EMEA
CEEMEA: Bouncing Back from the Brink
January 18, 2010

By Oliver Weeks, Tevfik Aksoy, Pasquale Diana & Alina Slyusarchuk | London, Michael Kafe & Andrea Masia | Johannesburg & Mohamed Jaber | Dubai

Growth to Resume, but Mostly as a Bounce-Back from a Weak Base

The main engines of growth in the region witnessed severe recessions in 2009 such that weighted average real GDP growth was -5.8%Y. On the back of decisive monetary policy responses as well as countercyclical fiscal policy measures, almost all economies are forecast to grow this year, with Russia and Turkey leading the pack. Our projections point to an overall real GDP growth rate of 3.8%Y (GDP weighted) in 2010, followed by a mediocre performance of 3%Y in 2011.

The fastest recovery in 2010 is expected from Russia, where a spectacular collapse in growth in 2009 was primarily inventory-driven. Growth is expected to be quite robust and again driven by an inventory cycle, the normalisation of gas production, fiscal stimulus and stronger household confidence. In Turkey, the simultaneous decline in external and domestic demand caused a sharp contraction in growth in 2009, which was partially being supported by loose monetary policy and various fiscal measures aimed at encouraging consumption. Given the fact that the economic slowdown de facto commenced in 2007, the size of the shock was manageable. Looking into 2010, we expect interest rates to remain mostly accommodative in 1H10 and the fiscal picture to broadly remain accommodative to help the economy revive. With improved external demand conditions in 2H, improvement in credit conditions and better consumer sentiment, we expect growth to reach 4%. A possible IMF Stand-By Arrangement with sufficient funding would raise the upside to growth by 1.1pp to 5.1%Y, in our view.

In Eastern Europe, Poland was not only one of just two countries that posted a positive growth rate in the CEEMEA space (with Israel), but also the strongest economy in 2009. We expect Poland to continue to outperform in CEE in 2010, with domestic demand remaining the main engine of growth. Our real GDP growth forecast remains above consensus and we believe that both the NBP and the Ministry of Finance will move to revise up official forecasts in the coming months. In the Czech Republic, the economy contracted quite sharply in 2009 but towards the end of the year some improvement in growth dynamics was noticed, with quarterly growth rates picking up, suggesting that recovery in underway. Being a very open economy, the Czech Republic should benefit from better EMU numbers, but the end of the incentives offered to the automotive sector in Germany coupled with the anticipated fiscal tightening are likely to constitute the main headwinds in 2010. Turning to Hungary, the dismal performance on the growth front was essentially due to the contraction in import demand in the EU, the continuation of the fiscal tightening that commenced back in 2006 and retrenchment by consumers who borrowed heavily in FX. While we anticipate some stabilisation in the economy this year, mostly driven by exports and inventory build-up, Hungary will likely remain a clear laggard on the growth front in the region. Finally, in Romania, the deep recession of 2009 should reverse marginally this year on the back of the improved investments and the re-stocking. Nevertheless, the growth picture is likely to remain weak.

Turning to South Africa, we see a real GDP contraction of 1.7%Y in 2009 stemming from weak consumption demand (about 60% of GDP) and a sharp fall in inventories. Gross domestic capital spending by the private sector also fell sharply, although the significant growth in the government's infrastructure spending helped keep overall GDFI in positive - albeit fast decelerating - territory. A narrower external gap helped to place a floor under GDP growth, however. For 2010, we expect the World Cup to help by adding about a full percentage point to GDP growth. Huge job losses and tighter consumer lending conditions are likely to impose a significant constraint on the recovery in private consumption, and we look for a recovery in private sector investment spending only in 2H10.  Government consumption spend should however accelerate from last year's pace as the government seeks to implement its delayed counter-cyclical fiscal programmes, while inventory normalisation should also add significantly to GDP growth.

In the Middle East, Israel was well positioned to weather the global downturn thanks to very timely and decisive policy action by the BoI and the Ministry of Finance. Thanks to the efficient and effective usage of both conventional and non-conventional tools, the economy posted positive growth in 2009, according to our forecasts. In comparison to the previous episodes, the recession experienced in 2009 was shallow and short, with overall annual growth amounting to 0.7%Y. According to our forecasts, the economy will grow by 3.7% in 2010, mainly driven by exports, but private consumption should contribute significantly to the headline figure as well.

Elsewhere in the Middle East, the drop in oil production and the slowdown in domestic demand hampered the real GDP growth in the UAE. The correction in the real estate market has significantly affected the construction industry, which is believed to have contracted significantly in 2009. Weak credit growth has remained an adverse factor, as has the lack of transparency about the strength of Dubai's public sector finances - a situation that culminated in Dubai World's debt rescheduling announcement this past October. Looking into 2010, the recovery is expected to be quite weak, with real GDP growth projected to be around 1%. Growth in the non-oil sector will likely be constrained by continued weakness in credit expansion, sluggish domestic demand and supply-side constraints. The mitigating factor will likely be the continued fiscal expansion in Abu Dhabi. 

