...but only modestly. But the translation from these commodity food price hikes to those at the retail level will be much smaller - adding perhaps 2-3% to food inflation. Given the low starting point, food inflation will likely run at a bit more than 2-3% in 2011. As discussed below, several factors mute the translation and pass-through. While the expected rise in food inflation is a big change from the 1-1.5% we expect this year, the direct impact on overall inflation will only amount to 0.2-0.3%, reflecting the small share of food in consumer budgets (7.8% for food and beverages at home, and about 13% including restaurant meals). It's worth noting that those shares have declined radically from the stagflationary 1970s, when they were 15.3% and 21.3%, respectively.
Broader spillovers? Nonetheless, the broader questions are first, whether the rise in both food and energy quotes will spill over into inflation generally by pushing up inflation expectations, wages and other prices; and second, whether such price hikes will tax consumer budgets.
The short answer to question one: Yes, but only to a limited extent. Food and energy quotes are not indicative of prices generally. They certainly influence inflation expectations, but despite their recent increase, inflation expectations by any metric are not surging; they are relatively well-anchored. Together with still-substantial slack in the economy, these developments mean that the rise in overall and core inflation we expect in 2011 will be gradual. Critically for investors, however, the Fed's aggressive easing, including QE2, has greatly reduced the tail risk of deflation and increased that of inflation. Increases in food and energy prices partly reflect that shift.
The short answer to question two is also yes, but to a limited extent, reflecting the relatively small share of food (and energy) in consumer budgets. Admittedly, a jump to, say, 6% food inflation would take a significant bite out of consumer budgets: It would add 0.4-0.5% to the inflation rate and take a similar amount from real spendable income, at a time when such income is growing by only about 2%.
It's worth noting that in emerging markets, the story is different: The weight of food and energy in consumer budgets and price indices is at least twice as large as in the US and other developed economies, so the impact on budgets is more substantial. Likewise, the influence on inflation expectations in EM economies is more pronounced. In the context of their strong growth, smaller margins of economic slack, and still-accommodative monetary policy, the upside inflation risks in those economies are genuine.
Four factors driving up commodity prices. Commodity food prices are determined in global markets, and several global factors are working to continue driving them higher. First, strong global demand, especially from fast-growing EM economies with rising living standards, is increasing the demand for protein, and thus meat and the feedgrains to produce it. For example, to meet this growing internal demand, China is expected to import a record quantity of soybeans this year, 13% more than last year and a whopping 330% more than at the start of the decade.
Second, weather has proven a significant headwind to global crops this year. Drought in the FSU coupled with flooding in Pakistan is largely to blame for an estimated 6% year-on-year decline in global wheat production. With demand remaining strong, global wheat stocks are likely to decline to 6.4 billion bushels by the end of this marketing year, down 11%Y. In the US, poor growing conditions in the late summer have led the USDA to reduce its yield forecasts for this year's domestic corn and soybean crops multiple times. With US corn production expected to decline by 4% from a year ago, commodity analysts Hussein Allidina and Bennett Meier project this year's domestic corn balance at its tightest level since 1995/96. They expect global corn stocks to decline 13% this year.
Third, rising energy quotes are pushing up production costs for farmers while at the same time encouraging the production of ethanol - a key driver for corn demand - which is blended with gasoline in the US. Finally, a weaker dollar has contributed to such price increases, both because most commodity prices are dollar-denominated and because investors view commodities as a weak-dollar hedge.
Inventories are also at relatively low levels, adding to price increases. The culprit: Among many of the world's major agricultural-producing countries, production has simply failed to keep pace with increased domestic and overseas demand. This shortfall is especially pronounced in soybeans, where EM demand has channeled much of the world's supply away from producing/exporting nations. In the US, the world's largest producer and exporter of soybeans, Hussein and Bennett project soybean stocks-to-use, a measure of inventories adjusted for demand, at 5.5% this year, up slightly from last year's 4.5%. But that level is markedly below the 8.5%, 10-year average. Across much of the western hemisphere, the story is the same; for example, Brazilian and Argentine soybean stocks are expected to decline by 1% and 9%, respectively, this year, although Chinese stocks are likely to build by 15%.
