Initial Market Reaction
The initial market reaction seems to have been relatively calm. Beyond Budget day, we think that the Budget is relatively positive for gilts in the medium term. This is important since ‘how much deficit tightening is enough' is, to a large degree, dependent on market sentiment. If the new government has presented a set of fiscal plans that the market ‘likes', that should help give the government scope for the kind of multi-year correction of the deficit that the economy is more able to handle.
Key Features of the Budget
A more ‘ambitious' deficit reduction plan: The new government has projected that it will reduce the deficit to 2.1% of GDP by 2014/15. This marks a more ‘ambitious' deficit reduction plan when compared to the previous government's projection for closer to 4% by 2014/15 and was broadly in line with our expectations going into this Budget.
Spending cuts to bear weight of deficit reduction... The Budget announced an additional £40 billion discretionary policy tightening by 2014-15. That includes an extra £32 billion spending cuts by 2014-15. That adds to the £52 billion cuts ‘inherited' from the previous government. Taxation will contribute £29 billion to the total consolidation (all by 2014-15), mostly on ‘inherited' tax changes announced by the previous government.
...increasing the chance of a successful consolidation: A higher mix of spending cuts versus tax rises has been shown in academic studies to increase the chances of a successful deficit reduction. This Budget shows an 80:20 split by 2015-16 (the spending share of the consolidation is 77% in 2015-16 according to the Budget).
Tough spending settlements ahead: According to Budget analysis, the planned fiscal consolidation could imply, in real terms, 25% cuts to non-protected departmental budgets over four years (i.e., areas outside health and overseas development). The spending review is set for October 20. Here we will get the departmental spending totals.
But these would have been worse without welfare cuts... The new government has also made significant cuts to the welfare bill, with specific measures amounting to £11 billion by 2014-15. That includes cuts to housing benefit and tax credit.
...and tax increases... The Budget presents net increases to taxation, amounting to £8 billion by 2014/15. The main revenue raiser here is an increase in VAT to 20% in January 2011.
...and there may be more to come on tax and welfare: Further changes may also shield departmental budgets more. Several reviews and consultations announced in the Budget might conceivably result in more tax raising and welfare cuts. These include further savings and reforms on welfare in the Spending Review, exploring a financial activities tax and an exploration of further changes to the aviation tax system.
But cuts may not save as much as anticipated: There are, of course, always uncertainties in budget projections, but we highlight in particular the biggest welfare ‘cut' planned: the switch to CPI from RPI indexation for benefits, tax credits and public service pensions. The Budget estimates this will save nearly £6 billon by 2014-15. However, the Budget/OBR appears to anticipate a very wide gap between CPI and RPI inflation (around 1.5pp by 2014/15). Further, any incorporation of owner-occupied housing costs into CPI inflation (as we ultimately expect) would narrow the gap between CPI and RPI inflation. Hence, we think that this policy change may not result in as much deficit reduction as is assumed in the Budget.
Mandate is forward-looking and based on structural deficit: Going into the Budget, one of the key unknowns was the ‘mandate' or target that the government would adopt and by which the OBR would judge the government's plans. The mandate is: "To achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period (2015-16 for this Budget)". The mandate has been supplemented by the additional target of getting public sector net debt (as a percentage of GDP) falling at a fixed date of 2015-16.
We foresee two potential problems with the mandate: First, a government could conceivably run deficits over the next few years, ‘promising' to cut spending and run surpluses further out into the five-year period, but not actually fully achieving this promise. Second, past estimates of the structural deficit (and the ‘starting point' of the rolling five-year calculation) are subject to revision, as the measure relies on estimating the trend level of output, which is difficult to pin down in real time.
The Economic Impact of the Budget
1. Impact on GDP growth
We leave our below-consensus 2011 GDP growth forecast unchanged at 1.2%.
The OBR thinks that, despite the ambitious deficit reduction, GDP growth will be >2% beyond 2010. Its growth forecasts do not show very large changes compared to its Pre-Budget estimates. Although more has changed in the forecasts than just the policy measures, its forecasts, although reasonable, are still above our central forecasts for 2010 (1.0%), 2011 (1.2%) and our published average GDP growth forecast for 2011-15 (1.9%). Hence, they look a little optimistic against our central case.
