United States
Review and Preview
July 01, 2008

By Ted Wieseman | New York

Treasuries made it two straight weeks of big gains over the past week, with a sizable rally across the curve that erased about two-thirds of the enormous losses at the front end seen during the week of June 13 and left the long end at is best levels in a month.  The FOMC statement upped concerns about inflation and lowered worries about growth a bit.  But, as we expected, there was no warning of the imminent rate hike that the market had been moving to price in, and futures were forced to adjust accordingly, significantly cutting the odds of an August rate hike and taking a full 25bp move out of the expected tightening through year-end.  Meanwhile, worries about the state of the financial system continued to mount, and risk markets were crushed as investors looked ahead to the possibility of another round of extensive write-downs when 2Q results are reported by banks next month.  The ongoing credit crunch shows no signs of any improvement – if anything, it’s getting worse – with ominous implications for the economy once the temporary bump to growth from stimulus checks fades.  Even with those checks rolling in and leading to one of the biggest monthly increases in disposable personal income ever in May, consumer confidence remains in absolute freefall, and another round of record highs for energy prices points to major further pressure on underlying income growth that should contribute to pronounced weakening in consumer spending a few months from now once the impact of the tax rebate checks, which will have been almost fully distributed within a couple weeks, fades.  As the future outlook for the economy looks increasingly grim and our confidence in our call for negative GDP growth in 4Q and 1Q rises, incoming economic data released the past week for the second quarter were actually better than expected overall and suggested that the economy has skirted recession temporarily.  New and existing home sales were mixed in May, but both series continue to point to signs of stabilization.  The durable goods report showed meaningful upside in capital goods shipments that pointed to stronger investment spending in 2Q.  First quarter growth was revised up a bit less than expected, but all of the downside surprise was in inventories, pointing to a smaller inventory drag in the current quarter.  And personal consumption spending was much stronger than we expected in May.  Even accounting for early reports of incredibly weak auto sales in June to be reported in the coming week, this still left 2Q consumption on track for a pick-up.  Taken together, these reports boosted our 2Q GDP forecast to +1.6% from +0.8%.  Looking ahead to the upcoming week’s key early June data, however, the tone of the economic figures is likely to turn much worse.  Weak results for jobless claims and additional regional manufacturing surveys continued to point to soft results for June payrolls and ISM.  And early indications are suggesting that June motor vehicle sales may have plunged to levels that would have been almost unthinkable not long ago.

For the week, benchmark yields fell 15-23bp, with the curve steepening moderately and the 10-year performing poorly on the curve.  The old 2-year yield fell 23bp to 2.61%, having now rallied 42bp since the 65bp collapse two weeks back, the old 5-year 19bp to 3.36%, the 10-year 15bp to 3.99%, and the 30-year 16bp to 4.535%.  Breaking the recent pattern of the market struggling during weeks of (now very heavy) 2-year and 5-year supply, the new 2-year ended the week at 2.65% after being auctioned Tuesday at 2.92% and the new 5-year at 3.37% after being auctioned Thursday at 3.44%.  Approaching quarter-end and turmoil in risk markets led to a big further move into cash, with the 4-week bill’s bond equivalent yield falling another 20bp to just 1.27%.  Yet another week of record energy prices, with August oil up another US$4.85 a barrel to US$140.21, and a more moderate view on real rates in light of the Fed’s more dovish tone than many investors feared, helped TIPS strongly outperform across most of the curve even in the face of such a sizable rally in nominals.  The 5-year yield plunged 30bp to 0.72% and the 10-year 22bp to 1.45%, though the 20-year just kept pace with nominals, rallying 16bp to 2.05%.  The 7bp rise in the benchmark 10-year inflation breakeven to 2.54% left it just barely below the two-year high hit in early March after a 20bp rise since the end of April.  Just about all of the recent increase, however, has come from a significant rise in the early years of that 10-year breakeven period, with the benchmark 5-year breakeven having risen almost 40bp over this period.  Swap spreads widened during the week’s Treasury rally, with the benchmark 5-year spread up 3.5bp to 92bp and the benchmark 10-year spread 1.5bp to 70.25bp.  Mortgages were underperforming substantially through early Friday amid the broader flight from spread product but rallied back strongly through the day Friday to only end the week a bit worse compared to swaps. 

Risk markets were broadly hammered, adding substantially to the Treasury market bid both from a flight to safety and from concerns about the implications of this weakness for the economic outlook.  The S&P 500 fell another 3% to just a bit above the lows hit in March.  In late trading Friday, the investment grade CDX index was 19bp wider on the week at 144bp, which would also be the worst close since March after a 30bp widening in the past three weeks.  High yield held up relatively better, with the index 43bp wider at 671bp through Thursday’s close and only trading marginally weaker late Friday.  The leveraged loan LCDX index had been holding little changed recently while credit markets were weakening, but there was a significant catch up in the latest week, with a 36bp widening for the week to 400bp through midday Friday.  The commercial mortgage CMBX market was also roughed up.  The AAA index widened 32bp to 147bp, the AJ index 84bp to 435bp, and the AA index 120bp to 658bp.  The higher-rated subprime ABX indices extended their recent collapse, with the AAA index down 3.03 points to 45.89 and the AA index 1.03 points to 10.89, both all-time lows.  The very poor performance of the ABX, CMBX and LCDX indices heading into quarter-end certainly continues to raise investor fears of major further 2Q write-downs by banks of holdings of subprime assets, commercial real estate loans and leveraged loans. 

