IMF – Page 11 – Digital Finance Analytics (DFA) Blog

A Shifting U.S. Policy Mix: Global Rewards and Risks

After a year marked by financial turbulence, political surprises, and unsteady growth in many parts of the world, the Fed’s decision this month to raise interest rates for just the second time in a decade is a healthy symptom that the recovery of the world’s largest economy is on track.

The Fed’s action was hardly a surprise: markets had for weeks placed a high probability on last week’s move. But market developments preceding the Fed decision did surprise many market watchers.

Especially striking were the sharp upward moves in longer-term U.S. interest rates, the dollar, and market-based measures of long-term inflation expectations soon after the U.S. presidential and congressional elections of November 8. No comparably abrupt market reactions preceded the Fed’s previous interest rate hike of December 2015 (see chart).

The dollar has risen further in the days following the Fed’s recent move.

Time will tell if these market developments point to a new trend. Most likely, however, the election marks a shift in the U.S. policy regime with potentially even bigger future effects on prices and activity—abroad, as well as in the United States. Spillovers outside the United States will be felt especially strongly in emerging market economies, where for some, the advantages of enhanced competitiveness due to weaker currencies may be finely balanced against vulnerabilities.

Something has changed

From the start of 2016 and through the U.S. election, Treasury yields had been particularly low. Discussion of the global outlook, including at the IMF, stressed the risks of protracted low growth and continuing deflation pressures—even secular stagnation, with persistently low interest rates.

Longer-term nominal interest rates are, however, strongly influenced by expectations of the future path of the Fed’s policy rate, which in turn responds to U.S. inflation pressures and the economy’s underlying strength. Thus, the sharp post-election turnaround in longer-term U.S. interest rates changed the conversation: it likely reflected not the looming December rate hike alone, which was already widely anticipated, but also a shift in expectations about the future interest rate path and future demand in the U.S. economy.

Consistent with those expectations, while last week’s interest-rate hike was itself not unexpected, the future path of interest rates that Federal Open Market Committee members anticipate also steepened, and now suggests three interest rate hikes in each of the next two years.

The timing of the abrupt asset-price movements—coming within days of the U.S. election—is the key clue about what moved markets. The election of Donald Trump as president, coupled with continuing Republican control of the Congress, ended six years of divided U.S. government.

Implications for the future

Republicans in Congress have long advocated lower personal and corporate tax rates. President-elect Trump campaigned on a platform that included not only substantial tax cuts, but also increases in some categories of government spending, notably defense and infrastructure.

At this early stage, it is hard to know precisely how the shift in fiscal policy will look. One thing seems clear, however: it will turn more expansionary through some combination of more spending and lower tax rates.

In general, any increase in U.S. aggregate demand will generate some rise in real output—as new workers are hired, others work longer hours, and machinery is used more intensively—and some upward pressure on inflation. With the overall unemployment rate at 4.6 percent and other measures of labor market distress largely recovered from the financial crisis eight years ago, there could be little remaining slack in the U.S. economy. Unless labor force participation and overtime work rise significantly, there is a chance that inflation pressure therefore rises noticeably. This seems to be what the Fed has in mind when it predicts it will raise the federal funds rate more quickly.

More rapidly rising U.S. interest rates signal further dollar appreciation. Tax incentives for U.S. corporation to repatriate their past profits held abroad, which some estimate at $2.5 trillion, could also push the dollar up. Given faster demand growth, the outcome will be a widening U.S. current account deficit, that is, more borrowing from abroad. Some of it will possibly finance a growing Federal fiscal deficit, depending on the precise features of the U.S. fiscal package, the extent to which it is paid for by budget cuts elsewhere, the path of government borrowing rates, and the economy’s growth response.

U.S. growth will respond more strongly, with lower inflation, if any infrastructure spending is carefully designed to boost potential output, while tax measures encourage investment, labor supply, and inclusion.

International challenges ahead

Given the United States’ central role in the world economy, big changes in its policy mix have first-order effects beyond its borders.

Advanced economies with currencies that depreciate against the dollar will benefit both from higher U.S. growth and from more competitive exchange rates. For most of these economies, currently struggling with below-target inflation, any resulting inflationary pressure would (at least initially) be welcome. They may also see upward pressure on interest rates, posing a fiscal challenge for countries that are highly indebted but do not benefit enough from the positive demand spillovers that are driving their interest rates upward.

Emerging market economies can also benefit from more competitive currencies and higher U.S. demand. But although many emerging market economies have increased their policy buffers (e.g., foreign reserves), reduced currency mismatches, and improved financial oversight frameworks, some could still feel stress, especially where there are pre-existing political or economic strains.

Historically, U.S. interest rates have been one of the key drivers of net capital flows into emerging market economies. Flexible exchange rates can be helpful as a buffer against rapid outflows, as they allow international portfolios to rebalance through currency changes rather than reserve losses. A combination of rising dollar interest rates and domestic currency depreciation could reduce liquidity or worsen balance sheets, however, especially given the importance of dollar borrowing by residents and non-resident corporates in emerging market economies. Furthermore, currency depreciation might spark higher inflation. Policymakers in emerging markets therefore will remain vigilant.

