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Capex Retrenchment – A Lot More to Go

Investment Cycle on the Slowdown Path

Official investment (as measured by gross capital formation) data tend to be released with a lag, but corporate sector fundraising activity tends to be a good proxy for this trend. Aggregate capex fundraising by the corporate sector rose to a new high of 14.5% of GDP (US$170 billion) in F2008 (12 months ended March 2008) but is estimated to slow to 8.6% of GDP (US$101 billion) in F2009 and 7.4% of GDP (US$82 billion) in F2010. We arrive at the aggregate figure by adding fundraising by the corporate sector through various sources, including bank credit, external commercial borrowing/foreign currency convertible bonds, domestic bond issuance, equity issuance and FDI inflows. If we include internal accruals generated by the corporate sector for this exercise, the total funding available for investment slowed to 14.9% of GDP (US$175 billion) in F2009 and should slow further to 12.5% of GDP (US$138 billion) in F2010 compared with 21.2% of GDP (US$249 billion) in F2008.

Based on the trend in fundraising activity and other capex indicators, we estimate that official industrial/infrastructure investment (including private corporate plus government capex) has declined to 23.6% of GDP in F2009 and should decline further to 20% in F2010 from the peak of 25% in F2008. Private corporate sector capex is estimated to have declined to 14.3% of GDP in F2009 and should decline further to 11% in F2010 from the peak of 15.9% in F2008. We estimate that public sector investment has increased to 9.3% of GDP in F2009 from 9.1% in F2008, but believe that it will slow to 9% in F2010. Similarly, household investment is expected to slow to 11.5% of GDP in F2010 from 12.8% in F2009 and 12.6% in F2008. Aggregate investment (including household, corporate and government) to GDP declined to 37.9% in F2009 and should decline further to 33% in F2010 from 39.1% in F2008.

Bottom of the Capex Cycle Is Ahead of Us

A number of indicators show that investment growth has decelerated sharply over the last 12 months. Capital goods output growth slowed to 10.2%Y during the three months ending February 2009 from the peak of 24.2%Y during the three months ending October 2007. Similarly, the trend for aggregate fundraising has suffered in the last 12 months.

Bank credit, equity issuance and foreign debt borrowing have trended down. Bank credit, which has been the largest source of fundraising for the corporate sector, is likely to slow further. Annual incremental bank credit funding had accelerated to an average of 6.7% of GDP in the four years ended March 2008, compared with 2.5% in the preceding three years. Bank credit accounted for about 40% of the total funds raised by the corporate sector in the past four years. We expect incremental bank credit to decline to just 4.5% of GDP in F2010.

Excess Capacity Burden Remains High

The corporate sector is suffering on account of large operating leverage. The gap between corporate capacity for growth and realized growth is expected to be much larger in the current cycle than in the mid-1990s; the capex binge was much larger in the current cycle. With the growth trend remaining higher for longer and continued easy access to risk capital from the international market, the corporate sector was far more aggressive in building capacity. Private corporate capex to GDP increased to 15.9% as of F2008 from 6.8% in F2004. In the 1990s cycle, it increased to 10.4% of GDP in F1996 from 6.1% in F1994. However, industrial production, which is some proxy for utilization of that capacity created, contracted by 1.2%Y in February 2009 from the peak of 13.6%Y during the quarter ended January 2007. In the 1990s, industrial production had decelerated to 1.5%Y by January 1997 from the peak of 13.7%Y during the quarter ended September 1995. Even with the recovery in industrial production to an estimated 6-7% by March 2010, capacity utilization for the corporate sector should stay relatively low, dissuading them from initiating any major new capex plans.

Global Credit Market Environment Should Also Be an Important Factor Affecting the Outlook

The weak global financial markets have resulted in a slowdown in capital inflows into India. While there has been some improvement over the last three months, the average CDS rate for Asia ex-Japan has remained significantly higher than levels recorded in early 2008. The average CDS for Investment grade 5-year bonds is currently at 278bp, compared with 106bp in early 2008. The Indian paper has seen a similar trend, with CDS rates at 245-425bp currently compared with 75-285bp in early 2008. While we expect a significant improvement in capital inflows to US$19.1 billion in F2010 compared with outflows of US$3.7 billion during the quarter ended December 2008, it will still be about one-fifth of the amount received during the 12 months ending March 2008.

Reminiscent of Mid-1990s Cycle

We believe that the current macroeconomic trend has similarities with the 1993-96 cycle. In the 1990s, private corporate capex to GDP increased to a peak of 10.4% in F1996 from a low of 6.1% in F1994. During that period, the capex cycle recovered sharply with the support of positive sentiment for emerging markets and due to investment sector deregulation implemented by the government. However, it was soon constrained by a tightening monetary policy triggered by signs of overheating.

