Standard measures suggest...still a lot: Most standard measures suggest a fairly large current output gap in the major advanced economies. For example, the OECD predicts that the output gap in the euro area and in the US, while expected to narrow this year, will remain in excess of 3%, implying that the level of actual output will be more than 3% below potential. With this much spare capacity left in the economy, it might seem reasonable to assume that domestic (as opposed to imported) inflation pressures will remain fairly subdued.
However, estimates of the output gap are highly uncertain and prone to revision: The OECD's own estimates of the output gap have been changing over time. Each December, the OECD re-estimates past, present and (two years into the) future output gaps based on the available data at the time of the estimate. For example, with hindsight, it appears that in the 2004-07 period, there was much less spare capacity in both the US and the euro area economies than the OECD assumed during those years, probably reflecting overly optimistic initial assumptions about potential output growth. To the extent that central banks, which use similar approaches to gauge the output gap, relied on these real-time estimates, they underestimated the underlying inflation pressures and kept interest rates too low for too long, and thus likely contributed to the inflation overshoots before the financial crisis.
Not a garden-variety recession: Due to the nature of the financial crisis and the Great Recession, estimates of potential GDP and the output gap are even more uncertain than usual. In particular, the crisis may have severely damaged the level (and the growth rate) of potential output by making part of the capital stock in the advanced economies economically obsolete. To see why, consider that the economic expansion of 2002-07 was fuelled by a credit boom - credit was cheap and widely available. The sectors that benefitted most from this boom were the financial sector (which helped to fuel the bubble), construction and real estate (which were artificially boosted by low interest rates and easy availability of credit) and consumer-related industries (as consumers thrived on easy credit and higher (perceived) housing wealth).
Capital and skills damaged: Yet, the post-bubble world looks very different: credit is no longer easily available, the financial sector is much more heavily regulated, housing markets are still weak and consumers remain in deleveraging mode. As a consequence, part of the capital stock in the credit-intensive sectors must have become economically obsolete. This not only applies to physical, but also to human capital. Workers who acquired special skills in sectors that benefitted from the credit bubble find their earnings capacity reduced in the post-bubble world and may not have the skills needed in other sectors that are now expanding.
Remember the Seventies? In fact, this shock to potential output is conceptually similar to the shock of the mid-1970s. Back then, the surge in oil prices destroyed a large chunk of potential output in the energy-intensive manufacturing sector. While the factories and shipyards were still around, many of them were no longer economically viable at higher energy prices. This time round, the credit crisis reduced potential output not in the energy-intensive but in the credit-intensive part of the economy. Back in the 1970s, the traditional models were slow to pick up the shock to potential output and thus massively overestimated the size of the output gap. As documented amply by the work of Athanasios Orphanides (now a member of the ECB Governing Council), real-time estimates in the mid-1970s overestimated the size of the US output gap by as much as 10 (!) percentage points, thus suggesting vastly more room for non-inflationary growth than actually existed. This (with the benefit of hindsight) overly optimistic view of the output gap contributed to overly expansionary monetary policies and helped to produce the Great Inflation of the mid-to-late 1970s.
Wide variance in gap estimates: Given the experience of the 1970s, central banks are naturally keen not to repeat the same mistakes, which may help to explain why the ECB has started to raise interest rates even though standard measures of the output gap still show ample slack. By contrast, the Fed seems to be placing more confidence in measures that show ample slack both in the overall US economy and also the labour market. Yet, different approaches to estimating potential output and the ‘natural' (non-inflationary) rate of unemployment yield widely diverging results for the US. We compare the Congressional Budget Office's output gap estimate to another estimate that we derive from a small model of the US economy which we have been using to estimate the natural (or neutral) rate of interest (see Global Economics: In Search of the Natural Rate of Interest, February 10, 2006). While the CBO estimate, which is widely used, shows actual output some 5% below potential, our own model-based estimate suggests a much smaller output gap and thus much less slack in the economy. Note that we do not claim that our estimate is the correct one and that the CBO estimate is wrong. We merely note that different approaches to estimate the output gap can yield widely divergent results.
This point is illustrated further by a comparison of seven alternative estimates of the US output gap and the implied natural rates of unemployment conducted by Justin Weidner and John C. Williams at the San Francisco Fed (John Williams recently became President of the San Francisco Fed and is thus now a member of the FOMC). In an update of a 2009 paper (see Update of "How Big is the Output Gap?", January 28, 2011), their alternative estimates of the US output gap in 4Q10 range from -7.5% to -1.8%, and their derived estimates of the natural rate of unemployment range from 5.2% to 8.6% (with the latter being not far below the actual rate of unemployment.