With the FOMC not signaling any near-term plan to raise rates and financial market turmoil intensifying, there was a major dovish repricing of the Fed path in the futures markets.  The August fed funds contract gained 3.5bp to 2.055% (cutting the odds of an August rate hike to about 25%), October 10.5bp to 2.195%, November 14.5bp to 2.315%, January 23bp to 2.41%, and February 24bp to 2.47%.  Eurodollar gains were led by a 30bp rally in the Dec 08 contract to 3.15% and a 29.5bp gain in the Mar 09 contract to 3.30%.  The front Sep 08 contract also strongly outperformed fed funds futures, gaining 20bp to 2.915%.  So there was a decent drop in forward LIBOR/OIS spreads, though the spot spread rose a couple of basis points to 73bp as a 1bp dip in 3-month LIBOR on the week to 2.79% didn’t keep pace with the dovish short-term Fed repricing.

Economic data released over the past week were mostly reasonably positive and pointed to stronger first half growth than we previously expected.  Although 1Q GDP was revised up less than expected to +1.0% from +0.9%, we boosted our 2Q forecast to +1.6% from +0.8% on upside in consumer spending, capital spending, inventories (thanks to a lower-than-expected result in 1Q that explained the smaller-than-anticipated upward revision), and miscellaneous details from the 1Q GDP revision and May personal income release.  On consumer spending, real PCE gained 0.4% in May, much stronger than we expected, largely as a result of a sharp gain in spending on services, with a particularly bizarre surge in real spending on utilities despite the unusually cool weather in May that according to other data sources significantly depressed utility output in the month.  Even building in a meaningful pullback in June, we see consumer spending gaining 1.6% in 2Q.  Weakness in June is expected to be particularly pronounced in motor vehicles, and after the rebate checks appear to have given a big boost to non-auto retail sales in May, the weekly chain store sales results are indicating that demand faded in June.  Meanwhile, the durables report pointed to stronger-than-expected capital spending.  Durable goods orders were flat in May, supported by a 12% gain in the volatile aircraft component.  Non-defense capital goods ex-aircraft orders, the key core gauge, fell 0.8% following a downwardly revised 3.1% surge in April.  Non-defense capital goods ex-aircraft shipments gained a larger-than-expected 0.6% in May, a third straight rise, and there was a significant upward revision to April.  Additionally, some of the details of the personal income report and GDP revision (most important being the consumer/business breakdown of motor vehicle sales) also pointed to better capital spending than we previously estimated.  As a result, we significantly boosted our 2Q forecast for overall business investment to +5.0% and the equipment and software component to +3.4%.  Just as the tax rebate checks are providing temporary support to consumer spending, the bonus depreciation schedules also contained in the fiscal stimulus bill also appear to be supporting capital spending for now. 

Meanwhile, home sales increasingly appear to be bottoming out.  New home sales fell 2.5% in May to a 512,000 unit annual rate.  With little net change over the past couple months, new home sales – along with existing, which gained 2.0% in May and are about unchanged over the past six months – continue to show some signs of stabilization after the prior collapse, as falling prices have sharply boosted affordability.  New homes available for sale fell 1.7% in April to a three-year low.  But with the sequential drop in May exceeded by the decline in the sales pace, the months’ supply ticked up to 10.9 from 10.7 in April, though this was still a small improvement from the 28-year high of 11.4 hit in March.  We estimate that about another 25% decline in starts will be needed to bring inventories towards more normal levels by early next year.

The key negative release among the week’s major economic reports was another collapse in consumer confidence.  The Conference Board’s measure of confidence plunged 8 points in June to 50.4, a low since February 1992 and one of the lowest readings ever.  The Michigan index fell to a downwardly revised 56.4 from 59.8, a low since 1980.  The current conditions index in the Conference Board survey fell another 10 points for a 50-point collapse over the past five months.  Views of both the current job market and the overall economy worsened much further, with the net view of the job market, which tracks reasonably well the unemployment rate over time, hitting its worst level since 2003.  The expectations index declined 6 points to the lowest reading ever, with continued worsening in expectations for the overall economy, job growth, and income growth.  With confidence in freefall, surging energy prices and the weak job market crushing underlying real income growth, housing and financial wealth sharply declining, and consumer credit much less available and more expensive, we think it is very unlikely that consumer spending will be able to hold up later this year when the temporary support from the tax rebate checks fades.

After the past week’s run of reasonably solid economic data, results are likely to be significantly worse in the coming week, which will be shortened by the holiday on Friday (resulting in an unusual employment Thursday) and early close Thursday.  Both the 4-week average of initial jobless claims and continuing claims moved to multi-year highs in the latest week ahead of Thursday’s employment report.  Results from the Richmond and Kansas City Fed manufacturing surveys were just as bad as the previously reported Empire State and Philly Fed, pointing to a significant pullback in the ISM on Tuesday.  And widespread early indications are pointing to extremely bad auto sales results on Tuesday.  Other releases due out include construction spending Tuesday and factory orders Wednesday:

* We expect the ISM to fall to 48.0 in June.  Based on the results of the various regional surveys, it appears that activity downshifted in June.  We look for a 1.6-point dip in the headline diffusion index, taking the level to a new five-year low.  In particular, the orders and production indexes are likely to show some slippage.  Meanwhile, the severe flooding in the Midwest and associated transportation disruptions may actually help to prop up the vendor delivery index.  Finally, we look for a further 1-point rise in the price index to 88.0, which would match a 29-year high.

