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United States Review and Preview August 26, 2008 By Ted Wieseman | New York Treasuries ended the past week narrowly mixed and the curve modestly flatter. It was a very quiet week, with a lot of investors out on summer vacations, contributing to thin trading and generally low volatility, aided by a very light economic calendar. Treasuries, though, mostly remained a sideshow within interest rate markets relative to mortgages and agencies, and Treasury moves were driven to a large extent by much more volatile activity in those markets, though also in mostly thin trading, as investors considered the prospects for the near and medium-term future of the structure of the mortgage finance industry. Agencies and mortgages performed very well through the first part of the week, surging higher on Wednesday in particular. But a divergence emerged thereafter, with agencies continuing to outperform while mortgages were mixed, sinking hard Thursday before catching a partial renewed bid Friday. In addition to more specific focus on the mortgage finance sector, the broader performance of financial stocks at times also drove Treasury trading, particularly Friday – when all of the week’s small net losses in the short and intermediate parts of the curve occurred – when a Reuters report about the possibility of a Lehman Brothers buyout by Korea Development Bank helped brokerage and bank stocks post decent gains that weighed on Treasuries. To a limited extent, Friday’s sell-off and significant curve flattening was added to by investors looking ahead to heavy supply in the coming week at the 2-year and 5-year auctions that might be difficult to take down, given the combination of seasonally thin markets this time of year on top of the additional constraints on market liquidity likely to result from quarter-end for a number of primary dealers. The past week’s economic calendar was light and had little market impact. The July PPI report was much worse than expected, with sharp gains in core inflation at the finished, intermediate and crude goods stages of production. After the odd spike last month that was driven by a regulatory change, housing starts resumed sinking, hitting a new 17-year low. Looking ahead a couple weeks to the key early round of August data, on a preliminary basis we look for fairly soft results after incorporating the latest jobless claims report and the Philly Fed survey, estimating a 75,000 decline in August non-farm payrolls and a one-point drop in the ISM to 49.0. Benchmark Treasury coupons all ended the week about unchanged, though small shorter-end losses and small long-end gains flattened the curve somewhat. The 2-year yield rose 2bp to 2.41%, the 5-year 3bp to 3.13%, and the 10-year 1bp to 3.865%, while the long bond rallied 2bp to 4.46%. After a rare recent period of outperformance mid-week, TIPS ultimately extended their horrible recent relative performance as energy prices plunged Friday to reverse most of what had been a decent bounce over the prior few days on geopolitical worries. For the week, energy prices still gained slightly – October oil rose US$0.65 a barrel to US$114.59 and September gasoline US$0.01 a gallon to US$2.87 – but TIPS mostly slightly underperformed, with only the long end doing a bit better, with the 5-year yield up 4bp to 1.21% and the 10-year 2bp to 1.68%. At just 1.93%, the benchmark 5-year inflation breakeven has now collapsed by 80bp since the peak was hit seven weeks ago. That peak breakeven of 2.72% coincided with the highs in oil near US$145 a barrel, but the retracement to the current sub-2% levels hasn’t been seen since oil was near US$75 a barrel a year ago. There wasn’t much focus on Treasuries in interest rate space over the past week, with agencies and mortgages instead the main drivers. Agencies had a very good week that began after relatively solid Asian participation at a 5-year pricing on Tuesday. Except at the front end, swap spreads tightened a bit on the week – the benchmark 5-year spread fell 1bp to 99bp and the 10-year 3bp to 71.5bp – and agencies substantially outperformed swaps, with 10-years richening about 13bp versus LIBOR to end the week near LIBOR flat (while the new 5-year richened a huge 25bp versus the 5-year Treasury from Tuesday’s pricing to Friday’s close). Mortgages tracked the strong agency performance through Wednesday, but then struggled badly again Thursday before getting a bid again on Friday. Still, performance for the week as a whole was reasonably good, building on the recovery off the all-time wides seen during the prior week, with 5.5% MBS outperforming swaps by about 10 ticks