Protectionism: which countries have room for fiscal expansion?

November 25, 2016 by In the long run

Protectionism: which countries have room for fiscal expansion?

Macro Letter – No 66 – 25-11-2016

Protectionism: which countries have room for fiscal expansion?

As globalisation goes into reverse, fiscal policy will take the strain
Countries with government debt to GDP ratios <70% represent >45% of global GDP
Fiscal expansion by less indebted countries could increase total debt by at least $3.48trln

…But now I only hear

Its melancholy, long, withdrawing roar…

Matthew Arnold – Dover Beach

Over the course of 2016 the world’s leading central banks have subtly changed their approach to monetary policy. Although they have not stated that QE has failed to stimulate global growth they have begun to pass the baton for stimulating the world economy back to their respective governments.

The US election has brought protectionism and fiscal stimulus back to the centre of economic debate: but many countries are already saddled with uncomfortably high debt to GDP ratios. Which countries have room for manoeuvre and which governments will be forced to contemplate fiscal expansion to offset the headwinds of protectionism?

Anti-globalisation – the melancholy, long, withdrawing roar

The “Elephant” chart below explains, in economic terms, the growing political upheaval which has been evident in many developed countries:-

Source: The Economist, World Bank, Lakner and Milanovic

This chart – or at least the dark blue line – began life in a World Bank working paper in 2012. It shows the global change in real-income, by income percentile, between 1988 and 2008. The Economist – Shooting an elephant provides more information.

What this chart reveals is that people earning between the 70^th and 90^th percentile have seen considerably less increase in income relative to their poor (and richer) peers. I imagine a similar chart up-dated to 2016 will show an even more pronounced decline in the fortunes of the lower paid workers of G7.

The unforeseen consequence to this incredible achievement – bringing so many of the world’s poor out of absolute poverty – has been to alienate many of the developed world’s poorer paid citizens. They have borne the brunt of globalisation without participating in much, if any, of the benefit.

An additional cause for concern to the lower paid of the developed world is their real-inflation rate. The chart below shows US inflation for specific items between 1996 and 2016:-

Source: American Enterprise Institute

At least the “huddled masses yearning to breathe free” can afford a cheaper television, but this is little comfort when they cannot afford the house to put it in.

Anti-globalisation takes many forms, from simple regulatory protectionism to aspects of the climate-change lobby. These issues, however, are not the subject of this letter.

Which countries will lose out from protectionism?

It is too early to predict whether all the election promises of President-elect Trump will come to pass. He has indicated that he wants to impose a 35% tariff on Mexican and, 45% tariff on Chinese imports, renegotiate NAFTA (which the Peterson Institute estimate to be worth $127bln/annum to the US economy) halt negotiations of the TPP and TTIP and, potentially, withdraw from the WTO.

Looking at the “Elephant” chart above it is clear that, in absolute per capita terms, the world’s poorest individuals have benefitted most from globalisation, but the largest emerging economies have benefitted most in monetary terms.

The table below ranks countries with a GDP in excess of $170bln/annum by their debt to GDP ratios. These countries represent roughly 95% of global GDP. The 10yr bond yields were taken, where I could find them, on 21^st November:-

