morgan stanley on latam: venezuela: a hard-currency tipping point

August 2, 2010

Economics This Week in Latin America Week of August 2-6

Weekly Spotlight (page 2): Venezuela: A Hard Currency Tipping Point, Revisited by Daniel Volberg. Given the limited transparency in Venezuelan data we cannot discount the risk that the $6.5 billion dollar surplus that the official balance of payments statistics are likely to show over the next two years could actually turn out to be a sizeable deficit.

¿Qué Pasó? / O Que Aconteceu? (page 6)

What’s Next? (page 7)

A Comparative Look (page 9): Regional Credit and Economic Trends.

From our Global Economic Team (page 10): Slam Dunk Stimulus by David Greenlaw. A change in mortgage refinancing requirements – involving recognizing the government’s existing guarantee on the principal value of a large part of the mortgage market – would almost immediately inject a significant amount of stimulus into the US household sector without any impact on the budget deficit and without distorting markets, argues our US team.

On the Horizon (page 13): Our Annual Economic Forecasts.

Latin America Weekly Calendar (page 14)

Recent Reports

This Week in Latin America Title Date

Brazil: Slowdown – Comfort or Caution? Gray Newman July 26, 2010 Mexico: Interest Rate Cuts? Nowhere in Sight Luis Arcentales July 19, 2010 Colombia: Fixing the Fiscal Daniel Volberg July 12, 2010 Argentina: The Case for Argentina Daniel Volberg June 28, 2010 Mexico: Consumers – Waking Up Luis Arcentales June 21, 2010 Latin America: The Renminbi Impact Gray Newman June 21, 2010 Brazil: Going Strong Marcelo Carvalho and Giuliana Pardelli June 14, 2010 Mexico: More than Just Cyclical? Luis Arcentales June 14, 2010 Peru: Resilience to Global Headwinds? Daniel Volberg June 7, 2010 Chile: Not Looking Back Luis Arcentales June 1, 2010

For important disclosures, refer to the Disclosures Section, located at the end of this report.

M O R G A N S T A N L E Y R E S E A R C H L A T I N A M E R I C A

Morgan Stanley & Co. Incorporated Gray Newman

[email protected] +1 (1)212 761 6510

Luis A Arcentales, CFA [email protected] +1 (1)212 761 4913

Daniel Volberg [email protected] +1 (1)212 761 0124

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M O R G A N S T A N L E Y R E S E A R C H

August 2, 2010 Economics

Weekly Spotlight Venezuela: A Hard Currency Tipping Point, Revisited by Daniel Volberg The decision to tighten capital controls in May appears to have postponed Venezuela’s day of reckoning. When rising capital outflows threatened to undermine Venezuela’s economic model, policymakers moved aggressively, severely tightening capital controls in late May. The ability of the authorities to effectively limit capital outflows – which reached $18 billion (5.5% of GDP) last year – should, in theory, significantly boost Venezuela’s balance of payments.

However, we suspect that given measurement issues and uncertainty around the value of Venezuela’s oil exports there is still risk that Venezuela may be facing a dollar crunch. The oil export data is a matter of heated debate and there is a risk that oil export numbers as reported in the balance of payments may be inflated. Therefore, while the published balance of payments statistics are likely set for a significant boost in the quarters ahead, there is still a risk that Venezuela may be faced with a dollar crunch despite the elevated oil prices. That raises the prospect that policymakers may eventually have to prioritize between essential imports and international obligations. In sum, it appears that Venezuela’s debt burden may be becoming increasingly onerous.

The Dollar Balance Venezuela’s economic model is built on an excess supply of dollars. Given the policy heterodoxy – especially the lack of property rights, expropriations and rising participation of the state in the production and distribution process – the supply of goods has become increasingly dependent on imports, as domestic production has fallen. In turn, Venezuela’s reliance on imports means that it must generate enough dollars to finance those imports.

Indeed, we reiterate our view that the key metric for measuring Venezuela’s economic viability is the dollar balance – the balance between dollar supply and demand. Dollar supply is largely a function of two elements: oil exports and external debt issuance. Meanwhile dollar demand has historically been driven by three factors: import demand, debt service obligations and capital outflows.

Given the new policy environment, we’d argue that the dollar balance needs a revision. We had estimated that

given recent trends in the drivers of dollar supply and demand Venezuela’s dollar balance for this year and next was likely to post a cumulative deficit of near $20 billion (see “Venezuela: A Hard Currency Tipping Point?” in This Week in Latin America, March 30, 2010). However, an important component of that analysis was the large and rising private capital outflow. Given that in mid-June authorities tightened exchange controls and effectively shut down private capital outflow, the dollar balance is due for an update.

