Monthly Archives: July 2011

Brazil: Bubble, bubble, toil and trouble?

Posted on by emmuser
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The debate rages on… Is Brazil is in a credit bubble? And if so, how worried should we be?

The FT’s Beyond Brics blog provides a range of views on the subject (see here, here and here), and I’m now jumping into the fray.

There is no doubt that Brazil’s economy is hot, as evidenced by hard data and anecdotal evidence. There is now a 3-month waiting list for imported luxury cars. Meanwhile, spend-happy Brazilians are heading abroad in droves, splashing out $16.4bn on overseas trips in 2010, a more than 50% jump from 2009.

Almost all analysts agree that consumers cannot keep spending at the same breakneck pace indefinitely. Household indebtedness is on the rise, and economic growth is bound to lose some steam. Nevertheless, I see no crisis on the horizon.

Fast credit growth is a common feature in recent banking crises, but not all credit booms end in tears. In fact, most don’t and Brazil falls into this majority. The country’s banking sector has strong capital buffers and should easily withstand the upswing in bad loans typically associated with fast credit growth. Financial stability is not in danger.

Putting Brazil’s Credit Growth in Context

First, let’s take a look at how fast credit is really growing. As seen in Figure 1 below, annual credit growth is brisk, at 20% on a nominal basis and 13% on an inflation-adjusted basis in May, but this is not a particularly new trend. Prior to the global financial crisis, credit was growing at a faster pace.

Figure 1: Real credit growth is now slower than in 2007-08 on an annual basis

Source: BCB, IBGE, my calculations

So what’s the worry? Well, some observers point to the sharp increase in credit-to-GDP, from less than 26% at the beginning of 2005 to almost 47% in June 2011, to illustrate the strong credit expansion. This shows that considerable financial deepening has occurred in recent years, which is not necessarily a bad thing. In fact, financial deepening tends to positively affect growth.

As seen in Figure 2 below, Brazil has relatively limited credit penetration.  The country’s low gross loans-to-GDP ratio provides a structural justification for the country’s fast credit growth, as it helps credit penetration in Brazil catch up with levels elsewhere.

Figure 2: Credit-to-GDP ratios in comparison           

 

Source: Fitch Ratings

Even though I am often wary of ratings agencies, I agree with Moody’s recent assessment of Brazil. The agency notes the country’s low credit-to-GDP ratio and says that “even if a bubble-like event were to materialize, its impact on the government’s balance sheet is not likely to be substantial.”

Nevertheless, if financial deepening occurs too quickly, it can result in a sharp increase in bad loans and jeopardise financial stability. The IMF expressed this concern in June: “Brazil is recovering strongly from the crisis. But new financial stability challenges are emerging in this, and other fast-growing regions.”

So let’s take a look at the banking system’s health.

State of the Banking System

Rapid double-digit credit growth cannot continue indefinitely and authorities need to continue to be vigilant about loan quality. Household debt burdens are on the rise, as are non-performing loans. Nevertheless, financial stability is not in danger as I detail below.

Figure 3: Bad loans have not risen significantly so far

*Amount of credit in arrears/total credit (90 days)
Source: SPC Brasil

Loans in default remain below their historical highs, as seen in Figure 3, and reforms to bankruptcy law in recent years has improved banks’ debt recovery prospects.

Moreover, Brazilian banks have strong capital cushions, as seen in Figure 4. Capital adequacy is well above the minimum required, enabling Brazilian banks to absorb even large loan losses.  According to the latest financial stability report from April 2011, even in an extreme scenario where bad loans rise to 10% (as a % of total corporate and individual loans), only financial institutions which hold 0.13% of total assets would be insolvent.

Figure 4: Banks have strong capital cushions

 

Source: Fitch Ratings

Analysts at Barclay give more reasons for comfort. As Roberto Attuch and Fabio Zagatti note (via FT), about 60% of consumer loans in Brazil are collateralised – secured against payrolls, cars or property – and are at fixed rates, making them safer.  Moreover, Brazilian banks are not dealing with currency mismatches (eg. borrowers who have taken out foreign currency-denominated loans, but earn in local currency), which threatens financial stability in certain eastern European economies, like Hungary.

