Brexit: Now Comes the Hard Part

According to James McCormack Global Head of Sovereigns at Fitch Ratings, nearly nine months after the UK voted in a referendum to leave the EU, the British government will soon provide notice to the European Council of its intention to withdraw under Article 50 of the EU Treaty, marking the beginning of exit negotiations. As contentious as the last year has been, first in debates on the merits of Brexit leading up to the referendum, and more recently amid criticisms of the government’s negotiating priorities and strategy, the period ahead promises to be even more combative.

Being the first country to leave the EU, the UK has no pre-established path to follow, and will forge ahead knowing only that Article 50 stipulates a two-year period to negotiate and ratify an agreement on the terms of exit, unless Member States unanimously agree an extension. There are five primary challenges facing the UK that are identifiable from the outset.

Timing is Tight, and the Exit Bill Looms

Most fundamentally, the UK will not be in full control of the negotiating agenda, and specifically the order in which issues will be addressed. Prime Minister May has said that a comprehensive free trade agreement with the EU is one of the government’s objectives, and that a smooth and orderly Brexit means having it in place by the end of the negotiating period. Most observers agree that two years is a short time to negotiate a free trade deal, but the actual time available to do so could prove even shorter, as some European leaders have suggested that the UK’s post-exit trade arrangements can only be negotiated once the most important terms of its exit have been agreed, which could take several months.

This may simply be an early negotiating tactic, but if less time is available, it becomes more likely a transition agreement would be needed to avoid what the prime minister has called “a disruptive cliff edge”. However, such an agreement would also take time to negotiate, and, once in place, it could reduce the urgency of reaching a final agreement, possibly drawing out negotiations well beyond two years.

The second major challenge faced by the UK will be settling the financial terms of its EU departure, or its “exit bill”, which EU leaders have indicated will be among the issues they seek to resolve up front. The main elements to be discussed will be future EU spending commitments agreed when the UK was a member state and EU officials’ pensions, and a figure of EUR60 billion has been bandied among European leaders. The amount will certainly be disputed by the UK, but it will have a strong incentive to agree to terms quickly and move on to more contentious and important issues, even though the concept of post-membership payments to the EU will be portrayed by some in the UK as an early and unnecessary concession.

Scotland and Other Internal Divisions

The three remaining challenges are domestic, and centre on Scotland, the lack of a unified national position on Brexit and the need to manage expectations.

The Scottish Parliament’s Culture, Tourism, Europe and External Relations Committee has published a report calling for “a bespoke solution that reflects Scotland’s majority vote to remain in the single market”. It would greatly complicate both the negotiations with the EU as well as border and logistics issues if such a bespoke arrangement were in place post Brexit. The lingering risk of a second independence referendum raises the stakes in how the UK government deals with any Scottish requests, and will require policymakers’ careful attention when government resources will already be stretched.

Beyond Scotland, it has been made clear in a variety of forums that the UK is not entering Brexit negotiations with unified views of the most desirable outcomes. In considering future UK trade arrangements, for example, Parliament’s International Trade Committee recently recommended joining the European Free Trade Area, and there are sure to be a raft of other proposals put forward on this issue alone from public and private sector groups. In the midst of negotiations, open debates within the UK can expose domestic political pressure points that could be strategically exploited by the European side. It may be of some comfort that the EU will be subject to similar internal disagreements, but the upshot of this is likely to be delays in formulating negotiating positions — an unfavourable outcome for the UK.

The final UK challenge as negotiations begin is managing expectations and uncertainties. Prime Minister May promised “no running commentary”, but there will be leaks, as with any negotiation. Progress will not be linear, in the sense that the UK and EU will appear alternatively to be closer to achieving their objectives, and financial markets may react accordingly. Domestic opponents of the UK government are likely to be quick to attribute any economic underperformance or market turbulence to shortcomings in the government’s approach to negotiations. The biggest associated risk is that the balance of public opinion shifts to a decidedly more negative view of Brexit, lending support to ideas already circulating on either a greater role for Parliament in approving the final negotiated agreement or another opportunity for the electorate to formally express its view.

Fed Embarks on New Phase of Normalization

The US Federal Reserve’s (the Fed) decision to hike interest rates by 25bps represents the beginning of a new phase of US monetary policy normalization, says Fitch Ratings.


