India: Taking stock of macro stability risks

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This post is a guest contribution by Chetan Ahya of Morgan Stanley.

What Really Caused Stretch Marks Early in the Current Recovery Cycle?
We believe the ideal outcome would have been to manage GDP growth closer to potential of 7.5-8% for the first 12 months immediately following the credit crisis – and then to gradually push growth higher as investment growth accelerated, lifting potential growth.

However, since the credit crisis unfolded, India’s policy-makers have been aggressively pushing growth back to pre-crisis levels as fast as possible. Unusually low real interest rates, loose fiscal policy and faster-than-expected global recovery have brought growth in India back close to pre-crisis levels. The credit crisis had a significant impact on investment in India. India’s investment trends tend to be highly influenced by the capital market environment. As the global credit crisis impaired capital markets, private corporate capex declined from 16.1% of GDP in F2008 to 12.7% in F2009 and further to 12.6% (our estimate) in F2010. On the other hand, the quick recovery in domestic demand from April 2009, driven by the government’s aggressive fiscal and monetary policy as well as an improvement in global and local sentiment, resulted in a capacity stretch much earlier in the cycle than was normal.

The good news is that GDP growth in F2011 could potentially be even higher than our forecast of 8.5%. However, this approach by policy-makers to maximize the growth opportunity came at the cost of rise in macro stability risks in the form of higher inflation, a wider current account deficit and tighter interbank liquidity – we have been highlighting this for some time now (see India EcoView: Inflation Risks Rising Fast, March 15, 2010 and India EcoView: Policy Support Maximizing Growth Opportunity but Macro Stability Risks Emerge, June 16, 2010). Moreover, a major crop failure due to drought in summer 2009 only added to the inflation management challenge.

Worst of the Macro Stability Risks May Be Behind
We see three key factors supporting this gradual improvement in some of the macro stability risks:

1) A steady rise in private corporate capex: Private sector capex has been accelerating over the last 10 months. We believe that it will soon begin to reflect in the form of commissioned capacity. The revival in capital markets as well as capital inflows and increased corporate confidence have fueled a significant pick-up in capex. For instance, as per the RBI data, aggregate resources raised by the commercial sector had risen by 47%Y as of September 2010. In this context, the key risk to our view of a continued steady rise in investments is potential risk-aversion among public sector banks due to recent corruption-related investigations. Similarly, we see the risk that contract awards for infrastructure and commodity-related projects might slow because of similar issues and a delay in mining approvals.

2) The tightening of short-term interest rates: We expect that this should start checking aggregate demand growth, reducing the non-food inflation pressures.

3) Recovery in G3 domestic demand and consequent rise in India’s exports: This is helping to reduce the trade and current account deficits.

Note, the risk to our view that the worst may be behind us is that oil prices quickly shoot up above US$100/bbl on a sustained basis and/or capital inflows into EM and India decline sharply. Under either of these conditions, the short-term cost of capital will spike up – hurting growth.

Tracking the Macro Stability Risks

1) Trade and Current Account Deficit Narrowing for Now
After widening for a sustained period from 2H09 when the recovery began, the trade deficit has shown a clear trend of moderating over the last three months. The monthly trade deficit stood at US$8.9 billion (7.1% of GDP annualized) in November. This is down from the peak deficit of US$13 billion (10.8% of GDP annualized) in August 2010. On a three-month trailing basis, the trade deficit narrowed to 7.3% of GDP, annualized as of November 2010, from 8.6% in October and the peak of 10.1% in August 2010. The improvement in the deficit has been supported by a faster rise in exports while imports have been steady. Over the last six months, seasonally adjusted exports have risen by 26.1%, whereas imports have increased by only 4.8%. We expect the trade and current account deficits to narrow over the next six months as rising investments help to build capacity and a steady reversal in monetary and fiscal policy contains demand growth. The key risk to our view would be a sustained rise in crude oil prices above US$100/bbl.

2) Aggressive Deposit Rate Hikes Should Help to Improve Interbank Liquidity
The persistent lag in policy rate hikes had meant that real deposit rates were unattractive. While bank loan growth is accelerating, deposit growth is decelerating. The gap between credit growth (23.7%Y as of the fortnight ending December 17, 2010) and deposit growth (14.7%Y during the same period) has remained high. Currently, the banking system loan-deposit ratio is already high at 75.8% as of as of the fortnight ending December 17, 2010. Similarly, the 12-month trailing banking system loan-deposit ratio is already tracking above 100%. Considering that the statutory liquidity ratio is 24% and the cash reserve ratio is 6%, we believe that there is a need to significantly accelerate deposit growth so that the system has adequate liquidity to support this rising credit demand.

There was a lag (relative to strength of growth and inflation) in deposit rate hikes as the RBI was slow in moving policy rates up – but the banks have finally moved deposit rates now. The State Bank of India (SBI, India’s largest public sector bank) recently raised deposit rates by 50-150bp across maturities. In the 1-2 year bucket (using the 555-day deposit rate as benchmark), SBI increased rates by 150bp to 9%. Indeed, over the last 12 months, short-term rates have moved up significantly. 91-day T-bill yields have risen by close to 310bp to 7.1% over the last eight months. The three-month commercial paper rate has risen by 480bp during the same period to 9.5% currently. We believe that these hikes in deposit rates should start improving deposit growth and reduce tightness in interbank liquidity over the next 2-3 months if the inflation rate does not spike up again.

