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Malaysia
Malaysia's New Economic Model: Making the Right Noise April 01, 2010 By Deyi Tan, Chetan Ahya & Shweta Singh | Singapore What's New? PM Najib announced the details for the New Economic Model (NEM) yesterday. This is the first stage of a two-stage process. What was announced yesterday laid out the strategic framework to achieve the three goals of a high-income economy, inclusiveness and sustainability. Specifically, policy measures will be formed based on the eight Strategic Reform Initiatives of: (1) re-energising the private sector to lead growth; (2) developing quality workforce and reducing dependency on foreign labour; (3) creating a competitive domestic economy; (4) strengthening the public sector; (5) putting in place transparent and market-friendly affirmative action; (6) building the knowledge base and infrastructure; (7) enhancing the sources of growth; and (8) ensuring the sustainability of growth. Going forward, a consultation process will follow, after which specific policy measures will be formulated and integrated into the 10th Malaysia Plan (2011-15), which will be announced around mid-year. Heading into the announcement, market expectations for the NEM were likely low as MSCI Malaysia was not outperforming MSCI EM. Meanwhile, market reaction following the announcement was also muted with the market closing flat. We have the following thoughts on what has been announced so far: 1) Taking a Critical Step in a Multi-Step Process: Getting the Problems Right Since PM Najib came into office in April 2009, he has discussed and addressed in fits and starts the various issues faced by the economy. Some of the issues/initiatives laid out in the NEM yesterday were not entirely new. Indeed, some have been addressed by policymakers in the past. Yet, what surprised us was that this was by far the most candid and comprehensive outline by policymakers of the impediments faced by the economy. Tricky issues that were less overtly discussed previously were touched upon in fairly strong language. To quote a few examples, policymakers highlighted the "cumbersome and lengthy bureaucratic procedures", that Malaysia "is losing its attractiveness as an investment destination", and that "private investors have taken a back seat". The report also mentioned that "the human capital situation in Malaysia is reaching a critical stage". Malaysia is not "developing talent" and what it has "is leaving". In addition, policymakers also pointed out that the implementation of ethnic-based economic policies has "increasingly and inadvertently raised the cost of doing business due to rent-seeking, patronage and often opaque government procurement...controlled pricing systems and subsidies result in resource misallocations...The mispricing leads to excessive consumption and wastage". Indeed, such issues are in line with the structural concerns we have been highlighting on Malaysia (see Malaysia Economics: Where Are The Structural Gaps? April 23, 2009). We believe that issues can only be adequately addressed when policymakers meet them head-on. To the extent to which our own expectations have been depressed by the recent policy delays on the retail fuel subsidy reform and the GST implementation, the stronger-than-expected policy tone highlighting the macro shortcomings suggests that the reform agenda has not fallen by the wayside. This would be a positive at the margin, in our view. 2) Execution Is Still the All-Important Key Word Some measures supporting the eight Strategic Reform Initiatives are already in place, such as from the previously announced National Key Result Areas. However, details for further concrete new measures will only be announced subsequently in the second stage. While policymakers appear to us to have gotten their reform bearings right and the latest policy tone suggests the intention for continued efforts on these fronts, we believe that effective implementation remains a crucial step in the pipeline. Given the changes in the political and economic climate, we have been watching out for a potential structural inflexion point since PM Najib's term started. Understandably, reform momentum does not unfold in a straight line, particularly when policies such as affirmative action are deeply entrenched. Some of the measures announced in the past, such as the relaxation of the 30% bumiputra equity requirement ratio, were well-intentioned, while others - such as the switch of language medium for teaching science and maths from English to Bahasa - can be viewed as a step backwards. Yet for the right measures, execution is key. Indeed, the NEM report itself also spoke of the need for "political will and leadership to break the log-jam of resistance by vested interest groups". So far, PM Najib has proven to be a much stronger leader compared to his predecessor in holding the UMNO party together. Still, the PM will need a critical mass of UMNO policymakers to agree to his reform agenda for effective implementation. The fact that a candid assessment report has been pushed out may hint at this somewhat. Having said this, given Malaysia's uneven track record for reform and given the muted market reaction yesterday, we suspect that it may be a case where market participants need to see more tangible and orchestrated change before they believe that a real structural turnaround is coming. 