United States
Review and Preview
April 08, 2008

By Ted Wieseman | New York

Significant front-end losses and small back-end gains sent the Treasury yield curve much flatter over the past week as a major further improvement in credit markets reduced investor fears about downside risks to the economic outlook even as incoming data continued to indicate that the economy is in recession.  It’s certainly a lot easier for investors to get their minds around the idea of a regular recession than some sort of systemic meltdown doomsday scenario that was becoming an increasing fear when disorderly credit markets were hitting their worst levels as Bear Stearns was blowing up three weeks ago.  Private sector payrolls declined for a fourth straight month in March, both ISM surveys improved slightly but remained in contractionary territory, and motor vehicle sales were dismal and production plummeted as the American Axle strike led to widespread shutdowns at GM plants.  For first quarter growth, the weakness in March motor vehicle sales and production was largely offset by a neutral construction spending report and modest upside in capital spending and inventories from the factory orders figures, but we still see 1Q GDP declining 0.5%, down marginally from our -0.4% forecast a week ago.  The further confirmation of ongoing recession from the early round of key March data and additional information bearing on 1Q GDP, however, was basically in line with investors’ expectations, with a recession now widely believed to be ongoing.  More important was the dramatic further improvement in credit markets and the perceived reduction in downside risks to the recession this pointed to, with the corporate investment grade CDX index tightening to its best level since early February, the AAA rated commercial mortgage CMBX index and leveraged loan LCDX index tightening to their best levels since January, and even the previously lagging AAA rated subprime ABX index rising to its strongest level in a month.  In response, previously highly popular curve-steepening positions were unwound and Fed rate-cutting expectations were scaled back, though a move through Thursday towards pricing just one more 25bp rate cut at month-end was partly reversed in response to the employment report, with a final move to 1.75% in June still priced in at week-end.  A reasonable chance is now seen, though, that the Fed could be hiking rates as soon as December.

On the week, 2s-10s flattened 14bp to 165bp and 2s-30s 18bp to 249bp, lows since the first week of February, with the 2-year yield up 16bp to 1.83%, 5-year 11bp to 2.635%, and 10-year 2bp to 3.48%, while the long bond yield dipped 3bp to 4.32%.  TIPS underperformed, with the 5-year yield up 19bp to 0.34% and 10-year 7bp to 1.19%.  Swap spreads tightened on the week, though all of the move came Friday, with the benchmark 10-year spread falling 5bp to 62.75bp, and agency MBS extended their recent improving trend, outperforming swaps by a decent amount. 

Though the week’s losses were significantly mitigated by a positive response to Friday’s employment report, the key driver through the week of the paring back in Fed rate-cutting expectations and unwinding of curve-steepening trades was a major further improvement in credit markets.  In late trading Friday, the recently introduced current series 10 5-year investment grade CDX index was 32bp tighter on the week at 110bp, while the off-the-run series 9 index was at 115bp, its best level in two months and way down from the closing wide of 193bp hit March 10.  Two other areas of significant recent focus recently – commercial mortgages and leveraged loans – also showed major further improvement.  These still seem likely to be areas that see significant write-downs as financial companies report 1Q results in coming weeks, but the recent improvement is certainly suggesting that 1Q may mark the worst of it.  On the week, the commercial mortgage AAA CMBX index tightened 23bp to 131bp, its best level since late January and less than half the wide close of 277bp on March 10.  And the leveraged loan LCDX index was 52bp tighter on the week through midday Friday at 370bp, the best level since mid-January and down from the wide close of 536bp on February 15.  Even the previously badly lagging high-rated parts of the subprime ABX market finally joined in the recent rally, with the current series AAA index gaining nearly 6 points on the week to 57.70, the best close since March 3 (though the low-rated ABX indices continued to sink).  Stocks were a secondary focus of interest rate investors compared to credit, but the S&P 500 also had a strong week, gaining 4.2%, though almost all of this came in a huge rally Tuesday, with little change in the rest of the week.

