How Much Can Be Expected from Fiscal Stimulus?
November 06, 2008
By Qing Wang & Steven Zhang | Hong Kong
Fiscal versus Monetary Stimulus
Monetary policy is typically viewed as the first line of defense against an economic downturn because a monetary policy response tends to be prompt and flexible in terms of timing and magnitude. The key advantage of fiscal stimulus relative to monetary stimulus is that it can boost economic activity more quickly, which is especially important if economic conditions are deteriorating rapidly. True fiscal stimulus implemented in time can provide a larger near-term impetus to economic activity than monetary policy. The Chinese authorities appear to have been following this policy approach. Since early September, the PBoC has cut the base interest rate three times and the ratio for required reserves (RRR) twice. Early this week, the PBoC announced that the administrative bank lending quota – the key policy tool used to rein in bank lending in 1H08 – would be scrapped. We expect at least four more 27bp rate cuts and multiple RRR cuts through 2009. While fiscal policy has been less active so far, we expect expansionary fiscal policy to play a dominant role in the authorities’ efforts to boost growth in 2009, now that a substantial slowdown is underway amid a global recession. The key question is, how much can be expected from fiscal stimulus? If History Is a Guide… The authorities are expected to hold the annual Central Economic Work Conference in the last week of this month. We expect that they will officially adopt a ‘proactive fiscal policy’ after this meeting. The last time when a proactive fiscal policy stance was adopted was in the aftermath of Asia’s financial crisis about a decade ago, and such a policy stance was maintained through 2002. About Rmb105 billion in special government bonds (or 10% of fiscal revenue and 1.3% of GDP) was issued per year during 1998-2000 to finance the fiscal stimulus package in the aftermath of the Asian Financial Crisis. During the 2001-02 global downturn, China issued Rmb150 billion in special government bonds (or 8.5% of fiscal revenue and 1.3% of GDP) per year to spur the growth. Potential Magnitude of Government Capex in 2009 Using history as a guide, we can estimate the potential size of the fiscal stimulus package in 2009. The Chinese authorities could potentially issue Rmb350-550 billion in government bonds to finance a fiscal spending program in their efforts to stimulate the economy, if the authorities were to make as strong a policy response (relative to the size of the economy or government budget) as they did during the Asian Financial Crisis and the 2001-02 global downturn. Specifically, we estimate that China’s nominal GDP could reach Rmb29 trillion in 2008. If the Chinese authorities were to issue the same amount of government bond relative to GDP as they did in their previous practice of ‘proactive fiscal policy’, or about 1.2-1.5% of GDP, the absolute amount could reach Rmb350-450 billion. Second, if the authorities instead choose to determine the amount of bond issuance using the share of fiscal revenue as a benchmark, the absolute amount could reach Rmb440-550 billion, or 8-10% of the current fiscal revenue, and equivalent to 1.5-2.0% of GDP. We actually think that the authorities will likely spend more than they did during previous downturns when they re-launch a ‘proactive fiscal policy’ in 2009. Here’s why: First, the negative impact of the global financial turmoil and attendant global recession on the Chinese economy will likely be more serious than that of either the Asian Financial Crisis or the 2001-02 global downturn. There appears to be an increasing consensus on this assessment among key policymakers. Higher downside risks warrant stronger policy responses. Second, China’s fiscal position has become much stronger now than in previous downturns. It should be noted that the ultimate capacity of fiscal spending to boost growth is determined by the government debt level instead of the magnitude of current fiscal surplus or deficit. While the Chinese government debt level a decade ago was lower than the current level at about 25% of GDP, the fiscal position back then was actually much weaker, if we take into account the government’s contingent liabilities stemming from the sizable NPLs in the banking system. NPLs were estimated to be about 40% of GDP, the bulk of which had been created after the austere macro-control measures managed to cool off the overheating economy during the 1992-96 boom and bust cycle. Third, the government now controls more fiscal resources than before. While fiscal revenue accounted for less than 12% of GDP in 1997, it reached over 20% of GDP in 2007. Fourth, in view of the relatively low level of public debt in China, if warranted (by the need to support growth), China can afford to run multi-year fiscal deficits without running into a debt sustainability problem, in our view. We therefore think that the Chinese authorities may well issue Rmb400-600 billion (i.e., equivalent to 1.4-2.5% of GDP or 7-10% of fiscal revenue) of government bonds to finance the fiscal spending program in 2009 to stimulate the economy. Impact of Tax-Reduction Measures Besides capex spending, the authorities will also likely introduce a couple of tax-reduction initiatives as part of the fiscal stimulus package for 2009: i) raising the minimum threshold of personal income tax (say, from Rmb2,000 to RMB3,000 per month); and ii) conversion of the value-added tax from production- to consumption-based. The overall impact of the former will likely be small, given that personal income tax is not an important source of tax revenue (i.e., less than 7% of the total tax revenue or 1.3% of GDP). However, the impact of VAT conversion will likely be quite significant. We estimate that the potential aggregate tax savings for the VAT-paying enterprises as a result of this policy change