UK
Fundamental Reasons to Be Optimistic on Inflation
April 27, 2007

By David Miles | London

Inflation has moved up fairly sharply in the UK over the past six months. It crossed the 3% level (based on the consumer price index) a few weeks ago — the first time it has risen more than 1% above the target level in the ten years since the Bank of England was made independent. Retail price inflation — a measure more widely used in assessing changes in the cost of living — is almost 5%.

We have argued that the next moves in inflation in the UK are likely to be down and that in the near term inflation is likely to move back — perhaps rather quickly — to target. But these short-term — and likely favourable — movements in inflation should not be seen as proof that there is no longer-term inflation problem in the UK.

The big question is whether the forces that have kept UK inflation low over the past 10 years are gradually unwinding so that inflation pressures over the next decade will be a good deal higher than since the late 1990s. The answer to that question is the most important factor in determining whether people who buy and hold longer-dated UK government bonds with yields at around the 5% level will get a decent return.

The centrality of labour market conditions

For the great majority of companies, by far the most important component of costs is wages and salaries. In the UK labour costs are on average about two-thirds of costs of production across the economy. So, the most important forces behind the generation of domestic inflation pressures over the next decade will reflect what is happening in the labour market. And it is here that fundamental factors at work are likely to keep inflation pressures in check.

First let’s look at recent history. Over the past few years — and despite the sharp increase in retail price inflation over the most recent period — there has been remarkable stability in the rate of wage increases. Excluding volatile bonus elements — which are discretionary to companies and not part of permanent wage costs — average annual wage settlements have stayed within the 3.5-4% level for some years. At the same time — and related to this great moderation in pay deals — corporate profitability is high, which means that firms are not struggling to keep their heads above water. We are not in an environment where companies are desperate to push up prices faster than costs so as to increase the return on corporate capital from below a sustainable rate.

Why have wage costs moderated so much?

There are three factors that have been behind the moderate level of real wage increases.

1. The labour force has been boosted substantially by large flows of immigrants — perhaps 500,000 workers from Eastern Europe have come to the UK since the accession of new countries to the EC a few years ago. This is a major factor behind the relatively rapid expansion of the labour force.
2. The degree of slack in the labour market is likely to be greater than suggested by standard measures of unemployment. Measured unemployment in the UK is well below the European average and also low relative to the UK average over the past few decades. But for many years the number of people who are getting sickness benefits, and not counted as unemployed, is vastly greater than those getting unemployment benefits.

This third factor is particularly important but often overlooked. In the UK over 2.6 million people claim incapacity benefit — that is, they receive a welfare benefit based on an assessment that they are too sick to work. They do not count as unemployed. The number of people claiming unemployment benefits — the so-called job seekers’ allowance — is under a million. There are around three times as many people of working age on sickness benefits as are receiving the job seekers’ allowance. It is likely that a significant proportion of those receiving incapacity benefit could work. The degree of hidden unemployment in the UK is therefore likely to be very great.

Of course, if those people who could work and are receiving incapacity benefit are — and will remain — outside the labour market, then maybe the huge numbers on sickness benefits don’t really create any labour market slack. But it is now a matter of priority to the government to get those who are of working age and claiming sickness benefits, but who can work, back into the labour force.

Already some proportion of the huge numbers on incapacity benefit may effectively be looking for work. Government pressure will be relentless over the next decade in raising that proportion. For that reason, even in the absence of continuing high immigration, the labour supply can rise a lot in the UK and likely will. To put it another way, the true level of unemployment in the UK is very much greater than official measures suggest and likely much nearer the European average than one might think. That will be an important factor in keeping domestically generated inflation pressures in check.  That is the main reason for being optimistic about the inflation outlook over the medium term.

 

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Japan
A Sense of Some Wavering
April 27, 2007

By Takehiro Sato (Tokyo)

Typically hawkish, but finer details also point to some BoJ ‘wavering.’

Some of the risks regarding wages/prices and overseas economies cited in the previous October Outlook Report are emerging, but the April Outlook Report maintained the bullish scenario and forward-leaning stance on monetary policy.   Overall, the Outlook Report is typically hawkish, but in the fine detail we also get a sense of some wavering on the part of the BoJ.   Its statements on the management of monetary policy going forward, too, could be interpreted as a half-step retreat.