Fed rate-cutting expectations were scaled back, though a more pronounced move through Thursday that had the market moving towards pricing in just one more 25bp rate cut was largely reversed after the employment report, leaving the market still priced for 25bp rate cuts at the April and June FOMC meetings, with the June move to 1.75% expected to mark the end of the easing cycle.  The May fed funds contract lost 3bp to 1.91%, moving from a toss-up between 25bp and 50bp at the April 29-30 FOMC meeting to more clearly favoring 25bp.  The July contract lost 3.5bp to 1.82%, and the now low-rate August contract 4.5bp to 1.80%.  We agree with the market’s expectation that 1.75% will mark the funds rate trough, though we think that the chances are better that the FOMC gets there in April instead of waiting until June.  This scaling back of near-term rate-cutting expectations was exceeded by a further rise in 3-month LIBOR to a 3-week high of 2.73%, resulting in the 3-month LIBOR/3-month OIS spread rising 4bp to 76bp.  This still severely strained and worsening situation in the interbank lending markets makes clear that even as the credit markets have hugely improved, the stresses on the banking system remain intense, and the resulting credit crunch will likely continue to be a major problem for the economy going forward.  The shift in Fed expectations was larger on a somewhat longer-term view.  Eurodollar futures losses (which extended through the Dec 10 contracts, with gains beyond that) were led by a 15bp decline in the Sep 09 contract to 2.83% and a 13.5bp drop in the Dec 09 contract to 3.09%, as more tightening off the late summer/fall expected trough in rates was priced in next year.  The Sep 08/Sep 09 spread steepened 6bp to 59.5bp and the Dec/Dec spread 5.5bp to 77.5bp, close to five-week highs. 

The key round of early March data were directionally mixed, but broadly consistent with ongoing recession, with a fourth straight decline in private sector payrolls and sharp rise in the unemployment rate, slight improvement in both ISM surveys but to levels still below the 50-breakeven level, and terrible motor vehicle sales results along with more information from GM on how severe the impact of the American Axle Strike has been on production.

Non-farm payrolls declined 80,000 in March, a third-straight fall, with private sector payrolls down 98,000, a fourth-straight drop.  Weakness was led by construction (-51,000), manufacturing (-48,000, with the American Axle strike leading to a big drop in motor vehicles), business services (-35,000) and retail trade (-12,000).  Other details of the report were mixed.  On the negative side, the unemployment rate rose to 5.1% from 4.8%, a three-year high.  And average hourly earnings rose a sluggish 0.3%, dropping the year-on-year pace to +3.6%, a two-year low.  On the positive side, the average workweek rose a tenth to 33.8 hours, resulting in a 0.2% gain in aggregate hours worked and a 0.5% jump in aggregate weekly payrolls, implying solid personal income growth.

The manufacturing ISM composite diffusion index rose marginally in March, but remained in contractionary territory for the third time in the past four months at 48.6 (versus 48.3).  The key orders (46.5 versus 49.1) and production (48.7 versus 50.7) indices declined, but this was offset by upside, though to still below the 50-breakeven level, in employment (49.2 versus 46.0) and a good gain in the now more heavily weighted supplier deliveries gauge (53.6 versus 50.1).  The industry breakdown remained weak, with eight sectors reporting expansion in March and eight contraction.   Meanwhile, the non-manufacturing ISM composite diffusion index rose to 49.6 in March from 49.3, holding barely below the 50-breakeven level.  The business conditions (52.2 versus 50.8) and orders (50.2 versus 49.6) indices both rose to levels above 50.  This was partly offset by a dip in the supplier deliveries gauge (49.0 versus 50.0), while the employment index (46.9) was steady at a weak level.  The industry breakdown was positive.  Eleven sectors reported growth, led by real estate, mining, agriculture and construction, and six contraction, including transportation, wholesale trade, educational services and finance. 

Motor vehicle sales fell to a 15.1 million unit annual sales pace in March, a low since October 2005, from 15.3 million in January and February, making for the worst quarter of sales in a decade.  The mix was weak.  Imports rose to 3.9 million from 3.6 million, while sales of domestically produced vehicles tumbled to 11.2 million from 11.7 million, a 15-year low.  And sales of trucks fell to 7.5 million from 8.0 million, a low since the 1998 GM strike.  GM reported that the parts shortages resulting from the ongoing American Axle strikes had resulted in complete or partial shutdowns at 30 plants and caused its assemblies in March to plunge 41% year on year.

