In its quarterly monetary policy meeting, the Reserve Bank of India (RBI) announced a 25bp hike in the repo rate, reverse repo rate and cash reserve ratio (CRR), in line with market expectations (as per Bloomberg survey). While the repo rate hike was in line with our expectations, the reverse repo rate hike was lower than our expectations of 50bp. This 25bp hike in the CRR should absorb a negligible amount of Rs125 billion (or US$2.8 billion) of excess liquidity from the banking system. Although the monetary policy statement released today and macroeconomic developments review statement released yesterday by the RBI appeared hawkish, the measures announced are not nearly as aggressive. We believe that the risk of a sharper-than-expected acceleration in credit growth and aggregate demand remains. At the same, the risk of inflationary pressures picking up and a widening of the trade deficit remain.
Strong Growth Forecast, Though Lower than Morgan Stanley Expectations
The RBI expects F2011 (12-months ended March 2011) GDP growth at 8% with an upside bias. We believe this to be a conservative estimate. We expect GDP growth to be at 8.5% in F2011 with an upward bias. We believe that apart from continued strength in private consumption, a strong pick-up in investment and exports will support this acceleration in GDP growth to 8.5%. While the first six months of acceleration in industrial growth since the trough in March 2009 was largely government spending and private consumption-driven, over the next 12 months we believe that as private consumption moderates, the rise in corporate capex and exports will ensure a strong GDP growth trend. Indeed, we believe that there is a risk of growth accelerating faster than our current expectations in the first half of the financial year if the RBI lifts policy rates in a lagged manner.
Credit Growth Target - Very Conservative
Bank credit growth troughed to 9% as of end-October 2009 before accelerating to 16.7%Y as of the fortnight ended March 26, 2010. The RBI expects non-food credit growth for F2011 to be 20%, compared with 16.9%Y in F2010. We expect credit growth to be stronger. Relatively low lending rates, a recovery in industrial activity, higher inflation and a revival in private corporate capex should result in an upward spike in credit growth to 24-25%Y by August 2010, based on our estimates. Indeed, we think that the RBI would need to lift policy rates towards normalized levels quickly to prevent an overshoot of economic growth and a rise in credit demand above 30%Y in the next few months. The key risk to our optimistic credit growth outlook is a potential double-dip in developed-world growth and risk-aversion in global financial markets.
Inflation a Concern for the Central Bank
The policy statement voices clear concern about inflation: "Inflationary pressures have accentuated in the recent period. More importantly, inflation, which was earlier driven entirely by supply side factors, is now getting increasingly generalised. There is already some evidence that the pricing power of corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will re-emerge, which are expected to exert further pressure on prices. Inflation expectations also remain at an elevated level. There is, therefore, a need to ensure that demand side inflation does not become entrenched." We have also been arguing that the inflationary pressure has been rising. Non-food inflation accelerated to 7.2%Y in March 2010 from 2.6% in December 2009. We believe that non-food WPI inflation will remain high in the range of 7.5-8% in the coming months.
Asset Price a Minor Issue
The macroeconomic developments review statement released yesterday did comment on the issue: "Another important segment of asset prices is the residential housing segment that has important implications for the behaviour of general prices and overall macroeconomic and financial stability. There has been a general upward pressure on housing prices in the recent period, which broadly co-terminates with the rise in stock prices, thus, indicating generalized asset price pressures." In addition, the statement mentioned that "a stronger recovery in India and the favorable interest rate differentials in the face of easy global liquidity conditions could lead to higher capital inflows, which may influence both exchange rate and asset prices. The strong rebound in asset prices needs to be monitored closely, given their implications for financial and macroeconomic stability." The monetary policy statement released today also mentioned, "Housing prices rebounded during 2009-10. According to the Reserve Bank's survey, they surpassed their pre-crisis peak levels in Mumbai."
No Mention of Trade Deficit or Current Account Deficit in the Policy Statement
We have been highlighting that in the globalised world, higher aggregate demand over aggregate capacity will not only be reflected in inflation, but also in a widening trade deficit. Over the past four months, while seasonally adjusted exports have risen by a cumulative 14%, seasonally adjusted imports have risen by a cumulative 37%. Excluding oil, seasonally adjusted imports have risen at an even faster rate of 42% during the past four months. The three-month trailing trade deficit widened sharply to 10.8% of GDP, annualised as of February 2010, from the trough of 4% as of March 2009. The peak of 14.3% of GDP came in September 2008, when oil prices shot up over US$140/bbl in July 2008 (impact comes with a lag). With oil prices currently at US$82/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 current account deficit at vulnerable levels, in our view. If the current account deficit widens to 3.5-4.5% of GDP, the risk of a currency weakness would increase significantly. Any decline in capital inflows or sharp rise in oil above US$100/bbl would cause an exchange rate depreciation - only adding to the inflationary pressure.