* We look for a 1.4% decline in May construction spending, which would be the sharpest drop since December, with a further decline in the residential category expected to be accompanied by a pullback in non-residential activity.  Spending in the public sector is also likely to edge lower this month.

* We expect motor vehicle sales to tumble to a 12.8 million unit annual rate in June.  The selling rate dipped to a 10-year low in May of 14.3 million, and we look for further significant slippage this month as high gasoline prices continue take their toll – especially in the truck and SUV sectors.  Sales appear to have fallen about 11% during the first half of 2008 compared with the same period a year ago.

* We forecast a 1.0% rise in May factory orders.  While the durables component held steady in May, another price-related jump in the non-durables category is expected to help boost overall factory orders.  Meanwhile, shipments are likely to post a modest rise, with inventories expected to rebound 0.7% following a flat result in April.

* We expect non-farm payrolls to decline 60,000 in June, which would be a sixth consecutive drop.  In fact, the anticipated decline would be even larger were it not for the return of an estimated 25,000 or so auto workers who were laid off in recent months because of a strike at a major parts supplier.  Significant job losses should continue to be evident in sectors such as construction and retail trade.  And we anticipate a pick-up in the pace of job declines within financial services.  Meanwhile, severe flooding across the Midwest is not likely to have a noticeable impact on the June job tally, but could be a more important factor in next month’s report.  Finally, while we believe that the unemployment rate will trend higher over the balance of the year, this month’s report is expected to show a partial reversal of the unusually sharp rise seen in May.

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Latin America
Mexico: No Immunity
July 01, 2008

By Luis Arcentales & Gray Newman | New York

For most of the year, there has seemed to be a disconnect between the US and Mexican economies.  Even as the US economy began to stagnate, the Mexican economy held up reasonably well.  Indeed, even at the industrial level where the link between both economies is the strongest, Mexico manufacturers seemed to have bucked the decelerating trend in the US, thanks in large part to a 22% gain in the auto sector in 1Q08.  While we still expected Mexico’s economy to slow over the course of 2008, we did not endorse the view – reflected in expectations as recently as two months ago for significant interest rate cuts – that the economy was slowing sharply (see “Mexico: Three Anomalies”, This Week in Latin America, April 7, 2008). 

Recent data, however, suggest that Mexico’s economy is feeling the pinch from the US slowdown.  At first sight, the signs of deceleration may not be evident as just as Semana Santa led to sharp declines in most March activity indicators, additional workdays have exaggerated April’s rebound when measured year over year.  The task of sorting through the calendar has been further complicated by the introduction of a new set of national accounts (2003 base) – finalized only last week with the release of the demand breakdown of 1Q GDP – by Mexico’s national statistical institute (INEGI).  But whether we look at March and April data after trying to smooth out the impact from the holidays or whether we focus on the first signs from May, there appear to be mounting evidence that growth in Mexico is shifting to a lower gear.   

Resilience, but No Immunity

Though hard to see on the surface, Mexico’s economy seems to be cooling down, echoing the slowdown in US manufacturing activity. While in and of itself the fact that Mexico’s export-focused manufacturing sector is closely following its US counterpart may not come as a surprise, the signs of weakness in Mexico seem to go beyond the industrial complex.  We warned against reading too much into March’s weak readings, which were more a reflection of the way INEGI presents the headline data rather than true underlying weakness (see “Mexico: Resilience Yes, Immunity No”, EM Economist, May 23, 2008).  Simply put, because of Semana Santa March this year had fewer working days than March 2007; by that same token, the rebound in most indicators during April has been grossly exaggerated. 

Looking beyond calendar swings, however, shows a softening in the pace of economic activity into April.   To try to smooth out the effect of Semana Santa, we decided to take the average growth between March and April.  The results of this exercise were surprisingly uniform: whether we compared them to the six or three months ending February, growth in the March-April period was slower, in some cases by a significant margin.  

For example, March manufacturing plunged 3.8% from a year earlier and rebounded by 9.5% in April, yielding growth over this two-month period of just 2.6%, less than half the 5.8% December-February pace.  The contrast is even more dramatic if we look at consumer goods imports: once we exclude record gasoline purchases, consumer goods gained an anemic 2.1% in March-April, a slowdown of over 12pp from the 14.9% December-February clip.  Similarly, the deterioration in consumer confidence and the slowdown in the newly revised employment figures appear to be intensifying. The comparison base includes strong leap-year boosted February activity figures; however, even if we take a longer six-month period, the magnitude of the March-April slowdown is strikingly similar.  

Alternatively, seasonal adjustment techniques could be used to correct for the shift in the holidays; however, because of the unusual combination of a leap year and March’s Benito Juarez’s holiday falling in the same week as Semana Santa, it is not hard to see why adjusting the data is challenging.  For instance, April’s solid 5.5% gain in industrial production was consistent, according to official data from INEGI, with a seasonally adjusted 20% annualized drop from March levels. 

