How Big Is the Fiscal Cliff in 2013?
April 13, 2012
By David Greenlaw
| New York
How Big Is the Fiscal Cliff in 2013?
Under current law, the US economy will experience a fiscal tightening of unprecedented magnitude at the end of this year. The main drivers include the scheduled expiration of the Bush era tax cuts, expiration of the 2010-11 payroll tax cut, expiration of emergency unemployment benefits, a budget sequester tied to the outcome of the failed Super Committee deliberations, other reductions in non-defense discretionary spending attributable to previously enacted budget appropriations legislation, defense spending reductions tied to a scaling back of activities in Iraq/Afghanistan, and the imposition of some new taxes on individuals imposed by the Affordable Care Act that was passed in 2010. While the Bush era tax cuts seem to get most of the attention, there are many changes that lie ahead under current law.
Of course, just about every Washington watcher believes that legislation will eventually be adopted that averts the full impact of the fiscal cliff. However, there is a very high degree of uncertainty regarding both the timetable for action and the specific nature of any tax cut extensions and/or spending cut delays. Indeed, even if the outcome of the November elections were known with certainty, it might still be quite difficult to peg the future course of US fiscal policy. Conceivably, it could be just as difficult to break through the political gridlock after the election as it has proven to be in recent years. Thus, the range of possible outcomes is very wide and a high degree of uncertainty is likely to prevail right up to - and maybe even through - the November election.
For quite some time, we have been using a working assumption that there will be a meaningful tightening of fiscal policy at the end of 2012, and this continues to be the main driver of an expected slowdown in US economic activity in 2013 (for our latest forecast update, see Staying the Course by Greenlaw and Wieseman, March 30, 2012). We have been a bit surprised that consensus forecasts - such as the Blue Chip survey - have consistently shown an acceleration in economic growth in 2013. Perhaps forecasters are assuming that the underlying momentum of the economy will outweigh any fiscal tightening or perhaps they are assuming that political gridlock will fade and far-reaching policy action will be adopted. Or perhaps forecasters have simply not been focusing on the potential fiscal cliff that lies ahead.
To begin, we sense that there is some confusion regarding measurement of the starting point for the debate. Recently, some respected analysts have pegged the magnitude of the potential fiscal tightening that looms in 2013 at 3.5% of GDP (for example, see "The US Cruises Toward a Fiscal Cliff" by Alan Blinder in the Wall Street Journal on March 20, 2012, "The US's Fiscal Time Bomb" by David Wessel in the WSJ on March 29, 2012 and "The Economic Consequences of the Fiscal Cliff" by the Committee for a Responsible Federal Budget,
March 29 2012). However, we believe that the 3.5% figure actually understates the magnitude of the problem. Our analysis suggests that the potential fiscal tightening in calendar year 2013 under current law is closer to 5% of GDP.
To be sure, measurement of changes in fiscal policy is complicated by a number of factors, the most important of which is the need to distinguish between cyclical effects on the budget (or automatic stabilizers) and exogenous factors. In its most simple construct, a cyclical adjustment will account for the fall-off in tax revenue and rise in expenditures for items like unemployment benefits and food stamps when the economy underperforms its long-run potential. There is a long history of research on this subject reflecting attempts by analysts to refine the methodology used to estimate the cyclical adjustments.
The Congressional Budget Office (CBO) recently updated its own estimates of the cyclical component of the federal budget using state-of-the-art methodology and published the figures in Appendix C of the latest Budget and Economic Outlook (January 2012). The CBO's data show a fiscal tightening of 3.6% of potential GDP in FY2013 (in Table C-2, this is the difference between the 2013 and 2012 values in the column labeled "Deficit or Surplus Without Automatic Stabilizers"). Since the CBO figures are based on current law - meaning that they assume expiration of Bush era tax cuts, imposition of the budget sequester, etc. - this may be the source for the recent references to a potential fiscal tightening of about 3.5% of GDP in 2013.
However, there are two problems with such an assessment. First, the estimates in Table C-2 of the CBO report were published in January and thus do not include the full impact of the payroll tax extension and other measures contained in the "Middle Class Tax Relief and Job Creation Act of 2012" that was signed into law in February. Adjusting for this legislation (which adds $88 billion to the budget deficit in FY2012 and $26 billion in FY2013), the estimated fiscal tightening in FY2013 amounts to 4.0% of potential GDP rather than 3.6%. Second, and most importantly, almost all of the looming fiscal tightening takes effect on January 1, 2013. Thus, an estimate based on a fiscal year comparison will understate the magnitude of the change (note that the fiscal year runs from October to September). For example, according to the official arbiter on revenue estimating - the Congressional Joint Committee on Taxation (or JCT) - the payroll tax cut is worth $114 billion in CY2012, and this would go to zero in CY2013 if we assume the tax cut expires. However, on a fiscal year basis, the change between 2012 and 2013 is only about -$91 billion (or $23 billion less than on a CY basis) because the tax cut would still be in effect during Oct-Dec of 2012. So, a fiscal year comparison understates the true magnitude of the change in tax policy that is faced on January 1. The same sort of understatement will be evident for the Bush era tax cuts. Indeed, even the spending sequester tied to Super Committee inaction has an effective date of January 1, 2013, meaning that a fiscal year comparison will lead to an understatement.
Adjusting for this calendar distortion, an estimated fiscal tightening of 4% of GDP on a fiscal year basis is more like 5% on a calendar year basis using a simple extrapolation. And, the calendar year effect seems far more relevant here because that's when almost all of the policy changes kick in. We illustrate estimates of the thrust of fiscal policy on a fiscal year basis in order to be consistent with the manner in which the CBO presents its historical data. The amount of fiscal stimulus or restraint might have been somewhat larger or smaller in any given period on a calendar year basis, but we strongly doubt that the extent of divergence in any given year is anywhere close to that seen in 2013. Also, it's worth noting that despite extension of the payroll tax cut, there is an estimated fiscal tightening of 1% of potential GDP in FY2012.
How does all this translate into a GDP impact? There is a great deal of debate and disagreement among economists on the size of the so-called fiscal multiplier associated with various tax and spending programs. Conventional estimates of the multiplier that is associated with the types of programmatic changes that are slated to occur under current law are probably in the range of 0.5-1.5. Thus, even if we apply an ultraconservative estimate that is at the lower end of the plausible range of multipliers, it seems almost certain that the US would enter into a recession next year assuming a current law scenario (i.e., a fiscal tightening amounting to 5% of GDP in CY2013).
