Global
Do not overlook natural interest rates
Feb 23, 2006

Joachim Fels (London) and Manoj Pradhan (London)

This piece appeared in the February 23, 2006 edition of The Financial Times.   It is based on our piece In Search of the Natural Rate of Interest, which appeared on this Forum in two parts on February 14 and 15.

How do central bankers and market participants know whether monetary policy is expansionary, neutral or restrictive?    One possible approach is to compare official interest rates to their long-run averages to gauge the stance of monetary policy.   Others judge the policy stance by looking at the growth rates of money or credit aggregates relative to some norm.   But these measures are rough yardsticks at best and could, at worst, send the wrong signals.   This is one reason why the concept of the ‘natural’ rate of interest, devised more than a century ago by Knut Wicksell, the Swedish economist, has enjoyed a renaissance in academic and central bank circles in recent years.

Put simply, the natural rate of interest is the interest rate that keeps output at its potential and inflation stable, once any shocks to the economy have played out.    Wicksell saw fluctuations of the interest rate set by the central bank around the natural rate as the main driver of the business cycle and swings in the price level.   His work foreshadowed and influenced the Austrian monetary business cycle theorists in the early part of the last century, most notably Ludwig von Mises and Friedrich von Hayek.

Following the Wicksellian approach, one can thus judge the stance of, say, the Federal Reserve’s monetary policy by comparing the actual level of the (real) Fed funds rate with the natural rate.    If the actual interest rate were above the natural rate, Fed policy would be restrictive, suggesting that the economy and inflation would eventually slow.   Conversely, if the Fed keeps interest rates below the natural rate, the economy and inflation would be expected to accelerate.   Yet, like another popular concept in economics, the output gap, the natural rate cannot be observed, it has to estimated.

Importantly, any estimate of the natural rate will have to take into account that it is a moving target.    It may vary over time in response to, say, changes in technology or private households’ time preference.   Assuming a constant natural rate, as in most applications of the popular Taylor rule (which states that the “real” short-term interest rate should be determined by three factors — the natural, or neutral, real interest rate; how far inflation is above or below its target level; and how far economic activity is from its “full employment” level) can therefore be quite misleading.   Using an approach first introduced by Thomas Laubach and John Williams, two Fed researchers, we combined a simple model of the US economy and a less simple statistical filtering technique to produce an estimate of the time-varying natural interest rate for the US.   Here is the result of this exercise: the natural rate declined from a peak of nearly 4% in the mid-1960s to a trough of slightly above 2% in the first half of the 1990s, reflecting the long-run decline in US productivity growth over that period.   Since then it has hovered between 2% and 2.5%, reaching lows in the early 1990s and again in the early part of this decade when the equity bubble burst.

Our latest estimate puts the natural rate at 2.25%.   With the core price index for personal consumption expenditures currently increasing by slightly less than 2%, the nominal natural rate stands slightly above 4% and is thus lower than the actual Fed funds rate of 4.5%.

Whether monetary policy is expansionary, neutral or restrictive can be judged by the gap between the actual level of the real Fed funds rate and the natural rate.    Between 2001 and 2005, this gap was strongly negative, indicating a very expansionary policy stance.   Consequently, the economy recovered vigorously from the shallow recession and inflation eventually rose from an undesirably low level.   However, the Greenspan-Fed’s 14 rate hikes have removed policy accommodation, with the real Fed funds rate rising to — and, more recently, even beyond — our measure of the natural rate of interest.

Judged by this yardstick, Ben Bernanke, the new Fed chairman, has inherited a monetary policy stance that is already slightly restrictive.    Further increases in the Fed funds rate beyond the current 4.5%, which he seemed to endorse in his testimony last week, would push policy further into restrictive territory.

Of course, any such estimates of the natural rate need to be taken with a large pinch of salt as the underlying model is fairly simple and the standard errors of such models are fairly large.    Moreover, a restrictive monetary policy stance may be exactly what the doctor ordered for an economy that threatens to overheat — a risk that Mr. Bernanke emphasised in his testimony.   However, with looming downside risks to the US housing market, the Fed may well be forced to reverse course later this year.   This would set the stage for a big rally in bonds and a re-steepening of the currently inverted yield curve.

