Globalization's New Underclass
Mar 03, 2006

Stephen Roach (New York)

Billed as the great equalizer between the rich and the poor, globalization has been anything but.  An increasingly integrated global economy is facing the strains of widening income disparities -- within countries and across countries.  This has given rise to a new and rapidly expanding underclass that is redefining the political landscape.  The growing risks of protectionism are an outgrowth of this ominous trend.

It wasn’t supposed to be this way.   Globalization has long been portrayed as the rising tide that lifts all boats.  The surprise is in the tide -- a rapid surge of IT-enabled connectivity that has pushed the global labor arbitrage quickly up the value chain.  Only the elite at the upper end of the occupational hierarchy have been spared the pressures of an increasingly brutal wage compression.  The rich are, indeed, getting richer but the rest of the workforce is not.  This spells mounting disparities in the income distribution -- for developed and developing countries, alike. 

The United States and China exemplify the full range of pressures bearing down on the income distribution.  With per capita income of $38,000 and $1,700, respectively, the US and China are at opposite ends of the global income spectrum.  Yet both countries have extreme disparities in the internal mix of their respective income distributions.  This can be seen in their so-called Gini coefficients -- a statistical measure of the dispersion of income shares within a country.  A Gini Index reading of “0” represents perfect equality, with each segment of the income distribution accounting for a proportionate share of total income.  Conversely, a reading of “100” represents perfect inequality, with the bulk of a nation’s overall personal income being concentrated at the upper end of the distribution spectrum.  In other words, the higher the Gini Index, the more unequal the income distribution.  The latest Gini Index readings for the US (41) and China (45) are among the highest of all the major economies in the world -- pointing to a much greater incidence of inequality than in economies with more homogeneous distributions of income, such as Japan (25), Europe (32), and even India (33). 

While the US and China suffer from similar degrees of income inequality, they have arrived at this point through very different means.  In the case of the US, there is nothing new about elevated readings of income inequality.  America’s Gini coefficient has been on the rise for over 35 years -- moving up from about 35 in 1970 to over 40 today.  What is new is how America’s income distribution has become more unequal in a period of rapidly rising productivity growth -- a development that has been accompanied by an extraordinary bout of real wage stagnation over the past four years.  Economics teaches us that in truly competitive labor markets such as America’s, workers are paid in accordance with their marginal productivity contribution.  Yet that has not been the case for quite some time in the US.  Over the past 16 quarters, productivity in the nonfarm US business sector has recorded a cumulative increase of 13.3% (or 3.3% per annum) -- more than double the 5.9% rise in real compensation per hour (stagnant wages plus rising fringe benefits) over the same period.

I don’t think it’s a coincidence that the relationship between productivity growth and worker compensation has broken down as the forces of globalization have intensified.   First in manufacturing, now in services, the global labor arbitrage has been unrelenting in pushing US pay rates down to international norms.  But the real wage compression in the US has not been uniform across the income spectrum.  In large part, that has occurred because increasingly broad segments of the American labor market are now exposed to a uniquely powerful competitive force -- the IT-enabled arbitrage.  Courtesy of the hyper-speed of sharply accelerating Internet penetration, the global labor arbitrage has pushed into areas that historically have been unaccustomed to wage competition.  In earlier research I found that the disconnect between compensation and productivity growth during the current economic expansion has been much greater in services than in manufacturing.  This once nontradable segment of the US economy is now feeling the increasingly powerful forces of the global labor arbitrage for the first time ever (see my 8 July 2005 dispatch, “Back to the Drawing Board”). 

The Internet has forever changed the competitive climate for most white-collar knowledge workers.  Courtesy of near-ubiquitous connectivity, the output of the knowledge worker can now be e-mailed to a desktop from anywhere in the world.  That brings low-cost, well-trained, highly-educated workers in Bangalore, Shanghai, and Eastern and Central Europe into the global knowledge-worker pool.  That’s now true of software programmers, engineers, designers, as well as a broad array of professionals toiling in legal, accounting, medical, actuarial, consulting, and financial-analyst positions.  Within this global pool of like-quality workers, a powerful arbitrage acts to narrow wage disparities.  As a result, real wage compression in open economies like the United States has moved rapidly up the value chain -- sparing an increasingly small portion of those at the very top of the occupational hierarchy.  In short, the IT-enabled global labor arbitrage is a guaranteed recipe for mounting income inequality.  Washington’s penchant for cutting taxes of the wealthy probably hasn’t helped matters either.

