Is Fiscal Policy Supporting Reforms?
May 19, 2008
By Eric Chaney | London
The ‘Fiscal Shock’ Has Failed
The ‘fiscal package’ passed on August 21, 2007 (known in France under its acronym ‘TEPA’) was sold by the new government as an important tool to bolster confidence and thus make reforms easier. Since then, it has become the main target of the government critics in the French political debate. When the project was made public, we had concluded that, from a strict economic angle, the fiscal side of the first reforms announced by PM Francois Fillon was ‘an unnecessary fiscal stimulus without long-term merits’. Real life has confirmed this diagnosis: the ‘fiscal shock’ was based on flawed economics, namely that fiscal stimulus generate high growth returns, and proved counter-productive in the French political debate. Yet, the new government’s fiscal policy is not as negative as some critics are saying, and it is not too late to re-design it so that budget decisions would support structural reforms. Despite Robust Growth, the Budget Deficit Rose in 2007 The provisional national accounts for 2007 published by INSEE on May 15 brought two interesting pieces of news. First, GDP growth was more resilient than previously thought in 2007: on a non-calendar adjusted basis, which is what matters for the budget balance, real GDP increased by 2.2% last year, in line with potential growth. Second, GDP data for 2005 and 2006 were each revised upward by two-tenths of a percentage point, to 1.9% and 2.2%, respectively. In short, French GDP has been growing close to potential over the last three years. The less good news is that, despite this supporting macro environment, the government budget deficit soared last year to 2.7% of GDP, after three years of decline. If fiscal policy had been neutral, the budget deficit would have been roughly stable at around 2.4% of GDP. Therefore, INSEE data reveal that there was a moderate fiscal stimulus last year, of around 0.3% of GDP, which no sudden demand contraction could have justified. On the contrary, final domestic demand was growing far above trend speed (2.8% in 2006 and 2007). Paradoxically, this fiscal stimulus might have added to domestic inflationary pressures, thus undermining President Sarkozy’s pledge to boost French households’ purchasing power. The 2007 Stimulus Came from the Local Electoral Cycle, Tax Cuts and Interest Payments Yet, last year fiscal stimulus was not the result of the August fiscal package. Instead, it came mostly from a spending spree by local governments and tax cuts decided by the previous cabinet. Public investment spending by local authorities (mostly municipalities) increased by a stunning 8.2%. In France, as in many countries, mayors stick to the time-honored political cycle: tighten fiscal belts after elections, boost spending in the year before, hoping that taxpayers have a short memory. Local elections took place last March and despite their generosity to spend taxpayers’ money, many incumbents lost their mandate: among the 952 cities counting more than 9,000 inhabitants, 150 municipal teams were ousted. To be fair, the municipal electoral cycle was not the only reason behind the rise of public deficits: income tax cuts, including a significant increase of the earned income tax credit (‘prime pour l’emploi’) amounted to 3.9 billion euros, or 0.2% of GDP. Last, interest payments on the national debt increased by 4.7 billion euros (0.2% of GDP). This latter move is a cause for concern for future fiscal policy: from 1996 to 2006, interest payments declined from 3.6% to 2.6% of GDP, as a result of ever lower long-term interest rates. This trend helped to contain the burden of an ever higher public debt. But this trend is probably over now, which implies that policymakers will have tighter fiscal margins in the future. The French Public Deficit Is Likely to Rise Further this Year For this fiscal year (which coincides with the calendar year, as in most EU countries), the government is aiming at cutting the overall deficit to 2.5% of GDP. We believe that this is a very ambitious target for at least two reasons. First, the TEPA bill should have a full-year impact of around 10 billion euros (according to PM Francois Fillon), or half a percentage point of GDP. The fiscal package is mostly made of income tax cuts (with a ceiling brought down from 60% to 50% of pre-tax income) and tax credit on overtime hours and new housing loans. Second, GDP growth is unlikely to reach the government’s target (between 2.0% and 2.5%). Although 1Q GDP growth was slightly stronger than we had expected (0.6%Q instead of 0.5%), we believe that the French economy is now cooling, as macro headwinds such as faster imported inflation, slower global trade, the strength of the euro and, last but not least, the impact of the credit crisis on bank lending, start to hit aggregate demand and to slash corporate profits. Cyclical