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India
How Global Funding Environment Influences India's Growth Trend?
February 08, 2012

By Chetan Ahya, Upasana Chachra | Singapore, Mumbai

Over the last few months, we have been highlighting that India’s growth outlook will be influenced by two key macro factors: (a) the global funding environment and its impact on capital inflows into India; and (b) domestic challenges in the form of (i) weak domestic macro stability, which reduces the room for aggressive counter-cyclical monetary or fiscal policy, and (ii) a weak macro environment, which is not conducive for quick revival in the investment cycle. In this note, we are reiterating our framework on how and why the global funding environment influences India’s growth trend.

Capital Inflows – A Critical Macro Link:

#1 Funding the Current Account Deficit

Since the credit crisis, India’s current account deficit has widened and moved to a range of 2.5-3% of GDP from 1-1.5% of GDP earlier. We believe that the government’s desire to stimulate domestic demand (with expansionary fiscal policy) at a time when external demand has been relatively slow has been the most important factor behind the wider current account deficit. Indeed, India is the only country in the region running a current account deficit. During the 12 months ending December 2011, we estimate that India will run a current account deficit of US$53 billion, -2.8% of GDP.

Moreover, India’s dependence on less stable non-FDI inflows to fund its current account is high. For the three years ending F2012 (year ending March 2012), we estimate that about 76% of the total capital inflows of US$184 billion have been from non-FDI inflows, including commercial loans, trade credit and portfolio equity inflows. Indeed, the dependence on debt-creating inflows has been much higher in recent years, given that the share of debt-creating inflows averaged only 44% in the 10-year period of F2001-10.

While India manages to fund its current account deficit with ease when global financial markets are relatively benign, in times of uncertainty, the high reliance on capital inflows to fund its current account deficit will bring the challenges of managing balance of payments and exchange rate volatility.    

#2 Large Net FX Outflows or Inflows Affect Domestic Liquidity Conditions

As the current account is in deficit, a slowdown in capital inflows will result in net foreign exchange (FX) outflows. The net FX outflows will cause a deceleration in reserve money growth. Moreover, any intervention in the FX market (selling dollars) to prevent excessive currency depreciation will result in tightening in domestic liquidity conditions. Indeed, as capital inflows slowed during August-December, reserve money growth has suffered. While there has been a rise in the money multiplier (which has helped to offset part of the deceleration in money supply), the growth in money supply (M3) decelerated from 17.3% in August to 15.8% currently.

This deceleration in money supply growth has kept interbank liquidity conditions tight. Over the last few months, interbank liquidity has been persistently higher than the central bank’s comfort limit of US$12 billion (about 1% of net time and demand liabilities). Although the RBI could have injected liquidity through open market operations and a reduction in the cash reserve ratio, the trailing inflation problem has meant that the RBI has had to err on the side of being conservative and was not able to pre-emptively inject liquidity in an aggressive manner.

#3 Commercial Sector Funding Is Highly Dependent on Capital Inflows

Foreign capital has been a key contributor to overall commercial sector funding in India. The direct contribution of various sources of capital inflows including portfolio equity inflows, foreign debt and FDI has been about 26% in F2012 (up to December) as per the RBI. Hence, the trend in capital inflows weighs heavily on the trend of investment growth in the country. Moreover, portfolio equity inflows and global capital market movement also influence the risk capital allocation behaviour in the domestic market. A high share of foreign ownership has meant that domestic stock market movements have been highly linked to the trend in global risk appetite and portfolio equity flows. This, in turn, influences the corporate sentiment for risk capital allocation behaviour and investment sentiment.

Great Monetary Easing Part 2 (GME2) to Reduce Funding Risks?

As our Co-Head of Global Economics, Joachim Fels, highlights, we are entering a second round of monetary easing which “will be aimed at minimising recession risks, preventing deflation and helping governments to stabilise debts and deficits” (for more details, see Sunday Start, What Next in the Global Economy, January 22, 2012). Indeed, we have already begun to see signs of this monetary easing around the world. On November 30, 2011, to ease the dollar funding problems of European banks, the Federal Reserve, along with the ECB, Bank of Japan, Bank of England, Swiss National Bank and Bank of Canada “agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points”. Moreover, our colleagues in Europe believe that the first Long-Term Refinancing Operations (LTRO) conducted by the ECB has significantly reduced the risk of a systemic banking crisis (for more details, see Don’t Underestimate the Impact of the LTROs, January 18, 2012).

Looking ahead, our global economics team expects meaningful easing measures from both the ECB and the Fed in the near term. In Europe, our colleagues expect that the second round of LTRO (due in February) could add an incremental €200-450 billion of additional funding into the banking system (for more details, see LTROs Underestimated, but Great Deleveraging Ongoing, February 2, 2012). This would then be followed up by a further 50bp policy rate cuts by the ECB in 1Q12 and eventually culminate in “broad-based asset purchases across countries and maturities only if it had exhausted its standard policy tools and still saw downside risks to price stability”. In the US, our economics team expects the Fed to announce a third round of quantitative easing (QE3) of roughly US$500-750 billion in April-May 2012.

