2011: Yes to rebalancing, no to asset bubbles and inflation risks

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

We believe that Asia ex-Japan (AXJ) will continue to lead the global growth trend in 2011. We expect regional GDP growth to be at a strong 7.9%, close to the trend-line (trailing five-year average) growth. This strong growth will be premised on sustained domestic demand, as the recovery in exports remains bumpy and below-par. In this context, the region could be effectively forced to move towards a more balanced growth model even as the push to domestic demand is supported by cyclical policy tools including loose fiscal and monetary policy. In many ways, this trend should appear to be similar to 2010. We think that the key difference between 2010 and 2011 will be that, as policy-makers push domestic demand with the support of monetary and fiscal policy, the side-effects of this approach in the form of inflation risks and asset bubble challenge will only exacerbate.

EM to Outpace DM, Led by AXJ

AXJ has seen a strong rebound in growth, led by China and India – a story that we been highlighting for a long time now. The rebound has been driven by domestic demand, supported by the underlying structural growth dynamics of the region and expansionary fiscal as well as monetary policies. In 2011, we expect AXJ GDP growth to be strong at 7.9% (closer to the trend-line of the trailing five-year average) compared with 9% expected in 2010. (Note: 2010 had the benefit of a low base effect in 2009 due to the credit crisis.) While growth in the AXJ region has already recovered back to the trend line, output in developed world countries such as the EU and the US is still below pre-crisis levels. In 2011, our global economics team expects a BBB recovery (bumpy, below-par, brittle) in the G3 economies.

Led by AXJ, the share of EM in world GDP on a purchasing power parity (PPP) basis has already risen from 37% in 2000 to an estimated 47% in 2010. According to the IMF, EM’s share is expected to reach closer to 50% by 2014. Leading this trend in the EM world would be AXJ, with its combined share in global GDP increasing to 30% in 2015 from 25% in 2010 and 16.8% in 2000. On the other hand, the US share is expected to decline to 18.4% in 2015 from 20.2% in 2010 and 23.6% in 2000. Similarly, the share of the euro area could decline to 12.8% in 2015, from 14.6% in 2010 and 18.4% in 2000.

On the Right Track Towards Balanced Growth Formula

The global recession and unprecedented sharp external demand shock have forced Asian countries to face up to the vulnerability in their export growth models. The above-trend global growth of 2004-07 was premised on the imbalanced formula of a debt super-cycle, consumer leveraging in the developed world and a giant export machine in C/A-surplus Asia. US households have now rediscovered the need to save and are unlikely to take on leverage with the same vigor. Asian exporters will therefore find it harder to extract growth beta in the current tepid G3 growth environment. The weakening of Asia’s export model has made it imperative for policy-makers to look for alternative growth sources.

Policy-makers have so far relied more on the easier path of reflating domestic demand via monetary policy easing and fiscal expansion. Monetary policy has been accommodative, with real rates remaining low and the fiscal deficit closer to all-time wides. Policy-makers have increased infrastructure spending and fiscal incentives to encourage consumer spending (see Asia Pacific Economics: Can Domestic Demand Lift the Burden of Rebalancing? July 27, 2009). Indeed, the current account surplus in the region has already almost halved to 3.8% of GDP during the four quarters ending June 2010, from 7.1% during 2007.

To be sure, the need for heavy lifting remains. Efforts to achieve more sustainable long-term domestic demand reflation are at far from desirable levels. The structural factors holding back the region’s domestic demand have been a lack of a social security net, poor public spending support for education and health, low levels of household credit penetration, and low household wealth, which have tended to necessitate higher household savings ratios. An added difficulty comes from the fact that a sizeable portion of savings are held by the corporate sector rather than by households. A closer look at the savings-investment gap for various economies also indicates that there is no single solution for Asia’s domestic demand reflation. In China, private consumption is the weaker link. In some parts of ASEAN, it is the low capex ratio that needs to be worked on. In Korea and India, we see a model already fairly balanced between exports and domestic demand, but there is still potential to lift investments higher.

The good news is that we believe policy-makers in the region are moving in the right direction, initiating structural changes to boost domestic demand on a sustainable basis. In China, policy-makers are steadily initiating measures, such as a rural pension scheme, provision of low-cost housing and increasing minimum wages. The governments of ASEAN, Korea and India are also moving in the right direction to support higher investments to GDP. Indeed, in 2011 we expect policy-makers in the region to continue to initiate more measures in the right direction.

