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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
In the last two weeks, the Federal Reserve injected hundreds of billions of dollars into the market for repurchase, or repo, contracts. This is a market in which participants trade short-term funds, usually at an interest rate that mirrors the Federal Funds rate set by the Federal Reserve. But in recent weeks, a shortage of funds led the interest rate to soar, initially close to 10 percent. The Federal Reserve then intervened in order to fix the mismatch between supply and demand. The question now is whether this is a temporary blip, or if the Fed will be called upon to continue intervening, thereby boosting its balance sheet (at a time when it is otherwise reducing its balance sheet). The Fed’s unwinding of quantitative easing has resulted in a decline in bank reserves, which partly explains why there is a reduction in the supply of short-term funds.1
The Fed’s balance sheet has declined by US$700 billion in the last three years. Meanwhile, commercial banks are not necessarily keen to lend their cash reserves, as they continue to earn interest from the Fed on these excess reserves. The result is that the size of the repo market has declined substantially in the last few years. At the same time, nonbanks such as hedge funds and securities brokers need cash to fund their purchases of corporate debt which have grown rapidly. This explains the imbalance in the market.
There are three issues going forward. First, if the Fed winds up permanently participating in this market in order to avoid future imbalances, it could complicate the task of implementing monetary policy. It will boost the Fed’s balance sheet at a time when it is intent on stabilizing the balance sheet, and it will complicate the setting of interest rates. Second, permanent Fed intervention could create an incentive for repo market participants to take excessive risks at a time when there might already be too much leverage in the corporate debt market. Finally, the troubles in the repo market could alarm investors, leading to a seizing up of credit in short-term markets—as happened 10 years ago at the start of the global financial crisis. Clearly, conditions are not similar to what happened a decade ago. Still, economic troubles often begin when investors panic because of perceived shortages of funds. Thus, the Fed might have no choice but to continue intervening in order to avoid panic.
For some time, US President Trump has been tweeting comments about the policies of the Federal Reserve. He has repeatedly called on the Fed to cut interest rates (to as low as zero), and has been critical of the Fed. These tweets have generally been seen as a distraction, not likely to influence Fed policy. Indeed, the Fed itself has said that it ignores such comments and conducts policy on the basis of actual data. However, a new study suggests that investors think otherwise.2 Published by the highly esteemed National Bureau of Economic Research (NBER), the study involved a statistical analysis of high frequency data to determine how the Federal Funds futures rate reacts to actual tweets. It found a strong statistical correlation between the President’s tweets and downward movements in the futures rate. In other words, when the President tweets that he wants the Fed to cut rates, investors downwardly revise their expectations of the Fed’s benchmark interest rate. This means that many investors believe that the Fed actually responds to the President’s tweets, whether the Fed actually does or not. Moreover, many investors evidently believe that the impact of the President’s tweets is not small. The study says that, on average, each tweet leads the futures rate to drop by 10 basis points. Given that, when the Fed cuts the actual rate, it usually cuts it by 25 basis points, this is not trivial. The report’s authors conclude: “Our findings suggest that market participants believe that the erosion to central bank independence is significant and persistent.” They add that the study finds that “markets do not perceive the Federal Reserve Bank as a fully independent institution immune from political pressure.”
What are the implications of this conclusion? First, investor expectations about interest rates matter. If the President can influence expectations, he can influence financial market conditions. Second, the Fed’s job, in part, is to set expectations about inflation by influencing expectations about financial market conditions. If the President influences investor expectations about Fed behavior, the Fed’s job is that much harder. Moreover, the Fed’s currency is its perceived independence and integrity. If this has been undermined, then it is likely that borrowing costs will be higher than otherwise. Indeed, there are studies showing that, in countries where central banks lack independence, investors expect higher inflation, thereby leading to higher borrowing costs. If nothing else, the study demonstrates the considerable power of the President’s words.
IHS Markit released the latest flash estimates of its purchasing managers’ indices (PMIs) for September, and the results suggest that the US economy continues to grow at a modest pace while the eurozone economy is “close to stalling.” The weakness in Europe is mainly driven by extremely weak conditions in the German manufacturing sector, itself influenced by the global downturn in trade and uncertainty about trading relations. PMIs are forward-looking indicators meant to signal the direction of activity in either the manufacturing or services sectors. The PMIs are based on subindices such as output, new orders, export orders, pricing, employment, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa.
The PMIs for the eurozone indicate an economy at its weakest in six years. The manufacturing PMI fell from 47.0 in August to 45.6 in September, an 83-month low and a level suggesting a rapid decline in activity.3 The services PMI fell from 53.5 in August to 52.0 in September, an eight-month low. This means the sector continues to grow, but at a modest pace. The composite PMI fell to a 75-month low. Markit says that the latest PMIs are consistent with real GDP growing just 0.1 percent from the second to the third quarter. It said that “the details of the survey suggest the risks are tilted towards the economy contracting in coming months. Most vividly, new orders for goods and services are already falling at the fastest rate since mid-2013, suggesting firms will increasingly look to reduce output unless demand revives.” The overall weakness of the eurozone is principally the result of a recession in the manufacturing sector. Manufacturing saw a decline in output for the eighth consecutive month, with the steepest decline in seven years. New orders also fell at the sharpest rate in seven years. The manufacturing weakness was principally the result of troubles in Germany. There, the manufacturing PMI fell from 43.5 in August to 41.4 in September, a 123-month low.4 Although Germany’s services PMI remained in positive territory, its composite PMI fell below 50, meaning that overall economic activity likely declined in September. Of particular concern was a decline in export orders for both manufacturers and service providers. Markit commented that “the uncertainty around trade wars, the outlook for the car industry, and Brexit are paralyzing order books, with September seeing the worst performance from the sector since the depths of the financial crisis in 2009.”
The PMIs for the United States were somewhat better than that of the eurozone. In the United States, the manufacturing PMI increased from 50.3 in August to 51.0 in September, a five-month high.5 Still, this is a level indicating very modest growth in activity. The separate services PMI increased from 50.7 in August to 50.9 in September. The composite index, at 51.0 in September, likely reflected modest economic growth. Markit said that the latest data is consistent with third quarter annualized real GDP growth of 1.5 percent. For manufacturers, the survey found a modest uptick in output and new orders, but a continued decline in export orders. For all sectors, it found a deceleration in employment growth. Markit concluded that “businesses continue to struggle against the headwinds of trade worries and elevated uncertainty about the outlook.” Commenting on the overall economic weakness, Markit said that “key to the recent deterioration has been a further spill-over of the trade-led slowdown in manufacturing to the service sector. Inflows of new service sector business almost stalled in September to register the smallest rise since the survey began in 2009.” It also noted that factory conditions are “among the toughest since 2009.”