Here is another way to look at the potential economic impact. The closest the US has come to experiencing a fiscal tightening of 5% of GDP in the post-WW II period was in 1969. In that situation, President Johnson and the Congress raised taxes by enacting the Revenue and Expenditure Control Act. The goal was to pay for the Vietnam War and try to curb inflation. The legislation imposed a 10% surcharge on individual income taxes retroactive to April 1, 1968 and on corporate income taxes retroactive to January 1, 1968. These surcharges were to remain in effect for two tax years. Telephone and automobile excise taxes were also increased. Moreover, previously enacted legislation imposed a hike in social security payroll taxes at the beginning of 1969. The CBO estimates that the fiscal tightening in FY1969 amounted to 3.1% of potential GDP (on a calendar year basis, it was probably around 3.75% of GDP). Throughout most of 1968 and into the early part of 1969, real GDP in the US was expanding at about a 5% pace and the unemployment rate was below 4%. But, by the end of 1969, the US economy had entered into a recession. No doubt, a series of Fed rate hikes starting in early 1969 contributed to the deterioration in economic activity, but most economists agree that the tightening on the fiscal side was probably the major factor that tipped the economy into recession.
So, how might the current situation play out? Given the budget shenanigans seen in recent years, there may be a non-zero probability of complete political gridlock leading to an unprecedented fiscal tightening and a recession in 2013. However, it seems more likely that policy-makers will reach agreement to avert some - or even most - of the fiscal tightening that lies ahead under current law. As mentioned earlier, our working assumption is that there will be a ‘meaningful' tightening of fiscal policy at the end of 2013 because it seems extremely unlikely (and perhaps even undesirable) that the fiscal cliff is averted in its entirety. Specifically, we expect an expiration of the payroll tax cut, some rejigged spending cuts and other miscellaneous measures to lead to about a 1.5% of GDP fiscal tightening in CY2013. Using a reasonably conservative estimate for the fiscal multiplier, this would shave about one percentage point from baseline GDP growth next year.
This sort of ballpark estimate seems appropriate, as there are a wide range of possible outcomes on the policy side and a similarly wide range of potential economic implications. Here is one specific example. A number of Washington watchers seem to believe that the tax rate on dividends is likely to rise sharply in 2013 even if most of the Bush era tax cuts are extended. Conceivably, a sharp jump in the tax rate on dividends could incentivize companies to make special one-time payments in late 2012 followed by a pullback in 2013. This could have an important impact on the path of personal income going forward. However, there is nowhere near enough clarity at this point to build something like this into a baseline economic forecast.
Unfortunately, there is no set timetable for legislative action, and many analysts believe that Congress is hopelessly gridlocked until after the election. However, there are some historical parallels that might help to assess the likely timing. For example, in 2010, the lame-duck session kicked off on November 15, and lawmakers took Thanksgiving week off and wrapped things up after passing a number of important measures - including the payroll tax cut and the most recent Bush tax cut extension - just before Christmas. The laundry list of items that Congress may have to grapple with in this year's lame duck session is unusually lengthy. In addition to the Bush tax extension, spending sequester and other items discussed in this note, it's likely that Congress will also need to pass a continuing resolution to fund the government (remember the government shutdown battle in spring 2011) and a debt ceiling hike (remember the debt ceiling scare in summer 2011). Moreover, some analysts expect Congress to take a crack at corporate tax reform during the lame-duck session. These are no easy tasks individually, let alone when they are all added on top of one another. It's conceivable that we will enter 2013 without knowing what tax rates will be for individuals and corporations. Such an outcome would entail significant confusion - and potentially represent an important headwind for both the overall economy and the financial markets.
The economic risks associated with policy uncertainty, as well as the potential for a meaningful tightening on the fiscal side, may be magnified because the Fed's ability to provide some cushion via monetary stimulus seems to be quite limited with the funds rate at the zero bound. Indeed, even if one believes in the effectiveness of unconventional monetary policies, over the last few years we have learned that there are important political and practical constraints involved in the implementation of such action.
Finally, although we are sounding an alarm bell regarding the fiscal cliff that looms for next year, action will eventually need to be taken that is aimed at addressing the unsustainable course of US fiscal policy over the longer run. As Fed Chairman Bernanke has delicately tried to explain during numerous appearances before Congressional committees, the ideal path would involve additional fiscal support over the near term combined with credible steps aimed at addressing the longer-run structural imbalance. We made this same point as last summer's debt ceiling debacle was playing out (see Next Steps, July 28, 2011). Of course, it remains to be seen whether politicians can come to grips with either of these fiscal challenges independently - let alone both together.
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Postal Reform: Return to Sender
April 12, 2012
By Robert Alan Feldman
Postal reform has been reversed: The ruling DPJ, the largest opposition party to the LDP, and the LDP's partner the Komeito have agreed to reverse the Postal Reform laws that were passed in 2006, in the wake of PM Koizumi's landslide victory in the 2005 election. The proposals by the DPJ, the LDP and the Komeito would reverse all the key parts of the Koizumi reform, and would eliminate incentives for efficient operations, both in the short and long run.
Because the three parties have majorities of votes in both houses of the Diet, the passage of the reversal bills is virtually assured. Reaction of the voters and citizens to the postal reform reversal is unclear, especially as the issue has received virtually no attention from the mainstream press.
While the postal reform reversal is not directly related to markets, we think the reversal clearly reaffirms a strong link between vested interests and policy in Japan. Thus, hopes for policy change in other areas, e.g., anti-deflation policy, may suffer.
Postal Reform: Return to Sender
Key changes proposed in the reversal bill of the Postal Reform law are as follows:
(a) The requirement to sell the entire holdings of the Postal Bank and Postal Insurance Company equity by 2017 was struck out, and replaced with a clause that only requires sale "as quickly as possible" in light of management conditions of the two institutions.
(b) The 5-Firms structure (Holding Company, Postal Delivery, Postal Network, Postal Bank, Postal Insurance) was reduced to a 4-Firm structure, through merger of the Delivery and Network companies (now called the "Post Office Corporation") -- which account for the lion's share of the employment and are most closely related to the ‘postal family' of firms.
(c) Post offices are all required to provide banking, insurance and funds transfer services nationwide on an identical basis in all post offices. The government is required to take measures to ensure that this occurs.
(d) Timing for application of the same regulatory rules that are used on private sector institutions to the postal entities will be relaxed.
(e) The role of the Postal Reform Promotion Committee will be to consider the progress of privatization. [This implies no power to govern actions by the entities.]
(f) The Postal Holding Company will own 100% of the shares of the Post Office Corporation.
(g) The purpose of the Post Office Corporation will be "to conduct business that contributes to the promotion of convenience for the residents of the regions, through use of the post offices, postal services, postal bank window and postal life window activities." This may include any activities that increase convenience of regional residents, and other activities that do not infringe on such activities.
(h) The Post Office Corporation must report business line results to the Minister of General Affairs; it must disclose its overall management conditions to the public.
1. The economic structure in the new law could significantly reduce incentives for efficient operations.
(a) There are no clear dates on sale of the equity portions, and thus no deadlines for improvement of business efficiency. Moreover, the Postal Holding Company is required to hold 100% of the Post Office Corporation, and so sales of the latter stock are impossible; only the holding company would be subject to market tests. Thus, a key element of the reform, to subject the postal system to market competition and pressure from investors, has been eliminated. The definition of "as soon as possible" gives bureaucrats and politicians full control on equity sale timing.