The prediction for three hikes in 2017 in the Federal Open Market Committee’s (FOMC) December 2016 Summary of Economic Projections was initially met with some skepticism in financial markets. However, by moving rates up again so quickly, the Fed now looks well on track to deliver. Two rate hikes within the space of just over three months and some marginal toughening up of the statement on forward guidance underscore the contrast with the glacial and hesitant approach to unwinding stimulus seen in the past few years. More broadly, Fitch believes that the recent US rate hikes could mark the beginning of a significant shift in the global interest rate environment, with benchmark US policy rates settling higher over the long term than current market expectations.

The decision to raise the Fed Funds target rate to 0.75%-1.00% marks the second rate hike in just over three months. This represents a major acceleration in Fed action. Fitch now expects a total of seven hikes in 2017 and 2018, bringing the policy rate to 2.50%. This contrasts with just two rate hikes in total between the end of 2008 and 2016.

Macro indicators through 2H16 and early 2017 reinforce the likelihood of a pickup in rate normalization over the medium term. GDP growth of 2.6% (annualized) in 2H16 was a significant recovery from 1H16, underpinned by improvements in private investment and industrial output. So far, jobs data this year have also been supportive, with the latest nonfarm payrolls, unemployment and private sector earnings figures all pointing to tightening labor market conditions.

Material fiscal easing should bolster positive domestic demand trends. President Trump’s agenda of tax cuts, fiscal stimulus and deregulation in the financial services and other sectors strongly indicates that some level of growth boost is likely. Although the precise form of stimulus remains uncertain, Fitch believes that fiscal policy could add up to 0.3pp to economic growth in both 2017 and 2018. Fitch recently revised up its US growth expectations in recognition of the increased likelihood of fiscal easing, higher private investment and improving global outlook. Fitch forecasts US GDP growth to accelerate to 2.3% and 2.6% in 2017 and 2018, respectively.

Fitch does not believe that the increased pace of Fed rate hikes poses a risk to US economic growth. However, the impact from dollar strengthening could have wider global effects, especially should this result in prolonged monetary policy divergence. US rate rises, combined with fiscal stimulus, at a time when the European Central Bank and Bank of Japan are continuing to pursue ultra-loose monetary policy, should prolong the dollar strengthening trend. Rising rates and dollar strength have historically added to external financing risks for emerging markets.

Fitch believes that market expectations for a permanently lower equilibrium interest rate in the US and the continuation of ultra-loose monetary policy for several more years could be increasingly challenged. This could result in a rapid shift in consensus expectations toward a higher terminal rate and a faster pace of normalization. Notably, market consensus was not expecting a March rate hike as early as last month, although healthy macro data releases and hawkish public statements from FOMC members resulted in a quick shift in expectations ahead of the actual decision.

Rising interest rates in 2017 and 2018 will not be a broad concern for US corporates in aggregate, but pockets of risk could challenge entities at the lower end of the rating spectrum, according to Fitch Ratings.

With current LIBOR levels at or above most pricing floors – USD 3M LIBOR was 1.11% as of March 8 – subsequent rate hikes would expose leveraged loan issuers to reset risk that could pressure credit profiles and cash flow generation. This risk is most acute for deeply speculative-grade credits with large amounts of floating rate debt, already large interest burdens, and limited to negative FCF.

Near-term interest rate risk is most evident for leveraged issuers who took advantage of longstanding favorable market conditions to issue large amounts of floating-rate debt, but whose credit profiles deteriorated due to secular challenges or idiosyncratic issues that resulted in higher leverage, depressed cash flows and limited liquidity.

Retail companies, for example, with high floating-rate debt exposure could be particularly exposed to interest rate risk if secular challenges offset the benefits of an accelerating economy on top-line growth.

From a credit profile perspective, we are less concerned about exposure to fixed-rate high-yield (HY) bonds. Historically, HY spreads do not increase meaningfully until after the Fed has concluded its tightening cycle. As a result, modest policy rate increases may not be accompanied by corresponding increases in spreads.

Interest rates typically rise in response to higher inflation, usually during economic recoveries, implying generally improving credit profiles. Fitch’s Stable Outlook for US Corporates in 2017 supports this view.

Moreover, companies have been proactive in managing maturity profiles. US corporates have aggressively refinanced during nearly a decade of low interest rates, pushing out maturities with long-dated, low-coupon debt to maintain historically strong interest coverage metrics and solid liquidity profiles. We expect fundamentals to remain stable as expectations of growth in cash flow are fueled by persistent cost controls, efficiencies, and revenue growth, albeit weak.