could be in the range of Rmb150-200 billion in 2009, or about 0.5-0.7% of GDP. The sectoral impact varies, depending on the share of machinery and equipment purchase in total fixed-asset investment for each sector. Implications The large potential for a strong fiscal policy response from the Chinese authorities should help to limit the extreme downside risk, preventing an outright hard landing of the economy, in our view. The actual size of the fiscal stimulus – especially the capex financed by bond issuance – will likely depend on how the private sector investment fares. While investment in the manufacturing sector is expected to slow substantially in response to much weaker exports, investment in the property sector will likely be the biggest swing factor in 2009. It is unclear at this juncture whether recent and further potential policy changes regarding this sector will help to prevent a collapse, and even stabilize investment, in this sector. In any case, we expect weaker-than-expected investment in the property sector to trigger a larger government-led capex program. The VAT conversion will, ceteris paribus, encourage investment in machinery and equipment. The positive cash flow implications – stemming from tax savings – for individual VAT-paying enterprises will hinge on the size of their capex program and final product sales. Sectors with large capex on machinery and equipment tend to benefit more. And only enterprises with sufficiently large sales revenue can fully realize the potential tax savings. Risks A fiscal policy response without the necessary transparency and communication with the market ex ante could run the risk of greatly compromising its growth-boosting impact by failing to boost private sector confidence. This is possible even if a large amount of spending was involved ex post, we envisage. While the impact of a strong fiscal stimulus package is a function of the amount of spending directly financed by the government, it also depends on how the policy package is implemented. A risk scenario is that the authorities are prepared to spend a large amount (e.g., Rmb600 billion); however, they decide to take an incremental approach by announcing and implementing a smaller program (e.g., Rmb300 billion) at the beginning of 2009 to test whether it works and only augment it with another package (e.g., Rmb300 billion) by mid-year when they realize that the program has failed to achieve the desired impact, or that the economic situation turns out to be worse than expected. This was in fact the approach followed by the authorities in 1999 and 2000. The risk with this muddling-through approach is that a smaller program may fail to give a sufficient boost to private sector confidence and therefore to catalyze private investment, making an augmented program inevitable. A more effective approach is for the authorities to announce upfront a sufficiently large spending program to demonstrate the authorities’ strong commitment to supporting growth, in our view. This should help to boost confidence and induce more private investment, greatly enhancing the effect of the fiscal policy and even negating the need for the authorities to implement their original spending program in full.
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Rising Risk of Disruptive Growth Shock in 2009
November 06, 2008
By Chetan Ahya | Singapore & Sumeet Kariwala | Mumbai
Summary The last few weeks of financial market developments have significantly increased the downside risks to our 2009 growth outlook. A high level of trade and financial integration in the region has meant a quick emergence of a vicious feedback loop. We see four key risks facing the region: 1) potential external demand shock; 2) a sharp slowdown in capital inflows and a rise in the cost of capital; 3) currency shock; and 4) increased financial instability risks. 1) Potential external demand shock: AXJ’s exports have grown 20.9% YTD in 2008, driven by the ROW (excluding the US, Europe and Asia). The ROW primarily includes emerging markets (the Middle East, Emerging Europe, Latam and Africa). Exports to ROW have grown 30% YTD in 2008 compared with 5.8% to the US and 18.3% to Europe. However, a further slowdown in the US and Europe and a potential sharp slowdown in ROW could result in a decline in the region’s export growth. Moreover, over the last four weeks, exports from the region have been affected by disruptions in the trade credit market and counterparty concerns. In the 2001 cycle, the region suffered a contraction in exports (in nominal USD terms) of 7%Y. With the risk of the global economy going through a deeper recession, exports could witness a decline in 2009. The follow-through impact on the region’s business capex cycle is likely to be severe. Many countries in the region have built large production capacities to feed global export demand. A sharp slowdown in exports can cause a major dislocation in the balance sheets of regional companies. Corporate investment demand will be hit significantly, in our view. 2) Sharp slowdown in capital inflows and a rise in the cost of capital: Capital inflows into the AXJ region are driven more by the global capital markets, which, in turn, are influenced by global liquidity and growth trends. Capital inflows into the AXJ region have risen significantly since 2003, in line with the trend in EMs. This easy access of risk capital played a key role in boosting the region’s domestic demand, particularly fixed investments. However, the recent disruption in global financial markets has indeed translated into capital outflows from the region. Year to date, the region has witnessed portfolio equity outflows of US$24.1 billion. FDI inflows have begun to drop significantly, and external debt funding has reached a standstill. The challenge of raising fresh debt funds is reflected in the sharp rise in CDS spreads for all the countries in the region over the last two months. Many countries have moved into a balance of payments deficit, reflected in the decline in FX reserves. 