Archive for the ‘Rising Powers’ Category

China: Responsible economic policy

October 5, 2010

Higher prices for GI Joe? Source: Google Images

Very nice, short piece today from CSFB (below) on what China is doing to correct the global imbalances (i.e., to reduce its trade surpluses, which mirror US and other countries’ trade deficits) and to shift its economy to a healthier foundation based on domestic demand.  While President Obama gets pre-election press pressuring China’s prime minister to let his currency appreciate, and while Dems in Congress led by Chuck Schumer grandstand, threatening to raise tariffs on China before the election, the Chinese authorities have instituted large wage increases across the board.  As a result, the real value of the Chinese currency could appreciate sharply, even if the nominal value (the focus of American politicians) appreciates in baby steps.  Hopefully, Schumer, Obama and Co., and above all the angry voters they are courting, understand the economics: that wage inflation undermines the competitiveness of a country’s goods as much as does currency appreciation.  

In spite of President Obama’s tough talk (or because of it?), he appears to have received a boost from China’s prime minister, who lauded his administration’s economic policies, much-maligned these days by the Republicans (who have few ideas of their own).  But, what China bashers don’t realize, and CSFB points out, is that low inflation in the US (i.e. the affordability of America’s consumption binge) has been underpinned over the last 10-15 years by China’s low wages cum undervalued exchange rate, Sir Alan Greenspan’s claims to perfection notwithstanding.  From computers to home improvement, Chinese goods have been cheap.  We won’t be able to count on this any more.  With America still in a near-recessionary funk, we’re not worried about inflation, but that could change.  Enormous government budget deficits have been accommodated by a massive monetary stimulus.  Hence, inflation, and all the economic distortions implied, may be one of a slew of economic problems facing the world’s leading (though declining) power in the years to come. 

From CSFB today: 

In contrast to the exchange rate, wage rates among migrant workers have risen much more aggressively, and we believe that this marks the beginning of the end of China’s export empire. Among 31 provinces, 27 have raised the minimal salary by an average of 22% this year and the remaining four will introducing legislation for salary hikes later this year. We think the move has been pushed by Beijing as part of an effort to shift the economy from export-driven to domestic-consumption-driven. In a survey Credit Suisse conducted, 39% of CEOs from multinational corporations placed a wage increase as something about which they were “very worried” or “extremely worried,” versus 18% for exchange rate appreciation.

The key question to be answered is whether foreign direct investments will leave China or move to the inland provinces. We believe most will move inland rather than leave China. China’s domestic demand is a major attraction for FDI. Besides, China’s infrastructure and administrative efficiency probably will keep FDI coming, for now. However, we project 20%-30% salary increases at the migrant workers’ market every year over the next four years (at least). This would eventually erode China’s competitiveness and push up its export prices. Perhaps we have seen the best time for China as the anchor of global disinflation, though it may take more than a decade for China’s export machine to fall.

Dong Tao +852 2101 7469 dong.tao@credit-suisse.com

Christiaan Tuntono +852 2101 7409 christiaan.tuntono@credit-suisse.com

05 October 2010

The RMB exchange rate saw a surge in appreciation in recent days, but we doubt the trend will last long. The Chinese currency saw nine consecutive days of appreciation against the USD, amidst USD weakness and heightened pressure from the White House and the Capitol Hill. But to us, Beijing has, in fact, been pushing for real exchange rate appreciation through salary increases, much more aggressively than with the nominal exchange rate. With export orders softening and domestic salary surging, we project only marginal nominal appreciation, which is politically motivated. We look for USDRMB at 6.67 by end of 2010 and 6.35 by 2011.

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China: Would Machiavelli be proud?

September 22, 2010
Chinese President Hu Jintao reviews army troops.  Source:  CCTV
Chinese President Hu Jintao reviews army troops. Source: CCTV

Machiavelli, more than any thinker in history, made his name synonymous with a type of human behavior — self-interested, cunning, ruthless.  He wrote about ancient Rome as well as Italy and the Mediterranean world of the 15th-16th centuries, extolling such leaders as Ferdinand of Aragon, the successful king of Spain who oversaw his empire’s aggrandizement, as well as the expulsion of alien elements from the Iberian peninsula. 

The extent to which a truly Machiavellian leader must be  cruel has been exaggerated.  If you read his treatises closely, the Florentine statesman was no fan of cruelty if it failed to strengthen the state.  Orgies of killing usually engender hatred in a state’s subjects, and Machiavelli argues that being hated is worse than being feared.  Being feared is better than being loved, he says, if one cannot be both.  According to Machiavelli, leaders must imitate both the lion and the fox — employing both military power and diplomacy — in order to outwit the wolves. 

I have argued for some time in this blog that the West, led by the United States, has done a fairly good job of anchoring China into international institutions wrought after the Second World War (see my post “Anchoring the Dragon,” of October 2009).  Privileges and power must be matched in international relations in order to avoid instability and conflict.  Machiavelli, were he around today, might not criticize Western diplomacy on the China question. 

Since 1979, China too has managed its foreign relations relatively well.   Deng Xiaoping, who led China after 1978, opened his isolated nation to the world, culminating in 2001 in China’s accession to the World Trade Organization, which this giant nation has used as a platform to become the greatest manufacturing juggernaut the world has known.  Likewise during the Cold War, China and the U.S. deftly used each other in classic Machiavellian fashion to balance against their mutual enemy, the Soviet Union, a quasi-alliance that deserves some credit for burying the Soviet empire late last century.

China’s exchange rate policy can be called Machiavellian.  The currency is kept low to promote exports in order to avoid the dependence on foreign capital that drove China’s Asian brethren — Korea, Thailand and Indonesia — to the brink of bankruptcy during the 1998 Asian financial crisis.  Still, China periodically revalues its currency in baby steps in order to blunt the anger of its trading partners, whose external borrowing expands to finance nagging trade deficits.

A NYTimes article today discussed how China is currently seeking to mend fences with the Obama administration over its exchange rate policy, as well as over tensions related to the Korean peninsula, the South China Sea and Taiwan.  Things are not as cozy with the United States these days because the US government is run by Democrats.  Democrats are more prone to grandstand against China on currency manipulation, human rights, and the environment than Republicans were.  The Chinese will compete this century with the U.S. for hegemony in Asia, not to mention globally, yet today they wish to do so quietly.  Surpassing Japan as the world’s second largest economy this year with GDP in excess of $5 trillion, the Chinese economy still falls well short of US GDP of over $14 trillion.  Hence, the need to be both a lion and a fox.   

Do not doubt that China intends to take over its renegade province of Taiwan one day, or to become the dominant power in East Asia.  China does not yet have the actualized military capability to obtain these prizes, so it bides its time and makes nice with the global hegemon as necessary.  On the other hand, China builds strong economic and diplomatic links globally to secure sources of raw materials and moral support, and continues to pump money into its military.  It plays a cute game on the Korean peninsula (see The Economist article below), alternately prodding and bolstering the tottering regime in Pyongyang, in order to show the Americans it is a player to be reckoned with on all things Asian.   Machiavelli would be proud.

(From a Sept. 9, 2010 post.)

From The Economist, September 2:

What lies behind the Dear Leader’s latest trip to China?

