Some EM Central Banks to Be Stress-Tested by Inflation
June 23, 2008
By Stephen Jen | London
Summary and Conclusions
Energy and food inflation has remained high. As the global economy has continued to exhibit signs of remarkable resilience, investors’ attention has, not surprisingly, shifted from ‘stag’ to ‘flation’. We are of the view that inflationary conditions will likely be negative for the currencies of many EM economies that are experiencing a negative terms-of-trade (ToT) shock. Stagflation would be even worse for these currencies. In contrast to developed markets, whose central banks could stay ahead of the inflation curve, we believe that developing market central banks will likely struggle to stay ahead of both the inflation and growth curves. The macroeconomic challenges to be faced by EM economies will be quite acute, and many EM currencies are likely to be penalised against the dollar. Monetary Policy and Oil Price Shocks Global energy and food price inflation poses a major challenge for monetary authorities around the world, with implications for currencies. Up to a certain threshold, say 6%, inflation should be positive for developed market currencies, in our view. Most central banks enjoy a meaningful enough amount of credibility that upside surprises to inflation should make investors look for eventual monetary tightening. The rule-of-thumb, thus, should be to buy the G10 currencies of countries that have upside surprises to inflation. Having said this, it is important to appreciate the acute dilemma monetary policymakers are facing, and that, at some stage, if these types of global inflation persist and accelerate, central banks in developed economies may have rather diverse reactions and approaches, and the aforementioned simple rule-of-thumb would no longer be appropriate. While much of the rise in oil and energy prices could be attributed to global demand for these products, from the perspectives of individual countries, oil and food price increases are supply shocks. Early work on the relationship on oil prices and developed market GDP suggests oil shocks were the dominant determinants of US recessions. For example, Professor James Hamilton (see Hamilton (1983) “Oil and the Macroeconomy since World War II”, Journal of Political Economy, vol. 91, (April), pp. 228-48) claimed that, since 1973, every upward spike in real oil prices has been followed by a surge in the US output gap. More specifically, Professor Hamilton demonstrated that an oil price shock had preceded (Granger-caused) all but one recession (in 1960) in the US since WWII. Since shocks of this type are stagflationary, the Fed and other central banks are obliged to counter these inflationary pressures and not fully accommodate this shock. A reasonable approach for central banks would be to follow the Taylor Rule, i.e., adjust the FFR (fed funds rate) in response to changes in the deviations in core inflation and unemployment from their targeted levels (see Ed Gramlich (2004), Oil Shocks and Monetary Policy, Fed Speech, September 16). It is also important to keep in mind how high oil prices could reduce the potential world growth rate.). In an influential piece of research, Messrs Bernanke, Gertler and Watson (1997) (“Systematic Monetary Policy and the Effects of Oil Price Shocks”, Brookings Papers on Economic Activity 1: pp. 91-142) argued that, at most, only half of the observed GDP declines after oil price shocks could be attributed to the oil shocks themselves, with the other half of the recessionary pressures coming from the monetary reactions to the oil shocks. This exaggerated compression in output growth can be interpreted as a price to pay to secure stability in inflation expectations. If, however, there is an underlying stagflationary trend coming from demographic pressures (aging and the shrinkage in the relative size of the work force in the US and other developed nations) and globalisation, the stagflationary proposition confronting central bankers could be more acute than during the last great oil shock in the 1970s. The bottom line here for developed economies is that oil shocks themselves are stagflationary and monetary reactions to these shocks have, during past episodes, exacerbated the declines in GDP growth, in exchange for more restrained inflation. Up to a certain point, inflation should lead to strong currencies as central banks tighten. But how developed market currencies perform as inflation rises will be a function of how stagflationary conditions get and how successful various central banks are seen at handling the stagflationary conditions. Policy Dilemma Will Be More Challenging for EM There are several reasons why