It's Time to Address the Fiscal Problem
October 01, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary
Over the years, the government has slowly and steadily addressed a number of critical structural issues, enabling the acceleration in economic growth. However, one area that needs improvement is the management of public finances. While fiscal discipline is important for macroeconomic policy credibility and sustainability, flexibility is necessary for managing unexpected shocks to the economic environment. A fiscal policy following both these tenets would help the government intervene during times of economic difficulties without increasing the risk of macro instability. Such a policy could give a government the ability to use the budget as a counter-cyclical policy tool to regulate aggregate demand. Unfortunately, India's fiscal policy appears not to have followed either of these two budget-management principles over the past few years. We believe that addressing this structural hurdle will be critical for sustaining strong 9-10% growth without increasing the risk of macro instability.
Global Credit Crisis Pushed Deficit Levels from Bad to Worse
After going through a phase of correction from the early 1990s to 1997, the underlying trend has been deteriorating. The national fiscal deficit (including off-budget items) as per our estimates is likely to remain high at 10.7% of GDP in F2010 after having widened to 11.8% of GDP in F2009. To be sure, a number of one-off factors took deficit levels to an all-time high in F2009: the government accelerated pre-election spending; a sharp rise in oil prices meant increases in the oil and fertilizer subsidy burden; wage hikes were implemented for central government employees; additional stimulus in the form of tax cuts; and increasing government spending overall. However, the poor record of public finance management is evident from the fact that the lowest point of the fiscal deficit in the past 10 years was 6.8% of GDP in F2008.
Internal Debt Is Averaging Significantly Ahead of Nominal GDP Growth
Since F1997, internal debt has grown at a compound annual growth rate of 14.3%, compared with 11.9% growth in nominal GDP. The main driver of this steep rise in internal debt has been faster deterioration in state governments' finances, with their internal debt having grown at 16.8% during the period compared with growth of 13.6% for the central government. We estimate that the public debt/GDP ratio will rise to 79.2% in March 2010 from 59.3% in March 1997. India now has one of the highest public debts and fiscal deficits among large emerging markets. India's public debt/GDP is over three times the average for Asia ex-Japan excluding India. Similarly, India's fiscal deficit is also the highest among key emerging markets.
How Does India Manage This Large Deficit?
We see a few key factors to explain this situation:
• Internal debt less external debt: First, and probably the most important factor that helps India to manage this high level of public debt, is the fact that India's deficit has been funded largely through domestic debt as opposed to external debt. In fact, the ratio of external public debt to India's total public debt in the past 10 years has averaged 10.2%, compared to 60% for all emerging markets.
• Limited capital account convertibility: The Reserve Bank of India (RBI) has been careful in liberalizing the capital account for residents. Over the years, the RBI has reduced the capital account restrictions for companies. However, there are still significant restrictions for individuals. Household savings remain captive for the government to fund its deficit.
• Mandatory purchase of government debt by banks: Banks are required to invest 24% of their total net demand and time liabilities (NDTL) in government-approved securities. This ensures a captive demand for government paper.
• Capital inflows ensure that the private sector does not suffer from crowding out: Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India has witnessed an unusually low real interest rate environment right at the time when its fiscal policy has been expansionary, as reflected in rising public debt/GDP. The key to lower-than-warranted real interest rates is the supply of global liquidity in form of portfolio and debt inflows. Almost 78% of the total US$216 billion capital flows that India has received over the past five years has been in the form of non-FDI flows.
Cyclical Reduction in Deficit Likely in the Near Term
With growth already recovering, we do not expect the government to announce fresh stimulus measures. There will be no major one-off expenditure increases such as wage hikes or farm loan waivers, in our view. Over the next 12 months, as tax revenues recover and government expenditure growth decelerates from a high base, we believe that there will be a cyclical reduction in the fiscal deficit. We expect national expenditure growth including the off-budget subsidy burden of 8.1%Y compared to national receipts growth of 13.8%Y in F2011. This trend will be similar to what we saw during F2004 and F2005, when national nominal expenditure growth slowed to an average of 10.6%Y even as national receipts growth accelerated to an average of 15.2%Y with the recovery in growth post the 2001-02 global slowdown. We expect the fiscal deficit to reduce to 9% of GDP in F2011 and further to 7.3% of GDP in F2012. We are assuming no major increase in privatization or any major structural change in expenditure management.
