India
What Do We Expect from Budget F2011?
February 19, 2010

By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai

What Do We Expect from the Budget?

The budget for F2011 (12 months ending March 2011) will be announced by the Finance Minister on February 26. We believe that investors will be watching the budget closely for the government's commitment on implementing key pending reforms. We think the budget for F2011 could focus on the following themes: a) roadmap for implementation of the Goods and Services Tax system; b) clear plan to improve health of public finances; c) confirm its plan to initiate meaningful steps toward divestment of the government's stakes in SOEs; d) acceleration in infrastructure spending, particularly in roads and power; e) direct tax reforms, and f) social/rural sector push. In addition, we expect the government to hike excise duty rates by two percentage points on almost all products and announce other tax measures in the February 2010 budget. Overall, we expect the central government deficit to reduce to 5.5% of GDP in F2011 from 6.8% in F2010. We expect further reduction in the deficit to 4.6% of GDP in F2012.

Each of the key policy issues likely to be touched upon are discussed in detail below:

a) Streamlining of indirect taxes - GST: The government has already announced its intention to transition to a consolidated nationwide goods and services tax (GST) system from the current system of different types of indirect taxes and multiple rates of indirect taxes. The new law will cover a wider base including all goods and services. The current system taxes production whereas the GST will aim to tax consumption. Indeed, current law levies tax on movement of goods from one state to another, effectively creating borders within borders. It distorts the allocation of resources and inhibits productivity growth. Transition to the GST will be an important milestone from a macro perspective. While the government had earlier announced its intention to implement it from April 1, 2010, it appears that it will be delayed and we expect the government to provide a clear guideline regarding the timing and implementation of the GST in the upcoming Union Budget.

b) Consolidation of public sector deficit: Over the last two years, several factors have pushed the fiscal deficit to unsustainably high levels. Some of these factors include: i) large increase in government expenditure prior to the general elections in May 2009; ii) sharp rise in oil and fertilizer subsidy due to the rise in commodity prices; and iii) fiscal stimulus during the credit crisis.  In F2010, we expect the central government deficit to remain high, at 6.8% of GDP, and consolidated fiscal deficit including state government deficit and off-budget expenditure items at 10.5% of GDP. Similarly, central government debt and national public debt to GDP should remain high, at 55.6% and 75.1%, respectively, as of March 2010 (our estimates).

The high level of fiscal deficit is weighing on longer-term growth potential. We believe that the government will take the first step towards reducing the deficit to more sustainable levels in the February 2010 budget. The recent report of the 13th Finance Commission will be a good guide for the government to move on this correction path.  The report is likely to be tabled in the forthcoming budget sessions of the parliament starting from February 22. We expect the government to announce a target deficit of 5.5% of GDP in F2011 compared with 6.8% in F2010. In our view, the government will be able to achieve this reduction by:

* Increasing tax to GDP: We expect the government to hike excise duty rates by 2pp in the budget. Note, as part of the stimulus measures, the government had cut excise duty by 4pp. Moreover, we see higher tax revenue collection on account of recovery in growth.

* Cutting expenditure as percentage of GDP: We see the government cutting expenditure to GDP by 0.6pp in F2011. We believe that the budget will target expenditure growth lower than the estimated nominal GDP growth of 14.3%. In our view, this should not be difficult, as there will not be any major one-off expenditure items like wage hikes or fresh stimulus measures.

* Raising non-tax receipts: The budget will target about Rs250 billion (0.35% of GDP) in divestments and potentially about Rs300 billion (0.4% of GDP) from 3G license fees (unless the government manages to collect this in F2010).

