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It’s been a busy summer, and you might not have had a chance to read everything as it came across your screen. So as your holidays wind down and you head to work, the editors at iMFdirect have put together some key blogs on hot topics to help you get back up to speed by September.
Public finances have had a rough year. A new reality is emerging. Against this backdrop, countries need to act now to boost growth and build resilience. They must also be prepared to act together to fend off global risks.
Worsening public finances
The April 2016 Fiscal Monitor shows that public debt continues to rise in every corner of the world. Fiscal deficits have also gone up in many countries. In advanced economies, once again, we will have to wait another year for debt ratios to decline. On average, public debt now exceeds the level observed during the Great Depression and is approaching the level immediately after World War II (Chart 1).
In emerging markets and low-income countries, fiscal deficits in 2016 are projected to be even higher than in 2009 during the global financial crisis. This represents a big shift compared to what we expected about a year ago; there’s been a large jump in future public debt ratios (Chart 2). The fiscal positions of commodity exporters have been especially hard hit because of the collapse in revenues. In the Middle East and North Africa, the cumulative fiscal balances of oil exporters alone are set to deteriorate by a staggering $2 trillion in the next five years, compared to the pre-crisis period 2004–08 (Chart 3).
Fundamental and far-reaching trends of the global economy are affecting public finances everywhere. These transformations include continued weakness in global activity and entrenched low inflation pressures in advanced economies, the decline in commodity prices (about 35 percent in the past 12 months and 65 percent since mid-2014 for oil), and the slowdown in trade. Emerging market and developing economies are also facing higher interest rates and dwindling capital inflows. Risks are also rising almost everywhere. These changes look like they are here to stay, at least for some time.
Countries need to adapt to these new realities but “no one-size-fits-all.” The appropriate policy response varies across countries, but the exact mix of measures depends on the nature of the fiscal challenge they face. We identify three main challenges.
Challenge 1: Avoiding the low growth-low inflation trap
Advanced economies are facing the triple threat of low growth, low inflation, and high public debt. This combination of factors could create self-reinforcing downward spirals. By this, we mean that continuous downward revisions in growth and inflation are associated with upward revisions in public and private debt as a share of GDP. This may lead governments, firms and households to cut spending in order to lower debt, depressing further economic activity and inflation.
To avert falling into such a trap, countries should follow a three-pronged approach based on expansionary monetary policy, growth-friendly fiscal policy and productivity-enhancing structural reforms. By growth-friendly fiscal policy, we mean measures that boost growth both in the short- and the medium-term (such as higher infrastructure investment) and policy actions that support the implementation of structural reforms. One example of this is using public funds to compensate those that lose from reforms (such as reforms promoting greater competition) and who could block their adoption.
In countries with fiscal space, the budget could also do more to support aggregate demand. Many countries lack this fiscal space and, of course, how much countries can do to support demand will depend on individual country circumstances—particularly on their debt level and current and future borrowing costs. In some cases, countries will not be able to slow down fiscal adjustment. But even in these circumstances, governments should protect growth by avoiding cuts to highly productive public spending and scaling down less efficient programs instead.
And what if the macroeconomic situation gets worse? What should countries do if there is a large slowdown in global growth and intensifying deflationary pressures which could precipitate the world economy into the downward spirals that we have just described? Then individual country’s responses would not be sufficient. Policymakers should act quickly and act together to fight the stagnation forces and deploy coordinated policies across the major economies of the world. The international response should combine growth-friendly policies on the demand and supply sides. It is particularly important that countries act simultaneously, because the beneficial effects from each country’s policies would be amplified. Of course, some economies would not be able to participate in the coordinated policy response, in particular those under market pressure. But they would still benefit indirectly from higher growth elsewhere through stronger trade and improved global stability.
Challenge 2: Addressing the big and lasting drop in revenues
Between 2014 and 2016, about two-thirds of all countries experienced a decline in their revenue-to-GDP ratios (Chart 4). Commodity exporters saw the largest revenue shortfalls—an average of 7 percent of GDP for oil exporters. As commodity prices are likely to remain low for some time, producers have no choice but to reduce public spending and align it with lower revenues. Nonetheless, this unavoidable adjustment can be made less painful by mobilizing non-commodity revenues and cutting poorly targeted and wasteful spending, including by reforming fuel subsidies. Countries that have accumulated financial assets in the past and are under less pressure from financial markets will be able to consolidate at a more gradual pace.
Challenge 3: Achieving development goals with constrained budgetary resources
Almost half of the low-income developing countries have a tax ratio below 15 percent of GDP. Low revenue mobilization is an important impediment to economic development not only because it limits the ability to fund pro-growth spending but also because a low tax ratio is often associated with a lack of institutional capacity, which is essential for growth to take off. Thus, adequate revenue mobilization is a fundamental component of a growth and development strategy.