on the week and 6% by about 4 ticks. We’ll need to see a much more substantial and sustained recovery going forward to get mortgage rates down to more reasonable levels. Average 30-year rates being offered to homebuyers in the latest week improved marginally, but at 6.47% remained near levels prevailing a year ago before the Fed began cutting rates and about 50bp higher than rates in the spring. Broad risk markets ended the week slightly softer, but a rally in financials Friday after the Lehman news weighed on Treasuries significantly. The S&P 500 dipped 0.5% on the week. Even after Friday’s bounce, financials ended a bit softer on the week, with the BKX banks stock index and the S&P 500 investment banks sub-index both down 3%. The S&P 500 thrifts and mortgage finance sub-index did much worse, and was more the focus during the week, losing 22% and mirroring the strong performance of agency debt. Broad credit indices did somewhat worse than stocks on the week, with the investment grade CDX index trading 8bp wider at 143 Friday afternoon. High yield held up relatively better, widening 18bp to 724bp through Thursday’s close and then rallying modestly Friday. With worries increasing about the possibility for significant commercial real estate write-downs going forward, a rollercoaster ride for the CMBX market attracted a lot of market attention. This market appeared to be in freefall through the first part of the week before rallying back hard to close the week mostly stronger. In the two weeks through Tuesday, the AAA index widened a huge 53bp to a post-March high of 209bp before recovering to close Friday at 181bp, a 5bp rally for the week. The junior AAA widened 213bp in the two weeks through Tuesday to 692bp but ended the week a net 14bp tighter at 547bp. Fed rate-hiking expectations had been further scaled back through most of the week, but this was more than reversed in Friday’s sell-off, though the market continues to just barely see the first Fed rate hike as more likely to come in January than December. The October fed funds contract gained 1bp to 2.205%, and November was flat at 2.06%, but January lost 3bp to 2.115%, February 4.5bp to 2.22%, and April 3.5bp to 2.325%. After the big previous widening, forward LIBOR/OIS spreads saw some improvement – though the spot spread was little changed at 77bp – as the front few eurodollar futures contract outperformed fed funds contracts, with the Sep 08 contract gaining 2.5bp to 2.83% and Dec 08 1bp to 3.055%, while Mar 09 lost 2bp to 3.085%. Across the curve, eurodollar futures moves didn’t get much larger than these small changes. It was a light week for economic news. The only major releases were PPI and housing starts. The producer price index surged 1.2% in July for a 9.8%Y rise, the biggest annual gain since 1981. This third month of major elevation came despite moderation in food (+0.3%) and energy (+3.1%) inflation. Much of the upside instead came from a 0.7% surge in the core, the biggest rise in two years, for a 3.5%Y gain, a high since 1991. The unreliable motor vehicle components contributed, but even excluding autos, the core jumped 0.5%. Capital goods showed particularly broadly based upside. Elevation in consumer goods was more scattered, with drug prices among the key categories seeing notable upside. News at early stages of production was ugly. The core intermediate surged 2.0%, a nearly 30-year high, and the core crude jumped 3.4%. Pass-through of surging goods prices to the consumer level will likely help to offset decelerating services inflation, driven by deceleration in the key owners’ equivalent rent component, keeping overall core CPI inflation somewhat elevated even as the economy turns down. Meanwhile, housing starts fell 11.0% in July to a 965,000 unit annual rate, more than reversing last month’s 10% gain to hit a new 17-year low. Multi-family starts plunged 24% to 324,000, reversing most of a 41% spike last month ahead of the implementation of tougher building codes in Looking ahead to the key early round of August data in a couple weeks, initial indications point to soft results. It’s impossible to get any sort of accurate picture of just what is happening with jobless claims on an underlying basis with the continuing distortions from state outreach programs for extended federal benefits. But based on a comparison to the behavior of claims after a similar episode in 2002, it appears that there may have been some underlying deterioration over the past month. If the 2002 pattern holds, next week’s claims report should give a much cleaner read on the underlying level of filings. In the meantime, our preliminary forecast for August