QE Coming of Age
February 03, 2012
By Spyros Andreopoulos | London
The financial crisis and its macroeconomic consequences forced central banks to use their balance sheets in unprecedented ways, and very aggressively so. Initially, market participants as well as central bankers themselves would probably have expected this use of the balance sheet to be temporary. And yet, roughly three years later, not only is no end in sight, but central banks are poised to up the stakes with more purchases in 1H12. On our forecasts, the Fed will embark on a further round of US$500-750 billion of Treasury and MBS buying, to be announced in 2Q; the Bank of England will likely announce an extension of its asset purchase programme in February by £75 billion; the Bank of Japan should increase the ceiling on its asset purchases; and even the ECB will join in the action with broad-based public and private sector bond purchases during the second quarter.
Yet not only is further balance sheet expansion imminent. The Fed's latest statement also suggests that balance sheet policy has arrived as a tool proper: "The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate".
This raises the following questions: Is balance sheet policy, which we define as a change in the size and composition of the central bank balance sheet for a purpose other than to steer the level of the overnight interest rate, now a permanent tool of monetary policy? Should it be? And if it is, what are the implications?
Before answering these questions, it is worth taking stock of what balance sheet policy has done so far, and what risks arise from these actions.
I. What Has Been Done? Actions
How have central bank balance sheets been deployed in the crisis? In what follows, we de-emphasise institutional detail in favour of the big picture. Naturally, the particulars of how a central bank uses its balance sheet (which assets are bought, in which market, and from whom) depend on the nature of the financial system it operates in. The ECB and the BoJ, which face more bank-based financial intermediation, pursue their goals through alleviating the situation in the banking sector, including bank funding. The Fed and the BoE, on the other hand, operate in economies where financial intermediation is more market-based - hence most of their interventions are directly in financial markets. We distinguish, schematically, three stages of central bank balance sheet policy:
1. Change in balance sheet composition through collateralised lending, no increase in monetary base: Initially, central bank balance sheets were used to address dysfunctionality in certain segments of financial markets and/or to relieve funding stress in the banking sector. Typically, this involved collateralised lending, whereby market participants posted illiquid securities and obtained liquidity, frequently on a longer-term basis, i.e., at longer maturities, than would normally have been the case. This lending was not allowed to expand the monetary base: central banks either sold other assets (leaving the overall size of their balance sheet unchanged) or sterilised the expansion in bank reserves that would have resulted via the issuance of other liabilities. This may be described as financial stability policy rather than monetary policy proper. In this case, the central bank acted as a market maker of last resort, sometimes substituting for a dysfunctional (money) market.
2. Change in balance sheet composition through collateralised lending, increase in monetary base - passive QE: As the crisis escalated in the wake of the Lehman Brothers collapse in September 2008, central banks had to allow an expansion of the monetary base. Rather than selling other assets or sterilising, they proceeded to issue bank reserves in exchange for the assets lent to them by their counterparties within the collateralised lending framework. We call this passive QE as the size of the central banks' balance sheet is determined by the private banking sector's demand for liquidity (see Manoj Pradhan, The Global Monetary Analyst: QE2, March 4, 2009). Among other reasons, this was done to accommodate the shift in liquidity preference on behalf of financial institutions, but also the public - corporates and households - who, unlike financial market participants, do not have access to central bank liquidity. For the public, an increase in liquidity preference could only be accommodated via an increase in the stock of money, which an increase in the monetary base facilitates.
3. Change in balance sheet composition through outright purchases, increase in monetary base - active QE: The next stage was outright, i.e., uncollateralised, purchases of assets, financed again through the issuance of central bank liabilities (bank reserves). We call this active QE, as the amount purchased and hence the size of the balance sheet are determined by the central bank. This is monetary policy proper. The objectives here were much broader, and macroeconomic, in nature: lower yields for households and businesses should support consumption and investment and lead to an overall reduction in the likelihood of deflation.
Active QE, and balance sheet policy in general, was aimed at substituting for interest rate policy, in a context where the ability of central banks to affect aggregate demand through the manipulation of the interest rate had reached or approached its limits (because of the zero bound to nominal interest rates).
II. Taking Stock: Consequences
During 2007/08, the private sector's liquidity and risk preferences underwent a tectonic shift - the relative valuations of almost the entire universe of assets changed dramatically. As a consequence, the private sector's desire to aggressively deleverage - shrink its balance sheet - has meant trying to dispose of a lot of assets. As the above schematic description demonstrates, central banks have used their balance sheets to effect:
• Liquidity transformation, by exchanging illiquid assets for liquid ones (T-bills and bank reserves, i.e., their own liabilities); often hand-in-hand with
• Maturity transformation, by exchanging long-term assets for liquid assets (again, their own liabilities); and
• Risk transformation, by exchanging risky assets for safe ones (again, their own liabilities).