3) Inflation Stays Too High for Policy-Makers’ Comfort
Headline inflation has moderated to 7.5%Y in November 2010 from the peak of 11%Y in April 2010, primarily due to high base effect in food prices. While non-food inflation remains high at 7.9%Y in November 2010 (versus the peak of 8.9%Y in April 2010), food inflation (primary and manufactured) has moderated to 6.6%Y in November from the peak of 19.2%Y in February 2010. We were earlier expecting the headline and food inflation (WPI) rates to moderate further to 6-6.5%Y and 5.5-6%Y by March 2011 – but we now raise our headline and food inflation forecast to 7%Y and 7.3%Y, respectively.

Key reasons for raising our food inflation estimates are:
(a) Unseasonal rains damaged the onion crop, pushing up prices of other vegetables: The onion crop in Maharashtra and Gujarat has been significantly damaged by unseasonal rains. These two states combined contribute about 40% of the country’s onion output. The sharp rise in onion prices has also had an impact on other vegetable prices. During the week ended December 18, 2010, higher vegetable prices pushed headline primary food inflation further upwards to 14.4%Y from 12.1%Y and 9.5%Y in the previous two weeks. Indeed, the weekly primary food articles index has risen by 3.5% over the last three weeks cumulatively. Typically, the primary food index declines MoM in December. However, the recent rise in vegetable prices is likely to push December primary food inflation index over the November number. We believe that vegetable prices could moderate when the next onion crop arrives in February-March 2011.

(b) Rise in edible oil and other soft commodity prices: Over the last three months, international prices of crude palm oil and other edible oils have jumped by 30%. Domestic edible oil prices are highly influenced by international prices as India is a big importer of edible oils. Edible oils have a weighting of 3% in the WPI. Edible oil prices as reflected in WPI always tend to lag the international prices. We believe that over the next three months the WPI edible oil component inflation will likely spike up. Similarly, other soft commodity prices have also been rising. For products where India is self-sufficient, the international prices don’t reflect one-to-one – but some pass-through is inevitable.

Rise in Oil Prices Could Compound the Inflation Problem
We currently expect non-food inflation (WPI) at 6.8% by March 2011, assuming that oil prices remain close to US$100/bbl. Hence, any upside surprise in G3 domestic demand could push crude oil prices to increase to US$110-120/bbl.

In this context, the recent announcement in the US of a potentially large fiscal stimulus in 2011 has increased the probability of such an outcome. If crude oil prices reach US$110-120/bbl for a sustained period of six months or more, we believe that headline inflation (WPI) could spike to 8-9%. This would increase the risk of disruptive policy actions to manage inflation pressures and thus would eventually hurt growth. Indeed, this could remind us of the macro environment in mid-2008.

Fiscal Deficit Reduction in F2012 Will Be Key
We believe that fiscal policy has to lift most of the burden of tightening. While short-term interest rates have moved up aggressively over the last 12 months, the government has delayed reduction in the core deficit (excluding one-off receipts like divestments and 3G license fees), supporting strong aggregate demand growth. The government is currently indicating its determination to cut the central fiscal deficit to 4.8% of GDP in F2012 from 5.5% in F2011 (7% excluding 3G revenues). We believe that this is a difficult target to achieve but, in order to manage the inflation risks, we think it will be critical that the government abides by this earlier stated target.

Source: Chetan Ahya, Morgan Stanley, January 5, 2010.

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The 10 economic factors in the world outlook for 2011 – and the 3 dominos

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Apart from geo-political risk-taking coming to a head around the 28th March, there are a number of negative headwinds building in the international economy, particularly in the United States and Europe. Despite bullish sentiment currently in ascendance in the stock markets, it is clear to many economists that the world is in for a turbulent time in 2011.

Of course, there is no one-to-one correlation between the economy and the stock market, and they tend to do their own thing for extended periods of time. However, this time around the magnitude of the approaching storm will not escape the stock market, in part because QE3, QE4 and QE5 are not likely to happen. Even if they do, the effect will be insufficient to maintain stock prices in the face of waves of indogenous and exogenous shocks to the US economy.

Additional QE shots will also be utterly useless to the economy when the macro-economic tectonic plates shift on a magna scale. In my analysis, the salient world economic and social developments coming in the next two years are going to happen due to the following tensions building to the point of explosion:

1  The sovereign debt crisis in Europe is putting great pressure on the EU financial system and is contributing to the difficulties in achieving growth in large parts of the EU. Although the EU ruling class is slowly beginning to conduct changes in the EU financial sector, it is taking far too long and it does not have the necessary political perspective and understanding to see that the structural imbalances in the eurozone are now moving to rip the eurozone apart.

Although EU institutions and their leaders are successively building what amounts to a federal system for loans to weak eurozone countries, it is more and more becoming evident that they have no real idea of the convulsions they are throwing the weaker eurozone countries into. The ECB and the European Reconstruction Bank are simply not intending to supply ailing nations with credit at reasonable rates, and the whole EU project is in great danger of failing altogether through mounting debt. There is an overhanging risk that the debt will cascade through emergency package after package until collapse and default of a debtor country is a fact, accompanied  thereafter by huge social upheavals across the 16 eurozone nations and ultimately across the entire EU of 27 countries as well.