From farm to table: Much smaller increases. Despite those powerful forces pushing up commodity prices, four factors typically mean that the translation of commodity to finished food prices is muted, and we think they will be operative today. First, the cost of raw materials is only a fraction of the price of finished foods. For example, packaged foods analyst Jackie Inglesby estimates that raw materials make up roughly 50-60% of the cost of finished product for companies she covers. Second, rising costs typically squeeze sellers' profit margins when wholesale costs go up. Packaged food analyst Vincent Andrews notes that consumers are sensitive to price, so food manufacturers "will face a more stark choice between sustaining margins or volume growth, as consumers laser focused on price are likely to pose a challenge". Grocery chain analyst Mark Wiltamuth reports that grocers in 1Q already had difficulty raising retail prices on dairy and meat products. Restaurant analyst John Glass notes that diners are also sensitive to price, so restaurant operators are now having to choose between traffic or margins. As grocery prices rise, consumers may return to restaurants that are able to absorb rising costs and hold the line on prices.
Moreover, when feedgrain quotes jump, wholesale meat prices typically plunge for a while as ranchers bring herds to slaughter; the increased cost of grain makes the marginal pound of meat no longer profitable. Finally, when prices of branded or more expensive foods rise, consumers will substitute cheaper brands and foods for more expensive ones. For example, consumers may switch to generic products from premium brands or to chicken from beef when prices go up. And John Glass notes that restaurant chains often hedge their food costs, delaying the pass-through of commodity prices into retail.
Econometric evidence. Econometric evidence bears out this story. An equation that relates changes in the CPI price index for food to changes in the producer finished food price and imported food price indexes shows consistent longer-run pass-through coefficients of 0.3 and 0.6, respectively. This means that over 1-2 years, about 30% of the rise in finished producer food prices, if sustained, would pass through to increases in the CPI for food. That seems to have been borne out in the 2007-8 food price boom, when US CPI food inflation peaked at 6.3%.
Modest upside risks to food and overall inflation. A steady weakening in the dollar and more pronounced excess demand conditions would obviously hike food quotes further. In addition, the rise in food and other commodity prices likely will sustain a higher level of inflation expectations, and that could push up overall inflation by more than we expect. But with overall inflation low and inflation expectations relatively well-anchored, there's little chance that rising food quotes will soon contribute to an upside breakout. And with inflation below the Fed's "mandate-consistent" rate of around 2%, higher food inflation shouldn't derail QE2.
In light of the recent heightened interest in global exchange rate misalignments, the relatively strong external balances of GCC countries may soon reignite the debate about the appropriateness of their existing exchange rate regimes. In this note, we address this issue with a particular focus on the idiosyncratic characteristics of GCC economies and on the potential effectiveness of exchange rates in addressing their external imbalances. We conclude that the current GCC exchange rate policies are appropriate and are likely to be maintained over the medium term. However, we do not rule out the possibility of heightened market speculation over the coming months. But, we think a material weakness in USD (that causes a spike in oil prices), or a sudden surge in inflation in the GCC, would be necessary for the revaluation trade to gather momentum. Our base case does not envisage either of these conditions developing. However, for investors wanting to position for the revaluation trade, we think that selling USD/QAR at the short end of the forward curve is best.
Why Are the Pegs Likely to Remain in Place?
Most GCC countries are currently running sizeable external surpluses, but that does not necessarily mean that their currencies are undervalued. All the GCC countries are expected to run current account (C/A) surpluses in 2010-11. In smaller, resource-rich countries, such as Kuwait and Qatar, these surpluses are expected to be significant.
Given the recent focus on external balances as a possible gauge of a currency's potential misalignment, some may argue that the GCC surpluses point to a fundamental undervaluation of their currencies. We would disagree with this view for the following reasons:
First, simply looking at the absolute value of a country's external balance could indeed be misleading. There is no one particular C/A level that would be appropriate for all countries. In fact, a country's ‘optimum' or ‘equilibrium' C/A balance, if it were to exist, would have to be determined by its idiosyncratic structural characteristics, including its income level, population size, fiscal spending, investment needs and resource endowments. Moreover, given the GCC countries' heavy reliance on oil and gas, they need to accumulate proportionally higher foreign savings (i.e., larger C/A surpluses) than other countries that are not economically dependent on depletable resources.