In China, it’s a different story altogether.   China remains very much a tale of two economies -- a booming development model at work in the increasingly urbanized coastal part of the nation in stark juxtaposition with relatively stagnant economic conditions persisting in the rural central and western portions of the country.  While fully 560 million urban Chinese are now participating in the economy’s rapid development dynamic, that still leaves a rural population of some 745 million on the outside looking in.  Interestingly enough, the accelerating trend of rural-to-urban migration has done little to arrest the inequalities of the Chinese income distribution over the past 15 years.  This is somewhat surprising in that urban per capita incomes in China (US$1,531 in the top 35 cities in 2004) are slightly more than three times those in rural areas ($488).  But the increase in China’s overall Gini Index from 35 in 1990 to 45 in 2003 not only reflects the impacts of an ever-widening income disparity between coastal China and the rest of the nation, but it is also a function of the increased divergence in the distribution of urban incomes.  On this latter point, a recent report of China’s Academy of Social Sciences notes that average incomes in the bottom quintile of urban Chinese workers are less than 5% of average incomes in the upper quintile. 

Significantly, Chinese income disparities in the Internet age may well have a very different connotation than in the past.  With increased IT connectivity in western and central China -- mainly in the form of the village kiosk -- the rural poor now have real-time access to the “outside world.”  This gives them a very vivid picture of the prosperity they are missing.  In that vein, the Internet has the potential to spark resentment and social instability in China’s two-track development model -- the very last thing the government wants.  The Chinese leadership is very focused on the income distribution issue, and is expected to make this a major topic of debate and policy action at the upcoming National People’s Congress.  That campaign has already begun.  On 21 February, a “new socialist countryside” program was unveiled jointly by the State Council (China’s cabinet) and the Communist Party -- focused on providing increased support for farmers together with improved education and healthcare for the rural population.  The plan also gives special attention to the role of finance in stimulating rural development, especially through increased bank lending to farmers, along with increased private incentives for investments in rural credit cooperatives.  This multi-year initiative is aimed squarely at the income distribution issues noted above.

As different as the problems are in the US and China, there is no economic issue in either country that hits the political hot button like income disparities.  And with both countries suffering from relatively high degrees of inequality, neither can be expected to backtrack insofar as the political response is concerned.  Given the mounting bilateral trade tensions between the two nations, this poses a worrisome problem: America’s increasingly populist politicians have responded to the income distribution problem by turning protectionist -- portraying China as the culprit for the pressures bearing down on middle-income US workers.  Even if this view is dead wrong, as I continue to believe is the case, for China, there seems to be no immediate escape from the growing political wrath of Washington (see my 24 February dispatch, “Saving Tensions and the Protectionist Backlash”). 

China, on the other hand, continues to cling to an export- and investment-led growth dynamic that not only fuels political resentment in the US but also seems to have a natural bias toward widening disparities in its income distribution.  Yet this same approach drives the vigorous employment growth that is absolutely vital in order to provide China with the scope to keep dismantling its inefficient state-owned economy.  The Chinese leadership knows full well that this is not a sustainable growth formula.  Its recent focus on stimulating private consumption and services is a clear recognition that a new recipe is needed.  But this will take time -- and quite possibly a good deal of it.  Meanwhile, China is engaged in a very delicate balancing act between reforms, which seem to be exacerbating income disparities, and externally-focused growth, which seems to be evoking a protectionist backlash.  In response, the Chinese leadership is turning to the micro management techniques of market-based socialism for answers -- namely, a gradual shift in its currency policy to diffuse external pressures and targeted income support measures to counter internal pressures.  Only time will tell if this is the right approach.