The object of the latest 750 bn euros support fund is to end the despicable scenes when the bond vigilantes, in cahoots with the rating agencies, pick off one weak EU economy at time and extract extortionate rates of interest, a fate hitherto experienced by Greece, Ireland and now Portugal. Once operational, this fund is intended to go a long way to eliminating the debt crisis in Europe altogether. Given the financial headwinds about to hit, this arrangement has not come a moment too soon. But will it be enough? The Stockholm professor, economic analyst, and author on economic growth, bubbles and crises, Stefan de Vylder, does not think so. He foresees the demise of the eurozone (see link).

China has lost confidence in the dithering US political and economic system, prone as the latter is to delays, lobbying, partisan interests and pork-barrel politics and has declared a willingness to assist Europe with support if necessary to achieve sovereign financial stability. The EU is an important export market for China and it is in the interest of China to assist the EU to weather its current sovereign debt crises.

On the face of it, the EU looks set to weather the approaching financial storm with much greater robustness than the US, even though the EU will, like most economies, be affected by any double dip in the US. But again, will the Chinese assistance be enough given the wide cracks fast developing in the EU? Furthermore, what will happen when China itself runs into great problems, which it is heading towards at rapid speed? I will continue with China later under factor 9.

2  The US first-time unemployment rate is as high as ever, 9.8%, while the real number out of work is estimated to be over 17 million people. Without any significant growth in the US economy (i.e. at least 6% per annum) these numbers are going to remain high for many years, perhaps a decade or more.

3  Every 400 000 new people out of work in the US puts further downward pressure on the US housing market as they default on their mortgages a few months down the line. Unsold US residential housing inventory is now close to four million homes and the average time to a sale 24 months. The market has 25% further down to go.

4  US large banks are still under pressure because they are still carrying toxic assets on their books (or off them) and are unwilling to lend to businesses, making it difficult for them to expand. A number of the larger banks are also being sued by other companies, for example Bank of America by PIMCO for fraud in relation to the value of the sub-prime mortgage-backed securities sold to them three years ago. Regional banks are also under pressure and another 500 are estimated to hit the wall in 2011.

5  Over 40 US states are bankrupt and will have a combined deficit of $200bn in 2011. How is the US going to deal with this? If more money is printed then the national debt will increase.

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Source: Paul Sandison, December 29, 2010.

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The crises of the euro

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This article is a guest contribution by Dr Stefan de Vylder*, well-known Swedish economist.

The 85 billion euros that were recently mobilised by the IMF, the European Union and various bilateral lenders to save Ireland – or, rather, to save banks and other private investors who have invested in Irish assets – confirms my view of the European Monetary Union (EMU) as a club with the wrong membership and a weak management.

Early in 2010, Greece was the ideal scapegoat. A huge fiscal deficit which previous governments had tried to cover up with the help of creative bookkeeping and outright cheating provided a reason for the vilification of Greece. But it was membership in the currency union that had made it possible for Greece – and, indeed, for all members of the union – to benefit temporarily from a rising euro and easy access to cheap credit. Neither the financial markets, nor the European Central Bank (ECB) or other EU authorities, were vigilant enough to warn of the danger of the growing bubbles and deficits that came to characterise a large number of the euro zone countries.

Yesterday Greece, today Ireland, tomorrow Portugal and Spain, the day after tomorrow perhaps Italy and France. A large part of the EU is in severe financial trouble and the recipient of punitive loans with adverse policy conditions attached. These are the prospects for an association that was formed with supposedly binding rules for responsible behaviour.

The cornerstone of the EMU was the so-called Growth and Stability pact, which stated that no member of the club was allowed to run a fiscal deficit exceeding three per cent of GDP. When Germany and France soon after the formation of the EMU broke this golden rule the stability pact was de facto buried. At present, the average size of the euro zone’s fiscal deficit is 6,5 per cent of GDP.

The next rule that was violated, and proved to be fiction last spring, was the “no bailout” clause in the Lisbon Treaty, which explicitly forbids the EU to rescue countries in crisis. Furthermore, the 110 billion package to Greece was, as was the case in the recent deal with Ireland, tied to the implementation of austerity policies that were so severe that even the IMF expressed its concern.

The loan conditions to Greece and Ireland are very tough. But the EU and IMF message could also be interpreted in the following way by countries in crisis: if you promise to reduce your deficits you may borrow enough euros to be spared. For the time being.

The third pillar of responsible behaviour was the European Central Bank, which was forbidden to bail out member countries in crisis by buying their government bonds. Today ECB is the largest – and soon, perhaps the only – together with China – single buyer of Greek and Irish bonds. The sellers are those private investors who with a sigh of relief are happy to find someone willing to buy their high-risk assets.

These rescue operations suffer from one major weakness: they fail to solve the main problems of the euro zone, which are rather likely to be aggravated.

Insolvency, not Illiquidity
If illiquidity, i.e. a temporary lack of liquid funds, is the problem, borrowing in order to bridge a brief financial gap is an excellent solution. But when a country – or an individual – is unlikely to be able to service its debt in a longer-term perspective, we are talking about insolvency. However, the crisis affecting a number of euro-zone countries is not a short-term liquidity crisis. If that had been the case, the rescue packages would have made sense. But we are dealing with a crisis of insolvency, not illiquidity.

The EU leaders are amazingly silent on the grave predicament the EMU is now in. Simply put, those EU countries unable to service their debts will not be helped by taking up new loans, especially not if these loans are given at exorbitantly high interest rates.

Click here for the full article.

Source: Dr Stefan de Vylder, December 29, 2010.

