Hitting the Speed Limit
May 22, 2007
By Daniel Volberg | New York
After four years of steadily improving growth — with 2006 posting the strongest increase in real GDP in more than a decade — Colombian policy makers are facing a quandary. The robust recovery in both household and investment spending has been accompanied by a flare-up in inflation which in turn threatens a steady disinflation path that has been ongoing for more than a decade.
Colombia’s central bank finds itself in an uncomfortable position. After reaching the mid-point (4.5%) of its inflation target range last year (4-5%), the central bank decided to set a slightly more ambitious target for 2007 of 3.5-4.5%, just as inflation caught it by surprise and began to tick up. In the first four months of the year, annual inflation has gone from 4.5% (at the end of 2006) to 6.3% in April — the most rapid pace in more than two years. And in its latest quarterly inflation report, the central bank admits that inflation is likely to remain elevated in the second quarter and that the bank is likely to miss even the upper end of its inflation target range for the year.The culprit? The central bank argues that the bulk of the uptick in inflation is due to food inflation. Indeed, it singles out food inflation for 80% of the uptick in inflation seen in the first quarter. It highlights three sources of food inflationary pressure: First and foremost, the central bank underscores the impact that El Niño — a weather phenomenon — has had on Colombian produce. El Niño has caused drought in parts of the country resulting in a shortage of produce. As a consequence, fruits and vegetables inflation was in excess of 20% in the 12 months through April and March. The central bank estimates that El Niño-related produce prices contributed nearly 45% of the uptick in inflation during the first quarter. The good news, however, is that the drought is now over and rainfall is plentiful, suggesting that the prices of produce should start normalizing in the next few months, helping to bring inflation down somewhat. Second, increased demand for agricultural and livestock products, particularly beef, from Venezuela appears to be putting pressure on some prices. With price controls in Venezuela leading to reduced local supply and food shortages, the demand for Colombian agricultural exports has grown dramatically. Exports of livestock to Venezuela in January-February of this year are up by more than 430% relative to the same period last year, and accounted for 16 percentage points of the 64% rise in exports to Venezuela according to DANE, the Colombian statistical institute. This source of demand pressure — while not susceptible to Colombian monetary policy — is likely to remain in force during 2007, the central bank admits. Finally, strong international prices of soft commodities have pushed up prices of corn, sugar and vegetable oils and are buffeting the Colombian economy. Given the prevalence of corn, sugar and vegetable oils as inputs in the processed food chain, the central bank admits that this effect is likely to last into the first half of 2008, assuming that there are no further hikes in international prices that could extend the pressure in Colombia even longer. It’s not just food: our three concerns
First, as the central bank highlights, even after the produce inflation flare-up subsides, Colombian food prices are likely to continue to suffer from Venezuelan demand as well as from strong international commodity prices. And because of the importance of food in the Colombian consumer basket, the uptick is likely to be broad-based and hence raises the risk that economic agents could use the food hikes as cover to raise prices of unrelated goods. And with headline inflation set to remain well above the central bank’s target of 4% and above the upper limit of 4.5% during all of 2007, the risk to expectations is considerable. Second, even when we strip out the food component of CPI, we still see a worrying acceleration on the inflation front starting in October of last year. Non-food inflation was up only 3.4% last October, but by April 2007 it was up 4.3%. While part of the uptick in non-food is coming from regulated prices, ex-regulated core prices are also on the rise. It hardly seems to be a coincidence