A simultaneous reversal in risk appetite for emerging markets and reduced capital inflows caused further tightening in interest rates and affected the corporate sector’s ability to raise funds from international investors. Moreover, a slowdown in domestic consumption meant that the corporate sector suffered on account of high operating leverage. This adversely weighed on their profitability and investment confidence. Private corporate capex to GDP declined gradually to 7.1% in F1999.

As in the mid-1990s, we believe that the combined impact of slowing domestic consumption, higher domestic cost of capital and reduced capital access from international capital markets will result in a further major slowdown in the investment cycle over the next 12 months. We expect private corporate capex to fall to 14.3% in F2009 and further to 11% in F2010 from the peak of 15.9% in F2008. Similarly, we expect total investment to GDP to decline to 33% in F2010 from 39.1% in F2008.

How Could We Be Wrong?

The upside risk to our estimates could be from a potentially faster recovery in global growth than currently implied in our team’s forecasts. Our economics team currently estimates global growth of -1.6% in 2009 and +2.6% in 2010. Stronger global growth would help India by way of increased financial risk appetite, implying higher capital inflows and stronger export growth. This in turn would mean lower real interest rates, a quicker improvement in capacity utilization and increased corporate confidence for investment. The second upside risk could be a positive surprise in the general election outcome. If we get a clearer verdict with either the Congress or the BJP getting about 170-180 seats out of a total of 543 seats in the parliament that allows them to form a coalition that will be narrow compared with the current ruling coalition, then this would likely increase the pace of reforms, boosting business confidence.

Current Account Deficits – Shrink to Fit

Until last summer, easily available cheap credit (mostly in FX in some cases) and strong income gains were fuelling a consumption binge across CEEMEA, which translated into C/A deficit widening to very high levels, well above those that preceded the Asian Financial Crisis of 1997. A drying up in credit availability, substantial currency depreciation and slower income gains will result in much lower current account deficits across the region this year and next, in our view. The dramatic shrinkage in funding gaps should be accompanied by severe recession almost everywhere, with collapses in consumption and imports already taking a heavy toll on tax revenues. In essence, as the IMF has also observed, what was a BoP problem has now become a fiscal issue. In addition, while C/A deficit gaps have dropped, some countries are seeing much smaller inflows or outright outflows in their financial accounts, losing reserves as a result: this is the case for instance in the Baltics, Bulgaria, Romania, Poland and Ukraine.

In this note, we survey the ongoing BoP transformation across CEEMEA. In Central and Eastern Europe, which had seen C/A deficit to GDP ratios reach double-digit levels in some cases, the adjustment is well underway, especially in the Baltics and the Balkans; in Turkey, a collapse in imports due to weaker consumption and favorable terms-of-trade (ToT) effects is bringing the C/A gap to the lowest level in five years. In South Africa, by contrast, we think that the improvement will be pretty marginal in 2009/10, as imports show resilience and ToT effects are overall negative.

Despite the drop in external funding needs, we remain quite cautious on CEEMEA currencies, on account of the weak growth backdrop and the rise in external debt that IMF support implies. In Central Europe, we still prefer PLN and CZK to HUF and RON on fundamental grounds. In the Baltics, currencies are not liquid enough, so we think it will be best to play the devaluation theme via sovereign CDS. In Turkey, we think the TRY could remain close to its current levels between now and year-end, as the IMF deal and local investor buying offset the weakening pressures coming from lower rates and external debt payments (see Turkey Economics: Positioning Is Still TRY Supportive, April 8, 2009). In South Africa, we maintain our overall bearish view on the rand, and see USD/ZAR heading to 10.00.

Central Europe and Balkans: Imports Collapse as Credit Dries Up

The adjustment in current accounts in Central Europe is happening primarily via trade (slower imports), but income deficits are also going to fall sharply, as foreign corporates see their profits shrink (so both reinvested earnings and dividends will drop). Some country details below:

Czech Republic: The latest data (February) show a narrowing of the 12-month current account due to some large current transfers from the EU. However, details show that the massive income deficit, which is entirely responsible for the C/A gap in the Czech Republic, is narrowing. This is because multinationals’ profits earned in the Czech Republic are set to shrink this year and next, and therefore dividends and reinvested earnings (both C/A outflows, though reinvested earning are ‘automatically financed’ as they are also recorded as FDI) will drop dramatically. Note that income outflows in January-February are already at the lowest level since 2004. This trend should become more obvious in the summer, when these outflows usually peak. We think that the current account deficit should trend much lower, towards 1.5% of GDP by year-end from 3.3% currently. On the funding side, EU inflows and FDI should still comfortably cover the gap. Overall, the Czech external accounts should continue to compare favorably with the rest of the region.

