In mid-November, the Democratic leadership in the House tried to extend the program for another three months at a cost of $12.5 billion (H.R.6419). But the effort failed and, as a result, some beneficiaries will see their payments lapse over the next few days. Although most Washington watchers believe there is a good chance that another short-term extension will be enacted during the lame-duck session or in early 2011 - possibly as part of a compromise agreement on tax cuts - it's worth examining the economic impact associated with an expiration of the program.
First, some background on the current benefits system. In the US, regular unemployment insurance is jointly funded by the federal government and the states and lasts for 26 weeks. An extended benefits program - known as EB - normally kicks in at that point for another 13 or 20 weeks (depending on economic conditions in the state). In 2008, a new federally funded benefits program was introduced which provided as many as 53 weeks of additional benefits (implying a possible 99 weeks of benefits under all the various programs for many recipients). This EUC program is the one now in jeopardy.
It's important to recognize that the phase-out of benefit payments to individuals currently covered by this program would be gradual. In particular, the program involves four tiers of varying duration - from six weeks to 20 weeks. Individuals who exhaust their current tier of benefits after November 30, 2010 will not be able to move to the next tier. In addition, individuals who exhaust regular and EB benefits after the week ending November 20, 2010 will not be eligible for EUC benefits. All EUC benefit payments would stop on April 30, 2011.
It's worth noting that federally funded extensions of unemployment benefits have been routinely adopted during previous recessions. However, the prior versions never approached the 53-week duration of the 2008 program. It's also worth noting that the extended benefit programs that were adopted during past recessions tended to remain in place until the unemployment rate was much lower than it is today.
Estimating the economic impact. As seen in the accompanying figure, the unemployment benefits share of personal income is historically high at present but is about on par with that seen in the deepest recessions of the post-war period (namely, the 1973-75 and 1981-82 recessions). So, how much of an economic impact would be associated with the loss of extended unemployment benefit payments? According to the BEA's monthly personal income report, total unemployment benefit payments in October amounted to $128 billion (SAAR). Based on the breakdown of recipients, we estimate that EUC payments accounted for $55 billion (SAAR) of the total. The loss of these payments would be worth about -0.4% of personal income - or roughly -0.1pp of income growth spread out over the next several months. Assuming that about two-thirds of the effect would be concentrated in 1Q, and that the propensity to spend of benefit recipients is relatively high, the direct negative impact on 1Q GDP could be as much as one full percentage point.
However, while there is a considerable amount of debate among policy analysts regarding the disincentive effect of extended benefits, it seems likely that at least some portion of the beneficiaries who were cut off would be spurred into "intensifying their job search" (as Bernanke has delicately termed it) and would find employment. Any such offset would temper the negative impact on consumption and GDP resulting from the loss of benefit payments.
We suspect that another extension of the EUC benefit program will eventually be enacted. If it is not, the impact on economic activity could be noticeable during early 2011, but would probably be short-lived.
Finally, for more details on the unemployment benefits system in the US, see Digging into Unemployment Insurance: A Primer, July 23, 2010.
From crisis to crisis: If European policy-makers had hoped for some rest after a busy weekend that culminated in the bailout package for Ireland, they were in for a rude awakening this Monday and Tuesday. Rather than calming the markets, the details of Ireland's rescue plan and, even more so, the Eurogroup's clarification of the post-2013 permanent crisis mechanism led to intensified selling pressure on peripheral bonds, which also spread to quasi-core markets such as Italy and Belgium. In our view, decisive action by governments and the ECB would be required to prevent a further deterioration of funding conditions for European sovereigns and banks. However, the steps that are likely to be taken in the near term probably won't suffice to end the crisis and prevent a spreading of debt worries from the periphery into the core, which has been our (dreaded) base case all year.
What went wrong? In our view, the announcements on Ireland and the future permanent crisis mechanism backfired for the following reasons (for details on what was announced, see Bailing Out Ireland and Beyond, November 29, 2010):
• First, markets view the average interest rate of 5.8% that Ireland will supposedly have to pay for the combined IMF/EFSM/EFSF loans, even though this is substantially lower than current market rates, as too high for a country that will struggle to generate much nominal GDP growth over the next several years.
