Different growth cycles: The growth cycle in the AXJ region clearly has the aura of sustainability that the advanced economies would welcome. Domestic demand in the AXJ region has been largely unencumbered by the balance sheet issues that households, banks and now governments face in the G10. Growth dynamics in the AXJ region have therefore been very successful in avoiding the BBB (Bumpy, Below-par, Brittle) recovery that the G10 economies are dealing with. Driven by an export recovery as well as domestic demand, AXJ manufacturing has surged. Notably, industrial production in the US and the euro area has yet to return to pre-recession levels, but those have already been breached in the AXJ region.
AXJ central banks to tighten before G10 counterparts: Not surprisingly, AXJ central banks have already made a start to the tightening campaign. Of the countries under our coverage, Malaysia was the first to hike rates in March. India started reversing its emergency liquidity measures in 4Q09 and its two hikes have set the stage for more tightening this year, with another 75bp expected by 4Q10. In China too, the PBoC directed banks to curb lending back in 3Q09, so the reversal of policy easing can be traced back to that time. Our China team expects a first rate hike to arrive in 2Q10, followed by renminbi revaluation during the summer, and potentially another rate hike in 3Q10, depending on when the Fed hikes and how inflation behaves. Taiwan is expected to start raising rates in 2Q10, while Korea and Indonesia will likely kick-start their tightening campaign a quarter later.
AAA liquidity to remain in place in the G10: On the other hand, G10 central banks besides the Fed and the RBA are expected to raise rates very slowly. The euro area and UK economies still face downside risks to growth and the ECB and the BoE are expected to deliver their first rate hikes only in 4Q10 and 1Q11, respectively. The BoJ, on the other hand, is expected to ease policy further as the anti-deflation momentum builds up even as growth is upgraded (see Forecast Upgrade: Upside for Economy, Deflation Dragging on but Over the Worst, Takehiro Sato and Takeshi Yamaguchi, April 8, 2010). For the Fed, our US team expects a first rate hike in 3Q10. Yet, even with the Fed likely to raise rates earlier than markets expect, the ultra-low level from which rates will be raised and the continued impact of its QE purchases will mean that liquidity will stay in the AAA (Ample, Abundant, Augmenting) regime there as well as in most other G10 economies in 2010, and probably for a large part of 2011 as well.
Central bankers will earn their pay: Central banking would be the cushiest job in the world if AXJ's economic performance and its expansionary policy stance could co-exist without any unwelcome side-effects. Alas, it is not so. Several side-effects abound. Inflation is the biggest. Asset (particularly property) price inflation is another. Inflation is already an issue in India and Indonesia. Even in China, inflation prints have been higher than expected, though still far from levels that would make central bankers uncomfortable. And upside risks are high for the entire region, given its strong domestic demand and a dependence on commodities.
Recent PPI/WPI data in the region indicate rising pressure on input/commodity prices. Indeed, the weighted average PPI for March for countries from which data have been released (China, India, Korea, Taiwan and Thailand) accelerated to 6.1%Y from 3.4%Y in December 2009. We believe that India faces maximum inflation pressures from higher WPI as the output gap is narrowing quickly. China is the only other country in the region where there has been a strong rise in output to above pre-downturn levels, but policy-induced counter-cyclical investments have meant low inflation pressure. Elsewhere in the region, there have been relatively moderate rises in capacity utilisation. Hence, relative to other central banks, we expect the RBI to initiate more aggressive monetary policy.
Why is asset price inflation a worry in AXJ and not in the G10? Frederic Mishkin's cogent argument (see "Not All Bubbles Present a Risk", Financial Times, February 12, 2010) stands us in good stead here. Asset price inflation, he argues, is more of a reason for concern for policymakers when it is accompanied by credit booms. This was an important driver of the financial turmoil and the ensuing recession in the advanced economies. How does this argument work now? As G10 economies have slowly recovered from the Great Recession, house prices have increased or stabilised almost everywhere, even in the US and the UK where housing problems were severe. These increases in prices, however, have not been accompanied by surging credit growth to the household sector (as was the case before the financial troubles began). From the point of view of economic fundamentals, the interaction between rising asset prices and credit growth suggests a belief in a prolonged expansion with very few downside risks. Buyers of such a favourable outlook are extremely difficult to find in the G10 economies. However, with growth looking far more sustainable in the AXJ region, and given its recent and expected outperformance, it is all too easy to find echoes of a belief in unfettered growth there. Property and asset prices are not yet a risk, but central banks are all too aware of the perils of ignoring them.
