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A Macro Trinity Grips as the Impossible Trinity Ebbs
March 18, 2011

By Manoj Pradhan | London

EM policy-makers are struggling with macroeconomic trade-offs and policy choices. Structural and cyclical factors have brought inflation to the forefront of the policy discussion and EM policy-makers have to choose whether to use interest rates or exchange rates to deal with it, or decide to allow higher inflation. For the first time in a year and a half, EM policy-makers actually have a window of a few months to raise policy rates without inviting strong currency appreciation, thanks to the ongoing portfolio outflows as investors prefer to wait on the sidelines for now. Ironically, but unsurprisingly, there is little willingness to put domestic growth at risk in the EM economies we cover given the escalation of global risks from the Middle East and now Japan in addition to lingering doubts about the sustainability of growth in advanced economies. Thus, the expenditure-reducing tool of policy rate hikes seems set to take away much of the stimulus provided over the last year and a half but will not lead policy into restrictive territory in order to safeguard growth. With protecting growth a policy priority, EM policy-makers therefore have to decide whether to use exchange rates to subdue inflation or allow currency values to remain steady and bear higher inflation and inflation risks.

A Macroeconomic Trinity of Growth, Currency Appreciation and Inflation

The interplay among growth, nominal currency appreciation and inflation is particularly interesting right now because it plays to the structural as well as cyclical constraints. Cyclically, the choice of protecting growth through only modest interest rate hikes also means (i) allowing either higher inflation and inflation risks and keeping currency values steady or (ii) leading inflation lower through currency appreciation by preventing the import of inflationary monetary policy from DM central banks and gaining some insulation against imported inflation from commodities.

Structurally too, EM policy-makers have ticked all the right boxes to improve the quality of growth. Inflation targeting, self-insurance via FX reserves, lower debt risks and the more recent move towards domestic demand growth all make for a better allocation of resources and have probably brought forward some of the investment in EM economies that might otherwise have happened only later. In part, this ‘encouragement' to growth has likely also accelerated the process of real exchange rate appreciation (which can be achieved through nominal FX appreciation or EM inflation running higher than DM inflation). Many combinations of nominal appreciation and EM inflation will satisfy the global rebalancing demands via real exchange rate appreciation, but more nominal appreciation than has been the case recently should help. It should not only help ease the pressure on inflation to do the bulk of the rebalancing but should also encourage consumption in countries where domestic demand is to be the next driver of growth.

In this regard, the renminbi could act as a catalyst for other EM currencies to allow appreciation as well. Our China economics team's year-end target of 6.20 for the exchange rate vis-à-vis the US dollar implies somewhat greater appreciation than markets are pricing in. Our EM currency strategy team believes that the risk is that much of this appreciation could be front-loaded. However, if the inertia in monetary policy also extends to exchange rate policy, implying no or slow currency appreciation, then the risks to EM inflation are clearly tilted to the upside.

Why Has Inflation Reared its Head in the EM World to Begin With?

Inflation is a particularly acute problem right now because cyclical and structural drivers are surfacing at the same time. Cyclically, EM economies had strong domestic growth last year but overheating concerns really flared up after a surge in exports on the back of accelerating G10 growth. Structurally, real EM exchange rate appreciation had been proceeding smoothly, thanks primarily to low DM inflation relative to EM inflation. This is no longer the case either as DM inflation concerns have escalated.

From a cyclical point of view, four factors are likely behind the uptick in EM inflation: (i) a cyclical rebound from a global slowdown in which EM economies suffered the least and recovered the fastest, (ii) ultra-expansionary monetary policy in the advanced economies that EM economies have continued to import, (iii) extraordinary policy support from EM policy-makers that is likely to be only partially withdrawn even though domestic output gaps have closed in the major EM economies, and (iv) higher commodity prices that are partly driven by loose global monetary policy and the resulting global recovery.

Structurally, the process of global rebalancing via the appreciation of the real exchange rate of EM economies also affects inflation in two ways: (i) it forces at least part of the real exchange rate appreciation to occur via EM inflation running higher than DM inflation (i.e., for the spread between the two to bear at least part of the burden), and (ii) when DM inflation rises, it pushes EM inflation higher as the spread between the two remains steady. In this note, we discuss first the structural and then the cyclical dynamics and the choices it forces on policy-makers.

