Japan
Still Cautious after Factoring for New Government's Austerity: F3/10-12 Outlook
November 18, 2009

By Takehiro Sato & Takeshi Yamaguchi (Tokyo)|

Our Outlook for Overseas Economies Is a Little Better Than Before; For the Domestic Economy We Nudge Down Our 2010 Forecast after Changes in the Political Situation

We have revised our economic outlook following publication of July-September GDP (annualized rate +4.8%). When we last reviewed our outlook (September 11), we emphasized our views that with the change of political leadership, the focus of economic policy was likely to shift from the corporate-oriented to the household sector-oriented, that the pattern of expenditures would depress the 2009 growth rate, but that this would work to lift the growth rate in 2010. Our basic view is unchanged. However, we have made some small adjustments to our outlook, given the 1H results being well above our expectations, the prospect of changes in political assumptions, and the increased likelihood of an austere initial budget for F3/11, some JPY10 trillion-plus smaller than the F3/10 total (including supplementary budgets) under initiatives from the new Finance Minister. We make three main changes: 1) we marginally raise our forecast for the economy in 2009, to reflect the 1H results; 2) we slightly lower our 2010 forecast as we factor more explicitly for fiscal austerity; and 3) we raise our price outlook for 2010 as we factor for the introduction of carbon taxes on the same scale as the outgoing provisional gas tax surcharge (already in our forecasts), and consequently, we foresee a neutral impact overall on consumer prices.

For 2011, despite the prospect of broader implementation of income support measures, we anticipate effective tax increases with expansion of the taxable bases for income and corporate taxes (due to elimination of or reduction in deductions for spouses/dependents, etc.). Hence, we estimate the net effect in terms of economic stimulus as unchanged from F3/11 - i.e., additional economic stimulus effects versus F3/11 will be zero - and that there will not be much sense of acceleration in domestic demand. However, for overseas economies, we see plenty of potential for macro policy taking on an expansionary bias in the lead-in to the political events of 2012, and we generally anticipate strength due to policy effects. We expect the growth rate in the Japanese economy, though lagging overseas economies, to pick up modestly towards 2H11, chiefly due to exports driven by overseas economies.

The Course of the Economy Based on the Altered Fiscal Policy Path of the New Administration

Japan and Asia preceded the US into recovery in April-June 2009, and in October-December, too, we do not expect Japanese manufacturing to show many signs of a slowdown (industrial production +8.3%Q in Apr-Jun, +7.2% in Jul-Sep, around +6% estimated in Oct-Dec). But there is plenty up ahead to hurt the recovery momentum. On the fiscal side, we expect changes in the expenditures pattern to result in a clear slowing of public works investment from Jan-Mar 2010. We also expect adverse conditions to persist in the employment and earnings climate. In manufacturing industry, the reduction of capacity surpluses and realignment fuelled by the downward shift in the global economic outlook in the wake of the credit turmoil are now major themes. With capacity utilization still low, we also anticipate curbs in surplus production capacity and cuts in regular employment to make ground. Signs towards the downside are already showing up in economic indicators. The current conditions DI in the October Economy Watchers' Survey turned negative again, month on month, over the previous month. This DI leads the direction of the economy by about three months, so it indicates another leveling off starting in January-March.

Factoring More Explicitly for the Impact from Fiscal Austerity in Our F3/11 Outlook

The government is targeting to cut budgets by at least JPY3 trillion to a JPY92 trillion level from the budgetary request for F3/11 (JPY95 trillion). Subtracting local allocation taxes and debt servicing costs from this, we estimate general account expenditures to be on a scale of JPY52 trillion. This implies that the size of F3/11 general account spending will shrink by more than JPY10 trillion from that in F3/10 (after the first supplementary budget). As F3/09 general account expenditures (final accounts) were about JPY53 trillion, we think that the F3/11 spending level will return close to the F3/09 level.

Holding other factors constant, reductions in government spending necessarily push down GDP. However, even if the size of general account expenditures shrank by JPY10 trillion year on year (2% of GDP), F3/11 GDP would not immediately fall 2pp, and the actual impact would be smaller. First, spending built in the budget includes property acquisition costs and subsidies, costs for various transfers and financing, and so forth. These items do not contribute directly to GDP (so-called ‘Mamizu (real water)'). Second, the impact from budget implementation on a single fiscal year tends to be smaller because the budgets often include spending which is partially rolled over to the next fiscal year. Third, we believe that the indirect impact through other demand components such as personal consumption has been weakening of late (i.e., the government spending multiplier is close to 1). Although we need to analyze details of the F3/11 budget to make precise calculations, we have already assumed in our report issued on September 11 that most of the additional F3/10 spending will be put back to F3/11.  