central banks in EM will likely have much greater difficulties in the months ahead: • Reason 1. Imported inflation cannot be offset. EM economies’ CPI baskets contain much higher weights for food and energy products than developed economies’ CPI baskets. This is important, because to offset inflationary pressures in these products – which are increasingly determined by international forces – EM central banks will need to somehow generate enough deflationary forces elsewhere in the economy. In other words, for EM central banks to achieve their targets on inflation, in the presence of high internationally determined energy and food inflation, they would need to be willing to drive the domestic economies into deep recession – a proposition that we believe is unlikely to be politically acceptable. The combined weights of energy and food products range between 30% and 70% for many EM economies, compared to around 25% for most developed economies. Further, actual food accounts for a bigger fraction of the retail costs of food items in EM economies, whereas in the developed world, the bulk of the retail cost of food items reflects retail, advertising and other service costs. In fact, it has been estimated that actual food accounts for some quarter to a third of the total cost of food products in the US. In any case, the point here is that fluctuations in international food commodities tend to feed into EM economies’ CPI far more easily than in the developed world, and such an impact tends to be so powerful that offsetting it would imply extreme measures by central banks. This cannot be positive for EM currencies. • Reason 2. Rolling back of energy and food subsidies to keep stagflationary pressure sustained. We have pointed out previously (Enjoy the Energy Subsidies While You Can, May 22, 2008) that half of the world’s population now enjoys energy subsidies and about a quarter of the world’s gasoline is subsidised. Our analysis in that note was limited to the gasoline market, but the same logic applies to other energy products and food items. Subsidies mute the impact of high prices on the quantity of demand (i.e., prevent the demand curve from being downward-sloping). With subsidies, global demand for food and energy is not ‘destroyed’. But as food and energy prices stay high and rise further, EM economies will be under pressure to roll back these subsidies. The end result is that stagflationary conditions will persist longer in EM with subsidies than elsewhere. Often governments are forced to roll back on the subsidies and, by construction, the timing of the withdrawal of these subsidies is likely to be bad, both from a macroeconomic and social perspective. This cannot be positive for EM currencies. • Reason 3. Inflation-targeting (IT) in general will be seriously stress-tested. The world’s headline inflation has trended lower over the past decades. Between 1997 and 2007, OECD headline inflation declined from 4.8% to 1.9%; BRIC headline inflation fell from 9.2% to 4.1%. (During this period, core inflation also fell, from 4.4% to 2.1% for the OECD countries, and from 4.4% to 1.3% for the BRIC economies.) While better, more disciplined monetary policies have likely played an important role behind this trend, other factors (such as globalisation, deregulation and luck (this includes the lack of major global military conflicts and absence of other major shocks)) have arguably been at least as important. In this ‘Goldilocksy’ environment of the past, it was relatively easy for IT regimes to look good. But if the structural trend in global inflation is indeed turning, then IT regimes could be stress-tested. In fact, rigid forms of monetary policy will be stress-tested if the natural rates of unemployment and corresponding inflation rates are shifting. Further, if indeed this worry about more rigid forms of monetary policy is justified, then it is reasonable to expect these stress-tests to be more extreme for EM economies than for developed economies, due to Reason 1 mentioned above. We believe that the likes of Korea, Thailand, South Africa, Russia and Turkey will need to consider the following options: raise the numerical targets on inflation, have a moratorium on applying their inflation targets, change the targeted inflation indices (from headline to core), or abandon IT altogether. None of the above will be supportive of their currencies, in our opinion. Bottom Line Inflationary pressures of the type we are dealing with (triggered by energy and food price shocks) will pose a considerable challenge to monetary authorities, particularly those in EM economies. We believe that this is a powerful theme, which will hurt many EM currencies.
