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Mexico
More than Just Cyclical June 16, 2010 By Luis Arcentales | New York While Mexico's economy has been in the midst of a strong external-led cyclical rebound, there are signs that a more positive story may be taking place with Mexico's export-focused industrial sector. If sustained, these favorable trends in industry may suggest a stronger long-term story with bullish implications for the economy and the currency as well. Mexico's economic recovery so far has been in great part driven by the strong bounce in industrial output and exports, reflecting the improvement in global and particularly US demand. By most metrics, the ongoing V-shaped industrial rebound has been quite impressive: in April of this year industrial exports topped their previous peak of July 2008, manufacturers added new jobs in the first five months of the year at a sequential pace in excess of 10% annualized and manufacturing output has expanded at a 16% annualized clip since bottoming last June. Meanwhile, leading indicators suggest that the industrial expansion has further room to go: confidence among Mexico's captains of industry is well above pre-crisis levels, the manufacturing diffusion index from IMEF has been in expansionary territory since August while the ISM new export orders' index has remained over 60 since March - the highest levels since 1988. Unlike the rebound from the 2001 recession, the good news today is that Mexico's export-linked manufacturers seem to be benefiting disproportionately from the upturn in the US economy, where they shipped over 80% of exports in the past year. Since late 2008, Mexico's share in the US imports market has been on a steady, sharp uptrend, gaining nearly 2 full percentage points to over 12%; indeed, by early 2010 Mexico's market share matched historically high levels reached earlier in the decade. This is no small development: absent the significant share gains since 2008, Mexico's industrial exports would be some 16% lower than current levels. Rather than just one-off factors, the good news is that Mexico's share gains in the US imports market may reflect a healthier, more flexible Mexican manufacturing sector. This may come as a surprise given the limited progress Mexico has achieved on the structural reform agenda; however, there are several positive factors that, in our view, suggest that there may be more than just cyclical forces at work. First, Mexico's recent share gains have not been just a consequence of swings in oil prices or exports from the auto sector. Second, unlike the experience that followed the 2001 recession when industrial jobs never recovered, this time around Mexico's captains of industry have been quick to slash payrolls, only to resume hiring at the first signs of a pickup in demand. Last, manufacturers have been able to keep labor costs in check, in some cases closing the labor-cost gap with some of the country's chief competitors. The jury is still out on whether the recent share gains are sustainable. Mexico is riddled with countless rigidities at the micro level, security concerns may hamper further investment and Mexico still has more work to do on the reform agenda. However, at the very least the recent trend should ease lingering fears about the eventual demise of Mexico's manufacturing base due to competition from abroad, particularly from China. More than Just Autos Far from just a reflection of gains in the auto sector and oil prices, Mexico's share gains in the US market have been more broadly based. Mexico's share bottomed most recently in August 2008 at 10.1% of the US imports' market and by April of this year it had gained a little over 2 full percentage points, according to our seasonally adjusted calculations. If we strip petroleum goods from the mix, the picture is very similar: since July 2008, the share of industrial goods has risen by 2.3 percentage points to 12.1% in April, just shy of the high of December 2001 (12.3%). The same result holds if we exclude vehicles and parts, which represent Mexico's single most important industrial sector: the share of non-auto industrial goods is hovering near 10.0%, up from just 8.2% in November 2008. Over the past year, Mexico has enjoyed share gains in sectors ranging from apparel to computers, engines, generators and, of course, cars and auto parts. With Mexico shipping over 80% of its exports to the US, this strong external-led dynamic has left a meaningful impact on exports: in April of this year auto sector exports were at historically high levels, whereas non-auto industrial exports were just 1% shy of their all-time high of July 2008. Had Mexico's market share remained constant at its August 2008 level, we estimate that in the year ending April Mexico's exports would have been nearly US$27 billion lower, the equivalent of 3 percentage points of GDP. Which countries have suffered at Mexico's expense in the US market for imports? The answer is not entirely clear as Mexico's gain