Brazil
Policy Drift?
November 03, 2009

By Marcelo Carvalho | Sao Paolo

When Brazil announced a new tax on capital inflows last month, the authorities said that the goal was to curb currency appreciation. However, we think that the new tax alone will be ineffective in changing underlying currency drivers on a lasting basis. Instead, we believe that it has added three concerns. First, it has increased policy tensions within the administration. Second, it has increased regulatory uncertainty. Third, it can raise concerns about policy drift. Indeed, the new tax could send a worrisome signal if it marks a shift in policy focus away from orthodoxy and towards a more interventionist approach - especially in light of signs that the authorities seem keen on playing a more active role in sectors like mining, oil and public sector banks. 

New IOF Tax: What Dutch Disease?

It's all about the currency. In an effort to curb currency appreciation, Brazil imposed a tax on foreign capital inflows in local equities and fixed income, effective October 21. It is a 2.0% one-way, upfront financial tax (IOF) on new purchases by foreign investors of local stocks and fixed income securities, regardless of the maturity of the investment. Foreign direct investment (FDI) is not taxed. The main goal is to curb currency appreciation. The authorities have also mentioned the objective of avoiding a bubble in the local stock market - but if that was truly the key motivation, then why not tax equity investments in general, including from local investors too?

What is the policy motivation? As the currency appreciates, local producers of manufactured goods have vocally complained about the loss of trade competitiveness. That said, it is hard to make a case for ‘Dutch disease' in Brazil today. Despite the potential loss of trade competitiveness under currency appreciation, it is interesting to note that industrial production has actually recovered steadily on rising domestic demand, and industrial jobs are rebounding quickly. 

This is not the first time that Brazil has put a tax on capital inflows. In March 2008, the government introduced an IOF tax of 1.5% on foreign capital inflows in the local fixed income market. But the measure did not prevent the currency from appreciating further. The tax was later removed, in October 2008, as the global turmoil started to hurt capital inflows. Contrasting with last year's tax, the IOF tax this time is set at 2.0% (not 1.5%), and it now also encompasses equity inflows, not just fixed income flows. Note that the bulk of recent capital inflows into Brazil have been in the form of FDI and equity inflows, while flows into fixed income have been much more muted. In fact, about three-quarters of IPOs in Brazil are typically bought by foreigners. As before, the new tax does not apply to FDI inflows.  

Unintended Consequences and Inconsequential Intentions

Does it work? Despite an initial knee-jerk market reaction, it seems unlikely that the new tax will do much to alter underlying currency drivers on a lasting basis. According to a Morgan Stanley investor survey conducted by our emerging market strategy team (see Asia/GEMs Equity Strategy - Investor Survey: Brazil's IOF Tax, October 22, 2009, by Vinicius Silva, Jonathan Garner and Michael Wang), the majority of respondents said that they are likely to add to their existing portfolio positions should prices fall more because of the tax, or that the IOF tax does not affect their allocation to Brazil. The economic literature on capital controls suggests that this type of restriction can have a short-term impact but tends to lose effectiveness over time, as the system becomes porous. We suspect that broader factors such as global liquidity conditions, international risk appetite and broader currency trends globally will remain important drivers, among other factors, for the currency outlook.

We maintain our foreign exchange view - our end-2010 forecast continues to assume the real at 1.70. On the one hand, prospects for a widening current account deficit could eventually start to weigh on the currency, all else constant. And the currency does not look cheap by historical standards, as usual valuation measures would appear stretched at the moment. For instance, the currency is stronger than long-run averages, when measured against a basket of currencies in Brazil's main trade partners and adjusted for inflation differentials - or what economists call the real effective exchange rate. For its part, the political calendar can add volatility to the currency, if it affects country risk perceptions going into general elections in October 2010.

On the other hand, there is a risk that appreciation could overshoot and extend further, depending on international conditions. After all, abundant global liquidity can spur international commodity prices, which in turn support Brazil's terms of trade and underpin the currency. Also, favorable growth differentials can help to attract capital inflows into Brazil, especially in the form of equity and FDI flows, as long as international risk appetite remains sufficiently robust. Brazil's recent currency appreciation must also be seen in a global context of broad US dollar weakening - in other words, swings in the Brazilian real over the last year have been less dramatic against a broad basket of currencies than bilaterally against the US dollar alone. In all, our forecast continues to assume that the real will remain supported over the forecast horizon.

Capital controls are not necessarily always the best option to deal with currency appreciation and its side-effects. Facilitating capital outflows, rather than restricting inflows, is one option. Reducing import tariffs is another. And if the authorities are worried about loss of industrial trade competitiveness, one positive alternative would be to encourage domestic productivity gains by addressing Brazil's own constraints such as infrastructure deficiencies, a byzantine domestic tax system and rigid labor laws.

The new tax can have unintended consequences too, as it introduces distortions. For instance, it could hurt the development of the local capital market, if local equity issuance suffers, and liquidity starts to migrate to ADRs (American Depositary Receipts) traded abroad - a market where larger companies typically have easier access than smaller ones. While the new IOF tax is estimated to bring R$4 billion to the public coffers per year (or 0.1% of GDP), it also increases the cost of funding for the Treasury's debt issuance. As foreign investment in the local fixed income market focuses on the long end of the local yield curve, the new tax also could hurt the Treasury's effort to extend its domestic debt duration and maturity profile.

Be careful what you wish for. Currency appreciation is not necessarily bad, after all. In particular, historically there has been a relevant empirical correlation in Brazil between currency appreciation and domestic capital formation (investment). One possible explanation for the correlation is that imports of capital goods needed for domestic capacity expansion, such as equipment and machinery, become more affordable in local currency terms as the currency appreciates.

