Prognostication Is A Risky Business

Surprise, surprise - BNM hasn't cut the OPR this time. My worry on this has generally been on whether the monetary transmission channel is working properly. They seem to think it is, despite the relatively slow movement of average lending rates downward, as well as factorng in the impact of fiscal stimulus kicking in by July.

I guess we'll see.

The Good and Bad of Financial Liberalisation

For full details read the press release from BNM:

"The liberalisation measures announced today aims to strengthen Malaysia 's economic interlinkages with other economies and enhancing the role of the financial sector as a key enabler and catalyst of economic growth. These liberalisation measures are consistent with the objectives committed under the Financial Sector Master Plan (FSMP) issued in 2001 to develop a resilient, diversified and efficient financial sector. More than 90% of the FSMP initiatives have been completed or are being implemented on an ongoing basis."

The operational measures are fairly minor, except for insurance and takaful companies which will now be allowed to open branches without limit, and onshoring of qualified offshore FIs. The other two categories are more interesting however: BNM is offering two new Islamic banking licenses (subject to a minimum capital base of USD1 billion), five new commercial banking licenses, and two additional takaful licenses. Foreign equity limits have also been raised to 70% for all institutions except for the depository banks, and potentially higher for insurance operators.

My first instinct as an economist is this is all good - the more competition, the greater should be the efficiency of the banking system, and the greater should be the impact on social welfare. It's also clear that BNM is pushing for the continued development of Malaysia as the centre for Islamic banking and takaful.

However, the pragmatist in me wonders what having all this additional capital pumped into the banking system will do to credit creation (I'm not familiar enough with the insurance sector to make a stab at commenting on the impact). Right now banks aren't lending enough and creating more competition won't necessarily reduce the headwinds against additional lending. On the other, if and when the economy recovers (i.e. when these new banks start business), that's additional capital looking for a source of yield in an already crowded local market.

It would be interesting to see what will happen. These new banks could conceivably cannibalize business (deposits and lending) from existing players, in which case we get the efficiency and welfare gains that we're looking for. If on the other hand they add on to existing business (in other words, if they have to resort to wholesale funding), then we have an increase in systemic risk and the potential for a credit boom-bust cycle.

Assuming the five CBs have a capital base of USD500 million each, adding the USD2 billion from the new Islamic banks gives a total of USD4.5 billion as core capital. Assuming an average of 13% RWCR, and that core capital is half that, that implies additional credit of USD72 billion, or about RM250 billion, which represents a third of current total loans.

If all that goes in as additional lending locally - we are in deep doodoo. In practice, some of it would be cannibalization, some of it additional lending, and some of it is going overseas. The crucial question from the point of view of systemic risk is, how much will be in which category?

Update:
Conditions for the new licenses have been released for commercial banks and for Islamic banks and takaful operators. The capital requirements for the new banking licenses were a lot more modest than I expected at only RM300 million as against the USD500 million in my example. That totals up to about USD2.4 billion in additional capital, which at a core capital leverage ratio of 16 adds up to about USD40 billion in potential additional credit or about RM140 billion. That's equivalent to something like only 19% of current loans outstanding, which reduces the potential for a boom-bust credit cycle.

The Labuan offshore liberalisation conditions are available here (warning: pdf link). This doesn't actually amount to much - essentially the only change is having your physical back-office located in KL rather than Labuan. The benefits are obviously better access to customers and human resources, but it appears nothing fundamental has really changed.

There Is Too A Point In Dropping Interest Rates

In today's business editorial in The Star, P. Gunasegaram clearly doesn't understand monetary policy:

"If Bank Negara decides to lower interest rates next week, as many people expect, there is little that it is likely to achieve but it will further erode returns to savers already, very low at around 2%...And the lower interest rates will weaken the already weak ringgit in the short term as those holding ringgit will get lower returns and, therefore, might opt to move into other currencies...Will there be any benefit from such a rate reduction? Not likely. Recent evidence is that interest rate reductions do not do anymore to stimulate the economy beyond a certain point. An example is Japan where interest rates have been around zero for many years with little effect on the economy."

The first point of misunderstanding is that what matters is the real interest rate, not the nominal interest rate. Japan's ZIRP didn't work not because nominal interest rates were low, but because first under conditions of deflation the real interest rate (nominal interest rates less inflation) was still positive. The zero interest rate bound puts a limit on the reduction of the nominal rate, but does not put a limit on the real interest rate. Monetary policy can still be net contractionary under those conditions.

