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India
Next Step Toward Monetary Policy Exit - A Rate Hike January 15, 2010 By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai Summary The Reserve Bank of India (RBI) will meet on January 29, 2010 to decide on the monetary policy measures to be taken, if any. Recall that in October 2009, the RBI reversed some of the unconventional liquidity support measures and tightened the prudential norms, particularly for the property sector. More important, the monetary policy statement clearly mentioned that those steps represented the first step towards ‘exit'. While it has been only three months since then, we believe that the incoming data in this period confirm our view that the RBI will increase the reverse repo rate (the rate at which commercial banks park excess liquidity with the RBI) by at least 25bp on January 29. In addition, we do not rule out the possibility of a 25bp hike in the repo rate (the rate at which the RBI provides liquidity to the commercial banks) and/or a 50bp hike in the cash reserve ratio (CRR). Strong Pick-Up in Domestic Demand Since June 2009, industrial production (IP) has seen a sharp rebound. Indeed, seasonally adjusted IP increased by 10.9% between March and November 2009. The bulk of this rise occurred between November and June 2009. This implies that the year-on-year growth will remain in the 9-10% range at a minimum until May 2010, even if the month-on-month rise going forward is close to zero. Our current forecast assumes average IP growth of 11% over December 2009-May 2010, considering that IP will continue to rise on a month-on-month basis. However, with today's IP data for November, it appears that there is upside risk to these estimates. The segment breakdown of the IP trend indicates that the growth recovery has been broad-based. While in the initial months, growth was driven by consumption - discretionary as well as staples - over the last three months capital goods demand has also recovered. Moreover, exports are beginning to recover rapidly. After the initial gradual recovery, over the last three months seasonally adjusted exports recorded a cumulative increase of 9%. Considering the trend in US ISM New Orders Index (three-month moving average), which leads India's exports by about four months, we believe that exports will sustain steady acceleration over the next six months. We believe that this exports recovery will mean even faster improvement in capacity utilization. Why Lift Rates When Credit Growth Is Still Weak? As of the fortnight ended December 25, bank credit growth was just 12.2%Y. Some investors argue that this will keep the RBI from hiking policy rates soon. We believe that underlying credit growth is probably stronger than that implied by the headline year-on-year number. Last year during this period, bank credit growth accelerated sharply for about two months due to the shift in corporate borrowing from fixed income mutual funds and non-banking financial companies. As the base effect should normalise by January-February 2010, bank credit growth should pick up to 15-16%Y. Moreover, we believe that bank credit growth is a lagging indicator. With IP growth recording a sharp pick-up from June 2009, we believe that it should be reflected in bank credit demand over the next two months. We believe that the sequential bank credit growth trend has already started accelerating, indicating that year-on-year growth will move very quickly over the next two months. Inflation Risks Rising Unlike in 2004 and 2005 when the recovery in growth gradually allowed adequate time for the private corporate sector to initiate capex plans, in the current cycle the recovery in growth has been sharp and the business investment cycle has been hit badly. The transition from low-capacity to full-capacity utilization is likely to occur in a much shorter period. For instance, in the current cycle the seasonally adjusted IP index has risen by 11% cumulatively in eight months from the trough, whereas in the previous cycle seasonally adjusted IP index took 19 months to rise by 11% cumulatively from the trough. Moreover, input price pressures appear to be emerging much earlier in the current cycle than in the previous cycle. For instance, crude prices reached US$83/bbl only by September 2007 - three years into the growth upcycle. Persistently high food prices and a recent major spike have also increased the risk of a generalized rise in inflation expectations. In other words, the growth-inflation trade-offs related to policy challenges are likely to emerge much earlier in the current cycle compared to the last cycle. We believe that rising capacity utilization and increasing global commodity prices imply that a policy rate hike is imminent. Initial Rate Hikes Unlikely to Hurt Growth Just as the rate hikes in 2004 and 2005 did not hurt the recovery in growth, we believe that the initial rate hikes this time round will represent normalization of rates rather than tightening. We believe that real interest rates are way too low for the level of growth in the economy. However, in our discussion with investors, we sense that a majority does not expect a rate hike in January 2010. This could cause some volatility in risky assets if we are right about the rate hike. Any Delay in Rate Hike Will Mean Quicker Rise Later We believe that if the RBI were not to hike policy rates in January, an inter-meeting hike in February will be imminent. Any further delay in a rate hike will likely have to be followed by a sharper rise later. Indeed, we expect the RBI to lift policy rates by a cumulative 150bp in 2010.