What Is the Medium-Term Solution?
We believe that the government needs to initiate a fiscal policy that will reduce the debt/GDP ratio to at least 63% - the average level in the 1990s. The two key factors that influence this ratio are the amount of primary deficit and the differential between nominal interest rates and nominal GDP growth. The primary deficit is total receipts less non-interest expense or in other words the fiscal deficit less interest payments. To reduce the debt/GDP ratio, we believe that the government really needs to address the primary deficit, which stood at 4.6% of GDP in F2010, as per our estimates. Assuming that the effective interest rate on government debt remains steady at current levels and nominal GDP growth averages 12.5%, we believe that the government needs to reduce the primary deficit to 0.5% of GDP (implied national fiscal deficit of 4.5% of GDP) by F2017 to cut public debt/GDP to 64% by that year. In the current political environment, it appears difficult that the government will be able to cut the fiscal deficit to 4.5% of GDP. If we assume that the government will cut the primary deficit to 1.8% of GDP and fiscal deficit to 5.8% of GDP, public debt/GDP would reduce to 67% by F2017.
How can the government reduce primary and fiscal deficits? We believe that a heavy fiscal deficit burden is one of the major hurdles to the government achieving its GDP growth target of 8-10% on a sustainable basis. A sustainable reduction in the government's deficit would likely have to entail difficult and sensitive measures, in our view:
• First, the government needs to cut non-interest revenue expenditure. If we compare with other countries in the region, India's tax/GDP ratio is one of the highest. The main reason for the high level of fiscal deficit appears to be higher expenditure. The government could initiate major expenditure reforms and move effectively to outcome-based expenditure management from the current outlay-based system to cut non-interest revenue expenditure. Over the past four years, there has been little control of non-development expenditure, which has been one of the key factors for the rise in total expenditure to 33% of GDP in F2010 from 28.4% in F2006. Indeed, including off-budget expenditure, total expenditure increases to 33.7% of GDP in F2010. In the same period, total receipts/GDP has increased by only 1.2%. Hence, the key to better fiscal management will be to cut expenditure/GDP gradually over the next few years. We expect that, by F2012, the government should be able to reduce its total expenditure to about 31% of GDP as long as no further stimulus measures are initiated. Note that some relief will be brought about just by the absence of one-off factors such as wage hikes and the large oil subsidy burden.
• Second, interest costs currently form about a quarter of total receipts and one-fifth of total expenditure. Indeed, interest costs have been consistently higher than capital expenditure since the mid-1990s. To control the interest cost component, India needs not only to stop accruing fresh debt for funding less efficient current consumption expenditure, but also to reduce its stock of debt/GDP as discussed earlier.
• Third, one more sustainable effort in cutting expenditure would be for the government to accelerate privatization of public sector companies to reduce the debt/GDP ratio in a short period. Currently, the government is also suffering from a high debt service burden arising from past debt. While public debt/GDP has been high, the good news is that the government's assets have also increased significantly over the past few years. We estimate the total value of listed government-owned companies at US$281 billion currently. We estimate the value of 224 unlisted companies at US$144 billion. This estimate is based on a P/E and P/B valuation using the averages of listed public sector companies. Thus, the total market value of government holdings in these companies (listed and unlisted) is estimated at US$425 billion. If, for instance, the government sells public sector companies stakes worth, say, US$50 billion in the next three years, it could potentially reduce debt/GDP by four percentage points. This could help to reduce the negative impact of the current high level of deficit on productive expenditure and growth.