Second, Japan's policy transmission mechanism (i.e. credit creation through the banking system) during the "lost decade" was broken. With zombie banks supporting zombie companies, monetary expansion gets trapped within the banking system, and did not support economic expansion.

Neither point is yet valid for Malaysia. With annual inflation dropping fast and potentially going negative by July, the real interest rate would be rising in the absence of a nominal interest rate cut. Given the current drop in output, higher positive real interest rates are an extremely bad idea. Just to underscore this point, here's average bank lending rates less annual CPI (log annual changes; 2005=100):



Secondly, Malaysia's banking sector is structurally sound, as (ironically) pointed out in this article in the same newspaper. Capital ratios are more than adequate, and non-performing loan ratios are flirting with all time lows. Monetary expansion and lower cost of funds will thus have a positive impact on borrowing and lending.

The second point of misunderstanding is real return to savers. With annual gross national savings well in excess of 30%, I don't think we need to encourage more savings - quite the opposite. With velocity of money already low and falling, reducing velocity further is another bad idea, and just reinforces the downturn in the economy.

The third point about the currency again confuses nominal and real rates, and misses the crucial "flight to safety" narrative of the USD over the last six months. It's true that interest parity conditions would imply, ceterus paribus, that maintaining nominal rates and thus allowing real interest rates to rise would maintain and/or strengthen the value of the MYR.

This is especially true since ceterus paribus doesn't apply - BNM is behind the curve in loosening monetary policy not only against advanced economies, but also regionally i.e. relative interest rates for MYR assets have been rising. On the other hand, demand for USD has been unnaturally high in recent months, as US financials pull back overseas investments as well as from Euro-dollar asset liability mismatches. This trend will reverse as US financial system leverage unwinds.

The billion-dollar question is - with trade suffering and the threat of imported inflation practically non-existent, does a higher MYR make economic sense?

I haven't fully worked out MYR trade/exchange-rate elasticities (something for a future blog post), but a quick regression estimate suggests a 1% rise in the USDMYR rate results in a 0.39% drop in exports and 0.24% drop in imports, both statistically significant. That is, MYR currency appreciation results in a contraction in total trade, which isn't exactly what we need right now.

One point I do agree with is that banks aren't passing on the full marginal cuts in the OPR to borrowers, as I pointed out here. That's something BNM has to work on.

Technical Note:
Source for average lending rates, CPI and external trade from BNM's Monthly Statistical Bulletin. Forex data from Pacific Exchange Rate Service.

IMF World Economic Outlook Forecasts

No I haven't read it yet (you can find it here), but I did have a look through the accompanying database. Here are the forecasts for advanced nations through to 2014:



Note the relatively rapid recovery expected in the US, the deeper recession in Japan, and the slower recovery in Europe. Not too surprising - the US has done the most in terms of policy response, Europe much less while being more exposed to the external sector, and Japan greatly exposed to global trade shortfalls as well as having less scope for fiscal policy action. What I find interesting is the expected slowdown post-2012 - a side-effect of greater accumulation of public debt leading to higher interest rates is my thinking.

Here are the tiger economies:



Much the same story, although growth stabilises after recovery in 2010-11, with Singapore and Taiwan expected to be the worst affected this year. The BRIC group looks better, although Russia will be badly hit by lower demand for oil and gas:



Last but not least, Malaysia and our two neighbours (sans Singapore above):



I'm thinking that the IMF might be a tad optimistic putting GDP growth at 6% for Malaysia - but I'd be happy if it came true. One request: can anybody tell me why Indonesia is not falling into recession?

Malaysia March Inflation Report

Nothing unexpected out of today's inflation report:



But we've had negative m-o-m growth since last August:



...driven by changes in these two categories (2005=100):




While the y-o-y number is more relevant to policymakers and investors, from a psychological standpoint the m-o-m number is probably more important in defining consumer and business behaviour. We're very likely to see negative numbers in the headline y-o-y rate, simply because of the high base level of last year. But on the ground, sustained deflation would be driven by what people see on a day to day basis.