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Emerging markets – higher for longer

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This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

EM economies have had quite a ride over the last few years, but 2010 has been exceptional not just because growth has been strong, but also because it has been strong with no major hiccups along the way.

2011 is likely to be slightly different: With excess capacity now largely gone or going very quickly, unbridled growth is no longer an option. Accordingly, we set out five themes for emerging economies for 2011: i) EM versus DM growth rebalancing, led by cyclical EM underperformance; ii) Rebalancing within the EM world as economies move towards sustainable growth without overheating, which means lower growth for some, higher for others; This salutary rebalancing will allow EM growth to remain higher for longer; iii) EMflation scare means markets will likely worry about inflation even though core measures remain benign; iv) Second stage of monetary tightening as EM central banks move beyond just removal of extraordinary monetary stimulus to reduce monetary easing even further, but stop short of a tight policy stance; and v) Capital flows to continue, FX appreciation trend to persist and mild capital controls to be put into place.

Three main risks: The risks to these calls are that: i) EM inflation turns out to be more difficult to deal with; ii) DM growth surprises to the upside, causing EM policy-makers to tighten policy; and iii) Euro-zone periphery problems spread to the core and then to funding and/or export markets.

As the BBB (Bumpy, Below-par, Brittle) recovery in the G10 continues, the focus remains on the EM world as the engine of growth. Our year-ahead note today suggests that EM economies will remain the drivers of global growth, but the glaring outperformance will be toned down somewhat this year. Inflation worries, removing some of the monetary accommodation and currency appreciation in response to capital flows should keep growth in the EM world from overheating – a salutary development.

Theme #1: EM versus DM Growth Rebalancing: EM Underperformance in 2011

Absolute EM Outperformance Is Structural…

The absolute economic outperformance of emerging markets (EM) over developed markets (DM) should come as no surprise to anyone. Given the structure of emerging markets and the vast pockets of under-utilised resources, growth rates of 3% or thereabout which represent trend growth in most DM economies can feel like a recession to many EM economies. We expect the absolute outperformance of EM markets over DM markets to continue as a structural story.

…and Relative Underperformance in 2011 Is Salutary

On a relative basis, however, we expect the degree of this outperformance to narrow in 2011, thanks to EM underperformance. In other words, the ‘spread’ between DM and EM growth should narrow even though DM growth is likely to fall from 2.6% to 2.2%. EM growth, on the other hand, will likely fall 1pp from 7.4% to 6.4%. The narrowing spread between DM and EM is therefore more of an EM story than a DM one. The AXJ region, with a 30% weight in the global economy and a 60% weight in the EM world, naturally dominates EM growth dynamics. We believe that a slowdown in the blistering pace of growth in the AXJ region and an even bigger fall in the smaller LatAm region will pull EM growth down to more sustainable levels and prevent overheating. The DM world, on the other hand, may actually see a small step up in growth if the newly proposed tax cuts in the US are implemented.

Policy Support and the Balance of Risks Supports the Narrowing DM-EM Spread

With the notable exception of the euro area, where uncertainty is still quite high, the balance of risks for the rest of the G10 now appears to be tilted to the upside in 2011. We believe that monetary policy will continue to stay its course and provide AAA liquidity, and fiscal tightening seems more popular in market debates than it is with policy-makers.

In the EM world, however, the biggest risk is that of overheating. Central banks in the fastest-growing EM economies have stayed away from too much tightening as they balance strong domestic demand against weak G10 (and particularly US) growth. If the upside risks in DM materialise, that could also be the trigger for faster-than-expected EM tightening in order to prevent a ‘double whammy’ of domestic demand- and export-led overheating. The balance of risks and the policy reaction to them also support this rebalancing.

External Rebalancing Already Underway

In addition to the coming growth rebalancing, a rebalancing of global current account imbalances has already begun. Many of the current account imbalances in the world have started to resolve themselves to less extreme levels, and we expect this theme to be an important one over 2011. As we have pointed out, the presence of current account imbalances themselves is not a reason to worry. Rather, it is only when these imbalances are the result of excessive consumption or savings or excessively risky investment that the problem arises. And it is precisely here that much of the necessary rebalancing seems to be occurring, with savings in the US rising and the contribution of consumption to growth likely to rise in China.

Theme #2: Rebalancing Within EM: Convergence of Growth Rates

Global rebalancing isn’t the only rebalancing show in town. There is a trend towards rebalancing within the EM world as well. As always, it is a mistake to paint the entire EM world with the same brush. A little less vulgar generalisation is to split the EM world into two blocs – a first bloc of countries where the output gap is closed or positive, and a second where the output gap has yet to close.

At first glance, the number of EM countries where the output gap is closed or positive appear to be rather small, but their size accounts for three-fifths of the EM world. There are several countries where the output gap has yet to close and a few where the output gap is quite large still. Clearly, policy-makers would prefer to slow down growth to a sustainable level where the output gap is positive, as is the case for China and Korea. In Brazil, India, Poland, Peru and Taiwan, policy-makers would like to stay as close to a closed output gap as possible and are likely to resist strong growth going forward. Policy action here is likely to just tap on the brakes to ensure that growth does not surge again with the output gap already closed or even positive.