More Policy Steps Needed to Avert Inflation and Trade Deficit Risks
We believe that the RBI has chosen a path of a frequent small rate hikes rather than a smaller number of large moves. In other words, while the policy statement mentions concerns about the inflation outlook, in our view, the actual measures show that the bias remains ensuring strong growth. Although in a normal cycle this approach would have been fine, we believe that the nature of the current growth cycle makes it imperative that the RBI move at a somewhat faster pace than it has chosen. The central bank appears to be of the view that the duration of recovery has been short. After all, it has only been since June 2009 that IP growth has started to rise in a meaningful way on a sequential basis. However, we believe that the pace of recovery is also important. The seasonally adjusted IP index shot up 13.6% between May 2009 and February 2010. With capacity utilisation close to full, low interest rates could fuel inflationary pressures. We believe that policy response needs to track the pace of recovery. More importantly, short-term rates are still very low, closer to the requirements of an economy in crisis.
We believe that the economy is in a fast recovery mode and that the RBI will need to start lifting policy rates toward normalised levels soon. Indeed, 91-day T-bill yields are still at 4.25%, close to the lows seen in the previous cycle. We believe that the RBI's actions need to be strong enough to lift short-term interest rates - say 91-day T-bill yield by about 125bp through to the end of the calendar year. To manage this, we think that the RBI will need to lift the repo rate by another 75bp and the reverse repo rate by another 100bp in 2010 as compared to our earlier expectation of an increase of 50bp and 75bp, respectively (this is in addition to the rate hikes that have already taken place in 2010 to date).
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Indonesia on India's Trail: Structural Cost of Capital Decline Story Is Intact
April 22, 2010
By Chetan Ahya l Singapore & Sumeet Kariwala l Mumbai|
Summary
The recent inflation data points in Indonesia remind us of the structural story we have been highlighting for some time. The story is that Indonesia's cost of capital will be declining on a structural basis. Core inflation has again decelerated to 3.6%Y in Mar-10 (compared to 4.4%Y a couple of months ago and a recent high of 7.4% in Feb-09). Indeed, the medium-term trend of core inflation has been steadily declining with lower troughs and peaks. Similarly, FX reserves have climbed further, improving the external balance sheet and confidence of international investors and rating agencies. Although the overheated stock markets have increased the risk of volatility in the near term, we believe that the structural story continues to unfold as expected. As we have been arguing for some time, Indonesia is likely to emerge as a story more similar to India than China (see Indonesia Economics: Adding Another ‘I' to the B-R-I-C Story? June 12, 2009). We see the development of Indonesia's macro economy and corporate sector reflecting India's trend from 1999 to 2005. In our view, the most important similarity will be the potential decline in cost of capital and therefore rise in corporate ROE spreads over the cost of capital. We have been arguing for some time that Indonesia's cost of capital will show a structural decline over the next three years. We believe that this trend will result in a virtuous cycle - boosting corporate profits, investments and GDP growth. The key risk to our thesis will be any unexpected turn in the political environment.
Flashback: What Explains the High Cost of Capital in Indonesia?
A weak political environment, high ratios of public and external debt to GDP, and poor corporate balance sheets have caused Indonesia's exchange rate to remain highly volatile since the 1997 crisis. This, in turn, resulted in higher inflation and higher policy rates. Moreover, unlike India and China, Indonesia has a relatively open capital account for its resident population. When an external event has caused some exchange rate volatility, residents have only added to that volatility by moving their rupiah bank deposits into dollar deposits. Exchange rate volatility and frequent macro shocks meant higher credit costs for the banking system. Banks have been persistently maintaining high net interest margins, partly to cover for high credit costs and uncertainty in the interest rate environment. The average net interest margin for the top four banks under Morgan Stanley's coverage is 730bp (2010 estimate). These are the highest spreads among banks in the region.
A New Beginning
We expect that an improved political environment, along with steady repair and restructuring of the government, banking system and corporate sector balance sheets, should now help to reduce the cost of capital on a structural basis. Over the last few years, the government has been able to improve Indonesia's macro balance sheet. The ratio of public debt to GDP declined to 28% in 2009 from the peak of 93% in 1999; external debt fell to 32% of GDP in 2009 from 157% in 1998. The government has reduced the share of external debt in public debt to 38% in 2009 from 100% in 1997. Moreover, local borrowing now largely funds the government's fiscal deficit. Indeed, the fiscal deficit has been maintained at very low levels - in the range of 0.5-1.7% over the last five years.
Corporate sector net debt to equity has been reduced to 37% in 2008 from 262% in 1998. The current account has largely been in surplus since 1999. Unlike India and China, Indonesia has big advantages: a strong resource base and structurally higher commodity prices. These factors increase the nation's export revenues and sustain the current account surplus.