Some upside risks to our 2011 forecast: On several measures, the new government's policies mark a less front-loaded fiscal tightening than expected, particularly in terms of spending cuts. All else equal, this would actually imply some upside risk to our below-consensus GDP growth forecast for 2011 (1.2% compared to consensus at around 2.0%).
• The OBR's calculations for the contribution to GDP growth from government is -0.7pp in 2011. We had tentatively built -1.3pp into our forecasts.
• Discretionary policy measures taken in this Budget reduce the deficit fairly steadily over the parliament, amounting to additional tightening of around £8 billion on average each year over the parliament (i.e., to 2014/15). The additional tightening in 2012/13 is actually larger than in 2011/12.
However, there are offsets: In particular, the VAT change, all else equal, lowers our forecast for consumer spending in 2011.
• The projected reduction in the deficit over 2011/12 is £33 billion. That incorporates tax changes, particularly relating to VAT that we had not incorporated as a central case into our consumer spending forecasts. All else equal, we think that the planned VAT rise would lower our forecast for the contribution to GDP growth from household consumption by about 0.4pp.
So, we leave our 2011 GDP growth forecast unchanged at 1.2% at this stage.
Medium-to-longer-term positives for GDP growth: The effects on the economy can clearly be broader than the ‘accounting effects'. There is no consensus in the economic literature on the economic effects of fiscal tightening; on the ‘fiscal multiplier' (or the size of the effect on GDP from a given change in fiscal spending or taxation).
The academic literature offers no conclusive evidence on the effects of fiscal tightening on GDP in the UK; even the direction of the effect is controversial. We are open to the idea that in the medium term the effects of this fiscal consolidation may be positive for GDP growth.
2. Impact on inflation
The VAT rise adds 0.5pp to our inflation forecast in 2011.
VAT rise keeps inflation above 2% over our forecast horizon: From January 4, 2011, the VAT rate will rise from 17.5% to 20%. We estimate that this would raise inflation by around half a percentage point from January 2011. On our forecasts, this will also keep inflation from dipping below 2% in 2011.
3. Impact on monetary policy
The risks are now more clearly skewed towards later and more gradual rate rises than our central profile (for a first rate rise in 1Q11). But the VAT rise is a complication.
The Bank of England's initial instinct is likely to be to ‘look through' the mechanical effect of the VAT change on inflation. That is especially since the VAT rise is part of an ambitious fiscal consolidation package, so that it may well expect inflation to be lower than before once the VAT change has ‘dropped out' of the year-on-year comparison.
However, this additional lengthening of the period of above-target inflation further increases the risks that household inflation expectations may ‘de-anchor'.
Although, on balance, this Budget supports the risk that interest rates stay ‘low for longer', the VAT change makes life more difficult for the Bank of England, particularly with inflation expectations already showing some signs of ticking up.
We were in Jakarta recently on a fact-finding trip, meeting with policymakers and companies to get an update on macroeconomic developments. The mood in general was upbeat with regards to the medium-term outlook. To be sure, there were concerns on the European sovereign debt front. However, trade linkages are lesser compared to other ASEAN economies, given Indonesia's domestic orientation. Meanwhile, on the political front, with the recent appointment of the new Finance Minister, Agus Martowardojo, we sense that tensions have decreased significantly. The parliament's focus is now returning to law-making. Given his corporate track record, there is confidence that the new Finance Minister will be able to implement the streamlining of bureaucracy and take tax reforms forward. Yet, some degree of doubt still remains on the pace of reforms, particularly since the democratic setup requires a level of buy-in from the various political parties. Below, we highlight the key macro themes from our trip:
Key Themes
1) Structural Decline in Cost of Capital:
The Story Remains Intact
The central bank highlighted that the inflation trend so far has been more benign than expected. Headline and core inflation stand at 4.2%Y and 3.8%Y, respectively, in May 2010, staying within the central bank's inflation target of 5%+/-1% for 2010. Bank Indonesia (BI) highlighted currency stability as one of the key factors. With rising foreign exchange reserves, the central bank has been able to manage currency stability better in the recent round of risk-aversion. Indeed, historically high currency volatility in Indonesia in the past has meant a high level of dollarization in the economy as a hedge. As a result, currency has tended to play a key role in inflation expectations.