The median GDP growth forecast in the policy board’s F2008 outlook is almost unchanged at +2.1%, but the forecast for the core CPI inflation rate of +0.1% has been lowered more than expected from last October’s +0.5% following weak CPI results out the same day.   Our impression is that this revision is too small (our forecast, after taking into account nationwide core data for March, is -0.1%), which means there is still some skepticism over the Bank’s outlook, but the downward revision itself was no surprise. The outlook for the economy and prices in F09, released for the first time, calls for steady economic growth of around 2% and relatively major improvement in prices of +0.5%. Under its forward-looking policy orientation adopted since the end of quantitative easing, the BoJ is keen to focus more on price rises to come than on weak price levels currently.

Overall, the Outlook Report leaves a typically hawkish impression, but we also get a sense of some ‘wavering’ on the part of the BoJ in the finer detail.   Actual prices have continued to trend below the BoJ’s forecasts, where the Bank does not have an impressive track record.   In the face of its forward-leaning stance, markets are likely to remain of two minds, continuing to price in a rate hike in August-September but without much conviction.   We doubt a unified consensus will form, since prices are expected to hold in negative territory for a duration that can hardly be deemed “temporary.”

Still see risk of price outlook being worse than expected. 

As above, the outlook for the economy is broadly unchanged.  The view on the current condition of private consumption is that the pace of improvement in the household sector has been ‘somewhat slow.’  On the other hand, with regard to the outlook, while acknowledging the delay in wage recovery, the report said that private consumption is likely to follow a moderate upward trend, in line with the upgrade in the February post-rate hike Monthly Report view that ‘private consumption has been firm.’

Regarding the current assessment of the corporate sector, the new fiscal year capex plans seen in the Tankan got off to a good start overall, especially in non-manufacturing industry, and the BoJ is gaining confidence about the current situation, now characterized as ‘strong corporate performance is likely to continue.’  For the capex outlook, the assessment is now ‘the rate of growth in business fixed investment will likely fall gradually,’ as some downside risks are coming to the fore with the coincident index of business conditions below 50% for two consecutive months, wage declines widening, and signs of real correction in the US housing market.   The overall tone is still upbeat, however.

The price outlook is for an improving trend even with the core CPI in negative territory. As it did in the October Outlook Report, the BoJ has again formally recognized that the sensitivity of prices to the output gap is diminishing, and thus the basis for forecasting price growth is very fragile. With price risks recently coming to the fore and with further deterioration in wages (one of the key props for a stronger price outlook), contrary to the Bank’s initial expectations, a convincing statement of the case for price recovery would be welcome.   This is likely to be wishful thinking, however.

To achieve the F08 outlook of +0.1% YoY, the so-called ‘core of core’ index would need to show YoY improvement of between +0.05 to +0.06 ppt every month from April.   The recent steady, low core-of-core readings suggest this is a tough task, and that another undershoot of the BoJ’s price outlook is likely.

Judging from the shape of the recently flat Phillips curve, we take seriously the possibility that the core CPI could remain negative almost throughout 2007.   Note that even if the output gap becomes more positive (the inflation gap widens), due to the marked lowering of price sensitivity, mechanical application of an econometric model could show absolutely no improvement in the core or core index.

Market implications

Regardless of whether its forecasts are on the mark, the BoJ’s outlook for the economy and prices is upbeat, and suggests that monetary policy will continue to normalize.   However, some subtle differences are discernible in the conclusion section.   The conclusion from the October report (‘the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices’) has been rewritten: ‘The Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation.’  In other words, they will adjust interest rate levels depending on the degree of improvement in the economy and prices; the other way around it could be read as saying that rates will not be adjusted unless there is improvement.

In addition to these subtle differences of impression, the growing uncertainty about overseas economies and the move back into negative territory for prices makes it unlikely that this Outlook Report itself will prompt the market to bring forward its expectation for the timing of a third interest rate hike. The BoJ has a poor track record for forecasting prices, and with the price trend set to be negative for some time to come, the market is likely to remain unreceptive to any campaigning for higher interest rates.