that the inflation uptick is coming as the economy is showing its strongest growth in more than a decade. While it is true that investment spending is growing at a double-digit pace, it does not seem to be keeping up with demand. After all, capacity utilization is running near 80% —the highest levels that we have seen in at least a decade. We suspect that this is indicative of the inability of suppliers to keep up with the fast pace of economic activity, at least in the short run, as GDP has been gaining ground. While real GDP grew by 6.8% last year, it was up by 8.0% in the fourth quarter. At the same time that production appears to be running into capacity constraints, credit growth has also been fuelling further consumer demand. Consumer credit has been growing at near 50% since February 2006. The fact that capacity utilization and credit growth have been at elevated levels for a prolonged period of time suggests that inflationary pressure has been building. Third, we are concerned that the central bank has confused markets with its dual focus on inflation and the exchange rate. Of course, around the globe central banks are trying to limit the appreciation of their currencies, particularly against the dollar. One needs to look no further than Colombia’s neighbor to the south, Brazil, which has intervened in currency markets in the first four-and-a-half months of the year to the tune of US$40 billion — well in excess of total intervention and reserve accumulation that we saw in 2006. But there are important differences. While Brazil’s central bank is actively slowing the pace of the appreciation of the real, it runs little risk of confusing markets as to the centrality of its focus on inflation-targeting: after all, the interventions are taking place as inflation is running near 3% — well below the 4.5% target. And the Brazilian authorities remain in a rate-cutting mode, given just how low inflation has remained below the target. While Colombia’s intervention — near US$4.5 billion in the first four months of the year — might seem modest compared to Brazil’s, the magnitude relative to the size of the economy is even greater than in Brazil. Colombia’s reserves now stand at US$19.8 billion —roughly 12.5% of GDP, and larger as a percentage of GDP than Brazil’s reserves. And Colombia’s intervention this year has been nearly nine times greater than all intervention in 2006. By leaving economic agents confused about how the central bank will respond to inflation — after all, the authorities seem concerned that rising rates can attract even more capital inflows and strengthen the currency — we suspect that the central bank’s credibility is suffering. Ultimately, diminished credibility is likely to mean even higher policy rates. We are calling for the policy rate to reach 9.5% this year — the highest nominal level in years, but likely needed to deal with inflation that we expect to end the year at 5.6%. And we expect the currency to strengthen accordingly. Indeed, we are revising our currency forecast to 1,850 for year-end 2007 from 2,400 originally. The measures announced earlier in May to introduce new mandatory deposits of 40% of all foreign loans for six months appear to have done little to slow the appreciation of the Colombian peso. While the move to double reserve requirements for checking (from 13% to 27%), for savings (from 6% to 12.5%) and for some time deposits (from 2.5% to 5%) may have a more important effect on slowing the growth in credit and hence some demand pressures, we suspect that the inflation picture is likely to remain a concern and to keep interest rates even higher. Bottom line
Higher inflation is likely to bring even higher interest rates in 2007. Admittedly, part of the uptick in inflation should reverse in the coming months with produce prices falling. But part of the supply shocks have created a base effect that is likely to last throughout 2007. That base effect plus strong demand is likely to drive monetary policy tighter still. And with the risk of sending confusing signals as the central bank tries to tackle inflation even as it maintains a dual goal of limiting the appreciation of the Colombia peso, we are concerned that the central bank will end up having to hike rates by even more than most expect.
