growth forecast for 2009. We should not simply extrapolate – and our forecast does not do that. We are on the record looking for growth recovery later in the year. The problem is that the starting point for growth in 2009 is much weaker than observers have assumed. In sum, don’t just extrapolate recent weakness, but don’t be fooled by false dawns either. What are the downside risks to our growth forecast? What can go wrong? Looking ahead, three headwinds can dampen the prospects for growth recovery later in the year. Headwind 1: Global Recession Beware of Asian aftershocks. Analysts in the ‘decoupling’ camp, if there are any left, would argue that Brazil is a closed economy, and therefore less sensitive to international developments. In our view, however, Brazil’s economy is much more sensitive to the global picture than observers often realize. For instance, there is a strong (if overlooked) historical correlation between Brazil’s industrial production and China’s total exports (see “Latin America: The Asian Aftershocks”, EM Economist, February 13, 2009). China’s exports fell 17.5%Y in January, worse than market expectations. Looking ahead, our China economist Qing Wang looks for year-on-year export declines in 1Q09 to be even deeper than those seen in 4Q08, indicating continuing deterioration in underlying fundamentals amid the deepening global recession (see China Data Releases: January Trade Plunges as Expected on CNY Effect, February 11, 2009). The global environment is key. We suspect that the links between Brazil and China go beyond the obvious trade channel of Brazil’s bilateral exports of commodities such as soybeans and iron ore. We suspect a third factor – namely, global growth – is a key driver behind the strong empirical link between Brazil and China. Through a variety of channels, the years of global abundance after 2003 provided strong support for China’s exports as well as for Brazil’s growth. The end of global abundance now pulls down both. Indeed, Brazil’s real GDP growth performance is more closely linked to growth in the OECD economies than analysts normally think. Protracted global recession remains a risk, if the global recovery expected for later in 2009 proves elusive. While the near-term weakness has already become clear in the data, a 2H recovery remains a forecast at this stage. That is, global recovery is coming, but it might take longer to materialize (see Richard Berner’s US Economics: Recovery Coming but “Back-Loaded” Stimulus Means Weaker Near-Term Outlook, February 9, 2009). Global growth forecasts have been cut back repeatedly over the last several months. The IMF has cut back its 2009 global growth forecast to 0.5% in its latest WEO update (as of January 28), confirming a pattern of steady downward revisions, after years of systematic upward revisions. Is the forecast cutting cycle over? The Morgan Stanley global economics team has already cut the global growth forecast to slightly below zero, but downside risks exist. Further global cuts into negative terrain cannot be ruled out, if individual country forecasts are marked down yet again. Last in, last out? Brazil has been late to join the global downturn. Brazil’s domestic policy response should help cushion the blow and avoid deeper recession. But sustained growth recovery in Brazil seems unlikely to truly take place much before the global economy finds firmer footing. There is typically a time lag between growth in OECD economies and growth in Brazil of about one quarter. If history is any guide, there could be downside risks regarding the strength of the expected second half recovery in Brazil. Headwind 2: Labor Markets Labor markets can fuel an important feedback loop. Labor markets typically lag behind the business cycle. The historical lag in Brazil seems about a quarter or so. As unemployment rises and wage earnings suffer with the growth downturn, then consumer confidence will weaken, and private sector consumption will wobble. The days of steady labor market improvement are over. Brazil’s unemployment rate had fallen steadily in recent years of fast growth, from a peak above 12% in 2003 all the way to an average of 8% last year. This may look high by historical international standards, but it is as low as it gets in Brazil’s recent history. Helped by seasonal factors, the headline unemployment rate fell to a multi-year low of 6.8% last December. Brazil is in the early stages of labor market deterioration. The unemployment rate is set to jump from an 8% average in 2008 to about 10% on average in 2009, on our estimates. On top of the underlying deterioration in lagged response to the growth recession, seasonal factors should also help push the headline unemployment rate sharply up by mid-2009, starting already in 1Q09. Formal jobs are hit hard. There has been a steady migration from the informal into the formal sector over the last several years of fast economic growth. But growth recession should slow, if not unwind, this process. Recent data on formal jobs already send worrying signs. According to Labor Ministry data on formal jobs (CAGED), headline net formal job losses reached nearly 655,000 in December alone. This is the worst figure since the start of the series in 1999, and almost twice as bad as seasonal factors alone would dictate. Indeed, once seasonally adjusted, net formal job creation turned outright negative in December for the first time in about a decade. Industrial jobs were hit the hardest, but firing was broadly based across the economy. Given the high costs of firing and hiring formal workers, recent massive dismissals suggest that employers fear the downturn will be more than just a temporary hiccup. Worsening labor markets will likely take a toll on consumer confidence. Business confidence in recent months has already posted the sharpest decline on record. By contrast, consumer confidence has weakened by much less, but this can be expected to change, with a lag. Amid rising unemployment, faltering wage gains and mounting job insecurity, subsequent weakening in consumer confidence is set to eventually hit consumption too. Headwind 3: Tight Credit To be sure, Brazil is in better shape than ever before to weather the global storm. If the current global recession had hit the region five years ago, then market and economic consequences would surely prove much more severe than now. Brazil arguably also has more cushions today than many in the emerging market space do to face the global downturn. To begin