Hungary: Hungary’s latest C/A data are for 4Q08 and as such are pretty dated. The large 8.4% (4qma) C/A gap was almost entirely due to income outflows (8.1%), mostly dividends and reinvested earnings. On the financing side, Hungary has experienced severe portfolio outflows (both bonds and equities), but the surge in ‘other’ inflows (IMF and EU money) should be more than sufficient to plug in the funding gap. Looking ahead, as in the Czech Republic, the income outflows are likely to drop this year as multinationals’ profits get squeezed. Meanwhile, the first few months of trade data for 2009 show that imports are collapsing faster than exports, so the overall trade balance is already improving slightly. Overall, it looks likely that the C/A gap will drop dramatically, to around 4% of GDP by year-end. 1Q data (out on June 30) should already begin to show clear signs of improvement. While Hungary’s financing gap is set to narrow, its debt stock remains a key source of concern: external debt stands at 113% of GDP, on an upward trend (the highest in EMEA outside the Baltics); government debt looks set to approach 80% of GDP this year, again at the top end of the range.

Poland: The C/A gap has narrowed by nearly one percentage point over the last few months, mostly as a result of a lower trade deficit (collapsing imports) and smaller income outflows. At 4.7% of GDP on a 12-month basis, the current account looks likely to continue to decline for much the same reasons as elsewhere (to around 3.5% of GDP), though slower remittances inflows (see Central Europe Economics: Dwindling Remittances, March 20, 2009) and a smaller reversal in income outflows imply that the drop will be less dramatic than in Hungary or Romania, for example. We see the C/A deficit at 3.3% of GDP this year, down from 5.3% in 2008. Importantly, we note that unexplained outflows remain huge, at 4.8% of GDP, which implies much larger financing needs than the current account balance alone suggests. Overall, Polish external balances are in a far less healthy state than commonly believed; however, while the ERM II anchor may prove elusive (see “Central Europe: Trip Notes”, EM Economist, March 6, 2009), an overall better growth track record and lower debt stock as a percentage of GDP (note however the significant deterioration in the budget) place Poland closer to the Czech Republic than to Hungary. Its superior fundamentals were the reason why Poland was recently granted access to the IMF’s Flexible Credit Line for US$20 billion. We believe that this greatly alleviates worries about funding needs in 2009/10 (see “Poland: Risks Abate”, EM Economist, April 17, 2009).

Romania and Bulgaria: Romania and Bulgaria experienced massive capital inflows in the last few years (mostly foreign banks’ credit) as well as significant FDI inflows, especially in the real estate sector. As elsewhere in the region, funding has dried up dramatically, and given how elevated credit growth had been ahead of the crunch, the correction in overall consumption growth and the C/A deficit has already been dramatic, and will continue to be so this year and next, in our view. In Romania, we expect GDP growth to move into deep negative territory in 2009 (-2.6% versus +7.4% in 2008), and the current account gap to narrow sharply to 8% of GDP by end-2009, from a peak of 13.6% reached in the last part of 2008. Bulgaria is experiencing a similarly dramatic correction, with GDP growth likely to turn negative in 2009, after recording an impressive 6% in 2008. The C/A deficit is tracking 22% of GDP (the peak was 26.5% in 4Q08), and the early 2009 numbers suggest that it may narrow to around 15% by year-end. The intensity of the Bulgarian adjustment could feel very severe. Given the strictures of the currency board (money supply is linked to reserves, which could continue to drop in the case of sharp capital outflows), we think that a currency regime change is a possibility late this year or in early 2010, though the government will almost certainly pursue the IMF route before considering abandoning the board.

Baltics and Ukraine: C/A Gaps Evaporate, but Pressure on FX Still Strong

Current accounts are improving in the region but financial accounts are deteriorating. Import collapses are also causing lower budget revenues, turning what was previously a balance-of-payments problem into a fiscal one. The sharp correction in domestic demand is particularly extreme in the Baltic states. February BoP data show current accounts in all countries contracting rapidly, with the trade balance being the main driver. Latvia and Lithuania face the sharpest contraction, both showing positive current account balances already in February. In both, imports are down on average by more than 40%Y and exports down by about 28%Y. In Estonia, the contraction is slower, with imports down 33.7%Y and exports down 25.2%Y. The C/A balance here is still marginally negative, but on a trailing 12-month basis it remains the lowest among the Baltic countries. The relative real appreciation of Baltic exchange rates compared to their trading partners will likely keep the C/A deficits in negative territory for this year, but the gaps should be in the low single-digits (as a share of GDP). Deteriorating confidence from international investors and a credit squeeze have resulted in financial account outflows and some reserve loss across all three economies. While Estonia is in a comparatively stronger position, we now expect eventual devaluation in Latvia, and probably Lithuania (see Baltic Economics: No Longer All for One? April 21, 2009). Estonia and Lithuania lost about 6% of their reserves in 1Q. If not for the €1 billion installment from the EU in February, Latvia would have spent 37% of its reserves in 1Q.

