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Chile The Inflation Challenge India Rising Credit Spreads and Slowing Consumption View GEF Archive

		The Global Economics Team

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Despite the recent string of dovish data, we believe that it is too early to be complacent on the inflation front.   The dovish camp argues that the current inflation ‘perfect storm’ will quickly subside.  However, we would argue that in the near term, upside inflation risks will dominate the policy debate and will require Chile’s central bank to maintain its tightening bias and hike one more time to 6.50%. The upshot: with recent peso gains apparently driven by widening interest rate differentials between Chile and the US, we suspect that the peso is likely to remain stronger for longer. Indeed, in the context of an inflation problem that contains a significant imported element, any sustained bout of currency weakness could force the central bank’s hand, thus capping the currency’s downside. 

Dovish signs…

The ranks of Chile watchers calling for the end of the tightening cycle have swelled of late as a string of dovish data has provided them with plenty of ammunition to call for the end of the tightening cycle. 

On the inflation front, January brought welcome, albeit modest relief.  Not only was January’s inflation reading below expectations, but it also pushed the annual pace down to 7.5% from the 11-year high of 7.8% in December.  Encouragingly, both clothing and produce posted meaningful monthly declines, displaying fairly normal seasonal behavior.  In addition, the decision by the finance ministry to allocate US$200 million to the Fuel Price Stabilization Fund showed up in the form of lower gasoline prices.  The impact of this subsidy on fuel prices will show up with more intensity in February’s inflation data – partly offsetting coming adjustments to electricity tariffs – leading to projections for a negative monthly change in headline inflation.  

Meanwhile, the central bank’s February expectations survey showed a modest decline in both year-end inflation (3.8% from 4.0% in January) and in the key two-year forward inflation measure (3.2% versus 3.3% in January), which is the relevant horizon for monetary policy. 

On the growth front, the economy ended the year at a sluggish pace and the outlook for 2008 points to more of the same.   Following the central bank’s own reduction in 2008 growth estimates in its quarterly inflation report of January 16 (to 4.5-5.5%), market expectations were trimmed to 4.6% from 4.9% previously – a level slightly below the generally agreed potential growth rate of around 5%.  In addition, December’s GDP-proxy IMACEC came in at 3.7%, a disappointing clip considering that December 2007 had one additional workday compared to the same month in 2006.  The central bank acknowledged that utilities and selected energy-intensive industrial sectors had been major drags; however, signs of broader deceleration have been evident for some time. Indeed, in the February communiqué, authorities acknowledged a worsening in the external backdrop while growth in domestic consumption, which in January had been characterized as being “dynamic”, was now showing “signs of deceleration” (see “Chile: Consumer Crunch Time”, GEF, January 29, 2008). 

The domestic picture is facing an additional headwind in the form of a possible energy crunch.  The combination of dwindling natural gas imports from Argentina, the failure of an important thermal plant and, above all, low rainfall – reservoirs are some 30% below historical averages – has prompted authorities to announce electricity-saving measures in an attempt to avoid possible rationing when seasonal factors cause demand to increase next month.  While it is too early to determine the extent of the potential rationing, there is no mistaking that Chile’s electric system faces a delicate balance characterized by thin reserve margins.

…but inflation risks linger

While recent signs have been undeniably dovish, Chile’s inflation backdrop will remain challenging in coming months, thus keeping the risk to policy rates tilted to the upside and underpinning our constructive view on the peso.  

Inflation is set to get worse before it gets better, in our view.  Indeed, we suspect that the central bank’s decision to maintain a “data-driven” tightening bias in February by stating that it “cannot rule out the necessity for hiking again” underscores authorities’ lack of comfort with the inflation backdrop (see “Chile: Missed Opportunity”, EM Economist, February 8, 2008).  After the modest annual drop to 7.5% in January, inflation is set to resume its upward trend, likely peaking above the 8% mark in March. The coming weeks will bring important adjustments to a series of backward-looking indexed prices, such as education and housing rentals. Moreover, electricity price hikes at the residential level are in the pipeline. 