3) Currency shock: A quick resurgence in the USD against the major currencies has meant a sharp depreciation of most currencies in the region other than those with large C/A surpluses. The KRW, INR, IDR and THB have depreciated by 27.2%, 18.1%, 16.9% and 15.7%, respectively, from their peaks. The sharp move in the currency has caused dislocations in the balance sheets of many companies and countries with external liabilities. Total external debt in the region was US$1.47 trillion (20.8% of GDP) as of March 2008. Apart from the currency depreciation loss on unhedged external liabilities, many countries are facing refinance risks. 4) Vicious feedback loop of risk-aversion in the financial systems: The sharp drop in capital inflows and increased contagion from the global financial markets has transmitted into most regional countries in the form of a rising cost of capital. While most countries have started cutting policy rates, the cost of borrowing for consumers and the corporate sector remains high. Indeed, in countries suffering the twin macro problems of a tight banking system and a current account deficit, the contagion from the global financial markets has been much higher. Korea, India and Indonesia (accounting for 35% of the region’s GDP) have witnessed a disruptive rate shock over the last three months. Many regional countries are facing the risk of vicious loop of a rise in non-performing loans and a downswing in the growth cycle. Offsetting Benefit from Falling Commodity Prices Continued strong global growth pushed commodity prices, particularly crude oil prices, to a new high by the middle of 2008. As a net importer of commodities, the AXJ region suffered from a negative terms-of-trade shock. The net commodities trade deficit shot up to 9.2% of GDP annualized during the three months ended May 2008 from 6.5% during three months ended May 2007. However, with the sharp fall in commodity prices over the last three months, we expect the commodities trade deficit to narrow sharply. The fall in commodities prices has also helped the regional inflation rate to peak, removing the hesitation among the central banks in the region to respond with loose monetary policy. Similarly, a reduced subsidy burden, particularly on food and energy, should also create some room for pursuing loose fiscal policy. Bottom line: Despite its strong long-term fundamentals, Asia is unlikely to emerge unscathed in an environment where the global economy is likely to see a deeper recession. We see increased downside risk to region’s growth outlook for 2009.
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Corporate Profits: Global Recession Intensifies Downside Risks
November 06, 2008
By Richard Berner | New York
Investors now understand that US and global economic and earnings recessions are underway and that downside risks to both prevail. US real GDP declined in the third quarter and most forecasters expect at least a mild recession through the first quarter of 2009. Much of the industrial world is either in or close to recession, and the upheaval in emerging markets strongly hints that growth in Latin America, Asia, and Central and Eastern Europe will soon slow significantly. Likewise, my colleagues in US equity strategy report that, with 51% of companies reporting in the third quarter, S&P operating earnings declined by 21.5% from a year ago, assuming consensus estimates for the companies that have not yet reported. When we last wrote about the downside risks to earnings, the consensus expected Q3 S&P operating earnings to be up 17.3% from Q3 2007 (see Downside Risks for Corporate Profits, March 17, 2008). A global hard landing is a growing risk. With such a radical downshift in earnings the key question now is how deep and how long will these downturns be? Reflecting the deleveraging of the financial system and the effects of the credit crunch on the global economy, we still think the risks for global growth are tilted towards weakness (see A Deeper US Recession Goes Global, October 6, 2008). If anything, incoming data in the past three weeks underscore the near-term downside risks. While it is not our base case, a hard landing in the global economy − meaning overall growth of just 1% in 2009 − is a growing risk (see EM Hard Landing: Scenario and Trade Ideas for 1% Global Growth, November 3, 2008; excerpted in this issue). Likewise, as we see it, a combination of domestic and global forces also poses ongoing downside risks to margins and earnings. A catalogue follows. At work are five domestic forces that are weakening margins and earnings. Most obvious, a deeper, longer US recession implies more weakness in top-line revenues, which, together with a reversal of operating leverage, have long been a one-two punch for domestically-generated earnings. A proxy for top-line sales − nominal GDP − may decelerate from over 5% growth in the year ended in Q3 2007 to zero by the third quarter of next year. Even if margins remained flat, such a deceleration in sales would put earnings growth under pressure. But the real story is the analytics of margins: In our view, the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy had skirted recession. Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line. Financing the boom with debt and buying back stock increased financial leverage and, of course, raised ROEs and earnings per share. Our strategy team estimates that corporate buybacks may have added 250bp to S&P earnings gains in 2006, and a whopping 300bp in 2007. That, of course, was then. Leverage − both operating and financial − works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenue going right to the bottom line. In addition, slower growth has crushed operating rates, reducing pricing power. In manufacturing, for example, operating rates have declined by 4.7 percentage points over the past year. Not only does that mean slower top-line growth, but the loss of pricing power drops straight to the bottom line. The good news for some companies: Costs for energy, materials, commodities, and imported goods are no longer rising, offering some margin relief. That’s not good news for aggregate profits, however. Measured in the National Income Accounts (NIPAs) associated with GDP, so-called inventory profits, which accrue when prices rise for goods held in inventory, added about 760bp to earnings growth in the year ended in the second quarter. The reversal in such phantom earnings will probably subtract a similar amount from earnings in the year ended Q2 2009. Finally deteriorating credit quality at both financial and nonfinancial companies is squeezing margins further, and the deleveraging of Corporate America is reducing ROEs and EPS. What about global factors? A global recession is weakening US top-line sales by undermining exports and is eroding the bottom line at US affiliates abroad. That contrasts with the past few years when growth abroad − and the higher oil prices that came with it − were powerful engines for US earnings. We estimate that global nominal GDP excluding the US may slow from 9.7% in the year ended in the second quarter to 5-6% by mid-2009. In a hard-landing scenario, nominal global GDP might slow to 1-2%. Measured in the NIPAs, earnings of US affiliates abroad jumped by 14.4% over the year ended in Q2 08, and could decline by a similar amount by the middle of next year. Such earnings amounted to a record 37% of overall earnings in the second quarter of 2008; S&P measures show a similar share. Importantly, that’s double the share of twenty years ago − the last time strong global growth consistently contributed to growth in the US. Consequently, the global impact on earnings today has doubled over the past two decades as US direct investment has spread abroad, and the recessions abroad will have a bigger impact on the bottom line than in the past. Likewise, the stronger dollar, if sustained, could depress US earnings through two channels. First, foreign earnings will soon begin to be translated from euros, Brazilian reals, and Korean won into fewer dollars. On a broad, trade-weighted basis, the dollar has jumped by 10.2% from a year ago, and our empirical work suggests that such a rise would reduce US earnings from abroad by at least 3% and as much as 6%, the latter cutting overall earnings by 150bp. It’s reasonable to expect those effects to continue into 2009. In addition, both global growth and a stronger dollar will hurt US companies trying to recapture market share. The 10.9% gain in real US goods exports in the year ending in August did not reflect the onset of either weaker growth abroad or a stronger dollar. Unfortunately, these earnings headwinds will reinforce the decline in domestically-sourced profits. There’s an even darker side to earnings from abroad, namely the potential for a vicious circle between them and domestic results. Last spring this outcome was merely a worry; now it seems increasingly likely. The US earnings downturn is spilling over into weaker earnings abroad, especially in Europe, which in turn may intensify the recession there and further undermine the earnings of US affiliates in Europe. Similarly, while NIPA data show that earnings of foreign affiliates in the US remitted abroad in the second quarter were flat with Q2 2007, we suspect that the strength is temporary. Such payments crashed in the last recession − from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001. For European companies the recent reversal of the euro is welcome relief but only a modest offset to the recessionary forces pulling earnings down; indeed, our European strategy team now expects a peak-to-trough earnings decline of 43% through the end of 2009. Weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth, in turn hurting US earnings abroad. Against this backdrop, what’s really perplexing is that Wall Street analysts don’t think that a weak 2008 will cast doubt on the vigor of next year’s results. On the contrary, in what we think is fundamentally flawed logic, they have maintained the existing level of their 2009 estimates (at more than $90 per share for S&P operating results), so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street projections for 2009 S&P 500 earnings now are 20% above 2008 estimates. By comparison, in early October we projected a 9.3% decline in 2009 after-tax economic profits that would leave the level below that in 2007. At some point markets will stop going down on bad news − when it has been fully discounted. A significant earnings recession is probably in the price, but a tepid upturn is not, with consequent downside risks to equities and lower-rated credit. Lower interest rates reflect risk aversion and a weaker economy, so they won’t likely promote significant multiple expansion until signs of economic recovery and an end to margin compression are visible. Thus, for now at least, earnings disappointments likely will be bad news for investors. But is the global recession the whole story? An equally important issue − one that is understandably getting little focus right now − may be the longer-term norm for earnings growth. A sharp swing in the regulatory pendulum seems likely to limit leverage and risk-taking by lenders, raising the cost of capital and restraining the availability of credit. Likewise, new speed limits may constrain the opportunities to leverage nonfinancial companies. Both will cap ROEs. And the current global downturn could promote a backlash against globalization and bring stepped-up protectionism. Such an outcome likely would reduce productivity gains, fostering a mix of higher inflation and lower long-term growth, and cap profit margins. None of that would be good news for earnings growth norms or for risky assets.
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