indicators such as the INSEE business survey or the closely scrutinized bank lending survey are all hinting at a turning point. In these circumstances, we believe that the average forecast of the private institutes advising the Ministry of economy and finances, 1.6% GDP growth for this year, is a reasonable forecast, with risks probably skewed on the downside. A combination of slower growth, tax cuts and higher spending would spontaneously increase the general government deficit by 0.6% to 0.7% of GDP, on our estimates. Even if, as seems likely, the government keeps current spending, including healthcare, in check, we think that it will be difficult to avoid a further increase of the budget deficit, which is likely to reach, if not to break, the Maastricht limit of 3.0% of GDP this year. Fiscal Policy Is Not Enough Supportive of Structural Reforms The 3.0% line and potential reprimands from the EU Commission are not critical. After all, the French fiscal policy is only moderately expansionist, since tax cuts are partially offset by the government’s will to cut spending, as heralded by the 11,000 planned headcount cut in the Education Department. The important question is whether fiscal policy is supporting the structural reforms that the government wants to implement. From this angle, past actions are not convincing. The social contribution and tax cuts on overtime hours are welcome, since they should increase the supply of labour by cutting its marginal cost and boosting its marginal return. However, the complexity of the reform makes it less effective than previously thought, and its effect is likely to be pro-cyclical, since companies’ demand for overtime hours should shrink as the economy slows. The tax credit on new mortgage loans might be welcome from a cyclical standpoint, since demand for housing loans is sharply decelerating, but it is unlikely to change the long-term potential growth of the economy. The next batch of tax cuts (a cap on income and wealth taxes, cuts in inheritance taxes) may be justified in the long run, since they will contribute to reduce excessively high marginal tax rates, but they should be financed by spending cuts in order to check the rise of the overall debt, which is not the case. It Is Not Too Late to Bend Fiscal Policy Toward Reform Support Since the 2009 budget is still work-in-progress, we think it is not too late to put budgetary policy more at the service of structural reforms. The general revision of governmental policies (RGPP) presented by the government on April 4 is supposed to go in this direction: its purpose is to simplify the structure of the civil service, leverage its strength and make it more cost effective. Some of the measures that were announced, such as reforming subsidies to the housing market, a system that is actually reducing the supply of new houses, were long overdue and are thus welcome. However, the ambition of this project looks very limited: according to the government, these reforms would cut overall spending by some 7 billion euros by 2011, that is, 0.3% of GDP at this time horizon. Paying for Reforms Implies More Drastic Spending Cuts Many structural reforms may be done without budgetary costs, as well illustrated by Mrs. Lagarde economic modernization bill (see Mrs. Lagarde Turns Sarkonomics into Supply Side Reforms, May 6, 2008). Yet, some important structural reforms not included in the modernization bill package, such as the abolition of entry barriers in many professions (notaries, pharmacists, taxi drivers…), the reduction of the weight of the state civil service or making the status of civil servants more flexible (following the examples of the UK, Italy and Sweden) will have budgetary costs. An example illustrates that point very clearly: how could taxi drivers accept a reform, which, by doubling the number of licenses, would cut by half the value of their assets (licenses are traded)? Paying for reforms is a sensible idea, developed with great details by Pr. Charles Wyplosz and Jacques Delpla in ‘La fin des privilèges, payer pour reformer’ (Hachette-Telos, 2007). In the case of France, where the general government debt, including pension liabilities is close to 100% of GDP and still rising, the only sensible way to pay for reforms is to cut spending on other items, such as welfare benefits and payrolls. Cutting spending by 0.3% of GDP will certainly not make room for costly structural reforms, and will do nothing to convince other EMU countries that France is not trying to free ride on the financial credibility provided by the single currency. The window of opportunity for structural reforms is still wide open in France. Yet, in terms of fiscal policy, there is not much time left: the budgets for 2009 and 2010 are the last ones for that purpose. Afterwards, the proximity of the 2012 presidential and general elections will make things much more difficult for reformers.