Monetary Policy Implications

Local press reports indicate that the new tax met with resistance at the central bank. A day after the finance ministry announced the new IOF tax on capital inflows, the central bank posted a short note on its website, indicating that it participated in the IOF tax discussions with the authorities in charge of what the note describes as ‘tax issues' (as opposed to currency measures). The note insisted in underscoring that the new IOF tax does not imply a change in the floating foreign exchange rate regime.

The central bank appears less concerned about sector implications of currency appreciation than other parts of the administration are, judging by local press reports. To be sure, the central bank has intervened in the spot foreign exchange market - since it resumed purchasing US dollars from the market in May 2009, it has already bought more than US$20 billion so far this year, as it "leans against the wind" and seeks to smooth currency moves, while it further builds its reserves stockpile as self-insurance against "sudden stops" of capital inflows. However, other parts of the administration do not seem to feel that the central bank has done enough to contain currency appreciation, according to local press reports.

From the narrow point of view of the inflation-targeting regime, currency appreciation can facilitate the central bank's job, if it helps to contain inflation pressures by taming prices of tradable goods. Therefore, if it succeeds in curbing currency appreciation, the new IOF tax could end up entailing interest rates higher than otherwise - which is perhaps ironic, in light of hopes for lower rates elsewhere within the administration. To flip the argument, there is a risk that rate hikes end up encouraging currency appreciation. Again, from the narrow point of view of the inflation-targeting regime, currency appreciation is actually one of the very transmission channels through which monetary tightening can work to contain inflation pressures.

Watch for potentially rising policy tensions within the administration. The central bank seems to be in no rush to hike rates at the moment. But when it eventually does hike, the risk is that higher rates could work against efforts elsewhere in the administration to curb currency appreciation. At the end of the day, policy tensions reflect Brazil's sub-optimal policy mix. Fiscal policy is too loose, which requires monetary policy to be tighter than otherwise. While fiscal and monetary policy worked in the same direction (easing) in 2009, domestic policies might go in opposing directions in 2010. Given prospects for fiscal policy to remain expansionary ahead of the general elections in October 2010, monetary policy tightening will need to carry the burden of the exit strategy.

Signs of policy tensions begin to emerge. The central bank is in no hurry to hike at the moment, but it does not advocate further stimulus at this stage either. In fact, the debate in the local fixed income market is about when the central bank will start to hike rates in order to start unwinding the monetary policy stimulus that it has put in place. By contrast, the fiscal authorities still appear keen on extending stimulus further. Indeed, the finance ministry announced last week that it will extend the (IPI) tax break on white-line goods for another three months, until end-January 2010.

In such an environment, potential changes at the central bank's board can grab market attention. The current president of the central bank has joined a political party recently, which is a requirement for running for general elections in October 2010. If he decides to run, the law requires that he steps down from government by early April, six months ahead of the elections. Local press stories say that other central bank board members might leave as well. While we assume that the institution will remain credibly and strongly committed to the inflation-targeting framework, regardless of changes in the individual composition at the board of the central bank, upcoming changes could raise new market concerns.

Policy Drift Underway?

Rather than the new 2% IOF tax itself, and besides policy tensions within the administration, we suspect that the real concern for investors is twofold: regulatory uncertainty and ‘policy drift'. The possibility of new, sudden changes in the rules increases perceived regulatory risk, and the new IOF tax can send a worrisome signal if it means a broader shift in policy focus towards a more interventionist approach.

On the regulatory front, investors seem to wonder whether the authorities could suddenly change the rules of the game again. It did not help investor confidence that high authorities indicated that there was no new tax in the pipeline on Friday, October 16, only then to announce the new IOF tax three days later, on Monday, October 19. According to a Morgan Stanley survey among investors, concern over further intervention is high, with the vast majority of respondents saying that they are somewhat concerned, if not very concerned, that the authorities could take additional measures to slow down the pace of currency appreciation. If the new IOF tax does not work to curb currency appreciation, then what comes next? One possibility is that the authorities increase the dosage, hiking the IOF tax from the current 2% mark. Another theoretical possibility is to introduce some sort of quarantine for capital inflows, in order to discourage short-term money. Taxes on capital outflows, as a way to discourage capital inflows, seem less likely at this stage, in our view. Yet another idea floating around is that the Treasury would start buying dollars in the spot market, in addition to what the central bank already does. Such a proposal would require congressional approval, might raise coordination issues with the central bank, and could create confusion in the market place. As for timing, the authorities seem willing to digest the impact of the IOF tax on markets for a while before considering new measures, but currency moves might prove to be a trigger for action too.

But the potentially more serious threat is the risk of ‘policy drift'. Compared to a year ago, the new IOF tax is higher (2%) and broader (including equity inflows) - but perhaps the key difference is that it now comes in a broader context where there have been increasing signs that the authorities appear inclined towards a more interventionist approach on the economy, seemingly drifting away from a more orthodox, market-friendly approach. Recent policy proposals towards the mining sector, the pre-salt oil regulatory framework and public sector bank lending illustrate the point.

