Review and Preview
June 03, 2008
By Ted Wieseman | New York
Treasuries posted big losses over the past holiday-shortened week, getting pounded Tuesday, Wednesday and most of Thursday before managing a comparatively modest rebound Thursday afternoon and Friday. The belly of the curve, especially the 5-year, led the losses, as it came under major pressure from mortgage-related paying in swaps as the recent backup in rates has caused elevated duration-hedging needs. Swap spreads saw periods of significant widening through the week as these pressures were felt, but they largely snapped back late in the week as it ebbed, contributing to the Treasuries’ late week bounce. For a market that seems to be very long already and desperately trying to get less so as rates continue surging higher, it was a bad week to come with a flood of new supply, so the 2-year and 5-year auctions went badly, the 5-year particularly so, as it saw record-low demand from final investors for a new 5-year sale. Quarter-end for several primary dealers certainly didn’t help matters in this regard either. In addition to the easing of mortgage-related selling, getting this unwanted supply out of the way was also key to allowing the market to rebound, as the week’s lows were set right after the miserable 5-year auction results were announced Thursday. Inflation fears that have rattled investors across markets recently remained a negative background issue as an earlier start to Fed rate hiking continued to be priced into futures, but with oil prices pulling back a fair amount on the week, TIPS actually performed as badly as nominals in the down-trade. Risk markets mostly traded moderately stronger on the week, but while this was at times an intraday problem for the Treasury market, the relatively modest net gains in stocks and credit on the week did little to explain the magnitude of the rout. Economic data were better than expected overall, but also a secondary concern. A number of releases bearing on GDP pointed to slightly less weak 1H growth. 1Q GDP was revised up a bit more than we expected to +0.9% from +0.6%, and we boosted our 2Q forecast slightly to -1.0% from -1.2%. The most notable data upside was in the durable goods report, where a surge in core capital goods orders might have started to reflect the impact of investment tax incentives contained in the fiscal stimulus bill. Or it might have just been noise in this notoriously volatile report. New home sales rose modestly (though from a significantly downwardly revised reading the prior month), which along with the prior week’s existing home sales report further suggested that home sales might be approaching a bottom. On the other hand, consumer spending extended its recent stagnation into early 2Q, with the level of real spending in April about unchanged from November. Even with some significant temporary sequential upside in coming months as some probably small part of the tax rebate checks are spent, we see consumption in 2Q as a whole on pace for only marginally positive growth. Consumer confidence readings from all three major surveys released during the week were absolutely abysmal, and underlying consumer fundamentals in general couldn’t be much worse, so we expect whatever upside to spending the rebate checks provide in the near-term to be short-lived.
On the week, benchmark yields rose 16-28bp, led down by a terrible performance by the 5-year. The old 2-year yield rose 18bp to 2.60%, the old 5-year 28bp to 3.40%, the 10-year 22bp to 4.05%, and the 30-year 16bp to 4.71%. The new 2-year ended the week at 2.64%, matching the awarded yield at Wednesday’s auction, and the new 5-year closed Friday at 3.41% after being auctioned Thursday at 3.52%. Both auctions tailed badly and saw very low demand from indirect bidders, especially the 5-year on both counts. With July oil down almost US$5 a barrel on the week to US$127.35, TIPS performed relatively poorly, with the 5-year yield up 28bp to 0.99%, the 10-year 22bp to 1.54%, and the 20-year 21bp to 2.11%. So there wasn’t much change in long-term market-based inflation measures, but survey-based measures showed further deterioration. The 5-year ahead median expectation in the Michigan survey was adjusted up a tenth to +3.4% for all of May from the early month reading of +3.3%, a high since 1995. As far as actual inflation figures, much worse numbers are on the way, but results in April, at least, were benign. The overall PCE price index rose 0.2%, while the core barely rounded down to +0.1%, keeping the annual rate steady at a slightly elevated +2.1%. The benchmark 5-year swap spread traded over 86bp Wednesday and Thursday when the mortgage-related paying was