Source: Haver, Timetric

The central bank has opted to keep policy rates unchanged at its four meetings this year. It sees the current level of inflation as transitory, brought about by a politically-motivated delay to utility price hikes. This seems prudent. Timetric forecasts inflation rising to 6.7% by year end, with price pressures emerging in the second half of 2012. Furthermore, the central bank has a strategy of attaining greater monetary stability – specifically it is aiming to bring inflation down to 4-5% in 2014 on a December-on-December basis. This is seen as a pre-requisite to Russian banks attracting long-term capital at lower rates. In order to meet this goal, monetary policy will likely remain hawkish.

That is not to downplay the impact of high lending rates. The housing market is hindered by a lack of demand. The cheapest available mortgage is well above 10% (President Putin has just called for the mortgage rate to exceed inflation by no more than 2.2 percentage points by 2018) and activity in the construction sector has underwhelmed. A recent dip in residential construction was mirrored by a fall in investment. Meanwhile, the economy continues to see capital outflows, despite a seeming moderation of political risks. After a strong Q1 (GDP grew 4.9% year-on-year), falling oil prices – with the price of the Urals blend trading around USD108 on 14 May, down from USD123 at the start of April – will put greater strain on growth.

This will increase the volume of dissenting voices that would like to see a move towards a more accommodating monetary policy. However, the central bank is unlikely to want to risk its reputation of being hard on inflation. Monetary easing may also be viewed as a shallow response to an economy crying out for comprehensive political reforms to attract greater foreign capital.

Yet the new government of Vladimir Putin will be under immediate pressure to deliver on the economy, which could raise political pressure for a loosening of interest rates. The central bank therefore has a tough task: it should remain alert to a possible stalling economy, while not losing sight of its medium-term strategy. We do not expect a shift in monetary stance anytime soon, but a worsening economic outlook could force the central bank’s hand.

However, rather than predicting the probability of growth exceeding 1.1% in a single month, we are interested in the mean of the final nine months of 2012. From a statistical viewpoint, we want to know what the chances are that a sample of nine observations will have a mean of at least 1.1%. This involves dealing with what is known as the sampling distribution of the mean.

According to statistical theory, the sample mean (derived from a normally distributed population) will have the same mean as the population but a standard deviation that is approximately equal to the population’s standard deviation divided by the square root of the sample size. Applying this to our example, this means our sample of nine will have a mean of 0.2% but a standard deviation of 0.63 percentage points (in other words, the mean of the sample will hover closely around 0.2%). As a result, we are able to derive that there is only a 9% probability that the mean of the nine monthly observations will reach or exceed 1.1% (the rate implied in the market consensus for 2012).

Of course, these monthly growth rates are not independent of one another. For example, strong monthly growth rates in industrial production are more likely in the wake of an economic downturn. As the government has implemented measures to support domestic industry this should bias future readings to the right hand side of the distribution. However, we still believe that a scenario in which monthly growth rates of industrial production average at least 1.1% in the final nine months of 2012 (as implied in the market consensus) is very unlikely.

Instead of excessive optimism on the part of the government, perhaps the other forecasts are overly downbeat? This is certainly a possibility, but the facts on the ground suggest otherwise.

First, the Ministry of Finance’s growth forecast for 2011 was wide of the mark. At the beginning of the year, it projected growth of 4.5%, higher than other forecasts at the time and far above the final growth figure of 2.7%.

Second, economic activity in the first two months of the year has proven sluggish. The central bank’s IBC-Br index (a proxy for GDP growth) rose by of 0.9% annually in February, following a 1.4% increase in January. High frequency indicators, such as the HSBC Manufacturing Purchasing Managers’ Index, suggest economic activity remained weak in March and April.

Brazil economic activity from Timetric

To achieve the government’s 4.5% growth target for 2012, economic activity would need to increase by an average of 5.2% annually in the March to December period. This seems highly unlikely. The last time economic activity managed to grow at this pace or faster was in February 2011.

The outlook is not all grim. We foresee growth reviving in the second half of the year on the back of fiscal and monetary stimulus, though not at the pace needed to attain 4.5% annual GDP growth. In April, the government announced a BRL65 bn (USD35 bn) package, which includes tax breaks for certain hard-hit sectors as well as an increase in subsidised loans, to support domestic industry. Meanwhile, the central bank has slashed the policy rate, SELIC, by a total of 350 basis points since August 2011, to 9%. Further rate cuts are likely, which will help invigorate the economy.