Inequalities of the income distribution have long been the Achilles’ heel of economic growth and development.  In an era of IT-enabled globalization, that seems more the case than ever.  History tells us that the pressures of widening income disparities are often vented in the political arena.  The steady drumbeat of protectionism is a very worrisome manifestation of that lesson.  To the extent the risks of protectionist actions come into play, the US dollar and real interest rates would probably bear the brunt of the financial market response.

Important Disclosure Information at the end of this Forum

Housing, Mortgages and Consumption - Comparing Australia, the UK and the US
Mar 03, 2006

Richard Berner (New York) and David Miles (London) and Gerard Minack (Sydney)

Are UK and Australian housing markets templates for the US?  Is the housing wealth-consumer spending link the same in the UK and Australia?  On the surface, it seems that their recent experience foreshadows what might happen to US housing and thus the American consumer.  In the UK and Australia, home prices and mortgage debt rose significantly and consumers extracted substantial equity from their homes during 2001-2004.  In 2005, however, home prices decelerated sharply, and debt service burdens seem to have risen significantly in the wake of interest rate increases.  Many believe that, as a direct result, consumer spending in the UK and Australia has slowed dramatically.  Based on those episodes, it would appear that US markets and consumers are only a year or so behind their Anglo-Saxon cousins, and that consequently, the downside risks for the US economy are multiplying. 

Closer inspection, however, suggests substantial differences across the three markets that invalidate such simple comparisons.  In our full report (just published), we use our knowledge of our own national housing and mortgage markets — about which we have each written extensively — and attempt collectively and collaboratively to compare and contrast them (see “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” March 2, 2006).  Each of us brings our own bias to the table, and none of us is shy about expressing it; that style fits our culture of collective engagement.  Rather than debate each other, however, our real goal is to find both common themes and differences across these economies that might shed light on their future direction.

In what follows, we summarize our main findings.  We analyze them in more detail with reference to the differences across markets in the report, which provides a discussion of the main features of each of the three markets with implications for US, UK and Australian consumer spending and the economies in each country, and the risks for financial markets.

Main findings

1. All three housing markets are sensitive to interest rates and credit conditions.  But the response varies significantly across markets, primarily because most US mortgage borrowers use fixed rate loans or hybrid ARMs, while in the other two markets, most loans come with variable rates.  Consequently, it appears that US housing is the least interest sensitive and Australia is the most.

2. New mortgage loan products and relaxation of lending standards made housing more affordable in all three markets over the past decade.  And in some cases, those new instruments probably also altered the apparent interest sensitivity of housing demand by enabling consumers to defer the effects of rising interest rates on monthly payments.  Again, these innovations appear to be most advanced in the US market.

3. Housing prices and housing wealth rose significantly in all three markets over the past five years, but by much more in the UK and Australia than in the US.  Nationwide house prices tend to be more volatile in those two markets compared with those in the US.  That may reflect the diversity of regional housing markets in the US versus in the UK and Australia.  London and Sydney prices may be a bit more volatile than in New York, but asynchronous regional economic developments likely damp the variability of US nationwide home prices compared with the other two economies.

4. Rising housing wealth boosted consumer spending in all three economies, but the effect per unit of wealth varies significantly across markets.  Estimates of this impact are just that — estimates.  And whether or not it matters that housing wealth is monetized via home equity extraction is still hotly debated.  But it appears that housing wealth gets the biggest bang for the buck in Australia, while it’s smallest in the United States.

5. Rising homeownership significantly boosts aggregate home equity extraction (also known as mortgage equity withdrawal or MEW) with little impact on consumer spending.   With homeownership rates stable, aggregate MEW may be smaller but may more accurately represent tapping home equity for spending or other purposes. 

6. The tax treatment of mortgage interest has a substantial impact on both the magnitude and disposition of MEW.   In the United States, mortgage interest is tax deductible, adding incentives for indebted homeowners to substantially reduce debt service after tax by swapping non-mortgage credit into a mortgage.  That has skewed US borrowing towards mortgage debt, making MEW look larger.  In contrast, mortgage interest is not deductible in either the UK or Australia, so the advantage of such debt swaps is limited to the more favorable interest rate available on mortgage credit. 