For the numerous countries whose output gaps are yet to close, growth has already been robust in many countries, but a temporary increase in growth until the output gap closes can be accommodated and is unlikely to worry policy-makers too much. Accordingly, we believe that the focus here will be on keeping policy from being excessively accommodative but accommodative enough to keep growth supported. The notable exceptions here are Hungary, Romania and Mexico, where the output gaps are still wide and negative and any and all growth would be welcome. Russia also has a wide output gap, and in spite of inflation concerns probably prefers to see higher growth for the near future. Another exception where the output gap isn’t wide but policy-makers are focused on keeping policy as accommodative as possible is South Africa, where policy rates have recently been cut by 100bp to keep the currency from appreciating and taking away the impetus to growth.

In summary, the difference in the strategies that policy-makers have adopted in the two blocs will likely push growth in both blocs to a sustainable level. Over 2011, this should lead to a convergence of growth rates towards sustainable levels in the EM world, allowing EM growth to stay higher for longer.

Theme #3: EMflation Scare

Looking from a different perspective, EM countries are fairly evenly divided among countries that have inflation concerns and those that do not. However, the percentage of the EM world that has inflation concerns is quite lopsided. With the heavyweights like China, India, Brazil, Russia, Korea and Poland all in the ‘inflation concerns’ camp, it is no surprise that four-fifths of the EM world falls into this category. Markets are particularly concerned that rampant growth here will create inflation problems. Yet, we are more sanguine about EM inflation for three reasons:

•           First, inflation in only four economies under our coverage (Argentina, Brazil, Indonesia and Saudi Arabia) is both high and driven by the factor that policy-makers are most likely to move against – domestic demand. In all other countries where inflation is a concern, it is the food and/or energy-related components of inflation that have pushed headline numbers high, whereas core measures have stayed soft. Clearly, the inflation concern is present because of the risk of food and/or energy inflation slipping into core measures, and that is what policy-makers are moving to prevent.

•           Second, early inflation problems like the one in India have been successfully kept under control – core inflation there is now manageable whereas food inflation is heading lower after a good agricultural season.

•           And finally, since inflation is a slow-moving variable and subject to base effects in year-on-year calculations, it is not unusual for inflation to turn down only slowly. Markets are usually convinced that inflation is under control when inflation turns down – evidence of that comes from the high correlation of many surveyed measures of inflation expectations to current inflation levels.

In summary, we expect an EM inflation scare rather than a full-blown inflation crisis or even the prospect of inflation derailing growth by prompting policy-makers to aggressively lower growth in order to quell inflation. With ultra-accommodative policies in the DM world, the risks however remain skewed to the upside.

Theme #4: Second Stage of EM Monetary Tightening

The first stage of EM monetary tightening was about getting policy rates away from ultra-accommodative levels as part of the policy stance against the Great Recession. As global growth consolidates, EM tightening begins its second phase, to make monetary policy less accommodative but stop short of making it outright restrictive. The one thing that allows central banks to act less aggressively is that most of the inflation in the EM world is in food and energy prices rather than core measures, as discussed above.

EM central banks constrained by internal versus external balance, and the trilemma: But monetary policy in EM economies isn’t a simple unconstrained optimisation problem. Central banks there are working under at least two constraints. First, they are balancing off strong domestic growth against weak DM growth. The BBB recovery in DM markets, uncertainty in the euro area and the mid-year slowdown all led EM central banks to slow down the pace at which they might have wished to tighten policy. Second, the constraints of the trilemma (discussed further below) have also kept EM central banks from tightening policy too much for fear of attracting even more capital flows and pushing currency values higher.

Once again, how quickly and how much policy-makers remove monetary easing depends on which bloc the economy belongs to. And this can be seen more readily in the first bloc of countries where output gaps are closing rapidly or have already closed. In economies, particularly in the AXJ region, where policy-makers want to cap growth and inflation, the emphasis appears to be on keeping growth from rising further or bringing it just a touch lower but not materially lower. In the second bloc, where growth will not raise as many eyebrows in policy-making circles, monetary tightening is likely to be limited, in our view.

Our forecasts bear out the two-bloc view: If our forecasts are anything to go by, this story is borne out to a large extent. In the EM world we cover, six central banks are expected to raise rates by more than 2% over 2010-11: Turkey, Israel, India, Brazil, Chile and Peru. Of these, only Turkey and Israel have output gaps that have not yet closed. Our colleague Tevfik Aksoy, who covers both countries, expects Turkey to start hiking rates quite rapidly only towards the end of 2011 (by which time the output gap will have closed), while Israel has been raising policy rates very gradually from a historically low level as a process of ‘normalisation’ of policy rates.

But what of the others whose output gaps have already closed or are positive? In Poland, our economist Pasquale Diana expects rate hikes to happen sooner rather than later, while our Korea economist Sharon Lam has long been suggesting that the Bank of Korea would find it useful to raise policy rates at a faster pace in order to ward off inflation in the future. And finally China. The PBoC is particularly constrained by the trilemma, given its strictly controlled exchange rate, and hence does not depend on policy rates as much. Instead, it relies directly on setting credit quotas. As it moves to keep inflation under control, the credit quota for 2011 is expected to be lower at Rmb7 trillion.

Tools of Monetary Policy

As the China case points out quite clearly, it is important to keep in mind that EM policy-makers do not rely on interest rates to as large an extent as their DM counterparts. Partly, this is because they are less reluctant to use other tools like restrictions on credit. However, the use of a wider range of instruments also stems from the fact that EM economies tend to be more exposed to trade, which makes exchange rates an important variable to control, and also that money and financial markets are not as organised as their DM counterparts so the use of more monetary instruments is almost a necessity. In the AXJ and LatAm regions, for example, central banks are more willing to take a more proactive role with the banking sector and either guide or set credit controls. This gives central banks there very powerful tools to control economic activity that are not reflected in policy rate moves.