We want to distinguish here between cyclical and structural inflation. To be sure, we do think cyclical inflation is likely to gather pace as growth momentum picks up further. Yet, improved macro stability, rising FX reserves and currency stability are driving a structurally lower inflation trend - which is currently underway and evident in recent datapoints.
We do not need significant currency appreciation from here for the structurally lower inflation trend to continue. Mere currency stability alone is a powerful enough force in anchoring inflation via expectations. Indeed, Indonesia's own experience reflects just that (see ASEAN MacroScope: Indonesia - EU Concerns, China Tightening & Inflation, June 4, 2010). Comparing point to point, the IDR has stayed in the vicinity of around 9,000 against the USD in early 1998 versus now - but the sporadic bouts of currency volatility in this period meant that inflation has averaged 13.6%, higher than the average of 7.9% in 1985-1996 when the currency weakened steadily at a 6.8% CAGR.
Now with the currency stability, structurally lower inflation will lower the cost of capital - in turn driving a virtuous growth cycle as capex growth acceleration is supported.
2) The Greater Challenge Is Capital Flows, Not Inflation
BI estimates that subsidy rationalization on administered prices could add 0.5pp to 2010 headline inflation, taking average inflation to around 5.3-5.5% (our own estimate is that the recent electricity tariff hikes alone will add 0.1-0.2pp to 2010 headline inflation). However, the central bank appeared to be less concerned about any major demand-side inflation pressures in the near term, as the supply-side response has been commensurate. Indeed, BI officials argued that capacity utilization has not tightened even though production has picked up. This implies that capex has been expanding in tandem, reducing the risk of a major pick-up in core inflation.
Indeed, some quarters of the central bank hold the view that the need to hike the policy rate in 2010 is lesser if inflation does not breach the inflation target of 5% +/-1%. To this point, we think the risks are skewed towards a further delay, with regard to our base case of the first rate hike in September 2010.
Rather than inflation, BI instead appears more concerned about the potential large capital inflows - and how they might exit the country in a disorderly fashion. To be sure, the fact that a significant portion of the economy is still unbanked and the need for further investment means that Indonesia cannot afford to shut its door to capital flows. Yet, capital inflows do introduce some challenges in policymaking.
Excess liquidity in the banking system (excluding statutory reserve requirements), as measured by the stock of open market operation instruments, stands at US$31.4 billion (14.7% of bank deposits) as at May 2010. In our view, if capital inflows into the region continue to rise, Indonesia is likely to face maximum challenge.
With local interest rate levels being the highest in Indonesia, the negative carry is the largest in the region. As FX reserves rise further, the central bank will likely continue to initiate more measures to discourage short-term debt inflows, in our view.
To be sure, the central bank has already taken some measures on this front. The central bank issues short-term tradable paper (SBI bills) to absorb short-term liquidity, and foreigners had been allowed to purchase this paper. Just last week, the central bank announced measures to lengthen the tenure of such capital flows and to discourage foreign investors from playing on this rate arbitrage window, which apart from adding quasi-fiscal costs, also increases the risk of volatility in the currency. As per the new measures, BI will issue new longer-tenure SBI paper of 9 months and 12 months. In the past, BI had only been issuing 1-month, 3-month and 6-month SBI bills. Moreover, investors now also need to hold all SBI bills for a minimum of one month, whether in the primary or the secondary market, as per new regulations.
BI also introduced a new term deposit facility for banks to park excess liquidity with the central bank. This facility can only be tapped by banks and, unlike the SBI bills, is non-transferable. This new instrument hence allows BI to withdraw liquidity from the system. Yet as this window is not open to foreigners, it avoids the problem of high foreign ownership in SBI bills, which contradicts with the objective of issuing such bills to withdraw liquidity in the first place, and also the currency volatility that this may bring as capital enters and exits the system.
3) Infrastructure Spending - At an Inflexion Point
Growth is a function of labour, capital inputs and productivity. Most policymakers and independent economists we met agreed that infrastructure constrains Indonesia's ability to achieve even higher GDP growth potential of 7-8%. On the labour front, Indonesia's demographic trend remains favourable. Over the next ten years, Indonesia will be adding 21 million people to its working-age population stock, versus 23 million in China. Its dependency ratio (ratio of dependents to working-age population) will also continue to decline at a time when most other Asian economies are heading up.
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