Building up a minimum tax capacity can support and complement broader state and legal capacity. In particular, stable taxation that is broad-based and governed by clear rules, is necessary for an effective budget process. Combined with improvements in expenditure efficiency, better revenue mobilization can help achieve the Sustainable Development Goals, including by enhancing the provision of health and education services and developing infrastructure. In practice, low-income countries should explore possibilities for raising new forms of revenue (for instance, by introducing or expanding the value added tax or the property tax) and strengthening tax compliance—two areas in which the IMF provides extensive technical assistance.
Beyond the country-specific immediate policy responses outlined above, there are two main objectives that all countries should pursue over the medium term:
Enhancing the resilience of public finances. In a risky environment, a key objective of fiscal policy is to make public finances less sensitive to shocks, such as a drop in commodity prices or a currency depreciation. But how can government reduce vulnerabilities? Principally by working on three fronts. First, countries can improve how they disclose and analyze risks. A comprehensive, reliable, and timely public reporting on the state of public finances can reduce the likelihood and magnitude of negative surprises. Such events are not uncommon. For instance, governments often provide guarantees to the private sector that may prove very costly when they are exercised. It is very important to disclose such guarantees, so that they do not pop up unexpectedly. Second, countries should take concrete measures to mitigate the risks they have identified. Very few countries have developed risk management strategies that actively reduce the probability that risks may occur and limit the government’s exposure to risk. Taking our previous example, countries could introduce caps to the amount of guarantees provided by the government. Third, governments should create adequate cushions to absorb the remaining risks that cannot be mitigated. For instance, budgets should include adequate “provisions,” which are safety margins to cope with unexpected events.
Promoting sustainable growth. Raising medium-term growth is necessary in all countries. In advanced economies, a lasting solution to the high debt problem is not possible without higher growth. In fact, a sustained increase in growth of 1 percentage point could bring debt ratios in advanced economies to their pre-crisis levels within a decade. In emerging and developing countries, strong growth is also warranted to raise living standards and finance development strategies. How do we increase growth? An IMF study suggests reforms of tax and expenditure policies could lift medium- to long-term growth by ¾ of a percentage point in advanced economies and even more in developing economies. The analysis in Chapter 2 of the Fiscal Monitor shows that some fiscal measures are very powerful tools for fostering innovation and productivity. In particular, fiscal support to private research and development (in the form of research and development tax credits or subsidies) costing 0.4 percent of GDP to the budget—less than half a percent of GDP—can deliver 5 percent higher GDP in advanced economies in the long run.
In sum, countries face big challenges in restoring vigorous growth, and healthy and resilient public finances. But the good news is that policymakers, individually and in concert, still have adequate policy tools to address these challenges and adapt to the new realities.
We support the introduction of negative policy rates by some central banks given the significant risks we see to the outlook for growth and inflation. Such bold policy action is unprecedented, and its effects over time will vary among countries. There have been negative real rates in a number of countries over time; it is negative nominal rates that are new. Our analysis takes a broad view of recent events to examine what is new, country experiences so far, the effectiveness of negative nominal rates as well as their limits and their unintended consequences. Although the experience with negative nominal interest rates is limited, we tentatively conclude that overall, they help deliver additional monetary stimulus and easier financial conditions, which support demand and price stability. Still, there are limits on how far and for how long negative policy rates can go.
Why are central banks using negative policy rates?
Once policy rates are cut to what used to be known as the ‘zero lower bound’, central banks can employ unconventional monetary policy measures to provide further stimulus if real interest rates are still above the levels consistent with price stability and full employment. Negative nominal policy interest rates are the latest addition to this unconventional toolkit. Six central banks so far have introduced negative rates that apply to some amount of the cash balances commercial banks hold with the central bank (Table 1). Negative rates aim to encourage the private sector to spend more and support price stability by further easing monetary and financial conditions. For smaller open economies, negative rates can also help discourage capital inflows and reduce exchange rate appreciation pressures.
There are synergies between negative policy interest rates and quantitative easing. Negative policy rates have thus far been associated with expanded central bank balance sheets as a result of quantitative easing or large-scale foreign exchange purchases. Quantitative easing compresses yields and term premia, though it has some limits since over time it reduces the availability of assets for further purchases by the central bank. Moving policy rates negative aims to lower money market rates and push down the yield curve further, and boost portfolio substitution effects, thereby increasing the potency of monetary policy. In fact, negative deposit rates tend to have more bite when a large amount of commercial banks’ reserves are priced at the negative rate.