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DEFCON-3 on Some Emerging Market Currencies
May 19, 2008
By Stephen Jen & Luca Bindelli | London
Summary and Conclusions There are reasons to be defensive on some emerging market (EM) currencies, even though most of them have performed very well against the dollar in recent years. Global growth is decelerating. While we favour loose economic coupling more than tight economic coupling, sentiment in many EM markets may be too high to accommodate this impending demand slowdown. Already, we have witnessed weakness in some of the AXJ currencies favoured by many investors. We fear that other EM currencies may also be vulnerable to some weakness vis-à-vis the US dollar. We stress that this is a tactical and cyclical call. From a structural perspective, we strongly believe that EM currencies should broadly outperform most G10 currencies. But we just think that a more than 5% depreciation in several EM currencies is a distinct risk in the coming weeks. A Word about the Title DEFCON stands for ‘defense readiness condition’ – a term used in the US. According to Wikipedia, it is “a measure of the activation and readiness level of the United States Armed Forces. It describes progressive postures for use between the Joint Chiefs of Staff and the commanders of unified commands. DEFCONs are matched to situations of military severity. Standard peacetime protocol is DEFCON 5, descending in increasingly severe situations. DEFCON 1 represents expectation of actual imminent attack”. Essentially, we are of the view that investors should be extra cautious about some downside risks to some EM currencies vis-à-vis the dollar – ‘DEFCON 3’ refers to an increase to force readiness above normal. Four Fall Lines, Applied to the EM Currencies This is an extension of our work on the four fall lines of currency dominos (see Four Fall Lines of Currency Dominos – An Ordinal Ranking, May 1, 2008, and The Dollar Smile and the Fall Lines of Dominos, April 3, 2008). Due to data issues, we were only able to compile data on the first (C/A position), third (commodity trade position) and fourth (trade exposure to US demand) fall lines. We make these observations from our findings: • The ‘Greater Chinese’ currencies should be more resilient. Relative to their peers, SGD, HKD, TWD and CNY rank high on our list, primarily because they all have quite large external surpluses. However, to partly offset this advantage, they also have relatively high trade exposure to demand from the US. Those who have followed the de-coupling debate should know that, in general, EM’s trade reliance on the US has declined steadily in recent years. This is also true for these four ‘Greater Chinese’ economies. However, they are still not small, ranging from 8.9% for Singapore to close to 20% for China. • Increasingly cautious on Latam currencies. As in Canada, some three-quarters of Mexico’s exports go to the US. While there are various reasons why the MXN has held up reasonably well so far, as our colleagues covering Mexico have pointed out, we just wonder if, from a risk-reward perspective, it makes sense to warehouse an exposure to MXN as the US slows. The ARS also looks vulnerable, but primarily because it is a reasonably large net commodities exporter, which could be vulnerable to a correction in commodity prices. The CLP stands out as a currency of a country whose net commodity trade position is 23% of GDP. The trajectory of global commodity prices will dictate the fate of these currencies. But with commodity prices already so high, we are more watchful of downside risks to these currencies as the world slows. • ZAR ranks low on our list. With its large C/A deficit and its net commodities trade surplus position, the ZAR looks more vulnerable than other EM currencies. Three Broad Stages of Any Financial Crisis We have suggested in our writing previously (see My Thoughts on Currencies, May 12, 2008) that it may be useful to consider three broad stages of any financial crisis. The first stage is the financial turmoil itself; the second stage is the impact on the real economies; and the third stage involves possibly major retracements in asset prices. During the financial turmoil, the dollar sold off hard partly because of a hyper-proactive Fed and partly because the rest of the world seemed rather immune to the financial shock from the US. EM was seen as the ‘safe haven’, as most EM investors and banks were not that deeply exposed to the toxic financial instruments as their developed country counterparts. EM equities and currencies outperformed during the first phase of this crisis. The dollar, at the same time, undershot. But as we enter the second phase – the real economic adjustments – we believe that many major EM economies will experience some slowdown. Already, recent data from China suggest that exports and industrial production may have downshifted in April. This is particularly remarkable, because recent data out of the US actually surprised on the upside and the US does not appear to have fallen into a recession yet. If demand growth in the US does turn more negative in 2Q, worse data will most likely show up in much of the rest of the world. While we think that the world will be resilient to a US recession, it will obviously not be totally immune to such an event. Asia’s policymakers are most proactive and pre-emptive about economic slowdowns and upward pressures on unemployment. In Dollar Smirks in Asia, May 1, 2008, we adopted a negative stance on the AXJ currencies, for the first time in two years. Populated positions in USD/MYR, USD/SGD and USD/TWD have been partly unwound. But we believe that there are further upside risks to most of USD/AXJ in the coming months. This third stage of this financial crisis will entail a recovery in the dollar and some weakness in EM currencies. Currency Weakness to Migrate from AXJ to Other Regions The AXJ currencies have already begun to weaken. But our view is that some Latam currencies, Eastern European currencies, the ZAR and the TRY