India
WPI Deflation to Give Way to Inflation
July 28, 2009

By Tanvee Gupta | India & Chetan Ahya | Singapore

Headline WPI Remains in Deflation Mode...

The headline Wholesale Price Index (WPI) has been in deflation mode since the first week of June 2009. WPI declined 1.17%Y during the week ended July 11, compared to the peak of 12.7%Y (average) in August 2008. Indeed, this is the first time since December 1978 that the WPI (in %Y terms) has been in negative territory. As we have been highlighting, the WPI will likely continue to be in a deflation mode during July-September 2009, before it begins to normalize, moving into an inflation mode from mid-October 2009 onward. We expect inflation to rise to 6%Y by March 2010. Moreover, we believe that IP has bottomed out and will gradually accelerate to 8%Y by March 2010. Does this mean that the RBI will move on the tightening path soon? We believe that it will prefer to wait for the economy to recover on a sustained growth path before moving to normalize interest rates. We maintain our view that the RBI will keep the repo rate unchanged in the upcoming monetary policy meeting on July 28, 2009. However, we believe that the central bank statement may make note of the need to start planning an exit strategy. The first rate hike will likely be in February-March 2010, in our view.

...Due to Base Effect of High Commodity Prices

We group the WPI components into four broad categories: 1) food; 2) fuel and electricity; 3) global commodities ex-mineral oil; and 4) non-food, non-global commodities. Only the food items component has remained at significantly high levels of 7.5-9.5% over the last four months. The other three have witnessed significant deceleration/deflation. The bulk of the decline in headline inflation to the current low of -1.17%Y during the week ended July 11, from the peak of 12.91%Y during the week ended August 2, 2008, has been driven by a sharp fall in global commodities ex-oil prices and oil. The high base effect of last year is accentuating the decline in WPI on a year-on-year basis. Moreover, low capacity utilization has resulted in lower core WPI inflation (non-food, non-global commodities inflation). Core inflation decelerated from the peak of 7.9%Y during the week ended September 20, 2008 to 3.3%Y during the week ended July 11.

Indeed, this trend in WPI is a global phenomenon. WPI (or PPI) is primarily reflecting the industrial intermediary product prices, which are highly influenced by international prices. All major countries in the world are witnessing deflation in PPI, which is similar to India's WPI. In June 2009, PPI fell by 13.2%Y for the US, 15.3%Y for China and 6.6%Y for Japan.

Higher Food Prices Keeping CPI in 8-10% Range

Higher food prices have kept CPI-Industrial Workers (CPI-IW) in the 8-10% range over the last 11 months. CPI-IW, after decelerating to 8%Y in March 2009 from the peak of 10.4%Y (in January 2009), accelerated to 8.6%Y as of May 2009 (last data point available). We believe that the most important differentiating factor between the two series is that food products account for a much larger share in the CPI than in the WPI. While in WPI, food products (primary) account for 15.4% of the weight, in the four CPI indices the weight is in the 45-70% range. Moreover, while the WPI basket largely includes tradable items, CPI includes both tradable and non-tradable inflation (which tends to be relatively sticky).

Inflation Outlook - Normalization Underway

WPI inflation trend likely to be U-shaped: We expect the WPI to decline on a year-on-year basis in July-September 2009, on a high base effect and slow domestic demand, before recovering to about 6% by end-March 2010. Our base case assumption is that the crude oil price (WTI) averages US$67/bbl in F2010 (year-end March), based on the oil futures path. With the recent retail fuel price hike, as per our oil and gas analyst, Vinay Jaising, current domestic fuel prices are marked to US$58/bbl. We are not building in any further price increase for domestic oil products by the government in the next nine months. On agricultural product prices, we are assuming a weak output for kharif (summer crop harvesting due in September-November 2009) and a stable outlook for rabi (winter crop harvesting due in April-June 2010). Hence, we expect the pace of acceleration in food prices to remain elevated in the near term and moderate later on.  We expect non-food, non-global commodities inflation to decelerate to 2%Y by September 2009 due to sluggish domestic demand, before recovering to 5.1% by end-March 2010.

CPI tends to follow trend in WPI but with a lag: Although CPI ex-food is already decelerating, high food prices should mean CPI will remain high over the next four months. We expect it to decelerate gradually from current levels to reach 5.5%Y by end-March 2010. We expect CPI to decelerate due to: 1) a moderation in food inflation; 2) increased pass-through of the decline in intermediate input prices (WPI) to finished product prices in the retail market; and 3) below-normal capacity utilization levels to keep a check on the corporate sector's pricing power (although we do expect capacity utilization to improve, we believe that it will remain below normal over the next 9-12 months).