Property prices are not at dangerous levels, and central banks are keen to keep it that way: Since the bottom of the global recession, property prices have rebounded in the AXJ region. Central banks have been paying a fair amount of attention to asset prices. Bank Indonesia recently made a Greenspan-esque statement questioning the fundamental reasons for high valuations. Chinese authorities have been doing more than commenting. There has been a sustained policy focus on the property sector and Chinese authorities are moving in a determined way to prevent unnecessary speculation there. Just last week, the Chinese authorities provided more stringent guidelines for lending in the property sector that affect second and third mortgage seekers (see Campaign Launched to Curb Rapid Property Price Increase, April 18, 2010). The RBI has been on top of this link between asset prices and credit for a while now. It views regulatory functions as an essential part of monetary policy and has been keen to at least partially insulate lending so that the financial system is neither adversely affected by asset price inflation nor a catalyst in fostering the same.
But the EM monetary toolbox is different...and quite flexible: Central banks in the AXJ region are already aware of the risks and are actively addressing them through various policy instruments. EM central banks in general are less certain about the mechanisms by which policy is transmitted to the economy, but they tend to use several more tools to influence the economy. Lending constraints, particularly to certain sectors of the economy, are an excellent example. By directly influencing or constraining the flow of credit to certain sectors of the economy, EM central banks are able to carry out a far more nuanced policy initiative than DM central banks.
The trilemma adds another dimension to the policy dilemma: Most AXJ economies tend to have a pro-growth tilt to their policy, particularly through their currency policies. The rationale is obvious when exports continue to play such an important role. Be it the PBoC - which has to deal with the pegged exchange rate - or the RBI - which faces a relatively flexible exchange rate, rapid currency appreciation is not a preference anywhere. Therein lies the ‘trilemma' of stable exchange rates, independent monetary policy and free flows of international capital: an economy can have two but not all three of these conditions in place. In our view, the trilemma is likely to be a growing concern in the AXJ region, particularly for the economies of Indonesia, China and India.
Indonesia has one of the highest policy rates in the region and therefore faces the greater challenge in managing capital flows. The central bank has recently been quite uncomfortable with these flows and stands prepared to impose controls on capital inflows if needed in order to get around the trilemma.
In China, policymakers seem to be on their way to allowing some nominal appreciation of the currency. Our China economics team expects currency appreciation to begin during the summer with a total appreciation of 4-5% this year. This gradual appreciation, however, is not without its own problems. Given that such an appreciation is widely expected, and that its beginning will reinforce that expectation, the risk is that even more capital flows into the economy. China's current regime of capital and credit controls may therefore have more work to do even if currency appreciation proceeds gradually. Frankel (NBER Working Paper No. 11274, 2005) finds evidence that sterilising capital inflows over time becomes increasingly difficult, leading to inflationary pressures. While this is not our base case, it is a risk that should not be dismissed.
Finally, one might expect policy in India to escape the attentions of the trilemma since the rupee has a greater amount of flexibility. However, international evidence (Obstfeld, Taylor, Shambaugh, NBER Working Paper No. 10376, 2004) suggests that even relatively flexible exchange rate regimes may have to deal with the trilemma. And given the RBI's concern about currency appreciation, it is possible that it will have an eye on the FX implications of its monetary policy decisions. As of now, FX reserves have not accumulated to the point that the RBI needs to sterilise them in large quantities. Yet, domestic demand has been strong, as is clearly evident in the trade and current account deficits, and this growth dynamic means that capital flows will likely continue to find their way to India.