3) The Signpost for Malaysia's Structural Inflexion Point; Balancing Political and Economic Goals The reform agenda will be a multi-year process. With Malaysia's level of GDP per capita, macro strategies need to evolve the economy from low-cost manufacturing towards higher-value-add industries. In our view, the crux to Malaysia's reform agenda and the structural inflexion point lies in the skill-set upgrade (raising the quality of the labour force either via education or via import of foreign talent). We believe that this needs to be addressed first. Without a suitably qualified labour force, other policy initiatives of creating a competitive domestic economy, jump-starting private sector-led growth and enhancing other growth sources would be futile. As we mentioned earlier, the reform agenda has been driven both by political and economic needs. PM Najib will want to implement a minimum threshold of reforms so as to keep the opposition alliance from capturing more ground, or enable the incumbent BN government to regain the two-thirds parliamentary majority. However, with the general elections due by 2013, the 10th Malaysia Plan (2011-15), in which the measures supporting the NEM will be incorporated, would be straddling two parliamentary terms. In terms of timing, we suspect that it may be relatively difficult to implement quickly politically unfriendly measures such as a complete removal of quotas and subsidies, which may alienate voters. We think this may be the reason for the recent delays on the retail fuel subsidy reform and the GST implementation, given the upcoming Sarawak state elections (due by July 2011). On the other hand, education system reforms would be one area that would help address Malaysia's root problem without being politically charged. In this regard, we would watch out for a critical mass on education reforms as an important signpost for Malaysia's structural inflexion point. Bottom Line: Now, Walk the Talk The market's and our expectations for the NEM have been low. However, what surprised us was that the NEM report had by far the most candid and comprehensive outline of impediments faced by the economy. We think that policymakers have properly outlined all the problems. The next step would be effective implementation. We suspect that market participants may want to see more tangible and orchestrated change before believing that a structural turnaround is for real. The fact that general elections are due by 2013 suggests that some measures may be politically difficult to implement. Yet, we think education reforms would be one area that would address the root problem in Malaysia without being politically charged. We would watch out for the extent of change on that front as an important signpost for Malaysia's structural inflexion point.
Japan
Money and Growth in the Reverse Correlation Zone April 01, 2010 By Robert Alan Feldman, Ph.D. | Tokyo Introduction The lower bound on nominal interest rates has been a crucial problem for Japan. As prices decline, the real interest rate has risen, choking off investment, worsening growth and worsening deflation even more. For Japan to return to stable, self-reinforcing growth, it is essential to break the vicious circle of lower prices, higher real rates, lower investment, yet higher output gaps, yet lower prices, etc. Breaking the cycle is far from impossible. Indeed, Japan's own economic history of the last 20 years suggests the very actions that are needed. Policymakers need only recognize and repeat what went right under BoJ Governors Hayami and Fukui, and replicate it. Should they do so, equity markets would likely rise. Moreover, a sustainable fiscal position would be closer, since growth would be more sustainable. The Lower Bound: ZIRP and Bond Yields The starting point of my argument is the lower bound on interest rates and/or bond yields. For policy rates, the lower bound is zero, as shown by the zero interest rate policy (ZIRP) of the Bank of Japan in 2001-06. It is less common to talk about a lower bound for bond yields. Indeed, the 10-year JGB has fallen below 1% during two periods, 1998 and 2003. However, a more bird's eye view of the nominal yields suggests that these movements were panic aberrations. Indeed, since 1999, the long-term yield has remained largely within a band of 1.2-1.8%. It is reasonable to consider 1.2% to be a