Europe
How Much Traction from All the Fiscal Policy Action?
January 23, 2009

By Elga Bartsch | London

Looking at the Reasons Behind the Fiscal Policy Debate

In the United States, economists seem to be in unanimous agreement that a major fiscal stimulus is needed to stabilise the ailing economy.  In Europe, by contrast, views seem to diverge between economists and policymakers.  In part, these differences in opinion might be rooted in general political leanings and the different stages of the election cycle.  Most of it though is likely to come down to different macro fundamentals, we think.  Fundamentals, such as the state of public finances, the role of credit constraints and, importantly, the expected reaction of private sector savings will likely have a bearing on how confident policymakers can be that a major fiscal stimulus will boost the economy.  Together with the features of the fiscal stimulus package itself, these fundamentals should determine the impact on domestic demand. 

In this note, we assess the chances of and discuss the factors for a successful fiscal stimulus in Europe.  We conclude that the chances of boosting the economy by fiscal policy measures vary widely between countries.  The credibility and sustainability of the fiscal policy programme are key for it successfully anchoring expectations of the private sector with respect to long-term income growth.  Another key factor, especially at the moment, is the proportion of credit-constrained households and companies. 

The Euro Area Finally Gets its Fiscal Policy Act Together

At the time of writing we count about €150 billion or 1.6% of GDP of discretionary measures to be put to work over 2009-10.  As the fiscal policy effort will likely be front-loaded, we estimate that the stimulus added to the economy via fiscal policy to be around €130 billion (1.4% of GDP) in 2009.  Thus far, euro area governments have set aside an additional €200 billion for bank recapitalisations and a further €1,700 billion for bank guarantees.  The size of the discretionary stimulus varies from 3.5% of GDP in Spain to as little as 0.2% of GDP in Italy, we estimate.  The largest package in absolute terms is being implemented by the German government.  Its stimulus totals more than €70 billion, equivalent to nearly 3% of GDP over this year and next. 

On the back of these discretionary measures and the sharp slowdown in the economy, we expect budget balances across the region to deteriorate very sharply.  It seems likely to us that for the euro area as whole the deficit will exceed the 3% threshold this year.  Taking into account the more marked deterioration in budget dynamics in late 2008 and the aforementioned measures, we now expect the budget deficit to balloon to 3.7% of GDP this year.  Only a handful of countries – the Netherlands, Finland and countries that have only recently joined the euro – won’t be sporting an ‘excessive deficit’ this year, according to the EU Commission.  With growth likely to remain sub-trend next year, a further (cyclical) deterioration seems to lie ahead in 2010. 

Policy Traction Depends on Characteristics of the Economy…

The euro area budget balance, which is also affected by sizeable automatic stabilisers such as rising unemployment benefits and falling tax revenues, will likely deteriorate by around €335 billion (or 3.5% of GDP) between 2007 and 2010.  Together with bank recapitalisations, this will likely cause the debt-to-GDP level to jump by nearly 10% of GDP within the space of just three years.  But how much bang for the buck will euro area taxpayers get in return? The impact on overall GDP growth will likely depend on both the characteristics of the economy as well as the features of the fiscal package.  Let’s start with the country characteristics.  Past experience suggests that fiscal expansion is more likely to be successful if a country has (see EU Commission – Public Finances in EMU, 2003, especially Part IV):

·         a smaller government debt-to-GDP ratio,

·         a larger degree of public underinvestment in infrastructure, education etc.,

·         a smaller expected future fiscal burden from ageing,

·         a lower propensity of households to save (i.e., a lower saving rate),

·         a larger share of liquidity-constrained households and companies,

·         a lower degree of openness, which reduces the propensity to import, and

·         a national monetary policy and a national currency to lever the fiscal stimulus.

Clearly, the last point does not apply to individual euro area countries, setting them apart from the US, the UK or Sweden.  An individual euro area country cannot inflate its way out of a debt spiral.  Instead, it has to deleverage to reduce the debt burden.  If deleveraging needs to happen against a background of sluggish growth and relative disinflation as a country tries to regain its intra-EUR price-competitiveness, the process might become even more painful. 

…and on the Features of the Fiscal Stimulus Package

In addition, the features of the fiscal expansion package itself will determine whether it can meaningfully stimulate aggregate demand.  These determinants would include the mix between increases in spending and decreases in revenues.  Within public spending, the breakdown between investment spending and consumption (such as higher public sector pay or transfers) seems to play a crucial role.  On the revenue side, there are differences between a reduction in direct and indirect taxes as well as social security contributions.  It is really these main features that seem more important to us than the fine-print in the draft budget legislation. 