In the mining sector, there are growing signs of a more interventionist approach - the authorities are considering a reform proposal that seeks to strengthen the role of the state in the sector, promote exports of higher value-added, and introduce more stringent conditions for mining exploration. The preliminary draft proposal is described in local reports as aimed at extracting more rents from the sector and increasing public sector control over new concessions. The new framework would introduce tougher conditions for miners to maintain exploration and production rights. The authorities also plan to create a regulatory agency and national mining policy council, to manage the sector more closely. Separately, the authorities are reportedly considering introducing a tax on iron ore exports, seemingly as a way to boost tax revenues from a sector that has benefited from high international commodity prices, as well as a way to diverge iron ore exports into local steel production. Indeed, there has been open public pressure on Brazil's giant iron-ore producer to increase its domestic investment and move up in the value-added chain to produce steel in Brazil, as a means to generate more jobs at home.

Similarly, draft proposals for the new regulatory framework regarding exploration of the pre-salt oil fields indicate a stronger role for the state in the sector. The government-controlled but publicly traded oil company would have a mandatory minimum participation of 30% of any new consortium, and would be the lead operator in all of them. A new state-owned oil company (Petro-Sal) would be created to oversee all the new contracts, with the mandate to look after the interests of the state. It would have 50% of the votes in the operational committee of each consortium, and a veto over any decisions, including the pace of oil extraction and the acquisition of goods and services.

Likewise, the authorities have pushed public sector banks to lend aggressively, including commercial banks, besides the national development bank (BNDES). Indeed, public sector banks have done most of the heavy lifting in terms of credit expansion so far this year. Standard measures of traditional fiscal stimulus this year in Brazil (about 1% of GDP) pale in comparison to quasi-fiscal stimulus through public sector bank credit expansion (more than 3% of GDP) (see "Brazil: The Credit Channel", EM Economist, August 7, 2009).

Will pragmatism prevail? Some observers can argue that the current administration is pragmatic. In that line of thought, if the authorities are leaning towards greater intervention in the economy, this is because they can afford to do it, as markets allow them to do so. However, the risk here is that market enthusiasm ends up fostering policy complacency, leading to future regret if global risk appetite eventually shifts and market sentiment turns less forgiving.

Bottom Line

Brazil's new tax on foreign capital inflows is intended to contain currency appreciation. But we doubt whether the new measure alone will alter underlying currency drivers. Instead, it raises new concerns about policy tensions within the administration, regulatory uncertainty and ‘policy drift' - a potential shift in policy focus away from orthodoxy and towards a more interventionist approach.

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Europe
From Athens to Dublin: Fiscal Sustainability in the EMU Periphery
November 03, 2009

By Spyros Andreopoulos | London

Executive Summary

We conduct scenario analysis in order to investigate fiscal sustainability for Greece and Ireland. Although both will likely have similar gross debt/GDP ratios for 2009 (110%) and 2010 (118%), on our estimates, there are meaningful differences in the underlying fiscal picture.

The most relevant differences are along two dimensions: (1) The measurement of the debt; and (2) The skew of the risk profile for the fiscal outlook.

(1) Which debt? Comparing gross debt can be misleading:

•           For Ireland, there is a meaningful difference between gross and net debt. Ireland has a significant amount of assets in the National Pensions Reserve Fund (12% of GDP as of September 2009); in addition, government cash balances are substantial (another 15% of GDP). Net debt/GDP for Ireland - the more appropriate measure of a government's fiscal position - is therefore about 27% lower than gross debt/GDP: 70% for 2009 and 90% for 2010, on our estimates.

•           Against a substantial part of the debt (gross and net), the Irish government has acquired assets - albeit of uncertain value. Unless the economic outturn is particularly bad (as is handicapped in our scenarios below), these assets will offer at least some payoff in the future.

(2) Skewness of the risk profile - Ireland more risky in short term, Greece more risky in long term: The risks surrounding the Irish fiscal position are mostly short-to-medium term; they emanate mainly from the possibility that the deep recession-cum-banking crisis would result in chronic weakness of the economy or even morph into a multi-year deflationary spiral. If the economy navigates this threat successfully, we reckon the fiscal outlook would improve substantially, albeit possibly still requiring additional fiscal efforts in the short term.

The risks for Greece are more skewed towards the medium-to-long term. A decidedly unfavourable long-term demographic outlook implies that Greece only has a narrow window of opportunity to reduce government indebtedness and implement the reforms that would allow faster growth during the demographic transition.

One simplified way to show the long-term risks is by comparing the primary balance (the budget deficit excluding interest payments) required to keep the debt from rising in our scenarios. The scenarios are not the same for the two countries and so their comparability is limited; however, a consistent result emerges: Greece requires higher primary surpluses (a negative deficit is a surplus) for debt stabilisation in all scenarios. This is in part due to the adverse long-term demographic projections.

A different way of looking at the same issue would be to ask which economy is, in the medium term, likely to generate the economic growth that would erode the debt. In other words, which economy is the more dynamic one? On the basis of past performance as well as current institutional reality, we believe that the answer is Ireland - provided the economy recovers reasonably quickly from the deflationary slump.

1. Fiscal Sustainability Scenarios

Given that interest payments on the outstanding debt are fixed, deficit and debt reduction require that the non-interest part of the government budget - the primary balance - be in surplus (see Budget Terms Glossary below). In what follows, we will therefore focus on the primary surplus as the fiscal authority's sole decision variable (implicitly assuming that defaulting on interest payments is not an option either government would consider).

In our benchmark analysis for both countries, we arbitrarily assume a primary surplus of 0.7% of GDP, maintained from 2013 until 2050, the end of the scenario horizon. If this primary surplus achieves a stable (i.e., non-increasing) debt/GDP ratio towards the end of the scenario horizon, we will conclude that fiscal policy is sustainable. If the debt path is increasing, we will conclude that fiscal policy is unsustainable. Our numbers include ageing costs as projected by the European Commission's working group on ageing populations (AWG). We emphasise that our scenarios do not have a bull-base-bear character. Rather, the attempt is to handicap the relevant risks for each country's fiscal outlook - both on the upside and the downside. Finally, because of the discrepancy between net and gross debt for Ireland discussed above, we will contrast net debt for Ireland with gross debt for Greece (as a share of the respective GDP).