France has pledged to cut taxes in 2020 by 10 billion euros, but a key watchdog worried about the fiscal deficit.6 The tax cuts are targeted at both corporations and households. France’s finance minister says that other countries in Northern Europe should follow suit. Specifically, he sees Germany as the key. He said: “It’s time for Germany to invest. Let’s not wait for the economic situation to deteriorate to take the necessary decisions. It’s true for Germany, but also for other countries such as the Netherlands.” He noted that “faced with a slowdown of growth in Europe, investment is the only effective response.” Germany’s government, however, appears reluctant to join the party.
Meanwhile, France’s High Council on Public Finances, which is an independent government body tasked with monitoring fiscal probity, said that the government is doing “practically zero” to address its structural budget deficit and criticized the plan to cut taxes. Still, France’s budget deficit will be 3.1 percent this year, which is only marginally above the European Union’s target of 3.0 percent, and it is expected to fall to 2.2 percent of GDP in 2020. The latter number would be the lowest in 20 years. Thus, at least in the short term, there doesn’t appear to be a fiscal problem. France’s finance minister said that “raising taxes is not an option.” Evidently cutting taxes is an option and is meant to stimulate the economy at a time when the eurozone economy is sputtering.
Brazil has long been one of the most protectionist large economies in the world, with relatively high tariff and nontariff barriers to imports of goods and services. That is starting to change. The new government of President Jair Bolsonaro has begun to implement significant reductions in tariffs, with the goal of reducing prices for consumers and costs for businesses, as well as compelling Brazilian companies to become more globally competitive.7 So far, 2,300 products have seen tariffs slashed, in some cases dropping from 20 percent to zero. In part, this process is being driven by the need to comply with a free trade agreement recently signed with the European Union which has not yet been ratified. Still, it appears that Brazil is intent on being prepared when the agreement becomes law.
However, the decision to cut tariffs also reflects the philosophy of the Economics Minister appointed by Bolsonaro, who is keen on creating a more globally competitive economy. Despite the recent cuts in tariffs, Brazil has a long way to go. Currently, the tariff on imported automobiles is 35 percent. Similarly, high tariffs are applied to many other key products—including some products that are not even produced in Brazil. As such, these protectionist measures are not actually protecting anyone. In any event, opening of trade is just one component in a larger plan to liberalize Brazil’s moribund economy.
The global real (inflation-adjusted) volume of trade increased steadily from the end of the last recession in 2009 until early 2018, and then started to decline at the time that the United States began the trade war by raising tariffs. By 2019, the volume of trade was steadily declining from a year earlier. The latest data, published in World Trade Monitor by the Netherlands Bureau for Economic Policy Analysis, indicates that the volume of global trade fell 0.4 percent in July versus a year earlier.8 This was the sixth time in the last eight months that the volume had decreased from a year earlier. What makes this unusual is that such a decline normally takes place during a recession. Yet although global economic growth has decelerated in the past year, the global economy continues to grow. Normally, economic growth and the growth of trade are closely correlated. Thus the current situation is a significant change from the past and is driven by a sharp change in trade policy in the United States, followed by retaliatory actions by other countries. Moreover, the weakness of global trade is likely to worsen. The US tariffs on China, which were mostly at the rate of 10 percent, increased dramatically in May and will increase again next month, with about half of US imports from China being taxed at a rate of 30 percent.9 As this works its way through the pipeline, prices will rise and consumer purchasing power will decline, thereby likely leading to a further decline in trade volumes.
Yet the decline in global trade volume is not simply driven by the loss of bilateral trade between the United States and China. Instead, the decline is broadly based, with both developed and emerging countries experiencing a decline in exports. In fact, in the first seven months of this year, exports either declined or failed to grow in the United States, eurozone, Japan, Middle East, and Central Europe.10 In part this reflects the impact on global supply chains of the US-China trade war. In addition, it also reflects the negative impact on business investment stemming from trade uncertainty. The result is that businesses are ordering fewer imported goods, both due to a decline in investment as well as uncertainty about future trading rules.
There is an interesting nexus between the US dispute with China and the US dispute with Iran. The United States, after having withdrawn from the nuclear agreement signed by six countries plus Iran, imposed substantial sanctions on Iran. These included sanctions on non-Iranian companies that engage in dollar-denominated transactions with Iran. The goal was to limit the ability of Iran to export oil and generate cash. These sanctions have been successful in that Iranian oil exports fell from around 2.5 million barrels of oil per day in early 2018 to just 500,000 barrels per day this past June and 200,000 per day this past August.11 About half of the recent shipments have gone to China. Meanwhile, Iranian exports of natural gas have remained relatively steady, with China accounting for most of the natural gas purchased.
Interestingly, the US government went easy on Chinese oil and gas companies that bought crude oil and natural gas from Iran—until now. Initially, the United States granted waivers to Chinese energy companies, but these were revoked in May of this year. Yet even after the waivers, the United States did not impose sanctions on these entities. However, that has now changed. This week, the US government imposed new sanctions on several Chinese energy companies and their executives in an effort to completely shut down Iranian energy exports.12 Yet this comes at a time when the United States is attempting to reach an agreement with China over bilateral trade between the two countries. It is reported that China is keen to continue importing energy from Iran and is not likely to accept the US action without protest. After all, China was one of the six countries that agreed to the nuclear deal from which the United States withdrew. China, as well as the four other countries, objected to the US withdrawal and is not pleased with the unilateral imposition of sanctions. In addition, China also purchases about half of the oil exported by Venezuela, another country that the United States has sanctioned. To avoid US direct sanctions, China obtains Venezuelan oil from a Russian energy company which purchases the oil in Venezuela and ships it to China. If the United States truly wants to shut down Iranian exports, it will likely intensify sanctions on Chinese companies. Thus, it is possible that the US action against Chinese energy companies would likely damage the ability of the United States to reach a trade agreement with China.
The United States and Japan have signed a limited trade deal.13 Japan had hoped to have a written commitment from the United States to immunize Japan against future increases in US tariffs on automotive imports. Unfortunately for Japan, such a commitment was not forthcoming. Rather, the United States verbally committed to avoiding such tariffs. US trade negotiator Robert Lighthizer said that, “at this point, it is certainly not our intention, the president’s intention, to do anything on autos, on 232s, on Japan.” His reference to 232 is to the US law that allows the president to impose tariffs on the basis of national security concerns. The United States has, on several occasions, threatened to impose tariffs on all automotive imports other than those coming from Canada and Mexico. This essentially means Japan and Germany.