(b) Public disclosure of operating efficiency by business line is no longer necessary. Thus, with the most inefficient part of the firm (the network company) now re-merged into a large entity, the incentive for efficient allocation of capital may fall.
(c) The regulatory playing field will favor the postal businesses. This will make the negotiations on the Trans Pacific Partnership even more difficult, in light of US concerns that the regulatory playing field will be unequal.
(d) The Post Office Corporation will be able to expand its business into virtually any area, at will, with only reporting requirement (no approval requirement). This could open the door to inefficient or politically triggered business activity.
(e) The government is required to ensure that the Post Office Corporation can carry out its operations. Thus, the government has written a blank check to cover whatever costs are needed to offset the inefficiencies of operations and keep identical services available.
2. The move solidifies the de facto alliance of the anti-reform factions of the DPJ and the LDP, i.e., that major parts of the two parties already have a de facto grand coalition.
The decision of the LDP to reverse the postal reform will be an important turning point for the party. One key factor behind the decision is that the LDP's major loss of seats in the 2009 general election left the party with a higher density of more old-guard Diet members. There is also the question of how to treat LDP dissidents. In the LDP's general meeting on the matter, Shinjiro Koizumi (the former PM's son, who is now a Diet member), Hidenao Nakagawa, and Yoshihide Suga spoke clearly against the agreement. However, General Council Chairman Ryu Shionoya declared a "unanimous agreement" on the matter.
The nNext question is how these opponents of the reversal bill react. They may simply abstain, or oppose, or leave the party. Should they vote against the party's stance in the Diet, the LDP would be faced with a decision on whether to discipline them. Another key event will be reaction from former PM Koizumi (now retired from the Diet) to the LDP action. If he speaks up, then the press will likely cover the matter.
In addition, action by LDP or DPJ members opposed to these changes - or by those who view the reversal of reform by the major parties as a political opportunity - may accelerate the momentum of political changes. Indeed, it is conceivable that the leaderships of both parties may want to force dissident elements out of their parties, in order to be able to forge a grand coalition. Such a result would likely accelerate the trend towards higher taxes, with little cut in government spending, and a standstill of structural reforms that threaten any vested interests. Such an outcome would in effect be a re-run of the Murayama government (of 1994-96).
With a grand coalition formed, there would be little reason for such a coalition to call a general election before the current Diet term expires, in August 2013. That said, by then, the alternative political forces (e.g., Mayor Hashimoto of Osaka, the Your Party) will have had much more time to organize, and could well pose a significant threat to the parties in a grand coalition.
The postal law reversal is hardly a direct market event; however, it is a clear sign that the vested interests in the political world are firmly in control. This evidence contradicts the hope that other aspects of policy, e.g., anti-deflation policy, will create fundamental change in the way that Japan operates. On the contrary, this is evidence that the country is still receding back to the stalemate of vested interests that brought the lost decade and the paralysis since PM Koizumi left office in 2006.
To the extent that foreign investors take the view that the postal reform reversal represents a return to the vested interest stalemate, their interest in Japanese markets may wane further. The implication of continued recession and deflation may help to keep JGB yields low for somewhat longer, and the yen stronger.
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CIS: Trip Notes
April 12, 2012
By Jacob Nell
| Moscow and Alina Slyusarchuk | London
Last week, we visited the main policy-making institutions in Russia, Ukraine and Kazakhstan with clients, including the central banks, ministries of finance and the economy in all three countries, as well as having meetings with the IMF, World Bank, embassy officials, and key analysts.
Russia: Looking for Policy Anchors
In Russia, beneath a new high-level policy consensus on macro-stability, structural reform and higher government spending, we found, an active debate on the appropriate anchors for fiscal and monetary policy. We also found a government in transition paralysis, which means decisions held over for the new government.
Political context: Tandem switch approaching... Putin returns to the presidency on May 7, and he has repeatedly indicated that he intends to propose Medvedev as the next prime minister. The direction of policy appears unchanged, i.e., the acceleration of political and economic reform, as set out in Putin's pre-election campaign and previously in Medvedev's modernisation agenda. In particular, following the election, Putin asked the government to prepare the Budget 2013 on the basis of his pre-election articles. At the same time, the Duma has already passed most of the laws required to implement the political liberalisation proposed by President Medvedev at the end of 2011, including direct election of governors and reduction of the thresholds to register parties and presidential candidates.
...but also transition paralysis: The government resigns when the prime minister resigns and a new government is appointed when a new prime minister is appointed. Since Putin and Medvedev have said they will not "pre-announce" the new government, no minister knows if they will be in the government in six weeks time or what role they will play. We expect substantial changes. Several of the most influential ministers in the previous government, including Sechin and Kudrin, have announced that they will not serve in the next government. Medvedev has suggested that no minister should hold a post for longer than six years, which implies change-out of several long-serving ministers, and both Putin and Medvedev have talked in terms of a new management team in government. This uncertainty translates into a reluctance to take decisions until the new government is in place, as well as lingering uncertainty about the pace and scope of the promised reforms.
More clarity by end-June: We expect Medvedev to be approved as PM by the Duma in mid-May, and shortly thereafter for him to announce the key members of his government. We think that the first major public outing for the new government with investors will be the St Petersburg Economic Forum in late June, and a key early indicator of priorities will be Budget 2013, the guidelines for which will be set out in June-July.
In any case, paralysis doesn't matter much: First, the economy is in a sweet spot, with inflation at 3.7%Y, unemployment below pre-crisis levels, growth running close to 5% and investment running at 15%Y. Second, the active policy debate of the last year has coalesced into a new Russian policy consensus, largely captured in the recent Strategy-2020 final report, published in mid-March. We see three key elements in the new policy consensus, which will, we think, underpin the new government's decisions:
• Macro-stability, based on sustained low inflation and a balanced budget, and backed by a strengthened fiscal and monetary framework;
• Structural reform, including privatisation and measures to improve the investment climate, to attract higher private sector investment;
• Higher government spending to tackle challenges in health, infrastructure and defence, financed from higher revenues as a result of growth, reallocation of 2% of GDP of current spending, raising a further ~1.5% of GDP in taxes, and increasing debt from under 10% to 25% of GDP.
Growing oil dependence: As officials at the Ministry of Finance pointed out, Russia depleted half of its reserve funds after the oil price fell below US$60/bbl for just five months in 2009, and the non-oil budget deficit and the balanced budget oil price have doubled since the crisis. Even after fiscal consolidation of over 5% of GDP in 2011, the non-oil deficit was 5% of GDP, above the 4.7% of GDP ‘sustainable' level of consumption of oil revenues.