Structural Pressures

Global Rebalancing over the Last Decade

Real exchange rate appreciation has been a natural consequence of the rebalancing process (see Emerging Issues: The Great Rebalancing, February 16, 2011). Real exchange rate appreciation can happen through any combination of nominal exchange rate appreciation and EM inflation running higher than DM inflation. Macroeconomic mathematics don't care if it is exchange rates or inflation doing the bulk of the adjusting, but markets and investors of course do. Since 2003, real exchange rate appreciation has happened in two extreme ways. First, from 2003 to 2007, most of the real appreciation was thanks to nominal exchange rate appreciation. This is a period when the renminbi was appreciating, prompting other EM policy-makers to allow their currencies to appreciate as well. The rapid nominal appreciation allowed a narrowing of the spread of EM inflation to DM inflation. By contrast, for the last couple of years, the nominal exchange rate has done very little even as the real exchange rate has resumed its trend of appreciation after the Great Recession. As a result, most of this appreciation has come about via a persistently wide spread between EM and DM inflation.

Which Way Forward?

Both these ‘corner solutions' are unlikely to be the way forward over the next year. The rapid nominal appreciation of 2003-07 needs a rapid appreciation of the renminbi to prompt other currencies to strengthen. This is an unlikely scenario - markets are pricing in 2-3% appreciation for the renminbi for the rest of the year. On the other hand, allowing inflation to do all the work is less market-friendly, which could put pressure on Chinese policy-makers to allow more currency appreciation. The balance of risks points to continued structural pressure on inflation but a stronger currency appreciation to suppress these inflation pressures should not be ruled out.

Cyclical Pressures

The Buildup of Cyclical Pressures

Contrary to the long-standing structural dynamics outlined above, the cyclical story only goes back to the Great Recession. EM policy-makers pulled out all the stops to avoid a severe economic downturn. These policies along with the EM ‘insurance' of FX reserves thwarted a serious downturn in the EM world and saw off any hint of a financial crisis there. Policy stimulus was kept in place for longer than would otherwise have been the case because of risks to DM growth.

In addition, EM economies have been importing the ultra-loose monetary policies from the advanced economies. How? Economies with a fixed exchange rate regime like China and the GCC countries directly import the monetary stimulus from the economy their currency is pegged to - the US. As for other EM economies, to the extent that they don't like their currency values appreciating against the renminbi, they are implicitly pegged to the dollar (although more loosely). The EM world is then in a soft nominal exchange rate targeting regime, importing inflationary monetary policy from the advanced world through this soft ‘peg'. Partly as a result of accommodative monetary and fiscal policies globally, the EM world's recovery from the downturn was very quick and very strong. The rebound in inflation from strong recoveries tends to be strong as well. Finally, just as domestic output gaps have closed, shocks to food and oil prices have added to inflationary pressures. Lower dependence on nuclear energy in Japan and possibly the rest of the world as public opinion potentially turns against nuclear energy generation could mean higher oil prices even in the medium term.

The Policy Response

Almost predictably, the EM policy response to the growth-inflation trade-off has been to protect growth by avoiding restrictive monetary policy. Given the global links between policies that we have outlined above, EM policy-makers are not fully in control of their own policies and economies. Making monetary policy restrictive would therefore require more aggressive tightening than usual - something that EM central banks are unlikely to be keen to do. Regardless of the region in question, we believe that only a handful of central banks will veer to the restrictive side of neutral. With the PBoC already moving slowly into neutral territory, the central banks of India and Brazil are likely to be mildly restrictive a year from now, while Turkey moves into outright restrictive territory by end-2011. Besides China, we would expect the central banks of Poland, Chile, Israel and Indonesia to also move into neutral territory to avoid adding more fuel to the inflation fire. These central banks aside, all of the other central banks we cover will stay in expansionary territory, in our view.

The reasons behind different regions avoiding a policy move into restrictive territory are different. The concern in the AXJ region, for example, appears to stem from the risk of lowering domestic demand aggressively, only to be hit by further shocks to growth or to find out belatedly that growth in the advanced economies is yet to become self-sustaining and/or robust. A less risky strategy is to support domestic growth now and tackle inflation only later if its dynamics remain stable at a higher level. In several of the Latin American commodity exporting economies, notably Brazil, the terms of trade shock from higher commodity prices and a stronger currency has delivered a 'two track' economy with robust spending and a less competitive industrial sector. Slowing down domestic demand would also mean slowing down an already weak supply side of the economy, a risk that central banks there will not take lightly. The picture in CEEMEA economies is quite mixed, but even there, we believe that policy-makers are unlikely to move policy into outright restrictive territory, the exception being Turkey.