with, Brazil has a viable banking system. This means that credit channels should be less clogged than elsewhere around the globe, and monetary policy easing therefore should have some traction. Brazil’s credit market is not fully clogged, but seems partially obstructed. We are not arguing that monetary policy does not work in Brazil. It does. But we suspect that its traction could prove less powerful now than in other episodes. After all, Brazil faces a tight credit market environment. Credit expansion is now slowing after years of fast growth, as banks adopt a more cautious approach. And while the policy interest rate is coming down aggressively, spreads for final borrowers are actually widening. This is understandable, given the inevitable prospective increase in delinquency rates, as the economy weakens and unemployment rises. Crucially, credit tenors are shrinking, as banks seek to reduce duration in their loan portfolios. A key ingredient of the credit-boosted consumer expansion of recent years was the steady lengthening of domestic loans. This is critical for the average Brazilian consumer, who typically has little idea of the cost of money but instead cares about whether the monthly installment fits the pocket. As the average length of loans now shortens, monthly payments start becoming too big to fit consumers’ shrinking budgets. Discretionary spending is likely to suffer the most. Taking into account our macro forecasts, our retail sector analyst Lore Serra suspects that growth in the sector will decelerate to the slowest pace since 2003 (see Brazil Retail: How Much Deceleration in 2009? February 12, 2009). While grocery sales should hold up, non-food discretionary items can be expected to suffer. Sales of credit-sensitive, discretionary, big-ticket items will probably take the biggest hit – ranging from household appliances to automobiles. Bottom Line Brazil’s recent growth collapse is a statistical ‘black swan’ – it sits in the extreme left of Brazil’s historical frequency distribution. The plunge is so rare that it is unlikely to repeat. There are signs of relief in early 2009, but beware of false dawns. Policy support should help cushion the blow, but three powerful headwinds can cap the eventual recovery: global recession, labor market deterioration and tight credit markets.
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In a League of its Own
February 19, 2009
By Luis Arcentales | New York
In the aftermath of the central bank’s unprecedented 250bp interest rate cut on February 12, Chile watchers began to wonder whether the peso would sell off. Instead, the currency strengthened sharply by more than 2% the following day, and the stock market even gained modest ground. At first sight, the peso’s immediate rally may seem odd: after all, Chile’s central bank has been the most aggressive in the region, slashing rates by 350bp since January to 4.75%. However, we see the peso’s move as a welcome sign of market differentiation in favor of Chile’s superior fundamentals (see “Chile: Time to Shine”, EM Economist, November 28, 2008). Global economic and financial woes, rather than country fundamentals, have prevailed in the sell-off in Latin American markets. Throughout the region, stock markets have posted sharp losses, currencies are significantly weaker and sovereign CDS spreads wider. Meanwhile, from Chile to Brazil and Mexico, the downshift in economic activity in the final quarter of last year was severe in both magnitude and speed. While no market has been spared, Chile has outperformed on many fronts. From its 2008 peak, Chile’s stock market is down just 16%, less than half the losses posted by Brazil and Mexico in local currency terms. This picture of outperformance, to different degrees, has repeated itself on both the currency and sovereign debt fronts as well. Given its superior fundamentals and proactive policymaking, markets have been rewarding Chile. And with the globe in the midst of a severe downturn of uncertain depth and duration, this differentiation seems well justified, in our view. Whether we focus on Chile’s fiscal position – fiscal assets equivalent to 15% of GDP at the end of 2008 – its proactive policymaking or sound regulation, Chile seems to be in an enviable position to engineer a normal cyclical downturn. Indeed, Chile has not been plagued by many of the pressure points that have afflicted the region: relatively currency weakness has not led to any high-profile corporate casualty, nor has it complicated policymaking, as reflected by the central bank’s aggressive monetary easing. Monetary Prowess No central bank in Latin America has been more aggressive in slashing interest rates as Chile’s. Since its first cut on January 8, the authorities have slashed rates by 350bp, essentially taking back, in a matter of five weeks, the cumulative 325bp of tightening that took place between July 2007 and September 2008. The unprecedented magnitude of the recent easing, which has caught markets off-guard, is remarkable, given how much criticism the central bank received last year for its decision to accumulate reserves starting last April and for its handling of the surge in inflation, which as of January was running at an annual rate of 6.3%, off from its 9.9% October peak, the highest rate in 14 years. But with inflation expectations improving and inflation already turning lower, the central bank has proactively reacted to cushion the sudden deterioration in economic activity of late 2008. Indeed, the authorities’ actions are encouraging as they show that relative currency weakness – the peso is currently hovering near 590, much weaker than the 430 level reached last March – has not compromised their ability to ease policy assertively. Not only has Chile’s central bank been the most proactive in the region, but Chile is the only major economy where rates cuts are likely to gain traction in cushioning the external shock. In the past, we have warned against overplaying the impact that monetary easing could have on economic activity in the region (see “Latin America: Easing Cycle Begins”, EM Economist, January 16, 2009). However, Chile has by far the deepest financial channel in the region, with credit approaching 80% of GDP, about twice the level of Brazil and nearly four times Mexico’s. Importantly, the central bank’s actions seem particularly relevant given the severe tightening in bank lending standards to large businesses, SMEs and consumers over the course of 2008. Indeed, lower