Theme #5: Continued Capital Flows, FX Appreciation, Mild Capital Controls

Capital flows to the EM world are a natural consequence of the economic outperformance, the two-track nature of the global recovery and the second stage of EM monetary tightening. In turn, this means that EM policy-makers have a hard battle on their hands with the trilemma – a constraint that allows policy-makers to choose only two out of the trio of mobile capital flows, a fixed exchange rate and an independent monetary policy.  The trilemma has been on our radar since early 2010 and its constraints have been frustrating more and more as capital flows have surged to chase better-quality returns in the EM world.

Currency War? No. Trilemma? Yes

A now-famous example of the frustrations that the trilemma can create for policy-makers is the declaration by Brazil Finance Minister Mantega calling the trend of rising EM currency values a “currency war”. Rather than being the result of a retaliatory escalation of currency tensions, the “currency war” is essentially a result of the constraints of the trilemma. Faced with large capital inflows and a need to lift domestic interest rates to keep economies from overheating, EM policy-makers have had little choice but to let currencies appreciate. And they will continue to face similar pressures if their growth outpaces the DM world or their policy rates keep rising. One of the two seems imminent for the EM world, and so does the prospect of continued capital flows and more worries about currency appreciation.

Capital Controls: Limited Effectiveness

Chinese policy-makers, with their comprehensive system of constraints on capital flows and domestic credit, have successfully avoided being shackled by the trilemma, as did the global economy during the Bretton Woods era and its regime of ubiquitous capital controls. However, unless applied as comprehensively as in China or universally as was the case during Bretton Woods, capital controls have a limited shelf life and limited effectiveness. A recent IMF report (see Capital Inflows: The Role of Controls, February 19, 2010, for more details) suggests that capital controls tend to affect the composition of capital inflows rather than their overall size.

Balassa-Samuelson and Structural EM Real Appreciation

The cyclical pressure on EM currencies discussed above is in sync with longer-term pressure on currency appreciation from the Balassa-Samuelson effect. Given higher productivity in EM economies, policy-makers there are going to have to let their currencies appreciate and/or allow higher inflation over a longer period. EM currencies will therefore tend to appreciate in trade-weighted terms on a longer-term basis, unless they are willing to tolerate higher inflation, which is possible but less likely, in our view.

Three Main Risks

Downside risks to the EM world and our 2011 outlook come from three sources – one from within the EM world but two from DM economies: i) More serious inflation risks in the EM world; ii) Much stronger-than-expected DM growth; and iii) Contagion of the euro-zone’s problems from the periphery to the core, and then to the rest of the world.

Inflation spreads to core measures: As noted above, inflation concerns in EM countries right now are still dominated by domestic demand in a handful of countries. In most other countries, food and/or energy prices are the ones that have inflated while core measures have remained subdued. Any spreading of inflation pressures to core measures will most likely invite a much stronger response from central banks, which could then push EM growth much lower than we expect.

Upside risks to DM growth: Policy-makers have been balancing off strong domestic growth against weak DM growth by tightening policy very slowly. Should the upside risks to DM growth materialise, this balance will be upset and policy-makers will probably push policy tighter rather rapidly. Note that, even here, policy-makers could get their policy moves just right in order to keep EM growth from falling because exports will likely also rise along with DM growth. Should a stronger dollar accompany stronger-than-expected US growth, EM policy-makers should find it easier to raise rates in an environment where EM currencies are falling or at least steady against the US dollar.

Euro-zone periphery problems spread to core: Finally, one of the risks that our global outlook has highlighted is a spreading of euro-zone periphery issues to the core. Should this contagion occur, it could spark further weakness in funding markets that EM economies rely on, or could spread to other parts of the world through weaker trade.

Source: Manoj Pradhan ,  Morgan Stanley, December 17, 2010.

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Roadmap to stronger, sustainable growth

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This post is a guest contribution by Richard Berner & David Greenlaw  of Morgan Stanley.

Breakthrough tax deal. We assume Congress will approve the tax/fiscal stimulus deal, which will add about 1pp to growth in 2011 relative to our earlier baseline, pushing our forecast to 4% over the four quarters of next year.  Implementation of the deal, which could begin on January 1, will shift the mix of stimulus from monetary to fiscal policy, so that the Fed will likely be less inclined to extend the current LSAP program beyond 2Q11.  And it suggests that yields will gradually continue to move higher, to 4% by end-2011.

As widely discussed, the deal will extend the expiring income tax cuts for all taxpayers for two years.  In addition to extending several other expiring provisions, it includes three key temporary elements which add new stimulus – a one-year payroll tax holiday for employees, a 13-month extension of emergency unemployment benefits, and full expensing of business investment outlays for 2011.  These will boost growth in 2011, partly at the expense of 2012.  We estimate that their expiration at end-2011 will net to an offsetting drag of about 0.5pp in 2012.  Together with other expiring provisions, the new stimulus amounts to about $400 billion above our December 3 baseline assumptions over 2011-12, or about 1.3% of GDP in each year.  We illustrate the estimates of the budget impact of all provisions; these are similar to what we published last week, but refined by the Joint Committee on Taxation and Congressional Budget Office.