Meanwhile, the new agreement commits Japan to reduce tariffs on US agricultural products and the United States to reduce tariffs on nonauto industrial products. The deal also calls for the elimination of customs duties on electronic goods such as videos, music, and electronic books. The latter provision is seen as a model for future trade deals involving electronic commerce. For Japan, the deal enables Prime Minister Abe to point to better access to the US market for certain industrial products. For US President Trump, it enables him to point to the conclusion of a trade deal while other such efforts remain unfinished. Both sides say that this is just the first of many agreements.
To no one’s surprise, the US Federal Reserve last week cut the benchmark federal funds rate by 25 basis points.14 It will now be in the range of 1.75 percent to 2.00 percent. This is the second interest rate cut in the United States in the past decade, the first having been two months ago. While this action was widely anticipated, many investors were especially focused on the degree of consensus—or lack thereof—within the Fed, and the outlook of policymakers. Last week’s action was not unanimous. Three members of the 10-member policy committee voted “no” on the rate cut—the largest number of dissenters on a policy decision in nearly five years. Of the three, two dissenters preferred to keep rates unchanged while one would have preferred a 50-basis point cut.
This division reflects uncertainty about what to expect from the economy. This uncertainty stems from two factors—the unpredictability of the trade war and confusion over the likely path of inflation. Currently, inflation remains low,15 below the Fed’s target, although core inflation (excluding volatile food and energy prices) is slightly above the Fed’s target. Plus, the economy has slowed, with weakness in business investment and exports.16 However, the labor market is tight, with unemployment at 3.7 percent, even as wages have accelerated. This raises the possibility of an inflationary wage spiral. The Fed noted that “uncertainties about this outlook remain. Although household spending has been rising at a strong pace, business fixed investment and exports have weakened.” Fed officials have also commented on the uncertainty generated by trade tensions.
Meanwhile, the 17 rotating members of the Fed’s policy committee were asked to submit their predictions on the future path of short-term interest rates. Interestingly, only seven of them foresee another rate cut this year while most others predict that the benchmark rate will be left unchanged or increased. This suggests that the Fed is not at the starting point of a sustained easing of monetary policy. This is consistent with previous comments by Fed chairman Jerome Powell, who described the last rate cut as a mid-cycle adjustment rather than a reversal of policy.17 Rather, the Fed appears to be in a wait-and-watch mode, much to the chagrin of US President Donald Trump. Trump has urged the Fed to dramatically cut rates, imitating the European Central Bank (ECB), which has set policy rates below zero.
In response to the Fed’s action, equity prices initially fell and then rebounded slightly, bond yields increased slightly and then fell, and the value of the US dollar rose against major currencies. Investors evidently see the Fed’s current inclination as not being especially supportive of growth, but not opposed to rising inflation. What was left unsaid was the potential impact of the current crisis in the Middle East. This is a true case of uncertainty, as no one can predict what will happen next there.
The US Federal Reserve has injected roughly US$300 billion into the repo market to stabilize short-term funding rates, which had risen precipitously.18 This was the first such intervention in the past decade. Repo (or repurchase) market exits provide an avenue for investors with a lot of cash to obtain a safe short-term return on that cash and for investors with substantial securities to obtain cash on a short-term basis. They enable the financial system to remain liquid. Normally, the repo rate mirrors the federal funds rate, which is set by the Federal Reserve’s policy committee. Currently, the fed funds rate is targeted at between 2.00 percent and 2.25 percent. Yet, recently, the repo rate surged to as high as 9.25 percent. That is when the Fed intervened to bring the repo rate back to a normal level. The repo rate had risen for several reasons, including a fall in the Fed’s reserves as it unwound its program of asset purchases. Additionally, the Federal government’s increased borrowing requirements—a result of the 2017 tax cut—have drained reserves from the financial system. These, as well as other technical factors, suddenly led to a loss of liquidity as investor demand for short-term funding exceeded supply, resulting in the surge in rates.
The Fed’s move came as market conditions signaled a funding shortage. Demand for short-term funds vastly exceeded supply, and demand for cash soared the day after the Fed’s action. Observers debated whether this reflected a burgeoning problem with credit market conditions or was simply a technical problem that can be addressed by Fed action.19 The surge in demand for cash might be reflective of investor worry. Individual investors are likely worrying about what other investors will do, prompting each of them to act in a way that exacerbates the shortage. This is known as panic, or the “herd mentality.”
Either way, if this panic not snuffed out by confidence-building measures by the Fed, it could lead to further problems in credit markets. For the Fed, however, the challenge will be to take strong action while, at the same time, not spooking investors. It is a tough balancing act, and perception matters. If investors believe there is an underlying problem, it could influence their behavior, leading to further stress in the market and a loss of credit availability. This is what happened 10 years ago when the market for commercial paper dried up suddenly, leading to the near failure of many financial institutions. On the other hand, quick intervention by the Fed ought to calm investor nerves and help avert a crisis. Activity in the market in the days and weeks to come will provide an indication as to what is happening.
In recent months, there has been considerable discussion on the possibility of a global downturn, including recession in either the United States and/or Europe. Normally, recessions come about because of one or more of three factors—a significant contractionary shift in monetary and/or fiscal policy; a financial crisis stemming from a loss of confidence due to excessive leverage; and a supply shock, in which the supply of some key commodities or goods is suddenly restricted, driving up prices and reducing purchasing power. The last recession, in 2008-2009, was due to a financial crisis. The recessions of 1974 and 1980 were both due to supply shocks as the global price of oil had skyrocketed.
Until recently, it appeared that a supply shock in the form of protectionist trade policies might be a key factor in driving the next downturn. This past weekend, however, saw a new supply shock that could play a role in reducing economic activity, depending on how the crisis unfolds. The price of crude oil soared following a drone attack on Saudi Arabia’s oil production facilities,20 leading the kingdom to shut down about half its productive capacity, or about 5 percent of global output. This entails a loss of output of about five million barrels per day.