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A Decorator’s Guide to Monetary Policy
May 22, 2007
By Serhan Cevik | London
Economic policies should provide a cushion against ‘unexpected’ developments. Like economists, interior designers rarely agree on what is right or not. But there are still certain rules in decoration like using accessories to smooth the edges and create a comfortable setting. Curiously, the same principles can be applicable to the making of monetary policy, in our view. Especially during transitional phases, a central bank should provide a reasonable cushion against ‘unexpected’ developments — emerging from the political front or changes in global conditions — to smooth the volatility of inflation and growth cycles. The case of Israel is just like that. While the shekel’s strength and deflationary readings tempt to experiment with lower interest rates, navigating through an uncharted monetary territory require extra caution as well as a comforting cushion for financial markets. To be frank, even though fundamental gains in the Israeli economy and accommodating undercurrents in the global financial system would allow for further easing of the monetary policy stance, we may well be approaching a critical risk-reward threshold and facing the risk of higher inflation in the future. The shekel has moved to the strongest level in years, especially against the dollar. After years of undervaluation, the shekel is now in line with our long-standing, once out-of-consensus estimation for its fair value against the dollar. This is a justified outcome, in our opinion, supported by economic and financial improvements as well as the dollar’s weakness around the world. Fiscal normalization — lowering the budget deficit from 5.4% of GDP in 2003 to 0.9% last year — and the structural shift in the current account balance from an average deficit of 2% of GDP a year in the 1990s to 4.9% in 2006 have turned Israel into a net creditor but also a point of attraction for foreign capital flows. The latest figures show that capital inflows remain robust, reaching US$3.3 billion in the first four months of this year, on top of US$24.4 billion last year. Therefore, even though the shekel remains undervalued against the trade-weighted currency basket and the strength of foreign capital inflows could still push it even to a stronger level, the risk of volatility is now higher and requires a cautious approach. The currency pass-through effect lowers inflation, but underlying trends point to an increase. The consumer price index posted a monthly increase of 0.5% in April, but the annual inflation rate kept declining from -0.9% in March (and 3.8% in April 2006) to -1.3% — the lowest reading in the last three years. However, unlike the previous episode of deflation, today’s inflation dynamics are not a result of weak demand, but instead reflect an unusual pass-through from the shekel’s appreciation that depresses dollar- linked prices (see Technical Deflation, November 20, 2006). For example, the housing sector, with a 22% weight in the CPI basket, recorded a 6.2% drop and pushed the headline inflation rate into the deflationary territory. This is why we call for caution and highlight underlying trends in the economy. Indeed, the annual rate of change in domestic prices measured by the GDP deflator already surged from -0.1% in 2004 to 0.8% in 2005 and 2.3% last year. Given the strength of domestic demand, we will see a steady, gradual increase in inflation towards the central bank’s target range over the next 12 months. The Israeli economy is growing at an above-trend pace, creating real inflation pressures. Judging from the prevailing inflation figures and the near-term outlook, the Bank of Israel could continue cutting interest rates, as expected, to weaken the shekel and thereby create inflation. However, we beg to differ on the wisdom of such a strategy that has so far failed to deliver its promise. First, the reasons behind the shekel’s appreciation are not very sensitive, at least in the short run, to interest rates. Second, and more importantly, with low interest rates and improvements in the labor market, the acceleration in domestic demand is pushing the rate of real GDP growth well above the potential growth rate and narrowing the output gap. The latest figures (like the rise in the purchasing managers index, booming retail sales and the lowest unemployment rate in a decade) point to stronger domestic demand and real GDP growth around 6% this year. Therefore, we see no fundamental reason for more rate cuts, especially given the lagged transmission of monetary easing in the last six months, and argue for having some cushions around in times of transition.
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Don’t Count on QDII to Affect Global Financial Markets
May 22, 2007
By Qing Wang | Hong Kong
The China Banking Regulatory Commission announced on May 11 that the scope of investment instruments by commercial banks under the Qualified Domestic Institutional Investor (QDII) scheme would be broadened to include equity and related structured products, in addition to fixed income. Some investors perceived this move as a major step towards an eventual lifting of China’s capital account controls. However, we caution against counting on the QDII scheme as a major conduit for capital outflows from China that could have a positive effect on global financial markets, at least for the next few years. We believe that China is not yet ready for genuine capital account liberalization. It might seem obvious that China maintains official FX reserves levels that are too high, but this is not the case, in our view. China will need to maintain a sufficiently large amount of official FX reserves until the soundness of domestic banking system is fully secured. Financial investment by Chinese investors under such private-sector-based initiatives as the QDII scheme is unlikely to become a major form of capital outflow in the foreseeable future. The magnitude of potential capital outflows under the QDII scheme will unlikely be large enough to have a material impact on the global financial markets in the next 1-2 years. Investors should instead watch for government-based initiatives such as the establishment of the State Foreign Exchange Investment Corporation (SFEIC).
