India
Inflation Risks Are Rising Fast
March 16, 2010

By Chetan Ahya & Tanvee Gupta | India

Robust Rise in Domestic Demand Has Pulled IP Growth Close to a 20-Year High

India is one of the very few countries in the Asia-Pacific region that did not see any major decline in its IP index during the credit crisis period. Moreover, IP growth has accelerated to 16.7%Y in January 2010 from the trough of -0.2%Y in December 2008, driven by expansionary fiscal policy, low interest rates and a quick rise in capital inflows. Indeed, seasonally adjusted IP increased by 14.1% between May 2009 and January 2010 (in just eight months). The initial part of the recovery was driven by private consumption, particularly discretionary spending. We believe that both policy support and revival of autonomous demand from the private sector have played a role in this sharp acceleration in growth. While rural consumption was supported through transfers from the government's balance sheet, urban recovery was more autonomous. Private consumption in the urban area was affected due to concerns about the job outlook and overall confidence in the economy. However, unlike in some of the other countries in the region, India did not see many job losses. Urban consumption has climbed back very sharply. Passenger car and two-wheeler sales growth accelerated to an average of 38%Y and 45.2%Y, respectively, during the three months ended February 2010 (versus 9.2%Y and 0.2%Y during the same period last year). Similarly, consumer durables production growth accelerated to a high of 38.6%Y during the three months ended January 2010 compared with -0.6% during the same period last year. As is evident from these data, it is not just the base effect behind this growth acceleration.

Capital goods production has also picked up significantly, though a large component of this appears to be driven by commercial and heavy vehicles. In addition, exports have shown a meaningful rise over the last four months. The US ISM New Orders Index, which leads India's exports by four months, indicates that exports will recover further over the next few months.

Capacity Utilization Rates Closer to Full

Unlike in the previous cycle, 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 was hit badly. The transition from low capacity to close to full capacity utilization is occurring in a much shorter period. For instance, in the current cycle the seasonally adjusted IP index has risen 16% cumulatively in 10 months from the trough, whereas in the previous cycle, the seasonally adjusted IP index took around 26 months to rise to close to 16% cumulatively from the trough. Moreover, exports recovery will mean even faster improvement in capacity utilization.

Since official capacity utilization data are not available, we look at a few proxy indicators.

1)         We illustrate that private corporate capex has declined significantly from the peak of 16.1% of GDP in F2008 to an estimated 12.5% in F2010. However, IP growth has accelerated over the last eight months. Hence, while capacity creation has suffered, production has risen sharply, pushing capacity utilization levels closer to full.

2)         We tried to compare the trend in the seasonally adjusted IP index versus gross fixed capital formation by the private corporate sector and public sector. We also tried to assess the recovery in IP compared to the hypothetical trend in IP, assuming that there was no credit crisis impact. Interestingly, actual IP has now recovered close to its likely levels had there been no credit crisis. However, the capex (private plus public) recovery has been significantly slower in comparison.

3)         Anecdotal evidence suggests that the corporate sector has started resorting to price hikes.

Non-Food Inflation to Spike Up Soon

The headline Wholesale Price Index (WPI) accelerated to 8.6%Y in January 2010 after touching a low of -1%Y in June 2009. However, this rise in headline inflation is largely due to higher food inflation. So far, policymakers have taken comfort because non-food WPI inflation has been below 5%. Similarly, higher food prices have kept CPI-Industrial Workers (CPI-IW) in the 8-16% range over the last 19 months. However, we believe that demand-side pressures are building fast. We believe that non-food WPI inflation will spike up to 6-6.5% over the next four months from 4.3%Y as of January 2010. Corporate pricing power is coming back against a backdrop of tighter capacity utilization and rising global oil and commodity prices - thus, non-food WPI inflation is bound to cross the Reserve Bank of India's (RBI) comfort zone of 5% soon. Persistently higher food prices and the rise in non-food inflation will likely mean a high risk of generalized inflation rate moving upwards.

Watch Out for Widening Trade Deficit Too

In a globalized world, higher aggregate demand compared to domestic supply will be reflected not only in higher inflation but also widening in the trade deficit. Some widening in the trade deficit was inevitable considering the strong domestic demand compared to external demand - but the gap is now too high. Over the last four months, while seasonally adjusted exports have risen by a cumulative 7.6%, seasonally adjusted imports have risen by a cumulative 41.5% over the same period. Excluding oil, seasonally adjusted imports have risen at an even faster rate of 51% during the last four months. The three-month trailing trade deficit widened sharply to 10.2% of GDP, annualized as of January 2010, from the trough of 3.2% as of April 2009. The peak of 14.2% came in September 2008 when oil prices had shot up over US$140/bbl in July 2008 (impact comes with a lag). With oil prices currently at US$81/bbl, the trade deficit already appears quite high. We believe that the underlying current account deficit is already close to 2.5% of GDP. Any further widening in the trade deficit could put the deficit at vulnerable levels. If the deficit widens to 3.5-4.5% of GDP, risk of currency weakness will increase significantly. Any decline in capital inflows or sharp rise in oil above US$100/bbl will cause exchange rate depreciation - adding to inflation pressure.

What Is Holding Back the RBI?

Although the RBI did hike its cash reserve ratio in January, we believe that the time has come for the RBI to manage the growth-inflation trade-off by lifting policy rates. So what is holding back the RBI?

First, the central bank appears to be of the view that the duration of recovery has been short. After all, it's only since June 2009 that IP has started rising meaningfully on a sequential basis. However, we believe that the pace of recovery is also important. As mentioned earlier, the seasonally adjusted IP index has shot up 16% between May 2009 and January 2010. With capacity utilization reaching closer to full, low interest rates could fuel inflationary pressures. We believe that policy response needs to track the pace of recovery.

Second, the central bank may also have been concerned that the growth has been driven by policy support and thus there is a need for caution in reversing the loose monetary and fiscal policy. We believe that the policy-driven domestic demand recovery is now being replaced by visible signs of improvement in autonomous domestic demand. The urban consumer, who did not get affected much during the crisis in absence of job losses, has come back quickly as sentiment improved from the quarter ending June 2009. Indeed, urban consumption has recovered without a major rise in household loan growth. Even if we assume that growth has been merely driven by policy support, the strength and the pace of recovery is surely likely to have surprised the policymakers, implying that the policy support is over-stimulating growth. Moreover, the recovery has already broadened with acceleration in capital goods production (investments) and exports growth.

Third, the RBI may have been concerned that the credit growth recovery has been slow. As of the fortnight ending February 26, 2010, bank credit growth accelerated to 15.8%Y from the trough of 9%Y as of end-October 2009. We believe that while credit growth is low relative to the RBI's comfort range of 18-20%, it is not that low considering that capital market funding has picked up significantly from last year. Moreover, bank credit growth is a lagging indicator and tends to follow IP growth by 4-5 months. Considering that IP growth has recovered so quickly, we believe that credit growth is likely to rise very quickly to above 20% in the next 3-4 months. Considering that the impact of monetary policy actions on the real economy and lending behavior tends to lag, if policy rate tightening is delayed, credit growth could shoot up above 25% in four months' time, in our view.

In any case, the RBI had mentioned in its January monetary policy statement that "main policy instruments are all currently at levels that are more consistent with a crisis situation than a fast-recovering economy". We believe that the economy is in a fast-recovery mode and the RBI will need to start lifting policy rates toward normalized levels soon. Indeed, the current reverse repo rate at 3.25% is a full 125bp below the previous cycle low of 4.5%, while growth has rebounded much more sharply than in the previous cycle.

Market Is Already Leading the RBI

So far, the RBI has shied away from increasing its policy rates, but rising inflation expectations are already causing weak deposit growth at scheduled commercial banks. It is no surprise that private sector banks have started increasing deposit and lending rates over the past month. Moreover, unlike the previous cycle, 91-day T-bill yields have already moved up ahead of the reverse repo rate hike. In the previous cycle, 91-day T-bill yields started rising only after the first reverse repo rate hike. Lastly, even the 10-year yields are beginning to move up again due to rising inflation expectations and potential strong credit growth demand from the private sector.

If the RBI delays reverse repo rate hikes, we believe that a spike in credit growth will in any case further absorb the excess liquidity in the system. Indeed, this will result in a shift in the policy rate in operation from the reverse repo to the repo rate with 91-day T-bill yields moving closer to the repo rate. (The reverse repo is the rate at which banks park excess liquidity with the central bank and repo is the rate at which banks draw funds from the central bank.) We have been expecting the RBI to hike the repo rate by about 100bp and reverse repo by 150-175bp in 2010. However, it is possible that a delay in the reverse repo rate hike may shift the policy rate in reference to the repo; thus, reverse repo rate hikes by the RBI would be less than what we are forecasting. In any case, the short-term market-oriented rates may yet rise in line with our expectations - although with a bit of a lag. We continue to believe that 91-day T-bill yields will further rise by about 100-125bp in 2010 from the current levels of 4.5% (has already risen by 50bp since October 2009).