China, India and Indonesia to Lead Domestic Demand Growth in the Region

We are optimistic that the region’s policy-makers will stand up to the challenge of boosting domestic demand on a sustainable basis, with China, India and Indonesia taking the lead. On a PPP basis, the three combined are estimated to account for 79.6% of the region’s GDP in 2010. This push in domestic demand should be reflected in the current account surplus declining further to 3.3% in 2011 from 3.9% in 2010 and 7.2% in 2007. Our China economist, Qing Wang, expects China’s growth to moderate a bit to 9%, with consumption growth at an even faster rate of 10%. We believe that India’s GDP growth will be 8.7% in 2011, compared with 8.5% in 2010, as investment growth accelerates further along with healthy growth in private consumption. In India, we expect private sector spending to accelerate even as government spending slows due to fiscal policy exit.

We also expect investment growth to accelerate in Indonesia, lifting its GDP growth to 6.5% in 2011, compared with 6% in 2010. We think that steady improvement in the macro balance sheet will continue to result in a structural decline in cost of capital, supporting a steady improvement in domestic demand. Similarly, with hopes of an improved political environment in Thailand, the fourth-largest developing economy in the region could also begin to lift its domestic demand, cutting external surplus.

Two Key Challenges for AXJ Policy-Makers

Currently, we believe that the region’s policy-makers are operating with an assumption that G3 domestic demand will continue to remain weak and so they are being careful in reversing the support from monetary and fiscal policy. We think it is imperative for policy-makers to ensure that domestic demand growth remains strong enough to offset the weak external demand. However, this approach brings the challenges of asset price bubbles and inflation. In our base case forecasts for 2011, we are already building in higher inflation pressures, pushing the region’s policy-makers to hike policy rates at a faster pace. Yet, we believe that rate hikes are unlikely to be disruptive. In the following paragraphs, we explain the framework to understand these risks of assets bubbles and inflation in detail.

How Serious Are Inflation Risks?

We believe that one of the key differences for the region in 2011 versus 2010 will be higher inflation pressures. We expect inflation to accelerate to 4.2% in 2011 from 3.1% in 2010 for the region ex India.

We expect policy-makers in the region to continue to support domestic demand in 2011 as we believe that domestic demand in the G3 will continue to see a muddle-through recovery, resulting in weak external demand for the region. With private corporate capex already recovering, we believe that capacity utilization is unlikely to be stretched in the region. However, with sustained strong growth for the second year, we believe that capacity slack is definitely likely to be lower in 2011 compared with 2010. Moreover, higher global commodity prices, even though they are driven by strong growth in EM, will likely begin to increase core inflation pressures.

We believe that policy-makers in the region will continue to manage with a combination of some exchange rate appreciation, some intervention in the FX market and simultaneous sterilization of excess liquidity and gradual tightening in monetary policy as domestic demand sustains high growth. In China, we expect policy rates to increase by 75bp to 6.31% by June 2011 compared with 25bp in 2010. For the region ex-China and India, we expect policy rates to rise by 70bp by June 2011 and an additional 40bp to 4.7% by end-2011, compared with a 40bp increase during 2010. In India, we expect policy rates to rise by 50bp by June 2011 and a further 50bp to 7.25% by end-2011, having already gone up by 150bp in 2010. Considering that domestic demand is the key source of growth, we believe that policy-makers will be careful not to initiate a disruptive rate hike policy unless developed world growth continues to surprise on the upside.

Upside-downside risk scenarios: Pace of external demand recovery will be the key. We expect a BBB (boring, bumpy and below-par) trend in external demand recovery in line with our global economics team’s outlook for domestic demand in the G3. After reaching a pre-crisis peak by July 2010, AXJ exports have been weak over the last 4-5 months, affirming that domestic demand growth in the G3 is unlikely to be strong during this cycle as it continues to suffer from the after-effects of the credit crisis. Indeed, our global economics team has a base case outlook of a BBB (boring, bumpy and below-par) recovery in the developed world. We believe that the region’s policy-makers are likely to aim for sustained growth in domestic demand growth due to this concern on the external demand (i.e., G3) outlook.

We believe that the key factor that will influence the region’s inflation outlook will be the pace of recovery in the developed world (particularly the G3). This will be exports as well global risk appetite and capital inflows to the region. Our base case outlook expects inflation in AXJ ex India to average 4.2% in 2011, from 3.1% in 2010 and 0.1% in 2009. (For 2011 our earlier estimate was 3.4%.) However, if domestic demand in the G3 surprises on the upside, resulting in a strong recovery in AXJ exports, then the risk of generalized inflation pressures will likely increase, forcing the region’s central banks to initiate disruptive rate hikes. Contrary to this, if the G3 were to experience a deeper slowdown, we would expect inflation to be at 3.1% in 2011 and policy rates to be lower than our base case expectation.