Risks to our inflation forecasts arise from potential increase in food and energy prices: The food and fuel categories are prone to supply shocks, both domestic and global. The upside risks to our inflation forecasts, particularly CPI, will be determined by the way food and fuel inflation pans out over the coming months.

Sustained Growth Recovery Underway

Since October 2008, the RBI has been very proactive in cutting interest rates to underpin growth and improve domestic liquidity conditions in view of the global credit turmoil. In fact, during this period, the RBI cut the repo and reverse repo rates by 425bp and 275bp, respectively, from the peak to 4.75% and 3.25%. In addition, it has injected US$84.6 billion in the banking system since mid-September 2008. Moreover, the government has also been pursuing an expansionary fiscal policy. This traction in monetary policy, together with fiscal support from the government, is helping the economy to move onto a gradual recovery path.

Various economic indicators are showing signs of improvement compared to the lows in QE December 2008. IP improved to 2.7%Y in May, after touching a low of -0.8%Y in March 2009 from the peak of 13.6%Y during QE January 2007. Similarly, consumer discretionary spending is showing signs of improvement. Passenger car sales accelerated to an average of 12.2%Y during QE June 2009 compared to the trough of 1.2%Y registered during QE January 2009. Two-wheeler car sales have also picked up, to an average of 11.9%Y during QE June 2009, after touching a low of -9.9%Y during QE December 2008. On the external demand front, while exports remain weak, declining 32%Y during QE May 2009 compared to the peak of 41.8%Y registered during QE April 2008, we expect the year-on-year decline to narrow from here (i.e., exports would still decline but to a smaller extent).

Interest Rate Normalization to Begin in Feb-Mar 2010

While inflation based on CPI remains high, in view of the recovering macro outlook, we believe that it is unlikely for the RBI to change its course of monetary policy action by hiking the policy rates (repo rate) in the near term. We maintain our view that the RBI will keep the repo rate unchanged in the upcoming monetary policy meeting on July 28. However, we believe that the statement may make note of the need to start planning an exit strategy. We believe that, by March 2010, IP growth will have accelerated to 7-8% and WPI inflation will have risen to about 6%Y, prompting the RBI to start normalizing policy rates. We expect the RBI to increase the repo rate to 6.25% by December 2010 from 4.75% currently, once firm signs of sustained economic recovery are in place. In the near term, if asset prices rise significantly, we believe that the RBI may initiate measures to tighten lending to the property sector and start sterilizing excess liquidity from the banking system.

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Brazil
What Is the China Link?
July 28, 2009

By Marcelo Carvalho | Sao Paolo

What does stronger growth in China mean for Brazil? Trade links, commodity prices and asset prices seem potential transmission channels. While the bilateral trade links between Brazil and China have grown rapidly, their direct impact on Brazil's growth still looks relatively limited on a narrow accounting basis. However, given the strong historical empirical correlation between international commodity prices and Brazil's real GDP growth, China's upgrades can add upside risks to Brazil's growth outlook if they translate into sustainably stronger commodity prices. In addition, asset prices and their influence on local confidence can play an important role too. 

Our China economics team has recently upgraded its real GDP forecasts for 2009 and 2010 (see Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009). The new China forecast sees 9% real GDP growth in 2009 (from 7% before) and 10% in 2010 (from 8%). Our China team argues that the aggressive policy responses so far this year will likely continue to fuel rapid investment growth in the remainder of 2009, while private consumption will likely improve steadily through 2010 as consumer confidence and employment improve. China's export expansion is also expected to resume in 2010 following a sharp contraction in 2009. What are the implications for Brazil? We can think of three main potential transmission channels:

Channel #1: Bilateral Trade

The trade link is the most obvious direct channel that comes to mind when considering China implications for Brazil. Outside of Asia, China's share in the total exports of trading partners is unsurprisingly higher for commodity-exporting countries, as is the case for several countries in Latin America, with the notable exception of Mexico. The share of China as an export destination has also grown in recent years. Our previous work also suggests that the lagged effect of Asian export growth on Latin America is particularly relevant for Brazil (see "Latin America: The Asian Aftershocks", EM Economist, February 13, 2009).

China has become an increasingly important trade partner for Brazil. The share of China in Brazil's total exports has grown from a negligible 1.8% back in 2000 all the way to 12.7% in the 12 months through June 2009, displacing the US as the most important individual trade partner for Brazil - although still significantly below the share of Europe as a region as a destination for Brazil's exports.