Why should this plan have more bang for the buck than ARRA? The fiscal stimulus enacted in the American Recovery and Reinvestment Act (ARRA) of February 2009 (Pub. L. 111-5) did not seem to add much oomph to the economy relative to its size; why should this smaller one produce more results?  In our view, there are two reasons.  First, the nature of the stimulus matters: Most of the latest stimulus (about 0.7pp) results from the new proposed payroll tax holiday for employees.  Such cuts accrue mostly to lower-income, budget-constrained taxpayers and show up quickly in spendable income, so they are more likely to be spent.

In contrast, the Making Work Pay (MWP) tax credit that was a key part of ARRA was disbursed slowly, and some empirical work suggests that taxpayers spent only about 13% of the incremental income, which partly showed up in withheld taxes and partly in rebates when taxes were filed.  Similarly, consumers spent about one-third of the one-time tax rebates in the 2008 stimulus package.  In addition, the MWP credit at $60 billion was smaller than the proposed payroll tax holiday.  Likewise, while ARRA’s grants to states and healthcare insurance premium (COBRA) assistance provided a helpful buffer for governments and individuals, these funds tended to be saved rather than spent.  Finally, outlays for the famously ‘shovel-ready’ infrastructure projects featured in ARRA took as much as a year to show up in spending.

A second reason why the current stimulus is likely to be more potent involves the state of financial conditions affecting households: We believe that liquidity-strapped consumers, suddenly denied access to borrowing in the credit crunch, were more likely in early 2009 to save their tax credits and other forms of stimulus or use them to pay down debt.  In contrast, the deleveraging process for households and lenders is far more advanced today.

Indeed, four factors already are promoting sustainable growth. First, balance sheet healing is more advanced and, courtesy of the Fed’s new asset-purchase program, financial conditions are gradually becoming easier.  Debt-to-income and debt-service-to-income ratios continued to decline in 3Q.  The Fed’s Senior Loan Officer survey indicated that banks’ willingness to lend to consumers has continued to improve and that banks have eased lending standards for consumer loans.  The glaring exception is that mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending.  And the ongoing issues around mortgage ‘putbacks’ continue to keep origination criteria from loosening.

Second, stronger global growth finally seems to be boosting US output.  Following a period in which surging imports overwhelmed domestic demand, and net exports depressed GDP by 3.5 and 1.8pp in 2Q and 3Q, respectively, we expect a sharp reversal in 4Q, with net exports contributing 3.2pp of the estimated 4.3% growth in that quarter.  Some of this volatility is statistical, as Dave Greenlaw and Ted Wieseman will demonstrate in a forthcoming note.  But much is fundamental, as hearty growth abroad and slower growth in US domestic demand augur a narrower trade gap.

Third, the time-honored cyclical dynamics of recovery, delayed by the credit crunch and the legacy of the financial crisis, are finally promoting the hand-off from rising output to increased hours, employment and income.  While November’s employment canvass was disappointingly weak in nearly every respect, including a downtick in the workweek, a broader perspective shows that rising hours have supported moderate gains in wage and salary income, and the improvement in a variety of labor market indicators – declines in jobless claims, rising job openings and surveys of hiring plans – points to renewed job gains.  Finally, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense.  Together with the acceleration we expect in economic activity, and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year.  And we think that improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback’ in outlays after the tax expensing provision expires.

Bottoming in inflation soon, gradual rise coming in 2011. Two factors should promote a bottoming in inflation soon and a gradual rise in inflation over 2011-12: 1) higher inflation expectations courtesy of the Fed, and 2) an acceleration to slightly above-trend growth that narrows slack in the markets for goods, services and housing.  The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed’s preferred gauge (the PCE price index) leaves it well below the Fed’s comfort zone.  While the Fed doubtless welcomes the rise in market-based inflation expectations, it’s not sufficient to make officials comfortable with the inflation outlook; indeed, the FOMC’s central tendency of only 1.3% core inflation in 2012 and 1.6% in 2013 strongly suggests that it isn’t thinking of an exit strategy from the current policy stance any time soon.  Taken at face value, the FOMC’s inflation outlook implies a ‘tighter’ relationship between inflation and slack in the economy than does ours; we expect a faster, albeit gradual rise in core inflation to 1.5% over the course of 2011.

Four downside, two upside risks. Despite these supportive factors, there are four key downside risks to the outlook for growth.  Most are familiar.  First, housing imbalances remain the most significant single downside risk; a decline in home prices larger than the 10% we expect would disrupt further the supply of credit, menace consumer balance sheets, and thus threaten consumer spending.  Second, state and local government finances remain fraught; faced with additional shortfalls, officials might cut spending and employment significantly further, especially as federal grants fade.  The good news is that revenues are starting to improve, which should mitigate that risk.  Third, if Europe’s sovereign crisis were to intensify further, it would (as in the spring) promote renewed risk-aversion and tighter financial conditions.  Finally, if China’s monetary policy tightening were to go beyond the three additional moves we expect, it could trim market expectations for future growth.

Conversely, two forces might promote upside risks to our still-moderate growth scenario.  First, a stronger global economy, especially if it shows up in US exports, could boost growth significantly.  Second, a persistently weaker US dollar could accelerate that process – one that we expect will play out in the next two years in any case.

Source: Richard Berner & David Greenlaw,  Morgan Stanley, December 16, 2010.

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2011 Outlook: Rebalancing, Reflation and Reconciliation

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This post is a guest contribution by Joachim Fels of Morgan Stanley.