Upside Risks to Inflation: Three Key Factors to Watch

We believe that the risks to our inflation forecasts are skewed to the upside. In this context, there are three key risk factors to watch for, including a potential further rise in food inflation, a rise in global commodity prices and persistent rise in asset prices pushing inflation in non-tradables higher.

1)         Food inflation is a bigger problem for developing Asia: Many parts of the region (India, Korea, Indonesia, Thailand and China) have had weather problems. The rise in global food prices at the same time is not helping AXJ. Food inflation tends to be a bigger problem for developing Asia – China, India, Indonesia and Thailand – as the weighting of food in CPI is high. If the upcoming crop season does not suffer from weather problems, food inflation may get a respite, but in the near term food inflation is a given, in our view. While persistent rises in food inflation can also weigh on core inflation through the inflation expectations channel, we think it’s hard to make a call that policy-makers will use monetary tightening in a disruptive manner.

2)         Potential rise in oil and global commodity prices due to the strength in G3 economies: Our base case outlook assumes a gradual rise in commodity prices. However, if commodity prices, particularly oil prices, rise quickly to US$110-120/bbl, markets would become concerned about a potential disruptive rate hike from AXJ policy-makers. The recent QE2 announcement, along with a rise in PMIs in the US, Germany, China and India, has indeed begun to push commodity prices higher even as the US dollar was stable or rising. We believe that this is the most important risk factor to the AXJ inflation outlook.

3)         Excess liquidity means risk of rise in inflation in non-tradable items: An open capital account along with hesitancy over allowing a quick appreciation in exchange rates have led to Asia’s monetary policy being constrained by low interest rates in the G3. Real rates are negative or very low across the region, even while GDP growth has been strong. Although a boost to domestic demand with low interest rates would be welcome, the key challenge for the region will be to prevent asset bubble risks.

Top cities in the region have seen a continued rise in property prices. However, the good news is that almost all central banks in the region are leaning heavily against asset prices, realizing that this is an important issue for achieving sustainable growth without increasing financial instability risks.

Inflation Risks – Bottom Line

•           Upside risks to inflation forecasts are materializing: Headline inflation in the region ex India accelerated to 3.5%Y in September 2010 from 2.9% in June and 1.8% in January. Currently, a large part of the rise in headline inflation in the region is being driven by higher food prices. India is the only country where food inflation is moderating due to a high base effect and better crops this summer.

Sustained growth trend and low interest rates should mean higher core inflation in 2011: We expect GDP growth in 2011 at 7.9% compared with 9% in 2010. While food inflation could moderate with better crops, we believe that core inflation pressures will rise in 2011 as capacity slack will be lower in 2011 versus 2009 and 2010. We expect headline inflation in the region (ex-India) to rise to 4.2% in 2011 from 3.1% in 2010.

•           Base case policy response forecast – acceleration in pace of rate hikes in region ex-India: Considering that domestic demand is the key source of growth, we believe that policy-makers will be careful to not initiate disruptive rate hikes. We believe that in order to achieve greater control of monetary policy, policy-makers in the region will continue to implement capital controls to discourage debt-related capital inflows.

•           Risks to our base case inflation forecasts are tilted to the upside: Three key risk factors to watch: (a) further spike up in food inflation; (b) sharp rise in global commodity prices in short span of time; and (c) persistent rise in asset prices in AXJ pushing inflation in non-tradable higher.

•           Strong recovery in G3 domestic demand would increase the risk of disruptive rate hikes and/or aggressive capital controls: We believe that the policy environment in the region is premised on the assumption of the weak recovery in G3 domestic demand. Hence, any major upside in that could force the region’s policy-makers to initiate disruptive rate hikes to manage the attendant inflation risks.

Deflation risk in DM brings asset bubble risks in Asia: As the G3 continues to see risks of downside growth, policy-makers there are biased to continue with abundant liquidity. The Fed recently announced its decision to increase asset purchases by US$600 billion until 2Q11. On October 6, 2010, the BoJ returned to the zero interest rate policy (ZIRP), and will consider a special asset fund with Y5 trillion (1% of GDP) of extra funding. Interest rates in the G3 are expected to remain low for long periods whereas strong growth and the rise in inflation have meant that the AXJ central banks have started lifting policy rates in the region over the past 12 months. This has already resulted in a widening of spreads between AXJ and G3 policy rates to close to all-time highs. Indeed, if central banks in the region choose to follow our rate forecast path, the spread in rates would only rise, increasing the risk of a further rise in capital inflows into the region.