The Trump administration’s tax proposal to cut the corporate tax rate to 15% and eliminate the tax-deductibility of interest expenses adds another layer of risk. Negative cash flow impact from the removal of interest expense deductibility may outweigh the positive cash flow impact from the corporate tax cut for issuers with high debt burdens and debt costs

Wage Growth Continues To Slow

The latest edition of the RBA Bulletin included a section of wage growth and this chart. Inflation adjusted wage growth is close to zero. Not good for households with large mortgages.  Interestingly they did not separate public and private sector growth, out data suggests public sector employees are doing better than those in the private sector!

The RBA says the job-level micro WPI data provides further insights into the slowing of wage growth in Australia over recent years. Following the
decline in the terms of trade, there has been a reduction in the average size of wage increases.

This has been particularly pronounced in mining and mining-related wage industries. The increasing share of wage outcomes around 2–3 per cent also provides further support for the hypothesis that inflation outcomes and inflation expectations influence wage-setting.

The Bank’s expectation is that wage growth will gradually pick up over the next few years, as the adjustment following the end of the mining boom runs its course. The extent of the recovery will, in large part, depend on how wage growth will respond to improving labour market conditions, including the level of underutilisation.

They observe that wage growth across all pay-setting methods has declined. Wage growth in industries that have a higher prevalence of individual agreements has declined most significantly over recent years,
following strong growth in the previous few years. This may reflect the fact these industries have been influenced by the large terms of trade
movements, but may also indicate that wages set by individual contract can respond most quickly to changes in economic conditions.

Wage growth in industries with a higher share of enterprise bargaining agreements have the lowest wage volatility, as the typical length of an
agreement is around two and a half years. While changes in wage growth and labour market outcomes by pay-setting may reflect differences in wage flexibility or bargaining power, these can be difficult to distinguish from a wide range of other determinants of wages, including variation
in industry performance, the balance of demand and supply for different skills, and productivity.

The share of wage rises between 2–3 per cent has increased to now account for almost half of all wage changes. This may indicate some degree of anchoring to CPI outcomes and/or the Bank’s inflation target. Decisions by the Fair Work Commission, which sets awards and minimum wage outcomes, are heavily influenced by the CPI. A little over 20 per cent of employees have their pay determined directly by awards, and it is estimated pay outcomes for a further 10–15 per cent of employees
(covered by either enterprise agreements or individual contracts) are indirectly influenced by awards.

Employment Data Disappoints

The ABS data on employment to February 2016 revealed a nasty surprise with trend unemployment restated higher, and seasonally adjusted also up. The question of course must be, given the various tweaks done by the ABS are these numbers accurate? The trend unemployment rate in Australia was 5.8 per cent. The trend participation rate was unchanged at 64.6 per cent.

Full time jobs were up a little by 27,100, but part time jobs fell 33,500; hence a net drop. Across the states, Victoria added 10,600 jobs, but Western Australia and Queensland jobs fell by 5,500 and 11,500, respectively.

New South Wales has the lowest rate at 5.2 per cent whereas Queensland had the highest rate at 6.7 per cent. Weirdly, in Western Australia the rate fell 0.4 per cent but this was to a fall in the state participation rate.

“Over the past year, we have continued to see a relatively steady trend unemployment rate between 5.7 per cent and 5.8 per cent,” said the Acting General Manager of ABS’ Macroeconomic Statistics Division, Jacqui Jones. It should be noted that January 2017 trend unemployment rate was revised up from 5.7 per cent to 5.8 per cent, as part of the standard monthly revisions.

The quarterly trend underemployment rate remained at 8.6 per cent. “The underemployment rate is still at a historically high level for Australia, but has been relatively unchanged over the past two years,” said Ms Jones.

Trend employment increased by 11,600 persons to 12,005,000 persons in February 2017, reflecting an increase in both full-time (4,600) and part-time (6,900) employment. This was the fifth straight month of increasing full-time employment, after eight consecutive decreases earlier in 2016.

Total employment growth over the year was 0.8 per cent, which was less than half the average growth rate over the past 20 years (1.8 per cent).

The trend monthly hours worked increased by 1.2 million hours (0.1 per cent), with increases in total hours worked by both full-time workers and part-time workers.

The trend participation rate was unchanged at 64.6 per cent.