heaviest, but came back in to end the week unchanged at 80.75 when this at least temporarily eased up. Risk markets mostly posted moderate gains on the week. The S&P 500 rose 1.8%, reversing half of the prior week’s sell-off. In late trading Friday, the investment grade CDX index was 8bp tighter on the week at 102bp after widening 19bp the prior week. The high yield index was 19bp tighter on the week at 579bp through Thursday’s close after widening 64bp the prior week, and the index was trading up slightly further Friday, while the leveraged loan LCDX index was 11bp tighter at 351bp through the midday Friday pricing after the prior week’s 25bp widening. Other markets didn’t do as well. The commercial mortgage CMBX index was mixed, with the AAA index flat at 106bp and the AJ 6bp wider at 340bp, though the lower-rated indices mostly posted small gains. The subprime ABX market had another rough week. The AAA index fell 2.17 points to 53.73, a two-month low, while all the lower-rated indices fell to a series of all-time lows through the week. A more hawkish Fed path was priced into futures, with the market shifting the expected timing of the first rate hike from the December to the October FOMC meeting, as the November fed funds contract lost 3bp to 2.14%. The January contract fell 11bp to 2.335% and February 11bp to 2.53%. 3-month LIBOR rose 3.5bp on the week to 2.68%, causing the 3-month LIBOR/OIS spread to rise 2bp to 68bp. Friday’s announcement from the BBA about LIBOR procedures, anticipation of which had at times contributed to periods of significant widening in forward spreads, ended up amounting to a bunch of nothing, but there wasn’t any significant market reaction in response. The front June eurodollar contract ended the week at 2.70%, so just marginal further upside is expected in 3-month LIBOR before this contract settles on June 16. There was a decent widening in forward spreads, however, as the Sep 08 contract lost 12bp to 2.84%, Dec 08 16bp to 3.11%, and Mar 09 20.5bp 3.325%. In line with the 5-year-centered weakness in Treasuries, the worst-performing eurodollar contracts were Mar 11 to Sep 11, which plunged 33.5bp. Economic data released over the past week pointed to slightly less weak 1H growth than we previously expected. 1Q GDP was revised up a bit more than we expected to +0.9% from +0.6%. Meanwhile, upside in the durable goods report in inventories and capital goods shipments and stronger-than-expected new home sales and prices were partly offset by a marginally more negative outlook for consumption pointed to by the personal income report and a more negative mix in the 1Q revision between final sales and inventories than we expected (and other assorted underlying details of the GDP revision). This slightly boosted our 2Q forecast to -1.0% from -1.2%. Durable goods orders fell 0.5% in April, but all of the downside was accounted for by a sharp decline in the volatile aircraft component. Motor vehicles were also down significantly again, reflecting both weak sales and a recently settled strike. However, the key core gauge, non-defense capital goods ex aircraft, surged 4.2% after three straight declines, possibly starting to reflect the impact of the tax incentives contained in the fiscal stimulus bill. Upside was led by machinery, which has rebounded sharply over the past two months after plunging in February, and a spike in electrical equipment that reversed a collapse in March. Core capital goods shipments (+0.5%) also showed modest upside, in contrast to the small decline we expected. This pointed to a smaller decline in business investment in 2Q than we previously expected, though this upside was partly reversed when we incorporated our April trade balance forecast and some underlying details of the 1Q revision and April personal income report that bear on investment. We see overall business investment falling 3.5% in 2Q after the upwardly revised 0.2% dip in 1Q, with the equipment and software component down 3.1% after a 0.9% drop. Meanwhile, durable goods inventories again came in significantly higher than expected, at +0.5%, pointing to less of a drag in 2Q from inventories. The inventory/sales ratio in this sector has risen substantially and looks quite bloated at levels last seen in the 2001 recession, so we expect that production cutbacks will be forthcoming to bring the situation into better balance. For 2Q growth, the upside in durable goods inventories was offset by a more negative mix than expected in the 1Q revision. 