These six findings suggest that while there are many similarities among the three markets, the differences are also important.   Indeed, those differences are substantial enough to warrant considerable care before using the experience of Australia for that of the UK, or either one of them as templates for the coming US experience. 

Housing is the most credit- and interest-sensitive part of any industrial economy, and the US proves the rule: Housing activity and home price increases likely are already fading.  But market participants who believe that housing and home prices are bellwethers for the US consumer likely will be surprised at the economy’s ongoing strength.  In the UK those that look to indicators of housing market conditions as a reliable guide to what will happen to spending are placing too much weight on a relationship which may have generated some correlation in the past but which is neither stable nor causal. 

As always, risks abound. Consumers — and thus housing — in all three markets are vulnerable to a significant jump in energy prices or to a significant rise in inflation.  If lasting, the former would undermine discretionary income and thus both spending and homebuying.  The latter would force policymakers to move to monetary restraint, which would be bad news for both housing and consumer net worth, and would raise the odds of a more significant consumer ‘ARM squeeze’.

Important Disclosure Information at the end of this Forum

Grandmothers vs. Hedge Funds
Mar 03, 2006

Robert Alan Feldman (Tokyo)

What’s New:   BoJ Moves Give Only Illusion of Clarity

BoJ moves in recent days have not resolved the debate about monetary policy, and leave forex markets speculating. The paths for both the overnight call rate and for excess reserves remain unclear.

Conclusion: See-saw Battle in Dollar-Yen

The see-saw battle in the forex market between grandmothers and hedge funds will continue. Grandmothers will keep buying foreign assets due to interest rate differentials. Hedge funds will continue to sell dollars on the expectation that rate differentials will shrink.

Market implications: Modest yen strength, little impact on equities

A mild strengthening of the yen toward Y106/US$ at end-2006 remains likely. The initial pattern will likely be saw-toothed, as grandmothers and hedge funds spar. As the government and the BoJ make peace over monetary policy, there will be less to spar about, and the path of the yen will become more stable.

Risks: Obtuse BoJ Could Destabilize Markets

Should the government-BoJ go badly, investors would expect a pre-mature rate hike. The bond market would become unstable, and the yen could surge. Even the economic outlook could be destabilized.

Battle Lines

The course of the yen-dollar exchange rate over the next few months will be largely determined by the ongoing battle between grandmothers and hedge funds. By grandmothers, I mean investors who look primarily at the interest rate differential between yen assets and foreign assets. Large rate differentials have been the primary reason that individual investors — such as grandmothers — have been so aggressive in buying foreign bonds. My colleague Stephen Jen has emphasized the role of these investors in determining the course of yen-dollar over the next year.

In contrast, by hedge funds, I mean investors who focus on changes of interest rate differentials, both current and prospective. Often, these players have leveraged positions, and so seemingly small pieces of information can have large impact. An example was the sharp yen appreciation of December 2005, when weak US data dampened expectations of further US rate hikes. The result was a breathtaking overnight strengthening of the yen.

A New Divergence of View

For several years, the grandmothers and the hedge funds have been driving the yen in the same direction. The level of interest rate differentials has been wide enough to trigger a major search for yield in foreign markets. At the same time, with the Fed in hiking mode while the BoJ kept rates firmly at zero, the hedge funds took long-dollar/short-yen positions. There was a convergence of views.

Now, things have changed. No longer are both types of investors headed in the same direction. The grandmothers still see large rate differentials, but are a bit more concerned over potential yen strength. It is possible to see a year’s worth of interest gains vanish overnight, after an adverse forex move. Meanwhile, the hedge funds see an end to Fed tightening and a start of BoJ tightening. With the direction (although not the timing) of interest differential changes clear, it makes sense to hedge funds to reduce their long-dollar/short-yen positions. This is especially true for leveraged players.

