Help is on its way. In addition, policy-type stimulus is already under way - without central banks having to lift a finger or utter a word. How? Markets are doing the job for the monetary policymakers, and very efficiently at that. For one thing, asset price inflation far outstripping growth and accelerating inflation expectations could have tempted central banks to hike, but recession fears and sovereign risks from Europe have led to a moderation in both. Further, the rally in Treasury bond markets (except in the euro area periphery) is exactly the kind of reaction that one would expect if policy rates were cut and /or central banks had ramped up QE programs to buy more government securities. As long as a recession doesn't materialise, this prevailing combination of softer risky asset prices and moderating inflation expectations has set the stage for AAA (ample, abundant and augmenting) liquidity to be provided for longer. Delayed tightening along with the rally in bond markets will support economic growth going forward.
Where is FAYRE value for Treasury yields? MS FAYRE, our proprietary fundamental model for US 10-year Treasury yields stands at 3.5%. The current deviation of about 50bp is not surprising given the flight-to-quality bid that exists during times of financial stress. The model uses the real fed funds rate, one-year ahead headline CPI inflation expectations from the Survey of Professional Forecasters and the volatility of inflation as inputs (see Joachim Fels and Manoj Pradhan, Fairy Tales of the Bond Market, July 26, 2006). The real fed funds rate (nominal policy rate deflated by core PCE inflation) remains in ultra-expansionary territory as core PCE at 1.3% and a nominal fed funds rate of 0.125% produce a negative real rate of -1.17%. Our US team expects core PCE inflation to rise to 1.8% by year-end and to stabilise at 2% next year. The real policy rate is therefore likely to fall further in the near future, and to start rising only when the Fed starts hiking rates next year. The fall and expected rise in core and headline inflation has been responsible for pushing inflation volatility higher recently, but we expect that inflation and inflation volatility are likely to stabilise.
The critical input at the present time is the inflation expectations number. The Survey of Professional Forecasters, conducted by the Philadelphia Fed, shows headline CPI is expected to print a 1.9% growth over the next year. Because the survey is conducted in the middle of the quarter, there is a chance that the full impact of the banking and sovereign risks may not be fully captured in the 2Q10 number. Hence, it is possible that the inflation expectations number, and therefore our estimate of fair value move somewhat lower in the near future. However, unless a significant slowdown or outright recession materialises, the survey is unlikely to record a very low number.
What's priced into 3% yields? The lowest value reported by the survey in the recent past was 1.6% in 1Q09 - a time when hopes of recovery were probably at their dimmest and a second Great Depression looked ominously close. Ceteris paribus, plugging a 1.6% number for inflation expectations into our model produces a fair value of 3% - very close to today's level. Taken at face value, this would suggest that the constraints on monetary and fiscal policymakers mean that markets are probably more worried about a policy-led rescue from a double-dip recession, even if they do not expect a great depression. In other words, even if the tail-risks are lower this time around, the base case for recovery that markets are pricing in is probably quite weak.
Rates outlook. Our US economics and strategy teams now expect that a combination of sovereign risks, moderating inflation expectations and technical factors mean that US Treasury yields could go as low as 2.75% before ending the year at 3.5% (see Richard Berner, Jim Caron and David Greenlaw, Recalibrating the Rates Outlook, July 1, 2010). However, according to the team, "moderate, sustainable growth, a rebound in private credit demands, a bottoming in inflation, and a Fed that begins to implement its exit strategy will push yields significantly higher in 2011. Indeed, we see a 150bp rise in both 10-year yields (to 5%) and fed funds (to 1.75%) over the four quarters of next year."
FAYRE value at 4.75-4.90% for end-2011. Using our US team's end-2011 forecasts of 1.75% for the fed funds rate, 2% for core PCE inflation and 2.6% for headline CPI inflation (assuming that inflation expectations stabilise around those levels, and assuming a range for inflation volatility), the FAYRE value for 10-year yields for end-2011 falls in a range of 4.75-4.90%. This is consistent with our US team's outlook for a 5% yield by end-2011. Indeed, the risk here is that inflation expectations and yields may rise faster in mid- to late 2011 if the combination of a sustainable recovery and delayed monetary tightening produce a sharper rise in inflation later.