Further significant inflation upside possible: Clearly, it is impossible to say without the benefit of hindsight which measure is the most accurate. Yet, given the experience of the 1970s and the nature of the financial crisis, we think there is a distinct possibility that there is much less slack in the advanced economies than is generally presumed. Together with a super-expansionary global monetary policy stance and EM-led global inflation pressures, this adds to our worries about potentially significant upside to inflation in the advanced economies over the medium term.
We visited Budapest on May 12, and had meetings with private sector economists, asset managers, Min Fin representatives, the IMF and political analysts. We go through our key takeaways in this note.
Inflation risks still on the upside. Most of our discussions revolved around fiscal policy, structural reforms and growth. Even so, when discussing monetary policy, we found broad-based agreement among local observers with our view that the NBH's recent CPI forecast is too benign. Rate stability is viewed as the most likely outcome, with the risks of a rate hike late this year still higher than those of a rate cut. Pressure on Governor Simor has abated over recent months and the relationship between the government and the NBH has improved, admittedly from a low level.
Structural reforms: a step in the right direction, for sure. The prevailing local view is that, after a shaky start and repeated communication issues, the government now ‘gets it' and appreciates how important it is to communicate a coherent message on budget discipline and the need to lower debt. The reforms cover all the right areas and the government has such a wide majority that the question of implementation is really one of political will. A two-thirds majority in parliament would also allow the government to tackle the issue of local authorities head on, something that no other government since the transition has been in a position to do.
The new constitution will also make it easier to keep the budget in check. The new constitution, which will include a 50% government debt rule provision, comes into effect next year. The new constitution will likely introduce a clause which limits the Constitutional Court powers to stop budget legislation as long as debt/GDP is above 50% (i.e., indefinitely, from where we are today).
The 2011 budget: looking through all the noise. The 2011 budget data will be affected by numerous one-offs. This, together with the absence of a real baseline scenario, makes any analysis of Hungarian fiscal trends quite complicated. To recap: the government targets a fiscal surplus of 2% this year, after a 4.2% deficit in 2010. Note, however, that this includes around a 9% of GDP lump-sum revenue which comes from the assets held in the second pillar being transferred to the state, of which 2% of GDP will be used to assume MAV and BKV debt and to replace certain PPP projects. It also includes crisis taxes worth around 1.2% of GDP. So, looking through these one-off revenues (10% of GDP, 2% used for debt assumption and PPP projects), the underlying budget deficit is in the region of 6% of GDP in 2011. This is a figure close to what the EC has estimated recently, and shows the need for consolidation measures to cap the rise in debt in the coming years. Hence, the rationale for the structural reform programme presented in March, which we analysed in Two Cheers for the Reform Package, March 2, 2011.
In that analysis, we showed that if the whole plan were implemented, the debt/GDP ratio would stabilise at around 65% of GDP, assuming no cyclical improvement in the primary balance. If the cycle were to provide a helpful boost to public finances, even a 60% implementation rate may be sufficient to stabilise debt/GDP at the same level. The news since then may have altered the debt levels somewhat (for instance, the near-term drop in debt/GDP may not be as steep), but not changed the underlying dynamics in a meaningful way, we believe.
Viability of the measures remains questionable. The most frequent criticism we heard during our visit (and one which the authorities accept) is that the analysis in the Szell Kalman plan and the Convergence Programme is too static. True, there are no major risks for the budget this year, partly because the one-off measures (crisis taxes, transfer of pension fund assets, purchase of the debt of the public transport companies and the PPP projects) will hide the underlying picture. Also, note that the government has not provided a budget deficit baseline which is clean of all one-offs. Once all the one-offs are accounted for, there seems to be a structural deterioration of about 1% of GDP between 2010 and 2011. The official budget will, however, print a surplus of around 2% of GDP, according to the convergence plan.
Risks around 2012 budget. While this year's picture will probably not give huge cause for concern to bondholders, we think that there are risks around 2012. For example, the plan shows that there are significant cuts in unemployment benefits, aimed at returning inactive people to the labour market. Given Hungary's low activity rate, these measures are clearly welcome. However, it is certainly not clear that as many as 400k people will return to the labour market and find a job soon. For those who do not, the alternative is either a job under the State Employment programme or a further loss in living standards. It is also important to realise that what matters for growth is the employment rate (employed/population of working age), not the activity rate ((employed+unemployed)/ population of working age). In other words, the key is whether those who join the labour force will find a job, and how soon.