1Q GDP was revised up a bit more than we expected to +0.9% from +0.6%, but all of the surprise was in a smaller-than-expected, though still substantial, downward adjustment to inventories from a 0.8pp add to +0.2pp, which has negative implications for the expected 2Q inventory correction. Combining the durables upside and 1Q revision negative, we continue to see inventories subtracting 0.6pp from 2Q GDP growth. In other modestly positive news on top of the durables report, new home sales rose 3.3% to a 526,000 unit annual rate in April after falling to downwardly revised 17-year low of 509,000 in March. Combined with the previous week’s report of only a small decline in existing home sales in April and little net change over the past six months, we are starting to see indications that the big improvement in housing affordability may be helping home sales start to bottom out. The number of new homes available for sale fell 2.4% for a 16.9% drop over the past year − not coming close to keeping pace with the 42.0%Y plunge in sales. Still, the sequential improvement in sales combined with the drop in homes for sale caused the months’ supply to dip to 10.6 from an almost record high of 11.1. Even if sales are approaching a trough, we estimate that single-family starts will need to plunge another 25% or so to bring inventories back towards a more balanced level of 5-6 months by the first part of next year. The median sales price surged 9.1%, but only as a result of a shift in the mix of homes sold. Still, this upside in prices combined with the gain in sales on top of the recent stability in existing home sales suggested that the brokers’ commissions component of residential investment will likely be down only slightly in 2Q. However, we still expect overall residential investment to be down about 25% for a third-straight quarter on another epic decline in new home construction and intensifying weakness in home improvements spending. The personal income report pointed to a slightly weaker trajectory for 2Q consumption. Real spending in April was flat, and while consumption growth for all of 1Q was unrevised at +1.0%, the pattern of revisions to the monthly figures in the first quarter provided a slightly more negative trajectory moving into 2Q. As a result, even assuming some significant sequential acceleration late in the quarter as some portion of the tax rebate checks are spent (a small portion, we expect), we trimmed our 2Q consumption estimate marginally to +0.5% from +0.6%. Aside from the temporary support from the tax rebate checks, pretty much everything that could be going wrong for the consumer is going wrong, so we expect consumption to slow back towards stagnation after a modest temporary boost in the coming months. With the weak job market pressuring nominal income and inflation accelerating, real wage and salary income growth has shown almost zero growth so far this year and is likely to turn sharply negative in the coming months. Consumer wealth is declining, with home prices and the value of stocks and mutual funds both down. Consumer credit availability has been tightened dramatically, and what is available is more expensive. And consumer confidence is approaching record lows across all major surveys. The overall Conference Board index fell five points in May to a 16-year low, with the expectations gauge at its second-lowest reading ever. Even after a slight upward adjustment from the early month reading, the Michigan survey was still at a 28-year low. And the weekly ABC News/Washington Post poll hit an all-time low in its shorter history back to the mid-1980s in the latest week. Economic data may be more of a market focus in the coming week as we get the early round of key May data. Releases due out include manufacturing ISM and construction spending Monday, factory orders and motor vehicle sales Tuesday, revised productivity and non-manufacturing ISM Wednesday, chain store sales results from most companies Thursday and the employment report Friday: * Based on the mixed results of the various regional surveys, we look for the national ISM to be little changed at 48.5 in May, modestly below the 50 boom/bust line. Strong export activity is expected to continue to provide support, resulting in the manufacturing sector holding up much better in this downturn than in a typical recession. Finally, the price gauge is expected to hold near the four-year high seen in April. * We look for a 1.7% plunge in construction spending in April. Another sharp decline in the residential component, combined with reversals of the recent gains in non-residential and government spending, should lead to the sharpest drop in overall construction spending since 1994. * We forecast a 0.5% rise in April factory orders. We look for a price-related gain in the non-durable sector to more than offset the dip in bookings of durable