• Second, while - apart from the interest rate issue - the overall package for Ireland was in line with expectations and included a much-needed major recapitalisation and reform of the banking system, the announcements provided no clarity on other peripheral countries under selling pressure such as Portugal and Spain.
• Third, and most importantly, the Eurogroup probably misjudged the impact on markets of the announcement on the future crisis resolution mechanism, the European Stability Mechanism (ESM), which will replace the temporary EFSF from 2013. By clarifying that participation of private investors in future bailouts would follow IMF rules and would be considered on a "case-by-case" basis rather than being automatic as envisaged by earlier proposals, finance ministers had hoped to calm markets. However, investors (correctly so) took the announcement as confirmation that haircuts for private debt holders would be an option if a country faces a solvency problem in the future. This implies that European government bonds will become a risky asset as they may not be redeemed at par. Moreover, the announcement that future ESM loans would be senior to private creditors' claims (and junior only to IMF loans) implies that any haircuts for private investors would necessarily be higher than if ESM loans were pari passu with private claims, as is currently the case for EFSF loans.
Government bonds no more: Taken together, and amplified by the fact that the Eurosystem seemed reluctant to step up its purchases of peripheral bonds under the Securities Market Programme (SMP) on Monday, investors took the announcements as a signal to further reduce their exposure to peripheral bonds and to bonds of other highly indebted quasi-core governments such as Italy and Belgium. It is important to note that the market moves largely reflected selling by long-only investors trying to reduce their exposure, rather than speculative short-selling. We re-emphasise the point that our colleague, Laurence Mutkin, already made a while ago: the bonds of several peripheral countries, while still being government bonds in name, no longer offer the advantages of a government bond - safety, liquidity, low volatility and a negative correlation with risky assets (see When Is a Government Bond Not a Government Bond? September 22, 2010). Hence, investors running a traditional government portfolio are exiting those markets. In short, peripheral government bonds have become an asset class in search of a new investor base.
What now? In these volatile markets, investors ask what can and, more importantly, what will policy-makers do to contain the contagion in euro area financial markets, now that it has started to spread beyond the periphery. All eyes seem to be on the ECB and high hopes are pinned on tomorrow's Governing Council meeting, followed by the usual press conference with President Trichet. These hopes have been fuelled by various press reports overnight, which hinted at the ECB announcing a major step at tomorrow's meeting by extending its Securities Market Programme (SMP) following some comments by ECB President Trichet yesterday (see "Trichet hints at bond purchase rethink", Financial Times, December 1, 2010).
ECB not ready for large-scale bond purchases: In our view, however, the ECB is further away from taking such a drastic step than markets appreciate. This is because of a deeply held view at the ECB that the sovereign debt crisis needs to be addressed first and foremost by euro area governments. ECB President Trichet emphasised this view at his hearing at the European Parliament on Tuesday, when he spoke about the need to complement the monetary union with a fiscal federation and, if memory serves us, for the first time sounded open to the idea of joint euro bond issuance.
Fiscal rather than monetary solutions: In the eyes of the ECB, the initial step-change to stem the sovereign debt crisis needs to come from the fiscal policy side, not the monetary policy side. As we see it, the ECB will want to use the fact that the euro area is at a critical juncture to get governments to complete some of unfinished work on euro area governance - a fiscal federation (see Fast-track to Fiscal Union? May 8, 2010).
In addition, many on the ECB Council think that it was a grave mistake to discuss a permanent crisis resolution mechanism at this vulnerable juncture. Even after Sunday's announcement by President Van Rompuy and Commissioner Rehn, a lack of clarity of what the new European Stabilisation Mechanism (ESM) exactly entails continues to cause confusion and concern among investors. In addition, the ECB is likely to be increasingly of the view that there is more to the financial crisis than just a temporary lack of liquidity. In the banking sector, in particular, it is additional capital that is needed (see Eurotower Insights: The Lure of Liquidity, June 17, 2010). These recapitalisations have to come from private investors, national governments or the EFSF/EFSM/IMF. They cannot come from the ECB. The ECB is only a lender of last resort.