Private Sector Expectations and Public Sector Credibility...

All these factors will eventually determine to what extent a fiscal stimulus package will work in stimulating the economy.  At first sight, spending programmes have a bigger impact in the near term than revenue reductions because a significant part of the latter likely lead towards higher private sector savings.  However, over the long term this difference seems to evaporate.  If expectations of the long-term growth potential and the long-term tax burden needed to stabilise debt are negatively affected, this could trigger negative repercussions on asset prices and hence private sector saving. (Forward-looking economic agents typically react to new information regarding current and future fiscal developments, not just the changes in current budget balance. As far as the bond market is concerned, the reaction to fiscal policy changes tends to be small, e.g., in a 10-25bp range for any persistent 1% rise in the debt-to-GDP ratio, if it is statistically significant at all.)  The credibility of the government’s commitment to stabilising debt in the long-term is key for expectations and private sector behaviour. 

…Determine the Private Sector Saving Reaction

The overall impact of fiscal policy on aggregate demand crucially depends on the response of private savings to the change in the fiscal policy stance.  In principle, changes in the fiscal policy stance can be offset or reinforced by changes in private sector saving.  Typically, there would be offsetting effects for any fiscal expansion.  These are caused by the propensity to save part of the additional income, by the propensity to buy imported goods, by a potential crowding out of private investments via higher interest rates and, possibly, by negative repercussions on asset prices and the resulting wealth effects.  The key question is how big these offsetting effects are and whether they could be so big that the fiscal expansion could become counterproductive. 

Private Savings Can Cause Considerable Offsets

The OECD finds substantial offsets in private savings across OECD countries, which range from about one half in the near term to almost three quarters in the long term (see Saving Behaviour and the Effectiveness of Fiscal Policy, Economics Dept WP 397).  In the long run, the offset is roughly the same for changes in spending and revenues.  The short-term offset is larger for revenues though.  Only public investment does not seem to cause a private saving offset.  Interestingly, in the US the saving response tends to reinforce rather than offset the fiscal policy stance.  (A number of measurement issues could blur the picture though. First, the saving rate can be distorted by the asymmetric treatment of capital gains and capital gains taxes. While capital gains are excluded from personal income estimates, capital gains taxes are nonetheless deducted when calculating disposable income. Sizeable, taxable capital gains thus lower the saving rate artificially. Second, inflation raises nominal interest rate payments, which are recorded in the National Accounts. The erosion of the real value of debt and the resulting transfer of wealth from creditors to debtors, by contrast, is not recorded. Third, estimating the cyclically adjusted budget balance is fraught with difficulties and subject to substantial uncertainties. Hence, past data are often revised substantially as estimates of the output gap are adjusted.)  The interaction between fiscal policy and private saving does not follow a linear line.  Instead there seem to be ‘trigger points’ linked to large fiscal deficits/high debt.  In anchoring private sector expectations on future fiscal policy, institutions like the Stability and Growth Pact can help to make credible commitments and anchor expectations.  (Alternative fiscal policy commitments include a so-called Golden Rule. The German constitution stipulates, for instance, that government borrowing must not exceed public investment unless there is a severe macroeconomic disturbance.  A pre-defined exit schedule from the temporary increases in government debt, a commitment to use future budget surpluses to pay down debt, or even a formal debt limit could provide a credible commitment.)

Counterintuitive Impact of Fiscal Policy Initiatives

There is ample evidence that fiscal consolidation can have a non-traditional, counter-intuitive impact on aggregate demand (see EU Commission – Public Finances in EMU, 2003 especially Part IV).  About half of the major fiscal consolidations in Europe in the past 30 years had such non-traditional effects.  This evidence provides important clues on the conditions under which today’s fiscal expansion programmes could falter.  Contrary to fiscal consolidation, where non-traditional effects are desirable, in the case of a fiscal expansion they are undesirable.  This is because they could undermine the effectiveness of the discretionary measures due to expectations of future tax hikes, etc.  Non-traditional effects on consumer and investment spending tend to be stronger if a consolidation leads to a permanent fall in the debt-to-GDP ratio – vice versa if an expansion would lead to a permanent rise in debt.  Fiscal consolidations with expansionary consequences are also more likely when consolidation is based on expenditure decreases rather than tax increases and when the initial debt-to-GDP ratio is high.  Hence, expansions are likely to work better if the initial debt ratio is low.  The read-across with respect to spending versus tax changes isn’t clear cut, as the greater leakage in the case of tax cuts has to be weighed against a positive expectations effect.  Cutting public sector wages seems to have positive repercussions for investment spending in the context of consolidation.  As boosting investment is not just increasing today’s demand but also tomorrow’s supply, raising public pay is probably not the most effective way to support the economy.