Another year, same themes: Looking into 2011, the five key themes we postulated for the 2010 global economic outlook a year ago should remain very much intact. Our ‘tale of two worlds’ continues to unfold, with robust growth in EM economies trumping the creditless, jobless and joyless ‘BBB recovery’ (bumpy, below-par, brittle) in the mature economies.  Within the latter, US economic growth should again top European growth, especially if the fresh tax deal between President Obama and Republican Congressional leaders gets enacted. Moreover, central banks around the world look set to keep policy super-expansionary, thus continuing to provide ‘AAA liquidity’ (ample, abundant, augmenting).  And finally, but importantly, the sovereign debt concerns in the mature economies, which we highlighted as our fifth major theme a year ago, should remain front and centre in 2011.  We continue to think that the European sovereign debt crisis will eat its way through the periphery and start to affect the core, and we wouldn’t rule out (though it is not our base case) that concerns about debt and deficits will also start to adversely affect the US in 2011.

The three ‘Rs’: Against this backdrop, we think that the global macro debate in 2011 will revolve around three ‘Rs’ – rebalancing, reflation and reconciliation – which encapsulate our key themes above. Further progress from the pre-crisis unbalanced global economy to a more balanced one is a pre-requisite for making this recovery sustainable over the next several years. During the rebalancing process, central banks will likely keep policy very expansionary, which should support the ongoing reflation of the global economy and financial markets. However, debt-laden governments are facing the huge challenge of reconciling conflicting claims by their creditors (private and public bondholders) and stakeholders (pensioners and other recipients of public transfers, users of the public infrastructure, taxpayers and public servants) on their limited resources. Which choices governments will be making between the various options – default, engineer strong growth, fiscal austerity, monetisation and/or force lenders to fund them at low interest rates – will likely be key for economic and market outcomes in 2011 and beyond.

Rebalancing: Our country economists forecast some good progress on the road to rebalancing in the upcoming year. In China, consumer spending will become the biggest contributor to GDP growth, contributing more than half of the 9% GDP growth we forecast for 2011, and the current account surplus should shrink by a full point to 3.6% of GDP.  In the US, conversely, net exports are expected to make a positive contribution to GDP growth, reversing this year’s drag on growth. More broadly, external imbalances are likely to shrink in most countries, largely reflecting the rebalancing from consumption to exports in the countries with current account deficits and vice versa in surplus countries.

This ongoing process of rebalancing from export-led to domestic demand-led growth and vice versa has two important implications. First, it requires a shift of resources (capital and labour) from the external to the domestic goods-producing sectors or vice versa, which takes time and thus weighs on growth in the meantime.  This is especially true in high-income economies where workers’ skills and the capital stock are often sector-specific. Hence, the ongoing rebalancing is contributing to the ‘BBB’ nature of the recovery in mature economies.  Second, as capital is often sector-specific, the sectoral shift in the drivers of growth requires new investment in the expanding sectors and should thus support capex globally, despite the fact that there is still considerable spare capacity in the (relatively) shrinking sectors.

Reflation: The combination of undesirably low inflation in the US, deflation in Japan, the ongoing sovereign debt crisis in Europe and a BBB recovery in virtually all of the mature economies implies that G10 central banks will keep their foot on the monetary accelerator for much or all of 2011.  With official interest rates near zero in major economies and quantitative easing in various disguises continuing at least in the G3, monetary policy looks set to remain super-expansionary and will support the ongoing reflation of the global economy, in our view.  True, we see many EM central banks, including the People’s Bank of China, raising interest rates in the upcoming year. However, in most cases we think the tightening will be moderate in order to prevent a sharp deceleration of economic growth and/or excessive exchange rate appreciation.

Given these constraints on EM monetary policies, the AAA global liquidity cycle should remain intact.  Yet, these constraints also imply that the risks to our relatively benign inflation outlook for EM economies are tilted to the upside.

Reconciliation: While rebalancing and reflation should provide support for the global economy and markets in 2011, the reconciliation of the many claims on debt-laden governments remains a gargantuan task for governments and a major source of downside risk to the outlook. In principle, governments have five options to deal with unsustainable debt trajectories: they can default, engineer strong growth, tighten fiscal policy, monetise and/or force lenders to finance them at low interest rates.  Of these, default or restructuring is likely to be avoided at all costs in 2011, given the severe systemic consequences – but that doesn’t mean markets won’t be nervous about potential defaults in the future, especially in euro area member states that are not true sovereigns any more. Engineering strong growth is virtually impossible for any length of time, given the BBB recovery. And a massive tightening of fiscal policy also looks unlikely in most countries outside of the European periphery, as many governments lack the public support to implement draconian measures à la Greece or Ireland.

This leaves most governments with only two options – monetise (if your central bank agrees) and/or take measures to ensure continued access to cheap funding from other sources. As our colleague Arnaud Marès has argued, the latter is inherent in financial regulation that requires banks, insurance companies and pension funds, explicitly or implicitly, to increase their holdings of government bonds for financial stability purposes. Alternatively, cheap funding could come from the IMF and/or other governments as in the recent cases of Greece or (less cheaply) Ireland.  And the former option – monetisation – is inherent in quantitative easing, which raises longer-term inflation risks if the banks’ excess reserves that are created in the process are not withdrawn in a timely fashion once banks start to use them to lend and create deposits.

Source: Joachim Fels, Morgan Stanley, December 10, 2010.

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