are all vulnerable to downside risks, even if investor risk-taking recovers further. Commodity Prices to Shift the Balance Within EM One factor that will likely accentuate this shift from weakness in the AXJ currencies to weakness elsewhere (Latam, South Africa) is a prospective decline in commodity prices. Such a development would clearly not be uniformly negative for all EM currencies, but should significantly tilt the balance between the AXJ and the commodity-exporting countries. The Order of the Currency Dominos Reiterating a point we’ve made in the past, we do not subscribe to the popular notion that the order of the fall lines of the dominos is by the size or the level of development of the economy. Specifically, there is somehow the notion that the US is the first domino, followed by Euroland, followed by the likes of the UK and Japan, then followed by the EM economies. It is sort of a ‘core-to-periphery’ concept, or, visually, a ‘planetary system’ notion whereby little planets circle the sun (the US), and the smaller the planet the further it is away from the sun. While this is an intuitive approach, it may not be the right characterisation of the new economic world order now. Specifically, what we have in mind is that the US domino could be followed by EM dominos, and the German and Japanese dominos could be last, i.e., positioned after the EM dominos. First, Germany is not the EMU. Mediterranean countries within the EMU have already begun to slow, but not Germany. In fact, its 1Q GDP growth massively outperformed expectations. Similarly, Japan’s economy has surprised many commentators and investors. Exports have been a bright spot in the US economy. Not coincidentally, the US, Germany and Japan are the three largest capital goods exporters in the world, with the largest demand for capital goods coming from EM. Our point is that the ‘German domino’ is likely to situate much further down the fall line than the ‘Italian domino’ or the ‘Spanish domino’. Second, the ordering of the dominos implies that getting EM right is critical in getting the call on Germany and Japan right. Third, for a period, EUR and JPY may not behave in as ‘obvious’ a way as some commentators may presume. Specifically, EUR/USD may not sell off as willingly as many think. Similarly, USD/JPY may not have an obvious storyline. All of the above underscores our view that, while we are constructive on the USD, we suspect that the dollar’s appreciation will likely be hesitant and asynchronous against different currencies. For now, there is a trading opportunity on the EM currencies. Bottom Line Now that the AXJ currencies have begun to weaken, we believe that some EM currencies in other parts of the world will also be vulnerable to a sell-off against the dollar.
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Expected Currency Appreciation = Inflation
May 19, 2008
By Stephen Jen | London
Summary and Conclusions While many equate currency strength with disinflation, we believe that currency appreciation in some cases can and has been inflationary, especially in China. This point could help to explain the recent change in China’s CNY policy, Russia’s RUB policy, and the difficult ‘trilemma’ confronted by the GCC countries. Exchange Rates and Prices Exchange rates affect prices in several ways. We highlight two channels through which exchange rates affect inflation here. First, a stronger currency may help to contain the imported price of goods in the international markets. The second channel through which exchange rates could affect inflation is via the expectations of future movements in exchange rates. The current levels of exchange rates could mechanically alter import prices in domestic currency terms; however, if investors expect a high probability of continued currency appreciation, capital inflows could force central banks to accumulate reserves. If not fully sterilised, this could lead to inflation. (There are, of course, other channels through which exchange rates affect inflation, such as how changes in the exchange rate affect the relative competitive positions of exports and imports, which in turn alters the balance of aggregate demand and supply in the economy in question, depending on how the Marshall-Lerner Condition is satisfied.) Of the two, the first channel is the most widely believed view, partly because it is intuitive. However, we believe that this is a very misleading view. First, to keep imported inflation low, the currency in question would need to appreciate perpetually. A stronger currency could only offset imported inflation temporarily. This is why the ECB is changing its rhetoric. From 1.20 to 1.50, EUR/USD’s ascent was excused by the ECB officials as having a calming effect on imported oil prices. Why is nobody from Frankfurt saying this anymore? We believe the reason is that the level of EUR/USD is so high that continued currency appreciation is no longer sensible. Additionally, while stronger currencies could temporarily ‘muffle’ imported inflation, when the nature of the inflation is global, as is the case now, unilateral strong currency policies have little effect on the underlying source of inflation. If anything, such policies could exacerbate global food and energy inflation as countries manage to temporarily avoid demand destruction from high food and energy prices. Finally, with an increasing portion of global financial assets being deployed to investments in commodities, the trajectory of the USD could drive commodity prices away from those consistent with demand and supply. Strong currency policies in many economies outside the US have fed a vicious circle between the USD and international commodity and food prices. Not only is the first channel through which exchange rates could affect inflation a more nuanced concept than some may think, the second channel of influence between exchange rate movements and inflation is, in some cases, much more powerful than the first. If general expectations on the future movements of exchange rates become deeply entrenched, large