Which is why I'm as much interested in what the level of the CPI is doing rather than its changes:



An essentially flat CPI, while not as dangerous as full-fledged deflation, can have the same dampening effect on businesses and consumer spending if only to a lesser degree. With a large output gap, flat price level and very low interest rates, businesses have no pricing power and workers no leverage for income increases. This can push back recovery further into next year.

We won't have March monetary aggregate data until next week, but M2 and M3 growth are slowing down faster than I'd like. No bets on whether BNM will cut interest rates at next week's Monetary Policy Committee meeting - I think it's a question of how much rather than yes or no.

The Hollowing Out Of Malaysian Industry?

Quah Boon Huat of MIER wrote a piece in today's STAR that's worth thinking about:

"If deindustrialisation is indeed in the cards for Malaysia, it cannot be positive deindustrialisation...Malaysia’s manufacturing sector is being affected by, among other things, rising production costs arising from a tightening labour market, and cheap exports (from, for example, China and Vietnam). The sector has also failed to make the transition to higher value added activities...The problems the manufacturing sector currently faces can be traced back to a lack of industrial deepening because of misguided institutional change during the 1990s."

This is spot on - there's no doubt that Malaysian manufacturing is declining, and the problems will only become more acute. This has been my view since 2006, when manufactured exports started falling off.

I'm not so certain on the other hand, if the situation is quite as bad as he is making out. Quah mentions that increasing incomes in the services sector is indicative of "postive" deindustrialisation, which at first blush is happening concurrently.

Here's the share of manufacturing in real GDP since 2000:



and here's the composite of the services sector:



(Ignore the last values in both charts - neither are "normal", due to the sharp falloff in global trade on the one hand, and a relative rise in government spending, as all the other sectors fell).

It does seem in terms of the Quah's narrative, that we're seeing the impact of both aspects of deindustrialisation, not just the "negative" kind. What else can we find from a drill down of the national accounts? Here are the losers:



...and the winners:



These seem to give more support for viewing what's occuring as "positive" deindustrialisation, rather than "negative".

Obviously there's a lot happening under these aggregate ratios, such as the role of foreign workers and changing patterns of consumption, but a more nuanced viewpoint seems called for rather than the sharp distinction made in the article.

I can't help but think that given it's providence, perhaps the role of the article was more to focus attention on the need for structural change in the economy, rather than a straightforward commentary on the current state of affairs. In that case, I'd say this was a job well done.

Forecasting Malaysian Trade: Some simple models

Last month, I did a simple forecast of Malaysia's exports based on import trends. Now that the February trade numbers are out, we can evaluate my simple regression.

To recap, this is the relationship between exports and imports based on a sample range of Jan 2000-Dec 2007:

Ln(exports)= 0.79+0.94 Ln(imports(-1))

Based on this, the February forecast was for exports to reach RMRM35,968 million with a 95% interval forecast (approximately 2 standard errors from the point forecast) of between RM43-RM30 billion. Compare that to the actual result of RM39,586.9 million, which is well into the upper end of the interval forecast.

It seems this sort of works - except that the gross error doesn't exactly inspire confidence. Two problems I can see here: first, the forecast has an in-built bias that is endemic to economic statistics, which is due to autocorrelation (also called serial correlation). Secondly, I have potential bias from seasonal differences as well, which I haven't accounted for.

One of the assumptions required for linear regressions using ordinary least squares (OLS) to be valid, is that the residuals (what's left after fitting the data) have to be independently, randomly distributed - in other words, their distribution should be approximately gaussian, and there should not be a systematic relationship between any of the residuals. In the case of my simple regression, this isn't true. Using a Breusch-Godfrey test* for 12 lags, I've got serial correlation at multiple lags – bad.

*The better known Durbin-Watson test is only valid for testing serial correlation for one lag only.

How to resolve these issues? I’ve got three choices:

1. Forget about trying a structural model, and use a stochastic model using an ARMA (Auto-Regressive, Moving Average) representation instead. In essence, I’d be modeling exports based on past values of exports. This is great for trending series, where structural changes aren’t an issue – which isn’t the case with Malaysian exports at this time. So that’s out.

2. Tackle the serial correlation problem directly, again using ARMA terms in the regression. I’d still have the structural component here, making this a better choice under the current circumstances.

3. Adjust for the seasonal effect and see if the serial correlation (or any other problems) still exists. Here, I have another two choices – I can apply seasonal adjustment to both export and import series, or I can try modeling the seasonal effect directly.