Inflation Will Be Lower on Average in 2010 Except in Turkey and in the Czech Republic

In comparison to the average inflation rate of 6.1%Y in 2009 we expect the regional average to ease to 4.7%Y this year and remain almost flat in 2011. The two countries where we expect inflation to rise this year are Turkey and the Czech Republic, while we anticipate a noteworthy slowdown in inflation in Russia.

In Central and Eastern Europe, we project inflation in the Czech Republic to gradually rise in 2010, on the back of increases in regulated prices and stronger growth.  In Hungary, the long-awaited softening in core inflation began towards the end of 2009 and, thanks to the stabilisation in the currency, inflation remained on an easing track. In fact, inflation could have been lower had the VAT hike in July 2009 not taken place. That said, we see inflation easing gradually in 2010, especially in 2H, as the VAT hike drops off from the base. Turning to Poland, headline inflation oscillated in 2009 due to energy and food prices, with a tendency to ease in 2H09 as the currency appreciated and food inflation eased. Core inflation was remarkably stable, which suggests that perhaps slack is being overestimated - this also suggests upside risks to the NBP's recent forecasts. This year we are expecting to see large base effects driving inflation significantly lower in 1H (energy and regulated prices) before it rises back to the official target in 2H. Finally, looking at Romania, we project that inflation will decline from an average rate of 5.6%Y in 2009 to 2.8%Y in 2010, mostly owing to base year effects but especially the stabilisation in the currency. The latter is particularly key on the inflation front as the FX pass-through on inflation in Romania remains quite high.

In Turkey, the widening of the output gap, lack of external and domestic demand as well as the low energy prices led to a sharp fall in inflation to record lows in 2009 before ending the year at 6.5%Y and below the inflation target of 7.5%. In 2010, we expect inflation to rise on the back of the indirect tax hikes as well as the base effects for most of 1H10. We also expect inflation expectations to deteriorate, which might have adverse implications for the pricing behaviour of goods and services. In line with the gradual improvement in domestic demand and the pent-up demand, coupled with a revival in credit growth, we believe that inflation risks will be on the upside. Hence, we expect inflation to rise to 7.7%Y and the 6.5% target to be missed in the absence of a sizeable adjustment in monetary policy. Israel missed the inflation target once again as the rate is forecast to have ended 2009 at 4%Y. We expect inflation to remain outside the 1-3% target range for most of 2010 but, with the monetary tightening in place, the fading out of one-off increases in VAT as well as the removal of the water surcharge, inflation should ease to around 2% by end-2010.

In South Africa, the impact of an index reweighting and rebasing helped CPI inflation return to single-digits (8.1%Y) at the start of 2009. Currency appreciation, weak domestic demand and a fall in food prices helped bring inflation down to 5.9%Y in October, placing it within the 3-6% target range for the first time since March 2007. Although we forecast that inflation must have closed the year at 6.4%Y (i.e., above the target band), this is largely due to base effects associated with the sharp fall in oil prices towards end-2008. This year, we expect inflation to dip below the target band, sustainably, in March. We expect CPI to range between 5.2% and 5.5% in 2H10, with an average reading of 5.5% for the year as a whole.

Elsewhere, in the UAE, we estimate headline inflation to have been around 1.7%Y in 2009 (based on official data).  But we believe that official CPI numbers are not consistent with what appears to be a much more significant drop in consumer prices. Anecdotal evidence shows that rents, which along with other housing costs have a 40% weight in the CPI, have dropped by about 15-30% on average in 2009, compared to an official estimate of about 1%Y in November. Looking into 2010, we believe that inflationary pressures will remain subdued, mainly due to a weak recovery in domestic demand and lower rents. Turning to Russia, we see that inflation declined from around 14% in 2008 to slightly less than 12% in 2009, owing to a tight monetary policy. We see a very favourable outlook in 1H10 despite excise tax hikes. Overall, we see average inflation dropping to a single-digits at 6.2%Y, marking one of the lowest rates seen in many years. That said, we forecast inflation in Russia to take the lead in the region in 2011.

Fiscal Challenges to Remain

A sharp fall in VAT and corporate tax revenues in 2009, combined with higher wage and interest expenses, led to a significant deterioration in the fiscal balance from 1% of GDP to more than 7% of GDP in South Africa. As a result, total government debt rose from 23% of GDP to an estimated 29%. The overall public sector borrowing requirement also surged from 3.9% of GDP in 2008 to an estimated 11.4%.  In 2010, we expect the recovery in GDP growth to help close the revenue gap somewhat and bring the fiscal deficit back to around 5% of GDP. A similar weakness in government finances was noteworthy in Poland. The fiscal balance deteriorated far more than expected in 2009 due to a combination of cyclical pressures and some fiscal easing. So far, the authorities did not announce any fiscal expansion plans for 2010, but on the other hand neither have they announced consolidation. We expect the government to aim to cap the debt/GDP ratio below 55% in 2010. Hungary's debt legacy remains a worry at around 80% of GDP. However, looking at how contained the deficit had stayed against such a dismal growth backdrop, one has to give credit to the fiscal authorities as Hungary had been among the most disciplined across the EU. In our view, the main risks looking into 2010 are: i) a new government in April 2010; and ii) complacency that may come from markets re-opening to Hungary. Turning to the Czech Republic, the deficit widened to 6.8%, far worse than anyone expected. The debt stock remains contained, however, but capping the deficit will be a major challenge in 2010. While some tightening measures have been put in place, we do not see these as ambitious enough, partly as there is little incentive to consolidate ahead of the May elections.