Ukraine: The BoP picture in Ukraine is similar to that of the Baltics, with the current account contracting sharply and financial account turning negative. The C/A recorded a surplus of US$0.5 billion in January due to gas import disruptions and then returned to negative territory. In 1Q exports were down 39.2%Y while imports nearly halved (-46.9%Y), narrowing the current account 4.2 times year on year. We see the C/A gap at just 1% of GDP this year (from 7.5% in 2008). The overall deficit on the financial account is narrowing though. It was US$0.9 billion in March (compared to US$2.2 billion in February), and in 1Q it was 24% lower than in 4Q08 due to the lower cash growth outside the banking system. Private sector debt rollover rates remain strikingly strong in March, 81% in the banking sector and 114% in non-financials. The NBU spent 20% of its foreign reserves in 1Q09, but a likely imminent disbursement from the IMF of around US$5.6 billion leaves the reserve position still relatively comfortable. We expect the UAH to be stable over the next 3-4 months but to weaken again in 3Q.

Turkey: C/A Gap Narrows Quickly, Expected IMF Package Likely to Be Sufficient

In Turkey, the current account balance has turned positive on a monthly basis, for the first time in five years, yielding a surplus of US$0.3 billion each in January and February, bringing down the 12-month rolling deficit to US$33 billion − the lowest print in the past two years. This reversal from a massive deficit to a surplus is the result of the shrinking trade deficit. Exports posted a significant 34%Y decline in February and a mere 9%Y rise on a 12-month trailing basis. However, the slowdown in imports was even more severe due to a sharp drop in commodity (mostly energy) prices, lack of domestic demand for imported goods and especially lower exports that are heavily dependent on semi-finished goods imports: in February, imports declined by a massive 46%Y, pulling down the 12-month rate to 5%Y. On the back of our GDP growth rate forecast revision and tame commodity prices, we lowered our current account deficit forecast from US$17.9 billion to US$9 billion for 2009 (1.4% of GDP), with risks tilted towards an even lower gap.

Financing remains a challenge but is manageable: A combination of the lowest net FDI inflow for over a year (US$0.5 billion), a US$2 billion portfolio investments outflow and a low debt rollover ratio on the part of the corporate sector (i.e., net payer of debt) resulted in a financial account deficit of US$2 billion in February. This figure is a source of concern, especially considering the fact that the private sector debt rollover rate eased to a monthly rate of around 75-80%. While this issue remains one of the top concerns surrounding the external sector, we continue to believe that a significant portion of the corporate sector external borrowing was based on deposit collaterals, and hence the capacity to repay is sufficiently high. That is, we see a lesser degree of systemic risk than the consensus view regarding the prospects of non-financial sector external debt. We note that the net errors and omissions had posted another sizable inflow of US$1.7 billion in February, taking the total figure to a significant US$15 billion between October 2008 and February 2009. The sharp rise in unexplained inflows coincided with the commencement of the weak(er) debt rollover rates seen in the private sector. We believe that these two issues might be closely related and that these funds are most likely under-the-mattress holdings by residents as well as a partial repatriation of funds held at offshore banks.

External financing gap should not be a major challenge, especially with an IMF program: As had been the case back in November 2008, we maintain our view that the overall external financing gap in 2009 could be handled without a major systemic problem. Compared to our previous projections, we now lower the current account gap, which reduces the overall financing need to some extent. On the other hand, we have also revised down our FDI assumptions and, most importantly, assumed a very conservative 50% debt rollover ratio for the private sector. This still yields a gap of some US$10-12 billion, which might mean a loss of reserves and/or currency depreciation. It should be borne in mind that, by nature, we are assuming no FX inflows associated with the net error term, which might turn out to be a strong assumption after all, as the indications so far had been pointing to the opposite (see above discussion). Hence, we maintain our view that an IMF Stand-By Arrangement with a credit facility of some US$20-25 billion would be more than sufficient to ease concerns regarding the financing gap.