The bigger risk to financial stability comes from events abroad, rather than fast domestic credit growth. The eurozone and US are embroiled in debt crises and the knock-on effects to emerging markets remain unclear. Brazil’s high loan-to-deposit ratio of almost 120% is a potential concern.

Brazilian banks are heavily dependent on wholesale funding to finance loans, rather than retail deposits, which tend to be a more stable source of financing.  Wholesale funding dried up during the global financial crisis and if it dries up again, that would severely constrain lending in Brazil and curtail economic growth.

Authorities Have Moved Proactively to Ensure a Soft Landing

The central bank is well aware that credit continues to expand at a fast clip and has taken numerous steps to safeguard financial stability and prevent an abrupt economic adjustment.

  • The central bank has embarked on a tightening cycle, and Brazil’s interest rate is the highest among major emerging markets. The SELIC rate (the benchmark interest rate) now stands at 12.5%.
  • Series of macroprudential measures:
    • In the latest attempt to slow credit growth, the central bank required banks to set aside more capital for credit card loans backed by wages and pensions. (See FT’s Beyond Brics)
    • In April 2011, the government doubled the tax on consumer credit to 3% a year from 1.5%.
    • In December 2010, authorities upped reserve requirements on time deposits held by banks to 20% from 15%.

Overall, Brazil’s central bank has actively used a mix of monetary policy, macroprudential measures and capital controls to prevent economic conditions from getting too bubbly. Despite rapid credit growth, there doesn’t seem to be much cause for concern right now.

Don’t underestimate the inventory effect

Posted on by emmuser
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Global manufacturing is showing signs of a slowdown (both in developed economies and emerging markets), as demonstrated by the latest PMI readings (see here and here). Many analysts appear caught off guard, and some banks have sliced their global growth forecasts. Citi became one of the latest to do so (see here). Analysts are citing a long list of factors – from higher commodity prices to uncertainty caused by the eurozone debt crisis – to explain the slowdown.

Certainly these are factors, but most (analysts at JP Morgan are an exception) are overlooking a key element that should have been predictable – the inventory cycle.

Inventory Cycle: Riding the Rollercoaster

Changes in inventory typically only have a modest impact on GDP growth, but it’s a different story during times of crisis and the immediate aftermath.

Companies slashed production during the downturn and sought to liquidate inventory, aggravating the massive contraction in GDP seen globally in 2008-09. Then, in 2010, changes in inventory provided a major boost to growth. See the figures below demonstrating this rollercoaster effect for the US, UK and Chile.

Figure 1: Changes in inventory contributed almost half of US GDP growth in 2010

Source: BEA

Figure 2: UK GDP would have contracted in 2010 if not for the positive boost from changes in inventory

 

Source: Eurostat

Figure 3: Emerging markets, such as Chile, also experienced inventory swings that dramatically affected GDP growth

 

Source: Banco Central de Chile

*Important Note: Inventory buildup does not automatically translate into GDP growth. For example, the UK experienced an increase in inventory in 2008, but because it was a smaller increase than the previous year, it resulted in a negative contribution to growth as seen in figure 2 above.

Basically, inventory building has to take place at a faster rate than the previous year – or inventory destocking has to happen at a slower pace  – to positively contribute to annual growth. See this post from Calculated Risk for a more detailed explanation.

Fragile Recovery

The temporary growth support from changes in inventory will subside in 2011 as the great rebuilding runs its course. The key question is: will other growth drivers will step in to fill the void?

As seen in the charts above, it’s a large void to fill and the results so far are not promising:

  • Weak Q1 2011 GDP outturns in several major economies
  • Signs of slowing global manufacturing activity.

In the US, economic growth in Q1 2011 disappointed as consumption growth halved from the previous quarter.

International Trade Connection

So far, I’ve focused mostly on developed economies, but what about emerging markets? How are they affected – if at all – by the fact that the positive growth effect from changes in inventory is fading?

  • First, as I show above, inventory effects provided temporary growth support to many economies, including numerous emerging markets, in the wake of the 2008-09 global financial crisis. And, unless more sustainable growth drivers take over, the pace of expansion in these economies will slow.
  • Second, the inventory cycle is intimately connected to world trade trends. As a result, the many export-dependent emerging markets are potentially vulnerable to the fading growth contribution from changes in inventory.