Romania had the worst fiscal performance in 2009. The deficit widened substantially due to poor control over expenditures as well as the drop in revenues. The IMF has helped, and been fairly lenient towards Romania's situation - indeed the IMF revised its fiscal targets once it took stock of the full extent of the recession earlier this year. The new cabinet approved the 2010 budget bill, which targets a reduction in the deficit from 7.3% to 5.9% of GDP, via painful measures such as a wage freeze in the public sector. Our view is that, despite the fragile majority, the budget will be approved in pretty much its current form. Despite the official declarations, the opposition parties are likely to hesitate to vote the budget down and risk triggering a collapse of the IMF assistance package. Note that, were disbursements to resume, Romania might receive €3.3 billion already in February (IMF+EU).

In Russia, the fiscal stimulus in 2009 was large but late, and almost non-existent in 2H. The 2010 budget is tighter, but we expect spending to be revised upwards, especially if the price of oil remains high. In the UAE, we estimate that the fiscal balance was negatively impacted by the significant drop in oil revenues in 2009. Expansionary fiscal policies are likely to have put additional strain on government finances. However, a clear distinction needs to be made between the fiscal situation of Abu Dhabi (which sits on massive oil reserves and foreign assets) and that of Dubai, which is currently having to deal with a significant public sector debt burden. Looking into 2010, we expect higher projected oil revenues to shore up government finances. We expect the expansionary momentum to continue in Abu Dhabi. However, Dubai will likely need to rationalise its public expenditures due to more restricted financing. In Turkey, the countercyclical spending in 2009 escalated the deterioration in the fiscal picture, and the rise in overall deficit to around 6% of GDP was almost entirely due to rising non-interest expenditures. The 2010 budget sees a deficit of 4.9% of GDP, which we believe is attainable, especially in light of the recent hikes in various taxes. On the fiscal front, the main event to watch in 1H10 will be the passage of the Fiscal Rule legislation that would provide a strong assurance against discretionary budget spending in the future. Israel's fiscal performance had been somewhat impressive as the government managed to undershoot the fiscal ceiling of 6% by 0.8pp to end 2009 at 5.2% of GDP. We expect the 5.5% deficit ceiling set for 2010 to be undershot as well and the deficit to ease to 4.5%. The main aim of lowering debt/GDP to 60% remains intact, although it is likely to take a few years longer than the initial target date of 2015, in our view.

Current Account Adjustments: A Mixed Picture

Dramatic falls in external gaps were recorded across most countries in Central and Eastern Europe. Aside from extreme examples like the Baltics, Romania had the largest adjustment, with the C/A gap easing to 5% of GDP in 2009 from a near 15% peak during 2008. The main reason behind the decline was obviously the recession and the sudden stop in funding that led to a rapid shrinking in external imbalances. We expect the C/A deficit to remain at around 5% of GDP in 2010 before rising to 6% in 2011. In South Africa, weak domestic demand and a consequential decline in import demand led to a significant improvement in the current account deficit in 2009.  This year we expect strong commodity prices and a slow recovery in both consumption and investment spending to combine with sharp service inflows associated with the World Cup to place a lid on the C/A deficit in 1H10. In 2H, however, a recovery in demand conditions should bring some pressure to bear on the deficit again. Also, while portfolio flows were very strong in 2009, and could well remain strong in 1H10, we look for a slowdown in the momentum in 2H. At a time when the C/A deficit is widening, this is likely to lead to some pressure on the currency. Essentially, we expect South Africa to maintain its status of a high C/A deficit country in the region in 2010 and 2011.

The recession and the sharp decline in oil prices resulted in a noticeable decline in the current account deficit in Turkey. From a high of 6% of GDP back in 2007-08, the deficit declined to around 2% of GDP in 2009, and we expect it to rise marginally to 3.1% in 2010 mostly because of higher commodity prices and a pick-up in growth. We project the deficit to rise slightly higher in 2011 to reach 3.4% of GDP. The main risk to our forecasts remains the price of oil, and any sharp move on that front would affect the headline numbers substantially, given the heavy reliance on oil and natural gas imports. At the other extreme, we have Russia with the largest surplus. In 2009 the current account remained comfortably in surplus, and we project the surplus to expand even further on the back of the likely rise in oil prices. This will result in further pressure for the currency to appreciate in 2010, in our view.

Elsewhere in Central Europe, in Poland the current account deficit has been narrowing, though not as dramatically as in countries which suffered bigger recessions. There are still several questions about data quality, however, with over 5% of GDP worth of unexplained outflows (so the ‘true' funding gap is much larger).  In Hungary, the adjustment in the C/A deficit was massive and 2009 may end with an external surplus. While it had never been a serious concern, the current account deficit narrowed to 1.5% of GDP in the Czech Republic. The country stood out for some time for having the best balance of payments position, and this is unlikely to change in the near term.