But ECB unlikely to rock the boat: Notwithstanding its conviction that the onus to contain the debt crisis is on governments, we believe that the ECB is unlikely to rock to boat, for instance by exiting its unconventional measures prematurely. Note that extending the existing measures already marks a turnaround in terms of the ECB's monetary policy stance. Until very recently, the ECB's plan was to continue with the gradual exit from its non-conventional measures in preparation for an eventual hike in the refinancing rate. It is clear, we believe, that this exit strategy will be put on hold in the current environment. In addition to putting the exit strategy on hold, the ECB has several policy options to reverse gears and add liquidity to the markets. These include:
• Prolonging existing refi operations, including the full allotment for the three-month LTROs for at least another quarter.
• Relaunching longer-dated LTROs, notably the six-month refi operations.
• Upsizing the SMP to safeguard the monetary transmission mechanism, possibly to include additional countries or securities.
• Restarting the covered bond buying programme which was closed last July.
• Last but not least, lowering the refinancing rate.
No Fed-style QE at this juncture: All these policy options are at the ECB's disposal within the existing policy framework and are likely to be considered before the Council contemplates unsterilised asset purchases of a similar magnitude as those of the Fed. As a multinational central bank, the ECB faces additional legal, institutional and financial constraints in conducting large-scale asset purchase programmes. If it does not navigate these constraints carefully, the ECB risks being negatively affected itself by the lack of a fiscal federation that is at the heart of the sovereign debt crisis. In addition, the ECB will be very aware, we think, that its policy actions during the crisis have likely contributed to national governments not addressing the root causes of their problem more aggressively in the time that the ECB bought them by providing unlimited funding to the banks and intervening in peripheral government bond markets.
Hence, as back in May, we believe that the ECB will likely want to see a major step-change from euro area governments before it would consider outright asset purchases. Given that the December diary is brimming with European policy gatherings, starting with the Eurogroup/Ecofin meeting next week and the European Council the week after, it seems unlikely to us that the ECB would already announce major asset purchases at this Thursday's meeting.
Summary
We believe that AXJ will continue to lead the global growth trend in 2011. We expect regional GDP growth to be at a strong 7.9%, close to the trend-line (trailing five-year average) growth. This strong growth will be premised on sustained domestic demand, as the recovery in exports remains bumpy and below-par. In this context, the region could be effectively forced to move towards a more balanced growth model even as the push to domestic demand is supported by cyclical policy tools including loose fiscal and monetary policy. In many ways, this trend should appear to be similar to 2010. We think that the key difference between 2010 and 2011 will be that, as policy-makers push domestic demand with the support of monetary and fiscal policy, the side-effects of this approach in the form of inflation risks and asset bubble challenge will only exacerbate.
EM to Outpace DM, Led by AXJ
Asia ex-Japan (AXJ) has seen a strong rebound in growth, led by China and India - a story that we been highlighting for a long time now. The rebound has been driven by domestic demand, supported by the underlying structural growth dynamics of the region and expansionary fiscal as well as monetary policies. In 2011, we expect AXJ GDP growth to be strong at 7.9% (closer to the trend-line of the trailing five-year average) compared with 9% expected in 2010. (Note: 2010 had the benefit of a low base effect in 2009 due to the credit crisis.) While growth in the AXJ region has already recovered back to the trend line, output in developed world countries such as the EU and the US is still below pre-crisis levels. In 2011, our global economics team expects a BBB recovery (bumpy, below-par, brittle) in the G3 economies.
Led by AXJ, the share of EM in world GDP on a purchasing power parity (PPP) basis has already risen from 37% in 2000 to an estimated 47% in 2010. According to the IMF, EM's share is expected to reach closer to 50% by 2014. Leading this trend in the EM world would be AXJ, with its combined share in global GDP increasing to 30% in 2015 from 25% in 2010 and 16.8% in 2000. On the other hand, the US share is expected to decline to 18.4% in 2015 from 20.2% in 2010 and 23.6% in 2000. Similarly, the share of the euro area could decline to 12.8% in 2015, from 14.6% in 2010 and 18.4% in 2000.