Exhibit 1 Venezuela: CADIVI Dollar Supply (US$ millions)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

2005 2006 2007 2008 2009 2010*

CADIVI Dollar Supply ($ mln)

Source: CADIVI, Morgan Stanley Latam Economics

Demand for Dollars Given the tightening in capital account restrictions, imports of goods are likely to be the most important driver of dollar demand this year and next. With the parallel market that had financed the bulk of imports in recent quarters now defunct, imports are likely to be financed through government sanctioned channels in the quarters ahead. The bulk of imports are likely to be financed through CADIVI – the government’s currency agency. Based on the dollars provided in the first and second quarters of the year we estimate that CADIVI will supply importers with near $30.3 billion this year (see Exhibit 1). For next year we expect CADIVI to boost dollar supply to near $35 billion as the economy continues to substitute domestic goods production by imports. In addition, a smaller portion of imports is likely to be financed via the SITME system – the central bank’s new dollar bond trading system

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that replaced the parallel market. Given that the SITME system has been operating at near $30-40 million dollars per day since it was introduced in mid-June, we expect this system to supply importers with hard currency totaling near $5 billion this year and near $8 billion in 2011. In sum, we are revising our forecast for imports to $35.4 billion in 2010 (from $28.9 billion) and $42.6 billion in 2011 (from $30.1 billion).

Exhibit 2 Venezuela: Balance of Trade in Services (US$ millions)

-9,000

-8,000

-7,000

-6,000

-5,000

-4,000

-3,000

-2,000

-1,000

01994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Balance on Services Trade ($ mln)

Source: BCV, Morgan Stanley Latam Economics

In addition to imports of goods, Venezuela is likely to continue to demand hard currency to run a significant net deficit in services trade. The balance of payments data shows that last year net trade in services posted a deficit of $7.6 billion (see Exhibit 2). And annualizing this year’s first quarter results suggests that Venezuela may post a deficit in the trade in services of at least $6.1 billion this year. For 2011 we expect a net deficit of $7.6 billion, in line with the average of the past three years. Add to that a net deficit in international transfers of roughly $0.5 billion this year and next, and we find additional dollar demand of $6.6 billion in 2010 and $8.1 billion in 2011. How will these extra dollars be obtained outside of the official channels of CADIVI and SITME? We suspect that the bulk of services may be related to PDVSA expenses that the national oil company can pay for directly.

Debt service obligations are likely to also be a driver of dollar demand. The consolidated public sector external debt stands at $58.2 billion, near 28% of GDP1. This external debt implies debt service – capital plus interest – of $5.6 billion this 1 We use the Bs$4.3 exchange rate to calculate dollar GDP. Using the Bs$2.6 exchange rate means public external debt is near 18% of GDP

year and $8.4 billion in 2011. Those debt service obligations are an additional source of dollar demand.

Finally, public sector capital outflows may require extra hard currency. While the authorities appear to have clamped down on private sector capital outflows, the public sector generated outflows of $7.1 billion in just the first quarter this year. Even assuming zero additional net outflows the rest of the year, this total would be significantly above the $3.8 billion average public sector capital outflows during the last three years. Thus, to be conservative we assume that this year’s capital outflows will remain limited to the $7.1 billion dollar public sector and $3.3 billion private sector outflows observed during the first quarter. In sum, we project total capital outflows of $10.4 billion this year; for 2011 we project public sector capital outflows declining to the $3.8 billion average of the past three years.

Exhibit 3 Venezuela: Projected Dollar Demand (US$ billion) Dollar Demand ($ billion) 2010 2011Imports of Goods (CADIVI) 30.3 35Imports of Goods (SITME) 5.1 7.6Balance on Trade in Services 6.1 7.6Balance on Transfers 0.5 0.5Debt Service Obligations 5.6 8.4Capital Outflows 10.4 3.8Total 58.0 62.9

Source: Morgan Stanley Latam Economics

In sum, overall dollar demand should still be substantial this year and next. Summing up our projection for imports, capital outflows and debt service obligations we find that dollar demand may be near $58 billion in 2010 and near $63 billion in 2011 (see Exhibit 3).

Dollar Supply The supply of dollars is likely to remain largely a function of oil exports. Oil exports in the first quarter totaled $15.7 billion and accounted for 95% of total exports. Given the average first quarter price of the Venezuelan oil basket of near $70 per barrel this implies an export volume of roughly 2.5 million barrels per day. Assuming that the volume remains stable and using the futures curve to project oil prices forward, we estimate that oil exports should total near $62.3 billion in 2010 and $65.6 billion in 2011 (see Exhibit 4). As an aside, the assumption on oil output stability may prove too generous: in recent years independent estimates suggest that Venezuela’s oil production and export volumes have been falling.

