Not the Time to Slow the Pace
January 23, 2007
By Gray Newman | New York
When Brazil’s central bank announces its decision on Wednesday January 24, there is little doubt that it will cut interest rates once again. Inflation expectations have fallen since the Copom last met on November 28 and 29, and the uptick in inflation of late has been limited to seasonal factors. Indeed, there is near unanimity in the market that inflation in 2007 will remain below the central bank’s target of 4.5%. Nonetheless, the market is divided, as was the Copom in its November meeting, on whether the rate reduction will continue at a 50bp pace or slow to 25bp.
We argue that the Copom should cut by 50bp. And because we believe that the Copom will make its decision based upon a thorough review of the latest economic data, we suspect that it will cut by 50bp, although a split in the voting is likely to remain. We would highlight three reasons for our call for 50bp. First, inflation expectations have been falling and remain below target. Market expectations for 12 months ahead have been below the 4.5% target since February 2006. In fact, the market is currently forecasting 2007 inflation at 4.03%. With actual inflation at 3.1% in December 2006, a strong real, high real rates and commodity prices coming off at the beginning of this year, there are no serious inflationary pressures in sight. Second, inflation remains below target. On a month-to-month basis, inflation has been well behaved, with readings of 0.21% in September followed by 0.33% in October, 0.31% in November and 0.48% in December. We are sanguine about the inflation outlook in Brazil since transitory factors account for the higher sequential rates in recent months. The main source of inflation in recent months has been agriculture — a transitory supply shock due to bad harvests. On a month-to-month basis, food inflation was 0.9% in October, 1.1% in November and 0.39% in December. In fact, the December data suggest that the food inflation shock is now virtually over. The main source of inflation in December was the adjustment of transportation sector tariffs — a one-off event. On an annual basis, inflation has been coming down steadily and ended the year at 3.14% after touching 3.02% in November. The only major subcomponent which remains above the headline target is non-traded goods inflation, which registered 5.45% on an annual basis in December. However, with a weight of under 35% of the IPCA basket, a continued disinflationary trend and a strong real keeping tradable inflation under control (1.03% y-o-y in December), we don’t expect this to be a major problem in the months ahead. Third, the real economy is showing mixed signs. Retail sales remain strong, up 9.2% in November. And industrial output gained ground in October, up 4.9%, and in November, up 4.2% — both reports showed month-over-month gains near 1% and hence double-digit annualized gains. But the retail sales growth is not new: it has been gaining ground since the third quarter of last year even as inflation — both headline and core — was falling. And the strongest growth in industrial production is coming from the capital goods sector: a positive sign suggesting that investment spending is gaining ground. It is true that domestic demand is growing more rapidly than the overall economy — in the first three quarters of the year, domestic demand averaged 3.9% versus 2.5% for GDP — as imports help to pick up the slack. And it is also true that this cannot continue indefinitely. However, we find this to be a curious and largely inappropriate criticism, given the size of Brazil’s near-record trade surplus and significant current account surplus. Excess in anything can kill, but Brazil does not even have a small current account deficit, much less one of a worrisome size. Indeed, we would encourage the 25bp camp to revisit May 2006: by the end of April, the Copom had cut interest rates by 400bp to 15.75%, and some might have argued that a pause was warranted to see what the impact of the cuts would be on aggregate demand and inflation. By May, the Copom had already been talking about the need for parsimony for a few months, and rates stood near record-low nominal levels. It is a good thing that the central bank did not move to pause: in the following months inflation fell. The fall in inflation was broad-based — with or without food, in core and headline measures — while domestic demand gained ground. While we agree that the central bank cannot wait until inflation rears its head to begin to act, given the fact that the gap between interest rates today at 13.25% and inflation at 3.1% remains so wide, we would argue that the burden of proof rests with those who would favor slowing the pace of the rate cuts. One of the most popular arguments circulating in Brazil in favor of a 25bp cut invokes personalities rather than policies. It argues that one or more of the minority of three that voted for a slowing in the pace of rate cuts last month will insist on slowing the pace of cuts. We also hear the argument that a group of the Copom members will now target 4% or treat 4.5% as the upper end rather than the midpoint of the inflation target. I find both discussions disturbing: Brazil’s central bank has a mandate to target inflation. The most likely path of inflation, rather than personalities, should drive the Copom’s decision-making process. The National Monetary Council has set that target at 4.5%. The wisdom of that target can be debated, but it is not the role of the central bank to make that change. There is also the matter of the lack of clarity on the fiscal front. A long-awaited program of economic reform measures was postponed repeatedly in late December, and while the final program is now set for release on Monday, January 22, it does not appear that Brazil’s policymakers will make much, if any, progress in reforming Brazil’s fiscal quandary, which includes an inadequately funded social security program and an ever-increasing spiral of current expenditures and tax burden. That concerns us and we suspect that it concerns the central bank as well. Inadequate fiscal provisioning can determine what the long-term equilibrium interest rate is, but we are suspicious of it having much, if any, impact on the pace of rate cuts today, especially considering the current gap between inflation, demand and interest rates. Bottom line Inflation in Brazil has plummeted even as real rates have remained largely unchanged. To some, this may appear to be an indictment of the current policymakers’ stance. We would argue to the contrary: we believe that the policy stance of the central bank is setting Brazil up for a period of extended low inflation, which in turn should allow real rates to drop farther than most Brazil watchers can imagine today. We would like to have seen more clarity from Brazil’s fiscal authorities, but doubt that it should have a significant impact on inflation dynamics in Brazil in 2007 and 2008. That in turn should allow the central bank to reach 11.25% by year-end 2007 and 10% in 2008.
