Société Générale Inflation To Ease The Debt Burden Special Edition May 2009

Eco-Insight Special edition

28 May 2009

Inflation to ease the debt burden Véronique Riches-Flores (33) 1 42 13 84 04 [email protected]

Q What message are markets giving us? Inflation expectations have changed radically.

Between end-December 2008 and end-May 2009, US long-term inflation expectations literally took off, chalking up the greatest surge ever seen over a comparable period. The yield on 10year government bonds gained more than 100 bp, despite the implementation of the Fed’s buyback plan. All told, the 10-30-year segment of the yield curve steepened by 100 basis points. Q No, inflation is not just around the corner. Short term, world inflation will turn negative at

INFLATION – part one The basis of the debate The aim of this document is to present the groundwork for reflection on the current inflation backdrop. A key topic for years to come, our discussion will be complemented by contributions from our various research teams.

least for a few months, until the energy-price-related base effect falls out of the numbers. Thereafter, the anticipated pick-up in unemployment and persistently weak production capacity utilisation worldwide will stand in the way of a spontaneous uptick in inflation. Q However, markets are looking beyond the next couple of months. Indeed, we consider that

changes in expectations could well reflect more structural factors: 1) exceptional economic policy responses to the current crisis provide fertile ground for an eventual return of inflation; 2) by recovering the reins of financial and economic regulation, governments have given themselves powers relinquished long ago and considerably increased the weight of the noncompetitive sector in the economy; 3) industrialised economies will be unable to get rid of excessive debt levels without help from inflation. Q The probability of an inflationary exit to the current crisis has definitely increased. Inflation

appears to be the only way to address the issue of excessive debt. As a substitute for insufficient growth in real wages, inflation can remove the debt burden while at the same time maintaining viable economic conditions. Cruelly efficient, inflation of only 3% p.a. would automatically send debt ratios down by one quarter over ten years, assuming growth in debt does not outstrip that of real GDP. With inflation at 4%, the stock of debt would be reduced by a third over an equivalent period. Q Inflation: when, and what will the impact be? After 20 years of global disinflation, the range

of tools available to economists to predict the exact timing of a return of inflation have been jeopardised. Identifying the return of inflation will thus require us to proceed in baby steps, attentively observing economic developments over the coming quarters: H2 09, when the global

economy recovers, will be the test, as we should then obtain more hints as to the timing of a return of inflation. Q Far from representing a panacea, the inflation option is more of a necessary evil in an

Please see important disclosures at the end of the document

economic context that has been pushed out of balance by the excessive borrowing of recent years. Blocking such an option would force industrialised economies to accept a painful deleveraging process that would carry an unsustainable cost.

Inflation to ease the debt burden

Contents 3 4 14 19 21

Inflation: why the concern? The impossibility of debt shedding for mature economies The credibility of an inflation scenario Can China act as a genuine barrier to a return of inflation? Inflation: when, and what will the impact be?

Tables index

5 6 6 8

Charts index

Trends in debt levels in the main industrialised countries Impact of the demographics on public spending – 2005 to 2050 Effort required to stabilise public sector debt at its 2008 level

Portion of growth in domestic demand attributable to excessive debt levels over past 10 years (1999-2008) 11 Green stimulus packages, 2008 $bn, as at 5 May 2009 13 Spread effects of a shock of 5% on Chinese or US imports on international trade, % of external demand addressed to each region/country for 2010e 14 Trends in public and private* debt ratios on various inflation scenarios– 2010-2020e

3 4 5 8 10 10 10 12 12 15 15 16 17 17 17 18 18 19 19 21 21 23 24 24 25 26 26

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28 May 2009

The impossibility of a return of inflation Assets of financial institutions versus nominal GDP – US, EMU, UK The consequences of deleveraging Private sector debt ratios (households and non-financial corporations) Projections of working age population, average annual growth rates, % Net migration as a % of working age groups Direct investment in emerging markets Structure of fiscal stimulus packages as a % of GDP – 2008-2010 Weight of China in global goods imports, % Change in central bank balance sheets, as % of GDP Monetary multipliers: US and the Eurozone Value added sharing in France, Germany and Italy Change in external trade and trends in wages as % of value added – 1990-2007* External trade and trends in wages as % of value added by country – 1990-2007 Soft commodity prices: underperformance difficult to reconcile with demand prospects Price of oil and global inflation Inflation: a credible exit? Breakdown of Chinese exports, % of exports of manufactured goods China’s market share of world trade in capital goods SG inflation forecasts: US SG inflation forecasts: Eurozone ECB equilibrium rate 100 day changes in US implied inflation (end-Dec 2008 to mid-May 2009) US Treasury yield curve, 10-30 yrs Sensitivity of US long-term rates model to inflation scenario Impact of 4% inflation on public and private sector debt in 15 years - % of GDP Shortfall in annual growth from a debt reduction equivalent to the impact produced by 4% inflation over four years

Inflation to ease the debt burden

Inflation: why the concern? Should we anticipate a return of inflation? Well, the jury is still out! After several months of discussion on the subject between economists, strategists and investors, sceptics use a number of strong and convincing arguments. The strength of underlying economic trends. Against the current backdrop and with expectations for the upcoming quarters unlikely to change dramatically, it is difficult to see

„

how to kick-start a bout of inflation: wealth destruction, tight credit, spiralling unemployment, worldwide under-utilisation of production capacities, a cyclical rebound in productivity, expectations of further fiscal rigour to come… all these factors suggest that, at present, we are more likely to see an intensification of downward pressure on prices. Indeed, our forecasts are unequivocal, pointing to underlying inflation of less than 1% on a 12-month horizon both for the US and the Eurozone. „ The difficulties of inducing a pick-up in inflation in a global world seeking the lowest labour costs possible, and when an even more abundant supply of such labour is likely after the

current crisis. Lack of employment, a key concern for the global economy overall, will be a major factor in exerting downward pressure on production costs. The current crisis could actually intensify wage competition which has been at the root of the trend towards global disinflation over the past 15 years. „ Money creation is currently non-inflationary as money has not gone into circulation. The expansion of central bank balance sheets has had a limited impact on the liquidity of

economies, as the resulting flows have mainly come back to central banks in the form of bank deposits, as borne out by the very weak growth of monetary aggregates. However, the issue is how the central banks could withdraw this liquidity once the banking system has returned to a firmer footing. A central bank dam against inflation. For three decades, central banks have successfully managing kept a lid on inflation and de facto the ECB cannot stray from its mandate of „

ensuring price stability. „

Finally, the belief that inflation cannot be decreed, as we learned from the Japanese

experience of the 1980s and beyond. The impossibility of a return of inflation U S Im p lie d in fla t io n r a t e s I n f l a t i o n b re a k e v e n - 1 0 y r 3 .0

S h r in k in g c r e d it

Debt dele v e r a g in g

F a llin g c a p ita lis a tio n

2 .5

In fla tio n c o lla p s in g

N e g a tiv e w e a lth e f fe c ts 2 .0

In d u s t r y d o w n s iz in g

1 .5

G r o w in g o u tp u t and e m p lo y m e n t gaps

1 .0

0 .5

0 .0 05

06

07

08

09 2008

10

11

12

01

02

03 2009

04

05

06

Source : SG Economic Research

28 May 2009

3

Inflation to ease the debt burden

All told, while numerous economists agree that resorting to inflation would be the best solution to the current crisis of excessive debt, most point out that current systems are fairly resistant to such an outcome. They see this option as wishful thinking. Yet, without help from inflation, the chances of the global economy shaking off its heavy debt burden are slim, if not totally illusory. Beyond the recovery period driven by government and central bank stimulus measures which will likely be felt for some quarters, medium-term prospects remain shackled by the unsustainable levels of debt held by various economic agents. Far from being spontaneous, the inflation debate stems directly from the necessity to find an acceptable way to deleverage industrialised economies – an imperative compounded by demographic trends. Accordingly our aim is not to assume that developed economies can spontaneously generate inflation but rather to examine if economic policy responses to the current crisis can change the paradigm of recent years and, in the end, enable less damaging digestion of debt levels over the long term.