More worrisome is that the first batch of May data paints a similarly soft picture.  Consumer confidence plunged at the fastest pace on record (-12.2%) and, once seasonally adjusted, it stood just 5% above all-time lows.  Interestingly, the wedge between consumers’ somewhat downbeat assessment of current conditions and more optimistic future outlook has closed, leading to a broad deterioration in confidence.  Indeed, consistent with this deterioration in sentiment, May retail sales came in on the soft side, though the calendar – one extra Friday, one Saturday and a favorable pay day – magnified the annual jump (+9.5%); meanwhile, consumer goods imports ex-gasoline posted a disappointing 2.7% decline.  And following a string of good gains, auto production stalled in May (+0.7%), which translated into a low 3.6% increase in manufacturing exports – the smallest in over three years.   We expect monthly GDP growth in May to be in the 1-2% range.

Despite the seemingly downbeat picture, we are sticking to our long-standing call for GDP growth of 2.6% this year.   Indeed, not all signs are moving in the wrong direction and the prospects for important fiscal stimulus above and beyond what has been budgeted – the 2008 program includes an ambitious investment budget of roughly 5% of GDP – should not be underestimated. One bright spot in May was the 12% jump in imports of capital goods, which are pointing to an improvement in investment during 2Q08 after a poor performance in the first three months of the year (+2.7%).

After showing no oil revenue windfall in 1Q08, due to a series of accounting charges that allowed Pemex in some cases to offset its 2007 tax bill, Mexico’s fiscal accounts should begin to see the benefits of high crude prices by mid-year. After all, the Mexican oil mix is currently running above US$120 per barrel − more than double the US$49 2008 budget estimate.  Indeed, we estimate that the additional resources could reach or even exceed 1.6pp of GDP this year, and this does not include the massive implicit subsidy being provided to Mexican consumers using gasoline and diesel (see “Mexico: Oiling the Fiscal Coffers”, This Week in Latin America, June 2, 2008).  Indeed, one of the few surprises from the 1Q GDP report released on June 25 was the subdued 0.7% increase in government consumption – despite a relatively easy comparison base – which at the very least suggests some payback may be forthcoming as early as 2Q.

Subdued for Longer

Even as we suspect that Mexico will show a fair amount of resilience in coming quarters, the outlook for the US into 2009 has darkened.  When we last revised our Mexico growth outlook in late 2007, our US economists’ base case was for a brief and shallow recession in 2008 followed by a strong cyclical rebound.  Since then, however, the prospects for a strong 2009 recovery have diminished due to several factors, including a deepening of the credit crunch that is undermining consumers’ ability to borrow, combined with the hit from higher energy and food prices and growing consumer caution in the face of declining housing wealth. Moreover, a profit and lending squeeze is expected to slow capital spending and hiring, while rising inflation and expectations are likely to prevent further monetary easing (see “The Double-Dip Supply Shock”, by Dick Berner and David Greenlaw, This Week in Latin America, June 16, 2008).  These developments, which are likely to keep US economic activity subdued for longer – our US economists see growth of around 0.5% over the next year – have prompted us to lower our 2009 GDP growth estimate in Mexico to 3.0% from 3.8% previously. 

Peso Outlook

With the peso hovering near the strongest levels in five years and a Mexican economy that seems to be cooling down, one key factor supporting the peso is starting to fade, suggesting some currency weakness ahead.   Earlier this year even as many expressed doubts about the rally in the peso, we pointed to three dynamics that provided fundamental near-term support for the currency – namely divergent monetary policy paths, the prospects for progress on energy reform and encouraging signs of economic strength at the start of the year (see “Mexico: Three Anomalies”, This Week in Latin America, April 7, 2008).  The latter factor now seems to be reversing, as suggested by the softer real economy data of the past three months.  Importantly, Mexico’s deceleration into May has coincided with a string of better-than-expected activity reports in the US, suggesting that the US economy temporarily skirted recession in 2Q08.  Moreover, tax rebates for individuals and the business tax incentives in the Economic Recovery Act of 2008 should provide support for the US during 3Q08. 

With new signs that the Mexican economy is likely to deteriorate even as the US shows resilience, we suspect that the peso could come under pressure.   However, with two of the three peso-positive factors still intact (divergent monetary path and progress on energy reform), we suspect that the peso’s weakening will be more limited this year than we had previously thought. 

Accordingly, we expect to see some peso weakness to around 10.50 by end-2008, a more modest weakening than our prior forecast of 11.1.  We are also adjusting our end-2009 peso forecast to 10.8, versus 11.3 previously.  

The FOMC statement last week upped inflation concerns a bit, but there was no warning of the imminent rate hike that the market had been pricing in; meanwhile, Banxico seems likely to deliver a second 25bp rate hike as early as July (see “Mexico: Time to Hike”, This Week in Latin America, June 16, 2008).  Therefore, widening interest rate differentials should continue to be peso-positive.  And even with oil prices at record highs – which traditionally had bred complacency among Mexican policymakers – we remain constructive on the prospects for the energy reform after the 71-day debate in congress ends on July 22.  While the opposition has expressed concerns about certain aspects of the executive’s energy reform bill, such as the schemes to allow Pemex to associate with foreign companies, we believe that the administration will be able to gain the votes necessary to pass a major reform in either August or September.  

