Concerns about 10-Year G-Sec Outlook Overdone
September 18, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary
The recent rise in the 10-year government bond yield above 7-7.25% and the high level of government deficit have raised concerns among investors about the risk of 10-year yields surging to 8.5-9%. We believe that the concerns are overdone and maintain our view that 10-year government bond yields will remain range-bound at around 7.0-7.5% until end-March 2010. We believe that there is adequate liquidity in the banking system and that the rise in bond yields has been due more to technical factors and the bunched-up government borrowing during the quarter ending September 2009.
What Is Causing the Upward Pressure on the 10-Year Bond Yield?
The government has continued to pursue an expansionary fiscal policy over the last six months to offset the adverse impact on domestic demand post the global credit turmoil. In F2010, we estimate the government's consolidated fiscal deficit including off-budget expenditure at 11.7% of GDP. The government is likely to raise Rs4 trillion through net market borrowing in F2010 compared with Rs2.6 trillion in F2009. It also had larger bond issuance under the 10-year segment during the first half of F2010. More importantly, many banks have been hesitant to purchase more long bonds, as they have exhausted the 25% limit for buying government bonds under the Held-to-Maturity (HTM) category. Currently, the Reserve Bank of India (RBI) allows banks to hold government securities up to 25% of their net demand and time liabilities (NDTL) in the HTM category. Hence, any incremental investment will have to be made under the Available-for-Sale (AFS) category, which could potentially expose banks to mark-to-market losses in the event that there is an adverse movement in bond yields. Typically, banks prefer to purchase longer-tenure paper under the HTM category to avoid volatility in reported income due to fluctuations in bond prices.
Why We Think Concerns about the 10-Year Bond Yield Outlook Are Overdone?
We expect 10-year bond yields to remain range-bound over the next 12 months. Three reasons why we believe that the 10-year yield will not rise sharply above 7.5% are as follows:
Banking sector liquidity is abundant: With credit growth remaining below deposit growth, the banking system remains flushed with excess liquidity. Excess liquidity in the banking system has increased to about US$60 billion currently (about 7% of the bank deposits). Banks have parked US$29 billion in reverse repo plus market stabilization scheme (MSS) bonds and US$30 billion in liquid mutual finds. Liquid mutual funds typically invest in short-term paper, and currently they yield annualized returns of 4-4.5%.
Moreover, banking sector excess liquidity continues to rise as bank credit is growing at a slower rate of 14.1%Y, while deposits are growing at 20.5%Y as of end-August 2009. The incremental credit-deposit ratio at 49.9% is currently close to 2003 lows. We believe that credit demand will start picking up only from November-December 2009. Typically, credit demand lags industrial production by 4-6 months. Even while we expect credit demand to pick up, we believe that it will remain around 20-22% (close to deposit growth), as we expect only a gradual recovery in the capex cycle in the next 8-9 months.
Rise in capital inflows adding to excess liquidity: Over the last four months, capital inflows (FII portfolio equity investments, FDI and foreign debt inflows) have increased significantly. With the RBI's intervention in the FX markets, foreign exchange reserves have increased by US$25.6 billion since the first week of May 2009 to US$276.3 billion currently. We expect capital inflows to continue in the range of US$45-50 billion over the next 12 months, ensuring that the balance of payments remains in surplus.
Borrowing demand has peaked: We believe that the government's borrowing will reduce going forward. We believe that fiscal deficit pressures should start easing over the next 3-4 months. Over the last 18 months, there were a number of factors that kept the fiscal deficit at unsustainably high levels. First, the government announced a big increase in spending pre-elections in F2009. Second, a sharp rise in the oil price pushed the oil and fertilizer subsidy to significantly high levels. Third, as lower crude oil prices reduced the oil subsidy burden, the government announced a fresh fiscal stimulus in the advent of a global crisis. The collapse in industrial production growth post the credit turmoil also reflected in poor tax revenue growth. However, going forward we believe that recovery in growth will help to improve tax revenue collections, and the government is unlikely to require any further increase in fiscal stimulus.
RBI's Exit Strategy - Implications for 10-Year Bond Yields
A stronger-than-expected recovery in industrial production has meant that the RBI will likely start hiking policy rates from January 2010, in our view. Indeed, we believe that if industrial production data continue to surprise to the upside, the RBI will likely start reversing monetary policy before end-December 2009. We think that this lifting of policy rates by the RBI is unlikely to cause a parallel rise in long bond yields. The yield curve (the gap between the 10-year bond and 91-day T-bill yields) at 305bp is already near the steepest point in history. We expect the yield curve gap to normalize closer to 200-250bp over the next 12 months, as the RBI lifts short-term rates. Short-term rates are close to their historical lows.