lower band limit for JGB yields. Inflation, however, can keep falling even after interest rates or bond yields have hit their lower bound. The most recent recession has shown more virulent deflation than the previous bout, in 2000-01. Indeed, in 1Q10, the real bond yield (nominal 10-year JGB yield less the change of the CPI ex food and energy) has been the highest since 4Q96. Japan's own recent history hints at what needs to be done today. Once the BoJ recognized that the rate hike of August 2000 was premature, it reverted to ZIRP, but added an important element, the so-called ‘time axis'. On March 19, 2001, the BoJ announced "New Procedures for Money Market Operations and Monetary Easing", and shifted the target for monetary policy from the overnight call rate to the level of current reserves at the BoJ. In addition, the BoJ stated that "The new procedures for money market operations continue to be in place until the consumer price index (excluding perishables, on a nationwide statistics) registers stably at zero percent or an increase year on year". There was a simultaneous shift to quantitative easing (QE) and use of a time-axis. This initiative was successful. As the reforms of the banking system kicked in, as other structural reforms were adopted, and as growth in China and other trading partners accelerated, the QE/time axis framework kept monetary policy accommodative until the goal of positive inflation was reached. However, the exit from the QE/time axis monetary regime, in March-July 2006, was premature in two ways. First, the trigger for exit, a 0% increase of consumer prices ex-fresh food, was set too low. Second, the time standard for ‘sustainability' was too loose, as shown by the subsequent course of events: The 2000-base CPI began to exceed 0%Y change in November 2005, at 0.1%. The rise accelerated to 0.5% in January data (reported at end-February). The BoJ announced its exit from QE on March 9, 2006, reverting to a target of ZIRP. On March 10, it announced its "understanding of price stability" to be a range of 0-2%, with a central value of 1%, and switched to the overall CPI (including fresh food) as the key indicator. The BoJ then hiked the overnight call rate to 0.25% on July 14, 2006. The CPI change (both overall and ex-fresh food) peaked in August 2006. Given that the CPI began to deteriorate almost immediately after the BoJ shifted back to rate-targeting, the exit from QE was clearly premature. This would not have occurred had the BoJ been using CPI excluding both food and energy: By that measure, deflation in 2006 was still very much in negative territory. Once the QE/time axis regime ended, in March 2006, the BoJ shifted towards an inflation outlook regime, with a 0-2% range, and a center at 1%. This mechanism seemed to commit the BoJ to a loose inflation target. In practice, as seen in the great deflation of 2009, there was no commitment from the BoJ that deviations below the target range would be met with extra monetary measures. The role of discretion increased and, in the end, deflation worsened. At this juncture, therefore, the key element in the debate is whether a different set of monetary operating procedures should trigger new BoJ actions. The government is pushing for an explicit inflation target, with an implication that deviations should be met with more aggressive measures. The effectiveness of any new measures may be gauged in part with reference to the reverse correlation zone model used here: Should a new monetary regime commit the BoJ to new measures until a positive CPI change has clearly been re-achieved, then the measures will likely contribute to a more sustainable recovery. Exiting the Reverse Correlation Zone There are several ways that Japan could return to sustainable growth. Already, progress has been made as a result of economic stimulus packages, both in Japan and elsewhere. The Chinese fiscal package in particular has generated a rise in Japanese exports which is spilling into GDP. Thus, an autonomous force has started the process of lowering real interest rates inside the reverse correlation zone. Japanese fiscal policy, first under the Aso government and now under the Hatoyama government, has acted similarly. The problem is what policies - both in monetary and the real economy - might sustain and enhance these positive factors. Can Monetary Policy Contribute? In the realm of monetary policy, a policy to enhance growth would be to move to a time axis - in terms of the reverse correlation model, this would move the ZIRP point to the right. Such a shift of the ZIRP point would extend the reverse correlation zone to the right, and lengthen the period where GDP increases are accompanied by lower real rates, and hence accelerate GDP. Such a policy is equivalent to repeating the Hayami/Fukui policy of linking the end of ZIRP to a specific value for the inflation rate. In