So that’s four different models to choose from, just because I’ve encountered one little problem. In practice, trying out and evaluating all four models would be necessary. So here are the baseline model results:

Baseline Model


Ln(exports)= 0.79 + 0.94 Ln(imports(-1))
Point forecast: RM35968
Upper bound: RM42547
Lower bound: RM29389
R2: 0.85

And the results from the rest:
ARMA (1,1) Model


Ln(exports)= 4.68 + 1.00 AR(1) - 0.63 MA(1)
Point forecast: RM45370
Upper bound: RM52965
Lower bound: RM37774
R2: 0.90

Structural ARMA(1,0) Model


Ln(exports)= 0.37 + 0.98 Ln(imports(-1)) - 0.36 AR(1)
Point forecast: RM38070
Upper bound: RM44546
Lower bound: RM31515
R2: 0.87

Seasonally Adjusted Model


Ln(exports*)= 0.38 + 0.98 Ln(imports*(-1))
Point forecast: RM39407
Upper bound: RM44264
Lower bound: RM34550
R2: 0.93

(*seasonally adjusted. Actual seasonally adjusted exports for February reached RM47045.)

Seasonal Effect Model


Ln(exports)= 3.84 + 0.98 Ln(imports(-1)) - 0.00 D2 + 0.24 D3 + 0.03 D4 + 0.10 D5 + 0.10 D6 + 0.11 D7 + 0.15 D8 + 0.14 D9 + 0.12 D10 + 0.10 D11 + 0.17 D12
Point forecast: RM34686
Upper bound: RM40054
Lower bound: RM29318
R2: 0.82

So – which model to choose? Based just on the ability to predict February exports, the obvious candidate would be the structural ARMA model, which has the lowest variance with respect to the actual result.

But what we want is not a model that minimizes error at one point in time, but rather at all points of time. In practice, this means looking at goodness of fit measures (R2), or information criterion (such as Bayesian Information Criterion). On that basis, the best model is the seasonally adjusted model, despite the massive RM7.5b error for February. I’d also consider the seasonal effect model, because it came in second in terms of information criteria.

What do the models say about March exports? Let’s see which one does best - watch this space next month:

Baseline: RM33832; Range: RM40.0-27.6b

ARMA: RM44618; Range: RM51.5-37.7b

Structural ARMA: RM33712; Range: RM39.9-27.5b

Seasonally adjusted: RM39792*; Range: RM44.7*-34.9*b

Seasonal Effect: RM43861; Range: RM49.4-38.3b

(*seasonally adjusted)

Bottoming Out?

I don't know how I missed these, but both IPI and trade February numbers for Malaysia were released last week (bad, bad RSS feed!). There are faint signs of hope that the economy, as far as production is concerned, is now bottoming out.

Industrial Production
The growth numbers are all bad (log annual changes, 2000=100):



But the raw indices themselves have gone flat or turned up, indicating some resumption in production (2000=100, seasonally adjusted):



My feeling is that these are related to China's massive stimulus package, which came into effect in November and is starting to turn up in their production statistics. The two main categories that have turned up are in iron & steel production, as well as refined pteroleum products, which tends to support this intuition:




Nevertheless, as per my previous post on IPI, there's little to be sanguine about these numbers. Capacity utilization looks pretty bad, which means many industries must be flirting with insolvency. If there isn't a bigger pickup in the next few months, a lot of capacity will be going offline.

External Trade
Trade is also looking up, although you wouldn't know it from the growth figures (log annual changes):



The trade numbers themselves are turning up however, and are even stronger on a seasonally adjusted basis:



Have we seen a bottom? It's impossible to say on the basis of one month's data, but I'm encouraged by the rebound. Note that this is happening even before the 2nd stimulus package was even introduced, much less kick in. Be that as it may, the stimulus is still necessary, especially the RM25 billion in credit guarantees. If there ever was an argument for fiscal support for industry, the time is now.

Unwinding Global Imbalances

As a quick follow-up to my last post, the BEA last night posted Febuary data on US international trade. There's been a marked improvement in the trade balance:



That's the lowest level in the trade deficit since November 1999. The bad news is that it's been driven by a sharp contraction in trade:




Interpreting this in light of my last post, I don't think there's any question that global trade and savings imbalances are being unwound right now and fairly rapidly, without a big adjustment in the USD (although I think that's probably still on the cards). Right now funding the deficit has fallen to an average of $1 billion a day, rather than the $1.9 billion required last year.