The impossibility of debt shedding for mature economies Although it is widely accepted by most economists that deleveraging has now become the over-riding imperative for all economic scenarios, detailed analysis of the exact implications of such a process is thin on the ground.

Deleveraging – a guide The concept of deleveraging refers to several

Assets of financial institutions versus nominal GDP – US, EMU, UK

types of adjustments varying in nature form one sector of the economy to another. The primary

200

meaning refers to reducing financial leverage. Deleveraging of the banking sector, in

125

particular, involves cleaning up bank balance sheets, ridding them of toxic assets and thereby enhancing sector solvency. Further out, this process should lead to normalisation of the size of

the

75 50 25 0 225

150

sector, and, in the end, normalisation of credit

125

economy,

generating

a

slowdown in lending growth. As shown by the

charts, growth in bank assets has outstripped the broader economy for some years. This gives a measure of the extent of the problem but says nothing about how it will be resolved, nor over what timeframe.

EMU

200

economies, with headcount reductions in the the

in

GDP

100

175

in

sector

100 75 50 225 UK 200 175 150 125 100 75 50 25 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 Source: SG Economic Research

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28 May 2009

Assets

150

industrialised

activities

banking

US

175

Inflation to ease the debt burden

The consequences of deleveraging

The banking sector

Tight credit conditions

US, Europe, EEC

The corporate sector

Low capex growth

Europe, Japan, EEC

Low credit appetite, higher savings

The consumer sector US, Europe, EEC

Lower spending/ higher taxation

The public sector US, Japan, Europe, EEC Source: SG Economic Research

The deleveraging process for non-financial agents will vary across sectors. The debt has become unbearable either because servicing has become too expensive compared to income or because the value of the assets bought on credit has declined dramatically. In theory, the deleveraging process should involve the repayment of debt by the sale of assets. In practice,

the sale of these assets aggravates the price decline and limits the efficacy of the approach. A sharp reduction in interest rates would ease the debt servicing burden, making higher debt burdens easier to manage and, depending on the extent of the fall in rates, reducing the

negative impacts of over-indebtedness on the behaviour of economic agents. The higher the debt, the greater the required decline in interest rates. Yet, considering that interest rates have been very low in recent years, the room to lower debt servicing enough to ease the debt burden is very limited at present. Trends in debt levels in the main industrialised countries Private, nonfinancial sector

End-1998 level o/w households

Public sector

Private, nonfinancial sector

End-2008 level o/w households

Public sector

2010* Public sector

US

126.5

66.1

64.5

175.5

97.3

70.5

97.5

UK

78.6

57.3

53.3

101.1

66.5

63.8

81.7

Japan

169.3

70.0

113.2

129.0

62.0

170.9

177.0

Sweden

84.2**

42.2**

83.5

114.0

66.0

41.1

38.0

Norway

114.0

74.6

30.8

167.0

106.7

52.0

52.0

77.0

40.3

80.1

105.4

52.3

71.2

83.8

% of GDP

EMU France

66.9

31.4

70.0

88.0

46.5

73.0

86.0

Spain

74.7

37.6

74.4

165.9

79.8

39.9

62.3

53.0

16.4

132.6

83.0

28.9

105.8

116.1

105.0

67.0

62.2

99.4

59.5

64.6

78.7

Italy Germany

* Official forecasts **2003-2008 Source: SG Economic Research,

28 May 2009

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Inflation to ease the debt burden

The issue of excessive public debt levels as we exit the recession is, of course, on a different scale. Excluding any marked deterioration in the perception of sovereign risk, states have much more room to manoeuvre in terms of funding capacity compared with private agents and have more scope to restructure repayment schedules. The urgency of the debt shedding process is, therefore, generally much less pressing than for private agents and the economic consequences of excessive debt levels held by states less damaging for economic growth on a short-term view. Longer term, the increase in the funding requirement of governments leads to crowding out, shifting capital flows away from funding private investment. Meanwhile, excessive public debt levels are equivalent to an unavoidable tightening of fiscal conditions, with negative consequences for economic growth. Though exceptional, the deterioration in

public finances from the current crisis will leave unaddressed the costs of meeting the needs of an ageing population. Impact of the demographics on public spending – 2005 to 2050 As a % of GDP

Healthcare

Long-term care

pensions

United States

3.4

1.7

1.8

Total

7.0

Japan

4.3

2.2

0.6

7.1

South Korea

4.9

3.8

7.8

16.4

United Kingdom

3.6

1.9

1.7

7.2

EMU

3.7

2.2

3.0

8.9

Germany

3.6

1.9

2.0

7.5

France

3.5

1.7

2.1

7.3

Italy

3.8

2.9

0.4

7.0

Spain

4.1

2.4

7.0

13.5

Greece

3.9

2.7

10.3

16.8

Ireland

4.0

3.8

6.5

14.4

Source: OECD Interim Economic Outlook, 2009

Against such a backdrop, efforts required even just to stabilise public debt levels after the current crisis appear largely inaccessible. The OECD estimates at 5-6% of GDP the annual public sector primary surplus required over the coming decades to stabilise public debt at the

level expected by 2010. Bringing debt back to around 60% of GDP by 2020 would thus require an effort of almost 8% of GDP on average. Effort required to stabilise public sector debt at its 2008 level As % of GDP

Germany

Primary balance corrected for cyclical changes 2008 2010

Annual budgetary surplus required to stabilise debt at its 2008 level up until 2050

Effort required to stabilise debt at the level targeted for 2010

1.9

-0.9

3.9

4.8

-0.9

-2.1

3.9

6.1

Italy

3.2

4.0

5.1

1.1

Netherlands

1.9

0.7

5.0

5.3

-0.8

-1.0

6.2

7.2

France

Spain Source: OECD

Income growth, the bottom line to kick start the debt shedding process The difficulty of determining the success of any deleveraging process is easily understandable especially when it involves, except for some rare exceptions, the complete spectrum of economic agents. The track record for economic agents shedding excess debt is far from glowing. Apart from the case of pure and simple cancellation of debt – an improbable scenario in the current environment – the means available to reduce debt, while protecting economic prosperity and social cohesion are fairly limited. Indeed, they can be summed up in one

6

28 May 2009

Inflation to ease the debt burden

condition: the ability of an economy, or a group of economic agents, to ensure that revenues grow faster than debt. However, all countries do not have equivalent means to do so. While theoretically easier for younger economies, where growth potential is generally higher, the situation is much less comfortable for mature economies, where growth is often reliant on increasing debt. As most mature economies are also ageing, the issue of debt shedding in the private sector becomes

even more pressing. With the prospect of insufficient revenue growth, these countries face the risk of seeing appetite for credit dwindle to such an extent that it could prevent genuine economic growth. Therefore, the debt shedding process could lead to persistently lacklustre credit growth, an eminently deflationary process that would have a devastating impact on the economies in question. Moreover, the end result for deleveraging is generally inefficient as private sector debt shedding frequently leads to an increase in public sector debt. A look at two significant episodes in excessive debt management in the recent past gives us a clear illustration of these two different situations. In the aftermath of the Great Depression in

the 1930s, US economic agents managed to reduce debt levels without much difficulty and without inflation getting out of control. The US economy was far from mature at that stage and this gave Mr FD Roosevelt’s New Deal considerable impetus, perhaps on a par with the situation we see in China at the moment. Second we have Japan in the 1990s, suffering from the mature state of its economy and much-weakened growth potential, with little chance of being in a position to lighten its debt burden. The debt shedding process initiated in the middle of the 1990s rapidly turned sour and led to deflation long before it could have benefited from the breath of fresh air from China in the past five years. It was only then that Japanese households were able to benefit from a fairly significant improvement in income and therefore a similar decline in debt levels. Even with this exceptional configuration, the boost from China was not sufficient to enable the public sector to start shedding debt: average real economic growth of 2.25% per year over 2004-2008 was only enough to ensure stabilisation of the public debt ratio at 179% of GDP from 2007.

