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		The Global Economics Team

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We had argued that Taiwan’s macro is relatively safe due to strong balance sheets. This is true, and we still do not expect Taiwan to see any systemic crisis from this global credit crunch. Now that financial markets around the world appear to be stabilizing somewhat, what shocked us is the magnitude of the global demand destruction. Taiwan can escape the liquidity crunch but not the correction in the real economy, and this is reflected in the record fall of its exports.

Consensus, including ourselves, did not expect that Taiwan’s export growth could have fallen over 40%Y in the past two months. Taiwan cannot afford to have exports falling so much because it is one of the most export-oriented economies in the region and does not have a strong service sector.

We understand that there are one-off factors that caused such a dramatic decline in exports, such as significant de-stocking and deleveraging that disrupted trade finance. Nevertheless, even if we have seen the worst export growth data, they will continue to be in double-digit negative territory for most of this year, in our view. Do not forget that the global economy this year is forecast to be at its worst since World War II. There are unavoidable consequences to such damaged exports, namely corporate delinquency and joblessness. The downside from here, however, is not exports but domestic demand. 

The Taiwanese government has been proactive in dealing with the challenges of the global economic turmoil. Meanwhile, improvement in the cross-strait relationship is materializing as promised by the new government. Yet, just being on track is not good enough now. 

Liquidity is abundant in Taiwan but confidence is lacking. In fact, confidence has been weak for almost a decade; it is only likely to tumble more during this recession, and is becoming more difficult to revive. It will require many reforms in order to push up such low confidence levels, but all the structural reforms are taking a backseat as resources are being used to put out the cyclical fire first. We are still highly convinced that cross-strait opportunities will continue to expand under this government, but it will not help Taiwan to climb out of this recession faster because the Mainland Chinese economy itself is in a hard-landing scenario.

We are therefore downgrading Taiwan’s 2009 GDP growth to -6% from our December prediction of 0.5%. This will mark a record fall in GDP growth in Taiwan this year. We are also revising down our 2010 forecast to 2.2% from 4%, implying that the economy will remain significantly below trend next year, because we do not see any driver of a sustainable recovery in Taiwan. After this downgrade, Taiwan has the lowest GDP forecast in the region.

Our bear case scenario for 2009 is -8.8% and bull case is -1.5%. Note that our base case is closer to the bear case because we believe that the worst is already happening and that further downside surprises should be limited. Room for upside, however, is larger since our base case has not taken into consideration any potential aggressive stimulus measures that could be undertaken by the government. We still have hope, but we will believe it when we see it.

Growth Already into Unchartered Negative Territory

It is not unrealistic to predict that Taiwan’s GDP growth will be a record low this year since the economy has already headed into unchartered territory. Export growth in January posted a record fall of 44%Y after -42% in December, which was worse than the previous bottom in 2001 when exports fell -31% in one month. Industrial production also plummeted 32% in December while retail sales declined 11%. The business cycle indicators clearly show that the economy is declining at an unimaginable rate. 4Q08 GDP growth, due for release on February 19, is almost certain to be a historically low number – we forecast -9%Y.

The disappointing export growth is the main reason for our downgrade this time. However, in terms of magnitude, we have revised down consumption and capex growth further. Export growth is only leading the weakness of the economy; it’s not the end of the story. Its ripple effect will cause soaring business closures, and aggressive cuts in capex and employment, which will in turn shrink household income and asset prices. A vicious cycle could develop if exports do not recover or policies are not accommodative enough.

Considering the current developments, our base case of -6% for this year is not an exaggeration at all. However, at the same time, we will not commit the mistake of simply extrapolating the current trend into the next few quarters because we know that the stimulus measures in Taiwan and around the world will gradually have an impact on the real economy, but of course the different magnitudes will determine each economy’s recovery path.