Soon after, oil prices fell sharply after Saudi Arabia’s energy minister Prince Abdulaziz bin Salman said that production would be restored to normal levels within a matter of weeks.21 The minister added that customers are receiving oil at normal levels as the kingdom has dipped into its reserves. Also, US President Trump said that he has ordered the release of emergency oil supplies “if needed.” This was meant to calm the nerves of traders and stabilize prices. Following the crisis of 1973-1974, the United States had established a substantial Strategic Petroleum Reserve. Over the last 40 years, oil from this reserve has been released on a few occasions, when there have been spikes in the global price of oil. Thus, there hasn’t been a shortage of oil. Although global equity, bond, and commodity markets initially reacted sharply, large movements quickly reversed when it became evident that the crisis did not involve a shortage of oil.22 The Saudi oil minister added that the planned IPO of Aramco, the state-run oil company, that is set to go public, will not be interrupted as a result of this crisis.
Given the relatively mild reaction of financial markets to the Middle East oil crisis, it appears that many investors are not yet concerned that this crisis will precipitate to a recession. There are two reasons for this. First, the global economy is already decelerating and not operating at full capacity. Thus, the loss of a modest oil production capacity is not likely to create huge bottlenecks. Second, the rise in the oil price is nothing compared to past episodes that contributed to recessions. It’s worth mentioning that in 1973, at the time of the Arab oil embargo, the oil price had quadrupled. In 1979-80, following the Iranian revolution, oil price had doubled. Thus, unless this crisis worsens—in which case there could be a further drop in production and rise in prices—it seems unlikely that it will have major impact on economic activity.
Meanwhile, the US government said that the attacks most likely came from Iran rather than from Yemen as claimed by Houthi rebels. Iran, however, denied this. The United States has indicated that it’s prepared to respond militarily. Trump said he is awaiting a decision by Saudi Arabia, adding that any retaliatory action would involve the Saudis and would be paid for by the Saudis. Meanwhile, Iran’s Supreme Leader Ayatollah Khamenei said that Iran would not engage in any talks with the United States “at any level” until the latter agrees to return to the 2015 nuclear deal that was signed by President Obama.23 This is not likely to happen during the Trump administration. “If we yield to their pressure and hold talks with Americans ... This will show that their maximum pressure on Iran has succeeded. They should know that this policy has no value for us,” Khamenei said. Iran appears to be determined to make the United States pay a price for having withdrawn from that deal; Iran has certainly paid a price due to increased US sanctions. It could be that Iran is betting that the United States would not be willing to engage in military action against Iran given the risk that this would lead to a larger war.
The worry that the oil crisis will worsen is causing traders and policymakers to lose sleep. A larger and more prolonged disruption of Middle Eastern oil production could have grievous consequences for the global economy, especially if there is a war involving Saudi Arabia and Iran. Moreover, such a war might drag in the United States and even Israel. At the same time, it is worth noting that today the world economy is less dependent on Middle Eastern oil than in the past. Since the 1970s, oil production has risen substantially in many other countries, including in the United States, which has seen a stunning increase in shale oil output. Moreover, the world is less reliant on oil than in the past—the efficiency of energy use has dramatically improved, thus rendering a much lower amount of energy used per dollar of GDP.
Rumki Majumdar of Deloitte India shares her views on the latest policy initiative of the Indian government.
India has announced several measures over the past month to boost investment and support economic growth,24 the latest being the cut in corporate tax rates from 30 percent to 22 percent, excluding all surcharge and cess. In another provision in the Income Tax Act, new domestic companies incorporated on or after October 2019 making fresh investments in manufacturing can pay an income tax of 15 percent instead of 25 percent. This move is expected to infuse fresh capital investment in manufacturing, the sector which has failed to take off so far at a desired pace despite several government initiatives. The cuts will be effective from FY 2019-20 (April 2019-March 2020), subject to the condition that the companies in question do not avail any exemptions or incentives.
At present, the Indian economy is going through its worst slowdown in six years.25 With lower corporate tax rates, the government has tried to address supply-side issues. Lower tax expenses will likely enhance profitability of many companies, which, in turn, will likely improve business confidence and spur capital investments. The new rates bring India closer to, and in some cases lower than, the corporate rates prevalent in many emerging and industrialised countries. This puts Indian companies on a better footing to compete against their peers in the world market.
However, the bigger problem is that of poor domestic demand. Consumers are buying fewer goods, leading to cuts in production and investment. Can the cuts in the corporate tax rate help generate demand? To some extent, yes, as companies are likely to increase hiring along with investments. Further, higher profitability will likely result in better asset valuations and improved wealth. The wealth effect could then spur demand as consumers will feel richer and thereby spend more. The government’s previous announcements to disburse more loans and the central bank’s move to ease limits on bank lending to the country’s troubled non-banking sector (with a view to improve consumer credit growth) are indications that both the government and the central bank are making efforts to propel the slowing economy upward.
That said, the corporate tax cuts will likely have an implication on the fiscal deficit as the government has to forgo substantial revenue. This limits the government’s ability to further ease fiscal policy in the future if it intends to meet the target fiscal deficit budget of 3.3 percent of GDP.
In his last act as president of the European Central Bank (ECB) before retiring in October, Mario Draghi has led the ECB policy committee in cutting the benchmark interest rates from -0.4 percent to -0.5 percent.26 In addition, the ECB resumed quantitative easing (asset purchases) at a rate of 20 billion euros per month. These measures, which had been expected, come as the eurozone economy appears to be at risk of recession. The economies of Germany and Italy failed to grow in the second quarter and Germany’s manufacturing sector continues to contract.27 However, there is concern among some investors as to the degree to which monetary policy easing will actually help the eurozone economy. Indeed, Draghi said that monetary policy alone might not be sufficient to revive growth in the eurozone. Rather, he joined the International Monetary Fund (IMF) and many business leaders in urging that the governments of the eurozone nations initiate fiscal easing. Specifically, he said that “now is the time for fiscal policy to take charge.” The reasoning is that, with negative bond yields in several eurozone countries (including Germany and France), and with Germany currently running budget surpluses, there is plenty of room for governments to borrow money and spend it on infrastructure. Governments would be borrowing free of charge and investing in capital that would likely have a positive return in terms of increased economic growth. In that sense, governments would likely avoid a ruinous increase in debt. However, there remains little evidence that governments, especially that of Germany, are thinking in such terms.