Experience of Swedish Banking Crisis Isn’t Encouraging

An example of a fiscal expansion that seems to have contributed to a contraction in economic activity is Sweden in the early 1990s.  At the height of the banking crisis, Sweden massively increased its budget deficit to offset a sharp rise in private saving.  The rise in private saving was partly due to negative wealth effects from correcting house prices.  But there is also evidence that concerns about the sustainability of the fiscal policy stance played a role in driving private saving even higher.  Automatic fiscal stabilisers, which tend to be high across the Nordic region, were allowed to fully adjust.  In addition, discretionary measures, mainly through tax cuts and bank bailouts, were implemented.  The deficit plunged by 15% of GDP (of which 8.5% was in cyclically adjusted terms) and the debt-to-GDP ratio rose by around 35 percentage points to more than 80% of GDP.  The Swedish experience suggests that deficits could be staying deep in the red for years to come and that a further substantial increase in debt lies ahead.

Crucial Role of a Potential Credit Crunch

A key feature driving the effectiveness of fiscal policy in the current situation is the fraction of credit-constrained households and companies.  The more prevalent credit-supply constraints are, the more powerful fiscal policy action can be.  This is because credit-constrained households see their current disposable income improving if public sector employment, wages or transfer payments are rising in the course of a fiscal expansion.  Contrary to non-credit-constrained households, credit-constrained consumers cannot benefit from lower interest rates and raise their borrowing.  Hence, the emergence of non-Keynesian effects crucially depends on the severity of credit constraints in the non-financial sector.  Survey evidence from both the banking sector and private sector would suggest that there are sizeable differences between countries.

In for the Long Haul: Beware the Burden of Ageing

The underlying long-run fiscal outlook will prove to be key for the chances of stabilising the debt level.  Continental Europe is in for a well-documented demographic demise, which will likely weigh on trend growth and on budget balances.  A considerable part of the negative repercussions on the labour force could be fended off by working longer.  The ECB projects the euro area budget balance to worsen by 5.5% of GDP between 2010 and 2050, thus arriving at an estimate that is about a quarter above the previous official EU estimates of the projected increase in age-related public spending (see ECB Working Paper 994 – Fiscal Sustainability and Policy Implications for the Euro Area).  According to the ECB projections, only Finland, Germany, Austria and Italy might get away with small or no policy adjustments.  Such long-term projections need to be taken with a pinch of salt, given their sensitivity to small changes in the underlying assumptions.  But they provide a rough idea of the long-term headwinds for fiscal policy.  The consumers’ trust in the long-term sustainability of public finances, including  public pensions, is vital for their saving reaction. 

Bottom Line
A significant deterioration in public finances lies ahead, both over our forecast horizon and beyond.  Wider budget deficits and bank-rescue operations should cause debt to climb quickly.  A large majority of countries will find themselves in excessive deficit procedure soon, and for the region as a whole debt will reach a new historical high.  We estimate discretionary fiscal measures to total about €150 billion (1.6% of GDP) over 2009/2010.  The boost to aggregate demand will likely be relatively muted in the near term.  Many measures will only take effect in the course of this year.  In addition, there will likely be some private saving offsets.  These offsets should be more pronounced for corporates than for households.  Nonetheless, the measures make us more convinced about the recovery that we are forecasting in 2H.  The chances of boosting demand through discretionary fiscal policy measures vary considerably between countries.  Anchoring expectations of the private sector with respect to long-term income prospects, the credibility of the fiscal policy measures and the sustainability of the debt-to-GDP ratio are key for success.  Another key factor at the current juncture is the share of credit-constrained households and companies.