If sharp exchange rate shifts and growing global imbalances follow the U.S. policy regime change, protectionist pressures become a major risk, as in past similar circumstances. Given the desire of advanced economy governments to maintain manufacturing, where emerging markets have made big inroads in recent decades, it is most likely that emerging market economies are the main targets for higher trade barriers erected by advanced economies.

Governments should therefore keep in mind that protection is likely to be counterproductive at home—even before trade partners retaliate, as they will be tempted to do. The integration of advanced economies into truly global supply chains underscores this danger. In an environment of sharply divergent policy mixes, as we may now be facing, the rules of the global trading system will be more important than ever.

Watch our recent video explaining how interest rates work:

China Must Quickly Tackle its Corporate Debt Problems

From The iMF Direct Blog.

China urgently needs to tackle its corporate-debt problem before it becomes a major drag on growth in the world’s No. 2 economy. Corporate debt has reached very high levels and continues to grow. In our recent paper, we recommend that the government act promptly to adopt a comprehensive program that would sacrifice some economic growth in the short term while rapidly returning the economy to a sustainable growth path.

Let’s first take a look at the dimensions of the problem. From 2009 to 2015, credit grew very rapidly by 20 percent on average per year, much more than growth in nominal gross domestic product. What’s more, the ratio of non-financial private credit to GDP rose from around 150 percent to more than 200 percent, or about 20-25 percentage points higher than the historical trend. Such a “credit gap” is comparable to those in countries that experienced painful deleveraging, such as Spain, Thailand, and Japan (see Chart 1).

This corporate credit boom reflected the government efforts to stimulate the economy in the wake of the global financial crisis, largely through lending for infrastructure and real estate. The outcome: overbuilding and a severe overhang of unsold properties, especially in lower-tier cities, along with excess capacity in related industries such as steel, cement and coal. The combination of heavy borrowing and falling profits led to excessive debt loads. The problem has been worst among state-owned enterprises that benefit from preferential access to financing and implicit government guarantees, which lower the cost of borrowing.

High-level decision

So what is the solution? First, the government should make a high-level decision to stop financing weak companies, strengthen corporate governance, mitigate social costs and accept likely slower growth in the near term. It needs buy-in at every level—state-owned enterprises, local governments, and financial supervisors. Here are the other steps China’s government can take:

Triage: Identify companies in financial difficulty and distinguish between those that should be restructured and those “zombie” companies that have no hope of survival and that should be allowed to exit. Because of the existing links between state-owned banks and corporations, a new agency could be created to perform this role.

Recognize losses: Require banks to recognize and manage impaired assets. So-called shadow banks—trust, securities and asset-management companies—should also be forced to recognize losses.

Share the burden: Allocate losses among banks, corporates, investors and, if necessary, the government.

Harden budget constraints—especially on state owned enterprises—by improving corporate governance and removing implicit guarantees to prevent further misallocation of credit and losses.

To make the program work and limit the short-term economic pain, other supportive measures are needed:

Improve the legal framework for insolvency: But large-scale and expedited restructuring also requires out-of-court mechanisms to complement the existing framework.

Ease the transition: Broaden unemployment insurance coverage, provide income support for displaced workers and help them find new jobs. The social safety net should be improved because closing or restructuring loss-making companies in industries such as coal and steel could result in substantial layoffs.

Facilitate market entry: Dismantle monopolies in services such as telecommunications and health care and foster greater competition.

Improve local government finance: Ensure sufficient taxing powers and revenue sources for local governments to discourage off-balance-sheet borrowing.

Risks appear manageable if the problem is addressed promptly. Indeed, it is encouraging that the government has recognized the problem and is taking action to address it. The comprehensive strategy we have outlined would allow China to reduce leverage, limit vulnerabilities, and return to a strong and sustainable growth path over the medium term.

Read our recently published working paper for more information.

Infrastructure Done Right

From The IMF Blog – iMFdirect

In the face of crumbling bridges and super-low interest rates, many countries are talking and planning to increase spending on infrastructure. And it’s not just about more spending; it’s about smart spending. This is something that the IMF has urged countries to consider for several years, starting with our Fall 2014 World Economic Outlook.

Bridges, roads, and highways, along with telecoms, ports and airports are all part of the backbone that supports a country’s growth and the global economy.

Investing in building schools, public housing and hospitals, known as social infrastructure, can provide a powerful impetus for economic activity and jobs in countries. Canada and the United Kingdom have announced and begun plans to invest billions in the coming years to fix and modernize their infrastructure, sorely in need of an upgrade. The incoming U.S. Administration has also indicated its intention to increase investment in infrastructure.

For the past several years, the IMF has analyzed the data and produced new research on the benefits and best way to spend taxpayer dollars on infrastructure. With interest rates still low, the IMF research suggests that debt-financed investment could virtually pay for itself by boosting demand in the short run and productivity in the long run. But that comes with a caveat: the quality of investment matters. So countries should invest well, where there is a clear need, and invest efficiently.