non-farm payrolls is for a 75,000 decline, which would be a slightly larger decline than seen in recent months. Meanwhile, the Philly Fed manufacturing survey showed some improvement in August, but remained at a weak level, rising to 46.7 from 45.4 on an ISM-comparable weighted average basis. The previously reported Market activity in the upcoming week is likely to be thin again, with a lot of investors certain to be on vacation, but at least the calendar is much busier. In Fed news, there will be a chance on Monday to react to any notable stories coming out of * We forecast July existing home sales of 4.90 million units annualized. The pending home sales index registered a slight uptick in June – to a level that matches the highest reading recorded in the past eight months. We look for about a 1% uptick in July resales. Going forward, we’ll be keeping a close watch on mortgage rates in an effort to determine whether the stabilization in resales that has occurred over the past six months or so can be sustained. * We forecast July new home sales of 510,000 units annualized. In July, the NAHB sentiment survey broke through the lower end of the relatively narrow two-point range that had prevailed for the prior 10 months. We look for about a 4% decline in sales, to a pace that is just a shade under the 17-year low hit back in March. * We look for about a 3-point rise in the Conference Board consumer confidence index to 55.0, reflecting the recent pullback in gasoline prices. Note that this gauge has lagged a little behind the * We expect durable goods orders to rise 0.2% in July. Company reports point to a rebound in the volatile aircraft category. Moreover, auto assembly plans suggest that a seasonal quirk could lead to a gain in advance bookings of motor vehicles. However, the underlying details of the report are expected to be consistent with the recent deterioration in the ISM new orders gauge. In fact, the key core component – non-defense capital goods excluding aircraft – is expected to be down 0.6%. Finally, we look for a modest uptick in core capital goods shipments and a slight moderation in the pace of inventory accumulation. * We expect 2Q GDP growth to be revised up to +2.5% from the originally reported reading of +1.9%. An unusually large adjustment to net exports accounts for the bulk of the anticipated revision. Inventories are also expected to be a bit higher than shown in the original estimate. * We look for July personal income to fall 0.3% and spending to rise 0.3%. The tax stimulus payments will distort the income and saving figures again this month. But even excluding this special factor, we estimate that personal income would show only a 0.25% rise in July. Meanwhile, consumption will be held down by another decline in purchases of motor vehicles. Finally, our translation of the July CPI and PPI data points to a 0.34% rise in the core PCE price index, with the year-on-year rate ticking all the way up to +2.5% from +2.3%.
Argentina
Default Fears August 26, 2008 By Daniel Volberg & Gray Newman | New York The decision by the authorities in mid-August to open a program of debt buybacks highlights one of the key investor concerns for next year – the specter of increased risk of default. Even as many of the region’s economies have seen credit rating upgrades – Investor Concerns Investor concerns center on three issues – Questions about It is true, of course, that rising debt service obligations are set to increase Meanwhile, falling commodity prices and burgeoning expenditure growth have contributed to investor concerns about the sustainability of the fiscal surplus. Last year, fiscal spending grew 47% relative to the year before, while revenues grew 40%. And while in the first seven months of 2008, fiscal spending growth has moderated to 34%, with commodity prices falling and GDP growth projected to slow as well, the risk is that next year’s revenue growth may slow considerably from the current pace of 38%, placing the sustainability of the fiscal surplus in doubt. That is because near 80% of federal fiscal revenues come from just four sources – value added (VAT), payroll (social security), income and export taxes. VAT, payroll and income taxes, which together account for nearly US$32.5 billion out of the total tax take of US$47 billion year to date, are largely driven by two factors – economic growth and inflation. And while export taxes are only US$6.2 billion so far this year, they are significantly larger than the overall fiscal surplus of US$4 billion. Thus, with soy prices down 20% in the last month and a half and with our forecast of economic growth of 4.7% in 2009 or a consensus forecast of 