Background – Two Views on Fiscal Policy

1. The Traditional View on Fiscal Policy

Most standard macro models predict that a fiscal expansion has a positive impact on growth via a so-called multiplier effect.  (The multiplier effect refers to the fact that an initial increase in government spending can lead to an even greater increase in GDP eventually because the extra money spent by the government creates more jobs, which in turn boosts consumer spending, which in turn creates jobs and so on. The size of the multiplier effect depends primarily on the marginal propensity to consume and the marginal propensity to import.)  They would also show that the impact of a rise in government spending would be larger than that of a reduction in taxation because households are likely to save part of their income.  The total effect on output depends on whether prices would start to rise relatively quickly in response to the fiscal expansion.  The standard assumption is that in the presence of excess capacity, prices will not rise relatively quickly.  Additional leakage stems from importing goods from abroad.  Exchange rate and interest rate adjustments can offset the fiscal stimulus via adverse changes in terms of trade and wealth effects.  The increased openness and expanded wealth effects have probably reduced the effectiveness of fiscal policy over time. 

2. An Alternative View on Fiscal Policy

Traditional macro models cannot explain why a substantial number of fiscal consolidations triggered faster growth, improved economic sentiment and spurred asset prices (e.g., Denmark, Ireland in the mid-1980s, Germany in the early 1980s).  These counterintuitive results need an alternative explanation: as consumers are forward-looking, they base their spending decisions on their expected long-term income, not just their current income.  Similarly, companies base their investment decisions on the expected long-term return and not just on the current profits.  Hence, expectations on the long-term income profile matter much.  Changes in expectations can offset – partly in the near term and fully in the long term – the initial impact of fiscal policy.  If expansionary fiscal policy dents long-term income expectations (say, due to concerns about future tax hikes), the boost will be greatly diminished.  Equally, if consumers expect a quick policy reversal (say, because debt is already elevated at the outset), the boost will be very limited.

Appendix – A Quick Refresher on Debt Dynamics

Closely linked to the issue of credible commitment to stabilising government debt are the workings of the debt dynamics.  Here we present a brief overview of how the so-called snowball effect works.  Essentially, debt-to-GDP rises when a country needs to borrow additional funds to pay interest on the debt outstanding because the primary balance does not cover interest payments.  Looking at the debt-to-GDP ratio, the nominator increases courtesy of the budget deficit while the denominator expands at the nominal GDP growth rate.  In mathematical terms, this can be written as

D = D _-1 + BB + SF. 

As percent of GDP, it becomes 

D/Y = D_-1/Y_-1 * (1/1+y) + BB/Y + SF/Y where

D is the general government debt, BB the general government budget balance, Y nominal GDP, y nominal GDP growth and SF the stock flow adjustment.  (General government budget balance measures the shortfall between current and capital revenue over the corresponding expenditure. It thus excludes all financial transactions and therefore must not be confused with the net borrowing requirement, which normally includes some financial transactions and usually just covers the central government. As a result, bank recapitalisations, which essentially are financial transactions, would typically not affect the deficit. They will, however, affect the debt level via the stock flow adjustment. Finally, please note that general government debt is not to be confused with government debt outstanding.)  All variables refer to the same period, unless they have a subscript _-1, in which case they refer to the previous period. 

The stock flow adjustment ensures that the deficit and debt dynamics are consistent by taking into account accumulation of financial assets, changes in the valuation of foreign currency debt and other statistical adjustments.  In normal times, the stock flow adjustments would be relatively small.  The various bank rescue packages would show up here to the extent that they include the acquisition of assets via bank recapitalisations as these transactions typically affect only the debt level, but not the deficit. 

Taking into account that the budget balance is the sum of the primary balance, PB, and the interest payments, i.e.,  BB = PB + D_-1*(1+i), where i denotes the implicit interest rate paid by the government, we get:

D/Y = D_-1/Y_-1 * (1+i)/(1+y) + PB/Y + SF/Y

Rearranging yields the change in the debt-to-GDP ratio as:

D/Y – D_-1/Y_-1 = PB/Y + D_-1/Y_-1 * (i-y)/1+y + SF/Y

The middle term on the right hand side of the equation is called the snowball effect.  It describes the impact real GDP growth, inflation and interest rates have on the change in debt.  The snowball effect becomes positive, causing debt to rise, if nominal GDP growth falls short of nominal interest rates paid on the debt.  Vice versa, a country can grow out of its debt if its nominal GDP growth exceeds the interest rate by a considerable margin.  Analytically, the snowball effect can be broken down further into real GDP growth effect and inflation.  So, even in the absence of real GDP growth, inflation will still help to contain the rise in debt. 