We are not the only ones revising Taiwan’s GDP forecasts. In order to check whether one’s assumptions are realistic or not, we suggest that readers look at growth breakdown. One common illogical assumption we often find is that some pundits forecast the ‘net export’ contribution to GDP growth to be negative this year and therefore the headline GDP number would be a wowing number. It is inaccurate to have a negative net exports contribution, which is exports minus imports, when domestic demand is so weak, which should only cause imports to fall much faster than exports. 

Taiwan Exports Not Only Losing on Demand but Also Competitiveness

Earlier last year, we argued that Taiwan’s export growth was becoming less dependent on the US and developed markets. In fact, export growth held up well in 1H08 despite an already slowing developed market. Unfortunately, it has turned into a global recession and the emerging market demand has failed to support Taiwan’s exports. For the first time since the Asian Financial Crisis, Taiwan’s exports to emerging markets are underperforming those to developed economies. In addition, not only are tech exports suffering, as was the case in 2001, but non-tech exports are just as bad.

What is more worrisome than the nosedive in demand is the ongoing threat in competitiveness. Taiwan has positioned itself as a successful OEM (original equipment manufacturing) and ODM (original design manufacturing) producer, but OBM (original brand manufacturing) is its weakest link. Such a passive strategy worked when global demand was strong, but it makes Taiwanese exporters lose flexibility as their fate is dependent upon end demand for their suppliers. Although all kinds of demand are weak during this global recession, there must be areas where demand is slowing less than others. However, Taiwan cannot actively compete for the right markets since it is only producing for its suppliers.

To make things worse, its relatively stable exchange rate means that export growth in local currency terms – a better proxy for corporate earnings – is just as bad. In January, for example, export growth in USD terms dropped 44% and similarly was -43% in NT$ terms. Meanwhile, it is also losing competitiveness to the Koreans as the KRW has depreciated 45% against USD since the beginning of 2008 but the NT$ has depreciated only 4% during the same period. Even if head-to-head competition with the Korean producers is not that significant, it could potentially become a bigger problem as the Koreans will make use of this opportunity to secure market share in all industries. Taiwan has been losing market share globally, which cannot be simply explained by its production relocation to China (in which it is also losing market share).

Corporate Delinquency Could Reach Record High

The disastrous export performance will certainly exacerbate the worsening credit risk problem in Taiwan. As this round of global recession has taken a heavy toll on corporate profitability, numerous enterprises have been aggressively downsizing operations in order to meet fading demand while those that failed to survive had to close down their entire businesses. Indeed, factory closures have been soaring rapidly since 4Q08, and we expect to hear more news related to the termination of deeply troubled manufacturing and trading companies in the near term. Since NPLs are a lagging indicator, the negative effects from the credit crunch and global economic downturn do not appear immediately. According to our self-constructed Taiwan Credit Risk Index, the latest data point confirms that credit risk has already surged to decade-high levels, implying more upside to NPLs in the future. Bad loan accumulation should prevail into next year, and the adjustment will be gradual unless aggressive debt restructuring is carried out.

Retailers to Suffer from Both Deflation and Volume Decline

It goes without saying that consumption in Taiwan will be under a lot of pressure. Private consumption growth in real terms already turned negative for the first time in 3Q08, and we expect that it will remain in negative territory for all four quarters this year. Taiwan’s consumption has been a confidence problem for years, and now adds to the challenges from a record fall in GDP growth. The latest jobless rate is already at 5% in December and definitely has more upside to go with the economy deteriorating and the labor market being a lagging indicator. Taiwan’s rising jobless rate is the most rapid among the Tiger economies in the region.

The government attempted to boost consumption through distribution of shopping coupons that amounted to NT$3,600 per citizen. This cost the government NT$85.7 billion, and it is estimated to boost GDP growth by about 0.67pp. We applaud the shopping coupon idea and its fast execution. Anecdotal evidence indicates that retail sales did see a significant improvement in January after the shopping coupons were distributed. The Taiwanese government’s shopping coupon policy was so well received that it’s been echoed by some local governments in China and is also becoming a hot policy request by citizens to their own governments in the region.