In short, central banks have, through expanding their own balance sheets, in effect liquefied the private sector's balance sheet and taken the unwanted assets off it. That is, central banks have used their balance sheets to act as a buffer, thus performing a crucial intertemporal stabilisation function. Note that central banks' balance sheet cannot, and should not, prevent deleveraging. Rather, they facilitate a smoother adjustment over time so as to alleviate the adverse macroeconomic effects of (too rapid) private sector deleveraging (see also The Global Monetary Analyst: The Past, the People, The Policies, October 26, 2011). Put differently, through using their balance sheets to provide these transformation services, central banks have eased funding conditions for banks, non-bank corporates, households and sovereigns. It is clear that central bank actions have both alleviated market stresses and had macroeconomic effects.
But this hasn't come without a price. We highlight two worries:
Fiscal dominance: When the medium-term path of the economy is determined by fiscal deficits and deleveraging, attempts to control inflation by increasing policy rates may prove counterproductive: higher policy rates increase sovereign funding costs; this weighs excessively on the economy and could force the central bank to back-pedal. In short, in economies under potential fiscal duress, monetary policy is constrained in its actions: we call this fiscal dominance (see Manoj Pradhan, The Global Monetary Analyst: Is Modern Central Banking Ancient History? October 19, 2011). Now, active QE for sovereign bonds - that is, the outright purchase of government debt in the secondary market - also provides financing for governments, albeit indirectly (purchases in the primary market, i.e., at auction, would be direct monetary financing; however, this would be illegal as it is prohibited in central bank statutes - see The Global Monetary Analyst: G3 Central Banks: Constitutional Issues, January 19, 2012). We think that QE locks central banks into a tighter embrace with fiscal policy and thus reinforces fiscal dominance over monetary policy: as public debt climbs, so must central bank government bond purchases to keep yields low, all else equal. In addition, given that exit from QE is not as easy as entry - exit will almost certainly have to be much more gradual - the more government debt accumulates on central banks' balance sheets, the more difficult and protracted the exit will be.
Equity provision by central banks? In this very context, current discussions regarding the ECB potentially taking losses on its Greek bond holdings provide a cautionary tale. By purchasing assets from an entity which subsequently proved insolvent, the ECB has in this case de facto provided equity, rather than simply liquidity. This is problematic not least because central banks are not democratically mandated to provide equity, which belongs to the realm of fiscal policy. For the central bank itself, the dangers are obvious: losses would ultimately have to be borne by the government - this creates the risk of curtailing the de facto independence of a central bank. More broadly, central bank balance sheets have taken on a great deal of risk. This risk has not disappeared, certainly not all of it. Since the central bank is but a branch of government, any risks materialising would end up with the sovereign - which in turn implies that the private sector would have to foot the bill in the end.
III. Looking Ahead
With more QE by major central banks ante portas, we ask: are there limits to balance sheet expansion? And should balance sheet policy become standard in central banks' toolkit? Yet, before answering whether continued balance sheet expansion is desirable, we must ask whether it is possible.
Are there limits to balance sheet expansion? There is no technical limit to balance sheet expansion because there is no limit to the amount of reserves a central bank can issue. Yet the ability of central banks to perform the intertemporal buffer function discussed above rests on them being the monopoly issuer of a liability that the private sector accepts as an asset and thus is willing to hold on its own balance sheet. This is only true if, and for as long as, central bank liabilities remain safe and liquid assets in the perception of the private sector. From this, the true limits of central bank balance sheet expansion follow immediately. The trick can work only for as long as the private sector is willing to hold these assets. That is, it is entirely a matter of confidence in the central bank and in particular in its commitment to maintain the real value of its liabilities - both reserves and cash. The ability to act as a buffer disappears if confidence were to disappear. We are not suggesting that we are necessarily close to such a point. Yet, as balance sheets keep climbing, we will probably be getting closer to this point rather than further away.
Does this mean balance sheet policies are here to stay - possibly forever? First, balance sheet policy, by its very nature, distorts market prices and hence influences resource allocation (to be precise, so does interest rate policy - but to a much lesser extent). While interfering with market pricing is exactly the point in times of financial market distress and severe economic weakness, presumably it is not something that can be deemed desirable in the long run. Take interest rate policy, the regular central bank policy instrument, as a benchmark. Under ‘normal' circumstances, the central bank only manipulates the overnight rate - by trying to steer the market overnight rate as closely as possible to some desired level. The pricing of the entire universe of financial assets - whatever the riskiness, duration, liquidity, etc. - is left to the market. Second, the effects of balance sheet policies as a macroeconomic tool are as yet insufficiently understood, certainly less so than ‘conventional' macro policy through the interest rate tool. In view also of the risks discussed above, we do not think that active balance sheet policy should become a permanent tool of macroeconomic management.
As an emergency tool, however, it is entirely legitimate - that is, as a continuation of conventional monetary policy at the zero lower bound for interest rates and/or when the transmission mechanism is blocked. That is, while we don't think that central bank balance sheets should remain bloated forever - and indeed, we think that they should return to ‘normal' as soon as the economy and markets allow it - monetary authorities should, and will, retain the option to expand their balance sheet when deemed necessary.
Normative considerations aside, what will actually happen? Central bank balance sheets are likely to remain bloated for a long period of time - indeed, the balance sheet expansions might even end up being quasi-permanent.