A new fiscal rule? The MinFin says that it plans to reduce the non-oil deficit to a sustainable level, and build up the reserve funds. However, on current budget plans, there will be no marked improvement in the non-oil deficit over the budget horizon - in fact, there is a deterioration in 2012 as a result of the programmed increase in spending, while the target level for the reserve fund has been lowered from 10% to 7% of GDP. The Ministry is developing a proposal for a new fiscal rule, setting the budget oil price assumption on the basis of the 10-year average oil price. Reinstating a rule for the management of oil revenues could provide an anchor for fiscal policy, and constrain pro-cyclical spending. But the current 10-year average oil price is US$63.1/bbl compared to the current spot price of over US$120/bbl. Generally, since the previous law setting rules for the management of oil revenues was suspended in the crisis in 2009, shortly after introduction in 2007, we think the government needs a track record of compliance for any new rule to be credible.
The successful corridor: The floating corridor regime has been a success to date, with inflation at a record low, and the CBR able to provide liquidity when needed during the recent risk-off trade. This success was reflected in the election campaign, when Putin endorsed the goal of lowering inflation to 4-5% by 2014, and the regime of inflation targeting. The CBR is not sure if the political will exists to move to a fully floating corridor by 2014, as currently planned. Nonetheless, given the high level endorsement, we expect further progress this year in the direction of a more flexible RUB, in the form of an additional 1 RUB widening of the corridor.
The quiet hawk: Despite inflation at 3.7%Y, the 9% strengthening of the RUB YTD and reasonably tight monetary conditions (M2 at 22%Y), the CBR's policy stance is currently neutral on rates and supplying less liquidity than the market demands. We think that the CBR does not want to cut rates or supply unlimited liquidity, since it sees inflation rising in mid-year when tariff increases are implemented in July and the base effect of the bad 2010 harvest falls out of the numbers, and more generally sees an upside risk to its 5-6% 2012 inflation goal, given unemployment below the natural rate, fiscal expansion and an economy growing at around potential. However, we do not expect pre-emptive policy action, given the lack of a public CBR inflation forecast and operational framework to guide expectations and justify action. Instead, we expect a shift to an explicit bias to tighten in reaction to inflation picking up with the July tariff hikes. This pushes back the CBR's first rate hike from our previous expectation of June-July to August-September. We look for a hike in the repo auction rate, which the CBR sees as the key policy rate in a situation of a shortage of liquidity.
Liquidity debate: There is an active debate in Moscow on liquidity. Some banks are pushing for increased provision of liquidity and provision of longer-term liquidity by the CBR, arguing that it is needed to prevent funding constraints curbing growth. Although somewhat masked by the high level of budget spending in 1Q, the authorities have been steadily reducing support in recent months. The CBR says that it is not seeking to tighten or ease policy through liquidity provision, but simply to satisfy "justified" demand, and that the banks have been demanding excess liquidity.
Ukraine: Holding the Hryvnia
Political context - elections: Ukraine has parliamentary elections on October 28 this year, and the ruling Party of the Regions faces a tough election to secure a working majority in the Rada, as the popularity of President Yanukovich has fallen from its peak of 40% after the 2010 elections to 8% in December 2011 (total approval), or 66% after the 2010 election to 30% in December (total or partial approval).
New economic team: Following the brief appointment of Mr Horoshkovsky to Finance Minister, and his further promotion to First Deputy Prime Minister responsible for economy and finance, the appointment of Deputy NBU Governor Mr Kolobov to Finance Minister and the appointment of the former Foreign Minister Mr Poroshenko to be Economics Minister, the government has a new economic team. We do not expect a revised economic strategy before the election, and of course the team may not be in place on the other side of the elections. However, it is helpful that Mr Poroshenko and Mr Horoshkovsky are experienced ministers, while Mr Kobolov's ties with the central bank and strong relationship with Governor Arbuzov may improve coordination between the central bank and the ministry of finance.
1Q slowdown: Although robust real wage growth and retail sales have supported consumption, the sharp slowdown in IP to 2%Y has seen Ukrainian growth slow at the start of the year to what the NBU estimates is 2%.
Financing focus: The focus of discussions was whether Ukraine could raise the BoP financing it needs - an external financing gap which the NBU estimates at US$6-7 billion - in order to defend the current peg to the dollar. The view we encountered in Kiev, from IFIs and the private sector as well as the government, was that the NBU could hold the rate at least until after the election at the end of October, barring a resumption of the euro crisis or a domestic policy error.
Financing options: Ukraine has increased the likelihood of being able to hold the hyrvnia, even in the absence of external financing, by raising nearly US$1 billion in FX funding of over a year's duration in 1Q12 from domestic sources. At this rate, Ukraine could raise a further US$2 billion in FX financing from domestic sources by the autumn. Even if other sources of external financing are not tapped, a decline of US$4-5 billion in FX reserves from the current level of just over US$31 billion would not by itself reduce Ukraine's reserves to a critical level.
Other sources of external financing: As discussed in previous notes (see Implications of a New Ukraine-Russia Gas Deal, January 31, 2012), Ukraine is also pursuing external financing from Russia (via a gas deal), from official sources (via the IMF), and from the market.
Russian gas deal: We still see a deal as a possibility, following Putin's inauguration on May 7, and in advance of the June repayment of the US$2 billion VTB loan. However, the easing of pressure on Ukraine's reserves means that Ukraine no longer needs a deal to hold the hryvnia, and it may prefer to avoid the controversy of selling a stake in the gas transit system to Russia in the run-up to elections, particularly if it can persuade Russia to roll over the maturing VTB loan or convert it into a longer-term security. However, we note that Ukraine's balance of payments is based upon an assumption of Naftogaz importing 27.4 bcma from Russia at a price of US$415/1,000 m³. If the contract has a higher minimum import volume or price, then the current account deficit could widen up to US$20.8 billion, or 11.2% of GDP, in our view.
IMF - a temporary separation? It is clear that there will be no resumption of the Stand-By Arrangement before the election. The government will not hike household gas and utility tariffs sharply or move to a more flexible exchange rate before the election, nor, following the recent 1.7% of GDP additional spending commitments, will a 2012 deficit of 2.5% of GDP be achievable. However, co-operation between the IMF and the government remains close, and there is broad strategic alignment. The government wants to privatise Naftogaz, which is only possible if it ceases to be loss-making - current estimates of NAK 2012 losses range from UAH 12-22 billion - which in turn requires that low domestic tariffs be raised to import prices. The NBU at a staff level is doing technical work on a more flexible exchange rate regime, with more emphasis on inflation-targeting. More widely, there is broad consensus in Ukraine that the high rates and tight liquidity which the exchange rate commitment has required since last July are undesirable. If the government post-election remains broadly unchanged, we expect a renewed IMF programme, implying a 1Q13 hike in tariffs and shift to a more flexible exchange rate regime.
Kazakhstan: Overheating Risks
Strong entry into 2012: According to preliminary estimates, 2011 GDP came out at 7.5%, above our expectations (6.8%Y). Since GDP growth was 7.0%YTD in 3Q11, this suggests an acceleration of growth at end-2011 to reach annual growth of 7.5%Y, providing a strong entry point into 2012.