It is this lever that would be used in the strategy of ‘inflating your way out’.  It becomes clear immediately from the last equation above that this strategy works better if nominal interest rates don’t reflect the higher inflation premium fully.  But this strategy can still work even if they do.  Contrary to countries with their own central bank and currency, individual EMU countries cannot inflate out of their debt.  Instead, they would have to deleverage, which many of them have done successfully in the past.  In the run-up to EMU, fiscal consolidation was helped by massive interest rate convergence and faster trend growth.  Going forward, deleveraging would need to be achieved against a background of sluggish growth, relative disinflation and interest rate divergence. 

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Korea
Has to Survive on its Own
January 23, 2009

By Sharon Lam | Hong Kong

Summary and Conclusions

If one had thought that the Korean economy was bad last year, it’s not entirely correct. As we have been emphasizing, Korea was ‘relatively’ resilient among the Tiger economies in 2008. It did not enter into a recession until 4Q08, versus Hong Kong in 2Q08, and Singapore and Taiwan in 3Q08. Its GDP growth slowdown has been much milder.

We have long identified China as one of the main reasons for Korea’s strength. Korea happily rode on the China boom during 2003-08 and emerged as possibly the fastest penetrator of China’s market through both capital and consumer goods. That was then. China itself is heading into a hard landing. The ‘China as savior’ story does not seem to be playing out, at least for the time being. 

Now Korea has to survive this global recession on its own. We do think that the Korean government has recently gathered its pace in terms of coming up with stimulus measures to prevent Korea from falling into a depression, yet it will take time for the plans to be executed. Right now Korea appears to be in a vacuum where growth can only slow (since exports are plummeting), China is no longer a source of growth, and stimulus measures are not having a meaningful impact yet. We therefore downgrade our 2009 GDP growth forecast for Korea to -2.8% from +2.7% and our 2010 GDP forecast to +3.8% from +4.5%. We expect CPI inflation of 2.8% in 2009 and 3% in 2010. We maintain our view that the Bank of Korea (BoK) will cut its policy rate from the current 2.5% to 1% by 2Q09 (see In a Mad Race to ZIRP? December 11, 2008) but will follow this with mild rate hikes in 2010. We see the Korean won (KRW) remaining weak in 1Q09. We expect USD/KRW to break through 1,400 soon and would not be surprised if it were to approach 1,500 in the near term. The key for KRW to stabilize, we believe, is an extension of its swap line with the US Federal Reserve beyond the April expiration date. Yet, we hold our view that the KRW will appreciate to 1,150 towards year-end.

Note that our substantial GDP downgrade is not intended to imply a doomsday scenario for Korea. It is more of a reflection of the current situation as growth plunges without any sort of support. We expect a mild recovery to be gradually staged due to the generous stimulus measures that are currently estimated to total around 4% of GDP this year. Positive year-on-year growth should return in 4Q09, we think.

The Very BAD

1) Growth Engine from China Failing in 1H09

Korea’s domestic growth has never really boomed post the credit card crisis, due to diverging wealth gaps and a lack of capital spending. Growth in Korea has been rather dependent on China, and this has played out well. China accounts for 23% of Korea’s total exports, or 28% if combined with exports to Hong Kong, as these are likely to be re-exported to China anyway. Exports to China alone accounted for 28% of Korea’s incremental GDP growth during 2003-08.

Consensus GDP growth for China this year has been centering on 7.5%, which would be a soft-landing scenario under which Korea’s exports to China would fall, but not crash. Yet, we have been seriously disappointed by the nosedive in Korea’s latest exports to China, which plunged 35% in December, after a 33% drop in November and a 4% decline in October, and these compared with five-year average growth of 22%. Given how closely related Korea’s growth is to China, we thought that the sharp drop in Korean exports might imply that China is also faltering.

Morgan Stanley’s China economist, Qing Wang, recently lowered his 2009 GDP growth forecast to 5.5% from 7.5% (see China: 2009 Outlook Downgrade: Getting Much Worse Before Getting Better, January 18, 2009), pointing to a hard-landing scenario in China that Korea would not be able to escape. In particular, our team expects China’s fixed asset investment to fall sharply in 2009, with property construction investment contracting by 12% in 2009, after expanding 11% in 2008. In fact, we have already seen a slowing in export sectors that are sensitive to China’s fixed asset investment.  Korean exports of civil engineering machinery and industrial machinery to China dropped 55% and 28%, respectively, in November. In contrast, our team is positive on China’s infrastructure investment this year, which is obviously because of the stimulus package, and expects such growth to pick up to 38% in 2009 from 9% in 2008. Yet, we should note that such a positive impact from infrastructure is not expected to kick in until late 2H09, and likewise for the impact on Korea’s exports to China.    