Other observers said that, not only would fiscal policy be helpful, but that a change in trade policy would also benefit the eurozone economy. Specifically, they have in mind US trade policy and the uncertainty surrounding US plans regarding trade with Europe. The US administration has threatened to impose steep tariffs on automotive imports from Europe. The impending exit of the United Kingdom from the European Union is also a source of uncertainty. Investors are worried that a no-deal Brexit will have a negative impact on the economies of Northern Europe. In addition, it can be argued that historically low interest rates are distorting financial markets, contributing to asset price bubbles, hurting bank profitability, and not necessarily doing anything to boost economic activity when borrowing costs are already low.
Meanwhile, US President Trump responded to the eurozone action by tweeting the following: “European Central Bank acting quickly. They are trying, and succeeding, in depreciating the euro against the VERY strong dollar, hurting US exports. And the Fed sits, and sits, and sits. They get paid to borrow money, while we are paying interest!”28 Only recently Trump urged the Fed to cut the US benchmark interest rate to zero or lower (see below). This is not likely to happen any time soon. Draghi responded to Trump’s comments by saying, “We have a mandate. We pursue price stability. And we don’t target exchange rates. Period.” Draghi will soon retire, to be replaced by outgoing IMF Managing Director Christine Lagarde. It is widely expected that Lagarde will retain the same approach to policy as Draghi.
Despite slowing economic growth and relatively high unemployment, wages in the 19 member eurozone have been accelerating considerably.29 In the second quarter of 2019, hourly wages in the eurozone were up 2.7 percent from a year earlier, the fastest rate of increase since 2009. Given that inflation is in the neighborhood of 1.0 percent, this means that workers are seeing a significant real increase in their purchasing power. In the larger 28-member European Union (EU), wages were up 3.1 percent from a year earlier. According to the European Union, the biggest wage gains in Europe in the second quarter took place in Eastern Europe. Specifically, wages were up 12.4 percent in Romania, 11.0 percent in Bulgaria, 10.6 percent in Slovakia, and 10.1 percent in Hungary. Wages were up the least in Portugal (up 0.9 percent) and Italy (up 1.1 percent). As for the largest economies in Europe, wages were up 3.2 percent in Germany, 1.7 percent in France, 1.1 percent in Italy, 2.8 percent in Spain, and 3.7 percent in the United Kingdom. Accelerating wages ought to cause an acceleration in inflation unless the wage gains are offset by productivity gains. Productivity growth has risen somewhat, but hardly explains the lack of inflation. More likely, the continued high unemployment in key countries such as France and Italy, which both had modest wage gains, helps to explain low inflation. In any event, ECB’s decision last week to ease monetary policy indicates that the central bank is not concerned about inflation, especially as it envisions slow economic growth.
Eurozone industrial production continued to decline in July.30 It was down 0.4 percent from the previous month and down 2.0 percent from a year earlier. This was the ninth consecutive month in which industrial production declined from a year earlier. That has not happened since 2013. Compared to a year earlier, production of capital goods was down 3.4 percent, boding poorly for business investment. In addition, production of intermediate goods was down 3.0 percent. Meanwhile, production of consumers goods was up. From a year earlier, industrial production was down 5.3 percent in Germany, 0.3 percent in France, 0.7 percent in Italy, and up 0.3 percent in Spain. Clearly, Germany is the problem. It has been hurt by weak external demand, trade tensions with the United States, uncertainty about Brexit, and disruption of its automotive sector due to changing regulations.
In a world awash in negative interest rates, the president of the United States has now endorsed negative rates for the United States. In a tweet, Trump said that “the Federal Reserve should get our interest rates down to ZERO, or less, and we should then start to refinance our debt. INTEREST COST COULD BE BROUGHT WAY DOWN, while at the same time substantially lengthening the term.”31 He evidently sees zero or negative rates as a way to reduce government debt service costs. In addition, he said that the “USA should always be paying the lowest interest rate” and that it’s “only the naïveté of Jay Powell and the Federal Reserve that doesn’t allow us to do what other countries are already doing.” He has previously cited the negative rates in Germany and France as contributing to the low value of the euro, thus improving the competitiveness of European exports.
It is not clear how far the Federal Reserve is likely to cut the benchmark interest rate. It has already reduced the rate by 25 basis points this past July and is widely expected to cut the rate again this month. However, there is uncertainty, and debate within the Fed, as to how much further the Fed will go. It will likely depend on data concerning inflation and employment, as well as the nature of the ongoing trade war. The United States has low inflation, but a very tight job market. It is possible that one reason the US administration wants the Fed to ease policy is to offset the negative impact of the trade war. Meanwhile, bond yields, having fallen in the past year as a consequence of investor pessimism about growth and inflation, have recently rebounded somewhat. In my view, the only scenario in which US bond yields would fall close to or below zero is if there is a significant recession. American banks have not been happy about low rates, and especially about the inverted yield curve. Still, they are taking note of the risk. One bank CEO said that his bank is preparing for a world of negative rates.
In the midst of debate about the optimal monetary policy for the Federal Reserve, there is the question on the efficacy of monetary policy. Would much lower short-term rates make much of a difference given that they are already historically low? Lower rates are meant to stimulate credit market activity and to ease the debt service burden for those businesses that are heavily leveraged. Yet at a time of uncertainty about trade policy and its impact, it is not clear that lower borrowing costs would generate more capital spending. In addition, lower rates often cause the currency to depreciate, thus improving export competitiveness. Yet a trade war involving restrictions on imports tends to boost the value of the currency which, in the case of the United States, has already happened. Thus it appears that the existence of the trade war could be an impediment to the ability of monetary policy to be impactful. Fed Chairman Powell hinted at this problem in recent testimony and speeches.32
When Japan’s national sales tax was last increased in 2014, from 5.0 percent to 8.0 percent, households went on a spending binge in anticipation of the tax increase. The result was that, once the tax increase went into effect, household spending collapsed, contributing to a temporary recession.33 Now, Japan’s government is planning to increase the tax once again in October, boosting it from 8.0 percent to 10.0 percent. It had been widely expected that households would spend with abandon before the tax increase. Yet this has not happened.34 This fact has led to a combination of optimism and pessimism. On the one hand, the fact that household spending has not surged means that, after the tax goes up in October, there is not likely to be a collapse in spending. This bodes well for avoiding a recession. On the other hand, some observers worry that households are not especially keen on spending at all. This is problematic given that the government is hoping that household spending will help to offset the weakness of investment and exports. Actually, there are some good reasons why household spending will not be as volatile this time around. First, fresh food is exempt from the increase. Second, the government has created incentives for spending on durable goods that are meant to offset the impact of the tax increase. Third, the government is instituting incentives for consumers to engage in cashless payments. These incentives could fully offset the tax increase. Thus it could be the case that households, aware of these various incentives, are not especially concerned about the impending tax increase. Still, the incentives will be only temporary and, eventually, households will feel the full effect of the tax increase. The government has been keen to implement this tax increase for some time. The purpose is to improve the long-term viability of Japan’s obligations to its elderly citizens. With an aging population and, consequently, rising pension and health care costs, the government was worried that, absent a tax increase, the already large budget deficit would balloon.