On the Right Track Towards Balanced Growth Formula
The global recession and unprecedented sharp external demand shock have forced Asian countries to face up to the vulnerability in their export growth models. The above-trend global growth of 2004-07 was premised on the imbalanced formula of a debt super-cycle, consumer leveraging in the developed world and a giant export machine in C/A-surplus Asia. US households have now rediscovered the need to save and are unlikely to take on leverage with the same vigor. Asian exporters will therefore find it harder to extract growth beta in the current tepid G3 growth environment. The weakening of Asia's export model has made it imperative for policy-makers to look for alternative growth sources.
Policy-makers have so far relied more on the easier path of reflating domestic demand via monetary policy easing and fiscal expansion. Monetary policy has been accommodative, with real rates remaining low and the fiscal deficit closer to all-time wides. Policy-makers have increased infrastructure spending and fiscal incentives to encourage consumer spending (see Asia Pacific Economics: Can Domestic Demand Lift the Burden of Rebalancing? July 27, 2009). Indeed, the current account surplus in the region has already almost halved to 3.8% of GDP during the four quarters ending June 2010, from 7.1% during 2007.
To be sure, the need for heavy lifting remains. Efforts to achieve more sustainable long-term domestic demand reflation are at far from desirable levels. The structural factors holding back the region's domestic demand have been a lack of a social security net, poor public spending support for education and health, low levels of household credit penetration, and low household wealth, which have tended to necessitate higher household savings ratios. An added difficulty comes from the fact that a sizeable portion of savings are held by the corporate sector rather than by households. A closer look at the savings-investment gap for various economies also indicates that there is no single solution for Asia's domestic demand reflation. In China, private consumption is the weaker link. In some parts of ASEAN, it is the low capex ratio that needs to be worked on. In Korea and India, we see a model already fairly balanced between exports and domestic demand, but there is still potential to lift investments higher.
The good news is that we believe policy-makers in the region are moving in the right direction, initiating structural changes to boost domestic demand on a sustainable basis. In China, policy-makers are steadily initiating measures, such as a rural pension scheme, provision of low-cost housing and increasing minimum wages. The governments of ASEAN, Korea and India are also moving in the right direction to support higher investments to GDP. Indeed, in 2011 we expect policy-makers in the region to continue to initiate more measures in the right direction.
China, India and Indonesia to Lead Domestic Demand Growth in the Region
We are optimistic that the region's policy-makers will stand up to the challenge of boosting domestic demand on a sustainable basis, with China, India and Indonesia taking the lead. On a PPP basis, the three combined are estimated to account for 79.6% of the region's GDP in 2010. This push in domestic demand should be reflected in the current account surplus declining further to 3.3% in 2011 from 3.9% in 2010 and 7.2% in 2007. Our China economist, Qing Wang, expects China's growth to moderate a bit to 9%, with consumption growth at an even faster rate of 10%. We believe that India's GDP growth will be 8.7% in 2011, compared with 8.5% in 2010, as investment growth accelerates further along with healthy growth in private consumption. In India, we expect private sector spending to accelerate even as government spending slows due to fiscal policy exit.
We also expect investment growth to accelerate in Indonesia, lifting its GDP growth to 6.5% in 2011, compared with 6% in 2010. We think that steady improvement in the macro balance sheet will continue to result in a structural decline in cost of capital, supporting a steady improvement in domestic demand. Similarly, with hopes of an improved political environment in Thailand, the fourth-largest developing economy in the region could also begin to lift its domestic demand, cutting external surplus.
Two Key Challenges for AXJ Policy-Makers
Currently, we believe that the region's policy-makers are operating with an assumption that G3 domestic demand will continue to remain weak and so they are being careful in reversing the support from monetary and fiscal policy. We think it is imperative for policy-makers to ensure that domestic demand growth remains strong enough to offset the weak external demand. However, this approach brings the challenges of asset price bubbles and inflation. In our base case forecasts for 2011, we are already building in higher inflation pressures, pushing the region's policy-makers to hike policy rates at a faster pace. Yet, we believe that rate hikes are unlikely to be disruptive. In the following paragraphs, we explain the framework to understand these risks of assets bubbles and inflation in detail.
How Serious Are Inflation Risks?
We believe that one of the key differences for the region in 2011 versus 2010 will be higher inflation pressures. We expect inflation to accelerate to 4.2% in 2011 from 3.1% in 2010 for the region ex India.