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The Balance Combining the dollar demand and supply it appears that the decision to tighten capital controls may have provided the authorities with a tight, but manageable dollar balance. With total dollar demand of $58 billion in 2010 and $63 billion in 2011 against a total dollar supply of $62 billion this year and $66 billion next year the authorities should be able to produce a better balance of payments snapshot than what we had expected just a couple months back. Indeed, doing the math, we find that the dollar supply could exceed dollar demand by a cumulative $7.0 billion the next two years.

Exhibit 4 Venezuela: Oil Exports (US$ million)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

*20

11*

Source: BCV, Morgan Stanley Latam Economics *Morgan Stanley projection

Debt Issuance While the dollar balance could be in surplus this year and next, we still expect the authorities to continue to issue external debt. A key source of demand for debt issuance comes through the SITME system that the central bank introduced in June. The system is a dollar bond trading system and therefore requires a constant supply of external bonds. The government has leaned heavily on the local commercial banks to supply the $30-40 million per day that the system has averaged since inception in mid-June. However, with total bank dollar bond positions now near $1.3 billion and bank foreign currency working capital needs near $1 billion, the system is at risk of running out of supply. Hence, we estimate that the authorities may issue a total of $6 billion in external debt to local market participants – largely commercial banks – to reload their ability to provide dollar bonds to the SITME system. And we suspect that the authorities may issue another $7 billion next year.

Not As Good As It Seems? It appears that by tightening exchange controls the authorities have regained control of the situation, but we suspect that there is significant uncertainty regarding the true scale of the challenge facing Venezuela. The key issue at play is that since 2004, PDVSA’s international transactions are independent of central bank control. The result is that the balance of payments statistics published by the central bank largely reflect PDVSA’s official statistics, rather than observed cross-border flows.

Exhibit 5 Venezuela: PDVSA Oil Exports by Destination (As % of Total, 2009)

North America52%

Europe10%

Asia12%

Caribbean22%

Other0%

Africa0%

Central America1%

South America3%

Source: PDVSA, Morgan Stanley Latam Economics

There is significant risk that officially reported oil export proceeds may be inflated. PDVSA reported that last year’s oil exports were 2.7 million barrels per day. Of that total, exports to the Caribbean, Central America, Africa and South America totaled 0.7 million barrels per day (see Exhibit 5). Exports to Europe, North America (principally the US) and Asia (mainly China) totaled 2.0 million barrels per day. The 0.7 million barrels per day of oil exports to the Caribbean and others may not be paid for in cash, but rather financed on credit with uncertain recovery value. In addition the exports to Asia may not be made at market prices, but rather at a discount. Thus assuming PDVSA’s export volume last year is a good proxy for the export volume this year and next, and applying the futures-curve-derived price for the Venezuelan basket we can estimate the portion of oil exports that is likely to generate hard currency. Using the official PDVSA numbers, we find that in 2010 oil export cash generation may be closer to $51 billion if we include exports to the US, Europe and Asia, or $43 billion if Asia is excluded. For 2011 a similar calculation means oil export proceeds of between $54 billion and $45 billion.

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Adjusting official statistics results in the dollar supply-demand balance tipping significantly into the red. After adjusting official figures to reflect the likely hard currency oil export proceeds, we find a significant shortfall in dollar supply relative to dollar demand. With total projected dollar demand of $58 billion in 2010 and $63 billion in 2011 we find that Venezuela may be faced with a cumulative shortfall of $16-33 billion over the next two years.

And there appears to be a significant discrepancy between official and independent statistics regarding Venezuela’s oil exports. OPEC reports that Venezuela’s total production in the three months through June was 2.2 million barrels per day. There is some controversy regarding these estimates – the OPEC numbers could reflect exports rather than total production. Even assuming that OPEC numbers reflect exports rather than production and using the official data to isolate the share of exports that is likely exported for hard cash (roughly 60-73%) we find that oil export proceeds could reach only $34-41 billion this year and $36-43 billion next year. Thus, excluding dollar debt issuance, the effective dollar shortfall this year and next could reach a cumulative total of $37-$51 billion.

Fears of Financial Strain A hard currency shortfall of up to $51 billion over the next two years would be a negative surprise for Venezuela watchers, in our view. Current market prices of Venezuelan

bonds in the next two years imply relatively limited risk of a problem. However, our work indicates that Venezuela’s ability to pay might be strained if the dollar shortfall is near $51 billion over the next two years. Between the near $29 billion in international reserves the central bank held as of last week and near $11-13 billion in other hard currency assets, we calculate that Venezuela’s public sector has a liquidity cushion of near $40-42 billion. With cumulative debt service costs of $13.9 billion this year and next, one can build a plausible case that the authorities may be faced with the prospect of having to choose to import goods and services or to honor debt service obligations within the next eighteen months.