The weakness in March motor vehicle sales and severely negative implications for production implied by the GM report on the American Axle impact pointed to weaker consumption and inventories in 1Q.  However, this was largely offset by upside in the factory orders report.  Core capital goods shipments were adjusted up a bit in February to -1.9% from the 2.1% decline initially released in the durable goods report, pointing to a slightly smaller decline in business investment in 1Q.  And overall factory inventories also rose a slightly higher-than-expected 0.5% in February.  Meanwhile, the construction spending report was superficially better than expected, but very soft, as expected, in the underlying details.  Construction spending fell just 0.3% in February, but only because of a surge in the unreliable home improvements component.  Overall private residential spending fell 0.9%, the smallest decline in almost a year.  The drop was strongly mitigated, however, by a 5.1% surge in the volatile and for GDP purposes irrelevant improvements component.  New homebuilding plunged 4.9%, extending a string of extraordinarily large declines.  Business construction has joined the downturn in housing, though to a much lesser extent, with private non-residential spending down 0.1%, a third straight decline.  Meanwhile, public construction rose 0.4% for a second straight month, but after a 2.3% plunge in December this still left it on a weak 1Q trajectory.  Combining the negative implications for consumption and inventories of the motor vehicle sales results, the slight upside in investment and inventories implied by the factory orders report and the neutral construction spending data, we trimmed our 1Q GDP forecast marginally to -0.5% from -0.4%.

There’s not much in the way of key economic news in the coming week.  The FOMC minutes will be released Tuesday and shed some light on why the Fed decided to disappoint market expectations, which investors took in stride, for a 100bp cut and instead only cut 75bp.  It appears that there may have been a significant split between the Board of Governors preferring a bigger move and a number of regional presidents preferring less aggressive action, which resulted in a 75bp compromise.  The monthly chain store sales reports due out from most companies Thursday will firm up expectations for March retail sales after the weak auto sales results.  The very early Easter this year will complicate interpretation of the reported results, however.  Other key data releases due out include the trade balance and Treasury budget, also on Thursday:

* We look for the trade gap to widen US$0.8 billion in February to US$59.0 billion, with exports down 0.6% and imports flat.  On the export side, aircraft industry data and factory shipments figures point to a significant pullback in capital goods, with further upside in food and industrial materials expected to provide a partial offset.  On the import side, petroleum products are likely to pull back somewhat from January’s record high and autos should be weak again, but port data point to an offsetting rebound in other goods after a couple of very weak months.

* We expect the federal government to report a US$47 billion budget deficit in March, much smaller than the US$96 billion recorded last March, though mostly as a result of calendar shifts (which sharply raised the deficit this February versus the prior year).  In particular, net revenues should be sharply boosted by a big decline in tax refunds because of a different calendar pattern, while spending should be significantly restrained by the movement of a large chunk of early March payments into February because March 1 fell on a Saturday this year.  We continue to see the 2008 budget deficit widening to US$400 billion from US$163 billion in 2007.

 

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Russia
Going for Growth
April 08, 2008

By Oliver Weeks | London

Policy disagreements within the government on how to react to accelerating inflation have become increasingly overt, but proponents of keeping growth unchecked appear to be winning out.  We now expect no action to slow the economy in the near term, though we continue to expect the current reluctance to tighten monetary policy and allow FX appreciation to be rethought later in the year.

Growth and Inflation Accelerating

Rosstat’s preliminary weekly CPI reports put monthly CPI in March at 1.2%, taking CPI growth on our calculations from 12.7%Y to 13.4%Y.  While Finance Minister Kudrin and some at the CBR acknowledge the risks from domestic overheating, Kremlin adviser Dvorkovich and most recently Economy Minister Nabiullina have explicitly rejected these arguments and prioritized growth.  Ms. Nabiullina told a conference this week: “It's crucial that the monetary and budgetary measures being applied do not restrict economic growth. We've only begun to launch the flywheel of economic growth and it's important not to cool it off, including with talk about the economy overheating.”  Such views appear to have Kremlin support.  At the same time, fiscal policy loosening continues to look irresistible, despite the best efforts of Mr. Kudrin.  Most of the rest of the government remains strongly focused on delivering the tax cuts indicated in President-elect Medvedev’s February economic statement in Krasnoyarsk.  We expect (PM) Putin to name a date and final rate for a significant VAT reduction in August.  The Ministry of Finance has already been forced to concede cuts in the oil extraction tax and a long delay in gas tax hikes.  Some further net tax concessions on more difficult oil extraction projects, more favorable amortization terms and income tax exemptions look probable.  Meanwhile, new social spending initiatives are announced almost daily.  In 2007, average (recorded) wages of federal state employees rose 47.9%.  Recent output and demand data have also been remarkably strong, with core sector growth up 10.4%Y in February and the Ministry of Economy estimating February real GDP growth at 8.2%Y.  Even the cautious Mr. Kudrin has now acknowledged that any anti-inflation measures will not be allowed to slow this. 