Nevertheless, the government’s over-optimism – if it turns into a pattern – bodes ill for Brazil. The Ministry of Finance’s resulting loss of credibility could negatively affect investor confidence. More importantly, the growth forecast is a key macroeconomic input for budget forecasting. By refusing to acknowledge reality and cut its GDP growth forecast, the government is able to avoid revising its fiscal targets downward, thereby sidestepping spending cuts or tax hikes, at least in the short-term.

Brazil’s government is not the only one in the world with rose-coloured glasses. According to a 2011 paper by Jeffrey Frankel titled “Over-Optimism in Official Budget Agencies’ Forecasts,” this is a widespread problem. The systemic bias is part of “governments’ tendency to satisfy fiscal targets by wishful thinking rather than by action.”

A particularly worrying aspect of this latest policy debacle is that it is yet another instance of the government back tracking on a key policy initiative, which again raises serious questions about its policymaking competency. It comes after some other major policy reversals, such as the postponement of plans to open up the retail sector to large foreign players in late 2011, and more recently the rolling back of an unpopular increase in duties on gold jewellery. The government’s credibility has been greatly undermined by these policy flip-flops, as the implication is that it lacks the foresight required to devise sound economic policies and the fortitude to see them through.

Despite this policy “paralysis”, foreign direct investment (FDI) inflows picked up strongly in the 2011/12 fiscal year (April-March), and this will provide the government with a platform to defend its management of the economy. The latest data show that inflows (excluding re-invested earnings) reached USD35.9 bn, up from USD22.3 bn in 2010/11.

Foreign direct investment in India from Timetric

However, we do not think the improvement in FDI last year should be interpreted as a sign of a resurgence in investors’ confidence in India. One reason is that FDI inflows last year were bumped up by some large projects, such as the USD7.2 bn investment by BP in fields operated by Reliance Industries. India’s stock market also continues to underperform those of other large emerging markets. But the jump in FDI does raise the question of whether the government’s failure to deliver sound and effective policies is actually deterring foreign firms from taking a stake in the country’s development.

A recent study by the Reserve Bank of India published in April 2012, entitled Foreign Direct Investment Flows in India, found that actual FDI to India in 2010/11 fell short of its potential level partly because of the “amplification of policy uncertainty”. The objective of the study was to determine why FDI inflows in India fell in 2010/11 whereas in most other emerging markets investment rebounded after the drop in the previous year, when the global financial crisis resulted in a sharp drop in global investment.

Although the conclusions of this study might be different if repeated for 2011/12, there is little doubt that the government’s poor policy performance has greatly unnerved investors in recent months, and the latest pronouncements on delaying the implementation of the GAAR will do little to reassure them. What investors yearn for is clarity and a greater sense of predictability in government policymaking, but that is not what they are getting in India.

Overlay from Timetric

Mining and quarrying provides the Exchequer with approximately 5% of total government receipts. The oil and gas sector with the financial services sector is consistently shown to be the largest tax payer in the UK according to this PWC report. UK oil exports of over 40 million tonnes in 2010 fell to under 35 m tonnes last year.

Overlay from Timetric

Of the three main components in mining and quarrying, extraction of crude petroleum and natural gas is 90% plus, and it is the biggest downward driver with no sign of an end of decline in sight.

Overlay from Timetric

Ageing infrastructure not lack of resource seems to be mainly responsible for recent production loss. Unscheduled maintenance issues, plant outages and previous lack of sufficient investment have hampered production. George Osborne’s 2012 budget has offered tax relief for the decommissioning of plant providing some scope for increased investment in infrastructure. It is forecast that oil and gas production will slowly improve, however it won’t be until 2020 that production will return to pre-2011 levels according to the Oil & Gas UK’s 2012 Activity Survey.

According to the meeting minutes, weak domestic economic activity and a fragile global environment support a benign inflation outlook. But given the lagged effect of interest rate cuts, we believe further monetary easing may backfire and raise inflation expectations in the second half of the year. This could force the central bank to backtrack and raise interest rates in order to keep inflation within its target range of 2.5% to 6.5%.

