Time to Shine
November 25, 2008
By Luis Arcentales | New York
With the era of abundance of the past five years coming to an abrupt end, it is time for Chile to shine. Chile’s prudent set of macro policies has put the country on a solid footing to deal with the downturn and potential dislocations in financial markets. Much has been said of how most of Latin America, including Chile, is in better shape to weather the deep global slump, based on the surge in international reserves, superior public debt profiles and better fiscal results. But with the global economy entering a recession of uncertain depth and duration, Latam watchers ought to ask themselves not only which countries can avert a crisis, but also which ones have the most levers to pull in order to lean against the strong global headwinds. And on both of these counts – namely macro stability and the ability to engage in counter-cyclical policies – Chile seems to be in a league of its own.
The rising cyclical tide of the past five years supercharged many Latin American economies, but Chile did not seem to be one of them. Now that the global tide is receding at an alarming pace, pressure points are surfacing throughout the region (see “Latin America: The Case for Caution”, EM Economist, October 24, 2008). Chile has not been immune to the pain from the global financial turmoil; however, the response by both the central bank and finance ministry has been effective in easing local funding pressures and extending targeted aid to sectors likely to suffer disproportionately from the credit crunch. Whether we focus on its ammunition – record reserves and fiscal assets of near 15pp of GDP – or its ability to deliver effectively, Chile seems to be in an enviable position to engineer a normal cyclical downturn even if the globe turns out to be less hospitable than we currently expect (see Beyond a Deeper Recession: Tepid Recovery, Richard Berner and David Greenlaw, November 10, 2008). Fiscal Firepower Far from just a by-product of the recent years of abundance, Chile’s fiscal strength has come from a prudent strategy focused on saving for a rainy day (see “Latin America: Shocking the Fiscal Abundance Story”, EM Economist, October 3, 2008). And that rainy day has arrived: armed with massive savings, Chile has ample room to conduct counter-cyclical fiscal policy even if tax receipts disappoint, whether driven by slower growth, lower copper quotes or both. Indeed, whereas higher growth and commodity prices have translated into higher expenditures throughout the region, in Chile’s case it has also generated massive savings and a sharp reduction in public indebtedness. Importantly, faced with growing expenditures, Chile has been able to execute: by 3Q08, 74.1% of the budget had been executed compared to 69.1% in the same period last year, while for public investment that figure was 70.3% versus 59.1% in 2007. Unlike any country in the region, Chile is sitting on a substantial war chest that allows it plenty of room to engage in fiscal stimulus, as Chile’s structural balance rule has allowed fiscal authorities to transform the country’s copper wealth into financial assets (see “Chile: Can’t Beat the Real Thing!” EM Economist, March 28, 2008). At the end of September, the main Economic & Social Stabilization Fund (FEES) had US$19.3 billion in assets while the smaller Pensions’ Reserve Fund (FRP) had US$2.4 billion. In addition, the Treasury was sitting on US$6.3 billion, which are simply funds derived from a mismatch between the point when revenues are received and the time when the actual outlays take place. With the peso selling off substantially in the past few months, it is worth highlighting that 92% of the government’s assets are in non-peso assets, leading to major translation gains if the authorities needed to liquidate some assets. And while the plan to diversify the FEES assets into equities (15% of total) and corporate debt (20%) remains on track – which we see as a sound financial strategy – today’s allocation of 70.8% of assets in sovereign debt and the remaining 29.2% of assets in bank deposits has meant that financial turbulence has had a limited impact on the value of Chile’s funds. On the debt front, since end-2002 the stock of (gross) government debt has fallen from 15.7% to a trivial 4.4% of GDP by September 2008. Not only does Chile have plenty of fiscal ammunition, but it has also been able to deliver it effectively, in our view. And Chileans appear to share this favorable opinion. Despite the sharp drop in equities, the peso and copper during October, the approval of the government’s handling of the economy soared to 44% from 32% in September, according to Adimark’s monthly survey. The government’s timely fiscal measures announced in early November worth US$1.2 billion target sectors that seem most vulnerable to the financial turmoil, indicating that the authorities have a good understanding of how to address the growing pressure points. The credit crunch has hit the more risky credit segments particularly hard, as is the case of SMEs. The government is addressing this issue by earmarking US$200 