Hope for a New Beginning Post 13th Finance Commission Report
The 13th Finance Commission will release its report on December 31, 2009. The report is likely to provide direction to the central and state governments on the effort to improve tax revenues and expenditure control. The commission is also expected to come out with a clear presentation of the underlying fiscal deficit and liabilities after considering the off-budget items including liabilities of the central government from oil, food and fertilizer. The commission will review the roadmap for fiscal adjustments and suggest a suitably revised roadmap with a view to maintaining the gains of fiscal consolidation through 2010-15. While we hope that the government will implement structural reforms to reduce the fiscal deficit, the report alone is no guarantee of a quick move on the part of the government towards this end. Indeed, government finances are off the targets recommended by the 12th Finance Commission.
What if the Government Does Not Reduce the Fiscal Deficit Substantially?
Clearly, an expansionary fiscal policy is currently supporting India's growth - seemingly without any major concomitant costs. The costs of this policy will be evident in the form of higher real interest rates, lower resources for productive expenditure and slower growth, in our view, and these costs will be magnified if global capital inflows slow down. One could argue that - considering India's long-term fundamentals - global capital inflows should continue unabated and a further rise in real interest rates would be prevented for longer. However, the past trend indicates that these global capital inflows have invariably witnessed significant moves up and down, influenced by global risk appetite and the macroeconomic environment. Moreover, the current high level of unproductive government expenditure and public debt is weighing on long-term growth potential. Government spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and the high starting point of debt. The government's development expenditure has averaged 14.6% over the past five years, declining from 17% at the start of the liberalization process in F1991.
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G20 and Central Banks: In Sync for Now
October 01, 2009
By Richard Berner | New York
At last week's G20 summit, world leaders made important, ambitious commitments: They appropriately gave important EM economies seats at the table, broadening the global policy dialogue. They committed to repair the global financial infrastructure to mitigate future financial shocks. They agreed to rebalance the global economy to make growth more sustainable. And they vowed to shun protectionism. Can they deliver over the next several months? And how do their commitments dovetail with the policy stance of central banks?
Legitimizing the EM economies' role is a landmark achievement. And financial regulatory reform is coming, broadly following the Financial Stability Board's (FSB) comprehensive architecture for strengthening financial stability and improving oversight and supervision. There is much work to do: Success for regulatory reform will hinge on lawmakers' and regulators' ability to translate those principles into specific rules and regulations and agreeing on who will enforce them.
However, we are skeptical that officials can make good on macro policy coordination or avoiding protectionism. Rebalancing the global economy requires coordinated macro and micro policies. That the G20 said nothing about the role of exchange rates in fostering external adjustment, or about policies that work towards internal adjustment, makes us skeptical that the group can get beyond the rhetoric of general principles. In fact, the large size of the group makes coordination harder than in the G7 or G8. With officials going their own way, one of our strategy teams' key themes - differentiating among markets (selling correlation) - seems to make perfect sense (for example, see Playing The Cyclical Decline In Correlation, August 12, 2009 and "Varied Central Bank Responses to the ‘V'", FX Pulse, August 13, 2009). And unless global growth accelerates sharply, the spate of recent protectionist actions may increase.
Legitimizing EM economies' role: A leap forward. Designating the G20 to be "the premier forum for international economic cooperation" not only gives EM economies seats at the big table but also gives them the responsibility to participate in and accept principles from the global policy dialogue. Including EM economies in the FSB further strengthens their roles and responsibilities. Promising to shift at least 5% of International Monetary Fund quotas to "dynamic emerging markets and developing countries" from over-represented countries is a big step towards legitimacy. Likewise, increasing their voting power at the World Bank by at least 3% similarly strengthens the EM economies' roles. Now that they have been admitted to the club, ensuring that their membership really is on a par with the original heavyweights is the next step.
Financial stability and regulatory reform. The principles and recommendations for regulatory reform set out by the FSB, central banks and others, if and when implemented, seem likely to create a more stable and less procyclical financial system that better supports sustainable economic growth. However, the G20 and FSB recognize that "policy development is not complete, and detailed implementation of the full set of needed reforms will take time and perseverance". The reforms set out in the FSB's "Improving Financial Regulation" cover the following key areas:
• Raising the quality, consistency and transparency of the Tier 1 global capital framework for banks, basing it predominantly on common equity and retained earnings. These rules won't be immediately effective: New rules will be set out by end-2009, calibrated in 2010 and phased in as financial conditions improve and recovery is assured.