Second, the fact that a country's current account balance is not in line with its long-term equilibrium level does not necessarily mean that its currency is misaligned. A country's C/A balance is simply a reflection of its internal savings-investment balance (i.e., C/A = savings - investments). As such, changes in a country's external balance are not only a function of external demand and real effective exchange rates, but are also affected by the rebalancing of domestic savings and investments. If it were indeed possible for a country's C/A balance to ‘converge' towards its equilibrium level over time, without requiring an adjustment in exchange rates, then the present exchange rate would not necessarily be misaligned. For example, if a country is currently running an above-equilibrium C/A surplus, but is expected to witness a significant increase in domestic spending over the medium term, then one could expect its C/A balance to converge towards equilibrium. If this decline brings the C/A in line with its long-term equilibrium level, then a nominal exchange rate adjustment may not be necessary. As such, the current exchange rate would not be considered fundamentally under-valued.
Third, the impact of high oil prices on the external and fiscal balances of GCC countries has been mitigated by a rise in domestic spending and a drop in oil production. Resource-rich GCC governments have been gradually increasing public spending to meet domestic investment needs and, more recently, to counter the impact of the global recession. Higher spending combined with lower oil production means that GCC countries are now in need of higher oil prices to balance their external and fiscal balances.
As a result, unless oil prices spike back up to their historical highs, GCC external balances are unlikely to return to their peaks of 2005-08, when they averaged around 29% of GDP.
Fourth, a moderate exchange rate revaluation may not be effective in reducing external surpluses in the GCC. The impact of an exchange rate adjustment on a country's external balance is very much dependent on the responsiveness of its trade flows to this adjustment. In essence, for an exchange rate appreciation to lead to a reduction in a country's trade surplus, it would need to cause a significant decline (increase) in the volume of its exports (imports). In other words, the exchange rate elasticity of its exports and imports must be high. But in the case of the GCC countries, this condition may not be satisfied. Hydrocarbons make up around 80-85% of GCC exports on average. These exports, which are priced internationally in US dollars, are not likely to be responsive to changes in GCC currencies.
We believe that the US's current monetary stance is broadly aligned with the needs of GCC countries - both favouring low interest rates. Excluding Qatar, we expect real GDP in the GCC region to grow by an annual average of about 4-5% over the near term. Although this is about 2pp higher than our growth estimate for the US, it is close to 2pp lower than our average growth projections for emerging markets (EM). Similarly, consumer price inflation, which we expect to average around 3% in the GCC over the next two years, should not be too far off that of the US, which we project to average around 2% over that period. At the upper end, we expect consumer prices in Saudi Arabia to increase by an average of around 5%Y in the near term, largely in line with our average projected EM inflation rate. With inflationary pressures expected to remain largely in check and growth prospects below EM averages, the focus of GCC monetary authorities would likely be on maintaining the growth momentum in the non-oil sector and catalysing domestic credit growth, which has slowed down significantly since 4Q08. In this respect, we believe that the US's low interest rate policy will remain well-aligned with the needs of the GCC countries over the near term.
More flexible exchange rates would be of limited effectiveness in taming inflation, which is not a main policy concern at the moment. At the height of currency speculation against GCC currencies three years ago, one of the main arguments favouring more flexible exchange rates was the belief that an appreciation would reduce inflationary pressures by limiting ‘imported' inflation linked to the weakening US dollar at the time. We believe that these arguments had their limitations back then, and are even less relevant at the current juncture, for the following reasons:
• First, the GCC inflation outlook has improved significantly over the past two years. Headline inflation in GCC countries has declined significantly since its peak in 2007-08.
• Second, inflationary pressures continue to be mainly driven by factors that are relatively insensitive to changes in exchange rates. In most of the GCC countries, headline inflation continues to be driven by fluctuations in rents and food prices.
• Third, the inflationary impact of weakness in the US dollar will likely be mitigated by the GCC countries' import composition. We estimate that around 35-45% of GCC imports are sourced from the US or from countries whose currencies are closely tied to the US dollar, namely China and Middle Eastern countries.
• Fourth, despite its recent weakness, we do not expect the USD to continue its recent slide against major currencies over the near term. Our currency strategists are currently projecting a strengthening of the USD against the EUR and JPY through 2011, while holding steady against the GBP.