The measures taken by the central banks in the developed world so far are beginning to reduce the global funding risks. This stabilisation in funding risks has been manifested in a narrowing of the Libor-OIS spreads to 42bp from the peak of 50bp on January 6, 2012. Spreads of Italian and Spanish two-year government bonds over German two-year government bonds have also declined to 284bp and 238bp, respectively, from 602bp and 448bp as of December 1, 2011.

This improvement in the global funding environment has, in turn, resulted in a revival of capital inflows into EM and India. If the revival in capital inflows is sustained, it will start reducing the pressure on commercial sector funding and help to ease the tightness in interbank liquidity to some extent.

Bottom line: As we mentioned in our regional economics note (see Asia Pacific Economics: Downside Risks to AXJ Growth Reducing but Not Totally Out of the Way, January 24, 2012), the systemic risks in the funding environment have been reduced and have given us some comfort that the probability of downside risks to the region’s growth have been reduced. The reduction of the funding stresses is particularly important for India, given the importance of capital flows. While the funding environment (and therefore capital inflow) improves and becomes less of a drag, we believe that the challenging domestic environment will mean that it will still be difficult to achieve a V-shaped recovery in growth. We will address the issue regarding domestic challenges in a follow-up note.

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Nigeria
A Summary of International Investor Views
February 08, 2012

By Andrea Masia, Michael Kafe | Johannesburg

Introduction: Following three weeks of marketing our views on Nigeria to more than 50 international investors in Europe and the US, we provide some feedback below on the key issues that dominated our discussions:

Liquidity: Together with poor reporting standards/disclosures, the lack of depth in the country’s equity, fixed income and currency markets featured at almost every meeting. Although Nigeria’s markets are somewhat deeper than their Ghanaian counterparts, the lack of liquid, investible names was seen as a key constraint to entry. To get around this, a number of investors who would otherwise prefer to take direct exposure to local names are forced to invest in global (and arguably more liquid) companies listed in either South Africa or the UK/US with direct Nigerian exposure. This is dilutive of course, but is seen as the next best alternative, given the apparent difficulty in getting trustee approval to relax mandate filters/restrictions – especially during the current crisis. We certainly got the feeling that significant amounts of potential frontier-destined cross-over money could pour in if Nigeria were to be included in the MSCI EM index.

Politics: While a decent minority of investors felt that the Jonathan administration’s consensus-seeking style had allowed it to successfully push through the historic partial deregulation of the fuel industry earlier this year at a time where it was already under pressure from Boko Haram – the faceless renegade terrorist group that had claimed responsibility for a number of high-profile bombings, most investors were concerned that the inability to fully deregulate the industry as originally intended could be a reflection of the government’s lack of decisive clout with regards to policy reform. The latter group of investors were also sceptical of the government’s ability to push the Petroleum Industry Bill through parliament in its current form – fearing that it might be forced to settle for a watered-down version. Finally, investors were concerned that the Boko Haram attacks could metamorphose into a broad-based civil unrest that is not only inimical to consumer sentiment, but also threatens national oil production.

The naira: We received some pushback on our view that USDNGN could trade as high as 168 in 1Q12. Investors generally saw the currency trading sideways in the absence of a significant deterioration in the Boko Haram attacks, with a few arguing that it could in fact appreciate in the coming weeks and months as EMFX in general finds support. With regards to the need for a competitive naira, most clients agreed with our view that a weaker naira is unlikely to have a significant impact on export growth, given the dominance of oil – which is independently priced in the international markets – in the country’s export basket. Not surprisingly, most investors were critical of the CBN’s decision to devalue the currency by a rather meagre 3% in November 2011, and agreed with our view that this risks sending the wrong message to market participants – who may well push for more.

Our off-consensus call on policy rates: Investors were of the view that our call for 150bp of Monetary Policy Rate hikes at the upcoming MPC meeting in March was rather aggressive and certainly out of consensus. Opinions gradually began to change post the January 31 MPC meeting, however, where Governor Sanusi indicated that an expansionary budget, or the emergence of second-round inflation pressures as a result of the increase in petrol prices, would probably result in tighter money – the two key factors (alongside a weaker currency) that drove our rate call.

Banking sector confidence: AMCON was generally held in high regard, and its role in bringing down banking sector NPLs was lauded. While some investors were concerned that presently tight monetary conditions could crimp banking sector earnings, most were of the opinion that things are looking up for the cleaned-up banks, who are now perceived to be better positioned to grow their businesses.

The Petroleum Industry Bill (PIB): After years of delay, investors appear to have excluded the passage of the PIB from their base case outlook. Unsurprisingly, therefore, there was some pushback on our view that the PIB will be passed in 2H12. There also appears to be a high degree of uncertainty as to what is holding up the process, and what exactly the bill would imply for the international and indigenous oil companies, the upstream oil sector and oil production volumes. Investors were excited about the potential part-privatisation of the Power Holding Company of Nigeria, however, as inadequate power supply is seen as a major drag on manufacturing activity and GDP growth more generally. Clients frequently pointed to the deregulation of the communication sector as an example of what could be achieved when key industries are opened up to private sector participation.