Risks

A path of steady growth for the economy from the April-June quarter onwards cannot be taken for granted.   The onset of a correction in manufacturing industries and negative growth for capex make this a crunch time for whether the US economy will miss a soft landing and go into a deeper soft patch, and subprime problems have caused financial institutions to rein in lending attitudes to individual borrowers.   This could well affect near-term US consumption, with a knock-on impact on the booming Japanese automobile exports.   The production rebuilding in manufacturing industry could therefore be unexpectedly limp from the April-June quarter, exacerbating the risks of a slowdown in Japan’s economy from mid-year, as happened in 2004.   We are also wary that the healthy expansion in domestic consumption in January-March may not carry past June, when local tax rates will in effect be raised.

If price deflation intensifies towards the summer and April-June GDP is weaker than foreseen, the market’s consensus for a rate hike in August or September could be blown away in a trice.   Our main scenario for the economy is basically upbeat like the BoJ’s, but does incorporate some degree of slowdown in the April-June and July-September quarters, and also factors fully for negative prices.   For us the ‘risk scenario’ therefore has a comparatively high probability and is not just an outside possibility.

 

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Japan
Financial Reform Mid-Term: B+
April 27, 2007

By Robert Alan Feldman (Tokyo)

The Report Card

The interim report of the government’s committee on financial sector reform was published recently.  The report is the first of a series of reform reports from task forces that PM Abe organized, and that will form a pillar of the ruling party’s platform for the Upper House elections in July.   The report is thus a harbinger of the aggressiveness likely to be seen in reports in other areas.

The financial sector report makes path-breaking proposals in many areas and is a major step forward.   In particular, the report is strong in areas such as personnel access, market rules and customs reform, new product innovation, and legal and accounting reform. However, its proposals on regulatory reform fall short, and the report fails to mention two crucial areas -- media reform and confrontation of organized crime.

With a touch of presumption, I give the report an overall grade of B+.   This grade reflects my subjective evaluation of the content of the report, according to the categories I outlined in my note of February 14, “Japanese Financial Market Competitiveness:  Concrete Ideas.”   I have added subjective weights of the different categories.   My overall grade of B+ is based on a “core subject” concept, i.e., that some aspects of the reform are core and others (somewhat) peripheral.   On core subjects, the report has a grade point average of 8.65, or a B+.   If the non-core subjects were included with my weightings, the overall grade would be B.

B+ Is a Good Grade

In these days of grade inflation, there is a tendency to see anything short of an A as a bad grade.   Not so.   Indeed, by the tough standards of global financial markets, a B+ is a good grade.   This is particularly true in light of the complexity of the subject and the short time that the CEFP subcommittee had to work.   Indeed, it is something of a minor miracle that the report could contain as much as it did.

That said, there is still much work to be done.   Hammering out concrete steps in some areas will be difficult.   For example, the report advocates a more thorough separation of professional and amateur investors.   This is a major step forward, because it separates the areas of application for the two competing philosophies of regulation, paternalism and self-responsibility.   However, there remains a need to write clear guidelines on where to draw the line between amateur and professional, and how to adjudicate disputes.   What should these guidelines comprise, and who will write them?   Who will check whether the guidelines serve the interests of the economy or merely those of the regulator?   Another tough issue will be accounting convergence, where the need to avoid extra disclosure burdens conflicts with the need to have common international standards.

Constant vigilance is needed.   The devil is in the details, and the details will be hard to find.   Most details are decided at the working level in regulatory agencies, far from the light of public scrutiny.   The media are not likely to help.   First, those involved in making the decisions often have an incentive to keep the information confidential, and so information is likely to emerge in the media only sporadically.   Second, even if information is available, few journalists have the degree of expertise needed to understand the implications.   Finally, interest in details of financial reform is limited (until things go wrong), and so the economics of taking up space in media do not favor broad exposure.

The Omissions

The major omissions from the report, organized crime and the role of the media, are understandable in one sense.   These issues have traditionally been taboo in the discussion of financial markets.   However, neither can stay off the agenda much longer.