Ironically, Portfolio Outflows Give EM Central Banks More Legroom than They Have Had for a While

Had EM central banks wished to tighten policy without the complications they have faced since their recovery from the economic downturn, this would have been a good time to do so. Portfolio outflows have meant that the traditional ‘Trilemma' (where policy-makers can choose only two out of free capital flows, monetary independence and a fixed exchange rate) is not the constraint that it has been on EM policy-makers in 2010, particularly since the introduction of QE2. Back then, strong capital inflows meant that any attempts by EM central banks to tighten policy were met by even stronger capital inflows to chase the ‘carry' from higher EM yields, pushing the currency value higher. Now, with portfolio outflows, higher policy rates would have been less likely to invite further currency appreciation. However, while EM policy-makers would have been keen to tighten policy more aggressively at several points in time last year, we think they are less likely to do so now in spite of greater flexibility.

Behind the Curve or Right Where They Want to Be?

Most investors voice concerns that EM central banks are ‘behind the curve'. EM fundamentals and rising inflation, they argue, need more tightening and central banks are late in the game. However, EM central banks would probably argue that they are positioned exactly where they want to be in order to provide some insurance from the risks to global growth that are now in place from tensions in the Middle East, lingering questions about the sustainability of DM growth and the latest concerns emanating from the tragedy in Japan.

In summary, it will come as no surprise to most EM watchers that central banks have chosen to protect growth through only a partial withdrawal of monetary accommodation via the tool of policy rate hikes. The policy choice for EM central banks then boils down to either allowing inflation and inflation risks to rise in order to keep exchange rates steady, or allowing exchange rate appreciation to provide some relief on the inflation front. This ‘macro trinity' of growth, exchange rates and inflation is also relevant for global rebalancing where the improved quality of emerging market growth has prompted real exchange rate appreciation for nearly a decade now. While either inflation or nominal appreciation will suffice for real exchange rate appreciation, a greater contribution from nominal exchange rates than has been the case recently will be salutary for two reasons. First, it will ease the pressure on inflation. Second, it will lend strength to the strategy of encouraging consumption in economies where domestic demand will be the next driver of growth. However, if monetary policy inertia extends to the willingness of EM central banks to let nominal currency values appreciate as well, the risks to EM inflation, both cyclically and structurally, are clearly tilted to the upside.

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United States
Assessing the Growth Outlook
March 18, 2011

By David Greenlaw | New York

Before assessing the domestic fundamentals, it's worth addressing the potential spillover impact of near-term disruptions in Japan's economic output.  US exports of goods account for roughly 9% of GDP.  In 2010, 4.8% of US goods exports went to Japan, so exports to Japan account for less than 0.5% of US GDP.  Given this relatively small weighting, the expected temporary drop in Japanese demand is unlikely to be sizeable enough to have a noticeable impact on US GDP.  Similarly, the quickening in Japanese demand that will eventually emerge as rebuilding efforts begin is unlikely to have a significant impact on US exports. 

What about other potential spillover effects?  There appears to be some concern that Japanese insurance companies will need to liquidate a portion of their Treasury holdings to finance rebuilding efforts.  However, the extent of Japanese insurers' liability is somewhat unclear.  Indeed, it appears that the large multinational reinsurers - who are not big holders of Treasuries - may actually be most exposed.  Also, the Japanese government appears likely to finance the bulk of any uninsured losses - specifically, via Bank of Japan balance sheet expansion.  A potential wildcard is the currency market impact and accompanying potential for FX intervention by Japanese authorities (see 3/11: Macro Observations on the Tohoku Earthquake, March 14, 2011, by our Japan Chief economist Robert Feldman for more discussion of the economic impact of the recent tragedy). 