Conclusion: On the whole, investors appear to be constructive on Nigeria despite the barriers to entry and the uncertain political outlook – challenges that were seen to be prevalent in most frontier markets and not just Nigeria. We were also encouraged by the greater interest in the country – compared to 2011 – and the extent of detail that investors were willing to discuss/debate.

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International Investor Feedback
February 08, 2012

By Michael Kafe, Andrea Masia | Johannesburg

Summary: We spent the past three weeks marketing South Africa, Nigeria and Ghana to international clients in the UK, continental Europe and the US, and provide some feedback on Ghana below (see South Africa: What Foreigners Think about SA Macro, January 30, 2012, and Nigeria: Summary of International Investor Views, January 6, 2012, for feedback on South Africa and Nigeria). 

The oil sector: Investors were keen to understand why the Jubilee oil field was unable to hit its 2H11 target of 120,000 bpd, and expressed some scepticism with regards to our view that oil production would rise to that level in 1Q12. As such, we had some pushback on our associated balance of payments and GDP growth forecasts. However, most investors agreed that although oil represents a relatively small share of the economy, it is a growing industry that cannot be ignored, given the huge positive spill-over effects that it is already having on the broader economy.

Also, investors lauded the government’s efforts to – through the Petroleum Revenue Management Act (PRMA) – ring-fence the country’s oil revenues and to effectively guide its allocation towards broad-based growth-accretive infrastructure spend. Of particular interest to investors was the government’s recognition of the need to avoid the ‘oil curse’ by ensuring that the country’s infrastructure programme is broadened to include other sectors such as agriculture and industry, and not just oil-related activities. In this regard, the 2012 Budget, which laid emphasis on infrastructural development in non-oil sectors such as road construction, the modernisation of agriculture, etc., was seen as particularly instructive.

We must highlight, however, that while investors were keen to participate in key growth sectors such as construction, financial services and, to a lesser extent, communications, the dearth of investible liquid names was often cited as a key drawback. This was seen to be a bigger problem than in Nigeria, where there appears to be greater penetration of South African and other global companies, thereby giving investors the opportunity to take an indirect – even if diluted – exposure through larger and more liquid offshore counters.

Fiscal outlook: Investors appeared particularly concerned about the country’s fiscal metrics. Specific concerns here include the pace at which public debt levels had risen after the country filed for and was granted debt forgiveness under the Hugely Indebted Poor Countries (HIPC) initiative just over half a decade ago. There were also concerns about possible fiscal slippage with regards to recurrent public expenditures ahead of the December 2012 elections – as was the case in 2008, where the deficit jumped to 13% of GDP, pushed up inflation and contributed to significant currency weakness. Most investors felt that our forecast of a 5.8% of GDP deficit in 2012 (government estimate 4.8%) was rather conservative, and that the deficit was likely to come in above 6% of GDP, driven in the main by public sector outlays on personal emoluments – especially expenses related to the much-publicised Single Spline Salary Structure (SSSS) that offered a 20% increase to public servants in 2011, most of which is to be disbursed in 1H12.

Currency: We found it interesting that we had very little pushback on our view that, despite the expected uptick in oil production, the cedi is likely to weaken in 2012. The fiscal outlook was often cited as the reason for such bearishness. Towards the end of our trip, however, there was a slim minority of clients who were willing to bet against the consensus view of cedi weakness. These were mostly fixed income clients who pointed out that, at double-digit yields, the country’s three-year paper looked attractive, notwithstanding their view on the currency. With most investors looking for (and perhaps positioned for?) a weak cedi this year, we believe that the risks to our USDGHC forecast may well be skewed to the downside.

Politics: Political concerns were two-fold: First, investors were concerned that the recent decision by the government to part-unwind the favourable tax dispensation earlier granted to mining companies (equalisation of corporate taxes at 35%, imposition of a 10% windfall tax, etc.) was indicative of a stealthy move to towards the left, and that Ghana was becoming increasingly hostile to business. However, we do not share this view, and point out that the normalisation of tax treatment is a common practice and the imposition of mining taxes is a common theme, especially among resource-based economies, where governments seek to take a larger slice of their resource endowment. Second, investors appeared concerned that, were the ruling party to lose the upcoming elections, the incoming regime could reverse some of the positive initiatives that the Mills government has begun. This, they felt, would take the country backwards.

Inflation and policy rates: Finally, we got some pushback on our view of double-digit inflation this year (government estimate 8.7%), as investors felt that we may have overstated the potential pass-through from a weaker FX and higher oil prices (thanks to the removal of the fuel subsidy at the beginning of this year) to headline inflation.  As such, most investors felt that our call for policy normalisation to begin as early as 4Q12 was premature. That said, it is also worth pointing out that a minority of clients felt that the Bank of Ghana may have to consider raising interest rates as early as mid-year, if the currency were to depreciate significantly.

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