So, there is a tug-of-war. The grandmothers still want yield pickup. Even if rate differentials shrink, they will likely continue to buy foreign assets. However, they will remain cautious about exchange rate levels. If there are any sudden yen appreciations, the grandmothers will lick their wounds for a time, before returning to foreign investments. In contrast, the hedge funds will be constantly reducing long-dollar positions, as the timing and pace of the shrinkage of interest rate differentials becomes clearer. Moreover, due to the (quite rational) herd-behavior of leveraged investors, adjustments could be sharp.

On balance, therefore, the most likely scenario for yen-dollar is — as Stephen Jen predicts — a modest strengthening of the yen by year-end toward Y106/US$, as the grandmothers and the hedge funds fight it out. The problem is how jerky the path will be. This is where the recent debate on monetary policy comes in.

Will BoJ Destabilize the Yen?

With the grandmothers fighting the hedge funds, the path of the yen will be very event —dependent. For example, If the hedge funds keep reducing dollar positions while grandmothers are licking their wounds, then a large movement of yen dollar could occur. Therefore, the need for stabilizing actions by the central bank is crucial. Over the last few weeks, however, the debate on monetary policy has been anything but stabilizing. A stable glide-path toward yen strength depends on re-establishing constructive debate on monetary policy.

In this debate, there are four issues. (1) When will BoJ end quantitative easing? (2) How fast will BoJ reduce excess reserves? (3)  When will BoJ end the zero interest rate policy (ZIRP)? (4) What will be the new rules for setting monetary policy in the post-ZIRP world?

The end of quantitative easing will be soon. Recent comments by BoJ officials and by government officials suggest that this end may come as soon as March 9, when BoJ ends its next Policy Board meeting, although the April 10 and April 28 meetings are more likely. In any event, very few expect the BoJ to postpone the end of quantitative easing until the May 18-19 meetings. Markets have interpreted this timing to mean a quick end to excess reserves and a quick end to ZIRP itself. However, the current market consensus is too aggressive, in my view.

The BoJ has publicly committed to ensuring the stability of financial markets. Indeed, Article 1 Section 2 of the BoJ law enjoins the BoJ to do so. Thus, it seems likely that BoJ will take a gradualist approach to reducing excess reserves, and could even take a zigzag strategy if market disturbances occur.

The actual end of ZIRP depends on the course of inflation. If, as my colleague Takehiro Sato and I think, the year-to-year changes of CPI peak out this spring, and head back toward the 0.1-0.2% range, it will be hard for BoJ to end ZIRP quickly. Clarification from the BoJ on exactly how they will link price movements to the end of ZIRP would be the single most important step BoJ could take to stabilize expectations. After all, quantitative easing was successful in part because BoJ declared a clear numerical target as an exit condition. Why revert to ambiguity when clarity has been so successful?

Defining clarity for the post-ZIRP world is also important. Current trial balloons suggest that the BoJ may be considering a “yardstick” for monetary policy, without declaring an actual inflation target.  The debate on this issue is ongoing, but a careful reading of the BoJ Law suggests that a BoJ-declared inflation yardstick or guidepost or target (call it what you will) would not be legal. This view is based on a careful reading of Articles 1 to 4 of the BoJ Law.

In those articles, the objectives of the BoJ are clearly stated to be (1) Printing banknotes and implementing currency and monetary control, (2) maintain an orderly financial system, and (3) contribute to the sound development of the national economy through price stability. Note that price stability per se is not a goal.  Rather, it is a tool to achieve a sound economy. Article 3 gives the BoJ autonomy, but ONLY on matters of currency and monetary control. Article 4 requires the BoJ to align its actions with the policies of the government.

These articles clearly put the setting of policy goals in the hands of the government, and require the BoJ to pursue those goals. With respect to operations, the BoJ has autonomy. So, is an inflation yardstick, guideline, or target a tool or a goal? In my view, given the pervasive impact of price movements on the economy, it is hard to argue that an inflation yardstick, guideline or target is merely a tool. Moreover, a BoJ inflation might not be consistent with the inflation assumptions behind the government’s fiscal reform plans. This, it makes both legal and practical sense to have an inflation yardstick, guideline or target set by the government, and not by the BoJ alone.