Trend series smooth the more volatile seasonally adjusted estimates and provide the best measure of the underlying behaviour of the labour market.

The seasonally adjusted number of persons employed decreased by 6,400 in February 2017. The seasonally adjusted unemployment rate increased by 0.2 percentage points to 5.9 per cent, and the seasonally adjusted labour force participation rate was unchanged at 64.6 per cent.

The US is healing but we can’t even admit we’re ill

From The NewDaily.

The Federal Reserve’s widely anticipated rate rise is a reminder that while the US has learned from its housing market crash, our political leaders have created a record bubble of mortgage debt by shying away from reform.

When Fed chair Janet Yellen announced Thursday morning (Australian time) the fed-funds rate had risen to a new target range of 0.75 to 1 per cent, it caused barely a stir in markets. The New York Stock Exchange rose 0.8 per cent, as the Fed signalled future rate rises are likely to arrive sooner than previously expected.

These days the Fed telegraphs each move so effectively that markets no longer ask ‘will they move or not?’, but more ‘does that move reflect what’s really happening in the economy?’

Yes, with its years of super low rates, the Fed did set the scene for the 2009 housing collapse that hit global markets like a tsunami. But its three rate rises since the GFC have been spot on – late enough to avoid choking the recovery, but early enough to prevent inflation getting out of hand.

At a press conference Ms Yellen said the Fed is pushing rates back towards “normal” levels because the US economy has returned to reasonable health – growing at a “moderate pace”.

Meanwhile, Australia’s rates remain at historic lows. So what are we doing wrong?

The biggest reason we’re not seeing US-style growth is, gallingly, entirely self-imposed. Our political leaders have skewed the economy heavily towards real estate investing.

The vast sums of capital tied up in housing could be establishing new businesses, or backing the expansion of existing ones. Instead, we’re a nation hypnotised by capital gains that thinks buying and selling the same houses back and forth is a productive industry.

It all began in 1999, when treasurer Peter Costello cut capital gains tax to a rate well below the personal tax rates of middle- and upper-middle class Australians. It was one of the most economically harmful policies ever dreamt up in Canberra.

It did not take the nation’s accountants long to point out to clients that investing in a property, negatively gearing it for a few years, and then banking the capital gain at the new rate would slash the investor’s tax bills.

During the same period, the US was experiencing a credit bubble for different reasons – super low rates, plus the advent of sub-prime mortgages.

When the early ‘sub-prime’ phase of the GFC finally began to be felt, US house prices tumbled. And when the sub-prime crisis worked its way through the banking system, global stock markets crashed too.

Whereas the US learned from this and started rebuilding, we arrested our correction and did everything possible to keep the credit bubble growing.

As the share market tanked in 2009, Australian policy makers decided that the sacred cow of house prices must be protected at all costs. The 2009 first home buyer’s grant kickstarted that defence, and was topped up by most state governments too.

Even though the Rudd government’s own tax review – the Henry Tax Review – had recommended reining in negative gearing and the capital gains tax discount, all that was ignored.

The tax lurks stayed, gleefully maintained by the Abbott and Turnbull governments, and the RBA joined in by cutting interest rates that blew the credit bubble larger still.

The lack of action by politicians has pushed responsibility for reining in the bubble to the Australian Prudential Regulatory Authority, which imposed a fairly weak ‘speed limit’ on credit growth two years ago.

And now the RBA itself is threatening to put more “sand in the gears” of the credit machine.

It’s all too little, too late.

Australia, having ‘escaped’ the house price collapse that swept through so many nations in 2009, is now stuck in a self-imposed debt bubble.

To Solve One Problem, Did The RBA Rate Cut Last Year Just Make Another One Worse?

From Business Insider.

When it’s all said and done, May 3, 2016, may well go down as the day when an attempt to solve a problem ended up creating an even greater one in Australia.

Six days after the release of Australia’s March quarter consumer price inflation (CPI) report — something that revealed headline CPI fell with underlying inflation also tumbling to fresh lows — the Reserve Bank of Australia (RBA) resumed a rate cutting cycle that began in late 2011, lowering the cash rate to a then record low of just 1.75%.

That reduction was followed three months later by another cut taking the cash rate to 1.5%, the level it remains at today.

Though there were other considerations, both were largely done in the name of helping to boost inflation — both near-term and in the future.

While the RBA’s response was not all that unusual — it is, after all, an inflation-targeting central bank — the twin rate cuts appear, in hindsight, may have actually created an even larger problem for the RBA.