the current case, the value for triggering an end to zero rates would not likely be "sustainably above 0%" as before, but rather "sustainably above 1%" or so. The reason for the higher trigger is simple: A cushion would make a subsequent return to deflation less likely. The policy debate over inflation targeting is spirited. The BoJ remains skeptical, while the government continues to push for such a target. The BoJ set its "understanding" of price stability, in spring of 2006. This "understanding" was clarified in December 2009, to be worded as "In a positive range of 2 percent or lower, and the midpoints of most Policy Board members' "understanding" are around 1 percent". The "understanding" is defined in terms of the overall consumer price index, excluding nothing. In contrast, the government's "New Growth Strategy" of late December 2009 set a target for nominal GDP growth of 3% and for real GDP growth of 2%. Finance Minister Naoto Kan has said explicitly in the Diet that the difference, a 1% rise of the GDP deflator, is an inflation target. On the surface, it appears that the government and the BoJ are in agreement on the figure of 1%. In fact, they are not. This is because the government speaks of the GDP deflator while the BoJ speaks of the CPI. The composition and formulae for the two indices are quite different, with the result that, on average for the last 10 years, the CPI change has exceeded the GDP deflator change by 0.9pp. Even by the BoJ's more conservative definition, however, the current state of prices must be considered deflation - since CPI change has been in negative territory since February 2009. Indeed, excluding fresh food and energy, the CPI change has been continuously negative since September 1998, only five months after the BoJ achieved legal independence - the only exception being Jun-Dec 2008. The issue, therefore, is not whether Japan is suffering deflation, but rather whether changes of the monetary policy regime can do anything about it. This is where the reverse correlation zone model comes in. With a higher ZIRP point (i.e., setting a level of inflation which Japan must exceed before the BoJ exits the zero rate policy), combined with sustained QE, fiscal policy and other stimuli to GDP would have a longer period to work. That is, shifting the ZIRP point rightward would extend the reverse correlation zone, and accelerate and lengthen the recovery. Can Growth Policy Contribute to Exiting the Reverse Correlation Zone? Growth policies can also contribute towards an exit from the reverse correlation zone, from both demand and supply sides. The impact of demand-side policies is simple: Anything that raises GDP while an economy is in the reverse correlation zone will lower the real interest rate, and make the recovery more sustainable. Demand policies from the new government continue to contribute to this process. The impact of supply-side policies - which I define to mean policies that enhance the marginal productivity of capital - is immediate. Successful supply-side policies will shift the marginal productivity line upward, and immediately increase the profitability of investment (as proxied by the gap between the marginal productivity of capital and the real interest rate). This spurs investment and thus raises GDP, which in turn (because the economy is starting in the reverse correlation zone) lowers real rates, and spurs more investment. The question for investors is whether policies of the new government will increase the marginal productivity of capital. So far, the record is mixed. On the positive side, some policies taken to reduce questionable spending will help. There were fierce debates during the Budget Assessment exercise last autumn, particularly over R&D spending. The general result, however, was that the government will invest more wisely. The likely impact is that private sector funds will no longer be mis-invested along with government funds. In contrast, several policies of the new government suggest that marginal productivity of capital may fall. For example: The DPJ's Policy Index states that the government will not require doctors to submit medical bills through a new electronic system, which could potentially open the door to continued worries of fraudulent billing and preventing complete data analysis of where care is most efficiently provided. The DPJ is reversing the crucial parts of postal reform, in particular postponing the sale of equity. Moreover, the DPJ has proposed that the government retain more than one-third of the shares of the Postal Bank and the Postal Life companies, raising questions about political and bureaucratic influence over the allocation of funds and about whether the financial regulatory system can provide a level playing field. The DPJ has proposed a ban on the use of temporary workers in manufacturing. The inevitable reaction has