What is the trilemma? In textbooks, the trilemma is defined as the balancing act of maintaining a currency peg, an independent monetary policy and free flows of international capital: only two of these three objectives are attainable. The inference is that a move away from a fixed exchange rate regime will eliminate the trilemma, restoring monetary independence. In practice, whether the peg is ‘hard' or ‘soft' matters less as the constraints of the trilemma apply to both regimes (Obstfeld, Shambaugh & Taylor 2008). In our opinion, the logic of the trilemma applies even to cases where central banks wish to avoid excessive appreciation of their currency. AXJ central banks are particularly vulnerable to this affliction, given the need to support the region's ongoing export recovery.
What can aggravate the trilemma? In our last note, we identified a few factors that could make the trilemma a major constraint on policy and a source of serious worry for the AXJ region. The list is short but potent: (i) Strong capital inflows; (ii) Divergence in the monetary policy paths of AXJ and developed economy central banks; and (iii) Inflexible exchange rates or low tolerance for excessive appreciation of exchange rates in the wake of monetary tightening. In our opinion, the risks of the second and third (interconnected) factors becoming binding constraints are rising.
Monetary tightening in Asia is underway: The story of economic outperformance in the AXJ region needs no re-telling. And with stronger growth comes the need to head off inflation risk before it becomes an inflation problem. Malaysia surprised everyone by being the first in the region under our regular coverage to tighten policy rates. The RBI's much-needed inter-meeting hike was in line with expectations of our India economics team (see Monetary Policy: Slight Surprise for Markets, Chetan Ahya, January 29, 2010) but (pleasantly) surprised markets. Another 200bp of rate hikes are expected from the RBI by 4Q09. And others are not far behind. If viewed from the lens of credit creation, the PBoC asked banks to slow down lending as far back as 3Q09, which suggests that the process of policy normalisation has been operational for a while now. Controlling the availability of credit is expected to remain the workhorse of monetary policy as the PBoC works on heading off overheating and inflation. Its first policy rate hike is expected to arrive as early as April, with a total of 81bp (in three steps of 27bp each) of rate hikes expected in 2010 with rates on hold thereafter through the end of 2011. On the vital matter of the currency, our colleague Qing Wang expects a small one-off revaluation during the summer, followed by gradual appreciation for a cumulative appreciation of 4-5% against the US dollar in 2010 (see Takeaways from Premier Wen's Conference, Qing Wang, March 14, 2010).
Greater monetary policy differentiation between AXJ and G10: Higher rates in the region are likely to bring what the RBI calls "perverse" capital flows into the region, intensifying the constraints placed by the trilemma on monetary policy. Importantly, monetary tightening in Asia has begun ahead of the developed economies. If the US hikes its policy rate in 3Q10 as our US team expects, AXJ should inherit some of the tightening and the trilemma could moderate. However, if rate hikes arrive later than we expect in the US, the euro area and the UK, then intact liquidity conditions in the G10 capital flows to the AXJ region could intensify along with the growing differential in policy rates.
Different strokes for different folks: There is quite a lot of differentiation in how AXJ economies deal with the trilemma, from the strict capital and credit controls that accompany China's soft peg against the US dollar, to the greater flexibility that the Indian rupee enjoys. Most other AXJ economies fall somewhere in between. The differentiation among AXJ economies is also a function of differing current account surpluses. The greater the surplus, the greater the export revenue and the pressure on the currency to appreciate in value. As of now, current account surpluses for the AXJ region are still below their 2007 levels (see "Living with the Trilemma", The Global Monetary Analyst, January 20, 2010), so it is safe to conclude that the pressure on the currencies is not yet as acute as it was then.
So far so good, but... These implicit and explicit strategies have kept the trilemma under control so far, but their success hitherto belies the risks ahead. Experience shows that it becomes increasingly difficult to control capital inflows over time, with the risk of inflation rising over time (see Frankel, "On the Renminbi: The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate", NBER Working Paper 11274, 2005). With Chinese growth all too likely to outperform all other countries and regions, continued capital inflows will likely bring greater upward pressure on the currency and a rising risk of inflation that the PBoC will not like. The modest currency appreciation and limited rate hikes will likely mean an increasing burden on credit constraints and controlling capital that flows into the economy and the banking system. For India too, rapid rate hikes will likely mean the risk of currency appreciation. Limiting excessive appreciation should mean increased and sustained intervention in foreign exchange markets if it wants to keep its rate hikes on track.
In short, monetary policy across the AXJ region faces similar constraints going forward despite the very different approaches. What could really help the region to tighten policy in an orderly manner without the constraints of the trilemma is sustained monetary tightening in the developed world. But with the risks to growth in developed markets likely to remain in place for a long time, such tightening is surely not forthcoming. Trying times.
Budget Analysis
Deficit numbers are a little better: The government made slightly larger reductions to its deficit forecasts than we had anticipated.
For the fiscal year 2009/10 the government has reduced its estimate of the deficit (PSNB-ex) by £11 billion to £167 billion. We had expected a reduction of around £5 billion. Although the government was on track to undershoot its PSNB forecast for 2009/10 by around £12 billion (largely on better-than-expected recent incoming tax receipts), we anticipated that it would leave itself more room for a worse-than-expected outcome in the (still to be published) March data.