The shopping coupons will expire by the end of September this year, but we believe that the positive impact is almost fully reflected already. This scheme is based on a similar program initiated by Japan in 1999. In March 1999, the Japanese government handed out shopping coupons worth roughly US$200 each to about 25% of its population which cost the government 0.12% of GDP in total. The coupons expired after six months in September 1999. Private consumption growth in real terms picked up from -0.1%Q (seasonally adjusted) in 1Q99 to +0.5% in 2Q99 but slowed to +0.1 in 3Q99, suggesting that the coupons might have had an immediate boost but did not last long.

We agree that the shopping coupon policy is a success, but is it enough to help get Taiwan out of recession? We think probably not. It is possible that the government will issue shopping coupons again in the near future, but the marginal benefit from such a policy should diminish. First, the excitement is likely to decrease and plus the impact will not be as big as the first time when it was distributed right before the Chinese New Year holidays. Second, expectation on continuous sales promotions will be formed when consumers know that there will be more shopping coupons coming, and this will put off current consumption in anticipation of more promotions. Third and most importantly, the bottom of the labor market and income growth have yet to be seen and spending power will likely deteriorate so much that it cannot be saved by mere shopping coupons.

An unwanted side-effect from the shopping coupons is that they could become a source of deflation. Aggressive promotions were carried out by the retailers in order to stimulate consumers to use their shopping coupons. It has worked well, but what’s next? It will be difficult for the retailers to normalize prices after the promotions when overall consumer sentiment is still so weak and spending power is shrinking. Along with the drop in commodity prices this year, we believe that deflation will return to Taiwan with a projection of headline CPI growth at -1% compared to 3.5% in 2008, and core CPI at -1.5% this year versus 1.3% last year. As a result, we believe that the retailers will suffer from both price and volume contraction this year.

Possible Liquidity Trap While Real Rate Also Climbs

Liquidity has never been an issue in Taiwan, but confidence and risk-aversion mean that abundant liquidity will not translate into growth. This is in fact a lingering problem that is likely to exacerbate in the next few quarters.

Since the Lehman Brothers’ collapse in September 2008, the Central Bank of China, Taiwan (CBC) has taken swift actions to stabilize the financial markets through lowering the deposit reserve requirement ratio and cutting interest rates six times by a total of 212.5bp. Reflecting the rise in liquidity, M2 money supply has surged sharply since September. Loan growth, however, is only beginning to decelerate, as capex is to sink along with the plunge in exports and business closures (not to mention that banks will be reluctant to lend with such a high risk of corporate delinquency). We believe that a liquidity trap is likely.

The current policy rate at 1.5% is not an historical low yet (it was 1.375% in 2003-04), but we see further downside to the interest rate outlook. We expect the policy rate to go down to 0.5% by 2Q09, and we think that the next rate cut could happen this month, i.e., another inter-meeting move since the next quarterly monetary policy meeting is not due until March (see In a Mad Race to ZIRP? December 11, 2008). Real interest rates, however, should not be favorable this year due to deflation. The rise in real rates should only add further pressure to asset prices, which are already daunted by declining income.

The possible liquidity trap and deflation mean that even record-low interest rates will not likely revive the economy.

Limited Benefits from Cross-Strait Policies in Near Term

We have been a bull, advocating the positive prospects from the improving cross-strait relationship that will provide capital, trade, human resources and confidence to Taiwan.  We have not changed our view. We also congratulate the new government for having fully committed to its policy agenda on cross-strait passenger and cargo traffic, removal of investment caps in China and discussion of MOUs. The most promising potential policy move will be an economic pact between the two economies, i.e., similar to a free trade agreement or the CEPA signed between Hong Kong and the Mainland in 2003. The opportunities that Taiwan can tap in the Mainland market are vast; yet, the story cannot play out when Mainland China itself is in a hard landing. CEPA boosted the Hong Kong economy when Mainland China was at the beginning of the boom stage. Unfortunately, it is bad timing for Taiwan now, as our team expects the Chinese economy to slow to a 19-year low this year of 5.5% GDP growth. Although we are confident that there will be continual breakthroughs on the cross-strait relationship, the near-term benefits that can be brought about should be limited and insufficient to turn around the Taiwanese economy.