Country	GDP	Base Rate	Inflation	Debt to GDP	10yr yield	Notes
Japan	4,123	-0.10%	-0.50%	229%	0.03
Greece	195	0.00%	-0.50%	177%	6.95
Italy	1,815	0.00%	-0.20%	133%	2.06
Portugal	199	0.00%	0.90%	129%	3.70
Belgium	454	0.00%	1.81%	106%	0.65
Singapore	293	0.07%	-0.20%	105%	2.36
United States	17,947	0.50%	1.60%	104%	2.32
Spain	1,199	0.00%	0.70%	99%	1.60
France	2,422	0.00%	0.40%	96%	0.74
Ireland	238	0.00%	-0.30%	94%	0.98
Canada	1,551	0.50%	1.50%	92%	1.57
UK	2,849	0.25%	0.90%	89%	1.41
Austria	374	0.00%	1.30%	86%	0.54
Egypt	331	14.75%	13.60%	85%	16.95
Germany	3,356	0.00%	0.80%	71%	0.27
India	2,074	6.25%	4.20%	67%	6.30
Brazil	1,775	14.00%	7.87%	66%	11.98
Netherlands	753	0.00%	0.40%	65%	0.43
Israel	296	0.10%	-0.30%	65%	2.14
Pakistan	270	5.75%	4.21%	65%	8.03
Finland	230	0.00%	0.50%	63%	0.46
Malaysia	296	3.00%	1.50%	54%	4.39
Poland	475	1.50%	-0.20%	51%	3.58
Vietnam	194	6.50%	4.09%	51%	6.10
South Africa	313	7.00%	6.10%	50%	8.98
Venezuela	510	21.73%	180.90%	50%	10.57
Argentina	548	25.75%	40.50%	48%	2.99
Philippines	292	3.00%	2.30%	45%	4.40
Thailand	395	1.50%	0.34%	44%	2.68
China	10,866	4.35%	2.10%	44%	2.91
Sweden	493	-0.50%	1.20%	43%	0.52
Mexico	1,144	5.25%	3.06%	43%	7.39
Czech Republic	182	0.05%	0.80%	41%	0.59
Denmark	295	-0.65%	0.30%	40%	0.40
Romania	178	1.75%	-0.40%	38%	3.55
Colombia	292	7.75%	6.48%	38%	7.75
Australia	1,340	1.50%	1.30%	37%	2.67
South Korea	1,378	1.25%	1.30%	35%	2.12
Switzerland	665	-0.75%	-0.20%	34%	-0.15
Turkey	718	7.50%	7.16%	33%	10.77
Hong Kong	310	0.75%	2.70%	32%	1.37
Taiwan	524	1.38%	1.70%	32%	1.41
Norway	388	0.50%	3.70%	32%	1.65
Bangladesh	195	6.75%	5.57%	27%	6.89
Indonesia	862	4.75%	3.31%	27%	7.85
New Zealand	174	1.75%	0.40%	25%	3.11
Kazakhstan	184	12.00%	11.50%	23%	3.82	***
Peru	192	4.25%	3.41%	23%	6.43
Russia	1,326	10.00%	6.10%	18%	8.71
Chile	240	3.50%	2.80%	18%	4.60
Iran	425	20.00%	9.50%	16%	20.00	**
UAE	370	1.25%	0.60%	16%	3.57	*
Nigeria	481	14.00%	18.30%	12%	15.97
Saudi Arabia	646	2.00%	2.60%	6%	3.97	*

Notes

*Estimate from recent sovereign issues

**Estimated 1yr bond yield

***Estimated from recent US$ issue

Source: Trading economics, Investing.com, Bangledesh Treasury

Last month in their semi-annual fiscal monitor – Debt: Use It Wisely – the IMF warned that global non-financial debt is now running at $152trln or 225% of global GDP, with the private sector responsible for 66% – a potential source of systemic instability . The table above, however, shows that many governments have room to increase their debt to GDP ratios substantially – which might be of luke-warm comfort should the private sector encounter difficulty. Interest rates, in general, are at historic lows; now is as good a time as any for governments to borrow cheaply.

If countries with government debt/GDP of less than 70% increased their debt by just 20% of GDP, ceteris paribus, this would add $6.65trln to total global debt (4.4%).

Most Favoured Borrowers

Looking more closely at the data – and taking into account budget and current account deficits -there are several governments which are unlikely to be able to increase their levels of debt substantially. Nonetheless, a sizable number of developed and developing nations are in a position to increase debt to offset the headwinds of US protectionism should it arrive.

The table below lists those countries which could reasonably be expected to implement a fiscal response to slower growth:-

Country	GDP	Debt to GDP	10yr yield	Gov. Debt	70% Ratio	90% Ratio	12m fwd PE	CAPE	Div Yld.
Saudi Arabia	646	6%	3.97	38	452	581	?	?	?
Chile	240	18%	4.60	42	168	216	15.6	?	?
New Zealand	174	25%	3.11	43	122	157	19.3	22	4.1%
Peru	192	23%	6.43	44	134	173	12.1	?	?
Bangladesh	195	27%	6.89	53	137	176	?	?	?
UAE	370	16%	3.57	58	259	333	?	?	?
Colombia	292	38%	7.75	111	204	263	?	?	?
Norway	388	32%	1.65	123	272	349	14.2	11.5	4.3%
Philippines	292	45%	4.40	132	204	263	16.4	22.6	1.6%
Malaysia	296	54%	4.39	160	207	266	15.6	16	3.1%
Taiwan	524	32%	1.41	166	367	472	12.8	19	3.9%
Thailand	395	44%	2.68	175	277	356	13.8	17.7	3.1%
Israel	296	65%	2.14	192	207	266	9.4	14.6	2.8%
Sweden	493	43%	0.52	214	345	444	16.1	19.8	3.6%
Indonesia	862	27%	7.85	233	603	776	14.7	19.6	1.9%
South Korea	1,378	35%	2.12	484	965	1,240	9.6	13.1	1.7%
Australia	1,340	37%	2.67	493	938	1,206	15.6	16.1	4.3%
Mexico	1,144	43%	7.39	494	801	1,030	16.6	22.4	1.9%
India	2,074	67%	6.30	1,394	1,452	1,867	15.9	18.6	1.5%
				4,649	8,114	10,432

Source: Trading economics, Investing.com, Bangledesh Treasury, Star Capital, Yardeni Research

The countries in the table above – which have been ranked, in ascending order, by outstanding government debt – have total debt of $4.65trln. If they each increased their ratios to 70% they could raise an additional $3.47trln to lean against an economic downturn. A 90% ratio would see $5.78trln of new government debt created. This is the level above which economies cease to benefit from additional debt according to Reinhart and Rogoff in their paper Growth in a Time of Debt.