Bottom line: The AXJ region has enjoyed a spectacular return to a sustainable growth path, unlike the G10 where the BBB recovery remains in place. G10 central banks are expected to keep a supportive AAA monetary policy regime in place which the AXJ economies will likely keep importing, either through fixed exchange rates or through capital flows. Ironically, despite being at the opposite end of the growth spectrum from the G10 region, the AXJ region seems less likely to face a rapid tightening of monetary policy. Central banks there have to balance rapid growth in their domestic economy against the still considerable risks to G10 growth. This delicate balancing act is most likely the reason why AXJ central banks are acting slower than markets have expected. The next few weeks and months represent the beginning of the tightening cycle for most central banks over the world. There is still a long way to go before monetary policy actually becomes restrictive. The policy surprise from AXJ central banks, if there is one, will likely be that they are slow to tighten rates in the early stages and have to compensate by ramping up their operations later in the cycle.
What's new: The Greek government has just announced that it will request financial aid from the EU/IMF. Doing so, it has started the three-step process towards financial aid. In the next step, the European Commission and the ECB need to confirm that Greece cannot fund itself in the market any more. In the final step, euro area governments will have to take a unanimous decision to disburse funds. In some countries, e.g., Germany, this process could take time. Yet, in line with our expectation, the German government is now hinting at the possibility of the IMF disbursing funds first, followed by those countries that have already completed the legislative process. Hence, the delay in parliamentary approval in Germany should not stand in the way of disbursing the first tranches of the aid package. France for instance has already taken a cabinet decision. In the Netherlands, the parliament passed a motion last week approving potential aid to Greece (thus reversing its decision from mid-February).
Impact on our views: In our view, the IMF portion of the aid package can be decided and disbursed in a matter of days. The aid package addresses the near-term liquidity risk in Greece and should see Greece through the upcoming redemptions/coupons. The long-term sustainability issue and thus the solvency question is only marginally affected by the activation of the package through the availability of lending at more favourable rates than the market currently offers. At the end of the day, the solvency question crucially depends on the ability of the Greek government to deliver on its austerity programme. Not only this year, but also in the years ahead. The aid package buys it a little more time though.
An IMF Stand-By Arrangement
IMF assistance for Greece will be provided through a Stand-By Arrangement (SBA). The SBA framework allows the Fund to respond quickly to countries' external financing needs, usually on the back of a BoP crisis. The targets under an IMF programme are typically designed to address these problems and fund disbursements are made conditional on achieving these targets. When a country borrows from the IMF, it agrees to adjust its economic policies to overcome the problems that led it to seek funding in the first place. These commitments, including specific conditionality, are described in the member country's letter of intent, which needs to be approved by the IMF's Executive Board (EB). The EB usually decides by consensus. Hence, the Greek request will likely be a talking point at this weekend's G20 meeting in Washington and the upcoming IMF Spring meeting. It might have well been these events that triggered the official request being made today. That said, yesterday's price action also might have made an impression on policymakers.
The Amount of Borrowing from the IMF
Normal borrowing limits were recently doubled to give countries access of up to 200% of quota for any 12-month period, and 600% of total credit outstanding. Greece's quota is currently SDR 823 million (€925 million), so this would only amount to €1.85 billion per year and €5.55 billion overall. However, the IMF can lend larger amounts above normal limits on a case-by-case basis under its Exceptional Access policy, which entails enhanced scrutiny by the Fund's Executive Board. During the recent global economic crisis, countries facing acute financing needs have been able to tap exceptional access SBAs, with several CEE countries such as Hungary receiving more between 1000-1,200% of their quota. In the case of Greece, press reports of the IMF adding another third to the EU package would suggest that up to €15 billion could be made available. The money can be front-loaded. But it is usually disbursed in tranches.