Bottom Line

After holding up better than many expected at the beginning of the year, we see new signs of weakness in Mexico’s growth path.   We suspect that record oil prices and revenues will help soften the blow, but expect 2008 and 2009 to be two challenging years with sub-par growth for Mexico.  This in turn is likely to temper and reverse some of the peso rally seen to date.  Mexico’s resilience is no guarantee that its economy is immune from the US slowdown.

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Latin America
Peru: More Rate Hikes Ahead
July 01, 2008

By Boris Segura | New York

Rising inflation has surprised Peru’s central bank. What began as a food inflation shock is threatening to become widespread inflation, driven by domestic demand growing well above potential GDP growth, as well as wage pressures.

The Banco Central de Reserva del Peru (BCRP) is not likely to sit idle. We therefore expect a tighter-than-anticipated monetary policy going forward, as the central bank attempts to bring inflation towards its target in 2009, to avoid missing its target for a third year running.

Accordingly, we are adjusting upwards our interest rate call. We now expect three more rate hikes in 2H08 to 6.50%, from our previous forecast of one more rate hike to 6%.  And we believe that the hikes could start as soon as the upcoming monetary policy meeting set for July 10. In 2009, we now expect two additional hikes to 7% in 1H, as aggregate demand pressures are likely to persist, and inflation takes longer to converge towards the central bank’s target.  We had previously expected rates to remain at 6% during 2009. 

Inflation on the Surface Is Food-Led

Food inflation is no doubt playing the dominant role pushing up Peru’s headline inflation. This influence takes on added importance in the Peruvian case, as food items there represent the highest weight in the consumer price index of the major Latam economies that we track. In fact, inflation excluding food is running at only a 1.9%Y clip.

Core inflation has been rising steadily since mid-2007 and now stands at 4.3% – well above the upper bound of the central bank’s inflation target – but the uptick comes in large part due to the fact that core also includes several food items.

Food inflation takes on added visibility in shaping overall inflation expectations in Peru, not only because of its weight in the CPI, but also due to the frequency of its consumption. This is why we fear that inflation perceptions are creating anxiety in the population. We believe that the monetary authorities should be vigilant regarding potential inflation drivers going forward, as what appears to be a relative price adjustment could translate into higher inflation expectations, which have been relatively contained lately. We identify three concerns:

The first one is an overheating economy. In its recently released inflation report, the central bank published its estimate of the output gap. As the report clearly shows, strong growth in actual GDP has created a positive output gap, despite an upward revision by BCRP of its potential GDP estimates – now at 7-7.5% versus 6-6.5% earlier.

We don’t see a deceleration of economic activity; if anything, economic activity is likely to be stronger. 2Q GDP growth is likely to print higher than 10%, up from 9.3% the previous quarter. Part of this could represent payback from a weak March, but it may also reflect strong growth in domestic demand. In fact, domestic demand pressures are likely to persist well into 2009.

The second driver is upward pressure on wages going forward. One argument we hear frequently is that, given the high levels of informality in the Peruvian economy, stronger labor demand translates into lower unemployment and not into higher wages. Reliable information on wages in Peru is hard to come by. We have managed to come up with some preliminary figures on wage pressures which show that for the first time in recent years, real incomes in Lima are likely to grow faster than labor productivity in 2008. In our view, this indicates that unit labor costs are rising in Lima, after a period of actual drops in this variable.

The third driver is a partial rollback of fuel subsidies. The fiscal authorities recently put a ceiling to the transfers to the Fuel Stabilization Fund (at around 1% of GDP this year), and are allowing higher international oil prices to be reflected in rising prices at the pump. We fear that this shock is likely to contaminate price formation in another whole host of products and services.

Inflation Path in Question

The central bank expects headline inflation to come back into its target range by mid-2009. BCRP sees headline inflation at 4.3% by year-end. More importantly, it still sees the balance of inflation risks tilted to the upside.

But we are concerned that the central bank is likely to be disappointed.  Given the upside risks to actual GDP growth and domestic demand that we see, we reiterate our year-end inflation forecast of 5.5% and believe that headline inflation is likely to have a tough time breaking the 5% mark during the rest of 2008. Actually, we don’t see Peru’s inflation converging to the BCRP’s target in 2009 either; according to the central bank’s own calculations, there is a 42% probability that inflation does not converge to the upper bound of its target next year.

We sense that the monetary authorities have been downplaying the pressures that fast growth in aggregate demand is putting on inflation.  Sometimes central banks have the unpleasant responsibility of being the voice of caution in the midst of a boom. This is indeed the case in Peru, where the economy has shown impressive growth over the last three years. At this juncture, it is key for the central bank to be clear and consistent in explaining to the public the reasons for inflation being above its target; it is debatable whether a turnaround in agflation alone will do the trick of bringing inflation down.