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Hong Kong
F2006/07 Budget
Feb 23, 2006

Denise Yam, CFA (Hong Kong)

Financial Secretary (FS) Mr. Henry Tang presented his third budget speech on February 22.   Realizing favourable results in the 2005/06 fiscal year, the government decided to “share” the economic success with the people by cutting salary taxes.

Strong economic growth (+7.3% year on year in 2005) and favourable asset market conditions boosted tax revenues and gave Hong Kong a surplus in its operating fiscal account of HK$5.8bn (estimated), the first since F1997/98.   Operating revenue excluding investment income is estimated at HK$192.5bn (14% of GDP), HK$11bn higher than budgeted originally.  Nevertheless, projecting this small consolidated surplus of HK$4.1bn (0.3% of GDP) in F05/06 and HK$5.5bn (0.4% of GDP) in F06/07, the FS has proposed giving up HK$2.7bn in salary taxes through lower marginal tax rates and extended tax deductions for mortgage interest payments.  This represents 7.5% of the government’s total salary tax revenues, or 0.2% of 2005 GDP.

In our view, the hasty move to cut salary taxes suggests that the government could be getting complacent with its finances a bit prematurely.   The better-than-expected results in the current fiscal year have been realized as the economy is riding on the strong side of the cycle.  Hong Kong’s fiscal revenues are dependent not only on the real business cycle, but also, and maybe even more, on asset market conditions, and have therefore always exhibited significant fluctuations.  In our view, the small surplus in F2005/06 is probably insufficient to warrant a cut in tax rates that will have a permanent impact on fiscal revenues, as opposed to one-off tax rebates.  On the other hand, the rationale behind the tax cut is to “share” the wealth, which ironically makes the latest policy move a pro-cyclical one: cutting taxes when the economy is growing above trend.  This also leads us to believe that the tax cuts could contain a political agenda: to buy popularity for the government for re-election in 2007.

Meanwhile, the budget documents reveal rather optimistic medium-range forecasts.   While the medium-term real GDP growth assumption (4% in real terms) looks reasonable, the exceptionally strong fiscal revenues in F2005/06 resulted partly from buoyant asset markets in terms of both price gains and heavy turnover, in our view, which may not be sustained even with respectable economic growth.  The government has had a less than impressive record in budgeting over the past decade.  Actual outturns often deviated from original targets by a wide margin.  We therefore maintain our scepticism towards the latest set of projections.

Salary Tax Cut Benefits the Middle Class

The FS proposes lowering the marginal rates of the second, third and top tax bands by 1 percentage point to 7%, 13% and 19%, from 8%, 14% and 20%, respectively.   Tax deduction on mortgage interest expenses, with a ceiling of HK$100,000 a year, will be extended to a maximum of 10 years, from seven years originally.  The width of the tax brackets (HK$30,000), allowances and the standard tax rate (16%) remain unchanged, nevertheless.

As the burden of fiscal tightening measures since F2003/04 has fallen disproportionately on the middle class, the latest tax cuts are aimed at reversing part of that.   For simplicity, assume that an individual is not eligible for any deductions apart from the basic personal allowance.  The largest drop in the effective tax rate (from 16% standard rate to 15.2%) as well as the largest absolute decrease in the tax bill (HK$6,400) will be seen by the HK$770,000 gross annual income group.   The threshold income level for the 16% standard tax rate moves up to HK$990,000.  The highest income groups (approximately 5% of the total number of taxpayers in F2003/04) — i.e. those earning more than this threshold — do not benefit from the latest tax cuts and continue to pay 16% standard rate.

Goods and Services Tax — Means to a Comprehensive Reform of Fiscal Revenue Structure

The budget speech confirmed the government’s intention to introduce of a Goods and Services Tax (GST) in Hong Kong, as a source of more stable and recurrent fiscal revenue and a means to widen the tax base and reduce the cyclical volatility of revenues.   While the rationale is indisputable, the government has held back from pushing the plan forward in the past few years in face of considerable political resistance.  We welcome the latest announcement as a breakthrough from inaction.  A formal nine-month public consultation will be launched in mid-2006, after which proposals will be submitted for consideration, meaning that it will be the government of the next term (after July 2007) that will be responsible for the decision and implementation.  Allowing three years for actual implementation, Hong Kong consumers are unlikely start to paying GST until 2010 at the earliest.