• Introduce a leverage ratio (as a supplement to the Basel II risk-based framework) aimed at reducing leverage and systemic risk.
• Develop measures such as a systemic capital charge to mitigate the risks posed by systemically important institutions.
• Introduce a new minimum global funding liquidity standard for banks by end-2009, and measures that could mitigate cross-border liquidity problems.
• Introduce a framework for countercyclical capital buffers above the minimum requirement, and develop more forward-looking provisions based on expected losses.
• Introduce a framework for the resolution of systemically important institutions on a cross-border basis.
Other areas of importance for regulators include:
• Strengthening accounting standards.
• Improving compensation practices.
• Expanding oversight of the financial system.
• Strengthening the robustness of the OTC derivatives market.
• Re-launching securitization on a sound basis.
• Promoting adherence to international standards.
These new regulations are aimed at promoting a balance between financial stability on the one hand and allowing financial institutions to innovate and earn reasonable returns on the other. My colleagues Betsy Graseck and Huw van Steenis believe that these changes will still allow banks to attain normalized ROEs of 12-20%. Moreover, the changes will be phased in so that banks will have ample time to adjust and new regulations won't impede recovery. New capital requirements, for example, will be phased in over a three-year period through the end of 2012. However, Betsy and Huw believe that regulators should announce the details of new regulations as soon as practicable, because "the uncertainty of what the capital requirements will be is driving banks to retain higher liquidity and higher capital levels than they would otherwise...and [that] is inhibiting strategic action" (see G20: An In-Line Call for Stronger B/S, Expect Details on Capital Standards YE 09, September 28, 2009).
Is the G20 on the same page as central banks? The G20 is committed to promoting recovery and won't withdraw policy support prematurely, so implementing exit strategies is far off, in our view. In the communiqué, leaders tried to strike a balance between "sustain[ing a] strong policy response until a durable recovery is secured...and, when the time is right, withdraw[ing] extraordinary policy support in a cooperative and coordinated way, maintaining our commitment to fiscal responsibility". Call us cynical or pragmatic; our guess is that national economic circumstances will dictate the timing of any fiscal exit strategies. The track record of the G7 or G8 in coordinating macro policies has been spotty at best, and the larger size of the G20 makes coordination more difficult. In the US, it's hard to imagine that members of Congress will invite G20 participation in budget deliberations. More important, we judge that it will prove difficult to implement any fiscal restraint against the backdrop of high unemployment. And, to be sure, it is hard to get right the timing of changes in fiscal stimulus (which is why it so often has turned out in the past to be highly procyclical).
But as markets heal, central banks are already moving to the next phase of their policy game plan. Like their G20 bosses, they are not implementing exit strategies from stimulus yet. But, as we have documented elsewhere, markets have healed much faster than economies. Thus, central banks are gradually winding down their support for markets (in the form of quantitative and credit easing) while maintaining their support for economic stimulus. Where they have implemented quantitative easing (QE), they are tapering it down. For example, the Fed has now announced a timetable to stretch out and slow down its large-scale asset purchase programs in Treasuries, MBS and agency debt, and the Bank of England announced that it will not extend its gilts purchase program. And central banks are gradually sunsetting liquidity facilities as they become less used. Some of that winding down is automatic, as the penalties built into most programs make them less attractive to market participants as markets heal. While most facilities (except the TALF) are set to expire on February 1, 2010, the Fed is scaling back auctions under the TAF and TSLF, has discontinued the MMIFF, and may begin to wind down the PDCF. The Bank of Canada will discontinue two liquidity facilities at the end of October, and the ECB will end 84-day dollar-denominated RPs, scaling back to 7-day operations.
To be sure, there is overlap between programs to support markets and those to provide economic stimulus. But as markets heal, financial conditions are becoming easier, so withdrawing official support for markets leaves support for economic activity intact. And appropriately withdrawing support for markets also will limit the extent to which the Fed and others would contribute to asset bubbles. For their part, however, investors and market participants will have to adjust to the removal of this life support, and it is likely that rates spreads in funding markets and yield spreads in securities markets will widen somewhat. In the view of our rates strategy team, for example, LIBOR-OIS spreads may widen slightly as these supports are wound down (see The Inflection Point: Trades for a Glass Half-Full or Half-Empty, September 8, 2009).