Though our outlook factors for most of potential spending cuts, we are now lowering our assumptions further for public investment and government consumption for F3/11 and onward, considering a likelihood that spending cuts will progress more than anticipated through the project itemization. Specifically, we now assume that public investment will be JPY0.7 trillion smaller on a nominal basis, and government consumption also JPY0.3 trillion less in F3/11 than our previous estimates. These changes lower our GDP estimates, all other things being equal, by 0.2pp from our previous forecasts. 

We Are Raising Our F3/10 Corporate Earnings Outlook

We are raising our forecast for F3/10 corporate earnings (recurring profit; corporation statistics (parent) base; corporations with greater than JPY1 billion capital, excluding financials) from -40%Y to -25%, on analyzing 1H results. The reason is that 1H results were strong overall, with some exceeding guidance, due to lower sales cost ratios brought on by inventory recovery. In 2H also, we expect production and exports to continue on a strong trend in Oct-Dec without showing notable deceleration, driven by solid demand in emerging countries. We believe that corporate activities are shifting from the ‘economic crisis' mode in F3/09 2H to a ‘normal recession' mode. We anticipate that the domestic economy will face a dip in Jan-Mar 2010 as we previously stated, and manufacturers' performance will accordingly deteriorate. However, we do not think that the impact on F3/11 corporate earnings will be so significant.

We look for profit to grow 15% in F3/11 and 10% in F3/12. However, as the absolute degree of profit decline in F3/09-F3/10 is substantial, we do not believe that corporate earnings will recover to the F3/08 level that predated the financial turmoil.

For reference, a 1pp change in our GDP outlook equates to a10pp change in our profit outlook. Also, a 5% JPY/USD forex fluctuation equates to a 3pp change in our profit outlook. Our forex (JPY/USD) assumption is JPY91/USD for F3/10 on average, and at this point, we do not think it is necessary to lower our outlook from the perspective of forex.

Upside/Downside Risks to Our Outlook

Upside risk to our outlook above includes that the gap between domestic and overseas interest rates may widen, and the yen may depreciate, due to a slower exit by the BoJ as leading central banks embark on exit policies, adding to relative pressure for monetary easing in Japan. Indeed, as we discuss below, we think the BoJ's exit timing will be put back to 2H11, lagging significantly behind other major central banks. Our forex strategy team now assumes an end-2010 rate of JPY101/USD, looking at the trends in the interest rate gap.

Upside factors also include a feedback loop from strong overseas capital markets. Global capital markets are supported by tailwinds, as Japan was in 1999, such as a stabilized financial system thanks to public capital injection, large-scale fiscal stimulus, and a better financial environment due to substantial monetary easing and expanded credit-guarantee programs. 

Meanwhile, downside risk to our outlook is the likelihood of more stringent regulations for financial institutions, dampening aggregate demand via asset reductions. Although the G20 has not unanimously agreed on strengthening regulations for equity capital, we think this could well become the de facto standard before it is set as an official rule. In such an instance, as various sources have already pointed out, Japanese banks, where the Tier 1 common stocks/retained earnings ratio is about 4% on average, could be at a relative disadvantage. To improve the Tier 1 ratio, we can imagine strategies that combine increases in capital, asset reductions and opting no longer to be governed by the standards of international banks. We think that asset reductions would have the greatest impact on the economy and interest rates. 

Although We Delay Our Rate Cut Timing Outlook, We Still Think Additional Easing Is Very Likely: Monetary Policy and Long-Term Interest Rate Outlook

We think that the possibility of additional easing has receded, also in terms of interest rate policies, as the BoJ has taken the step of ending its extraordinary purchasing of CP/corporate bonds within 2009, ahead of other leading central banks. While the BoJ seems to have committed officially to a soft US-style duration policies at the Monetary Policy Meeting at end-October, it has shifted towards a greater balance of upside risks in its Outlook Report, and has been working on both soft and hard measures, including the future exit strategy.

However, we think that political pressures toward maintaining an easy monetary environment will build up while anti-deflationary measures become a core political issue in 2010. In that context, we believe that the decision at end-October to cut various measures for supporting corporate finance represents the beginning of new forms of easing, rather than the start of tightening. We expect the BoJ to implement successive easing measures in response to JGB market conditions, such as the rate cut, increased JGB purchases and more explicit commitment policy duration. In this case, we believe that the BoJ will reexamine the ‘banknote rule', which sets the cap for long-term JGB holdings, as it increases purchasing amounts. In reality, though, we think the BoJ would most probably reexamine the definition of medium- to long-term government bonds held by the BoJ, and subtract the remaining medium- to long-term JGBs with shorter than one-year duration from the medium- to long-term JGB holding balance. Partially because long-term rates have been somewhat unstable recently due to concerns about the government's fiscal policies, we believe that the likelihood of such measures being implemented will become stronger when concerns emerge about the sustainability of monetary easing effects due to a rapid rise in long-term rates.

