The macro data appear to support this view on the surface. In DM economies, credit growth is dragging along at extremely low levels, and even though loan growth in China has fallen since the beginning of the year, credit growth appears to remain strong in other EM economies. Thus, credit growth is creating more confusion at a time when investors are already uncertain about the growth outlook. Rather unhelpfully, credit growth is weakest where it is most needed (US), has turned weaker than people are comfortable with in some places (in China, raising fears of a hard landing) and is still strong where not needed (EM economies like India, Brazil, Russia and Turkey where overheating is a concern).
However, consistent with our constructive view on global growth and EM resilience, the risks from apparently misfiring credit are overdone, in our opinion. The broad-based economic recovery and policy support in the US implies upside risk for credit growth there, while credit strength in EM is in line with the nature of the global two-track recovery. As for China, credit is actively used as an important (perhaps the most important) tool of monetary policy; it is more of an instrument, and less of a signal about fundamentals. Lending in China thus reflects the desired tightening of policy by the PBoC, a strategy that can be arrested or reversed rapidly if necessary. With the exception of Turkey and South Africa, the EM world under our coverage shows credit growth broadly in line with the economic recovery and suggests no immediate reason for concern. The risk to this benign scenario emanates from near-zero real policy rates in the EM (and DM) world designed to keep growth from falling sharply, a policy that could fuel further credit growth at a pace that outstrips fundamentals and might require more aggressive tightening later. A recent study from the IMF (Guo and Stepanyan, March 2011) finds that loose EM as well as global monetary conditions could push credit growth higher.
We highlight countries where we believe the possibility of credit bubbles forming and hurting the economy is elevated going forward. For now, the risks are typically small: credit issues are manageable because (i) credit penetration in most EMs is low, suggesting a lower impact of credit on the economy, (ii) slowing growth should endogenously curb credit growth, and (iii) policy tightening already applied (in China, India and Brazil) or underway (in Turkey and Russia) should also put a brake on credit growth. However, if the inflation-growth mix were to turn adverse, credit growth would start to look more out of sync with fundamentals, pushing NPLs higher and increasing the prospect of a hard landing. In this sense, credit in these economies is itself levered to macroeconomy.
Elevated risk of credit bubble: China, India, Brazil, Russia, Turkey, Indonesia.
Low risk of credit bubble: South Africa, Korea, many of the low credit growth CEEMEA countries.
Credit Growth in Recoveries
Credit lags recoveries (see The Global Monetary Analyst: Credit Confusion, February 4, 2009). We have shown that credit growth has usually rebounded in the US economy only after an economic recovery sets in. In a similar vein, the EM world has seen an earlier and stronger return to growth in the two-track global recovery so far, so stronger credit growth in that part of the world should come as no surprise. Further, the slowdown in the EM world was not a result of a credit crisis or a housing downturn as was the case in the DM world. Research from the IMF (Claessens et al) shows that 80% of recoveries that follow a credit crisis and the bursting of a housing bubble tend to be creditless recoveries which usually involve lower and more tenuous growth, much like the ‘BBB' (Bumpy, Below-Par, Brittle) recovery we expected DM economies to experience. On the other hand, recoveries that are not preceded by such problems, as has been the case in the EM world, generally experience recoveries accompanied by robust credit growth. From this perspective too, EM credit growth seems to be a natural consequence of the differentiated causes of the economic cycles in the EM and DM economies and, therefore, should not be a reason for alarm.
Are Credit Booms a Problem?
Should we worry about credit booms? This is a question that has increasingly moved to the forefront of concern among policy-makers, economists and investors. There has been extensive research on this question in recent years, and even more since the recent global financial crisis.
Booms Do Go Bust
Previous research focused mainly on the emerging markets (or on samples combining EM and DM economies) and examined recent post-war history for ‘early warning signals' of financial crises. In that literature, among the more robust predictors of imminent financial crises was unusually high past credit growth, or the deviation of credit measures from the path of GDP (this includes research by scholars such as Kaminsky and Reinhart, and by BIS authors including, notably, Claudio Borio). More recent research in economic history suggests that credit booms elevate the risk of a crisis, even when we focus on DMs, but extend the sample back to the nineteenth century (see Schularick and Taylor, 2010). Thus, policy-makers ignore credit booms at their peril, and this lesson seems to be clearly factored into Basel III and other policy responses aiming to ‘lean against the wind' to moderate the credit cycle in the future.
Is EM Credit Growth ‘Excessive'?