Political considerations may further reduce the incentive to veer away from the current exchange rate policy. According to US Treasury data, as of 2009, Middle Eastern oil-exporting countries held around US$350 billion worth of US equity and debt securities, about 4% of total foreign holdings. The actual holdings of these countries are likely to be even higher. Moreover, anecdotal evidence suggests that a significant share of these assets is held by GCC monetary authorities and sovereign wealth funds. If the current GCC pegs to the US dollar were to be loosened, one would expect a decline in these countries' holdings of US assets. Such a move would likely put downward pressure on the US dollar. More importantly, if the GCC countries were to start diversifying their reserves away from the US dollar, this may encourage other emerging markets to do the same, which may put into question the dollar's current position as the leading global reserve currency. This, we would argue, may not be in the best interest of the US at the moment. Given their strategic alliance with the US, GCC countries may therefore wish to avoid such an outcome, especially during these times of heightened geo-political uncertainty in the region.
Lastly, adopting a tepid approach to potential exchange rate reforms would be counter-productive. During the recent period of rapid inflation in the GCC (2007-08), there were calls for halfway measures to curb imported inflation. These included allowing for a one-time revaluation of GCC currencies against the US dollar, while maintaining the pegs. We believe that such an approach would have significant negative consequences - mainly because any sign of wavering on the long-standing official position on the pegs to the US dollar would likely invite large, destabilising speculative flows into the region.
Is There Any Value in the GCC Revaluation Trade?
Given the above analysis, it seems there is little evidence to support the argument that the GCC exchange rate pegs are about to break. Nevertheless, this does not mean that the GCC currency forward markets will not move to price in the possibility of an exchange rate move.
Indeed, there was limited risk of the GCC adjusting their pegs back in late 2007 and throughout 1H08, but this did not stop the GCC forward markets from pricing in meaningful appreciation of the local currencies as oil prices rose, though only to be rapidly repriced as the global economy started to slow dramatically.
Current market and economic conditions bear little resemblance to the late 2007 and early 2008 period, which explains why so little is priced into the GCC forward curves at present even as oil prices have trended higher since the start of 2010. Saudi forwards are pricing in the most appreciation, at about 0.3% over the next 12 months. Speculation in the revaluation trade is least evident in the Qatari market, with the forwards pricing in a depreciation of around 0.2%. If the revaluation trade does gather any momentum, we think that Qatari forwards should price in the most appreciation, as we explain later, and thus offer the best risk/reward.
Only if We See an Oil Spike or a Return of Inflation
During the 2007-08 period, there were three key factors that led to speculation over revaluation. First, oil prices were heading higher very quickly. Second, inflation was a genuine concern in the GCC a few years ago, as described above. Finally, the USD was weakening quickly.
The USD weakness was the key factor behind the revaluation story a few years ago for two reasons. First, the weak dollar led to concern that the GCC region would import unwanted inflation from the rest of the world. Second, the weak dollar was causing oil and other commodity prices to rise quickly, increasing the level of external surpluses in the GCC. In other words, the weak dollar was intensifying the first two factors cited above.
Today though, oil prices have been going more or less sideways for the past six months, and although they have been gaining a bit more upward momentum recently, WTI crude is still a long way from the US$145/bbl highs seen in the middle of 2008. On price pressures, GCC inflation is not only a lot lower than back in 2007, but there is also little evidence of strong upward price pressures at the moment. The key similarity is the USD, which has been weakening rapidly recently, and we expect the Fed's QE policy to weaken the USD even further by year-end. Although our G10 FX colleagues anticipate that the USD will appreciate against the EUR during 2011, they foresee continued weakening this year, with the EUR/USD expected to reach 1.46 by year-end.
But for the story to really gain any serious momentum, we think we would need to see either some evidence that oil prices might spike higher, or an emergence of inflationary pressure in the GCC. A move to 1.46 in EUR/USD would likely lift oil prices to some degree, but if that is the end of the USD weakness, then it seems unlikely that we will see any oil price spike. Absent these conditions, the weak dollar in isolation does not pose much of a threat to the GCC pegs, in our view.
Admittedly, there is currently an additional focus on global imbalances, and the role they play in global currency misalignments. The GCC region does run sizeable current account surpluses, which could lead some to speculate that the GCC region would come under some pressure to revalue their pegs. But, as shown above, restrictions on the size of GCC external surpluses would be inappropriate and are therefore unlikely to be applied to the GCC region, even in the unlikely event that the G20 agrees on measures to limit the size of current account imbalances.