Why does it matter? The Convergence Programme shows a fiscal tightening worth approximately 2% of GDP next year. True, this is offset by some tax cuts, but the latter primarily favour richer households, who have a lower propensity to consume. In short, it seems fair to say that the overall fiscal stance turns restrictive in 2012. The example of the last years in Europe shows a very clear negative correlation between the fiscal stance and growth: countries which tighten the budget also tend to grow less, in standard Keynesian fashion. The government's growth assumptions show household consumption gains of 3.1% this year and 2.2% next year; overall GDP is forecast at 3.1% in 2011 and 3.0% in 2012. None of these numbers look totally out of reach, but the risks appear clearly tilted to the downside. If growth were to disappoint, the government may well choose to revise the most unpopular reforms, or perhaps loosen spending elsewhere. And given that the reforms are already proving unpopular with the electorate, a return to a more populist stance, especially in the second half of the parliamentary term, is a key risk.
Our overall impression from our conversations is that not enough risks of an adverse feedback loop on growth from the austerity measures are built in. The authorities seem to assume that small and medium enterprises, which account for 60% of total employment, will meet the bulk of the increase in labour supply. Also, there is a belief locally that the new flat tax regime may boost growth to the extent that it did in other CEE countries earlier in the decade (e.g., Slovakia in 2001-02). However, we question a reliance on that evidence, as Slovakia and Romania among others would have enjoyed booming growth regardless of the flat tax. What drove growth in these countries was primarily the combination of cheap money and abundant FDI, not the switch to a more generous tax regime.
When would we get worried about implementation? The Convergence Programme neatly sets out a timetable that allows us to track progress. Failure to announce details on labour market reforms by July 1 would, for example, increase our concerns. Delayed budget execution in 2011 (see above) would not necessarily make us very negative, as there would still be ample time to act ahead of 2012 and the government has shown huge determination when under pressure.
Moratorium and FX debt conversion. Another key issue that was discussed extensively was the plan to deal with the ongoing moratorium on foreclosures and evictions, which is scheduled to end on July 1. This moratorium has been in place since 2010 and has created tensions in the housing market, increasing moral hazard (even some of those who can pay do not), and preventing portfolio cleaning. Plans on what to do after the moratorium ends are, of course, interlinked with the plans to help out distressed FX borrowers.
The solution discussed, and which seems to have been confirmed by articles in the local press over recent days, envisages the fixing of the FX rate for troubled borrowers until 2015 (at, say, CHF/HUF of 160). For borrowers who are not already 90 days overdue, the bank would offer a HUF-based loan (3M BUBOR until 2015, then a market rate) to cover the difference between the actual and the ‘fixed' FX rate. The state would guarantee 100% of these HUF loans in return for an annual fee until 2015, 25% of them afterwards.
The impact on monthly cash flow for the households and banks could be material. At the current CHF/HUF rate of 214, this would mean that monthly repayments on a ‘typical' CHF mortgage with the FX capped at 160 would fall by over 30% per month. The bank would presumably have to fund the remaining part on the HUF market and in essence ‘lend' it to the troubled borrower.
No payment would have to be made on these ‘new' HUF loans until 2015, but ultimately the household would still be liable for the loan. So, in essence, households would get a boost to their disposable income in the near term, but spread the pain over the medium term. Note that if after 2015 the monthly payments were to rise by more than 15%, the bank would have to extend the duration of the loan.
In terms of properties that are repossessed after July 1, the state will likely only allow 1% of them to be sold per quarter in year 1, 2% in year 2, and so on, until year 5 (no limitations). This is stricter for the banks than the 5% per quarter which had been mentioned.
In addition, early press reports have indicated that mortgage borrowers who are deemed to be socially in need (no more details were given) can force the bank to sell the property to the state at distressed prices (30-50% of market value, depending on location), and can then rent the same property from the state at a preferential rate.
Moreover, if the borrower and the bank agree, the property can be sold on the market and the debt forgiven. In this case, the bank has to offer a subsidised rent and also a subsidised HUF loan (for a limited period of time, at rates linked to HGB yields) to help the borrower to purchase cheaper accommodation. We do not have final confirmation from the government, but more details should be forthcoming in the coming days.
The government has announced that it plans to continue to levy the bank tax also in 2013 and 2014, albeit at roughly half the amount, unless there is an EU-wide tax that is lower. In that case, the government would apply the lower rate. Note that the extension of the bank tax until 2014 is not new news, as it had been indicated before.