Open capital accounts along with hesitancy in allowing a rapid appreciation in exchange rates have led to Asia’s monetary policy being constrained by low interest rates in the G3. Real rates are negative or very low across the region, even as GDP growth has been strong. Although a boost to domestic demand with low interest rates would be welcome, we believe that the key challenge for the region will be to prevent asset bubble risks. Top cities in the region have already seen a sharp rise in property prices. As we have learnt from Japan, the unintentional side-effects of loose policy measures from the fuelling and bursting of asset bubbles could be a setback to the longer-term blueprint of domestic demand reflation.

The good news is that the policy-makers in the region are not shying away from leaning against the rise in asset prices and have already initiated measures which reduce the financial instability risks. Almost all central banks have announced measures to control credit allocation to the property sector. Policy-makers have tightened the prudential norms for mortgage lending to check speculative property demand.

Source: Chetan Ahya,  Morgan Stanley, December 6, 2010.

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Brazil: Inflation showdown

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This post is a guest contribution by Gray Newman of Morgan Stanley.

In July, Brazil’s central bank faced significant criticism when it slowed the pace of its rate-hiking cycle – a cycle that had just begun in April – and prepared to stop hiking all together at its next meeting. The abrupt end to the hiking cycle was difficult to understand.  After all, the factors triggering the start of the rate-hiking cycle in April – robust domestic demand, fiscal stimulus ahead of the October elections, and rising inflation expectations – all remained in place in July.

We were puzzled as well. While we noted that domestic production had started to slump, domestic demand (which is a much more important driver of inflation) remained ‘red hot’.  Some argued that political forces were beginning to set the monetary policy agenda.  We argued that however difficult it would be to handicap near-term policy decisions – we ended up removing any hikes from the remainder of 2010 – we expected that the central bank would have little choice but to resume hikes in 2011 (see “Brazil: Slowdown – Comfort or Caution?”, This Week in Latin America, July 26, 2010).  Our call that rates would need to rise to 12.5% in 2011 was widely questioned at the time.

Now, just a month to go before the new administration takes office – and a new central bank governor, Alexandre Tombini takes over as new central bank head – the mystery of July appears to be resolved, at least in part. The abrupt end in the hiking cycle came as the central bank uncovered evidence of possible fraud at the country’s 21st largest lender and began to investigate to see if others were also involved.  The central bank admits that there were “absolutely legitimate” questions regarding its abrupt end in the hiking cycle, but argues that it could not divulge news of the troubled bank pending its investigation.  The implication of course is that with the resolution of the central bank’s investigation into the troubled lender (no other lenders have been implicated), the central bank can resume its hiking cycle.

Indeed, Brazil’s interest rate markets, which only a few months ago had been sceptical of rate hikes in 2011, are now beginning to price in rate hikes as early as the next meeting that concludes on December 8. And inflation readings – last week’s reading of the leading consumer price index, the IPCA-15 (November) posted its second-largest gain (0.86%) for the year – have raised considerable concern that Brazil is facing a major inflation problem.

While we reiterate our forecast that the central bank is likely to restart its rate-hiking cycle in 2011, we would warn against exaggerating the inflation challenge facing Brazil as well as the policy response. Four thoughts are in order.

First, a significant portion of the uptick in inflation as measured on an annual basis may be short-lived – year-over-year inflation is set to rise during 4Q and fall in 1Q11. Indeed, if we set inflation for each month beginning in 4Q with the average (seasonally adjusted) pace seen in 1H10, you would see year-over-year inflation rise by 70bp trough to peak from August to December 2010 and then drop by 70bp through April 2011.  The ‘uptick’ as measured by the annual inflation reading in 4Q would no more tell you about inflation dynamics in Brazil than would the sudden ‘downturn’ in the first months of 2011.

Of course, inflation in October and November are rising above the seasonally adjusted average of the first half of the year.  Our exercise is not designed to argue that inflation is not a concern, but only that the annual numbers released for October and to be released for November and December may exaggerate the worsening just as next year’s readings for the first four months of the year may exaggerate an improvement.

Second, most of the uptick in the annual readings has been concentrated in food: precisely where you should not be focused. While we have seen some broadening in the number of goods facing a larger price increase, the biggest change in recent months in the overall consumer price index (IPCA) has come on the food front.  Food IPCA has risen from a 4.1% annual reading in August to just under 7.5% in October.  While food prices have responded to global pressures, the uptick has been exaggerated again, given the base of comparison used for the annual readings.  Unless you expect to see another major move up in food commodity prices (not the base case for our commodities team, which believes that most prices have peaked), Brazil’s food inflation should show signs of easing in the coming months.