Higher oil prices: Our oil assumption is now revised up from US$109/bbl to US$120/bbl for 2012. On Ministry of Finance estimates, an extra US$10/barrel adds KZT 30-50 billion (US$0.2-0.3 billion) to budget revenues and KZT 300 billion (US$2 billion) to the oil fund.
Fiscal policy loosening - 4% of GDP increase in spending: The original 2012 budget plan was quite balanced. Assuming oil prices at US$80/barrel, revenue growth was planned at 12% compared to the 2011 revenue plan and expenditure growth was planned at 11% compared to the 2011 expenditure plan. However, since the budget was adopted, planned spending has been increased by an impressive 4% of GDP. First, in January, President Nazarbayev announced an accelerated programme of state-led investment, funded by the Oil Fund. In total it includes 800 projects with total investment of US$60 billion by 2014, to be financed partly by government and partly by the private sector. We estimate that the new initiative adds about US$5 billion (2.4% of GDP) expenditure on top of planned investment in 2012. Second, in February, the 2012 budget oil price assumption was increased from US$80/bbl to US$90/bbl, and expenditures were raised by KZT 507 billion (up 9% or by 1.6% of GDP), including KZT 300 billion on the purchase of a KMG stake in the Karachaganak project.
Higher growth and inflation: Based on the strong entry into 2012, higher oil prices, and 4% of GDP fiscal loosening, we revise up our growth forecast from 6%Y to 7%Y in 2012. Although the NBK is not concerned about exceeding its 6-8% 2012 inflation target, we see it rising to 8.5%, just above target by end-2012, given the following sources of inflation pressure:
1. KZT appreciation pressure: As oil prices rise to average US$120/bbl in 2012 from an average US$109/bbl in 2011, the NBK has to intervene more aggressively to prevent KZT appreciating against USD, as shown by the US$2.1 billion intervention in February. This in turn increases domestic liquidity, which could in theory fuel credit expansion and inflation. However, in practice, the combination of NBK operations to sterilise the additional liquidity by issuing NBK notes and attracting bank deposits, and the problems at Kazakh banks, with their high level of NPLs, are likely to prevent strong credit expansion, as seen in the still subdued rates of monetary growth (M2: 18.3%Y).
2. Looser fiscal policy: The combination of the additional budget spending of 1.6% of GDP and the additional Oil Fund investment of 2.4% of GDP amounts to an impressive US$8 billion (4% of GDP, KZT 1.2 trillion) increase in spending compared to the original 2012 budget plan. We note that it will not be inflationary to the extent it finances imports which create new capacity domestically, for instance by financing the Kazakh stake in the Kashagan and Karachaganak projects, as opposed to contributing to domestic demand.
3. Limited spare capacity: Unemployment is at a historical low of 5.4%, pointing at a low level of spare capacity in Kazakhstan. However, these data may understate the level of underemployment in the economy.
4. Harvest dependency: Food accounts for 44% of the consumer basket and the good harvest of 2011 contributed significantly to the inflation slowdown as food inflation fell to 5.2%Y in March from 13.7%Y in August 2011. We also note that inflation in Kazakhstan (4.6%) is higher than in Russia (3.7%) and Ukraine (2%), and fell less as a result of the good 2011 harvest, which may point to higher underlying inflation pressures, although it may also reflect the rise in some Kazakh food prices, particularly meat, following entry into the Customs Union with Russia.
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South Africa and Nigeria: Macro Revisions - Resounding Resilience
April 12, 2012
By Michael Kafe and Andrea Masia
Summary: Following the publication of Global Forecast Snapshots: Policy Prop for BBB Expansion, March 28, 2012, and upward revisions to our oil price assumptions last week, we provide an update on our South Africa and Nigeria macroeconomic forecasts. With higher growth, lower inflation, narrower twin deficits and sustained low interest rates, South Africa appears to be in the ‘Goldilocks' zone. We have upgraded our 2012 GDP forecast from 2.5% to 3%, thanks largely to a more constructive view on the South African consumer as well as a less downbeat view on the international environment. We also have a more constructive view on the fiscus. Despite a higher oil price profile, we revise our 2012 CPI forecast from 6.2% to 6%. On the external accounts, our global team's optimistic view on China leads us to tweak our current account deficit from 4.5% of GDP to 4.2% in 2012, and from 4.7% to 4.5% in 2013.
For Nigeria, higher oil prices should translate into currency stability, while a less restrictive outlook on monetary policy should help lift GDP to 7.5% (7.2% previously) in 2012 and 8% in 2013 (7.5% previously). A stronger and more stable naira suggests that inflation, although still on an upward trajectory, should remain well-behaved. We now expect CPI to peak at ‘just' 13.5%Y (from 13.3% when we published our annual outlook - see CEEMEA 2012 Outlook: Slowing Growth and Growing Risks, January 11, 2012), and to average some 12.9% this year (12.4% previously).
South Africa - Goldilocks Zone?
Consumer buoyancy to lift overall GDP growth: Our earlier GDP growth estimate of 2.5% for 2012 was based on our expectation that the Treasury would push ahead with the redistributive tax policy that it had pre-announced in the February 2011 Budget. However, the February 2012 Budget not only awarded some R9.5 billion in income tax relief but also softened up on its redistributive tax treatment on pension, provident and retirement fund contributions, which are now expected to affect only the super-rich with earnings of more than R1.1-1.3 million per annum (i.e., less than 100,000 registered taxpayers out of a 55 million population). And with the implementation date of the amended tax proposals having been postponed to March 1, 2014 (from March 1, 2012 initially), it is quite clear to us that the mild headwinds to upper-income households that we were concerned about (see South Africa Chartbook: Mild Headwinds on the Horizon for Households, January 16, 2012) could be even milder than we had expected. This, together with a much better-than-expected 4Q11 GDP outcome, encourages us to lift our 2012 private consumption expenditure forecast from 2.9%Y to 3.5%Y.
New-found commitment to infrastructure to boost GDFI: With regards to gross domestic capital formation, the most recent outcome of 7.2%Q was well in excess of our 4.1%Q forecast; and while we still look for a meaningful deceleration in 1H12, we believe that the government's new-found commitment to infrastructural upgrades suggests that our earlier forecast of 3.5% for 2012 and 4.2% for 2013 may be conservative. We have therefore revised our forecasts to 4.5% for this year and 4.6% for 2013.