Implications: We maintain our view that Korea will be the biggest beneficiary of China’s stimulus measures, as it is already China’s second-largest source of imports after Japan, and it is gaining market share in China while Japan is losing share. However, Korea will probably have to endure a painful 1H09 – with a mere 3% growth rate in China – before it can see support in 2H09 from infrastructure. The downside risk to our thesis is that Chinese industries take this opportunity for aggressive restructuring that could reduce their reliance on imports – this is a development worth monitoring, in our view.

2) Significant Destocking Required and Hurts SMEs

Korea’s inventory growth took off in 2008 and was expanding at +18%Y in September and October last year, with some limited easing in November. This was the steepest inventory accumulation since the excessive capex expansion in 1995-96. The inventory growth in 2008 was most significant in the chemical, fabricated metal, semiconductor, electronic component and PC sectors.

Implications: Such a high inventory level, combined with the crash in demand, means that Korea’s production growth will have to slow more sharply than in a normal cycle. Industrial production growth has already sunk to -14%Y in November (latest data), and we believe that it could bottom at -20% in 1Q09, with an average -8% growth rate for the full year. Meanwhile, manufacturing capex will likely shrink by 20% in 2009, but this should be partly offset by flat growth in construction due to the government’s stimulus measures. SME manufacturers face the biggest risk, and this is likely to cause the SME delinquency rate to soar in 1H09, in our view.

3) Shrinking Employment; Jobless Rate Higher than it Seems

Despite the recession backdrop, Korea’s unemployment rate still seems healthy, as it is little changed from 3% at the beginning of 2008 to only 3.3% as of the latest data in December. We know that labor market conditions are often a lagging indicator, so Korea’s jobless rate will likely rise. Yet, we think that Korea’s unemployment is actually much higher than the official data suggest, due to the pro-cyclical nature of the labor force participation. Interestingly, Korea’s labor force participation goes together with GDP growth, i.e., the labor force shrinks when the economy slows, and vice versa. This seems a bit counter-intuitive, as more people should be looking for jobs when the economy deteriorates. Could it be that Koreans are too impatient to look for jobs? Or that they understand the cycles too well and wait for the right moment?  Or that young people decide to stay in school longer rather than hit the job market, i.e., the ‘kangaroo generation’ that continues to depend on their parents? 

Whatever the reason, Korea’s jobless rate is underestimated, in our view. If we were to include people who have given up looking for jobs, we estimate that Korea’s unemployment rate would be 5% instead of 3.3%, with more upside to come.

To make things worse, Korea’s employment contracted year on year in December for the first time in five years. More business closures and layoffs are expected, especially as SME bankruptcy filings are likely to rise, with SMEs accounting for 88% of Korea’s total employment.

Implications: It goes without saying that consumption will be hit by the struggling labor market, which is only at the beginning stage of deterioration and is worse than it seems. We have been bearish on Korea’s consumption growth due to the overspending in the last few quarters and a weak currency dampening sales of luxury goods. Now we are looking for a broad-based consumption slowdown. The adjustments in both employment and consumption seem to have slowed when compared with other macro indicators, and we think that they need to catch up. We expect negative year-on-year private consumption growth to last throughout 2009.

The OK

1) Improving Trade and Current Account Surplus

Last year’s current account deficit – the first in ten years – has drawn much concern from the market and even led many to predict a crisis in Korea which resulted in sharp KRW depreciation. We argued that KRW depreciation had gone beyond fundamentals in 3Q08, as we predicted that Korea’s current account would swing back into surplus starting in 4Q09, and it did. The current account posted surpluses of US$2.1 billion in November and US$4.8 billion in October, after an average monthly deficit of US$1.5 billion in the first nine months of 2008. The reasons for the current account surplus are straightforward: a drop in commodity prices, a more-than-proportionate decline in imports than exports due to weak domestic demand, and less overseas spending due to the weak currency. In fact, the consensus view now is that Korea will have a current account surplus in 2009. We expect the trade surplus to be 3.2% of GDP this year after a 1.3% deficit in 2008 and the current account surplus to be 2.4% of GDP after a 1% deficit in 2008.