L-Shaped Recovery Unless More Fiscal Policies

In terms of the growth rate, we predict that Taiwan’s year-on-year GDP growth will bottom in 1Q09, but nonetheless we are not calling for a celebration just because of this, since we view such a recovery as more graphical and technical due to a low base effect rather than a meaningful improvement in fundamentals. All economies in the region are projected to recover in 2H09, as trade should climb up from the bottom, but the magnitude of the recovery will differ depending on the strength of the domestic economy – which is Taiwan’s main weakness. We expect Taiwan’s growth to be below trend in both 2009 and 2010.

The biggest lingering problem with Taiwan is the lack of momentum and confidence, which run the risk of turning into a vicious cycle as negative sentiment can cause deflation, capital outflow and a liquidity trap to repeat and to worsen. Negative sentiment can cause continual weakness in consumption, therefore slashing pricing power, and the expectation of lower prices reduces current consumption – and the cycle repeats. Similarly, risk-averse banks cutting lending causes a shortage in finance and increases corporate delinquency, thus forcing the banks to tighten even more. Negative sentiment can also lead to capital outflow, weakening the currency, reducing NT$ investment appetite – and then even more capital outflow. Taiwan has gone through all these cycles, and what we worry about most is that if sentiment tumbles further in this recession, then it will be even tougher for Taiwan to break through these unwanted cycles. This explains why we do not see a strong recovery soon. 

A sharp turnaround in global growth could certainly push Taiwan’s growth above trend, but it is too risky to bet on such optimism. Taiwan needs internal policy to recover, which can come from monetary, fiscal and cross-strait. However, as we have argued earlier, the upside from further rate cuts and cross-strait policies will be limited, so the only hope is to rely on fiscal stimulus.

The announced fiscal policies so far amounted to roughly 2% of GDP, including shopping coupons, NT$500 billion infrastructure spending in four years (with NT$70 billion on bridge reconstruction and NT$50 billion on urban renewal this year) and tax cuts. These kinds of stimulus measures may be unprecedented but unfortunately will not be enough to battle against a global recession and record export fall of over 20% this year, in our view.

Our base case forecast has taken into consideration policies that have been announced but not more potential stimulus. We think it is very likely that the Taiwanese government will formulate more supportive measures going forward, which could include more shopping coupons, tax rebates, front-loading infrastructure projects, purchase of assets and temporary job creation. After all, with central government debt at 31% of GDP (or 38% including local governments) versus the OECD average of over 70%, Taiwan has room to run a much bigger fiscal stimulus program. The potential upside is substantial, but we will only believe it when we see it. 

Appendix: Bull/Bear Growth Scenarios – Asymmetric Risks

Bull Case

Even in our bull case scenario, we do not bet on a very strong global recovery. We expect the bull case to be reached with more government support measures at 5% of GDP, up from the announced 2%, which would help achieve a milder recession than in 2001. Growth in 2010 would surge above trend due to a pick-up in exports, asset prices and the continual liberalization via the cross-strait relationship, enabling Taiwan to leverage the rebounding growth in China. No sharp NT$ appreciation is expected, however, as a means to support exporters, and interest rates remain low.

Bear Case

Global recession lasts throughout the year and loops back to financial markets, causing another round of capital markets turmoil. Trade rebounds in 2Q09 after too much de-stocking, but deteriorates again in 2H09, and it is too late for the Taiwanese government to step up supportive measures, which work with a time lag. The NT$ depreciates sharply due to near-zero interest rate, capital outflow and as the most direct and immediate policy to help the exporters.