Negative real rates have been seen in both advanced and emerging markets and developing economies when inflation is higher than nominal interest rates. It is negative nominal interest rates that are new. When nominal rates become negative, the transmission mechanism of monetary policy may also differ as there are non-linearities associated with the downward stickiness of retail deposit rates. The latter are unlikely to fall below zero as retail depositors could switch to cash to avoid the negative rate.
How do negative policy rates work? The experience so far
There are several transmission channels of negative rates: through portfolio rebalancing, bank lending, and via the exchange rate.
The portfolio balance channel appears to have operated normally at negative rates. Wholesale interest rates have fallen with central bank deposit rates (see Chart 1). Money market trading activities appeared to have declined, but it is not clear whether these effects reflect negative rates per se, or the substantial surplus liquidity associated with quantitative easing that reduces the demand for trading. Lower risk-free wholesale rates have tended to encourage investors to switch from low yield government securities to riskier assets such as equities, corporate bonds, or property. In addition, lower wholesale interest rates have reduced the cost of funds for those borrowers such as large corporates who can directly finance in commercial paper and corporate bond markets.
The impact of negative rates on bank lending has differed across banks, reflecting different funding models and lending practices. While wholesale bank funding costs have fallen, decreases in lending rates have been limited by retail deposits remaining anchored at zero or above. Banks that rely more heavily on customer deposits for funding have hence been less able to reduce lending rates. In most cases, lending rates have fallen since the introduction of negative policy rates but there is a wider dispersion of experiences compared to wholesale markets. Some retail lending rates have even increased somewhat (see Chart 2). Lending rates have tended to fall more in banking systems with a higher proportion of variable rate loans, shorter loan maturities, or high levels of competition among banks. This explains why corporate loan rates appear to have fallen further than retail rates, in part reflecting a greater prevalence of loans indexed to the interbank market. In terms of lending volumes, while it is too early to draw definitive conclusions, credit growth in the euro area for example, has picked up since the introduction of negative rates.
Banks benefit overall from policies that support price stability and growth, through stronger borrower creditworthiness, lower nonperforming loans, reduced provisioning costs, and capital gains on the securities they hold, and those more reliant on wholesale funding have seen a reduction in costs. Yet banks’ net interest margins appear to have been squeezed by the combination of negative rates and quantitative easing, although this pressure has been offset to some extent due to a number of mitigating factors. Some banks have been able to raise alternative sources of income through fees or commissions. Many central banks have exempted a portion of commercial bank balances held at the central bank from the negative rate (the so called “tiering” system) thus reducing any potentially perverse impact on bank margins.
The impact of negative central bank rates on the exchange rate has been mixed. Portfolio rebalancing in some cases has led to cross-border capital outflows and exchange rate depreciation. In some cases central bank actions have had the beneficial effect of reducing capital inflows (for example in Denmark) while elsewhere other factors have driven the exchange rate.
Are there limits to the use of negative policy rates?
The use of negative policy rates may have its limits—both in terms of the extent to which central banks can set rates at negative levels and the length of time they can remain negative. Individuals and corporates could substantially increase the use of cash as a store of value—and even as a means of payment—if rates are expected to be substantially negative and for a long time. Indeed, so could banks: instead of working balances held at the central bank to cover interbank transactions, banks could hold vault cash for settlement between each other.
Ballpark estimates by staff for the tipping point at which a move into cash would become worthwhile range from minus 75 basis points (bps) to minus 200 bps. Some of the costs of using cash as a store of value, or for large-value transactions, are of a one-off nature: these might include expanding vault capacity, transporting cash to private sector vaults, and setting up systems. Since these one-off costs would be spread over time, the length of time for which negative rates were expected to endure would be important both in the decision of whether or not to undertake them, and for the interest-rate equivalent added cost to transactions. The tipping point will likely vary by country. It would also be influenced by the value of the highest denomination banknotes. The physical space required for storing US$1 million equivalent would be similar in Denmark, Hungary, Japan, and the United States; but lower in the eurozone and Switzerland where there are higher denomination notes (EUR 500 and CHF 1,000). There is some evidence of the demand for large value notes increasing in Switzerland already (see Chart 3).
But perhaps more important than the physical limits as described above, there may also be significant political economy and social limits to the use of negative nominal interest rates. The public may feel that they are being “taxed” if and when deposit rates increasingly turn negative. As a result, public support for the negative interest rate policy could be weakened.
Are there unintended consequences?