What benchmark for growth after the credit bubble? It would appear totally unrealistic to expect debt to return somehow to more sustainable levels given the current backdrop. The economic cost of such an adjustment would be too high. It is true that growth potential for mature economies has shifted structurally lower. This is not only because demographic trends reflect greying populations but also because structural benchmarks have been markedly skewed by years of excessive credit-driven growth. Without this exceptional support, the prospects for growth are significantly lower.

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Inflation to ease the debt burden

From credit binge to credit diet. Significant growth shortfall In the table below, we provide estimates of nominal domestic demand growth over the past ten years, adjusted for what could be seen as having been generated from excessive private sector debt over the period. The outcome

is

eloquent,

underlining

Private sector debt ratios (households and non-financial corporations) 200

% of GDP

the

importance of credit as a substitute for

175

US

structurally weak growth.

Furthermore, the ‘residual’ growth rates are much less dispersed, underlining the significance of debt trends in the relative performance of the different economies considered over the past ten years. By way of comparison, in this table we also provide domestic demand growth numbers for Germany and Japan, which, all told, are only slightly lower than the numbers for the vast majority of the other economies once adjusted for over-debt trends. Indeed, with these two examples, we have a clear picture of what the shortfall in economic growth represents in terms of debt

150

Norway

125

100

UK 75

EMU 50

25 1950

1960

1970

1980

1990

2000

2010

Source: SG Economic Research

shedding in the absence of credit growth (as was the case in Germany) or when the stock of debt shrinks (as was the case in Japan). Portion of growth in domestic demand attributable to excessive debt levels over past 10 years (1999-2008) Average growth in nominal Average annual growth in private domestic demand debt** (A) (B)

LT debt differential*** Residual average annual growth in nominal domestic demand (C)=(B)-(A)-1.5** (A)-(C)

US

4.9

8.2

1.8

3.1

UK

4.9

7.4

1.0

3.9

Sweden*

4.1

8.4

2.8

1.4

Norway

5.9

10.5

3.1

2.8

EMU

4.1

7.3

1.7

2.3

France

4.3

7.6

1.8

2.5

Spain

7.3

18.0

9.2

-2.0

Italy

3.8

7.9

2.6

1.2

Germany

1.9

0.8

-2.6

4.5

Japan

0.1

-2.5

-4.1

4.3

*2001 to 2008 ** Households and companies only ***i.e. 1.5% per year estimated on US market trends between 1960 and 1990 Source: SG Economic Research

Spain is undoubtedly and by far the economy in Europe that benefited most from support from the spiralling debt of its economic agents – both households and companies – in recent years.

Starting from private debt levels that were lower than the regional average, warranting a certain amount of catching up, the Spanish economy went into a spiral, sending debt levels close to those of the US economy in just 10 years. If we subtract from observed economic growth what we consider to be in excess of the sustainable long-term trend (see table), the ‘residual’ growth ends up deeply in negative territory. This approach might, however, be somewhat excessive, given Spain’s low starting point in terms of debt. A more balanced

8

28 May 2009

Inflation to ease the debt burden

approach would involve measuring the extent of credit support in Spain relative to the Eurozone trend. This would nonetheless equate to still spectacular yearly support to growth in Spain of around 4% over the past ten years. At the other end of the spectrum for the Eurozone, we have Germany as the major exception.

After excessive debt building ahead of time, as part of the country’s reunification between 1990 and 1995 and the debt shedding process that followed, we can estimate that the German economy suffered a shortfall in nominal growth of around 4% p.a. stemming from the overheating that took place in the early 1990s. The case of France, in an intermediate position, confirms that the support in terms of economic growth provided by over-credit growth is far from negligible and, contrary to Germany, we calculate the boost at close to 2% per year. Excluding this support, French GDP growth would have been around 2.5% in nominal terms, and probably lower than 1% in real terms, which is

not all that surprising when we consider that industrial production in the country literally stagnated over the past ten years. All told, the case of the US is not as exuberant as might be expected. The support to economic growth provided by excess credit, while not negligible at just under 2% per year, is certainly

not the greatest in our sample. At 3.1%, ‘residual’ domestic demand growth for the US economy remains higher than for most of the other countries, partly due to recurrent fiscal support over the last ten years. Indeed, this outcome is much lower than what is usually considered by economists as the growth potential for the US economy: with inflation at 1.52%, real spontaneous growth of the US economy suggested by this approach would not exceed 1-1.5% per year.

Structural growth reserves already dried up Potential growth prospects for industrialised countries have, as we know, been altered by the predictable impacts from the demographic shock in store that, among other things, will have a sharply depressing impact on the pace of growth of the working age population. According to the latest data from the UN, the pace of growth of the 16-64 age group is likely to decline into negative territory, or, at best, trend close to zero p.a. from 2015, equating to a shortfall in potential growth of 0.5% to 1.5% compared with the last 20 years. Generally constructed from very conservative assumptions regarding immigration, these projections are also probably among the most optimistic. There is no doubt whatsoever that the credit bubble and its related impacts on economic growth, in particular in the construction sector, has indirectly favoured migratory flows in recent years and enabled many countries to stave off the initial impact of greying populations. The US, the UK, and Spain, which were the major beneficiaries of these trends, could suffer from migratory flows drying up against a backdrop of normalisation of credit conditions.

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Inflation to ease the debt burden

Projections of working age population, average annual growth rates, % 2.5%

USA

Net migration as a % of working age groups

10%

Spain

UK 2.0%

France

Italy 8%

USA

Italy 1.5%

Spain

UK 6%

Germany

Germany

1.0%

Japan

France 4%

Japan

0.5%

2% 0.0% -0.5%

0%

-1.0%

-2%

-1.5%

45-50

40-45

35-40

30-35

25-30

20-25

15-20

10-15

05-10

00-05

95-20

90-95

85-90

80-85

75-80

70-75

65-70

60-65

55-60

55 60 65 70 75 80 85 90 95 00 05 10 15 20 25 30 35 40 45 50

50-55

-4%

-2.0%

Source: SG Economic Research, ONU 2008

Expectations for productivity gains are not that much more encouraging, at the moment. Recent years have been relatively favourable to productivity gains thanks to the introduction of

new communication technologies in the production process and then by progress achieved during years of intense competition in industry. The situation could be much less favourable in the future.

Direct investment in emerging markets 350 Bn USD Total

300

First, because, in the absence of a new innovation cycle, productivity gains cannot be achieved ad infinitum. Second, because the shortfall in terms of economic growth after a period of abundant credit could, here too, be significant. Undeniably, abundant liquidity set a very favourable backdrop for investment and for the spread of new technologies and progress in the production process worldwide. Productivity

China Eastern Europe

250

Russia Brazil

200

150

100

50

0 2000

2001

2002

2003

2004

2005

2006

2007

Source: SG Economic Research, IMF

in industrialised countries and perhaps even more so in emerging countries benefited from this major support and this is likely to be particularly difficult to preserve further out. All told, the credit crisis completely levelled the playing field for the workings of the global economy and we can draw one obvious conclusion: our economies will have great difficulties absorbing excessive debt levels from the past and finding substitutes for credit-driven growth.