Recent economic data out of the US haven't helped matters. Payroll and ISM numbers were weaker than expected, while the severe drop in the prices paid component of the ISM has added grist to the deflation mill. However, economic expansion in the last few months has broadened with nearly two-thirds of manufacturing sectors showing expansion. Our US team notes that decent personal income growth, ongoing help from the fiscal stimulus, the beginning (rather than end) of inventory accumulation and the beneficial impact of AXJ growth on net exports will all support growth (see Richard Berner, David Greenlaw, Ted Wieseman and David Cho, Growth Scare, July 2, 2010). Sovereign risks are undoubtedly a source of serious concern, but markets have probably overreacted in their assessment of the solvency risks in the region, according to our euro area team. While the outlook for growth remains weak, the risks in the region are roughly balanced (see Elga Bartsch, Daniele Antonucci, The Mediterranean Diet, June 7, 2010).
Markets have removed headwinds to monetary policy... Looking back, hikes in the policy rate - particularly by the Fed - have been prompted by rising inflation expectations (see Manoj Pradhan, Growing Pains, September 23, 2009). Given the experience of the Great Recession, policymakers would probably have paid much more attention than usual to asset prices had they kept outstripping growth. Market concerns about the sovereign risks in the euro area and the possibility of a double-dip recession have been pushing equity markets lower and, probably more importantly, have dampened inflation expectations. With the dual risks of rising inflation expectations and rapid asset price inflation out of the way, central banks now have a degree of freedom that they didn't have just a few months ago. Accordingly, the major central banks are likely to stay on hold for longer. Our US economics team now expects the first hikes from the Fed to arrive in 1Q11. The ECB is even further behind, with the first hike expected only in 3Q11.
...and have elicited a rate-cut /QE-like response in yields. With not much priced in by way of hikes in the front end of yield curves, markets didn't have too many hikes to remove. However, bond yields have fallen, with the 10-year US Treasury bond yield falling below 3%. Bond yields are an important part of the monetary transmission mechanism and we expect cuts in the policy rate to translate into lower bond yields and a lower cost of borrowing for households and firms. In fact, we believe that purchases of Treasury and MBS assets were designed to get around this traditional relationship between policy rates and bond yields and directly lower long-term yields and spreads. Part of the success story of ‘active QE' programs comes from the fact that Treasury yields and mortgage spreads were much lower after the programme. By pushing bond yields lower now, markets are doing exactly what any rate cuts or further enhancements of QE programs would have achieved...without any action from the central banks.
Asset markets part of transmission mechanism. Asset markets are an important part of the monetary transmission mechanism and risky assets have often carried the baton for central bank policy. While interest rates traditionally carry the bulk of the policy message across to the real economy, the credit and asset channels of monetary transmission also play an important role in the transmission mechanism. Back in the middle of 2009, when rate cuts by the Fed were less effective thanks to wide spreads in lending rates, and when lending was contracting rather than expanding, it was asset markets that did the job for the Fed (see Manoj Pradhan and Spyros Andreopoulos, Between a Rock and a Hard Place, August 19, 2009). A strong rebound in the equity market and narrowing spreads gave the economy a timely boost and set it along the road to expansion. And asset markets are back on the frontline, easing financial conditions at a time when doing the same through official policy actions is not straightforward.
BBB recovery delivering a bumpy ride. The focus on economic weakness clearly depends on the data flow in the near term. As long as a recession doesn't materialise, markets may well be delivering a policy-type stimulus by creating an easing of financial conditions of the kind that central banks would love to be able to recreate. In particular, moderation in inflation expectations and lower bond yields are likely to play a key role in keeping the expansionary stance of monetary policy in place for longer, supporting economic growth and real assets. Finally, a low level of conviction among investors most likely means that positions in risky assets and bonds are light. If prevailing concerns are seen to be a growth scare, both risky asset prices and bond yields could move higher. In the near term though, yields could stay low or move somewhat lower, keeping financial conditions easy. A recovering economy would find this helpful in further consolidating the BBB recovery.
Summary
The South African Reserve Bank's June 2010 gross FX reserves data showed a brisk US$503 million increase. The net international liquidity position also improved by some US$261 million. The details of the report, however, suggest that naked FX purchases through the month were at least US$770 million, funded mainly by the National Treasury. While we do not ordinarily comment on the monthly FX reserves data, we believe that this particular set of data holds some interesting finds: First, the data show that South Africa no longer owns ‘borrowed' reserves. Second, the larger-than-normal scale of accretion confirms that the government is indeed serious about stepping up the pace of opportunistic reserve accumulation. And finally, the higher pace of reserve buildup suggests to us that the fiscal authorities have turned more bullish on the country's revenue prospects.