We have long been strong supporters of GST, seeing it as a constructive way to improve the stability of fiscal revenues and the sustainability of the fiscal system, in line with the international trend of migrating from direct to indirect taxes.   It has been politically difficult to introduce GST in Hong Kong over the past few years amid adverse economic conditions.  Given the likely resistance to introducing this new tax, the best way to implement it may be to include it as part of a revenue-neutral comprehensive tax reform — i.e. bundling it with cuts in other taxes simultaneously to make the new tax more acceptable.  Therefore, we had expected the government to hold back from tax cuts and save some ammunition for GST introduction, instead of cutting direct taxes as soon as in the current fiscal year.  This, again, suggests that the government is now being rather optimistic on the fiscal front in the next few years.

Hong Kong remains in need of a rebalancing in fiscal revenues, as highlighted by the FS in the budget speech.   Revenues of a non-recurrent and capital nature, and those related to the strength of the property sector, continue to account for a large portion of total revenues.  Although land premium, asset sales and investment income fell short of original targets in F2005/06, the government has continued to project ambitious targets (though downwardly revised) from these sources in its medium-range forecasts.  In the next five fiscal years, the government now targets HK$172.1bn in land, HK$52.7bn in other assets, and HK$72.2bn from investment income on fiscal reserves.  Meanwhile, property-related revenues have trended upwards to an estimated HK$80bn in F2005/06, or 31% of the total, the highest since F1997/98.

In considering future tax changes, the government will need to assess not only their financial impact, but also, perhaps, their behavioural impact — at least to an extent that will not significantly sacrifice the “simplicity” of the tax system.   For example, there is much discussion on extending and/or lifting tax allowances or deductions for (1) child support, (2) medical insurance payments and (3) voluntary contributions to retirement saving schemes, to encourage childbirth and savings accordingly.  We look forward to seeing radical fiscal reform measures in the next few years in combination with the introduction of GST, guiding Hong Kong towards a more sustainable fiscal system.

Maintaining Economic Forecasts

The Hong Kong economy grew by 7.3% in real terms in 2005, broadly in line with our 7.4% forecast.  We are maintaining our 5% growth forecast for 2006, representing a noticeable yet orderly slowdown from 2005, consistent with our call for slowing growth in China.  Leading the slowdown will be the dip in trade growth to single-digit rates, the slowest since 2002, but services exports will remain a key growth driver, in our view.  We forecast 2% CPI inflation in 2006, picking up further from 1.1% in 2005, on the back of the protracted process of rental contract renewals.

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Malaysia
4Q05 Slower Than Expected
Feb 23, 2006

Deyi Tan (Singapore) and Denise Yam, CFA (Hong Kong)

4Q05 GDP growth slower than expected: 4Q05 GDP rose 5.2% year on year (YoY), slower than our (+6%) and market expectations (+5.7%), and also slower than 3Q’s 5.3%.  Growth averaged 5.3% for the full year, down from 7.1% in 2004.

Downside surprise in investment: The downside surprise came from the slowdown in fixed investment (+0.4% YoY vs. +9.6% in 3Q) as well as de-stocking.   Gross investment plunged 18.3% YoY in 4Q.  The trend is consistent with what we have been observing in capital imports, but the decline was sharper than we expected.  We believe this could be due partly to a payback from the uncharacteristically strong readings in 2Q (+6.7% YoY) and 3Q (+9.6% YoY).  For the full year, fixed investment growth accelerated to 4.7% YoY from 3.1% in 2004.

Slight easing in consumption growth:   The deceleration in liquidity expansion due to the decline in foreign reserves in 4Q appeared to have curtailed consumption growth (+9% YoY vs. +10.4% in 3Q), despite observed buoyant sentiment.  With the labour market not showing any discernible improvement over time and payrolls growth, which usually outpaces consumption momentum, now lagging somewhat, current strong consumption appears to be sustained by liquidity.  With tightening liquidity ahead, there could be a further moderation to consumption, in our view.

Improvement in external balance expected:   The trade cycle turned up in 4Q05.  Exports (+10.4% YoY) outpaced imports (+8% YoY), underpinned by strong electronics and resource commodity exports.  The external balance contributed 3.4 percentage points (pp) to growth (vs. -1.4 pp in 3Q).  External demand should continue to stay strong at least through 1H06.