Budget Terms Glossary

Primary expenditure: All budget expenditure items except interest payments on outstanding debt.

Primary balance: Primary expenditure less total revenue. If primary expenditure exceeds total revenue, the primary balance is in deficit (primary deficit). If primary expenditure is less than total revenue, the primary balance is in surplus (primary surplus).

Net borrowing (general government deficit): Excess of total expenditure over total revenue. If total expenditure exceeds total revenue, net borrowing is positive and the budget is in deficit.

Net borrowing versus primary deficit: By definition, the primary deficit is the general government deficit (net borrowing) excluding interest payments on the outstanding debt. Put differently, net borrowing is the sum of interest payments and primary deficit:   

1.1 Greece

The focus of our scenarios for Greece is the supply side of the economy. In the long run, GDP growth will likely be constrained by labour force growth - which in turn depends on population growth. Greece's population and hence the labour force is projected to decline over the next four to five decades. In the medium term, structural reforms in labour and product markets could boost employment and growth (as in our ‘Continued Convergence' scenario below). Conversely, factors that make labour and product markets more rigid will restrain employment and overall economic growth (as in our ‘Lost Decade' scenario).

1. ‘Continued Convergence' scenario: Here, it is assumed that broad structural reforms increase GDP growth and lower unemployment in the transition period as the economy converges to a new equilibrium with a lower labour force (see Appendix A in the full report for numerical assumptions of all scenarios). The results, for a variety of interest rate levels, are illustrated. Appendix C in the full report shows the primary surplus levels for which the debt ratio is stabilised, depending on the interest rate.

•           In the baseline case of a 5% implicit interest rate on the debt, the debt ratio at the end of the forecast horizon is 158% and rising. Higher interest rate levels lead to even higher debt ratios: fiscal policy is not sustainable.

•           Until roughly the middle of the scenario horizon, the debt ratio is actually decreasing or stable (except for the case of a 7% interest rate). The fact that it increases thereafter testifies to the strength of the demographic headwinds Greece faces.

•           Depending on the (implicit) interest rate on the debt, the primary surplus that stabilises the debt/GDP ratio is 2.1-4.0% of GDP (see Appendix C in the full report).

•           The level at which the debt ratio is eventually stabilised also increases with the interest rate on the debt. In this scenario, the debt/GDP ratio is stabilised at 88-96% of GDP, depending on the interest rate.

•           Debt stabilisation is achievable: primary surpluses of the magnitude required have been attained in the recent past on a sustained basis. 

•           However, stabilising the debt would require substantial additional fiscal measures: according to our back-of-the-envelope calculations, for the debt-stabilising 2.1% of GDP primary surplus to be achieved by 2013 necessitates a permanent fiscal consolidation of at least 10% of GDP over the next four years.

2. ‘Baseline IMF' scenario: We assume that the economy evolves according to the baseline scenario in IMF (2009), with no deviations.

•           Given the benchmark assumption of a 0.7% of GDP primary surplus, fiscal policy again turns out to be unsustainable in this scenario. Even for a 5% implicit interest rate, the terminal debt ratio is very high (at 224%) and rising.

•           The debt-stabilising primary surplus (as a share of GDP) is 2.6-4.7% for the range of interest rates on the debt we consider here. Such primary surpluses would stabilise the debt ratio at 107-113% of GDP.

•           The highest primary surplus/GDP ratio on Eurostat records for Greece was 4.6% in 1998: high interest rates may well require unprecedented primary surplus levels.

3. ‘Lost Decade' scenario: We assume that the economy ‘loses' the coming decade to social unrest and poor labour relations; this acts as a negative supply shock which lowers growth but increases inflation. Structural reforms are enacted after 2020 and bear fruits only later.

•           Once again, fiscal policy is not sustainable: debt/GDP is high and increasing at the end of the scenario horizon (218% in 2050 for a 5% interest rate).

•           Stabilising the debt ratio in this scenario requires, depending on the interest rate on the debt, a primary surplus/GDP ratio of at least 2.4% (4.7% for a 7% implicit interest rate on debt). Debt would be stabilised at levels exceeding 118% (see Appendix C in the full report).

Summary

Fiscal sustainability in Greece requires substantial fiscal consolidation over the coming years. As such, the primary surplus levels (as a percentage of GDP) required to keep the debt ratio from rising have been achieved in the past. However, Greece will need to show a consistency in its budgetary policies it has not shown before (recall that the debt-stabilising primary surplus will have to be maintained indefinitely for debt stabilisation). The upcoming demographic transition and its economic impact through slower growth and higher health and pensions expenditure mean that Greece has very little margin for error if it wants to ensure fiscal sustainability.

1.2 Ireland

An assessment of Ireland's fiscal outlook is complicated by the fact that much of the debt is a result of the government acquiring impaired assets from the banking sector (see Scenarios on Irish Fiscal Sustainability, July 21, 2009, for more details). The value of these assets is difficult to establish at this point, and will ultimately depend on the performance of the Irish housing and commercial real estate sectors over the medium term. This, in turn, will rest crucially on the prevailing macroeconomic conditions, particularly on whether and how soon the economy will be able to escape the current deflationary slump.