As to how sustainable this is, about half the reduction in y-o-y imports comes from a lower oil bill, and another sixth or so from lower imports of cars. If and when growth resumes, both these categories are likely to pick up again, so we're not out of the woods yet.

iCapital Lays An Egg

iCapital in an article in the Star today talks about the 'perception' that current global imbalances have to be unwound is wrong:

"One of the most often cited global imbalance is the high saving, low consuming Asians and the high spending, low saving Americans...According to this school of thought, the global economy is heading for a serious and protracted contraction because Americans need to save more while Asians are not spending enough...So if Americans save more, where will the global demand come from? If there is insufficient global demand, how can the export addicts of Asia expand?...So, the way to solve the current end-of-the-world contraction is for the global savings/spending imbalance to be rectified. Unfortunately, this would take years. Now you get the drift of why they think the world economy will be down and out for many years to come?...i Capital really does not buy into this argument. When this is all over, when we are over the Lehman panic, for the record, Capital Dynamics, i Capital, and its boss would want to be known as non-bear...Is there any cast-in-stone law that says the global savings/spending imbalance needs to be rectified now? Is there any rule that says Americans must save more now?"

and...

"First, the less than one billion people in the Western economies plus Japan have enjoyed much higher standards of living for a very long time, while the five billion-plus people in the rest of the world have either been in poverty or struggling for a very long time...This global imbalance should have been corrected a long time ago but it has instead persisted for a very long time despite all the aid given by the wealthy developed economies...Second, the imbalance in the perception of the developing countries by the rest of the world and the perception of the developed world by the rest of the world has existed for a very extended period too...This global imbalance in the perception of the developing countries by the rest of the world and the perception of the developed world by the rest of the world needs to be rectified but will it ever be? So do not be surprised if the global imbalance of high saving, low consuming Asians and high spending, low saving Americans persists for a while longer."

What are these guys smoking? I don't have a problem with their conclusion: capital markets are I think forming a bottom and anybody with the capital and patience to invest should find some great medium term bargains right now. But the basis for their view on the other hand is built on a house of cards. There is a real serious global imbalance, which is also right now being unwound.

Comparing the global consumption-savings imbalance to cultural perceptions is disingenuous at best; there aren't any market forces acting on those, but there are on global trade and capital flows. The US savings rate is rising, not because it was underestimated in the first place, but because Americans are actually beginning to save.

The meme iCapital is disputing is high saving, low consuming Asians; low saving, high consuming Americans - how much of this true? Going back to the national accounts identity:

Y = C + I + G + NX

where Y is income
C is consumption
I is investment
G is government deficit
and NX is net exports
In addition I = S (savings)

For a given level of income and government spending, excessive consumption and investment turns up as a negative value for the NX term, and vice versa. In short, a trade deficit indicates excess consumption and investment (or for that matter, excess government spending). The opposite is true for a trade surplus - savings in excess of consumption.

To get a finer understanding of this, it must be understood that I = savings, does not necessarily imply investment must equal domestic savings - international savings can be involved as well. Second, savings covers not just individuals, but also corporate and government savings. Third, international trade and capital flows are zero-sum; the existence of a trade deficit implies a surplus somewhere else, same with capital flows.

With that background, what's the record on the US trade deficit? (1992-2008)



And as a ratio to GDP (1992-2008):



I dare anyone to say there isn't a problem here, but that it is also beginning to reverse. Here are the countries/regions that have the largest trade surplus against the US as of January 2009:

China - 46.9%
Other Pacific Rim countries 17.4%
Canada & Mexico - 11.8%
OPEC - 9.2%
EU - 7.9%

That's pretty clear. It's actually even easier to see than that, because the US actually compiles statistics on personal income, expenditure and savings. Here's personal savings as a ratio to personal income (1947-2008):



So on that score, I think there is no question that over-consumption in the US is true and that the savings rate has been declining over time, and moreover this over-consumption was financed by savings elsewhere including Asia and the Middle East.