Sep 2nd 2010 | Beijing

NORTH KOREA’S leader, Kim Jong Il, must have been on an urgent mission when he boarded his bulletproof train and headed to China for the second time in less than four months on August 26th. With America’s former president Jimmy Carter in town, devastating floods in the north and a rare conclave of his ruling party only days away, Mr Kim had much to keep him at home. But buttering up China appears to be a new priority.

Both China and North Korea, as is their wont, kept quiet about the visit until after Mr Kim’s return on August 30th. By then Mr Carter had left with an American, Aijalon Gomes, who had been serving eight years’ hard labour for entering the country illegally in January. Mr Gomes’s release was a rare gesture of conciliation to America after months of heightened tension caused by the sinking in March of a South Korean naval vessel.

America responded, however, by giving details of sanctions on several North Korean individuals and entities suspected of “illicit activities”, such as dealing in weapons or drugs, or procuring luxury goods for Mr Kim or others. The decision to impose them had been announced in July.

China has complained loudly about America’s recent muscle-flexing, particularly its joint military exercises with South Korea. These are due to resume on September 5th with drills in the Yellow Sea, which China regards as uncomfortably close to its own shore. China began its own naval exercises in the Yellow Sea on September 1st. The official news agency, Xinhua, called them “routine”, but a decision to draw attention to them could be intended to show resolve in the face of the American and South Korean manoeuvres. The results of an international investigation into the sinking of the South Korean ship, which blamed it on North Korea, were released after Mr Kim’s last trip (his first foray abroad in four years). China has refused to accept the findings. By rolling out the red carpet again, it showed it has no plans to reconsider.

Less clear is why Mr Kim wanted to go back so soon. Much speculation has suggested that it could be related to the forthcoming party conclave, the first on such a scale since 1980. North Korea says it will be held early in September. One popular theory is that Mr Kim wants the gathering to endorse the appointment of his son, Kim Jong Un, to a senior party post. The idea would be to groom him to succeed his father, whose health has not been robust. The younger Mr Kim is in his late twenties and is believed to be jobless. Rumours of his rise as heir apparent have long been circulating, and it is plausible that his father would want to inform China if confirmation of this is imminent.

No mention was made of Kim Jong Un or the succession issue in official Chinese and North Korean reports. It is not even known if he went on the trip. But Kim Jong Il did spend some time inspecting sites related to the revolutionary days in China of his own late father, Kim Il Sung. Mr Kim spoke of the need to “hand over to the rising generation the baton of the traditional friendship” between the two countries.

China’s president, Hu Jintao (pictured with the Dear Leader), wished the party meeting in Pyongyang a “signal success”. The Chinese media played up Mr Kim’s reported agreement with his hosts on the need for an “early resumption” of multinational talks on North Korea’s nuclear programme. Prospects for this remain dim, but some analysts believe that North Korea might try to get negotiations restarted as a way of relieving economic pressure. For the moment, China is North Korea’s lifeline. Diplomats say trade between the two countries has picked up in recent months. In return for food, North Korea has given China a new lease on harbour facilities in the north-eastern port of Rajin.

The prospect of a power transfer in Pyongyang worries China. Global Times, an English-language newspaper in Beijing, accused America and South Korea of wanting to “create turmoil” in North Korea and said a smooth transition there was “vital” for stability in north-east Asia. Victor Cha of the Centre for Strategic and International Studies, a Washington think-tank, says that Mr Kim’s mysterious visit at least made it clear that China would stick with its ally to “the bitter end”.

China: the price of directed lending

September 21, 2010
China: How long can that heart rate stay elevated?  Source: Google Images
China: How long can that heart rate stay so elevated? Source: Google Images

China is an economically successful country.  Growth rates of 8-11% per year.  Fx reserves north of $2.4 trillion, closing in on 20% of US GDP.  Investment rates that represent 40-50% of GDP (vs. 15-20% in the US).  Private credit growth of 32.5% last year, vs. 5.6% in the U.S.   A Human Development Index that now stands at 49.7, vs. 26.5 in India, and per capita income (PPP basis) that is twice as large as India’s.  Can China keep this up?

I have long said in this blog that China is not strictly comparable to Western market economies, where governments use market signals such as interest rates to nudge the massive private sector in a certain direction.  In China the central government directs banks to lend and pushes local governments to invest.  Not to scoff at the stimulus packages in Western countries — featuring government spending and liquidity injections, but in China, when the authorities mandate a stimulus, they sure get one.   The lead lining in the silver cloud, however, is that when loans and investment projects “season” in China, sizeable loan losses and fiscal liabilities can result.  This is just what rating agency Fitch argued at a conference in Shanghai and Beijing last week (see press release below).   

China has the wherewithal to handle some deterioration in its banks and sovereign balance sheet, given its low level of government debt (under a quarter of GDP), small deficits (under 3% of GDP), and full inoculation against a balance of payments crisis (featuring its Chinese wall of fx reserves and current account surpluses in the neighborhood of 5-10% of GDP).  Nevertheless, with a massive banking sector (broad money represents over 180% of GDP) and heavy state involvement in the sector, banking problems could conceivably become sovereign debt problems.  Fitch assigns China a Banking System Risk Indicator of D/3 (vs. C/3 in the US and B/1 in Canada).  This statistic ranks countries based on the quality of their banks (A-E, E being the lowest) and on systemic banking risk (1-3, 3 being the highest risk).  So, directed lending and stratospheric credit growth have a dark side. 

Furthermore, as Fitch suggests, China, like Japan, will have to shift to an economy driven more by its consumers and less by external demand (i.e. exports) in order to respond to angry trading partners like the U.S. and to have a more sustainable trajectory of economic growth.  Such a shift will be even more difficult with problems in the banking system and higher government debt.

Fitch: China’s Ratings Supported By Strong Sovereign Finances, But Possible Stimulus ‘Hangover’
17 Sep 2010 2:01 AM (EDT)


Fitch Ratings-Beijing/Singapore-17 September 2010: Fitch Ratings says China’s ratings remain supported by the sovereign’s strong finances, underpinned by the foreign reserves stockpile, and by the economy’s strong growth track record. However, the agency raises concerns over a potential ”hangover” from the government’s aggressive stimulus efforts in 2009, including strong credit growth, which could still see the emergence of problems requiring sovereign support to clear up, for example in the banking system. The hesitant recovery of the global economy remains a background source of risk for China.

Leading off Fitch’s annual Sovereign and Banking Conference in Shanghai and Beijing this week, Andrew Colquhoun, Head of Asia-Pacific Sovereigns, reviewed China’s robust economic performance through the global crisis. China’s strong growth owes much to the government’s stimulus efforts, but Mr. Colquhoun noted that some of the costs of the stimulus may be yet to materialise on the sovereign’s balance sheet, such as debts of local government investment companies and, in a downside case where banking sector problems emerge, holes in bank balance sheets. Mr. Colquhoun also discussed the longer-term prospects for a transition to a more consumption-led growth model in China in the context of a still-hesitant global economic recovery – potentially a bumpy transition.