10

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Inflation to ease the debt burden

What are the alternatives for economic growth? Apart from immediate remedies to the crisis aimed initially at fostering conditions to ensure credit growth, without which our economies cannot expand, it is structural growth initiatives or inflationary policies that hold genuine hope of avoiding a Japanese-style debt shedding scenario.

Green initiative is appealing but, at best, would take several years to pay off Responses in the form of structural development policies aimed at increasing medium/longterm growth potential are therefore most definitely welcome. In this respect, the focus favoured by western governments is to concentrate on green policies which it is true are appealing as such approaches will also be necessary to ensure, further out, that growth can indeed be achieved in a sustainable way. Regardless of the attraction of such a new approach and what we can expect it to yield (See SG’s SRI Green New Deal report dated 19 March 2009), the devil is likely to be in the detail, which still has to be defined, and, on a best-case scenario, is likely to take several years to pay off. Green stimulus packages, 2008 $bn, as at 5 May 2009 Total funds

Total “green” funds 2008 ($bn)

“Green” portion of the total incentive measures

“Green” incentives as % of 2008 GDP

Germany

104.8

13.8

13.2

0.4

Argentina

3.7

0

0

0

Australia

26.7

2.5

Canada

31.8

2.6

8.3

0.2

China

586.1

200.8

34.3

4.8

France

33.7

7.1

21.2

0.2

India

13.7

0

0

0

5.9

0.1

1.6

0

Indonesia

0.2

Italy

103.5

1.3

1.3

0.1

Japan

485.9

12.4

2.6

0.3 0.1

Mexico

7.7

0.8

9.7

Saudi Arabia

126.8

9.5

7.5

1.8

South Korea

38.1

30.7

80.5

3.2

United Kingdom

30.4

2.1

6.9

0.1

United States

972

112.2

11.5

0.8

European Union

38.8

22.8

58.7

0.1

2 609.6

395.9

198.6

G20 non-EU

Sources: SG Equity Research, Potsdam Institute

Furthermore, among the different stimulus packages announced in recent months, while government commitments to infrastructure may appear surprisingly large, the amounts involved are in fact utterly derisory given the huge stakes involved in fine-tuning structural growth policies under current circumstances. And the amounts allocated to infrastructure for Europe are practically non-existent.

28 May 2009

11

Inflation to ease the debt burden

Structure of fiscal stimulus packages as a % of GDP – 2008-2010 8% Tax cuts Public expenditure

6% 4% 2%

Isl.

Ire.

Ita.

0% Swi.

Fra.

Por.

Ndl

UK

Bel.

Jap.

Swe.

Ger.

Spa.

Can.

S. K.

US

-2% -4% -6% -8% -10% Source: SG Economic Research, OECD

China and its stimulus measures provide a glimmer of hope In light of the above and considering the current backdrop, we can obtain a better understanding of the hopes hanging on the Chinese stimulus package aimed at rebalancing the country’s growth drivers via attempts to boost domestic demand. The growth potential that a catch-up in domestic demand could represent is considerable, as shown in the table below.

Cars

Current penetration

Estimated date of saturation

Units per 100 households

Year

No. of units at saturation Millions

6

0.6

2022

~2060

412

~100

Bicycles Washing machines

99 96.7

97.9 45.9

2007* ~2012

2005* ~2015

198 270

249 234

Refrigerators Air-conditioning

94.9 94.4

26.1 8.54

2010 2010

2015 2033

230 230

234 165.5

53.12 45.12

3.68 43

2012 2006 (48%)

2023 2044

270 92.4

212.5 98.2

137.35 164.07

94.38 77.84

1990s 2004

2010 2010

100.7 180.9

238 238

90.53

68.36

2004 (96.2%)

2010 (70 %)

174

166.6

Computers Cameras Colour televisions Mobile phones Telephones

Source: SG Economic Research, Glenn Maguire Chief Economist Asia The adjusted polynomial suggests that the point of saturation has already been exceeded

However, a successful outcome for this policy is far from certain regarding the potential benefits this could eventually bring for the rest of the world. Indeed, uncertainty also prevails on the exact timetable and content of the policy.

China continues to account for minimal opportunities on an international level, representing barely 7% of global imports after the growth surge of recent years, i.e. less than half of the portion accounted for by the US and by the extra-European imports of the EU-25. Moreover, given the high extent to which China specialises in consumer goods, the boom in domestic demand is first likely to benefit local manufacturers, with limited implications globally, if only in terms of demand for raw materials.

12

28 May 2009

Weight of China in global goods imports, % 22 20 18 16 14 12 10 8

China US Lat. Am. EU- 25 (extra EU)

6 4 2 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 Source: SG Economic Research/FMI

Inflation to ease the debt burden

A simulation from our world growth model of the spread effect of a sharp acceleration in Chinese demand compared with what an equivalent recovery in US demand would generate gives us a clear picture of what to expect from China’s impact on international markets at the moment. These estimates show that the spread effect on the global economy from China is less than two times lower than that of the US on average with even a wider differential for the spread effect to the rest of Asia. For illustrative purposes, in the table below, we summarise the successive impacts of a shock of 5% on Chinese and US demand for trends in international trade by major region/country. Spread effects of a shock of 5% on Chinese or US imports on international trade, % of external demand addressed to each region/country for 2010e Impact of a shock of 5% on Chinese imports Direct impact

2nd round impact

Total

Impact of a shock of 5% on US imports Direct impact

2nd round impact

Total

US shock/ Chinese shock

US

0.3

0.1

0.4

0.0

0.4

0.4

1.0

Japan

0.9

0.1

1.0

1.0

0.5

1.5

1.5

UKU

0.1

0.2

0.3

0.7

0.5

1.2

3.5

EMU (ex intra-zone)

0.2

0.1

0.3

0.7

0.3

1.0

2.9

Germany

0.2

0.2

0.4

0.4

0.5

0.8

2.2

France

0.1

0.2

0.3

0.3

0.4

0.7

2.5

Italy

0.1

0.1

0.2

0.3

0.3

0.7

3.0

Asia (ex Japon)

0.1

0.2

0.3

1.4

0.4

1.9

6.3 4.3

LatAm

0.5

0.2

0.7

2.6

0.4

3.0

Central & Eastern European countries

0.2

0.2

0.5

0.3

0.5

0.8

1.8

Africa/Middle East

0.5

0.2

0.7

0.9

0.5

1.4

1.9

Source: SG Economic Research

This analysis should guard against excessive optimism. China did not have the resources to decouple from the western world, nor does it have the power to make up for the structural lack of growth in industrial countries in the near future.

28 May 2009

13

Inflation to ease the debt burden

The credibility of an inflation scenario Having reviewed the situation, we can now see just how tempting an option inflation may be to tackle the current deleveraging issue. As a substitute for insufficient growth in real wages, inflation appears to be the only means by which excessive public and private debt levels could be absorbed while at the same time ensuring that viable economic conditions are maintained. Incredibly efficient, an inflation rate of 3% p.a. would automatically cut debt levels by onequarter over ten years, assuming that the stock of debt does not increase at a faster pace than real GDP growth. At 4%, debt levels would decline by one-third over an equivalent period. Trends in public and private* debt ratios on various inflation scenarios– 2010-2020e Debt levels 2010

Debt levels 2020 With inflation at 1.0%

Hseholds

Corp.

Public 2

Hseholds

Corp.

With inflation at 2%

Public

Hseholds

Corp

With inflation at 3%

Public

Hseholds

Corp.

With inflation at 4%

Public

Hseholds

Corp.