already started: Firms are moving more factories offshore, cutting employment of not only temporary workers but full-time workers as well. This happens because inflexibility of labor reduces the expected marginal productivity of capital. Crucial decisions on productivity policy are yet to be made. The New Growth Strategy of December 2009 was vague on most details of where new demand sources can be discovered and how resources can be mobilized to meet such demands. Thus, it is natural for investors to focus on upcoming decisions by the DPJ on the next phase of growth strategy and fiscal reform. So far, there are few hints as to how these debates will settle. The BoJ, the Government and Game Theory Game theory may have insights on when policy might change. The current debate between the BoJ and the government may be seen as a two-person game. The BoJ has a decision of whether to ease further. The government faces a decision of whether to implement productivity-enhancing structural reforms. The economic consequences of each combination are shown in the cells (see our full report), along with our sense of what the relative payoffs for the players might be. In the upper left, where BoJ eases and the government is aggressive on productivity reforms, deflation ends and growth accelerates. The BoJ gains because it is no longer under threat of a loss of independence, and the government gains a great deal because of the political implications of higher growth and ending deflation. In the lower right, where neither player moves, both the BoJ and the government have very negative payoffs. The off-diagonal cells are very important as well. The upper right cell shows the case where the BoJ eases, but the government fails on productivity policies. In this case, deflation persists and growth is weak. In these circumstances, the government is likely to blame the BoJ, and reduce independence. But the political implications of weak growth are bad for the government. Both lose moderately. The lower left cell shows the case where the BoJ does not ease, but the government succeeds in productivity policies. In this case, deflation moderates and growth rises. The BoJ benefits because the better economy will reduce pressure to lower BoJ independence; the government gains because of the better economic circumstances. With the payoffs, there is an interesting asymmetry: The government has a dominant strategy (i.e., to pursue structural reform), but the BoJ does not. That is, regardless of what the BoJ does, the government is better off in this payoff matrix by implementing the productivity-enhancing policies. For the BoJ, things are different. If the government fails on productivity reform, the BoJ is better off easing. If the government succeeds on productivity reform, the BoJ is better off doing nothing. The BoJ does not have a dominant strategy here. This approach may explain the current impasse between the government and the BoJ. The government is unclear of whether to pursue productivity policies, due to internal political factors. That is, the government is not sure what the payoff matrix really looks like, either economically or politically. With government direction unclear, the BoJ cannot decide what to do. Thus, for the BoJ, the optimal strategy is to wait for the government to decide. The implication of this model is rather interesting: Of course, investors are properly focused on BoJ policy and inflation targeting. Any convincing move by the BoJ towards inflation targeting, especially a revival of the Hayami/Fukui QE/time axis/approach, would extend expectations for a more prolonged, more sustainable recovery. However, the BoJ's actions may be heavily dependent on the government's decision on productivity policy. However, the timeline for government decisions on the latter is still somewhat loose; so less attention to Japan by global investors may well be a rational response to the impasse in the policy game. Conclusion In light of the practical details of policy making, it is fair to conclude that Japan is not likely to exit the reverse correlation zone soon. Even if export growth does pull the economy back into the Normal Zone, once there, the rise of real interest rates or negative shocks could push the economy back to the reverse correlation zone. Over the rest of the year, particularly after the July election, it is prudent for investors to watch carefully whether the BoJ reverts to a time axis with QE, and whether the government adopts policies to raise the marginal productivity of capital. Such a combination could be quite positive for the extent and duration of economic recovery. Should either part of this combination fail to occur, though, the recovery will be shorter and shallower. Please see the full report, Japan Economics: Money and Growth in the Reverse Correlation Zone, March 31, 2010, for more details and the Appendix.
