Inflation Is Still Dead
Jan 31, 2006
Gray Newman and Luis Arcentales (New York)
There has been a great deal of fanfare about Mexico’s progress on the inflation front of late. One of the most popular lines making the rounds among investors is that Mexico’s inflation has now fallen below that of the US. It is true when narrowly defining inflation by looking just at the past few months. Since September, headline inflation in Mexico has been below its US counterpart. In November, for example, year-over-year headline inflation in Mexico reached 2.91% compared with 3.5% in the US. Even after Mexico’s uptick in December, annual inflation ended the year at 3.33% compared with 3.4% in the US.
Is low inflation new? Indeed, many Mexico watchers appear ready to celebrate a recent break in Mexico’s inflation history. It is understandable in some ways. After all, year-over-year measures of inflation broke new record lows during most of the second half of last year. Indeed, in November year-over-year inflation broke below the 3% target, reaching 2.91%. And even with the uptick in December, Mexico ended the year with a new record low for year-end inflation. Yet we would argue that the current improvement in inflation is really not that new. Indeed, we think that inflation in Mexico has been dead for nearly three years now. Take a look, for example, at the slowdown in the inflation rate in 2005. Nearly three-quarters of the improvement in inflation came from better-behaved prices of non-core goods and services. Of the 186-basis-point reduction in year-end inflation from 5.19% in December 2004 to 3.33% in December 2005, 137 points of the decline came from non-core inflation. The bulk of the improvement came in Mexico’s ever-volatile, ever-popular (and ever-tasty) agricultural products over which monetary policy is particularly poorly suited to have much of an impact. We are not arguing that a decline in non-core’s contribution to inflation is bad news. The good news is that the upturn in non-core inflation has reverted and appears not to have had the spillover effects that the central bank was concerned about in 2004. Banco de Mexico is rightfully pleased on this front and is likely to highlight such an achievement on Tuesday, January 31, when it releases its Monetary Policy Program for 2006 along with its quarterly inflation report. But the improvement in the far more important measure of core inflation was much more muted in 2005. Indeed, core inflation in Mexico has been running below 4% for three-and-a-half years now. For most of past three years, it has been running between 3.5% and just below 4%. In the past six months, it appears to have moved to below 3.5% and could run closer to 3-3.25%. But before highlighting this as a major breakthrough, it is worth noting that much of the improvement in recent months has come as core good prices have slowed after an uptick in late 2003 and during 2004, which corresponded to a weakening peso. With core services inflation appearing to have stabilized, much of the improvement in core in 2006 is likely to be predicated on core goods prices, which in turn appear to be sensitive to the exchange rate. Low inflation perceptions are new What has changed, however, is the manner in which market participants are viewing Mexico’s inflation story. In December and then more dramatically in early January, Mexico’s headline inflation releases showed a significant deterioration on the inflation front even as expectations have not suffered. During the first half of January, year-over-year inflation reached 3.8% according to our estimates, up substantially from 2.91% in November. And, as do most of the local inflation watchers, we expect headline inflation to approach or reach 4% at the beginning of 2006. Of course, most argue that today’s uptick is largely just the result of a statistical quirk that is now fading. The base period against which year-over-year changes are measured provided an unusually favorable backdrop in September, October and November (falling jitomate prices in late 2005 compared with rising jitomate prices in 2004). But in December and now in January, the base effect is less pronounced. It is easy to see through the headline gyrations and instead focus on the good core results. Today’s nonchalance stands in sharp contrast to late 2004, when a similar bout of inflation, brought on by a handful of goods led by jitomates, sent headline inflation soaring and pushed inflation expectations higher. Then, as today, we argued that the core numbers showed little room for concern. But then, unlike today, there was widespread concern among local watchers about the direction of inflation. It is difficult to determine why local inflation watchers are responding differently to a set of transitory headline events this time around. In part, Banco de Mexico can argue that it has gained credibility by preventing past episodes of supply shocks from contaminating unrelated prices (so-called “second round” effects). A track record matters and the central bank has made progress on that front. But we suspect that at least in part, some of the difference may simply be part of the view that has gained ground around the globe that low inflation and low volatility are here to stay. Rates story Banco de Mexico surprised most Mexico watchers in December by cutting interest rates by 50 basis points to 8.25% when the market was looking for 25 basis points (and a few for no cut at all). The central bank surprised again last week, not with its announcement of another 50-basis-point cut to 7.75%, but with its statement that it felt that it had “limited space” to continue easing monetary policy in the coming months. We suspect that most analysts will read this to mean that another cut is possible in February of 25 basis points: that is our call. But March’s meeting is really up for grabs. Our bias is to expect a pause in March as the central bank looks at the Fed and Mexico’s modest beginning-of-the-year inflation hiccup before considering its next move. Bottom line The good news in Mexico is that inflation is showing no signs of coming back from the dead. While Mexico cannot expect to escape supply shocks, especially given the heavy weight of rainfall-sensitive produce in its consumer basket, a credible central bank can build a track record that slowly begins to expose the supply shocks as transitory affairs with little relevance for price setting. On that front, Banco de Mexico should be congratulated. Whether inflation ends the year at 3% or 3.3% or 3.6%, we suspect that 2006 will represent another step forward for the central bank. This would be grounds for an even greater celebration, if only tackling inflation were Mexico’s greatest challenge. Instead, as the central bank will no doubt highlight once again in its report this week, the greatest challenge for Mexico comes in moving forward on a host of much-needed reforms to boost both public and private investment to deal with its loss of competitiveness. Unfortunately, on that front, we are not upbeat.