Structural positives still in the making; hang on to cyclical positives for support:   The rising trajectory in global demand and ongoing loose liquidity will continue to sustain growth at a decent pace in the short term.

Though the market seems to be fairly happy with Prime Minister Badawi’s cabinet reshuffle last week, and there has been gradual momentum in dismantling rent-seeking and GLC reforms in the past year, it has not been enough to create an obvious structural uplift in private investment to fill up the void after the government abandoned pump-priming.    Meanwhile, the Central Bank raised the overnight policy rate by 25 bp to 3.25%.  Interest rate decisions will depend on inflation movements going forward.  Future inflationary pressures would be dependent on fuel prices and electricity tariffs revisions, without which inflation should ease on higher base effects.

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Spain
More Competitive Than You Think
Feb 23, 2006

Vincenzo Guzzo (London)

Impressive numbers to trigger more scepticism.   In 2005, Spain grew by nearly 3.5%, two percentage points better than the euro area.  The pace of domestic demand was even faster: 5.3% from a year earlier.  A GDP deflator of 4.5% means that the progress in nominal terms was very close to 10%.  The economy added more than half a million jobs and wage income surged by more than 6%.  No matter how good these numbers may sound, investors are increasingly sceptical.  The consensus view is that Spain’s external position is deteriorating rapidly owing to a significant loss of competitiveness.  Soon, the economy will have to pay a toll on these growing imbalances.  Historically low interest rates and sizeable transfers from the EU budget have led to a boom in the construction sector, which in turn is driving the current phase of economic expansion.  With the ECB now moving to a tightening cycle and the EU structural funds fading away, the construction sector will fall and strong economic growth will evaporate.  We disagree.

Imbalances are building, but …  True, net exports weigh adversely on GDP growth, inflation is higher than on the rest of the continent, and real effective exchange rate keeps appreciating.  We acknowledge risks to our optimistic view of the country, but think that none of these factors provides conclusive evidence of falling competitiveness or it will be able to tilt the balance towards significantly slower economic expansion.  Let us see why.

I) Negative net export contribution might be a sign of strength rather than weakness.   Between 1998 and 2005, Spain’s net export contributions subtracted on average 1.3 percentage points per year from annual GDP growth.  This may seem a dismal performance.  In fact, it is a by-product of the country’s outperformance on its trading partners.  Net exports were simply the mirror image of domestic demand.  They weighed more heavily on GDP precisely when domestic demand accelerated: in 1998-99 and in 2004-05.  The explanation is straightforward: for a given import content of demand, periods of faster domestic demand brought in faster imports.  During those years, exports were not deteriorating; stronger imports were merely outpacing them.  The OECD measure of export performance, a ratio between export volumes and export markets for goods and services, allows us to draw similar conclusions.  Over the past 10 years, export volumes have advanced in line with export markets leaving Spain’s market shares broadly stable.  If exports did not keep up with imports, this is simply due to weak external markets, not to loss of competitiveness.

II) Inflation differentials might be a response to productivity differentials.   Wide inflation differentials are another source of concern.  Since the launch of EMU, Spain’s consumer price inflation has exceeded that of the euro area by a full percentage point.  Once again, this is not necessarily evidence of falling competitiveness.  Balassa and Samuelson (BS) first pointed out the possible link between inflation and productivity growth in catching-up economies.  When a country opens up to trade, the productivity in its tradable goods sector tends to rise faster, gradually closing up the gap with the level prevailing in the world economy.  This acceleration in productivity leads to higher wage growth in the traded goods sector and, if labour is perfectly mobile across sectors, in the non-traded goods sector too.  In the latter, however, productivity does not benefit from enhanced competition and higher wage growth simply leads to higher inflation via faster unit labour cost.  Other factors such as residual wage indexation mechanisms are also behind Spain’s inflation differential, but overall there seem to be some BS effect in the Spanish economy.  In previous works (Worried about Inflation? Lessons from the South, September 12, 2003), we showed that nearly half of the inflation differential between 1992 and 2003 was probably due to a BS effect.