UK
The Only Way Is Up? The Potential for Higher Inflation after a Temporary Reprieve April 01, 2010 By Melanie Baker & Cath Sleeman | London Investment conclusion: Beyond the next two years, we should be worried about high inflation outcomes. While pension fund demand means that UK inflation protection is already demandingly priced relative to the MPC's inflation target, we think that the downside risk of being long protection is limited due to the persistence of this demand. Short-Term Inflation Outlook: A Bumpy Ride Over the Next Two Years Our central case is still that CPI inflation declines significantly over the rest of this year, spends all of 2011 below target, gradually increasing to hit the target in 1Q12. Our economic models, incorporating our below-consensus GDP forecasts, suggest downside risks to our inflation forecasts. With this in mind, we lower our inflation forecasts slightly and push back the date we expect monetary tightening to start into 2011. However, inflation has been surprising on the upside and further inflation shocks seem likely (mostly upside ones). This risks the continued missing of the inflation target and that inflation expectations might become ‘unhinged'. Expect a bumpy road ahead. Recent upside inflation surprises: Despite a substantial margin of spare capacity, CPI inflation has not fallen to the extent that we expected at the end of 2008. Although central Bank of England forecasts (as of November 2008) were actually too high, nevertheless at successive inflation forecasting rounds, 2009 inflation ultimately came in higher than the Bank of England expected too. Lots of shocks: drivers of higher-than-expected inflation: Over 2009, inflation outcomes have been broadly stronger than expected. Monthly inflation has been consistent with meeting the Bank of England's 2% target. Over the last two years, monthly inflation has only been below this line six times (out of 24 outturns). Drivers of higher-than-expected inflation included: • Lagged effects of currency weakness: In 1H09, inflation rose sharply in several components of inflation that have a high import content (particularly clothing/footwear, recreation and culture (includes DVDs and flat-screen TVs for example), communication (includes mobile phone handsets) and furniture/furnishings). • Higher oil prices and VAT: In 2H09, currency effects continued to boost inflation. Higher oil prices led to a big increase in transport inflation and changes in VAT boosted inflation significantly at the turn of the year. Beyond the Next Two Years: The Only Way Is Up? So long as the Bank of England is required to maintain a 2% inflation target, we don't think that investors should be overly concerned about prolonged periods of significantly above 2% CPI inflation. We think that monetary policy works so that, as long as the government of the day sticks with the current monetary policy framework, 2% CPI inflation is a reasonable longer-term assumption. However, we see significant potential for two alternative outcomes here: First, the government of the day decides to raise the inflation target. We don't think that this outcome, by choice, is likely. Second, maintaining the inflation target becomes untenable thanks to any of four pressures. These are: 1) Inflation expectations become unhinged because of missing the inflation target and forecasting errors. 2) Commodity prices cause significant longer-term inflation pressure. 3) The government finds it near impossible to eliminate the structural deficit (and hence inflation expectations rise significantly), potentially because; 4) Demographic trends mean that it is hard for the real economy to grow fast and the tax burden on workers needed to pay for age-related expenditure is politically (and economically) unpalatable. Taxation pressures on worker incomes lead to significant wage pressures. These four sources of inflationary pressure could mean that, with the current monetary policy regime intact, the costs to the real economy of trying to return overall inflation to 2% (likely significantly higher real interest rates and a very weak domestic economy) would ultimately become politically untenable and force a change in the monetary policy framework. We raise our own average forecast for 2011-15 from 2.0% to 2.4% on the back of some of the upside risks analysed in this report (consistent with RPI inflation at about 3.0% before building in any changes in interest rate profile). This reflects some of these inflation pressures coming through, with the Bank of England ultimately steering inflation back to target. However, the longer-term pressures (particularly demography) are likely to play out more strongly beyond this horizon, and it is the period beyond 2014/15 where we are most concerned about a scenario where the inflation target becomes untenable. For further details, see The Only Way Is Up? The Potential for Higher Inflation after a Temporary Reprieve, March 31, 2010.
Global