Important Disclosure Information at the end of this Forum
Mounting External Account Vulnerability
June 23, 2008
By Michael Kafe & Andrea Masia | South Africa
Summary The Quarterly Bulletin released by the SARB showed that the country’s current account deficit rose further, to 9% of GDP in 1Q08. As has been the case lately, the bulk of the deficit is made up of net invisible outflows − mainly dividends. However, this time around, the marginal deterioration was driven a lot more by a doubling of the visible trade deficit than the net invisibles. Elsewhere, demand-side data provided in the bulletin were generally higher than we had expected, although the hugely negative external sector deficit provided significant offset. Oil Imports Lift Trade Deficit The balance on visible trade rose from a deficit of R26.7 billion in 4Q07 to R61.5 billion in 1Q08, thanks largely to a strong increase in imports that fully offset relatively modest export growth. Exports rose 7.2% from R572.9 billion in 4Q07 to R614.3 billion in 1Q08, despite a 7.2% fall in volumes as the combination of load-shedding by national electricity producer Eskom, the temporary closure of certain mines due to safety audits and a slow resumption of operations following the Christmas and Easter holidays, hurt mining output significantly. The rise in export volumes was driven by a 16% increase in export prices, particularly commodity prices, which rose some 20% over the quarter. Imports, on the other hand, rose a huge 12.7%, thanks largely to higher oil prices. South Africa not only imported crude petroleum, but also some higher-margin refined petroleum and diesel products. Increases were also reported in machinery, electrical equipment, vehicles and chemical products. The import bill was also driven by the acquisition of a third submarine by the South African navy. However, total import volume growth was up only 3.4%, after having trended sideways in 4Q07. Dividends and Services Keep Net Invisible Gap Wide Interestingly, there was no deterioration in the net invisible payments − although they still account for the bulk of the current account deficit. In fact, the share of net invisibles in the current account deficit fell from an average of 72% in 2007 to 68.4% in 1Q08. The single largest component of net invisible payments, however, remained dividend payments (53%). These payments have remained uncomfortably high, thanks to the huge tide of portfolio investment inflows in recent years: gross dividends declared and paid out on these inward flows have risen from R55 billion a year ago to R93 billion in 1Q08. As we have pointed out in earlier research (see South Africa: Dividend Payments Abound, December 12, 2007), these chronic interest and dividend payments have dug a permanent hole in the country’s current account balance, with negative consequences for the currency anytime there is a dry-up in capital inflows. This time around, net service payments on transport services (mainly freight and insurance) also rose significantly. Financial Account Excluding FDI Looks Vulnerable The balance of payments on the financial account improved from R34.3 billion in 4Q07 to R44.5 billion, thanks largely to a R40 billion direct investment inflow that was largely driven by the 20% acquisition of Standard Bank by the Industrial and Commercial Bank of China. Outside of that, the rest of the balance sheet was pretty disappointing. In fact, were it not for the Standard Bank deal, the surplus on the capital account would have been inadequate to fund the burgeoning current account deficit. Net portfolio investments sank into further deficit from -R6.1 billion in 4Q07 to -R20.6 billion in 1Q08, while net other investments − an increasingly popular category for carry trade players − fell from R34.9 billion to R30.7 billion. This time, even unrecorded transactions − a de facto glorified balancing item that has proven very helpful in the past − were down from R19.8 billion to a mere R3.3 billion. With the capital account excluding direct investments now becoming increasingly weak, at a time where global financial risk aversion is likely to limit foreign investor interest in acquiring South African assets, we would like to stress that prospects for rand strength − outside of what we believe is an overstated carry trade argument − are increasingly bleak. We are therefore inclined to revise our year-end US$/ZAR forecast from 8.20 to 8.50, and regard any short-term dip below 7.60 as an opportunity to buy US$/ZAR. Robust Domestic Expenditure Still Elsewhere, the bulletin showed that annualized gross domestic expenditure (GDE) recovered from the 4Q07 reading of 0.2%Q to post an impressive 14.2%Q reading. This was quite surprising, given prior knowledge that overall GDP had fallen to 2.1%Q in 1Q08. We had expected a GDE reading of some 4.5%Q. The key surprises for us were in inventories, government consumption and, to a lesser extent, household consumption. Moderate Deceleration in Household Consumption Household consumption decelerated from 3.8%Q in 4Q07 to 3.3%Q in 1Q08. We had expected a much steeper deceleration to 2.5%Q, given what we knew about vehicle sales, retail trade and general macroeconomic conditions. We were therefore quite surprised when the governor mentioned in the June 12 MPC statement that consumption was in fact as high as 3.3%Q. According to the bulletin, durable goods spending indeed fell 8.1%Q in 1Q08, thanks to a fall in household expenditure on motor vehicles, durable recreational and entertainment goods. There were, however, increased outlays on furniture and appliances, although the latter could not offset the huge declines elsewhere. Semi-durables consumption, on its part, accelerated further from 8.4% in 4Q07 to 10.5% in 1Q08, thanks to strong expenditure outlays on textiles, furnishings and recreational goods, as well as clothing and footwear. After slowing from 5.2% in 3Q07 to 1.9% in 4Q07, non-durable goods rose to 3%Q in 1Q08 as expenditure on recreational goods rose. But this was offset by decelerating food and beverages, tobacco, fuel and power and medical products consumption. We find it interesting that expenditure outlays on discretionary items such as entertainment and recreation appear to have held up despite tight financial conditions. Looking forward, we expect the discretionary components of the household expenditure basket to come under pressure. Chunky Capital Formation Lifts Investment-to-GDP Ratio Gross domestic fixed capital formation accelerated further from 14.1% in 4Q07 to 14.7% in 1Q08, lifting the ratio of gross capital formation to GDP from 21% to 21.5%. The growth here appears to have been rather chunky, as opposed to broad-based, driven in the main by Gautrain-related investments and some agricultural machinery purchases in anticipation of higher food prices. The upgrading and expansion of provincial infrastructure also helped to lift general government consumption, while a general lack of demand led to a sharp increase in manufacturing sector inventories.