has not come exclusively from a single country. For example, the early stages of Mexico's recent share rebound in manufactured goods - between late 2008 and mid-2009 - coincided with massive share gains by China as well; among the US large trading partners for industrial goods, these gains seemed to come in part at the expense of Canada, Germany, Japan and the UK. More recently, whereas Mexico has continued to gain share and Canada has also improved, China has moved down from record-high levels while Germany and the UK have dipped as well. The relatively real weakness in the exchange rate may have played a role, but we would warn about overplaying this factor. For example, the real exchange rate weakened between late 2001 and 2004 by a meaningful amount but Mexico experienced steady share losses in the US market. During 2005-07, Mexico made modest share gains even thought the real exchange rate was stable. Since its lows in 1Q09, the real effective exchange rate has soared by nearly 20%, according to our calculations, and currently is within 10% of its long-term average. Despite the currency swings, Mexico has enjoyed steady share gains. Not Standing Still An important, positive feature of the ongoing industrial revival is that it has coincided with employment gains in the sector. Today's episode stands in sharp contrast with the recovery that followed the recession in 2001, which was largely jobless. After shedding some 15% of all formal jobs between December 2007 and July 2009, industry has hired new workers in every month since last August. By 4Q09, industry was adding workers at a 7.8% annualized sequential pace, accelerating to over 10% annualized in the January-May 2010 period. Though the series are somewhat bumpy, industry began adding temporary workers as early as July, coinciding with the first pick-up in production. By contrast, the industrial upturn from the 2001 recession was essentially jobless: between mid-2003 - when industry finally bottomed out - and the end of 2007, industrial output rose 16% and manufacturing exports rose over 60%; however, employment was stagnant. The ongoing pick-up in industrial hiring may signal a more flexible industrial complex in Mexico, which adapted quickly to the deterioration in global demand and particularly US manufacturing conditions. In the current cycle - in contrast to the previous recession - employment levels adjusted aggressively and almost in tandem as demand dried up, as well as rebounding with the first signs of a pick-up in exports and output. Indeed, whereas industrial confidence peaked in December 2000 when manufacturing was already turning lower, in the current cycle confidence rolled over at the start of 2007, nearly a year before the actual slump in manufacturing output actually began. Since the 2001 recession, Mexico's industrial sector seems to have undergone a meaningful adjustment, which may have put it on more solid ground to benefit from the ongoing improvement in external demand. Two examples are the textile and auto sectors. Back in 2000, the Mexican textile industry exported some US$12 billion and accounted for nearly 13% of all industrial jobs. Facing fierce competition from abroad, by 2008 this labor-intensive sector had shed over 40% of all jobs - nearly three times the pace of the rest of industry - as exports plunged by over a third over the same period. Interestingly, since late 2007 textile exports have remained more or less stable and, by April of this year, textile exports had recovered essentially all the ground they lost in the recession. The auto sector, in many respects, represents the flipside of a multi-year slump in textiles, which only recently appears to have subsided. Exports of vehicles and parts have averaged over US$5.0 billion per month so far in 2010 - a historically high level - amounting to 27% of all manufactured exports from Mexico. While part of this comes from a reversal of the massive inventory adjustment of 1H09, it also reflects an important secular trend as production from the Canada and the US has moved south of the border. Indeed, in the first four months of this year Mexican light-vehicle production soared to 2.3 million annualized units even though US sales ran at a modest 11.0 million annualized. The last time Mexico sustained production in excess of 2 million units annualized was between mid-2007 and late 2008, a period when US auto sales averaged 14.5 million annualized units, a third higher than current levels (in the first four months of 2010, the US accounted for 70% of all car exports and 59% of Mexican car output). So far this year, auto exports from Mexico to the US have soared 72.5%, eclipsing all its competitors including Germany (+20.7%), Japan (-2.5%) and Korea (-10.6%), according to auto-sector chamber AMIA. The Cost Factor Another encouraging piece of Mexico's industrial story is how manufacturers have been able to keep labor costs in check. Since 2002, unit labor costs in the manufacturing sector have moved