What Can Take the 10-Year Bond Yield to 8.5-9%?
We see two potential risks to our view that the 10-year bond yield is likely to remain range-bound. First, if oil prices were to rise sharply to US$100-110/bbl in the near term, it could result in a major increase in the oil subsidy burden on the government. The bond market could become concerned about the potential increase in the fiscal deficit. However, if oil prices were to rise gradually over the next 12 months as the growth trend picks up, the market should absorb the burden better as tax revenues would have also picked up. It would also allow the government more time to transfer some burden to the consumers by increasing retail fuel prices.
Second, the government could continue to pursue a loose fiscal policy, though we see a lower probability of this risk occurring. The government-appointed 13th Finance Commission is likely to release its report advising the government on the plan to implement fiscal consolidation. We believe that as long as the government resists announcing any further fiscal stimulus, the fiscal deficit should be reduced significantly over the next 12 months.
Bottom Line
We maintain our view that the 10-year government bond yield will remain in the 7-7.5% range until end-March 2010. Excess liquidity stock in the banking system remains high. With bank credit growth significantly below deposit growth, incremental surplus liquidity available for subscribing to government bonds will continue to be comfortable. We believe that the government will ensure that the 10-year bond yield does not rise above 7.5% by either reducing the tenure of borrowing or increasing the HTM limit for banks to purchase the 10-year bonds under that category.
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Medium-Term Program - it Is Home-Made
September 18, 2009
By Tevfik Aksoy | London
The new 3-year Medium-Term Program: Numbers look internally consistent and achievable, in our view. Turkey's long-awaited Medium-Term Program (MTP) has been made public by the Deputy PM and State Minister Ali Babacan. In comparison to previous MTPs, especially the most recent one published earlier in the year, we believe that Turkey's new program portrays a more consistent and achievable set of forecasts. In our view, this marks a positive step forward and raises the credibility of the figures noticeably.
However, we see some blanks to be filled in: The forecasts and overall framework do not fully explain how the government will achieve its goals, in our view. Moreover, we see a heavy reliance on a cyclical improvement in growth and associated rise in revenues. In addition, the program does not include contingency plans for a possible extension of the global downturn, which could be important, given the lack of clarity regarding the future of Turkey's relationship with the IMF.
Agreement with the IMF: However, Mr. Babacan indicated that the IMF would be analyzing the MTP and that the discussions going forward would be based on the main premise of the government's program. Provided the government finds acceptable any potential additional measures or the timing of any fiscal adjustment proposed by the IMF, then it seems to be ready to move forward. Mr. Babacan added that borrowing from the IMF would be cheaper and that any additional factor to increase the credibility of the MTP would be beneficial. Hence, our take is that the government is still willing to pursue a stand-by program but only if it materializes on Turkey's own terms. That makes us preserve our cautious optimism regarding a possible deal in the near term as the new framework signals a very slow adjustment on the fiscal side (and debt dynamics), which also relies heavily on a cyclical improvement in revenues.
Much better than the previous version: Looking at the details of the revisions in the forecasts and the internal consistency of the numbers, we notice the following:
• The new forecasts appear much more realistic. The economy is expected to contract by 6% in 2009 and grow by 3.5% in 2010. These are very much in line with our forecasts, and the government's 2009 figure is more pessimistic than our -5.2%Y. In 2010, we have exactly the same growth rate, while for 2011 our GDP growth forecast is slightly higher than the official figure at 4.2%. The framework seems to be based on the expectation that a gradual pick-up in global growth will materialize in the coming years, and the base year effects, as well as lower domestic borrowing costs, could spur growth.
• The unemployment and the current account forecasts are all realistic, in our view, while inflation forecasts, which are taken as-is from the central bank projections, seem optimistic. We expect similar patterns in unemployment and the current account, but we believe that inflation will be hitting a plateau and will increase slightly in 2010 on the back of the pick-up in growth and commodity prices. That said, this aspect of the program is not a significant pillar.