The real question isn't whether there will be a redressing of global imbalances, but rather to what extent and in what form it will take. A country can usually sustain an imbalance of the current account, if it is supported by fundamentals like demographics. An older population base, with a significant ratio of retirees, would generally be dissaving, thus inducing an excess of imports over exports (by that argument, Japan ought to be running a deficit - another imbalance waiting to be fixed).

But the US is not in this position. While it’s true that imbalances can and do persist over time, this crisis is likely to cause a structural change in the US relationship with the rest of the world. The shock to the consumer psyche isn't going to disappear even with the flood of liquidity in the banking system, or the massive stimulus package that's already being rolled out. An increase in the US savings rate should be taken as a given. Will it return to the level of the 1970s? Perhaps not - but a complete redressing of global imbalances doesn't require that.

The easiest way to address the US trade and capital flow imbalances is through a change in relative prices i.e. a fall in the USD or equivalently an appreciation of the currencies of trading partners. The harder, more painful way is through balance sheet adjustments i.e. deleveraging.

I think both are happening or will happen in the case of the USD, especially with the pressure on the exchange rate from monetary expansion and government borrowing. And this will cause a retreat in US imports and Asian exports. And neither is this necessarily bearish for capital markets.

Technical Note:
All trade, personal income and GDP data from the Bureau of Economic Analysis

Malaysia National Debt Update

Malaysian federal government expenditure and revenue have finally been updated for 4Q 2008. First the raw data:



There’s a clear seasonal structure to government fiscal operations, revolving around income tax collection that typically comes in from 3Q onwards. On an annual basis:



Government revenue has always been sufficient to cover ongoing operational expenses. The monkey wrench in the works (at least from a balanced budget perspective), is development expenditure a.k.a. subsidies and investment. That said the fiscal balance as a ratio to nominal GDP is still below the level where rating agencies and investors start getting worried:



On the other hand, we’re most likely going to breach that level this year and next. The effective income tax rate doesn’t look too bad (direct taxation as a ratio to nominal GDP):



And taking away from petroleum income taxes, it looks even better (direct taxation less petroleum income tax as a ratio to nominal GDP):



The debt to nominal GDP ratio has continued to fall:



But again, this is set to rise this year and next. In terms of magnitude, last year saw a net addition of RM39.7b in national debt, which dwarfs the last record of RM27.9b in 2004. The total stands at over RM306.4b, which handily beat my assumption of RM280b in my last national debt post. It also means that my back of the envelope calculation of RM365b by the end of 2010 will essentially be reached that much more quickly, and we will likely be well over RM400b instead by the end of 2010. Sobering numbers.

Deconstructing IPI Numbers

I finally got around to stitching together the IPI numbers - literally. As my last post on this subject mentioned, DOS has changed the basis of the index to 2005, which means some fancy footwork with splicing the different indexes together. The reason why I wanted to do this is to get a relatively longer view of trends within the industrial sector - which you can't do when the current 2005 index only runs for two years in the monthly series.

In any event some interesting things emerged. Here are the annual log changes in the main indexes, going back to 1999 (which was about the most I had patience to do today):



Note that mining seems to be holding up pretty well - pity it's only got a weight of 23.37. Manufacturing is of course the primary contributor to the downturn. Here are the actual indexes (2000=100):




In terms of output, we're approximately back to the level of 2004. If we take the maximum IPI level as representing full capacity utilisation (there's always some slack, so 90% would probably be a better approximation), then industry is running at about 80% capacity, and manufacturing alone at about 73%. That doesn't strike me as being sustainable for any length of time.

Of course, the main problem we have is with the electronics sub-sector (the electrical side of things has long been declining):



E&E output is now back to the same level as August 1999, nearly a decade ago. In terms of the drop in output, it's about 50% below the peak which was reached a short 15 months ago. Rubber, wood and chemicals also show sharp drops, if not quite as catastrophic as E&E:



In domestic manufacturing, the biggest drop is in construction related manufacturing:



All in all, not a pretty picture. The biggest concern is less the sharp declines in output, but rather how long the downturn will last. At this rate, with virtually no slowdown seen in output declines, there is going to be a lot of destruction on the ground of Malaysia's manufacturing capacity if this goes on for more than a few months. Which in turn implies that the risk in the banking system is significantly higher than most people expect.

The inclusion of RM25 billion loan guarantees in the 2nd stimulus package looks better by the minute, especially since it will be available almost immediately. I'm not sure it will do more than buy a little time though.