In the UAE, the external account was negatively impacted by a 40% drop in average oil prices in 2009 and an estimated 12% decline in oil production due to lower OPEC production ceilings. Hydrocarbon exports make up about 40-50% of the UAE's total gross exports, or closer to 70% if we exclude net exports. Looking into 2010, we expect a strengthening of the UAE's external account on the back of a projected increase of about 30% in average oil prices and a 2% marginal rise in oil production. We expect import growth to be weak on sluggish growth in the non-oil sector. In Israel, the sharp decline in imports in 2009 and a better-than-expected performance on the exports front led to a current account surplus of some 3.6% of GDP. This allowed the country to yield the highest surplus in the region after Russia. We expect the surplus to be maintained in 2010, but to be at a lower rate in 2011.

Monetary Policy: First in, First Out

Last year, most central banks across CEEMEA engaged in monetary easing, some more aggressively than others. Policies will differ in 2010, largely depending on what stage in the easing cycle central banks are at. Essentially, we expect the first ones to start the easing cycle to lead the hiking cycle this year. In Central Europe, we think the Czech Republic and Polish monetary authorities will start taking rates higher (by 100bp and 50bp, respectively) this year, but probably not before mid-year. Romania and Hungary (especially the former), which have lagged the easing cycle due to prevailing concerns about FX weakness, are set to remain in easing mode. We think that the National Bank of Romania has another 125bp of cuts in the pipeline this year (after the surprise January cut), and the Hungarian central bank could take rates to 5.50% (75bp lower than current), but always keeping an eye on risk conditions, as usual. In Russia, policy loosening began late and we think it is far from over.  With inflation still falling and the authorities uncomfortable with RUB appreciation, we still expect another 150bp of rate cuts in 1H, and no rate hikes in 2010.  In South Africa, with inflation back into the target range in 2010 (and little threat of a target breach in 2011), we look for policy normalisation only in 1Q11, although we admit that the SARB may feel compelled to engineer an earlier tightening as other global central banks remove monetary accommodation, or as the currency weakens. Israel had been the first bank to commence the easing cycle and the first to hike. We expect the tightening to continue this year with as much as 150bp, mostly taking place in 1H. The Turkish central bank seems comfortable with the inflation outlook, but we differ. We expect rates to be kept on hold during the first half but anticipate a total hike of 150bp in 2H.

Political Outlook: Active in Ukraine and Central Europe and Stable in the Rest

The primary short-term political risk in the region is clearly Ukraine's imminent second round presidential election, possibly to be followed by early parliamentary elections around May.  We think that a victory for Victor Yanukovich is probable.  We expect a challenge to any result, but aimed primarily at making room for political negotiation and not backed up by serious popular unrest.  Most feasible outcomes will be an improvement in the current political arrangement, but possible parliamentary elections would risk diverting political attention from a serious fiscal position and from IMF negotiations until mid-year.

The political agenda is quite full in Central Europe, with elections scheduled in Poland, Hungary and the Czech Republic. In Poland, the presidential elections will take place in October 2010, when PM Tusk is expected to run for president, with polls already placing him well ahead.  The parliamentary elections are scheduled to take place in 2011, which suggests that expecting an ambitious fiscal consolidation in the near term would be too optimistic. In Hungary, the parliamentary elections are scheduled for April 2010. The centre-right Fidesz is likely to triumph and oust the Socialists. A large majority at the parliament would clearly be very good for governance, but at this juncture little is known about Fidesz's plans. Turning to the Czech Republic, we see parliamentary elections scheduled for May 2010 as an opportunity to resolve the current impasse. However, the polls are still close, it remains difficult to predict the winner and we cannot rule out another hung parliament. Romania may be the only country in CE that does not have elections in 2010. Prime Minister Boc recently received a confidence vote in the parliament, but the current majority is shaky and relies on the support of independents.

In South Africa, with no near-term elections in sight and the initial uncertainty surrounding the presidential elections having been left behind, political risk in South Africa has dissipated somewhat.  However, the Left continues to make noises about changing the SARB's inflation mandate to include growth and unemployment, and forcing the SARB to change its hands-off approach to currency management.  These noises are likely to remain in 2010, but unlikely to result in significant policy shifts, in our opinion.  

We do not expect any significant domestic political noise in Russia, the UAE or Israel in 2010. In Turkey, we expect the political scene to get gradually active towards the end of the year ahead of the general elections scheduled for summer 2011. While there are slight noises surrounding a possibility of early general elections, we dismiss the possibility almost in full.