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The Current Account Challenge
Jan 31, 2006
Chetan Ahya and Mihir Sheth, CFA (Mumbai)
What's New? The rising current account deficit is threatening to slow the virtuous cycle of strong capital inflows: sharp fall in real interest rates, stronger consumption growth, above-trend GDP growth attracting higher capital flows. The rise in the current account deficit has caused accrual in foreign exchange reserves (net injection of foreign liquidity) to decline sharply, resulting in short-term interest rates (91-day T-Bill rate) rising by 150 basis points to 6.7% over the past four months. Conclusion: Our base case view is that the current trend of almost zero net annual foreign liquidity will continue to push real interest rates higher, hurting debt-funded growth. Assuming that government and corporate business investments rise moderately, we think overall growth momentum will still slow from the current 8% to an average of 6.5% over the next four quarters. Where could we be wrong? We think the key upside risk comes from a rapid and possible change in the government’s policy response, such as large-scale privatization of PSEs and/or increasing infrastructure investments by about US$20 billion per annum (from current US$25-30 billion). Such a response could also help boost FDI inflows and ease the transition to higher sustainable investment-driven growth. India’s consumption cycle is overstretched India has been witnessing a virtuous cycle of high capital inflows: a sharp fall in real interest rates, stronger consumption growth, above-trend GDP growth attracting higher capital flows. A positive trend in global liquidity-driven risk appetite has helped this trend over the last three years. While this global trend provided India with an excellent opportunity to jump-start a new aggressive capex cycle so as to drive higher sustainable growth, most of this foreign liquidity has largely been used to fund unsustainable consumption growth. Continued leveraging has pushed India’s total debt to GDP ratio up by 28 percentage points over the last five years, even as aggregate investment to GDP has remained largely steady. Incrementally, there are excesses building up in the system with the continued use of a large part of foreign liquidity flows to boost consumption. Initially, this consumption growth, supported by government and household borrowing, was not necessarily bad, as it helped improve domestic capacity utilization. However, we believe that, since early 2004, a rising proportion of this consumption is being met through imports. In other words, incrementally, every rupee of consumption boosted by borrowing does not generate the same positive impact on domestic output. More importantly, it is posing significant macro stability challenges, including a deterioration in credit quality (a point that the Central Bank has also been highlighting), assets bubbles (particularly property prices) and a widening current account deficit. Current account deficit is the major stumbling block India’s current account deficit shot up to US$7.7 billion (annualized US$30.6 billion, or 4.2% of GDP) during the quarter ended September 2005, from a surplus of US$2.2 billion (annualized US$ 9.1 billion, or 1.6% of GDP) in September 2003. Emerging markets in general have different fundamentals, with their current account balances being positive; however, India is one of the few now running a large current account deficit (Exhibit 1). While the current account deficit per se would not necessarily be a concern, what is worrying is that the key driver of this deficit has been non-capex-related spending by the government and households. The widening current account deficit is now seriously challenging the virtuous cycle of global liquidity-driven growth. Although foreign capital inflows are still relatively high, they are being offset by a rising current account deficit, resulting in a sharp decline in net foreign liquidity injection (that is, forex reserve accretion) in the system. 12-month trailing net annual foreign liquidity (NFL) injection declined from US$40 billion in mid-2004 to US$6.5 billion as of December 2005. Indeed, during the quarter ended December 2005, there was a US$5.3 billion outflow of NFL. This direction of NFL has pushed the market-oriented short rates (91-day T-Bill) from 5.2% to 6.7% over the past four months. We believe India needs 12-month trailing NFL (that is, forex reserves accrual) of least US$20-25 billion over the next 12 months to ensure that there is no major rise in the cost of capital, which would threaten its consumption-driven growth. Where do we go from here? The direction of foreign liquidity-driven growth can be analyzed in two stages. The first is to estimate the likely trend for net injection in foreign liquidity (rise in forex reserves). If the net foreign liquidity injection is high, the second stage is to estimate policymakers’ willingness to allow this liquidity to be absorbed by the domestic economy to fund debt-driven growth. We believe that the trend at the margin indicates a likely reversal in liquidity-driven growth at both these stages. Stage I analysis: trend in net foreign liquidity injection At current levels of strong credit growth (which builds only a moderate capex cycle), we think India needs a minimum net