Speaking on the prospects for Asia-Pacific banks, Jonathan Cornish, Head of Fitch’s North Asia Financial Institutions team says the agency sees risks building in banking systems across the region, particularly in China due to rapid asset growth – even though Asian banking systems have generally proved resilient during the global financial crisis, and have in general continued to benefit from a relatively benign operating environment as a result of the robust performance of many Asian economies.

Charlene Chu, Fitch’s Senior Director of Financial Institutions, provided an update of Chinese regulators’ efforts to curb the risks surrounding the growing popularity of informal securitisation, or the re-packaging of loans into wealth management and/or trust products, by Chinese banks. Ms. Chu was one of the earliest analysts to raise awareness about informal securitisation in China. She said that despite the recent tightening in regulations, net issuance of some wealth management and trust products has not slowed thus far in Q3, owing to a number of grey areas in the new rules that offer banks significant room to maneuver with this activity.

Li Zhenyu, director of financial institutions and structured finance at Lianhe Ratings, Fitch’s JV partner in China, also discussed the evolution of formal asset securitisation in China.

Contacts:

Andrew Colquhoun
+852 2263 9938
andrew.colquhoun@fitchratings.com

Jonathan Cornish
+852 2263 9901
jonathan.cornish@fitchratings

Charlene Chu
+86 10 8567 9898 ext 112
charlene.chu@fitchratings.com

Latin America: Economist Special Report

September 19, 2010
Latin America: anti-inflation consensus and strong fx reserves  Source: vivirlatinamerica.com
Latin America: anti-inflation consensus and strong fx reserves Source: vivirlatino.com

The Economist’s lengthy Special Report on Latin America last week is worth a read (see leader below), even though it failed to emphasize and adequately explain two critical causes of the region’s recent success — 1) the consensus among Latin American politicians that conquering inflation has benefitted the poor and strengthened democracy; and 2) the massive build-up in fx reserves that has insulated the region from the global crisis, driven in part by healthy macro policies.  These issues were mentioned in passing by The Economist, but not given the focus deserved.  On the other hand, the longer articles in the Report on education, the informal economy and productivity were rich in detail and deserve a read. 

Latin America’s performance during the global economic crisis that began in 2008 was notable for the fact that the recession there was mild and the subsequent rebound robust.  One used to say that when the United States sneezed, Latin America caught the flu, but this time, the region has been inoculated against the contagion that has spread throughout the advanced economies.  In the 1980s, 90s and early 2000s, when economic shocks occurred in the advanced economies — including rising interest rates and lower prices for commodities and financial assets, this led to fiscal and balance of payments crises in Latin America, and often near or outright sovereign defaults (a la Greece).  This time, the Latins were ready.  The reason — strong fx reserves immunizing them from shifts in international capital flows.  How did they achieve this Gibraltar of reserves?  Through higher demand for their commodities from China and others, to be sure, but also through sound macro policies — floating exchange rates, an inflation-targeting monetary policy, and at least some fiscal restraint.  These policies have ensured that the balance of payments (the supply and demand of foreign exchange) adjusts to shocks, thereby bolstering investor confidence, which in turn limits capital flight during a crisis.  It’s a completely new ball game for most Latin countries.  Let’s hope they don’t let the weakest of these pillars — the commitment to fiscal prudence — slip, or they risk a return to the bad old days of boom and bust, especially when commodity prices inevitably weaken.

The Economist likewise points to Latin America’s strengthening democratic institutions as providing the political stability required to promote growth.  No argument there, but I would give a lot of credit for this to the taming of the inflation monster in the region.  After years of hyperinflation, driven by fiscal deficits and monetary accommodation, Latins broke the cycle in the nineties.  When leftists subsequently came to power, the fear of a fiscally-induced return to inflation rocked the capital markets.  President Lula was a case in point (see my post on the matter).  During his election to a first term in 2002, the bond markets sold off to default spreads, but recovered early in his tenure when they realized that this leftist, former union leader, imprisoned by Brazil’s military regime in the 1970s, retained much of his predecessor’s macro policies.  He did so because he understood that his constituency, the poor, had been hurt by inflation more than any other segment in society.  You see, the poor cannot index to inflation.  The understanding of this dynamic has led to a broad consensus in Latin society on economic policy, even when political institutions are weak and ineffectual, as in Peru and Mexico and to some extent in Brazil.  Deeper reforms that would underpin improvements in productivity, education, and the state bureaucracy remain elusive.  However, the three key pillars to macroeconomic stability (and to the political consensus) — again, flexible exchange rates, inflation targeting and fiscal prudence — remain largely in place.  With GDP growth averaging 5.5% per year in the five years to 2008, the impetus to reform is currently lacking.  See my in-depth analysis of Latin democracy here in Scherblog, written during the region’s last major election cycle (2005-07), when I discussed the delicate balance between populism and reform.   

As  a long-time Latam hand (I managed Fitch’s Latin American Sovereign Ratings group for seven years), I believe more emphasis than you will find in The Economist Special Report should be paid to the region’s 1) anti-inflation consensus, and 2) victory over the rollercoaster of balance of payments crises.   Have a read in any case…

Leader on Latin America from The Economist (Sept. 11-17):

The United States and Latin America

Nobody’s backyard

Latin America’s new promise—and the need for a new attitude north of the Rio Grande

Sep 9th 2010

THIS year marks the 200th anniversary of the start of Latin America’s struggle for political independence against the Spanish crown. Outsiders might be forgiven for concluding that there is not much to celebrate. In Mexico, which marks its bicentennial next week, drug gangs have met a government crackdown with mayhem on a scale not seen since the country’s revolution of a century ago. The recent discovery of the corpses of 72 would-be migrants, some from as far south as Brazil, in a barn in northern Mexico not only marked a new low in the violence. It was also a reminder that some Latin Americans are still so frustrated by the lack of opportunity in their own countries that they run terrible risks in search of that elusive American dream north of the border.

Democracy may have replaced the dictators of old—everywhere except in the Castros’ Cuba—but other Latin American vices such as corruption and injustice seem as entrenched as ever. And so do caudillos: in Venezuela Hugo Chávez, having squandered a vast oil windfall, is trying to bully his way to an ugly victory in a legislative election later this month.

Yet look beyond the headlines, and, as our special report shows, something remarkable is happening in Latin America. In the five years to 2008 the region’s economies grew at an annual average rate of 5.5%, while inflation was in single digits. The financial crisis briefly interrupted this growth, but it was the first in living memory in which Latin America was an innocent bystander, not a protagonist. This year the region’s economy will again expand by more than 5%. Economic growth is going hand in hand with social progress. Tens of millions of Latin Americans have climbed out of poverty and joined a swelling lower-middle class. Although income distribution remains more unequal than anywhere else in the world, it is at least getting less so in most countries. While Latin American squabbling politicians blather on about integration, the region’s businesses are quietly getting on with the job—witness the emerging cohort of multilatinas.

As they face difficulties in an increasingly truculent China, no wonder multinationals from the rich world are starting to look at Latin America with fresh interest. Sir Martin Sorrell, a British adman, talks of the dawn of a “Latin American decade”. Brazil, the region’s powerhouse, is the cause of much of the excitement. But Chile, Colombia and Peru are growing as handsomely and even Mexican society is forging ahead, despite the drug violence and the deeper recession visited on it by its ties to the more sickly economy in the United States.