Fiscal Policy Is Not Supportive

Another factor complicating the fight against inflation is an expansionary fiscal policy. The authorities expect a (nominal) fiscal surplus north of 2% of GDP, hardly a sign of fiscal largesse. However, when you compute a structural fiscal balance (subtracting from government revenues the effects of higher-than-potential GDP growth and high commodity prices), the picture changes. In 2008, the fiscal impulse (change in primary structural balance) is equivalent to 1.3% of GDP; public expenditure is to set rise 12% in real terms.

This surge in public expenditure was not totally unexpected. The major nominal fiscal surplus in 2007 was not sustainable: regional governments were not as effective in executing projects as one could hope, probably due to lack of managerial expertise and fear of violating anti-corruption regulations. However, we believe they have been getting up to speed lately: in the first five months of the year, public investment grew by 45% over the same period from last year.

In order to fight off inflation, the policy mix needs rebalancing, in our view. To accommodate a more relaxed fiscal policy, the central bank will need to implement a tighter monetary policy in order to bring inflation down.

The PENdulum

After partial capital controls were imposed in April, the nuevo sol has given back this year’s gains.   Since then, the monetary authorities have essentially been escorting non-residents out of the Peruvian short-term yield curve. This has reversed the currency’s appreciation trend: After appreciating to levels below 2.70 in April, the PEN is now trading closer to 3.

Bad technicals are trouncing good fundamentals. We still think that, based on fundamentals, the currency should be trading stronger. However, there might still be more pain to come in the next few weeks, as maturities of BCRP’s CDs in the hands of non-residents are material. But we expect the good fundamentals to assert themselves later in the year.

Of course, the recent bout of currency depreciation may have inflationary consequences. In the first months of the year, the currency appreciation helped to partially accommodate a burst of imported food inflation. Its sudden reversal now threatens to ‘add fuel to the inflation fire’.

In our view, the central bank holds the key (via the use of reserves) to prevent further disorderly currency depreciation. During the first four months of this year, the central bank bought US$8.7 billion via FX intervention. Its international reserves, at US$35.6 billion, are clearly adequate; it can easily use some to fight off unwarranted currency dynamics.

Monetary Policy Implications

The central bank is likely to face strong inflation pressures going forward. Most of the inflation risks “surprised” to the upside, as BCRP acknowledged in its latest inflation report. We don’t expect relief anytime soon, and therefore we visualize a challenging inflation picture in the coming months.

Despite cumulative hikes of 125bp since July 2007, BCRP’s reference rate, in real terms, does not look particularly restrictive. Notwithstanding increases in reserve requirements to try to cool down credit growth, we suspect that the central bank is likely to hike by more and by longer than previously expected.

This restrictive monetary policy plus more aggressive central bank intervention in the FX market bode well for the nuevo sol. These moves would certainly tighten monetary conditions, putting the brakes on an overheating economy.

Bottom Line

Facing strong domestic demand pressures on inflation, less-supportive fiscal policy and a weaker currency, the central bank is likely to implement tighter monetary policy. This in turn should provide Peru’s central bank with a fighting chance of making inflation converge to its target next year, anchoring inflation expectations and solidifying its hard-won credibility in the process.

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China
China: Counting Hot Money
July 01, 2008

By Qing Wang | Hong Kong

Surge in ‘Hot Money’ Inflows?

China’s FX reserves were reported to have reached US$1.8 trillion by end-May, suggesting that on average US$53.7 billion in FX reserves per month were accumulated in the first five months of the year.  This is a marked acceleration from last year’s pace of US$38 billion per month.  Many market observers believe that a surge in ‘hot money’ inflows may have contributed to the bulk of the rapid FX reserve accumulation.

Indeed, if one takes the residual approach by using ‘FX reserve accumulation deducted by the sum of the trade surplus and net FDI inflows’ to measure ‘hot money’ inflows, which is the practice of many market observers, the estimated ‘hot money’ inflows amounted to US$147.6 billion in the first five months of the year, US$117 billion in 2007, -US$2.7 billion (i.e., outflows) in 2006 and US$49 billion in 2005.

However, the residual approach to measuring ‘hot money’ has several drawbacks that tend to yield inaccurate estimates. First, this indicator treats some items under the current account such as remittances and income, for which high-frequency data are not available, as part of hot money flows. This tends to overstate the amount of hot money flows.  Second, this indicator is a net flow concept and fails to take into account capital outflows/inflows originating from China-based financial institutions, which are at times heavily influenced by domestic policy changes.  Third, changes in US dollar-denominated FX reserves could simply reflect changes in the cross rates between the US dollar and other major reserve currencies (e.g., euro, yen); however, this indicator attributes these valuation effects to changes in ‘hot money’ flows.

The True Picture: A Closer Look at BoP Flows

China’s SAFE recently released detailed balance of payments (BoP) data for 2007.  Based on SAFE’s data, we constructed an analytical version of China’s balance of payments table.  We make the distinction of cross-border non-FDI and non-equity flows originating in China and foreign countries.  Our definition of ‘hot money’ is the sum of ‘cross-border capital flows originated from foreign sources and unidentified sources (i.e., errors & omissions in the BoP, excluding the valuation adjustment due to changes in the cross rates between the US dollar and other reserve currencies)’.

Based on the balance of payments data, we are able to obtain what we believe is a more accurate picture of the ‘hot money’ situation.  Our observation is that ‘hot money’ inflows have been significant, but more stable than measured under the residual approach.