Direction of 10-year GSec Yields and the Yield Curve in the Near Term to Be Determined by RBI Action

We have been arguing for some time that the large government borrowing program has been mostly priced into 10-year GSec yields. We believe that if the RBI acts soon by hiking the reverse repo, then 10-year yields should remain in the 7.5-8% range. Indeed, the 10-year yield is already close to an 8-year high if we compare it with the historical trend, excluding the period of recent credit crisis when it had spiked to around 9% for a few weeks. We believe that if the RBI hikes policy rates soon, pushing short-term rates higher, inflation expectations will be checked and future bank credit growth expectations will also remain in a more comfortable range of 20-22%. Since February 2010, the yield on 10-year GSec has increased by 40bp on rising inflationary expectations in the context of a large government borrowing program.

The spread between the 10-year government bond and 91-day T-bill yield, at 350bp currently, is already close to the steepest point in history following the Asian Financial Crisis, when the currency depreciated sharply and FX reserves declined to low levels due to capital outflows. Assuming that the RBI hikes policy rates in line with our expectations, we believe that the yield curve will normalize closer to 200-250bp over the next 12 months as short-term rates rise. The spread was about 130bp during the ten-year period before the recent credit crisis unfolded.

The RBI's policy actions will be important for the public sector banks' lending rates. If the RBI delays reverse repo rate hikes, even as more market-oriented rates (like 91-day T-bill yield and private sector banks' lending rates) may rise, public sector banks may delay their lending and deposit rate hikes. Public sector banks account for 74% of the total banking system's loans. Hence, delayed policy rate hikes will mean stronger future credit growth and weaker deposit growth in the system. We thus believe that if the RBI does not resort to any inter-meeting rate hike and opts for only a 25bp (instead of 50bp) rate hike on April 20, when it is scheduled to meet next, then the risk of the 10-year bond yield rising to 8.5% will increase. Other key factors which could push 10-year yields to higher levels would be a quick sharp rise in oil prices above US$100/bbl and/or quick reversal in capital inflows.

Bottom line: We remain bullish on India's growth outlook both from a structural as well as cyclical perspective. We maintain our GDP growth forecasts of 8.5% for F2011 and 8.4% for F2012. However, we believe that in the near term investors need to be mindful of the emerging transient risks of a potential spike in core inflation and widening in the trade deficit. We believe that this has also increased the uncertainty of the policy outlook.

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Brazil
Stronger - for Now
March 16, 2010

By Marcelo Carvalho | Sao Paolo

We are upgrading our 2010 real GDP forecast to 5.8% from 4.8% before. While the new forecast mainly reflects a stronger statistical carry-over effect from recently released (and revised) 2009 GDP data, it also incorporates more robust growth momentum in early 2010 as well as changes in the composition of growth, with stronger domestic demand on the heels of faster private sector consumption and investment. Still, we reiterate our view - investors should not confuse a near-term pop in growth with long-term sustainable expansion. Brazil's economy should finish 2010 on a softer note than it ended 2009, on the back of upcoming monetary tightening in response to rising inflation pressures. Indeed, we are also revising our IPCA inflation forecast to 5.0% from 4.5% before, in light of recent inflation data amid signs of a tighter output gap. 

We expect the central bank to start tightening soon. The timing of the first rate hike remains a close call. We continue to assume April, as we suspect that the monetary policy committee (Copom) does not feel ready to hike quite yet - but a hike on March 17 cannot be ruled out. We continue to see policy rates rising 225bp this year, to finish 2010 at 11.0%. But we now foresee a more front-loaded path than before, once the Copom starts tightening, given the new growth and inflation scenarios. A front-loaded path could also make it easier for the Copom to avoid changing policy rates too close to the October presidential elections. 

Stronger Growth

Most of the change in our GDP forecast has to do with the recently released and revised quarterly path during 2009 and its statistical implications for 2010. The economy expanded 2.0%Q (seasonally adjusted, not annualized) in 4Q09, extending a sequential expansion that had started in 2Q09. Incorporating upward revisions to previous quarters too, the resulting statistical carry-over effect for 2010 now stands at 2.7%, better than our initial estimate of a figure around 2.0%.

Our revised forecast also incorporates robust momentum in early 2010 and a change in the growth composition, with stronger domestic demand on the back of robust private sector consumption and investment, while net exports become a larger drag on growth. Investment was already the highlight of the recent 4Q real GDP report - it jumped 6.6%Q (seasonally adjusted, not annualized), and thus overshot sequential growth in the overall economy by a wide margin. Looking ahead, near-term prospects for investment look favorable, judging by leading indicators such as business confidence. For its part, improving labor markets, easier credit conditions, tax incentives and robust consumer confidence should help to support household consumption in the near term. In all, we estimate that domestic demand could grow by something in the 7-8% range on average this year, stronger that our previous forecast in the 6-7% range and much better than last year's 1.2% expansion. On the other hand, the drag on growth coming from net exports will likely intensify this year, as imports grow much faster than exports. 

However, we reiterate our view: Brazil's economy will likely go into 2011 on a softer tone than it has entered into 2010, for two main reasons. First, growth often tends to accommodate after a statistically easy, strong initial rebound from recession. Second, and more importantly, upcoming rate hikes will slow the economy down the road.

The latest monthly numbers suggest that growth remains robust so far in 2010, although recent indicators appear a bit more mixed than the picture we had, say, three months ago. For instance, retail sales were very strong in January, climbing 2.7%M, a record-high monthly gain since the start of the series back in 2000, on a jump in sales of durable goods. However, that came after a disappointing December reading, and may have been boosted by a sales rush before the expiration of tax breaks on white-line goods at end-January, besides one more weekend in January than in December.

For its part, industrial production shows some accommodation. Industrial output grew sequentially in January by 1.1%M, after two negative prints which had interrupted ten consecutive months of steady expansion from the recession's trough back in December 2008. On average during the three months through January 2010, industrial production was flat in sequential terms. Partial leading indicators (like paperboard sales, automobile production and traffic in main roads) suggest a positive sequential reading for industrial production in February. In all, while growth in early 2010 remains robust, we suspect that the expansion will accommodate at a less feverish pace than the sharp rebound during the initial stages of recovery. 

Rate hikes should help to cool the economy. The second reason to expect growth deceleration later in the year is the likely policy response. Despite potential prospective growth accommodation, recent domestic demand expansion looks too strong for lasting health, given the worsening inflation picture and limited slack in the economy. The central bank is expected to begin hiking interest rates soon. In turn, monetary tightening should cool down the expansion, as upcoming interest rate hikes work to unwind previous emergency stimulus. 

In other words, while average real GDP growth in 2010 should be robust, investors should not confuse a strong short-term rebound with long-term sustainable growth. One risk is that observers start getting carried away in extrapolating the recent rebound.   A great deal still needs to be done on the structural reform front in order to boost Brazil's growth potential to a higher sustainable level. At the end of the day, sustained faster growth will continue to depend on promoting the conditions that encourage productivity gains. That includes fostering a more market-friendly business environment that addresses issues including Brazil's labor market rigidities, a heavy tax burden and a byzantine tax system. On that front, the biggest risk for Brazilian policymakers is that complacency on the back of strong near-term growth ends up undermining prospects for the structural reforms that are needed to promote sustained longer-term growth.

In fact, fears of near-term overheating seem well founded, as inflation pressures are building and the current account deficit is widening - see "Brazil: Mind the Current Account Gap", This Week in Latin America, February 1, 2010, and "Brazil: Inflation Pressures", This Week in Latin America, February 22, 2010. In light of recent inflation surprises in an environment of shrinking slack in the economy, we are revising our IPCA inflation forecast to 5.0% from 4.5% before. Given the newly released real GDP data, updated estimates of the so-called ‘output gap' (or the distance between actual growth and its longer-term trend) suggest that there is little spare capacity left in the economy.

Consumer price inflation came out above expectations during January and February. IPCA inflation now cumulates 1.5% so far this year, already reaching in two months what the central bank had forecast for the entire 1Q10. Although seasonal and one-off factors may have exaggerated recent headline readings, measures of core inflation have been picking up as well.

Inflation expectations have increased. Indeed, against a backdrop of strong domestic demand, the run-up in inflation has pushed up the market consensus forecast for 2010 IPCA inflation to the 5.0% mark, above the 4.5% official target, from a trough of 4.2% late last year. It is interesting that the market consensus forecast for 2010 inflation has increased, but the consensus view for 2011 and for 12-month-ahead inflation have remained close to the 4.5% target so far - perhaps a sign of increasing central bank credibility.

Monetary Tightening

We are tweaking our interest rate forecast in light of rising inflation pressures amid tight spare capacity in the economy. We maintain our end-2010 policy rate forecast of 11.0%, for a tightening cycle of 225bp this year. But our forecast now looks for a more front-loaded path through the year, once the Copom starts hiking, although we continue to pencil in no hike in March. Before, our old forecast had three consecutive hikes of 25bp each in April, June and July, followed by three consecutive hikes of 50bp in September, October and December. Our new forecast now looks for three consecutive hikes of 50bp each in April, June and July, but then a pause in September and October, amid elections, before the Copom catches up with a 75bp hike in December. The first round of presidential elections takes place on October 3, and the run-off is on October 31.