But right now, how close are we to another credit boom, this time in the EM world? Like any comparison, measuring whether credit growth is ‘too high' requires a reasonable yardstick against which we can measure excess growth. We use nominal GDP growth as the yardstick. ‘Excess credit growth' - the difference between nominal credit growth and nominal GDP growth - for EM economies remains in relatively benign territory despite strong credit growth in many economies. Accordingly, most economies are clustered around the 45-degree line. The BRICs and two outliers - Turkey and South Africa - illustrate the many facets of the EM credit story.
The BRICs and Turkey...
The BRIC economies and Turkey have, at different times over the last year-and-a-half, worried about excessive credit growth and have used ‘quantitative tightening' strategies to deal with the influx of liquidity and its effect on front-end interest rates and credit creation (see Emerging Issues: QT, March 30, 2011). The central banks of China, India and Brazil started down this path much earlier. As a result, nominal growth and credit growth in these economies is already moderating.
The CBR and CBT have embarked on QT policies only in 2010 and are therefore yet to see very much credit moderation, but it is not unreasonable to expect them to follow a similar path. The monetary policy of the CBT, in particular, has already done very well in achieving its dual objectives of weakening the currency via rate cuts and withdrawing liquidity from the banking system via RRR hikes (see Turkey Economics: Overheating Is in the Eye of the Beholder, May 24, 2011).
...in Stark Contrast to South Africa
The South African economy, on the other hand, suffers from the rather un-EM-like issue of very poor credit growth, at a level far below nominal GDP growth since the trough. Our South Africa team suggests such weak credit growth is likely to persist because of regulatory reforms imposed on banks precisely in order to avoid excessive credit growth. While corporate and housing loan demand has been weak, South African banks appear to be geared to take advantage of a rising rate environment (see South African Banks: FY10/1H11 Results Season Review, March 22, 2011). The risk to credit growth therefore seems to stem from the risk that the SARB tightens policy earlier or faster than it needs to.
The South Africa story makes for an interesting contrast with Korea. Like South Africa, credit growth in Korea has been anaemic. However, the Korean economy has a positive output gap that contrasts sharply with significant slack in South Africa. While the SARB has turned hawkish recently (see South Africa: Hawkish SARB Portends Earlier Tightening, May 12, 2011), the BoK kept its policy rates on hold at its last meeting and is unlikely to raise rates as aggressively as its strong domestic fundamentals might suggest. Thus, weak credit growth has, in part, conveniently allowed the BoK to push monetary tightening further into the future but does not seem to have deterred the SARB much.
Policy Risks to Persist
Many critics of the Fed, and QE, and other ultra-loose policies in the DM world, claim that excessive global liquidity is being created, and with the DM recovery sluggish, it is naturally flowing into the better-performing EM economies. The EM economies, in turn, fearful of pricking a bubble and denting their growth prospects, are then often charged with getting behind the curve.
Thanks to global risks, monetary policy in the EM world is not expected to tighten aggressively (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011) and real policy rates are expected to rise only modestly, thanks mostly to the expected downshift in inflation thanks to strong base effects and falling commodity prices. Policy easing makes for ideal conditions in which credit growth can prosper, at least in an EM world free from the DM world's financial sector impairments. If EM central banks also believe that their economies are now fundamentally more resilient than ever before, they might be tempted to allow more of a build-up in credit than in the past. One hopes that the lessons from history will guide EM policy-makers to resist the temptations of excess.
Despite Policy Risks, EM Credit Issues Are Contained
While the risks from easy monetary policy are likely to remain in place for a significant period of time, we point to three other factors that suggest EM credit issues are contained (at least as of now):
EM Credit Penetration Varies Greatly but Is Generally Low
A simple ratio of the stock of private credit to the level of nominal GDP shows that ‘credit penetration' varies widely in the EM world but generally at a low level. With a few exceptions like China at 125% and Hong Kong at 190%, credit penetration is generally quite low in EM economies and strong credit growth therefore has a rather limited ability to play havoc with macro-stability. For all the concerns about credit growth in India and Turkey, their respective penetration ratios stand at around 50% and 40%. When compared with the equivalent ratio of 165% for the US, the risks from credit growth confronting EM policy-makers look less worrisome.
Further, in EM economies the expansion of money and credit in the economy often takes place at the expense of the unorganised sector. The trend in rising credit/GDP ratios can thus be a benign one, making bubbles even more difficult to spot. But such transitions from unorganised to organised markets should proceed at a relatively slow pace, implying that a rapid build-up in credit relative to output growth should still be viewed with concern by policy-makers.
