Surprise Rate Hike: Symbolic but Also Marks the Beginning
June 28, 2010
By Sharon Lam | Hong Kong
Interest rate normalization justified. At its 2Q monetary policy meeting, the Central Bank of China, Taiwan (CBC) unexpectedly raised its policy rediscount rate by 12.5bp. This marks the first rate move since February 2009, bringing the rediscount rate from a historical low of 1.25% to 1.375%. During the global recession from 3Q08 to 1Q09, the CBC cut interest rates by an aggressive 237.5bp. Thus, the mild rate hike is an asymmetrical move. We believe that it is going to take a long time for Taiwan's policy rate to go back to the pre-crisis level of 3.625%.
Although this rate hike was a surprise to the market, we think that it is justified. As we have been arguing, Taiwan's central bank should start normalizing interest rates sooner rather than later. Pre-empting inflationary pressure would favor a rate hike, but we have also been arguing that rates need to be normalized when the economy is recovering; otherwise, the central bank would have only limited ammunition to support the economy should a slowdown occur again. This is especially true in Taiwan's case, given that the policy rate was so low, and the central bank has to avoid any future risk of running zero interest rates. We kept our call of a 2Q rate hike until May when external uncertainties hit the economy, which we thought could have delayed a rate hike. The CBC's move suggests that concerns over external demand could be overdone. We welcome the CBC remaining prudent in implementing its monetary policy, which we believe is in the best interests of the economy.
Upside in domestic economy and asset prices. We believe that this rate hike is also a reflection that the domestic economy is recovering faster than expected. Consumer confidence stands at a six-year high. Job creation in the private sector also came in stronger than expected, particularly in the manufacturing sector as companies are expanding capacity (see Labor Market Recovery Continued in May, June 22, 2010). Taipei property prices on average have rebounded by 25% from the bottom a year ago, and anecdotal evidence suggests that the surge is much more in high-income areas. Although affordability is declining, Taiwan's property prices will remain supported, in our view, due to abundant domestic liquidity, which is amplified even more by repatriated flows from overseas Taiwanese to buy property in Taiwan in recent months. The CBC used a significant portion of its policy statement today to focus on home loan risks and urged banks to tighten risk management on mortgage growth. The central bank also mentioned that it is working with the government on measures to ensure healthy development of the property market. Mortgage loan growth has rebounded to 6.3% from almost 0% a year ago. We do not think that Taiwan's mortgage growth is getting out of control, but social discontent with deteriorating affordability is creating some pressure on the authorities to take action. It is therefore not that surprising to see the CBC respond with symbolic rate hikes. However, we think that administrative measures will be more effective in cooling property prices, as liquidity is too abundant in Taiwan and there is no strong case for aggressive rate hikes by the CBC, given the low inflation.
Impact from mild rate hikes is limited: As we have written before, the asymmetric rate hike means that liquidity is only going from ‘super abundant' to ‘very abundant' (see Exit Strategy Will Begin, but Liquidity Remains Abundant, March 24, 2010). Short-term interest rates are hovering near zero. Excess liquidity (as measured by M1/GDP) is also at a historical high and should continue to rise this year, albeit at a milder pace. We believe that it will also take a long time for interest rates to reach neutral levels, given the fragile recovery cycle amid ongoing concerns over demand in developed economies. Meanwhile, since the CBC holds monetary policy meetings only once a quarter, future rate hikes should be gently paced. Due to high savings and excess liquidity, Taiwan is not a credit-driven economy to begin with and thus it is less sensitive to rate hikes, not to mention mild rate hikes.
Rethinking inflation risks in the region: Inflation in Taiwan is the lowest in non-Japan Asia, with YTD CPI growth at 1.2% and the latest May reading at only 0.7%. However, we have also been warning that inflationary pressure is building, as indicated in the WPI data which averaged 7.6% YTD with the sharp rise to 9.4% in May. As the economy is recovering, it is inevitable that the higher wholesale and production prices will be eventually transmitted to the end consumers. This is not a Taiwan-specific phenomenon, as other countries in the region are starting to express rising concerns over inflation. For example, both the central bank and ministry of finance in Korea have sounded more hawkish recently, commenting on the need for price stability as inflation could be higher than their expectations. Asset price inflation is also not to be ignored. Housing rent accounts for 20% of Taiwan's CPI basket; thus, the upside in property prices will also feed into CPI growth. Taiwan's surprise rate hike could be followed by other central banks in the region, particularly Korea. However, since Taiwan's rate hikes are likely to be milder than others, the rate hike itself is unlikely to provide any lasting strength to its currency, in our view. We believe that the TWD's move will be determined by its capital flows, which is ultimately a confidence indicator of economic and political development in Taiwan.