lower, with the exception of a brief period in late 2008 and early 2009 when output collapsed at a much faster pace than manufacturers were able to lay workers off. Since then, however, the move has been fully reversed as, despite industry's rapid rebound in hiring, output has recovered more rapidly. All this against a backdrop of muted wage pressures: real wages in manufacturing have grown just 1.5% on average in the past ten years; moreover, at a time when news of Chinese wage-related labor strife abounds - our China economist Qing Wang thinks recent outsized wage hikes by some manufacturers do not represent a systemic problem - surveys in Mexico still show that there is still ample slack in the market for production personnel. Muted wage pressures in Mexico - which partly reflect sluggish productivity growth - have helped in some cases to close the labor-cost gap with some of the country's chief competitors, including China: according to our estimates based on data from the International Labor Organization, earnings in manufacturing in China last year were around 88% the level of Mexico's compared to just 27% in 2001. Bottom Line Mexico's economy is in the midst of a strong external-led cyclical rebound and there are signs that a more bullish story may be taking place with Mexico's export-led industrial sector. The meaningful share gains by Mexico in the US imports' market of late may reflect, in our view, a healthier, more flexible manufacturing sector. This view may come as a surprise, given the limited progress Mexico has achieved on the structural reform agenda, ranging from changes in labor regulation to competition; however, there are several positive factors, including successful efforts by manufacturers to keep labor costs in check and swift payroll adjustments, which may suggest that there could be more than just cyclical forces at work. If sustained, these favorable trends in industry may suggest a stronger long-term story with positive implications for the country and the currency as well.
Brazil
Going Strong June 16, 2010 By Marcelo Carvalho & Giuliana Pardelli | Sao Paolo Brazil's economy is robust, growing at a Chinese-like pace. Brazil is going strong. But this should not last long. With little slack left in the economy, recent blockbuster growth is too strong for lasting health, in our view. The economy is overheating, and will need to cool down. If the global growth outlook starts to be revised down significantly, and prospects for China and commodity prices darken, then external headwinds should blow against Brazil's expansion. If not, Brazil's monetary policy committee (Copom) should remain in tightening mode for now. Either way, Brazil's growth will need to slow into 2011. Going Strong Brazil's economy is booming. Real GDP growth accelerated to 9.0%Y in 1Q10, from 4.3%Y in 4Q09. The first quarter posted the fastest growth pace since early 1995, when the economy was booming on the heels of the real stabilization plan, launched in mid-1994. While base effects help the annual comparison, sequential growth is clearly very strong. The economy grew by 2.7%Q in 1Q, accelerating from 2.3%Q in 4Q09 - all seasonally adjusted. These numbers are not annualized. At an annualized pace - as headline real GDP growth numbers are presented in the US, for instance - Brazil expanded at a breakneck sequential pace of 11.4% in 1Q. The recent actual quarterly history implies a stronger mathematical boost to the 2010 average growth outlook. Besides strong 1Q data, recent past growth history was revised up as well, entailing a much stronger statistical carry-over for average real GDP growth in 2010. At one extreme, if there were no sequential growth in the remaining three quarters of the year, then average real GDP growth in 2010 would still be a very solid 6.0%. At the other extreme, if strong sequential expansion seen in 1Q were to continue throughout the year, then the 2010 average annual growth would be 10.3%. We think reality will fall between those two extremes. The simple maths pushes our 2010 real GDP forecast to 7.9%, from 6.8% before. This is not a change in view. Instead, it simply marks-to-market the annual figure, taking into account the new actual GDP series, and keeping unchanged our quarterly forecast for the sequential growth path going ahead. Note that our forecast continues to assume sequential growth deceleration in the remainder of the year, after a sharp gain in 1Q. Our 2011 real GDP growth forecast remains unchanged at 4.0%. Domestic demand leads the way, outpacing overall GDP growth. Private sector consumption climbed 9.3%Y, while investment jumped 26.0%Y, the fastest pace on record. Does stronger investment make the expansion more sustainable? Keep in mind that investment is typically very sensitive to the business cycle, undershooting in downturns and overshooting in upswings. Investment plunged in the 2009 recession and is now bouncing back sharply. In all, however, the investment ratio currently still remains relatively