Flirting with QE
April 08, 2009
By Manoj Pradhan | London & Chetan Ahya | Singapore
RBI’s Liquidity Injection Package Represents ‘Active QE’
The Reserve Bank of India (RBI) announced on March 26 that it would purchase government securities under its open market operations in the amount of Rs800 billion (US$16 billion) between April and September 2009. In addition, it will also unwind the MSS (market stabilization scheme) bonds to the tune of Rs420 billion (US$8.4 billion) over the same period. These measures represent a net injection of liquidity into the system and are likely a response to the sharp drop in M1 recently. Since September 2008, India’s foreign exchange reserves have declined by US$34 billion. This, we believe, has resulted in a sharp deceleration in M1 growth to 12.7%Y as of March 13, 2009 from 19.4%Y in August 2008. Additionally, the choice of purchasing longer-term government securities and MSS bonds as a vehicle to inject liquidity should have the added advantage of capping and possibly reversing the sell-off in bonds since the start of the year, which persisted even after a 50bp cut in policy rates on March 4. Both the net injection of liquidity to shore up M1 and the possible lowering of bond yields lead us to classify the RBI package as ‘active quantitative easing’ – outright purchases of assets with a view to increasing money supply and possibly easing financial conditions at the same time. This policy measure is in the same vein as the measures introduced by the Fed, BoE and the BoJ, but on a much smaller scale. The size of the package is meaningful at present, with the total open market purchases amounting to around one-third of the net central government borrowing needs during April to September. However, unlike the major central banks that have increased the size and scope of their QE programmes, we believe that the RBI will do neither. Instead, we believe that there is a chance that the RBI may actually not use its entire announced package if M1 and bond yield conditions turn benign over the next few months. QE Without ZIRP? An interesting aspect of this active QE package is that the RBI has chosen to implement it with policy rates well above zero. We have argued elsewhere that active QE needs not be implemented in conjunction with ZIRP (see “QE2 − Size Matters”, The Global Monetary Analyst, March 25, 2009). Currently, the policy rate (repo rate) in India is at 5%. This package aims to flatten the yield curve, which has risen close to a historical high. We believe that these liquidity injection measures initiated by the RBI, a likely further deceleration in banks loan growth and improvement in the government’s consolidated fiscal deficit (including off-budget subsidies), should result in the 10-year bonds declining to 6-6.25% over the next two months and further to 5.5% by end-2009. Could the RBI Announce an Extension of This Active QE? If the RBI extends this QE package, it could have an adverse impact on the foreign exchange market, in our view. The risk clearly is that the RBI increases the size of its open market purchases, particularly if bond yields remain stubborn and refuse to fall in line with policy rate cuts. The RBI may face this choice if the new government formed post general election in May 2009 initiates populist measures, which result in a widening of the fiscal deficit. However, we believe that the new government will hesitate to initiate such a move to avoid a downgrade in the sovereign debt rating and consequent challenge in managing the market forces. S&P has already revised its outlook on India’s long-term sovereign credit rating to negative from stable. Currently, India’s sovereign rating is at the last notch within the investment grade category. Any downgrade would push India’s rating to below investment grade. Understanding QE Defining quantitative easing: Quantitative Easing (QE) is in operation when the central bank allows or indeed pursues a rapid expansion of the monetary base. The mechanics: The monetary base is the sum of currency in circulation and reserve balances of the commercial banks (the balances that commercial banks maintain with the central bank). Suppose that the central bank lends the commercial bank electronic cash (i.e., simply adds the amount to the credit balance of the commercial bank held at the Fed) in return for a financial security as collateral. The collateral security sits on the asset side of the central bank’s balance sheet, and the central bank credits the reserve balance of the commercial bank, which sits on the liability side of the central bank’s balance sheet, with (electronic) cash. Under normal circumstances, if the increase in reserve balances (and hence the monetary base) is unwelcome, the central bank would simply sell some securities in the open market to reduce the cash balances of commercial banks – an operation known as ‘sterilisation’. Effectively, the central bank replaces the risky and illiquid security previously held by banks with either cash or with a safe, liquid government security if the first transaction is sterilised. Under QE, however, the central bank would conduct the first transaction without sterilising it, thus allowing the reserve balance of the commercial bank, and therefore the monetary base, to expand. ‘Passive’ and ‘active’ QE: We distinguish between two types of QE, passive and active, depending on the degree of control that the central bank exerts over the increase in the monetary base. Passive QE: In response to credit market stress, central banks put into place many programmes to increase liquidity in the financial system. These allowed eligible financial institutions to approach the central bank, hand in government or other securities