We reiterate our view that the Copom will hike less than the local yield curve has priced in for this year, as we look for policy rates to increase 225bp in 2009 while the local fixed income market prices in about 100bp more than that. In our view, short-run monetary policy cycles should be seen within a longer-term secular context of declining real interest rates in Brazil, which still remain high by international standards. This means that monetary policy cycles in Brazil should entail lower peaks and a narrower amplitude than before. Besides, as the central bank gains credibility over the years, it should be able to get more ‘bang for its buck' in terms of the response of market inflation expectations to monetary action, as the expectations channel strengthens. Similarly, the credit channel has become more effective too, as credit has risen steadily as a share of the economy, reaching 45% of GDP at the end of 2009, all the way up from 22% of GDP back in late 2002 - even though part of the credit expansion last year had to do with aggressive lending by public sector banks like the national development bank (BNDES).

What are the risks to our policy rate outlook? The obvious domestic upside risk to our rate call is that domestic demand fails to cool down enough, while inflation expectations climb steadily higher towards the 6.5% tolerance ceiling. By contrast, downside risks to our policy rate call seem largely associated with an unexpected sudden deterioration in the global environment.

The central bank is likely to embark soon on a monetary tightening cycle, although the exact timing of the first hike is a close call between March 17 and April 28.  Our bias remains that a first hike in April looks more likely, but March cannot be ruled out. Arguments in favor of a March hike include the rapid deterioration in the inflation picture, including rising inflation expectations, against tight slack in the economy. Also in favor of March is the idea that ‘the sooner the better' - if the central bank concludes that rate hikes are indeed inevitable, it would be better to start earlier rather than later. In addition - the argument goes - if the central bank governor indeed is to step down by end-March in order to run for elections, a first hike already in March would probably make things easier for his successor at the central bank.

In contrast, there are arguments supporting the notion of a first hike in April. First, if it can, the Copom might prefer to wait until the quarterly inflation report comes out, at the end of March. The lengthy report would provide the central bank with a convenient communication channel to explain in detail its thinking, and to pave the way for a subsequent hike in April. After all, while the January Copom minutes were surely more hawkish then before, they were not as hawkish as markets had anticipated and fell short of sending a sense of immediate urgency for a March hike. And there was little explicit public policy signaling since then, despite the hike in reserve requirements. If the central bank wanted to send a signal to the markets in-between policy meetings, one option is for the head of the central bank to give an interview to the press, hinting at hikes. But he has not.

Second, as the governor of the central bank might step down by end-March, the Copom might prefer to wait until uncertainty about this issue is out of the way, before embarking on a tightening cycle. Third, the central bank might cite global uncertainties as a reason to wait-and-see, until it gets more clarity on the evolving external environment. Fourth, the Copom could mention mixed signs on recent indicators to justify waiting a bit longer until it becomes clearer where underlying growth settles.

In addition, the Copom seems less nervous about high-frequency data gyrations than market players are. Instead, the Copom looks at trends - it sees the economy as a slow-moving transatlantic ship, not a high-speed boat. While measures of core inflation are picking up, they are not a disaster. Also, the central bank looks at the balance of risks - if the Copom does not hike in March and instead waits until April, is its credibility then irreparably damaged? We do not think so.

Watch policy signals - voting score, policy statement, Copom minutes. Copom watchers and market players are divided on the timing of the first hike - it would be no surprise if Copom members themselves feel divided on the issue, as we suspect. In that environment, a 25bp hike might prove a compromise between no hike and a 50bp move.

A split vote decision is a distinct possibility, in our view. A majority of Copom members may decide to stand pat in March, but a vocal dissenting minority could vote for a hike. Note that there might be an asymmetry here - a decision to stay on hold could easily come with a split vote, but a decision to start hiking is more likely to be formally unanimous, as the Copom in this case would likely prefer to show a unified front against the public criticism that such a move typically entails. In fact, tensions within the administration could well increase in the coming months, as parts of the administration have indicated that they do not judge rate hikes are necessary - and the political calendar may complicate the matter. 

Formal policy communications will likely turn more hawkish. Whatever the Copom decides to do on March 17, the accompany brief policy statement and the subsequent Copom minutes on March 25 look set to take a more hawkish tone than before, and investors should be ready to hear increasing talk about a deterioration in the ‘balance of risks' around the inflation outlook.  

Bottom Line

While our new growth forecast mainly reflects stronger base effects, it also incorporates robust momentum in early 2010, with faster domestic demand. But we reiterate our view: a near-term rebound should not be confused with sustained long-term growth. The economy is likely to enter 2011 on a softer note than into 2010, as monetary tightening (which we now see more front-loaded) should slow the pace of the economy's expansion.

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CEEMEA
CEEMEA: Why Trade Matters
March 16, 2010

By CEEMEA Economics Team|

Trade flows set to recover, from a depressed base: In this week's focus, we look at trade patterns across CEEMEA. Overall, the openness of these countries, as proxied by goods export/GDP, varies widely across the region. The small economies of Central Europe are significantly more open than the global norm, which partly explains the authorities' almost obsessive focus on FX rates. Bigger economies with larger domestic sectors tend to be broadly as open as the global average, or even less so, as in the case of Turkey. Exports were hit particularly badly in the recent recession, as a result of which they are a smaller share of GDP today than they were two years ago. Imports were, however, hurt even more by the collapse in domestic demand, as well as some fall in import prices (commodities mostly), so overall trade balances have improved dramatically almost everywhere, and net trade has been the main engine of GDP growth over the last year. What does the future have in store? Our newly published forecasts (see Global Forecast Snapshots, March 10, 2010) suggest that global trade volumes will rebound this year and next, and this is consistent with our export forecasts across the region. For the countries (as in Central Europe) where exports have a high import content and where domestic demand and investment are recovering partly due to re-stocking, import growth should rebound from depressed levels and may show even more momentum than export growth. Therefore, we think that the bulk of the improvement in the trade balance is behind us, and some deterioration in the coming years is likely, though not back to the days of explosive trade and C/A deficits of 2007-08.

Focusing on commodity patterns: Looking at the breakdown of trade by sector, two distinct groups emerge. In the first, the economies of Central Europe and Turkey are heavily geared towards manufacturing and autos. In Central Europe in particular, machinery and transport material (wider than just autos) account for 60% of exports in Hungary, 50% in the Czech Republic and 40% in Poland. The auto sector on its own is responsible for around 20% of total exports across the region. The German car incentive scheme was hugely helpful to avoid an even bigger recession in Central Europe, and its expiry has raised fears of a ‘W' (double-dip) ahead, especially in the Czech Republic, one of the main beneficiaries. Manufacturing also accounts for the lion's share of imports across the region, as a great deal of parts are imported from abroad for assembly and re-export.

In Turkey, autos, machinery and white goods have over the past decade increased in importance over textiles and agriculture. The move up the ‘value-added' chain has made Turkey one of the top providers of these goods in Europe.

In the second group (Russia, Ukraine, South Africa) we find the commodity exporters. Russia's 2009 export data show a fall in the share of raw material exports since the pre-crisis period, but this does not indicate any progress in diversifying the economy away from commodity dependence, in our view (fuels are 64% of exports). A collapse in demand in the metals sector, and Gazprom's reluctance to adjust prices downwards, brought sharp but temporary falls in exports in these sectors. LNG and unconventional gas sources are a serious long-term threat to Russian export volumes, but we see little progress so far from other sectors in filling the gap.

In Ukraine, steel exports were worth approximately 10% of GDP in 2009 (30% of total exports). The sector was hurt badly last year but is already recovering. Food exports (6.5% of GDP) are currently highly volatile and weather-dependent, but longer-term prospects for the sector look strong, though we do not expect much progress on land privatisation under the current government. On the import side, the sharp hike in gas import prices this year will be the main challenge, though scope for further gains in fuel efficiency still looks high.

In South Africa, roughly 60% of exports (12% of GDP) are commodities - mainly minerals, precious stones and base metals such as gold, platinum, coal, steel and diamonds - thus making South Africa a commodity-dependent economy, with significant reliance on global demand patterns. Within the commodity export basket, platinum group metals account for some 30% (down from a pre-crisis level of 40%), gold accounts for 27% (up from 23% before the global crisis), and coal accounts for a relatively steady 16%. The crowding out of platinum by gold is largely driven by a significant outperformance in the price of gold, as gold export volumes have significantly underperformed that of the platinum group. But perhaps the most interesting development in recent times is the soaring importance of iron ore, which has doubled from 7% in 2007 to some 15% presently, thanks largely to a sharp rise in production and export volumes, as well as a spike in global prices. With regards to imports, manufactured products account for some 40% of the basket. A significant proportion of the transport equipment (excluding aircraft and vessels) are vehicle components and parts that that are reassembled and exported. Commodity imports (mostly petroleum crude and products) account for no more than a fifth of imports, giving a commodity gearing ratio of 1:3, in favour of exports. In other words, the country stands to benefit significantly from commodity price rallies, as exports generally provide about three times coverage to the rise in commodity import costs. Similarly, for South Africa to benefit from a commodity downturn, oil prices need to fall off three times as fast as the decline in the key commodity exports such as gold, platinum, coal and iron - which is unlikely to be the case. Thus, the country - and, as a corollary, the currency - tends to perform poorly during commodity booms, but does relatively well during rallies.