UK
Exit Strategies: Unwinding the Unprecedented
January 18, 2010

By Charles Goodhart & Melanie Baker, CFA | London

Summary and Conclusions

Market rates and official policy rates can rise before QE is fully unwound (reversed), although this will likely meet with some resistance among central bankers in some quarters.  There are good reasons why a central bank might want to raise interest rates before fully reversing QE, or even starting to reverse QE, and the two tools can be operated independently.  However, we think it likely that QE will start to be reversed as policy rates rise.  Beyond concern for inflation, other factors may affect the QE decision (and more strongly than the interest rate decision), including lending/deposit growth and the state of debt markets.  QE will be harder to reverse in the UK than in the US (or euro area), in our opinion.  Fortunately, there's no hurry.  We would not expect any significant moves to unravel the existing stock of QE in the UK until the overall strategy (fiscal and monetary) of future economic plans can be discussed with the incoming government after the next election.  On the fiscal front, we still think that more needs to be done than is in the existing government's plans.

Monetary Policy Exit: No Hurry to Unwind QE

One view - QE needs to be unwound before market (short) rates can rise: QE was not begun by most central banks until official interest rates came close to the zero lower bound.  So, the assumption is often made that the effects of QE on the balance sheet of the central bank will need to be unwound before official interest rates can start to be raised again.  Indeed, this would be so if the marginal interest rate that the central bank offered on commercial bank deposits it holds were to be kept at zero. This is because, so long as such deposits remained much in excess of minimum reserve requirements, very short-term market interest rates could not then rise much, if at all, above zero.  So, the central bank would have no way of making its official rate effective; it would just be ‘beating on air', and central officials would not like that.

Our view - the corridor system means that interest rates can rise without unwinding QE... Almost every central bank has now shifted to a ‘corridor' system.  Commercial banks can get all their deposits at the central bank remunerated at a rate lower than (often by 0.5 or 1%) the official rate, but related to that rate.  There is nothing to stop central banks raising the whole corridor (consisting of discount, (upper bound); official; deposit (lower bound) rates) together while leaving the stock of QE in place.  Of course, the very short-term market rate would then hover close to the bottom of the corridor, rather than fluctuate around the official rate. 

... but this will likely meet with some central bank resistance: The technicians at the money market desks at central banks would likely not be in favour of this approach, since it is their métier to use open market operations (OMO) to keep the overnight market rate closely in line with the official rate.  Since that is in their ‘DNA', a mechanism for raising interest rates by ‘fiat', with market rates propped up by the central bank deposit rate without any need for their skills of calibrating OMO, would likely be most unwelcome.  So, there is likely to be a sizeable constituency within each central bank advocating that the effects of QE on central bank balance sheets be entirely reversed before an increase in nominal interest rates from their present rock-bottom levels should be contemplated.

The UK's ‘special case' - corridor system temporarily suspended: In the case of the Bank of England, all reserves held by commercial banks at the central bank are being remunerated at the policy rate (currently 0.5%).  In the UK's case, the corridor is simply currently very narrow (to be effectively non-existent).  Since reserves are fully remunerated, commercial banks are not using the deposit facility and the market overnight rate trades close to the policy rate (slightly below it, given that not all commercial banks and building societies operating in the UK have access to Bank of England deposit facilities).  However, the same considerations apply - there will likely be some resistance to raising rates before unwinding QE, but with or without a re-instigation of the corridor system, this is still possible.

So, while there is some slight presumption that QE would be reversed in the UK before interest rates are raised, there is absolutely no need for that to be so. 

Central banks may not want to use both tools (QE reversal and rate increases) simultaneously:  There are many possible scenarios in which different monetary policy committees could feel a need to raise interest rates before reversing QE.  Interest rates are a much more effective weapon (than QE) for controlling inflation or stemming an exchange rate collapse.  That would be much more the case at a time when a precipitate withdrawal of the stock of QE might seem inappropriate, for example in view of the condition of bank portfolios or of debt market sentiment.

QE and interest rates can operate independently: The two instruments (interest rates and QE) can, and at times should, be operated independently.  We believe that central banks will continue to vary interest rates with the aim of keeping the forecast/expected rate of inflation close to target (subject to the zero lower bound), irrespective of the coincidental stock of QE.  This means that in the UK, we can forecast interest rates separately from our forecast of QE.  Our forecast of Bank of England interest rates depends sensitively on the political and fiscal outcomes next spring/summer.  The tougher (weaker) the fiscal measures, the later (sooner) will interest rates have to be raised.

Where does that leave QE in the UK? As stated in our earlier note of November 23 (Quantitative Easing: Necessary, Successful and Ready to Wind Down), we believe that the flow increase in QE should, and will, be paused in February.  But we purposefully refrained then from speculating on the timing of withdrawals of future flows/stocks of QE.  Our central case is that QE starts to be withdrawn at the same time that policy interest rates are raised:

•           Need policy consistency: Clearly, it would not make much sense to have QE and interest rates varying in opposite directions. 

•           Post-February QE could be restarted: At one limit, should fiscal retrenchment and/or other adverse ‘headwinds' be forecast to presage a W-shaped second leg to the recession, say at end-2010 or 2011, one could even envisage restarting a programme of positive QE. 

•           But lowering inflation is likely to be consistent with higher rates and less liquidity: Under conditions in which an increase in interest rates was being considered and/or decided, one would expect some simultaneous reduction in the stock of QE.