domestic rates – in a context of more limited external financing and cautiousness among local banks – have sparked a meaningful increase in domestic corporate issuance, which has allowed companies to successfully refinance debt, fund working capital and finance new investments as well. The local capital market in Chile has been put to work in cushioning the global credit crunch. Last November, a major pulp and paper producer re-opened markets by successfully placing over US$200 million in debt. In January alone, Chile’s state-run oil company sold over US$300 million in bonds domestically, a large retailer placed debt worth US$104 million, the country’s largest fertilizer maker sold US$173 million in debt and a wood panel maker successfully issued US$100 million to refinance debt, among others. Given indications of large corporate issuance in the coming months, lower rates – combined with the temporary cut in stamp duty and good demand from pension funds and insurance companies – should partly offset the severe external shock. The success of companies placing debt domestically has been in part a reflection of Chile’s sound regulatory framework, in our view. Given the speed at which the financial pain in the industrialized world has spread into emerging markets, pressure points that could have been prevented by better regulation have quickly appeared. On this front, Chile stands out once again for not having provided any bad surprises. While the Chilean peso has weakened along with other regional currencies, there have not been any high-profile corporate casualties in Chile. Currency appreciation had lulled companies, in Brazil for example, into a false sense of security, encouraging them to bet on further currency strengthening. In similar fashion, several Mexican corporates entered into structured positions betting on persistent low volatility. Despite fairly similar currency moves, Chile has not seen any major corporation fall victim to currency bets. We suspect that this speaks of superior corporate governance and regulations, which include reporting to the central bank any type of derivative exposure. Indeed, within Latin America and even on a global basis, Chile earns high marks for the transparency, predictability and soundness of its regulations – many of which, such as the General Banking Act of 1986, came out of the banking crisis of the 1980s (see Macro and Micro Radars, 2nd Half 2008, November 24, 2008). And the central bank’s rate cuts have been only the last in a series of proactive actions. Last September, the central bank ended its US dollar accumulation strategy prematurely – the program was only 70% completed – citing a “relevant deterioration in global financial markets”. The bank resumed currency swap operations for one month, later extending the program to six months in the form of US$500 million in 60- to 90-day swaps up to a maximum amount of US$5 billion. In addition, the central bank added an extra degree of flexibility to the banking system with the currency denomination of its reserve requirements (see “Chile: Pragmatism Prevails”, EM Economist, October 10, 2008). Finally, the range of accepted collateral for repo operations was expanded. The central bank indicated that further rate cuts are in the cards, based on the statement from the February 12 meeting. Given a “significant fall” in the outlook for inflation and a deeper economic slump than expected in the Monetary Policy Report from January 14, the authorities decided to front-load rate cuts. Indeed, given the severity of the downshift in economic activity during 4Q08 and the first part of 2009, the central bank’s guidance of 2-3% real GDP growth in 2009 is overly optimistic, in our view. The statement pointed out that, in the most likely scenario, the policy rate will “converge in the short term to levels implied in financial instruments for the middle of the year”, indicating at least another 75-100bp in easing based on February 12 interest rate swaps. In our view, the balance of risks clearly points towards more aggressive policy action going forward, and we see policy rates at 2.75% this year – slightly above the historical low of 1.75% in 2004, as the country was in the midst of a bout of deflation – from 5.75% previously. In addition, we do not believe that further peso weakness is warranted and see the currency strengthening slightly further, to 560 this year from our previous forecast of 640. Fiscal Firepower Given the pace at which economic activity is slowing, a dose of fiscal stimulus is just what Chile needs. And with a cumulative fiscal surplus of 21.7 percentage points of GDP between 2006-08, Chile’s public sector has ample room to lean against the strong global headwinds. At the end of last year, Chile’s government was sitting on assets equal to 15% of GDP, with US$20.2 billion in the main Economic & Social Stabilization Fund (FEES). The smaller Pensions’ Reserve Fund (FRP) had US$2.5 billion, while the Treasury was sitting on an additional US$2.8 billion. Over the past few years, this massive asset accumulation was accompanied by a significant reduction in gross government debt, which plunged from 15.7% in 2002 to just 5.2% of GDP by 2008. Starting points are important, but also the way in which governments put these funds to work. In Chile’s case, the message contained in the various fiscal stimulus packages is one of a government that has resources to help the economy and is putting these funds to work in a sound way, in our view. The two rounds of measures announced in 4Q08 worth roughly US$2 billion were focused on the credit crunch and the sectors that seemed most vulnerable, including SMEs – via loan guarantees and other credit facilities – and housing, in addition to recapitalizing state-owned BancoEstado. As the credit turmoil morphed into a real economy one, so did the government’s measures: the US$4.0 billion package unveiled in January included business tax cuts, US$700 million for infrastructure, US$1.0 billion to fund Codelco’s fixed investment and handouts for low income families. Bottom Line With superior fundamentals and proactive policymaking, Chile has been rewarded by markets. And with the globe in the midst of a severe downturn of uncertain depth and duration, this differentiation seems well justified, in our view. Whether we focus on Chile’s fiscal assets equivalent to 15% of GDP, its sound policymaking or regulation, Chile seems to be in an enviable position to engineer a normal cyclical downturn.