The focus of our Irish scenarios is therefore on the shape of the Irish economic recovery and the interaction between macroeconomic outcomes and asset recovery. Hence, in our scenarios, asset recovery depends on economic performance, and the outcomes reinforce each other: a good macroeconomic turnout will likely result in high asset recovery; a poor one will likely imply low asset recovery. In all three scenarios, we assume that the ‘bad bank' is unwound in 2020, and the proceeds from the asset sales reduce debt in that year (see Appendix A in the full report for the detailed assumptions behind our scenarios).

Finally, an important technical point: in the case of Ireland, our debt numbers are for net, rather than gross debt. This is because the difference between the two measures is substantial for Ireland on account of a) the sizeable government cash balances (around €25 billion or 15% of GDP); and b) the National Pensions Reserve Fund (around €21 billion or 12% of GDP). 

1. ‘Benign Normalisation' scenario: We assume that the economy rebounds strongly following the crisis and achieves healthy potential growth in the following decades (dictated by demographic constraints in the long term). Using the Swedish experience of the 1990s as a benchmark, we assume a 94% recovery on the banking sector assets.

•           For a 5% interest rate, the benchmark assumption of a 0.7% of GDP primary surplus is almost sufficient to stabilise the debt ratio: in 2050, the debt ratio is at 70% and increasing only very mildly. For all other interest rate levels, however, the debt ratio diverges.

•           The primary surplus that does stabilise the debt ratio is relatively low and, in the case of a 5% interest rate on debt, very close to the benchmark. With this interest rate assumption, a primary surplus of 1% of GDP would stabilise the debt ratio at 56% by the end of the scenario horizon (see Appendix C in the original report).

•           Overall, the primary surplus levels required for debt stability are not high compared to the historical record. Although economic performance is, by assumption, not as stellar as in the pre-crisis past, achieving the necessary primary surplus should not require too much of a stretch - provided the economy escapes the deflationary slump.

•           In the short term, achieving the debt/stabilising primary surplus will require substantial fiscal consolidation: a minimum of 11% of GDP over the next four years, on our estimates.

2. ‘Protracted Adjustment' scenario: We assume that the economy converges from above to the average living standard of its trading partners. Recovery on banking sector assets is assumed to be 30%.

•           The benchmark 0.7% of GDP primary surplus is not sufficient to stabilise the debt ratio under any (implicit) interest rate. With a 5% interest rate on the debt, the 2050 debt ratio is 124%, and increasing.

•           The debt-stabilising primary surplus is at least 1.5% of GDP. With a 5% interest rate, this primary surplus would stabilise debt/GDP at 84% by the end of the scenario horizon. At 7%, a primary surplus of 4% of GDP would have debt at a stable 93% by 2050.

•           Again, such primary surpluses (as a share of GDP) would not be new to Ireland. However, achieving them will be much harder, given the weaker performance of the economy.

3. ‘Competitive Deflation' scenario: This scenario assumes a decade of Japan-like stagnation in 2010-20, when real GDP rises by a sluggish 1% every year and deflation prevails. This decade of deflation allows Ireland to regain competitiveness; subsequently, the economy performs well, though it does not reach the levels of growth seen in the pre-crisis decades. Due to the weak 2010-20 decade, the recovery on the banking sector assets is assumed to be a mere 10%.

•           Because the economy performs well in the long run, for a low interest rate level (5%), the benchmark 0.7% primary surplus assumption is almost sufficient to stabilise the debt ratio. With a 5% interest rate, the debt-stabilising primary surplus is 0.8% of GDP - only marginally higher than our benchmark. For higher interest rates, the required primary surplus is substantially higher (see Appendix C in the full report).

•           Even with fiscal policies that are sustainable in the long run, the trajectory of the economy in this scenario points to a significant risk. In the medium term (in our scenario over the next decade), debt/GDP could be very high: even with a 5% interest rate, it would reach 150% (in 2019 - we assume the recovery on assets occurs in 2020).

•           Importantly, given the state of the economy in this scenario, achieving the debt-stabilising primary surplus levels may be very difficult.

Summary

Sustainability of Ireland's public finances will depend crucially on how quickly it recovers from the deflationary slump. With a reasonably quick recovery, Ireland should be able to achieve a sustainable debt path - even though the required fiscal adjustment over the next few years is substantial. Yet our scenarios also highlight risks. Slow growth would already cause significant difficulties and would demand even greater fiscal adjustment. And if the economy were to remain mired in deflation and low growth, debt could climb sufficiently to test financial markets' confidence in Irish assets. Ireland may not be able to afford a Japan-like ‘lost decade'.

2. Beyond Debt

Our analysis highlights the importance of economic growth as a condition for long-term fiscal sustainability. Economic growth is not only necessary for debt control; it is also the least painful way for a society to achieve fiscal sustainability. In this section, we will focus on one simple question: which country is more likely to achieve, and sustain over the medium run, healthy growth rates?

The sheer depth of the current slump in Ireland, combined with the need for all sectors of the economy to reduce indebtedness, indicates that the risk of a prolonged slump exists - with adverse consequences for fiscal sustainability, as our scenarios demonstrate. A lot will depend on whether the ‘bad bank' scheme - an asset swap which will divest the banking system of its impaired assets (in exchange for government bonds) - will work. From a macroeconomic perspective, we think that the ‘bad bank' approach is the right one under the circumstances, though it is difficult to predict whether and to what extent it will succeed - not least because the evolution of the economy will be crucial.

The risk of Greece sliding into an outright deflationary slump is small, we think, even though the current contraction will be painful. Economic stagnation is more of a concern (see our ‘Lost Decade' scenario). Even in such a case, the debt ratio will likely be somewhat lower than Ireland's for the deflation case.