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Domestic Demand Recovery Underway
January 23, 2007
By Chetan Ahya | Mumbai
Summary
Indonesia’s domestic demand appears to have finally started reviving after showing a weak trend over the past year. Signs of domestic demand recovery are evident in most cyclical indicators, including auto sales, electricity consumption, non-oil imports and credit growth. We expect domestic demand (ex inventories) growth to accelerate over the next 12 months. We believe that both monetary and fiscal policy will be able to support a revival in domestic demand. Macro stability continues to improve … Indonesia’s macro stability indicators have continued to improve over the past 12 months. The fiscal balance remains within a comfortable range, enabling a steady reduction in public debt/GDP. The current account surplus has widened and has helped to reduce the external debt burden. Improved macro stability in turn has led to better sentiment regarding the currency, thereby containing inflationary expectations. … supporting normalization of interest rates
Bank Indonesia has cut the policy rate (1M SBI rate) by 325bp since April 2006 to 9.5%. We believe this could be reduced by an additional 75bp by end-2007. The rate cuts are likely to happen at a more gradual pace though (i.e. at 25bp per meeting instead of the average rate of 50bp seen in the past few months) and lead to a decrease in real interest rates to a level of about 2.5-3.0%. Commercial banks’ lending rates have not yet fully reflected the quantum of BI rate cuts. Although the borrowing costs for corporate and consumer loans have started to decline over the past six months, banks have been lagging Bank Indonesia’s rate trend so far. Hence, bank lending rates are likely to fall by more than the BI rate cuts in 2007. We believe that this should reinforce the recovery in credit demand that is just beginning to pan out. Fiscal policy focus shifting from stability to stimulus
The government’s balance sheet has witnessed significant structural change over the last few years, with the public debt/GDP ratio falling to an estimated 36.4% as of end-2006 from 100% in 1999. We believe that the government’s balance sheet has transitioned from a phase of fiscal adjustment to now having the fiscal capability to stimulate the economy. Our broad analysis indicates that public debt/GDP will continue to decline until the fiscal deficit/GDP ratio remains below 3.5%. Hence, we believe that the government has adequate room for pursuing productive public capital expenditure even if it requires some expansion of the fiscal deficit. The government has been attempting to change the mix of public expenditure in favor of development spending. We believe that this is beginning to provide some acceleration in infrastructure spending. Indeed, in our view, the inflection point in infrastructure investment trends has already occurred. In 2006, government estimates indicate that real public infrastructure spending grew 26% YoY. Moreover, there is also likely to be a modest rise in private sector participation, particularly in the roads sector, in response to continued efforts to reform the PPP-related institutional framework. In the telecom sector, private sector participation has already increased significantly. We believe that, if the government continues its efforts to implement reforms related to the infrastructure sector with the same vigor as witnessed in the last two years, Indonesia’s infrastructure investments could increase to at least 3.5-4% of GDP (in line with the average in developing countries) over the next 4-5 years from around 2.3% seen in 2006. Recovery in domestic demand
With the aggressive monetary easing undertaken by the central bank since 2Q06, most cyclical demand indicators are now showing signs of recovery. Some of the key data that point towards recovery include: • Credit growth: After decelerating sharply from the peak of 31% YoY in September 2005 to 9.7% YoY in August 2006, Indonesia’s commercial banks credit growth picked up to 12.1% YoY in November, driven by higher loans to the services and manufacturing industries. • Non-oil imports: Momentum in non-oil and gas imports, which is a broad measure of domestic demand, has also improved considerably, accelerating to 21% on a YoY 3MMA basis in November 2006 from a low of -7.5% (3MMA) in May 2006. • Industrial production: The three-month moving average of industrial production growth recovered to -0.4% in October (last available data point) from a low of -7.7% in March 2006. • Auto sales: While still in negative territory, both motorcycle and car sales growth has decidedly bottomed out from the -29% and -54% YoY seen in the middle of 2006. Motorcycle sales and domestic car sales were -9.7% YoY and -12.3% YoY, respectively, in November. External demand likely to be a dampener
We believe that weakening external demand in the coming months could to some extent, offset the acceleration in domestic demand and weigh on overall growth. Non-oil and gas exports in Indonesia accelerated to a peak of 26% YoY (3MMA) in November (versus 10.7% in April) on the back of exports of raw/crude materials despite the export deceleration seen in other ASEAN countries. However, the next 12 months could see slower growth in exports on account of sluggish growth in importing countries and weaker oil and gas prices. The US ISM New Orders, which have historically led Indonesia’s export growth by about six months, are signaling a palpable slowdown ahead. Potential reversal in global risk appetite a key risk factor
Indonesia has witnessed a significant turnaround in its balance of payments in the last four quarters, from a deficit of 1.3% of GDP in the quarter ended (QE) September 2005 to a surplus of 5.4% of GDP in QE September 2006. This improvement is supported by a high level of basic balance (comprising the current account balance and FDI), which accounted for two-thirds (at 3.4% of GDP) of this surplus in QE September 2006. However, the remaining one-third is made up of relatively less stable inflows, including portfolio equity and debt. We believe that any sharp reversal in global risk appetite will weigh on these less stable inflows and, therefore, the domestic interest rate environment. The echo effect of the global capital markets instability on volatility of Indonesia’s exchange rate and therefore inflation and interest rates has been high due to its relatively lenient capital account controls. Bottom line
We believe that Indonesia’s domestic demand growth recovery is underpinned by structural as well as cyclical factors. We estimate that Indonesia is likely to be the only country within the ASEAN-5 region to see acceleration in its GDP growth in 2007 amid the global soft landing. We acknowledge the contribution of Tanvee Gupta to this report.
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