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Macro Lows and Policy Response Risks
February 19, 2009
By Shweta Singh | India, Chetan Ahya & Deyi Tan | Singapore
Unlike 1997/98, No Balance Sheet Dislocations but Slowdown in Growth Will Still Be Painful Like other ASEAN economies, Thailand entered this global recession with a relatively clean balance sheet compared with 1997 and 1998. Corporate credit declined to 61.9% of GDP in 2007 from a high of 144.3% in 1997. Public debt dropped from 49.2% in 1997 to 37.2% in F2008 (ending September 2008). On the external sector front, forex reserves have built up. External debt dropped to 23.4% of GDP (September 2008) from a high of 94.4% (1998). At the same time, short-term external debt (as a percentage of FX reserves) has improved to 24.5% (September 2008) from 142.0% in 1997. Indeed, there are no balance sheet imbalances like those in 1997 and 1998. Nonetheless, the magnitude of the global recession coupled with domestic political conditions means that the ongoing growth dislocations will still be painful. Incoming Data Are Unequivocally Bad High-frequency data on external and domestic demand continue to show macro weakness in varying intensity. External demand has turned down sharply, in line with the export trends elsewhere in AXJ. December exports (in US$ terms) contracted sharply by 12.5%Y (one of the largest declines since data became available in January 1994). This compares with the 47.4%Y surge as recently as July 2008. Specifically, while export demand from the US and EU continued to remain in negative territory, export demand from the rest of the world (excluding the US and EU15), which had been holding up well at 20.7%Y as early as September 2008, registered an 8.5% decline in December. Spillover from external linkages and domestic political conditions are also causing domestic demand indicators to soften. Specifically: • Capacity utilisation: Excess slack is building up and operating leverage is dropping. Manufacturing production contracted 8.0%Y, 3MMA in December 2008 (versus a peak of 13.6%Y, 3MMA in February 2008). Capacity utilization has dropped from a peak of 75.4 (3MMA) in March 2008 to 61.8 (3MMA) in December (versus a low of 60.4 in February 2002 and 56.1 in September 1998) Similarly, electricity and cement consumption remained in negative territory at -3.8%Y (3MMA) and -13.5%Y (3MMA), respectively. • Investment indicators: Amid the increasing slack, the pullback in capex is also growing more evident. Private investment index declined 0.1%Y (3MMA) from a peak of 6.2%Y (3MMA) in April 2008. Business sentiment has dropped to 36.5 (3MMA) in December, the lowest data available since March 1999. Commercial vehicle sales further dropped 32.6%Y (3MMA) in December 2008. • Consumption indicators: Similarly, momentum in the private consumption indicator also dipped to 0.7%Y (3MMA) in December, the lowest since the 0.3%Y (3MMA) in July 2007. Consumer goods imports decelerated to 4%Y (3MMA) in December (versus a peak of 31.0 in September 2008). Consumer confidence has softened further to 74.7 (3MMA), from the high of 80.0 in April 2008. Room to Pursue Expansionary Fiscal Policy, but Size and Execution Are Key We expect GDP growth to be weak at 0.7%Y in 2009. This would be the lowest since the 1997-98 Asian Financial Crisis. Fiscal policy responses are undoubtedly needed, and Thailand has the room to pursue an expansionary fiscal policy. Indeed, ratios such as public debt/GDP (37.2%), debt repayments/ central government budget (11.0%), central government budget deficit/GDP (0.8%) and public debt service/government revenue (11.0%) remain below the government’s own stipulated fiscal