Lower electricity tariffs to cap 2013 CPI: Our inflation forecasts have improved marginally in 2012, thanks largely to the surprise decision by the National Electricity Regulator of South Africa (NERSA) to reopen the current Multi-Year Price Determination (MYPD 2) and award Eskom a 16% electricity tariff increase for this year - down from 25.9% previously (see "South Africa: 2H12 CPI ‘Delectrified'; More to Come in 2013", CEEMEA Macro Monitor, March 9, 2012). More importantly, NERSA also ruled that municipalities should pass on no more than 11.03% to households. The much lower household tariff increase (the relevant one for CPI) combines with a significant downside surprise in the February 2012 CPI outcome (6.1%Y versus our forecast of 6.5%Y and consensus expectations of 6.4%Y) to cap our 2012 CPI forecast at 6.0%Y (6.2%Y previously), despite our assumption that oil prices are now likely to average some US$122/bbl this year (US$109/bbl previously) and US$117/bbl next year (US$105/bbl). Looking forward, we believe that inflation has already peaked at 6.3%Y in January and is likely to move broadly sideways over the next quarter or two, before falling back into target by October 2012.
CPI reweighting to keep 2013 inflation unchanged: For 2013, our CPI forecast of 5.4%Y remains unchanged, as we expect the upcoming CPI reweighting and rebasing exercise scheduled for January 2013 to lift the annual average print by 0.2pp, thanks largely to an expected increase in the weight of electricity outlays (for a more detailed discussion, see South Africa CPI: Rebasing Revisited, March 26, 2012). We will revisit our inflation forecast on a sustained upside break of 8.20 in USDZAR or US$135/bbl in Brent oil prices.
A more constructive fiscal outlook: Latest estimates from the National Treasury show that tax collections for the 2011/12 fiscal year were somewhat better than expected, allowing the fiscal deficit to fall to 4.5% of GDP - some 0.3pp below our 4.8% of GDP forecast. This suggests to us that the country's tax buoyancy has improved at a much faster rate during the post-crisis period than we had anticipated. Looking forward, we have bumped up our combined 2012 personal, corporate and value added tax estimates by some R5 billion a year in the next two years. This, together with a higher nominal GDP denominator, results in a lower fiscal deficit of 4.5% of GDP for 2012/13 (i.e., unchanged from last year), and from 4% to 3.8% of GDP in 2013. We keep our funding and public debt profiles unchanged, however, as we believe that the Treasury may take advantage of a better-than-expected revenue take to do some pre-funding and potentially rebuild its much depleted sterilisation account balance.
A more favourable external payments position in 2H12: On the external accounts and currency, we have turned slightly more constructive. Our global economics team now expects global GDP to come in at 3.7% in 2012 (3.5% previously), and 4% in 2013 (3.9% previously), thanks in part to a modest upgrade in Asian GDP. Not only have we upgraded China's GDP from 8.4% to an above-consensus 9% print, but we have also upgraded our capex assumptions for Japan, leading to an upward revision from 1.1% to 1.8% in Japanese GDP growth. With China having become South Africa's single largest trading partner and Asia accounting for the bulk of South Africa's commodity exports (some 60% of total export revenues), we believe that better growth prospects in Asia are likely to have a positive impact on South Africa's external accounts. We have therefore shaved 0.3pp off our initial 2012 current account deficit forecast of 4.5%. Also, the upward revision to our GDP forecast points to a slightly more equity-friendly environment, while our view of a declining CPI profile from 2H12 onwards also points to a bond-friendly environment that should help to attract international investor inflows. In short, we look for a slightly more favourable external payments position.
With regards to the currency, our call for general weakness in CEEMEA currencies in 1Q12 was largely based on our dim view of European growth prospects. Although our view on European growth remains broadly unchanged, the perceived success of the LTRO has tempered market pessimism to a large degree, allowing CEEMEA currencies to hold up much better than we had anticipated. The rand was no exception: Contrary to our call for USDZAR to depreciate from 8.10 in 4Q11 to 8.65 in 1Q12, the currency in fact appreciated to 7.45 in early March before weakening to 7.67 by the end of the quarter. We remain cautious on the rand for the remainder of the first half of this year, but continue to look for a modest appreciation in 2H. We aim to provide full details of our rand forecasts in an upcoming note.
Nigeria - Macro Resilience
GDP - still on a growth charge: With oil prices now expected to come in much higher at US$122 bbl (US$109 previously) in 2012 and US$117 bbl (US$105 previously) in 2013, and global growth now expected to come in a touch higher than we had initially hoped for, we believe that Nigeria has a unique near-term opportunity to side-step the growth deceleration which we had initially expected to unfold in 2012 and 2013 (see Nigeria: Five Investor Themes for 2012, January 16, 2012). As a result, we have upgraded our GDP forecasts from an already respectable pace of 7.2% in 2012 to 7.5% and from 7.5% to 8.0% in 2013. We maintain our view that the Petroleum Industry Bill (PIB) is likely to come into effect in late 2012, resulting in average oil production (OPEC) volumes of 2.25 mbpd this year and 2.40 mbpd in 2013. However, our price assumptions for oil are higher by 12% in 2012 and 6% in 2013, boosting our oil sector GDP forecast to 3.9% in 2012 and 4.4% in 2013 - around 0.3pp higher in both years.
We expect the benefits of monetary stability and an appreciating exchange rate to be felt the most in the non-oil sector. Specifically, we believe that the construction, wholesale & retail and financial sectors stand to benefit the most, and have upgraded our forecasts accordingly. We see further upside potential as power generation infrastructure is rolled out by the Power Holding Company of Nigeria. This is of course contingent on a successful completion of the part-privatisation of that entity.
External position to improve further: Our higher oil assumption also suggests an improved outlook for Nigeria's balance of payments over the upcoming 18 months, led in the main by a larger-than-previously-anticipated surplus on the current account. On our estimates, Nigeria's trade balance could swell to some US$45 billion over this period, as export growth outpaces the growth in refined crude imports. On the net invisible line, we have also pencilled in some upside to our previous income payment assumptions on the back of a likely increase in dividend payments. Finally, we see net inward transfers of US$20 billion in 2012 and US$22 billion in 2013, as unrequited transfers (mostly inward Diaspora flows) improve. Net-net, we expect a current account surplus of 9.5% of GDP in 2012 and 8.4% in 2013. This is much higher than our earlier estimate of 8.9% in 2012 and 7.1% in 2013.
On the financial account of the BoP we have turned somewhat more constructive on FDI and portfolio-related inflows as global conditions improve and liquidity remains abundant, revising our net financial transactions estimate up to US$3.9 billion from an outflow of US$0.1 billion in 2012 and to US$8.1 billion from US$7.2 billion in 2013. Together with the larger surplus on the current account, we believe that the CBN now has the scope to meaningfully accumulate FX reserves through 2H12, although probably at a more moderate pace than the quick-fire US$2.7 billion rate reported for 1Q12 alone. On the whole, we look for some US$4.0 billion of official FX accumulation this year, resulting in a FX reserve stock of US$37.0 billion. The healthy balance of payments position suggests that our year-end targets of USDNGN 160 for 2012 and 158 for 2013 may be somewhat pessimistic.