BNM Watch

A more up to date account will have to wait until next week, but there are a few things going on that should be noted.

First, the loss of reserves I noted here, has leveled off:



I'm taking it that what we saw was part flight to safety on the part of foreign funds, part a desire to increase liquid assets, and part deleveraging. Whatever the reason, the massive outflow of foreign exchange we saw last year has stopped, which reduces the pressure on BNM to equilibrate domestic money supply (loss of forex is contractionary), as well as pressure on the MYR.

Nevertheless, M3 growth has continued to slow:



We won't see the impact of velocity until at least the 1Q GDP data is out, but my basic feeling is that money velocity is dropping and will continue to drop this quarter. That said, I'm much more comfortable with growth in the monetary base as it is than I was a couple of months ago - there's enough liquidity in the market.

What concerns me now is real interest rates - they're too high. CPI inflation is dropping fast, but the headline rate is probably less of a guide than the level of the CPI itself, considering the rapid rises in the first half of 2008:



The last three months have been effectively flat - about as close to zero as you can get it without someone fiddling with the figures. The annualised m-o-m growth is about 2.1% in February, which roughly equates to price stability. That's the same level as the OPR, but 350bp lower than average lending rates. Between November and February, the OPR has been cut 150bp, but average lending rates have fallen just 50bp:



I think another 50bp cut in the OPR is definitely on the cards, but more importantly there has to be some pressure on the banking system to reduce lending margins. It's not dropping fast enough or far enough for my tastes, and the loan-deposit ratio (total loans over M3) has been below 80% for most of the last two years and hasn't been above 90% since 2002. This financial conservatism (which I'd applaud any other time) renders BNM monetary policy stance rather meaningless.

While I understand bankers' caution in light of 1997-98, this might be taking liquidity preference a little too far. I'm not ignoring credit evaluation concerns here - but there should be a few more projects out there that might be helpful, but require a lower cost of capital to be viable.

Interest Rates and Yield Curve in February 2009

Since last night's release of the BNM Monthly Statistical Bulletin, I've been busy updating my databases. My planned post on forex regimes will have to be put on hold while I digest (and regurgitate) all this new data - so there will be a bunch of stuff coming out on this blog over the next few days.

First, spreads in the interbank market in February have returned to positive again but just barely:



Looking at the levels, we can see here the impact of the cuts in the OPR on interbank rates:



The yield curves on BNM bills and TBills remain strongly negative however. On the other hand, given the anticipation over the stimulus package (remember, we're looking at February data here), the yield curve for MGS steepened sharply:



I know it looks like a bunch of spaghetti thrown by a patricidal 3 year old, but there's actually some sanity in the chart. Each line represents the indicative yield for a particular MGS maturity, which ranges from 1 year to 20 years. Lines moving closer (or crossing over) means the yield curve is flattening or inverting, while lines moving apart means the yield curve is steepening.

There's a sharp drop in yield at the short end, and an increase in yield at the long end. Some interpretations:

1. Flight to liquidity (risk aversion) - the market wanted more liquid instruments as economic news worsened. Prices would then be bid at the short end compressing yields, while the opposite would happen at the long end.

2. Anticipation of new supply - there was a lot of speculation over the size of the stimulus package, which had particular implications for 3 year maturities and above. Greater supply of bonds relative to demand would of course reduce price, and increase the yield.

3. Anticipation of inflation - under normal circumstances, a steepening of the yield curve would signal expectations of future inflation. Since the times aren't normal, and we're likely to have 2009 GDP under the full employment level, I'd discount this - for now.

Data from March (available here) indicates 10 year MGS yields falling back a bit, while yields on 3 year and 5 year maturities going up about 30bp.

Be that as it may, what worries me is that the spread hasn't been this high since the USD peg was abolished:



That reflects a lot of continued uncertainty in the market (higher risk premiums demanded, not inflationary expectations), and just as importantly makes capital market borrowing for the government relatively more expensive. Our soon-to-be PM's little comment about RM200 billion extra for the 2010 budget doesn't help either.

There's enough liquidity in the market to fund the RM35 billion required by the 2nd stimulus package, but I'm starting to think that a syndicated term loan from the banks (as happened in 1998) might begin to make sense soon, especially if BNM cuts the OPR by another 50-100bp.