Two weeks ago, IMF Deputy Managing Director Tao Zhang gave a speech about how countries can meet the growing needs, and challenges, of investing in public infrastructure.

Why Productivity Growth is Faltering in Aging Europe and Japan

From The IMF Blog.

Many countries are experiencing a combination of declining birth rates and increasing longevity. In other words, their populations are aging. And graying populations pose serious issues for people, policymakers, and society.

Health care costs rise, mainly because older people need more of it. Pension payments—whether from public or private plans—also increase at the same time there are relatively fewer younger workers paying into the pension systems. And there are also fewer people producing goods and services relative to the total population. The old-age dependency ratio—the number of people over 65 divided by the number of people between 15 and 64—rises. In other words, there are economic strains and many countries that haven’t faced them yet will soon.

One way to alleviate those strains would be to increase the amount of goods and services each worker produces—that is to boost productivity. Productivity is a major driver of economic growth. When it is rising, more goods and services are produced from the same amount of input—giving society more output to divvy up. When productivity is falling, GDP growth is retarded.

How aging affects productivity

But two recent papers by IMF economists suggest that there are limited prospects for productivity to come to the rescue. That’s because not only is the overall population aging, so are those still in the workforce. And the aging workforce is holding down productivity growth in both Europe and Japan.

The decline in productivity in Japan and Europe manifested itself in what economists call Total Factor Productivity, which is the portion of economic growth that is not the result of changes in inputs (such as capital and labor). Total factor productivity measures how efficiently capital and labor are used in the production process and is affected by such things as innovation, institutions and the quality of the workforce.

Productivity generally increases until workers are in their 40s, then tails off until they stop working. In Japan, for example, workers in the 40 to 49 age group were the most productive, with productivity declining after that. Authors Yihan Liu and Niklas Westelius calculated that the aging workforce could have reduced Japan’s annual total factor productivity growth by as much as 0.7–0.9 percentage points between 1990 and 2005. The decline was largely due to the reduction in the 40 to 49 age group. Starting in 2010, the 40 to 49 group increased a bit, but after 2025 shifts in the working age population age will again reduce total factor productivity growth.

The story is similar for 28 countries in Europe. Authors Shekhar Aiyar, Christian Ebeke, and Xiabo Shao found that the growing number of workers aged 55 and older on average “lowered total factor productivity growth by about 0.1 percentage points each year over the past two decades.” But that varied across countries. In Latvia, Lithuania, Finland, the Netherlands, and Germany, workforce aging shaved about 0.2 percentage points off annual total factor productivity growth.

Future could be worse

Under current demographic projections, the future will be worse. From 2014 to 2045 workforce aging will intensify in Europe and could reduce annual total factor productivity growth by 0.2 percentage points. But in countries where aging will be most pronounced—Greece, Hungary, Ireland, Italy, Portugal, Slovakia, Slovenia, and Spain—annual total factor productivity growth could be reduced by as much as 0.6 percentage points.

Aiyar, Ebeke, and Shao write that some of the effects of total factor productivity erosion from workforce aging might be offset in Europe by such policies as:

Broadening access to medical services to improve the overall population health;

Improving workforce training;

Reforming labor markets to make it easier for older workers to change jobs; and

Promoting technological innovation to improve overall productivity—among other things, through increased spending on research and development. To the extent that such changes (for example, devices that reduce physical labor associated with manufacturing) disproportionately benefit senior workers, they could mitigate the adverse effects of an aging workforce on total factor productivity growth.

Global House Prices: Time to Worry Again?

From The IMF Blog.

During 2007-08, house prices in several countries collapsed, marking the onset of a global financial crisis. The IMF’s Global House Price Index, a simple average of real house prices for 57 countries, is now almost back to its level before the crisis (Chart 1). Is it time to worry again about a global fall in house prices?

The classic study of financial crises by Carmen Reinhart and Ken Rogoff has taught us the folly of claiming “this time is different.” Still, there are several reasons to think that the present conjuncture is a time for vigilance but not panic.

First, unlike the boom of the 2000s, the current boom in house prices is not synchronized across countries. And within countries, the boom is often restricted to one or a few cities. In many cases, the booms are not being driven by strong credit growth: some house price increases, particularly at the city level, are due to supply constraints.

Second, countries are now more active in the use of macroprudential policies to tame housing booms. As our former Deputy Managing Director Min Zhu declared: “The era of benign neglect of house price booms is over.”

Lack of synchronicity

A closer look at the global index reveals three clusters of countries (Chart 2, left panel).

The first cluster—gloom—consists of 18 economies in which house prices fell substantially during the global financial crisis and have remained on a downward path.

The second—bust and boom—consists of 18 economies in which housing markets have rebounded since 2013 after falling sharply during 2007-12.