Debtflation Temptation April 01, 2010 By Spyros Andreopoulos | London We have argued for some time now that there are substantial upside risks to the medium-term inflation trajectory globally. One of the main reasons - but not the only one - is the dire fiscal outlook in developed economies. We think that central banks may generate, allow or acquiesce to higher inflation in order to help overlevered public - but also private - sectors with their debt burdens: debtflation. A rational, forward-looking central bank may decide to generate or live with a controlled amount of higher inflation now, rather than find itself in a more difficult position a few years down the line because of unsustainable debt evolutions. Regular readers will be familiar with the ‘debtflation debate' - see The Global Monetary Analyst: Debtflation, October 21, 2009, The Global Monetary Analyst: The Return of Debtflation? February 10, 2010, and The Global Monetary Analyst: Debating Debtflation, March 3, 2010, for our arguments and US Economics: We Can't Inflate Our Way Out, Richard Berner, February 19, 2010, and The Global Monetary Analyst: Default or Inflate or..., Gerard Minack, February 23, 2010, for pushback from our colleagues. Irrespective of where one stands on this debate, we think that a look at the laundry list of some of the most important factors regarding the temptation to inflate is instructive. The obvious metric is of course the total amount of public debt - the higher, the bigger the incentive to inflate. This is borne out by ample historical and statistical evidence on the link between sovereign fiscal positions and inflation. But there are further factors which determine the incentive to inflate: the average duration/maturity of the debt; the currency denomination of the debt; the share of domestic versus foreign ownership; and the proportion of inflation-proof debt in the total amount of outstanding debt. This is how each of these factors affects the incentive to inflate: • Public debt overhang: The higher the outstanding amount of government debt, the greater the burden of servicing it. Hence, the temptation to inflate increases with the debt. • Maturity of the debt: The longer the maturity of the debt, the easier it is for a government to reduce the real costs of debt service. To take an extreme example, if the maturity of the debt is zero - i.e., the entire stock of debt rolls every period - then it would be impossible to reduce the debt burden if yields respond immediately and fully to higher inflation. Hence, the longer the maturity of the debt, the greater the temptation to inflate. • Currency denomination of the debt: Own currency debt can be inflated away easily. Foreign currency-denominated debt on the other hand cannot be inflated away. Worse, the currency depreciation that will be the likely consequence of higher inflation would make it more difficult to repay foreign currency debt: government tax revenues are in domestic currency, and the domestic currency would be worth less in foreign currency. So, the temptation to inflate increases with the share of debt denominated in domestic currency. • Foreign versus domestic ownership of debt: The ownership of debt determines who will be affected by higher inflation. The higher the foreign ownership, the less will the fall in the real value of government debt affect domestic residents. This matters not least because only domestic residents vote in elections. Note that unlike domestic owners, foreign owners may not necessarily be interested in the real value of government debt since they consume goods in their own country. But they will nonetheless be affected by the inflation-induced depreciation. So, the temptation to inflate increases with the share of foreign ownership of the debt. • Proportion of debt indexed to inflation: By construction, indexed debt cannot be inflated away. Hence, the higher the proportion of debt that is indexed to inflation, the lower the temptation to inflate. To these purely fiscal arguments we add another dimension, private sector indebtedness: • Private sector debt overhang: An overlevered private sector may generate macroeconomic fragility and pose a threat to public balance sheets. Hence, high private debt also increases the incentive to inflate. We have compiled data on these factors at the end of the article for the US, UK, Japan and some euro area sovereigns. We also look at past inflation performance, measured by average and peak inflation rates for the period 1960-2008. These are - admittedly rough - proxies for the attitude towards inflation in the respective societies. How do these countries compare on our metrics? The public debt situation is familiar and requires no elaboration that the euro area as a whole has a similar level of gross debt as the US and the UK - though the average masks the familiar core-periphery divide in sovereign balance sheets. On the private debt front, the standouts for household indebtedness are the US and the UK (as well as euro-zone members Spain and Portugal). Japan has highly levered corporates, both financial and non-financial, while the UK has a highly indebted financial sector. Euro area corporates are more indebted than US corporates. Overall, high levels of debt, to the extent that they indicate macroeconomic fragility and a threat to public sector balance sheets, are a problem everywhere in the G4 economies. Taking into account both public and private sector balance sheets, the temptation to inflate is substantial in all these economies. There is also little to separate the countries in our sample with respect to currency denomination. All have debt that is almost in its entirety denominated in their own currency. In terms of the average maturity of the debt, the UK is a clear outlier at 13.5 years - suggesting a significant temptation to inflate. In the US, on the other hand, the outstanding maturity is the lowest in our sample. However, average maturity of Treasury debt is set to rise quickly to post-war average levels on our US team's forecasts - and possibly beyond, if the historically strong positive correlation between the debt ratio and average maturity is anything to go by. With regards to foreign ownership of debt, the euro area sovereigns have a very high degree of foreign ownership. However, because of cross-euro area holdings, what matters in this context is the share of debt held outside the euro area rather than outside an individual euro