Who Trades with Whom?

The Central European countries trade overwhelmingly with the euro area (50-60% of total exports), for geographical proximity reasons as well as the nature of their industrial sector: global companies have for over a decade invested heavily in the region to use it as a low-cost manufacturing hub to serve Western European markets. Central Europe-based plants import capital goods and machinery from Western Europe, assemble them and re-export them to the same countries (imports from EMU are 50% of total imports). As we have observed in the past, the correlation between the German and CE industrial cycles has risen steadily over recent years (see CE Industry: No Longer a Bottomless Pit, June 23, 2009). An interesting phenomenon that has taken hold over recent years has been the rise in intra-regional CEE trade: in 2000, just 10% of Central Europe exports went to other CEE countries; today, that ratio is already 16%, and rising. Increasing integration, as well as the emergence of a new class of consumers in emerging Europe, probably are the main reasons for this.

The share of Turkey's euro area exports was significantly high until the past few years, but due to the country's efforts to diversify markets and also the lack of solid growth in the euro area, there has been a shift away from that market. Essentially, Turkey's exports to the euro area came down by 1 full percentage point of GDP in just two years (2007-09) while an opposite change, i.e., a 1.1 percentage point of GDP increase, materialised to the Middle East. This was helped not only by the relatively better performance of the middle eastern countries in terms of income growth and consumption, but also the Turkish government's increased efforts to improve trade relations with neighboring countries as well as the Gulf. Another interesting change took place in Turkey's share of exports towards Africa. As captured mostly under the ‘other' classification, some rise of 0.7pp of GDP materialised between 2007 and 2009. We expect the Middle East and Africa to gain further importance in Turkey's external trade, especially as Europe lags in growth. Not surprisingly, and given the proximity issues, Asia including Japan and China take almost no meaningful share in Turkey's exports. On the imports front, the euro area takes the top spot followed by CIS (mainly Russia), which provides oil and natural gas. Not surprisingly, Turkey runs a trade deficit with China by nearly 2 percentage points of GDP and, in our view, that is partially based on the fact that a significant portion of Turkey's exports are actually based on imported goods. Hence, Turkey's import bill seems to have a close link with its exports performance.

In Russia, the fall in exports to Euroland (from 40% of total in 2007 to 34% in 2009) mainly reflects temporarily lower gas demand and Gazprom's slow price response. We expect this to recover, but also see a longer-term shift towards China (6% of total in 2009) as new pipelines are completed. On the import side, the steady rise in Chinese imports, politically sensitive among import-competing firms, highlights Russia's interest in CNY revaluation. With a stronger CNY and weaker EUR, we see a significant political window for further RUB appreciation against the EURUSD basket this year.

In Ukraine, direct exports to China have been growing rapidly with the recovery of the steel and iron ore markets, but from a low base. While Russia's external trade is oriented to the euro area (trade turnover was 14% of GDP in 2009), Ukraine's external trade links are stronger with CIS countries (28% of GDP) followed by the euro area (13% of GDP). Much will depend on the progress of possible negotiations over membership of the Russia-Belarus-Kazakhstan customs union. We are currently sceptical about this materialising. However, under the new government, trade links with Russia are likely to improve, with anti-dumping barriers to metal exports currently widely in use. 

South Africa's geographical exposure has gradually shifted away from Europe and the US, towards Asia (mainly China and Japan) and Africa in recent years. Although there was the occasional odd month in the past where Asian exports superseded Europe, it was only in 1Q09 that Asia overtook Europe to become South Africa's largest trade partner on a sustained basis. For the record, Asia's share of South Africa's exports (mostly resource and mineral exports) has risen from some 27% in 2006/07 to 31% in 2H09, while that of Europe (mostly semi-manufactures and fruits) fell from 34% to 29% over the same period. In our view, it is this fortuitous product and geographical mix that supported South Africa during the recent global recession.

Conclusion

In such a diverse region, it is hardly surprising that trade patterns are so diverse across countries, both in terms of commodities and regions. Some countries are manufacturing-heavy (Central Europe, Turkey), while others (Russia, Ukraine, South Africa) are more geared towards commodities; geographically, Central Europe remains overwhelmingly exposed to euro area demand, while other countries appear to have a more diversified export market structure. When we try and capture concentration in product and markets (using a HH index), we see that only Central Europe displays high concentration in both, which is a source of potential vulnerability, we think.

Another interesting conclusion from our analysis is that there are slow but definitely noticeable trends of increased intra-EM trade. Central Europe trades more with CEE, Russia and Ukraine with China, and Turkey with the Middle East. This is also clearly borne out in the data from the IMF DOTS. We think this is an encouraging phenomenon, and absolutely consistent with our macro team's theme of a move to an increasingly EM-led world.

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Italy
Inching into the Core
March 16, 2010

By Daniele Antonucci | London

Summary and Conclusions

Fiscal concerns brought the so-called EMU periphery under the market spotlight. According to the conventional view, all the countries generally associated with this group (Italy, Spain, Portugal, Greece and Ireland) are characterised by a degree of fiscal profligacy, a poor record of implementing structural reforms, a lack of cost competitiveness and sizeable current account deficits - unlike core EMU countries. Thus, fiscal problems in the smaller peripherals are just a taste of things to come. What if Italy, the biggest of all, gets into difficulties?

With Italy's public debt amounting to around €1,750 billion or almost one-quarter of EMU public debt, the consequences for the euro area will be substantial. Is Italy the next in line after Greece and the small peripherals? There are grounds to challenge this consensus view, we think. True, Italy has its own long-standing deficiencies (see Italy Economics - Assessing the Damage, October 26, 2009), but it measures favourably with the ‘typical' peripheral country. We approach this issue from six different perspectives:

•           First, Italy is not yet regarded as a core EMU country in all respects, but it is increasingly behaving like one from a fiscal standpoint. Contagion in the bond market has been more limited than in the rest of the EMU periphery, and debt affordability does not look set to deteriorate sharply.

•           Second, courtesy of fiscal prudence during the crisis, and a relatively small overall and primary budget deficit, Italy has less work to do in terms of tightening fiscal policy than the ‘typical' EMU country. As in the other large euro area countries, fiscal consolidation will start next year - not this year.

•           Third, this does not mean that Italy will not face higher debt servicing costs over the next couple of years - all EMU countries will. But courtesy of the long maturity of its debt, it will take several years for the cost of servicing the debt to rise meaningfully in Italy - longer than in most other EMU countries.

•           Fourth, the long-term sustainability risk to Italy's public finances is medium, as pension reforms have helped to reduce the projected cost of an ageing population. We think that the market is underestimating the relevance of this factor, which is crucial from a sovereign solvency perspective.

•           Fifth, Italy's competitiveness gap with core EMU countries is appreciable, but smaller than depicted by price-competitiveness indicators. Indeed, from a long-term perspective, Italy has protected its market share more successfully than it is generally assumed.

•           Sixth, unlike in the small EMU peripherals, the current account deficit is manageable and no credit-fuelled housing and consumer boom-turned-bust has taken place recently. This means that there is no pressing need for the Italian private sector to deleverage considerably.

1. Is Italy a Peripheral EMU Country? Not really

The bond yield and CDS spread widening over the past few months are symptomatic of concerns about short-term debt rollover and long-term debt sustainability risks in many countries. Sovereign risk appears to be driving financial markets lately. Indeed, the question that seems to be on many an investor's mind, i.e., ‘after Greece, who's next?', has many potential candidates for an answer.

Predictably, and in some cases without much supporting evidence, these candidates are perceived to lie mostly within the so-called EMU periphery. However, without denying evident long-standing deficiencies in these countries, a closer look at the facts reveals that the EMU periphery is a very heterogeneous entity from both a broad economic and fiscal standpoint (see Portugal and the EMU Periphery, February 15, 2010).

In particular, the distinction between core and peripheral EMU countries is not clear-cut. Indeed, while Germany, France, the Netherlands and Austria, for example, feature in virtually all definitions of core EMU, the constituents of the periphery reflect, in some instances, dynamics dating back to the pre-EMU period - now no longer applicable (see the following sections). This is relevant because the size of these countries is remarkably different. To the extent that sovereign risk concerns in the market contribute to enforce fiscal discipline in one small country, then the direct consequences on the euro area economy would be limited. Conversely, fiscal tightening in one large country would depress euro area growth by a meaningful margin.

Take Greece, for example - which accounts for about 2.5% of euro area GDP. A downturn in this country would have contained repercussions on its European neighbours. The same applies to, say, Portugal (1.8%). At the other end of this range, a downturn in Spain (11.7%) or Italy (17%) - the biggest country among those generally considered to belong to the EMU periphery and the largest sovereign borrower in Europe - would exert meaningful negative effects on the euro area. This is not to say that world markets cannot be correlated on a daily basis, or that contagion effects cannot spread regardless of the fundamentals. Rather, it is an observation that size is important too - especially once the dust settles.