Virtuous Cycle of Confidence
We expect improving macro stability to bolster the confidence of international investors and non-resident Indonesians. In our view, capital inflows and remittances are likely to continue to improve. For example, in India, remittances from non-resident Indians (NRIs) have been rising - from US$16 billion in the financial year ended March 2003 to an estimate of US$53 billion in F2010. Similarly, capital inflows into India have risen sharply. We believe that Indonesia will see an improvement in remittances and capital inflows, even if the trends may not be of the same magnitude. Moreover, as the local population gains confidence in the currency and repatriates international wealth, this should help to reduce the cost of capital further, in our view.
India has shown a similar trend. Just as India was forced to initiate structural reforms to improve macro stability following its 1991 balance of payments crisis, Indonesia was forced to initiate structural changes after the 1997 crisis. By 2002-03, India's external balance sheet had improved significantly; FX reserves reached US$75 billion by March 2003 and capital inflows had surpassed US$10 billion per annum. The corporate sector also made a major improvement in its productivity, cutting its debt-equity ratio to 25% in 2003 from 75% in 1996. The cost of capital fell sharply; yields on 10-year government securities declined from 11.5% in January 2001 to 5.5-6.0% in 2003. Banks' lending rates followed the trend, opening up a big gap between corporate sector ROE and the cost of capital.
Bottom Line
In the short term, Indonesian markets appear cyclically overheated, but we believe that from a medium-term perspective, the nation's economy and markets will go through a major structural change over the next few years, offering attractive investment opportunities. We think that the decline in cost of capital over the next three to four years will attract the private sector investment and accelerate GDP growth. In this environment, we believe that the rate-sensitive sectors - such as financials, consumer (discretionary spending) and property - should benefit from structurally higher demand growth. Like India, we believe that this trend will result in a rise in corporate profit to GDP and therefore market cap to GDP. The key risk to our positive view on Indonesia would be any unexpected turn in the political environment.
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BoJ-Government Debate: Important Developments
April 22, 2010
By Robert Alan Feldman, Ph.D. & Takehiro Sato l Tokyo|
Two important developments pushed the inflation-targeting debate forward on April 20. First, FM Kan advocated a 1-2% inflation target in Diet testimony. Second, the deliberations of the DPJ's anti-deflation study group included a presentation advocating aggressive monetary policy and changes in the BoJ Act. These two developments keep the yen-weakening trade idea intact.
FM Kan
According to press reports, FM Kan called for "a goal of 1 percent, or something a little higher, like 2 percent, and work with the BoJ until that goal is met". This statement was made in the Diet, in the presence of BoJ Governor Shirakawa, and thus was a clear move in the BoJ-government debate on monetary policy. In addition, FM Kan's statement pushed the BoJ to concentrate in the higher end of its own 0-2% range, with an important addition, a time axis. FM Kan's statement about "working with the BoJ until that goal is met" means that he wants accommodative policy to continue until the CPI has hit his target rate of increase. This is precisely the concept behind the ‘time axis' used by Governors Hayami and Fukui.
DPJ Anti-Deflation Group
Separately, the DPJ's Diet group on ending deflation met again on April 20. They reissued the statement from April 14, calling for aggressive monetary policy to end deflation and for revision of the BoJ Act to include employment as a target. More telling, however, was the presentation from a macroeconomics professor, Yasuyuki Iida of Komazawa University. The Iida presentation called for:
a) Use of CPI ex food and energy as the measure for inflation targeting
b) A time axis for setting policy, with a CPI > 1% for a year as the trigger
c) Return to quantitative easing
d) Outright purchase of JGBs by the BoJ to suppress the JGB yield to 1%
e) Weakening of the yen to Yen120/USD through unlimited intervention
f) Major fiscal spending plan, with bonds absorbed by the BoJ
g) Revision of the BoJ Act to create a three-stage system for setting monetary policy:
i. When CPI change is between 1% and 3%, the BoJ would decide
ii. When CPI change is less than 1%, MoF/government would decide
iii. When CPI change exceeds 3%, a panel of BoJ/MoF/government/private experts would decide
Note that items a, b and c are identical to the signposts that we discussed in Money and Growth in the Reverse Correlation Zone, March 31, 2010. The remaining ideas are far more aggressive than others so far. The idea of changing decision regimes on the basis of CPI change is new to the debate.
Conclusion
These developments will likely keep pressure on the BoJ to ease more. FM Kan and the DPJ Anti-Deflation group are heading in the same direction. The latter may be generating ideas to be tested against public opinion, and those that survive might be adopted by FM Kan. The impact of these actions on the BoJ's Outlook Report, to be issued on April 30, will be important. Although the BoJ may well raise its CPI outlook to above 0%, the implication of Kan's statements and of the Iida presentation is that merely positive CPI growth is not good enough to satisfy the government.
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