III) Real exchange rate appreciation might hide significant structural adjustments.   Another argument often raised to support the case of a deteriorating external position is Spain’s productivity stagnation and the related real effective exchange rate appreciation.  When deflated by unit labour costs, today’s real exchange rate is 10% higher than in 1999 for the economy as a whole and nearly 15% higher for the manufacturing sector.  At face value, these numbers would require a large adjustment in relative prices and wages.  Things are better than they appear though.  Large migratory flows, a shrinking underground economy, and dramatic progress in the labour market, with nearly seven million jobs created in only 10 years, have all come at the expense of labour productivity, thus inflating unit labour costs.  No doubt, Spain’s total factor productivity would benefit from further investment in infrastructure, human capital and R&D, but, as the country approaches some lower-unemployment equilibrium, the outlook for the marginal productivity of labour is not as bleak as recent data may suggest.

Bottom line: We think that Spain will continue to outperform by a wide margin, our current GDP forecast for this year standing at 3.3% versus 2.1% for the euro area.

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Egypt
Conquering Fear of Change
Feb 23, 2006

Serhan Cevik (London)

The 2005 elections, despite all the shortcomings, marked the beginning of political change.    All around the world, voters demand — and even, in some cases, drive — institutional change for greater political and economic freedoms.   We have witnessed the most significant of such openings, astonishingly, in the Middle East, as the wave of political transformation, travelling across the region, has carried the ‘Arab Street’ into national assemblies.   And Egypt is no exception.   With the introduction of a constitutional amendment allowing the direct and competitive election of the president, last year’s presidential and parliamentary elections marked the beginning of democratic transformation in Egypt’s monotonous political landscape.   Even though some observers still argue that democratisation is a threat to political stability, we believe that underlying changes, albeit challenging, represent an opportunity to break the mould of autocratic regimes that have brought nothing but underdevelopment and social exclusion in the Middle East and North Africa region.

The rise of the Muslim Brotherhood reflects a protest vote against the status quo.    The Muslim Brotherhood — an officially banned organisation — has made unprecedented gains in parliamentary elections, increasing the number of seats from 17 to 88 in the 454-seat parliament.   In our view, the Muslim Brotherhood, taking advantage of anti-American sentiment in the Middle East, has benefited from the support of marginalised segments of Egyptian society.   In other words, protest votes against the status quo’s failure to improve socio-economic conditions, not necessarily growing support for political Islam, made the Muslim Brotherhood the biggest opposition bloc in the national assembly.   Moreover, the erosion of the National Democratic Party’s majority may represent a historic shift in politics, but the extent of its prevailing majority — 72.5% of law-making seats — is still more than enough to maintain ‘stability’ in government and during transition towards a more liberal political order.   In our opinion, since exclusion fuels fanaticism, the key issue at this stage of progress is the broadening of parliamentary representation to absorb ‘marginal’ groupings into legitimate political life.   Therefore, we do not see pluralist democracy as a threat, but actually as the best mechanism to build a broad consensus on political and economic reforms the Egyptian economy needs to realise its full potential.   From such an angle, the latest election results reveal encouraging signs of change.   For example, electoral competition — measured by the ratio of candidates to parliamentary seats — increased from 4.7 in 1976 to 8.9 in 2000 and 11.7 last year.   As a result, the share of opposition in the new parliament increased to 27.5% of the total number of seats, creating the most diverse assembly in Egypt’s history.

Political democracy alone does not guarantee a liberal order.    Free and fair elections can lead to further democratisation as well as openly-hostile autocratic regimes.   In other words, elections alone are not enough to establish liberal democracy and to improve the welfare of the people.   Without a certain political culture and a proper institutional framework supporting the rule of law, political mobility would not automatically result in democratic transformation and the constitution of liberty.   Indeed, there are as many lawless democracies as undemocratic states of law around the world.   Therefore, moving away from a one-party mentality is just the first step in the right direction, but not enough to create modern institutions and liberal democracy.

Economic development and democratisation are essential for the sustainability of the other.   The relationship between democratisation and economic development may not be apparent in the short run, but there is overwhelming evidence suggesting that countries with greater political and economic freedoms produce faster economic growth and greater prosperity than countries that limit civil liberties and economic rights (see, for example, Morton Halperin, Joseph Siegle and Michael Weinstein, The Democracy Advantage: How Democracies Promote Prosperity and Peace, Routledge, 2004).   This is why we firmly believe that Egypt needs a paradigm shift in institutional development to accelerate the emergence of a productive private sector and to achieve sustainable improvements in socio-economic conditions.

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