The good news is that Italy not only does not seem to be as fragile as the other peripherals from a fiscal standpoint; it also compares favourably to some of the core countries. That Italy is a new addition to the core of the EMU is perhaps an overstatement. But the fact remains that, in terms of both the economic policies that its government has put in place and how the market has reacted to these policies, Italy has weathered the fiscal storm relatively well. For example, at 5.1% of GDP on our forecast, its budget deficit will likely be one of the lowest in the euro area this year - together with Germany - in sharp contrast with France (8.1%). It may not yet fully belong to core EMU, but Italy is the core of the EMU periphery.

Contagion - Not That Much So Far

Recent market dynamics seem to confirm our view that Italy is somewhat ‘special' among the EMU peripherals. Indeed, although bond yields and CDS spreads have widened in Italy too, they have done so to a much lesser degree than in Greece, Portugal, Ireland or Spain, for example.

Italy's 10-year bond yield spread against Germany is still wide relative to its post-EMU average (15-25bp). But this is not because the yield on Italian bonds has risen sharply. Since the onset of the financial crisis in July 2007, the yield on 10-year bonds in Germany has declined by 150bp to 3.16%, while it has come down by 75bp or so in Italy.

These dynamics go beyond economic considerations. The main catalyst behind the spread widening is not country-specific. All else being equal, when there is lower risk appetite and higher volatility - as is still the case - a shift towards safer or more liquid assets tends to take place. This drives down the yield of the benchmark.

What's more, the risk of facing a ‘buyer's strike' on the Italian bond market seems lower than in other EMU peripherals. Indeed, the so-called ‘home bias' effect seems to be more of a factor in Italy. This effect refers to a typical pattern in financial markets: in case of adverse news - which could potentially push interest rates higher - foreign holders tend to hold on to the debt to a lesser degree than domestic holders. While the former might liquidate the bonds more easily when prices fall, the latter might wait for longer (to the extent that they are not convinced that the country will default) - after all, higher interest rates would boost their incomes.

As is well known, one country that benefits from the ‘home bias' effect is Japan - where the vast majority of the public debt is held by residents. In the EMU, Italy stands out relative to the other peripheral and core countries for its high share of public debt held domestically. Indeed, residents hold about 60% of the Italian government debt. This compares to one-quarter for Portugal and Ireland, one-third for Greece and about 40% for Spain. In Germany and France too, the share of public debt held domestically is lower than in Italy. What's more, issuance is going rather well in Italy, with the government having already covered almost 20% of the estimated 2010 funding needs (on our forecast).

Italy Behaves More Like a Core Country in Some Respects ...

So, barring an unlikely U-turn in fiscal policy, Italy does not look particularly vulnerable to the contagion from the situation in Greece that affected other peripherals. However, there is a more fundamental reason for this: debt affordability, i.e., the ability of a country to contract a large amount of debt at an affordable cost. On this measure, Italy - together with Portugal - really is different from the ‘typical' EMU peripheral country.

Looking at the sensitivity of interest rates to the debt trajectory, we see that debt affordability has hardly deteriorated in Italy from 2007 - and we expect it to worsen only by a small degree over the next two years despite rising public debt. What's more, the slope of the debt trajectory in Italy is similar to that of core EMU countries, reflecting its ability to contract a larger debt at an affordable cost.

... and Looks Like the Core of the Periphery

So, Italy may well be the core of the EMU periphery. However, the difference between the solid debt affordability of Italy from the shaky one of other peripherals (with the exception of Portugal, which truly looks like a core EMU country from this perspective) does not necessarily make Italy and, say, Germany alike. Indeed, the starting point in Italy (higher debt and interest) is different from that of core EMU countries (and less favourable).

Still, the steep debt affordability curves of Greece, Ireland and, to a lesser extent, Spain do indicate that, as the debt/GDP ratio rises, so does the cost of servicing the debt as a share of revenues (which gives an indication of a country's ability to cover interest expenses) - and quite quickly. Conversely, rising debt implies smaller increases in the cost of debt servicing in Italy. With debt and interest payments rising everywhere, Italy's position is an advantage.

2. Fiscal Tightening - Getting the Timing Right

This does not mean that Italy will not tighten its fiscal policy. We do expect a more stringent public purse not only in Italy, but also in Germany and France. However, unlike in Spain, Greece, Portugal and Ireland (where fiscal policy is already - or about to become - more restrictive), we think the expected tightening will not happen this year, but probably next year.

Both the Italian and French budget deficits will remain broadly unchanged in 2010, based on the respective budget laws. What's more, the German government has promised tax cuts this year and will likely cut spending to make room for these cuts, but not by much (see Germany Economics - Mending Europe's Largest Economy, September 28, 2009).

Smaller Fiscal Shortfall in Italy than in the EMU - Why?

The 2009 budget deficit widened by around 2 percentage points of GDP on a year earlier in Italy, much less than in most of its European neighbours. This has to do with two main factors: fiscal austerity and a more contained worsening of the primary balance (i.e., the budget balance excluding interest payments). More specifically:

•           Mindful of the high debt - and conscious that market discipline would have punished any fiscal slippage - the Italian government has implemented one of the smallest fiscal packages in Europe. EMU countries with more fiscal leeway, both at the core (e.g., Germany) and at the periphery (e.g., Spain), put in place a more expansionary fiscal policy.

•           Unlike other countries (e.g., France), Italy has managed to maintain a primary budget surplus for most of the past decade. This means that Italy - unlike France - did not need to borrow in the market to cover its interest payments. Indeed, Italy's primary budget looks in a better shape than in most EMU countries.

Of course, the recession triggered a shortfall in revenues and an increase in spending - courtesy of the functioning of the so-called ‘automatic stabilisers' - in all European countries. In Italy, this resulted in a primary budget deficit last year. But this is likely to be a temporary deterioration: we expect a balanced primary budget in 2010 and a small surplus in 2011. In France, conversely, the primary balance dipped into negative territory in 2002, and has remained there ever since. The chances are that the primary deficit will stay well in the red in 2010-11, to the tune of 5.5% of GDP on average.

The upshot is that Italy has less work to do in terms of cutting its budget deficit than the ‘typical' EMU country. Indeed, bringing the deficit from around 5% of GDP this year to less than 3% in 2012 (as requested by the European Commission) implies a more limited fiscal consolidation than in the other peripherals. The other side of this austerity policy is that the stimulus provided by the government to cope with the economic fallout of the financial crisis has been limited. But the magnitude of the plunge in GDP last year was not atypical in Italy (which is, incidentally, one of the few EMU countries where economic sentiment is above its long-term average).

What's more, Italy did not need to provide a great deal of support to its financial sector - unlike other European countries. Apart from capital injections amounting to around 0.6% of GDP (the average in the G20 is 2.2% of GDP), the Italian government did not need to purchase assets from/lend to financial institutions. In addition, no bank guarantees were needed either. Thus, the upfront government financing to support the financial sector amounts to a mere 0.6% of GDP in Italy - six times lower than the G20 average, according to the IMF (see The State of Public Finances Cross-Country Fiscal Monitor, November 2009).

How Long Does it Take for the Cost of Debt to Rise?

Of course, this does not mean that the cost of debt servicing will not rise over the next couple of years. We believe that all EMU countries will face higher costs, for two reasons: first, interest rates will rise; and second, the stock of debt will rise too. However, getting the timing right is key, in our view.

Will an increase in interest rates of, say, 100bp be immediately reflected in the cost of servicing the debt? The answer is no. It all depends on the average maturity of the debt, which is roughly seven years in Italy. This means that it will take seven years for the cost of servicing the debt to fully reflect a 100bp increase in interest rates.

Germany, the Netherlands, Belgium and Finland have the shortest debt maturity in the EMU, while Italy, Spain, Greece and Austria have the longest. Of course, the above-mentioned calculation assumes unchanged behaviour. Clearly, governments might start to issue shorter-dated bonds, for example, as this would imply a slower increase in their borrowing costs when interest rates rise. But all else being equal, the cost of funding is likely to increase more quickly in the former group of countries than in the latter.

3. Revisiting Fiscal Sustainability

Although short-term fiscal risks appear moderate in Italy, it is natural to wonder whether its funding model is viable in the long term. In its recent Sustainability Report, the European Commission simulates the path of the debt/GDP ratio for all the European Union member countries through 2060. By then, the ratio would reach 205.9% in Italy. However, as alarming as this might sound, most other countries would be in a much worse fiscal position, according to this (admittedly very uncertain) exercise.

For example, by 2060 the debt/GDP ratio would be 318.9% in Germany, 431.3% in France and 766.6% in Spain. Indeed, the European Commission's assessment shows that the long-term sustainability risk to Italy's public finances is medium - the same category for Germany and France. Conversely, the long-term sustainability risk to the Irish, Spanish, Greek and Dutch public finances is high. Outside of the euro area, the UK is another country at high long-term sustainability risk. Naturally, these projections - based on the assumption of no government policy change - are unrealistic, and in the above-mentioned report the Commission clarifies that the simulation exercise is not a forecasting exercise. Of course, it is unlikely that bond markets would keep financing government debts amounting to a multiple of the GDP of the respective countries - or that governments would maintain their policies unchanged in the presence of ever-increasing debts.