Public

US

97.3

78.1

97.5

88.0

70.7

88.3

79.8

64.1

80.0

72.4

58.1

72.5

65.7

52.7

UK

64.3

33.4

81.7

58.2

30.2

74.0

52.8

27.4

67.0

47.8

24.9

60.8

43.4

22.6

55.2

Sweden

65.3

47.6

38.0

59.2

43.1

34.4

53.6

39.0

31.2

48.6

35.4

28.3

44.1

32.1

25.7

Norway

102.2

58.2

57.0

92.6

52.7

51.6

83.9

47.7

46.8

76.1

43.3

42.4

69.1

39.3

38.5

53.8

53.2

83.8

48.7

48.1

75.9

44.1

43.6

68.7

40.0

39.6

62.4

36.4

35.9

56.6

EMU

65.9

France

46.8

38.8

86.0

42.4

35.1

77.9

38.4

31.9

70.5

34.8

28.9

64.0

31.6

26.2

58.1

Spain

82.4

88.8

62.3

74.6

80.4

56.4

67.6

72.9

51.1

61.3

66.1

46.4

55.7

60.0

42.1

Italy

29.6

55.2

86.0

26.8

50.0

77.9

24.3

45.3

70.5

22.0

41.1

64.0

20.0

37.3

58.1

Germany

61.2

41.0

78.7

55.4

37.1

71.2

50.2

33.6

64.6

45.5

30.5

58.6

41.3

27.7

53.2

Japan

66.6

72.0

177.0

60.3

65.2

160.2

54.7

59.1

145.2

49.6

53.6

131.7

45.0

48.6

119.6

* With growth in private debt equivalent to real GDP growth (stable debt levels versus real wages). Excluding demographic costs for the public sector. SG estimates, Official forecasts Source: SG Economic Research 1

2

Is such an outcome in any way credible? None of the recognised economic models at our disposal point to such an outcome, particularly bearing in mind the Japanese experience that inflation cannot be decreed. However, an economic model is only relevant when extrapolations can be made from past experience. It is therefore not designed to anticipate major upheavals, shocks or shifts in paradigms. This is one of the reasons than can explain why no economic

model foretold the risk inherent in the credit crisis that we are now experiencing. The economic model of recent decades, built around increasing international trade, has revealed its shortcomings: the need to offset the negative impacts of worldwide redistribution of wealth by credit policies that are unsustainable long term; insufficient supply of natural resources and energy resources required to meet the needs of emerging economies set for catch-up; excessive unbalancing of added value sharing which, all together led to the current mess, amounts to a step backwards from the priorities that had been centre stage in recent years. Yet, many of these changes appear to be early indicators of a possible return of inflation further out.

Exceptional economic policy responses heralding inflation It is with the type and mix of economic policies designed to tackle the current crisis that the first pieces of the puzzle that could eventually lead to a pick-up in inflation appear to have been laid down.

The return of government involvement in economic matter … Following the gradual ceding of power over the economy to the free market in recent decades, the recent governmental intervention represents a cultural revolution, the effects of which are likely to be felt long after the present crisis. By taking back the reins of economic and financial

14

28 May 2009

Inflation to ease the debt burden

regulation, governments have given themselves powers relinquished long ago and considerably increased the weight of the non-competitive sector in the economy.

The stimulus packages adopted by different governments throughout the world clearly favour national economies. Indeed, there is nothing more protected that the infrastructure building business and strategies of sustainable development that governments worldwide are unanimously espousing. The direction of government policy at present is in stark contrast with the priorities of recent decades.

...and a whole range of non-conventional monetary policy measures leading to a massive surge in money supply by the central banks, corresponding already to more than 10% of the GDP of the four major regions of the industrialised world if we take together the balance sheet expansion by the Fed, the ECB, the BoE and the Bank of Japan! Never before have central banks managed to counter the shrinking money supply stemming from a credit crunch. The outcome had an automatic deflationary impact. The current situation is in stark contrast with this, even though a significant portion of the money created is not yet in circulation, sitting instead in the form of bank deposits with central banks. As proof of the lack of circulation of this new money, we can see that growth in money supply continued to crumble and money multipliers, i.e. the relationship between money supply and the monetary base, collapsed quite literally in recent months. Change in central bank balance sheets, as % of GDP

Monetary multipliers: US and the Eurozone 12

32 % of GDP

Forecasts for US

Japan

28

M2/monetary base

11

* 10

24

9 Average

20

8 16

Euro area US

7

EMU 12

6 8

US

5 UK

4

4 00

01

02

03

04

05

06

07

08

09 10

00

01

02

03

04

05

06

07

08

09

Source: SG Economic Research

Nevertheless, it is hard to imagine how central banks could recover all of the liquidity injected into the system even once the current crisis has been resolved. To be completed within a tight timeframe, such a policy would be equivalent to exceptional tightening of financing conditions which economies that have just exited recession are likely to find very tough to stomach. Further out, a significant portion of the money supply created by central banks is very likely to end up in circulation, thereby creating imbalances between money supply and asset supply.

Against a backdrop of upward wage rigidity, such a prospect could turn out to be very favourable for asset prices, in a similar way to what we have seen over the past ten or fifteen years, and would not be any more inflationary for prices of goods and services. Therefore, assuming persistent upward wage rigidity is the basis on which any approach to the question of inflation should be considered at present. Could this situation change?

28 May 2009

15

Inflation to ease the debt burden

Towards a rebalancing of value added sharing? The decline in the portion of income that makes up value added is mainly the result of an intensely competitive global environment Value added sharing in France, Germany and and the arrival of a glut of low-cost products on western markets from emerging countries and then almost exclusively from China. Considered beneficial for everyone, this trend encountered very little resistance: emerging countries found in export activity the foundations for their economic development and western consumers found that disinflation gave them back some of the purchasing power lost through structural unemployment. Nevertheless, this system may have reached its limits during this crisis with China’s role in setting worldwide prices fading owing to the contraction in international trade as a result of the current crisis (see pages 21 & 22).

Italy

Compensations as a % of VA 57.5 55.0 France 52.5 50.0 47.5 Germany 45.0 42.5 Italy

40.0 37.5 1975

1980

1985

1990

1995

2000

2005

US

54 53 52

A shift in how value added is shared, which

51

would be impossible to achieve against a

50

backdrop of intensifying competition, is

49

much

when

48

competition is less intense, particularly if

47

economic growth is more autonomous as

46

easier

to

contemplate

suggests the different stimulus policies introduced by numerous countries to boost domestic demand. All the more so when we consider that the threat of delocalisation of

45 50

55

60

65

70

75

80

85

90

95

00

05

10

Source: SG Economic Research

production to lower cost countries appears to have eased. Although impossible in an increasingly competitive world, a shift in sharing value added becomes much easier to contemplate in a world where competitive pressures ease, all the more

so if economic growth is more autonomous, as suggested by stimulus measures implemented by a number of countries, particularly if this coincides with efforts to ease the threat of delocalisation of production to low cost countries.

16

28 May 2009

Inflation to ease the debt burden

Change in external trade and trends in wages as % of value added – 1990-2007*

External trade and trends in wages as % of value added by country – 1990-2007

Ger.

Ita . UK

Jap. Spa.

20

Compensation/VA, %

Swe .

External trade as % of GDP

70

65

18 16 14

60

12

55

US

Sweden

France

Germany Jap.

10 8

UK

50

6

.

4

US Fra

2

Compensation as % of value added

45

Italy

0 -7

-6

-5

-4

-3

-2

-1

0

External trade as % of VA 40 0

10

20

30

40

50

60

Source: SG Economic Research *except for Sweden from 1993 to 2007

Therefore, it is more likely that easing of wage policy will come from the public sector and from government intervention. The debate on this topic has already begun in Germany in recent months and developments here will be very interesting to watch. After the well-known sacrifices made by Germany in recent years, German public opinion is starting to question the relevance of the country’s growth model. The depth of the crisis in Germany has seriously shaken the belief that external competitiveness is the key to success. As the country gets ready for major elections, the prospect of a significant shift in economic policy in favour of fostering domestic demand led growth did not take long to become part of the election campaign. More generally, the extent of the social impact of the current crisis and the inability to address issues in a timely manner are likely to increase pressure on governments to adopt new measures in terms of social policy and to take a more flexible approach to public sector wage policy.