goods. Meanwhile, shipments are likely to post a sharp rise (+1.5%) and inventories should show a modest advance (+0.4%). * Preliminary surveys for May pointed to little, if any, improvement in activity relative to the dismal 14.4 million unit selling rate that was recorded in April (in fact, April’s performance was the worst month since the 1998 GM strike). However, promotional activity appears to have picked up over the past couple of weeks, so we look for a modest uptick in May sales to 14.9 million units annualized – a pace that wouldn’t even reach the subpar performance seen during 1Q. * We expect 1Q productivity to be revised up to +2.7% and unit labor costs to +0.7%, reflecting somewhat higher output and wages as seen in the latest GDP report. Indeed, the measure of output that is relevant for the calculation of productivity was pushed up by 0.3 percentage points. However, compensation growth was revised by an even larger amount (+0.5 percentage points). Moreover, compensation was pushed up quite a bit in 4Q (from +4.6% to +6.3%), so we should see a sharp upward revision to unit labor costs in that quarter (from +2.8% to perhaps +4.3%). This should help push the year-on-year growth rate in 1Q up to +0.8% – versus the originally reported +0.2%. Note that base effects point to a likely uptick in this year-on-year rate over the next few quarters. * Following a moderation in the pace of job loss during April, we expect to see renewed deterioration in May and look for a 65,000 drop in non-farm payrolls. Such a result would extend the run of declines in overall payrolls to five months and private sector payrolls to six. Two sectors that showed surprising upside in April – finance and business services – are likely to turn down in May. Otherwise, we expect recent trends to continue, with sizable further declines in manufacturing, construction and retail trade partly offset by continued strength in healthcare-related fields. Meanwhile, the unemployment rate is likely to unwind the downtick seen in April, as the spike in the household survey’s often volatile measure of employment is not repeated. Earnings gains are expected to remain muted in nominal terms and negative after adjusting for inflation. Finally, after registering a downtick last month, the average workweek is likely to hold steady at a level just a shade above the all-time low.
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Mexico: Oiling the Fiscal Coffers
June 03, 2008
By Luis Arcentales | New York
With oil prices at new record levels, one would assume that Mexico’s fiscal authorities must be celebrating: after all, oil-related revenues accounted for 35% of public revenues last year. Not only have spot crude quotes soared to historical highs, breaking the US$130 per barrel threshold, but the futures’ curve structure has also begun to shift – with long-term contracts nearing US$140 per barrel at one point in late May – on fears of insufficient future oil supplies. With markets betting that high crude prices are here to stay, it is natural to assume that Mexico’s fiscal coffers should be overflowing. Indeed, in 1Q08, Mexico’s average price of oil proceeds was almost US$70 per barrel, 40% above the US$49 estimated in the budget. (The average price of oil proceeds is lower than the average price observed during the quarter (US$83) due to the normal lag between the time of shipment and its recognition in the fiscal accounts). Yet, despite soaring oil quotes, Mexico’s Finance Ministry has been in a feud with politicians after claiming that oil revenues fell short in 1Q, posting a small M$8 billion shortfall versus the budgeted amount of M$221 billion. It may be hard to believe, but several culprits were at play as falling oil output (-8%) and declining export levels (-12%) conspired with growing fuel subsidies and some fiscal adjustments that were carried over from 2007 to wipe out any windfall. While the feud with Congress and state governors anxious for their share of the oil abundance has intensified this past week, the 1Q ‘shortfall’ is unlikely to be repeated during the rest of the year. By mid-year, Mexico’s fiscal accounts are likely to begin to show the benefits of high oil prices in the form of excess oil revenues, defined as oil-related receipts in excess of the budgeted M$866 billion for all of 2008. This windfall could reach, or even exceed, 1.6 percentage points of GDP by year-end, according to our estimates, and should complement an already ambitious 2008 fiscal budget, thus helping to offset some of the drag from deteriorating external conditions (see “Mexico: Tempering the Link”, This Week in Latin America, December 17, 2007). But as much as the additional