4.5% in stark contrast to the 8.1% average growth in 1H08, it is not hard to extrapolate that fiscal revenues may slow in the months ahead. And with the authorities so far showing few signs of cutting expenditure growth, questions about sustainability of the fiscal surplus are adding to the concerns that the authorities may not be prepared to deal with next year’s rising financing needs. Not as Bad as it Seems While market jitters appear to be justified by the deterioration in fundamentals, we suspect that the situation may not be as bad as it first seems. The markets are signaling a drastic deterioration – in the past 13 months, 5-year CDS widened by nearly 600bp to the widest point in the past three years for which data are available. Whether current market prices suggest that default is imminent is up for discussion, but we would argue that the risk of a default next year is limited. We start with the fact that while total debt payments (buybacks, capital and interest) coming due next year are US$20.2 billion, only buybacks, bonds and guaranteed loans to the tune of US$14.7 billion are likely to be at issue – we suspect that the rest (largely multilateral and central bank debt) is likely to be rolled over without a hitch. Here are our four thoughts on why we suspect First, the authorities have deep pockets, having saved part of the proceeds of the past five years of abundance. According to our calculations, the federal government may have near US$10-11 billion in savings in the banking system and US$47 billion in international reserves at the central bank. We estimate that nearly US$4 billion out of the US$10-11 billion in savings are working capital, leaving US$6-7 billion to help offset any difficulties in meeting 2009 financing needs. As for the international reserves, it is true that legally they cannot be deployed for servicing bonds or guaranteed loans, but they can be used to pay bilateral and multilateral creditors. Of course, dipping into savings and reserves is not a good signal, nor a long-term solution to a fundamental problem, but it does buy the authorities time. Second, local sources should help offset some of the debt service coming due next year. Local pension funds are going to have to invest part of their new funds in new public debt securities, helping cover part of the debt coming due. Using data provided by the Economy Ministry on social security tax collection, we estimate that pension funds may be able to provide between US$1.8 and US$3 billion in new funding next year. Using the lower estimate and not counting the savings, that leaves a total of US$12.9 billion left to cover. Third, authorities could tighten fiscal policy to free up cash. Subsidies are the fastest-growing item on the fiscal spending side. In the first six months of the year, energy and transportation subsidies grew (in nominal terms) by 110% and 39%, respectively. In fact, if subsidies continue growing at their current rate, then energy subsidies would reach US$4.1 billion by the end of 2008 and transportation subsidies another US$2.9 billion. Together they would account for nearly 55% of all subsidies this year. Significant increases in residential energy and public transportation prices – prices that have been largely unchanged since 2001 – would be both healthy for the overall economy and would allow for significant fiscal savings (see “Argentina: Credit Crunch or Energy Crisis”, This Week in Latin America, August 13, 2007). While the authorities have been reluctant to take this course, we suspect that the idea of raising energy prices continues to be under consideration, even after the modest increase instituted last month. Should the authorities decide to raise prices by roughly 30%, that could provide them with an extra US$2.1 billion. That leaves the authorities with US$10.8 billion to cover. Finally, we suspect that the authorities are set to enjoy a significant fiscal surplus next year. We estimated an econometric model to help quantify the effects of inflation, growth, commodity prices and other macroeconomic fundamentals on fiscal revenues. Our finding is somewhat surprising, but reassuring – even in the event of another 30% correction in the price of soybeans, GDP growth slowing to our forecast 4.7% pace and with inflation near 23%, the primary fiscal surplus is set to be 2.1% of GDP or US$8.7 billion (assuming an exchange rate of 3.25). This is far below the 3.4% of GDP primary surplus that is likely this year, but it is still a substantial amount of money. That leaves the authorities with US$2.1 billion to cover, most likely by issuing debt to There are risks to our call for a healthy fiscal