When economic activity picks up, the activity of organized crime naturally increases as well.   The costs of ignoring the issue are demonstrated by the recent murder of a candidate for mayor in Nagasaki, by other brazen murders, and by the bombing of a newspaper office.   Indeed, PM Abe has twice referred to these incidents in his weekly e-mail magazine, implying increased attention to the issue.

The role of the media is also under increased scrutiny.   For example, a recent newspaper headline stated that a certain company would be de-listed.   Although the source of the report was not made clear and the wording of the article was not definite, many investors concluded that the report was true.   Because many funds are prohibited from owning de-listed stocks, some sold the stock on the news.   The story, however, turned out to be wrong, and these investors lost money.   Separately, a television station reported an action at a recent Bank of Japan monetary meeting even before the action had taken place.   While the BoJ has asserted that the report was speculative, there has been no third-party investigation.   Because of the crucial role of the media in corporate governance and in price formation in financial markets, these media problems must be solved if Japan is to recoup its position as an international financial center.

When the final report from the working group is published (most likely in early June), the milestones to judge it will be (a) whether the proposals become more concrete, and (b) whether the omitted items are included.

Personnel Decisions

In the end, effective reform depends on energetic leadership.   Those making the final decisions on reforms must be committed to a reform philosophy, and must ensure that day to day actions reflect that philosophy.   The leadership of Prof. Takatoshi Ito, who oversaw the drafting of the interim reform, was exemplary.   Investors have high expectations of the incoming head of the Tokyo Stock Exchange, Mr. Atsushi Saito, who demonstrated a solid track record at the Industrial Revitalization Corporation of Japan. However, when push comes to shove, leadership will also have to come from Economics Minister Hiroko Ota and even PM Abe.

Another key milestone will be upcoming personnel decisions.   The recent signs are not encouraging.   For example, the TSE recently announced the tentative appointment of a former Vice Minister of Finance, who spent most of his career in the Budget Bureau, as the head of the TSE’s new self-regulatory organization.   This decision by the TSE flies in the face of the Ito Working Group recommendations.   This appointment drew a storm of protest from the Abe government and from the Diet, which has been trying to eliminate such ‘parachute’ jobs for ex-bureaucrats.   If the latter appointment is withdrawn by the TSE, it will be a sign that the reform process is accelerating.

Upcoming appointments in the bureaucracy must also be watched carefully.   Particularly important will be the one for the new Commissioner at the Financial Services Agency. The appointment of a new commissioner from the private sector would be a clear sign that the Abe government wants to push financial sector reform faster and more aggressively.

 

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Currencies
Russia: The Newest Member of the ‘SWF Club’
April 27, 2007

By Stephen Jen | New York

Summary and conclusions

The conversion from traditional reserves to SWFs will fundamentally alter the way financial markets operate and how risky assets perform, in my view. 

The recent approval given by Russia’s Duma for transforming its Oil Stabilization Fund (OSF), capping the reserve portion to 10% of GDP and diverting the excess reserves to the Future Generations Fund (FGF) is important.  Like other SWFs, the FGF will be invested in riskier assets with higher expected returns.  This is yet another clear step taken by a major central bank to enhance the return on its foreign reserve holdings.  The emergence of SWFs will have fundamental implications for the balance between private and public sector capital, and will be supportive of risky assets, in my view. 

Russia’s announcement

On April 11, the Duma approved the transformation of the OSF, proposed by President Putin in early March, to split it into a Reserve Fund and an FGF.  This structural change will come into effect on February 1, 2008. 

The OSF was established on January 1, 2004, with the aim of stabilizing the monetary impact of changes in oil prices.  The tax proceeds above the threshold of US$27 a barrel were saved in the OSF.  As of April 1, 2007, the OSF had US$109 billion invested in sovereign bonds of the US (45% of the total), Euroland (45% of the total) and the UK (10% of the total).  The OSF formed a part of the total official reserves of US$357 billion, which makes Russia the world’s third-largest holder of official reserves.   