Duration of Credit Growth
A study of a very long history of money, credit and output suggests that credit growth that builds up over time can indicate a rising risk of a credit crash. Given that the economic recovery and credit growth are both around only two years old tells us that the time to worry about such a detrimental build-up of credit is very unlikely to have happened yet, but must be watched carefully going forward.
Credit as a Policy Instrument
Finally, unlike their DM counterparts, EM policy-makers are far less reluctant to employ a wide variety of instruments and monetary policy channels in order to deliver the desired monetary policy impact. AXJ central banks as well as those in Brazil and Peru are quite willing to impose restrictions on bank lending in order to guide credit and therefore output and inflation in the desired direction. In the case of China, in particular and to an extreme, credit growth is used actively to persuade the economy to move in the direction that policy-makers want. This ability to control or at least direct credit stands in sharp contrast to DM policy transmission mechanisms where the credit response comes from the reaction of financial institutions to the incentives set by monetary policy-makers via changes in the policy rate and/or the quantity of money.
In summary, credit growth in the EM world does not appear to be ‘excessive' in spite of ultra-loose monetary conditions in the DM world and near-zero real policy rates in EM economies. Credit growth, where strong, has been growing endogenously in line with nominal GDP growth, and one would therefore expect that slower growth should push credit growth lower. Where liquidity from DM quantitative easing has been a concern, we have seen EM quantitative tightening measures designed to drain liquidity from the banking system. Finally, credit penetration in EM economies is by and large far lower than the equivalent DM values, suggesting lower macroeconomic risk from credit growth. While this is a benign scenario at the moment, the risk is that policy support for growth in the DM and EM world could provide an ideal platform for credit growth over the next year. EM policy-makers might then be required to act more aggressively in the future to curb excesses.
With the release of the 1Q GDP report, a growing number of Mexico bears seem to have come out of hibernation. After all, the economy grew just 4.6% in 1Q compared to a year earlier which, though in line with our own forecast, missed consensus (5.0%) by a meaningful margin. Even more worrisome, the ranks of the Mexico bears point out, sequential GDP expanded at a modest 2.1% annualized clip in 1Q, the slowest pace in a year. And the latest GDP figures were just one of several mixed data points of late, including March's GDP-proxy IGAE as well as the most recent industrial output and car production figures, all of which declined sequentially (see "Mexico: Auto Shock", This Week in Latin America, April 18, 2011).
But behind the below-consensus 1Q GDP report, we are seeing signs of a stronger consumer in Mexico. Indeed, Mexico's economy seems to be in the midst of a rebalancing act, with domestic demand becoming an increasingly important growth driver - with positive implications for the sustainability of the ongoing recovery, in our view.
Questions about the prospects for domestic demand are not surprising, given that it has lagged during this cycle: whereas surging exports reached new historical highs in 2Q10 and overall GDP topped its pre-crisis peak in 4Q10, domestic demand was still some 2% below its pre-crisis level (see "Mexico: The Two-Tier Economy", This Week in Latin America, May 10, 2010). But with the drivers of consumption and investment - which first appeared in 2H10 - gaining further ground in 2011, the outlook for domestic demand this year remains favorable, in our view. Indeed, the handoff from external strength into domestic momentum is already taking place: while Mexico won't release 1Q expenditure details of the national accounts until June 21, in 4Q10 domestic demand already contributed with essentially all the growth in GDP while net exports were a modest drag for the first time in two years.
Consumption Drivers Falling into Place...
There are good reasons to be constructive on the outlook for consumers in Mexico. First, the main driver of the modest recovery in consumption since mid-2009, namely employment creation, has continued to gain ground in 2011, with the quality of job creation gradually improving in recent quarters. Moreover, overall inflation has remained very well behaved; in turn, muted inflation has translated into positive real wage gains for consumers. Last, the one factor that had been missing from the recovery in consumption, namely credit, is now showing more tangible signs of a turnaround. Against this favorable backdrop for consumers, it is not surprising to see that confidence has held up remarkably well in the face of rising prices for some staples like tortillas and bread.