South Africa: C/A Deficit to Narrow Marginally in 2009/10

In contrast with the rest of CEEMEA, we expect the C/A deficit in South Africa to narrow only marginally in 2009/10, thanks to relatively inelastic capital import demand (as the government rolls out a number of infrastructure projects ahead of the 2010 FIFA World Cup), and a sharp fall in commodity export revenues. While there may be some import compression as lower oil prices and weaker private consumption and investment spend place a lid on overall import growth, we believe that this is unlikely to fully offset the strong growth in infrastructure-related imports. Also, South Africa is negatively geared to commodity price downturns, given that commodity exports account for as much as three-fifths of exports, but only a fifth of imports. For South Africa’s trade balance to improve during a commodity downturn, commodity import prices (mainly crude oil and petroleum products) need to fall by more than three times the decline in commodity export prices – a rather tall order, in our view.

February improvement in trade deficit a damp squib: It is against this background – among other reasons – that we are inclined to dismiss the sharp improvement in February trade balance from -R17 billion to -R0.6 billion as a one-off blip. First, the sharp improvement comes hard on the heels of a record deficit in January, suggesting that this may be more of a technical rebound than the beginning of a sustained recovery. Second, the reading was largely driven by a much-publicized jump in manufactured and mining exports that was entirely seasonal. With commodities accounting for some three-fifths of exports, it is difficult to see how a continued deterioration in export performance could be averted while global demand remains weak. Third, it is difficult to see a sustainable recovery in manufactured exports (20% of the export basket) when the local manufacturing industry itself is in a historic recession. On the whole, we expect South Africa’s goods and services deficit to widen in 2009/10, and to likely become the dominant driver of the current account deficit – particularly as corporate earnings and dividend payments shrink.

Fickle capital flows a major concern: South Africa’s inordinate reliance on fickle portfolio flows has always been a major drawback – particularly during times of global risk-aversion. Fortunately, a sharp unwind in non-resident portfolio bond and equity positions towards the latter part of 2008 was met by a fortuitous jump in ‘unrecorded transactions’ (a de facto balancing item), and FX repatriations by commercial banks. However, it is important to note that the stock of banking sector FX deposits has already halved from its September 2007 peak of US$26.2 billion. At some point, this cushion may become too thin to matter. One must also remember that capital outflows are not a necessary condition for a high deficit country to face currency pressures: a drying-up in capital inflows alone may suffice. We maintain our bearish view on the ZAR, and recommend going long USD/ZAR at current levels of 9.00 for an eventual move back to 10.00 or higher. Short-term technical and transactional flows (e.g., VODACOM) may present near-term headwinds to this trade.

Falling Inflation Supports Rate Cuts

Large economic slack and global disinflation have joined forces to pull Brazil’s inflation outlook below the official target center. In turn, falling inflation opens the door for further monetary policy easing. The market consensus is looking for a 100bp rate cut on April 29, but we believe that there is room for a 150bp rate cut.

Inflation Heads South

Inflation is set to fall below the central bank’s 4.5% target. Headline consumer price inflation (IPCA) slowed from a recent peak of 6.4%Y in October 2008 to 5.9% in December last year, and then to 5.6% in March 2009. Looking ahead, we expect IPCA inflation to drop to the 4.5% annual target by around mid-year, and then to fall further, towards the 3.0% mark by end-2009.

Inflation components will likely rotate: market-driven price inflation should fall, while administered price inflation should rise. Backward-looking, so-called administered (or monitored) price inflation has run below headline inflation over the last couple of years. But it has been trending up since early 2008 and seems likely to rise further. The central bank assumes that administered prices will rise from 3.5% in 2008 to 5.5% in 2009, while we and the market consensus expect 4.5% this year. One wild card here is regulated fuel prices – a cut in domestic gasoline and diesel prices could reduce IPCA inflation by a few tenths of a percentage point. For its part, market-driven price inflation has slowed from a recent peak of 8.0%Y in 3Q08 to 7.1% last December and 6.1% in March 2009 – we assume a further decline, all the way to about 2% by end-2009.

Looking ahead, inflationary pressures seem subdued. Wholesale price inflation has trended lower over the last several months. In particular, volatile agricultural wholesale price inflation had jumped higher around mid-2008 but has since come down all the way to zero.

Currency pass-through to inflation is proving remarkably muted, despite significant currency depreciation in late 2008, and unlike the 2002/03 experience. Why? We can see four possible explanations. First, as the inflation-targeting regime matures and the central bank gains credibility, the currency loses importance as an anchor for inflation expectations. Second, the real effective exchange rate seems to have moved towards its longer-term average in the recent episode, but away from the historical average back in 2002/03. Third, ongoing global disinflation helps. Fourth, a weakening domestic economy probably helps to reduce the pass-through coefficient.