Beyond concern for inflation - factors affecting QE reversal decisions: Several factors, besides concern for inflation, are likely to influence decisions on (reversing the stock of) QE.  In our view, these extra factors relate to the concurrent behaviour of banks and the state of (government) debt markets:

•           Lending and deposit growth: The faster the rate of growth of the monetary aggregates, both credit expansion and deposits, the quicker should QE be withdrawn.  With monetary expansion remaining so sluggish, there is no need for speed on this account, rather the reverse.

•           Level of concern about debt markets:  Next, there may be concern about the effects of central bank debt sales on financial markets.  In the US, those private sector credit markets that the Fed has been supporting may still be fragile.  In most countries, public sector deficits remain so large that there is concern about adding further to the supply of government debt instruments.  At a time when there is likely to be international agreement that banks should hold more liquid assets, a straight swap of central bank deposits into short-dated debt would seem a fairly obvious step.  Since a sale of public sector debt by the central bank is the same, for all practical purposes, as a sale by the Treasury (DMO in the UK), it would be necessary to coordinate between the central bank and the treasury.

The effects of QE can be reversed without exactly reversing QE: Central banks do not have to sell the assets purchased in the process of extending QE in order to reverse the effects on their balance sheets.  In the short run they can use reverse repos, and the Fed has already had some experimental dummy-runs of this mechanism, but there would seem to be limits to the scale of this operation, and to the tenor of the repo.  Beyond this, should a central bank not want to resell its existing holdings into the market, perhaps because the market for such particular assets is saturated, it can, in principle, issue its own liabilities (central bank bills and bonds) at some other maturity and terms.  The Peoples Bank of China did just this when it wanted to sterilise foreign currency inflows and had run out of holdings of government debt.  In the US, however, concern about the constitutional position of the Fed might prevent such a step, i.e., the view that such issuance by the Fed would be a quasi-fiscal measure (infringing on both the powers of Congress and the independence of the Fed).  Elsewhere (including in the UK) such constitutional concerns are less in evidence.

QE harder to reverse in the UK... In this case, reversal means a flow decline in the Bank of England's holdings of gilts, beyond those that reverse naturally on maturity.  Securities that will mature in the near term form a relatively small proportion of assets purchased outright by the Bank of England, but many more by the Fed.  In the Eurozone's case, its long-term refi operations will roll off over the coming 12 months.  In both the Fed and ECB cases, this will make the running-down of QE somewhat easier to manage than in the UK. 

...but there's no hurry to reverse QE in the UK: Apart perhaps from a negotiated swap of central bank reserves for gilts, we see at this stage no great hurry (having presumably paused QE in February) to start reversing it.  Beyond such declines as occur naturally on maturity, concern about adding to already greatly inflated debt issuance makes us think that the Bank of England will wait for a time to observe the effect on debt markets of pausing positive QE purchases before moving in the opposite direction to reduce the stock of QE.  In particular, if QE is paused in February in the UK, we would not expect any significant moves to unravel the existing stock until the overall strategy, fiscal and monetary, of future economic plans can be discussed with the incoming government after the next election.

Fiscal Policy ‘Exit': More Tightening and Faster

The existing government forecasts (December's Pre-Budget 2009) already embody a significant fiscal tightening.  However, the deficit on these forecasts will still be at 4.4% of GDP by 2014-15 and public sector debt, as a percentage of GDP, does not start declining until 2015-16 (from a level of around 80% of GDP, depending how you measure it). Such high debt levels would leave the UK vulnerable to being unable to boost fiscal spending significantly should another crisis hit. The government might also want to build in more ‘room' in case a large proportion of the contingent liabilities built up over the financial crisis materialise. The GDP growth forecasts used in the Treasury's profile continue to look on the optimistic side to us. 

The relatively high primary deficit (i.e., the bit of the deficit that is not related to interest repayments) also leaves the UK too close to a ‘knife-edge' equilibrium, in our view.  Debt dynamics are worsening when the nominal interest rate paid on government debt exceeds the nominal growth rate - that implies an increasing government debt to GDP ratio unless continually running a primary budget surplus.  By knife-edge equilibrium, we mean that if investors fear that the longer-term nominal growth rate will be below the average interest rate on debt - i.e., they start to worry that debt dynamics are unstable - then investors will demand higher yields in return for buying and holding government debt.  That itself will push up the average interest rate paid on government debt (and may directly lower GDP growth), forming something of a self-fulfilling prophecy.  However, if investors are, or become, confident in the ability and willingness of the government to control its deficit, the interest rate on government debt demanded by investors may fall and again be self-reinforcing.

What needs to be done: We think the government should aim to reduce indebtedness (specifically the public sector net debt/GDP ratio) faster. 

Starting point - existing government forecasts:  Existing Treasury forecasts already show a significant fiscal tightening.  On its estimates, the cyclically adjusted deficit will decline from a peak of 9.0% in 2009-10 to 3.1% by 2014-15.  However, most of the announced measures only kick in after 2010-11.  The unwillingness of the government to take measures, such as the proposed cap in public sector pay settlements any earlier, has led to some scepticism about whether the existing or the next government (no matter which party wins the election) would actually carry through with them at this later date.  Moreover, on the government's existing forecasts, debt dynamics appear to remain adverse until 2012-13. 