low, at 18% of GDP, similar to the levels seen before the global crisis hit in late 2008. There is little spare capacity left in the economy. The recent pace of expansion is well above any reasonable estimate of Brazil's ‘potential' growth. It is no wonder then that measures of ‘slack' in the economy show a tight picture. Indicators of the so-called output gap - that is, the difference between actual growth and the trend - reveal that industry and the overall economy are running above trend. Indicators of capacity utilization in industry look stretched. According to the national industry association (CNI), for instance, capacity utilization jumped to 83.0% in April, seasonally adjusted. That is comparable to pre-crisis peak levels, and exceeds the long-run average of 81.0%. A separate survey from FGV tells a similar story - the latest data show 84.9% in May, above a long-term average of 82.4%. In sum, while there is hope that investment can expand supply over time, any resulting capacity expansion so far has not been able to fully accommodate rising demand pressures. Likewise, labor markets are tight. The unemployment rate has fallen to 7.0% on average during the three months through April, seasonally adjusted. That is the lowest on record, since the start of the (admittedly short) series back in 2001. It is also below central bank estimates of the so-called non-accelerating inflation rate of unemployment (NAIRU). Being a lagging indicator, labor markets look likely to tighten further going ahead. It is no wonder that wage pressures are building, and anecdotes of labor shortages abound. Looking ahead, there are tentative signs of some growth moderation in 2Q - but the economy remains strong. After months of steady sequential expansion, industrial production was down 0.7%M in April. Likewise, partial proxies suggest retail sales will have been sequentially down in April. Still, industrial production during the three months through April is up 18.6% over a year ago, and on average grew at a fast annualized sequential pace of 18.2%. Soft April data should be seen as sign of growth moderation, rather than the start of an outright downturn. After all, partial numbers for May are patchy but suggest sequential recovery from April's monthly decline - all seasonally adjusted. Automobile production fell 7.1%M in April but then recovered 2.9% in May, after a tax break (IPI) on car sales ended in March. Similarly, electricity consumption fell 0.9%M in April but gained 1.2% in May. Likewise, paperboard sales declined 1.4%M in April but bounced back 5.3% in May. Finally, heavy vehicle traffic in toll roads was down 1.0%M in April but up 2.4% in May. Tightening Mode Despite global uncertainties, a red-hot domestic economy keeps the Copom in tightening mode. As widely expected, the central bank hiked rates by 75bp to 10.25% at its June meeting, in unanimous vote, repeating April's initial move. A laconic, boilerplate accompanying statement did not add much, just noting that the Copom is "continuing the process of adjustment in monetary conditions". All eyes now turn to the Copom minutes, to come out on Thursday June 17 - the central bank will have an opportunity to elaborate on its updated thinking about global developments and domestic factors. We expect that global considerations will figure more prominently than before in the minutes, but domestic drivers will likely remain the main focus of the report. Looking ahead, the central bank still has more tightening work to do, in our view. Our forecast continues to see two further consecutive rate hikes this year, of 75bp each (July 21 and September 1), so that the policy rate finishes 2010 at 11.75%, or 300bp higher from its starting point at the beginning of the year. Our scenario contemplates domestic growth deceleration in Brazil, and assumes the global economy avoids a double-dip - see "Global Outlook: Just Say No to the Double-Dip", Global Forecast Snapshots, June 10, 2010. What are the risks for Brazil's rate outlook? Market sentiment on the rate outlook will likely face a tug-of-war between domestic factors and global concerns. We and the market consensus expect Brazil's economy to decelerate going ahead, after a booming 1Q. But if we are wrong, and the economy rekindles instead, then growth reacceleration would likely reignite the policy debate about whether the central bank should tighten more aggressively. In that scenario, observers could start to wonder again if the Copom should speed up its tightening pace, to 100bp. After all, support for domestic demand can be found in expanding employment and wages, rising credit volumes, narrowing bank spreads and longer lending tenors. On the other hand, Brazil would not be immune to deteriorating global conditions, if we start to see significant downward revisions to the global growth outlook. In particular, we believe Brazil remains sensitive to international commodity prices - and hence to developments in China, more so than in Europe (see "Brazil: Global Headwinds?" This Week in Latin America, June 7, 2010). In a worsening global scenario, external headwinds would help cool down Brazil's expansion, and the central bank's tightening would turn less aggressive. In this case, observers could start to wonder if the Copom would slow down its hiking pace, say to 50bp. Our view: a red-hot economy will keep the Copom in tightening mode for now, most likely hiking at a pace of 75bp per meeting. While domestic strength can keep alive the debate about how much tightening is necessary to sufficiently cool down the economy, a significant turn for the worse in the external environment could mean less aggressive tightening in Brazil than otherwise. At the moment, the Copom does not seem to count on a major global slowdown to do the job of cooling down Brazil's overheating economy. In other words, a significant global downturn can change the central bank's thinking - but, until then, the Copom likely keeps hiking rates. Bottom Line Strong recent growth history forces a statistical upgrade to our 2010 average real GDP growth forecast to 7.9% now, from 6.8% before. The maths changes, although our view ahead does not. Brazil's economy is going strong - but this should not last. If the global economy takes a significant downturn, Brazil will not be immune. If not, the central bank will keep hiking rates in order to cool down a red-hot economy.
UK
Better-than-Expected Starting Point: Budget Preview June 16, 2010 By Melanie Baker, CFA & Cath Sleeman | London Summary and Conclusions We assume that after the Budget on June 22 we will be looking at sharp cuts in real government spending over the next few years, and with these cuts more front-loaded than on the previous government's forecasts. This is one of the key reasons why we maintain a below-consensus forecast (by around 1pp) for UK GDP growth of only 1.2% for 2011. We tentatively assume that the Budget will show a decline in the deficit to 2% by 2014-15, requiring an additional £20 billion real government spending cuts or £10 billion additional real spending cuts and £10 billion in tax increases compared to the previous government's plans. The Office for Budget Responsibility (OBR) reported on the outlook for the economy and fiscal finances on ‘existing government policies'. The Budget will be held on June 22, when the OBR will also make a judgment on whether the government has a better than 50% chance of achieving ‘the fiscal mandate' and it will produce updated forecasts. OBR Review: A Better-than-Expected ‘Starting Point' for Deficit Reduction The OBR forecasts effectively give us the ‘starting point' for the government's Budget. This starting point is somewhat better than we'd expected - by the end of the detailed forecast horizon in 2014-15, its central deficit forecast looks very similar to the previous government's (rather than worse as we'd anticipated). With a starting point similar to the previous government's, how much the government will ultimately cut spending and raise taxes by will depend on how fast it wants to reduce the deficit. • Lower GDP forecasts versus previous government, but impact on the deficit is offset by other assumptions and a better ‘starting point': We had thought that the OBR would show lower GDP growth forecasts (which it has) and therefore somewhat higher deficit forecasts by the end of the parliament compared to the previous government. However, with the budget already coming in much better than expected in 2009-10, there were clearly some offsets. It also uses a central case rather than ‘cautious' assumptions for underlying variables including, for example, unemployment. • Lower near-term deficit; but similar deficit versus previous government by 2014-15: In the near term, the 2010-11 deficit is some £8 billion lower (i.e., better) than forecast by the previous government (£155 billion on the OBR forecasts compared to £163 billion in the previous government's Budget 2010 report). In addition, the data today do not incorporate "any measures announced or introduced by the Coalition Government", including the £5.7 billion ‘in year' spending cuts. So the forecast deficit for 2010-11 should be revised lower by another £5.7 billion (i.e., to £149 billion). By the end of the horizon in 2014-15, the numbers published by the OBR look similar to the previous government's (£71 billion and 3.9% of GDP compared to £74 billion and 4% of GDP on the previous government's forecasts). • Still too optimistic on GDP growth? Its GDP growth forecasts still look a little on the high side to us, but its inflation forecasts look a little lower than our own forecasts. Comparing the nominal GDP growth forecasts to ours, the OBR figures look similar to ours until 2012-13 onwards, when they are about 0.4-0.5pp higher than the numbers that we have been using in our own fiscal projections. • But it'll be taking a broader look at fiscal sustainability: The outlook for the longer term may imply the need to take further action on age-related expenditure, for example. 