Embarking on the beginning of a rate hike cycle: We now expect the CBC to start raising interest rates in every quarterly meeting by 12.5bp going forward. This means that another 25bp for the rest of this year, and 50bp in 2011. The rediscount rate will reach 1.625% by end-2010 and 2.125% by end-2011, on our estimates, which would still be well below the pre-crisis level. However, we do not rule out the possibility of rate hikes at a greater magnitude of 25bp in one meeting if inflationary expectations rise further. Yet, inter-meeting moves between the quarterly meetings are unlikely, unless a crisis arises.
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Vuvuzela-Like Blowout in 1Q CAD
June 28, 2010
By Michael Kafe & Andrea Masia | Johannesburg
Summary
The South African Reserve Bank's June 2010 Quarterly Bulletin shows a genuine acceleration in the pace of economic recovery in 1Q10. According to the Bulletin, the country posted a relatively strong reading in private consumption spend - mostly expenditures on durables and semi-durables - while gross fixed capital formation moved out of negative territory to deliver a flat reading. Importantly, inventory drawdown occurred at a much lower pace than expected, thereby contributing significantly to a sharp rise in gross domestic expenditure. On the whole, the details in the QB are not symptomatic of an economy that is screaming for further monetary stimulus. We therefore maintain our view that policy rates are likely to remain on hold throughout the remainder of this year.
The QB also shows that the country posted a higher-than-expected 1Q10 current account deficit of some 4.6% of GDP, relative to our and consensus forecasts of 4.1% and 3.9% of GDP, respectively. The wider deficit appears to have been driven by a return to trade deficits and lower-than-expected travel inflows - including inflows related to the 2010 FIFA World Cup. The country's external position appears well capitalised - even if this is mostly fickle portfolio capital and inherently volatile unrecorded transactions.
Consumer Stages a Strong Comeback
After posting five consecutive quarters of negative growth, household consumer spend turned modestly positive in 4Q09 and accelerated further to 5.7%Q (seasonally adjusted and annualised) in 1Q10, supported by exceptionally strong growth in durables, semi-durables and non-durables. After posting an already high reading of 15.2%Q in 4Q09, household expenditure on durable goods accelerated further to 16.8%Q in 1Q10, thanks to continued buoyant spending on new motor vehicles, recreational and entertainment goods, furniture and household appliances. Semi-durables also posted a 12-year-high reading of 28.4%Q, thanks to increased outlays on clothing and footwear and semi-durable recreation and entertainment goods. We suspect that the strong growth here was driven by household spending on World Cup regalia including the popular stadium horns (vuvuzelas) and football-related clothing. For the first time in seven quarters, non-durable goods expenditure also posted a positive reading in 1Q10. And while expenditure on services fell by 4.6%Q, this was largely due to reduced spending on transport services - possibly delayed local holiday and other related spending ahead of the World Cup. On the whole, the consumer appears to have benefited from higher real wage and disposable income growth, lower interest rates, a lower debt burden and, by implication, lower debt-service costs. We note that government consumption expenditure also rose quite strongly (7.3%Q versus our forecast of 4.5%Q). Although most of the upside here reflects the acquisition of two military aircraft by the army, it is important to note that the growth in public sector wage awards also featured prominently.
Gross Fixed Capital Formation the Weak Link
Not surprisingly (particularly given renewed concerns that fiscal deterioration in peripheral Europe could eat into core Europe and eventually move across the Atlantic), the business sector remains cautious. Gross domestic capital formation by the private sector continued to contract in 1Q10 - albeit at a lower rate of -0.7%Q, compared to -2.3%Q and -14.5%Q in the preceding two quarters. And while increases were reported in capital outlays by the construction, finance, commerce, transport and communication sectors in 1Q10 (presumably last-minute infrastructural upgrades ahead of the World Cup), we note that capital formation contracted in agriculture, mining, manufacturing and social and personal services. At the public corporation level, fixed capital expenditure rose by 7.4%Q (8.7%Q in 4Q09 and 17%Q in 3Q09), thanks to the acquisition of new buses, refurbishment of domestic airports, the building of new train stations and the upgrading of existing railways ahead of the FIFA World Cup.
Significant Deceleration in Inventory Depletion
The stock of real inventories fell by R8.7 billion in 1Q10 - a relatively positive outcome when one considers that inventories had been in freefall since mid-2008, averaging -R48 billion in the last three quarters of 2009. According to the SARB, inventories in the communication sector edged higher as operators built capacity in anticipation of an influx of network users during the World Cup. Coal inventories were also built up in anticipation of higher demand from the energy-intensive sectors of the economy, and in recognition of the higher demand for electricity during the World Cup. The mining, commerce, agriculture and transport sectors also added to inventory stocks. However, these were fully offset by significant destocking in the manufacturing sector.