Foreign Loan Legacy
Historically, South Africa has had to rely on borrowed reserves to boost its international reserve position. In 1995, some 20% of the country's foreign exchange reserves were borrowed (mainly bilateral credit lines with multilateral lending institutions and banks). This ratio rose to a peak of 59% during the 1998 Asian financial crisis, when significant amounts of capital (both portfolio investments and FDI) left the country as the currency weakened to new lows, forcing the South African Reserve Bank (SARB) to rely heavily on foreign credit lines (mainly short-term borrowing) to plug the hole. The SARB also ran up a significant oversold FX position at the time. Since the fall of 1998, however, the SARB made a conscious effort to unwind both the forward book and foreign credit lines.
There was a brief period in 2H01, when another currency crisis hit the country as foreign investors withdrew significant amounts of short-term deposits from the South African banking system. To meet the huge demand for foreign exchange in the wake of the capital flight, and to meet delivery requirements on maturing forward contracts that were becoming somewhat difficult to roll over fully, the SARB was again forced to borrow FX reserves - including the much-publicized US$1.5 billion syndicated loan facility that was eventually used to part-pay maturing FX forwards. Thankfully, the currency's recovery from a low point of R12.4/USD in December 2001 has allowed the SARB to fully unwind its net short FX position at a relatively manageable cost. A major milestone was reached in February 2004 when its oversold forward book was squared up; and again in June 2010, when all outstanding borrowed reserves were paid off.
Looking forward, we expect the country to benefit from the positive sentiment associated with the elimination of borrowed reserves. We think this, together with a continuously improving fiscal position should encourage the rating authorities to upgrade South Africa's outlook from negative to neutral by the end of this year.
Stepping Up the Pace of Reserve Accumulation
Second, our analysis shows that, after adjusting for valuation effects in gold, SDR's and currency movements, gross FX reserves rose by roughly US$450 million in June - some US$152 million less than suggested by the official US$603 million headline print. It is also important to remember that, during this month, the SARB paid back the final tranche (US$350 million) of its borrowed reserves, received a US$661 million deposit from the National Treasury, and all but closed out a US$32 million net long forward position that it had initiated in May. After taking all these flows and valuation adjustments into account, we estimate that net FX purchases by the SARB were in the region of US$109 million. Together with the Treasury's US$661 million deposit, it appears that the authorities bought at least US$770 million in the spot market.
At Least US$770 million?
Yes. Usually, receipts of FX deposits from the Treasury derive from the proceeds of foreign bond sales or extraordinary receipts from the liquidation of foreign assets. In June, however, it appears that the FX deposits of US$661 million were direct purchases of foreign exchange by the SARB on behalf of the Treasury. In fact, we believe that the SARB may have bought more than US$661 million on the Treasury's book if one considers that the published figure of US$661 million is a net, rather than gross, figure. One must remember that the Treasury holds two FX deposit accounts at the SARB. One for reserve accumulation, and the other for normal day-to-day transactions. The SARB only publishes the net balance on the two accounts. Hence, it is entirely feasible that gross purchases for the reserve accumulation account were more than US$661 million if there was a drawdown on the second account during the month.
This could well have been the case, because provisional financing figures released by the National Treasury show that the Treasury's sterilization deposits at the SARB were up ZAR5.7 billion (some US$745 million) in June. This is higher than the change in net FX placements (US$661 million) at the SARB. While the residual US$84 million (about R640 million) may have been due to an increase in deposits at the Corporation for Public Deposits (CPD), or a placement to part-sterilize the US$109 million - given the SARB's limited capacity to sterilize its FX purchases in the face of very weak demand for its debentures presently - we believe that the extra R640 million placement in the Treasury's sterilization account at the SARB could also be indicative of higher gross FX purchases for the reserve accumulation account.
Fiscal Revenue Outperformance
Finally, the fact that the Treasury is willing to throw more funds at reserve accumulation suggests that it has been pleasantly surprised by the extent of the fiscal revenue overshoot so far this year. Recall that the Treasury's annual budget does not make a specific allocation for FX purchases. Allocations for this expenditure item are therefore highly contingent on on-going revenue performance and to a less extent, cost control. It is still early days. However, we would highlight that, for the fiscal year to date, total tax revenues are some 12% of annual budget - compared to 11% by the same time last year.