Important Disclosure Information at the end of this Forum
Vietnam: Reining in the Tiger Cub
June 23, 2008
By Chetan Ahya & Deyi Tan | Singapore & Shweta Singh | India
Summary In recent weeks, concerns about Vietnam’s macroeconomic outlook have increased. We visited government officials, banks and companies last week to get a better understanding of the macroeconomic developments. Vietnam is facing the classic overheating problem of a typical emerging market attempting to move from a centrally planned economy with a large public sector presence to a market-oriented economy dominated by the private sector. Opening up the economy has created unprecedented foreign interest in the macroeconomic development of the country. However, a weak institutional framework to manage this transition to a market-oriented economy has pushed a number of macro indicators to unsustainable levels. A pegged exchange rate, large capital inflows and a loose monetary policy supported a strong credit cycle and major asset price euphoria. Inflation reached a high of 25.2%Y in May as the trade deficit shot up to an unsustainably high level of 49% of GDP (custom basis, 3M trailing sum, annualized percentage of GDP). The government is facing a major challenge to rein in the overheating economy. Loose Monetary Policy at the Heart of Overheating in the Economy… Vietnam has witnessed the classic overheating in an economy driven by large capital inflows and loose monetary policy. Increased foreign interest in Vietnam’s economic development story led to a spike in capital inflows. In 2007, the capital account balance rose to 24.6% of GDP (US$17.5 billion), we estimate, from 5.1% in 2006 and 5.8% in 2005. Foreign direct investment (FDI) and the portfolio investment balance accounted for 9.2% and 8.8% of GDP, respectively, in 2007. During the first five months of 2008, the trend appeared to continue. The central bank had intervened in the foreign exchange market to avoid appreciation of the Vietnamese dong (VND), resulting in a rise in domestic liquidity. While the State Bank of Vietnam (SBV) sterilized a part of this rise in liquidity by way of open market operations (OMO) and an increase in the cash reserve ratio, it did not fully sterilize it. With domestic interest rates higher than the return earned by the SBV on dollar reserves, the cost of sterilization was high, and this high cost probably weighed on the SBV’s decision. Not surprisingly, credit growth accelerated to 54% in 2007 after growing at an average of 32% in the last four years. We estimate that the credit to GDP ratio spiked to 93% as of December 2007 from 71% as of December 2006. Vietnam’s credit to GDP ratio is now one of the highest in the region relative to its per capita income, reflecting the excesses in the current credit cycle. Strong credit growth delivered by the relatively under-developed banking sector caused misallocation of capital. Banks were funding households’ purchases of equity shares. Banks also increased their exposure to the property market significantly by way of lending to real estate companies and construction companies and to individuals for mortgage loans. ...Reflected in Asset Market Boom The lagged impact of loose monetary policy was reflected in a major increase in domestic demand (particularly construction) and a sharp rise in asset prices. Even as domestic demand and asset prices rose sharply, there was a delay in hiking policy rates. The VN Index rose from 167 at the end of 2003 to a peak of 1,171 in March 2007 and the index traded at a P/E of more than 50 times in early 2007. Similarly, property prices in Ho Chi Minh City and Hanoi increased by 100-200% between 2004 and 2007. The SBV has since put an end to the stock market euphoria by restricting banks from funding purchases of equity shares. In January 2007, banks were ordered to stop extending new credit to securities companies under their control. They may lend to non-affiliated companies, but such lending is restricted to 20% of their charter capital. SBV also increased the risk weight on loans related to share purchases to 150%, meaning that banks now need to hold more capital against these loans. A bank’s shareholding in a firm or investment fund is now limited to 11% of the firm’s charter capital. Most importantly, SBV imposed an aggregate ceiling of 40% of an individual bank’s charter capital for all such investments. …and a Spike in Domestic Demand and Inflation Inflation has continued to accelerate, reaching 25.2%Y in May 2008 from an average of 8.6%Y in QE Sep-07. Core inflation (ex-food and transportation) has risen to 11.7%Y in May from 6.6%Y in QE Sept-07. Indeed, the rise in inflation has meant a sharp decline in real lending rates for the banking sector. The SBV kept the base rate at 8.75% until May 19. Apart from this, the government has always capped lending rates for banks at 1.5 times the base rate. Hence, until