as collateral, and receive (electronic) cash in their account at the central bank. The programmes were instituted by the central bank but the participation was entirely up to private institutions so that the central bank cannot perfectly control the size of the monetary base through this type of QE. We place all such programmes in the category of passive QE. Active QE, on the other hand, consists of all outright purchases of risky or government securities funded simply by crediting the seller’s account (directly if the asset is purchased from an eligible counterparty, indirectly if not) with electronic cash. (Note that the purchases of risky assets carried out by a central bank on behalf of the government are typically funded by the sale of Treasury bills and thus are not quantitative easing as the impact on the monetary base is sterilised.) Such purchases also lead to an increase in the size of the central bank balance sheet and an increase in reserve balances and the monetary base. Crucially, through the outright purchases, the central bank has perfect control over how much it can increase the monetary base. The only limit to the increase in the balance sheet is the government’s willingness or ability to backstop potential losses on the asset on the central bank’s balance sheet. QE to M1: For the QE regime to work, some of the electronic cash in the reserve balances held by the Fed has to be converted into demand deposits of the non-banks (which are an important part of M1). This can be done either i) when an asset is purchased from a non-bank and the seller of the asset puts the funds into a checking account or, ii) when commercial banks make loans or buy assets, crediting the demand deposit account of the borrower/seller. Either way, it sets into motion a chain of demand deposits because commercial banks are only required to hold a fraction of the demand deposits (say 10%) as reserves. They can use the remaining 90% to buy more assets or make more loans, thereby creating multiple demand deposits on the basis of one transaction. An increase in M1 is therefore an essential first step to QE getting some traction in the economy. The problem, of course, has been that, in the current environment, banks have been reluctant to do much with their reserve balances. They have preferred to park their reserves with central banks and earn very low yields.
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Depth and Breadth Matter
April 08, 2009
By Richard Berner | New York
The time-honored business cycle metrics of depth, duration and dispersion suggest that the current recession is on track to be the longest, deepest and broadest of the post-WWII period. Yet recent data are clearly showing less intense declines and some have turned mildly positive, possibly signaling future recovery. Among them: Consumer spending has picked up, home sales have stabilized, overall and export orders in the ISM canvass have reversed some of their recent plunge, and production cuts are beginning to limit the imbalance between inventories and sales. We think there is less to these improvements than meets the eye (for example, see Perfect Consumer Storm Not Over, March 31, 2009). Even so, it appears that the most acute declines in this recession are behind us. Classic gauges of depth and breadth support our view that the recession has further to run and that the coming recovery will be modest. Evidence for that claim is especially critical now that equity markets are fully embracing this ‘second derivative’ trade. To be sure, there is also legitimate optimism over some recent policy actions: The Fed’s aggressive moves to step up the volume of credit and quantitative easing (QE) on March 18, details that clarified the Public-Private Investment Program, the FDIC’s extension of the Temporary Liquidity Guarantee Program, the agreement at the G20 meeting to step up massively resources for the IMF, and a proposal to increase the FDIC’s line of credit all add up to plusses for the US. But whether fiscal stimulus and QE get traction is still the critical part of the discussion. In our view, they won’t get substantial traction until there is more progress in restarting the securitization markets and in fixing the financial system – and that progress will take time. It’s important to calibrate the economy’s progress as well. Recessions are ‘recurring periods of decline in total output, income, employment and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy’. They are thus defined in terms of the depth of decline, the duration and the dispersion across industries – the three Ds. Monitoring indicators of breadth (dispersion) and the forces promoting weakness remain critical to assessing depth and duration. This downturn is already setting records or will soon do so in depth, duration and breadth. Even if the recession ended last month, if our estimate of a 6% annualized decline in 1Q real GDP is on the mark, real output will have declined by 3.3% from its numerical peak in 2Q08 – the deepest peak-to-trough decline of any post-war recession. And if it lasts until May, it will be the longest (by comparison, output in the 1973-75 recession declined by 3.1% and it lasted 16 months). Being global, it has hammered nearly every part of the economy including exports. Diffusion indexes are helpful summary indicators of how widespread the changes in direction in economic activity are. The verdict now? Most of these measures show that the current recession is already or will soon be far deeper and broader than past downturns. The March manufacturing ISM index has bounced three points off its December lows, and orders have surged by 18 points. Yet judging by factory labor inputs in March (hours