policy sustainability guidelines. The IMF has recommended a global fiscal stimulus of 2%. By this benchmark, and given the plans in the pipeline, we believe that Thailand’s fiscal policy response does not appear to be too inadequate. Specifically, the F2009 fiscal deficit was originally expected at -2.5% of GDP, but a mid-year supplementary budget of Bt117 billion (comprising key measures such as tax cuts, cash handouts, measures to boost tourism and SMEs) has recently been approved. This is expected to bring the fiscal deficit up to -3.5% of GDP, from -0.9% in F2008. This will push up government expenditures to 19.4% of GDP, from 17.8% in F2008 and 18.2% in the original F2009 budget. This represents new incremental government spending of 1.5% of GDP for 2009. Additionally, a Plan B stimulus package, worth Bht100 billion and in the pipeline for approval, would bring new spending up by a further 1% of GDP. However, we believe that execution risks amid continued political uncertainty remain the key obstacle to the effectiveness of the fiscal policy response. To this point, we note that in the aftermath of the September 2006 coup, central government expenditures fell to 14.3% of GDP (quarterly annualized) while following the establishment of an interim government, expenditures rose to 21.8% of GDP (quarterly annualized) in the next quarter. Moreover, recall that several expansionary measures such as large infrastructure projects that were initiated by the last government were also delayed, partly due to political instability. Monetary Policy Response Might Be a Better Bet Unless we can get better clarity on the political front, we believe that monetary policy could be a relatively more effective policy tool. Recall that Thailand did not participate as much as other countries in the region in this credit boom. This offers slightly more room for an increase in leverage to support growth. Moreover, inflationary pressures are ebbing amid the commodity price disinflation, given that Thailand follows a mark-to-market fuel pricing regime. Further, with the extension of fiscal stimulus measures (such as provision of subsidized utilities and public transport services) until July 2009, risks are now tilted towards deflation concerns. The Finance Ministry and the BoT have agreed to narrow the 2009 inflation target range to 0.5-3.0% (core inflation, quarterly average) from 0.0-3.5% in an attempt to diffuse these pressures. The central bank has also lowered its 2009 inflation forecasts to the range of -1.5-0.5% from the earlier range of 3.0-4.0%. Core inflation is also expected to moderate and come in the range of 0.5-1.5% from the earlier forecast range of 2.0-3.0%. Consequently, the BoT has already embarked on an aggressive easing cycle, cutting rates by a cumulative 175bp to 2.0%, and we expect policy rates to reach a trough of 0.5% by 2Q09. Bottom Line While balance sheet imbalances such as those in 1997-98 are not present, ongoing growth dislocations will be painful, given the magnitude of the global slowdown. External and domestic demand indicators have reached new lows in some instances and policy responses are required. As it is, fiscal stimulus is in the pipeline. However, we believe that execution risk amid political uncertainty is the key impediment to the effectiveness of fiscal policy. In this regard, monetary policy easing could be a more effective tool, and we expect policy rates to reach a trough of 0.5% by 2Q09. Overall, the macro outlook for 2009 is expected to be poor, and we expect GDP growth of 0.7%Y. In 2010, we expect a tepid recovery of 3.4%Y. However, in our view, risks are skewed to the downside with regard to the rebound.