1) The OBR has lowered the trend rate of GDP growth used in its forecasts to 2% from 2014 from 2.25% over the next three years (and 2.75% on the previous government's forecasts) as "demographic changes reduce the growth of the potential labour supply". 2) The OBR will be taking a broad look at fiscal sustainability. "We believe that a comprehensive analysis of fiscal sustainability needs to account for the dimensions and issues discussed so far. To do this, we need a full understanding of public sector liabilities and longer-term fiscal pressures". These liabilities and fiscal pressures include an ageing population, private finance initiative (PFI) contracts, unfunded public service pension liabilities and contingent liabilities. June Budget Preview What we are likely to see: A scenario for deficit reduction The likely outcomes for this Budget are more uncertain than usual. We don't know what deficit the new government will effectively target and by when. We do, however, now know what the starting point for those forecasts will be, represented by the OBR numbers published today. We illustrate our tentative central case Budget projections, and assume that the government aims for a 2% of GDP deficit in 2014-15. To reach that target would require an additional £10 billion of tax rises and £10 billion real discretionary spending cuts compared to the previous government's plans as presented by the OBR (alternatively £20 billion of spending cuts but no net additional tax rises), in our view. What to watch We will be particularly watching: 1) the ‘mandate'; 2) the tax spending mix; and 3) specific tax details: 1. The ‘mandate'/deficit-reduction target. The ‘mandate'/deficit-reduction target will be released in the Budget and is one of the most important unknowns. This will determine how much deficit reduction the coalition government will aim for over the parliament. It will provide the benchmark that the OBR will then judge the government against and be a benchmark for markets against which to judge the success of any fiscal tightening. The Conservative Party first described its idea for an OBR in September 2008, laying out the following mandate: 1. Falling debt as a percentage of GDP 2. A balanced current budget, adjusted for the cycle The mandate could also be in the form of a target for the structural deficit, particularly since the Coalition Agreement includes a more general statement: "to significantly accelerate the reduction of the structural deficit over the course of a Parliament". We can foresee several problems in this case, not least that the structural deficit is itself hard to pin down and prone to revision (see Fiscal Risks: OBR, June 14, 2010, for more details). We have assumed that an accelerated reduction in the structural deficit will translate into a more ‘front-loaded' profile for deficit reduction in the Budget and to a lower forecast deficit than on the previous government's forecasts by 2014-15. The previous government forecast a 4% of GDP deficit by 2014-15. We tentatively assume that the new government will look for something like a 2% deficit. 2. The tax/spending mix. The mix of policies announced for the reduction in the deficit from the 2009-10 levels is important for at least three reasons: 1) Academic analysis suggests that deficit reductions that are dominated by spending cuts rather than tax rises tend to be more successful; 2) The tax/spending mix has an impact on the likely economic consequences of deficit reduction. Academic analysis suggests that the economic effects of tax and spending decisions are different. A rise in direct taxation would also have higher near-term inflation implications than other tax and spending decisions; and 3) The tax/spending mix gives us a better handle on what departmental budgets will look like. Once we can work out the implied real discretionary spending cuts being forecast, that gives us a much better handle on the ‘pain' that will fall on non-protected departmental budgets. 3. Specific tax details. We will be keeping an eye on at least three key elements of the tax programme: changes in capital gains tax; any changes in VAT; and income tax and national insurance contribution changes: • Capital gains tax (CGT): The coalition government plans increases in CGT for non-business assets, but has not provided detail on this. CGT is clearly a point of controversy within the Conservative Party: compromises made in the Budget may be revealing. Changes to CGT may also have implications for our house price forecasts if the incentives to hold buy-to-let property, for example, are strongly affected. In this case, the timing of any CGT change will also be important. • Changes in VAT: Many expect VAT to rise in this budget (from 17.5% to 20%). This is administratively a relatively quick change to make in taxation, but is not without controversy, hitting lower earners harder in the sense that they will tend to spend a higher proportion of their income. Analysis by NIESR also