million for SMEs programs via development corporation Corfo; in addition, it is injecting US$130 million into a fund (Fogape) that guarantees loans to the SMEs. State-owned BancoEstado will receive US$500 million in fresh capital to boost its ability to lend and enhance its competitive position relative to private banks. Lastly, the package includes subsidies for the acquisition of new houses. Data from Chile’s construction chamber show that sales of new houses and apartments dropped 23% in 3Q, while the stock of houses for sale rose to 23 months, up from 17 months a year earlier. All these actions follow a US$850 million package unveiled on October 13 to boost guarantees for exporters’ credit lines (US$50 million), guarantees for long-term funding for SMEs investment (US$500 million), a line of credit for small businesses’ working capital (US$200 million) and US$100 million for credit lines for non-banking factoring. Taken together, the message contained in these fiscal measures is one of a government that has resources to help the economy and is putting these funds to work in a smart way. With local USD liquidity drying up, the Treasury took advantage of its strong liquidity position by opportunistically depositing US$1.1 billion in local banks in early October. Since then, with help from the central bank, the Treasury has successfully auctioned a further US$700 million in 91-day deposits. Monetary Wisdom No central bank in the region has probably come under so much heat as Chile’s for its decision to intervene in currency markets and for its handling of the surge in inflation, which as of October was running at an annual rate of 9.9% – the highest in 14 years. In fact, we were critical of the move starting April 14 to start accumulating US$8 billion due to the need to “strengthen Chile’s international liquidity position”, which at the time we found inconsistent with the urgent task of addressing mounting price pressures and keeping inflation expectations in check (see “Chile: A Risky Bet”, EM Economist, April 11, 2008). Indeed, even as it intervened in currency markets, the central bank was forced to aggressively hike its target rate by 200bp to 8.25% between June and September, as the inflation outlook worsened. With the benefit of hindsight, the rapid deterioration of the global backdrop of late has validated the central bank’s action to accumulate reserves. We are not trying to minimize Chile’s still challenging inflation outlook or the pain it has caused to consumers (see “Chile: Dark Clouds for the Consumer”, EM Economist, August 22, 2008). Instead, the central bank took a bet that has paid off, leaving it in a far stronger position to deal with the global credit crunch. The central bank’s credibility has been further enhanced, in our view, by its firm and successful actions to deal with the funding pressures in the domestic market. First, the central bank proactively concluded its USD accumulation strategy prematurely – the program was only 70% completed – on September 29, citing a “relevant deterioration in global financial markets”. At the same time, the central bank resumed currency swap operations for one month, later extending the program to six months in the form of US$500 million in 60- to 90-day swaps, up to a maximum amount of US$5.0 billion. In addition, the central bank added an extra degree of flexibility to the banking system by allowing institutions holding USD deposits to use pesos, euros or yen for the purpose of satisfying reserve requirements (see “Chile: Pragmatism Prevails”, EM Economist, October 10, 2008). Finally, the range of accepted collateral for repo operations was expanded. Slashing interest rates, after all, would have been the wrong medicine to address the funding pressures, in our view. In an extraordinary move that, in our view, further enhanced its credibility, the central bank unveiled a new set of forecasts. Citing the “drastic changes…in the international scenario”, the new forecasts include lower 2009 GDP growth (2-3% from 3.5-4.5% previously) and inflation (4.0% by end-2009 from 4.9%). Importantly, the central bank went beyond a simple forecast update by acknowledging today’s environment of heightened uncertainty. In our view, to have the central bank openly admit the unprecedented level of uncertainty suggests that its members are ready to act accordingly, as they have already done. Indeed, if the credit crunch were to intensify, we believe that a plan with further measures that would be quickly implemented has already been outlined. No Skeletons in This Closet With all the challenges posed by the global financial crisis, the importance of a solid regulatory framework can often be ignored. However, given the speed and magnitude at which the financial pain of the industrialized world has spread into emerging markets, pressure points that could have been prevented by better regulation are quickly appearing. In Chile’s case, so far, no skeletons have appeared. While the Chilean peso has sold off by a similar magnitude as other regional currencies, there have not been any high-profile corporate casualties in Chile. My