Consistent messages on timing from central banks. Thus, the Fed and other central banks are sending two consistent messages: First, a slow and uncertain recovery and low inflation mean that the Fed doesn't want to remove its support for economic activity through QE or low rates prematurely. The Fed has made that abundantly clear in its post-FOMC meeting statements, in the minutes of FOMC meetings and in speeches by Fed officials. They affirmed last week that they "will continue to employ a wide range of tools to promote economic recovery and to preserve price stability...[and...the FOMC] continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period".
But second, neither do they want to foster new asset bubbles or overstay their welcome and risk escalating inflation expectations. The tapering of QE and withdrawal of liquidity facilities should not be seen as the first step to traditional tightening. But they do set in motion the process of winding down non-traditional facilities and set the stage for central banks to evaluate under what circumstances and when more traditional tightening will occur.
In our view, that's the key message in Fed Governor Warsh's remarks last week (see Longer Days, Fewer Weekends, at the 12th Annual International Banking Conference, Chicago, Illinois, September 25, 2009). He noted that because several of the Fed's non-traditional programs to provide monetary stimulus were established under section 13(3) of the Federal Reserve Act, when the "unusual and exigent circumstances" standard in 13(3) no longer applies, the Fed should unwind such non-traditional policy tools. More controversially, Warsh challenged the presumption by some that slack in the economy would keep the Fed on hold for two years or more. He noted that "...when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom". Of course, he acknowledged that policy actions would depend on the outlook for growth, inflation and financial conditions; policy commitments and reactions are conditional on circumstances.
That message, considering its nuances, hardly seems unconditionally hawkish or in conflict with the Fed's current strategy. While it is a warning against complacency on the part of market participants, it seems to fit the Fed's risk management script. And it is hardly unique: Other central banks, like the ECB, want market participants to understand that exceptional measures will have to be unwound as exceptional circumstances return to normal (see ECB President Jean-Claude Trichet's The ECB's Exit Strategy, at the ECB Watchers Conference, Frankfurt, September 4, 2009). That shift will matter for markets globally. For the Fed and the ECB, conditional on economic circumstances, the shift will eventually include ending the exceptionally low level of policy rates. We continue to be comfortable with our call that the Fed will begin hiking the federal funds rate in mid-2010.
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As the Policy Cycle Turns...
October 01, 2009
By Joachim Fels | London
While financial markets keep feasting on the global liquidity glut, there is a subtle but undeniable shift underway in the central bank community towards eyeing not only the end of easing, but the beginning of tightening. To be sure, our central bank watchers expect the Fed, the ECB and the Bank of England to start nudging rates higher only from around the middle of next year, and the Bank of Japan to even ease policy further. However, several other G10 and emerging market central banks look set to tighten policy over the next 3-6 months, and it appears likely that the rhetoric from those who will remain on hold over that period becomes gradually more hawkish (less dovish). This combination of action by some and talk by others may well challenge the prevailing post-Jackson Hole and post-G20 consensus that rates in the major economies will remain low for longer.
A little more than a month ago, the Bank of Israel became the first central bank to tighten policy in this cycle (see "Jackson Hole 0, Jerusalem 1", The Global Monetary Analyst, August 26, 2009). The move was aimed at bringing inflation back into the 1-3% target band. While the BoI paused (in line with our expectations) at last week's decision, probably in response to currency appreciation, our Israel watcher Tevfik Aksoy expects at least one more hike of 25bp before year-end and more tightening in 2010.
We continue to think that the next central bank in line to raise rates is Norges Bank in Norway. However, our Norway watcher Spyros Andreopoulos brought forward his forecast of a first hike from December to October last week, following the Norges Bank's statement that a rate hike was considered at last Wednesday's meeting (see The Global Monetary Analyst, September 23, 2009). With the labour market more resilient than expected and a strong consumer spending recovery underway, Norges Bank appears to have become increasingly uncomfortable with its current stance - an impression that was underlined by Governor Gjedrem's comments earlier today that interest rates are now "extraordinarily low".