Brazil's exports to China are heavily concentrated in iron ore and soybean. Soybean represents about 38% of Brazil's bilateral exports to China, while iron ore accounts for about 30%. These two commodities combined therefore represent about two-thirds of Brazil's bilateral exports to China. By contrast, Brazil's imports from China seem widely spread across individual categories. In bilateral trade, while the top 10 export categories account for 88% of Brazil's exports to China, the top 10 import categories account for only 20% of Brazil's imports from China.

However, the direct trade impact on growth looks limited. While the bilateral trade links between Brazil and China have grown rapidly, their direct impact on Brazil's growth still looks relatively limited on a narrow accounting basis, as Brazilian exports to China represent less than 2% of Brazil's GDP. In 2008, for instance, Brazilian exports to China grew 52.6% - but while prices of bilateral exports increased 60.2%, volumes (quantum) fell 4.7%, according to data from Brazil's ministry of industry and commerce. From the point of view of Brazil's national accounts, the direct contribution to Brazil's growth from expansion in bilateral exports to China would thus be negative, as far as volumes are concerned. This conclusion is reinforced once imports are taken into account - the total dollar amount of Brazilian imports from China jumped 58.8% in 2008, with prices rising 36.3% but volumes also climbing 16.5%. With bilateral export volumes going down and import volumes going up, the contribution of bilateral net exports to growth was negative, in volume terms. 

Channel #2: Commodity Prices

There is a significant empirical correlation between international commodity prices and Brazil's real GDP growth. We find this correlation remarkable. After all, Brazil is often described as a relatively closed economy, given that the share of exports in GDP has been less than 15% in recent years, and commodities represent only about half of Brazil's total exports, which is a relatively low ratio by Latin American standards. Still, the empirical historical correlation between Brazil's real GDP growth and international commodity prices is too strong to ignore.

Perhaps this could be described as an empirical regularity in search for a theoretical explanation, as the exact channels often do not seem fully understood. It seems that there is more to the commodity story than just a narrow direct accounting effect. How do the transmission mechanisms work?

One possibility is that there is a third set of broader factors - perhaps global conditions such as global liquidity and global risk appetite - which help to drive Brazil's economy as well as China's exports and imports, along with commodity prices, with implications for broader capital flows, overall investor sentiment and local business confidence. In this case, the empirical correlation between Brazil's growth and commodity prices might reflect co-movement rather than direct bilateral causality.

Another possibility is that rising commodity prices promote Brazil's currency appreciation, which, in turn, facilitates imports of capital goods, thereby supporting domestic investment. Indeed, commodity prices are a crucial determinant for Brazil's terms of trade (the ratio of export prices over import prices). And there is convincing evidence that the terms of trade are a key driver for Brazil's currency. In turn, a stronger currency tends to facilitate imports of capital goods, which normally correlate with domestic investment trends. After all, Brazil excels in the production of commodities, given its comparative advantage in terms of geography, natural endowment and expertise - but Brazil often seems to lack the technology needed for the efficient production of more sophisticated capital goods, such as machinery and equipment.

Yet one more potential transmission channel may have to do with inflation and monetary policy. On the back of rising commodity prices, currency appreciation can work as a disinflationary force. While higher commodity prices have the potential to add upside risks to global inflation, the broader impact from currency appreciation often appears to be the dominant net effect for domestic inflation. In turn, benign domestic inflation supports monetary easing, which is growth-positive. Put another way, global factors may enhance Brazil's non-inflationary growth prospects, if currency appreciation helps to consolidate a benign domestic inflation environment.

Last, but not least, commodity prices may have an influence on foreign direct investment (FDI) inflows as well. Primary sectors (agribusiness, oil and mining) have gained an increasing share of total FDI inflows into Brazil over the last years. Primary sectors accounted for US$13.0 billion or 29.2% of total FDI into Brazil in 2008. That figure compares with 14.7% in 2007 and 6.9% in 2006. It also seems higher than usual estimates of the share of the natural resources sector in the broader economy. So far this year (January-May), primary sectors accounted for just about 11.0% of total FDI inflows into Brazil. So, if the China-commodity story is for real, then there may be upside risks for FDI inflows into this sector going ahead. Note that China typically does not show as a relevant country of origin in terms of FDI flows into Brazil, although this picture could change over time.

Looking ahead, we feel agnostic on commodity prices. According to its most recent estimates, as of July, the IMF expects growth in non-fuel commodity prices to rebound from -23.8% in 2009 to 2.2% in 2010. One reason for some concern comes from evidence that gains in commodity prices have been riding a wave of liquidity as speculative positions have risen significantly - see Hussein Allidina and team's The Commodity Call - Commodities Rally on Greenback & Green Shoots, June 4, 2009. Still, besides moves in the US dollar itself, China is widely seen as a key player for international commodity prices. If China's rebound translates into sustainably higher commodity prices, then Brazil should benefit, if history is any guide.