worked fell by 2.1%), manufacturing production continues to fall and to show broad-based weakness. Factory production has tumbled more than 15% from its 2007 peak, matching the 1973-75 decline, and the three- and six-month diffusion indexes for industrial production, at 14.1% and 15.7%, respectively, are the lowest or next-to-lowest readings on record. What about broader gauges that cover the entire private economy, not just manufacturing? The NABE canvass is only quarterly, but the January survey already showed record weakness in 4Q08 in all industries. Employment diffusion indexes tell a similar story. The overall 6-month index for private non-farm payrolls at 15.7% stood at a record low in March, and the 3-month index at 16.4% was just a tick above February’s record low. In our view, this deep downturn will not promote a V-shaped recovery, as some have in the past. Although it’s dangerous to say ‘it’s different this time’, it is different. Deep downturns often promote V-shaped recoveries because they constrain spending, thus building up ‘pent-up’ demand. This time, we think that the ongoing credit crunch will stymie pent-up demand. For example, in normal times it takes 13 million light vehicle sales to keep the stock of light vehicles on the road constant, given normal scrappage rates. With sales below 10 million units, it might be logical to think that pent-up demand for vehicles is building. Indeed, our auto analyst, Adam Jonas, is encouraged by the March rise in light vehicle sales from 9.1 to 9.8 million units, and believes that pent-up demand is now so strong that a ‘cash-for-clunkers’ subsidy such as that proposed by Rep. Debbie Stabenow (D, MI) of between US$1,500 and US$10,000 per vehicle will quickly lift sales temporarily to as much as 15 million units (see Junk in the Trunk, March 31, 2009 and SAAR Improvement in March Could Signal Sales Bottom, April 2, 2009). Obviously, the bang will depend on the bucks put on the hood, but we suspect that the bang per buck will be fairly small, because in the credit crunch, lenders are demanding more collateral (bigger downpayments). Loan-to-value ratios on auto loans plunged from 95% last summer to 86% in January, and sales cratered in response. Likewise, deep output recessions often signal that inventory liquidation will turn to accumulation, promoting snapbacks in output and eventually in hiring. Not this time. Despite six quarters of inventory liquidation, the real inventory-sales ratio in manufacturing and trade in January at 1.426 came within a whisker of its 2001 high of 1.43. That’s because sales in the year ended in January tumbled by more than 8%, and inventories have declined by only 2%. Aggressive production cuts and plunging imports may finally be reducing the imbalance between sales and stocks. Unfortunately, in the current downturn, we think that the ongoing credit crunch will delay both sales and thus hiring. As evident by the 3.5% plunge in payrolls over the past year – the most acute decline since 1958 – this means that the adverse feedback loop from production to income and spending is likely to continue. Moreover, there are less widely appreciated downside aspects to deep and broad downturns, if they are lasting. First, capital spending and cushions from the rest of the economy are key casualties of depth and breadth. That’s because, the deeper the recession, the more severe the decline in operating rates and profit margins, which bodes ill for pricing power, capital spending and hiring. Industrial operating rates have already plummeted to record lows of 66.8% in manufacturing, and we think they will bottom at 62%. Margins, in our view, seem likely to fall all the way back to 2001 levels. The time-honored relationship between those gauges and capital spending suggests that declines will continue in investment for most of 2009. There is a dark side to broad recessions: The broader the recession across sectors, the less one industry is able to rely on others to cushion the downturn. In the recession of 2001, a deep tech bust resulted in only a mild recession because housing and consumer spending held up well. This time virtually no sector of the economy is immune from the credit crunch, so it is difficult to find any cushions of demand. Likewise, the current global recession means that neither the US nor its trading partners can rely on each other for export demand. As evidence, despite a seven-year decline in the dollar, real US goods exports have been crushed in this recession, plummeting at a 43% annual rate in the last six months, and there are only faint signs of stability in the ISM export orders index. In our view, policy traction will be the deciding factor shaping the timing and strength of recovery. We think that fiscal stimulus, repair of the financial system and monetary ease will help to promote positive US growth late in 2009 and sustainable recovery starting in 2010. The key to policy traction lies in breaking the credit crunch, with sequencing flowing from funding to credit markets. Traditional estimates of the effects on the economy of fiscal stimulus may overstate the impact for two reasons. As their net worth declines and looks increasingly uncertain, consumers may save much of coming tax cuts. Moreover, tight credit may limit the ‘multiplier’ effects of spending programs. Restarting credit markets, repairing viable lenders’ balance sheets and liquidating others, and foreclosure mitigation are essential. Evidence on credit availability is mixed: Fewer banks tightened lending standards in January for the first time in three years, but small businesses report that credit is harder to get than in nearly 30 years (see Policy Traction: The Key to Recovery, February 1, 2009).