c) Divestment of state-owned enterprises: The current high level of fiscal deficit will likely make it difficult for the government to increase its spending on rural infrastructure and other development expenditure. We believe that in such an environment the government will need to augment its financial resources though divestment of stakes in government companies. Since the formation of the United Progressive Alliance-led coalition government in May 2004, the pace of the divestment in state-owned enterprises has been slow. The total proceeds from divestments during the five years ended March 2009 were just US$3.1 billion. As per our estimate, the value of the government's stakes in the listed state-owned enterprises is about US$300 billion. If we include the unlisted companies, the total value would be around US$450 billion. The divestment program, we believe, can play a key role in augmenting government resources for investment in productive areas such as rural infrastructure without causing deterioration in government finances. The government has announced its intention to bring down its stake in all listed entities to 75%. We expect a significant pick-up in government divestments from March-April 2010. In F2011, we believe that the government could collect about US$5 billion from divestments.

d) Acceleration in infrastructure spending: After steadily rising to 5.7% of GDP in F2009 from the trough of 3.6% in F2005, infrastructure spending has remained largely lackluster over the last year. We expect infrastructure spending to start rising from F2011 again. The key areas where we expect meaningful increases in spending are transportation (national highways) and power sectors. The ministry of transportation intends to award US$20 billion worth of road contracts on an annual basis over the next three-and-a-half years. Our infrastructure analyst, Akshay Soni, believes that the government will be able to issue contracts worth about US$12-13 billion over the next 12 months (the first year) compared with US$6-8 billion worth of contracts issued over the last 12 months. Similarly, we think that the momentum in implementation of electricity projects is also likely to pick up further. Also with credit markets improving and capital markets normalizing, private infrastructure spending in general should reaccelerate. We expect infrastructure spending to rise to 7.1% in F2012 from an estimated 6% of GDP in F2010.

e) Direct tax reforms: The Ministry of Finance has already put out a draft of new code for direct taxation. The thrust of the new code as the foreword of the code says is "to improve efficiency and equity in direct tax system by eliminating distortions in tax structure, introducing moderate levels of taxation and expanding the tax base". For broadening the tax base, the code will minimize exemptions. The removal of these exemptions will improve tax to GDP and improve efficiency in allocation of resources. The new code will also simplify the language and law to reduce litigation and check tax evasion. Moreover, the new code also aims to encourage long-term savings. The tax incentives for savings will be rationalized. The code aims to follow the Exempt Exempt Tax (EET) rule under which initial savings contribution and accrual of interest are exempt but, on withdrawal, it would be subject to normal taxes. We think the Ministry of Finance is likely to start implementing the new code from the February 2010 budget.

f) Social/rural sector push: Higher allocation towards the social and rural sectors has been the key feature of the UPA government over the last few years. The government gave a big rural sector push under the National Rural Employment Guarantee Act (NREGA) with spending under this scheme increased to US$8.1 billion (0.6% of GDP, budget estimate) in F2010 from US$1.4 billion in F2005. We believe that the budget will maintain that emphasis. The central government has lifted social spending to 1.6% of GDP in F2010 (budget estimate) from 0.9% in F2004. In this year's budget, we expect the central government to continue its push by increasing expenditure on social welfare such as education, health and rural support.

Will These Measures Surprise the Consensus?

Most of the measures, which we expect to be announced in the budget, are known to have been in the pipeline for some time. We believe that the market will be expecting the government to deliver on at least 80% of this. The two broad issues - fiscal consolidation and tax reforms - should not be difficult to achieve. On fiscal consolidation, the government should be able to demonstrate the commitment by cutting the deficit target by at least 1% of GDP in F2011, considering that pick-up in growth will ensure higher tax revenues and absence of one-off expenditure items will mean lower expenditure growth. Similarly, on tax reforms, much of the groundwork has already been done.

Stock Market Implications

According to our India Strategist, Ridham Desai, historical precedent does not favor the market for the next six weeks. The markets are usually flat in the month ahead of the budget and, in two out of three years, fall in the month following it. Indeed, in 1979-2009, March was the market's worst month with two out of three years witnessing negative returns averaging 2.7%. The 15-day period post the budget produced an average negative return of nearly 4%. The extent of the sell-off has been worse over the past three years, with the market losing 9% on an average in these years.