Thus, it seems to me that the BoJ’s scope for independent action on setting an inflation target is limited. Under these circumstances, further debate with the government and with members of the Diet will be needed. In the end, I expect an inflation targeting regime to be introduced in Japan, centered on the Council of Economic and Fiscal Policy (See Inflation Targeting: A Trojan Horse for Structural Reform, Morgan Stanley, January 10,2006.) As this debate develops, it will be clear to investors that this is less a fight about policy than a debate about a credible process for achieving optimal results. In the end, a constructive debate is likely to stabilize market expectations.


So, the grandmothers will fight with the hedge funds, and every syllable of the debate on monetary policy will be scrutinized with a microscope. The final result, however, will be a monetary regime for the post-ZIRP world. This regime is likely to have clear rules for the BoJ, and clear obligations and objectives for the government. The implication will be more stable markets and a smooth glide path for the yen.

As the BoJ and the government make peace with each other.

Important Disclosure Information at the end of this Forum

QE Likely Ends Next Week
Mar 03, 2006

Takehiro Sato (London)

Nationwide core CPI positive YoY for a third straight month, and the margin increased

The nationwide core CPI for January was positive at +0.5% YoY (+0.1% YoY in December). The nationwide core rate extended the recent string of positive results for three months, in line with our forecasts. The baseline CPI, adjusted for special factors (the core of the core) saw the rate of growth increase to +0.17% YoY (+0.02% YoY in December).

More importantly, the January nationwide US-style core CPI was +0.1% YoY (+0.1% YoY in December) for the second straight month of growth. Since the Japan-style nationwide CPI has been in positive territory for 3 straight months, and further, the margin of growth has been rising, and further still, there has been a consistent growth trend in the US-style core, this is a boost for the BoJ, which is eager to lift QE.

Nevertheless, nationwide core CPI may still lag in F2H06

We anticipate continued positive momentum for core CPI over the next half year, but new price fluctuation factors will be emerging thereafter that apply downward pressure on the index in the second half of F2006. These factors should gradually fade from Apr-Jun, trimming the core CPI result to +0.3% in Apr-Jun, +0.2% in Jul-Sep, and +0.1% in Oct-Dec and Jan-Mar 2007. Investors should also watch out for revisions to the benchmark year and the reshuffle of the components scheduled for August this year. We think revised core CPI might slip to -0.1% to -0.2%. There is still a risk that the core CPI rate will stagnate in the second half of F2006.

Yet we do not anticipate renewed deflation and the outlook for low, stable prices mainly discounts for enhanced productivity mainly in the broadly-defined public sector. There is even a possibility of Japan’s potential growth rate exceeding the 1% level from productivity gains. It would be difficult to explain the almost complete lack of a reaction from general prices despite three straight years of real economic growth in the 2-3% range if this has not happened.

Monetary policy scenario

With stably positive prices confirmed in the CPI data, we think the Bank is likely to end QE at the MPM to be held on March 8-9.  Although the Bank is likely to offer a new guideline for monetary policy in its reversal statement, we are not expecting much. BoJ officials find the existing commitment overly specific and aggressive and are unlikely to adopt a new guideline that tightly restricts future policy action, even if a new numerical targeting framework is adopted.

As for a rate hike (an end to ZIRP), it will depend on future fundamentals, and especially prices.  We think it will be vital for the core CPI from this Apr-June quarter to consistently outperform the lower end of the targets to be set.  However, we remain cautious on this front. Given the improvements in productivity and potential growth, we expect a rate hike later than early autumn 2006 (which the market currently targets), because the core CPI inflation rate for F2H06 and beyond is likely to prove weaker than currently expected by the BoJ.  In other words, the market is overly discounting presently for the rate hike.

Achievement of a +2% nominal growth rate promised by the government is another key factor for policy management. Once this is accomplished, government officials will no longer have a solid basis for restricting BoJ action and might even welcome a rate hike to highlight that deflation is over. The prospect of the economy reaching 2% nominal growth one year ahead of schedule in F2005 hence might seem to be good news for the Bank. However, the GDP deflator’s negative margin is likely to widen to -1.3% YoY in F2005 undermining the authority of a declaration that deflation has ended.