The third—boom—comprises 21 economies in which the drop in house prices in 2007–12 was quite modest and was followed by a quick rebound.

Not only are there differences across countries, but the situation differs within countries. China offers a good example. While land prices overall have kept up a steady upward march, this masks tremendous variation at the city level. Beijing has “experienced one of the greatest booms ever seen in housing markets,” according to Joe Gyourko, an expert at the University of Pennsylvania. With his co-authors, Gyourko has constructed a residential land price index for 35 large cities in China based on government sales of land to private developers. These data show that prices have increased in inflation-adjusted terms by about 80 percent a year in Beijing over the past decade but by only 10 percent a year in Xian. Whether this pattern of price increases will continue depends on the balance between supply and demand, which varies across cities as well. Some other examples are those of Amsterdam, Oslo, and Vienna, where house prices are rising far more than the national averages.

Supply constraints

Many of the past housing booms were driven by excessive credit growth. But this time supply constraints appear to be playing a big role in driving some of the price booms. Residential permits have grown only modestly in the “boom” and “bust and boom” country clusters (Chart 2, right panel). The impact of supply constraints is evident in the case of many of cities. In Copenhagen and Stockholm, the increase in the housing stock has not kept up with population growth, feeding some of the price increase observed there. In recent years, the IMF has also flagged the role of supply constraints in some cities in Australia and Canada, as well as in many European countries—France, Germany, the Netherlands, Norway, and the United Kingdom.

Increased vigilance

Another difference from the pre-crisis period is that national and international regulators are being more vigilant about monitoring house price booms and using macroprudential policies to tame them. The use of such policies has been quite extensive in the period since the crisis, particularly in the “gloom” and “boom” clusters (Chart 3).

The IMF has been urging macroprudential measures, alongside measures to boost supply, in many countries including Australia, Canada, and several European countries. This is because, even if house price increases are due to supply constraints, their impact of household indebtedness could have adverse implications for financial stability.

Just last week, the European Systemic Risk Board published a set of country-specific warnings on medium-term vulnerabilities in the residential sector for eight member states: Austria, Belgium, Denmark, Finland, Luxembourg, the Netherlands, Sweden, and the United Kingdom. This provides a good example of the kind of vigilance that will be needed to keep the past from again becoming prologue.

IMF Updates Global Housing Watch

The latest IMF’s Global House Price Index—an average of real house prices across countries—is now almost back to its level before the financial crisis. But there are significant variations, and policy responses.

Developments in the countries that make up the index fall into three clusters. The first cluster—gloom—consists of 18 economies in which house prices fell substantially at the onset of the Great Recession, and have remained on a downward path. The second cluster—bust and boom— consists of 18 economies in which housing markets have rebounded since 2013 after falling sharply during 2007-12. The third cluster—boom—comprises 21 economies in which the drop in house prices in 2007–12 was quite modest and was followed by a quick rebound.

Gloom = Brazil, China, Croatia, Cyprus, Finland, France, Greece, Italy, Macedonia, Morocco, Netherlands, Poland, Russia, Serbia, Singapore, Slovenia, Spain, Ukraine.

Bust and boom = Bulgaria, Denmark, Estonia, Germany, Hungary, Iceland, Indonesia, Ireland, Japan, Latvia, Lithuania, Malta, New Zealand, Portugal, South Africa, Thailand, United Kingdom, United States.

Boom = Australia, Austria, Belgium, Canada, Chile, Colombia, Czech Republic, Hong Kong SAR, India, Israel, Kazakhstan, Korea, Malaysia, Mexico, Norway, Peru, Philippines, Slovak Republic, Sweden, Switzerland, Taiwan.

Credit has expanded much faster in the boom group than in the other two.

Construction gross value added and residential building permits have stagnated in the gloom group relative to the other two.

Among the gloom group:

In China, excess inventory remains high. The IMF assessment points out that for lower-tier cities, where multi-year excess inventory levels are particularly acute, restricting new starts seems warranted, for example by tightening prudential measures on credit to property developers.

In Netherlands, the turnaround in house prices presents an opportunity to remove some of the incentives for excessive leverage—thereby reducing the likelihood and intensity of boom-bust cycles.

There are some concerns about sustainability in a few boom or bust and boom economies:

IMF assessments state that in Belgium, Canada, Luxembourg, Malaysia, Malta, and the United Kingdom, additional macroprudential measures may be needed or considered if housing market vulnerabilities intensify.

In the case of Norway, the IMF assessment points to a substantial overvaluation. In some other cases—Belgium, Korea, and Morocco—the assessments do not find overvaluation.

IMF assessments point to supply constraints as a factor driving house prices in a number of countries where prices have rebounded, including Denmark, Germany, New Zealand, and the United Kingdom.

Many countries have been actively using macroprudential tools to manage house price booms. The main macroprudential tools employed for this purpose are limits on loan-to-value ratios and debt-service-to-income ratios and sectoral capital requirements.

Figure 6 shows that macroprudential policies have been very active in the boom group, followed by gloom group, and bust and boom group.