Peru
Growth Takes Off, Will Rates Follow?
February 19, 2010

By Daniel Volberg | New York

Peru's economy has only recently started to recover from last year's downturn, but the central bank is already signaling that it could move away from its accommodative stance.  Indeed, while the economy hit bottom around the middle of last year, it was not until late 2009 that growth finally shifted into higher gear.  We continue to expect strong growth in 2010 - our forecast for real GDP growth is 4.9% - driven largely by a recovery in domestic demand.  This is roughly in line with consensus that has shifted up in recent months, catching up with our forecast.  But if we prove right on growth, then interest rates should rise as well, and here we suspect that consensus may still have some catching up to do. The consensus of Peru watchers expects policy rates to rise by only 200bp, to 3.25% by year-end.  In contrast, we expect the central bank to embark on a more aggressive monetary policy tightening campaign in 2H10, lifting the policy rate by 350bp to 4.75%.

Good Growth Ahead

Economic recovery has picked up steam in recent months. Indeed, the monthly GDP growth data suggest that the economy shifted into higher growth gear in September-November and high-frequency indicators, such as electricity demand, point to a strong December and January as well.

Looking ahead, we expect the economic recovery to continue picking up steam in the months ahead. We see economic growth coming largely from domestic demand and driven by three factors.

First, recovering confidence and employment should continue to boost private consumption. Consumer confidence has rebounded and is now back near levels not seen since mid-2007. Barring a major global dislocation, we suspect that confidence may remain strong in the months ahead.

Combined with recovering employment, robust consumer confidence should allow the consumer to continue boosting demand.  True, the unemployment rate has risen sharply in the last few months of the year - casting doubts on the sustainability of a strong recovery.  But we suspect that this increase may actually be a positive signal of rebounding confidence because, in contrast to late 2008 when declining employment pushed the unemployment rate higher, the recent rise in unemployment is driven by labor force participation growth.  The number of individuals entering the workforce is outstripping the number of jobs available - a possible sign that improved conditions are bringing back individuals who had been discouraged and had stopped looking.  Indeed, employment continues to grow and we suspect that if the economy continues to recover it may not be long before the surge in individuals seeking employment gets matched with a job opportunity, forcing the unemployment rate back down again.  In fact, quarterly GDP data show that sequential growth in private consumption had already turned positive during 2Q09.

Second, monetary stimulus should continue to provide growth support in the near term. We suspect that the effect of last year's aggressive rate cuts is still filtering through to the economy, as policy tends to work with a significant lag - typically 12-24 months.  After all, the central bank slashed rates between January and August, with the bulk of the cuts - 475bp - coming in the April-August period, so we should expect to see the benefits of last year's policy easing in the months ahead.  Indeed, it comes as little surprise that credit - the part of the economy most sensitive to monetary policy - has started rebounding during October-December, a little less than a year after the first rate cut last year.  Indeed both consumer and business credit is recovering and we suspect that this should provide a further catalyst for stronger economic recovery.

Finally, in addition to consumer demand and policy stimulus lending support to economic recovery, we see room for significant investment growth ahead.  With capacity utilization rising sharply, business investment needs to post a strong recovery to keep up with expected robust growth in final demand.  After all, while inventories ballooned early last year and ample spare capacity was created, in recent months the conditions appear much tighter. Inventories were slashed in 2009 - taking off near 3.7pp from headline GDP growth in the first nine months of the year.  And capacity utilization has been rebounding rapidly since last July-August.  In this environment, it is reasonable to expect business investment to grow and indeed investment intentions have staged a remarkable recovery in recent months, reaching levels not seen since Peru's growth heyday. Indeed, a net of half of all major businesses in Peru are expecting to invest in the months ahead.  Traditionally, strong investment has been a key growth driver in Peru, and we see that trend continuing this year.

