Of Credit Cushion, Inflation and Trade Deficit
August 20, 2009
By Deyi Tan, Chetan Ahya | Singapore & Shweta Singh | India
A Credit Cushion for a Credit-Induced Global Recession...
Vietnam and China's macro stories have some similarities in this cycle. Amid the global recession, aggressive policy measures such as a loose monetary policy helped the China economy recover from a trough of 6.1%Y GDP growth in 1Q09 to 7.9%Y in 2Q09. Credit creation in January-July 2009 reached a high of Rmb7.8 trillion. This is about 26% of GDP and exceeds the 2008 total by 86%.
In Vietnam, the US$1 billion interest rate support scheme that provides a 4% loan interest subsidy (for which the loan tenure has been extended from nine months to 24 months) served a similar purpose. Credit growth in Vietnam accelerated from a bottom of around 10%Y in March 2009 to around 24%Y in July. This is so even as credit growth in the AXJ ex-China region decelerated from a peak of 22.3%Y in November 2008 to 10.9%Y in June, with banks staying cautious regarding new lending. Indeed, total loans disbursed under the interest rate subsidy scheme as of August 13, 2009 stood at VND395 trillion, and this likely underpinned the ~VND250 trillion in total credit creation in the first seven months of 2009. New loan creation is about 17% of GDP. To put this in perspective, new loan creation in economies such as Singapore stood at less than 0.1% of GDP for January-June 2009. Yet unlike China, where there is abundant liquidity, the strong credit disbursement in Vietnam happened alongside a compression in NIMs as VND deposit rates rose between 30-100bp from January 2009. Still, helped by the loose monetary policy and with the banking sector being a relatively more developed source of funding compared to the capital markets, the Vietnamese economy bottomed out from 3.1%Y in 1Q09 to 4.4%Y in 2Q09.
...as External Demand Indicators Stayed Weak
Indeed, credit disbursement has provided a cushion at a time when external demand indicators remained weak. Data on credit breakdown to the various sectors are not available on a monthly basis. However, details from 2Q09 GDP suggest that the interest rate subsidy program has benefited primarily the industrial sector (+4.4%Y in 2Q09 versus +1.4%Y in 1Q09), such as manufacturing (+2.0%Y versus +0.5%Y) and construction (+9.8%Y versus +6.9%Y) and, to a lesser extent, the agricultural sector (+2.2%Y versus +0.6%Y) and the services industry (+5.7%Y versus +5.6%Y).
The pick-up in headline growth has panned out despite the fact that, on the external front, exports momentum on a 3MMA basis has yet to bottom, reaching -26.7%Y in July (versus -22.4%Y in June). Excluding commodities to strip out the base effects from prices, exports are also still declining, at -22.3%Y, 3MMA in July (versus -17.7%Y, 3MMA in June). On the other hand, FDI flows also remain weak. Committed FDI for January-July 2009 stood at US$10.1 billion (versus the full-year target of US$20 billion). This is US$17.3 billion on an annualized basis, which is 26% of the pace in 2008. Implemented FDI in January-July is US$4.6 billion (versus the full-year target of US$8 billion), which is US$7.9 billion on an annualized basis and 68% of the pace in 2008.
Limitations to Policy-Driven Recovery Due to Inflation Pressures...
In our view, limitations to a policy-driven recovery due to potential inflation and trade deficit pressures suggest that the growth baton will have to be passed from the policymakers to make way for a market-based export-driven recovery. We believe that a market-based export-driven recovery is in the cards, as signaled by the US ISM New Orders indicators. For now, however, with the strong credit growth and the initial GDP uptick, there has been increased market chatter regarding potential inflationary pressures. Unlike in the developed world, Vietnam has a functioning banking system that can push liquidity out into the real economy via credit growth. Assets typically reflate ahead of CPI. It is no different this time round, in our view. Mortgage activities have restarted and, as in other economies in Asia such as Singapore, property transactions volume has picked up. Anecdotally, residential property prices bottomed out in 2Q09, with a smaller price rise seen in the luxury segment and a larger price pick-up in the mass-market segment. In some selected projects, prices have risen by as much as 20-30%.