QDII expanded, Hong Kong market rallies The Hong Kong stock market rallied strongly on the news that the QDII scheme would be expanded to include equity and related structured products, as investors expected this relaxation to lead to large inflows of fresh funds from the Mainland to Hong Kong (see Hong Kong: Can QDII Lead to Lower HK$ Interest Rates? May 14).
Indeed, the potential amount of funds outflow could be huge when China opens its capital account. China’s current account surplus was US$250 billion in 2006, and we expect a surplus of this magnitude to be sustained in the next few years. If the Chinese authorities were to decide that China’s official FX reserves were too high and opt not to accumulate reserves further, China would need to generate an equally large capital account deficit (or net capital outflows). If Chinese investors were allowed to make US$200-300 billion of offshore investment per annum in the coming years, it would significantly affect the global financial markets. However, we do not believe that this will materialize in the foreseeable future (i.e., the next 1-2 years), as China is not yet ready for genuine capital account liberalization, in our view. Does China hold too much FX in reserve? Let us first take a step back and ask a seemingly basic question: does China hold too much FX in reserve? Many market watchers would say the answer is an obvious ‘yes’, given that official FX reserves now exceed US$1.2 trillion (as of March 2007) and continue to increase at more than US$20 billion per month. However, when it comes to determining FX reserves adequacy for a country, there is in fact no commonly accepted theoretical framework to make a definitive assessment.
Some ‘rules of thumb’ suggest that China has more than enough FX reserves. Two popular indicators of FX reserves adequacy are 1) import coverage ratio, and 2) short-term-debt coverage ratio. ‘Adequate’ reserves should cover 3-6 months of imports and 100% of short-term debt, according to the ‘rule of thumb’. Latest data show that China’s import coverage ratio reached 17.5 months by March 2007. This is not only well above the recommended benchmark, but also much higher than most of emerging market (EM) economies, including China’s peers in Asia. Meanwhile, China’s reserves are 5.8 times its short-term external debt at end-2006, much higher than the recommended benchmark. Nevertheless, not all reserves adequacy indicators point to the same conclusion. The ratio of reserve coverage for broad domestic money supply is another important indicator for reserves adequacy. Specifically, one of the main purposes of a country’s FX reserves is to meet the demand for foreign currency when the domestic residents want to convert their domestic currency holdings into foreign currency. Such a need may arise in times of loss of confidence in the currency in general or the banking system in particular, leading to capital flight. In other words, there is always a risk that a portion of a country’s broad money (including cash and bank deposits) will be mobilized against official FX reserves to finance capital flight. Thus, the extent to which a country’s FX reserves cover broad money is an important gauge for reserves adequacy. It turns out that China’s FX reserves adequacy is actually the lowest among its emerging market (EM) peers when measured by the coverage ratio to broad money supply (M2). This is because, despite the sizeable FX reserves, China has one of the largest stocks of broad money in the world. China’s M2/GDP ratio was 1.7 at the end of 2006, while this ratio for a large majority of other EM countries was well below 1.0.
Some may argue that the FX reserve coverage for broad money is not particularly relevant to China, because this indicator is designed for countries that have an open capital account and a relatively fixed exchange rate regime. Since capital account controls still constrain domestic residents from freely converting their domestic currency holdings and taking them abroad, the size of the domestic money supply does not really constitute a potential drain on the official FX reserves. Nevertheless, taking a forward-looking approach, we believe that the relatively low coverage ratio for broad money is among the reasons why the Chinese authorities continue to hold huge amounts of reserves. As China progressively liberalizes capital account transactions, this coverage ratio will become increasingly relevant.
Not yet ready for genuine capital account liberalization We believe that liberalization of China’s capital account is bound to be gradual and that the pace will hinge on the improvement in the soundness of its domestic banking system. Although remarkable progress has already been made with regard to financial restructuring of the largest commercial banks, it remains too early to judge the extent to which the reform measures taken so far have fundamentally transformed these banks into modern financial service institutions. Until Chinese authorities can be sure that the banks operate on a truly commercial basis and exercise effective control over the new generation of non-performing loans, they cannot be sure that banks could withstand the potential shift of deposits by their customers from onshore to offshore (e.g., through schemes like the QDII). Until then, we do not believe that China is ready for genuine (private sector-led) capital account liberalization. In the meantime, China will continue to maintain sufficiently large amounts of FX reserves, in our view.