injection of foreign liquidity of at least US$20 billion to ensure that the cost of capital does not rise significantly. However, if current account and capital inflows remain at the levels seen in the second half of 2005, NFL inflows over the next 12 months are likely to be US$1.7 billion. Indeed, we estimate that annual capital flows would need to rise by over 50% in C2006 to US$51 billion from US$34 billion in C2005 to ensure an annual NFL of above US$20 billion. With FDI inflows currently at a run rate of US$4.4 billion annualized (only 15% of total capital flows); we think there is little support likely from this area even if the government manages to increase these flows by 50% over the next 12 months. Hence, in our view, higher capital inflows will have to be sourced largely from less stable sources, such as FII portfolio equity investments and debt. The challenge is likely only to get tougher if the current account balance continues to widen further, in line with the current trend. Stage II analysis: policymakers’ view on absorbing NFL We believe that the capex cycle should have started about two to three years back to take advantage of foreign liquidity inflows. However, a weak policy response and reduced corporate risk appetite have delayed the investment cycle. In our view, the policymakers should have taken stern action to prevent excesses arising from low real rate funded growth in form of credit risks, asset bubbles and declining net financial savings. Predicting the policymakers’ level of tolerance for these excesses has been difficult. We have been wrong so far in expecting policymakers to be more aggressive in their actions to stall this leverage-driven growth cycle, considering that this has come at the cost of rising risks to macro-stability. However, from the statements made by the Central Bank in the last monetary policy announcement, it appears that policymakers are now more concerned and may take real interest rates higher. Pursuing an aggressive capex cycle will be even more challenging To make the transition from unsustainable debt-funded consumption growth to more sustainable investment-driven growth, India needs to pursue an aggressive capex cycle. To ensure sustained growth of 8%, we believe the investment to GDP ratio needs to rise by 5-6 percentage points to 32-33% — even if we assume higher capital productivity implied by an incremental capital output ratio of 4.1 compared with the last five years’ average of 4.3. Reaching an investment to GDP ratio of 32-33% would require either a sharp rise in savings to GDP or greater reliance on foreign savings that is, higher current account deficit). However, given the starting point of India’s current savings to GDP ratio (estimated to be at about 26-27% in F2006) and an already high consumption-driven current account deficit (3.6% of GDP during F1H2006), we think it will be difficult to achieve the required investment to GDP ratio in the near term. Little room to tolerate crude going to US$85/bbl We estimate India’s net oil import bill was about US$8.9 billion (annualized US$35.7 billion) during the quarter ended September 2005, when crude oil prices (WTI) averaged US$63/bbl. Should crude oil prices rise by US$20/bbl from current levels to US$85/bbl, India’s net oil import bill could increase by over 35% to US$48.1 billion (annualized), pushing the current account deficit to 5.9% of GDP, on our estimates. It would also challenge the government’s capability to protect the domestic economy further from higher oil prices. The challenge is likely to be more daunting if oil prices rise due to a supply shock instead of a demand shock, considering the differing impact on global risk appetite and capital inflows. Where could we be wrong? Our base case view is that the current trend of almost zero NFL will be maintained, taking real interest rates higher and hurting debt-funded growth. Assuming that government and corporate business investments rise moderately, we think overall real GDP growth momentum will still slow from the current 8.0% year on year to 6.5% on average over the next four quarters. We think the key upside risk comes from a rapid and possible change in the government’s policy response, such as large-scale privatization of PSEs and/or increasing infrastructure investments by about US$20 billion per annum (from current US$25-30 billion). Such a response could also boost FDI inflows and help ease the transition to higher sustainable investment-driven growth. Upside risk also comes from potential continuation of current consumption-driven growth, with annual NFL rising to US$20 billion and consequently real interest rates remaining low. This could arise on account of: (a) a quick decline in US interest rates and a weakening of the US dollar, attracting large debt capital inflows to India; (b) a sharp fall in oil prices without being associated with a major worry on global growth, the latter being necessary to ensure continued risk capital inflows into India; and (c) a huge increase in FII portfolio investments to US$25 billion-plus per year from the current trend of US$10 billion. However, this trend could result in continued deterioration of macro imbalances, particularly the current account deficit, increasing the risk of a disruptive growth shock.
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