One of the arguments made by US President Trump is that the Chinese government is eager to strike a deal because the trade war has led thousands of companies to leave China, thus leading to the loss of millions of jobs. Trump recently said that “the United States tariffs are having a major effect on companies wanting to leave China for nontariffed countries. Thousands of companies are leaving. This is why China wants to make a deal with the US.”35 Separately he claimed that this movement has caused the loss of three million jobs. However, a new study by the Peterson Institute finds that, since the trade war began, the pace of foreign direct investment (FDI) into China has not changed and that thousands of foreign companies continue to pump money into China.36 Specifically, the study noted that FDI is running at about US$140 billion annually and that it has grown about 3.0 percent per year, both before and after the trade war began. The study acknowledged that a relative handful of companies have left China, but that this pales in comparison to the roughly 500,000 foreign firms still operating in China. It is likely that many companies are considering shifting some or all of their operations out of China. However, they are likely awaiting greater certainty about what the trading environment will be in the near future. In any event, the fact that there has not been a mass exodus of companies from China could mean that the Chinese government is not necessarily overly anxious about completing a trade agreement with the United States.
There are two significant reasons why companies are likely reluctant to depart. First, many foreign companies are in China in order to serve the local market. US import tariffs are not likely to influence them. In addition, many foreign companies produce in China for export to countries other than the United States. Again, US tariffs will not likely be a factor for them. Second, it can be hugely expensive and highly disruptive to shift production out of China, especially if there is uncertainty about whether other countries will provide the quality and efficiency for which China is known. There are anecdotal reports that some companies, having shifted production from China to Vietnam, are not happy with their decision, with some even returning to China. Plus, there is likely concern that the United States could impose tariffs on other countries. Indeed the United States has threatened tariffs on Mexico and discussed possible action against Vietnam—both countries that have been seen as potential sites to which facilities can be shifted.
Meanwhile, Chinese outbound FDI to the United States has nearly collapsed, dropping from US$46 billion in 2016 to only US$5 billion in 2018.37 Outbound investment to Europe has fallen as well, but not by as much. The drop in outbound investment has many explanations. These include Chinese government efforts to curtail capital outflows in order to stabilize the currency, US government restrictions on inbound investment in technology companies, and uncertainty about trade and other aspects of the US-China relationship.
There are currently US$17 trillion worth of bonds in the world that are trading with a negative yield.38 This includes US$16 trillion in government bonds as well as roughly US$1 trillion in corporate bonds. The majority of the negative yielding debt was issued by three countries: Germany, France, and Japan. This unprecedented situation raises a number of questions.
One of them I often hear is this: How is it possible for negative yields to exist? Why would any investor purchase a bond that offers a negative yield? The answer is that many large institutions need to keep some part of their portfolios in safe assets where there is no risk of capital loss. Given that they cannot simply stuff cash in a mattress, they are willing to accept a negative yield on bonds for which there is no risk of capital loss or default.
Yields on bonds are negative for several reasons. These include low and declining expectations of inflation, low expectations of economic growth, strong demand for safe assets at a time when business investment is weak, and expectations that the European Central Bank (ECB) will resume purchases of government bonds. Some observers see the negative yields as evidence of a bubble in the bond market. Others, however, believe that stark demographics have contributed to a long-term trend of very low inflation, thus ensuring that bond yields will remain low or negative for some time to come.
Yields on US government bonds remain positive, in part a reflection of faster economic growth and higher inflation than in Europe and Japan. The reality, however, is that although US yields are positive, they are actually negative when adjusted for inflation. The yield on the 10-year bond is currently 1.44 percent while the so-called breakeven rate is 1.55 percent.39 The breakeven rate is what investors expect of annual inflation over the next 10 years. Thus the real yield on the bond is roughly -0.1 percent. In other words, investors expect that, after inflation, they will lose some of their capital when purchasing US government bonds. It is not the first time this has happened. A long-term bond yield is, theoretically, a prediction about the future of short-term rates. Thus a negative real yield means that investors expect future short-term rates to be lower than the rate of inflation. This implies that they expect the Federal Reserve to cut rates in the future in order to offset weak or negative economic growth.
Is it possible that nominal US yields will fall into negative territory? Yes. If investors were to become more pessimistic about US growth and inflation, and if the Federal Reserve reverts to asset purchases as part of an effort to ease monetary policy during a future recession, then yields could fall quite quickly. Moreover, trade uncertainty has boosted the attractiveness of safe assets. US Treasuries are seen as especially safe (along with German and Japanese government bonds). If the trade war worsens, one can imagine a scenario in which money flows more rapidly into US Treasuries, suppressing yields and boosting the value of the US dollar. Actually, this is already happening with US bond yields falling and the US dollar rising.
Until about 30 years ago, most recessions in industrial countries came about due to economic overheating and the commensurate tightening of monetary policy. A decline in demand led to a surge in inventories and the need to cut back production, contributing to a recession. In recent decades, however, this has not been the case. Rather, recessions have mostly come about due to financial imbalances. Plus, they’ve come about less frequently than in the past. This reflects the shift away from a goods-based economy toward a less volatile services-based economy, implementation of information technology thereby enabling better inventory management, and better central bank management of inflation expectations. What will cause the next recession? Financial imbalances remain a possibility, especially as the world has loaded up on corporate debt. But the next recession might come about due to a collapse of investment in light of trade wars and trade uncertainty.
It is worthwhile to recall the Smoot–Hawley tariff in the midst of the Great Depression. While economists mostly agree that the Smoot–Hawley tariff did not cause the Depression, they also agree that it exacerbated the downturn significantly. The tariff, which was legislated by the US Congress in 1930, caused import prices to rise by more than 40 percent. It was followed by retaliatory action by other countries. It led to a 66 percent decline in global trade.40 It reduced real consumer purchasing power, stifled business investment, and contributed to a very sharp decline in asset prices. While the tariff actions recently taken by the United States and China are not as dramatic, they are the most significant protectionist actions since the Great Depression and are already having a negative impact on global economic activity.