Moreover, that forecast incorporates sharp cuts in net investment such that overall spending in real terms is set to be flat on average over the coming few years.  Net investment is set to decline to 1.25% of GDP on the government's forecasts by 2013-14.  We are concerned about the dangers of cutting net investment significantly to help achieve a fiscal tightening (since this could damage overall productivity); however, that level of investment would be in line with the average since 1980 (as a percent of GDP).

Tax increases are already planned in the shape of increases in national insurance contributions in 2011-12, and the main stimulus measure, the VAT tax cut in December 2008, has just been reversed.  There will be cost saving measures, including a 1% cap on public sector wage settlements in 2011-12 and 2012-13.  However, as pointed out above, these measures are still forecast to leave the UK with a sizeable deficit after a five-year period, and to leave the level of public sector net debt at a high level relative to GDP for a prolonged period.

An optimal level of debt - lower a bit sooner: The government's old net debt ‘limit' was 40% of GDP.  We note that research by the IMF suggests that fiscal stimulus undertaken during recession tends to be more effective in economies with low levels of public debt, and the debt-to-GDP level where the marginal impact becomes negative is 60% of GDP - although it notes high uncertainty in the estimates of the threshold debt levels.  Since Budget 2009, political consensus seems to have firmed around the idea of further planned fiscal tightening (largely using spending cuts rather than tax increases). Rating agencies have also said that they would like to see additional fiscal tightening to avoid putting the UK's credit rating under threat.

Importance of the structural deficit: Some of the increase in the deficit since the start of the financial crisis will naturally be unwound as the economy improves.  Tax receipts will rise and expenditure on, for example, jobless benefits should fall.  In order, therefore, to know how much to actively raise taxes or cut spending, it is important to work out what the cyclical element of the deficit is and what the structural element is. 

Unfortunately, it's not an easy thing to work out what's structural and what's not (for example, it depends on what you think has happened to potential output and whether you think certain parts of the tax base are unlikely to return as much revenue when the economy does recover).  There appears to be a significant amount of disagreement on the size of the structural deficit: 9% is the Treasury's estimate of the non-cyclical deficit for 2009/10 (as a percentage of GDP), 6% is NIESR's estimate of the structural deficit and 11.4% is the EU Commission's estimate for 2010 (though this is for the ‘Treaty' definition of the general government balance rather than the Treasury's public sector net borrowing definition).  Given the Treasury's assumptions on the size of the structural deficit and the evolution of the economy, the Treasury's estimates are that this structural deficit will fall to 3.1% by 2014-15, given the planned path for fiscal policy.  If the Treasury's assumptions are too conservative (i.e., if it has apportioned too much of the recent increase in the deficit to an increase in the structural deficit), then the deficit could decline faster without further policy changes.

How to reduce the structural deficit: Say the government wanted to get the structural deficit down close to zero and over a faster timeframe; what path of spending could generate an additional 4% of GDP reduction in the deficit by 2013-14 (where 4% of 2008 GDP, for example, is £58 billion)? 

In terms of a nominal spending path, it matters which areas of spending are effectively ring-fenced.  Debt service payments will of course also need to be made.  NIESR, for example, estimates that a reduction in the volume of government consumption culminating to 10% of the baseline level, involving shedding public sector jobs to the tune of around 30,000 a quarter for five years, would only get you halfway to a 4% deficit reduction.

If, by contrast, you wanted to focus this 4% correction over the three fiscal years 2011-12 to 2013-14 to avoid cutting spending too early into what will likely be a fragile recovery, we estimate that nominal departmental current spending (so excluding debt service and social security benefits for example) would then have to fall about 3.5% in each of those three years on our own forecasts (which admittedly assumes a weaker GDP profile than assumed by the Treasury).  That would be very painful, coming on top of the big cuts in investment spending that are already planned.  However, it seems likely that if such a rapid deficit reduction were planned, it wouldn't all be implemented through current departmental spending.

Whichever government emerges post-election, it will inevitably face some tough decisions.  By the time we get to the end of 2010, we think we will likely be looking at an outlook for significantly more fiscal tightening than on the current government plans.

Getting the timing right...and silver linings: We would expect significant fiscal tightening to begin in earnest in 2011.  There are several reasons why it makes sense to us not to wait any longer than that:

•           The recovery should be on a slightly steadier footing: The economy should be showing significant self-sustaining growth momentum, particularly because trade-weighted sterling is likely to remain at levels that are weak relative to pre-crisis years, on our currency team's view.  Assuming significant fiscal tightening, monetary policy would then also likely remain very loose.  This should help the economy through a period of fiscal adjustment. 