Bottom Line We are not ready to make the call that Venezuela is facing an imminent financial dilemma. We are however concerned that given the limited transparency in Venezuelan data, we cannot discount the risk that the $6.5 billion dollar surplus that the official balance of payments statistics are likely to show over the next two years could actually turn out to be a sizeable ($51 billion) deficit. And while Venezuela watchers appear to have grown more vigilant over the past few months, we suspect that it is still prudent to remain cautious given the continued intensification in policy heterodoxy, potential for negative surprises due to the lack of transparency in the data, and rising event risk in the months ahead.

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¿Qué Pasó? / O Que Aconteceu? Last Week’s Economic Releases (Week of July 26-30) Argentina Construction Activity Indicator

(June) 10.1% y-o-y Construction activity slowed from the near 12% growth pace in May as the robust economic recovery appears to be peaking out.

Argentina Supermarket Sales (Real) (June) = 19.0% y-o-y Consumption remains one of the key drivers of recovery – while other indicators of activity

may be peaking, sales continue to power ahead. Brazil Current Account

(June) = -$5.2 billion Much wider than expectations (-$3.2 billion) – pushing the 12-month deficit to 2.1% of GDP –

explained by a surge in earnings outflows ($4.2 billion). FDI was weak at just $708 million. Brazil Public Sector Primary Balance

(June) R$2.1 billion Fiscal policy remains highly expansionary: narrower-than-expected surplus (R$3.9 billion), bringing the 12-month balance to just 2.1% of GDP, well below 2010 target (3.3% of GDP).

Brazil Copom Minutes = NA Dovish tone. Though economy still running near potential, inflation outlook has improved due to stimulus withdrawal, domestic slowdown amid uncertain global backdrop (see page 9).

Brazil IGP-M (Final) (July)

= 0.15% m-o-m Higher than consensus (0.05%) in great part driven by pickup in soy (3.9%) and iron (2.5%) wholesale quotes. Consumer prices in check (-0.17%) driven mainly by lower food (-1.05%).

Brazil CPI – FIPE (Third Release) (June 23-July 23)

= 0.19% m-o-m São Paulo prices accelerate from 0.12% driven partly by subsiding food deflation (-0.22%). Most groups moved marginally higher, offset in part by seasonal clothing declines (-0.49%).

Colombia Unemployment

(June) = 12.8% The unemployment rate remained stable despite continued strong growth in the economy.

Part of the reason appears to be an increasing participation rate.

Mexico IGAE (May) 8.9% y-o-y Fourth straight sequential gain, putting 2Q GDP growth on track to approach 10% annualized

– one of the strongest prints in the past decade. June data so far suggests further growth.

Mexico Remittances (June)

= -2.0% y-o-y On the soft side, likely reflecting some payback after May’s outsized gain (+12.6%). Overall trend is still improving, though decelerating at the margin, both in US dollar and peso terms.

Mexico Leading Index – Conference Board (May)

= -1.4% m-o-m First decline since February 2009, confirming the ongoing deceleration in the key six-month trend; strength among components is narrowing, suggesting a cooling off in growth ahead.

Mexico Inflation Report (2Q)

= NA Though report had a dovish tilt – as Banxico sees improved inflation balance of risks – both growth and inflation forecasts were unchanged, suggesting Banxico is firmly on hold for now.

Mexico Tax Revenues (Real) (June)

= -1.6% y-o-y Revenues ahead of budget by M$4.7 billion with good gains in activity-linked VAT (+20.9% YTD) and income taxes (+12.6%); spending up 1.0%, including a -3.9% drop in investment.

Source: Government data, Morgan Stanley Latam Economics

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What’s Next? Tuesday, August 3 Brazil’s June IP Morgan Stanley Forecast: NA; Consensus: 11.7% y-o-y

• Industrial output has stalled in the past two months and June is likely to bring another poor performance. We would not be surprised to see a negative report on a month-over-month basis. World Cup watching may have played some role in June weakness, but recall the weakness pre-dated the games by a few months.

• São Paulo’s industrial indicator posted a -0.6% sequential decline in June – the second consecutive pullback; preliminary data, ranging from auto production to corrugated paper shipments, point to June weakness.

100

105

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115

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130

135

May-06 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10

Brazil: Industrial Production(2002=100, seasonally adjusted)

\

Source: IBGE, Morgan Stanley Latam Economics

Wednesday, August 4 Mexico’s July Consumer Confidence Morgan Stanley Forecast: NA; Consensus: 88.7

• Though consumer confidence has been moving higher throughout 2010, the pace of improvement accelerated substantially during the second quarter.

• The ongoing improvement in confidence, which we think is likely to continue in coming months, seems to reflect an increasingly supportive consumer backdrop of persistent job creation and modest real wage gains thanks to the downturn in inflation, which dipped to 3.96% in the second quarter.