Monetary Passivity Continues 

Tightening of Russia’s remarkably loose monetary policy would be the obvious response to the inflation threat (see also Russia: Monetary Stalemate, February 14, 2008).  The central bank is of course not an independent player.  It has also argued that it does not expect to be able to drive an active monetary policy until the current account moves into deficit, and prompts the market to see risk on the RUB as two-way.  In this context, current balance of payment trends are not encouraging for monetary activism.  4Q data showed a quarterly current account surplus of US$25.0 billion, the largest since 1Q06 and well above the CBR’s initial estimate.  The annual 2007 surplus was 6.0% of GDP.  Although the medium-term trend remains for the surplus to shrink, we are raising our 2008 current account forecast to 7.0% of GDP. 

This remains largely a terms-of-trade phenomenon.  Export volume growth was only 7.4% in 2007 against 30.4% growth in import volumes.  Unit labor costs grew 23.6% in 2007.  The combination of a consumption boom and stagnant energy output volumes is likely to drive the current account into deficit, but only by 2010.  On the capital account side – a more important driver of the domestic economy since much of the oil revenue is sterilized in the stabilization funds – net capital inflows in 4Q were a remarkably strong US$24.1 billion.  The CBR estimates that this reversed to a US$18.5 billion outflow in January-February, but it is still expecting a net inflow of around US$40 billion in 2008 as a whole, well down on 2007’s US$84 billion (the Finance Ministry expects a US$25 billion inflow).  We had expected the lull in capital inflows to offer an opportunity for more tightening of short-end rates, but although CBR Governor Ignatyev has reiterated threats of higher policy rates and reserve requirements, action does not look imminent to us now.  Both the CBR and the Finance Ministry remain focused on liquidity provision to the banking sector ahead of April’s VAT payment spike, with preparations for deposit auctions for surplus budget funds proceeding rapidly.  Both the effective refinancing rate and required reserve rates (6.25% and 4.5-5.5%, respectively) remain strikingly low by regional standards.  For now, the CBR continues to argue that the more flexible exchange rate policy needed to regain control of monetary policy would be counter-productive – the stimulus to inflows from allowing appreciation outweighing cheaper import costs. 

Lobbyists Can’t Have it All 

Tighter external credit conditions will make a contribution to slower growth and inflation.  Money supply growth is already slowing – M0 to 30.0%Y in February and M3 to 43.9%Y.  Nevertheless, this looks inadequate to constrain inflation to us.  Like the CBR, we expect significant capital inflows to resume.  Gazprom has already returned to the Eurobond market, and despite some high refinancing requirements, state-backed companies can still raise money abroad at attractive levels, albeit at higher spreads.  We see no sign that they will tolerate proposals to constrain such borrowing in the absence of liquid domestic markets.  On the supply side, the Federal Tariff Service has proposed that retail and industrial electricity tariffs will now rise by 20-23% next January, against a previously planned 15.5% and 12.5%, respectively.  Retail gas price hikes are already planned at 27.7%.  Wholesale food market prices show no signs of slowing.  All raise the risk of entrenching relatively sticky inflation expectations.  Meanwhile, other fundamental drivers of domestic inflation – including the consumption boom, labor shortages, capacity constraints and weak competition – are unlikely to be reversed in the short term.  Risks to our 13.0% end-year CPI forecast (and our 6.7% real GDP growth forecast) are increasingly to the upside.  However, we continue to expect eventual policy tightening as the distributional impact of sustained inflation starts to bite politically, and to threaten banks’ deposit base.  Commodity exporter lobbyists will have to accept that their desires for a weak RUB together with low inflation and a stable economy are increasingly incompatible.  Given state companies’ and Mr. Putin’s focus on RUBUSD, we still expect an eventual recovery in USD against the EUR to present a new opportunity for nominal RUB appreciation against the basket. 

 

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India
Inflation Spikes Up: Is Monetary Tightening the Right Response?
April 08, 2008

By Chetan Ahya,Tanvee Gupta | Singapore,India

Inflation Rate Continues to Rise Further

Headline inflation (WPI) accelerated further during the week ending (WE) March 22, 2008, to a four-and-a-half-year high of 7.0%, from 6.7% during WE March 15, 2008. Inflation was 5.1% during WE March 1, 2008, and 3.1% during WE November 24, 2007. Inflation is now significantly higher than the central bank’s comfort zone of 5%. The pace of acceleration in inflation has been much more rapid this time, compared with the acceleration during the July 2006-March 2007 period, when inflation moved from a trough of 4.6% to a peak of 6.7%. We believe that this acceleration occurred during a time when domestic demand was very strong. Indeed, during the period when inflation was accelerating significantly above the central bank’s comfort zone (November 2006 to March 2007), industrial production growth averaged 13.3%. The economy was overheating, with the trade deficit widening, asset prices rising sharply and credit growth averaging 30%. 