The central bank had hinted that rate cuts could come to a halt after the March meeting minutes indicated there was “a high chance of a scenario that contemplates the SELIC rate sliding to a level slightly higher than its historical low”. Market watchers had expected a confirmation of this statement in the April minutes.

Instead, the COPOM indicated that “given the cumulative and lagged effects of the policy actions implemented so far, any additional monetary easing moves should be conducted parsimoniously”. By referring to additional monetary easing actions, albeit in a prudent manner, the COPOM suggested further SELIC rate cuts may be on the cards for later this year although not necessarily in the next few meetings.

The view of a weak global backdrop restraining aggregate demand, and therefore allowing for further rate cuts, was shared by government officials earlier in the week. In a conference held by the Brazilian-American Chamber of Commerce, the president of Brazil’s national development bank (BNDES) Luciano Coutinho said the deceleration of global growth, particularly Asian economies, provided “a window of opportunity” for Brazil to test lower interest rates in 2012.

Policymakers believe that global uncertainty is one of the main factors explaining a slow recovery in domestic economic activity. The IBC-Br economic activity index, a proxy for GDP growth, receded both in January and February on a monthly seasonally adjusted basis, now clouding the economic growth estimate for Q1 2012. The COPOM meeting minutes highlighted that the 12-month accumulated growth rate of economic activity has decelerated since November 2010, standing at 1.9% in February 2012.

The central bank has emphasised different reasons for cutting the SELIC since it began the present rate cut cycle in August 2011. The justifications have shifted from the possibility of a eurozone breakup, to the deflationary effects of commodities price falls, to the slow recovery of domestic economic activity. The last change in tone in the meeting minutes could make it more difficult for the central bank to maintain credibility and contain inflation expectations if it is interpreted as the central bank giving in to political pressure from the government to spur growth.

Overlay from Timetric

Stalling is not so bad you might say, so long as GDP’s not falling! That’s where this second chart presents a more depressing view – you will see the production component declining, shown here in dark blue. (Most of what is not production in GDP, is services, with construction and agriculture accounting for very modest shares.) Production fell much further and for longer than services before it showed signs of recovery. The recovery didn’t last long before stalling and heading back into decline again. It really doesn’t look as if production is going to pick up soon and contribute to the recovery – it hasn’t really bounced back from the recession yet.

Overlay from Timetric

Looking at historical trends shown in the final chart, production was broadly flat for the whole decade preceding the financial crisis. Services, in contrast, showed significant positive growth leading up to 2008, and drove the rise in GDP. Production has now resumed the flat pattern seen pre-financial crisis, but at a lower level – roughly 10 percent lower – a worrying outlook for British growth prospects, given the growth in services has yet to reach pre-recession rates.

Overlay from Timetric

Inflows of FDI averaged around USD16 bn per quarter in 2011 and the first quarter of 2012, almost double the average level of inflows per quarter seen in the previous four years. Some analysts argue that the timing of the FDI increase is suspicious as it comes on the heels of a rise in the financial transactions tax on certain types of portfolio investment. In October 2010, the government hiked the tax on foreign inflows into fixed income securities to 6% in an effort to limit the strength of the local currency.

If FDI were masking foreign portfolio investment inflows, then we would expect the data to show a fall in portfolio investment mirroring the rise in FDI. Yet, this is not the case, at least not in the first half of 2011, when portfolio investment inflows rose compared to their levels in previous years.

FDI and portfolio investment inflows from Timetric

Given the available data, it is impossible to determine with certainty how much portfolio investment is entering the country disguised as FDI, but other factors suggest it is a relatively small amount.

The Institute of Applied Economic Research (IPEA), a government-led research organisation in Brazil, compared FDI in the first two quarters of 2011 against the same period of the previous year and found that most of the inflows – roughly two-thirds of the total, or USD20 bn – were the result of large-scale transactions of over USD100 m each, which suggests they were long-term investment, rather than disguised portfolio investment.

Also, it is worth noting that one large transaction can dramatically influence the data. For example, SINOPEC, China’s largest petrochemical company, acquired a 40% stake in Repsol Brazil in the amount of USD7 bn, which helps explain the extraordinary increase in FDI registered in December 2010. Consequently, the timing of the government’s increase in the financial transactions tax in October 2010 may have been more coincidental than causal in terms of the jump in FDI.