First, even if all goes smoothly and the recovery proceeds slowly but surely, it will probably take central banks many years to exit, even if you discount the fiscal dominance argument. Asset sales would have to proceed with the utmost caution - indeed, risk-aversion implies that central banks would rather err on the side of caution and sell too little, too late - just one of the reasons why we are worried about inflation in the long term. Second, if (i) the recovery remains bumpy, with more growth scares; and/or (ii) we revert to recession at some point over the next few years, it seems almost certain that balance sheets will be deployed again. So, in the near-to-medium term, the only way for balance sheets seems to be up. Finally, because of the possibility of economic shocks, the unwind of balance sheets might even take the shape of ‘two steps forward, one step back'. That is, unless we are wrong in the above and balance sheets can indeed be reduced rapidly, a balance sheet reduction that's on the way could be interrupted by a large deflationary shock, which necessitates renewed expansion, and so on.
What are the implications of quasi-permanent central bank balance sheet expansion? The long-term adverse consequences on capital allocation aside, the main question here is whether it would be inflationary. The short answer is, not necessarily. Roughly speaking, to avoid inflationary effects, the permanent part of the expansion in the monetary base should not exceed the increase in the economy's long-term liquidity preference. Clearly, the latter is not an animal that is easy to pin down, not least because it depends on risk-aversion and the evolution of the economy. And of course, central bank balance sheets themselves distort the very prices that would indicate such shifts.
Conclusion: We believe that although there are no technical limits to balance sheet expansion, central banks should not jeopardise confidence in their own liabilities by issuing too many of them - confidence is the ultimate constraint. While QE/balance sheet policy is by now firmly established as a central bank policy tool, the deployment of outright asset purchases for macroeconomic reasons should remain confined to extraordinary macroeconomic circumstances - occasions where the conventional interest rate tool has exhausted its potency at the zero lower bound. That said, reverting balance sheets back to normal is likely to take a long time - so long, that balance sheet expansion could end up being quasi-permanent. This could be inflationary unless the size of the monetary base keeps in lockstep with the evolution of the public's liquidity preference over the long term.
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2012 Election Series - ‘Social VAT' - So What?
February 03, 2012
By Olivier Bizimana | London
‘Social VAT' is not a reform per se from candidates in the upcoming elections. Rather, the measure has been proposed by the current government and should be implemented after the elections. The parliament is expected to vote on the reform before the elections though. Still, given the pre-election campaign context, the proposal has generated a lively debate across the political spectrum. In addition, the presidential candidate, Francois Hollande, has already said that he will reverse the reform if elected, as the VAT would weigh on household purchasing power.
The Case for ‘Social VAT'
Last Sunday, President Sarkozy announced the introduction of ‘social VAT' in France. The proposal aims at cutting employer social security contributions by €13 billion and replacing them with a value added tax (VAT), raising the standard rate by 1.6pp to 21.2% to finance social security. The measure would be completed by an extra increase of 2pp in social welfare tax (contribution sociale généralisée) on investment income.
The main arguments in favour of introducing a ‘social VAT' are essentially threefold:
i) Social security contributions in France are elevated and fall more heavily on the labour inputs, which discourage businesses from hiring new employees, but instead to use more capital-intensive technologies. In addition, assuming unchanged policies, population ageing is likely to put upward pressures on social expenditures in the years ahead, which is likely to raise social security contributions even further. Hence, other sources of financing, which would not weigh on the labour inputs, have to be mobilised to finance social security. In particular, a ‘social VAT' would have the advantage of being applied to all income (labour and investment income). In addition, the measure would improve the competitiveness of domestic products compared to imports, which are subject to VAT. As the cut in social security contribution would reduce labour costs, it could also lower the costs of exports.
ii) The international evidence suggests a positive impact. The most often mentioned examples of countries that have replaced part of social security contributions with a VAT to finance social security are Denmark and Germany. For example, Denmark reduced social security contributions paid by employers (financing unemployment benefit and disability). In turn, the VAT has been increased by 3pp to 25% between 1987 and 1989. The VAT increase had little impact on inflation over that period. Still, it is difficult to establish whether the strong performance of the Danish economy was due only to the reduction in social security contribution. Indeed, the reform was part of broad macroeconomic measures implemented to stabilise the economy and restore competitiveness. Germany increased the VAT rate by 3pp to 19%, on January 2007. However, in case of Germany as well, the aim of the measure was not to boost competitiveness of businesses. Only one-third of the receipts generated by the VAT hike have been used to finance the cuts in employer social security contributions (financing unemployment benefits), the remainder being used to reduce the fiscal deficit. In fact, the measure was part of reforms aimed at restoring the sustainability of public finances. As German businesses were already highly competitive compared to their European peers, it is difficult to establish whether the measure has further improved their competitiveness. In addition, inflation picked up after the introduction of the measure, though less than proportionally to the VAT hike, presumably because high profit margins of German companies allowed them to absorb part of the VAT increase, in a context of strong economic growth acceleration.
iii) Government reports, based on large macroeconometric models, have shown that the introduction of a ‘social VAT' in France may improve the competitiveness of the French economy and support job creations. More specifically, the reports concluded that the impact on competitiveness would be larger if the cut in social security contributions was targeted at highly skilled workers. By contrast, the measure would generate more job creation if were targeted at low-paid workers. For example, reports published by the French ministry of finance showed that an increase in the standard rate of VAT of 1.5pp (2pp cut in employer social security) would lead to up to 300,000 new jobs (around 1.8% of total employments in competitive sectors) if targeted at the minimum wage workers (SMIC) in the medium term, compared to around 30,000 if it is generalised to all workers.