colleague Marcelo Carvalho argues that years of steady currency appreciation lulled companies in Brazil into a false sense of security, encouraging them to bet on further currency strengthening (see “Brazil: Corporate Debt Pressure Points”, EM Economist, October 31, 2008). In similar fashion, several Mexican corporates entered in derivatives contracts, betting on persistent low volatility of the peso. Despite similar relative currency moves, Chile has not seen any major corporation fall victim to currency bets. We suspect that this speaks of both superior corporate governance and regulations, which include reporting to the central bank any type of derivative exposure. Beyond the hits to specific companies, such derivative losses have made it more difficult for the business sector to access credit; in contrast, credit in Chile has not shut down, as shown by the successful local placement of over US$200 million in debt by a major pulp producer in early November. Within Latin America and even on a global basis, Chile earns high marks for the transparency, predictability and soundness of its regulations − many of which, such as the General Banking Act of 1986, emerged from the painful banking crisis of the 1980s (see Macro and Micro Radars, 2nd Half 2008, November 24, 2008). Indeed, Chilean banks are considered the 18th most sound out of 134 countries surveyed by the World Economic Forum. In terms of securities’ market regulation, Chile earns the 14th spot worldwide. As investors look for regulatory vulnerabilities that could lead to the next accident in the emerging market space, they are likely to be disappointed by Chile. Bottom Line With the era of abundance of the past five years coming to an abrupt end, it is time for Chile to shine. Chile’s prudent set of macro policies has put the country on a solid footing to deal with the ongoing cyclical downturn and potential dislocations in financial markets. With the global economy entering a recession of uncertain depth and duration, Latam watchers ought to ask themselves not only which countries can avert a crisis, but also which ones have the most levers to pull in order to lean against the strong global headwinds. And on both of these fronts, namely macro stability and the ability to engage in counter-cyclical policies, Chile seems to be in a league of its own.
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Colombia and Peru: The Debt Debate
November 25, 2008
By Boris Segura | New York
Although Peru has enjoyed a more favorable profile among debt investors in recent years than Colombia, the latest market sell-off has seen both countries suffer. Indeed, it is difficult to discriminate between the two when looking at the most recent five-year credit default swaps. While both countries share similar traits – small, Andean economies that have both benefitted from the abundance of the past five years as commodity exporters – we believe that Peru’s economic and debt dynamics are superior to those of Colombia. Once things settle down, we expect Peru’s risk to be lower than Colombia’s. This outcome is more likely in an environment where risk is re-priced and investors become more discriminating across credits. Peru: More Sustainable Public Sector Debt Peru’s public sector debt burden appears to be more manageable than Colombia’s. Peru made impressive progress in reducing its public sector debt-to-GDP ratio during the era of abundance, whereas Colombia’s advance was much more modest. In fact, Peru’s debt burden is half that of Colombia. Healthier fiscal accounts and stronger growth dynamics in Peru do the trick. This increased debt sustainability in Peru reflects not only favorable growth dynamics but also stricter fiscal discipline. For three years in a row, Peruvian authorities have been able to deliver fiscal surpluses – certainly helped by the commodities boom – despite strong social pressure to increase public spending. In the case of Colombia, a more rigid expenditure structure, including generous tax benefits, and unsuccessful attempts at tax reform have left fiscal accounts on a less even footing (see “Colombia: Fiscal Pressure Points”, EM Economist, November 7, 2008). In fact, we think that in the short term Colombia is likely to suffer a more challenging fiscal situation than Peru. This stronger fiscal starting point allows Peru some flexibility. Given Peru’s relatively low public sector debt burden and an expected 2% of GDP in its fiscal stabilization fund by the end of this year, the country is well positioned to eventually engage in some anti-cyclical fiscal policy, offsetting some expected drop in tax revenues without having to slash public spending. However, we fear that Colombia doesn’t enjoy the same luxury. Peru: Better Growth Prospects Recent economic growth in Peru has been impressive, while Colombia has also shown an above-trend record. As has been the case in most of the region, recent economic dynamism in these two countries has been helped by a favorable external backdrop – including high commodity prices, cheap capital and strong external demand, among other factors. But we expect the