• Perhaps most importantly, the fiscal projections point to a rather less ambitious stance. The forecasts for the central government deficit suggest that the projected 6.6% (of GDP) figure will improve modestly to 4.9% in 2010 and 4% in 2011. This is a rather slow adjustment and, from the brief mention of the nature of the process, we understand that the improvement will be based on a pick-up in tax revenues associated with the improvement in growth and slightly lower interest expenses. Non-interest expenditures are projected to rise in 2010 to 34.3% of GDP from 33.6% in 2009. Spending is expected to be cut back to 33% in 2012.
• The primary balance (i.e., budget deficit excluding interest outlays) is projected at -2.1% in 2009 and expected to improve to -0.3% next year, only to post a slight surplus of 0.4% in 2011. This, in our view, demonstrates a very gradual adjustment and not only results in a longer period to stabilize debt to GDP but could also open the program to risks of internal and external exogenous shock. That is, in the event of an unexpected decline in growth, a sudden currency depreciation and/or rise in real interest rates, debt to GDP will continue to rise much faster than in the authorities' base case assumptions. This is not to say that the base case program should be designed to address these possible shock scenarios, but we believe that it is something the IMF could stress if a stand-by arrangement gets underway. Especially in comparison to the extremely tight fiscal policy of 2002-07, the picture on the primary surplus front looks rather weak. A counter argument would be that overall debt to GDP had improved substantially and that Turkey does not need to tighten as much but, as previous experience suggests, tight fiscal policy can actually be expansionary.
• As a result of the slow adjustment process, debt to GDP, which stood at 39.5% of GDP in 2008, will rise to 47.3% in 2009 and 49% in 2010. In 2012, the government expects debt to GDP to improve to 47.8%. In comparison to most developed markets, as well as those under the emerging classification, debt to GDP is clearly lower, and this seems to be giving the government a level of comfort. While there is merit to this view, the short nature of the maturity of the domestic debt, the presence of the crowding-out effects and rapid re-pricing of debt makes the ratio look less comfortable than it suggests. Also, in an environment of scarce global credit, clearly a stable (if not declining) debt to GDP outlook would be much more preferable.
Establishing a fiscal rule framework: We were encouraged by the government's intention to institutionalize a fiscal rule framework. According to the MTP, a fiscal rule would be put in place by 1Q10, and the budget of 2011 will be based on this. On the positive side, this will allay concerns regarding the deviations from the expenditure targets and limit surprises on the borrowing (issuance) front. On the negative side, the rule will be put in place nearly five quarters from now, and this gives little comfort regarding fiscal implementation in 2010.
Overall, we perceive the MTP as a consistent and achievable framework with forecasts broadly in line with ours. However, we still believe that there are some blanks that need to be filled in, especially in the fiscal area, to smooth the road to fiscal adjustment. While there is little to infer regarding future relations with the IMF, we still believe that the government is open to the idea, and unless the IMF pushes for dramatic changes in the overall picture, a stand-by arrangement strikes us as plausible. If the two sides cannot reach an agreement, we still believe that the MTB would be implemented; however, in this case, the reaction of market participants and analysts might be simply along the lines of ‘seeing is believing'.
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‘Up' With ‘Swing'?
September 18, 2009
By Joachim Fels | London
Financial assets have continued to rally across the board in recent weeks, buoyed by record levels of excess liquidity that central banks have been and keep pumping into the system (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27, 2009). Most investors now have fully embraced the theory that we are in a ‘sweetspot', where an only tepid economic recovery and below-target inflation prevent central banks from removing conventional and unconventional stimulus until well into next year.
In fact, our global team's baseline economic scenario for 2010-11, which we laid out in detail in last week's Global Forecast Snapshots (‘Up' Without ‘Swing', September 10, 2009), is consistent with a continuation of the ‘sweetspot' for quite some time. While the global economy is currently in a rebound phase that started in 2Q09, with output expanding at a 4%+ clip, we continue to expect a fairly ‘dull' expansion in 2010, which will still require much policy support and should only become more self-sustained in 2011. Hence, we only expect the major central banks to start removing some stimulus from about the middle of next year, especially as many central bankers still fret about deflation risks and keep worrying about the fragility of the financial system.
However, while we think that a ‘dull' expansion, with global GDP growing considerably more slowly over the next couple of years than during the previous upswing, is the most likely outcome, there are of course significant risks in both directions.