Provided Ireland does manage to avoid a bad macroeconomic outcome over the next five years or so, we believe it is more likely than Greece to achieve growth rates that would help to reduce the debt ratio over the medium-to-long term. In the medium term, Ireland's investment-friendly institutional climate and its flexible labour market are more likely to prove conducive to growth and the Irish economy will likely outperform. Greece, on the other hand, would need to implement difficult and wide-ranging structural reforms to enhance the economy's growth potential. It is difficult to say at this point whether there is currently, or likely to exist in the future, a broad enough consensus in society which would take the country in that direction.

In the long term - at least over the next 40 years - demographic projections also indicate more adverse developments for Greece than for Ireland. This suggests that Greece appears to have a narrow window of opportunity only for the implementation of the necessary structural reforms.

3. Conclusion

Although in an apparently similar fiscal situation at the moment, there is much that separates the economies of Greece and Ireland. For bond market investors, we think the differences can be summarised in terms of the risk profile for the fiscal outlook. The risks surrounding the Irish fiscal position are primarily short-to-medium term; they emanate mainly from the possibility that the deep recession-cum-banking crisis would result in chronic weakness of the economy or even morph into a multi-year deflationary spiral. If the economy navigates this threat successfully, we reckon that the fiscal outlook would improve substantially, albeit possibly still requiring additional fiscal efforts in the short term.

The risks for Greece on the other hand are more skewed towards the medium-to-long term. A decidedly unfavourable long-term demographic outlook implies that Greece has a narrow window of opportunity only to reduce government indebtedness and implement the reforms that would allow faster growth during the demographic transition. 

Please see the full report published on November 2, 2009 for the Appendices.

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United States
Review and Preview
November 03, 2009

By Ted Wieseman | New York

Some big back-and-forth moves through the week on mixed economic reports ended on the strong side for the Treasury market the past week, with a substantial rally Friday as stocks plunged to their first monthly loss since February, helping drive sizeable front end-led gains for the week as a whole. Getting through a somewhat bumpy run of record supply and into month end-related buying added to the strong close to the week as well on top of the equity and, to a somewhat more limited extent, credit market losses. All four auctions went well by any reasonable absolute standard, with high overall bid/covers and good distribution to final investors, but after extremely strong results at the 2-year sale Tuesday and 5-year TIPS reopening Monday, investors were disappointed initially that the 5-year Wednesday and 7-year Thursday tailed and didn't reach the lofty 3+ bid/covers of the earlier auctions. Economic data through the week were mixed, adding significantly to the week's day-to-day swings. The Conference Board's consumer confidence index plunged and showed absolutely dismal results for the closely watched question on current labor market conditions, increasing anxiety about the coming week's employment report, though a continuation of the big recent improving trends in jobless claims was a much more positive labor market sign later in the week. New home sales retrenched somewhat after a huge prior rebound off the early year-record low, though at least inventories also continued declining to new lows. And the durable goods report was somewhat mixed, with strength in core capital goods orders but some weakness in core capital goods shipments that had investors wary of a downside surprise in the GDP report. In the event, growth didn't disappoint, posting a solid 3.5% gain in 3Q, close to our forecast on good upside in consumption - led by cash-for-clunkers-boosted auto sales but with reasonably solid growth in ex autos spending as well - and residential investment and a slower, but in absolute terms still intense, pace of inventory liquidation. We continue to see growth moderating in 4Q, and this will likely lead to a continuation in coming months of the more mixed tone to the incoming data that was seen in October after a much broader run of upside surprises through most of the summer. Recent data have been solid enough, however, so that the 4Q slowdown looks like it will probably be a bit more muted than we previously thought. In particular, with the solid back-to-school shopping season leading to a much more solid trajectory for non-auto retail sales moving into 4Q, offsetting the cash-for-clunkers payback, 4Q consumption now appears on track to slow to only about +2% from +3.4% in 3Q instead of the +1% we anticipated at the start of the month. Largely as a result of this, 4Q GDP growth at this early point appears to be on pace for about a 2.5% increase instead of the +2.0% we saw a month ago.

On the week, benchmark Treasury yields fell 6-15bp and the curve steepened, which was a pain trade, as it seems that many investors had been moving into flatteners recently, a move that probably makes sense going into the FOMC meeting but didn't work in the most recent week. The old 2-year yield fell 15bp to 0.85%, 3-year 15bp to 1.41%, old 5-year 14bp to 2.29%, old 7-year 12bp to 2.96%, 10-year 9bp to 3.39%, and 30-year 6bp to 4.23%. Bill supply shrank much in October, which intensified the squeeze at the front end, with the 4-week yield down 2bp to 0.01% and 3-month 1bp to 0.05%. As a result of the paydown of almost all the SFP cash management bills, total bills outstanding fell by US$134 billion in October. Even with this big decline, however, it's hard to understand how bills can be so scarce when the increase over the past couple of years still amounts to about US$1 trillion. TIPS performed very well, mostly outperforming nominals even as a bit of a rebound in the dollar pressured commodity prices. As at the 10-year auction earlier in the month, the very strong demand at the 5-year TIPS auction apparently signaled a broader shift into the sector regardless of the short-term oil price moves that often drive relative performance on a day-to-day basis. The 5-year TIPS yield fell 21bp to 0.61%, 10-year 10bp to 1.38%, and 20-year 7bp to 2.02%. The 5-year TIPS yield has now been more than cut in half since mid-August, ending the week at its lowest level since July 2008, while the 10-year yield reached its lowest level since March. Thanks to a big day of outperformance Wednesday, when the prior backup in rates contributed to unusually low origination activity that was also seen in a big drop in the weekly mortgage applications survey, the MBS market about kept pace with the Treasury rally. This left MBS yields back down near 4.25% after they had risen to two-month highs approaching 4.5% Monday. The improved tone later in the week should keep 30-year conventional mortgage rates near the 5% level they've been averaging recently after a bit of a back-up from recent lows near 4.875% reached a few weeks back. Home sales will likely see some near-term downside if the first-time homebuyers' tax credit expires, but the current combination of mortgage rates and home prices still makes for unusually high levels of housing affordability that should be supportive going forward.