And, while the relationship between revenue performance and the commensurate allocations for reserve accumulation will no doubt be distorted by irregular leads and lags, we believe that the new-found gusto with which the Treasury has stepped up allocations for reserve accumulation suggests that it is pretty comfortable with the revenue trajectory. This positive revenue performance solidifies our expectation that tax revenues will print ahead of official estimates of R647 billion in the present fiscal year. Our long held view is for a tax overshoot of some R50 billion, or a final estimate of R700 billion.
Final Thoughts
FX purchases in the month of June appear a little more aggressive compared to historical levels given the modest 0.5%M appreciation in the currency. We maintain our view however, that in a market where daily turnover can reach levels as high as US$14 billion, against a reserve holding of some US$40 billion (i.e., less than three days of market turnover), any attempt to massage the currency weaker would simply result in a buildup of FX reserves - without any meaningful impact on the value of the ZAR.
The Rebalancing Lesson from the 2008 Developed World Crisis Is Yet to Be Mastered, but...
As the developed world frets about consumer develeraging in the US and sovereign debt contagion in Europe, ASEAN policymakers should be pleased that their macro balance sheets have been restored to health post the 1998 crisis. Yet, past deleveraging as ASEAN economies corrected domestic demand excesses of pre-1998 have left it to the export machine to fill the growth void during the interim. With renewed concerns about a global double-dip and structural export demand, the realization of the need for these economies to wean themselves off the export machine and engage in macro rebalancing has been re-awakened. The recent depeg of the Chinese RMB and minimum wage hikes likely push the Asia region in that direction somewhat.
...the Leverage Lesson from 1998 Asian Crisis Was Well Learned
With the benefit of hindsight, the 2008 developed world financial turmoil was familiar to ASEAN in more ways than one. It was only a decade ago that the 1998 Asian financial crisis hit these economies. Back then, current account deficits in ASEAN were common as corporates overinvested, the same way the US saw current account deficits due to overconsumption by households. The development of global capital markets and short-term capital inflows from the developed world to the ASEAN region amid managed exchange rate regimes and incomplete sterilization resulted in rapid liquidity growth, which helped fund growth in ASEAN pre-1998. In a reversal of roles, the US consumption binge was similarly funded by the excess liquidity generated by the export machine of the developing world. In both instances, financial institutions, moral hazard, and regulatory frameworks played key roles in the transmission of liquidity, credit and debt into resource misallocation and asset bubbles: bank credit in the case of ASEAN and shadow-banking in case of the US. When the uptrend in asset prices reversed, these growth stories were turned on their heads.
In its aftermath, ASEAN economies, in particular the corporates, learned the 1998 lesson well. In correcting the excesses, the non-household private sector in particular, has deleveraged since 1998. Bank credit to corporates in Indonesia fell from a peak of 47.5% of GDP in 1997 to 12.8% in 1Q10, in Malaysia it fell from 101.2% in 1997 to 51.0% in 1Q10, in Singapore it went from 68.9% in 1998 to 55.3% in 1Q10, and in Thailand it declined from 142.2% of GDP in 1997 to 67.4% in 1Q10. Private external debt has also been paid off, falling from 86.3% of GDP in 1998 to 12.0% of GDP in 1Q10 in Indonesia, from 53.9% in 1997 to 29.1% in 1Q10 in Malaysia, and from 65.6% in 1998 to 20.0% in 1Q10 in Thailand. To start, the ASEAN crisis was less about fiscal imprudence or overextension of household balance sheets. Yet, where the currency crisis did lead to a ballooning in external government debt, notably in Indonesia and Thailand (given the relatively higher share of external funding and the extent of currency depreciation), policymakers also undertook fiscal consolidation and built up foreign reserves to pare down debt levels.