Policy Tightening

With stronger growth on the horizon, we expect policymakers to begin removing monetary stimulus in 2H10.  It is true that with headline inflation at just 0.4%Y in January, it remains well below the lower bound of the target range (1-3%).  And the recent uptick in inflation - from 0.25%Y in December - has been largely driven by a weather-related supply shock in food and discretional adjustments to regulated prices.  Indeed, we agree with the central bank that demand-side inflation pressures remain limited for now.  But we suspect that if the robust growth of recent months is sustained, the authorities will need to act quickly and pre-emptively in order to contain inflation pressures next year.

After all, underlying inflation may be less benign than the recent low headline inflation releases suggest.  Indeed, core inflation has had a much less pronounced decline than headline inflation - at 2.2%Y in January, it is only just nearing the central target.  Thus, while in the near term demand-side inflation pressures are likely to remain limited by the still ample slack in the economy, underlying inflation has been sticky and the robust growth recovery may be quickly removing the slack and pushing capacity utilization rates higher.

To pre-empt a significant uptick in demand-driven inflation, we expect the central bank to embark on a policy tightening campaign in 2H10.  We suspect that by mid-year the authorities will begin to focus on potential inflationary pressures in 2011.  And in order to ensure that inflation stays within the target range next year, we expect the authorities to act this year and lift the policy rate from the current 1.25% to 4.75% by December.  Indeed, given our expectation that the authorities maintain headline inflation near the target this year and next, our projection for nominal policy rates at 4.75% by year-end would bring real policy rates a little above their long term average - or neutral - level of around 2%.  In contrast, the consensus expectation of just 200bp of interest rate hikes would keep real interest rates below the neutral level and implies continued, albeit reduced, monetary stimulus throughout the year.  We suspect that this may be inconsistent with a strong growth rebound that is quickly removing the slack from the economy.

Risks to Our Forecasts

The risk to our forecasts for interest rates and growth, highlighted by the turbulence in world markets in recent days, may come from a relapse in the global economy.  The most direct transmission channel may come through falling commodity prices, a decline in global trade and a retrenchment in confidence. In this scenario, we suspect that both growth and interest rates projections would have to be revised down.

Bottom Line

Peru's growth dynamic has shown a spark in recent months, signaling that the end of monetary stimulus may be in sight.  We expect a domestic demand-driven growth rebound to continue this year and next, thanks to rebounding confidence and credit, near-term monetary stimulus and strong investment growth as businesses adjust to a more robust demand growth environment and capacity constraints.  But once the growth rebound appears on sure footing in 2H10, we expect the authorities to shift focus away from growth support and onto fighting inflation pressure.  We reaffirm our out-of-consensus call for a more aggressive policy tightening cycle in 2H10, with rate hikes of 350bp to 4.75% by year-end.

Global
ER, RR, IOR and RRR
February 19, 2010

By Manoj Pradhan | London

How many ‘r's can you fit in a title? If you were following central bank exit strategies this week, then quite a few. First, Fed Chairman Bernanke's speech on February 10 sketched quite a fluid picture at the Fed, where a vibrant debate about the different nature of this tightening cycle seems to revolve around some innovative yet practical strategies. Comments about a possible path of controlling excess reserves (ER) through reverse repos (RR), term deposits and the interest on reserves (IOR) tool were interpreted as hawkish messages by markets. This in spite of Bernanke reiterating the commitment to keep rates low for an "extended period" and assurances that many of the actions in the near future represent only a normalisation of procedures, not policy tightening. Then the second Required Reserve Ratio (RRR) hike by the PBoC on February 12 unnerved investors worried about a more rapid tightening in China. We believe that such concerns are misplaced here too. China's RRR move was more about controlling liquidity within the banking system than about removing policy accommodation from the real economy. After the strong export numbers and the ensuing capital inflows, ER within the banking system would have continued going up sharply without the RRR hike at a time when the PBoC is trying to normalise the flow of credit.