May 19, banks could charge a maximum rate of 13.1%. Additionally, from February 2008 to May 2008, banks were directed to offer a maximum deposit rate of 12%. Thus, deposit and lending rates were kept at lower levels than warranted by supply/demand and inflation. While low real lending rates meant stronger demand for credit, low real deposit rates resulted in slower deposit growth. According to a recent World Bank report, credit growth accelerated to 63%Y in March 2008 compared with 33%Y at the start of 2007. Deposit growth decelerated to about 40%Y in March 2008 from about 55% in December 2007 and about 45% in January-February 2007. Indeed, some of the small banks suffered a liquidity crunch, having to borrow in the interbank market at very high rates of 25-30%. Supply-side factors such as food and energy added to the inflation pressures. Of the current inflation rate of 25%, food & foodstuff has contributed 18.6 percentage points. A sharp rise in domestic rice prices has been a key factor driving food inflation. Rice exports have been allowed to continue until recently. Bad weather and its adverse impact on crops resulted in some stress in the domestic market. A spike in international prices and news of increased shortages in various countries in the region heightened anxiety in the domestic market, particularly in March and April. Balance of Payments Stress Strong credit growth resulted in a major spike in imports over the last eight months. Import growth (custom basis) stood at 70.5%Y for January-May 2008 compared with an average of 28.4%Y during QE Sep-07. Import growth has accelerated not only for capital goods such as machinery but also for automobiles, steel and fertilizers. We believe that high inflationary expectations and precautionary advance purchases by residents are key reasons for this spike in import growth. Higher prices of some international commodities also contributed to the acceleration in import growth, as Vietnam imports all of its refined oil needs. The jump in imports over the last few months has pushed the trade deficit to unsustainably high levels. Based on balance of payments data, during 1Q08, the trade deficit and the current account deficit increased to US$7.05 billion (38.2% of GDP on annualized basis) and US$5.29 billion (28.6%), respectively. Strong growth in remittances and FDI ensured that the overall balance of payments remained in surplus at US$3.0 billion. However, amid declining investor confidence and slowing capital inflows, the government is facing challenges in containing balance of payments pressures. First-Round Corrective Measures Slow in Pace The government initially attempted to control the overheating by taking administrative measures, persuading banks to slow credit growth. Policy rates were lifted by only a minimal amount. On February 1, 2008, the SBV increased the base rate to 8.75% from 8.25% and raised the cash reserve ratio from 10% to 11% for deposits under 12M and from 4% to 5% for deposits between 12M and 24M. Moreover, in the second week of February, it instructed banks to subscribe to 365-T-bills worth US$1.3 billion (around 2% of total deposits) at a coupon of 7.8%. The increased stretch on liquidity forced banks to hike deposit rates. Depositors started moving from one bank to another based on which one could offer higher deposit rates. At the end of February, however, the SBV announced a 12% cap on deposit rates. We believe that the decision to limit the rise in interest rates at a time when inflation was rising fast only added to the complexities. Implementing Aggressive Policy Measures Now While the government delayed implementing measures to control the overheating in the economy, it has recently taken the following steps: (a) Tightening of monetary policy: On May 19, the SBV hiked the base rate to 12% from 8.75%. On June 10, it was hiked further to 14%. More importantly, on May 19, the SBV removed the 12% cap on deposit rates. While the lending rate is still limited to 1.5 times the base rate, with the rise in the base rate, banks can now charge up to a maximum of 21% (1.5 times 14%). Banks have since increased deposit rates to about 15-17% and lending rates to 20-21% from a maximum lending rate of 12.4% in January 2008. (b) Fiscal policy tightening: The government aims to cut spending to slow aggregate demand. It plans to reduce its recurrent expenditure (excluding salary) by 10% and to cut capital spending on projects funded by government bonds. We believe that the government is likely to try to reduce its fiscal deficit to 4% of GDP in 2008 from 5% in 2007. (c) Slowing business activity of SOEs: SOEs are expected to focus on core businesses; their investments in banking and securities are subject directly to the PM’s approval. Large Exchange Rate Adjustment Unlikely We believe that the SBV is unlikely to opt for a major one-off exchange rate adjustment. In our view, the