Cuts to 1Q GDP tracking estimate.  Back here at home, our tracking estimate of 1Q GDP, which is updated following release of every relevant indicator, has drifted steadily lower over the course of the past six weeks.  Specifically, since January 28 (when 4Q GDP was released), our tracking estimate for 1Q has slipped from 4.5% to 2.9%.  The deterioration has been fairly steady along the way, but the biggest contributors were the foreign trade reports released on February 11 and March 11, along with the February 15 retail sales report.  Interestingly, the Treasury market rally over the past month or so has synced up reasonably well with the downward drift in our tracking estimate of 1Q GDP.  Over the past month, we have also slightly lowered our full-year GDP forecast (4Q over 4Q) from 4% to 3.9% (see Oil Shock: A Mild Challenge to the Expansion, March 4, 2011). 

Why has growth decelerated?  We think that much of the deterioration in 1Q GDP has been tied to the impact of unusually severe winter weather in some parts of the country.  As evidence for this view, we cite our favorite proxy for weather-related influences - the "Not at work due to bad weather" series in the household employment survey - which has been quite elevated in recent months.  In fact, the situation in early 2011 looks similar to that which prevailed at the same point a year ago.  In 2010, conditions swung from unusually severe in Jan/Feb to incredibly mild in Mar/Apr.  At the time, we probably didn't appreciate the degree to which this unusually dramatic change in weather conditions was influencing the data.  In hindsight, it appears that the impressive employment gains seen in March and April 2010 were really just a head fake tied to weather-related factors.

Good news on the labor front.  An improvement in labor market conditions is critical to sustaining above-trend economic growth in the US as the impact of monetary and fiscal stimulus eventually wanes.  The good news is that a variety of indicators point to a more sustainable pick-up in employment growth going forward from here.  Specifically, we have had a steady string of upward revisions to payrolls; weekly jobless claims have finally sustained a move below 400,000; and the household survey - which, although quite volatile on a monthly basis, sometimes does a better job than the establishment survey of capturing labor market developments around important turning points - has shown very rapid employment gains in recent months.

What about headwinds?  Obviously, there are still a number of important headwinds acting as a restraint on economic growth.  The one that we get asked about the most is the state & local sector.  To be sure, municipal budgets are still under considerable pressure, and cost cutting will continue for the foreseeable future.  However, the extent of the headwind associated with a contraction in the S&L sector may actually be starting to shrink a bit.  There are tentative signs that the pace of decline in S&L employment may be moderating.  Moreover, the extent of the headwind associated with the S&L sector was never all that large to begin with.  The S&L sector's direct contribution to GDP growth has never been more than minus a few tenths of a percentage point in any recent quarter.  Finally, according to the latest survey by the National Conference if State Legislators (NCSL), the aggregate budget gaps being faced by state governments is getting smaller as tax revenues begin to accelerate.  Although the budget estimates for F2012-13 are not directly comparable to the historical figures (because some states have not yet reported the size of the gap they are facing), the latest projection for F2012, which starts in July, is slightly smaller than the gap that was projected for 2011 at this same time a year ago. All in all, we expect the S&L sector's direct contribution to GDP growth in 2011 to be close to zero.

Another headwind worth mentioning is housing.  To be sure, there may be further downside pressure on home prices until the inventory (actual and shadow) of unsold homes normalizes.  But, with affordability near a record high, the degree of any price decline going forward from here is likely to be quite modest relative to what has been experienced in recent years.  Moreover, new housing construction is simply not a key driver of the overall economy these days.  Specifically, residential investment accounts for just 2% of GDP at present - versus a peak of more than 6% during the 2005-06 timeframe.  In other words, homebuilding has shrunk by about two-thirds over the past several years relative to the rest of the US economy.  The weighting is now so small that residential construction activity can go up or down a fair amount and not really have a noticeable impact on the overall economy.

Two tailwinds: capital spending and exports.  The drag from housing activity and from state and local government budget cuts should be more than offset by growth in exports and capital spending.  Reflecting the strength in global economic activity, exports have been supportive of US growth for some time now - and appear poised for further upside (see Growth Debate Over, Inflation Debate Begins, January 7, 2011).  In addition, capital spending is growing again (after slipping well below depreciation expense during the recession), thanks to pent-up demand and the business expensing provisions of the new tax deal (see Roadmap to Stronger, Sustainable Growth, December 14, 2010).