The economy has continued to generate new jobs, which should keep supporting consumer spending. Formal jobs expanded at a seasonally adjusted 4.6% annualized pace in the first four months of the year, led by strong pick-up in hiring in manufacturing (almost 9% annualized). Though hiring has decelerated from last year's pace of over 5%, the quality of job creation has improved materially, as measured by the participation of temporary positions. Last year 30% of all new formal sector jobs were temps, but so far in 2011 that share has declined to just 19%, according to our calculations. The rate of unemployment has declined during 2011, though it remains at elevated levels. Importantly, the recent drop in the unemployment rate has been associated with an upturn in labor participation, suggesting an underlying improvement in labor market conditions. Moreover, the rate of underemployment has also shown a significant decline in recent months (see "Mexico: Are the Good Jobs Finally Returning?" This Week in Latin America, February 28, 2011).
Consumer incomes have also benefited from rising real wages. The pick-up in real wages reflects both the very benign trend in overall inflation combined with a slight uptick in nominal wages to an average of 4.5% so far in 2011, as measured by contractual salary negotiations. Comparing two measures published by the central bank, real wages have increased by 0.8% on average in 2011 - up from 0.3% last year - representing a modest tailwind for consumers.
After facing a prolonged credit crunch, consumers are enjoying improved credit conditions. With Mexican banks in good shape, we suspect that part of the pick-up in credit has been driven by better demand for loans, which in turn may reflect improved labor market conditions. But whether this is a supply or demand-side phenomenon - or, more likely, a combination of both - the important issue is that bank loans to consumers are accelerating. In 1Q, consumer credit rose at a sequential 14% annualized pace in real terms, led by an 18% jump in loans to purchase durable goods. Commercial banks and government officials have guided to credit growth of around 15% this year, a healthy pick-up from still very low levels of penetration - the stock of total consumer loans is just 4.0% of GDP or twice the level of remittances.
Recent data suggest that the consumer turnaround is taking hold. For example, car sales have been growing at a 14% annualized pace so far this year, topping the 900,000 annualized unit threshold in April - the first time since October 2008. And though Semana Santa exaggerated the growth in sales reported by the retail chamber ANTAD in April, our calculations indicate that seasonally adjusted sales have increased sequentially for five consecutive months. And imports of consumer goods (excluding oil) rose sharply in 1Q, reaching the highest levels so far this cycle.
...as Capex Gets Un-Squeezed
The renewed relative momentum in domestic demand also reflects the ongoing recovery in investment spending, led by a rebound in machinery and equipment outlays (see "Mexico: Capex Un-Squeezed", This Week in Latin America, March 28, 2011). While we have heard countless claims for Mexico's apparent ‘investment strike'- ranging from the impact of rising violence to renewed competition from Asia - a simpler factor seemed to be behind the anemic trend in investment: Mexico had been suffering from ample excess capacity. The good news is that this picture has quickly changed: capacity utilization is now running well above its long-term averages to levels that in the past have led to double-digit growth in machinery investment. Importantly, the move higher in capacity utilization is taking place in a context of still positive business confidence and a supportive external environment, including an improvement in Mexico's terms of trade. Indeed, INEGI's index of capex plans shows that sentiment towards new investment, though slightly below the 50 neutral threshold, is at levels that in the past have been consistent with a strong expansion in capital expenditures.
Trends in construction have been mixed, as public sector spending has been offset by a pullback in the private sector. Going forward, construction should benefit from public works - the execution of the federal public investment budget in 1Q was near historical highs - as well as from the election cycle later in the year and into 2012. Better credit conditions, moreover, should gradually lead to a turnaround in so-far anemic private sector construction (see Mexican Construction: Micro/Macro Disconnect, April 1, 2011).
While we see good reasons to expect solid momentum in domestic demand going forward, for this to materialize Mexico still needs a supportive external backdrop, in the form of positive growth in US industrial output - where the link to Mexico is strongest - as well as support from the terms of trade (see "Mexico: Squeezed from Abroad", This Week in Latin America, November 10, 2010). Though our US team recently trimmed its GDP growth expectations to 2.8% in 2011, it still believes that the economy is in the midst of transition from a productivity-led recovery to a more mature expansion sustained by job creation and associated income gains (see US Forecast Update: Slower Growth in 2011, May 6, 2011). However, the outlook is not without risks, including the impact on consumers from higher oil prices and the recent cross-currents observed in labor markets, given how critical employment creation is to our US call.
Bottom Line
The Mexican economy is in the midst of a rebalancing act as domestic demand takes an increasingly important role as a growth engine. Above-trend capacity utilization is translating into a pick-up in fixed investment; meanwhile, consumers are benefiting from positive labor market conditions as well as modest real wage gains and a welcome acceleration in credit. Absent a downturn in the US economy, Mexico watchers should find that the country's growth dynamic is likely to become increasingly better balanced, with positive implications for the sustainability of the recovery.
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