Specifically, the two methods yield quite different estimates of the amounts of hot money inflows for 2005 and 2007.  In particular, the residual approach substantially underestimates the true amount of hot money inflows in 2006.  Such a sizable discrepancy is mainly due to a very large amount of outbound investment in medium- and long-term (MLT) debt securities by Chinese financial institutions in 2006.  This large amount of outflows offset the true ‘hot money’ inflows such that net flows – the definition of ‘hot money’ under the residual approach – are very small.

Capital outflows originating in China are mostly carried out by domestic financial institutions and closely reflect government policy, in our view.  For instance, we think that the large amount of purchases of MLT debt securities that originated in China in 2006 reflected the special FX swap arrangements between the PBoC and several large domestic banks in 2006, under which the banks were asked to park their funds (some of which were raised from the mega bank IPOs in Hong Kong) offshore.

The unwinding of the FX swap arrangements should have resulted in capital inflows in 2007, as banks repatriated these funds onshore.  However, the BoP table does not show inflows of similar amounts taking place in 2007.  This could be explained by the fact that the PBoC raised the ratio for required reserves (RRR) and asked several large commercial banks to deposit these reserves in US dollars instead of renminbi.  In practice, this arrangement may have been carried out through these commercial banks transferring the MLT FX debt securities purchased under the FX swap arrangement to the PBoC.  Since this transaction is between domestic commercial banks and the PBoC, namely between two resident entities, it does not show up in the balance of payments.

We also note that a large amount of unspecified outbound short-term investment was carried out by China-based sources in 2007.  A large part of this transaction may be connected with the recapitalization of CIC and related operations, we suspect.

Potential Explanations for Renewed ‘Hot Money’ Inflows

Estimates of ‘hot money’ under the residual approach would put the total amount for January-May at US$148 billion.  In this context, there is now heated discussion among market observers about the potentially very large amount of ‘hot money’ inflows into China.  We estimate that non-FDI and non-equity net capital inflows may have been about US$80 billion, with a large part of the rest being accounted for by the rapid increase in investment income earned on the sizable and still rapidly rising stock of FX reserve assets, which stood at US$1.8 trillion at end-May.

In any case, the US$80 billion in non-FDI and non-equity net capital inflows is a large amount because this balance item has historically been negative, even when ‘hot money’ inflows were substantial.  However, we think that the actual amount of ‘hot money’ inflows may not be as large as suggested by the US$80 billion inflows.

First, we suspect that FX inflows as a result of capital repatriation by China’s own financial institutions may have again played an important role.  In particular, we estimate that domestic banks may have accelerated the reduction in foreign exposure in their balance sheets in the wake of the US sub-prime crisis and the attendant global capital market turmoil.  Commercial banks’ net foreign assets by end-1Q were down US$16 billion from the level at end-December 2007, while the reduction for 2007 as a whole was only US$12.6 billion.  This trend may have continued in April and May.  Other China-based non-bank financial institutions and even non-financial corporates may have taken similar action, resulting in capital inflows, in our view.

Second, the rapid increase in renminbi deposits in Hong Kong constitutes another source of capital inflows into China.  Hong Kong residents are allowed to change up to HK$20,000 into renminbi per day per bank account.  Renminbi deposits in Hong Kong by end-April amounted to US$6.4 billion (e.g., up by nearly 130%) from the level at end-December last year.  The settlement of these offshore renminbi deposits between Hong Kong banks and their mainland counterparts constitutes capital inflows.  This particular type of capital inflow is legal and subject to close monitoring by the regulatory authorities and, strictly speaking, should not be treated as ‘hot money’ inflows, in our view.

We therefore estimate that the truly unexplained net FX inflows that could potentially be treated as ‘hot money’ inflows could be an amount to the tune of US$50 billion in the first five months of the year, or averaging US$10 billion per month.  This is a large sum, and an acceleration from the average pace of ‘hot money’ inflows in 2007; however, it is much smaller than that estimated under the residual approach.

Fallacies of Estimates of ‘Massive’ Hot Money Inflows

Some China observers have recently come out with estimates of ‘hot money’ inflows into China that put the total stock of ‘hot money’ in China at about US$800 billion, or indicate that nearly half of China’s US$1.8 trillion FX reserves have been contributed by ‘hot money’ inflows.  These estimates attract considerable attention from market participants, the official community and the media, adding to the rising concern about the potentially serious consequences of such large ‘hot money’ inflows.

These estimates vastly overstate the true magnitude of ‘hot money’, in our view.  The calculation is based on a key premise: a large part of China’s current account surpluses and inbound FDI in the past few years is actually hidden ‘hot money’ inflows.  Specifically, a recent study by China’s Academy of Social Sciences, a top think tank in China, argues that China’s trade surplus before 2004 is considered as ‘normal’, and any trade surplus exceeding this ‘normal’ level should be considered as ‘hot money’ inflows hidden under legitimate international trade transactions. The conclusion is that 60-70% of the observed trade surpluses, or US$300-400 billion, are ‘hot money’ inflows!

When some market observers estimate the ‘hot money’ under the guise of FDI, they argue that, since there is a large and positive discrepancy between the net cash flows generated by the existing stock of FDI and the actual profit repatriation by these foreign investors to their home countries, this discrepancy should be treated as ‘hot money’ inflows, as these funds can potentially leave the country very quickly.