High Social Security Contributions, a Hurdle to Job Creation
In France, the financing of social security relies mainly on social security contributions from labour input. The amount of social contribution affected to the financing of social security was about €390 billion in 2009 (64% of total resources). Among those, employer social contribution amounted to €217 billion, while the employee contribution amounted to €101 billion. The high taxation on labour income in France is a problem, especially if compared to other developed countries. France has indeed one of the highest shares of social security contributions from wages. In particular, social contributions paid by employers are one of the highest among OECD countries at almost 30% of total labour costs in 2010, compared to 14% for the average OECD or 16.2% in Germany, France's main trading partner.
The Value Added Tax (VAT); a Potential Source of Financing
In France (mainland), three VAT rates are applicable. Most goods and services sold are subject to the standard VAT rate of 19.6%. The reduced VAT of 7% applies to necessity items (food consumption and cultural products such as books). Finally, a super-reduced rate of 2.1% is applied to newspapers and some pharmaceutical products reimbursed by social security. Overall, the VAT is an indirect tax for which the receipts are affected in large part to the state budget. The net VAT receipts represented around €125.4 billion in 2010, almost half of the state budget receipts. Hence, VAT receipts might be a potential source for financing social security, especially because the standard rate of VAT in France is slightly lower than the European average, suggesting that there is still some scope to raise it without creating distortion compared to EMU trading partners.
The ‘Social VAT': Weighing Costs and Benefits
The objective of the proposal is to cut social security contributions. In turn, a fraction of the VAT receipts would be transferred to finance social security. This measure increases the tax base to finance social security, as the VAT is levied on all consumed products (domestic and foreign), while social security contributions are only levied on gross salaries. In addition, increases in the social welfare tax (contribution sociale généralisée) on financial income follow the same logic of shifting away from taxation on labour income. Ultimately, a cut in social security contribution is expected to reduce production costs, which should allow a reduction in prices net of VAT.
An Almost (Theoretically) Inflationary/Fiscal-Neutral Reform
The net impact of the ‘social VAT' is deemed to be almost neutral for both inflation, at least for domestic products, and public finances. Assuming, for instance, a generalised cut in social security contributions financed by an increase in the VAT rate, we can show a simplistic illustration of the expected benefit from that measure.
We assume that a 1.6pp increase in the standard VAT rate to 21.2% is used to finance the cut in social security contributions. In turn, firms would lower their prices net of VAT by the same amount in order to preserve their competitiveness. In this example, the level of prices inclusive of VAT remains unchanged. So there are no negative effects on consumers of domestic products and wages. However, as imports are subject to VAT and do not benefit from the cut in labour costs, the aggregate price level should go up.
For public finances, the reform is deemed to be neutral as well, as the taxation on consumption is used to compensate the cut in social security contributions in order to finance social security.
Still, this illustration is quite simplistic, as we assume that companies have no pricing power and will be cutting their gross operating surplus. In practice, the impact on prices of domestic products would depend on how businesses adjust their prices net of VAT.
The Pros
The expected positive effects of shifting taxation from labour income to consumption are as follows:
- Stimulates employment in all the sectors (tradable and non-tradable) and increases the attractiveness of France for foreign companies, as the costs of labour and production are reduced;
- Improves competitiveness of French products, as the cuts in social security contributions lower export prices, while the VAT hike raises import prices (exports are not subject to the VAT). The decline in export price improves price competiveness, while the increase in the VAT benefits domestic products relative to import products, provided they are highly substitutable.
The Cons
The social VAT is likely to lead to an increase in the level of prices though, if companies do not reduce prices net of VAT. In turn, this would likely lead to:
- A rise in inflation, which would erode household purchasing power and dampen consumption and growth;
- Lower employment in the medium term, as higher inflation would push up wages, in particular the minimum wage (SMIC), which is indexed to inflation, as well as the levels of wages around it;
- A deterioration in public finances, as the rise in inflation, through indexation mechanisms, induces an increase in social transfers, pensions, unemployment benefits and public wages;
- A transfer of profit within sectors, in particular from businesses with lower pricing power to those with a higher pricing power that have the ability to pass the VAT hike on to consumers.
The Uncertainties
Besides these negatives effects, even the expected positive impacts are surrounded by high uncertainty.
- Even if firms were able to absorb part of the increase in the VAT, easing inflationary pressures, this may, on the other hand, weigh on their profits and ultimately their investment;
- The benefit in terms of competitiveness gains is likely to be limited. In particular, the gap in production costs between France and many countries, especially emerging economies, is so large that the cuts in social security contribution would not be enough to reduce those costs significantly. The competitiveness against developed countries with similar production cost structures is likely to improve though. But this gain is likely to be short-lived, as the main trading partners may implement the same measure.
In Practice, What Are the Likely Effects on Inflation?