Those cuts, along with other factors such as the Turnbull government’s reelection ending in political uncertainty over the tax treatment of housing, put a rocket under property prices in Sydney and Melbourne, already the most expensive in the country.

While there’s debate over just how much they’ve increased given varying readings from individual market providers, in simple terms the answer is a lot, in particular driven by resurgent investor activity in these markets.

It’s created a conundrum for the RBA perhaps even greater than just one year ago.

Bill Evans, chief economist at Westpac, summed up the problem perfectly earlier today.

“Even though income growth and inflation are too low and there remains ample spare capacity in the labour market the (RBA) has no flexibility to cut rates,” said Evans.

“The evidence is clear that the rate cuts the Bank embraced last year in the face of low inflation fuelled house prices and household leverage. The Bank is concerned about possible excesses in the housing market.”

Now, like then, inflation remains stubbornly low and unemployment (and especially underemployment) high, creating conditions that are leading to record-low wage growth which are then feeding back into a lack of inflationary pressures.

It’s easy to understand why some believe that the only inflation the RBA succeeded in creating was in housing prices in just two Australian cities, rather than delivering appropriate policy settings for the remainder of the country.

To be fair to the new RBA governor Philip Lowe, a man who took over that title the month after the RBA last cut rates, he’s well aware of the problem, telling parliamentarians last month that he’d like to see unemployment a bit lower and inflation a bit higher.

His reluctance to use monetary policy to speed up this trend, however, was that further rate cuts “would probably push up house prices a bit more, because most of the borrowing would be borrowing for housing.”

He’s hamstrung, in other words, as Evans suggested earlier today.

Other parts of the economy would no doubt benefit from lower borrowing costs, and potentially a lower Australian dollar, but that can’t be delivered by the RBA because of financial stability risks in Australia’s largest, most expensive and economically most important housing markets.

Though no one knows whether the RBA’s conundrum will self-correct, allowing the bank increased policy flexibility to benefit the broader Australian economy, the question that needs to be asked is whether we should wait to find out the answer.

That answer is undoubtedly no.

What is required is a coordinated response to reduce risks in the Australian housing market that will free up monetary policy to do its one and only job — to bring forward or pull back demand within the economy when necessary.

That task will fall to Australia’s banking regulator, APRA, in consultation with the RBA, along with state and federal politicians.

There’s noises being made that suggest this is already occurring, but the longer house prices in Sydney and Melbourne are allowed to run away unfettered, the greater the likelihood that the RBA will be unable to make a difference for the broader economy if and when its required.

That’s a scenario that no one wants to see tested in reality.

Addressing Persistently Sluggish Growth

A new report from the IMF “Labor and Product Market Reforms in Advanced Economies : Fiscal Costs, Gains, and Support” looks at concerns about persistently sluggish growth amid high public debt and mounting long-term fiscal pressures in advanced economies.

High on the agenda are a range of reforms designed to strengthen the functioning of product and labor markets. Nevertheless, progress toward these reforms has remained slow because of political opposition and concerns about their distributive and short-term economic effects. Reform adoption may also have been hindered by strained government budgets.

This raises questions about the fiscal costs and gains from reforms. To what extent can reforms help strengthen fiscal positions over the medium term? Can policy packages combining reforms with temporary upfront fiscal support yield a net fiscal gain over the medium term as well as facilitate implementation?

Persistently sluggish growth has led to growing policy emphasis on the need for structural reforms that improve the functioning of labor and product markets in advanced economies. However, reforms have progressed slowly because of political opposition and concerns about their distributive and short-term economic effects. At the same time, the ability to cushion these effects is hindered by high public debt and mounting long-term fiscal pressures. This note provides new empirical analysis, numerical simulations, and case studies to assess the fiscal impact of labor and product market reforms in advanced economies and evaluate the case for complementing reforms with fiscal support. As such, it provides a major addition to recent IMF analysis that examined the output and
employment effects of reforms.