Global disinflation helps. After a sharp run-up throughout 1H08, global inflation has turned decisively lower over the last several months. Looking ahead, the IMF foresees global CPI inflation slowing from a peak of 3.4% in 2008 to 1.8% in 2009, with zero inflation in advanced economies and 4.4% in emerging markets.

A weak domestic economy helps to curb inflation. Brazil’s output gap has widened dramatically. That is, the economic slump in late 2008 brought real GDP growth significantly below its potential. And while there are recent ‘green shoots’ of sequential recovery, we fear that a double-dip cannot be ruled out. The end result: resource utilization in the economy has declined sharply, as seen in a sudden plunge in industrial capacity utilization around the turn of the year. Under low operating rates and limited corporate pricing power, profit squeezes seem more likely than inflationary pressures.

Not surprisingly, market consensus of inflation expectations keep coming down. The consensus for IPCA inflation in 2009 continues to fall, from a peak of 5.4% late last year all the way down to around 4.2% in recent weeks – therefore already below the official 4.5% target center. Interestingly, the market consensus for 2010 inflation has also started to drift lower in recent weeks, after being firmly stuck at the 4.5% target mark for several months.

Rates to Fall Further

Falling inflation expectations make room for further rate cuts. Indeed, if history is any guide, it seems there is a significant correlation between market consensus expectations for IPCA inflation (12-months ahead) and policy interest rates, perhaps with a time lag on some occasions.

The central bank’s own inflation forecasts are coming down too. In its latest quarterly inflation report, as of late March, the central bank revised down its forecast for 2009 IPCA inflation to 4.0% from 4.7% before, under the reference scenario of unchanged policy rates and a stable exchange rate. Likewise, it cut its 2010 IPCA inflation forecast, also to 4.0%, from 4.2% before.

The market consensus expects COPOM to cut rates by 100bp, but we see room for a 150bp cut when the monetary policy committee announces its decision on the evening of April 29. We see three main reasons for a larger room to cut. First, the economy has opened a wide output gap, with plenty of slack in resource utilization. Second, inflation expectations are falling steadily, below the central bank’s 4.5% target. Third, in the ‘balance of risks’ facing the COPOM, the risk of deeper recession is a more dangerous threat than the risk of rising inflation, in our view.

Watch the accompanying policy statement and the subsequent COPOM minutes, out on May 7, aside from the (split?) voting score, for clues on next policy moves. If the COPOM indeed opts for a bold 150bp rate cut now, it could present its decision as ‘buying insurance’ against the tail risk of a deeper recession. In this case, the COPOM might highlight its role as a ‘risk manager’, and it could underscore the concept of ‘balance of risks’ around the base-case outlook.

The central bank currently seems to contemplate two main scenarios. In the first, the global turmoil would last for longer, extending into 2010, and its negative repercussions for Brazil’s economy would persist throughout the forecast horizon. In the second, if the global recovery comes sooner and faster than anticipated, then the recuperation in financial conditions and confidence, besides rising commodity prices, could imply rising inflation risks. At least until recently, the central bank has judged the first scenario as the most likely.

By contrast, a slowdown in the pace of cutting (say, to 100bp or less) might signal a change of perceptions at the central bank. In this case, the COPOM might prefer to highlight the lagged impact of the cumulative easing already implemented so far (100bp cut in January, and 150bp rate cut in March). In this ‘proceed-with-caution’ case, the COPOM might prefer to signal a slower rate-cutting pace going ahead, perhaps in order to minimize the odds of subsequently having to hike rates too soon.

Any rate cut from here would bring rates to uncharted territory, as the policy rate currently already stands at a historical low of 11.25%. In all, we expect rates to slide to unprecedented lows – our forecast assumes a 150bp rate cut now in April, and then another 150bp cut at the subsequent meeting in June. Rates would therefore decline to 8.25% by mid-2009, and remain there through year-end.

Rates are coming down. How long can they stay there? The debate here boils down to structural versus cyclical considerations. Analysts in the ‘multiple equilibrium’ camp would argue that once real rates fall, they may well stay there sustainably. By contrast, observers in the ‘emergency cuts’ camp would argue that ongoing aggressive rate cuts are an emergency response to fight recession, and that structurally lower real interest rates would likely require structural reforms. Who is right? We do not know. While both camps have good arguments, we sympathize more with the latter. In our view, policy rates might have to go up at some point in late 2010. That said, the local yield curve seems too steep right now, as it appears to price in rate hikes already by early next year.

Global Economic Forum

Two main proposals. Congress is mooting two competing scrappage proposals. Reps. Steve Israel (D-NY) and Jay Inslee (D-WA) and Sen. Dianne Feinstein (D-CA) support the Accelerated Retirement of Inefficient Vehicles Act of 2009. ARIVA would give consumers vouchers worth $2,000-4,500, which could be used to purchase more fuel-efficient vehicles or spent on public transit.