Which measure of liquidity? To correctly interpret whether central banks are really tightening policy or simply managing liquidity, it is important to distinguish between funds within the banking system and those that are available to private individuals and institutions in the real economy (see "Liquidity Liquidation?" The Global Monetary Analyst, January 27, 2010). When central banks drain an excess of funds within the banking system, the operations usually leave behind sufficient funds for the smooth functioning of interbank borrowing/lending. There is therefore little impact on the cost of funds for banks and consequently very little impact on the real economy. It is when policy rates are raised that the real economy is affected. Viewed from this perspective, it is clear that excess funds, if allowed to stay within the banking system, would in fact keep putting downward pressure on interbank lending/borrowing rates.

RRR hikes by the PBoC are similar in spirit to the RR operations expected from the Fed: The second RRR hike by the PBoC falls into the liquidity management category. According to our China economist, Qing Wang, the RRR hikes have been instituted in response to strong export growth and ensuing capital inflows that led to a rise in excess reserves. The PBoC action should not be seen as having occurred despite a stable ratio of excess to total reserves, therefore implying a policy tightening. Rather, it is because of central bank draining operations - RRR hikes included - that the ratio is stable. Imagine if ER at the Fed had been stable after QE - one would have to assume that the Fed had been draining these reserves. And just as early draining of reserves at the Fed will not constitute outright policy tightening, the PBoC's RRR hike is almost entirely about draining funds from within the banking system.

A clearer picture at the Fed and the ECB: Details of dealing with ER and the overall exit strategy at the Fed, and to a lesser extent at the ECB, became a little more transparent last week. In his prepared statement for the Committee on Financial Services, Chairman Bernanke provided an outline for a possible sequence of actions that the Fed might take in its exit from ultra-expansionary monetary policies. In particular, RR and term deposit operations could be deployed to drain ER in large quantities in a short period of time before actual policy tightening begins (see Draining Reserves at the end of this piece for some more details of these operations). Governing Council Members Weber and Orphanides provided a somewhat similar sequence of measures for the exit at the ECB (though probably over a different timeframe). Weber suggested that policy tightening would be preceded by withdrawal of excess reserves, and by a reduction in the maturity of outstanding liquidity before that. In an interview on February 12, Orphanides stated that "the phasing out of some unconventional measures should not be misinterpreted as a desire to remove policy accommodation from the economy", indicating that the management of liquidity and excess reserves would not adversely affect the accommodative monetary policy stance.

Signaling? Perhaps markets are fully cognisant of all we have said here, and have simply interpreted the PBoC's RRR hikes and the discussion of exit policies at the Fed and the ECB as a signal of forthcoming policy tightening. Since draining reserves to remove the downward pressure on interbank rates is a precursor to tightening, one may view liquidity and excess reserve management as a signal for rate hikes. This could be particularly true for the PBoC, which does not follow the relatively open communication strategy of the Fed and the ECB. However, our conversations with clients suggest that this is not the case. Those that are worried by the RRR hikes are interpreting it as a monetary tightening rather than liquidity management within the banking system. Large-sized operations to drain ER in the US and the ECB will certainly be an important signal that policy tightening is approaching, but this is a long way away yet.

When do we expect policy tightening? Our economists expect the Fed to start draining reserves and the ECB to allow Euribor rates to drift up before raising policy rates in 3Q10. Contrary to the US, where our economics team sees risks to its economic outlook as more balanced, risks to the euro area economy are relatively more skewed to the downside, which in turn raises the risk of a later-than-expected exit by the ECB. For China, we expect multiple RRR hikes from the PBoC contingent on the need for liquidity management, with the first of three base rate hikes for 2010 arriving as early as April. An exit from the renminbi peg is expected only in 2H10.

The rise of the IOR: In his statement, Chairman Bernanke stated that there is little information to be had from the fed funds market, given that banks are holding so many excess reserves. The IOR is thus expected to serve as the policy rate instead of the fed funds rate at least in the early part of the tightening process. The IOR could be raised around the same time that reverse repo and term deposit operations were being ramped up, if required. The growing emphasis on ER means that the Fed's management of the same will also take on greater significance.