The Rebalancing Tool: Investment versus Consumption
That ASEAN economies have taken the 1998 lesson too far may have contributed in part to the rebalancing that needs to take place. To be sure, the double-dip scenario is not our base case (see Global Forecast Snapshots: Just Say No to the Double-Dip, June 10, 2010 by Joachim Fels and the global economics team). Still, we thought it worthwhile to discuss the macro rebalancing, which is inevitable. In conventional lingo, the Chinese-style macro rebalancing means reducing savings (read: current account surplus) and increasing consumption. However, in ASEAN, we think rebalancing is more likely to come via investment. Gross domestic savings in 2004-07 had actually fell (with the exception of Malaysia) compared to the pre-Asia crisis period of 1994-97, and total consumption ratios (private plus public) mostly rose even as ASEAN economies adapted to Asia's new exporter status.
Indeed, rather than poorer consumption, ASEAN's export surpluses had came primarily at the expense of weaker capex. Put another way, ASEAN economies were simply not channeling their savings into investment, but were exporting it abroad. In the new equilibrium period of 2004-07, fixed capex ratios remained below their pre-1998 levels, suggesting the scope for higher productive/non-speculative investment in ASEAN economies as a means for macro rebalancing. Specifically, in Malaysia, private capex stood at 10.9% of GDP in 2004-07, about one-third of the 30.5% seen in 1994-97. In Thailand, while private equipment capex rose to 16.1% of GDP in 2004-07 (versus 18.0% in 1994-97), private construction capex was fairly depressed at 4.4% of GDP (versus 11.1% in 1994-97).
Is there room for more consumption? Comparing ASEAN economies with countries of similar income levels indicates that ASEAN's gross domestic savings rates are much higher compared to the average. Prima facie, this would suggest scope for consumption as a rebalancing tool, too. We think it depends. In our view, the scope is bigger for economies such as Singapore, which have already achieved high-income status, rather than for upper middle-income economies such as Malaysia or lower-middle income economies such as Indonesia and Thailand. Typically, savings rates tend to have a positive relationship with the economy's income level. This is why lower-income economies suffer from the dilemma of needing investment to ‘take off', but lacking the savings to finance it. Hence, rather than increasing consumption, we think Malaysia, Indonesia and Thailand are better placed, tapping on their high savings rates to increase investment and raise potential growth trajectory.
A Multi-Style and Multi-Speed Rebalancing Process
Macro rebalancing will likely hold different meanings for different ASEAN economies. The bigger the economy and population size, the greater will be the need to rebalance and move toward a stronger domestic demand base. This is the case for Indonesia, Thailand and, to a lesser extent, Malaysia, and as we argued above, we believe that rebalancing via investment rather the consumption is the more optimal scenario.
However, smaller economies like Singapore will still be able to maintain an export-oriented strategy. Singapore faces a theoretically infinite export demand market by virtue of its small size and can ‘free-ride' on the positive externalities from macro rebalancing efforts in other economies. While policymakers could choose to rebalance toward consumption, Singapore's small domestic demand and population base makes it an unattractive option. For Singapore, macro rebalancing would not be one of rebalancing away from exports toward domestic demand. Rather, it would be one of rebalancing away from old export markets in the developed world to new export markets in the developing world.
Now, where do ASEAN economies stand in terms of the rebalancing game? We think economies like Indonesia and Singapore are slightly ahead in the rebalancing process compared to Thailand and Malaysia. To begin with, Indonesia's economy is relatively more balanced as its current account surplus is smaller than other economies. In addition, in the period 4Q09-1Q10, gross fixed capex in Indonesia had risen further to 31.6% of GDP from 23.8% in 2004-07. We think this will likely continue amid our thesis on the structural decline in the cost of capital. Meanwhile, in Singapore, policymakers have already begun to focus on new export areas catering to new demand from the emerging trends of urbanization, growing affluence, and ageing in Asia as we had highlighted in previous research (see ASEAN MacroScope: Macro Rebalancing Singapore-Style, July 30, 2009).
However, in Thailand, fixed capex ratios fell further to 23.8% of GDP in 4Q09-1Q10 from 27.3% in 2004-07, and in Malaysia, it fell to 18.6% from 20.9%. In our view, the political climate will likely have to improve in Thailand to spur further investment. In Malaysia, policymakers will have to execute on their plans. Policymakers will have to shift their focus from physical to non-physical infrastructure such as education. A suitably qualified labour force will have to be built to unleash growth potential and drive government transformation. The subsidy systems, which have impeded progress on the competitiveness front, will have to be rolled back. A structural inflexion point in these areas will help to jump-start private investment momentum, both local and foreign.
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