Loan-to-value ratios: Gloom = Brazil, China, Finland, Netherlands, Poland, Serbia, Singapore, Spain. Bust and boom = Estonia, Hungary, Iceland, Indonesia, Latvia, Lithuania, New Zealand, Thailand. Boom = Canada, Chile, Czech Republic, Hong Kong, Israel, Korea, Malaysia, Norway, Philippines, Slovak Republic, Sweden, Taiwan.

Debt-service-to-income ratios: Gloom = Cyprus, Netherlands, Poland, Serbia. Bust and boom = Estonia, Hungary, Ireland, Latvia, United Kingdom, United States. Boom = Canada, Hong Kong, India, Israel, Malaysia, Norway.

Sectoral capital requirements: Gloom = Brazil, Croatia, France, Italy, Poland, Russia, Serbia, Spain. Bust and boom = Bulgaria, Estonia, Iceland, Ireland, Latvia, Lithuania, New Zealand, South Africa, Thailand, United Kingdom, United States. Boom = Australia, Belgium, Colombia, Hong Kong, India, Israel, Korea, Malaysia, Norway, Peru, Slovak Republic, Switzerland, Taiwan.

The Hidden Costs Of Bank Support

During the GFC, a number of banks were bailed out to stop them failing using tax payer funds. Whilst the immediate crisis passed, there is still a residual level of support to banks, and an expectation that if they got into financial difficulty, they would be bailed out. This allows them to gain funding cost advantages (priced closer to their countries credit rating). The level of support though is unclear, and the cost to society not fully understood.

So the newly released working paper from the IMF – Whose Credit Line is it Anyway: An Update on Banks’ Implicit Subsidies makes interesting reading.

It is safe to say that the recent designation of particular institutions as systemically important by regulators has had a non-negative impact on the perception that these institutions would be assisted in the event of a crisis. So-called living wills are intended to render the default of these institutions manageable but the process remains murky, failing to establish confidence that a default could be managed in a controlled manner. Indeed, U.S. regulators recently ruled that many of the current plans, submitted by the banks themselves, remain non-credible.

Therefore, the issue of preventing public sector involvement in the resolution remains unsolved. The other primary pillar of the reform agenda is to decrease the probability of such events occurring in the first place, most notably via higher capital requirements. In addition to the direct benefit of making the institutions safer, this reduction in default probabilities has the benefit of allocating potential losses to a greater extent to shareholders and thus reducing the implicit subsidies received by the institutions.

They use an option pricing model to assess the value of the implicit support provided to a sample of the 11 global systemically-important (G-SIB) banks with a surcharge of 1.5 percent or higher, as defined by the FSB in 2015. Here are the banks studied.

They find that the baseline result shows total subsidies for the 11 banks peaked at 135bn USD in 2009 before declining to 62bn USD last year.

Therefore the weighted average subsidy for eleven G-SIBs peaked at 70 bps during the crisis and has declined to approximately 35 bps in the post-crisis era, which is in line with the literature although towards the lower end of the range.

They conclude that while these subsidies have declined in the post-crisis era as volatility has declined and capital levels have increased, they remain non-trivial. Even conservative parameterizations of default and loss probabilities lead to macroeconomically significant figures.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

IMF Highlights “New Mediocre” Risks To Australian Economy

The IMF concluding statement says Australia is transitioning from the mining boom with strong growth and relatively low unemployment, but has not been immune to symptoms of the “new mediocre”. Wage and price pressures are weak, underemployment has risen, and non-mining investment is yet to fully recover. Ensuring the return to full employment under weak global conditions will need continued accommodative monetary policy and quality infrastructure spending, which will also boost long term growth potential. A coordinated fiscal and monetary policy response may also be needed if large downside risks were to materialize. Prudential policies have helped reduce housing related risks, and efforts to strengthen financial sector resilience should continue.

Context

Australia’s economic performance has remained remarkably robust in comparison to other advanced economies despite lower commodity prices and the end of the mining investment boom. The resilience to the large shocks since 2011 reflects a flexible exchange rate acting as a shock absorber, an accommodative monetary policy stance, export orientation to the dynamic Asia region, flexible labor markets, relatively high population growth, and strong institutions.

Still, Australia has been confronted with symptoms of the “new mediocre,” albeit to a lesser extent than in almost all other advanced economies. Growth has been lower since the global financial crisis (GFC), with much of the related decline in potential growth because of moderating population growth. As elsewhere, the recovery has fallen short of expectations in 2014-15, because of external and internal factors, including in non-mining business investment. While unemployment has remained relatively low, underemployment and longer-term unemployment have risen, and nominal wage growth and inflation have been weak.

House prices and household debt ratios have risen further in the low-interest environment post-GFC, up from already high pre-crisis levels. Other macro-financial vulnerabilities relate to the perennial, sizeable net external liabilities, intermediated in part through the banking sector.