…essential to absorb the probable surge in commodity prices further out The situation on different commodity markets may not be a stranger to such a policy shift. Indeed, it is difficult to imagine a recovery in global growth that would not be accompanied by a rapid surge in most commodity prices, including energy, industrial and food raw materials. Prices for soft commodities, which have seen an exaggerated surge driven by speculation last year are still at historically low levels in real terms which look hardly compatible with long-term prospects for both supply and demand (see Demographics: the challenges facing the world economy) Even with sustainably weaker global growth, continued efforts for emerging markets to catch up will remain the structural source of growth in demand with expectations likely to quickly feed through to price trends as soon as global growth prospects start to improve. In this

Soft commodity prices: underperformance difficult to reconcile with demand prospects 9600

100=31/12/08, log. scale

4800 2400 1200 Agricultural raw materials

600 300

Food

150 75

71 74 77 80 83 86 89 92 95 98 01 04 07 10 Source: SG Economic Research

respect, our analysts anticipate a general uptrend in industrial and food raw materials in quarters to come, with initial impacts likely to be felt by consumers fairly rapidly.

28 May 2009

17

Inflation to ease the debt burden

Price of oil and global inflation 7.0 130

6.5 Oil, WTI

110

6.0 5.5

90 5.0 70

4.5 4.0

50

3.5 30

3.0

Inflation (RHS) 10

2.5

1999

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Sources: SG Commodity & Economic Research

The inflation scenario, while particularly difficult to model, is far from whimsical. Changes in market expectations since the start of the year appear to lend non-negligible weight, which can undoubtedly be attributed to the factors we mention above. Inflation: a credible exit?

THE INFLATION OPTION

US Implied inflation rates Inflation breakeven - 10 yr 3.0

Social unrest 2.5

Deglobalisation

Rebalancing of the profitwage sharing

2.0

Commodity price pick-up 1.5

A forceps recovery

1.0

Money stock

0.5

0.0 05

06

07

Source: SG Economic Research

18

Keynesian policies

28 May 2009

08

09 2008

10

11

12

01

02

03 2009

04

05

06

Inflation to ease the debt burden

Can China act as a genuine barrier to a return of inflation? It is true that the penetration of Chinese products in world trade has had a significant amplifying impact on disinflationary trends worldwide over the past two decades. The deterioration in competition worldwide and the related losses in industrial employment, furthermore, largely fueled downward pressure on wages, de factor participating in the shift in value added seen in most industrialised countries. The success of the Chinese economy therefore largely contributed to the significant disinflation trend seen in the country in recent years, before, turning, between 2005 and 2008, to a significant source of inflation, particularly with the knock-on effects it had on demand and then on raw material prices. What is the situation today? What impact can we expect from China in terms of price setting internationally?

There is no consensus on the answer to this question, not even among SG economists. It is clear that the complex nature of the issue warrants debate. Hereafter, we provide the main lines of reflection which, from identical observations, lead to debate on the topic with our chief economist for Asia, Glenn Maguire.

Observations 1- the shift from standard consumer products to high value added items Progress achieved by the Chinese economy in shifting to

Breakdown of Chinese exports, % of exports of manufactured goods

China’s market share of world trade in capital goods

high value added items and those with high technological

60

20%

content has been considerable in recent years, as we can see if

50

we observe the change in the breakdown of Chinese exports.

40

In just 15 years, Chinese products have moved up to second place capital goods

worldwide for and transport

items in 2007 and we cannot rule out the possibility of China claiming the top spot in 2008. At the same time, the structure of Chinese

exports

has

Capital goods Clothing and textiles

18% 16%

30

20

Germany

14%

China

12%

US

10%

Japan

8%

France

6%

Sth Cor

4%

10

Italy UK

2%

0 1990

1994

1998

2002

Source : SG Economic Research

2006

0% 1995 1997 1999 2001 2003 2005 2007 Source : SG Economic Research, ONU

shifted

considerably, leaving less and less room for items with low value added, such as standard consumer goods such as textiles and

apparel in particular.

2- A radical break in economic policy of the Chinese government After 20 years of an almost exclusive focus on penetrating the export market, the government’s decision during 2008 to attempt to bolster domestic demand represents a major shift in policy. The resultant growth in productivity gains led to an unprecedented catch-up in living standards, without an equivalent surge in prices. Steps taken to foster the development of transport infrastructures as well as those for healthcare, education and housing as well as efforts to boost the incomes of the least fortunate are aimed, initially at least, at boosting the savings rate so as to ensure a solid base from which to generate strong domestic demand. Further out, this transition should boost China’s trade surplus. It is probably an essential prerequisite to a rebalancing of current account balances worldwide and a normalisation, further out, of how real exchange rates are seen in China.

28 May 2009

19

Inflation to ease the debt burden

Are these changes likely to strengthen, or on the contrary reduce, the disinflationary impact of China on the world stage? These changes are likely to reduce the disinflationary impact of China (V. Riches-Flores)

These changes strengthen the likely disinflationary impact from China (Glenn Maguire).

There are several reasons why these changes, all told, could reduce the disinflationary impact of China on the rest of the

The bulk of Chinese disinflationary pressure is in front of us, not behind.

world. 1- The opening up of the Chinese market over the last 20

1 — As China moves up the value added chain, the range of goods on which it exerts disinflationary forces is growing not

years largely helped in transferring the technology required to improve the country’s industrial base. The resultant

shrinking. Look at India, the Tata NANO – a brand new motor vehicle for sale for $2000.

growth in productivity gains led to an unprecedented catchup in living standards, without an equivalent surge in prices. China’s current policy aimed at boosting the living standards of those that were left behind by the country’s success in recent years is based on developing services. Developing these activities is unlikely to be as much of a drain on capital

2 —Labour intensive production continues to be carried out in low labour cost centres such as Vietnam and Bangladesh where labour costs are between 70%-80% lower than those in China.

or lead to as much productivity gains as was the case in recent years. The country’s ability to offset the increase in

3 — The portion of wages in products with a greater technological component is lesser than for lower value

the standard of living by productivity gains as comfortably as it did in the past is therefore hampered.

added products. The influence of the wage component on the final price of the product is, in turn, lower.

2- The glory days in terms of the influx of standard consumer goods from China to developed countries are probably behind us owing to the high level of market share already reached in most developed counties. Yet, even at lower cost, the ability of capital goods to fuel disinflation is nothing like that of standard consumer goods exported over the past 20 years. Furthermore, with the desire to boost domestic demand, China’s export policy could automatically become less aggressive. 3- The trend in favour of sustainable development goes against the widespread movement of globalisation of the past two decades. The desire to reduce energy consumption

4 — The policy of boosting wages targets rural populations in particular. It is likely to have only a limited impact on costs in the manufacturing industry. The policy of developing services is aimed at protecting the situation of households in terms of social security and healthcare coverage where the quality of service has deteriorated markedly, and thereby leading to a decrease in savings to fund these services. 5 — The development of Infrastructure will improve the country’s productivity and should lead to a decline in production costs, particularly thanks to more efficient

transport networks. is incompatible with increased use of freight transport throughout the world and the desired new sources of growth China has not yet passed through the Lewisian turning are aimed more directly at supporting local industries. It is point when developing countries' industrial wages begin tempting to see this as a mandatory step backwards from to rise quickly at the point when the supply of low-cost globalization, that internationally.

could

also

reduce

competition labour tapers off.