surplus. It critically depends on the pace of expenditure growth. We assume that fiscal expenditures would grow at 34% – the average pace of 1H08. This assumption is also consistent with our model’s estimate of expenditure growth that is projected based on, among others, GDP growth, inflation and previous pace of spending. Here is the risk: next year is a mid-term election year, and the authorities have seen their approval ranking tumble in recent months from near 55% in January to near 20% in July, setting up the possibility of fiscal stimulus. Recall that last year in the run-up to the presidential election, expenditure growth accelerated to 47% from 27% the year before. In fact, if instead of assuming expenditure growth at the pace of 1H08, we assume that spending will grow at the pace of the average of the last four quarters (3Q07-2Q08), then next year’s projected 2.1% of GDP primary surplus turns into a primary surplus of only of 0.4% of GDP (US$1.6 billion). While we acknowledge this risk, we suspect that the authorities have a deep commitment to maintaining a fiscal surplus and continuing to rein in public spending. Indeed, they appear to have been alarmed at the pace of expenditures engineered in the run-up to the last election, prompting public statements to that effect and a (ultimately unsuccessful) push to raise export taxes. Bottom Line Investors have been increasingly jittery and pessimistic about
Colombia
No More Hikes August 26, 2008 By Boris Segura | New York Despite the fact that In what follows, we will expand our reasoning why Banco de la Republica is likely to stay on hold for the foreseeable future. Inflation Outlook Is Still Challenging The inflation picture in Perhaps more importantly, ex-food inflation is not likely to roll over easily. In its latest inflation report, Banco de la Republica expresses concern about the indexation mechanisms in regulated prices (utilities, fuel and transportation) and potentially wages. Regarding non-tradables inflation excluding food and regulated prices, even when the ongoing deceleration of the economy is helping to keep it under control (more on this below), the central bank does not expect a decisive break below 5% until 2H09. In fact, the central bank qualifies its statement, stressing that the link between slower growth and lower inflation would only work if inflation expectations decrease and wages remain contained. The recent correction in international commodity prices is likely to aid inflation. In particular, we should get some relief on food inflation. Also, Banco de la Republica expects an improved supply of local non-processed food during the first months of 2009, as its production is currently being ramped up. In terms of fuel prices, the relief should not be meaningful, as the authorities partially subsidized them during the oil crude price run-up. Looking ahead to 2009, there is a non-trivial probability that the central bank misses its target again. Its inflation projection only foresees headline inflation reaching its 4% target in early 2010; ex-food inflation should have a hard time converging to the target in 2009 as well. We broadly agree with Banco de la Republica’s assessment, although we are slightly more pessimistic. Given indexation of regulated prices and some contamination of inflation expectations and wages, we are revising our year-end 2009 inflation forecast. Thus, we expect the central bank to miss its target for a third-year running. Expectations: Surveys from Mars, Breakevens from Venus? The July 25 rate hike was a credibility-enhancing move by Banco de la Republica. As we argued last month, the deterioration in inflation expectations was increasing the risk of them becoming unhinged, and the central bank needed to safeguard the credibility of its inflation-targeting regime by hiking rates (see “Colombia: A Case for Hiking Rates without Delay”, This Week in Latin America, July 21, 2008). The market agreed with our assessment. After the rate decision, there was a strong rally in Colombian fixed income markets. The yield curve flattened, and breakeven inflation expectations moved down accordingly. However, inflation expectations based on surveys conducted by Banco de la Republica do not show improvement yet. Twelve-month-ahead inflation expectations have moved 100bp higher since April. However, these surveys tend to be adaptative to actual inflation. Therefore, we should expect survey-based inflation expectations to come down in due course. The truth lies somewhere in between. Even when breakeven inflation is showing improvement, not all of it can be credited to the latest hike by Banco de la Republica. In fact, (nominal) local