The 1.6pp increase in the standard rate of VAT, planned for October 1 this year, is likely to push up inflation. Indeed, the standard rate of VAT applies to most of goods and services sold in France. Therefore, the impact of the VAT hike is likely to be visible on the level of overall prices. In addition, we believe that a rise in prices seems almost inevitable in the short term:
- The increase in VAT would push up the prices of imports;
- Prices of domestic products would increase, as the VAT hike would apply to goods produced before the implementation of the reform;
More importantly, the impact on prices would depend on companies' initial financial situations and the degree of competition on markets:
- Some companies may seek to restore their profit margin, especially SMEs, instead of reducing their prices net of VAT;
- The lack of competition in some sectors may lead businesses to maintain high margins.
- The increase in the VAT would take place at a moment when businesses' financial position will still be weak, following a recession and in a context of tighter financial conditions.
Overall, French Inflation Will Be Higher than Our Current Forecast
If we assume that, given the weakness of the domestic demand, companies do not reduce their prices net of VAT, this would increase headline inflation by around 0.75pp. Headline inflation would pick up above 2% to 2.5%Y in October 2012, and remain above 2.0%Y throughout most of 2013. In this scenario, annual average inflation would reach 2.1% in 2012, the same level as in 2011. All things being equal, euro area headline inflation would remain almost unchanged on average in 2012 (but would go up by 0.2pp in October), and increase by 0.2pp on average in 2013.
However, if companies absorb part of the increase in the VAT, the initial rise in inflation would be slightly lower, around 0.5pp - and around 0.1pp in the euro area.
What Are the Corporate Impacts?
The macroeconomic impact will depend on whether the cut in social security contribution would be significant to push down production costs. In addition, the positive impact on employment and competitiveness would depend on whether businesses are more labour or capital-intensive. Also, their initial financial position as well as the degree of competition on their markets is crucial to assess their ability to reduce their prices net of VAT.
Overall, the impact on corporates will depend on:
- The pricing power;
- The labour intensity;
- Bargaining power of unions.
We have estimated the potential impact of a ‘social VAT' on a number of European companies in different sectors under Morgan Stanley coverage that have the most exposure to France.
Based on the number of employees those corporates have in France, we estimate the impact of a 4pp reduction in employer social security contributions (around 1.2pp reduction in the labour costs in France) and the implications on their operating profit (EBITDA/EBIT). The results show that, given the small cut in the labour costs, overall, major positive effects on competitiveness and job creation are unlikely to materialise with ‘social VAT' alone. More specifically, there are three key conclusions:
1) The reduction in the labour costs is fairly negligible for most of corporates under coverage, except the ones that have a higher exposure to France and labour-intensive.
2) The impact on operating profit is very small for all businesses, in particular because, for most of them, their exposure to France is, on the whole, limited. Even for labour-intensive corporates, the impact on their operating profit is very limited.
3) Most of the corporates have a limited scope to reduce their prices, essentially because their profit margins are already under pressure from rising costs (energy, maintenance) and/or high competition. This suggests that even for businesses, for which the reduction in the labour costs might be relatively significant, they may pass, at least partly, the VAT increase onto consumers.
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Budapest Trip Notes
February 03, 2012
By Pasquale Diana | London
On Preconditions, Conditions, Policy Advice and Deal-Breakers
On track for an IMF/EU deal, judiciary issue is key: The prospect of an IMF/EU assistance package figured prominently in all our discussions. Prior to our trip, we thought the main obstacle to the official start of the negotiations was the issue of the NBH Act. And in particular, the issues related to the governor's salary, the number of MPC members, the MPC oath to the government and the merger between the government and the central bank. While a compromise on the NBH Act seems fairly easy to reach, in our view, our trip has revealed that the judiciary issue is as important as the NBH Act.
What is the judiciary issue? Some background: In a nutshell, starting on January 1, 2012, the government lowered the retirement age of judges from 70 to 62 years. This would force 274 judges to retire early, in a move which the EU judged discriminatory on age grounds: the EC does not see any objective justification for treating judges and prosecutors differently than other groups, especially at a time when retirement ages across Europe are being progressively increased, not lowered. Also, the Hungarian government has already communicated to the Commission that it intends to raise the general retirement age to 65, which raises even more questions about the judges' issue.
Some action needed by February 17: It is not clear how the judiciary issue will be addressed, and the EU has not provided clear guidelines. Given the rising tension in Brussels regarding the government, the European Commission is likely using this opportunity to exert as much pressure on Hungary as possible, we think. It is now up to the authorities to come up with some proposals to address the Commission's concerns. They need to do so by February 17, which will be a month after the infringement procedure was initiated. The next parliamentary session begins on February 13, so presumably some measures must be drafted soon.
The preconditions are really the conditions: Once the two key issues are resolved (NBH Act and the judiciary) then it seems that an agreement with the EU/IMF is well within reach. In fact, based on previous experience, two/three weeks would be sufficient to announce a package. Note also that the IMF is already very familiar with all Hungarian issues, so the amount of extra due diligence required would be limited. The real obstacles to the deal therefore appear to be the NBH Act and the judiciary. In other words, the preconditions to start the talks officially are really also the conditions needed to complete the talks successfully.