Visible Trade Deficit and Lower Travel Inflows Lift CAD
Turning over to the external sector, the Bulletin showed that South Africa's current account deficit deteriorated from 2.9% of GDP in 4Q09 to 4.6% in 1Q10. This was slightly higher than our forecast of 4.1%. The trade balance swung from a surplus of R25 billion in 4Q09 to a deficit of R12.9 billion - slightly higher than our forecast of a R10 billion deficit. According to the SARB, the wide deficit was due to the combination of weaker export demand from Europe, lower gold production and an increase in the volume of merchandised imports by households and vehicle manufacturers.
Technical Correction in Exports - as We Expected
Specifically, export volumes of machinery and electrical equipment, agricultural products and transport equipment destined for the EU and US contracted. The contraction/ correction here is no surprise, as it comes off the inexplicably high base that was reported for 4Q09 (for a more detailed analysis of the 4Q09 data, see South Africa: Heavy Reliance on Portfolio Capital, March 24, 2010). Demand conditions out of Europe are a key source of risk from both a BoP as well as a GDP perspective, in our view. According to our estimates, South African manufactured exports are three times more leveraged to European GDP prospects than to fluctuations in the currency (see South Africa: Gauging Susceptibility to the Vagaries of European Growth, June 21, 2010). Gold export volumes also fell 16.5%Q, due to operational issues at the mines.
Domestic Recovery Sucks in Imports
With regards to imports, the recovery in domestic economic activity had a positive impact on business expectations, and encouraged manufacturers of motor vehicles, parts and accessories to expand production capacity. This led to a higher volume of imported machinery and electrical equipment, as well as vehicles and transport equipment. Even so, the headline 8.6%Q increase in the volume of manufactured imports was somewhat exaggerated by some rather chunky items such as aircraft, boilers and turbines.
Net Travel Flows Widen Invisible Deficit
On the net invisible payments, the net income line rose by R46.3 billion as dividends and interest payments on direct investments rose from R39 billion to R46 billion, while that on indirect investments rose from R28 billion to R30.6 billion. But while the overall increase in dividend payments was in line with our expectation, the net income line came in below our forecast of -R50 billion thanks largely to a surprise R10 billion jump in dividend inflows on non-direct investments, which helped lift total income inflows to R39.5 billion versus our forecast of R34.4 billion. The Bulletin does not disclose the source of this chunky dividend inflow - the fourth-highest in history.
We were in for a surprise in net service payments too. Net service payments of R129.3 billion were slightly higher than our forecast of R126 billion, thanks to an increase in freight costs and generally higher expenditures by South Africans on foreign transport, travel and other services. We had expected South Africans to delay international travel until after the World Cup. It appears that this may not have been the case.
Also, overall service inflows of R95.5 billion fell far short of our R105.4 billion estimate, thanks largely to a shortfall in transport and travel receipts. We find it interesting that transport, travel and other receipts actually fell in 1Q10 - a quarter where we had expected World Cup receipts to boost the reading. While it is plausible that World Cup-related travel flows may have come in lower than our expectation, the mere size of the shortfall here suggests that there is more to it than just the World Cup.
Financial Account Still Dependent on Portfolio Capital
The financial account showed a significant improvement in capital flows, although the quality of the flows remains an issue. Net foreign direct investment swung from -R5.6 billion in 4Q09 to R4.6 billion in 1Q10, while portfolio investment inflows accelerated further from an already high reading of R31.5 billion to R38.5 billion. However, we note that the latter figure includes some R15 billion from the issuance of a US$2 billion foreign bond. The placement of the proceeds of this bond at the SARB underscores the huge jump in net reserves too, which amounted to some R23.8 billion over 1Q10. These significant one-off improvements are unlikely to be sustained going forward.
We are less concerned about the R13.5 billion outflow in net other investments, however, as this largely reflects the partial redemption of short-term loan finance to the banking sector - the residual being explained by a decline in non-resident deposits with the South African banking system (carry trade), presumably after the SARB cut the repo rate to a multi-decade low of 6.5%.
On the whole, the external accounts show that South Africa's current account deficit remained well-funded in 1Q10. However, most of that funding is still very heavily skewed towards fickle portfolio flows and unrecorded transactions. We continue to highlight that, for as long as South Africa runs a structural current account deficit that requires offshore funding, it will always be vulnerable to the vagaries of global risk appetite. Until now, the fortuitous exodus of capital from developing markets into emerging markets has been positive for the ZAR. However, our currency team believes that, after outperforming much of the CEEMEA region recently, ZAR now looks likely to underperform in the coming weeks (see "ZAR: Coming Under Pressure", FX Pulse, June 24, 2010).
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