Moderately higher inflation unlikely to elicit policy action: Although undershooting most forecasters' expectations in February, we believe that CPI is still one month away from bottoming - at 11.2%Y in March - before starting its grind higher to peak at some 13.5%Y in 3Q12. Food inflation is the primary driver of our inflation view, led in the main by rising energy costs and the introduction of a plethora of levies that are to be imposed on various imported foodstuffs. However, once the base effects of 2011 and 2012 fall out the wash, CPI should begin to trend lower into 2013, ending the year at 11%Y. Such an inflation trajectory should combine with stability in the currency to encourage monetary officials to keep policy on hold for the foreseeable future, in our view.
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In Limbo, Waiting for the EC's Response
April 13, 2012
By Pasquale Diana
The background: On March 7, the European Commission sent two reasoned opinions on the issues of the retirement age of judges and the independence of the data protection authority, noting failure to comply on these matters. Also, the EC sent two administrative letters on the independence of the judiciary and the central bank, requesting further clarification. The Commission gave Hungary one month to reply.
The reply arrived a week before the April 7 deadline: This is obviously positive at first sight, though we do not know any details at this stage. The EC will probably take at least a few days to go through the Hungarian reply, and then issue its opinion (last time it took just under three weeks).
Although we have no details on the Hungarian reply, we have collected information from various articles in the local press and compiled some summaries.
On the key issue of the NBH Act, the authorities allegedly said that they would commit to not expanding the current MPC or adding a new deputy governor while Simor is still the governor. At the same time they maintained that the salary cap applied to the governor will continue to apply, as it does to all public sector officials. Note that the NBH disagrees on this point as NBH members are not public sector employees, but managers of a company owned by the state. Such wage limits are not applied to managers of other state companies, argues the NBH, hence they are discriminatory. Therefore, while there has been progress on the central bank law, it is not clear that all the issues were addressed successfully. Also note that the ECB has yet to issue on opinion on the proposed changes to the NBH Act. This opinion, probably to be released in the coming week or two, will likely form the basis for the EC's response on the NBH issue.
On the issue of the judiciary, the Hungarian authorities included a proposal to introduce a standard retirement age of 62 years for prosecutors and judges, but to allow them to stay until the age of 70 if they so wish. According to Hungarian EU representative Gyorkos, the government also addressed concerns about the independence of the judicial system (no details were made available).
On the issue of the data protection authority, it looks as though this will go to the European Court of Justice. We would stress that this is probably the least serious of the three issues and on its own is unlikely to be a deal-breaker, in our view.
Some progress, but will it be enough? We stress that the information we have so far is incomplete, but it does look as though progress was made in some key areas, though we do not know at this stage whether this will be enough to start official talks soon. The NBH issue looks absolutely key, and the promise not to expand the MPC under Simor's term may or may not be sufficient. We will probably have a clearer idea after the ECB issues its opinion.
If the negotiations start officially, it is hard to say how long they could last: We assume about one month, based on previous experience. But given that the IMF may well impose its own conditions during the negotiations, the process may get delayed. We sketch out three scenarios below, with our subjective probabilities attached.
Bull case: Hungary gets the all-clear: In this case, formal negotiations can start very soon. These can last any length of time (at least a month, we believe, possibly more). The IMF has been quiet for now, but it is likely to voice its issues and conditions during the formal negotiations. So, even if these preconditions (EC infringement procedures) are met, the negotiations will not be easy. In the best case scenario, Hungary could see a package announced by mid-year (this used to be our previous forecast) - subjective probability: 25%.
Base case: There remain sticking points, but progress has been made: In this case, Hungary has not cleared 100% of the issues but has done just enough to at least start the talks officially. It is possible a few changes may be required to the NBH Act or to the judiciary, which would further postpone the official start of negotiations. The official talks could therefore begin some time in May/June. These talks take some time, the IMF sets its own conditions during the official talks, and the assistance package eventually gets announced by July-August (our base case) - subjective probability: 40%.
Bear case: The EC sends two of these issues to the European Court of Justice, talks break down, deal gets delayed indefinitely: The EC could decide that Hungary has failed to comply, and takes two of these issues to the ECJ (data protection, judiciary). Also, the ECB could issue a negative opinion of the proposed NBH changes, which would cause a further delay. Unless the Hungarian authorities take proactive action against this, it is unlikely that negotiations can officially start, in this scenario. Also, if risk appetite is sufficiently benign, there is a risk of Hungary pulling out of the talks entirely on the grounds that it can fund itself on the market even without a safety net - subjective probability: 35%.
Flows, Stocks, Rollover - Why a Funding Line Matters
The 4Q balance of payments and external debt data published this week underscore some of the themes we have been stressing over the past few months: while the flow position of the Hungarian economy looks strong, the stock position remains challenging, in terms of rollover needs. Also, banks continue to delever aggressively.
External funding capacity reached 3.6% of GDP in 2011: The 4Q current account release showed a surplus of €149 million (consensus: €262 million), which took the 2011 total to +€1,431 million, or a surplus of 1.4% of GDP. Taking into account a capital surplus of 2.1% of GDP (mostly EU funds), Hungary has an external financing capacity of 3.5% of GDP.
Trade surplus still the main driver: The goods trade surplus eased somewhat in 4Q, to €795 million, after €838 million in 3Q. On a four-quarter basis, the trade surplus still stood at 4% of GDP, which rises to 7.2% if we also include the services balance. This was enough to offset the outflows on the income balance (6.3% of GDP), mostly payments on external debt and dividend outflows.
Funding side: FDI weak, portfolio inflows strong; banks continued to delever: Both inward and outward FDI were strong in 4Q, but this was due to ‘capital in transit'. In net terms, FDI was €1,240 million in 4Q, but around zero in the year as a whole. Portfolio flows were negative in 4Q (-€1,183 million) but positive for 2011 as a whole (+6.5% of GDP), mostly due to inflows into the government bond market in the first three quarters of the year. Meanwhile, banking sector outflows continued, with banks pulling out short-term funding to the tune of over €3 billion in 4Q alone.
Flow story encouraging, but stocks dominate: While Hungary's strong current account surplus stands out in CEE, so do its high external debt (130% of GDP) and its high rollover needs: short-term external debt is 24% of GDP, almost half of which sits in the banking system. Maturing long-term debt also looks rather high (14% of GDP over the next year, 40% of which is in the banking system). Large upcoming maturities on external debt dwarf the current account surplus, and explain Hungary's large overall external funding need this year. We believe that an EU/IMF deal would be highly beneficial to keep rollover rates high, and reduce uncertainty.
NBH watch - rates on hold, as expected; where do we go from here? As universally expected, the MPC kept rates unchanged at 7% on March 27. According to Governor Simor, the MPC discussed both a 25bp cut and a 25bp hike in rates, but an "overwhelming majority" voted to keep rates on hold. Simor added that Hungary's relative risk position had deteriorated over the last month and that Hungary needs the EU/IMF deal as soon as possible. Also factoring in upside risks to CPI, rates might have to be maintained at the current level for "several quarters", Simor said.