What about the IMF? So far, we have mostly discussed the European Commission. We have done so for a reason: it appears clear that the EU is set to be the tougher negotiating partner. Also, the position of the EU and the IMF are fully aligned, and we believe that a deal with the IMF is unthinkable without EU support. It follows that fulfilling the EU's requirements is key. While there has been some speculation that the IMF would ask Hungary to undo the flat tax, we believe that changes in the tax system would fall into the category of policy advice rather than preconditions. Of course, even the IMF would probably walk out under certain circumstances. For example, an extension of the crisis taxes beyond 2013 would be a deal breaker, we think.
Excessive Deficit Procedure (EDP) and suspension of cohesion funds: How credible? The EDP and the threat of suspending a given percentage of structural funds starting already in 2013 also featured in our meetings. Hungary has been in the EDP since it joined the EU in 2004, and the process has now run its course. Clearly, the EU would only ever grant assistance if the budget targets specified in the programme were consistent with an exit from the EDP. In other words, should assistance be granted, Hungary would be lifted from the EDP, provided it managed to stick to the agreed targets. We think that suspension of cohesion funds would be an extreme decision and would only be carried out under extreme circumstances. After all, the EU has a great deal of leverage over Hungary now, but we believe that it would not want to set any precedents on this issue.
A deal is likely, in our view, but the relationship with the IMF/EU could remain shaky: Policy-making is very centralised in Hungary around the figure of PM Orban. This is why his recent conciliatory tone towards the IMF and EU is the strongest indication that a deal is likely to eventually materialise. However, we cannot help but notice that thus far it has been mostly words, and little in the way of policy changes. We will need something concrete from the government over the next couple of weeks in order to be reassured. Also, the authorities would like the government to take ownership of the programme, and not to simply view it as a safety net that it can just abandon or choose to overlook once funding markets improve. We still assign around a two-thirds probability of a deal by April, although this is somewhat lower than before we visited Budapest. In other words, we are a bit more cautious now.
Banks will be an important part of any IMF/EU deal: Roughly 50% of the short-term external debt coming due is in the banking system. Deleveraging is already well underway in Hungary to a much more severe extent than elsewhere in CEE, therefore it is absolutely crucial to ensure that it takes place in an orderly manner (for more background, see also "Stress-Testing CEE in 2012: The Deleveraging Saga", CEEMEA Macro Monitor, December 16, 2011). Our meetings confirmed our prior belief that the EU and the IMF will not be happy being the ‘funding plug' that replaces bank funding. Rather, they will likely insist on coordinating foreign banks in Hungary in order to ensure sufficiently high rollover rates.
NBH: current disagreement on the Council revolves around the probability of an IMF deal: The recent decision to leave rates on hold (Morgan Stanley: 25bp, consensus: 50bp) was probably the result of a 4-3 split on the board (see also Hungary: Changing Gears, January 24, 2012). The February 15 minutes will offer greater insight on the discussion, but we believe that the disagreement stemmed from the subjective probability assigned to an IMF deal. The doves seem to implicitly assume a deal will get done, which implies that there are no reasons to hike rates further as the assistance package will be sufficient to reduce refinancing risks (and by extension currency risks). The hawks likely favour a more conservative approach, and saw no reason to halt the tightening cycle until words are followed by action on the part of the government.
Conditions for rate cuts later in the year are falling into place: We think that the recent rate hikes in November and December were entirely justified: the NBH believed that the combination of near-term CPI risks and financial stability concerns related to HUF depreciation warranted a rise in interest rates. That said, while near-term CPI risks remain elevated, it is also true that the medium-term picture remains benign, with the staff projection showing inflation easing to sub-3% in 2013. And assuming an assistance package eases concerns around the currency, the NBH can be more relaxed on this front also.
Assuming that a deal is struck by April at the latest, we think interest rates have peaked at 7% (previously: 7.50%). Also, we think that the NBH is likely to gradually move to an easing bias in the coming months. Growth risks remain firmly tilted to the downside, and the core inflation picture is not a concern. Assuming external risks are capped by a sizeable (€15-20 billion) precautionary SBA, we think that the NBH will be able to take back at least the recent 100bp of rate increases by the end of this year. We thus see rates at 6% by end-2012.
A step closer to normality - FX sensitivity set to decrease: In several of our meetings, we discussed the possible effects of the agreement concluded between the banks and the government in mid-December. One interesting implication to us is that, assuming a high participation in the provisional exchange rate fixing programme (which runs through to 2016), most households would no longer see their monthly repayments on FX mortgages fluctuate with the exchange rate. Rather, the difference between the real FX rate and the fixed rate will accrue in a buffer account which is payable (at no interest to the borrower) starting in 2017. Obviously, the currency moves still matter. That said, the NBH should be able to ignore short-term volatility to a greater extent, as the monthly repayments will not fluctuate. Again, under-hedged corporates and local councils who borrowed in FX (and the government of course) will still feel the effect of near-term moves in the FX. But overall, it seems fair to say that the December scheme would reduce the near-term sensitivity of the economy to FX swings. That alone would grant the NBH more degrees of freedom than it currently has. Hence, it is supportive of rate easing later this year.