As we see it, the main downside risk to our base scenario would now be a premature monetary or fiscal tightening. Previously, the main sources of downside risk were the presence of serious imbalances - ultra-low savings rates, excessive house prices, over-investment in some sectors - that had built up during the boom and were still in the process of being corrected in the recession. However, several of the imbalances have now either been corrected or are less severe, implying that the inherent recessionary forces have faded. Therefore, the most plausible double-dip scenario now is one where policymakers tighten policy prematurely. Note that this is what our Japan team is forecasting - a double-dip recession next year once the new government enacts a major fiscal tightening in the new fiscal year. However, in most other countries we think that policymakers are acutely aware of the double-dip risk and are thus more likely to keep accommodation for longer.
Interestingly, our conversations with investors over the past several weeks suggest that, while most embrace our central ‘dull' expansion scenario, they are much more focused on the downside or double-dip risks than on any upside risks, with many dismissing a ‘hot' scenario as extremely unlikely. However, we would warn against underestimating the upside risks to a ‘dull' expansion scenario, and we think that a ‘hot' or ‘blow-out' scenario is especially worth exploring as investors do not seem to be prepared for it at all.
The reason why significant further upside surprises on global growth should not be dismissed easily is that it remains extremely difficult to gauge the impact on growth of the unprecedented monetary and fiscal stimulus that has been put into place globally, especially as the major central banks are still engaged in their respective QE programmes. One important lesson from this year's events is that monetary policy, provided it is aggressive and unconventional enough, can be very effective even if banks are struggling and are reluctant to lend. Sharp rate cuts and the announcement of QE helped to dispel deflation fears, led to a normalisation of inflation expectations and thus lowered (expected) real interest rates earlier this year. These actions also sparked a major rally in risk assets from March, which in turn improved balance sheets in the financial and household sector and opened up capital markets for corporates. Moreover, near-zero interest rates in the US and Europe eased monetary conditions in those emerging market economies that peg to the dollar or the euro, adding to their domestic stimulus packages. Thus, it didn't come as a surprise that China was the first major economy to emerge from recession, given that it imports easy money from the US through the exchange rate link without having the US's financial sector problems. (We described all these transmission channels in "Money Talks", The Global Monetary Analyst, May 6, 2009.)
The point worth noting here is that we may all still be underestimating the effects of the stimulus that has already been put into place and is still playing out. If so, growth would not moderate from its current 4%+ global pace going into 2010 as in our base case, but accelerate further. The most plausible upside scenario, in our view, would be one where Asia keeps motoring ahead with domestic demand strengthening further in response to the stimulus, leading to a surprisingly strong revival of global trade. Rising export demand from EM would lift production and stimulate capex in the advanced economies, which has fallen precipitously over the past year or so. True, much of this capex would be to replace outdated equipment (IT equipment ages fast) and to upgrade existing production facilities, rather than expanding capacities, but the impact on output and employment could still produce a better development in the labour market than we currently anticipate, with some positive knock-on effects on income and consumer spending.
Such a growth burst would probably not spark an immediate policy reaction, given policymakers' worries about financial fragility, so growth could well pick up considerable momentum before policy reacts. However, markets would probably start to price in earlier and more aggressive tightening, and bond markets, which have rallied in recent weeks, would likely sell off. Depending on the size of the sell-off, risky asset markets would probably also be affected. With growth above expectations, central banks would probably lift their inflation forecasts, which are usually based on models where output gaps in various guises play a prominent role. This, in turn, would eventually lead to a more pronounced tightening of monetary policy during 2010 and 2011, especially as inflation would likely move significantly above targets in 2011. A sharp tightening of monetary policy, especially if combined with fiscal tightening in 2011 and beyond, could well push the global economy into another (this time policy-induced) recession by 2012.
Again, this blow-out scenario is not our base case. But we deem it more likely than most investors we have met over the past several weeks. In fact, we have met only few who were willing to seriously consider such a scenario. This suggests to us that the biggest risk to buoyant asset markets is currently not some downside surprises to growth in the next few months - these would rather prolong the bond rally and make investors even more confident that monetary policy will be on hold for longer. The biggest risk right now to markets, in our view, is that the economy goes ‘up' with rather than without ‘swing', which would raise big question marks over the still-powerful excess liquidity story. For more details on how investors should prepare for the end of easing and the beginning of tightening, please refer to the Strategy and Economics Team's joint report, "The End of Easing", Cross Asset Strategies, September 1, 2009.
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