Cautious stance ahead: The statement mentioned upside surprises to CPI early this year, reflecting high pass-through of high oil prices and indirect tax hikes. Although the disinflationary impact of weak domestic demand will prevail in the medium term, inflation will remain high in the coming months, the NBH said. This warrants a "cautious" policy stance. The NBH also updated its CPI and GDP forecasts. These show a higher CPI path, averaging 5.6% in 2012 and 3.0% in 2013 (relative to 5.0% in 2012 and 2.6% in 2013 in the November report). The GDP forecast has barely changed - the NBH expects 0.1% in 2012 (unchanged) and 1.5% in 2013 (1.6% previously).
Inflation forecast details - still rather benign, but some upside risks: The first thing that strikes us about the inflation forecast is that, despite this year's CPI shocks, inflation is still expected to be sub-3% by 3Q13, just one quarter later than in the previous forecast. In essence, the NBH continues to assume that the weak domestic demand backdrop and the large output gap bear down on prices once this year's one-off shocks are out of the system. Note also that the forecast assumes a sharp fall in oil prices from current levels, though the Council believes that there is a "significant" risk that oil prices remain elevated throughout the period. In two out of the three risk scenarios, inflation is higher than projected in the baseline. Overall, it seems fair to say risks are tilted to the upside, in our opinion.
Lower rates possible, EC/IMF deal is key: The report also says that the base rate consistent with the baseline scenario will stay at the current level for the next few quarters, and then can decrease gradually if inflation falls in line with the forecast and there is a lasting improvement in the risk perception of Hungary. Comments this week by MPC members Gerhardt and Kocziszky also confirmed this, and linked the sustainable improvement in risk metrics to the EC/IMF deal. The Inflation Report mentions that if the risk premia remain at their current level and the exchange rate depreciated as a result, rates would not be lowered even in 2013. While no hikes were mentioned explicitly, we think that the MPC could revert to at least discussing rate increases if risk deteriorated sharply in the coming weeks (say, EUR/HUF above 310) and the prospects of an EC/IMF deal did not look good.
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Revising Up Both Growth and Inflation Forecasts
April 12, 2012
By Tevfik Aksoy
Strong evidence of rebalancing: 4Q growth data for 2011 delivered some key information: First, at 5.2%Y, 4Q11 growth was faster than expected, not only because of the strength in domestic demand but also due to a visible positive contribution from net exports, i.e., rebalancing gained pace. Second, the full-year growth rate reached 8.5%Y and, with the revised (up) 2010 growth rate of 9.2%Y, the economy grew by an average 8.9% over the past two years, pulling 10-year average growth up to 5.4%Y. Third, the growth data showed very obvious signs of a sharp deceleration. Essentially, the sequential growth rate dropped to 0.6%Q (2.4% saar) in 4Q from 1.3%Q recorded in both 3Q11 and 2Q11 - another sign that monetary policy has been successful in curbing excessive growth.
There has been a significant shift in the balance of the economy from predominantly domestic demand-led growth to a more balanced dynamic with a positive contribution from net exports. This is particularly important not only because it is a reflection of the success o policy traction but also the fact that it had been happening amid serious weakness in demand in the euro area. Clearly, a decline in imports played a significant role, but exports have been particularly stronger than was initially anticipated.
Revising up our growth rate forecast: Since late 2011, our growth rate forecast for Turkey in 2012 stood at 2%Y, which was a reflection of our overall bearish stance towards global growth, the well-known issues in Europe and the anticipation of an adverse impact of European deleveraging. In contrast, global liquidity conditions have so far been better than expected, no impact of deleveraging has so far been felt and Turkey's exports seem to be doing well thanks to increased sales to Germany and the efforts to diversify markets that led to a sharp rise in exports to the Middle East.
Despite the fact that 1Q12 saw a noticeable loss of growth momentum, which is likely to lead to flat to slightly negative sequential growth, we believe that there have been some signs of improvement heading into 2Q. Especially the consumer and business sentiment surveys have been consistently signaling a pick-up in demand in the near term. Taking into account all of these, we are revising our 2012 GDP growth forecast to 3%Y from 2%Y, also adding a marginal 0.1pp to our growth forecast for 2013 (4.5%Y). While the new forecast for 2012 is better than our initial figure, it is still significantly low and below the potential growth rate. Hence, we believe that the implications of this upward revision on inflation and the current account will be minor.
Risks are evenly distributed: With the upgrade to our growth forecast, we believe that the upside and downside risks are now more evenly distributed. On the upside, we see an improved global picture, gradual easing of monetary policy, faster credit growth and the dissipation of geopolitical risks as the main factors. On the downside, the key risks seem to be related to higher oil prices, an extended tight monetary policy and of course another bout of weakness in Europe.
Inflation highlights: March CPI inflation surprised on the downside at 0.41%M, beating our below-consensus (0.6%M) forecast of 0.5%M and posting the lowest monthly rate since July 2011. Owing partially to a decline in food prices (-0.33%M) but also quite tame services prices in general (0.3%M), the headline print helped the 12-month trailing inflation rate to stay unchanged at 10.4%Y. The main contribution to inflation came from energy-specific sectors such as transportation (1.15%M), which was expected.
Some encouraging signs: While the overall inflation picture is still far from being benign, there are some encouraging signs: For instance, housing rent prices rose by just 0.19%M in March, bringing the annual price change to 4.5%Y. The monthly change in rent has so far been one of the lowest in history. Reflecting the softness in demand and declining sales momentum, furniture and car prices dropped by 0.45%M and 0.47%M, respectively. If the current trend remains in place, we believe that the non-energy component of inflation is likely to remain tame and keep underlying inflation dynamics in check so that once the recent hike in energy (and related) prices dissipates, inflation will revert to the desired path commensurate with the official targets.
Energy prices distorted the inflation picture - revising our CPI forecast higher: Our inflation projections for 2012 were based on the assumption that the currency would remain more or less stable, there would not be any additional tax hikes (as promised by the government) and changes in food prices would behave in line with past seasonal patterns. So far, we have seen no major deviation in these, and even the increase in oil prices in 1Q12 was offset to some extent by the currency appreciation so that the anticipated utility price hikes were delayed. However, the government finally decided to pass the cost increases to the consumer by raising electricity prices by around 8% and natural gas prices by 18%. The direct impact of these would be to add some 0.5pp to inflation immediately. Taking this into account and the change in our growth rate call, we are revising our year-end inflation forecast to 7%Y from 6.4%Y previously.
CBT to maintain a tight grip: Our new inflation forecast is clearly significantly higher than the 5% official target and, in order to make sure that the target remains a meaningful reference, we believe that the current (tight) monetary policy implementation should remain in place. We expect the CBT to keep a tight grip on liquidity control credit expansion, maintain currency stability and watch any deviations in medium-term inflation expectations.
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