Headline inflation remains subdued for now amid the high base effects of commodity prices. July headline inflation reached a low of 3.3%Y, a level last seen in January 2004. Our rudimentary measure of core inflation (excluding food and transportation segments) shows it at 5.1%Y in July. With retail fuel prices being adjusted upwards and with base effects wearing out, a re-normalization of 2010 inflation levels back to a 7% average would be consistent with the US$75/bbl oil priced in by the futures curve. The slack opened up by the 2009 macro slowdown would buy some time before demand-pull inflation pressures become a concern, in our view. Yet, the rate of credit expansion from here on would be key to watch. The State Bank of Vietnam set the 2009 lending target at 25-27%. Credit growth year to date is around 20%. If the lending target is to be adhered to, credit disbursement for 2H09 will have to slow to less than half the pace of 1H09. The delicate task of policy adjustment will likely have to take place to reduce the possibility of demand-pull inflationary pressures, in our view.
...and Widening Trade Deficit
The trade deficit is another issue to watch, in our view. It gives an indication of demand that cannot be met domestically and is a source of pressure on the currency, and hence inflation, given the high level of dollarization in the economy. The strong policy response led to a turnaround in import momentum from -41.0%Y 3MMA in March 2009 to -21.3%Y, 3MMA in July, despite the fact that exports have yet to bottom. This has led the trade balance to turn from a surplus of +6.6% of GDP (3M trailing sum, annualized) in March 2009 to a deficit of -16.4% in July. The current deficit widening might be less worrisome if the credit expansion has led to some degree of restocking or capex investment in export industries that would translate into future export growth, and hence close the trade gap. However, a look at the import details shows that steel imports contributed the most to the import turnaround between January and July. To the extent to which the steel imports data are suggesting a pick-up in construction activities which might not contribute to future export growth, we think that a further widening in the trade deficit could impose limitations on the current mode of policy-driven recovery.
Bottom Line
Like China, Vietnam's economy bottomed out in 2Q09 on strong credit expansion. New credit creation stood at about 17% of GDP in January-July on the back of the interest subsidy program. However, we believe that potential inflation pressures and a widening trade deficit could impose limitations on the policy-driven recovery. In our view, the growth baton will have to be passed from the policymakers to make way for a market-based export-driven recovery.
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Between a Rock and a Hard Place
August 20, 2009
By Manoj Pradhan & Spyros Andreopoulos | London
Introduction
Monetary policy usually finds traction in the real economy through different ‘channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.
The Sequence of Events in Economic Recovery
In a garden-variety recession, policy rate cuts lead to declines in lending rates and slow traction in the form of a better outlook for consumer and business spending. Risky assets usually rally a quarter or two before the recession ends, whereas credit growth usually picks up only after recovery sets in (see "Credit Confusion", The Global Monetary Analyst, February 4, 2009). The Great Recession has not scrambled this sequence of events but it has changed the timing and response of some. Because of the freezing of credit markets, the interest rates that matter for borrowers fell much later than they would have during a more typical episode. Also, given the massive task of repairing balance sheets that confronts commercial banks and households in particular, spending and borrowing are likely to remain subdued. The risk is that credit growth could lag the end of the recession by more than usual. However, risky assets seem to have stuck to the script and rallied ahead of the bottom in economic growth by a familiar lead time.
Interest Rate Channel Less Effective So Far
When central banks cut policy rates, other interest rates respond quickest to the policy move. By providing cheaper borrowing rates to households and businesses, central banks aim to encourage spending and spur production. This is the ‘interest rate' channel for monetary transmission. This channel typically carries the bulk of the burden of resuscitating the economy. Untraditionally, during this current cycle, interest rates that matter to borrowers have fallen very slowly and much later than the cuts in policy rates. Even as they have fallen, however, they have met households who are reluctant to exploit these low rates, given the desire to save in the US and the UK and the conservative habits of German and Japanese households.
Credit Channel Likely to Be Subdued as Well
During a recession, credit flows to the private sector usually fall. Banks are less willing to lend and households and firms are less willing to borrow. Policy rate cuts normally provide commercial banks ‘carry' via a steeper yield curve, allowing them to borrow money at low rates and lend it at higher rates. In this cycle, central banks have had to resort to unconventional measures in addition to rate cuts to ensure that banks had the benefits of a steeper yield curve and an abundance of liquid funds to lend if they so desired. Surveys suggest that banks are becoming more receptive to lending but credit will likely grow with a lag (again see Credit Confusion) and quite slowly thanks to banks and households slowly rebuilding their balance sheets.
Asset Price Channel Leading the Charge...
Risky assets have outplayed the other channels by a margin over the last few months. This is an encouraging sign for central banks, who will undoubtedly welcome the economic traction that accompanies rising asset prices. A rise in equity prices should enhance the incentive to invest because the higher price of existing capital implied by higher share prices increases the relative attractiveness of investing in new capital (Tobin's q). Back in March, with the worst of the economic bad news likely already having been delivered and ultra-expansionary policy in place, risky assets rallied and rallied hard, which is a positive for investment. A possible bottoming in the housing market in the US and the UK would mean that Tobin's q could be applied to the housing sector as well. Households are more likely to buy new houses if house prices are rising, and this encourages homebuilding activity. Also, rising asset prices have supported the balance sheets of financial institutions.