Two things lie behind Latin America’s renaissance. The first is the appetite of China and India for the raw materials with which the continent is richly endowed. But the second is the improvement in economic management that has brought stability to a region long hobbled by inflation and has fostered a rapid, and so far sustainable, expansion of credit from well-regulated banking systems. Between them, these two things have created a virtuous circle in which rising exports are balanced by a growing domestic market. Because they were more fiscally responsible during the past boom than in previous ones, governments were able to afford stimulus measures during the recession. There is a lesson here for southern Europe: Latin America reacted to its sovereign-debt crisis of the 1980s with radical reform, which eventually paid off.


The danger of complacency

Much has been done; but there is much still to do. Building on this success demands new thinking, both within Latin America and north of the Rio Grande.

The danger for Latin America is complacency. Compared with much of Asia, Latin America continues to suffer from self-inflicted handicaps: except in farming, productivity is growing more slowly than elsewhere. The region neither saves and invests sufficiently, nor educates and innovates enough. Thanks largely to baroque regulation, half the labour force toils in the informal economy, unable to reap the productivity gains that come from technology and greater scale.

Fixing these problems requires Latin America’s political leaders to rediscover an appetite for reform. Democracy has brought a welcome improvement in social policy: governments are spending on the previously neglected poor, partly through conditional cash-transfer schemes, a pioneering Latin American initiative. But more needs to be done, especially to improve schools and health care, if everyone is to have the chance to get ahead. Also needed is a grand bargain to tackle the informal economy, in which labour-market reform is linked to a stronger social safety-net. And, even if some things like infrastructure and research and development plainly need more government spending, the worry is that triumphalism over escaping the financial crisis may prompt a return to a bigger, more old-fashioned state role in the economy—despite the failure of these policies in the region in the past.

Getting these things right will be easier if relations with the United States improve. Latin America needs to shed its old chippiness, manifest in Mr Chávez’s obsession with being in the hated yanqui’s “backyard”. More sensible powers, notably Brazil, should be much louder opponents of this nonsense. As they start to pull their weight on the world stage, working with the United States will become ever more important.

The attitude of the United States needs to change too. Worries about crime and migration—symbolised by the wall it is building across its southern border—are leading it to focus on the risks in its relationship with the neighbours more than on the opportunities. This is both odd, given that Latinos are already the second-largest ethnic group north of the border (see article), and self-defeating: the more open the United States is towards Latin America, the greater the chances of creating the prosperity which in the end is the best protection against conflict and disorder. After two centuries of lagging behind, the southern and central parts of the Americas are at last fulfilling their potential. To help cement that success, their northern cousins should build bridges, not walls.

Russia: Is the sovereign rating useful?

September 8, 2010

 

Does Russia’s sovereign rating tell us any more than the oil price?

Fitch Ratings today published a press release revising the “Outlook” on its “BBB” rating of Russian government bonds to positive from stable (see a Fitch press release below).  Rating agencies – Moody’s, Standard & Poor’s and Fitch – have been under fire since their high structured real estate ratings were downgraded rapidly during the recent financial crisis, suggesting that these ratings were wrong and therefore not a useful guide to investors.  Over the last two years, financial regulators have had their plates full preventing a 1930s-style banking collapse.  As a result, though they would like to kick the rating agencies in the pants to shake out the mediocrity, they haven’t had the time.  Are credit ratings useful? 

Yes and no.  Sometimes rating agency analytical reports are good, comparatively unbiased guides to the safety of bonds from sovereign governments and corporations, especially relative to investment bank reports.  However, the ratings themselves are sticky and often follow changes in creditworthiness (sudden ones anyway) rather than lead them.  Rating agencies don’t want to stick their necks out.  Conflicts of interest (agencies are paid by the bond issuers) are not to be dismissed, though somehow there is a more arms-length analytical relationship between bond issuers and the agencies than between the same and the investment banks, who fall over themselves to extol the virtues of clients that issue debt or equity.

Furthermore, sometimes a bond issuer’s profile is so tied to the price of a commodity (say, oil) that an investor is better off tracking the commodity price than bothering with ratings.  This is the case with “Rising Power” Russia.  Russia’s economy has long been dominated by energy exports.  Little has been done to diversify the economy in the way that its BRIC peers — China, Brazil and India — are diversified.  Energy prices rise and Russia’s ratings improve, and vice versa.  Yet the agencies go to great lengths to spell out the details of Russia’s credit profile in their reports.  As I said, sometimes the reports are good, especially for an econ nerd; but, the rating actions themselves – the reason agencies are paid so handsomely — can be of little use.

With oil prices rising rapidly over the last decade, Russia’s sovereign ratings rocketed from near-default levels (CCC) in 2000 to investment grade levels (BBB) today.  The ratings peaked at BBB+ from 2006 to 2008, when the price of a barrel of oil topped out at around $140 before collapsing to near $50 during the dog days of the global economic crisis in the fall of 2008.  That’s coincidentally when Fitch put Russia’s ratings on a Negative Outlook, before lowering the ratings to BBB in February 2009.  Since then, oil prices have clawed back to around $75 per barrel, and Fitch has again moved the Rating Outlook, first to Stable and then today to Positive.  This is all well and good, but the oil price was nearly as useful a guide as the ratings over this time frame, just as it was in 1998 when Russia defaulted on its bonds amid oil prices in the neighborhood of $10 a barrel.  Yes, the rating reports are informative, but if the agencies are to be more useful to investors (and society), they should try harder to predict financial developments and have their ratings lead, rather than follow, these developments.  And, they should show some skill at this before the regulators get around to kicking them in the pants.   

FROM FITCH RATINGS TODAY:

  Fitch Affirms Russia at ‘BBB’; Revises Outlook to Positive   
08 Sep 2010 8:04 AM (EDT)

Fitch Ratings-London-08 September 2010: Fitch Ratings has today affirmed Russia’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘BBB’. The Outlooks for the Long-term IDRs have been revised to Positive from Stable. At the same time, Fitch has affirmed Russia’s Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB+’.

“The Russian economy is recovering after being hit hard by the global financial crisis. The outlook revision to positive reflects Fitch’s belief that the decline in inflation, shift to a more flexible exchange rate policy, sizeable repayments of private sector external debt, stabilisation of the banking sector and rising foreign exchange reserves should serve to reduce the country’s financial vulnerabilities,” says Ed Parker, Head of Emerging Europe in Fitch’s Sovereigns team.

Real GDP grew by 5.2% year-on-year in Q210, having contracted by 7.9% in 2009. Fitch forecasts growth of 4.3% in 2010 GDP and 4% in 2011 and 2012 – broadly in line with estimated potential. Recovery appears to be fairly balanced, and is supported by the rebound in oil prices, rising real incomes and stabilisation of financial confidence and capital flows.

The private sector has strengthened its balance sheets, where vulnerabilities had built up in the boom years. It repaid a net USD80bn in external debt in the two years to June 2010, including USD51bn of short-term debt, reducing its refinancing requirements and foreign currency exposures. Banks are liquid and have high reported capital ratios of around 19%. Asset quality appears to have stabilised, though Fitch estimates total problem loans at about 25% (including restructured loans at extended maturities and off-balance sheet exposures). A sizeable current account surplus, which Fitch forecasts at 4.6% of GDP in 2010, is helping Russia to rebuild its foreign exchange (FX) reserves, which have risen by USD92bn from their low in Q109 to USD476bn – the third-highest in the world – providing a formidable buffer against shocks. Russia is a large sovereign and overall net external creditor, the latter equivalent to 24% of GDP at end-2009, compared with a net debtor position for the ‘BBB’ range median.   