The IMF Borrowing Rate
The IMF lends at below market rates, hence providing some budgetary respite to the countries who tap into its programmes. The IMF lending rate is tied to the IMF's market-related interest rate, known as the basic rate of charge (currently 1.25%), which is itself linked to the SDR interest rate (currently 0.25%). Large loans carry a surcharge of 200bp, paid on the amount of credit outstanding above 300% of quota. If credit remains above 300% of quota after three years, this surcharge rises to 300bp, and is designed to discourage large and prolonged use of IMF resources. Thus, initially, Greece could borrow at a rate of 3.25% (1.25% plus 200bp) plus a one-off service charge of 50bp on each amount drawn. Repayments are due within 3.25-5 years of disbursement, which means that each disbursement is repaid in eight equal quarterly installments beginning 3.25 years after the date of each disbursement.
IMF Could Ask for Additional Austerity or Adjustment Measures
There is a risk that the IMF might ask for additional fiscal or structural measures over and above the current programme agreed with the EU partners. While we deem this risk low given the size of the planned fiscal tightening, we cannot entirely rule out such a response. Even if the IMF does not demand measures that go meaningfully beyond the ones that have been agreed with the EU, we cannot rule out that the Fund will make some additional demands; even if it is just to assert its role as an institution in its own right. If so, this could delay an agreement, creating market uncertainty in the meantime. In addition, disbursements of the different tranches of the IMF loan will be conditional on meeting these requirements. The failure to implement the measures in time could lead to the programme being suspended.
The Timeline for IMF Lending
The Fund has emergency procedures in place to help provide financing at short notice. The Emergency Financing Mechanism was used in 1997 during the Asian crisis; in 2001 for Turkey; and in 2008-09 for Armenia, Georgia, Hungary, Iceland, Latvia, Pakistan and Ukraine. It can be used when a member country faces an exceptional situation that threatens its financial stability and a rapid response is needed to contain the damage to the country or the international monetary system. In this case the Executive Board is informed about a member's request for assistance; a staff team is quickly deployed to the country (which in the case of Greece has already happened); and then as soon as the IMF staff reach an understanding with the government, the IMF Executive Board considers the request to support a program within 48-72 hours. Given the preparatory work the IMF has done already, a programme can likely be drafted very quickly and a decision by the Executive Board decision could be taken over the weekend or early next week. The upcoming G20 meeting will provide an opportunity for G20 leaders to talk this over in detail.
The Actual Disbursement of the Funds
Once the IMF has decided that it will provide lending to Greece, it will likely ask the larger central banks within the ESCB (or maybe even all of them for the sake of cohesion) to provide EUR to the Greek government. In exchange for these freshly minted euros, the ESCB will receive SDRs from the IMFs. This creation of money by the IMF (a decision by Finance Minister to bump up the IMF's lending capabilities) has attracted some criticism from central bankers (notably J Stark and A Weber), and is one of the reasons why the ECB initially was against the IMF getting involved. Note that the ESCB would not take any risk as far as lending to Greece is concerned. Its lending relationship is with the IMF, who will have to bear the risk on its lending to Greece. Typically the IMF only starts to worry about this risk when a country that it has lent to is already in arrears. In the case of Greece, it is unlikely that the IMF will demand its debt to be senior to others from the outset.
Financial Market Reaction to IMF Programmes
The empirical evidence on IMF programmes acting as a catalyst for private sector capital flows is mixed. In a summary of the academic literature, G. Bird and D. Rowlands (1997, 2002) find that the IMF often fails to act as a catalyst. In fact, an IMF involvement can even be counterproductive. They argue that the commitment by the government to its policy agenda is more important than the involvement of the IMF. Where it exists, the catalytic effect of an IMF programme is only weak and partial and depends on the country, notably its income and its debt level as well as the initial conditions in the country. Bordo, Mody and Oomes (2004) find that IMF programmes catalyse capital flows into countries with bad, but not very bad fundamentals. Meanwhile, Mody and Saravia (2003) report a stronger catalytic impact for precautionary arrangements and for countries where the economic situation has not yet deteriorated drastically. In general, the academic findings strongly depend on samples and econometric procedures. Thus, any generalization has to be viewed with caution. There seems to be no strong evidence though that IMF involvement serves as a ‘seal of approval' to investors and lenders - even though the signal might be stronger for middle-income countries with (potential) access to global capital markets. Typically, we will see significant volatility in markets ahead of the decisions on the disbursements of different tranches of the programme.
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