Main findings of the analysis:

  • Most labor and product market reforms can strengthen medium-term public finances indirectly by raising output. In some cases, such as lower entry barriers for firms, this indirect fiscal gain can be sizable. In other instances, the gains can be amplified or offset by the direct fiscal impact of the reform. For instance, unemployment benefit reforms improve fiscal outcomes both indirectly and directly through lower spending, but the up-front costs of labor tax cuts and higher spending on active labor market policies are only partly recouped over time as output rises. A budget-neutral implementation of these reforms can yield unambiguous fiscal gains.
  • The effects of reforms on fiscal outcomes depend on business cycle conditions. Employment protection reforms strengthen fiscal positions in an expansion, but weaken them in periods of slack due to their short-term output cost. Similarly, the fiscal gains from unemployment benefit reforms are larger under strong cyclical conditions. In contrast,  debt-financed labor tax cuts and active labor market policy spending have stronger indirect positive effects on public finances in times of economic slack because of larger fiscal multipliers, which must be weighed against their direct costs.
  • Under weak cyclical conditions, a package combining certain labor market reforms—such as easing job protection or reducing the level or duration of unemployment benefits where particularly high—and credible, temporary, and well-designed up-front fiscal stimulus on average can yield a net fiscal gain over the medium term. This is because the stimulus enhances the effect of these reforms on output and thereby on tax revenues. The package is self-financed over the medium term insofar as the increase in tax revenues from the reform exceeds the financing cost of the initial stimulus. The cost of temporary up-front fiscal stimulus may also be fully offset by subsequent gains if it helps reduce political obstacles to major reforms that yield medium-term fiscal gains, for instance by improving their distributive impact. However, country-specific circumstances—such as government funding costs and their response to stimulus, the magnitude and quality of that stimulus, and the strength of reform implementation—affect the extent to which such gains can be reaped.
  • Case studies suggest that fiscal incentives have indeed facilitated reforms by alleviating transition and social costs. These incentives comprised permanent reductions in distortive taxes and one-time measures, accompanied by a strong consensus and political commitment to reform. Even so, reforms have occasionally been reversed. Incentives have been provided in the context of either a supportive overall fiscal stance or fiscal consolidation—in which case they were financed by other reforms or harmful cuts in public investment. Policy implications—The case for temporary fiscal stimulus and incentives for labor and product market reforms depends on the type of reform, the initial cyclical position, the credibility of the political commitment to and consensus for comprehensive reforms—including strong ownership—and available fiscal space.
  • Countries with fiscal space can use it to provide temporary up-front reform support, especially if there is economic slack. Such support can take the form of targeted budgetary incentives to mitigate adjustment costs, especially for the most vulnerable; recalibration of distortive fiscal
    measures; or other spending that raises long-term output—for example, infrastructure spending on high-return projects. A strong commitment to reforms is an essential prerequisite.
  • In countries that lack fiscal space, the decision to provide up-front fiscal support depends on the credibility of the government’s commitment to strong implementation of comprehensive reforms and sustainable fiscal policies. If these are forthcoming, temporary up-front fiscal support could in theory help mitigate the short-term economic or social costs of some reforms while delivering a medium-term fiscal gain. However, if a country’s commitment to fiscal prudence and reforms lacks credibility because of weak ownership or a track record of reform reversals or weak implementation, fiscal support is not warranted even when cyclical conditions are weak. In such cases, careful prioritization and sequencing of reforms are crucial to maximize output and fiscal gains and ensure that they are widely shared. Lower-cost measures with a beneficial impact on output and public finances, such as product market reforms, should be
    implemented first. Labor market reforms should be designed in ways that mitigate possible short-term costs—for example, passing employment protection reform that takes effect over time can immediately boost hiring. Unemployment benefit reforms, labor tax cuts, and active
    labor market policies should be implemented in a budget-neutral manner. Fiscal incentives could be considered, but as part of broader growth-friendly fiscal rebalancing. However, offsetting their cost by cutting public investment would be highly counterproductive.
  • The design and implementation of fiscal rules should encompass the flexibility to incentivize reforms and acknowledge their medium-term fiscal benefits. Such flexibility reduces the risk that support for reforms will be offset by harmful cuts in public investment. To preserve the credibility of the fiscal framework and confidence in efforts to ensure fiscal sustainability, such flexibility should be conditional on a credible political commitment to strong reforms (possibly only after the reforms), as well as on a strong medium-term fiscal plan. Institutions such as politically independent fiscal councils and productivity commissions can be helpful on this front.

The Fundamental Disconnect

You only have to look at the trends on housing credit growth and wage growth to see the problem. Using data from the ABS and RBA, we can see that in recent times credit to households for housing has been growing significantly faster than wage growth (note the two different scales) whereas in the 2000’s, before the GFC hit, wage growth was higher, and able to support such credit growth.  No wonder household debt is at a record high.