fiscal spending, particularly in infrastructure, is good news for the Mexican economy, it also brings with it a cautionary tale. The relatively modest oil-related windfall – which is small by historical standards, considering this year’s massive gap between the US$49 per barrel budget estimate and actual crude prices – is emblematic of the precarious situation of Mexico’s energy complex and the urgent need for progress on the reform front (see “Mexico: The Slippery (Oil) Slope”, EM Economist, July 10, 2006). In other words, Mexico’s pubic sector is receiving increasingly fewer benefits from high oil prices due to the combination of mainly declining output and rising fuel subsidies. Indeed, we estimate that fuel subsidies this year alone could reach US$24 billion or almost 2.2% of GDP, nearly five times the cost incurred during 2007. The Oil Windfall With current futures prices suggesting that Mexico’s basket could average nearly US$100 per barrel this year, Mexico’s fiscal accounts should be well-oiled. Indeed, even with soaring gasoline and diesel subsidies, falling output and a stronger peso, we estimate that by year-end the authorities will be sitting on over US$17 billion or 1.6 percentage points of GDP in above-budget oil revenues. Relative to budget estimates, crude prices above the US$49 level could yield over 5 percentage points of GDP. But that is where the good news stops: the combination of a stronger peso, disappointing output levels and, importantly, fuel subsidies could knock off about three quarters of the benefits from higher oil prices. The benefits from high oil to Mexico’s fiscal coffers also contain a cautionary tale, however. Considering the likely gap between actual and budgeted oil prices, the potential 2008 public sector oil windfall is quite modest compared to those of the past few years as Mexico’s fiscal accounts are progressively generating less bang from every additional above-budget oil buck. For example, in 2004, crude prices were US$10 per barrel above the budget estimate (US$20), leading to US$12 billion in excess oil revenues. The average gap during 2005 and 2006 was slightly above US$14 per barrel, which in each of the two years generated US$10 billion in excess revenues. This year, the gap between the US$49 per barrel budget estimate and the price derived from futures – a 2008 average of around US$99 per barrel based on end-May readings – could reach an unprecedented US$50 per barrel. Against this backdrop, our projected US$17 billion oil windfall represents a startling disappointment compared to Mexico’s recent history. In the very unlikely case that oil output – at 2.875 mbpd in the first four months of the year – were to match the budget’s 3.134 mbpd estimate and the peso sold off to average 11.2 for the year, the oil windfall would nearly double to almost US$30 billion, based on our calculations. Less Bang for Every Oil Buck The main factor behind the relatively small 2008 windfall is the surge in fuel subsidies, which could eat up nearly 40% of the revenues derived from the spike in crude quotes. This year alone, subsidies on gasoline and diesel could top US$24 billion or almost 2.2% of GDP, up from just 0.4% of GDP in 2007. While Mexico is still a net beneficiary when it comes to rising oil prices, at current levels we estimate that each additional one dollar increase in WTI would cost Mexican fiscal coffers around US$350 million in subsidies. Just as Mexico’s fiscal accounts remain addicted to oil, surging oil subsidies could be creating a similar addiction on the consumer and business fronts to stable, low fuel prices. Given the recent surge in oil prices and Mexico’s practice of adjusting gasoline prices by 3% each year, fuel subsidies are starting to balloon. In April, for example, the cost to consumers of premium gasoline was M$8.9 per liter, which represents a 20% discount to producer prices once value-added taxes and costs such as petrol station commissions are stripped. In the case of diesel, Mexicans could buy one liter for M$6.0, a price that implies a discount of 48% relative to producer costs. Oil Spending Spree Mexico’s fiscal rules guarantee that a large share of the excess oil revenues this year will get spent. The first use of the oil windfall is to compensate for a series of above-budget expenditures, including higher financing costs due to interest rates or exchange rate changes and, of course, the cost of fuel and electricity subsidies. After these holes are filled, excess oil receipts find their way into a series of stabilization funds, most of which are at or very close to their legal ceilings. Once full, the 2008 oil windfall is split in equal parts between the Pension