capital flows could dominate the trajectories of the balance of payments and, in turn, the evolution of official reserves and monetary aggregates. I think that the case of China is the best example of this process. The Case of China One of the key structural forces of inflation in China, as is widely agreed, is the persistent and large rise in its official reserves, roughly half of which have, in recent years, been sterilised. What makes China’s case rather remarkable is that China not only runs a large C/A surplus (which averaged 7.4% of GDP during 2005-07), but it has also received very large capital inflows. Official reserves grew sharply from 2002 (US$286 billion) to 2005 (US$819 billion), but really accelerated in 2007 (reserves increased by US$461 billion). What is perhaps even more remarkable is that, while China’s C/A surplus has continued to expand, the growth in net capital inflows in 2007 accounted for 59% of the total increase in reserves. To spell this out, China’s massive C/A surplus last year of US$206 billion accounted for ‘only’ 41% of the increase in official reserves. We argue that much of these large capital inflows may have been motivated by the general expectation that the CNY would continue to appreciate against the dollar at a rapid pace, and that having a short USD/CNY exposure was a high-yield zero-risk investment. Thus, rather perversely, while Beijing’s ultimate objective of bringing the value of the CNY more in line with the economic fundamentals should eventually lead to a more sustainable BoP position, the process of getting there is inflationary. In sum, while many have argued that the stronger CNY has helped China to contain inflation, we believe that precisely the opposite is the case. Theoretically, the only way around this dilemma confronted by China is to have a maxi-revaluation in the CNY against the dollar of a size so large that few investors would believe that the CNY can appreciate further. This is the only effective way to halt the speculative capital inflows into China. The practical obstacle, however, is that it is not clear how big such a move in USD/CNY would have to be. Related to this question are the concepts of the ‘fair value’ and the ‘equilibrium value’ of USD/CNY. The former is the value of USD/CNY that is consistent with the underlying economic fundamentals (e.g., productivity, terms of trade, etc.), while the latter is the value of USD/CNY that will help to close China’s BoP surplus. We believe that the current spot USD/CNY is already close to the ‘fair value’. However, to close China’s BoP surplus, USD/CNY would probably need to decline by a massive (50%?) amount. Would Beijing feel comfortable implementing a step revaluation in CNY from 7.00 to 3.50 in one go? We doubt it. The Case of Russia After having probably allowed the RUB to appreciate as a temporary policy reaction to surging commodity price inflation during 1H07, the Central Bank of Russia effectively reverted to a basket peg last summer. One of the key motivations for the CBR to re-adopt a less flexible exchange rate policy appears to have been the view that expected appreciation in the RUB was becoming a key driver of capital inflows, leading to inflationary pressures. The Case of the GCC Currencies The IMF’s Middle East and Central Asia Director Moshin Khan, in a statement issued earlier this week, said that the GCC countries should not revalue or modify their exchange rate regimes at this point, despite high and rising inflation throughout the region. The main argument he made was that any move in the exchange rate, if not massive enough to significantly alter investors’ expectations, could perversely draw in more hot money and add to the already high inflationary pressures. Our View on the CNY, RUB and GCC Currencies At the beginning of the year, we argued that, as soon as the first signs of a global slowdown became evident, Beijing would slow down the pace of CNY appreciation. This was an argument that was ‘mercantilist’ in nature, but a second argument for a slower pace of appreciation had to do with the overwhelming expectation of rapid CNY appreciation with zero risk. Having said the above, we believe that Beijing will resume the pace of CNY appreciation again, as soon as the global economy regains traction. Our recommendation is for investors to stay away from the USD/CNY trade, as it is likely to underperform the NDF. The short USD/RUB trade, on the other hand, is still sensible, in our view. Russia’s inflation (14% in April) continues to accelerate towards the 15-20% zone, which will make the issue a political rather than economic one now. Unlike the CNY, HKD or the GCC trades, the carry on this trade is still positive, which makes USD/RUB the most sensible ‘de-pegging’ trade to retain. With a positive carry, time is on the investors’ side to wait for an eventual revaluation/appreciation in the RUB. With the FFR likely to have bottomed, but with oil prices now above US$120 a barrel, the GCC trades have, in our opinion, become slightly less compelling, though Qatar is still at some risk of moving under pressure. We reiterate our call that the GCC will need to follow China’s footsteps to one day adopt a regime that will permit an independent monetary policy. Any form of a peg (USD, EUR, or a basket peg) would perpetuate the ‘trilemma’ confronted by the GCC policymakers. For now, we recommend that investors back off on the ‘de-pegging’ trades in the GCC. Bottom Line While there is a deeply entrenched market opinion about strong currencies helping to contain imported inflation, we believe that the links between exchange rates and inflation are much more nuanced. In fact, expectations of future currency movements are a major driver of official reserve movements, and therefore inflation, in many emerging economies. We believe that China’s decision to slow down USD/CNY’s decline makes sense. We believe that the ‘de-pegging’ bets around the world, with the exception of the RUB, should be unwound.
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