suggests that a 2pp increase in VAT could lower GDP by 0.6% by the second year after the rise. In terms of the impact on inflation, we would expect an increase in VAT to 20% to add around 0.5pp to inflation in the 12 months following the rise. An immediate rise in VAT therefore could see CPI inflation stay above 3% until December 2010 and then above 2%. With inflation outcomes already high in the UK, that could make life more difficult for the Bank of England. It would presumably be inclined to ‘look through' this rise in VAT but, with inflation already well above 2%, a further rise in VAT could increase the perceived risks that household inflation expectations become ‘de-anchored'. • Income tax/national insurance changes: Among other changes, the coalition government planned to increase income tax thresholds and offset some of the planned increase in National Insurance Contributions. However, it is not entirely clear to us how these various tax changes will balance out. We know, for example, that the coalition plans to raise income tax thresholds to £10,000, but we don't know how quickly and from what starting point. This will matter for the impact on household disposable income growth (and therefore potentially on consumer spending growth) in each year. We show some of the specific fiscal-tightening measures and the offsets to these that have been announced and that we will be hoping for more specific detail on in the Budget. How much does the government need to cut? We think that the new government should aim to get the government debt to GDP ratio to fall faster than the previous government projected and to aim for a lower peak. Evidence suggests that at government debt levels beyond 60% GDP, fiscal stimulus becomes ineffective. We replicated a framework presented by our colleague Daniele Antonucci for other economies for the UK. Given the scale of the UK's primary deficit, a reduction in debt/GDP looks implausible in the very near term. ‘How much is enough' is also, to a large degree, dependent on market sentiment. If the new government presents a set of fiscal plans that the market ‘likes', that may give the government scope for a multi-year correction of the deficit (that the economy is more able to handle). If the government presents plans that are perceived as ‘going too slow', a sharp adverse market reaction may follow that then effectively forces the government into taking very sharp front-loaded action on deficit reduction that is additionally painful for the domestic economy. If the new government presents a set of plans that are perceived as ‘going too fast', and the market then seriously questions their feasibility; this would also be negative for markets, adding to the pain for the domestic economy. Unfortunately, it is very difficult to know in advance what the market would consider to be ‘just right' on the fiscal plans. This will in part be a function of the wider financial environment and government communication. What are the economic implications of fiscal tightening? Government spending and investment have boosted GDP significantly over the past few years in a direct, accounting sense. This looks set to change. On our central forecast, government spending contributes negatively to GDP growth from next year. However, the effects of fiscal spending on the economy can clearly be broader than the ‘accounting effects'. There is no consensus in the economic literature on the economic effects of fiscal tightening; on the ‘fiscal multiplier' (or the size of the effect on GDP from a given change in fiscal spending or taxation). Calculation is difficult where some government spending varies systematically with the business cycle (e.g., jobless benefit payments) and where it matters whether people see any spending cuts, for example, as likely to be matched by lower taxation or followed by higher government spending at a later date. The estimated effects of higher taxes and lower spending can also be different. Adjustments in fiscal policy may also, of course, be accompanied by adjustments in monetary policy. In a recent report (Euroland Economics: The Mediterranean Diet: Too Harsh for EMU Health? June 7, 2010), our colleague Daniele Antonucci collated fiscal multipliers for the euro area. Although of the same sign at least, these multipliers were of differing size (e.g., -0.5 to -1.6 for the impact on the level of GDP from a decrease in government spending worth 1ppt of GDP after three years). The academic literature offers no conclusive evidence on the effects of fiscal tightening on GDP in the UK; even the direction of the effect is controversial. We assume that, given some of the evidence above and the multipliers for the euro area, the effect of spending cuts and tax rises will at least be negative for GDP in the near term. Our euro area team assumes a multiplier of -0.7. Given the evidence above, it seems likely that this is smaller for the UK. We are open to the idea that in the medium term the effects may be positive. |