Inflation has declined to 6.1% in August, from double-digit rates 12 months previously. The Central Bank of Russia has shifted to a more flexible exchange rate and independent monetary policy regime, with positive real interest rates, which has the potential to help reduce inflation, dollarization and the risk of financial instability. However, the Central Bank of Russia has yet to build up a track record in this area.

Russia’s public finances have deteriorated over the past two years, though remain a rating strength. Fitch forecasts the budget deficit at 4.7% of GDP in 2010. Moreover, the budget balances at an oil price of around USD100pb, highlighting its vulnerability to a severe and sustained oil shock. However, general government debt is low, at only 10% of GDP at end-2009, compared with the 10-year ‘BBB’ range median of 35%. Moreover, the government has USD127bn (9% of GDP) in its sovereign wealth funds (1 September 2010), providing substantial financing flexibility, as demonstrated in 2009.

Weaknesses that weigh on Russia’s sovereign rating include its poor governance, institutions and corruption; a weak business climate that constrains investment, diversification and growth; exposure to commodity prices (and therefore the global economy); and a history of high and relatively volatile inflation.

In terms of potential triggers for future rating actions, a tightening of fiscal policy that significantly reduces Russia’s non-oil and gas budget deficit and its vulnerability to oil price shocks could lead to an upgrade. Material structural reforms that improve the business climate, banking sector and governance could also lead to an upgrade. A longer track record of implementing a more flexible exchange rate policy and anchoring inflation at the mid-single digit rate could put upward pressure on the ratings; as could a material strengthening in the external balance sheet. Conversely, a severe and sustained drop in oil prices could lead to negative rating action.

China: Growth slowing

July 15, 2010
China: the government tries to manage the economy.  Source:  Google Images China: the government tries to manage the economy. Source: Google Images

Shallow piece in the NYTimes today on a modest slowdown in economic growth reported in China for the second quarter, prettily written by non-economists.  For a better analysis, not so elegantly written, have a look at the CSFB note from today (below) that explains that growth has slowed due to slackening investment (in Chinese terms — down from a strong expansion of 3% per month in April and May to 1.4% month/month in June) and to downturns in the property and stock markets.  CSFB sees this modest slowdown as exactly what the Chinese authorities are looking for to keep inflation in check and as giving no indication that monetary policy will be tightened much further from its current setting.  CSFB notes that consumer demand and, notably, exports remain quite robust in China.  

What should be underscored about China is that the state still calls a lot of the shots in that economy, much more so than in Western economies (well, okay, there is always France).  The central government directs banks to lend and regulates credit to local governments, which impacts investment, including real estate and infrastructure.  So, in addition to the traditional levers of fiscal and monetary policies which we’re familiar with in the West, the Chinese government has more heavy-handed policy tools (although in the wake of the financial bailouts in the West, we shall see how interventionist the state becomes). 

Also worth understanding is that while China now plays a major role in the world economy, it cannot alone drive the world out of its doldrums.  Whether or not there is a double-dip recession, and odds are there may well be in some countries, will be determined in the massive economies of the US, Europe and Japan, still reeling from the financial shocks and consequent poor public debt dynamics of the last few years. 

From CSFB today:

China
Dong Tao
+852 2101 7469
dong.tao@credit-suisse.com
The economy expanded by 10.3% yoy in Q210, less than the market consensus of 10.5%. While the headline growth figure seems acceptable, we estimate that annualized quarter-on-quarter growth dropped to about 1.9%, from 2.7% in Q110. A large part of the growth deceleration came from inventory corrections and a slowdown in fixed asset investment. Based on our calculations, total fixed investment growth moderated to about 9% qoq (sa) in 2Q from about 13.4% in 1Q. However, the growth momentum was supported by robust consumption and rebounding exports. Meanwhile, inflationary pressure has eased.
Retail sales grew by 18.3% yoy, versus 18.6% yoy in May. Sales have remained very solid despite the anecdotal evidence of slowing auto and home appliance sales. We think it is the consumers from smaller cities and rural areas, who are less exposed to the property and stock market downturns, who have delivered. The resilience in private consumption continues to be the pillar of our argument that economic growth will moderate but not collapse in H210 and that Beijing is in no hurry to ease.
Fixed asset investment grew 24.5% yoy in June, versus 25.6% in May, and, on our calculations, fixed investment growth moderated to 1.4% mom (sa) in June from over 3% in the previous two months. In view of tightened credit conditions faced by local governments, we expected infrastructure investment to decelerate further, although remaining large in absolute terms. Housing construction activities seem to have held up well for now, but we anticipate a sharp slowdown in H210 if transaction volumes do not pick up quickly. The slowdown in fixed asset investment will be the key determinant for growth over the next 12 months, in our view.
Industrial production growth saw a sharp fall to 13.7% yoy in June, from 16.5% in May and 18.6% during the first five months. On a seasonally adjusted month-on-month basis, we estimate that industrial production declined by 0.8%, the first decline since November 2008 (excluding the Chinese new year period). This is consistent with the decline in power consumption growth in June and the suspensions of production in the steel and auto sectors. We believe inventory corrections will continue for at least a few more months, based on our discussions with manufacturers, who are concerned about the property sector and a global “double-dip”. Government policies, such as suspending export tax rebates and promoting energy-saving measures, and its supportive stance towards labour compensation, may also play a role. The floods along the Yangtze River are likely to cause production problems as well.
CPI inflation softened to 2.9% in June from 3.1% in the previous month. Inflation softened by 0.6% on a month-on-month basis. This occurred despite bad weather conditions. In view of the slowdown in economic activity in H210, we expect a further small easing in production costs. However, surging wage rates and rising food prices may prove to be stubborn. Food prices have started to rise again in July, as reduced production of summer crops has been confirmed. More importantly, ‘hot money’ is competing with the state purchasing agent in purchasing grain from farmers. A crucial factor that pulled headline inflation down was falling pork prices. However, that trend has reversed and pork prices have edged up over the past 2-3 weeks. The consequences of “foot and mouth disease” and surging feed costs are starting to become evident, and we expect a significant rise in pork prices in H210. Pork counts about 8% of China’s CPI basket. We are revising down our year-average CPI forecast for 2010 to 3% from 3.7%, based on a weaker outlook for growth and falling production costs. However, we set our year-end inflation target at 3.3% to reflect the inflationary pressure from food and services (through wage hikes). We now expect one 27bps interest rate hike in both the one-year lending and deposit rates by the end of this year, and two more hikes in 2011.
While growth momentum may have fallen ‘one notch’, we believe demand for commodities may have gone down ‘two notches’. However, we still think that economic growth is unlikely to collapse in the way it did in 4Q08, as consumption remains solid and liquidity remains ample. Other than for CPI and the interest rate outlook, we are not changing any of our forecasts.
We believe that this set of data will not result in much in terms of policy changes. The moderation in growth is exactly what Beijing has aimed at, in our view, and the pace of softening seems to be acceptable (the government focuses on the year-on-year growth number). The government has already entered a ‘pause’ phase in its tightening strategy, and we do not expect much in the way of new tightening measures. Neither do we expect the policy gear to be shifted to easing mode, at least in Q310. The central bank has resumed the net draining of liquidity in its open market operations this week after the listing of a major commercial bank, and the authorities have reiterated their determination to squeeze the ‘bubble’ in the property market.