rates looked oversold in mid-July, and the government has not executed any more debt swap operations since the US$500 million done in May. This operation was partly behind the explosion of the cross-currency swap curve, which also dragged the local rates curve with it. Our own diffusion index for ex-food inflation should provide some comfort. Ex-food inflation is becoming less diffused; last June’s jump actually was more of a blip. This leaves us a little bit more sanguine about the prospects of inflation expectations going forward. Orderly Deceleration of the Economy Observers are worried about the sharp drop in growth between 4Q07 and 1Q08. GDP growth went from 8.4% in 4Q07 to 4.1% in 1Q08. We argued earlier that 1Q weakness may have been exaggerated (see “ Banco de la Republica adjusted its growth estimates downwards. In its latest inflation report, the central bank lowered its growth forecast for 2008 from a 4-6% range to 3.3-5.3%, with a most likely point estimate of 4.3% (from 5.2%). After a sustained dose of monetary tightening, it is inevitable that the economy is decelerating. After all, rates of growth of 8.2% like 2007’s are not sustainable in an economy whose potential GDP growth hovers around 6%. According to the central bank, the output gap is still positive, but shrinking; we expect it to dissipate by year-end. From the expenditure side, the slowdown is likely to be generalized. Again, we are seeing no collapses but slower growth across the board. Investment is likely to lead the charge, with exports holding in quite well this year, due to surging oil and mining exports. From the supply side, interest rate-sensitive sectors are leading the deceleration. For example, industrial production and retail sales have been weak throughout this year; the same has been seen in construction (mostly civil works) and financial services (credit growth is decelerating and non-performing loans are on the rise). We expect 5% growth in the 2Q report. We expect some recovery in investment, from a depressed reading in 1Q, as well as a further drop in imports (mostly durable goods). This reading would be consistent with our full-year GDP growth forecast of 4.6%. There is downside risk to our growth forecast. Slower global growth could dent so-far strong export volumes and prices. Another risk factor is potential economic trouble in Monetary Policy Response As explained above, there is a non-trivial probability that Banco de la Republica misses its inflation target for the third consecutive year in 2009. What should be its monetary policy response? Unfortunately, its most recent inflation report does not provide us with a longer-term assessment of inflation by the central bank. The central bank should not heed incipient voices that are now pushing for rate cuts. We sense an orderly, soft landing of the economy. As such, there is no need for monetary stimulus to prop up economic activity. Besides, the central bank should minimize contamination of inflation expectations which, although down, are still well above its inflation target. We expect Banco de la Republica to stay on hold for at least the rest of the year. Unless inflation and inflation expectations deteriorate, we don’t see the central bank hiking either. We feel that the central bank has done its tightening job, hiking by 400bp over the last 30 months. Its intervention rate in real terms is certainly high. Banco de la Republica is likely to keep a hawkish discourse. We were pleasantly surprised by the reaction of monetary policymakers to the criticism of its latest rate hike on July 25. On several occasions since, the central bank has forcefully responded to charges that its policy stance is choking the economy and that “a little more” inflation doesn’t matter. Minutes of the July 25 meeting and the latest inflation report elaborate further on the reasons why the central bank is uncomfortable with the inflation outlook. Bottom Line We contend that Banco de la Republica has ended its monetary tightening campaign. Headline inflation should peak soon, and cumulative tightening has all but eliminated the positive output gap in the economy. But the central bank should ignore the siren song for rate cuts. The economy is going through a ‘soft landing’, and the inflation outlook is challenging; under these conditions, a rate cut would send a contradictory signal. Inflation expectations are still high, and the central bank should avoid the risk that high expectations can pose to faster wage growth. In our view, the battle to limit expectations from feeding through to higher wages is probably the greatest challenge facing the central bank in the coming months.