The other G10 central bank likely to raise rates before year-end is the Reserve Bank of Australia (RBA), which has been making hawkish noises for some time now, most recently expressing some concern that house prices are rising too fast. Our global equity strategist and Australia watcher Gerard Minack expects the RBA to begin tightening before year-end, but is looking for fewer hikes next year than the markets are pricing in.
Still more cutters than hikers, for now... Note, however, that over the next three months, we still expect the rate-hiking central banks (Israel, Norway and Australia) to be outnumbered by rate-cutters. Our global team expects five central banks to cut rates (further) in 4Q. Four are in the CEEMEA region - Russia, Turkey, Hungary and Romania - where the easing cycle started relatively late. The fifth, but certainly not least, is the Bank of Japan: our Japan watcher Takehiro Sato is forecasting a further reduction in the already low nominal policy rate (0.1 %) to 0.05%, coupled with a commitment to keep the rate low for an extended period. His out-of-consensus view is based on the rising risk of a deflationary spiral - underscored by a combination of a Japan-style core inflation rate of -2.4% and yen appreciation - and the prospects for a major fiscal tightening by the new government next year.
...but more hikers than cutters from 1Q10: While rate-cutters should still outnumber hikers in 4Q09, we expect hikers to gain the upper hand from the start of 2010. Only Hungary and Romania are expected to reduce rates further in 1Q, while five other central banks are forecast to follow Israel, Norway and Australia into tightening policy. Besides the Bank of Canada and the Czech National Bank, our team is looking for three Asian central banks to start a tightening cycle, namely the central banks of India, Korea and Taiwan. Another seven central banks should then follow in 2Q10, including the ECB, the Bank of England and the Swiss National Bank within the G10, plus the central banks of Brazil, Russia, Indonesia and Peru in the EM universe. We then expect the remaining G10 central banks (with the sole exception of Japan) - the US Federal Reserve, the Swedish Riksbank and the Reserve Bank of New Zealand - to join the hiking club in 3Q10, along with many more EM central banks including the People's Bank of China.
More hawkish rhetoric likely... While we expect most major central banks to start raising rates only from 2Q10, it appears quite likely that central bank rhetoric will become gradually more hawkish (or less dovish) over the next several weeks and months. Taking their cue from such rhetoric, markets will likely price in hikes in policy rates, thus implicitly helping to tighten policy well before rates are actually raised. True, the economic data flow - while indicating that the recovery has started even in laggards like the US, the euro area and the UK - still remains mixed and inflation looks set to remain well below target for quite some time. Also, banks still remain capital-impaired and, as the latest IMF Stability Report published today argues, still have only revealed about half of their likely losses on impaired assets. However, provided that asset markets keep rallying in the near future - which is our strategists' central case - policymakers will increasingly conclude that this improves the economic outlook via the stabilising effect of higher asset values on balance sheets in the corporate, household and financial sector.
...on rising fears about potential new asset bubbles: Moreover, we believe that some central bankers will start to worry about paving the way for new asset bubbles and will therefore argue for earlier tightening than the outlook for consumer price inflation may warrant. This has already started in emerging Asia (and Australia), where officials have expressed concern about real estate prices. But it is also likely to become an issue for (some) central bankers in Europe and the US if and when markets continue to pace ahead. To be sure, for now, policymakers are relying on rising asset markets to help establish a sustainable recovery. But the longer the rally in risky assets lasts and the more signs of a sustainable recovery emerge, the likelier it becomes that central bankers will move on to address the risk of a new bubble.
Bottom line: Slowly but surely, the global monetary policy cycle is turning. True, the transition we see next year is only one from a super-expansionary policy stance to a still-very-expansionary one. However, as more and more central banks start to hike rates over the next 3-6 months and others - while still sitting on their hands - start to sound more hawkish, the market consensus that all will continue to be well on the liquidity front could easily be challenged in the period ahead.
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