On the other hand, we expect the exit timing will be pushed back to after Jul-Sep 2011, as the BoJ itself anticipates deflation to continue for three years through F3/12 in its Outlook Report. However, we do not expect to see deflation to wind down in this particular period, and indeed find it difficult to envisage an exit strategy being implemented during this time. However, we believe that the BoJ would want to normalize its monetary policies earlier than the market anticipates, once financial markets start functioning normally. Also, the exit timing of overseas central banks is an important element. Our US economic team expects the exit policy to be implemented in July-Sept 2010. We think it is natural for the BoJ to want to follow with rate hikes when overseas central banks move to gradually hike rates from mid-2010. However, with the BoJ expecting deflation to continue even after 2011, we think that up to 0.25% will be the maximum hike the BoJ can implement during such a period, and do not anticipate any further tightening.

Concerns about Fiscal Sustainability Remain, but Macro Balance Is Very Robust: Long-Term Interest Rates Outlook

Long-term rates have become somewhat unstable as the sharp deterioration in F3/10 tax revenues becomes clear, and the sense of uncertainty about fiscal policies after the change of political leadership escalates. In particular, overseas investors seem to be increasingly concerned about Japan's fiscal sustainability.

1) Without a commitment in the medium term to control spending under the DPJ, budgetary expenses will continue to grow, and high fiscal debt levels will spell continued deterioration in bond market supply/demand. 

2) As society ages, Japan's household saving rate will continue to sink. The domestic saving-investment gap will no longer be able to offset mounting budget deficits. As a result, long-term interest rates will rise in step with risk premiums.

3) Writedowns on bank-held JGBs will show up on P/Ls due to changes in international accounting standards. Banks will find it harder to hold JGBs, hurting supply/demand in the bond market.

The above are simply one side of the story, and probably based partly on misconceptions, for each of which we offer a brief explanation below.

First, the deficit is set to swell to a record JPY50 trillion in F3/10.  It would be unfair to blame this on the new administration's fiscal policies, however, stemming essentially from a significant shortfall to the tax revenue outlook that was inherited from the previous administration. The initial budget draft for F3/11 had requested a record JPY95.0 trillion, but Finance Minister Hirohisa Fujii is seeking a more restrained request of JPY92.0 trillion. Although JPY92.0 trillion in the initial budget is still of record proportions, this represents over JPY10 trillion in tightening for the initial F3/11 budget, given that spending will likely swell after the second supplementary budget is issued, to even higher than the current JPY102.5 trillion. Because of the difficulty in reducing fixed outlays (debt service costs), budgetary belt-tightening will likely be directed at general expenditures. With this, we forecast a JPY10 trillion or so reduction in the F3/11 budget for new obligation bond issuance. This would set the tone for the JGB market for the next 3-6 months, triggering concerns about worsening supply/demand caused by additional issuance to supplement government revenues. But we also expect supply/demand to tighten from mid-2010, halting the surge in long-term interest rates. That said, we do think that the new government needs to commit to a balanced budget target for the medium term if it is to help the JGB market regain investor confidence. The current lack of such moves could be a risk.

Second, discussion of Japan's macro balance should not be confined to the household sector but look at the saving-investment gap in the private sector as a whole - households as well as corporates. With corporate moves to rein in debt and slash capex as the Lehman shock cycled through, the corporate saving-investment gap added momentum to the expansion of surplus funds, and this helped to finance the budget deficit that had increased further since the previous administration. Going forward, though we expect the sharp contraction of capex to come to a halt, we also expect, as symbolized by recent bank lending and banks' lending stance, the drive to shrink corporate debt to persist. This reduction of debt is, in macro terms, a reduction of negative saving (i.e., a rise in saving), which along with saving in the household account, we expect to contribute to healthy maintenance of Japan's macro balance. Indeed, while the saving-investment gap in the household account worsens during recession, improvement in the corporate gap tends to help the private sector gap overall to find equilibrium. Conversely, when the economy is expanding, corporate saving tends to decline as capex increases, but household saving stabilizes due to income growth. At any rate, we believe that Japan's macro balance is more robust than what overseas investors envisage, and we do not expect the current account balance to slip readily into deficit.