Indonesia
Coming Interbank Liquidity Squeeze August 26, 2008 By Chetan Ahya, Deyi Tan | Singapore & Shweta Singh | India Domestic Demand Growth Remains Strong Domestic demand (ex-inventories) remains strong at 6.9% in 2Q08 after recovering from the trough of 2.3% in 3Q06. Consumption as well as investment demand indicators indicate a healthy trend in 2Q08. Motor vehicle sales grew at an average of 43% during the last three months. Non-oil and gas imports grew at an average of 49%Y during the three months ending June 2008. The lagged impact of a cumulative 450bp policy rate cut between April 2006 and December 2007 is driving the credit growth and supporting aggregate demand in the economy. Credit growth accelerated to 33.6%Y in June 2008. It is likely to exceed the highest level reached post the 1997-98 crisis (33.8% in April 2001). Real policy rates at -3.1% (as of July 2008) and real prime lending rates estimated at less than 0% (as of July 2008) offer support to this trend. Many Hurdles in Sustaining this Trend Low Exchange Rate Volatility Helping to Extend the Trend this Time In the past, strong domestic demand has pushed import growth, narrowing the current account surplus. Reversals in the global risk appetite at the same time would result in exchange rate volatility. Typically, during such uncertain times, the locals have also added to the currency volatility by switching into dollar deposits from rupiah deposits. This environment could force the central bank to pursue a tightening monetary policy aggressively. The tightening could help to check the exchange rate volatility and slow aggregate demand, which reduces the inflationary pressures. However, so far in the current cycle, sharp rises in the prices of commodities such as coal and crude palm oil have meant that the current account surplus has remained reasonable at 2.3% of GDP (1Q08), ensuring that the exchange rate does not depreciate. However, sustained non-oil import growth at a time when commodity prices are declining will narrow the foreign trade balance and increase the risk of weakening the exchange rate. Non-oil import growth has averaged 49% during the three months ending June 2008. Capital inflows are also likely to slow further due to reduced global risk appetite for emerging markets. Tightening Interbank Liquidity Will Be the Biggest Hurdle in the Current Cycle While the CPI inflation rate has moved to 11.9% from the trough of 5.3% in November 2006, the policy rate has increased to 9.0% currently, from 8.0% in January 2008. We believe that if Bank Initially, this acceleration in credit growth did not result in a tightening in liquidity, as the bank credit-deposit ratio was low. However, at 72.7%, the bank credit-deposit ratio is now close to full capacity. Banks have to impound approximately 9-10% of rupiah deposits (which account for about 83-84% of the total banking sector deposits) in cash reserve ratio (CRR). On dollar deposits, the required CRR is 3.0%. Banks tend to invest about 20-25% of the deposits in government bonds (meeting the government’s fiscal deficit). Not surprisingly, interbank liquidity has begun to tighten as the bank credit-deposit ratio crossed into the 70-72% range. Our estimates indicate that if banks continue with the current 33% credit and 15% deposit growth, the banks’ credit-deposit ratio will likely increase to 75% in four months’ time (December 2008) and 84% by June 2009. We think this will likely do very little for funding the government’s fiscal deficit. We believe that the banks are unlikely to be able to manage the current 30-35% credit growth as liquidity pressures will likely rise significantly. The initial signs of the tightening interbank liquidity are evident in the recent Jibor (Jakarta Inter-Bank Offered Rate) trend. The spread of Jibor over Bank Quick Moderation in Domestic Demand Would Help to Maintain Macro Stability We believe that the ideal outcome could have been an aggressive policy tightening by the central bank, ensuring moderation in credit growth to 20% and domestic demand to 5-5.5%. This would also ensure that the current inflationary pressures do not become vicious. The current gradual tightening approach will mean that the market forces will likely take charge and cause an automatic tightening. More importantly, it will likely increase the risk of a disruptive tightening in the case of either a major fall in commodity prices, taking away the support of current account surplus, and/or major global financial market risk-aversion, which could result in capital outflows. |