Commentators have focused on the potential negative impact of negative rates on bank profitability. Banks appear to have been unwilling or unable to reduce retail deposit rates to negative territory, and their net interest margins may have been squeezed. Overall, as mentioned before, to the extent that negative interest rates help to support domestic demand, banks are likely to benefit through improved credit quality, reduced nonperforming loans, and increased loan demand. They may enjoy capital gains on their bond holdings. Admittedly, for banks that are unable to generate greater earnings by increasing the volume of their lending, or by charging fees to depositors, negative rates could be a significant profitability challenge.
Another concern is that if policy rates remain negative for too long, there could be increasing spillovers to savers, with negative social consequences, although this is true also of low, positive rates. If low or negative rates persist, they could undermine the viability of life insurers, pensions, and savings vehicles. Low rates make it difficult for insurers to meet guaranteed returns, and with substantial duration mismatches, this will eventually force losses on life insurance policy holders.
There may also be excessive risk-taking. As banks’ margins are squeezed, they may start lending to riskier borrowers to maintain their profit levels. Banks may also be encouraged to rely more on cheaper but volatile wholesale funding sources. Weak loans could become harder to detect, and vital corporate restructuring could be delayed. Negative interest rates may induce boom and bust cycles in asset prices. These potential risks require close monitoring and supervisory scrutiny. Prudential authorities may need to respond with stronger policy actions.
Although the experience with negative nominal interest rates is limited, we tentatively conclude that overall, they help deliver additional monetary stimulus. Wholesale interest rates have fallen as have some bank lending rates, which should help support demand and price stability. Still, it’s important to emphasize that, while monetary policy is critical to the battle against weak growth and deflationary pressures, there appear to be limits on how far and for how long negative policy rates can go. This underscores that monetary policy cannot be the only game in town. It should be part of a balanced and potent approach that also includes well-designed structural reforms, growth-friendly and supportive fiscal policies, and prudential policies that enhance the resilience of the financial sector.
Sculpture of the euro outside the European Central Bank, Frankfurt, Germany: Convergence of core inflation towards the ECB’s medium-term objective is likely to be gradual (photo: Alex Domanski/REUTERS/Newscom)
The euro area economy is in its fifth year of recovery, unemployment is close to its pre-crisis level and the output gaps of most countries have closed. Yet, core inflation continues to be low, notwithstanding temporarily high headline inflation due to higher energy prices.
It may look as if the traditional Phillips curve relationship between core inflation and unemployment has broken down over the past five years.
During 2012 to 2014, the euro area experienced a “missing disinflation” episode, where inflation stayed at relatively high levels despite high and increasing unemployment. From 2014 to 2017, there was a “missing inflation” period, with little inflation pressure despite considerable reductions in labor market slack. Some have attributed this to a broken Phillips curve, to difficulties in correctly quantifying slack, or low global inflation.
However, our new study shows that what may seem like an inflation puzzle is nonetheless consistent with a conventional Phillips curve.
We use a standard version of the Phillips curve, where core inflation depends on inflation—what people expect inflation to be in the future—past inflation, and the unemployment gap.
We find that the relationship between core inflation and unemployment is stable, meaning that inflation continues to react to labor market developments. This is true even when considering other measures of slack, such as the output gap, or a broader measure of unemployment that includes those who are underemployed or only marginally attached to the labor force.
What may seem like an inflation puzzle is nonetheless consistent with a conventional Phillips curve.
The key to the puzzle lies in the strong persistence of euro area inflation. In the euro area, the coefficient on past inflation is high, much higher than for US inflation, for example. Similarly, the coefficient on inflation expectations is much lower for the euro area than for the US
What does this mean? It implies that, in the euro area, following a period of weak demand and low inflation, it will take a much longer period of strong demand to get inflation back to the inflation objective. In other words, there is a substantial time lag in the transmission of improving labor market developments to prices. Taking this lag into consideration appears to “solve” the inflation puzzle: core inflation finally aligns with labor market developments.
We also test the alternative hypothesis that low euro area inflation is the result of global low inflation. We do this by including a number of global variables in our Phillips curve, namely the foreign output gap, foreign inflation, non-oil import prices, oil prices, and the nominal effective exchange rate. However, we do not find supporting evidence. Not only are the contributions of global factors to inflation dynamics less important than those of domestic factors, but global factors were also not consistently deflationary in recent years.
What does this mean for monetary policy?
Our findings suggest that convergence of core inflation towards the European Central Bank’s medium-term objective is likely to be gradual. Due to the persistence in the inflation process, a too early withdrawal of monetary accommodation could be a mistake with long-lived consequences.
This conclusion reinforces the case for being “patient, prudent and persistent”. It underlines the importance of the ECB’s commitment to keep policy rates at their current, extraordinary low levels—at least through next summer—and as long as necessary. This will support the slow process of returning inflation to its objective, through both stronger demand and well anchored inflation expectations.