A competing bill sponsored by Rep. Betty Sutton (D-OH), the Consumer Assistance to Recycle and Save (CARS) Act (H.R. 1550), gives consumers purchase incentives for turning in vehicles that are eight years or older to buy more fuel-efficient vehicles or to obtain a transit voucher. To qualify, fuel efficiency for new car purchases would have to be at least 27 mpg (highway), and for trucks, 24 mpg. The incentives would range between $3000 and $5000 depending on fuel efficiency. A key provision of the Sutton bill would apply incentives to work trucks; without it, the impact would be smaller.

The ‘cash for clunkers’ idea has gotten more traction since President Obama endorsed it on March 30, promising that funding could be drawn from the $787 billion American Recovery and Reinvestment Act (ARRA). At this writing, it appears that the two camps are working to iron out their differences, and the chance that a bill will be enacted is growing. The question now is what will be the impact on sales and the economy.

The bullish view. Some observers, like Morgan Stanley auto analyst Adam Jonas, believe that a cash for clunkers incentive could boost vehicle sales considerably, based on the experience of scrappage incentives in Germany. Following the introduction of those incentives, car sales in Germany jumped by 40%. And many observers, including Larry Summers, head of the White House National Economic Council, believe there is substantial pent-up demand, as 14 million new light vehicle sales per year would be needed just for replacement, far above the March pace of 9.8 million.

A closer look under the hood suggests that cash for clunkers might not provide such a big boost. Eligibility for the incentives is one hurdle for ARIVA: Trade-ins would have to get 18 miles per gallon or less and the purchased vehicle would have to offer a 25% improvement over the average federal fuel efficiency standard (currently 27.5 mpg for passenger cars). The American Council for an Energy Efficient Economy (ACEEE) estimates that only about 12 million vehicles on the road (5%) would qualify. That would substantially limit its potential impact. In addition, the UAW opposes ARIVA because it could boost sales of imports.

In contrast, under the CARS bill, roughly half the light vehicles on the road would be eligible. The UAW favors CARS, because it would be limited to cars and trucks assembled in North America. (NB: This restriction could run afoul of WTO rules and could trigger protectionist measures from abroad. At this writing, it appears that Rep. Sutton may be willing to broaden the bill to include all vehicles.)

But bang for the buck is a hurdle for either proposal. Here are some rough calculations: Under the Sutton bill, roughly half the consumers who own a vehicle could qualify for the incentive. The average incentive of $4000 per vehicle is 16.6% of the average new vehicle price ($24,122), according to Commerce Department data. But to calculate the net incentive, one must deduct the average trade-in value that we estimate at $2600, because the consumer loses the trade-in if they cash in the voucher. (One could also analyze the loss of trade-in by adding it to the price of the vehicle and counting the incentive as a discount off that higher price. That would take account of the value the dealer would realize by selling the parts.) The incentive, net of trade-in, would be roughly 5.5% of the average new vehicle price (we guesstimate that the average trade-in value for sedans eight or more years old is about $1800, and for pickups about $3800, using Kelly Blue Book data). Given that the voucher plan might expire at the end of 2009, consumers could be quite sensitive to such a discount. If the price elasticity is 2, a 5.5% discount might spur an 11% increase in unit sales. Since only half of the vehicles on the road are eligible for the incentive, that would yield a 400,000 increment to sales.

We illustrate the sales increment for a variety of elasticities and eligible vehicles. They are designed to be illustrative: While we include an elasticity of 1, we think that may be too low, given the probable ‘use it or lose it’ nature of the incentives (most would expire at the end of 2009). And the elasticity of 4 is probably a bit too high, given today’s circumstances. Based on these calculations, therefore, we would expect that the CARS plan might increase sales by anywhere from 400,000 to 800,000, depending on the restrictions imposed.

Four additional factors could alter the sales impact, one positive and three negative. On the plus side, additional manufacturers’ incentives could boost the sales total. OEMs’ average incentives ran at $3848 in March, but there is no reason why they might not put some more money on the hood to be sure that the program caught fire. However, that would not alter our thinking on bang for the buck − only the bucks involved.

Yet there are three negative factors. One is that the Administration might eliminate the sales tax incentive currently in the stimulus package (ARRA) in order to limit the cost. ARRA allows a tax deduction for sales and excise taxes paid on the purchase of a new vehicle; those deductions are worth about $300 to the typical taxpayer. In addition, clunker owners typically buy newer used cars, rather than new ones. So the incentive would have to be extended to include such used cars to have a bigger impact; again that would affect the bucks rather than bang per buck.