What does it all mean for the HUF? In essence, it looks as though the government would be taking on some of the households' FX risk, at least temporarily. The banks, meanwhile, will continue to have the short-term CHF-denominated liabilities on their balance sheets which will need to be covered if their borrowing cannot be rolled over fully as a result of the reduced cash flow that the banks receive. If this is the case, then demand for CHF will take place as Hungarian banks repay part of their debts. If Hungarian parent banks do not see any deterioration in the quality of their assets, then presumably local banks will be able to still roll over their liabilities, with no FX impact. Meanwhile, the banks will receive smaller monthly payments from households who participate in the scheme, and will have to fund the rest in HUF. Note, however, that they do not shoulder more of the FX risk: this has simply been shared between the household and, for the next few years, the government.
The situation may be more serious if the stock of properties that the banks is forced to sell back to the state at distressed prices were high: the banks would only be able to recover say 40% of the market value of the asset, and be in negative equity for the rest: this would leave them net short CHF, and trigger demand for FX.
But at present, it seems too early to speculate on the value of the stock of these properties. According to NBH data, the value of housing-related loans (housing loans + home equity loans) to households stood at around HUF5,115 billion at end-2010. Of this, households owning more than HUF478 billion (1.7% of GDP) in foreign currency-denominated mortgages were more than 90 days overdue on their repayments, thus classifying their debt as non-performing. If in our bear case scenario all were sold (either under a forced sale, to the state, or over the coming years) on the market at distressed prices (say, 40% of the market value), this would leave the banks with a funding gap of at most €1 billion worth of CHF. Spread over time, this kind of flow is unlikely to disrupt the market much. What's more, it's not clear at this stage whether home equity loans will be eligible for this kind of treatment, given that these are largely loans taken out for consumption purchases.
Of course, we need to bear in mind that, for the foreseeable future, net creation of FX mortgages will be negligible, so net FX repayments will be a drag on HUF. This is simply the reversal of the HUF-positive flow which took place when these mortgages were created. That is surely a drag on the forint; however, the current account position looks solid enough to us to be able to withstand this, especially as the duration of the CHF loan stock is over 10 years, so this repayment flow will take place gradually. What's more, the potential restarting of the EUR borrowing schemes later this year could provide a partial offset.
Conclusions
We continue to think that the structural reform plan addresses all the right areas, and believe that implementation is key. The lack of a clear and transparent baseline will make analysing the fiscal dynamics this year tricky, but we think that, aside from external shocks, there are no significant risks this year.
For 2012, the situation is more complex and the macro risks are substantial, we think. The Convergence Programme shows a fiscal tightening worth approximately 2% of GDP next year. The example of recent years in Europe shows a very clear negative correlation between the fiscal stance and growth: countries which tighten the budget also tend to grow less, in standard Keynesian fashion. This is why we think that the risks around the government's growth assumptions are clearly tilted to the downside. If growth were to disappoint, the government may well choose to revise the most unpopular reforms, or perhaps loosen spending elsewhere. And given that the reforms are already proving unpopular with the electorate, a return to a more populist stance, especially in the second half of the parliamentary term, is a key risk, in our view.
Third Update to Post-Quake Economic Outlook
Outlook Revisions Reflect Developments since Our Last Forecast Review (March 31)
Real GDP in January-March showed a second straight quarter of negative growth as a result of the earthquake, falling 0.9%Q (annualized -3.7%), but we believe that the domestic economy absorbed the direct effects of the quake during March and had already embarked on a recovery trajectory by April. For example, March saw the largest fall in production activity on record, but we expect METI data for April-May to show a swift recovery. April 10 was the deadline for submitting responses to METI's aforementioned survey of production forecasts, and forecasts for a strong rebound in April-May carry some uncertainty. However, on the other hand, consumer spending was already picking up in April as the ‘stay-at-home' mood dissipated and we understand it is relatively brisk now, so we think we can reasonably take the view that economic activity, aside from external demand, has been heading gradually back to normal since April. With regard to external demand, however, Japan posted a trade deficit for early/mid-April due to plummeting exports and import substitution, and we expect the deficit to have endured for the whole of April. We expect external demand to exert significant downward pressure on growth, particularly in the April-June quarter.
Positive and Negative Developments Since Our Last Update
Positive developments since we reviewed our outlook on March 31 are (1) besides the avoidance for now of planned power cuts in eastern Japan, upgrades to electricity supply plans which have made it possible to narrow the target for corporate electricity savings in the summer from 25% initially to 15%, and (2) the outlook for earlier-than-expected resolution to supply chain issues as a result of corporate efforts to tackle the obstacles.