For example, the global liquidation of inventory in 2008-09 went hand-in-hand with a massive contraction in world trade as detailed by Philippe de Rougemont of the Bank of France and Kaboski, Alessandria and Midrigan in a working paper.

To explain this relationship, Kaboski et al. use the US and Japan as an example. “[T]he massive drop in U.S. auto sales together with large inventory holdings led to a sharp contraction in the production of exports for the U.S. in Japan, roughly 2.5  times the drop in sales.”

The lesson is that the inventory correction in the US negatively affected Japan through the trade channel. The same goes for the many export-dependent emerging markets. They remain vulnerable and are going to be adversely affected by any slowdown in world trade that results from rebuilding running its course without other growth drivers filling in.

Are markets mispricing risk in South Eastern Europe?

Posted on by emmuser
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Are financial markets accurately pricing in the risk of contagion from Greece to eastern Europe?

That is the question raised by fellow econ blogger Edward Hugh and by FT Alphaville in recent commentary. It’s a legitimate question since financial markets are not infallible and failed to see the global financial crisis coming.

Risk of contagion from Greece

There is no doubt that South East European (SEE) economies  – Bulgaria, Romania, Serbia – have significant ties to Greece.  Bulgaria looks particularly exposed given its strong trade and investment ties to Greece, as well as the fact that Greek-owned banks hold almost 30% market share in the country, as seen in Figure 1 below.

Figure 1: SEE economies have important direct ties to Greece

Source:  National statistics offices, Deutsche Bank
Note: Data is for most recent year available (2010)

Figure 2: The major Greek banks all operate in South East Europe via subsidiaries

Source: Raiffeisenbank
*Only major banks have been included.
**as of end-2009

Nomura analysts draw out a list of scenarios that detail the potential ramifications of SEE economies’ exposure to Greece. The least bad (and most likely) outcome is that Greek-owned banks cut back on lending in the region, which in turn constrains the ongoing economic recovery. As Nomura argues, this is probably already happening.

In an extreme scenario, SEE governments could be forced to step in and purchase/bailout the local subsidiaries of Greek banks. However, this scenario is unlikely.  As Deutsche Bank notes, banks in the SEE region tend to be very well-capitalised and do not have significant holdings of Greek sovereign debt.

Are CDS spreads out of whack?

The large gap between Greek CDS spreads and those in South East Europe (SEE) looks odd given the significant economic ties detailed in the figures above. CDS spreads on Greek debt have shot up in recent months, while spreads on most SEE sovereign debt have stayed range-bound – mostly around 250bp for Bulgaria and Romania – and are lower than earlier this year.

However, it’s important to go back to what a CDS spread actually reflects. While increasingly used as a barometer of general country risk, credit default swaps (CDS) are basically derivatives used to insure against a default and are better viewed as a proxy for a government’s willingness and ability to make good on its debt payments.

While Bulgaria, Romania and Serbia will certainly experience negative spillover effects from Greek troubles, they’re unlikely to default and that is what CDS spreads reflect – the likelihood of default. When viewed from this perspective, CDS spreads for these countries are not as out-of-whack as they initially appear.

Why are sovereign defaults in these economies unlikely?

  • Public debt levels are extremely low (see chart below)
  • Romania has an IMF program
  • Bulgaria and Serbia have the option of seeking IMF funding if they run into trouble and need to bail out their banks

 Figure 3: Public debt levels in SEE are far lower than in the eurozone periphery

Source: Eurostat, National Bank of Serbia

Hungary is a whole different story and I’ll use another post to explore why markets may be mispricing risk there.

See related links:

Hungary Mortgage Relief: Another Move to Delay the Pain

Posted on by emmuser
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Hungary is back to the same tricks. Just as the government adopted short-term, stopgap measures to delay the pain of a needed structural fiscal adjustment (See: Fitch Raises Hungary’s Ratings Outlook: Odd Timing), the country is going the same route in dealing with households’ high levels of foreign currency borrowing.