Risk markets took a big hit the past week to cumulate to a moderate correction from the recent highs. The S&P 500 lost 4% on the week for a 6% drop since the October 19 high. For all of October, the index was down 2%, obviously nothing too significant in itself, but it was the first down month since all the way back in February. In the latest week, high-beta financials plunged 7%, and the bounce in the dollar and corresponding pullbacks in commodity prices also contributed to poor performance by materials (-7%) and energy (-5%) stocks. But the weakness was very broadly based, and all major sectors saw significant losses. Credit markets also took a significant hit. In late trading Friday, the investment grade CDX index was 9bp wider at 109bp, the one mild positive in that being that it would only match the Wednesday close instead of going out at a new low in a month, like stocks. High yield traded more closely in line with equities. Through Thursday, the HY index was 28bp wider at 666bp, but a point-and-a-half drop Friday had it on pace of a more than 60bp widening on the week to the worst level since the beginning of October. Other markets also took major hits. The commercial mortgage CMBX market was down big, with the AAA off 5%, junior AAA 5%, AA 8% and A 5%. This left the AAA down about 2% on the month, but the reversal in the lower-rated indices has been much more pronounced after enormous rallies in September. The junior AAA surged from 47.15 on September 14 to a high of 60.60 on September 29, a 29% rally in a couple weeks, but at Friday's close it was down to 50.11, for a 17% pullback from the high. The subprime ABX market also was hit the past week, with the AAA index off 2.13 points (-6%) to 31.00. Recent prior performance had been strong, however, so this still represented a modest gain for the month.

Real GDP rose at a 3.5% annual rate in 3Q, ending a run of four-straight declines (and five of the prior six quarters). A slower, but in absolute terms still very intense, pace of inventory liquidation added 0.9pp to growth, while net exports subtracted 0.5pp as imports (+16.4%) rebounded a bit more sharply than exports (+14.7%). Final domestic demand gained 3.0%, paced by a 3.4% gain in consumption after a near-record drop in the year through 2Q and a 23.4% rise in residential investment after 14-straight declines. The cash-for-clunkers-driven surge in auto sales accounted for much of the consumption upside, but ex autos spending gained a solid 1.8%, highest in two years. Business investment (-2.5%) on the other hand remained soft on weakness in structures. Cash-for-clunkers payback in consumption and not as big a boost from a further slowing in the rate of inventory destocking should lead to a more moderate pace of growth in 4Q, but a better trajectory to ex auto retail sales - which posted a real gain of 0.3% in September on top of a 0.55 rise in August even as a correction in auto sales caused overall real spending to fall 0.6% - points to a somewhat more muted slowdown than we thought a month ago. 4Q growth at this early point appears to be on track for a gain near +2.5%, which would leave annualized 2H growth at +3%. We continue to look for this muted rebound to extend into 2010, when we forecast 3.2% GDP growth on a 4Q/4Q basis.

Against the upside in GDP, the week's other two key releases - consumer confidence and new home sales - were weaker. The Conference Board measure of consumer confidence fell 6 points in October to 47.7 as pessimism about the labor market reached extreme levels. The University of Michigan index was also weaker, falling to 70.6 from 73.5 (though this was revised up from the early October reading of 69.4). In the Conference Board survey, the current conditions index fell 1.3 points to 20.7, a low since early 1983 and not far from an all-time low. The percentage of respondents describing jobs as plentiful fell a couple of tenths to just 3.4%, while the percentage describing jobs as hard to get rose nearly three points to 49.6%, the worst net view since May 1983 when the unemployment rate was 10.1%, a level that was likely nearly reached this month. New home sales fell 3.6% in September to a 402,000 unit annual rate after a huge prior rebound off the record low hit in January. Even after this pullback, however, sales are up 22% from that early year trough. With single-family home completions hitting a record low in September as they continue to catch up with the prior collapse in starts, inventories of unsold homes continued to fall even with the drop in sales, declining 4% to 251,000 units, a low since 1982.

The upcoming week has a very busy calendar, with the FOMC meeting, the key early round of data releases for October highlighted by the employment report Friday, and the Treasury's quarterly refunding announcement on Wednesday. The Fed is in an interesting position at the moment. While the end of the recession means that it is clearly time to start thinking about exit strategies, the reality on the ground is that quantitative easing is in the process of a big further ramp-up. Because most of the emergency liquidity injections (including TAF and related lending through foreign central banks, CPFF, PDCF and discount window borrowing) have largely unwound on their own as market conditions have settled down, there has recently been only a limited offset to the Fed's ongoing mortgage and agency purchase programs. So excess reserves have recently been surging to new highs after having been roughly stable for most of the year, and this will likely extend into next year. Excess reserves were a bit below US$800 billion at the end of August before rising to US$987 billion in mid-October. This Thursday's report should show a move above US$1 trillion, and we expect a peak near US$1.2 trillion early next year, for about a 50% further increase in a six-month period. As this is happening, however, certainly the Fed is already thinking carefully about when and how to bring this back down, and so heading into the FOMC meeting, it's clear that a change in the wording of the official statement is very much in play. Our base case at this point is that the Fed begins reverse repos to drain excess reserves in March, as the MBS and agency purchase programs are wrapping up. In our view, it is a close call on whether the FOMC decides to adjust the "extended period" wording at this meeting to start to move a bit rhetorically towards this shift or waits until the December session to do so. The recent data flow has been somewhat mixed, but we suspect that the solid GDP report together with broader indications that a subpar but sustainable economic recovery is starting to unfold tips the scale toward the likelihood that a change will occur this time round, though if markets remain under pressure in coming days, that could certainly keep policymakers from doing anything just yet. We expect any tweaks they do make to the key policy language to be quite minor at this point. We're thinking that the change might involve something along the lines of substituting "a highly accommodative monetary policy" for "exceptionally low levels of the federal funds rate".