We believe that this cycle of rising inflation is very different. Domestic demand and the overall growth trend have already slowed down significantly. Industrial production decelerated to close to a four-and-a-half-year low of 5.3% in January 2008. Average industrial production growth during the three-month period ending January 2008 was 6%. During the current cycle, the inflation acceleration primarily reflects higher global commodities. Most of the rise in inflation from the trough of 3.1% in November 2007 to 7% during WE March 22, 2008 has been driven by higher prices of base metals, fuel and food items.

Fiscal Measures Unable to Rein In Inflation

So far, the government has been using fiscal measures and moral suasion to control inflation. It has announced a number of measures to reduce inflation pressure including: (i) restricting exports of certain products; (ii) encouraging imports by reducing import tariffs; (iii) lowering excise tariffs; and (iv) persuading domestic producers to maintain restraint in resorting to price hikes in line with the increase in international prices of global commodity products. While some of the recent measures should help to lower the inflation rate to less than 7%, it is unlikely to fall into the central bank’s comfort zone.

Is Monetary Tightening the Right Response?

With inflation rising by 1.9 percentage points in just three weeks, some market constituents have started to build in a policy rate (repo rate) hike by the central bank. The central bank is due to announce its next monetary policy statement on April 29, 2008. The key argument in favor of a policy rate hike is that it would be necessary to manage inflationary expectations.

In our view, monetary tightening is not the ideal solution, as domestic growth has decelerated sharply. The relatively high level of lending rates has already resulted in a sharp reduction in consumption growth. Leveraged spending by households has already declined sharply, as reflected in two-wheeler sales, consumer durables production and mortgage lending growth. Consumer goods production growth has decelerated sharply to 4.3% during the three months ended January 2008 from a peak of 18.5% in June 2005. Two-wheeler sales have been declining year on year for the past 11 months (not including the slight recovery in March due to a cut in the excise tariff). Growth in fresh mortgage disbursements has remained low at single-digit levels for the last few quarters.

In addition to the sharp deceleration in consumption growth, the export sector has suffered a slowdown due to weakening demand in the developed world and appreciation in the rupee. Export growth in rupee terms has weakened to an average of 7.9% over the past six months compared with 23.3% during the 12 months ending March 2007. A leading indicator for India’s exports (US ISM New Orders Index) predicts a further slowdown in exports over the next six months. Hence, two out of the three key engines of growth (e.g., consumption, exports and capex) are already faltering. We also expect investment growth to slow over the next six months.

Unless the central bank believes that fiscal policy is going to revive growth meaningfully, which we doubt, the case for a further policy rate hike is weak. Indeed, we believe that domestic demand is likely to slow further due to: (i) the lagged impact of current high level of prime lending rates; (ii) increased risk aversion in the domestic banking system, as reflected in widening spreads for household loans other than mortgages and widening corporate bond spreads; and (iii) increased risk aversion in the global financial markets, which would reflect reduced access to foreign funding for small- and medium-sized Indian companies. In other words, past monetary policy tightening and effective additional tightening caused due to risk aversion in the financial system are likely to work their way through, resulting in a further slowdown.

What Measures Can the RBI Initiate?

We believe that the RBI will likely keep the repo rate (the rate at which it injects liquidity) on hold at the next meeting on April 29. We believe that if the CRB Commodities Index increases by another 5-8% from current levels and capital inflows remain positive, the RBI could allow further appreciation of the rupee to some extent. If commodity prices rise by 10% or more and capital inflows continue to be positive before April 29, the RBI could initiate a hike in the cash reserve ratio (CRR) and/or reverse repo rate (the rate at which it absorbs excess liquidity) by 25bp on April 29. We believe that the most relevant measure for assessing the financial condition would be the banks’ lending rates. We believe that any move by the central bank that results in a hike in domestic lending rates could push GDP growth below our estimate of 7.1% for F2009. (Note that our estimates are already below consensus GDP growth, which is estimated at 8% as of mid-March.) Similarly, if the CRB Commodities Index declines by 8-10% over the next few days, the RBI is unlikely to take policy action on April 29, as this would take away the inflation pressure.