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No Surprise Today
February 19, 2009
By Sharon Lam & Katherine Tai | Hong Kong
GDP plunged to record low at -8.4%: 4Q GDP came in much worse than consensus expectations at -6.8% but closer to our forecast of -9%. This recession is much more severe than in 2001, when the previous record low was -4.6%. In nominal terms, growth plunged even more to -9.1%. Taiwan could be the weakest AXJ economy in 2009, and USD/TWD could hit 36.5: 4Q growth in Taiwan was way below the other Tiger economies in the region, with Korea at -3.4% and Singapore at -3.7% (Hong Kong data due next week). We do not think that the worst is behind us, and our 2009 GDP forecast of -6% for Taiwan would be the weakest in non-Japan Asia (see No Sight of Meaningful Recovery, February 10, 2009). We are bearish on Taiwan since exports account for 70% of GDP and there is no support from the domestic service sector; meanwhile, monetary policy is not as effective due to weak confidence and deflation, and fiscal policies announced so far seem insufficient to us. We forecast USD/TWD to reach 36.5 in our base case and 40 in our bear case (see TWD Moment, February 13, 2009). Record-low rate won’t help much: The CBC cut its rediscount rate by 25bp along with the GDP data release. The policy rate is now at a record-low 1.25%. This cut was milder than our expectation of 50bp, which indicates to us that this might not the last rate cut, as the CBC probably wants to save more bullets for later. We predict that the policy rate will bottom at 0.5% by 2Q09 (see In a Mad Race to ZIRP? December 11, 2008). We estimate that rate cuts will save about NT$210 billion in interest burden this year (1.7% of GDP); however, this is unlikely to lead to loan growth due to risk-aversion, and thus there is a very limited multiplier effect on the economy. Rate cuts are the fastest policy response to hopefully help to ease the fall in confidence, in our view. A Glance at the 4Q08 GDP Breakdown Private consumption surprisingly improved (-1.7% in 4Q versus -2.1% in 3Q): 1Q09 might see even more improvement due to the shopping coupons distributed by the government (NT$3,600 per citizen) before the Chinese New Year. Indeed, the shopping coupon idea was such a success that it may prompt the government to issue again in the near future, we believe, but we warn that the marginal benefit from such policy will likely diminish. The excitement is likely to decrease, and the impact will not be as big as the first time when it was distributed right before the Chinese New Year holidays. Second, an expectation of continuous sales promotions will be formed when consumers know there will be more shopping coupons coming, and this could put off current consumption in anticipation of more promotions. In fact, shopping coupons could be a source of deflation this year, and we forecast 2009 CPI growth at -1%. Third, and most importantly, the bottom of the labor market and income growth is yet to be seen, and spending power will likely deteriorate so much that it cannot be saved by mere shopping coupons. Taiwan’s currently unemployment rate of 5% is already the highest among all Tiger economies, and we believe that it could reach a record high of 7% by the end of this year. We forecast private consumption growth to show negative year-on-year growth for all four quarters this year. Private sector capex not far from record low in 2001 (-32% in 4Q versus -13% in 3Q): Although exports plunged into unchartered negative territory in 4Q, the drop in capex by the private sector is not yet as bad as in the 2001 recession (when it slowed by 39%). It goes without saying that the fall in exports is leading to business closure and investment cuts by corporates. Destocking is reported to be rapid in the last two months but it is yet to be completed, in our view. Judging from previous cycles, it took about 12 months in Taiwan for destocking to be over and inventory to start piling up again. The fall in construction investment eased (-14% in 4Q versus -20% in 3Q): The ease in construction investment decline, however, can be attributed to a low base effect. We do not think that private sector construction activities will pick up in 2009, despite record-low interest rates and the drop in commodity prices. Sentiment is the key to drive the housing market, and we believe that it will be difficult to revive Taiwan’s long-depressed confidence level in the near future, with a possible record-high jobless rate coming. In fact, what we worry most about is the vicious cycles in the economy led by such weak sentiment that can cause deflation, liquidity traps and capital outflows to repeat. Hopes for the construction sector will have to come from government measures – so far the government has announced a four-year NT$500 billion infrastructure project (with NT$150 billion approved for this year – 1.2% of GDP), yet unfortunately we do not think that this is enough to get Taiwan out of this deep recession fast enough. We already knew exports would be bad (-20% in 4Q versus -0.6% in 3Q): Monthly data had already revealed the record fall in exports last quarter, and January data was even worse. Import fell faster at -22.6% in 4Q. Due to its heavy reliance on exports, there is the common perception that Taiwan will also recover faster when global demand picks up in 2H09. We disagree. Technically, we expect Taiwan’s year-on-year GDP growth to bottom in 1Q09 and return to positive territory in 4Q09 due to the low base, but we do not believe that this will be a meaningful recovery. We expect the harm to be brought about by exports to the domestic economy to last longer than expected. Exporters need to be saved in order to reduce the ripple effect to the rest of the economy. Taiwanese exporters are not only hurt by the global demand destruction, but also on the competitive front due to lack of branding. Meanwhile, Taiwan’s export growth in local currency terms is just as bad as that in US$ terms due to a relatively stable NT$ exchange rate in 2008. External demand is not in the government’s control, but the exchange rate is. We believe that confidence has to be revived by growth, not just a strong currency.