The approved plan includes the following changes.  First, all oil tax proceeds (including those from the first US$27 per barrel) will now be saved.  Second, tax receipts associated with natural gas transactions will also be diverted to the OSF.  Third, the budget can claim resources from both funds but the total transfer cannot exceed 3.7% of GDP; this cap will be effective in 2010, with the intermediate targets being more flexible.  Fourth, after February 1, both the Reserve Fund and the FGF will be managed by an agency under the supervision of the Ministry of Finance.  Fifth, the FGF will be invested in a wider array of assets, including equities, oil options and other assets outside the sovereign bond space. 

The Finance Ministry announced that the OSF is expected to reach US$142 billion or so by the time the FGF is established on February 1, 2008, assuming an oil price of US$55 a barrel.  10% of GDP is around US$110 billion.  This means that once the Reserve Fund reaches US$110 billion, the ‘excess reserves’, i.e., US$32 billion (US$142 billion – US$110 billion), will be diverted to the FGF.  This will be the ‘seed capital’ when the FGF becomes operational next February.

My ‘guesstimate’ is that, based on some simplifying assumptions, we should expect the FGF to grow at around US$40 billion a year. 

Look at this announcement in a broader context

I began to alert investors to this trend of SWFs in Sovereign Wealth Funds and the Official FX Reserves, September 14, 2006, and have since regularly covered this issue.  China has already made an explicit announcement of its intention to establish such a fund, which is likely to be massive in size at its birth (likely to ‘weigh in’ at US$300 billion) and grow by US$200 billion or more a year.  Korea’s KIC will likely be enlarged as well, perhaps up to US$100 billion.  There is now talk that Japan may also go down the same path.  With more than US$900 billion in reserves, Japan’s prospective decision to tier its reserves and allocate some assets to a SWF will be a very important step.  Oil exporters have already been quietly expanding their SWFs.  My ‘guesstimate’ is that global SWFs now total some US$2.3 trillion, and will grow by US$500 billion a year.  In this broader context, Russia’s announcement is not at all surprising. 

Here are some of the thoughts I have.

•           Thought 1.  Shift of power from private to public sector.  There has been much talk about shifting economic power due to globalization.  But this discussion is predictably focused on the geographical aspect of power transfer from a uni-polar state centered on a hegemonic US, to a multi-polar state with Euroland, Asia/China and the oil exporters commanding more economic power.  We believe that this perspective of power shifts is too narrow.  Among others, an important dimension of power shifts is from the private to the public sector.   This raises many questions about transparency, regulatory considerations and ‘insider information’.  

•           Thought 2.  The profile of the world’s financial risk is fundamentally altered.  What is the role of the IMF?  This has been an often-asked question.  While we have no doubt that there will be financial crises in the future, the days of an emerging market/currency collapsing due to a balance of payments crisis may be behind us. Future financial crises may take very different forms, e.g., involving fractures in developed markets or the banking systems rather than a collapse in a particular emerging currency.  Given the rich external positions of most industrializing and emerging markets, a repeat of the Latin American Crisis of the early 1990s, the Asian Financial Crisis of 1997 or the Russian Crisis of 1998 is almost inconceivable.  As the net external asset positions in these countries are further enhanced by a more aggressive investment strategy through the SWFs, the trend reduction in the risks of balance of payments crises should extend, fundamentally altering how the IMF provides financial relief. 

SWFs could become sources of financial instability, given their sheer size.  This raises the issue of transparency and the question of whether the world needs a watchdog for international capital flows and whether more transparency will be demanded from these SWFs.  Also, should the IMF become this ‘world’s FSA’, rather than just a lender of last resort?

•           Thought 3.  Risky assets should remain better supported.  I am not saying that risky assets will unconditionally rise, without limit.  But if a group of investors decide to start to release a part of the US$5 trillion worth of assets currently invested primarily in sovereign bonds issued by the US, European countries and the UK, and instead invest in equities, corporate bonds, private equities, commodities and real estate in a wider range of economies, the balance between sovereign bonds and risky assets must change.  In other words, risky assets will likely trade higher than suggested by the economic fundamentals. 