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Trip Takeaways and Debates
April 08, 2009
By Deyi Tan, Chetan Ahya | Singapore & Shweta Singh | Mumbai
Trip Takeaways We visited Ho Chi Minh and Hanoi over four days and met with government officials, corporates and consultants. Below, we highlight the key macro takeaways and debates from our meetings. Macro #1: Is Positive Growth Good Enough? We came away from the meetings sensing a disconnect between macro versus micro and foreign versus local sentiment. On the micro level, corporates believe that a slowdown is at hand. However, earnings/profitability guidance remains relatively sanguine. The view is that even as the developed world undergoes economic contractions, Vietnam will still be able to muster positive growth, given the bigger domestic demand base and rural sector. More fundamentally, local banks have stayed away from toxic assets, which led to a souring of global banks’ balance sheets. Foreign institutions invested into Vietnam re-affirm the long-term structural story. Yet, they also tend to be more pessimistic about the short-term outlook compared to local corporates. Some have moved liquid assets out of Vietnam, to repatriate money home. The debate: In our view, the linkage between Vietnam and the fallout of global financial markets appears to be under-appreciated. Ceteris paribus, we agree that a more defensive rural sector and a sizeable domestic demand base should ensure a natural rate of growth that is higher than other small but more open economies in a global recession scenario. However, what is more relevant, in our view, is that Vietnam has also extracted growth delta from the global exuberance of the past few years via the conduits of foreign direct investment (FDI), portfolio inflows and exports. These inflows, coupled with a stance to keep the Vietnamese dong competitive, have led foreign reserves to quadruple from US$6.4 billion at end-2003 to a peak of US$26.7 billion in March 2008. Incomplete sterilisation means that this liquidity, through banks’ intermediation, eventually found its way into the system either into productive capacity expansion (fixed capex and real estate infrastructure) and/or speculative assets (equities and property). These, in turn, buoyed domestic demand through the multiplier, income and wealth effect. Indeed, outstanding credit has grown from 48% of GDP in 2003 to 87% in 2008, with Vietnam having the highest credit penetration among economies with similar per capita income (such as Indonesia and India). With deleveraging, the liquidity booster provided by FDI, portfolio flows and trade is receding and, with that, the growth delta. As a comparison, disbursed FDI as of 1Q09 stood at US$5.6 billion at an annualised rate, half the pace of the US$11.5 billion disbursed in 2008. Net foreign buying (3-month trailing sum, annualised) in Ho Chi Minh Exchange has come off from a high of US$1.7 billion in April 2008 to US$11.5 million in March 2009. Additionally, we note that corporates have made expansion plans over the past years predicated on expectations of trailing growth performance. With this capacity coming on-stream, the demand destruction would imply negative operating leverage and earnings decline. To the extent to which Vietnam’s linkage to the world is not fully appreciated, the added surprise is the expectation gap, which we think could be negative and sizeable. Macro #2: Excesses and Paybacks Banks remain hopeful regarding the NPL cycle that they are confronting. However, from what we gathered, the real estate and banking sectors continue to be pressure points. Amid the headcount reductions, average asking rents for office space have declined by 20-30% from the peak to around US$60psm (Grade A), US$28psm (Grade B) and US$20psm (Grade C) in Ho Chi Minh city. With Grade A and B office space likely to see an increase of 49% by 2009, given the lagged nature of supply, more rental softness could be expected, given the slower pace of take-up. As it is, landlords have started to restructure agreements to make it more affordable for tenants. On residential, average prices of luxury apartments in Ho Chi Minh have corrected by about 30-50% from the peak in 1Q08. Launches have slowed and developers appear to be downsizing apartments to improve affordability. Meanwhile, in the banking sector, bearing testimony to the macro slowdown, the credit cycle is reversing with loan growth decelerating from a peak of 64%Y in April 2008 to around 12.1%Y in February 2009. As a result of weaker demand, banking liquidity conditions have loosened up with 1M interbank rates (7%) returning to levels seen in early 2008 from highs of 20% in July 2008. The debate: Based on our conversations, NPLs remain in low single-digit territory. However, NPLs are a lagging indicator, and we believe that banking sector stress from macro and asset markets slowdown remains a concern for two reasons: • First, 46% of the overall loan book was disbursed