exchange rate adjustment priced in the non-deliverable forwards (NDF) market is unlikely to come through. As of June 19, the one- year forward NDF is pricing in a 33% depreciation of the VND. The SBV will resist making such a large adjustment. First, any major one-off depreciation would increase the risk of instability in the FX market. Second, with inflation already at 25% as of May, any sharp depreciation would seriously damage domestic confidence, and inflationary expectations could intensify. We believe that the SBV will likely allow a further minor depreciation of 4-5% over the next three months. If circumstances warrant, the SBV could choose to hike the prime rate (policy rate) by an additional 2-3% over the next 1-2 months, we think. Real Economy Adjustments Will Likely Be Painful Efforts to restrict banks’ funding of equity share purchases and increased concerns about the macro outlook have pushed the VN Index down 68% from its peak in March 2007. The sharp drop in the equity market has weighed on the property market. According to CB Richard Ellis, residential property prices in Ho Chi Minh City have fallen 25%, from US$6,000psm in 2007 to US$4,500psm currently. Meanwhile, residential property prices in Hanoi have fallen by about 10-20% from US$3,500psm in 2007. The sharp increase in lending rates is beginning to cause a significant slowdown in real economic activity. In our conversations with banks, they indicated that they have significantly cut back on credit disbursements. Not only is the cost of borrowing high, but banks are also hesitant to lend, as they are not sure if the borrower will be able to service loans at the level of interest rates. According to the SBV, credit growth has decelerated from 6.3%M in January to 1.2%M in June. We believe that property prices will likely fall further. We expect GDP growth to slow sharply, to 5.5-6% by 1Q09 from 7.5% in 1Q08 and 8.5% in 2007. Full-year GDP growth will probably be 6.5%, below the government’s revised target of 7%. Corporate sector earnings are likely to be hit significantly. Companies will be reporting earnings before mid-July. Apart from slowing growth and the higher cost of borrowing, the corporate sector will probably report losses on cash surpluses parked in marketable securities. Additionally, many companies have increased their exposure to real estate. Balance of Payments Stress to Diminish by 4Q08 We expect import growth to slow from the current 70% level to 25-30% over the next 3-4 months and then to 15-20% by year-end. The spike in interest rates will not only slow real business demand for imports but also halt the precautionary and speculative demand. The slowdown in capital inflows, particularly portfolio inflows, means that the balance of payments could be negative during the third quarter. To address this gap over the next 3-4 months, we believe that the government will opt for a combination of (a) a drawdown on FX reserves, (b) increased borrowing from multilateral agencies for infrastructure projects, and (c) encouraging the corporate sector to borrow from the international markets. We expect the trade deficit to narrow to US$4.5 billion during 4Q08 from US$7.05 billion in 1Q08. We believe that this gap will be adequately matched by remittances, FDI and official development assistance from multilateral agencies. Supply-Side Inflation Pressures to Linger Even though the slowdown in domestic demand and asset price deflation should help to reduce core inflation, food and energy prices could continue to keep the headline inflation rate high. The government has already implemented some measures to address food price inflation. It has increased the supply of rice in the domestic market and announced a moratorium on new contracts for rice exports. The government cannot completely block exports, as that would hurt farmers, though it might benefit the urban population. Domestic rice prices have fallen over the last six weeks, but the overall stock of rice in the country is still low. The government hopes to bring rice prices down further post the April-June harvesting season. While the government raised domestic fuel prices by 12-36% in February, international crude oil prices have shot up by 31% since then. The government can afford to continue subsidizing domestic fuel prices, as Vietnam is a net exporter of oil (it exports crude oil and imports refined products). However, the risk remains that if there is any further major spike in oil prices, the government might have to hike domestic fuel prices. External Account Vulnerability High, but a Severe Shock Will Likely Be Avoided While there are many signs that Vietnam is facing macro conditions similar to those faced by Thailand and a number of other Asian countries pre-1997, we believe that this is not a fair comparison. We expect three key factors to prevent Vietnam from facing a similar external shock. First, the key