Third, the much bigger concern that we have been highlighting since mid-year is that domestic demand continues to grow at a much faster pace than domestic production (the ‘growth mismatch’). A prolonged period in which demand exceeds supply is likely to lead to higher inflation (as demand outstrips supply), a greater current account deficit (as a portion of demand is met with imported goods and services) or both.  Brazil’s growth mismatch can clearly be seen in both the growing current account needs as well as in worrisome services or non-tradable inflation (see “Brazil: Financing Mismatch”, This Week in Latin America, October 18, 2010).  The real problem facing the next administration’s policy-makers is not that food prices have temporarily risen – in part the effect of base periods of comparison and largely due to external factors outside the purview of central bank policy – but that services inflation has been running above 7% for much of 2010 and well above the overall 4.5% inflation target.  (Indeed it is the strength of the Brazilian real which has helped keep tradable inflation down.  Recall that Brazil, unlike many other emerging economies, is a major exporter of foodstuffs and rising dollar prices have helped to strengthen the Brazilian real, thus tempering the impact on local prices – that is, of course, when the authorities are not limiting the strength of the currency.)

Finally, while we expect the central bank to restart the hiking cycle that was cut short after the July decision, we still have questions regarding the reaction function of the new leadership which takes control in January. We have little doubt that if the current team remained in place, the central bank would resume interest rate hikes – as early as this month or, if not, in January.  But we believe that there is a difference in view among some of the key policy-makers in the next administration, which are intent on lowering Brazil’s real (and nominal) interest rates, with the more immediate task at hand for the central bank.  This can be averted if the central bank makes clear that its actions in early 2011 are in response to the business cycle and does not openly contradict the longer-term, structural view in favour of lower interest rates.

The key for Brazil to be able to reduce interest rates on a structural basis is likely to lie not with monetary, but with fiscal policy. Brazil’s overall fiscal stimulus in late 2010 was little changed from where it stood in mid-2009, despite the rapid rebound in demand.  The fiscal authorities have recently suggested that a significant fiscal adjustment will take place at the beginning of the next administration.  That indeed would be positive and could pave the way for a structural shift away from the current mix in Brazil, which has been dominated by loose fiscal and tight monetary policy.  But again, we await more details from the finance authorities.  In contrast, talk from some policy-makers of a new core inflation measure that would show less inflationary pressure is more worrisome. We think that Brazil’s current mix of monetary and fiscal problems demands a structural rethinking of fiscal policy, not simply a new inflation measure to add to the myriad of inflation indices already present in Brazil.

Bottom Line

Once again all eyes appear to be on Brazil’s central bank as Brazil-watchers await for clues as to when the new leadership will respond with a rate hike. We suspect that the excessive focus on the central bank and its policy response is misguided.  Brazil has a chance to rethink the balance between tight monetary and loose fiscal policy – that is the much bigger macro challenge facing policy-makers, in our view.  Absent significant progress on that front, the next central bank will likely find that it has limited degrees of freedom.

Source: Gray Newman, Morgan Stanley, December 1, 2010.

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Household deleveraging – largest decline on record

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This post is a guest contribution by Asha Bangalore, Vice Pesident and Economist at The Northern Trust  Company.

The soft trajectory of consumer spending and continued reduction in residential investment expenditures reflects the sharp reduction in household debt.  Outstanding home mortgages have dropped from $10.606 trillion in the first quarter of 2008 to $10.126 trillion in the second quarter of 2010 (see Chart 1).  Household credit card debt has fallen roughly $157 billion from the peak in the third quarter of 2008 to $2.41 trillion (see Chart 1).

Total outstanding household debt as a percentage of GDP has fallen roughly six percentage points between 2009:Q1 and 2010:Q2 (see Chart 2).  This decline is the largest on record in the post-war period.  The drop of household debt as a percent of GDP in the early 1980s (48.95% in 1980:Q2 vs. 46.65% in 1981:Q3) was significant but smaller than the current occurrence and it was the result of credit controls imposed in the inflation battle of that period.  The lifting of credit controls led to a sharp reversal in the mid 1980s (see Chart 2).  The root cause of the current deleveraging is an entirely different story where severely indebted households are cutting back on borrowing to finance expenditures.