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F12/13 Budget – Limited New Initiatives, More Handouts
February 03, 2012
By Denise Yam, CFA & Ernest Ho | Hong Kong
Summary and Conclusion
Financial Secretary (FS) Mr. John Tsang presented the F2012/13 Budget on February 1, his fifth and last before the end of his current term this July.
The macro backdrop for budget planning this year featured:
1) a fiscal surplus exceeding the original budget by a wide margin in current fiscal year;
2) sustained concern over inflation;
3) sustained concern over housing affordability amid a supply shortage; and
4) slowing economic growth to below-trend in 2012, meaning the need for some fiscal support.
While realising yet another respectable budget surplus in the current fiscal year (estimated at HK$67 billion, 3.5% of GDP), we had not expected radical or visionary initiatives at today's speech, given the imminent change in government (July 2012). Apart from reiterating ongoing economic initiatives, namely those in support of Hong Kong's core industries, the FS reassured us of the government's commitment to increasing land supply in the coming years for both residential and business use. We interpreted this as a strong message that the government is recognising the need to reverse the shortage accumulated since the turnaround in Hong Kong's economic fundamentals in 2003. Fiscal concessions were again rather substantial, despite opinions that bonus financial resources could be directed to projects or initiatives more conducive to longer-term economic development. Giveaways - including tax rebates, tax cuts, waiver on property rates and public housing rents, bonus social security allowances, and electricity subsides - total HK$36 billion (1.9% of GDP), nevertheless falling short of last year's HK$61 billion (HK$36 billion in the HK$6,000 Scheme). For F2012/13, the government budgets for a small deficit of HK$3.4 billion (0.2% of GDP). Stripping out investment income on reserves, there will be a fiscal injection into the economy of 3.5% of GDP.
F11/12 - Another Year of Inaccurate Budgeting
As expected, the government now estimates that it will post a budget surplus of around HK$66.7 billion in the current fiscal year, or 3.5% of GDP. This is yet another year of a significant deviation from the budgeted amount, which was a deficit of HK$8.5 billion, adding to Hong Kong's "poor budgeting record", once again demonstrating how domestic policy can do little to dampen the large influences on the economy from external exogenous factors. Revenues are estimated to exceed the original estimate by 17% to reach HK$433 billion, while expenditures fall short by 3% (HK$366 billion).
The upside surprise in revenues in F11/12 is attributable mainly to better-than-expected land premium (HK$83 billion versus HK$62 billion budgeted), profits tax (HK$118 billion versus HK$97 billion budgeted) and salaries tax (HK$52 billion versus HK$48 billion budgeted) revenues. Meanwhile, the government booked HK$31.3 billion in investment income, close to the budgeted HK$30.5 billion. As a result, Hong Kong enjoyed a surplus in its operating fiscal account for the seventh straight year, of an estimated HK$38.2 billion (versus HK$8.8 billion budgeted deficit originally), nonetheless down from HK$60.5 billion in F10/11. The operating balance before investment income also sustained a surplus, of HK$7 billion (or 0.4% of GDP, versus HK$39.3 billion deficit budgeted).
"Support" and "Stimulus" in F12/13
Against the backdrop of slowing GDP growth this year to a below-trend level (we forecast 2%), fiscal support or relief was anticipated. We are therefore not surprised that, despite suggestions that bonus financial resources could be put to projects and initiatives more conducive to longer-term economic development, the government has again unveiled quite a significant giveaway package in F12/13, in response to public demands. The FS even introduced a salaries tax cut, the first since F08/09, through an increase in basic and dependents allowances. We are nonetheless relieved that the government has refrained from offering a blanket cash handout similar to last year's HK$6,000 Scheme.
In addition, concessions were extended or expanded as part of the inflation relief efforts in a bid to alleviate household burden. On the other hand, we welcome the support offered to the business sector, especially for SMEs, with measures including a profits tax rebate (75%, up to HK$12,000), waiver on business registration fees, and enhancement of the SME Financing Guarantee Scheme, etc.
For the 2012/13 fiscal year, the government projects a 10% drop in revenue (to HK$390.3 billion), but a 7.5% increase in expenditure, roughly closing the surplus position in the current fiscal year. The projected budget balance for F12/13 is a small deficit of HK$3.4 billion, or 0.2% of GDP. Stripping out investment income on reserves, there will again be a fiscal injection into the economy of 3.5% of GDP, down from the 4.6% budgeted last year (and actual injection of 0.7%). The fiscal stance, nevertheless, is projected to turn broadly neutral from F13/14 onwards.
F12/13 Giveaways Summary
Fiscal ‘sweeteners' at the latest budget include:
1) Personal income tax rebate - doubled up: A 75% (same as last year) rebate will be granted on personal income taxes (salaries tax and personal assessment), with the cap lifted to HK$12,000, from HK$6,000, costing the government HK$8.9 billion. Taxpayers essentially receive the same total amount (HK$12,000) as in F11/12 (HK$6,000 from tax rebate and HK$6,000 from cash handout).
2) Cut on personal income taxes: Although there were no cuts in tax rates, the government increased the basic allowance on personal income tax, unchanged since F08/09, by 11%, to HK$120,000 for single persons and HK$240,000 for married couples. Allowances for dependents were also raised, by 5% for children (to HK$66,000 each), 5.6% for parents (to HK$38,000), and 10% for siblings (to HK$33,000) and disabled dependents (to HK$66,000). These, collectively, will cost the government HK$2.6 billion a year.