•           Political momentum and a sense of crisis: If the next government is elected on a platform of further fiscal tightening, it would make political sense to push forward with ‘difficult decisions' before the standard ‘mid-term blues' kick in and politically tough decisions become arguably more difficult.  In a coalition government with a platform of additional fiscal tightening there would always be the risk of defection of a junior coalition partner.  A tough negotiation process would likely ensue and an agreed fiscal platform would likely take additional time to emerge.  Nevertheless, that could still result in significant fiscal tightening in 2011.

•           A good time to take difficult longer-run decisions: Aging will be a significant problem for the UK and many other economies.  The IMF has estimated that in terms of its impact on fiscal projections, for advanced G20 economies, aging has ten times the impact of the financial crisis.  In the UK, the dependency ratio looks set to increase markedly and the costs of aging rise significantly over coming years.  If, as part of a fiscal tightening, the new government pushes back the state retirement age even further than already planned or tackle public sector pension benefits for example, the UK could paradoxically come to look reasonably well placed compared to its peers on the long-run fiscal sustainability front.

•           Fiscal tightening doesn't have to be negative for growth: We also note that there is a strong case for suggesting that, at least in the medium term, a significant fiscal tightening (especially if focused on reducing public sector expenditures) could be positive for GDP growth.  It is not clear how ‘Ricardian' UK households are at present, but there is presumably a point at which the public start to worry about the fiscal outlook such that a fiscal tightening (especially largely through spending rather than tax increases) could encourage private sector spending (implying less need to save to pay for future tax rises).  Moreover, public expenditure as a percentage of GDP is at its highest levels since the early 1980s.  Of course, this ratio will decline as the economy recovers and leads to lower spending on ‘automatic stabilisers' such as jobless benefits.  Nevertheless, there may be some productivity gains from moving more activities into the private sector.  Measured public sector productivity (admittedly difficult to measure) has been lower than private sector productivity. 

Case studies: We look briefly at two episodes of fiscal tightening: the UK in the early 1980s and Canada in the 1990s:

•           UK in the early 1980s: In 1981, the Thatcher government instigated a particularly controversial Budget.  The UK was mired in recession (GDP contracted 2.1% in 1980 and 1.32% in 1981).  Inflation had declined from its recent peak but was still at 12.6%Y on the RPI measure by March 1981.  Monetary policy was tight.  The unemployment rate was 9% and climbing.  The Thatcher administration announced tax rises and planned cuts in spending (including a one-off tax on banks).  Despite the fiscal tightening, GDP growth turned positive in 1982 and remained so until the 1990s recession.  Unemployment, however, rose rather sharply and remained stubbornly above 11% until 1987.  While this action helped inflation to decline significantly (one of the main aims), the deficit did not decline sustainably as a percentage of GDP until the mid-1980s. 

•           Canada in the 1990s: There were several attempts at tax increases and expenditure restraint in the early 1990s budgets.  Under a new government in 1994, the government established a government spending programme review and no area of spending was protected.  There were firm fiscal targets, but spending cuts were not arbitrary.  Six tests were put in place for spending programmes, compelling all departments to subject all programmes and activities to scrutiny.  The focus of fiscal tightening was very much on spending cuts.  The deficit shrank sharply over the next few years.  From 1997 onwards, the economy experienced several years of strong growth.  Note that this consolidation took place against a backdrop of an economy that had emerged from recession in the early 1990s and actually saw relatively strong growth in 1994.  Growth slowed significantly in 1995 and 1996 (although remained positive).  The fiscal consolidation was characterised by a strong political will and transparency, and monetary policy was broadly supportive (the policy rate was cut significantly between late 1995 and 1997).

In both these cases, monetary policy was able to offset some of the tightening impact of fiscal policy on domestic demand.  In the UK's case, a heavily front-loaded fiscal tightening could mean the Bank of England delaying rate rises until 2012.

Political Complications

2010 is an election year and fiscal proposals (albeit in broad rather than detailed terms) look set to be a major feature of election campaigning.  At this stage, it appears that the main opposition party, the Conservatives, is advocating a more front-loaded programme of fiscal tightening than the incumbent Labour party.  The election is likely in May, but could come any time before the first week of June.  The leader of the opposition Conservatives, David Cameron, has said that he would hold an emergency budget within 50 days of the election.  On top of this, any coalition government would presumably take some time to form a detailed fiscal programme.  This means we may not have a clear view on the fiscal outlook until the election, and possibly until well after the election, particularly if there is a change in government.

To increase the levels of fiscal uncertainty, there is a good probability of a hung parliament at the next election, according to some of the polls.  The initial market reaction to such news would likely be negative and this would likely mean a more protracted negotiation on a fiscal platform and a period where proposals for tightening could ultimately be watered down (whether the new government acted as a minority government or in tandem with another party).  That is particularly the case since any very significant fiscal tightening measures could well prove pretty unpopular publically (absent a sense of fiscal crisis at least).  Furthermore, Westminster does not have a recent history of hung parliaments (the last being 1974) and its style of politics is more adversarial than consensual.

However, we would guard against being implacably downbeat in the event of a hung parliament.  Other countries manage to get things done despite such a set-up.  It is plausible that a strong coalition in favour of significant further fiscal tightening emerges and this satisfies markets (and ratings agencies).