Mexico: Consumer Confidence(Seasonally adjusted, Jan. 2003 = 100)

75

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85

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95

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105

110

115

Oct-01

Jun-02

Feb-03

Oct-03

Jun-04

Feb-05

Oct-05

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Feb-07

Oct-07

Jun-08

Feb-09

Oct-09

Jun-10

3mma

Source: INEGI, Morgan Stanley Latam Economics

Thursday, August 5 Peru’s Monetary Policy Meeting Morgan Stanley Forecast: 2.25%; Consensus: 2.25%

• With economic growth significantly above potential and no signs of slowing yet, we expect the authorities to continue tightening monetary policy

• While some of the tightening has been done via reserve requirement hikes, interest rates remain too low and need to be raised to slow growth to a more sustainable pace and thus maintain inflation within the 1-3% target range.

Peru: Policy Interest Rate(Annual rate)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

Mar-05

Jul-05

Nov-05

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Jul-10

Source: BCRP

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What’s Next? Friday, August 6 Brazil’s July IPCA Morgan Stanley Forecast: NA; Consensus: 0.02% m-o-m

• Lower food prices – the previously-released food component in the consumer index of July’s IGP-M declined -1.05% – likely were the main factor keeping overall inflation in check during July.

• The improvement on the inflation front of late, however, seems to go beyond just food: the latest IPCA and IPCA-15 core measures have shown an encouraging downturn at the margin.

Brazil: Inflation(% change, y-o-y)

-5%

0%

5%

10%

15%

20%

25%

30%

35%

Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10

Admin. PricesMarket PricesIGP-MIPCA

Source: FGV, IBGE, Morgan Stanley Latam Economics

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A Comparative Look: Regional Credit and Economic Trends Latin America: Real GDP Growth*

(% change y-o-y)

-5%

-3%

-1%

1%

3%

5%

7%

4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03 4Q04 4Q05 4Q06 4Q07 4Q08 4Q09 4Q10

Source: Statistical institutes, Morgan Stanley Latam Economics *GDP PPP weighted

Annual economic growth likely peaked in the second quarter in Latin America. For example, Mexico grew 4.3% in 1Q and seems on track to approach 8% in 2Q, while in Brazil GDP rose 10.8% on average in April-May on a year-over-year basis, up from 9.0% in the first quarter. However, strong annual comparisons can mask divergent sequential trends: whereas Mexico’s economy reaccelerated sharply in 2Q – to a sequential 2.5-3.0% non-annualized clip, according to the central bank – Brazil is clearly decelerating from its breakneck 1Q pace (2.7% non-annualized).

Brazil: Selic Rate (Annual Rate)

8

10

12

14

16

18

20

22

24

26

28

Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10

Source: BCB

Global Interest Rates(Annual rate)

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10

Policy RateInflationReal Policy Rate

Source: National data sources, Haver, Morgan Stanley Global Economics

Global monetary policy remains highly accommodative, fully one year into the global economic recovery, according to our global economists Joachim Fels and Manoj Pradham (see “The Big Easy,” in Global Monetary Analyst, July 28). Although almost half the central banks under Morgan Stanley’s coverage have started to lift policy rates or tightened monetary policy though other instruments, the weighted global policy rates remains in negative territory and even eased further during the first half of 2010, causing global liquidity to grow to yet another record high recently.

Morgan Stanley's US Business Conditions Index(Diffusion index, seasonally adjusted)

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Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-100

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Morgan Stanley BusinessConditions Index (3mma)

ISM Manufacturing Index

Source: ISM, Morgan Stanley Research *Shaded areas indicate recessions

Brazil’s central bank delivered a dovish message in its July minutes, in sharp contrast to June’s tone which was characterized by a cautious inflation outlook and an economy running ahead of itself. Though the economy is running close to potential, in July the Copom pointed to an improving inflation picture amid uncertainty about the resilience of global growth while, domestically, the withdrawal of fiscal incentives as well as tightening of monetary policy have cooled the economy off, paving the way for a reduction in the pace of rate hikes ahead.

Business conditions have deteriorated in the US. Our US team’s proprietary MSBCI index stabilized at a weak 42% in early July, with the headline index remaining below the critical 50% threshold for the second straight month. Looking beyond sentiment surveys, 2Q GDP grew just 2.4% annualized with consumer spending up a modest 1.6%. Our US economists point out that the inventory implications of the 2Q GDP report may be pointing to a slower growth trajectory in the second half of the year than they had expected.