Recent Developments, Outlook and Risks

After a pickup in economic activity from mid-2015, Australia has advanced markedly in its recovery but experienced a downshift in inflation in early 2016. Annual growth has increased to over 3 percent, partly on account of temporary factors. Both headline and core inflation are now below the RBA’s 2 to 3 percent target range.

Economic slack has started to moderate, although the fall in the unemployment rate has likely overstated the improvement in labor markets. The underemployment rate—defined as the proportion of employed persons in the labor force seeking to work more hours—has risen, as some 80 percent of jobs created over the past year have been part-time jobs.

On the macro-financial side, prudential policies have resulted in a tentative stabilization of housing-related vulnerabilities. APRA’s prudential measures introduced in late 2014, including tighter lending standards focusing on debt serviceability, have improved the risk profile of new loans. Overall housing credit growth and market turnover have remained lower than last year. But with the declines in longer-term interest rates and continued strong demand, including from nonresidents, upward pressure on house prices has remained strong in some cities. While household debt has continued to be high, risks to banks and to household balance sheets are mitigated by the ongoing strong growth in deposits in mortgage offset accounts.

Banks’ balance sheets have become more resilient . APRA’s analysis suggests that, after raising capital, CET-1 capital ratios of Australian banks have, on a comparable basis, narrowly moved into the upper quartile of international peers (broadly in line with the Financial System Inquiry recommendation that banks’ capital positions be “unquestionably strong”). As banks prepare to meet net stable funding ratio requirements by 2018, the share of stable funding in their liabilities has already increased, including higher shares of domestic deposits and longer-term debt.

The baseline outlook is for a continued gradual recovery. After strong momentum, growth is expected to moderate somewhat over the next two years. The disinflation experienced in 2015-16 is expected to start reversing. On the macro-financial side, house price inflation is expected to realign with broader measures of nominal income. The accumulation of net external liabilities should slow in the absence of valuation effects.

The balance of risks has improved but is still tilted to the downside. On the upside, the momentum of the recovery could be stronger, as recent strong growth and terms-of-trade improvements could boost business confidence and unlock stronger business investment. On the downside, investment could be more subdued, as corporate profits could remain under pressure for longer. Consumption growth could turn lackluster if wage growth stayed low. On the external side, there are risks to global trade from rising populism and nationalism in large economies and from tighter and more volatile global financial conditions. A major concern is that external risks with a large impact, including a sharp growth slowdown in China, could interact with or even trigger domestic risks, especially a housing correction.

Policy Discussion

Australia’s transition following the end of the mining investment boom is well advanced but adequate policy support remains critical to secure the return to full employment in a fragile global environment and longer-term growth. The lack of significant price and wage pressures suggests persistent slack, which, if prolonged, risks hurting medium-term supply potential.

Monetary Policy

The monetary policy stance should remain accommodative in a still disinflationary global environment. While Australia’s low inflation is more recent than in most other advanced economies, policy decisions should remain predicated on the possibility that inflation may return into the target range later than expected, given international experience. In this regard, the RBA’s prompt monetary policy response to the lower-than-expected inflation in early 2016 has reinforced its commitment to the inflation targeting framework. Prudential measures to address housing-related risks have mitigated concerns about the impact on balance sheets and financial stability from lowering policy rates further. With the expected very gradual return of inflation into the target range, lengthening the forecast horizon in monetary policy statements could clarify the RBA’s expectations about the inflation path.

Fiscal Policy

Australia has fiscal space even though recent budget targets have been missed and debt has risen. Metrics such as the debt-to-GDP ratio suggest that there is fiscal space under both the baseline and economic stress scenarios. In IMF staff’s view, the worse-than-planned budget outcomes over the past few years have reflected the weaker-than-expected growth rather than policy easing. Forging ahead with consolidation would most likely have resulted in lower growth over that period.

The government appropriately plans to balance the budget over a 5-year horizon while making the expenditure composition more growth-friendly. The change in the expenditure composition focuses on supporting longer-term growth through spending on infrastructure and other measures supporting longer-term and inclusive growth, including measures to boost innovation and address youth unemployment.

In IMF staff’s view, the pace of targeted fiscal consolidation under the baseline should be more gradual and some of the growth-friendly spending should be ramped up.

The May 2016 budget targets front-loaded fiscal consolidation, especially in FY2017/18 where the adjustment is penciled in at roughly 3/4 of a percentage point of GDP. Such an ambitious pace could be counterproductive in the current phase of the recovery. Australia has the fiscal space for undertaking more gradual consolidation to a balanced budget by FY2020/21, the target in the budget.