Our business conditions survey supports positive growth outlook.  Belying any ill effects from either severe winter weather or surging energy prices, the Morgan Stanley Business Conditions Index (MSBCI) continued its strong showing in early March. Signaling expansion for the eighth consecutive month, the seasonally adjusted headline index repeated its February reading of 70%. Similarly, the composite MSBCI was also unchanged this month at 72%. In our view, this month's results confirm that the sharp drop in the headline index in February was merely an overdue correction in analyst sentiment (see Business Conditions: Firms' Pricing Power Leaves Profits Debate Unresolved, March 11, 2011).

What to watch?  Obviously, employment and consumer demand are critical to sustaining above-trend growth in the US - and gasoline prices represent a key identifiable risk factor.  As discussed, capex and exports are also expected to be important drivers of the US expansion, but because of inherent volatility, developments on these fronts are much harder to track with any degree of confidence on a real-time basis.  Also, we believe that the inflation data will be critical to timing the Fed's exit.  Policy-makers are anxious to see the economy enter a sustained growth phase so that the amount of slack can be reduced.  They probably won't begin to move toward the exit door until core inflation and/or inflation expectations push them in that direction.  On that score, the latest run-up in the University of Michigan's expected inflation gauges is unlikely to trigger a meaningful shift in the Fed's assessment of inflation risk.  Indeed, a short-term spike in survey-based measures of expected inflation represents a typical response to the type of move in gasoline prices that we have had recently.  However, the Fed will be watching to see if the elevation in survey measures of expected inflation is sustained over the course of coming months, and they will also be monitoring market-based measures of inflation expectations.

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Assessing Post-Quake Economic Path & Policy Responses: Tankan Preview
March 18, 2011

By Takehiro Sato | Tokyo

Deadline for Mar Tankan Questionnaire Returns Was the Day of the Earthquake (Tankan TBA Apr 1, 8:50am JST)

The deadline for companies to return completed questionnaires for the March Tankan was the day of the earthquake, March 11. The BoJ has not so far disclosed the number of companies that had responded by that deadline, so it is unclear how much quake impact will be reflected in this Tankan. Whatever the Tankan outcomes, we think the economy will undoubtedly contract sharply in the near term due to the shock to both demand and supply. We expect the subsequent June Tankan to provide more precise confirmation of the impact.

Economic Impact of the Earthquake and its Aftermath: Relationship between Damage to National Wealth and GDP

It is too soon to put a figure on the impact of the earthquake and subsequent events, and hence too soon to incorporate the effects of ensuing countermeasures in our economic outlook. From the size of the earthquake and extent of collateral damage, we expect the total damage to exceed the approximate ¥10 trillion caused by the Kobe earthquake and deplete some of Japan's national wealth (stock), which was about ¥8,000 trillion at the end of 2009. Yet depletion of the national wealth does not show up in GDP, a flow statistic. Though the shocks to both supply and demand may cause a fall in Apr-Jun GDP on a scale not seen since the Lehman shock, this is a different story from the loss of national wealth.

Over time we can expect the focus of the government response to shift from the current rescue and lifeline restoration efforts for survivors to support for reconstruction. The civilian sector is also likely to embark on reconstruction efforts of its own. As the government starts implementing a fiscally funded reconstruction support package, we can expect that reconstruction demand (a flow item) to start showing up in a positive light in the GDP data from the latter part of 2011. For reference, we look at how industrial production performed in the wake of the Kobe earthquake and also the Lehman shock. Production slumped - partly due to a sudden, sharp gain in the yen - after the Kobe quake but picked up again from the latter part of that year as fiscal stimulus measures took effect.

We reiterate that with the total amount of damage and scale of reconstruction demand still unknown, we are not yet in a position to reflect the quake's impact into our forecasts. Further, although we expect reconstruction demand by definition to increase GDP, we would stress that we are not saying GDP will increase because of the earthquake.

Forecasts for Business Conditions DIs: Modest Decline for Large Manufacturers, Higher for Large Non-Manufacturers

We expect only a minor decline in the headline (business conditions DI, current conditions, large enterprises, manufacturers) based on anticipation of a rebound in domestic production in response to export recovery, despite a drop driven by policy factors from Oct-Dec. We also expect the future conditions DI to be about flat in relation to the current DI. Large non-manufacturers may have reported improvement in current conditions due in part to surprising underlying firmness in consumption notwithstanding the end of government measures to stimulate personal spending. Yet such responses from companies would have preceded the earthquake's impact, so unfortunately there will be little we can draw from them.