The other perspective is the cash rate, which has been cut to an all time low, and we see wage growth and rates trending in the same direction.

Whilst you can argue that lower rates means repayments are lower for many, the gearing effect of larger mortgages off the back of the home price boom, has created a major problem, with many households close to the edge at current low interest rates, and with low wage growth, no sign of this pressure relenting. Indeed, if rates rise (either officially or from market pressure) significantly more households will be stressed. Many will also struggle to pay off the capital.

These charts, together should have been a warning to regulators. The settings are wrong.

I think you can argue that we should be aiming for credit growth to match income growth, to stop the rot – but consider the impact on the banks (who rely on mortgage growth for profitability) home prices (a reduction in mortgage availability will force home prices lower) and housing affordability (credit rationing would lift the price of loans).

Even small adjustments might well create the conditions for a property market crash, with all the consequences that follow.

There is an old joke, when a driver stops to ask a local for directions, and the answer is “if I were you, I would not start from here”. The regulators have the same problem!

How Tourism Affects China’s Current Account Surplus

From The St. Louis Fed Economic Synopsis.

China has been running a current account surplus since 2000, which has been a policy issue regarding exchange rates and currency manipulation. A current account surplus means that China has been a net lender to the rest of the world. China’s current account surplus reached 10 percent of gross domestic product (GDP) in 2007 and then started to decline until 2011, when it fell to 1.8 percent of GDP. The current account surplus has been stable since then, with a slight tendency to increase in more recent years. In particular, in 2015, the current account was around 3 percent of China’s GDP, but it has not returned to the high levels reached in 2007. What are the main factors behind the decline?

The current account is composed of three main categories: (i) the trade balance (net earnings on exports of goods and services minus payments on imports of goods and services); (ii) the net income to foreign factors (compensation of employees, investment income); (iii) and transfers.

In China’s case, the main component behind the current account trend is a decline in its trade surplus. A trade surplus indicates that China has been earning more on its exported goods and services than it has been paying for its imports (i.e., it has had positive net exports). As Figure 1 shows, net exports in China, as a percentage of GDP, closely track the current account and have been declining since 2007. Indeed, the trade surplus was around 9 percent of GDP in 2007 and fell to 3.5 percent of GDP in 2015. This decline has been driven by both a decline in the surplus of traded goods and an increase in the deficit of traded services (Figure 2). However, the goods surplus has picked up again since 2011, while the services deficit has become more pronounced. Interestingly, trade in services was roughly balanced between 2000 and 2007 and later became a deficit, reaching around –1.7 percent of GDP by 2015. Thus, even though the value of China’s exported goods has exceeded the costs of its imports, China has been importing more services than it has been exporting. Even more interesting is the fact that the increase in China’s services deficit has prevented its current account surplus from rising despite the increased trade surplus in goods.

Figure 3 shows the main categories of China’s international trade in services. One category stands out: travel services, which includes mainly tourism. China’s increasing services deficit has been driven mainly by overseas tourism- related consumption. According to a recent report, two population groups in China have been driving tourism: Millennials (young people 15 to 35 years of age) and a growing middle class. The report indicates two primary reasons for increased tourism by these two groups. On the one hand, young people travel for exposure to overseas experiences. On the other hand, Chinese travel for shopping, which accounted for 30 percent of overseas Chinese spending in 2015. The prime shopping destination currently is Hong Kong, but new destinations such as Japan, Korea, and Europe are expected to become increasingly popular.

Overall, the increasing trade deficit in services, spurred mainly by the rise in tourism, seems to be an important factor in the recent trend in China’s current account. As a result, the current account surplus is increasing only slightly despite a larger increase in net exported goods in recent years. What factors could change this trend? Fluctuations in exchange rates in the main destinations for Chinese tourists could affect tourism. For instance, a depreciation of the yuan could slow the increase in the travel services deficit while concurrently increasing the earnings in exports of goods—all of which could generate a larger current account surplus.

Home Prices Power Away (In Places)

The latest CoreLogic Market Indicator Summary, out today, highlights the divergent home price outcomes across the states. Results to 12 March show Sydney still moving strongly ahead, with Melbourne not far behind. Perth, on the other hand remains under pressure, with falling values.

We really need different economic settings across the states, lower interest rates in the West, but higher in the East. What IS a poor regulator to do? Of, course – “monitor the situation“.