United States
Recovery Coming but “Back-Loaded” Stimulus Means Weaker Near-Term Outlook
February 11, 2009

By Richard Berner & David Greenlaw | New York

We still think recovery is in prospect for the US and global economies, despite the profound weakness in activity around the world.  Indeed, a key theme for our global team has long been the notion that the weaker economic activity becomes now, the more aggressive will be the policy response, increasing the chances of recovery in 2010.  The critical uncertainty − one that arises in every recession − is whether or not policy will get traction.  We strongly believe that it eventually will, given that officials are now crafting comprehensive plans to fix the financial system. 

US Forecast at a Glance

(Year-over-year percent change)	2008A	2009E	2010E
Real GDP	1.3%	-2.7%	1.8%
Inflation (CPI)	3.8	-1.2	2.4
Unit Labor Costs	0.5	2.3	1.3
After-Tax “Economic” Profits	-6.7	-29.8	7.5
After-Tax “Book” Profits	-14.0	-21.7	9.1

Source: Morgan Stanley Research  E = Morgan Stanley Research estimates

Nonetheless, the US recession likely will be deeper and recovery slightly later than we thought last month.  The reason: Fiscal stimulus and financial rescue plans likely will be less timely and targeted than we expected a month ago, implying a weaker near-term outlook.  Consequently, we now expect a 2.7% contraction in GDP in 2009, compared with a 2.4% decline last month.  We still expect that policy stimulus will begin to lift output by late this year, but now project five consecutive quarters of contracting output, a peak to trough decline in real GDP of 3.6%, and a recession that lasts 22 months − all post-WWII records. 

Lower oil prices should provide a modest offset, boosting consumers’ discretionary spending power.  Our commodities team expects WTI crude to average $35/bbl over 2009 − lower than today’s $40/bbl − while recovery will lift quotes back to $55/bbl in 2010 (see Global Oil Outlook – 2009: The Global Engine, Stalled and Flooded, February 2, 2009).  Lower oil prices are only one factor behind the plunge in inflation.  The deepening downturn has intensified the risk of deflation, as rising economic slack increases the prospective US output gap to more than 7%.  Slack overseas will put downward pressure on import prices, and the dollar has strengthened.  We think aggressive monetary policy, a global rebound, and increased commodity prices will prevent US inflation from slipping below zero − but the risks, especially over the next year, are tilted toward lower inflation.

In contrast with that bleak view, there are some very recent signs of stabilization in the economy that, coupled with hopes for aggressive stimulus, have helped to promote a rally in risky assets.  Business surveys, such as the ISM canvasses, the German Ifo survey and our own business conditions survey, improved in January, though they remain well below their October levels.  Fewer US and European banks tightened lending standards over the past three months, signaling that the credit crunch has intensified at a slower rate. 

In our view, however, it is too soon to regard those data as harbingers of recovery.  Instead, they probably indicate that the risks around our baseline view are more evenly balanced.  Indeed, the recession has a way to run: Apart from uncertain stimulus, inventories are top heavy, rates have backed up, and activity is collapsing abroad (see Output, Prices and Profits – The Vortex, February 2, 2009). 

Moreover, outside of the aforementioned business surveys, incoming data continue to be weaker than expected.  A combination of lower construction spending and factory inventories than initially assumed by the government implies a downward revision to 4Q GDP from -3.8% to -4.5%.  Also, the January slump in vehicle sales to a 9.5 million annual rate indicates not just consumer and business retrenchment, but also that more production cuts and layoffs are coming.  Indeed, payrolls tumbled by nearly 600,000 in January, by nearly 1.8 million in the past three months, and by 3.6 million since the recession began.  With initial jobless claims jumping to more than 600,000 − a 26-year high − in the final week of January, there’s no relief in sight.  We now expect the unemployment rate, which leapt another 0.4% in January to 7.6%, to approach 10% by year-end. 