Peruvian economy to grow faster than Colombia’s going forward. In fact, most recent estimates place potential GDP growth in Peru at 6.5-7%, versus 5-5.5% in Colombia – even though both countries have similar levels of relative economic development, as measured by per capita income. In other words, faster economic growth in Peru vis-à-vis Colombia going forward should not be seen merely as a ‘catch-up’ effect. In fact, BanRep has recently cut sharply its estimates of potential GDP growth for Colombia, due to higher-than-expected inflation and a series of negative supply shocks. Both countries have enjoyed an investment boom in recent years. The total investment share in GDP has been increasing throughout this decade. This is one of the most important drivers behind faster economic growth and higher potential GDP growth. Peru: Lower External Vulnerability In recent years, Peru has seen a sharp decline in its net external debt (total external debt minus international reserves) as a percentage of exports of goods, services and income − a general measure of an economy’s external vulnerability. As for Colombia, despite enjoying net external debt below that of Peru earlier in the decade, its net external debt as a percentage of exports saw only a modest fall during the era of abundance. Also, Peru has less short-term external debt as a proportion of international reserves than Colombia, further buttressing its defenses against a sudden stop of international capital flows. Peru’s public sector is a net external creditor, unlike Colombia’s. Peru’s international reserves more than cover public sector external debt – partly a reflection of more ambitious fiscal efforts in Peru, but also stemming from aggressive reserve accumulation. This offers an important line of defense at a time when we expect weaker currencies across Latin America. A Couple of Caveats Peru’s financial system is significantly more dollarized than Colombia’s. Thus, real depreciation of the Peruvian sol is likely to have larger balance sheet effects than similar moves of the Colombian peso. This is why monetary authorities in Peru are more enthusiastic about intervening in the exchange rate market to ‘smooth’ currency moves. This facet shows in recent intervention strategies in the FX market. Whereas the Colombian authorities have so far spent US$145 million ‘defending’ the country’s currency since early September, Peru’s central bank has spent US$5.6 billion ‘smoothing currency moves’ over the same period. Peru’s efforts to defend the exchange rate risk are undermining its economy’s external strength. The Peruvian authorities have been spending international reserves at a brisk pace recently in an effort to support the nuevo sol. Bottom Line We don’t believe that fundamentals justify a convergence in external debt valuations of Peru and Colombia. We think that Peru’s debt dynamics are in better shape than those of Colombia. Compared to Colombia, Peru’s debt sustainability is superior, its growth prospects are brighter and its external vulnerability is lower, in our view.
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A New Renminbi Regime?
November 25, 2008
By Qing Wang & Steven Zhang | Hong Kong
The ‘Lonely’ Renminbi Among the major currencies in the emerging market space, the renminbi is the currency that has registered the largest appreciation so far this year against the US dollar (7.8%), in nominal effective terms (13.4%) and real effective terms (13.5%). In particular, the renminbi is the only major EM currency that has appreciated against the US dollar. A Departure from the Previous Policy Course? The PBoC published its 3Q Monetary Policy Report on November 17. As usual, the report presents a comprehensive review of the latest economic and policy developments and discusses the near-term policy outlook. However, the report was virtually silent on the exchange rate policy outlook, except for mentioning the need to maintain a stable currency. This is a conspicuous departure from its past practice. The PBoC has published 14 monetary policy reports since July 2005, when China de-pegged the renminbi from the US dollar and adopted a managed float exchange rate regime. In all 13 reports published prior to the 3Q08 report, there was a paragraph or two devoted to the discussion of the renminbi exchange rate policy, featuring the familiar policy lines such as “following a proactive, manageable and gradualist approach”, “further enhance the flexibility of the exchange rate”, “maintain the exchange rate broadly stable at an equilibrium level”, and so on. However, none of these statements is included in the 3Q08 report, which begs the question as to whether there has not been a major shift from the previous policy course on the renminbi exchange rate issue. A New Renminbi Regime? The Chinese authorities launched the reform of the renminbi exchange rate regime on July 21, 2005 by de-pegging the renminbi from the US dollar and adopting a managed float exchange rate regime with reference to a currency basket. In practice, the USD/CNY trajectory resembles that under a typical crawling peg regime. Since