Risks to a smooth transition to policy tightening: The transition to a less accommodative policy stance is not guaranteed to be smooth for the Fed, the ECB or the PBoC. In China, strong capital inflows and a fixed exchange rate may limit monetary flexibility, leading to an earlier-than-expected exit from the fixed exchange rate (see "Living with the Trilemma", The Global Monetary Analyst, January 20, 2010). The Fed has very little experience with the IOR tool and its use may not be as effective as the Fed envisages. According to our Chief US Fixed Income Economist David Greenlaw, "The IOR programme was introduced in autumn 2008 in order to help prevent the effective fed funds rate from falling too far below the official target rate as the Fed balance sheet ballooned. However, for a variety of reasons, the funds rate traded well below target for an extended period of time. The majority of Fed officials seem to believe that the programme will work more effectively going forward. But, they have publicly admitted that they cannot be certain".

Simply postponing the macro problem? Further, both the Fed and the ECB seem to be assuming too much control over reserves and liquidity. The use of RR and term deposits means that funds are returned to commercial banks on maturity.

With the economic improvement and steepening yield curve that our US team expects, commercial banks may find it a good risk/return decision to move these funds into the real economy (see "Reversing Excessive Excess Reserves, The Global Monetary Analyst, October 28, 2009, and Higher Yields Won't Kill the Economy, Richard Berner, January 22, 2010) rather than simply earn an interest rate in the neighborhood of the risk-free IOR. The risk therefore is that these methods of draining reserves simply postpone the macro problem of burgeoning excess reserves. The minutes from the December 2009 FOMC meeting echo this risk: "Moreover, a few participants noted that banks might seek, as the economy improves, to reduce their excess reserves quickly and substantially by purchasing securities or by easing credit standards and expanding their lending. A rapid shift, if not offset by Federal Reserve actions, could give excessive impetus to spending and potentially result in expected and actual inflation higher than would be consistent with price stability." Only when the Fed's balance sheet returns to a normal size will these risks completely abate. Waiting for agency debt and the many 15- and 30-year MBS that the Fed purchased in its QE programme to mature may not be enough. Instead, the Fed may have to actively divest some of its QE holdings further down the road, with one eye on the housing market and the other on yields (see again Reversing Excessive Excess Reserves).

AAA liquidity regime intact: In summary, none of the communiqués and actions by the Fed, the ECB or the PBoC suggest that a policy tightening is underway. In turn, this means that the AAA (ample, abundant, augmenting) liquidity regime is still very much in place. When they do raise rates, we expect that central banks will do so in a measured way. We expect policy rates to remain below neutral for all of 2010 and probably for a significant part of 2011 as well.

Appendix: Draining Reserves

ER sit on the liability side of the Fed's balance sheet. The traditional way of draining reserves was to sell T-Bills to commercial banks. This would mean that commercial banks would replace cash on the asset side of their balance sheet with the T-Bill of an equivalent quantity. However, ER held by the Fed now stand at US$1.1 trillion and the size makes it difficult for reserves to be drained in the traditional way. The Fed is thus seeking a two-pronged strategy to drain reserves: first, ‘sell' T-Bills to commercial banks only to repurchase the same T-Bills after a specified period (i.e., the reverse repo); and second, provide term-deposit facilities to commercial banks.

In a repurchase agreement (i.e., a repo), a commercial bank agrees to sell T-Bills (or other securities) and repurchase them after a specified period at a price specified before the transaction. The difference between the selling and buying price implicitly yields the repo rate. In a reverse repo transaction, the commercial banks would buy T-Bills from the Fed with an agreement to resell the same after a specified period for a price specified before the transaction.

On the Fed's balance sheet, ER on the liability side would fall and so would the stock of T-Bills from the asset side. For the commercial bank, it would amount to replacing one asset (cash held in the form of ER at the Fed) with another (T-Bills). Term deposits would work much the same way, by locking away part of the ER in a term deposit. Note that the commercial bank receives interest either through the repo rate, the interest on term deposits or through the IOR. The Fed can simply roll over these reverse repos and term deposits as they mature, offering interest rates as warranted by market conditions at the time of the rollover.