This grim economic backdrop has galvanized Washington’s policy machinery into motion.  However, while the policy picture is starting to come into focus, it is still changeable.  The Senate’s proposed fiscal package is broadly similar to the one passed by the House a week ago, although details are still unclear and the Senate hasn’t approved it.  As we see it, the key point is that while the Senate version packs more near-term punch than the legislation passed by the House last week, it is still relatively back-loaded and does not provide needed bang for the buck.  Thus, the final bill appears likely to provide less stimulus than we thought probable a month ago.

The Senate fiscal plan currently weighs in at $780 billion over F2009-19, although the addition of mooted auto and housing tax breaks could lift it to $820 billion.  It contains about $250 billion in tax cuts, including about $130 billion in individual “Making Work Pay” payroll tax credits.  Even with some changes to withholding rates in 2009, these credits will not provide much upfront cash for consumers.  Unlike a payroll tax holiday, they will come mainly as refunds in the spring of 2010.  Ditto for other tax credits, such as an expansion of the one on earned income.  In contrast, last month we thought the package would include reduced withholding rates effective April 1.  Either way, we assume that consumers will save half to three-quarters of the tax cuts as they boost saving and pay down debt.  The 3% drop in consumer credit in the last three months of 2008 signals that such paydowns are underway.  The final package may also include relief from the alternative minimum tax.

The Senate plan also includes about $320 billion of “infrastructure” spending, although only about $90-115 billion represents actual outlays for highways and bridges; such spending likely will occur over several years.  Aid to state and local governments for Medicaid (FMAP) and unemployment insurance amounts to $40 billion; that’s helpful but it will still leave state and local budgets stretched.  Nutritional assistance (food stamps) and help to pay healthcare insurance for those who have lost their jobs (COBRA) likely will also be included.  House and Senate conferees meeting this week may yet agree to bring forward spending hikes and tax cuts, meeting the OMB promise that 75% of the boost would occur in the first 18 months.  But the clock is ticking.

Fixing the financial system was always going to take time, but the risk is that implementing a plan will take longer and could be less potent than we hoped in January.  Treasury Secretary Geithner this week likely will unveil a plan that uses a mixture of carrots and sticks to fix the financial system.  Unlike the piecemeal, hands-off approach in TARP I, Mr. Geithner probably will use a more comprehensive and intrusive strategy.  The plan is expected to include four elements: (1) Provide capital if needed following a uniform stress test of assets; (2) Help clean up balance sheets by sharing funding with private investors; (3) Expand the Fed’s soon-to-be implemented TALF program to embrace a broad array of assets, and (4) Mitigate mortgage foreclosures.  The plan won’t likely embrace nationalization for any institution, but will liquidate insolvent institutions and probably use receivership for some. 

Appropriately, Mr. Geithner likely will tailor the treatment to fit different assets and institutions, and may compel institutions to accelerate the cleanup process.  First, his plan will probably require that managers apply a stress test that is uniform for each asset class across institutions to appraise ‘tail risk’ in loan and securities portfolios.  That will help recalibrate the magnitude of potential losses.  The plan may then use TARP funding to provide capital injections for systemically important institutions.  The form could ultimately be dilutive, for example with convertible preferred.  In addition, the plan may provide guarantees for some assets, either for so-called “accrual” assets or those not posing systemic risk.  The plan likely will propose a public-private partnership to fund a bad bank or a TALF-like structure to finance and ultimately dispose of ‘tail risk’ and/or mark-to-market assets.  Guarantees or backstops may be provided for assets in this structure.

More-troubled institutions will get tougher treatment: Shareholders in systematically important institutions could be diluted as the government converts preferred into common shares.  And “prompt corrective action” under standard FDIC protocol will be used to liquidate insolvent institutions (for more details and Betsy Graseck’s assessment of the implications for banks, see Expected Tsy Plan a Plus for Stronger Banks, More Uncertainty for Weaker Ones, February 8, 2009). 