India’s infrastructure bottlenecks

June 16, 2010

An excellent New York Times article yesterday discussed how democratic politics and bureaucracy in India prevent the elimination of infrastructure bottlenecks, especially in transportation.  The article focused on India’s railway system, where freight rates are expensive, travel times excessive, and traffic volumes inadequate to the task of fostering strong economic growth…of the pace we see in China.

It is an interesting comparison — China vs. India, one which would require more time and space to adequately address than this blog can provide.  For the moment, I will raise the long-standing dichotomy between two development models — the authoritarian and the democratic.  In Latin America, analysts have often underscored the success of the Pinochet model in Chile, whereby a brutal authoritarian regime from 1973-90 swept away roadblocks and bottlenecks caused by democratic politics, unleashing that country’s growth potential and allowing it to develop more rapidly than many of its historically more democratic neighbors.  Moreover, with a sound economy in place, Chile was able to make the transition to a functioning democracy with two relatively cohesive coalitions of the right and left.  Yet there was a cost in terms of social cleavages, human rights abuses, and at times political stability.  Throwing people out of helicopters is not civilization.

General Augusto Pinochet and friends, the junta that ruled Chile from 1973-90.  Source:  http://acalzonquitao.files.wordpress.com/2008/09/_pinochet_junta.jpg
General Augusto Pinochet (seated) and friends, the junta that ruled Chile from 1973-90. Source: http://acalzonquitao.files.wordpress.com/2008/09/_pinochet_junta.jpg

Arguably, Russia and China have followed the Pinochet model, Russia after the economic disaster created under failed democrat Boris Yeltsin.  China has done quite well with this model, but nervous Chinese leaders understand that unrest, if not social upheaval, is always a possibility in China if the political monopoly fails to consistently deliver the economic goods.  India labors under a vibrant, if at times inefficient and somewhat corrupt, democracy.  Nevertheless, Indians know that if a government fails to deliver economic growth, they can “throw the rascals out” at the next election.  This introduces a measure of political stability into the system, which is often lacking in authoritarian regimes.  And, given India’s enormous ethnic and religious cleavages, it is perhaps this vibrant democracy that prevents the country from tearing itself apart.  Slow trains and slow growth — the price Indians pay for stability (and decency)?

Image above:  General Augusto Pinochet (seated) and friends, the military junta that ruled Chile from 1973-90.  Source: http://acalzonquitao.files.wordpress.com/2008/09/_pinochet_junta.jpg

Couples therapy: China and the U.S.

June 16, 2010
Nixon & Mao: Mutual dependence goes back a long way.   Source: www.china-profile.com
Nixon & Mao: Mutual dependence goes back a long way. Source: http://www.china-profile.com

I have long said in my China posts that China does not have a lot of options right now besides buying US treasuries.  The AP article below describes how China has increased its purchases of US debt in recent months.  If you are going to hold your currency undervalued in order to run massive current account surpluses and amass fx reserves — because you were spooked by how the likes of Korea, Indonesia and Thailand were brought to their knees with low fx reserves in the 1998 Asian Crisis — then you will have to invest your massive fx reserves somewhere.  The dollar is a logical choice because of trade, deep US markets and the dollar’s reserve currency status. 

Since the beginning of the Great Recession of 2008-09, many observers warned that Chinese fx reserves could be shifted suddenly to other currencies, perhaps the euro and the yen.  Even before the sovereign debt crisis in Europe unfolded earlier this year, I suggested that euro assets did not look so great — given the slow-growth, sclerotic economies in the euro zone.  The same goes for yen assets, given that Japan has barely grown in the last twenty years.   Other emerging market economies (Brazil, India) are growing smartly, but they have small asset markets, compared to the depth and variety of markets in developed countries.  Ben Bernanke used to argue before the Great Recession that capital floods the US market and causes, rather than finances, US current account deficits.  This is because the return on US assets — driven by robust US output growth — is better here than elsewhere.  Now, with the euro crisis in full swing and Japan still stagnant, his argument has some appeal again.  It is still specious because it gets US households with their abysmal savings record off the hook, and it gets Bush and his irresponsible tax cuts off the hook as well.  The latter got Bernanke appointed to the Fed, so was all in a day’s work.

Is there a problem with all this foreign investment in US assets?  Yes.  The US must reduce its imbalances with the rest of the world in order to avoid the financial havoc that a massive dumping of dollar assets in the future could wreak.  We’re okay now because dollar holders have few options and the rest of the world looks a bit dodgy.  But foreign holdings are large.  Foreign holdings of US treasuries represent 28% of US GDP, with China holding 23% of this and Japan coming in second with 20%.  The US government is in hock to East Asia.  

Another nettlesome problem of this foreign appetite for the relative safety of US treasuries is that it keeps interest rates low in America, putting less pressure on Barack Obama & Co. to come up with a medium-term fiscal consolidation plan.  They’re still talking about another fiscal stimulus.  US government debt is set to rise above 90% of GDP next year and deficits will hover near 10% this year and next.  Government debt is often measured relative to GDP, but a better measure is debt relative to government revenues; this is because governments after all must service debt with revenues.  US government debt to revenues last year was 300%, higher than just about any other investment grade country in the world, with the notable exceptions of Japan and India.  (Debt by this measure was likewise higher than in such euro-crisis countries as Greece and Italy.)  So, the US has a fiscal migraine, while the Obama administration fiddles.  The Economist last week said this about Obama: “…he has done little to fix the deficit, shown a zeal for big government and all too often given the impression that capitalism is something unpleasant he found on the sole of his sneaker.”  Scrape that off your sneaker, tell OMB Director Peter Orszag to zip up his pants, and get to work!

And let’s be glad the Chinese are still buying, but not get too cozy in the knowledge of the same…

Image above: Nixon and Mao: Mutual dependence goes back a long way.  Source:  http://www.china-profile.com

From AP:

China and other countries buy US Treasury debt

China boosts holdings of US Treasury debt by $5 billion, second consecutive monthly gain

ap

Martin Crutsinger, AP Economics Writer, On Tuesday June 15, 2010, 11:38 am EDT

WASHINGTON (AP) — China boosted its holdings of U.S. Treasury debt in April for the second straight month as total foreign holdings of U.S. government debt increased.

China’s holdings of U.S. Treasury securities rose by $5 billion to $900.2 billion in April, the Treasury Department said Tuesday. Total foreign holdings rose by $72.8 billion to $3.96 trillion.

The sizable gains are being driven by fears that Greece and other European governments could default on their debt. Worries over possible defaults have sparked a flight to safety and that has benefited U.S. Treasury securities. Treasurys are considered the world’s safest investment — the U.S. government has never defaulted on its debt.