We expect the Japanese economy to post 2% nominal growth again in F2006 and stick with our forecast for a rate hike in Apr-Jun 2007 once the F2006 2% nominal growth is officially confirmed. We currently doubt that the GDP deflator will reach a positive level for F2006, but anticipate a positive result one quarter later than previously expected from Oct-Dec 2006. This outcome should support a rate hike along with 2% nominal growth.

Near-term market trends

It is unclear whether short-term market rates will be static at extreme lows as occurred in the previous ZIRP environment after the Bank restores ZIRP. We think the unsecured O/N call rate might take off from 0% even with BoJ current account reserves sharply higher than required levels, since tighter financial institution stances should create an environment in which slight changes in capital market conditions respond to changes in short-term rates. QE reversal therefore is likely to raise volatility in the short-term market. Removal of the policy duration guideline will increase the sensitivity of long-term rates to short-term market movements. Yet we maintain our view that dips in the market after QE reversal would provide buying opportunities. Investors should be primarily concerned about decline risk, rather than temporary upswing risk, for long-term rates in F2006.

Important Disclosure Information at the end of this Forum

Tax Reform Ahead
Mar 03, 2006

Vincenzo Guzzo (London) and Javier Rodriguez (London)

One reform, several goals.  On January 20, Spain’s Ministry of Economy announced a reform of the tax system.  The draft, presented to cabinet and submitted to local authorities, unions and employers, encompasses a broad range of measures affecting personal income taxes, corporate taxes, as well as environmental levies.  The goals are multiple: not only delivering some income redistribution and a simplification of the current system, but also providing a more neutral treatment of savings and better incentives for investment and entrepreneurship, alongside with a more efficient use of environmental resources. The reform should keep tax pressure broadly unchanged over the business cycle and be able to fit well within Spain’s federal framework.

First leg to be effective in 2007.  The government should be able to produce a final draft to submit to Parliament over the next few weeks.  While there is still uncertainty on the exact measures included in the package, we think that chances of final parliamentary approval are relatively high.  The income tax reform as well as the measures on the environment should become effective in 2007 together with the first leg of the corporate tax reform, whose full implementation however should spread through 2011.

Top marginal rate down to 43%.  Let us go through the details of the reform starting from personal income taxes.  The reform should lower the top marginal rate from the current 45% to 43% and reduce the number of brackets from five to four.  Income below €5,000 should become tax-free and, once we account for basic allowances on labor income, the no tax area should stretch all the way up to €9,000.  As of now, the two thresholds are €3,400 and €6,900 respectively. The first two brackets should merge into one and a tax rate of 24% should apply to income of less than €17,000 (currently €14,000).  The two intermediate tax rates should stay at 28% and 37%, but the upper bounds of the brackets they apply to should shift to €32,000 (from €27,000) and to €52,000 (from €47,000).

Some redistribution effect. The government estimates that while 99.5% of the taxpayers will benefit from these measures, redistribution effects should be noticeable.  More specifically, according to their calculations, the average rebate will likely be around 6%, but 60% of the taxpayers should be able to save around 17%.  Despite the reduction in the top marginal rate, higher allowances should grant greater progressiveness. In particular, deductions on dependents should increase on average by between 20% and 30%, while seniority and disabilities should also grant access to higher allowances than presently.  On our own simulations, a close inspection at the new tax curve and a comparison with the previous regime also reveal noticeable benefits for low- and medium-income taxpayers, with a reduction of the average tax rate in excess of three percentage points for some.  The result is even more favorable for taxpayers with dependents, because of the interplay with higher allowances.

A single 18% flat rate for all saving products: towards a more efficient allocation of capital. The reform should also introduce a single tax rate of 18% for all savings products, ranging from bank deposits to savings accounts, from dividends to capital gains.  The government will try to achieve a more neutral treatment of capital.  In the past, tax experts often stressed (see among others OECD, Options for Reforming the Spanish Tax System, Economics Department Working Paper 249, 2000) how preferential tax treatment skewed investment towards long-term savings such as home ownership, insurance and pension schemes, at the expense of fast growing businesses.  The 1998 tax reform tackled already the issue of neutrality and reduced the sources of distortion substantially.  The new reform takes this strategy to the next level, aiming to leave asset allocation exclusively up to individual preferences and expected returns.  These measures will likely lead to a more efficient allocation of capital, trigger higher capital/labor substitution and ultimately raise the marginal productivity of labor. The Spanish stock market should benefit from these changes.