When the next recession comes, will central banks be able to act? Yes, but with interest rates already low, central banks are constrained to a degree never before seen. Would lower interest rates do anything when they are already historically low or negative? Possibly not, especially in countries where rates are close to or below zero. And would quantitative easing (asset purchases) make any difference if business investment is held back by trade uncertainty? We don’t know. However, it is likely that quantitative easing would not be as impactful as in the last recession, especially given that financial market stress is not likely to play as large a role in the next recession as it did in the last one. Finally, would governments engage in fiscal stimulus? That is a political question and is already a source of debate in Germany. Still, in an environment of historically low interest rates and stifled business investment, fiscal policy could be the best solution to a downturn absent a reversal of the trade war. Notably, fiscal stimulus in China is already having some positive impact there.41
The US government released its latest employment reports last week. There are two reports: one based on a survey of establishments and the other based on a survey of households. The establishment survey findings42 revealed that 130,000 new jobs were created in August, the lowest in three months and relatively low compared to growth over the past year. Monthly job growth has averaged 158,000 in 2019, down from 223,000 in 2018. Thus it appears that the job market is decelerating. That said, it should be noted that job growth continues to exceed the level needed to absorb new entrants into the labor market. Thus it remains a healthy and very tight job market. Employment in the mining industry, which includes oil and gas production, fell for the third consecutive month as relatively low energy prices took a toll on employment in the industry. The manufacturing sector produced only 3,000 new jobs after producing only 4,000 in the previous month. We already know that manufacturing output is declining, so the weakness in employment is no surprise. There were only three industry categories that saw strong job growth. These were professional and business services (such as Deloitte), which was up 37,000; health care, which was up 36,800; and government, which was up 34,000. The third category was boosted by temporary hiring in anticipation of conducting the decennial 2020 census. Excluding the surge in government employment, job growth was fairly modest.
In addition, survey results reveal that average hourly earnings were up 3.2 percent from a year earlier, lower than the growth rate seen earlier in the year. Thus despite the tightness in the job market, we are not seeing an acceleration in wages. This is a surprise and a puzzle for economists. It demonstrates that, contrary to past experience, the tightness in the job market is not creating inflationary pressures. There is a debate among Federal Reserve leaders as to whether the weakness in wages will be sustained or is only a temporary phenomenon. If temporary, then higher inflation remains a risk and the Fed should be cautious about easing monetary policy. If, however, the weakness of wages is here to stay, then the Fed can more confidently ease monetary policy.
The findings of a separate survey of households43 indicate that the unemployment rate remained steady at 3.7 percent in August. The number of people participating in the labor force grew much faster than the growth of the working age population. The result was that the participation rate increased to match a level last seen in February and the second-highest level since 2013. The participation rate had steadily fallen since the start of this century but stabilized around 2014.
Last week, the United States imposed a 15 percent tariff on US$112 billion in imports from China.44 Some more tariffs are set for October and December. The tariffs imposed last week target apparel and other consumer goods, auguring an increase in consumer prices in the months ahead. Chinese retaliatory tariffs also went into effect, specifically targeting soybeans and other farm products. In addition, China submitted a complaint to the World Trade Organization (WTO),45 saying that “the tariffs imposed by the United States severely violated the consensus reached by the two heads of state in Osaka.” This was in reference to the agreement between Presidents Trump and Xi to postpone further tariff action while negotiations take place. China’s Commerce Ministry added that “China will firmly safeguard its own legitimate rights and interests and resolutely uphold the multilateral trading system as well as the international trade order.” The WTO action means that China intends to adjudicate the dispute, thereby reducing the likelihood that an agreement will be reached through bilateral negotiations.
The two sides were set to hold high-level meetings this month. However, China has indicated that the United States must halt new tariffs in order for talks to proceed. In response to the WTO action, equity prices and bond yields fell as investors became more pessimistic about a resolution of the trade dispute. The yield on the US government’s 10-year bond fell to 1.44 percent, the lowest level since July 2016.46 This meant that the inversion of the US yield curve became more intense. The value of the Chinese renminbi fell to the lowest level in more than 10 years, approaching 7.2 renminbi to the dollar. Interestingly, there is evidence that the Chinese economy, having been buffeted by the trade dispute, is rebounding modestly, with manufacturing activity increasing in August according to the latest purchasing manager’s index.47 This is likely the result of government stimulus. It could mean that China’s government feels sufficiently confident about growth, and pessimistic about the prospect for an agreement with the United States, that it will not make any further concessions on trade.
In the midst of relatively slow growth and the threat of further troubles from the trade war with the United States, China’s policymakers last week took further steps aimed at stimulating domestic demand. Specifically, the central bank cut the required reserve ratio (RRR) for banks,48 thus enabling them to boost the volume of lending. This was the third time this year that the RRR has been cut. The latest cut will enable banks to boost lending by about US$126 billion. In doing this, China’s central bank is acting consistently with many other central banks around the world that have been easing monetary policy. It is now widely expected that China’s central bank will also cut interest rates.49 One potential impact will be to stimulate further depreciation of the Chinese renminbi. Lately, the central bank has allowed the renminbi to decline in value. This helps to offset the impact of US tariffs on Chinese exports to the United States. It also boosts the competitiveness of Chinese exports to other countries. And, it irritates the United States, which recently labeled China a currency manipulator. Still, China’s leaders appear unfazed by US concerns.
It seems likely that policymakers will continue to ease monetary policy in order to boost domestic demand at a time of stress on China’s export sector. This is especially true in light of reports that a trade deal is highly unlikely any time soon. However, it should be noted that monetary policy tends to act with a lag. Therefore, it may take some time before results are seen. Meanwhile, China’s economy could decelerate further as the impact of new tariffs kicks in.
When I was in graduate school more than 30 years ago, there was a class offered entitled “The economics of uncertainty.” It examined the economic impact when participants in the economy lack all the information needed to make decisions. It mostly focused on microeconomics, analyzing how buyers and sellers in a given market act when there is a paucity of information. It examined the impact on output, demand, pricing, and investment. As a student focused on macroeconomics, I found the class to be interesting but not especially relevant to the topics that interested me. Boy was I wrong!
Today, uncertainty is arguably the dominant factor driving the global economy and the principal factor creating the risk of recession. Imagine you are a US-based technology company that produces goods in China. If you know with metaphysical certainty that the United States will impose a 25 percent tariff on all Chinese imports next week, that those tariffs will remain in place for a decade, and that the United States will not impose similar tariffs on other countries, you might not be happy, but you can make an informed decision. You might decide to invest heavily in shifting production from China to Vietnam or you might invest heavily in technologies meant to reduce your costs. You could even decide to do nothing, hoping that US consumers will not be especially price sensitive. The point is that with a degree of certainty, you can decide on an action.