The government recently announced a mortgage relief programme that gives borrowers temporary relief at the expense of banks. Unfortunately, it could leave Hungary’s economy worse off over the medium-to-long term as compared to the government simply doing nothing.

Exchange Rate Fix

Hungarian households have engaged heavily in Swiss franc borrowing, particularly for mortgages, and the strong franc is making it hard for them to repay their debt. Over 60% of mortgage loans in Hungary are foreign currency-denominated. One of Prime Minister Viktor Orban’s campaign pledges in 2010 was to help these households.

For mortgage borrowers who opt in (only those not yet in default can do so), the programme fixes the Swiss franc exchange rate at 180 forints. However, as seen in the graph below, the current Swiss franc exchange rate is roughly 220 forints.

Figure 1: The Swiss franc has steadily strengthened against the forint


Source: Oanda

So how will the government pull this off? Well, potentially by making the banks the fall guys.

The difference between the fixed and actual spot exchange rate will accrue in a separate account and borrowers are set to begin repaying the outstanding amount in 2015 at market interest. [UPDATE on SEPTEMBER 8: I initially stated that the banks would assume a temporary loss given the difference between the fixed and actual spot rate. However, this is incorrect since banks won't have to write down any of these loans, at least in the period to 2015. According to currency strategist Win Thin, the account where the difference between the market and fixed exchange rate accrues "remains the obligation of the debtor, but the government backs this with a State Guarantee, for which the creditor banks pay a fee. After the end of 2014, the accrued debt will then have to be paid off by the debtor." The concern is that in 2015, borrowers still won't be able to meet their debt servicing obligations and either the government or the banks or both will take the hit and have to write off the debt.]

Foreclosure moratorium lifted

A ban on foreclosures was imposed in mid-2010. Under the programme, the government will allow banks to start foreclosing on properties of homeowners in default, which initially sounds positive for banks.

However, banks will only be allowed to auction off such properties at a snail’s pace, starting at 2% of properties in default this year and up to 5% by 2014, according to news reports. This means that the lifting of the ban is unlikely to positively influence banks’ balance sheets in a significant way.

National Asset Manager

A new state asset manager will be created to buy the homes of troubled borrowers, who can then stay in their homes as renters. According to a report by the International Law Office, banks will be allowed – or even required – to sell these properties at between 35% and 55% of their original estimated value. The potential negative implications for banks are obvious.

Risky strategy

Hungary’s austerity-averse government seems to find banks an easy target to lean on in an effort to attain fiscal salvation and retain popular support. The mortgage relief programme contains a number of elements that are bad news for banks (as detailed above). This follows parliament slapping an extraordinary, three-year tax (equivalent to 0.5% of assets over Ft50bn) on banks in 2010 to temporarily shore up public finances.

The government’s strategy is risky. The uncertain business environment, caused by the government frequently changing the rules of the game on banks, will make them less likely to lend and could lead them to reevaluate the strength of their presence in Hungary.

Figure 2: Lending growth has remained stagnant so far in 2011

 

Source: National Bank of Hungary

For example, in the wake of the bank tax, Erste Bank CEO Andreas Triechl warned the government: “We’ll have ways of showing that you can’t do everything with us. We have other countries where we can invest more.”

Foreign-owned banks dominate Hungary’s financial system (apart from OTP). While it’s highly unlikely that any banks would pull out, they could opt to scale back their presence and focus more on other countries, which in turn would make it more challenging to get Hungary’s economy back on track.

Bottom Line: Mostly show, Little substance

According to the EBRD, the mortgage relief programme will only marginally help consumption. “[T]he macroeconomic impact is likely to be small (0.2-0.4% of GDP depending on the propensity to consume).” Moreover, the programme could lead banks to further constrain lending, dragging out Hungary’s protracted economic recovery further.

Notably, the government is delaying the day of reckoning (when the exchange rate on foreign currency mortgage loans is due to revert back to the market rate) until 2015, which is after the next parliamentary election scheduled for mid-2014. The timing is a sign that the programme is politically motivated rather than a real effort to get the economy back on track.