A flat ceiling for allowances on contribution into pension funds… Pension funds traditionally benefit from a favorable tax regime.  With a rapidly ageing population threatening the sustainability of its first public pension pillar, Spain like several other industrial countries, has increasingly relied on a number of tax incentives to foster the development of a second pillar of privately funded schemes. This is however not the most efficient solution.  First, there is no conclusive evidence that tax breaks may materially raise aggregate household savings.  Furthermore, the current tax regime does not favor annuity flows over one-off capital payments at maturity.  Finally, allowances on contributions into individual and company schemes under specific assumptions exceed by far and large those of most other countries.  Against this background, the reform introduces a flat €8,000 ceiling for tax breaks on pension funds contributions, which altogether will not be able to exceed 30% of labor income (50% for individuals over 52).  Moreover, these allowances will apply exclusively to those beneficiaries opting for annuity flows.

… and housing investment. Typically the other source of distortion for the Spanish tax system is the treatment of housing.  The 1998 reform has already curtailed the incentives for housing investment, but benefits have remained generous and progressively led to an ownership ratio in excess of 80%, one of the highest by international standards.  In particular, the current regime entitles homeowners to tax breaks of 25% of their annual mortgage payments (both interest and principal repayments) during the first two years and 20% thereafter up to a ceiling of €4,500 and 15% up to €9,015. These benefits had distributional effects in favor of high-income earners, likely contributed to the overvaluation in house prices, and channeled capital away from other areas of productive investment.  The reform will likely keep the maximum deduction basis unchanged at 9,015, but set a unique allowance rate of 15%.  This new flat ceiling should result in annual total allowances of up to €1,352, potentially well below the present threshold.

Main corporate tax rate gradually down to 30%: SMEs better off. Together with the measures on personal income, the reform will likely target a gradual restructuring of the corporate tax system.  Between 2007 and 2011, the main corporate tax rate should gradually ease from the current 35% to 30% (and from 30% to 25% for small and medium enterprises), at a steady pace of one percentage point a year.  In addition, the government will aim to remove the large number of allowances still in place, with the notable exception of the one on double taxation.  The winners should be the small and medium enterprises, which tend to make less use of most of these deductions.  As a result, these changes should support economic activity in a number of sectors such as tourism, retail and business services where SMEs play a pivotal role.

Indirect taxes to move higher: inflation threat. On our calculations, the combination of these measures should imply overall a net stimulus for the economy of around 0.5% of GDP, part of it kicking in 2007 and the rest spread over the 2007-11 period.  With GDP up 3.4% last year and domestic demand growing at a torrid 5.4%, Spain would end up running a moderately pro-cyclical fiscal policy, if it did not take measures of the opposite sign.  More likely, indirect taxes will move higher.  In particular, environmentally related taxes that still account for a relatively small share of revenue will likely be on a rise.  These measures will trim the expansionary impact of the reform and try to tackle the issue of Spain’s secular high dependence on energy.  In inflation-prone Spain, the risk is that a one-off adjustment in prices, which typically come with higher indirect taxes, turn into a further protracted pick-up in inflation.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International Limited and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley & Co. International Limited, Taipei Branch and/or Morgan Stanley & Co International Limited, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at

Important Disclosures

This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International Limited, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Morgan Stanley & Co. International Limited, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.

Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.

 Inside GEF
Global Economic Team
Japan Economic Forum
 GEF Archive
 Webcasts & Podcasts
Stephen Roach
Weekly Commentary
Stephen S. Roach is a Managing Director and Chief Economist of Morgan Stanley.
View this week's Webcast
The password for this webcast is "roach".

You can view this webcast using Windows Media Player, RealPlayer, or your telephone.
 Search Our Views