These estimates have serious flaws, in our view.  First, if, according to these studies, only about 30-40% of trade surpluses reflect the real underlying economic activity, how can the fact that exports have been a major driver of growth in China in the past few years be explained?  Without a significant contribution of net exports to growth, has the 11%+ GDP growth over the past three years been real?  What is the explanation for the very strong industrial profit growth and the relatively tight labor market in the last few years?  In short, the argument that the bulk of sizable trade surpluses since 2005 were hidden ‘hot money’ inflows contradicts the remarkably strong real economic performance during the same period.

Also, for example, a foreign investor spends US$100 million on an investment project, and the successful operation of this project generates net cash flow of US$20 million per annum.  If this investor decides to reinvest these earnings instead of repatriating them back to the home country, how can one argue that, while the original investment amount of US$100 million is FDI, the subsequent reinvestment is not, and should instead be treated as ‘hot money’?

We estimate that cumulative inflows into global emerging market dedicated funds in 2005-2007 amounted to about US$100 billion.  In this context, it is entirely inconceivable that investors around the globe would want to bring as much as US$800 billion into one particular emerging market (China) in the last three years in a non-transparent and even perhaps illegal way, which carries very high regulatory risk.

Overdone Concerns about Negative Impact of Potential ‘Hot Money’ Outflows

A key reason for ‘hot money’ becoming a popular issue among market participants is the concern about the potential negative impact on the economy if ‘hot money’ inflows were to turn suddenly into outflows.  The common fear is that in the event of ‘hot money’ outflows, the renminbi exchange rate would come under considerable depreciation pressure and there could be serious domestic liquidity shortages that may potentially destabilize the domestic banking system.

While these concerns are not entirely unwarranted, they are overdone, in our view.  First, despite the considerable uncertainty in the current market environment, the underlying fundamentals of the Chinese economy remain very robust, and we do not envisage circumstances that could bring about a major downgrade of investors’ medium-term outlook for the economy and thus reverse the direction of capital flows.

Second, we estimate that the potential amount of the ‘hot money’ stock is likely to be US$200-300 billion.  Even if all these funds were to leave China, this would be unlikely to generate much depreciation pressure on the renminbi exchange rate.  With US$1.8 trillion in FX reserves outstanding and rising, China should be able easily to defend the renminbi exchange rate in the event of potential outflows of a magnitude of about 15% of the total FX reserve stock.

Third, the potential negative impact of ‘hot money’ outflows on domestic liquidity can be easily mitigated as well, in our view.  With China’s current ratio for required reserves (RRR) at 17.5%, one of the highest levels in the world, the potential liquidity impact as a result of US$200-300 billion ‘hot money’ outflows could be effectively offset by the PBoC lowering the RRR.  We estimate that the liquidity impact of US$200-300 billion in outflows could be offset by a reduction in the RRR of about 500bp from 17.5% currently to 12.5%.  Even at 12.5%, the RRR level is still very high by international standards.

Do Not Confuse ‘Hot Money’ Outflows with ‘Capital Flight’

In the ongoing debate about the impact of ‘hot money’ flows, we believe that there is a considerable confusion over two distinct concepts: ‘hot money’ outflows and ‘capital flight’.  While a short-term change in the direction of the exchange rate or the domestic-foreign interest rate spreads could cause a reversal of ‘hot money’ flows, only a major loss of confidence in the financial system, the currency and the strength of the economy in general could potentially trigger ‘capital flight’.  Moreover, while ‘hot money’ flows involve only cross-border capital flows originated in foreign sources, ‘capital flight’ would include outflows by both foreign investors (or non-residents) and domestic residents, with the latter often playing the primary role.

It seems to us that much of the concern about the negative impact of outflows of ‘hot money’ is actually concern about the effect of ‘capital flight’.  Indeed, while the impact of ‘hot money’ inflows and outflows is moderate and manageable, that of broad-based capital flight is much larger and more profound.  However, ‘capital flight’ is a distinctly different issue from ‘hot money’ outflows.  It is possible that ‘hot money’ flows could reverse in the short term, especially if US-China interest rate spreads were to narrow and/or the expectations of renminbi appreciation to weaken.  However, we think that the probability of ‘capital flight’ in China is very low, given the fundamental strength of the economy and existing capital account controls which – albeit not water-tight – are still largely effective.  We therefore believe that the impact of ‘hot money’ outflows tends to be exaggerated and the attendant concerns unwarranted, to the extent that there is considerable confusion between the two concepts.

Policy and Market Implications

Although ‘hot money’ inflows have become important over time, we do not believe it is the fundamental factor that influences China’s external balance of payments and exchange rate.  ‘Hot money’ inflows and potential outflows will not materially change the big macro picture such as trends for the exchange rate and liquidity creation.  In the same vein, the regulatory authorities’ recent stepping up of the monitoring of cross-border capital flows is unlikely to have a significant impact on China’s balance of payments situation, in our view.  The bottom line is that the potential impact of ‘hot money’ inflows and outflows is quite manageable and should not influence investment decisions that are based on assessments of the fundamental strength of the economy.

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