Bottom Line

While market constituents are beginning to discount a potential hike in the repo rate, we believe that the RBI will likely resist such a move on April 29 when it is due to announce the next monetary policy statement. Even if inflation pressure increases further due to higher global commodity prices, we believe that the RBI is more likely to demonstrate its commitment to containing inflationary expectations by hiking the cash reserve ratio or the reverse repo rate rather than the repo rate.

 

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China
A Policy Proposal: Government-Financed Inflation-Proof Deposits
April 08, 2008

By Qing Wang | Hong Kong

Introduction and Overview

In Dissecting the Policy Uncertainties: A Revisit to Our Four-season Framework, March 25, 2008, we discussed the potential policy response in the event that inflation is out of control. We made a call for allowing faster and even one-off revaluation of the exchange rate instead of consecutive rate hikes as a primary policy tool to tackle inflation. We have since received lots of feedback from clients. Many share our view that the room for China to hike rates has indeed become quite limited and there is still considerable room for the renminbi to appreciate against the US dollar. However, some question whether the Chinese authorities would allow a large one-off revaluation of the exchange rate even if inflation were to be out of control, given the authorities’ gradualist policy approach. Indeed, both aggressive rate hikes and large exchange rate revaluation have their obvious downsides and thus face strong opposition from different quarters of the government.

We are not in the business of making policy recommendations. However, in light of the enormous uncertainties as well as heated debate on the inflation outlook and its policy implications both inside and outside the policy-making circle, we would like to share some thoughts and make a concrete policy proposal this time. In this note, we explore an alternative anti-inflation approach − the Government-financed Inflation-proof Deposits (GID) scheme, under which the government subsidizes households to ensure non-negative real interest rates on certain types of their saving deposits with the objective of enhancing the policymakers’ anti-inflation credibility.

The GID scheme should be a powerful policy tool in managing inflation expectations. The GID scheme − albeit not optimal − appears to be an anti-inflation policy of least resistance, given the current policy dilemma and enormous domestic and external uncertainties. A GID scheme should achieve the same effect as asymmetric rate hikes but without much negative impact on the banks’ NIMs. Under a GID scheme, the government essentially pays the households to buy anti-inflation credibility. In view of the currently strong fiscal position, the GID scheme − if appropriately designed − should be financially viable.

The GID scheme should be viewed as policymakers’ effort to enhance their anti-inflation credibility. Unlike the traditional monetary tightening that tends to bring about ‘pain’ (i.e., slower growth) before ‘gain’ (i.e., low inflation), a successful implementation of the GID scheme should be positive for the economy and market both immediately and in the longer run. While the probability of introduction of a GID scheme is low in the near term, we suggest that investors put this potential policy tool and its economic and investment implications on their radar screen, especially if the risk of out-of-control inflation were to rise again.

Who Should Pay for Disinflation?

Inflation − when reaching an advanced stage − is almost all about expectations and does not have much to do with the underlying genuine demand and supply, in our view. To bring inflation under control or achieve disinflation, it is critical to break the vicious cycle of inflation expectations: high inflation → high inflation expectations → high inflation. Under normal circumstances, a price in the form of slower output growth will have to be paid. Moreover, to effectively turn inflation expectations around would require that the magnitude of a policy move be large enough and/or its frequency high.

In this context, and as we have argued, determining which anti-inflation policy tools − interest rate hikes or exchange rate appreciation/revaluation − to use boils down to deciding on which sector − domestic demand-oriented or exports-oriented − will assume the bulk of the adjustment costs.

But, can we hurt either domestic demand or exports-oriented sectors but still effectively anchor inflation expectations? We think the answer is a qualified ‘yes’, but there is no free lunch, and someone has to pay for it.

Price controls can help to stabilize inflation expectations in the very short run, but this is not sustainable. To impose price controls is essentially to ask owners of companies affected (or investors) to pay for the anti-inflation cost in the form of squeezed profit margins. This is not sustainable, as it is fundamentally against investors’ commercial interest: why would investors sacrifice their private business interest for the sake of public goods (i.e., low inflation)? Investors either find ways of getting around these controls or simply scale down their operation to minimize losses, causing shortages and exacerbating the inflation problem.

Providing government subsidies to the low-income population helps to ease the negative impact of inflation on their life, but it does not help to control inflation expectations. In a similar vein, the government providing subsidies to producers to boost supply helps only over the medium term, given the production cycle, but does not help to address the immediate issue of containing strong inflation expectations that tend to drive demand constantly ahead of supply.

To bring down out-of-control inflation, the policymakers’ credibility in fighting inflation is the key. Only when the general public is convinced that the policymakers are able to rein in inflation, can we afford to allow the conventional supply-boosting and/or demand-reducing measures to work over time to shift the supply-demand balance, and eventually achieve disinflation.