Restructuring Fund (FARP) and 25% each between investment projects of the federal government, the states and Pemex. Given the administrations’ focus on infrastructure spending and Mexico’s past history, it is clear that a large share of the oil windfall should ultimately translate into a fiscal boost. Since its creation in 2000, the Oil Stabilization Fund (FEIP) has been emblematic of the tendency of Mexico’s public sector to spend its excess oil wealth. Yet, given the public sector’s high dependence on volatile oil revenues, the potential impact of the FEIP – whose balance at the end of March 2008 was US$5.3 billion or just under 0.5% of GDP, already exceeding its legal limit – in smoothing the adjustment to a protracted drop in oil prices appears limited at best. And just as it was the case in 2007 when legislators decided to spend the first M$20 billion of the monies earmarked for the FEIP, this year the amount will reach M$28 billion, thus reducing the expected accumulation of resources in the Pensions Fund (FARP), where all above-limit FEIP monies are required to go. While today’s favorable oil backdrop means that accumulation of assets for a rainy day is not an imperative, the tendency of the Mexican fiscal authorities to boost spending during the good times underscores the growing risk to a public sector which remains heavily dependent on oil receipts (see “Mexico: Oil Abundance or Addiction?”, This Week in Latin America, March 20, 2006). What is more important, of course, than the narrowly defined ‘windfall’ – namely the difference between budgeted revenues and expenditures based on oil price assumptions and actual revenues – each year as oil prices have exceeded ever-rising budget assumptions, is the magnitude of the increase in budgeted oil-related revenues themselves. Compared to 2005 and 2006 – when the budgets contained oil at US$27 and US$36.5, respectively – budgeted oil revenues during 2007 and 2008 – using an oil reference of US$42.8 and US$49, respectively – have translated into nearly US$15 billion (about 1.4 percentage points of GDP) in additional spending each year. Bottom Line With crude quotes at historical highs, Mexico’s fiscal accounts should be well-oiled this year, generating potential above-budget oil receipts to the tune of 1.6% of GDP. Combined with an already ambitious 2008 budget, ample fiscal outlays should help to offset part of the drag from the slump in US economic activity. But the 2008 oil windfall should also serve as a reminder of the urgent need for progress on energy reform. Excess oil revenues in 2008 are likely to be modest by historical standards, once we consider the massive gap between budgeted and actual crude prices. Mexico is progressively deriving fewer benefits from high oil prices, as it struggles with rapidly falling oil output, rising imports and surging fuel subsidies. The time to act on energy reform is now.
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10-year G-Sec Yields – Heading to Seven-Year Highs
June 03, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary The macroeconomic environment for the long-duration government bond market is steadily deteriorating, in our view. After moving in a narrow range over the last two years, we think that 10-year bond yields will likely shoot up to a seven-year high of 8.75-9.00% over the next six months from 8.15% currently, even as GDP growth is likely to weaken during this period. Five Key Factors to Weigh on the 10-Year Bond Yield Outlook We believe that there are five key factors that will push the 10-year bond yields to new highs: Inflation likely to touch double digits soon: Headline inflation (WPI) has already risen to a three-and-a-half-year high of 8.1%Y (provisional) as of the week ending May 17, 2008. Over the last few weeks, the provisional estimates have been revised up by about 100-150bp. By that measure, there is a high probability that inflation for the week ending May 17 will likely be revised to around 9%. We believe that headline inflation will rise further to double digits due to the depreciation of the rupee and the likely increase in domestic fuel prices by 15-20%, affecting the sentiment for G-sec paper. While the bulk of the acceleration in inflation over the last five months has been due to increases in prices of global commodity-linked products and food products, we believe that the risk of some pass-through from these increases in commodity prices has increased, considering the magnitude of the rise in oil and other commodities. Considering that growth has already been slowing, our base forecast assumes no further policy rate hikes. However, if oil prices rise to US$150/bbl and stay at those levels