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. . . From Our Global Economics Team Slam Dunk Stimulus by David Greenlaw If it were possible to inject a significant amount of stimulus into the household sector of the US economy over the near term and this stimulus had zero impact on the budget deficit, did not require an exit strategy, did not distort the markets, and took effect almost immediately, wouldn’t it seem like a slam dunk? Such an option actually exists in the form of a change to mortgage refinancing requirements. The Fed – and market forces – have pushed mortgage rates to historic lows (see Exhibit 1). However, many homeowners are unable to take advantage of the low rates because they are blocked from refinancing by a high loan-to-value ratio (LTV), appraisal problems, unemployment, and low credit score, etc. This problem could be addressed if the Government merely recognized the guarantee that already exists on the principal value of a very large portion of the mortgage market – specifically, the mortgages that are backed by Fannie, Freddie and Ginnie – and acted to streamline the refi process.

Exhibit 1 Mortgage Rates Fall to Historic Lows

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6

8

10

12

14

16

18

20

75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

Percent

30-Year Fixed Rate on Conventional Mortgages

Source: Freddie Mac

How Many Borrowers Could Be Impacted? As seen in Exhibit 3, roughly half of all US households have a mortgage. Of these 55 million households, 37 million have mortgages whose principal value is already guaranteed by the Federal government. Yet, when these homeowners apply for a refinancing, the application is subject to a standard underwriting process that involves an LTV test (requiring a property appraisal), an analysis of the borrower’s FICO score, and income verification. Obviously, the drop in home prices during the past few years means that many borrowers will not

meet the LTV requirement – especially since there has been a significant tightening in the appraisal process according to press reports. Indeed, our housing analyst Oliver Chang estimates that more than one-third of all agency-backed mortgages outstanding now have an LTV above 80% (see Exhibit 2). Looking at the principal value of these mortgages, the proportion is even greater (a little above 40% of the total) because an outsized share are located in California, where property values are higher than the national average. There are probably an additional 10% or so of borrowers who don’t qualify for refinancing because of job loss or a low FICO score. Thus, we believe that perhaps 50% of the outstanding principal value of agency mortgages may not be refi-able at present. As seen in Exhibit 4, this estimate is broadly consistent with actual versus predicted prepayment speeds that currently prevail in the mortgage market.

Exhibit 2 High LTV's Act as an Obstacle to Refi

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

00 01 02 03 04 05 06 07 08 09 10

Principal Amount

Number of Mortgages

Share of Outstanding Agency Mortgages

Note: Includes second liens Source: Morgan Stanley Research Exhibit 3 Housing and the Mortgage Market

Households 112 million

Homeowners 75 million (67%)

Have a Mortgage 55 million (49%)

Conforming (Fannie/Freddie) 31 million (27%)

Other Govt Guaranteed (FHA/Ginnie) 6 million (5%)

Other 18 million (16%)

Sources: Census Bureau, Federal Reserve Survey of Consumer Finances, Fannie Mae, Freddie Mac and eMBS.

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Exhibit 4 Prepayment Speeds Are Running Well Below Expectations

0%

1%

2%

3%

4%

5%

6%

2006 2007 2008 2009 2010

Predicted

Actual

Prepayment Speeds (as a share of outstandings)

Source: Morgan Stanley Research

How large is the potential impact on household cash flow? As seen in Exhibit 5, the average interest rate across all outstanding mortgages stood at about 6% as of 2010 Q1. In the agency space, our mortgage strategist Janaki Rao estimates that the median rate on the universe of outstanding 30-year fixed-rate mortgages is currently 5.75%. With the 30-year fixed rate for new originations now hovering around 4.50%, the potential rate reduction would be an average of 125 bp. Assuming a $200,000 principal balance, the debt service reduction for the typical borrower would be about $2500/year. And this would represent sustained cash flow savings over the life of the mortgage – not a one-time benefit. Economists have long established that such a permanent change induces a more powerful spending response than a one-off rebate. In the aggregate, $2500 of annual savings on an estimated 18.5 million mortgages (50% of the government-guaranteed market) amounts to $46 billion per year. As a comparison, that’s more than the cost of the latest extension of unemployment benefits and more than taxpayers saved under the Make Work Pay tax credits in the big 2009 stimulus legislation (the American Recovery and Reinvestment Act, or ARRA).

Not only would there be an immediate benefit to the economy from streamlining the refi process, but any future monetary stimulus aimed at reducing mortgage rates would carry a more powerful impact. In his Monetary Policy Report to Congress, Chairman Bernanke indicated that the Fed would consider additional securities purchases if the economic recovery faltered. A change in the refi process along the lines that we recommend would increase the impact of the Fed’s remain bullets.