And the outlook for food and energy prices – which accounted for the bulk of the 2007 inflation surge – isn’t getting much better. The central bank’s central base scenario that food quotes should “not be an additional source of pressure” appears to be at risk in the near term, even if softer global demand eventually brings prices lower later in the year.  Since the third quarter of last year, wheat is up nearly 45% while corn quotes rose 50%.  In fact, industrial chambers have hinted at the need for further price adjustments in response to skyrocketing soft commodity quotes, combined with higher energy costs.  Moreover, the ongoing drought adds another risk element to the dovish view that food prices will remain well behaved as they did during January. 

While the jury is still out on whether low rainfall leads to rationing and over the medium term its impact should be disinflationary via weaker economic activity, the electric system’s precarious balance should translate into higher costs in the near term.  Some offset on fuels has come from the Fuel Stabilization Fund and unchanged tariffs on the Transantiago transportation system.  There could be additional administrative measures to come such as cuts in fuel taxes.  Overall, however, we see a very difficult near-term picture, before a powerful base effect brings annual inflation lower in 2H08.

The currency lever 

Given the nature of the current inflationary shock – caused predominantly by international commodity prices – the exchange rate channel is the most suited to dealing with the problem.  Indeed, recent peso strength played a role in the central bank’s decision to keep rates on hold in February, as signaled by the statement’s uncharacteristic reference to the “persistence of the (significant) appreciation” in the exchange rate as a key determinant in future policy actions.  For example, since the release of the most recent quarterly inflation report in January, wheat and corn gained 8% and 12%, respectively.  Against this backdrop, we suspect that the peso will remain stronger for longer.  We make three observations on this subject:

First, monetary policy decisions affect the exchange rate instantaneously or at most within a matter of months.  By contrast, output is less sensitive to monetary policy decisions than the exchange rate – we estimate that in Chile’s case the impact of interest rate changes on growth comes with a lag of 6-8 quarters.  Thus, the central bank has room to tighten further to mitigate the current inflation problem – which is likely to intensify in coming months – without jeopardizing economic growth in the near term.  The adverse effects of tightening on growth could be partly offset by some fiscal stimulus, which in the near term could take the form of more fuel subsidies or targeted help to selected sectors – both of which are already taking place – and, in 2009, from the possible flexibility of the structural surplus rule to allow for more spending (see “Chile: Conserving Abundance”, EM Economist, February 15, 2008). Further, the central bank has already discussed the possibility that today’s uncertainty could require some policy ‘fine-tuning’ which would translate into taking back some of the hikes in a more proactive way than in the past once the exchange rate has done its work (see “Chile: No Time for Inflation Complacency”, GEF, January 23, 2008). 

Second, since the peso began to float in 1999, the pass-through from the currency to inflation has been very limited.   In our view, this is testament to the credibility and effectiveness of the central bank’s inflation-targeting regime and the flexibility of the exchange rate.  However, given the imported nature of today’s inflation problem – as of January non-tradable prices already showed signs of moderation while tradables continued to trend higher – peso appreciation is the most suitable lever to keep inflation from deteriorating further from already high levels, in our view. 

Third, our estimates for the peso show that the recent strengthening is not fully coherent with fundamentals, and thus we expect depreciation over the medium term closer to the 490-500 range.  We warn of further peso appreciation in the near term, while expecting some weakness by year-end or into early 2009. 

Bottom line

Chile is facing its most daunting inflation challenge in over a decade.  With limited if any relief likely in the near term and given the largely imported nature of the inflationary shock, peso appreciation is the tool most suited to dealing with the problem.  The upshot: the peso is likely to stay strong in the near term as any prolonged bout of currency weakness could prompt action by the central bank.