4- Accelerated development of China’s domestic demand could well lead to further pressure on raw material resources and could fuel a structural increase in base metal prices throughout the world.

Although it is still to early to determine whether or not this strategy will, in fine, be inflationary it is tempting to believe that these changes point to a much less disinflationary context overall than in the past.

20

28 May 2009

Inflation to ease the debt burden

Inflation: when, and what will the impact be? After 20 years of disinflation, and against the current financial crisis and recession backdrop the range of measures available to economists to determine when exactly we could expect a return of inflation have been reduced dramatically.

The expected increase in unemployment worldwide suggests that we are likely to witness a marked decline in the pace of wage growth in the coming quarters. Furthermore, the collapse in capacity utilisation should continue to put significant downward pressure on producer prices. The level of use of resources has been, by far, the key variable in all inflation models in recent decades, including the factors mentioned above in these models such as the influence of the competitive arena, as well as social and political variables is beyond the reach of most economists. Nor does modelling the impact of the surge in the monetary base yield more satisfactory results: the models have all indicated that the monetary component alone is not sufficient to generate inflation (in this respect, see the ECB’s working paper No. 749, May 2007 ‘Excess growth and inflation dynamics’). While inflation is a probable outcome and potentially welcome to address the issue of excessive debt levels in developed countries at the moment, modelling such a scenario is probably impossible at this stage. Capturing this change will thus require us to proceed in baby steps, attentively observing economic developments over the coming quarters that could gradually validate an exit scenario entailing inflation and that economists could, in fine, then be able to make more precise forecasts of the shape and level of acceptable inflation levels for central banks.

The H2 09 test In the very short term, inflation rates are likely to continue to experience downward pressure owing to annualised base effects linked to energy prices. Our forecasts call for slightly negative inflation from the summer of 2009 in the Eurozone, and very negative numbers in the US, of around -2.5%. Therefore, confirmation of an inflation scenario is likely to be difficult to obtain in the coming months. SG inflation forecasts: US

SG inflation forecasts: Eurozone

1.0 %

4.5

%

1.5

6

%

%

5

4.0 0.8

1.0

SG forecasts

mom

SG forecasts

mom

3.5

0.5

3.0

4 0.5

3

2.5 0.3

2

0.0

2.0 0.0

1

-0.5

1.5

0 1.0

-0.3

-1.0

-1

0.5 -0.5

-1.5

-2

0.0 yoy (RHS)

yoy (RHS) -0.8

-0.5 2006

2007

2008

2009

2010 2011

-3

-2.0 2006

2007

2008

2009

2010 2011

Source: SG Economic Research

28 May 2009

21

Inflation to ease the debt burden

The way that our economies tackle the automatic increase in inflation expected during the second half of the year, when base effects linked to energy prices go into reverse and energy prices increase, will undoubtedly give us a better understanding of the risks linked to a pickup in inflation further out. At that time, two scenarios could be contemplated: „

Either, the pick-up in inflation short circuits the economic recovery against a backdrop of

significant declines in employment, or, at best, lacklustre labour market trends. At that stage, a further deterioration in demand would likely lead to an extension to support measures to boost economic growth. The inflation scenario, seen as less probable, would only be conceivable once growth has recovered which could require stepped up efforts on reflation from governments and central banks and could therefore be put off until much later. „ Or, the surge in inflation is “digested” by the economy, offset by stimulus measures and by the international recovery. Such a backdrop could very quickly lend itself to upward

adjustments to inflation expectations by the markets and by the economic agents: then, the prospect of an inflationary exit to the current crisis increases significantly. Changes to inflation expectations are a pre-requisite to confirmation of any inflation scenario. Keeping a close eye on trends in inflation expectations will therefore be key in determining the probability of materialisation of the inflation scenario. In any event, if an inflationary spiral were to kick in, it would most certainly take several quarters before being visible in wage trends, if we are to base our assumptions on foreseeable economic conditions.

Varying probability of an inflation scenario, depending on the economy considered The probability of an inflation scenario taking shape, as one might expect, varies significantly depending on the economy we look at. At this stage, how concerted economic policy to exit the recession is will be a major differentiating factor for inflation risk. Apart from the extent of monetary policy support, the extent of structural stimulus policies and their impact on domestic demand, which some could assimilate to protectionism, will also be a key factor in determining the risk of a return of inflation.

Europe, at best the follower, but certainly not the leader The US economy is undoubtedly the most likely candidate to experience an inflationary exit to the current crisis. Not only are economic stimulus measures much more significant than elsewhere, built on a very ambitious fiscal package, but the mix of public deficits and zerorate monetary policy and Fed treasury buybacks, which is negative for the dollar, also significantly increases the likelihood of an inflationary outcome. Conversely, the situation in Europe is very different from what is going on state side and much less likely to spark a spontaneous resurgence of inflation. The economic policy mix is, in general, much less buoyant while the monetary policy mix in the UK is very different from other European countries, with only marginal government efforts to foster structural change. In any case, Europe will not be the leader in this process, but rather the follower, and how far behind remains difficult to predict given uncertainty on central bank intervention against a global backdrop of a return of inflation.

But, the ECB’s ability to prevent such an outcome is very limited in the short term Regardless of the ECB’s reticence to adopt the same policy response as that introduced by the Fed and amid fears that such efforts could lead to inflation, current ECB policy is dictated by the very low level of inflation and the persistent uptrend in unemployment anticipated over

22

28 May 2009

Inflation to ease the debt burden

the coming quarters. Short term, against a backdrop of dangerously low inflation, the task of the ECB will be to do everything within its power to bring inflation back to positive territory, as its mandate requires it to do. The ECB’s ability to manage any potential deterioration in global inflation prospects over the longer term is thus practically non-existent, as it would only be able to intervene at a very late stage, when cyclical indicators suggest that the Eurozone is indeed at risk, in other words not

for several quarters, if we are to base our predictions on current forecasts. Therefore, it is not very conceivable that the ECB could dramatically tighten monetary conditions early enough to stave off a resurgence in inflation in the Eurozone coming from outside that region owing to the anticipated extreme fragility of the economic situation in quarters to come, on the back of prolonged widening of the output gap. In our view, the equilibrium interest rates compatible with such a situation are crystal clear: our forecasts leave the door open for a prolonged period of rates at the current level of 1% or

ECB equilibrium rate 5.0

%

4.5

Repo

4.0 3.5 3.0 2.5 2.0 1.5 1.0

Estimate

0.5 0.0 99

00

01

02

03

04

05

06

07

08

09

Source: SG Economic Research y=0.11 X1+0.24 X2+1.02 X3-0.59 X4+3.61 X1= change in core inflation rate, X2=CUR gap, X3=employment gap, X4= 09/11 effect

perhaps even slightly lower. Longer term, the ECB’s ability to hold back any resurgence of inflation will depend more on the resilience of inflation expectations to any surge in interest rates rather than on the more or less restrictive nature of monetary policy. The idea that the Eurozone can escape a global inflationary trend nevertheless makes little sense. Would this involve changing the ECB’s

statutes in time? Probably yes. The debate on the ECB’s inflation criterion is not new and it is more than ever justified in view of the continued rise in the number of new members to the more inflationist economic backdrop. The modification of the ECB’s statutes in favour of a more flexible approach rendered necessary by the extension of the monetary union and changes in the global environment could then meet the demands of an increasing number of governments and constitute a considerable step forward for the union.