The program will likely also include some more explicit plans and funding for mortgage foreclosure mitigation.  That would help homeowners, slow the adverse feedback loop from housing to the economy and back, and restore market functioning by writing down mortgages to realistic values.  Yet such mitigation poses daunting challenges.  Not all foreclosures can or should be prevented.  Offering help to the three million borrowers who are in serious trouble will create moral hazard by attracting the 52 million who aren’t.  It is hard to segregate imprudent borrowers and lenders from those who were more circumspect but who have been snared by the housing meltdown.  Poor underwriting has resulted in redefault rates of 50% or more for modified loans. 

As with cleaning up balance sheets, the least-bad policy options include both carrots and sticks.  Carrots might include the Mayer-Hubbard approach of offering a subsidized 4½% or even 4% mortgage rate to make refinanced loans affordable; using the IndyMac or similar protocols to reduce payment-to-income ratios to 38% or even 31%; and refinancing into FHA-guaranteed loans so that the taxpayer takes the redefault risk.  The Obama Administration has promised to use $50-100 billion for foreclosure mitigation, possibly through this channel.  The biggest stick is mortgage “cram-down”: legislation that would allow the modification of a mortgage contract’s terms in bankruptcy.  Cram-down has benefits and costs: Reducing the value of mortgages to below an appraised value of collateral would help stressed homeowners.  Although pending legislation would restrict cram-down to existing mortgages, the precedent will likely prompt lenders to price the risk into tighter mortgage lending terms.  Such tightening probably will be most acute immediately following cram-down’s implementation, just when officials would like to ease mortgage credit.  And it would be harmful for investors (see The Cram Down Lowdown: Part I, February 5, 2009 and Cramdown: The “Stick” in the Coming Policy Actions, February 8, 2009). 

Despite a deepening recession and the threat of deflation, a torrent of Treasury supply is weighing on the bond market as fiscal stimulus looms.  In our view fear of supply has been a key factor pushing up 10-year yields by 90bp to 2.9% since the beginning of the year.  In addition, uncertainty over the Fed’s plans to purchase Treasuries has fueled the sell-off.  We and interest rate strategist Jim Caron believe that yields could rise further to test the Fed; officials may decide to cap them if the backup threatens the economy.

We estimate that net marketable borrowing will be close to $1.65 billion in F2009 (note: this figure assumes elimination of the SFP program by the end of the year, which reduces the borrowing need by $300 billion).  And, we now expect roughly $1.8 trillion in gross coupon issuance in F2009 – up from $724 billion last year.  We base these estimates on a cash-flow budget deficit of close to $2 trillion in F2009 and $1.25 trillion in F2010.  Obviously, the degree of uncertainty on the budget outlook is considerably greater than usual.  The composition of the financial rescue plan could alter issuance significantly.  An insurance guarantee program has low upfront fixed costs.  But other structures could require significant start-up funding.  We are currently assuming about $150 billion of outlays above that already authorized by the TARP. 

Treasury debt managers face several challenges.  Most obvious are the financing pressures associated with a record budget deficit.  Another is the recent drop in the average maturity of Treasury debt that presents greater rollover risk.  The average debt maturity has slipped to 48 months from the historical range of roughly 60 to 70 months.  Changes announced by the debt managers last week are aimed at spreading out issuance across the curve and preventing any further shortening of maturity.

Interestingly, stepped-up Treasury issuance in the intermediate and long end of the curve may conflict with the Federal Reserve’s stated goal of moving mortgage rates lower.  Since the famous Accord struck in 1951, the Fed and Treasury staffs have certainly collaborated, but they are independent agencies.  The Treasury’s debt managers are charged with achieving the lowest-cost financing over time and are understandably concerned about rollover risk in an environment of mounting budget deficits. 

With 10-year Treasury yields reaching 3% on the back of the refunding announcement, the Fed’s willingness to purchase long-dated securities is being tested.  We suspect that yields may be getting close to the point where the Fed will start to buy.  This would represent a classic monetization of the public debt to fight the downturn and deflation.  Indeed, with deflationary pressures in the US economy mounting − and with the Fed promising to implement a preemptive exit strategy once the financial sector stabilizes − any inflation risk associated with such a scenario appears to be quite remote.

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