The deficit for fiscal year 2010/11 has also been revised down, by £13 billion. That reflects the better ‘starting point' from 2009/10, the assumption that some of the higher-than-expected tax receipts in 2009/10 will be sustained, one-off factors (including the timing of the Bank Payroll Tax) and lower estimated debt interest payments.
CGNCR and issuance numbers better than we'd feared: The CGNCR (Central Government Net Cash Requirement) was revised considerably lower (and by more than we had expected) for 2009/10. Since the DMO had already raised financing on the basis of its previous CGNCR forecast, that helped to lower its planned gilt issuance for 2010/11.
Broad shape of the projections is similar to Pre-Budget Report (PBR), however: The government still aims to cut the deficit by around a half in four years and still plans to shift to fiscal consolidation in 2011/12 rather than in 2010/11. It still plans to improve the deficit using a mix of revenue raising and spending reduction measures (with spending measures being a bit more important in overall deficit reduction).
There Were a Few New Policy Decisions
A number of new spending/stimulus measures were announced (e.g., stamp duty relief for first-time buyers for properties valued up to £250k and additional payments to pensioner households). There were also some further revenue-raising measures, including additional stamp duty on properties worth more than £1 million, increases in tobacco duty and freezing of inheritance tax thresholds). Total new policy decisions in the Budget amount to a modest net stimulus of around £1.4 billion in 2010/11 (and a net tightening in later years). Overall, these new decisions looked fiscally neutral.
The projections for total real government spending growth are broadly unchanged. Average real spending growth is still expected to remain flat over 2011/12-2014/15.
The debt and deficit are still large: The big picture has not changed. In absolute terms, or as a percentage of GDP, the deficit figures are still very sizeable. The Treasury expects the deficit to come in at 11.8% for the fiscal year 2009/10 (down from 12.6% on the Pre-Budget Report (PBR) forecasts), 11.1% in 2010/11 and the deficit is still at a relatively high level of 5.2% in 2013/14 (from 5.5% in the Pre-Budget Report).
Government debt peaks at around 75% of GDP on the national Public Sector Net Debt measure (excluding financial interventions) and at about 89% on the European Maastricht basis.
The Pace of Deficit Reduction Is Still Disappointing...
The Budget forecasts embody a significant fiscal tightening. The structural deficit is estimated to decline from 8.4% in 2009/10 to 3.1% in 2013/14, broadly the same percentage point decrease as was incorporated into the Pre-Budget projections.
However, the debt levels at the end of the forecast horizon are still high (and the Budget's illustrative projections for 2019/20 still show debt above 60% of GDP). This would leave the UK vulnerable to being unable to boost fiscal spending significantly if a further crisis hits.
...and the Budget Forecasts Are Still Based on Optimistic GDP Growth Assumptions: Further, the government forecasts for GDP growth, specifically beyond 2010/11, still look optimistic to us. For example, the government expects GDP growth of between 3 and 3.5% in 2011 compared to our own forecast of only 1.2% and consensus expectations of 2.1%. In particular, its forecast for growth in domestic demand looks significantly stronger than ours.
However, if slower growth does materialise, the impact on the deficit projections may be mitigated by some elements of caution already built into the projections. In addition, although the government expects strong GDP growth ahead, it also assumes that this growth will be less ‘tax-rich'. That presumably partly reflects the rebalancing in the economy that it expects.
Bottom line: Overall, the numbers were better than expected, but we continue to think that, with a distinctly below-par economic recovery in prospect, bigger spending cuts will be necessary to meet the government's targets on the deficit. The forecasts in the Budget need to be ‘probability weighted' since we are only weeks away from a general election. However, the current deficit is still very large and, whoever wins the election, we believe there is substantial fiscal tightening ahead.
Implications for Gilts
What does this mean for gilts? Gilt sales in the next fiscal year will still be a huge £187 billion despite a £26 billion decrease from that implied at the PBR. The majority of the adjustment comes from carrying over a cash balance of £24 billion driven by much higher-than-expected tax receipts in the final few months of the year. In addition, rather than reducing T-bills outstanding, as we had expected, the DMO used the surplus to bring down gilt issuance in F2010/11.
Highlights from the DMO remit.
• Index-linked gilt issuance will increase from £29 billion to £38 billion (13% of gross issuance to 20%), with the number of planned auctions increasing to 15, up from 12.
• Supplementary issuance to remain at about £40 billion, with up to 10 syndications throughout the year.
• There will be 37 planned conventional auctions in 2010/11, down from 46 in 2009/10.
• There is a slight change in the distribution of conventional issuance: a small increase in proportion of long conventional gilts, a small reduction in mediums and no change in the proportion of shorts.
• There is a small decrease in the T-bill market in 2010/11, compared to about a £19 billion increase in 2009/10.
The gilt market bear-steepened on the day; 10y and 30y gilt yields were 5bp and 8bp higher, respectively. We believe that this reflects the DMO's intention to term out gilt issuance. Thus, the DMO increased the proportion of both long conventional and index-linked gilts and plans to reduce the size of the T-bill market by a small amount.