sources of Vietnam’s balance of payments surplus are FDI, private equity and portfolio equity inflows, and non-short-term debt. None of these sources of funds is likely to move out of the country quickly. Even portfolio investors are finding it difficult to sell due to low liquidity. Vietnam’s external account to GDP ratio is also low at under 30%. Second, there is no capital account convertibility in Vietnam. Individuals are not allowed to remit money from abroad or to move their bank savings deposits in VND to foreign currency deposits. Third, FX reserves are estimated to be at a reasonable level of US$23-24 billion as of 1Q08. FX reserves are about 4.9 times monthly imports, higher than the adequacy benchmark of 3 times. Banking Sector Stress Is the Bigger Risk We believe that the banking sector will face major challenges over the next 12 months. Although most banks have recently reported low non-performing loans as per Vietnamese accounting standards, the underlying NPL levels as per international accounting standards are likely to be higher. We believe that the banking sector’s credit risk management systems are yet to be fully modernized. The coming slowdown in growth and increased cost of debt servicing will likely result in a further rise in NPLs from small and medium-sized companies. The declines in the equity market and in property prices are also beginning to translate into more NPLs. Banks’ ability to raise capital from the international market is likely to be further impaired in this environment. The duration of the current downturn will be key in determining the outcome of the banking sector’s problems. Time to Reflect on Difficult Structural Reforms We believe that the government needs to use the current challenging environment as an opportunity to push through a series of difficult reforms. In our view, the government has to address several challenges to ensure sustained 8% GDP growth: First, Vietnam’s banking system and capital markets still lack the required robustness. A strong banking sector is a key ingredient of faster and stable economic growth in transition economies. An efficient financial sector can promote savings and enable the flow of a larger share of savings into productive investments. The efficiency of the banking sector will be important for systemic stability of the financial system. The recent developments in the stock market also indicate the need to strengthen the regulatory framework related to capital markets. Second, while Vietnam’s infrastructure spending has been picking up, the current state of its infrastructure is still poor. Vietnam must continue this incremental spending, but, increasingly, building modern infrastructure will require technical as well as financial support from the private sector. The government needs to introduce measures to strengthen the legal and policy framework for private sector participation. Third, Vietnam is facing the bigger challenge of building the soft infrastructure – economic and political institutions required for effective management and monitoring of a liberalized market-oriented economy. It needs to strengthen the overall institutional framework, including its judicial system, the presence of independent media, and regulatory agencies for capital markets and industries like telecom, electricity and oil & gas. Fourth, Vietnam needs to increase spending on education, particularly tertiary education. Over the last two years, Vietnam has been facing significant shortages of skilled labor. Indeed, a number companies including multinationals operating in Vietnam are currently facing a significant increase in labor turnover. While Vietnam’s primary education system has been sound, the tertiary education sector needs improvement, in our opinion. Fifth, rising income and wealth inequality is likely to increase discontent among the lower- and middle-income population. As per the World Bank’s Gini coefficient measure, inequality in Vietnam was relatively high at 0.36 in 2006. We believe that this number has deteriorated further in recent years. To ensure social stability, the government must initiate adequate policy measures to provide a safety net for the lower-income population, we believe. Bottom Line We believe that the government has initiated the right policy measures to address the current inflation and balance of payments challenges head-on. We expect the government to continue to rely on monetary policy as the key tool to reduce the macro imbalances. The growth cycle is likely to see a shock over the next 12 months. However, we believe that Vietnam should be able to avoid a major external shock as priced in the non-deliverable forward exchange rate market.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley Dean Witter C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and FirstRand Investment Holdings Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
|