Third, contrary to concerns expressed by some overseas investors, adoption of international accounting standards may speed up banks' shift to JGBs. Details of rules to be applied domestically to international accounting standards have yet to be fixed, and we believe that this is partly to blame for the market participants' jitters. If banks succeed in their quest to keep appraised earnings on JGBs held in banking accounts from being directly reflected in income statements, there would be absolutely no change in the status quo. Rather, with tightening up of lending and risk appraisal of cross-held shares, we might even see an accelerated shift of funds out of such assets and into safe and near-safe assets - namely, JGBs.

In conclusion, though we do not rule out the possibility of interest rates rising further in the near term on concerns about worsening supply/demand, considering Japan's macro environment we believe that surplus funds are bound to flow into the JGB market at some point. On balance, we think that long-term interest rates will be blocked by a 2% cap, and trend within a tight mid-1% range. 

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Ukraine
Worse to Come
November 18, 2009

By Oliver Weeks | London

While Ukraine's real economy is benefiting from global recovery, its political tensions and lack of government funding options leave it still particularly fragile, in our view.  The IMF has softened on Mr Strauss-Kahn's statement that cooperation is suspended until after the elections, and the PM has achieved unexpected deals on previous IMF tranches.  However, we continue to think that another disbursement under the current government is unlikely.  Even if the controversial law on social standards were to be rescinded, several other loan conditions - including a gas price hike and a realistic 2010 budget - look unlikely to be addressed before the election, in our view.  The Fund is demanding consensus and cooperation among lawmakers, which no longer looks possible in the current set-up.  We still think that sovereign default and a new gas crisis are both unlikely, but see a significant risk that it takes longer than the market expects to form a new government and reach a new IMF deal.  In the meantime, we believe that FX reserves are now adequate to ward off another devaluation spiral, but are likely to fall alarmingly low by 2Q10. 

Some progress, externally driven: Despite minimal compliance with IMF recommendations, Ukraine has seen some progress from the 1Q09 trough.  A recovery in steel export prices, down 6% from September's highs but still up 50% from March's lows, has led a significant rebound in industrial production and GDP, largely independent of government action.  The Industry Ministry reports average capacity utilization in mining and metallurgy up from 34% in November 2008 to almost 70% currently.  GDP is up 5.2% seasonally adjusted between 1Q and 3Q on our (non-annualized) estimates, while industrial production has risen 11% seasonally adjusted between June and October.  Recovering exports and the import collapse brought by a 60% UAH depreciation during 4Q08 have brought the current account rapidly to balance.  The financial account remains well in deficit, at US$1.4 billion in September, driven primarily by locals moving cash holdings to FX.  The NBU estimates foreign debt due in 2010 at US$24 billion, but rollover rates on foreign debt have proved higher than many initially feared.  In September these stood at 57% for the financial sector, but 123% for non-financial corporates, whose actual foreign debt appears to have been initially overestimated.  NBU FX intervention was down to only US$303 million in October.  After US$12.5 billion of IMF disbursement, FX reserves stand at US$27.7 billion, worth 17 months of average monthly FX intervention in the last 12 months and a significant cushion.  The weakness of the USD and appreciation of the RUB and EUR also help to reduce depreciation pressure on the UAHUSD axis.  With election campaign funding also usually bringing capital inflows, we think it will still be possible to resist the UAH going through 10.0 to the USD. 

 

Disruptive gas dispute looks unlikely: We also still think that a repeat of last January's disruptions to European gas supply is unlikely.  Meeting the gas import bill will not be straightforward.  Naftogaz's structural funding deficit continues to worsen.  In September household and utility prices were only 26% and 36% of a rapidly rising import price, and a domestic price hike remains unlikely before the election.  While the gas import bill in 1Q-3Q was US$5.8 billion, in the same period Naftogaz collected the equivalent of US$3.4 billion from domestic customers, including from the sale of domestically produced gas.  However, state FX funds remain available to pay for gas.  The October payment, US$480 million, came from an IMF special SDR allocation worth US$2.1 billion, which can be used without breaching IMF program reserve floors.  The bills for November and December gas, due seven days after the end of the month, thus look comfortably manageable to us.  January's bill will be harder, particularly as we expect a price hike of around 35%.  Under the current contract, prices will reset in line with average fuel oil and gasoil prices over the previous nine months, and the current 20% discount is due to expire.  However, that there is no formal contract expiry this year makes brinkmanship look less likely.  The 25 bcm now in storage in Ukraine exceeds current annual consumption, allowing the price shock at least to be smoothed.  Meanwhile, the gap between spot and contract prices in Europe gives Gazprom every incentive to avoid supply disruptions that might allow European consumers to justify buying less than contracted amounts.  This gives Ukraine leverage it may be tempted to exploit, but both leading presidential candidates now have constructive relations with the Russian government that they are unlikely to want to risk.  In return for a waiver of take or pay fines, and possibly a further concession on price, we would expect Ukraine to use existing FX reserves to meet monthly gas payments until the IMF returns. 