In our view, the critical issue, before the supply-boosting effect (thanks to government subsidies to farmers) and demand-reducing effect (due to slower exports amid a US-led slowdown in external demand) kick in, how can policymakers manage to prevent inflation expectations from running out of control. We suggest that, for this purpose, the government should spend money, but in the right way.

Lacking Anti-Inflation Credibility? Buy it...

To break the vicious cycle of high inflation driven by strong inflation expectations, the policymakers need to establish a strong inflation-fighting credibility. This can be earned through a solid anti-inflation track record and/or decisive policy action (e.g., aggressive rate hikes and/or currency appreciation) that signals the policymakers’ resolve to bring down inflation regardless of the cost to the economy.

Since the Chinese authorities do not appear to have a solid anti-inflation track record and, as discussed above, there is currently strong resistance to either aggressive rate hikes or a much faster and even one-off revaluation of the exchange rate, we believe that the only way for the Chinese authorities to establish credibility is to buy it. We suggest that introducing a Government-financed Inflation-proof Deposits (GID) scheme should be a concrete and effective approach for the authorities to establish their anti-inflation credibility in a relatively short period of time (but at a cost, of course).

Under a GID, the government subsidizes − out of its own budget − the households with the objective of ensuring non-negative real interest rates on certain types of their savings deposits at the banks. The government promises households that the purchasing power of their long-term deposits will not be eroded by the high inflation. The households will therefore see no need to withdraw their bank deposits to buy real goods and services to hedge against inflation. Knowing that their bank deposits − which are still the main form of Chinese households’ financial wealth − are inflation-proof, households’ spending behavior will less likely change much as to exacerbate inflation (e.g., hoarding).

The authorities’ anti-inflation credibility should be enhanced by the GID scheme. If inflation cannot be brought down below the level of nominal interest rates on these deposits, the government will have to keep paying the depositors, and the higher the inflation, the higher the cost to the government. In other words, under the GID scheme, the government penalizes itself for not being able to bring inflation down. In this sense, its incentive in tackling inflation is aligned with those of the households, and the anti-inflation effort therefore should carry more credibility.

...but for How Much?

Can the government afford this GID scheme? At first look, the GID could turn out to be a very expensive program. As of end-2007, the total amount of households’ savings deposits stood at about RMB17 trillion. If the current 1-year benchmark deposit rate is 4.14%, the government will have to pay about a 6% subsidy if the prevailing inflation rate is 10%. This will translate into a total payment of RMB1 trillion per annum, or about 20% of total government revenue or 4% of GDP in 2007. Obviously, such a program is too expensive to be financially viable.

However, in practice, a potential GID scheme will likely cost much less, in our view. The GID scheme should not be viewed as a program under which the government is to guarantee the purchasing power of the entire stock of household deposits. Rather, it should be viewed as a program that is specifically designed to signal the authorities’ determination to fight inflation. To this end, we think that the government only needs to compensate for long-maturity (e.g., longer than three years) saving deposits.

We estimate that if the GID scheme only covers 3-year or longer-maturity deposits, the cost is about 1% of total fiscal revenue, or 0.3% of GDP. It is possible that some deposits of shorter maturity may be converted into longer-maturity deposits, only if deposits of long maturity are made inflation-proof. We estimate that assuming all deposits of 1-year to 3-year maturity are converted into deposits of over 3 years, the cost will increase to 2.2% of total fiscal revenue and 0.7% of GDP, which is still quite manageable, in our view.

There are several factors that suggest the actual cost for a GID scheme − if it is successful − could be substantially smaller than the ex ante estimate. First, in estimating the cost, the inflation rate is assumed to remain high at 10% for 12 months. In practice, to the extent that the GID program can succeed in anchoring inflation expectations and lowering the actual inflation rate, the average inflation rate could turn out to be significantly lower than 10% and thus the actual cost will be substantially smaller. For instance, if the average inflation rate is 8%, the cost will be 30% less. Second, for those depositors who opportunistically convert their short-maturity deposits into long-maturity deposits, they may convert their deposits back into short-maturity ones once inflation comes down even before the maturity date, thereby forfeiting their compensation (due to early contract termination) and lowering the actual cost for the GID scheme. Third, in practice, the government may only compensate the deposits up to a certain amount (e.g., RMB50,000) per person, and the rationale is that the GID scheme aims primarily to protect the interests of the low-income population who suffer the most from food price-driven inflation and have limited means to hedge against inflation risk.