Qatar Offers the Best Risk/Reward
Of all the GCC pegs, we think that the only market where the revaluation story can gain any momentum is in Qatar.
Domestic credit growth has been growing faster in Qatar than elsewhere in the GCC, while we expect real GDP growth in the non-oil sector to be strong too, at around 11%. The size of Qatar's current account surplus is likely to be very significant this year too, surpassing all in the region except Kuwait.
The forward market is pricing in a depreciation of the Qatari riyal over the coming year of around 0.2%. This compares to a 0.3% appreciation priced into the SAR market and a virtually flat AED curve, where we see little potential for the revaluation story to gain much momentum.
We illustrate the current pricing across the QAR forward curve. The implied appreciation shown is quoted in annualised terms. As is clear, the market is pricing in the least appreciation of the QAR at the shorter end of the curve in annualised terms. Accordingly, if an investor wished to gain exposure to the GCC revaluation trade at all, we think that selling USD/QAR with short-dated tenors is the best strategy.
Turkey's infamously wide current account (C/A) deficit issue is back on the agenda. The most recent balance of payments data were only minor surprises as both the current account and the capital account developments had been in line with the trends of the past six months. However, especially the current account deficit had been persistently high and beating even the most conservative estimates, on the back of the strength in imports and lacklustre performance of exports.
Highest deficit since end-2008: In September, the C/A deficit at US$4.1 billion exceeded both the consensus and our expectations and brought the 12-month rolling deficit to US$37.2 billion (~5% of GDP). This has been the highest deficit reached since end-2008, but still quite far from the maximum deficit seen back in 3Q08 (US$49 billion).
Trade deficit widened significantly: Over the past year, the trade deficit widened by nearly 80%, with imports rising 23%Y while exports growth staying at just 13%Y. Energy and related imports grew by 13%Y in September and reached US$35 billion. Needless to say, the weak demand from Europe coupled with the weakness of the euro in 1H10 played a significant role in the widening of the trade deficit. However, the main reason was the heavy usage of imports in manufacturing and even in consumption that originated partially from the strength of the lira.
Weaker tourism revenues: On the services front, which essentially comprises tourism revenues, the performance was also quite disappointing. Despite the rise in the number of tourists visiting the country, revenues did not go up. While there are valid explanations for this, such as the changes in the country of origin of visitors from high income to lower, the ‘all inclusive' vacation packages that bring less revenue to local business, etc., the 6%Y decline is difficult to justify.
C/A deficit high but actual issue is the quality of financing: The main difference between the pre-crisis picture and what we are witnessing currently is that the nature of the financing shifted from an FDI-funded deficit into a more portfolio flow and debt-creating type. With FDI flows easing to just US$4.6 billion over the past 12 months while portfolio flows stand at nearly US$13 billion, it is clear that the US$37 billion C/A deficit was financed by banking and corporate sector borrowing. In our view, this is a double-edged sword: During times of ample liquidity and rising C/A deficit, almost all sorts of flows of financing are usually welcome. However, this clearly raises risk in times of risk-aversion, as we had experienced recently on a global scale. Turkey's case is not an exception, but that said, we should also note that the nature of the debt-creating financing had improved significantly. The external borrowing both by the banking sector and the corporates had been with favourable interest rates and with long maturities. Exactly a year ago the corporate sector's external debt rollover ratio was 48%, so the current rate of 75-80% does not look bad. Therefore, we do not consider the issue to pose significant near-term risks to the stability of the economy or the currency.
Portfolio flows remain strong: A key point regarding the financing side had been the strength of portfolio flows, which covered some 27% of the current account deficit over the past year. Predominantly via debt securities, total portfolio flows have been rising decisively since October 2009, when they stood at exactly US$0 (zero) on a 12-month rolling basis. This also explains the sharp drop in bond yields to record-low levels and the stock market index, which reached an all-time high. While dependence on portfolio financing is clearly not ideal, we do not believe that the flows would reverse abruptly to bring financing concerns on the table. This is mostly due to the fact that most of the inflows into the bond market had been for investment purposes rather than short-term trading, in our view.
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