The reduction in total private sector debt (businesses and households) is also significant and compares closely with the situation after the 1990-91 recession (see Chart 3).  Private sector debt as a percent of GDP peaked in the first quarter of 2009 (177.8%), with the second quarter reading at 167.9%.  A similar reduction in the 1990s was spread over nearly four years.  This sharp decline in consumer and business sector spending has resulted in the elevated jobless rate.  These numbers are being tracked closely for an early confirmation of improving conditions.  It is not a mere coincidence that economic growth gathered steam only after private sector credit growth was visible following the 1990-91 recession.

Chart 3

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 29, 2010.

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EMflation

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

The passing of the ‘sweet spot’ in China almost had a slow inevitability about it, given its recession-defying growth performance and stimulatory policy environment. Policy focus in China now appears to have shifted rapidly from a narrow campaign to curb property speculation last year to a much broader mandate to quell inflation in 2011 (see China Economics: 2011: A Year of Reflation, November 21, 2010). Inevitably, extrapolation is rampant. Will the rest of EM go the China way? Is the sweet spot for EM growth behind us? Just as inevitably, there is no single answer for the entire EM world. Surveying our EM economics team suggests that inflation is not a universal problem in EM, nor is policy tightening likely to be severe enough to derail growth. In economies where inflation is already a concern for policy-makers, commodity prices have played a role in more cases than domestic demand-led inflation. For these countries, appropriate policy tightening is necessary and is likely to have a salutary effect on growth dynamics. In many other EM economies, however, inflation is not a problem (at least not yet). In a few cases, there is enough slack in the economy for policy-makers to focus mostly on growth for now. EM monetary policy-makers are likely to keep tightening policy, but policy rate hikes probably constitute more of a normalisation of the monetary policy stance rather than a move to an outright restrictive position.

Tapping the expertise of our EM teams: Is inflation a problem? Where it is a problem, what are the main drivers of inflation: food and/or energy prices, or domestic demand? Has the slack in the economy dwindled enough to kindle inflationary pressures? What actions will policy-makers take as part of the tightening process? These are the questions we asked our economics teams in order to understand where inflationary tensions lie and what the likely policy response is.

Is inflation a problem? The EM world appears to be split fairly evenly on this issue. Inflation is already a concern in many AXJ economies, notably in India, where the central bank has raised rates by 150bp in 2010 to ward off inflation. To a lesser extent, other AXJ economies (with the exception of Taiwan, Thailand and Malaysia) are wary of inflation and central banks have moved to take policy rates off the low levels that were in place during the Great Recession. The exception to this rule is Indonesia, where inflation risk is moderate but relatively higher than the rest of the AXJ region. Outside the AXJ region, the economies of Brazil and Peru in Latin America and Poland, Hungary and Romania in the CEEMEA region are grappling with an inflation problem as well.

Our China economics team expects inflation to become the macro focus in 2011 because of cyclical as well as structural factors (see again China Economics: 2011: A Year of Reflation). Cyclically, the lagged effects of ultra-expansionary monetary policy are expected to drive inflation higher. Structurally, the shift in production from the tradable to the non-tradable sector will lower overall productivity, leading to higher inflation. Policy-makers will be keen to push inflation expectations lower, possibly through a combination of some constraints on domestic credit expansion and/or constraints on money growth, some currency appreciation and policy rate hikes.

In other EM economies, inflation is not an immediate problem: In some cases, overall inflation is not high and the metric that matters for policy-makers, core inflation, has remained well behaved (e.g., in Malaysia and Thailand). In other economies like Mexico, Russia and the UAE, the slack in the economy is large enough that the risk of inflation rising sharply seems to be a small one.

Where inflation is a problem, what are its main drivers? Inflation being a concern for policy-makers is a necessary but not a sufficient concern for an aggressive tightening of policy. It is very important to identify the drivers of inflation. Is inflation driven by food or energy or other commodity prices? Or is stronger domestic demand responsible for inflation concerns? If it is the former, policy reaction is likely to be muted. However, central banks will be more likely to take action to quell domestic demand if it is pushing inflation higher.

Food and energy inflation as drivers of inflation: If headline numbers are driven by internationally traded commodity prices, EM central banks are likely to adopt an approach similar to the one they had in 2007. Then, EM central banks resisted tightening as international commodity prices were driven by strong global demand and central banks were individually incapable of lowering international prices through tighter monetary policy. Clearly, collective action would have helped, but the difficulties of creating such a like-minded group and the difficulties of sustaining commitment in this monetary policy cartel would have proved formidable – and this when growth was exceptionally strong globally without a strong hint of the oncoming global recession. Today, a similar consensus appears to exist among EM central bankers, but for very different reasons. EM economies now appear to be growing sustainably, providing a bid for food, energy and other commodity prices. At the same time, ultra-loose monetary policies from the major central banks have pumped enough liquidity into the system to drive up asset and commodity prices. Getting EM central banks to collectively hike rates by enough to offset liquidity injections from the major central banks appears to be close to impossible, given that this would almost certainly put domestic growth in the EM economies in question at risk.