But stronger external position is a mixed blessing: A more comfortable balance of payments position, apparently lower gas risk, a less threatening Russia, and recovery among Ukraine's neighbors are mixed blessings, however. The moral hazard pressure on the IMF and EU to turn a blind eye to government non-compliance has fallen as contagion risk declines. Meanwhile, the cost of the FX and balance of payments adjustment on the domestic economy has been huge.  Non-payments on FX loans in the banking sector have reached levels which risk normalizing non-payment even among some solvent borrowers.  Officially reported NPLs are at 8.9%, though the IMF sees sub-standard, doubtful and loss loans already at 30%.  Morgan Stanley bank analysts Ronny Rehn and Hadrien de Belle see NPLs reaching 35%, and loan losses of 25%.  Aggregate bank credit and profitability data are boosted only by directed state bank loans to Naftogaz, on which the NBU has ruled reserves are not required.  Progress on state-led bank recapitalization has been slow, while Fitch has estimated that the banking system needs another UAH100 billion of new capital, based on problem loans reaching 40% and loan losses of 28%.  With the loan to deposit ratio currently at 228% and bank loans to GDP at 81%, a genuine resumption of domestic credit still looks very distant to us.  Meanwhile, a relatively severe swine flu outbreak should further constrain recovery, while poor weather conditions suggest that this year's grain harvest will be down almost 20% on 2008.  The main macro casualty of the import collapse, however, and the most immediate constraint on growth is the government's fiscal position. 

Primary problem remains fiscal: Even if gas costs are met from FX reserves, it is much harder to be optimistic about the fiscal outlook.  Unlike a gas deal, fiscal progress also requires co-operation from parliament.  Analysing budget execution is made difficult by reduced disclosure and concerted efforts to bring forward revenue and delay due tax refunds.  The Treasury reported state revenue in January to October as just 0.9% below its ten-month plan, yet it was 40% below the annual plan.  The 2009 budget still assumes real GDP growth of 0.4%, while -15% is more probable for us.  The official general government deficit in 1Q-3Q was UAH25 billion, while the budget estimates sovereign debt amortization for the year at UAH45 billion.  However in 1Q-3Q domestic debt outstanding rose UAH41 billion, and the budget also received US$4.6 billion directly from the IMF - underlining the magnitude of off-budget commitments.  At end-September, government deposits at the NBU stood at just UAH6.9 billion.  (The 2008 average was UAH21 billion.)  The current pace of revenue and spending would imply a state budget deficit of at least UAH50 billion for 4Q even without implementation of the minimum wage hike and other pre-electoral spending rises, implying a broad 2009 public sector deficit of slightly over 10% of GDP.  Clearly social spending will be prioritized in the next three months, at the expense of tax refunds and most other items, but from February wage and pension arrears may start to build. 

Alternative deficit funding highly expensive: While several countries are now running wider fiscal deficits, in Ukraine's case funding this will become unusually difficult.  The Finance Ministry issued T-bills yielding almost 30% in late October when it had no other options for meeting a roll-over spike.  Such levels will both prove expensive to maintain and crowd out any lending to the private sector.  However, subsequent offers around 20% have so far met minimal demand.  The Ministry has proposed CPI and FX-linked issues to reduce yields, but these seem unlikely to reduce costs materially.  A planned €500 million from the EC looks unlikely in the absence of IMF approval.  Further monetization looks inevitable to us. Already the NBU has acquired UAH28 billion of this year's government bond issuance, with most of the rest held by state banks and Naftogaz (foreign demand has been non-existent). New government spending plans, UAH9.8 billion for the Euro 2012 football championship and UAH1 billion for swine flu, are ‘financed' from NBU profits that the NBU does not expect to make, implying further emission.  So far, inflation, while high, continues to slow, and M2 is down 1.4%Y.  However, full monetization of a UAH50 billion deficit would raise the monetary base 28%.  With UAH demand likely to prove fragile, we expect to see some reacceleration of inflation in the coming months, with further depreciation pressure on the UAH.  FX reserves remain adequate to lean against this in the context of a balanced current account.  We do not expect an inflation-depreciation spiral, but reserve depletion is likely to become a growing concern and, in the IMF's absence, NBU restrictions on the FX market are already tightening further.   