Forecasts for F3/12 Management Plans (Large Enterprises)

1) Small Sales and Profit Gains in F3/12

With regard to sales and profit plans, gaps between parent and consolidated performances mean that the Tankan figures really only serve as a point of reference. Company forecasts (consolidated, Toyo Keizai basis) for F3/12 look for sales 4.1%Y and profit 12.1%. We expect the BoJ Tankan to indicate roughly the same direction, with forecasts for sales 3% and recurring profit 10% or so.

It appears that domestic corporations are seeing genuine improvement in export profitability. By our estimates, chiefly due to recovering capacity utilization rates and lower input costs, the rate for profitable exports (all industries) has been approximately ¥83/USD in Jan-Mar 2011, a little better than Oct-Dec 2010. This relates to domestic parent companies, and on a consolidated basis, where increasing overseas production provides a hedge against forex exposure, we think the point for profitability has been better still. However, the current surge of the yen rate dampens these corporate efforts.

2) Capex Plans to Show Modest Increase for F3/12

It is hard to get a complete picture of capex from the Tankan alone, given the gap between parent and consolidated figures. For example, the December Tankan showed capex for F3/11 projected to rise by single digits at 4.3%Y (parent data for large enterprises in all industries, excluding land investment), whereas the Nikkei Shimbun's Capex Survey (November) of consolidated data for almost the same period indicates double-digit growth of 11.5% since it covers overseas manufacturing subsidiaries. The divergence is too wide to be ignored. For F3/12, we think the domestic capex plans of Tankan firms, covering domestic corporations, will be downbeat. We look for all firms in all industries to project 2.0%Y: 4.0% for manufacturing and 1.0% for non-manufacturing.

We expect the capex utilization ratio, a leading indicator of capital spending, to recover to nearly 75% in Jan-Mar, a level that would point to a sustained capex recovery, in reaction to the production rebound. Production cuts and suspensions due to disruption of distribution after the quake now make the outlook very unclear, however.

Policy Implications: Fiscal and Monetary Weapons to Be Harnessed Together

The government and BoJ are poised to mobilize the might of fiscal/monetary policy to keep the economy from new lows. The first policy response has come from the monetary side.

The BoJ doubled the asset purchasing program that forms part of its comprehensive easing strategy from ¥5 trillion to ¥10 trillion at the MPM immediately after the earthquake on March 14. Together with the provision of a massive ¥15 trillion liquidity in the money market, this represented a strong BoJ commitment to a return to sustainable growth.

Purchasing caps for a range of asset classes - mainly risk assets - were raised, in an effort to forestall damage to the economy from risk avoidance. Moves to more than double the purchase cap for corporate debt, where BBB spreads have become quite tight, plus for J-REIT purchasing, were a positive surprise in comparison with their market size.

Given the downside to production activity threatened by supply-side constraints, we expect a fiscal policy response via several bouts of supplementary budget spending to fund restoration work. At present it is impossible to quantify the total damage cost, and the size of the supplementary budget for restoration is opaque, but given the likelihood that damage will top the Kobe quake, we would expect an initial supplementary budget of ¥10 trillion or so - larger than the one following the Kobe disaster. We think several bouts of supplementary spending on a similar scale or larger will probably follow.

These supplementary budgets are likely to mean new JGB issuance in F3/12 will breach the cap on new bond issuance of ¥44.3 trillion in the Mid-term Fiscal Management Strategy, but we do not think this would impair the government's credibility. With a massive demand shock looming for Japan's economy, we believe new JGB issuance can be readily financed domestically as to date, via a decrease in real asset investment and consumption in the private sector. The BoJ can also support the expenditure increase from additional bond issuance by enlarging its asset purchasing fund and monthly outright JGB purchasing operations. In this respect, we think the BoJ's measures taken on March 14 may be only a first step.

We have been emphasizing for some time that with deflation dragging on, the exit timing for QE is nowhere in sight, and the recent disaster pushes this back even further. The market's view to date that 3-4 rate hikes will come in the next five years is overdone, and we see further scope ahead for this to readjust.

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