3) Extension on tax deduction on home loan interest by five years to a total of 15 years, while maintaining the ceiling of HK$100,000 per year. This will cost the government HK$540 million per year in the next five years.
4) Lifting the cap on tax deduction on MPF contributions to HK$15,000 from HK$12,000. This will cost the government HK$360 million per year.
5) Bonus social security (CSSA, elderly, disability) allowances were again offered for one month, costing the government HK$2.1 billion.
Meanwhile, concessions were extended and/or expanded to alleviate inflation, similar to the preceding few budgets. Measures to manage inflation appear to have become a key aspect of fiscal policy in recent years, because Hong Kong has its hands tied from using monetary and exchange rate policy for such a purpose. Ironically, this approach involves spending more (instead of restraining demand) to lower the cost of living. In other words, the fiscal measures lower the statistically reported headline inflation rate without alleviating underlying inflation pressure. This year's inflation-relief measures include:
1) Extending and increasing the concession on property rates, which had been a key giveaway since 2007. The concession will apply to all four quarters in the coming fiscal year, with the cap lifted to HK$2,500 (from HK$1,500) per property per quarter, costing the government HK$11.7 billion.
2) Waiver on public housing rents for two months (HK$1.9 billion).
3) Subsidy on electricity bills of HK$1,800 per residential account (HK$4.5 billion), similar to that offered in F11/12.
We estimate that these measures combined will lower the headline inflation rate by more than 1pp in F12/13. However, we shall await details on the exact timing of the concessions to estimate the impact on our 2012 inflation forecast (5% currently).
Together with the support offered to the business sector, the giveaways in the latest budget are generous, totaling HK$36 billion (1.9% of GDP), although falling short of last year's HK$61 billion (3.2% of GDP), of which HK$36 billion was attributable to the HK$6,000 Scheme.
First Personal Income Tax Cut since F08/09 Helps the ‘Middle Class'
With the increase in the basic allowance on personal income tax, those earning between HK$240,000 and HK$1.52 million a year see the largest absolute decrease in tax payment, of HK$2,040, before taking into account the effect of other allowances. The HK$240,000 annual income level sees the largest drop in the effective tax rate, by 0.85pp, to 3.5%, while the threshold annual income level at which the standard 15% tax rate kicks in rises to HK$1.62 million (from HK$1.52 million). The significance of this measure is that it benefits the bulk of what we consider the ‘middle class' (those earning between HK$240,000 and HK$1.52 million a year), while the wealthier group (those taxed at 15% flat rate) will not benefit because there had been no changes to tax rates.
Reiteration of Ongoing Initiatives
As with previous years, the budget also provided an update on the economy's development plans, although there were limited new initiatives in the latest speech.
A considerable portion of the speech was dedicated to assuring the Hong Kong people that land supply will be actively increased for residential, both public and private, as well as business/commercial uses. We found the message encouraging, as the government now appears more convinced of the accumulated supply shortfall since 2003 upon the turnaround in the economy (see New HOS - Addressing Demand/Supply Imbalance, October 12, 2011), although it remains to be seen how fast the new supply of land and construction could come to the market and help alleviate the shortage.
Meanwhile, regional cooperation and infrastructure development will remain core initiatives to enhance the long-term growth of the four traditional pillar industries (financial services, trading and logistics, tourism and business/professional services) and six industries with competitive advantage (medical services, education services, environmental industries, testing and certification, innovation and technology, cultural and creative industries).
Yet again, although we had no specific expectations for this last budget of the current government, the latest speech fell short of addressing Hong Kong's structural fiscal issues. Because of the dependence of government revenues on sources associated with the asset markets, e.g., land premium, property rates, stamp duties and profits tax from property and banking sectors, we have witnessed significant swings in fiscal results and a poor budgeting record. The annual budget is often dominated by one-off measures in response to the results of the previous fiscal year. The government has been justifying "conservatism" given the vulnerability of the economy and fiscal outturns to excessive volatility, but, in recent years, has been silent on exploring ways to stabilize government revenues through restructuring the tax base. Further, there were no initiatives to explore ways to enhance the management and investment of the fiscal reserves, projected to reach HK$662 billion (35% of GDP) by end-March. By allowing one-off measures to dominate the annual budget once again, the Hong Kong government risks missing the window of opportunity to push through fiscal reforms in times of strong economic growth. Without concrete measures to restructure the tax base and enhance the management and investment of the fiscal reserves, the fiscal outturns will continue to fall prey to excess volatility along with the economy.
All in all, the budget speech contained limited new initiatives, which was not surprising given the imminent change in government. Generous fiscal concessions and support measures represent some support to the economy in the coming year, but we will look to the new government (from July 2012) for any radical and visionary economic policies. Specifically, the outgoing government had been keen to uphold the "small government", "big market" and "big society" principle, so available financial resources even with simple and low taxes had been largely rebated to the people rather than more ambitiously invested for sustainable development, in fear of the government becoming too "big". We will be eager to see whether the new leadership makes any changes to this conservative stance.
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