Specifically, as my colleague Henry McVey has pointed out, the returns on (risk-free) sovereign bonds and those on equities are very different, with sovereign bond yields being remarkably low while the return on equities is relatively high.  For these two markets to be less out-of-sync, both bond yields and the P/E ratios will need to rise.  The fact that private equity flows and M&A activities are so strong is a reflection of the perception that equity prices are too low, relative to the prevailing interest rates and the pool of liquidity available to be deployed.  In my writings, I have highlighted (i) excess global liquidity arising from a fundamental mis-match between savings and investment, (ii) a global shortage of investable financial papers (our ‘Asset Shortage Hypothesis), and (iii) a more balanced global economy between the three pillars supporting risky asset prices.  We now add the SWFs as the fourth pillar, one that is longer term in nature. 

(I observe that, just as private investors are turning somewhat nervous about valuation, leverage and other risks, SWFs are moving into risky assets.  I personally suspect that the SWFs will be able to drive the markets.) 

•           Thought 4.  Rising risk of financial protectionism.  So far, the notion of ‘protectionism’ has been confined to trade.  However, going forward, the counterpart of the cumulative trade surpluses — official reserves and SWFs — will likely become a source of political tensions, I suspect.  The complications of CNOOC and Dubai Port could become recurring events, now that a good part of the official reserves is made available for equity acquisitions.  The transformation of these foreign central banks from creditors to owners could lead to political reactions not just in the US, but also in Australia, Canada and other countries offering assets that reserve-rich nations find desirable. 

•           Thought 5.  These general trends are not that sensitive to changing oil prices.  While Russia’s FGF and Norway’s GPF will obviously be positive correlated with oil prices, the pace of growth of Asia’s SWFs will be negatively correlated with oil prices.  In a previous piece, I argued that 80% of the impact on reserves/SWFs from oil prices changes will be ‘transfers’ between Asia and the oil exporters.  Specifically, given that Asian countries are intensive oil importers, rising oil prices effectively transfer reserves from Asia to the oil exporters, and falling oil prices reverse this transfer.  Only one-fifth of the net impact from changing oil prices shows in the change in the aggregate reserves of Asia and oil exporters.  In other words, the trend growth in the world’s SWFs is a function of the world’s savings-investment imbalances, and not so much the level of oil prices. 

Bottom line

The membership of the ‘SWF Club’ continues to expand, with Russia as its latest, but not last, inductee.  The emergence of the SWFs will fundamentally alter the way financial markets operate and trade, in my opinion.

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India
INR: RBI’s Tough Task of Fine Balancing: Part II
April 27, 2007

By Chetan Ahya and Mihir Sheth | Mumbai

Part I of this piece was published in the EM Economist, April 10, 2007

Rupee has appreciated to a nine-year high

Part I highlighted the RBI’s increasingly complex task of trying to pursue an independent monetary policy, a relatively open capital account and a managed exchange rate. We highlighted the possibility of the RBI having to let the rupee appreciate against the US dollar as it chooses to maintain an independent monetary policy (higher interest rates to control overheating) and an open capital account over a stable exchange rate regime. Since then, the Indian rupee has appreciated rapidly by 4.7% against the US$ — a perceptible shift in approach towards currency management. In this follow-up note, we further analyze the dynamics of this trend and its potential implications for export growth and the trade deficit.

Spike in capital inflows in the last few weeks

India’s foreign exchange reserves have increased by US$23 billion in the last 10 weeks — this implies an annualized run rate of US$120 billion and compares with a US$40 billion accretion in the 12-month period prior to these 10 weeks. This surge has resulted in cumulative appreciation of the rupee of 7.3% against the US dollar in this period. With the current account continuing to be in deficit, this increase in reserves is driven by strong capital inflows. A bulk of this rise is due to non-FDI (foreign direct investment) inflows — primarily debt, portfolio equity and private equity inflows. Although FDI flows have picked up recently, in our view non-FDI flows would have accounted for about 75% of the total capital inflows.