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Policy Traction: The Key to Recovery
February 19, 2009
By Richard Berner | New York
Now that President Obama has signed the US$787 billion American Recovery and Reinvestment Act of 2009 (H.R. 1) into law, the question is: Will policy stimulus work? We believe that the combination of massive fiscal stimulus, a comprehensive plan to fix the financial system, and ongoing monetary ease will help to promote a return to positive US growth late in 2009 and a moderate, sustainable recovery starting in 2010 (see Recovery Coming but ‘Back-Loaded’ Stimulus Means Weaker Near-Term Outlook, February 9, 2009). However, uncertainties remain. Risks are two-sided. The key to whether or not such policies get traction lies in breaking the vicious circle between the credit crunch and the economy, with needed sequencing flowing from funding to credit markets. The Financial Stability Plan outlined by Treasury Secretary Geithner last week is aimed at those goals, but critical details are missing (see below). Until that plan is clarified and implemented successfully, there is a risk that even aggressive policy will get little traction soon and the US economy will languish. At the same time, however, the macroeconomic impact of policy stimulus may surprise us by its strength if the Financial Stability Plan is quickly strengthened and executed. Consequently, investors should not rule out the chance that policy initiatives will quickly come together and promote a traditional, vigorous rebound. In what follows, we try to outline the elements involved in assessing those risks. First, we look at the uncertainty surrounding the short- to medium-term effects of fiscal stimulus on the economy. H.R. 1 contains four basic elements: government spending such as on infrastructure; ‘transfers’ such as increased aid for states for Medicaid or unemployment insurance benefits; tax cuts for individuals such as the ‘Making Work Pay’ payroll tax credit; and tax cuts or benefits for businesses (the last is a small component of H.R. 1). Economists generally agree that federal or state and local government spending typically gets more bang for the buck than tax cuts. Whatever the merits of particular spending programs, most have both a direct and indirect (or multiplier) effect on output as they create jobs and income. In contrast, tax cuts are partly saved, so their impact is smaller. The table from the Congressional Budget Office below illustrates reasonable ranges for seven policy options. Based on this menu, H.R. 1 should offer some potent stimulus: It contains about $100 billion in genuine, high-impact infrastructure outlays, transfers like those mentioned above, tax cuts for lower- and middle-income workers, and a few business tax cuts. The final plan improved on the initial bill by cutting out some low-impact items like a broad five-year net operating loss carryback provision. Policy Multipliers: The Cumulative Impact on GDP of Various Policy Options | High | Low | Purchases of Goods and Services by the Federal Government | 2.5 | 1.0 | Transfers to State and Local Governments for Infrastructure | 2.5 | 1.0 | Transfers to State and Local Governments Not for Infrastructure | 1.9 | 0.7 | Transfers to Persons | 2.2 | 0.8 | Two-Year Tax Cuts for Lower- and Middle-Income People | 1.7 | 0.5 | One-Year Tax Cuts for Higher-Income People | 0.5 | 0.1 | Tax-Loss Carryback | 0.4 | 0 |
Source: Congressional Budget Office However, the estimates above are assessed over 10-12 quarters, and even in the best of times, the impact on output of infrastructure spending is likely to come at a leisurely pace, whether projects are shovel-ready or not. In contrast, tax cuts could take effect immediately by adjusting withholding rates. While there are some withholding rate adjustments in H.R. 1, much of the tax cut impact will actually occur with refunds in 2010. And it is worth noting that about US$83 billion of the US$399 billion stimulus effective in F2010 is an extension of the ‘patch’ for the alternative minimum tax that Congress has routinely enacted in past years, so it really adds nothing to expected fiscal thrust. The good news: CBO’s scoring of H.R. 1’s F2009 budget impact is about US$15 billion higher (to US$185 billion) than the Senate bill we assessed at midweek. But the upshot remains that the stimulus package is relatively back-loaded, with less than 25% of the overall 10-year impact occurring in the current fiscal year. Moreover, such traditional estimates of the effects on the economy of fiscal stimulus may overstate the impact for two reasons. First, as their net worth declines and looks increasingly uncertain, consumers are likely to save much of coming tax cuts. Against the backdrop of falling home prices and the ongoing losses in financial wealth, we guess that consumers are apt to spend only about one-quarter of the tax cuts. Moreover, tight credit may limit the ‘multiplier’ effects of government spending programs. For example, infrastructure outlays may create jobs for a while, perhaps even years. But the credit crunch means that contractors who hire the construction workers for the designated project probably will still have difficulty financing new equipment for coming projects. Those factors likely will limit policy traction, at least for the next several months until credit availability begins to improve. Reviving the intermediation process would change that picture significantly and increase the potency of fiscal stimulus. Restarting credit markets, repairing viable lenders’ balance sheets and liquidating others, and foreclosure mitigation are essential. Some believe that lingering concerns about credit availability are overblown, with monetary policy at full throttle, interest rates down, unsecured interbank (Libor-OIS) lending spreads below 100bp, and some markets functioning again. The evidence on this point is mixed: Over the past six months, fewer banks tightened lending standards for the first time in three years. Corporate bond markets are more accessible, with overall corporate issuance up 8% so far in 2009 (US$95 billion YTD) versus US$88.2 billion for the same period in 2008, and non-financial corporate issuance is up 68% YTD (US$73 billion versus US$43.4 billion in 2008). But small