area country. Even though we have no hard data to back this up, anecdotal evidence suggests that most of the government debt is held within the euro area - due to the high degree of financial market integration. This would moderate any temptation to inflate, since euro area sovereign debt is mostly held within the euro area. Leaving the euro area aside, the US has the highest proportion of foreign-owned debt (nearly 50%) - a reflection of the dollar's global reserve currency status - and Japan the lowest (around 7%), with the UK somewhere in the middle (28%). Bearing in mind the caveat about the euro area, the US certainly stands out along this dimension of inflation temptation. Finally, the proportion of debt indexed to inflation is low in Japan, the euro-zone and the US but very high in the UK, where inflation-proof debt makes up 20% of total debt. This provides an important counterweight to the debtflation temptation arising from high debt and ultra-long debt maturities. So, which economies stand out with respect to overall inflation temptation? We think the temptation is higher in the US and the UK than in the euro-zone - if the ECB conducts monetary policy for the average - and lowest in Japan. Here's why: From our bird's eye view of the numbers, Japan probably has the worst balance sheet, followed by the UK and the US - assuming that what matters for the euro-zone is the average and not its weakest link(s). On the other hand, Japan's public debt is mostly held domestically and its debt maturity is relatively short. These factors moderate the temptation to inflate arising from high public and private indebtedness. Indeed, the fact that the Japanese economy as a whole is a net foreign creditor to the tune of 50% of its GDP is another indication that much of the leverage of individual sectors is debt held by other domestic sectors - public debt for example being held by households and financial institutions. This means that the temptation to inflate is ultimately very low, despite high leverage. The euro-zone seems to occupy the middle ground in our inverse beauty contest on just about all metrics. Risks to (price) stability for the euro area arise to the extent that the average masks some vulnerable economies. For example, there have been calls recently for the ECB to generate higher inflation because this would help the struggling periphery: expansionary policy would stimulate demand, and regaining competitiveness for the peripherals would require fewer outright nominal wage cuts. The incentive to inflate for the ECB would, in our view, arise to the extent that it perceives higher inflation to be conducive to rebalancing the euro-zone; this would make a hypothetical break-up less likely, thereby preserving the status - or even the very existence - of the Frankfurt institution. We attach a very low probability to this scenario, however, not least because the institutional set-up of the ECB ensures that no particular (group of) countries' interests prevail. How about the US and the UK? We've already noted that both public and private sectors are highly levered. In the US, foreign ownership of public debt is very high, and the share of inflation-proof debt is relatively low (though higher than any of the euro area countries in our sample) - factors favourable to inflation. Debt maturity is short by international standards, but rising quickly towards the US historical average - and possibly beyond, if the historical correlation between debt and maturity is anything to go by. In the UK, debt maturity is very long but the share of inflation-proof debt is elevated. However, the UK has had a much worse inflation performance historically: average and peak inflation rates have been substantially higher than in the US. Overall, while the temptation to inflate in the two countries is higher than in the euro-zone or Japan, it is difficult to distinguish between the two. Of course, our list of factors is far from exhaustive. In particular, it does not capture the ‘soft' aspects of the problem. Reputation is clearly a factor in this context. A reputation for stability - in the central bank context this means achieving low inflation on a sustained basis - takes a long time to build but very little to lose. This speaks against inflation as a course of action for central banks. How about timing - when are we likely to see inflation if the risks were to materialise? Clearly, variations in the pace of cyclical recovery imply a different near-term inflation outlook for different economies. Our US team expects the inflation outlook to start turning towards the middle of the year; in the euro area, inflation will likely remain subdued for a while longer, given the tepid recovery; and Japan will likely remain mired in deflation for some time. Hence, inflation is unlikely to become a near-term worry. Returning to our debtflation framework, incentives also suggest that it is too early for the authorities to generate inflation. Some clients have pushed back - and we agree - that, for practical purposes, the duration of debt is shorter than meets the eye because large current deficits mean large immediate financing needs. From a strict ‘rational debtflation' point of view, the optimal timing for inflation would be when the bulk of borrowing is behind us (and maturities are longer in the US). On our forecasts, deficits will be slow to come down (see Global Forecast Snapshots: What Fiscal Tightening? March 10, 2010). Hence, inflation may still be a good 2-3 years off. But if we are right about output gaps being smaller than commonly appreciated, or if strong EM economies put pressure on commodity prices, then inflation may appear sooner than many think. |