for 4-5 months, we believe that the central bank will likely hike policy rates. Consolidated fiscal deficit to cross 9% of GDP: In a bid to soften the adverse impact of rising commodity prices on inflation and cost of living for the poor, the government is incurring off-budget subsidies on oil, electricity, fertilizers and food. In addition, the government has committed to two major expenditure items, including a farm loan write-off and an increase in its employees’ wages. Neither item has been provided for in the proposed F2009 (12 months ending March 2009) budget released on February 29, 2008. Including the off-budget expenditure items, the underlying F2009 deficit for the central government will be about 6.2% of GDP in F2009, instead of the headline estimate of 2.5%. The combined centre plus state deficit including off-budget liabilities will be about 9.4% of GDP in F2009, according to our estimates. Our estimates assume an average crude oil price of US$100/bbl in F2009. If oil prices stay at current levels, the oil subsidy and fiscal deficit burden will rise further. Domestic oil products are marked to an implied average of US$65/bbl. With the government having increased domestic fuel prices by only 26% for petrol and 34% for diesel (average for the country) over the last four years during the period in which international crude oil prices have shot up about 225% to US$129/bbl currently, the subsidy burden continues to spike. In F2009 (12 months ending March 2009), if crude oil prices average US$120/bbl, we believe that the oil subsidy (including the burden on oil companies) will increase to US$40 billion (3.2% of GDP), compared with our current assumption of 2.2% of GDP. Widening current account deficit: India’s current account deficit was 2.0% of GDP during the quarter ended December 2007 (last data point available). The four-quarter trailing sum was 1.1% as of December 2007. Higher oil prices would result in a widening of the current account deficit. India imports about 70% of its crude oil and refined products requirements. A US$10/bbl increase in crude oil prices results in higher imports, a trade deficit and a current account deficit of US$7 billion (0.6% of GDP). If oil prices stay at current levels, we believe that the current account deficit could widen to 2.75-3.25% of GDP in F2009. Risk aversion in financial markets and potential slowdown in capital inflows: Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India has witnessed an unusually low real interest rate environment right at the time when its fiscal policy has been expansionary, as reflected in rising public debt (including off-budget liabilities) to GDP. The key to lower-than-warranted real interest rates is the supply of global liquidity in the form of portfolio, private equity and debt inflows. About 85% of the total US$183 billion capital flows that India has received over the past four years have been in the form of non-FDI flows. Inflows of capital in the past have followed the trend for emerging markets in general. We believe that if the current global financial risk aversion continues for a longer period, capital inflows into emerging markets and India could slow. The IMF estimates that net private capital inflows into developing and emerging economies will decline to US$330 billion in 2008 from US$605 billion in 2007. Potential further depreciation of the rupee: We expect the RBI to intervene in the near term, checking the volatility, but the direction of the rupee is unlikely to change if the trade-weighted US dollar continues to rise, in our view. Our currency economics team expects EUR/USD to move to 1.46 by end-3Q08 and 1.40 by end-4Q08. We believe that in such an environment, the rupee would continue to weaken against the USD. The further widening of the current account deficit and the potential slowdown in capital inflows will likely add to the depreciation pressure. Excess Liquidity to Cushion the Pressure in the Near Term In the next few weeks, bond yields could still rise gradually due to the stock of excess liquidity. Excess liquidity stock represents the foreign capital inflows that the Reserve Bank of India (RBI) has sterilized by the issuance of monetary stabilization scheme bonds and issuance of reverse repo paper (liquidity adjustment facility, LAF), and the central government’s surplus funds deposited with the central bank. As of mid-May, the excess liquidity stock was US$43.6 billion (down from the peak of US$$63.4 billion as of February 2008). If capital inflows continue to slow, the excess liquidity stock would be unwound, further pushing 10-year bond yields higher, in our view.
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