We expect policy-makers in the region to continue to support domestic demand in 2011 as we believe that domestic demand in the G3 will continue to see a muddle-through recovery, resulting in weak external demand for the region. With private corporate capex already recovering, we believe that capacity utilization is unlikely to be stretched in the region. However, with sustained strong growth for the second year, we believe that capacity slack is definitely likely to be lower in 2011 compared with 2010. Moreover, higher global commodity prices, even though they are driven by strong growth in EM, will likely begin to increase core inflation pressures.
We believe that policy-makers in the region will continue to manage with a combination of some exchange rate appreciation, some intervention in the FX market and simultaneous sterilization of excess liquidity and gradual tightening in monetary policy as domestic demand sustains high growth. In China, we expect policy rates to increase by 75bp to 6.31% by June 2011 compared with 25bp in 2010. For the region ex-China and India, we expect policy rates to rise by 70bp by June 2011 and an additional 40bp to 4.7% by end-2011, compared with a 40bp increase during 2010. In India, we expect policy rates to rise by 50bp by June 2011 and a further 50bp to 7.25% by end-2011, having already gone up by 150bp in 2010. Considering that domestic demand is the key source of growth, we believe that policy-makers will be careful not to initiate a disruptive rate hike policy unless developed world growth continues to surprise on the upside.
Upside-downside risk scenarios: Pace of external demand recovery will be the key. We expect a BBB (boring, bumpy and below-par) trend in external demand recovery in line with our global economics team's outlook for domestic demand in the G3. After reaching a pre-crisis peak by July 2010, AXJ exports have been weak over the last 4-5 months, affirming that domestic demand growth in the G3 is unlikely to be strong during this cycle as it continues to suffer from the after-effects of the credit crisis. Indeed, our global economics team has a base case outlook of a BBB (boring, bumpy and below-par) recovery in the developed world. We believe that the region's policy-makers are likely to aim for sustained growth in domestic demand growth due to this concern on the external demand (i.e., G3) outlook.
We believe that the key factor that will influence the region's inflation outlook will be the pace of recovery in the developed world (particularly the G3). This will be exports as well global risk appetite and capital inflows to the region. Our base case outlook expects inflation in AXJ ex India to average 4.2% in 2011, from 3.1% in 2010 and 0.1% in 2009. (For 2011 our earlier estimate was 3.4%.) However, if domestic demand in the G3 surprises on the upside, resulting in a strong recovery in AXJ exports, then the risk of generalized inflation pressures will likely increase, forcing the region's central banks to initiate disruptive rate hikes. Contrary to this, if the G3 were to experience a deeper slowdown, we would expect inflation to be at 3.1% in 2011 and policy rates to be lower than our base case expectation.
Upside Risks to Inflation: Three Key Factors to Watch
We believe that the risks to our inflation forecasts are skewed to the upside. In this context, there are three key risk factors to watch for, including a potential further rise in food inflation, a rise in global commodity prices and persistent rise in asset prices pushing inflation in non-tradables higher.
1) Food inflation is a bigger problem for developing Asia: Many parts of the region (India, Korea, Indonesia, Thailand and China) have had weather problems. The rise in global food prices at the same time is not helping AXJ. Food inflation tends to be a bigger problem for developing Asia - China, India, Indonesia and Thailand - as the weighting of food in CPI is high. If the upcoming crop season does not suffer from weather problems, food inflation may get a respite, but in the near term food inflation is a given, in our view. While persistent rises in food inflation can also weigh on core inflation through the inflation expectations channel, we think it's hard to make a call that policy-makers will use monetary tightening in a disruptive manner.
2) Potential rise in oil and global commodity prices due to the strength in G3 economies: Our base case outlook assumes a gradual rise in commodity prices. However, if commodity prices, particularly oil prices, rise quickly to US$110-120/bbl, markets would become concerned about a potential disruptive rate hike from AXJ policy-makers. The recent QE2 announcement, along with a rise in PMIs in the US, Germany, China and India, has indeed begun to push commodity prices higher even as the US dollar was stable or rising. We believe that this is the most important risk factor to the AXJ inflation outlook.
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