Chile: Latin America’s Wunderkind

Posted on by emmuser
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Chile’s finance minister, Felipe Larraín, swung through London this week with a contingent of business people in tow to celebrate ‘Chile Day’ on June 27. The event was aimed at promoting the country as an investment destination. Given Chile’s strong institutions and envy-inducing macroeconomic performance, they certainly have a lot to celebrate. Mr. Larraín stopped by the London School of Economics for a public airing of his marketing pitch and managed to impress your resident blogger.

Why is Chile the economic envy of the region?

Highest sovereign credit rating in Latin America

  • Fitch upgraded Chile’s rating to A+ in February 2011, citing the country’s ‘structural strengths’ and ‘very strong institutional framework.’
  • Moody’s upgraded Chile’s rating to Aa3, the fourth highest investment grade, in June 2010, around the same time that it cut Greece’s rating to junk.
  • Ratings agencies are notoriously behind the curve, but Moody’s move came as a positive surprise in the wake of Chile’s ‘financial resilience’ to the devastating February 2010 earthquake.

First South American member of the OECD

  • Chile became the 31st member of the OECD’s club of advanced economies in January 2010.
  • In welcoming Chile, the organisation noted Chile’s  ‘prudent tax policies’ that gave it the leeway for stimulus measures to weather the global financial crisis as well as the country’s ‘groundbreaking’ pension reforms in the early 1980s.

Solid public finances

  • The country has one of the lowest public debt levels in the world at less than 10% of GDP at the end of 2010. This is a sharp contrast from the lofty levels in most advanced economies.
  • Chile needed $8.4bn in financing for reconstruction efforts after the earthquake. Officials showed an admirable political willingness to raise taxes – something the far-more-indebted US has shown no stomach for – as well as issue debt, rather than tap its sovereign wealth fund.
  • The government issued a global peso bond for the first time in history in July 2010: US$520Mn in 10-years at a yield of 5.5%.
  • Chile has a fiscal rule to help maintain fiscal discipline by insulating public spending from short-term copper price fluctuations and the business cycle. See this recent IMF paper on the rule.

Strong institutions

  • Chile has the strongest institutional quality in Latin America and ranked 28th out of the 139 countries surveyed globally in this category, according to the latest Global Competitiveness Index, due to transparent policymaking and low levels of corruption.

Balanced growth

  • For a small open economy, Chile has surprisingly strong domestic demand. The ratio of consumption (private + government) to GDP in 2010 was 70%, which is in line with that in many advanced economies as well as with bigger emerging markets, such as Turkey.
  • Consumption showed considerable resilience during the global financial crisis. As seen in the graph below, consumption is the only GDP component that has positively contributed to growth every year in the 2007-10 period.

Source: Banco Central de Chile

  • Export-led economies, such as the Czech Republic and Hungary, where export-to-GDP ratios exceed 70% of GDP, are more vulnerable to downturns in world trade and contracted more sharply than Chile during the global financial crisis.

No impending danger of overheating or a sudden stop in capital flows

  • Gross capital inflows are strong, at 16% of GDP in Q1 2011, but are driven by FDI, making the economy less vulnerable to a sudden stop in capital inflows. FDI is generally considered less prone to reversal than foreign inflows into equities and debt securities.
  • Bank lending to the private sector – at around 10% y/y – is growing at a measured pace, much slower than in many other countries in the region (eg. Brazil, Colombia, Peru).

BUT….

Fate is largely tied to China

  • Those who think a hard landing is on the way in China should be wary about Chile.
  • Asked what an abrupt China slowdown would mean for Chile, Mr. Larrain artfully dodged the question and simply said he doesn’t expect such a scenario.
  • China bought about a quarter of Chile’s exports in 2010 and Asia as whole accounts for about half of exports, a higher percentage than in Argentina or Brazil.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

Chile is still copper country

  • The country’s exports are not very diversified and copper continues to dominate, leaving the economy vulnerable to any downturn in global demand for the metal.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

The IMF: An Increasingly European Institution

Posted on by emmuser
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Christine Lagarde, France’s former finance minister, now formally helms the IMF. This was no big surprise (See May blog post: Why Emerging Markets Are Not in the Running for Top IMF Job)

Increasingly, the IMF looks like an institution run by and for Europeans. As seen in the chart below, the vast majority of the IMF’s outstanding loans are to European countries.

Source: IMF