Election delay may be long and expensive: While a short-term budget gap may be manageable, we remain concerned that political delays after the elections risk turning out expensively long.  Given the destructiveness of relations between the current PM and president, echoed in hostility between the NBU and Finance Ministry, the presidential election is effectively a pre-condition for progress.  However, a long inter-regnum would be hard to afford.  The first round election on January 17 will almost certainly be followed by a second vote, likely around February 21.  (Official results will take a further ten days.)  Current polls give Victor Yanukovych a comfortable lead, but with Yulia Tymoshenko's support rising the outcome is likely to be close, and may well then be subject to challenge and fraud allegations.  We do not expect unrest, given the unpopularity of all candidates.  But once there is a victor he or she will then have to select a prime minister to be confirmed by a parliament that in its current set-up has proved incapable of forming a stable majority.  A new president may be tempted to call early parliamentary elections, possibly to coincide with municipal elections in May.  Tymoshenko's position on this remains unclear but Yanukovich has now confirmed that he would prefer to dissolve the Rada.  Technically, this would likely require blocking parliament from convening for at least a month.  While again a positive long-term step, it would risk delaying formation of a government into 2H10, while FX reserves continue to bleed.  It is not certain that a new parliament would be more effective than the current one, but it seems likely that a government formed on the basis of the current Rada would be unstable and would struggle to support the difficult spending decisions the IMF would require.  With the current IMF program anyway close to expiry, a new government is likely to need to negotiate a new program, based around a new 2010 budget.  We would expect either next president eventually to sign a new IMF deal, but under Yanukovich there may be slightly greater delay, given weaker existing relations with the Fund and the doubts some in his party have expressed about the need for a program.  Unless steel prices keep rising, we estimate that FX reserves could be around half current levels in the absence of an earlier IMF deal.

Debt still manageable, but likely to be a better time to buy: Sovereign and state guaranteed debt at the end of September stood at a relatively modest UAH279 billion, 32% of GDP.  (Naftogaz restructuring will have added a further 1.5% of GDP.)  While yields on recent T-bill issuance have raised concerns of a 1998 GKO-type bubble, at the end of September only 3% of sovereign debt was in T-bills.  53% of debt was to multilateral institutions or other sovereigns, mainly at below-market rates.  An immediate explosion in debt service costs looks unlikely to us.  However, to put the fiscal position back on a sustainable path will require aggressive cuts to the current 2010 budget draft.  The World Bank estimates that the current draft would imply a deficit over 8% of GDP even assuming gas prices are raised and before the cost of minimum wage and pension hikes (estimated at UAH20-70 billion, depending on whether the law is changed to limit indexation to low wage workers).  The official 4% of GDP deficit projection is based on a superficially reasonable 3.7% real GDP growth and 9.7% inflation, but these are based off still highly unrealistic assumptions for 2009, with nominal GDP assumed 15% higher than we expect.  The Rada has just proposed a further UAH157 billon of unfunded spending commitments.  Inserting more realistic assumptions will be a painful political challenge that may take some months to agree.  The next sovereign Eurobond maturities are JPY35 billion in December 2010 and US$0.6 billion in March 2011, by which time we do expect a new IMF program to be in place.  However, rising debt service costs and falling reserves in the meantime suggest that higher risks of default are likely to be temporarily priced into bonds. 

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Mexico
Beyond a Dual Downgrade
November 18, 2009

By Gray Newman, Luis Arcentales & Daniel Volberg | New York

After a tumultuous turn in recent weeks, Mexico's congress is putting the final touches to the federal government's 2010 budget. This year, however, the budget is likely to receive greater scrutiny than in most years for one reason: the potential threat that at least one of Mexico's three principal rating agencies will downgrade the country's sovereign credit rating. Investors have been parsing the public comments from the rating agencies, particularly from the two that have Mexico on negative outlook. We find the focus on Mexico's rating a bit surprising. After all, it was only a year ago that the rating agencies were (rightly or wrongly) under considerable attack from many in the investor community. Imagine you had taken a part of the year off from looking at markets: you'd likely be very surprised to see just how important the verdict of the rating agencies now appears to be, at least in Mexico. Faced with the uncertainty surrounding the next decision by the rating agencies, as well as the precise timing of any move, our advice is two-fold.

First, we think Mexico watchers should start with the assumption that both of the two rating agencies that have Mexico on negative outlook will downgrade the sovereign's foreign debt rating from BBB+ (three notches above the cutoff for investment grade) to BBB. We usually shy away from making calls on what a rating agency will do. But after exploring the rationale by both of the agencies in question, as well as reviewing the evolution of the liquidity and solvency ratios of Mexico relative to its peers, we think that a dual downgrade (that is, a downgrade by two agencies) is the most likely scenario.