Note that China's trade data - rather than domestic indicators - seem more clearly correlated with international commodity prices. For Brazil, the empirical evidence suggests a significant correlation between China's total imports and Brazil's industrial production. Our China economics team has revised up its forecasts for China's total exports and imports this year and next, but only slightly. In the latest forecast, China's total import growth is now expected to rebound from -13.0% in 2009 (-25.4%Y in 1H09 alone) to 10.0% in 2010, revised up from 9.0% before. Similarly, China's total export growth is expected to rebound from -16.0% in 2009 to 9.0% in 2010, revised up from 7.0% before.

Channel #3: Asset Prices

Another potential transmission channel from China to Brazil may be associated with asset prices, such as the local stock market performance. To be fair, it is hard to completely dissociate this channel from the commodity channel, as local equity performance in Brazil in part reflects commodity prices too, given the relatively large share of commodity-related names in Brazil's local stock market. Still, if prospects of rising domestic demand in China spur its local stock market, then such improvement may spill over as a confidence boost for better sentiment towards emerging markets more broadly. And Brazil is often seen among international investors as the poster child for emerging markets - China represents about 19% of the MSCI equity index for emerging markets, with Brazil coming second with 15%. Our equity strategist, Vinicius Silva, highlights that active capital markets, strong growth and market over-performance have brought Brazil's weight within MSCI Latin America to more than two-thirds of the overall regional index lately, from a previous share in the range of 30-40% at the start of the decade. 

In turn, improving local market performance in Brazil can support local sentiment and business confidence. After all, the stock market performance is frequently included as a key ingredient in the construction of leading indicators. At the end of the day, confidence is usually the critical ingredient for any cyclical expansion. Indeed, in Brazil there is a strong empirical correlation between domestic business confidence indicators and real GDP growth, with the latest data suggesting significant improvement during 2Q09.

It is probably not a coincidence that the world's largest initial public offerings (IPOs) so far this year are coming from Brazil and China. China State Construction Engineering Corporation, the country's biggest housing contractor, has recently raised US$7.3 billion in Shanghai in the largest IPO in more than a year. For its part, Brazil's Visanet is reported to have raised US$4.3 billion in its recent offering. After an unprecedented IPO frenzy in 2007, the IPO market dried up in Brazil in 2008, but now seems to have re-opened on the heels of better local stock market performance. Whether markets are running ahead of the economic fundamentals is open to debate. But there is little doubt that improving market performance supports local sentiment and confidence. In a potentially self-reinforcing fashion, ‘the better it gets, the better it gets', in the sense that rising equity markets encourage IPOs and secondary issuance, thereby providing companies with enhanced ability to refinance debt and invest. Of course, there is always the risk that equity markets keep improving until they don't. But if recent trends continue, they would add upside risks to our Brazil growth forecast.

Risks Ahead

What are the external risks to the outlook? In a bear case scenario, global growth relapses as China's stimulus fades while global demand falters. Our China team believes that the key risk to the China outlook lies in external demand, and argues that while strong policy responses could help to achieve a meaningful decoupling between China and the rest of the world, there is no absolute lasting decoupling as China remains deeply integrated into the global economy. For Brazil, in an external bear case scenario, commodity prices suffer, Brazil's terms of trade deteriorate, global risk appetite shrinks, capital flows dwindle and confidence takes a hit. To be fair, Brazil's newly found ability to run domestic counter-cyclical policies may help to cushion (but would not eliminate) Brazil's growth sensitivity to a commodity price downturn. In a bull case scenario, the global economy recovers faster than anticipated, as healing in developed economies speeds up and China expands faster, arguably encouraging global risk appetite and supporting commodity prices, which would help Brazil's terms of trade, encourage capital flows and boost domestic confidence.

Bottom Line

What does stronger growth in China mean for Brazil? Trade flows, commodity prices and asset prices seem likely transmission channels. The direct impact on growth from bilateral trade with China appears limited, in light of the relatively small share of exports to China in Brazil's economy. However, given the significant empirical correlation between international commodity prices and Brazil's real GDP growth, stronger performance in China can improve Brazil's growth outlook if it translates into sustainably stronger commodity prices. In addition, linkages through asset prices and their influence on local sentiment and business confidence can play an important role too. If recent trends continue, they add upside risks to our Brazil growth forecast.

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