Rising cost of sterilization makes it difficult for the RBI to intervene in FX market

Even though the RBI may be concerned about the overvaluation of the currency and the widening trade deficit, we believe that it is forced to let the currency move to the overvalued zone, as excessive intervention in the FX market is resulting in a large injection of liquidity into the banking system. Two years back, when domestic capacity utilization was low, the system could absorb this liquidity. With capacity utilization increasing to near-peak levels, this liquidity has, over the last few months, posed a challenge to macro stability. To control this overheating, the RBI is forced to sterilize this excess liquidity via reverse repo (until recently), market stabilization scheme (MSS) bonds and cash reserve ratio hikes.

Although many other Asian countries face a problem of excess liquidity, we think that the sterilization cost problem is more acute in India’s case, as there is negative carry involved (rates in India are significantly higher than in Asia and the US).

Rising sterilized liquidity balances and a sharp rise in short-term interest rates have led to an increase in sterilization costs to an estimated US$1.2-1.4 billion (annualized in April 2007) from US$0.7 billion in January (annualized). Indeed, if the RBI had not resorted to cash reserve ratio hikes and instead had used the reverse repo/MSS mechanisms, the sterilization cost would have been even higher at US$1.8-2 billion annualized in April 2007. This cost is currently being borne by the banking system as the money parked under the cash reserve ratio with the RBI earns no interest even as banks continue to pay a weighted average deposit rate of 6.25-6.75% (including low-cost deposits) on them.

Burden shifts to exchange rate

We believe that in early March, the RBI made a clear shift in exchange rate management approach to allow faster appreciation of the currency. The rupee has appreciated by about 8.4% since early March compared with 3.4% in the preceding six months. Apart from reducing the pressure on liquidity management, the currency appreciation will only help in reducing the inflation pressure. Over the last two months, the commodity research bureau index has increased by 6.1%. The impact of the appreciating currency will help offset this rise of global commodities. Note that global commodity-linked products have a weighting of 37% in the wholesale price index. 

Collateral damage will be felt on export growth

We believe that the recent sharp appreciation against the dollar could result in a further slowdown in export growth. On a real effective exchange rate basis (REER, trade-weighted rupee adjusted for inflation differentials with trade partners), the Indian currency has moved to its highest level in the last 14 years (the maximum period for which we have data). On a REER basis, the rupee is now about 10% above its 10-year mean. Apart from the appreciation in currency, slower global demand growth is an added challenge for the export growth trend. We believe that dollar goods export growth, which recently slowed to just 7% (average during the three months ended February), could potentially slow further to 0-3% in the next 3-4 months. Export growth in rupee terms has already slowed to 6% in this period. This trend would only cause further widening in the current account deficit excluding remittances, even as the overall current account deficit may remain with manageable limits.

Although from a macro stability perspective one can look at the current account including a sustainable component of NRI remittances, we believe that, in the context of assessing the implications for the relative currency competitiveness and domestic output growth, the current account deficit excluding non-resident Indians’ (NRI) remittances (CADEXR) is a better measure. It widened to the high level of 5.1% of GDP at quarter-end December 2006. We believe that this deficit could widen further to 6-6.5% of GDP over the next 2-3 quarters, if the rupee appreciation trend is maintained. We believe that if export growth during the 12 months ended March 2008 (F2008) falls to 0-5% YoY in rupee terms compared with an estimated 23% in the 12 months ended March 2007 (F2007), it would reduce overall GDP growth by 0.8-1.2% points in F2008.

Capital controls next?

We believe that currently the RBI is focused more on slowing domestic demand growth and reducing inflationary pressure. Fighting the impossible trinity, the RBI has so far chosen to let the currency appreciate and has tried to achieve greater effectiveness in management of monetary policy. However, after the recent sharp appreciation, we estimate that on a real effective exchange rate basis, the rupee has moved further away from its mean by about 10%. We believe that the medium-term implications of an overvalued currency on macro stability are that the RBI may have to start intervening soon to soften the pace of appreciation. However, this intervention would also necessitate a further hike in the cash reserve ratio. While the RBI may continue with the intervention for the next three months or so, if the pressure of capital inflows persists, it may have little choice but to initiate some capital controls on debt-oriented inflows. Some soft measures have already been announced recently — such as limiting returns on non-residents’ deposits and restrictions on banks’ borrowing from abroad.

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