Exhibit 5 Effective Interest Rate on Outstanding Mortgages

4

5

6

7

8

9

10

11

12

77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

Percent

Current 30-Year Fixed Rate for New Originations

Source: Bureau of Economic Analysis

Who needs to act? Anything related to the GSEs is highly toxic in Washington these days, and politicians are sure to tread carefully when a legislative initiative involves Fannie and Freddie – even when the change seems to be such a clear-cut winner as this one. However, in our view, Fannie and Freddie’s regulator – the Federal Housing Finance Administration (FHFA) – has the authority to implement the type of changes in the underwriting process that are involved here. Most importantly, we are not recommending any change to the qualification for new mortgages – only refis. Thus, there is no subsidy involved, and credit quality actually improves somewhat due to the lower payment burden. This implies fewer foreclosures going forward and less credit risk for the guarantor of the mortgage (i.e., the US government).

What’s changed? Until recently, it may have made sense for the agencies to reevaluate the credit quality of a borrower who already had an agency-backed mortgage when they submitted a refi application. That’s because Fannie and Freddie shareholders represented a capital cushion between the borrower and the US government. But Fannie and Freddie are no longer listed on the NYSE (as of June 26), so this cushion no longer exists, and the Federal government stands alone as the guarantor of the principal value of agency-backed mortgages. In addition, Fannie Mae and Freddie Mac have been in Federal conservatorship since September 2008. These agencies had long enjoyed the implicit guarantee of the Federal government, and this step created an even “stronger backing” according to regulators.

Who would be the winners and losers? While the US household sector would be the clear beneficiary of a

12



streamlined refi process, the losers would be the holders of agency MBS. Prepay speeds would rise dramatically and MBS spreads would adjust accordingly. Admittedly, this could temper the magnitude of our estimated benefit to borrowers – unless the Fed were to step in and serve as the backstop buyer once again.

The notion that the Federal government should recognize the mortgage guarantee that is already in place when establishing the qualifications for refinancing has been raised by others in the past. For example, Glenn Hubbard and Chris Mayer of Columbia University advocated such a policy in numerous forums over the past couple of years (for example, see their Wall Street Journal op-ed “First Let’s Stabilize Home Prices,” October 2, 2008). However, the Hubbard/Mayer proposal surfaced at a time when mortgage rates were considerably higher than they are now and involved a subsidy for the borrower in addition to streamlining the refinancing process (they argued that the government should subsidize the differential between a normal mortgage spread to Treasuries and the unusually wide spread that prevailed at the time). Presumably, their proposal would have helped to stabilize the housing market, stem the rising tide of foreclosures, and

provide a cash flow benefit to the borrower. When the Congressional Budget Office scored the proposal as having a significant impact on the budget deficit – due to the subsidized mortgage rate – political support quickly evaporated. But since that time, the Fed has accomplished one of Hubbard/Mayer’s main objectives – shrinking the mortgage spread. And the markets have driven Treasury yields to extremely low levels. All that’s left is to streamline the refi process.

Finally, a streamlined refi process for agency mortgages is not inconsistent with other foreclosure mitigation programs that are already in place (such as HAMP). If the government wants to subsidize restructurings or principal writedowns for distressed borrowers, that is fine. Indeed, a streamlined refi process would likely reinforce the impact of these initiatives and help alleviate the strategic default problem. The bottom line is that market conditions have created a potentially costless windfall that is not being used. Quite simply, there is no need for a case-by-case credit analysis when the principal value of the mortgage is already backed by the government.