Besides the initial reaction, we do not think that the Budget and remit should have a substantial impact on our recent recommendation to be long gilts versus Bunds in 30Y. We cite a number of reasons:
• The uncertainty of the impending election will likely keep monetary policy rhetoric muted, thus short-dated rates are less likely to rise and there is a possibility that a post-election supplementary budget by a new government could result in further fiscal tightening.
• The proportion of total issuance through syndication has increased from approximately 14-16%. This will prove marginally positive for long-dated gilts, as it puts less pressure on the balance sheets of the dealers.
• The Budget projections for CGNCR over the next five years were revised down by about £7 billion per year. We would expect this to feed through to gilt issuance and be positive for gilts over the long term.
• A more immediate reason to buy gilts is that at the end of March, the iBoxx All Stock Index will extend by 3.14 months and the Over 15-Year Index will extend by 4.97 months. For the All Stock Index this will be the biggest extension since June 2009, and for the Over 15-Year Index this is the biggest index extension since June 2006.
The 30Y gilts-Bund spread is back to the February wides of 77bp. We set a target of 57bp and a tight stop-loss at 82bp.
Summary
The South African Reserve Bank (SARB) published its 1Q10 Quarterly Bulletin (QB), showing that the country's current account deficit had shrunk further to a 4.5-year low of 2.8% of GDP. This was lower than our forecast of 4.5% of GDP and consensus expectations of some 3.8%. The QB ascribes the much lower-than-expected deficit to strong manufactured exports (mainly vehicle and transport equipment). The bulletin also shows a significant deterioration in the quality of capital flows on the external payments account: It appears that, faced with a rising shortage of long-term direct inward investment, South Africa relied on inherently fickle portfolio inflows to fund its entire 4Q09 current account deficit. Although capital flows are fungible, it is important to remember that heavy reliance on volatile portfolio capital is often risky
Elsewhere, the QB showed that consumer spend swung back into positive territory a quarter earlier than we had expected, thanks largely to a whopping 15%Q (seasonally adjusted and annualised) recovery in durable goods (mainly new motor cars and entertainment goods) that completely masked weak performance in the remainder of the consumption basket. Gross domestic capital formation was weaker than expected and, although improving, inventory de-stocking remains at uncomfortably high levels.
Rising Import Intensity as Recovery Kicks in
Thanks to a 5%Q recovery in gross domestic expenditure (GDE), import volumes rose by as much as 8%Q in 4Q09. This is despite the fact that the recovery in GDE was mainly supported by a deceleration in the pace of inventory decumulation (inventories contributed 4.1pp to growth), rather than a strong rebound in the traditionally high import-intensive drivers of growth such as consumption and investment demand. Strong increases were recorded in both oil and non-oil imports, with the increases in non-oil imports such as manufactures (mainly vehicle components and parts, machinery and electrical goods) and chemical products outstripping the growth in crude oil imports. This development confirms our view that the upcoming recovery will be import-intensive, and will likely drive the current account into steep deficit in 2H10.
Did Manufactured Exports Really Shoot the Lights Out?
But rising import intensity was not the most noteworthy news in the external accounts section of the QB, in our opinion. The biggest surprise for us was the fact that the relatively strong growth in total imports was more than offset by even stronger growth in manufactured exports - mainly vehicles, transport equipment, machinery and electrical equipment.
While anecdotal evidence in higher-frequency data no doubt pointed to some recovery in vehicle exports, we certainly did not expect this category of exports to have such a spectacular impact on total export proceeds. To be clear, although monthly export data published by the South African Revenue Services (SARS) showed that the share of manufactured exports had risen from 17% in 3Q09 to 22% in 4Q09, the data also showed that imports rose by more than twice the pace of total export growth. This was what informed our forecast of a R10 billion trade deficit for 4Q09 - after adjusting for seasonality.
Our optimism was also tempered by the monthly SARS data showing that commodity exports, which account for a much larger 60% of total exports, advanced only moderately in 4Q09. Interestingly, the QB confirms that increased sales of platinum group metals, precious stones and pearls were largely offset by a contraction in the volume of mineral exports, allowing for total mining exports to advance only marginally. This implies that manufactured exports must have ‘shot the lights out' in 4Q09.
Truth be told, we are somewhat agnostic. If anything, we are reminded of 4Q08, where SARB data initially overstated the country's vehicular exports, only to be revised towards more realistic levels a quarter later (see South Africa: Optical Improvement in 4Q08 CAD, March 26, 2009, and South Africa: Technical Correction in 1Q09 CAD, June 19, 2009). We would not be surprised to see a similar development this year.
Moderate Divided Payments Cap Net Invisibles
With regards to the net invisible payments, transfers and services were in line with expectations, although income payments were slightly lower than our forecast, thanks largely to a decline in dividend payments on direct investments. However, it is our opinion that dividend payments on direct investments will pick up later this year, thanks to the recovery in the vehicle manufacturing sector (most vehicle companies in South Africa are foreign-owned companies that are not listed on the local bourse, and hence qualify as inward FDI).
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