The key question is whether the government can afford a GID scheme. We believe that the answer is ‘yes’. First, the actual cost will likely be particularly large. As discussed above, the potential cost varies depending on how the program is designed. But it will likely be less than 3% of total fiscal revenue or 1% of GDP. Second, the government’s current financial position is the strongest in many years. Fiscal revenue increased by 32% in 2007, and the overall budget was in surplus of about 0.7% for the first time since 1986. More importantly, we estimate that the government debt level is very low at only about 15% of GDP.

A Policy of Least Resistance

Given the enormous domestic and external uncertainties featuring in particular a great dichotomy between a cooling external environment and domestic inflation, the authorities have become understandably cautious about taking aggressive policy actions − be it interest rate hikes or renminbi exchange rate appreciation.

We have made a call that a much faster appreciation and large one-off revaluation of the renminbi instead of aggressive interest rate hikes will likely play a primary anti-inflation role (see Dissecting the Policy Uncertainties: A Revisit to Our Four-season Framework). At the same time, we also recognize that the resistance to a large one-off revaluation of the exchange rate is considerably strong.

In this context, if inflation is out of control, a GID scheme − albeit not an optimal policy option − could become the policy of least resistance, in our view. First, a GID scheme should achieve the same effect as asymmetric rate hikes − where interest rates on deposits are raised more than those on lending − but without much negative impact on banks’ net interest rate margins (NIMs) − as it is the government, not the banks, who pays. Second, with no corresponding hike in lending rate, it will not have much of a negative impact on investment growth and will not exacerbate the firms’ financing costs amid an upcoming slowdown. Third, by only compensating households’ long-term deposits, the GID is not designed to reward those short-term speculators. Therefore, higher de facto nominal interest rates on long-maturity deposits per se under the GID scheme will not attract new hot money inflows, while a hike of the benchmark interest rate hikes will attract new hot money inflows.

Only countries that have a robust fiscal position are able to implement a relatively low-cost anti-inflation program like the GID scheme. The stronger the government’s fiscal position, the more likely a GID scheme will be successful in anchoring inflation expectations and bringing inflation under control. In countries where large budget deficits and expansionary fiscal policy are responsible for causing inflation, one cannot expect these governments to enhance their anti-inflation credibility by spending more!

Implications

We think that the GID scheme could become the policy of least resistance because it has a relatively small, immediate negative impact on the economy and the market. Although the higher effective nominal interest rates on long-maturity deposits are the key for the GID scheme, we suggest that this policy be viewed as policymakers’ effort to enhance their anti-inflation credibility instead of a conventional monetary tightening. Unlike the traditional monetary tightening which tends to bring about ‘pain’ in terms of output loss before ‘gain’ in terms of low inflation, a successful implementation of the GID scheme should be positive for the economy and market both immediately and in the longer run, in our view.

A GID scheme should be contemplated if inflation is out of control (e.g., over 10%), in our view. While the probability of introduction of a GID scheme is low in the near term, we suggest that investors put this potential policy tool and its economic and investment implications on their radar screen, especially if the risk of out-of-control inflation were to rise.

A Final Thought

China is one of the main beneficiaries of the globalization that has brought great world economic prosperity. Over the past five years, China has enjoyed robust growth and has not squandered the gains. In particular, the balance sheet of the economy in general and the government in particular has improved markedly and fundamentally, which puts China in a favorable position compared to many other countries to cope with various shocks, domestic or external. The fundamental economic strength provides the Chinese policymakers with considerable leeway and flexibility in managing the economy without being forced to take such austere measures that run the risk of bringing about a hard landing of the economy.

Indeed, some parts of the global economy are in crisis, and China is not immune. However, with an appropriate response, we believe that the Chinese economy can meet the global challenges and come out of the downturn in good shape. A GID scheme − if warranted − could be an important element of such a policy package, we believe. The word ‘crisis’ in English has a very negative connotation including disaster, catastrophe, emergency, calamity, predicament and so on. However, the word ‘crisis’ in Chinese combines two characters with distinct meanings: ‘danger’ and ‘opportunity’.

When we initially made the call for an ‘imported soft landing’ with 10% GDP growth for 2008 back in early December, our view appeared rather cautious compared with the then market consensus (see Journey into Autumn: An Imported Soft Landing in ’08, December 3, 2007). Now some seem to consider this call as ‘too optimistic’. However, we are as convinced as before that an ‘imported soft landing’ is the most likely scenario in 2008.

 

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