As a result, we expect the KRW to appreciate over the course of 2009, but we are cautious on 1Q09, since the expansion in the current account surplus is unlikely to be significant in the next 2-3 months. This is because exports are adjusting much faster than imports at the moment, but we believe that weakness in domestic demand will persist and cause the trade and current account surpluses to widen later. We expect USD/KRW to break through 1,400 soon and would not be surprised if it approached 1,500 in the near term. The key, in our view, is for Korea to secure an extension of its swap line with the Fed beyond the April expiration date. Yet, we hold our view that the KRW to appreciate to 1,150 towards year-end.

2) Significant Improvement in Terms of Trade

Not surprisingly, Korea’s export and import prices in contract terms (which are mainly USD-based) are plummeting, with import prices falling 18.3%Y in December while export prices dropped 15%. This implies that the freefall in export growth data is not just a volume effect but also a price phenomenon. 

In KRW terms, the price declines have been much milder, apparently because of KRW depreciation. In either case, import prices are dropping much faster than export prices, and so Korea’s terms of trade have significantly improved. The terms of trade appear to be an important indicator for this externally led economy.

3) No Deflation and Negative Real Interest Rate

Korea’s inflation rate is easing slower than in other countries due to its weak currency, rigid labor costs and high food prices. We forecast CPI inflation to average 2.8% in 2009, down from 4.7% in 2008, but in contrast to economies in the region that are facing deflation risks. We expect the BoK to keep cutting interest rates, as we believe that the macro data will continue to disappoint in 1Q09, causing sentiment to deteriorate again. The real interest rate turned negative in mid-2008, and we expect it will remain so throughout 2009. This may not be desirable in economic terms, but at least it helps to provide some relief to asset prices in Korea as compared with countries facing deflation.

Some may argue that the BoK should not cut interest rates so aggressively when inflation is just within its target range, not lower. However, we see interest rates as more of a tool now in managing consumer confidence to avoid any vicious cycle, and also as an immediate support for the economy while waiting for the fiscal policies to become effective. Meanwhile, low interest rates should not cause the KRW to depreciate since Korea’s capital flows are driven more by growth prospects rather than interest rate parity. We do not expect low interest rates to prevail in Korea but rather to act as a temporary buffer; we look for rates to start to normalize after the recession. 

Mild Recovery Until Stimulus Plans Run at Full Steam

There is no debating that the forthcoming macro data will deteriorate further. We believe that the recession is likely to persist in 1H09, and the recovery may not be exciting. The growth rate trajectory may look V-shaped, but fundamentals should take a long time to heal completely.

Nevertheless, we recognize that the Korean government’s latest effort in stimulating the economy should make a difference eventually. The government has already committed KRW140 trillion (15% of GDP) in terms of liquidity support, tax cuts and fiscal expenditure to help to turn around the economy; this is a rather considerable amount even on a global basis.  Meanwhile, the government has continued to formulate its medium-term growth plans despite the current turmoil.  Around KRW130-150 trillion (circa 15% of GDP) is planned to be invested during 2009-13 on infrastructure projects, including the Green New Deal; this amount is equivalent to an average 3% GDP boost to the economy in each of the next five years. The infrastructure projects will clearly take a long time to have any effect on the economy and cannot prevent a recession, which is already underway.  Nonetheless, we believe that early actions should help to prepare the economy to turn around faster than the others, once the global growth inflection point comes.

Most of the government aid is currently allocated to the SMEs, and we believe that this is warranted. However, we question whether consumers are getting enough support. More proactive policies such as tax refunds could help to generate demand. Korea has the capacity for more stimulus growth since it is the only country in the region that has consistently run a fiscal surplus since 2000 and its government debt, at 33% of GDP, is far below the OECD average of more than 70%.

Appendix: 2009 Growth Scenarios

Bull case: Global economy and China start to recover in 2Q09, albeit mildly.  The government expands spending through earlier execution of infrastructure projects and stimulates consumption through tax refunds.  The BoK still cuts aggressively in 1Q09 (which, in turn, helps the economy), and normalizes the rate in 2H09.  Inflation returns but is checked by the stronger currency.  KRW remains weak in 1Q09, helping exports, but ends the year with almost 30% appreciation from the trough in 1Q09.

Bear case: Global recession lasts throughout the year and loops back to the financial market, causing another round of capital markets meltdown.  Unemployment rate reaches double-digits in developed economies.  The government pours in more resources to support the economy but not enough to offset the crash in the private sector.  However, deflation is still avoided because of the weak currency.  The BoK does not bring the rate to 0% but close, yet market rates are more sticky due to tighter liquidity.  USD/KRW goes above 1,500 at one point but soon appreciates due to the weak USD.