Nevertheless, we do not expect the course to recovery ahead to be smooth. Negatives from the angle of the economy are (1) the possibility of production line operating rates remaining low even after operations resume, and potential for supply chain issues to continue having an effect, including fresh suspension of production or further declines in operating rates depending on the situation with parts procurement, (2) the possibility that uncertainty about future electricity supply will linger after the summer and into the medium term, including tighter supplies with suspension of nuclear plant operations and the start of new regular maintenances, and (3) from the angle of external demand, the possibility of slow export recovery and increased import substitution lowering the contribution to growth.
On the policy side as well, negatives include (1) use of virtually the full amount of the first supplementary budget in recombined existing expenditures, preventing much feed-through to stimulation of new demand, and (2) the mounting likelihood that the next large supplementary budget will not be drafted until the summer or later, as a result of issues relating not just to reconstruction plans but to funding sources too. Hence, though we expect downward momentum in April-June GDP to be less severe than we foresaw initially - indeed, in terms of direction we believe the trend is already towards recovery - we do not hold very high expectations of V-shaped recovery momentum from July-September, or October-December.
High Oil Price Is a Looming Risk for Overseas Economies
Conditions in the global economy, previously viewed as a lifeline for the Japanese economy, are also becoming less certain due to the high oil price. In 2007-08, as the oil price moved further into the $100/barrel level, the global economy was already decelerating before the Lehman shock, and did not take long to enter full-fledged recession. The Japanese economy peaked in October 2007, and the US also entered recession a little later in December 2007. The US economy is no longer in recession, but balance sheet correction in the household sector is still curbing upside potential, and our US economic team has also lowered its growth outlook for 4Q11 from +4.0%Y initially to +3.3%Y.
Based on the data so far, US economic momentum in April-June, in employment and elsewhere, looks weak in relation to how far demand was pushed back by heavy snow in January-March. Housing prices are still in a moderate downtrend as well, while there is a strong possibility that a gasoline price stalled far above $4/gallon will curb consumer sentiment. Another risk of some concern is rewinding of excess liquidity in global markets if QEII is abandoned as expected at end-June. This is because the markets seem to have factored for the ending of QEII, but possibly not to the full extent. The outlook for European economies, too, is increasingly unclear as a result of the ECB's premature rate hike and reignition of sovereign debt worries. In emerging markets, clouds have started to form over the outlook for the Indian and Brazilian economies due to currency appreciation on the back of high primary product prices and dramatic inflows of capital.
Deflation Wins in the Post-Quake Inflation/Deflation Stakes
For prices, domestically we expect a positive year-on-year upturn in the core CPI in April-June in a backlash to the effects of removal of high school education fees, followed by a downturn with the revision of the CPI baseline effective from July data. Although price falls resulting from the revision of standards stem from purely technical factors, they may well be taken to symbolize worsening deflation. Expansion of the output gap due to negative growth up to now may also exert further downward pressure on prices from 2012, at a lag of three quarters or so. Consequently, counter to the consensus that prices will rise due to supply chain problems caused by the earthquake, instead we expect the downtrend to be exacerbated. We think this also has implications for monetary policy, as we discuss later in this note.
Our Outlook Is Revised Down for 2011 and F3/12 Is Unchanged, While We Maintain for 2012 and Revise Down for F3/13
In our third update of the post-quake outlook for the economy, taking account of changes since the end of March, for 2011 (F3/12) we now expect a milder fall in the economy in 1H than we envisaged initially, despite a lower base effect in Jan-Mar, and hence maintain our outlook for F3/12 (while downgrading C2011 outlook). Yet we do not foresee particularly strong recovery momentum for F3/12 2H and later; we revise down our forecasts for F3/13 (maintain for C2012).
On a quarterly basis, for near-term GDP we expect a 3.7%Q annualized fall in April-June and a move from negative to positive growth of 2.3% in July-September, both largely due to changes in the contribution of external demand. The reason why we expect a steep fall in April-June GDP despite industrial production and consumption-related data picking up from April is that we expect a very negative contribution from external demand during the period, due to falling exports and increased substitution with imports. Due to lingering supply chain issues, we expect the trade balance to stay in the red in both April-June and July-September. At the same time, we expect GDP growth as a whole to turn positive in July-September, again mainly on comparative contributions from external demand. From October-December on, as both the first and second supplementary budgets start to roll out, we expect the economy to track at around +4% on an annualized basis, driven by public works investment and government spending.
Fiscal Policy Assumptions: Risk of Delays in the Next Large Supplementary Budget
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