Finally, roughly 90% of vehicles sold in the US are financed, and credit is still hard to get. The change in loan-to-value (LTV) ratios from the captive finance companies provides a graphic illustration of the importance of downpayments or collateral. LTVs fell from 95% in 2007 to 86.4% in the latest data (February), representing a near-tripling of downpayments from $1500 to $4000 for the typical vehicle. Sales plummeted in response. Regardless of incentives, buyers still need to have more skin in the game than two years ago. Only a dramatic improvement in asset-backed securities markets and lenders’ appraisal of risk would change that.

GDP impact. If the Sutton plan were to hike US light vehicle sales and production by about 600,000 units at an annual rate, it would only boost GDP by about 0.1%. Concentrated into a short timeframe, of course, the annualized effect on a quarter would be larger. But the impact could be even smaller if, in the current environment, producers simply used it to draw down inventories. In any case, the effect on both sales and the economy would be temporary, as the incentives would likely sunset at the end of 2009, so sales and output gains today would borrow from those in 2010.

Why not mimic the success in Germany? In Germany a similar incentive caused auto sales to spike 21.5% in February and 40% in March. However, the German experience is unlikely to be a template for any US incentive program for several reasons.

The German program offers a cash incentive of €2500 on the purchase of a new, more fuel-efficient vehicle. It was originally limited to €1.5 billion, but its success prompted Chancellor Merkel to increase the size to €5 billion. Although the program has been a roaring success in boosting overall sales, it has only helped one domestic carmaker (VW), as people tend to buy smaller, foreign-assembled cars.

Several factors suggest that the US response will fall short of that in Germany. First, German consumers are in better shape than their US brethren, with higher saving rates (nearly 12%) and stronger balance sheets (household liabilities/disposable income is 98% versus 134% in the US). Second, substantially higher gasoline prices in Germany relative to the US and a CO2 emission tax effective July 1 provide a bigger incentive to replace older cars with more fuel-efficient ones (the current tax is based on engine displacement rather than CO2 emissions).

More important still, OEMs selling in the German market paired significant incentives of their own with those from the government. The OEM incentives often doubled the total package to €5000 per vehicle. Clearly a 20%+ discount can go a long way to boosting demand − but this involves putting more money on the hood rather than more bang per euro. Indeed, while it boosted unit sales, the incentives may have shifted demand from premium OEMs such as Mercedes and BMW to foreign makers of smaller cars such as Toyota. And, of course, there will be ‘payback’ when the incentives expire, as some of the demand borrowed from the future.

The experience in other European countries suggests that scrappage incentives alone won’t significantly boost sales in the US. For example, incentives in Austria, Italy and France are only slightly smaller than those in Germany, but sales are still flat to down year over year.

To be fair, it is early days for some of these foreign schemes. A J.D. Power and Associates survey suggests that two-thirds of UK respondents believe that the just-announced government-backed £2,000 “scrappage” incentive for vehicles nine years of age and older will stimulate the new-vehicle market. “Furthermore”, the report notes, “40 percent of all respondents with qualifying vehicles indicate that they would be either “likely” or “very likely” to purchase a new vehicle within the next six months as a direct result of the incentive”. But the evidence so far is not especially encouraging. Stay tuned.

Other Currencies

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* The future of reserve currencies
* New Zealand cuts rates to 2.5%
* BoJ revises down growth forecast

Germany slashes 2009 growth forecast

The German government has confirmed that it expects the economy to contract by 6 per cent this year, revising down its January projection of a 2.25 per cent fall in gross domestic product - Apr 29 2009 17:48

* Germany’s woes spark talk of Weimar
* Eurozone economic confidence rebounds

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The first significant rise in eurozone economic optimism for almost two years has created a slightly less bleak backdrop for emergency measures to be unveiled by the European Central Bank next week - Apr 29 2009 17:42

* Wolfgang Münchau: The eurozone needs a co-ordinated strategy
* Signs worst is over for eurozone

The future of reserve currencies

Karthik Sankaran at Covepoint Capital answers readers’ questions on the dollar, its competitors for reserve currency status, and other aspects of the currency markets, on Tuesday, May 5 - Apr 29 2009 11:07
German business confidence rebounds

A surprisingly sharp rise in German business confidence has provided further evidence that Europe’s largest economy is over the worst of its recession and is closer to returning to growth than previously thought - Apr 24 2009 10:27
UK business confidence stabilises

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Lex: Yuan for all?

Recent developments have hinted at a new determination to internationalise the renminbi, but enthusiasts for a new world order should take a step back - Apr 22 2009 19:58
Lehman collapse led to euro note ‘hoarding’

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Insight: Dollar still reigns supreme

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