Ahead of Wednesday's FOMC announcement, the Treasury will give its quarterly refunding announcement. We look for a US$82 billion refunding package consisting of US$40 billion 3s, US$25 billion 10s and US$17 billion 30s, which would be an increase of another US$1 billion for the 3-year and US$2 billion for the 10-year and 30-year. We also expect the Treasury to confirm a shift from 20-year to 30-year TIPS starting January. The debt managers appear determined to reverse the shortening in the average maturity of the outstanding Treasury debt that has occurred over the past couple of years in an expeditious manner. We believe that they would probably like to boost the average maturity of the Treasury debt outstanding from its current unusually low level of about 4 years up to an elevated 6-7 years. To accomplish such a substantial shift in the average maturity of the stock of outstanding debt over a reasonable timeframe will require a much bigger extension in the average maturity of the flow of new debt being sold. So, we expect the Treasury to continue paying down bills over the next year, and we expect the upcoming auction announcement to see a continued move higher in longer-maturity issue sizes. So, even though overall Treasury issuance will likely be a lot lower in fiscal 2010 than fiscal 2009, the duration of the issuance and overall gross coupon sales will likely be much higher.

In addition to the employment report on Friday, key data releases due out include ISM and construction spending Monday, factory orders and motor vehicle sales Tuesday, non-manufacturing ISM Wednesday, and productivity and chain store sales Thursday:

* The regional reports for October were mixed (3 up and 3 down). However, a couple of those posting increases - Empire and Chicago - were up a lot. So, we look for a small rise in the national ISM index relative to 53.0 from 52.6 in September. In particular, we look for a rebound in both orders and production along with a continued climb in the inventory index (which is actually reflective of a slower pace of decline). Finally, the price gauge is expected to tick up to 65 (versus 63 in September) as a result of higher quotes for energy-related items.

* We look for a 0.2% dip in September construction spending following an uptick in August. In particular, residential activity is expected to flatten out, reflecting the fact that the volume of houses under construction is still declining even though new starts appear to have bottomed. Meanwhile, the non-residential category appears poised for some further significant declines, given widespread stress in the commercial real estate sector. Finally, we look for a modest uptick in the public category, although there is scant evidence that infrastructure projects funded by the fiscal stimulus legislation enacted back in February are having any meaningful impact on the data.

* We expect factory orders to rise 0.6% in September. The durable goods component of orders showed a 1% rise, but some price-related softness in the non-durables category should help to shave the growth in overall factory bookings. Meanwhile, shipments should also show a modest gain (+0.5%), while inventories continue to slide (-0.8%). This implies another slight dip in the I/S ratio (to 1.37 from 1.38).

* Industry surveys point to a solid rebound in motor vehicle sales in October, so we look for an improvement to 10.4 million units annualized from the subdued 9.2 million unit pace seen in September, which obviously reflected a cash-for-clunkers payback. The recent sales rebound largely reflects greater availability of some popular models that were in very short supply in the immediate aftermath of C4C. Note that even with the recent sales boost tied to the success of C4C, sales on a year-to-date basis are down 25% from 2008.

* We forecast a 6.6% gain in 3Q productivity and 4.5% drop in unit labor costs. The combination of a solid gain in output (+4.0%) and a further decline in labor input (-2.6%) implies another very sharp jump in productivity. Indeed, if our estimate for 3Q is close to the mark, the productivity growth seen in the past two quarters would be the best since 2003 and the third best in the last 25 years. Moreover, the year-on-year growth rate should jump all the way from +1.9% to +3.6%. Meanwhile, unit labor costs are likely to post a sizeable decline for the third consecutive quarter, and the year-on-year rate should drop all the way from -1.2% to -3.4%. This reflects the unusually aggressive cost control that has been helping to sustain corporate profitability.

* We look for a 150,000 decline in October non-farm payrolls. The downtrend in jobless claims points to a likely moderation in the pace of payroll decline. Moreover, factoring in BLS's preliminary estimate of the 2009 benchmark revision, it appears that the level of private employment is below the July 2003 trough - even though the economy's output is now 10% higher in real terms. This performance reflects strong gains in productivity over the past several years, but such gains can only be stretched so far. As demand begins to firm, companies will need to add some labor in order to grow top-line revenues, and we believe that the labor market is in the process of transitioning to just such an environment. In October, we look for a slower pace of job loss in sectors such as construction, retail trade and government. Meanwhile, the steady climb towards a 10% unemployment rate is expected to continue. However, labor force participation appears to be drifting lower (after having risen during the first half of the year), and this is helping to temper the pace of increase in the unemployment rate, so we look for only a further 0.1pp uptick in October to 9.9%. Finally, we look for a flat workweek and only a very slight uptick in the average wage rate.

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