And indeed, food inflation appears to be the main driver (or the joint main driver) of inflation in a large number of EM economies. The big risk, naturally, is one of second-round effects of food price inflation on core inflation. This is particularly true where food inflation is high, domestic demand is strong but domestic demand-led core inflation has not yet picked up. The ideal example in this category is Indonesia, where food inflation has been a problem for a while and where domestic demand has been strong as well. The risk of a pass-through from food to more general inflation is therefore a worry. Turkey shares similar concerns but food prices are expected to normalise there, cutting down the risk of a pass-through into more general inflation.

Domestic demand-led inflation: In a handful of economies (Brazil, Indonesia, Israel, South Africa and Saudi Arabia), however, domestic demand-led inflation is the most important concern (though Israel really has only a housing price inflation worry). Of these economies, Indonesia has been pointed out as the economy that has moderate risk both from domestic demand pressures as well as the risk of pass-through from food prices to overall inflation. Brazil and Israel have both used rate hikes so far, partly to address inflation concerns. Both central banks are expected to further raise policy rates in order to bring inflation under control as needed.

Is slack so little now that inflation is likely to be a problem in the near future? A surprisingly large number of economies report that economic slack is still present, but that the output gap is not very wide.

In some economies, the output gap is closed, indicating that a continuation of rapid growth may start putting upward pressure on inflation going forward. In some cases, the output gap is still negative and quite large. Prominent in this category is the Russian economy, where the output gap has narrowed but still remains quite large. It is not surprising, then, to note that Russian policy-makers appear to be giving much more support to pro-growth policies than to anti-inflation ones. The South African economy is the other economy where the output gap is large enough for policy-makers to ignore inflation concerns for the moment. Two rate cuts of 50bp each recently delivered by the SARB provide strong evidence of this.

What is the policy response likely to be? In light of the above, it may appear somewhat surprising, at first blush, to note that monetary tightening seems to be almost universal in the EM universe that we cover. However, monetary tightening becomes easier to understand when we differentiate between normalisation of rates and moving to an outright restrictive monetary policy stance. Many of the policy rate hikes, particularly in the case where the output gap is still negative and inflation is not a problem, represent normalisation of policy to a stance that is a little less expansionary. Even in the economies where inflation is a problem and the output gap has either closed or is very narrow, we don’t expect policy rates to be hiked to an extent where they will begin to hurt growth. Even for the outperforming AXJ economies, policy tightening is likely to be calibrated to just keep growth from rising further rather than pushing it lower. Policy actions are thus unlikely to derail growth in the EM economies.

Constrained by the trilemma: Even if monetary policy-makers wanted to be aggressive, they would be bound by the constraints of the trilemma (monetary policy-makers can achieve only two out of the trinity of unconstrained capital flows, a stable exchange rate and independent monetary policy).

At a time when capital inflows into EM economies have been aggravated by the Fed’s QE2 salvo, avoiding currency appreciation will severely limit the amount of monetary tightening central banks can attempt. Of course, central banks may choose to break the flow of capital into the domestic economy through the use of capital controls, but to do that, they would have to rival the extensive controls that China has in place. In our view, the kind of capital controls we have seen so far (taxes on capital inflows into domestic fixed income markets) are more likely to change the composition of inflows towards equity flows, but not change the overall level of capital inflows.

Which monetary policy tools? Contrary to their developed market peers, EM central bankers are not reluctant to use the many tools at their disposal, including policy rates, the exchange rate, liquidity constraints, capital controls and even strong moral suasion to banks regarding lending activities. Focusing on a narrow set of tools, however, interest rates and exchange rates appear to be heading higher going forward, except for India, Thailand, Hungary and Brazil, where there appears to be limited scope for further currency appreciation. In many cases, policy-makers may prefer to have less currency appreciation but may not be successful in warding off capital inflows and the resulting upward pressure on their currency. In any event, EM economies appear to be set for a gradual appreciation of their currencies, probably thanks to a combination of tighter monetary policy and steady capital inflows in line with the constraints of the trilemma.

In summary: The policy response to inflation in overheating economies is likely to lead to a salutary slowdown in these economies rather than a hard landing. Where inflation is not a problem, policy rates may be hiked, but this will likely be more for the purposes of normalisation of policy rates than for creating a restrictive monetary policy stance. If successful, these dual strategies should allow solid growth to persist in the EM world. The key risk remains that the combination of relatively easy domestic monetary policy in EM countries and even more easy money imported from the leading economies will push inflation higher. The policy response then would have to be stronger if EM central banks wish to protect medium-term growth by keeping inflation under control.