Still, these simulations are useful, we think, because they rank all the European countries on the same metrics, thus highlighting the risks faced and the need for deep structural reforms to bring potentially exploding public finances under control.

Until the early 1990s, Italy's public debt rose much faster than that of the rest of Europe. Since then, a slow reversal has been at work. With the financial crisis, this trend has accelerated, and Italy's public debt now accounts for less than 25% of total EMU debt, for the first time since the mid-1980s. The above-mentioned Commission's report suggests that the share of Italian public debt in the EMU could shrink further over the next decades, to only 15% of EMU debt in 2030 - in stark contrast with the trend in other peripherals.

Is the Market Underestimating the ‘Reform Factor'?

Over the past 20 years, a large number of reforms have had a deep impact on the Italian economy. Admittedly, given the poor state of the Italian public sector in the early 1990s, the scope for improvement was considerable. So, a large part of the fiscal consolidation occurred through efficiency gains.

Various pension reforms contributed significantly to reducing the long-term fiscal costs. The lengthening of the working period to calculate the pension payments and the postponement of the retirement age were the two pillars of the reforms. Over the past 15 years, the average retirement age has increased by around three years (to 61 years).

Crucially, the European Commission expects a decrease in pension expenditure of 0.4% of GDP between 2009 and 2060 in Italy - against an increase of 2.7% of GDP in the euro area. Thus, the gap between pension expenditure in Italy (where it is the highest in the euro area, currently accounting for 14% of GDP) and in the euro area (11.2%) will close. Similarly, Italy's projected healthcare spending is lower than in other peripheral and core EMU countries, and its projected costs of long-term care are not particularly high either.

Furthermore, there were important reforms in other areas too, ranging from enhancing labour market flexibility to curbing excessive regulation:

•           The ‘Treu package' (1996) and the ‘Biagi law' (2003) improved labour market flexibility by introducing new types of part-time and temporary contracts, creating incentives for on-the-job training and facilitating labour mobility.

•           The ‘Taglia Leggi law' (2005) - or law for cutting laws - established whether certain laws had been superseded by new legislation and, if so, abolished them. Under this ruling, almost 33,000 laws were suppressed.

•           The ‘Bersani laws' (2006) helped to remove obstacles to competition in retail trade and professional services by eliminating the minimum fees for a range of professions and relaxing the restrictions on advertising.

Clearly, Italy has a lot to gain from these reforms. For example, in its latest Economic Survey of Italy, the OECD estimates that Italy could expect an additional increase in productivity of 14% over the next decade by aligning its regulatory standards on current OECD best practices.

4. The ‘Competitiveness Issue'

Conventional wisdom has it that Italian competitiveness has worsened over the past decade, as suggested by the appreciation of its real effective exchange rate. According to this indicator, based on unit labour costs, while Germany has improved its competitiveness and France has maintained it, Italy and other EMU peripherals have lost ground - now that these countries can no longer use currency depreciation to boost their export competitiveness within the euro area. However, unit labour costs may provide a biased picture in the case of Italy, given the gains in official employment numbers - courtesy of workers previously employed in the so-called ‘shadow economy'.

Furthermore, unit labour costs are an input of cost competitiveness - not the output, i.e., the price at which goods and services are bought and sold. In other words, tracking consumer price developments is an alternative - and perhaps more reliable - way to monitor changes in competitiveness across the euro area. Of course, there are various price indicators available, and none of them is free from drawbacks. From a price-competitiveness standpoint, we find it helpful to think in terms of core prices, which strip out volatile components such as energy and fresh food, as they don't have much to do with domestic economic dynamics.

Let's compare the change in core consumer prices relative to the euro area average since 1999 with the change in unit labour costs relative to the euro area average.

The picture that emerges is that the competitiveness gap between Italy and, say, Germany or France is smaller when consumer prices are used. What's more, Italy ranks better than the small peripherals on the latter measure, while it ranks worse than Spain and Greece on the former. In our view, Italy is closer to core EMU than the rest of the periphery.

Of course, Italy has lost market share in world exports over the past decade or so. But this is not surprising. In an increasingly globalised world, the entry of new producers from emerging economies in the international markets naturally implies a contraction of the market share (but not necessarily of the absolute export levels) of the advanced economies as a whole.

In other words, although the (world export) pie is now bigger, it is also cut into more slices. Each slice can be bigger in absolute terms, but proportionally smaller relative to its share of the original pie. What's relevant is that this contraction has not been even, with some developed economies experiencing a more pronounced decline.

Taking a long-term view and focusing on the large euro area countries, what emerges is that, while Germany is the clear outperformer, Italy is closing the gap with France in terms of importance in world markets. Of course, Spain is somewhat special compared to the other large EMU countries; its performance reflects a lower starting point and close ties with Latin America:

•           While Italy - as well as Germany and Spain - has gained market share since the 1950s, France has lost ground.

•           Italy has continued to gain market share until the early 1990s; France until the late 1970s - and at a slower pace.

•           Market share started to decline in both Italy and France at about the same time - presumably because of competition from emerging market producers.

The upshot is that real effective exchange rate-based indicators do not capture all aspects of competitiveness. Non-price or qualitative competitiveness factors, such as product design, branding, distribution and customer service, play an important role as well. If incorporated in the analysis, these factors may reveal that Italy's competitiveness gap is less significant.

Consistent time series are not available, making it difficult to test this hypothesis. Still, some tentative support may be found in the more pronounced drop of Italy's export market share in volume than in value. This may reflect the attempt of some Italian firms to change their product mix and to target the high end and more remunerative market segments, while moving lower-quality productions abroad. In all, we think that Italy's competiveness gap with Germany and some other core EMU countries is appreciable, but not as large as is generally depicted.

Moreover, what really matters is not export competitiveness - which can only be estimated - but export performance, i.e., how a country's exports fare relative to those of comparable economies. On this yardstick, the pace of growth of Italy's extra-EMU exports - which is the most appropriate measure in a currency union, we think - is in line with the euro area average and better than France's.

From a different angle, Italy's current account deficit is in line with that of France and smaller than in other EMU peripherals. Indeed, the size of Italy's current account deficit is quite manageable, in our view. This means that, to fund its external imbalance, Italy does not need to attract foreign capital to a great extent.

Conversely, this issue is particularly pressing in Greece, Portugal and, to a lesser degree, Spain. These countries were able to fund their current account deficits courtesy of large portfolio investment flows - which are sensitive to changes in market sentiment.

5. Balance-Sheet Recession Avoided

Turning to the domestic economic situation, there is no pressing need for the Italian private sector to deleverage considerably. At the onset of the financial crisis, Italy was characterised by a low private sector debt/GDP ratio, moderate loan growth and a not particularly overstretched housing market. This sets Italy apart from the credit-fuelled housing boom-turned-bust economies in parts of Europe.

The house price/income and house price/rent ratios suggest that house prices are still much more overvalued in Spain, Ireland and the UK, for example, than in Italy. Indeed, unlike in the housing market hotspots in Europe, Italy's house prices don't need to decline substantially to bring the house price/income ratio in line with its long-term average.

Italy has not really experienced a housing bubble - at least not recently. Thus, there is no structural reason for construction investment to contract sharply. Unsurprisingly - given the depth of the recession - house prices have declined in Italy, but only by around 5% from their peak. This compares with a 10.5% drop in Spain, and considerably more in the UK and Ireland, for example.

Conclusions

The main takeaway for financial markets is that while Italy has its own long-standing deficiencies, it measures favourably with the ‘typical' peripheral country. We don't think that Italy will be the next in line after Greece and the small peripherals. Clearly, Italy is not yet regarded as a core EMU country, but it is behaving like one from a fiscal standpoint. Whether Italy will earn a place in core EMU one day remains to be seen, but this process has market implications in its own right.