July 21, 2005, the renminbi already appreciated against the US dollar by slightly over 20% from the pre-reform USD/CNY level of 8.27 over a period of three years and four months. However, the USD/CNY rate has been kept in a very tight range between 6.81-6.85 since July 2008, the three-year anniversary of China’s exchange rate reform. The renminbi now appears to have returned to a nearly hard peg (to the US dollar) regime after three years’ practice of a crawling peg, which has resulted in about a 20% appreciation of the renminbi against the US dollar. Is this a new renminbi regime? Or may it well be an interim arrangement, the purpose of which is to anchor expectations and maintain financial and monetary stability amid a global financial crisis? Only time can tell. In any case, we believe that there has been a meaningful change in China’s exchange rate policy, the central element of which is stability amid the global financial crisis. It is worth emphasizing that China adopted a similar strategy during the Asian Financial Crisis a decade ago. No Market Basis for Sustained Depreciation The currencies of a large number of emerging market economies have experienced rather large depreciation against the US dollar since mid-year. Moreover, China’s export growth has already decelerated significantly since the beginning of this year and is expected to decline sharply in the coming quarters amid a global recession. In this context, many investors start to wonder how long the renminbi can remain stable before following its EM peers to depreciate. However, we believe that the risk of a sustained renminbi depreciation is low, if the renminbi exchange rate is to be determined freely by the market. Specifically, the renminbi exchange rate – as one of the most important macroeconomic variables – is still fundamentally undervalued and needs to appreciate toward its equilibrium level over the medium term, in our view. Without central bank intervention, market demand for FX must be greater than supply for a renminbi depreciation to materialize. This is possible if: 1) China’s current account balance turns from surplus into deficit, and the deficit is large enough to offset net capital inflows under the capital account; or 2) China’s current account is still in surplus, but net capital outflows under the capital account are large enough to offset this surplus. However, neither scenario is likely in the foreseeable future, in our view. Here’s why: First, given the sizable trade surplus at the current juncture, import growth would have to outpace export growth by a large margin for a sustained period to turn the trade balance from surplus to deficit. For instance, we estimate that, even if export growth were to drop to 10%Y and import growth grew twice as fast (i.e., 20%Y), a sustained trade deficit would not emerge until after June 2010. Second, China’s capital account balance has been in surplus (i.e., net capital inflows) in 14 of the past 15 years. The exception was 1998, when net capital outflows were recorded, reflecting the impact of the Asian Financial Crisis. Therefore, it is hard to envisage China experiencing significant net capital outflows unless: 1) a major financial crisis were to emerge of the same magnitude as that of 1997-98, which could trigger massive capital flight; or 2) the Chinese government were to lift capital controls, inducing a large amount of capital outflows. Neither is probable, in our view. With regard to scenario 1, even if this were to be a repeat of the Asian Financial Crisis, we think that the probability of meaningful capital flight out of China would be low. China’s outsized FX reserves can surely help to head off any downward pressure on the renminbi, if this is the Chinese authorities’ objective. This should help to inject confidence and maintain stable expectations, which are critical to preventing capital flight. With regard to scenario 2, we do not believe that the Chinese authorities would risk removing capital account controls, especially when the global financial market is in turmoil and the Chinese economy is entering a serious cyclical downturn. As long as there are net FX inflows (through either the current account surplus or the capital account surplus), the supply of FX should be greater than demand in the market, and the renminbi exchange rate should be under appreciation pressure unless the central bank intervenes. If the central bank were to intervene in the FX market aggressively, it would be able to bring about a renminbi depreciation despite large net FX inflows. To engineer this, the central bank could buy more FX than the market is willing to sell initially, thus bidding up the price of FX. However, we seriously doubt that the central bank would conduct this type of ‘super-aggressive’ intervention on a sustainable basis. In practice, the typical policy response of central banks facing large FX inflows is to intervene with the objective of slowing the pace of domestic currency appreciation instead of completely reversing the appreciation trend, as this would entail much more accumulation of FX reserves than otherwise. A