Whilst this analysis is overly simplistic, the quantum of new issuance is not beyond the realms of possibility – India’s ratio reached 84% in 2003, Indonesia’s, hit 87% in 2000 and Saudi Arabia’s, 103% in 1999. Nonetheless, the level of indebtedness is higher than many countries have needed to entertain in recent years – ratios in Australia, Mexico and South Korea, though relatively low, are all at millennium highs.

Apart from the domestic imperative to maintain economic growth, there will be pressure on these governments to pull their weight from their more corpulent brethren. Looking at the table above, if the top seven countries, by absolute increased issuance, raised their debt/GDP ratios to 90%, this would add $3.87trln to global debt.

Despite US debt to GDP being above 100%, the new US President-elect has promised $5.3trln of fiscal spending during his first term. Whether this is a good idea or not is debated this week by the Peterson Institute – What Size Fiscal Deficits for the United States?

Other large developed nations, including Japan, are likely to resort to further fiscal stimulus in the absence of leeway on monetary policy. For developing and smaller developed nations, the stigma of an excessively high debt to GDP ratio will be assuaged by the company keep.

Conclusions and investment opportunities

Despite recent warnings from the IMF and plentiful academic analysis of the dangers of excessive debt – of which Deleveraging? What Deleveraging? is perhaps the best known – given the way democracy operates, it is most likely that fiscal stimulus will assume the vanguard. Monetary policy will play a supporting role in these endeavours. As I wrote in – Yield Curve Control – the road to infinite QE – I believe the Bank of Japan has already passed the baton.

Infrastructure spending will be at the heart of many of these fiscal programmes. There will be plenty of trophy projects and “pork barrel” largesse, but companies which are active in these sectors of the economy will benefit.

Regional and bilateral trade deals will also become more important. In theory the EU has the scale to negotiate with the US, albeit the progress of the TTIP has stalled. Asean and Mercosur have an opportunity to flex their flaccid muscles. China’s One Belt One Road policy will also gain additional traction if the US embark on policies akin to the isolationism of the Ming Dynasty after the death of Emperor Zheng He in 1433. The trade-vacuum will be filled: and China, despite its malinvestments, remains in the ascendant.

According to FocusEconomics – Economic Snapshot for East & South Asia – East and South Asian growth accelerated for the first time in over two years during Q3, to 6.2%. Despite the economic headwinds of tightening monetary and protectionist trade policy in the US, combined with the very real risk of a slowdown in the Chinese property market, they forecast only a moderate reduction to 6% in Q4. They see that growth rate continuing through the first half of 2017.

Indian bond yields actually fell in the wake of the US election – from 6.83% on 8^th to 6.30% by 21^st. This is a country with significant internal demand and capital controls which afford it some protection. Its textile industry may even benefit in the near-term from non-ratification of the TPP. Indian stocks, however are not particularly cheap. With a PE 24.3, CAPE 18.6, 12 month forward PE 15.9 the Sensex index is up more than 70% from its December 2011 lows.

Stocks in Israel, Taiwan and Thailand may offer better value. They are the only emerging countries which offer a dividend yield greater than their bond yield. Taiwanese stocks appear inexpensive on a number of other measures too. With East and South Asian growth set to continue, emerging Asia looks most promising.

A US tax cut will stimulate demand more rapidly than the boost from US fiscal spending. Protectionist tariffs may hit Mexico and China rapidly but other measures are likely to be implemented more gradually. As long as the US continues to run a trade deficit it makes sense to remain optimistic about several of the emerging Asian markets listed in the table above.

November 11, 2016 by In the long run

Yield Curve Control – the road to infinite QE

400dpiLogo

Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

The BoJ unveiled their latest unconventional monetary policy on 21^st September
In order to target 10 year yields QE must be capable of being infinite
Infinite Japanese government borrowing at zero cost will eventually prove inflationary
The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”. New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21^st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited. This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21^st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds. Zero-coupon bonds are not a joke – 28^th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.