Source: Manoj Pradhan, Morgan Stanley Views, November 26, 2010.

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Natural gas: Worse than coal and diesel in greenhouse emissions?

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This post is a guest contribution by Dian Chu, market analyst, trader and author of the Economic Forecasts and Opinions blog.

Natural gas has long been touted as a cleaner alternative because it releases about half as much of the greenhouse gas carbon dioxide as coal does. Although the natural gas market is in the doldrums right now due to a supply glut, with advocates like T. Boone Pickens pitching it as the fuel of the future, many market players are betting on increasing natural gas demand from transportation fuels and the generation of electricity to continue for years to come.

Well-to-Wheel: 25% CO2 Reduction

Indeed, the U.S. Congress is considering a bill − Natural Gas Vehicles (Division B, Title XX) − that would push to replace diesel with natural gas in heavy vehicles. Part of the argument is that natural gas is substantially cleaner than diesel − about 25 percent less greenhouse gas emission.

In fact, a working paper by the International Energy Agency (IEA) says this much: on average, a 25% reduction in carbon dioxide equivalent (CO2-eq) emissions can be expected on a well-to-wheel (WTW) basis when replacing gasoline by light-duty vehicles (LDVs) running on compressed natural gas (CNG).

Lifecycle Analysis: 60% more CO2.

However, not everyone is that certain about natural gas’s green prospect.  Dr. Robert Howarth, professor of ecology and environmental biology at Cornell University, indicates that using natural gas rather than diesel in vehicles could actually increase climate change, according to his preliminary finding dated Nov. 15 of a research paper to be under peer review.

“Using the best available science, we conclude that natural gas is no better than coal and may in fact be worse than coal in terms of its greenhouse gas footprint when evaluated over the time course of the next several decades.”

His preliminary analysis includes not only the amount of carbon dioxide from the combustion emission, but also the impact of natural gas leaks from Methane. By adding methane into the “lifecycle” calculation of climate impact, natural gas could be significantly worse than diesel and coal (see graph).

Howarth’s results show that using natural gas would emit the equivalent of 33 grams of carbon dioxide per megajoule − about 60 percent more than just 20 grams of carbon dioxide per megajoule by using petroleum fuels.

Separately, MIT also came up with a study that on a CO2 equivalent grams per megajoule basis, diesel scored at 10.7 and gasoline at 14.4, with natural gas smack in the middle at 12.5.

The two studies make different assumptions and therefore yield significantly different results. Although natural gas is the focus of both papers, they illustrate there’s a need for a more thorough study to fully assess the potential full impact before passing legislations promoting any fuel source.

Part of Natural Gas Vehicles (Division B, Title XX) U.S. Senate bill would incentivize the development of natural gas vehicles by providing $3.8 billion in rebates.  The rebate costs are to be offset by increasing the amount of money oil companies pay into the Oil Spill Liability Trust Fund, from 8 cents per barrel to 21 cents per barrel. And this 13 cents delta most likely will end up in our gas tank.

So, in short, in a rush to meet the emission goal, we could be subsidizing something that might or might not yield the climate change result as expected. It is standard practice in business decision process to look at the “total cost of ownership” (TCO) of a new product or service. Legislation should undergo a similar vigorous evaluation process as well.

Source: Dian Chu, Economic Forecasts and Opinions, November 22, 2010.

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Is inflation lurking around the corner?

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This post is a guest contribution by Asha Bangalore, vice president and economist at The Northern Trust  Company.

The potential inflationary impact of the second round of quantitative easing, QE2, is at the top of the list of charges critics have complied against the Fed.  Let us look at the current evidence on inflation, inflation expectations, and the Fed’s tool kit to fight inflation to conclude if the fear of inflation is credible.

Starting with the Consumer Price Index (CPI), the October CPI rose 0.2% and the core CPI, which excludes food and energy, held steady.  The year-to-year change of both price measures shows a decelerating trend since the early part of the year (see chart 2).

The Fed’s preferred price measures of personal consumption expenditure index and the corresponding trimmed mean index from the Dallas Fed also indicate a low inflationary environment (see chart 2).  Therefore, there is no evidence of a sharp increase in prices, currently.

Moreover, there are ample unused resources in the economy.  The operating rate of the nation’s factories is roughly 8 percentage points below the historical average (see chart 3).

Continue reading Is inflation lurking around the corner?

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