The April increases eased concerns that lagging foreign demand will force the U.S. government to pay higher interest rates to finance its debt with private economists forecasting strong gains in May as well because of the debt crisis.

“We will state the obvious that flight to safety will most likely continue to favor the United States in the second quarter,” said Win Thin, senior currency strategist at Brown Brothers Harriman & Co. in New York. “Given that the European crisis intensified in May, we would expert further large-scale inflows.”

Gregory Daco, U.S. economist at IHS Global Insight, said that demand for U.S. debt was also being helped by the fact that the profit outlook for many U.S. companies is bright and the U.S. economy is forecast to grow at a stronger pace this year than Europe.

China is the largest foreign holder of Treasury securities. The monthly gains in March and April came after six consecutive months when China was either reducing its U.S. holdings or keeping them constant. The stretch raised concerns that China might shift money away from Treasury securities.

The 1.9 percent rise in total holdings of U.S. debt in April followed an even bigger 3.5 percent increase in March.

The Treasury reported that net purchases of long-term securities, covering U.S. government debt and the debt of U.S. companies, increased by $83 billion in April. That follows a record monthly gain of $140.5 billion in March.

The higher interest in U.S. bonds has helped push interest rates lower. It’s a welcome development for the government, which faces the task of financing record federal budget deficits. The federal deficit hit an all-time high of $1.4 trillion last year. It is expected to remain above $1 trillion this year and in 2011 as well.

Japan, the No. 2 foreign holder of Treasury securities, also increased its holdings in April. It boosted them by $10.6 billion to $795.5 billion.

Other countries registering gains in their holdings in April were the United Kingdom and various oil exporting nations.

India: Solid GDP growth, weak finances

June 14, 2010
India's fractious politics keeps government debt high.  Source: Google Images
India’s fractious politics keeps government debt high. Source: Google Images

In an earlier post, I discussed  a theory I developed that democratic countries with divided, often coalition, governments generally produce weaker public finances than countries where two dominant parties alternate in power.  India is the posterchild for the former, with government debt at about 80% of GDP, very high for an emerging market economy.  In order to keep weak coalitions together, governments must buy off constituencies, at the expense of sound public finances.  We shall see if India’s current government led by the Congress Party can deliver on promises to reduce the government debt burden.

India’s weak fiscal position (with government deficits at around 6% of GDP)  have constrained its credit ratings to low investment grade.  Below find a press release issued today by Fitch in which the rating agency adjusts the rating outlook on India’s sovereign bonds to stable from negative, not due to improved management of government finances, but to stronger GDP growth prospects.  The one-off positive impact on government accounts of recent telecoms auctions also helped sovereign creditworthiness.

CSFB published a note today (also below) explaining how output growth is starting to bump up against capacity constraints.  Fitch forecasts output growth at a healthy 8.5%, though the Reserve Bank of India might tighten monetary policy, keeping the expansion in check.  This is because of another important characteristic of Indian political economy — political sensitivity to inflation.  India is a populous country with high levels of poverty, so when inflation creeps up even a point or two, especially for food prices, people starve (or at least become more malnourished).  In a place as big as India, this can mean millions more malnourished people.  Complicated policy making…

From Fitch Ratings:

Fitch Revises India’s Local Currency Outlook To Stable; Affirms at ‘BBB-‘   
14 Jun 2010 5:33 AM (EDT)


Fitch Ratings-Mumbai/Hong Kong/Singapore-14 June 2010: Fitch Ratings has today revised the Outlook on India’s Long-term local currency Issuer Default Rating (IDR) to Stable from Negative. At the same time, the agency affirmed India’s Long-term foreign and local currency IDRs at ‘BBB-‘. The Outlook on the foreign currency IDR remains at Stable. Fitch has also affirmed the Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB-‘.

“India’s strong growth prospects and the one-off positive impact from the telecoms auctions underpin Fitch’s forecast that government debt to GDP ratio will decline, easing the near-term pressure on India’s local currency ratings. However, public finances remain a clear weakness, and downward pressure on the ratings could resume if India veers too far off the deficit reduction path as outlined by the Thirteenth Finance Commission,” said Andrew Colquhoun, Director in Fitch’s Asia-Pacific Sovereigns Group.

Fitch projects general government debt to fall to 80% of GDP by end-March 2011 (end-FY11) from 83% at end-FY10, reflecting the impact of strong GDP growth on the denominator and the one-off revenues from the 3G licence and broadband spectrum auctions. The agency has revised India’s FY11 growth forecast up to 8.5% from 7% on signs of strong growth momentum, including industrial production growth of 17.6% in April 2010, year-on-year. The telecom licence auctions together netted the government INR1,060bn, representing about 1.6% of projected FY11 GDP, as against the INR350bn budgeted originally (Fitch’s February review of India took the cautious approach of assuming zero auction revenues). The agency anticipates some pressure on the government to spend some of the revenue windfall and estimates an additional 0.3pp spending in FY11, still delivering a net 1.3pp fiscal saving.

However, fiscal management remains relatively weak. Fitch anticipates that the central government’s deficit on the government basis (including privatisation and auction receipts as revenue and excluding some off-budget items) to be at 5.7% of GDP in FY11, just 1pp down from FY10, despite the 1.6% of GDP reaped from the telecom auction. The report of the Thirteenth Finance Commission (TFC) in February laid out a path of deficit reduction towards a “golden rule” of borrowing only to finance investment by FY15. India’s track record on sticking with medium-term fiscal plans is not good, although the Congress-led government has at least voiced its commitment to debt reduction. If the authorities stray too far from the TFC’s consolidation path and debt ratios resume rising, it could impact the ratings negatively.

A significant drop in the country’s growth momentum to below Fitch’s projections would worsen India’s debt dynamics and put downward pressure on its ratings. However, India’s credit profile continues to benefit from the largely local-currency profile of its debt (95% of the stock), and from the sovereign’s stable access to domestic-currency financing, mainly from the banking system. Signs that India’s banking system was under stress would likely be negative for the sovereign ratings, although this is not the agency’s base case. Inflation remains uncomfortably high, with wholesale prices up 10.2% in the year to May, prompting the central bank to hike rates twice in response so far in 2010. An intensified inflation shock that is severe enough to disrupt macroeconomic and/or financial stability would be negative for India’s ratings.

India’s strong external finances, including its sovereign and overall net creditor status and official reserves of USD271bn by June 4 2010 (up 3.6% on a year earlier), continue to support its foreign currency ratings. By contrast, poor physical infrastructure, underdevelopment reflected in low average incomes, and weak governance indicators relative to rated peers constrains the ratings.

Contacts: Andrew Colquhoun, Hong Kong, Tel: +852 2263 9938; Vincent Ho: +852 2263 9921.