While general government spending on infrastructure has increased in FY2016/17, this increase primarily reflects higher spending by states, not the Commonwealth. Indeed, capital spending is expected to increase by ½ of a percentage point of GDP in the current budget year, but these efforts are not expected to be sustained as spending is projected to level off in the next fiscal year and to decline thereafter. A more sustained, multi-year increase in spending on efficient infrastructure also at the Commonwealth level would be desirable, considering that Australia has infrastructure needs and fiscal space, the funding environment is favorable, and that the expected return to full employment is gradual. The boost to growth under these conditions should largely contain the impact of more gradual consolidation with higher infrastructure spending on the public debt-to-GDP ratio, provided that discipline in recurrent spending is maintained. If high-impact downside risks were to materialize, fiscal policy should support aggregate demand, as monetary policy could be constrained. Unlike in previous downturns, monetary policy may soon be constrained by the lower bound on nominal policy rates. Contingency plans and a pipeline of infrastructure projects would help in reducing the implementation lags involved in undertaking fiscal stimulus.
A long-term debt anchor could strengthen the current fiscal framework. It is a strength of the framework that it requires the Commonwealth government to report against a medium-term fiscal strategy based on “principles of sound fiscal management.” IMF staff recommends to consider augmenting the current medium-term budget balance anchor with a longer-term debt anchor. The latter would provide certainty about debt and fiscal policy in the future and, if implemented over a 5- to 10-year horizon, would be sufficiently flexible to allow for countercyclical support if needed.

Managing Macro-Financial Vulnerabilities

With more acute risks concentrated in a few specific housing market segments, policies should focus on further strengthening resilience to housing market and other shocks with macro-financial implications.

With continued upside risk to house prices, APRA should stand ready to intensify targeted prudential measures, if investor and other risky lending or house price growth were to re-accelerate. However, the scope and extent of tightening need to be carefully calibrated, so as not to trigger a sharp correction.

APRA should continue to actively encourage banks’ efforts to robustly anchor their capital position in “unquestionably strong” territory, given a highly concentrated banking sector where banks have similar business models.

Treasury’s preparation of new legislation to further the regulatory reform agenda should continue to complete the implementation of the recommendations of the Financial System Inquiry, including on the crisis management toolkit and bank resolution. APRA should continue in its effort to implement prudential steps to strengthen the loss absorbing and recapitalization capacity of banks and introduce leverage ratios, in line with the international agenda.

The macro-financial resilience of the economy to housing market shocks could be enhanced through tax reform . The tax system provides households with incentives for leveraged real estate investment that likely amplifies housing cycles.

Keeping Up Productivity Growth

Maintaining high productivity growth rates may be challenging. Overall labor productivity growth in Australia has remained broadly stable over the 2000s. However, in some of the services sectors with a growing employment share, labor productivity growth has been weak, as has multifactor productivity growth more generally.

The government’s reform agenda appropriately focuses on fostering innovation and strengthening competition . It includes the government’s National Innovation and Science Agenda, which allocates $1.1 billion over four years to boost innovation and entrepreneurship in the high tech sector. We encourage its envisaged continuation and, if effective, its expansion. On competition, the measures recommended by the Harper Review would strengthen services sector competition and ultimately productivity. The process of implementation is underway, but will require extensive collaboration between the Commonwealth government and the governments of the States and Territories.

We welcome Australia’s intention to continue efforts toward further trade liberalization, both in regional and multilateral fora. Expanding access to service export markets could also strengthen services sector productivity in Australia and elsewhere, while the social safety net and active labor market policies would mitigate the cost to those who shoulder the burden of adjustment.

Fixing the Great Distortion: How to Undo the Tax Bias Toward Debt Finance

From the IMF Blog.

“The Great Distortion.” That’s what The Economist, in its cover story of May 2015¸ called the systematic tax advantage of debt over equity that is found in almost every tax system.

This “debt bias” is now widely recognized as a real risk to economic stability. A new IMF study argues that it needs to feature more prominently on tax reform agendas; it also sets out options for how to do that.

Debt bias: Why we should (still) worry

The IMF’s recent Fiscal Monitor shows that global debt levels have risen to a record 225 percent of world GDP. And high corporate debt poses significant economic stability risks—especially in the financial sector: no one needs any reminder of the enormous damage from distress and failure of large financial institutions.

Since the global financial crisis, many governments have strengthened policies to mitigate excessive corporate borrowing, notably by tightening regulatory capital requirements for financial institutions.

That’s good. But most tax systems continue to do exactly the opposite: they allow interest to be deductible, but not the costs of equity finance, and so encourage corporations to finance themselves through debt rather than equity. Chart 1 clearly shows that this tax discrimination in favor of debt is still widespread.

In advanced economies, the tax bias has increased debt ratios in nonfinancial corporations by, on average, 7 percent of total assets (about 15 percent of GDP). Our new results find that, despite their special status, financial institutions show a very similar response. Debt bias thus amplifies financial and macroeconomic stability risks—and the effect is too big to keep ignoring.

What can be done?

There are two broad ways to mitigate debt bias: limit the tax deductibility of interest, or provide a deduction for equity costs. There is now plenty of experience with both.

Limiting interest deductions

Some 60 countries have some form of limitation on interest deductibility. The details of the rules on these limitations vary greatly—and those details matter.

39 countries apply the limitations only to “related-party” debt (between affiliates within a multinational group). New analysis reported in our paper finds that (as one might expect) these rules have no discernable impact on firms’ borrowing from unrelated parties—which is what gives rise to stability concerns.