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On the Horizon Latin America Annual Economic Forecasts Argentina Brazil Chile Colombia Mexico Peru Venezuela Region Real GDP growth (%) 2007 8.7% 6.1% 4.7% 7.5% 3.3% 8.9% 8.2% 5.9% 2008 6.8% 5.1% 3.7% 2.4% 1.5% 9.8% 4.8% 4.2% 2009 0.9% -0.2% -1.5% 0.4% -6.5% 0.9% -1.9% -2.1% 2010E 4.6% 7.9% 4.1% 5.2% 7.0% -6.2% 5.3% 2011E 2.4% 4.0% 3.8% 4.0% 6.4% -1.2% 3.6% Inflation (year-end, %) 2007 8.5% 4.5% 7.8% 5.7% 3.8% 3.9% 22.5% 6.2% 2008 7.2% 5.9% 7.1% 7.7% 6.5% 6.7% 30.9% 8.2% 2009 7.7% 4.3% -1.4% 2.0% 3.6% 0.2% 25.1% 5.3% 2010E 10.5% 5.8% 4.4% 5.0% 2.2% 45.0% 8.5% 2011E 10.7% 5.5% 4.1% 3.4% 2.5% 38.5% 7.5% FX rate (year-end vs. US$) 2007 3.15 1.77 496 2,015 10.91 2.98 2.15 2008 3.45 2.34 629 2,249 13.69 3.11 2.15 2009 3.81 1.74 506 2,043 13.09 2.88 2.15 2010E 4.20 1.65 1,875 11.85 2.80 4.30 2011E 4.30 1.70 1,800 12.10 2.75 4.30 Current account balance (% GDP) 2007 2.8% 0.1% 4.5% -2.9% -0.8% 1.3% 7.9% 0.6% 2008 2.2% -1.8% -1.5% -2.9% -1.5% -3.7% 11.9% -0.4% 2009 3.4% -1.5% 2.5% -2.3% -0.6% 0.2% 0.5% -0.3% 2010E 3.1% -2.6% 0.6% -0.9% 0.7% 5.8% -0.8% 2011E 2.9% -2.5% 0.0% -1.5% 0.4% 3.5% -1.1% Trade balance (US$ bn) 2007 13.3 40.0 23.6 -0.8 -11.2 8.3 23.0 97.4 2008 13.2 24.8 8.8 0.5 -15.3 3.1 45.7 78.8 2009 17.0 24.7 13.3 1.7 -4.7 5.9 19.2 77.0 2010E 23.6 0.2 6.6 -7.1 6.1 26.9 69.8 2011E 26.4 -5.2 4.7 -14.2 4.1 23.1 47.2 Interest rate (year-end) 2007 10.28% 11.25% 6.00% 9.50% 7.50% 5.00% 11.18% 2008 15.07% 13.75% 8.25% 9.50% 8.25% 6.50% 17.25% 2009 9.32% 8.75% 0.50% 3.50% 4.50% 1.25% 15.00% 2010E 11.00% 11.00% 4.25% 4.50% 3.25% 15.00% 2011E 12.00% 12.50% 6.50% 6.00% 5.00% 15.00% International reserves (US$ bn) 2007 46.2 180.3 16.9 20.9 78.0 27.7 33.5 403.5 2008 46.4 206.8 23.2 23.7 85.4 31.2 42.3 459.0 2009 48.0 239.1 25.4 25.0 90.8 33.2 35.8 497.2 2010E 60.0 250.0 28.0 110.0 38.0 28.0 539.0 2011E 62.0 250.0 28.0 122.0 40.0 28.0 555.0 Public sector balance (% GDP) 2007 1.1% -2.7% 8.6% -2.8% 0.0% 3.1% -2.8% -0.7% 2008 1.4% -1.9% 5.0% -1.8% -0.1% 2.1% -2.6% -0.5% 2009 -0.6% -3.3% -4.6% -3.8% -2.3% -1.9% -8.2% -3.1% 2010E -1.0% -3.0% -3.6% -2.7% -1.4% -4.5% -2.7% 2011E -1.1% -2.4% -2.9% -2.5% -0.5% -3.5% -2.2%

E = Morgan Stanley Latam Estimates Source: Morgan Stanley Latam Economics

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Latin America Calendar Weekly Data Releases (August 2-6)

Date Country Statistic Morgan Stanley

Forecast Consensus Last

Monday August 2

Argentina Tax Revenues (July)

38.5% y-o-y 33.3% y-o-y 39.4% y-o-y

Brazil Trade Balance

(July) $2.0 billion $1.9 billion $2.3 billion

Chile Consumer Confidence*

(July) NA NA 47.9

Peru CPI

(July) 0.30% m-o-m 0.33% m-o-m 0.25% m-o-m

Venezuela CPI*

(July) NA NA 1.8% m-o-m

Tuesday August 3

Brazil IP (June)

NA 11.7% y-o-y 14.8% y-o-y

Brazil CPI – FIPE (Final)

(July) NA 0.20% m-o-m 0.19% m-o-m

Mexico Manufacturing Confidence

(July) NA NA 50.6

Mexico Manufacturing Trend Index

(July) NA NA 55.3

Wednesday August 4

Mexico Consumer Confidence (July)

NA 88.7 87.5

Thursday August 5

Chile IMACEC (June)

NA 6.0% y-o-y 7.1% y-o-y

Colombia CPI

(July) 0.16% m-o-m 0.10% m-o-m 0.11% m-o-m

Mexico Leading Economic Indicator – INEGI

(May) NA NA -0.6% m-o-m

Peru Monetary Policy Meeting 2.25% 2.25% 2.00%

Friday August 6

Brazil IPCA (July)

NA 0.02% m-o-m -0.09% m-o-m

Chile CPI

(July) NA 0.7% m-o-m 0.0% m-o-m

Colombia Monetary Policy Minutes NA NA NA

NA = Not Available or Not Applicable; *Earliest possible release date; Source: Morgan Stanley Latam Economics Estimates

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Latin America Economics Team Gray Newman .............................(212) 761-6510 [email protected] Daniel Volberg ............................(212) 761-0124 [email protected]

Luis Arcentales .......................... (212) 761-4913 [email protected]

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morgan stanley on latam: venezuela: a hard-currency tipping point

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