...but Risky Asset Rallies Come at a Cost
One of the most important lessons from the Great Recession is the damage that asset bubbles can wreak. As the Fed and the ECB kept policy rates low for a very long time after the 2001 recession to ward off deflation concerns, they chose to allow an ultra-expansionary policy to inflate asset prices. Even though economic growth in the next couple of quarters could be very strong, the medium-term outlook for the major economies and therefore for global growth remains quite fragile. Policymakers therefore may end up having a repeat of the 2001-type dilemma on their hands.
Between a Rock and a Hard Place
If the imbalance between risky asset prices on one hand and interest rates and credit on the other persists for a significant period of time, the transition from über-expansionary policy to a neutral stance could be an extremely tricky balancing act for central banks. In the long run, asset prices cannot keep exceeding the growth potential of the economy. However, over shorter horizons, a loose policy regime with plentiful excess liquidity can lead to significant asset price inflation when markets see an improving economic outlook. If policymakers allow asset prices to surge because the other transmission channels have been weak, they risk inflating the type of bubble that got us here in the first place. If they decide to head off asset prices by tightening policy, they risk raising rates into a weak recovery! The transition to a neutral policy stance thus requires greater balance between the channels of monetary transmission - ideally from interest rates and credit growth gaining better traction in the economy as asset price inflation cools down. This balance is far from guaranteed. Worse, a revival in credit growth could further stoke asset price inflation. Not the best news for central banks.
Inflation Targeting Too Stringent
What could central banks do if they find themselves in such a situation? Using the interest rate tool to quell asset price inflation when the economy is yet to recover fully would risk sustained deviations from the inflation target on the downside. At the same time, it would expose central banks to criticism from politicians and the public since the policy might jeopardise the recovery. Central banks might try to counter the pressure by arguing that pricking asset price bubbles would foster price stability over a longer time horizon by preventing crises such as the current one. But this riposte would be problematic in the current policy framework. Deliberately using policy rates to pursue objectives other than inflation - especially in a way that is detrimental to achieving the inflation target - is incompatible with the inflation-targeting (IT) orthodoxy. More to the point, pursuing asset prices could deliver a fatal blow to the transparency of the monetary policy regime. If the public is unclear about what the objectives of monetary policy are, it could lose faith in the central banks' commitment to price stability and inflation expectations would become unanchored. One of the main advantages of IT - transparency - would then be rendered defunct.
A Way Out?
Assuming CBs want to ‘lean against the wind' of asset prices, is there a way for CBs to escape the strictures of orthodox IT without risking the loss of their holy grail, the credibility of monetary policy? Price level targeting (PT) may be the answer. Under PT, the central bank aims at a certain path for the price level, with the rate of increase in the price level given by the inflation target (see "From Inflation Targeting to Price Level Targeting", The Global Monetary Analyst, July 15). PT differs from IT in that past deviations from the inflation target have to be corrected. For example, with a price level target path consistent with 2% inflation, if inflation in one period is 1%, then it would have to be 3% in the next period. The undershoot in one period would have to be compensated for by an overshoot in the next period in order to return to the price level target path. In short, PT is essentially ‘average inflation' targeting.
How Would PT Help Central Banks?
By effectively increasing the time horizon over which the inflation target can be achieved, it would give monetary policy much-needed flexibility to, if necessary, pursue asset price inflation in the short term. At the same time, long-term inflation expectations would remain anchored since monetary policymakers would commit to achieving 2% inflation on average. Indeed, inflation expectations under PT would themselves have stabilising effects on the economy. While inflation undershoots the target temporarily in order to burst the bubble, the public would know that this would soon require a compensatory overshoot. Short-term inflation expectations would then rise, decreasing real interest rates. This would, in turn, increase spending and output.
In summary, the transition from ultra-expansionary policy to a neutral stance may be very tricky if the imbalance between different channels of monetary transmission persists. Central banks may find themselves hiking into a weak recovery to quell asset prices, or they might compensate for the weakness in the interest rate and credit channels and allow asset prices to rise but risk inflating another bubble. Central banks could gain some much-needed flexibility by thinking outside the IT box - but whether they will make a dramatic move and switch to a PT regime remains to be seen.
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