21 countries have rules applicable to all debt, related party or not. On average, these rules do reduce the external debt-to-asset ratio by around 5 percentage points—a significant effect.

Limitations on interest deductibility thus can work, but only if they cover all forms of debt.

Allowing a deduction for equity

Several countries—Belgium, Cyprus, Italy, and Turkey—have introduced an allowance for corporate equity (ACE). This retains the deduction for interest but adds a similar deduction for the normal return on equity.

Economists tend to like the ACE: it neutralizes debt bias and also eliminates tax distortions to investment. And the allowance continues to win over policymakers: Switzerland will soon introduce it, the Danish government has recently proposed its adoption, and the European Commission included it in its recent proposal for a common corporate tax base in the European Union.

And the ACE works. Chart 2 reports new evidence on the effect of the Belgian allowance on corporate debt ratios in nonfinancial firms (left) and banks (right), relative to a synthetic control group of companies in other countries.

The impact is significant and large: the debt ratio in Belgium is almost 20 percentage points lower than in the control group for nonfinancial firms and almost 14 percentage points lower than in the control group for banks.

The main hesitation about the ACE is the potential revenue loss. We find that if the allowance were given to all equity, corporate income tax revenue would fall by 5-12 percent (Chart 3, left panel).

But governments can reduce the revenue cost while preserving the efficiency gains from the ACE by giving it only in respect to equity added after some base year—as is done in Italy and Switzerland and has been proposed in Denmark and by the European Commission.

This reduces the first-year revenue cost to about 1 percent of corporate income tax revenue (Chart 3, right panel). In the financial sector, moreover, the allowance might be granted only for equity above what is already required due to minimum regulatory capital requirements, which would further reduce the fiscal costs.

No better moment

Since the global crisis, debt bias has become much more widely recognized as a real macroeconomic concern. Governments have taken some steps to fix the distortions it creates.

But the issue has not gone away, and in the financial sector, tax policies (which encourage debt finance) and regulatory policies (which do the opposite) continue to be fundamentally misaligned. In our view, debt bias needs to figure more prominently in countries’ corporate tax reform agendas. The approaches discussed here have proven effective, and they can be tailored to countries’ circumstances. The revenue impact is currently muted by low interest rates. There will be no better moment than now to address the “Great Distortion” once and for all.

Does Growth Create Jobs?

From the IMF Blog.

The link between jobs and economic growth is not always a straight line for countries, but that doesn’t mean it’s broken.

Economists track the relationship between jobs and growth using Okun’s Law, which says that higher growth leads to lower unemployment.

New research from the IMF looks at Okun’s Law and asks, based on the evidence, will growth create jobs? The findings show a striking variation across countries in how employment responds to GDP growth over the course of a year.

In some countries, when growth picks up, employment goes up and unemployment falls; in other countries the response is quite muted. A pick-up in growth—through a stimulus to the demand side of the economy, for instance increased government spending on infrastructure—will result in more jobs.

Some countries generate more jobs from growth than others

The extent of job creation in the short run varies across countries. This chart shows how much employment increases when growth picks for the Group of Twenty advanced and emerging economies, which together account for the lion’s share of global GDP and employment.

While Okun’s Law holds overall for the United States, the relationship between unemployment and growth since 2011 did deviate from the historical pattern because the depth and duration of the great recession—the period following the global crisis in 2008—led to so many more people losing their jobs.

In South Africa, Australia, and Canada, a 1 percent increase in GDP is matched by an increase in employment of 0.6 percent or higher. In contrast, there is virtually no response of employment to growth in China, Indonesia, and Turkey.

The extent to which changes in growth account for changes in unemployment and employment also varies across countries. GDP growth accounts for over 70 percent of the variation in employment in Canada and the United States, about 40 percent in Russia, the United Kingdom, and Australia, and very little in many other countries.

For the majority of countries around the world, taking account of growth is an important part of understanding short-run changes in unemployment. For other countries, there are several possible explanations for the weakness of the jobs-growth link. In some cases, reported unemployment rates may not fully reflect the true unemployment rate. Some countries are going through rapid structural change and unemployment may be driven by this longer-run trend rather than short-run fluctuations.

You can’t have one without the other

This then begs the questions: Where will growth come from? Global growth has been too low, for too long, and for too few. The answer is found on both the demand and supply side of the economy.

For example, if companies do not see their sales improving, they will not increase their capacity to produce more, so it is essential to ensure that the demand is there to sustain supply. But without supply measures, gains in output based solely on a stimulus to demand will prove temporary. The range of supply measures varies, from removing bottlenecks in the power sector to reforms in labor and product markets. In many countries, there is a strong case to increase spending on public infrastructure, which would provide a much-needed boost to demand in the short term and would also help supply.

All this means countries need to use all policies—monetary, fiscal, and structural—to maximize growth within countries and amplify the impact though coordination across countries.

This “three-pronged” approach would free up more policy space—more room to act—than is commonly assumed.