business surveys (from the NFIB) report that credit is harder to get than at any time since 1981. Loans outstanding at weekly reporting commercial banks are growing, but much of that growth represents household and business draws on existing lines of credit (and the large-bank aggregates are distorted by the acquisition of Washington Mutual (a thrift) by JP Morgan Chase (a commercial bank)). Importantly for an economy in which more than half of credit is still intermediated through securitization, securitized pools of consumer credit are declining sharply. Thus, we remain concerned that the deleveraging of financial institutions’ balance sheets and impairment of the securitization process will extend the credit crunch. Consequently, we think that a comprehensive fix is still needed. As we’ve noted previously, the Treasury’s Financial Stability Plan involves four elements that, taken together, represent a more comprehensive approach to fixing the financial system than anything seen so far. 1. The ‘comprehensive stress test’ will be used to standardize judgments on whether lenders are viable and whether they will get new capital injections, are merged with stronger institutions, or are liquidated. Mandatory for banks with assets in excess of US$100 billion, this test will clarify the state of their balance sheets and reduce uncertainty for investors. If the attached restrictions make lenders reluctant to accept the terms for new capital, however, they may limit the success of this element in breaking the vicious circle of capital impairment and a further tightening of credit conditions. 2. A public/private investment fund (PPIF) would partner public and private capital and use guarantees and loss sharing to induce investors to bid for ‘toxic’ assets. It is intended to be an alternative to a good bank/bad bank structure, aimed at absorbing bad assets from lenders’ books. However, other than a US$500 billion to US$1 trillion target for the pool, details on this component – especially on how it will structure incentives for market participants to value toxic assets and who will absorb losses – are scarce. Lacking such details, large-cap bank analyst Betsy Graseck is skeptical that this plan will be effective; it might simply widen the gap between the strong and weak banks. 3. Expanding the Fed’s TALF program to US$1 trillion and including CMBS and private-label RMBS would help restart the intermediation process. We like the TALF conceptually, believe it will improve market functioning and applaud the extension; indeed, we’ve expected it. However, delays in getting the original TALF running leave us concerned that extensions will create further difficulties in execution, and it is unclear how quickly the expanded version can be launched. 4. The Obama administration this week will unveil a US$50-100 billion foreclosure mitigation effort, possibly including the carrots of a subsidized mortgage rate to make refinanced loans affordable; using the IndyMac or similar protocols to reduce payment-to-income ratios to 31%; and refinancing into FHA-guaranteed loans so that the taxpayer takes the re-default risk. The biggest stick is mortgage ‘cram-down’: legislation that would allow the modification of a mortgage contract’s terms in bankruptcy. Cram-down has benefits and costs: Reducing the value of mortgages to below an appraised value of collateral would help stressed homeowners. Although pending legislation would restrict cram-down to existing mortgages, the precedent will likely prompt lenders to price the risk into tighter mortgage lending terms. Such tightening probably will be most acute immediately following cram-down’s implementation, just when officials would like to ease mortgage credit. And it would be harmful for investors. Notwithstanding its pitfalls, we like the Financial Stability Plan in broad outline, but believe that success will hinge on details, incentives, execution and more funding. The Obama Administration seems hesitant to ask Congress for more money, perhaps because the votes aren’t there to provide it. Lacking clarity and details, the risk is that the uncertainty about policy will create hesitation among lenders and borrowers, and worsen the downturn. These developments have important implications for the Fed and the yield curve. If fiscal policy lacks traction because initiatives aimed at fixing the financial system are inadequate or take time to implement, monetary ease will also be less effective than normal. Such headwinds will intensify the burden on the Fed to prevent economic worsening by using its balance sheet for both ‘credit’ and quantitative easing. By credit easing we mean that the Fed’s balance sheet provides funding for liquidity or credit facilities such as the Commercial Paper Funding Facility or the TALF. Quantitative easing in the traditional sense, aimed at reducing rates and hedging against deflation, could be implemented by buying Treasuries, which would monetize budget deficits. Such purchases would flatten the Treasury yield curve. Although uncertainty is high, risks appear roughly evenly balanced and hinge on policy enactment. ‘Ugly’ and ‘good’ scenarios illustrate the divergent risks in both directions (representing an update of our risk assessment framework; see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008). The new ugly scenario depicts the circumstances if policy fails to get traction: scant recovery and heightened deflation risks. In that scenario, fiscal stimulus barely negates the headwinds of recession and results in zero growth (0.9% on a 4Q/4Q basis), with mild deflation taking hold in 2010. The Fed would likely keep the funds rate essentially at zero for the foreseeable future. Conversely, the good scenario depicts a nearly traditional, vigorous recovery that likely would entail the need for policy to reverse course late this year. The key driver of such a scenario in our view would be prompt resolution of the uncertainty surrounding the Financial Stability Plan and implementation by mid-2009. That scenario might involve 3% real growth in 2010 (5% on a 4Q/4Q basis), a 1.2 pp drop in the unemployment rate over the course of that year, and a 300bp ‘renormalization’ of the funds rate by mid-2010.
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