Second, we would encourage investors to look beyond today's ratings debate. Whatever the outcome in the coming months - and our sense is that changes, whether in the form of a downgrade or a move back to stable outlook, are likely to take place in the near term - investors should not lose sight of the long-term challenge facing Mexico, which is to boost potential GDP growth. Behind the commendable management of Mexico's public debt, behind the torturous political negotiations to approve some form of tax measure this past month to help patch up a growing public sector deficit, and behind the public sector's overdependence on pro-cyclical oil revenues, is one overarching challenge: Mexico needs to do much more to boost its sustainable growth path. 

Boosting potential growth is no easy task. It is very easy for armchair analysts in New York or London to dole out policy advice from the comfort of their posts. But in reviewing Mexico's growth record, we cannot help but believe that the economy would be returning to a stronger and more sustainable growth path if more was done in three areas: address shortfalls in human capital through a thorough rethinking of education policy; strengthen the laudable recent steps in funding infrastructure; and finally, ensure that a regulatory environment is in place to promote competition and foster a thriving entrepreneurial base throughout all sectors of the economy.

Why a Downgrade?

Our reading of the rating agencies suggests that they remain concerned that Mexico policymakers have not done enough to address three concerns: an excessive budgetary dependence on oil revenue (the flipside to a low non-oil tax base), limited fiscal savings (virtually wiped out by 2010), and insufficient progress in boosting long-term growth. While the authorities have made progress in the 2010 budget negotiations to boost non-oil tax revenues, it is not clear that the actions taken to date have been sufficient to trigger a move by the two rating agencies back to a stable outlook from the current negative outlook.

In the case of one of the rating agencies, the negative outlook was first announced in November 2008 amid enormous financial market uncertainty. Since then, the global economy has improved and the turmoil in financial markets has subsided. Neither Mexico's external accounts nor the financial stress experienced by some Mexican corporations at the time - both raised as concerns a year ago - have proved to be significant issues. 

But, the bar is much higher in the case of the rating agency that announced in May 2009 that it was putting Mexico on negative outlook. By May of this year, financial markets had stabilized, the US and Mexican economies were no longer showing signs of a worrisome downward spiral and yet Mexico's outlook was moved from stable to negative, largely on concerns that Mexico would not adequately reform its fiscal policy. Whatever the benefits derived from Mexico's recent budget process for fiscal year 2010, it is not hard to imagine that the rating agencies will decide that not enough has been done to address Mexico's "underlying structural fiscal vulnerabilities" - excessive reliance on oil revenues, lack of significant fiscal savings and a low non-oil tax base.

The rating agencies can also make an additional element: the move is not solely about Mexico. Since the global turmoil accelerated just over a year ago, most of Mexico's peers (those in the broader BBB class including BBB+, BBB and BBB-) have either experienced a downgrade in rating or a deterioration in outlook. For Mexico to maintain its current rating, it would need to show that it had outperformed its peer group (even if that meant its deterioration was more modest than others). Yet, work by Daniel Volberg, using the most common solvency and liquidity ratios, suggests that Mexico has remained in a similar position of disadvantage relative to it peers during the past year - a position of disadvantage relative to a group that has seen its average rating downgraded. (For the purposes of Daniel's work, he has used the ratings of the group of broad BBB credits as rated by Standard & Poor's in 3Q08 and then compares them with the latest available data in mid-2009.)

The Timing of the Downgrade

We suspect that the first downgrade could come later this month or next following a review of the fiscal measures approved in their finality by Mexico's congress on November 15. However, a downgrade by a second agency seems more likely set for late in the year or early next year. What seems clear to us is that both rating agencies feel certain pressure to move away from the ambiguity of a negative outlook. The real choice is either a move to a stable outlook or a downgrade by one notch to BBB. The actions taken by the authorities in recent months (the budget, the lifting on the caps for the oil stabilization funds, as well as the move to takeover the power company, Luz y Fuerza del Centro) are set to be judged against a bar that looks at Mexico's longer-term challenges of fiscal flexibility and growth. 

What it Means for Markets

We suspect that the pace of recovery of the Mexican economy will be much more important for equity markets and investors watching local rates in the coming year than a rating change from investment grade BBB+ to investment grade BBB status. While our Mexico economist, Luis Arcentales, expects a modest recovery in 2010 and consensus estimates for next year's GDP growth are near 3%, Gray Newman has a bias that the recovery could be stronger. Gray argues that the significant decline in 1H09 should make for a very easy base and hence boost Mexico's GDP reports at the beginning of 2010. And Mexico's peso weakness, which stands in sharp contrast with the rapidly appreciating currencies of many of Mexico's emerging market peers, should also benefit Mexico's manufacturing base and feed through to the Mexican consumer. So far, the data seem to be going in Luis's favor: the recovery in 2H09 has been modest despite the benefits that a weaker currency might provide, and concerns abound over the strength of the recovery in the industrial plant in the US, Mexico's dominant trading partner.