An alternative way of examining structural imbalances, other than looking at the current account balance, is through the national account identity of investment and savings. Given the following: Y = C + I + G + NX, we can simply rewrite and rearrange such that S – I = NX. In other words, a country’s excess savings (defined as the difference between income and consumption) over investment is equal to its external balance. The chart below shows the case for China.

China’s imbalances from Timetric

In fact since 1994, China’s savings has consistently been greater than investment, with the gap widening more significantly following accession to the World Trade Organisation in 2001. The trade surplus ballooned to 8.8% of GDP in 2007, and has since narrowed to around 4% in 2009 and 2010 (outcomes for 2011 are still unavailable). So it’s clear that although China has a high investment rate (investment is the strongest driver of economic growth), the primary reason behind its imbalance is an excessively high saving rate. And this largely reflects China’s domestic policies, including the lack of a comprehensive social welfare system, low and state-subsidised costs of production, and restricted labour mobility stemming from the Household Registration System (Hukou). These domestic policies have encouraged Chinese consumers to over-produce and under-consume, as reflected in the downward trend in household consumption as a share of GDP, the ratio falling to 33.6% in 2010 – the lowest rate on record and the lowest rate for any major economy in the world.

The policy discourse on China’s exchange rate as the root cause of global imbalances has gradually evolved from heated exchanges, leading to a potential ‘currency war’ as phrased famously by the Brazilian finance minister in 2010, to discussion on these wide array of domestic factors within China. Reforming the exchange rate by allowing greater flexibility in the price of the renminbi based on market forces is considered to be only part of the solution, rather than a panacea for solving global imbalances. In fact, a white paper by the US Chamber of Commerce in China stated that revaluing China’s exchange rate “would likely result only in a modest decrease in the current trade deficit” between the United States and China while focusing on other price distortions, such as factor pricing in China, would possibly result in greater adjustments’.

There is little reason to feel positive about India’s economic position at present or the medium-term outlook, a sentiment that has been a pervading theme in our recent Weekly Briefings. India’s economic problems are manifold: economic growth has slowed, the government’s fiscal position is precarious, the current account has deteriorated, capital inflows have diminished, inflation remains stubbornly high, the exchange rate has again come under downward pressure and policymakers in general appear ineffectual, constrained in part by the coalition government’s frailty.

In the statement supporting its recent decision, S&P highlighted its concerns over “high fiscal deficits and a heavy debt burden”, adding that it expected “only modest progress in fiscal and public sector reforms”. In effect, the agency is implying that the government will fail to meet its fiscal consolidation targets.

We are also not convinced, given the difficulties the government is likely to encounter in trying to reduce its subsidies bill and increase tax revenue. The government has set a budget deficit target equivalent to 5.1% of GDP in the 2012/13 fiscal year and 3.9% in 2013/14, but we forecast that it will remain close to 6% of GDP. For 2011/12 the government had originally targeted a deficit of 4.6% of GDP, but the expected outturn is a deficit close to 6% of GDP, with the failure to meet the target caused by a combination of weak revenue growth and overspending.

India’s public sector debt also remains uncomfortably high for an emerging market. In its recent report following its Article IV consultations with the government, IMF estimated that the stock of central government debt as a percentage of GDP stood at 50.2% at the end of 2011/12, while general government debt (which includes state government debt) stood at 66.2%.

India’s fiscal postion from Timetric

There is no suggestion at present that India’s government is actually close to defaulting on its debt. But the risk indicators are worsening, and according to S&P the decision to apply a negative outlook to India’s long-term credit rating indicates that there is a one in three chance of a downgrade in the rating within the next 24 months. It suggested that a downgrade was likely if India’s growth prospects dimmed, if the external position deteriorated further or if fiscal reforms slowed.

While in the US attending the recent annual Spring meetings of the IMF and World Bank, the finance minister, Pranab Mukherjee, tried hard to make a convincing case that there was no need to panic and that the government was not suffering from policy paralysis. However, he had little to offer in the way of supporting evidence.

The finance minister has acknowledged that there are three priorities: putting the economy back on a “high growth path”; controlling inflation; and consolidating the fiscal position. A failure to deliver on these could see India’s government suffer the ignominy of having its debt assigned junk status, as well as the pain of increased borrowing costs.