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United States
Review and Preview
March 16, 2010

By Ted Wieseman | New York

The Treasury curve saw a decent flattening move in quiet trading over the past week, with 2s-30s hitting its lowest level since late January, as a continued run of improved economic data after a soft patch over the prior few weeks pressured the short end while the longer end was boosted by strong demand at the 10-year and 30-year auctions and perceived near-term value among some investors as peak long zero yields rose above 5%.  Curve flattening was also supported by substantial renewed pressure on overnight financing rates Friday after some moderation much of the week from the prior week's run up, and there was also some market speculation that the Fed could soften its extremely dovish policy language in Tuesday's FOMC statement. We expect the "extended period" language to be modified soon but probably not as early as the coming week's meeting.  Even so, the move towards the exit has already begun in a meaningful way as the ramping back up of SFP issuance that is draining bank reserves and sharply boosting Treasury supply is already adding to upward pressure on the overnight repo and effective fed funds rates. We continue to expect reserve draining to accelerate over the summer, when we look for term deposits and large-scale reverse repos to add to the ongoing liquidity draining being conducted by the Treasury on the Fed's behalf through the SFP program. In preparation for this next stage, the New York Fed moved over the past week to add major money market funds as counterparties for repo operations, as the primary dealer system by itself probably doesn't have the balance sheet capacity for the ultimate volume of reverse repos the Fed will need to implement. The economic data calendar over the past week was quite light, but what was released added to the prior week's run of solid numbers to further suggest that the economy held up better than feared early in the year during severe weather disruptions and some paybacks from late 2009 tax incentive-driven boosts. A much narrower-than-expected trade deficit in January and surprisingly strong underlying retail sales in February, with a partial offset from lower inventory numbers - a positive for future growth - led us to boost our 1Q GDP estimate to +2.5% from +2.0%, partly reversing a persistent run of downgrades in February from our initial 1Q GDP tracking estimate of +3.0%. We still think that 1Q growth was meaningfully depressed by the severe weather and other temporary paybacks and production consolidations, and we look for a snapback in 2Q with an acceleration to +4% GDP growth. Meanwhile, any concerns about how well the market would absorb the latest run of heavy long-end supply were not realized yet, as all three of the week's auctions, 3-year, 10-year and 30-year, saw very strong demand, allowing the long end in particular to recover significantly Thursday afternoon and Friday after being weighed down by pre-supply pressures for nearly a week starting soon after the employment report release. We continue to think that a major shift in the supply/demand balance in the credit markets after an unprecedented run of private sector debt reduction in 2009 offset record Treasury issuance will substantially boost long-end real yields over the coming year (see The Coming Rebound in Private Credit Demands by Richard Berner, March 12, 2010), but at least for this week there clearly remained ample demand to absorb the still surging Treasury coupon supply even at current abnormally low real yield levels. 

On the week, moderate losses at the shorter end and small gains at the long end resulted in a significant curve flattening, with 2s-30s moving 7bp lower to 367bp, a low since January 27 after having risen to a two-week high of 380bp Tuesday.  The 2-year yield rose 6bp to 0.96%, 5-year 7bp to 2.42%, 7-year 5bp to 3.15% and 10-year 2bp to 3.71%, while the 30-year yield dipped 1bp to 4.63%. TIPS outperformed on the week even as commodity prices came under a bit of pressure as worries rose about the possibility of more near-term moves by China to restrain liquidity after a batch of stronger-than-expected February data reports. The 5-year TIPS yield rose 2bp to 0.21%, 10-year fell 2bp to 1.45% and 30-year fell 2bp to 2.13%. TIPS inflation expectations saw a significant pullback in February as worries about Greece mounted, but as that situation has calmed down, breakevens have started to reverse higher, with the benchmark 10-year inflation breakeven hitting a three-week high of 2.26% after a 4bp rise the past week. Supply pressures contributed to poor relative performance by Treasuries versus other rates markets through the first part of the week, but this partly reversed as the long end of the Treasury market rallied once the 30-year auction was out of the way. Swap spreads ended up mixed on the week, with the benchmark 10-year spread widening by 0.25bp to 4.75bp after reaching a record low close of 2.75bp on Wednesday, but the benchmark 2-year spread fell another 0.5bp to 20.75bp, a low since 2003. Mortgages saw a big run of outperformance versus Treasuries in the week through Wednesday, partially reversing Thursday and Friday. Over the first couple of weeks of March, though there have been some dislocations along the coupon stack as investors have tried to adjust from buyouts of delinquent mortgages from MBS, current coupon MBS yields have been quite stable, holding near 4.33% even as the 5-year Treasury yield has risen 13bp. Mortgage yields haven't moved far from this level since mid-January actually, which has kept 30-year conventional mortgage rates close to 5% the past couple of months, only about a quarter-point above the record-low weekly average of 4.71%.  We're expecting another month of weak home sales results in February, but the extension and expansion of the homebuyers' tax credit on top of these low rates and depressed home prices have left housing affordability at unprecedented levels heading into the key spring selling season, and the mortgage applications survey this week suggested that home purchases may be starting to pick up after the recent severe payback from sales pulled forward ahead of the initially scheduled expiration of the tax credit. 

The rising financing rate pressures that drew significant market attention the prior week were easing somewhat most of the past week, but they resumed in a significant way Friday afternoon, and our desk expects this to extend into next week. The overnight Treasury general collateral repo rate averaged 0.14% much of the week, including the first part of the day Friday after increases the prior week to a high of 0.19% on March 5.  But upward pressure became increasingly evident Friday afternoon, with rates backing up to near 0.30% in the late afternoon. Effective fed funds was also moving back up, averaging 0.16% Friday through the late afternoon after having dipped to 0.14% Tuesday and Wednesday from the recent high of 0.17% on March 5. Ongoing heavy increases in Treasury supply - another US$25 billion in new SFP bills were issued Thursday on top of another US$4 billion at the regular weekly bill settlement, and there will be another US$60 billion of net coupon issuance when this week's auctions settle Monday - continue to sharply boost available Treasury collateral in the repo market. On top of this, the GSEs are deploying a big chunk of their cash to buy delinquent mortgages out of their MBS pools. Fannie Mae's initial purchases will be spread out over a few months, but Freddie Mac's purchases were done in one fell swoop, with settlement on Monday. 

Risk markets barely moved any day of the past week, extending a recent sluggish trend, but for stocks mostly minor day-to-day moves recently have been largely on the positive side and added up to a decent rally. The S&P 500 gained 1.0% over the past week to its best level of the year after a 7% rally the past month. The best-performing sectors in the past week were financials and technology and over the past month financials, industrials and healthcare. Energy, materials and financials were generally the highest-beta sectors earlier in the year, but recent upside in the dollar and rising concerns about tightening in China have restrained commodity prices somewhat recently. Credit also moved very little in the past week but lagged stocks by not managing to put together a run of minor rallies. The investment grade CDX index tightened 2bp Monday to 83bp and then stayed there all week. This is the best level since mid-January but wider than the tight close for the year of 76bp on January 11 and only slightly better than the 85bp close to 2009 while the S&P 500 is now up 3.1% year to date. High yield performance was similarly muted, with the index tightening 5bp to 515bp Monday and then only slightly extending the upside through the rest of the week. Similar to IG, the best close so far in 2010 for the HY CDX index was 468bp on January 11 and the latest week's levels were only slightly better than the 518bp close to 2009. Another area moving to its best levels of the year the past week was muni bond credit protection. As Greece, to a significant extent, faded as a major market worry, prior knock-on fears about state finances also eased, with the 5-year MCDX index trading about 12bp tighter late in the week near 138bp, a low since January 8 after widening out to as high as 180bp on February 4. 

There wasn't much economic data out the past week, but key releases extended the more positive recent trend that started with the run of key early data for February the prior week. In particular, upside in the trade balance and underlying retail sales led us to boost our 1Q GDP forecast to +2.5% from +2.0%. We boosted our forecast for final sales more, to +2.6% from +1.9%, but there was some offset on overall GDP from unexpected further declines in January wholesale and retail inventories. Economy-wide inventory/sales ratios, however, are at or near record lows across major sectors after a huge inventory correction over the past year, so any 1Q downside in inventories should be made up going forward, as inventory destocking will need to swing to modest accumulation going forward to stabilize I/S ratios. Although the current quarter growth outlook looks a little better now, we still think that activity was meaningfully depressed by the East Coast snow storms and some tax credit paybacks, and we continue to look for a snapback to near +4% GDP growth in 2Q. 

The trade deficit narrowed to US$37.3 billion in January from US$39.9 billion in December, with exports (-0.3%) and imports (-1.7%) weakening a bit after huge rebounds in the last eight months of 2009 following the collapse in global trade seen from mid-2008 into last spring. Both exports and imports of autos pulled back somewhat after spiking around 75% in the second half of last year. In addition, on the export side, capital goods were softer in line with aircraft industry data (after unusually strong aircraft exports in December) and factory shipments numbers. Capital goods imports were also down, as were imports of consumer goods, in line with some moderation in growth in inbound cargo shipments at the key West Coast ports after a major prior rebound. Based on these results, we now see net exports being neutral for 1Q GDP growth instead of subtracting 0.5pp. While the January trade gap improvement was driven by a pullback in imports, a much more positive export-led further narrowing should support GDP growth in the coming quarters. We look for net exports to add about a half-point to GDP growth in the year starting in 2Q, supported by a big divergence between quite strong emerging markets growth boosting exports against somewhat sluggish US domestic demand restraining import growth. 

The outlook for consumption is also better after a stronger-than-expected retail sales report. Retail sales rose 0.3% in February, as a 2.0% pullback in auto sales partly offset a 0.8% surge ex autos. In line with the surprisingly robust chain store sales reports despite the bad weather, general merchandise (+1.0%), clothing (+0.6%), sport, books and music (+1.2%) and electronics and appliance stores (+3.7%) posted big gains. The weather was probably actually a significant positive for grocery stores (+1.3%) and building materials (+0.5%) as consumers stocked up on supplies ahead of the blizzards.  The key retail control grouping that feeds into GDP (sales ex autos, building materials and gas stations) surged 0.9% in February, but January (+0.6% versus +0.8%) was a bit lower. Incorporating these results, we boosted our forecast for 1Q consumption to +3.2% from +3.0%, which would be the best gain since 1Q07.