From CSFB today:

India
Devika Mehndiratta
+65 6212 3483
devika.mehndiratta@credit-suisse.com
April IP surprised on the upside, with the index rising 17.6% yoy compared with our and consensus estimates of 14.3%. In seasonally adjusted level terms, the IP index had been flat in recent months – after strong gains from June to December 2009, IP was flat in January and February and then declined in March (Exhibit 6). In April, the IP index increased by a notable 3.4% mom.
The large upward surprise in April IP was not that broad-based, however. It was dominated by a 33% mom jump in the capital goods sub-index. This sub-index has been volatile recently (Exhibit 7). It jumped over 30% in December/January, fell back in February/March and was up again by 33% mom in April. A breakdown by product for capital goods is not available for April yet, but data until March showed that these large ups and downs were limited to only a few goods such as computers, ship building & repair, railway wagons, and oil wells/platforms.
Capacity constraints could become an issue. Even if we assume that the broad trend in capital goods (even though volatile) indicates that corporate investment activity is picking up, it is possible that, in the months ahead, capacity constraints start to show up. Anecdotal evidence suggests that industries such as autos, fast moving consumer goods, steel and power are operating near full capacity (the power sector has been capacity constrained for years). This could slow the pace of month-on-month rises (from around 3% pace in April) in industrial production going ahead.
Could the RBI now hike policy rates inter-meeting before the scheduled July meeting? An inter-meeting hike is not entirely inconceivable, but we would still maintain that it is unlikely. This is because: 1) the RBI has indicated ‘cautiousness’ in its policy stance in recent comments, and 2) monetary conditions have anyway tightened in recent weeks triggered by the large one-off 3G auction-related borrowings by telcos. The short-term call rate has consequently moved up from the reverse repo rate (3.75%) to the repo rate (5.25%) without the RBI having taken any policy tightening action since April.

Is there a Yuan bloc in Asia?

June 8, 2010
Asian currencies tracking China's yuan?  Source:  Google Images
Asian currencies tracking China’s yuan? Source: Google Images

Interesting Economist article (below) discussing whether other Asian currencies — the Korean won, Thai Baht, Singapore dollar, Malaysian Ringgit, New Taiwan dollar, Vietnamese dong, Indian rupee, Indonesian rupiah — track the Chinese yuan in order to maintain competitiveness in US markets relative to China as well as access to the Chinese market.  There have been a number of econometric studies on the matter.  The bottom line is that many Asian currencies, like the Chinese yuan, track the US dollar closely — some call it Bretton Woods II — though the correlation has declined since the economic crisis, as the US economy and US monetary policy have been going through anomalous conditions.  Tying strictly to the US dollar right now might mean some unwanted inflation in accelerating Asian economies.  Still, China’s currency remains essentially fixed to the dollar.  Ultimately, a revaluation of the Chinese yuan, and its Asian brethren, is needed to address the current account imbalances that persist and threaten global economic stability.  The euro crisis has, however, thrown a wrench into that adjustment, leading to some safe haven capital flows into the US dollar, just when the greenback needs to decline in an orderly fashion.

 From the Economist on-line:

 Asian currencies

Chips off the block

Currencies around Asia are more flexible than you think

Jun 3rd 2010 | HONG KONG | From The Economist print edition

AMID all the diplomatic ding-dong over China’s yuan, it is easy to lose sight of emerging Asia’s other currencies. There is not much din over the dong, for example. While China has kept the yuan pegged to the dollar since July 2008, ignoring complaints that it is artificially cheap, Vietnam’s currency, the dong, has depreciated by 13% against the greenback over the same period, unremarked and unprotested. South Korea and Taiwan, the only countries besides China ever to be labelled currency manipulators by America’s Treasury, have seen their currencies cheapen by 17% and 6% respectively.

China’s critics justify their preoccupation by invoking a “yuan block”. China’s neighbours and rivals are reluctant to allow their currencies to rise too far against the yuan, for fear of losing China as a customer, or losing out to it as a competitor. Thus although China accounts for only 19% of America’s imports, its peg, it is argued, frustrates a broader realignment of currencies in the region.

Does such a yuan block exist? For over a decade before July 2005, it was impossible to say. Since the yuan did not move independently of the dollar, it was hard to know if China’s neighbours were in thrall to its currency or America’s. But for the following three years, China allowed the yuan to crawl slowly upwards against the dollar. A 2007 study by Chang Shu, Nathan Chow and Jun-Yu Chan at the Hong Kong Monetary Authority took advantage of this interlude to measure the influence of China’s yuan on other regional currencies.

Using a method popularised by Jeffrey Frankel of Harvard University and Shang-Jin Wei of Columbia, they looked at the fluctuations of Asian currencies against the Swiss franc. Insofar as the Thai baht and the dollar mirrored each other’s moves against the Swiss currency, the authors could conclude that the baht was under the dollar’s spell. But if the baht and the yuan strengthened against the franc when the dollar did not, they could identify the separate pull of China’s currency.

That pull was strongest on the Korean won, Thai baht, New Taiwan dollar and Singapore dollar. But it also seemed to reach as far as the Indonesian rupiah and even the Indian rupee. The economists’ results suggested that if the yuan were to appreciate by 1%, independently of the greenback, the Singapore dollar, New Taiwan dollar and the Thai baht would rise by 0.58%-0.68% in sympathy. The Korean won would strengthen one for one.

Since July 2008 the yuan has not moved an inch against the dollar. Does that mean that other members of the yuan block have also stood still? Hardly. Malaysia untethered its currency from the dollar one day after China in July 2005. But unlike China it did not retether it during the crisis. The ringgit fell by 15% from April 2008 to March 2009, before regaining much of that ground over the next 14 months. The won’s wobbles have been even greater. It lost 40% of its value from February 2008 to March 2009, and remains 25% below its pre-crisis peak.

Most of emerging Asia’s currencies strengthened against the dollar this spring. The ringgit rose by 8% from February to May, after Malaysia’s independent-minded central bank raised interest rates in March and again on May 10th. In April Singapore’s Monetary Authority said it would allow a “gradual and modest” appreciation of its currency. But since the debt crisis in Greece unnerved investors, these currencies have mostly lost value again.

This block isn’t scared any more

The flexibility shown by Asia’s currencies is noteworthy, even if most of their flexing has been downwards. Economists used to accuse the region of a “fear of floating”. In 2003 Michael Dooley of the University of California, Santa Cruz, with David Folkerts-Landau and Peter Garber of Deutsche Bank argued that a de facto dollar standard prevailed in much of the region, akin to the “Bretton Woods” regime of fixed dollar parities that emerged after the second world war. But a paper published on May 19th by Ila Patnaik and her colleagues at the National Institute of Public Finance and Policy in Delhi documents a gradual thinning out of the Bretton Woods II regime.

They use a similar method to Messrs Frankel and Wei to show how closely Asia’s currencies track the dollar, euro, yen and pound. They give each country a Bretton Woods II score, based on the rigidity of its currency, especially relative to the dollar. In 2003 the average score in Asia was about 0.85 (a score of one represents a hard peg to the dollar). But the score has since dropped steadily to 0.75.

The new flexibility should stand Asia’s economies in good stead. Their ties to the dollar once guaranteed stable prices at home, as well as competitive exports abroad. But America’s monetary policy, suited to an economy with flat prices and high unemployment, is too loose for a region now growing so rapidly. As Asia’s recovery outstrips America’s, the region’s central banks will have to raise interest rates, as Malaysia, Vietnam and India have already done. Their currencies will appreciate as a result.

This appreciation will be easier to stomach if the yuan also strengthens. But China’s neighbours should not wait for this to happen. Even members of the so-called yuan block should not let the yuan block their progress.