Inflation, the lesser of two evils While the prospect of a return of inflation offers the huge advantage of being able to consider that excessively debt laden economies could shake off this burden under less painful conditions, thereby enabling them to avoid a Japanese-style scenario, it is perhaps the only positive we can identify for such an outcome. In the short/medium term, i.e. before it creates more room for demand following a easier deleveraging, a resurgence of inflation would, it is true, have a negative impact on economic growth and would be likely to shake the sentiment of greying populations which are likely to view such tends as putting the value of their assets in jeopardy. Shorter term, an exit to the current crisis that is accompanied by inflation is very likely to have negative consequences for the consumer. Indeed, inflation is most definitely a factor of economic regression for less developed economies, and could put a spanner in the works of any policies aimed at boosting economic growth in emerging countries, although the negative perception of such an outcome could be eased depending on the level of monetary hoodwinking.

28 May 2009

23

Inflation to ease the debt burden

Volatility returns to forex and interest rate markets Furthermore, a return of inflation will also have a significant destabilising impact in economic and perhaps political terms also generating greater instability on forex and capital markets. In this respect, the appearance of risk premiums suggesting a potential return of inflation, even on a longer-term horizon, could very rapidly change how forex and capital markets behave. The current situation is unique in that we have a post credit bubble economy with the particular feature of being almost simultaneously driven by the inflation and deflation risks, and this could very quickly cause expectations to shift dramatically as soon as the spectre of deflation and systemic risk have been removed.

Scenario already partially factored into market rate expectations The dramatic shift in market expectations in recent weeks is more revealing of the changes that are likely to occur in the present context. In recent months implied 10-year inflation expectations went from almost zero in November/December 2008 to slightly above 1.5% today in the United States, thereby chalking up the greatest quarterly rise in its history. Equivalent to the bottom end of the range of market expectations between mid-2000 and mid2003, current expectations are not compatible with a scenario of a return of inflation. Yet, the pace of the adjustment, accompanied by dramatic yield curve steepening at the long end (50bp for the 10-30 year curve in the US since end-December), is nevertheless very surprising against such an uncertain economic backdrop. The probability of a more marked change in expectations against the backdrop of economic recovery that we describe in our global scenario could have significant repercussions on long-term interest rates well before we see confirmation of a return of inflation in the price statistics. 100 day changes in US implied inflation (endDec 2008 to mid-May 2009) 1.5 Inflation breakeven-10yr 1.0

US Treasury yield curve, 10-30 yrs

1.3 1.0

0.5 0.8

0.0 -0.5

0.5

-1.0

0.3

-1.5 0.0

-2.0 -0.3

-2.5 -3.0

-0.5

97 98 99 00 01 02 03 04 05 06 07 08 09

90

92

94

96

98

00

02

04

06

08

Source: SG Economic Research

The sensitivity of long-term interest rate prospects to inflation is high against a backdrop of surging public deficits. Over recent weeks, we have seen the disappearance of the so-called “conundrum” in the bond markets whereby long-term rates held well below what could be expected in the economic climate prevailing since 2004. Our long-term interest rate model highlights the risk of 10-year rates rising in the coming quarters, pointing to an environment of heightened sensitivity to even very modest increases in inflation projections.

24

28 May 2009

Inflation to ease the debt burden

Sensitivity of US long-term rates model to inflation scenario 10

10 yr rates

Central scenario

Alternative scenario

9 8 "Conundrum" 7 6 5 4 3

01/10

10/08

07/07

04/06

01/05

10/03

07/02

04/01

01/00

10/98

07/97

04/96

01/95

10/93

07/92

04/91

01/90

2

Equation: i = 035*r+0.8*P+1.52*USD+0.09*ISM-0.0006D-3.79 R2=0.928 With: I= 10-year USD rate, r= 3m USD rate, P=underlying annualised inflation rate (excluding energy and food), USD=exchange rate USD/DEM, ISM= PMI index ISM, D= year-on-year change in budget deficit * Central scenario: ISM at 55, underlying inflation at end-2010 at 0.6%; alternative scenario for core inflation at end-2010 stable at 1.8% other variables unchanged Source: SG Economic Research

Therefore, maintaining core inflation at its April level of 1.8%, rather than the decline in inflation projected in our central scenario, could, alone, warrant an increase in the 10-year rate to around 5% during 2010 rather than the 4% indicated further out on our central scenario that considers a decline in underlying inflation to below 1% by end-2010.

…And perhaps also partly factored into the forex markets Periods of inflation generally lead to greater forex market volatility, reflecting more or less significant losses in relative real value of different currencies. Shorter term, an increase in the probability of an inflation scenario could sanction the economies most exposed to this type of scenario, in this case the dollar. Further out, the materialisation of a global inflation scenario would lead to a much more random backdrop for emerging markets, as it would weaken economic prospects in these regions, lessening their appeal.

Inflation against deflation: a rock vs a hard place Far from representing a panacea, the inflation option constitutes more of a necessary evil in an economic context that has been pushed out of balance by the excessive borrowing of recent years. If as the current crisis teaches us, restoring economic stability requires us to unburden our economies of the excessive debt, then it is undoubtedly the only feasible way of going about it. Blocking such an option would force the industrialised economies to pay a very high price. To conclude we show the results of these estimates in the graphs below. As part of our conclusion we compare what a return to inflation of 4% could provide for debt shedding efforts versus what would be required in the absence of inflation. The outcome of our forecasts is crystal clear: inflation of 4% over 15 years would wipe out up to 140% of GDP of public and private debt in Japan, and up to 120% of US debt or 100% of that of Spain. To arrive at a similar outcome without inflation would require annual efforts to shed debt

28 May 2009

25

Inflation to ease the debt burden

amounting to respectively 8%, 6.5% and 6% for each of the countries mentioned, in other words, it would clearly be impossible to achieve. Impact of 4% inflation on public and private sector debt in 15 years - % of GDP 4% inflation over the next 15 years would cut debt ratios from 75% in the case of France to by 100% in Spain

France

-38%

-39%

Germany

-35%

-44%

UK

-36%

-45%

EMU

-37%

-47%

Italy

-52%

-40%

Spain

-28%

-74%

US

-43%

-78%

Japan

-79%

-57%

- 160%

--140%

-120% -

-100% -

-80% -

Public sector

-60% -

-40% -

-20% -

0%

Private sector

Source: SG Economic Research

Reducing debt by the same proportion would call for a 6% to 9% shortfall in annual economic growth, depending on the economy.

Shortfall in annual growth from a debt reduction process equivalent to the impact produced by 4% inflation over four years France Allemagne Germany R-U UK Coût Cuts de réductionde la dette to private debt

UEM EMU

Coût Cuts additionnel lié à la debt dé to public CoûtAdditional de réductionde la detteprivée cuts linked to

Italie Italy

demographics Espagne Spain Etats- Unis US Japon Japan - 10.0%

- 8.0%

- 6.0%

- 4.0%

Source: SG Economic Research ** Minimum scenario adjusted for European convergence factor

26

28 May 2009

- 2.0%

0.0%

2.0%

4.0%

Inflation to ease the debt burden

SG Economic Research

Benoît Hubaud

+(33) 1 42 13 61 08

[email protected]

Véronique Riches-Flores

+(33) 1 42 13 84 04

[email protected]

James Nixon

+(44) 20 7676 7385

[email protected]

Olivier Gasnier

+(33) 1 42 13 34 21

[email protected]

+(44) 20 7676 7165

[email protected]

Stephen Gallagher

+(1) 212 278 44 96

[email protected]

Aneta Markowska

+(1) 212 278 66 53

[email protected]

Asia-Pacific Glenn Maguire

+(85) 221 66 5438

[email protected]

Research associates Francois Cabau

Rodrigo Armijo

Louis Harreau

Khrisha Swampillai

David Yen

Nikhil Mehra

Pauline Lez

Eurozone

UK

Brian Hilliard North America

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