Global
The China Cracker January 15, 2010 By Joachim Fels & Manoj Pradhan | London Off with a bang... Among the world's major economies, China was the first to emerge from the Great Recession last year. It thus seemed natural that it would also be among the first to start exiting from ultra-expansionary monetary policies. Still, the People's Bank of China managed to surprise markets on January 12 with an earlier-than-expected first hike in the reserve requirement ratio (RRR) for large depositary institutions from 15.5% to 16%, which will become effective on January 18. Global markets took note, with bonds rallying and equities selling off, underscoring our view that while last year was all about the exit from the Great Recession, this year will be all about the exit from super-expansionary global monetary polices (see "Five Themes for 2010", The Global Monetary Analyst, January 6, 2010). ...but this fits the script: While this RRR hike came earlier than we expected - our China team had been looking for a first hike in early 2Q - we think that it is fully consistent with our global script for this year. • First, our ‘tale of two worlds' theme sees economic growth in emerging markets significantly outperforming the bumpy, below-par and boring ‘BBB recovery' in the advanced economies. We expect this to lead to earlier monetary tightening in Asia ex-Japan (AXJ). • Second, the Chinese RRR move is in line with our view that many central banks are likely to start soaking up some excess reserves in the banking system in 1H10 before raising official interest rates in 2H. • Third, we continue to think that central banks will crawl rather than rush towards the exit and will thus slow but not derail the powerful global ‘AAA liquidity cycle' (ample, abundant, augmenting), which is still in full swing. Asia leads in terms of growth... China's early RRR hike looks likely to have been prompted by two factors that both illustrate the strength of the Chinese and Asian recovery, and thus our ‘tale of two worlds' theme. First, bank lending surged in the first week of January, pointing to upside risks to our China economists' forecast of 18-19% annual loan growth in 2010. Strong credit growth raises the risk of asset bubbles and, further down the road, inflationary pressures. Second, China's trade data for December showed a surge in imports (56%Y) and higher-than expected export growth (18%Y), which came on the heels of a higher-than-expected manufacturing PMI reading for the same month. The recent strength in China's external trade was mirrored in data from other Asian economies: our Asia-Pacific economist Chetan Ahya notes that exports by China, India, Korea and Taiwan combined (accounting for two-thirds of the region's exports) jumped by a seasonally adjusted 13% on the month in December - a strong acceleration from an average 2% monthly pace since the recovery began last March (see Asia-Pacific Economics: Rising Risk of Earlier-than-Anticipated Policy Exit, January 12, 2010). ...and in terms of tightening: Against the backdrop of strong data and the Chinese RRR hike, we believe that the focus in Asia will now shift to India, where Chetan Ahya and team forecast a 25bp rate hike from the RBI on January 29 (against market expectations of no change), and to Korea, where our economist Sharon Lam expects a hike this quarter which could come as early as at the February 11 monetary policy meeting. Likewise, we have penciled in a first hike in Taiwan in 1Q. In China, further RRR hikes look likely over the next several months, but our team continues to expect the first hike in interest rates only in 3Q, when we also expect the Fed to start raising the funds rate. Liquidity tightening before rate hikes... The Chinese move is also in line with our view that many central banks will start withdrawing (some) liquidity from the banking system first, before embarking on increases in official interest rates. In fact, our China economists view the RRR hike more as liquidity management rather than an outright tightening. With the RMB pegged to the USD dollar for now and China running a balance of payments surplus - fed by a trade surplus, FDI and hot money inflows - the PBoC needs to drain liquidity in order to control rampant money supply and credit growth, and the RRR adjustments are the most effective tool to achieve this. ...also in the US and the euro area: Likewise, in advanced economies like the US or the euro area, the banking system is awash with excess reserves (though for different reasons - QE rather than a currency peg), some of which the Fed and the ECB will want to drain before embarking on rate hikes. In the US, we expect the Fed to soak up some excess reserves - through reverse repos and/or term deposits - once the MBS purchases have been phased out at the end of this quarter. In the euro area, the ECB is already phasing out some of its non-standard longer-term financing operations. In both cases, as in China, these measures will set the stage for a smoother exit from monetary easing, though they do not constitute an outright tightening by themselves. ‘AAA liquidity cycle' derailed? Not so. We do not view the recent and the coming Chinese RRR hike(s) as a threat to the global liquidity cycle. Rather, the Chinese move is a symptom of rampant global excess liquidity in the hands of non-banks that is pouring into China in search of above-zero returns. As we have argued before, to undo the ‘AAA liquidity cycle', the major central banks would have to raise interest rates above their ‘neutral' or ‘natural' levels, which we deem unlikely for this year and, perhaps, also next year. With current official interest rates at record lows and most major central banks only starting to raise rates cautiously and gradually in 2H10, we expect global liquidity to remain ample, abundant and augmenting. Bottom line: The PBoC's early RRR hike marks the beginning of the exit from ultra-expansionary global monetary policies, which we expect to be the dominant theme for markets this year. With Asia leading the global cycle, other central banks in the region will follow soon - we expect India, Korea and Taiwan to hike interest rates this quarter. But most major central banks - including the PBoC, the Fed and the ECB - will likely focus on draining some of the excess reserves in their banking systems before embarking on gradual rate hikes only in 2H10. Hence, we continue to expect the global liquidity cycle to remain intact. Worries that global monetary policy will become restrictive in the foreseeable future are thus exaggerated, in our view. |