to borrowers at the peak of the cycle in the past two years. This is one of the highest in the region and poses a concern amid the issue of profit sustainability of marginal borrowers heading into a growth cycle trough. More specifically, although real estate exposure has been placed at a relatively low 6-10% of the loan book, we note that the transparency of the data could be low due to the likelihood of ‘loans leakages’ as many corporates have ventured out of core businesses into real estate development over the past few years. The lack of cash flow from poor office space take-up or weak apartment transactions would hinder loan repayment ability, in our view, leading to more real estate NPLs, loan restructuring and pressure on banks’ profitability. • Banks have adopted conservative valuation at half of market pricing and loan-to-value of around 70%, effectively disbursing real estate loans at 35% of market valuation. While this seems to give banks a comfortable buffer against the property market slowdown, anecdotally we learnt that some developers have financed projects by part loan and part equity, hoping to make up for the shortfall of construction costs through sales transactions, which have since dried up. To the extent to which more funding is not forthcoming, we believe that project completion is an issue and would pose pressure for banks that have been aggressive real estate lenders. Macro #3: Policy Responses and Dilemmas Policymakers are counting on policy responses to cushion the slowdown and monetary, exchange rate and fiscal policy responses are being undertaken. On policy rates, with the State Bank of Vietnam having eased by a cumulative 700bp since September 2008, it appears that the bulk of monetary policy easing has been done. Our conversations with banks suggested that further policy rate easing might be less effective in lowering lending rates, as it could lead depositors to look for higher returns elsewhere. In terms of exchange rate policy, stability alongside flexibility is the policy mantra. Indeed, the trading band was recently widened from +/-3% to +/-5%. In our view, the authorities are likely to be less inclined towards aggressive dong depreciations due to the potential impact on confidence and the low price elasticity of resource exports. However, we believe that allowing orderly currency depreciation in line with the inflation rate of 6-7% could be the comfort zone. Fiscal responses are slowly rolling out. A US$6 billion fiscal stimulus package is planned for which the US$1 billion interest rate subsidy programme is a key element. Current take-up of the subsidy programme stands at VND202 trillion compared to the total potential loan disbursements of VND420 trillion. The debate: With the bulk of monetary policy easing done, the gear appears to be shifting towards fiscal response. However, funding could pose a constraint here. Indeed, according to IMF estimates, the 2009 fiscal deficit (including off-budget expenditure and net lending but excluding recently announced stimulus measures for which details are still not fully available) could come to -8.2% of GDP (~9% of the deposit base), up from -4.7% in 2008. We agree that gross domestic savings in Vietnam are high, at around 30% of GDP. However, most Vietnamese still do not have a banking relationship, making it difficult to fully mobilise the un-banked savings pool to meet funding needs. We estimate that the loan-to-deposit ratio stands at around 86%. Around 8% of the deposit base goes into government bonds/loans. Even if we conservatively estimate that the reserve requirement (RR) takes up another 2% of the deposit base (this is the average of the RR ratio for short-term and long-term VND deposits; RR ratios for foreign currency deposits are higher), this leaves only 4% of the deposit base idle to plug a fiscal funding gap equivalent to about 9% of the deposit base. In this regard, we believe that two scenarios are likely. The planned fiscal response could eventually be curtailed by funding constraints. If active fiscal pump-priming is still pursued, then government bond yields would have to rise to attract external/local funding and/or private borrowing could potentially be crowded out. Bottom line: Similar to other regional economies, Vietnam faces one of its worst macro slowdowns since the late 1980s. While it should still register positive growth, the growth delta it has extracted from FDI, portfolio and exports is likely to reverse and operating leveraging is likely to turn negative. The real estate and banking sectors continue to be pressure points. We believe that banking sector stress is a concern, as Vietnam has the second-highest unseasoned loan book in the region. While policymakers are relying on policy response to cushion the downcycle, we note that still relatively tight liquidity conditions amid a large un-banked savings pool could pose fiscal funding constraints.
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