India
Rising Credit Spreads and Slowing Consumption
February 20, 2008

By Chetan Ahya, Singapore

Retail loan growth slows after sustained rise for three years

Retail loan growth has slowed significantly over the past year to an estimated 16% in QE March 2008, compared with an average of 50.1% between F2004 and F2006 (total of SBI Bank, ICICI Bank, HDFC Bank, HDFC Ltd., Axis Bank and Corp Bank.). The private sector players, which account for the majority of the market share in this segment, are choosing to slow retail loan growth. The slowdown is across the board for almost all retail loan segments, including unsecured consumer, automobile, consumer durable and mortgage loans. The worst-affected area has been low-ticket loans.

Rise in credit spreads

As in many other parts of the world, India has witnessed the rise in credit spreads for household loans. The key reason for risk aversion in the banking sector is the rise in credit costs, particularly for the lower and middle-income population, due to:

· Rising cost of living: Low and middle-income households have seen a significant increase in their cost of living in major cities.

· Higher lending rates, resulting in increased debt servicing ratio: Aggressive monetary policy tightening by the RBI since 2H06 has meant an increase in deposit costs, forcing the banks to pass on these costs.

· Recent political noise against tough loan recovery effort by the banks: Political noise against aggressive recovery efforts by banks has actually made the borrower more complacent in repaying loans.

For instance, for some low-ticket loans like two-wheelers, one of the large players informed us that the credit costs have increased from around 180bp to about 350-400bp over the past two years. Credit costs are now beginning to rise for car loans as well. This rise in credit costs has made most of the private players risk-averse. Most have increased the credit spreads for consumer loans. Some of the large players are charging two-wheeler loan rates of 18-22%, from the bottom of 9.5% in 4Q05. Private players are now demanding unusually high credit spreads of 700-800bp for two-wheeler loans, compared with unsustainably low 300-400bp spreads in 4Q05.

Slowing credit-funded household spending

Credit-funded household spending had been one of the most important drivers of GDP growth over the past four years. The higher cost of borrowing is slowing retail loan growth. We believe that this slowdown in credit growth is adversely affecting household spending. This is already reflected in two-wheeler vehicle sales declining by an average of 5.4%Y over the past ten months. Similarly, consumer durable sales are declining by an average of 1.7%Y over the past eight months. The overall consumer goods component of the Index of Industrial Production has slowed to an average of 6.4%Y during the three months ended December 2007, from 13% seven months back. Fresh mortgage disbursements by three large players (ICICI Bank, HDFC and LIC Housing) slowed to just 2%Y during QE December 2007, compared with 30%Y in QE June 2006.

We expect GDP to slow to 7.5-8% during QE March 2008 from the peak of 10.2% during QE September 2006 on weakening private consumption and exports. This trend is also reflected in a sharp deceleration in revenue growth for a broad basket of 1,524 companies (excluding oil and gas and finance companies) to 13.4%Y during QE December 2007 from the recent peak of 28.9%Y during QE September 2006. Strong business investment growth is the only key positive driver. However, we believe that continued weak growth in household spending and exports will likely start weighing on business investment too. We therefore estimate that GDP growth will continue to slow over the next three quarters.

What will help to reverse this trend?

Retail loan rates are high and need to decline by 100-250bp. A green signal from the RBI by way of a reduction in policy rates and/or risk weights could ensure a meaningful cut in lending rates. The RBI is however deferring the policy rate cuts as it is concerned about the inflation risks emerging from higher oil and food prices. We believe that if commodity prices fall 20-25%, it will create room for the RBI to allow a meaningful cut in lending rates, ensuring a recovery in leveraged spending by households. Lower commodity prices, particularly soft commodities, could also help to reduce the high cost burden on consumers by improving their real disposable income.

Equity market implications

From a portfolio perspective, our strategist Ridham Desai remains underweight the consumer discretionary sector. In contrast, he is overweight the consumer staples sector, which should not be affected by the interest rate environment.

 

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