more general point is that an exchange rate is a function of a balance of payment position. Historical and cross-country experiences suggest that an economic downturn does not necessarily lead to deterioration in balance of payment positions and thus a weak currency. A case in point is Japan. The Japanese economy underwent a hard landing after the stock market bubble burst in early 1990. However, the yen continued to strengthen against the US dollar for the next five years. This was because Japan still ran a large current account surplus, which kept the yen on an appreciating trend against the US dollar. The recent experiences in US and China are also quite telling: despite a substantial economic slowdown in both economies, their trade balances have in fact improved, with China even having registered a record trade surplus in October. This is because notwithstanding the decline in export growth, import growth has decelerated even faster on the back of weakening domestic demand. Pros and Cons of Renminbi Devaluation While arguing that there is no market basis for renminbi depreciation, we recognize that the renminbi exchange rate remains largely a policy instrument – that is tightly managed by the authorities – instead of a market-determined price variable. We therefore cannot rule out completely a renminbi devaluation, if the authorities see a compelling case to do so from a policy perspective. There are both pros and cons of a renminbi devaluation. The most obvious benefit is to help Chinese exporters by making their products more competitive. That said, the current difficulty faced by the Chinese exporting industry has more to do with a substantial deterioration in external demand than a strong exchange rate, in our view. In this context, while an exchange rate devaluation may help to cushion the downside for exports, it would not be able to change the trend. We see at least three arguments that call for caution against a renminbi devaluation at the current juncture when the market sentiment toward many EM market economies is very fragile. First, a devaluation may trigger large capital outflows from China, running the risk of destabilizing domestic financial markets. Second, if the renminbi – the symbol of stability in the region – falters, it could have a major negative spillover impact on the currencies in the rest of the region. This is a consequence that the Chinese authorities – who have plans to promote the renminbi as a major international currency over the long run – are unlikely to want to face. Third, with the US democrats – who tend to take a tougher stance vis-à-vis China on trade issues in general and the renminbi exchange rate in particular – in control of both the White House and Capitol Hill, the Chinese authorities may not want to antagonize their US counterparts by devaluating the renminbi, especially when the latter are in their early days in office. Weighing the pros and cons of a renminbi devaluation, we believe that the benefits are outweighed by the costs. Specifically, the benefit of helping to maintain monetary and financial stability in China and the region and a healthy Sino-US relationship is enormous. Moreover, the Chinese authorities are implementing other fiscal measures to help the exporters, including raising the VAT rebate, removing export tariffs and allowing easier access to bank lending by the SMEs in the exporting industry. Implications Despite the outlook for substantially weaker exports in the coming quarters, a sustained renminbi depreciation against the US dollar is unlikely, in our view. We expect a broadly stable exchange rate against the US dollar over 2009 under an emerging new (and perhaps interim) renminbi regime. While a stable renminbi against the US dollar does preclude the renminbi appreciation/depreciation in trade-weighted terms, it does have important implications for financial market investment, the funding currency of which is the US dollar. In fact, a stable renminbi has been the main reason for the ‘outperformance’ of the Chinese stock market since August as compared to its EM peers. Our colleague, Stephen Jen, believes that there is still substantial downside risk to EM currencies (see EM Currencies: Sell into the Rally, October 30, 2008). Looking ahead, we expect that a stable renminbi exchange rate against the US dollar will likely continue to be an important factor underpinning the performance of China’s stock market. Risks In the event that China’s trade surplus were to narrow sharply or China were to suffer a serious deflation, we could not rule out completely the possibility of a depreciation of the renminbi against the US dollar. This is not an implausible scenario, especially if the G3 economies were to experience a multi-year severe recession that would lead to a significant shrinkage in international trade volumes. However, this is not our base case scenario for either the global economy or for China, and we consider it a low-probability event (see Further Growth Forecast Downgrade Amid a Deeper Global Recession, November 10, 2008).
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