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Global
Battle of the Gaps
January 23, 2009

By Manoj Pradhan | London

Interest rates have fallen precipitously in the G10 as central banks have consistently beaten market expectations to deliver hefty rate cuts over the past several months. Our empirical models, however, suggest that the natural or neutral rate of interest – the interest rate that would deliver steady inflation in the absence of shocks – has fallen relatively sharply as well both in the US and the euro area. This implies that policy is not quite as expansionary as the rapid cuts in policy rates would suggest. Policy rates have to work harder to get below neutral. Further, these models suggest that potential output growth has also fallen so that the output gap is not as negative as GDP prints might indicate. A negative output gap implies economic slack, which tends to push inflation lower. A narrower output gap therefore means less downward pressure on inflation.

Natural rate estimates at their lowest levels since the 1960s: Our measures of the natural rate of interest and potential output are derived by using a sophisticated econometric technique called Kalman Filtering on a simple macroeconomic model featuring output, inflation and interest rates (readers interested in the details of our model can email us). In our model, the natural rate and potential output share long-term, but not necessarily short-term, dynamics.

Therefore, it is not as surprising that both have moved in the same direction. What is surprising is the extent to which they have fallen.  In fact, feeding the model with the most recent data on output, inflation and actual interest rates, our natural rate estimates are now at their lowest levels in the US and euro area since the respective beginnings of our sample (1962 for the US and 1970 for the euro area). These estimates support the notion that the financial crisis and its global ramifications have created major headwinds for sustainable growth and for monetary policy.

The real rate gap matters for economic recovery... The natural real rate of interest has fallen to roughly similar levels in the US and the euro area, around 1%. With US policy rates near zero and core PCE inflation at 1.9%, the real fed funds rate stands at -1.8% and the real interest rate gap (the difference between the actual and natural real rates) remains expansionary at -2.8% . The real interest rate gap in the euro area, by contrast, is at a miserly -0.1%, thanks to a slowly falling 3-month euribor rate of 2.4% and HICP inflation of 1.6% against a natural rate of 0.9%. Our ECB watcher, Elga Bartsch, expects the official policy rate to bottom out at 1.0% but also points out that the overnight interbank borrowing rate (EONIA) could fall to near zero (see “ECB to Enter ZIRP?” The Global Monetary Analyst, January 7, 2009), bringing 3-month euribor rates lower. The lower estimate of the natural rate, however, raises the risk that the ECB’s rate cuts may not yet have provided much of a monetary stimulus.

...while the output gap matters for inflation: A negative output gap is indicative of slack in the economy and usually leads inflation lower. The more negative the output gap, the greater is the slack in the economy and the greater the downward pressure on inflation. Our model suggests that potential output may also have fallen sharply so that the slack in the economy may be smaller than many believe. As a result, the fundamental downward pressure on inflation may not be as strong. If monetary and fiscal stimulus is successful in stemming deterioration in economic growth, and we believe that this will indeed be the case some time in 2H09, then a return to inflation worries may be on the cards earlier than expected. We believe that inflation markets are far from pricing in this view.

In particular, US breakeven inflation (the difference between the yields on nominal and inflation-protected bonds of comparable maturity) shows headline CPI inflation pricing of just -17bp over the next five years and 60bp over the next ten. In our opinion, this is a bet that markets may well lose over that horizon, but some further deterioration in the near-term outlook for inflation could occur as economic data continue to come in weak.

The battle of the gaps: In a nutshell, the arguments above suggest that the real interest rate gap and the output gap may both be narrower than is commonly perceived. Juxtaposed, these gaps capture the essence of the policy dilemma very well. The lower natural rate and the narrow real rate gap suggest that central banks would have to cut rates by more in order to provide monetary stimulus. Where rates are already at zero, there is thus additional pressure on central banks to use unorthodox policy, given that the main weapon is less effective. On the other hand, the drop in potential output and a narrower output gap mean that the inflation threat that is currently off most radar screens may reappear. Compensating for the narrow real rate gap with strong policy measures may put at risk the downward pressure on inflation exerted by the narrow output gap.

On balance, we think that central banks will err on the side of caution and keep an expansionary policy in play until they are convinced that economic recovery is entrenched. Inflation may currently appear to be a concern for another day, but tomorrow isn’t far away.

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