We note how the government has used FX reserves to cover for broad money in recent years. In December 2003 and April 2005, the government used FX reserves to recapitalize the state-owed commercial banks (US$45 billion injection into Bank of China and China Construction Bank in December 2003, and a US$15 billion injection to Industrial and Commercial Bank of China in 2005). Before their recapitalization and restructuring, these banks were technically insolvent, with huge amounts of non-performing loans on their balance sheets. In other words, official FX reserves were used to recapitalize the banks so that they could honor their liabilities (i.e., deposits), which make up a large part of China’s broad money. These operations are concrete examples of how FX reserves were set aside to cover part of the domestic broad money.
Despite the large amount of funds that could potentially flow out of China (as a counterpart to the current account surplus), we expect the authorities will keep tight control over the actual amount and the pace of outflows under private sector-led initiatives like QDII. The current QDII quotas held by commercial banks total about US$14.5 billion, 50% of which is permissible for investing in overseas equity and related structured products. The authorities will likely wait until the current quotas are more or less used fully before raising the cap. Moreover, we expect only a gradual adjustment in the cap over the next 1-2 years.
Government-led initiatives to play a dominant role As we argue that high expectations for meaningfully accelerated relaxation in private sector-led capital outflows in the foreseeable future is unjustified, we recommend that investors should instead watch for more government-led initiatives for ‘capital outflows’, such as the planned establishment of a State Foreign Exchange Investment Company (SFEIC). The PBoC has played a dominant role as China’s biggest outward investor in the past few years. As the investments remain on the PBoC’s balance sheet, such ‘outflows’ show up as the accumulation of official FX reserves.
In future, we believe that the Chinese authorities will try to strike a balance between 1) inducing some non-official reserves outflows (e.g., overseas investments by SFEIC), and 2) maintaining a certain degree of control over these flows so that the funds are accessible and could be utilized similar to official reserves at the authorities’ own discretion. The establishment of SFEIC could serve this purpose. Although a government-led rather than private sector-led initiative, making investments through the SFEIC should open a channel for outbound investments that could reduce China’s balance of payments surplus. It is generally believed that the SFEIC will invest in financial assets other than those typically treated (by the IMF) as official reserve assets, including high yield bonds, equity funds, and even single-name blue-chip stocks. Nevertheless, we do not expect the SFEIC to follow an aggressive investment strategy, given the need for China to maintain sufficient reserves that could be readily used to weather disturbances in the financial system if such a need arose.
According to senior government officials quoted by the local press, the SFEIC may not begin functioning fully until late 2007. In the interim, as China continues to experience large current account surpluses and foreign direct investment inflows, we believe that state-owned financial institutions will continue to play a role in China’s ‘capital outflows’ through holding foreign currency assets on their balance sheets. In other words, to ease the appreciation pressure on the renminbi and slow the pace of official reserve accumulation, domestic financial institutions will be encouraged to hold on to their foreign currency assets through currency swap arrangements with the central bank. We believe that both these approaches are specific forms of government-induced ‘capital outflows’. These funds will most likely remain invested in high grade bonds or money market products.
In particular, this is what we believe took place last year: China’s balance of payments statistics for 2006 revealed that almost all FX reserve accumulation (US$247 billion) was contributed by the current account surplus, while the capital and financial account was nearly balanced (with a small surplus of US$10 billion). Substantial amounts of ‘capital outflows’ were reported in the form of investments in foreign debt securities, which offset FDI and IPO-related equity inflows. We believe that this reflected the ‘investments’ made by domestic financial institutions under special arrangements (e.g., currency swap arrangements) with the PBoC.
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