The greatest impact from a downgrade would appear to come in debt markets or perhaps in the currency market, but even there many market participants argue that a downgrade by at least one rating agency is already priced in. Mexico's credit default swaps, while rallying of late, remain wide to credits such as Brazil (BBB-), which has a current rating two notches below that of Mexico (BBB+). Some participants argue that debt and currency markets have not fully priced in a downgrade to BBB by two of the three rating agencies. We'll leave that discussion for our strategy team, but would add one observation. Although it is difficult to argue that a dual downgrade (that is, a downgrade by two agencies) is positive for the pricing of Mexican assets, we would suspect that the downgrades would be accompanied by a return to a stable outlook. The current position in which two rating agencies have Mexico's outlook set at negative (since November 2008 in the case of Fitch Ratings and since May 2009 in the case of Standard & Poor's), may have raised the bar, making it more difficult for investors to build a case to buy Mexican debt instruments, given the concern over the timing of a single- or dual-downgrade. Once the downgrades take place and the outlook has changed to stable, investors should be able to focus on the relative strength of Mexico's credit fundamentals with less concern about the timing of a possible rating change.

We feel strongly that if a downgrade takes place, Mexico's outlook will be moved to stable. In our review of the metrics being used by the rating agencies, we could find little evidence to support Mexico being reclassified as a BBB- credit, the lowest investment grade rating. Indeed, public comments by an official at one of the rating agencies suggested that a ‘two-notch' downgrade from BBB+ to BBB- is not being contemplated. A move to BBB with a negative outlook would, from our perspective, be viewed too close to a move to BBB-, and this does not appear to be the signal that the rating agencies wish to send.

The Debate in 2010

The real debate in 2010 is likely to depend on the strength of growth in the Mexican economy. If economic activity surprises on the upside (which is Gray's initial bias), then we suspect that investors will begin to shift their attention away from our long-term concerns that revolve around Mexico's limited progress in boosting potential GDP and the public sector's oil addiction, which tempers Mexico's ability to engage in counter-cyclical fiscal policy. But whether Gray's biases play out or Luis's view of a modest recovery in 2010 turns out to be a more accurate forecast, we agree that the challenges for Mexico's long-term growth prospects remain much the same as they were before the turmoil that engulfed the globe last year. Growth in 2010 could surprise to the upside, but we would caution against confusing a statistical rebound after the significant fall seen in 2009 with a stronger, long-term growth path.

And without stronger growth, as Luis Arcentales and Daniel Volberg have argued repeatedly this year, Mexico is likely to find it challenging to improve its fiscal house (see "Mexico: Zipping Up the Fiscal Straightjacket", EM Economist, October 30, 2009). Despite all of the focus on Mexico's oil dependence, Luis and Daniel forcefully argue that GDP growth assumptions matter even more. 

Luis and Daniel find that, assuming trend GDP growth of 3% and expenditures rising at roughly half the pace of recent years in real terms (about 3.6%), in the absence of tax reform Mexico was headed for a fiscal deficit of 3.6% of GDP in 2015. 

In contrast, the authorities' original proposal would have been of significant help - Luis and Daniel estimate that if it had been adopted, the fiscal deficit would have largely stabilized, heading towards 2.6% of GDP. Instead, the final bill was watered down when Congress removed the 2% ‘anti-poverty' consumption tax (that would have included food and medicine) and instead raised the VAT tax (excluding food and medicine) by 1%. Luis and Daniel find that the revised tax reform means that, under the same 3% GDP growth and 3.6% real expenditure conditions, the fiscal deficit may be heading towards 3.2% of GDP. And the risks are much higher if growth disappoints. For example, if you work with growth at half their initial assumption (only 1.5%), then the fiscal deficit would approach or even go beyond 5% of GDP under all scenarios. Of course, in those circumstances we would expect the authorities to cut expenditures - but the exercise is designed to show just how sensitive Mexico's current fiscal situation is to growth. 

Bottom Line

Be ready for renewed focus on Mexico's rating, especially if - as we suspect - both rating agencies currently with a negative outlook move to downgrade. That move could create a near-term jolt to investor sentiment. But we suspect that much of the handwringing will subside if growth returns stronger in 2010. In a way, we think that would be a mistake: our concern is that even with stronger growth in 2010, Mexico has not made much progress in tackling what needs to be done to strengthen its long-term growth profile. Mexico's fiscal dilemma is largely just another symptom of the underlying shortfall on the potential GDP growth front. Out of crises often taboos are broken and reforms are born; that does not appear to be the case in Mexico in the aftermath of the severe downturn of late 2008 and 2009. Instead, we fear that another opportunity has been largely lost.

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