The economic calendar is a lot busier in the coming week, with focus on Tuesday's FOMC meeting. There will probably be a somewhat more upbeat view on the economy in the statement, but we don't expect the key policy language to change just yet.  In particular, we don't expect any alterations in the extremely dovish "exceptionally low levels of the federal funds rate for an extended period" language. We do believe, however, there is a reasonably high probability that the key wording in the statement will be adjusted at the next meeting on April 27-28, perhaps by retaining the "extended" phrase while dropping ‘exceptionally' - implying that monetary policy is likely to remain accommodative for quite a long time, but that accommodative does not necessarily mean a zero fed funds rate. We expect that a resumption of the run-up in inflation expectations seen in the second half of last year and early this year as the economy continues to show sustainable improvement, the unemployment rate continues to appear to have peaked in October, and job growth turns positive, will ultimately be the trigger for the next stage of Fed tightening. This will likely take the form of the ramping up of the term deposit program and reverse repos over the summer followed shortly by the beginning of rate hikes. Key data releases due out in the coming week include IP Monday, housing starts Tuesday, PPI Wednesday and CPI and leading indicators Thursday:

* We forecast a 0.2% decline in February industrial production. The employment report showed a sharp 0.9% decline in hours worked within the manufacturing sector. However, some of this decline appears to have been attributable to the impact of unusually severe winter storms that arrived right around the same time that the labor market survey was conducted. In past such instances, the Fed has always applied an adjustment to the hours data to account for the likelihood that factory activity was not as depressed during the rest of the month. However, we still look for headline IP to post its first outright decline since last June, driven, in part, by a drop in motor vehicle assemblies. Note that the latest assembly schedules point to a sharp rebound in auto output during March, which is likely to be reinforced by some upside in other sectors as weather conditions return to normal. Survey data also point to continued underlying strength in the factory sector. All of this points to a very sharp snapback in IP for the month of March.

* We look for a drop in February housing starts to a 500,000 unit annual rate. The February employment report showed that hours worked in the construction sector posted one of the sharpest declines seen during the past couple of decades. Thus, starts are expected to plunge 15% in February, largely as a result of the unusually severe weather experienced across parts of the nation. Both single and multi-family categories are likely to show some fall-off.

* We forecast a 0.1% decline in the headline producer price index in February and a 0.1% increase in the core. A partial pullback in wholesale gasoline prices following some hefty gains in prior months should lead to a fractional decline in the headline PPI for February. Meanwhile, the sharp increases in categories such as light trucks and drugs, which led to some elevation in the core PPI reading for January, are unlikely to be repeated this month. So, we look for the core to be near the underlying trend of +0.1% per month.

* We look for the headline consumer price index to tick up 0.1% in February and for the core to be flat. Gasoline prices flattened out in February, following some hefty increases in prior months. Moreover, while quotes for fruits and vegetables continue to soar in response to poor growing conditions in some parts of the nation, milk and bread prices have started to edge down. So, the food category is expected to post only a fractional increase this month. Meanwhile, the core is likely to be restrained by ongoing softness in the shelter category (which has a 40% weighting) and a more modest rise in medical care costs than in January. On a year-on-year basis, the core is likely to round down to +1.3%.

* The index of leading economic indicators should rise 0.2% in February, its eleventh straight gain extending - even after factoring in the more modest increases seen over the past couple of months - the best run since 1983. The main positives in February should be the yield curve and real money supply, while the manufacturing workweek (a weather impact) and stock prices are likely to represent significant offsetting negatives. We may need to update our estimate following release of the building permits data on Tuesday.

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United States
The Coming Rebound in Private Credit Demands
March 16, 2010

By Richard Berner | New York

From bust to rebound.  Private credit demands are poised to rebound, following a record-setting bust over the past 18 months.  The bursting of the housing and credit bubbles promoted massive loan losses that decimated the capital at leveraged lenders, forced deleveraging of intermediaries' balance sheets and promoted the most severe credit crunch in 70 years.  In our view, that sudden withdrawal of credit availability, which actually began in the fall of 2007, was the primary factor promoting recession.  Conversely, we also believe that the ebbing of the credit crunch has encouraged economic recovery, aided mightily by aggressive policy stimulus.  But the sharp decline in credit demands continued in the fourth quarter and has yet to reverse.

That reversal is coming.  While it has been painful and is yet incomplete, the credit crunch has promoted a financial purging and healing process that has been even more rapid than we expected ten months ago when we last estimated system-wide credit losses.    Household deleveraging and rising wealth have substantially restored balance sheet health and, coupled with increasing income, have given consumers more wherewithal and confidence to borrow again.  For its part, Corporate America will likely soon start accumulating inventories and boosting capex, perhaps sooner than expected.  We expect that the combination of rising household and corporate credit demands and massive Treasury borrowing needs will put significant upward pressure on real yields in 2010-11.

Credit availability improving.  There is no mistaking the improvement in credit availability.  While the credit crunch is not completely over, the credit headwinds to growth are abating.  For example, high-yield issuers have brought $43 billion to market year-to-date, compared with $11 billion for the same period last year.  And the winding down of the Term Asset-Backed Securities Lending Facility (TALF) is a good sign that the ABS market can function on its own, with the final tranche of loans collateralized by eligible newly issued and legacy ABS scheduled to be accepted on March 31, 2010.

To be sure, despite these improvements, banks remain relatively reluctant to lend, and access to credit for households and small businesses is still somewhat impaired.  The Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in January, but at a slower pace.  While that seems ominous, it's pace that matters for growth.  Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating.  We find that every 10-point drop in the proportion of banks tightening standards recently allows a 1pp increase in bank lending growth.  Moreover, the net percentage of loan officers willing to lend to consumers moved into positive territory for the first time in 2.5 years, and to a four-year high.  Finally, the NFIB small business canvass showed that credit was slightly easier to obtain in February for the first time since the recession began.

New era for households does not mean no borrowing.  American consumers have begun what looks like a long process of deleveraging their balance sheets and rebuilding saving, aimed at restoring a more sustainable balance between household debt and the ability to carry it.  One measure of sustainability is the debt service ratio - household payments of interest and principal on debt in relation to disposable income.  By that metric, courtesy in part of lower interest rates and our expectations for a further recovery in income, consumers are already about halfway through the process.  We believe that 11-12% is a sustainable debt-service ratio, consistent with debt/income of 80-100%; the former metric is halfway there, while the latter has some way to go. 

Correspondingly, it's a new era for American consumers, one of rising thrift and moderate growth in consumer spending.  Consumer deleveraging likely will continue into at least the summer as debt paydowns and write-downs exceed new originations.  Soon after that, we think consumer borrowing - including consumer credit and mortgages - will begin to grow, although much more slowly than income.  Indeed, consumer credit turned up in January after declining for 15 of the previous 17 months; it's too soon to argue that those data represent a turn higher, but they hint at stability.  In our view, even stability in consumer borrowing following the unprecedented bust of the past two years will change the supply-demand balance in credit markets. 

Corporate financing inflection point arrives.  In contrast with the languid turn in consumer borrowing, corporate borrowing likely will turn up much more quickly for three reasons.  First, corporate balance sheets were not the problem in this recession; by and large, debt/EBITA has been subdued.  Of course, the ratio rose in recession, but it is quickly falling as earnings bounce back.  Second, corporate access to funds in the aggregate has improved faster than for consumers.  Finally, and most fundamentally, corporate external financing needs are likely to turn positive soon as companies turn from inventory liquidation to accumulation, as capital spending begins to recover, and as the growth in corporate cash flow inevitably slows.  The combination of these developments is likely to boost corporate credit demands, perhaps sooner than expected.

Treasury financing update.  We expect that the Treasury will issue $2.4 trillion in coupon securities in the current fiscal year.  The budget deficit will likely be slightly lower this year than last, and overall Treasury financing needs more so (as most TARP outlays and recent repayments have been moved off budget).  But the duration of Treasury issuance this year will be much higher than last, driven by the Treasury's effort to reverse the significant shortening in the average maturity of the debt seen in 2008 and 2009, when huge increases in T-bill issuance funded much of the initial spike in the budget deficit.  While the debt managers said at the February refunding that coupon sizes have peaked and could be reduced later in the year, at current record levels, net coupon issuance remains enormous at each mid-month and end-of-month settlement of biweekly auctions, and this is being offset by sizable net bill paydowns.  Even if supply is pared a bit in coming months, gross coupon issuance is likely to be nearly a third bigger in fiscal 2010 than it was in fiscal 2009, when it was already a record by a very wide margin. 

Supply-demand balance points to higher yields.  Treasury yields have remained low partly as there has been little competition from private borrowers.  Competition is coming, even in a moderate recovery.  With growing concerns about the sustainability of US fiscal policy, we think that shift will promote significant increases in real yields this year.

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