However, if you don’t know if tariffs will go up or down, if you don’t know whether other countries will be targeted, and if you don’t know what other changes in trading rules might be implemented, then it is difficult to decide what to do. This, by the way, describes the current environment, and it that has already caused countless companies to put major investments on hold.50 That, in turn, has meant a slowdown in overall business investment in the United States, Europe, and China, and disrupted supply chains that were designed to take advantage of a world of liberal trade. And, finally, this uncertainty has contributed to the slowdown in economic growth around the world. It can be argued that the uncertainty about tariffs has done more damage than the tariffs themselves. However, the tariffs have only recently risen to a level that will be onerous to consumers and businesses. Thus, the direct impact of tariffs is likely to be much greater in the months ahead than was true in the past year.
Lately, uncertainty has become greater. In a recent week, China boosted tariffs on the United States, the United States responded by threatening to boost tariffs on China, the US president “ordered” US companies to get out of China, the US president said he had second thoughts, his advisors said he didn’t, and then the president said that China was coming back to the table and a deal might be in the works.51 All of this happened in a matter of days! Amid this, investor sentiment has gone back and forth, with asset price volatility being relatively high.
Many business leaders have started to express frustration. They are extremely averse to uncertainty and would most likely prefer the certainty of onerous tariffs to uncertainty about everything. Josh Bolten, who leads the Business Roundtable and was Chief of Staff to President Bush, said, “The risk is that everybody’s going to slam on the brake, and that would be a disaster.”52 He said that the latest mix of policies could “disrupt trade and commerce in a way that would cause huge damage—not just to the Chinese economy, but to the global economy and the US economy.” Jay Timmons, who leads the National Association of Manufacturers in the US, said, “America’s manufacturing workers will bear the brunt of these retaliatory tariffs, which will make it even harder to sell the products they make to customers in China.” And David French of the National Retail Federation noted, “It’s impossible for businesses to plan for the future in this type of environment. The administration’s approach clearly isn’t working, and the answer isn’t more taxes on American businesses and consumers. Where does this end?”
Finally, uncertainty extends beyond the realm of trade. The uncertainty about how trading relations will evolve has created uncertainty about how central banks will react. Recently, Federal Reserve Chairman Jay Powell expressed concern about this issue. He said that the Fed must “focus on things that seem likely to affect the outlook over time or that pose a material risk of doing so. But fitting trade policy uncertainty into this framework is a new challenge.”53 In other words, setting monetary policy in the midst of trade uncertainty represents new territory for the Fed and, consequently, means uncertainty for investors who follow the Fed’s actions. Powell added, “Trade policy uncertainty seems to be playing a role in the global slowdown and in weak manufacturing and capital spending in the United States.” Finally, Powell offered thoughts about how the trade situation is likely to influence policy decisions, saying, “While monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade. We can, however, try to look through what may be passing events, focus on how trade developments are affecting the outlook, and adjust policy to promote our objectives.”
When the United States announced it would impose new tariffs on China, the Chinese central bank allowed the renminbi to depreciate. It did this by not intervening in currency markets in order to prop up the value of the renminbi. The United States responded by labelling China a “currency manipulator.” This term is meant to describe a situation in which a country has intervened in the currency market in order to artificially reduce the value of its currency. However, in China’s case, the opposite had happened. The central bank simply stopped intervening in the market, allowing market forces to determine the value of the currency. In fact, the IMF now agrees with this assessment. When the United States said that China is a currency manipulator, it asked the IMF to concur. The IMF has not. Rather, the IMF has issued a report saying that China ought to allow the value of its currency to decline in the face of increased trade restrictions.59 Specifically, an IMF official said that China’s currency is “assessed to be in line with fundamentals.” Another IMF official noted, “If there is a shock, the exchange rate ought to be part of the adjustment and should be allowed to depreciate. That is what exchange rates are for. In principle let the market decide.” The US label is more symbolic than anything else. It sets the stage for the United States to impose sanctions. Yet the tariffs already implemented are far more onerous than any sanctions that could be introduced. Still, the label shook Chinese officials, leading to a quick stabilization in the value of the currency. Now, with the IMF backing up China, it becomes more likely that China will feel it can let the currency fall further with impunity.
It now appears that China’s principal response to the US imposition of higher tariffs is to let its currency fall. In August, the renminbi fell 3.8 percent against the US dollar, the largest single-month decline since 1994.60 The renminbi is in the midst of a natural depreciation. The only thing that has changed is that the central bank has not intervened to prop up its value. A further decline in the value of the renminbi is expected to partly offset the impact of rising tariffs and help to improve the competitiveness of Chinese exports. Currently, US tariffs on Chinese imports are scheduled to rise in September, October, and December. China has responded by imposing new tariffs on imports from the United States. The Chinese tariffs, combined with a rising value of the US dollar, will significantly hurt US export competitiveness. Given the negative consequences for the United States of a decline in China’s currency, there has lately been talk about the possibility that the US Treasury will intervene in currency markets to cause a depreciation of the dollar against the renminbi or against a broad basket of currencies.61 Doing so would be unprecedented in modern times and would likely spark a political conflict between the two countries. The dollar has lately been strong despite an easing of monetary policy by the Federal Reserve.
In Argentina, a crisis is brewing largely because of the results of the recent primary election—incumbent President Mauricio Macri, who is held in esteem by the investment community, was defeated by the Peronist candidate, Alberto Fernandez. Fernandez is expected to return Argentina to populist policies if he wins the general election later this year. The election result led to a very sharp drop in the value of the peso as investors sought to take money out of the country. Last week, Macri announced that although the government is not illiquid, he will delay payment on Argentina’s US$101 billion debt. Specifically, he would postpone the US$7 billion payment toward short-term debts. In addition, he would delay repayment on US$44 billion in loans from the IMF.62 The peso and bond values fell sharply on this news. While investors were not pleased, many indicated that this helps to reduce default risk and buys the government time. It also alleviates stress in anticipation of the election. Still, some investors worry that they are being asked to help a president who will likely lose and who will be succeeded by someone that will be less likely to service the country’s debts. Fernandez has criticized the austerity plans of Macri but has not offered an alternative. Argentina’s economy is set to do poorly in the coming year.
Meanwhile, Standard & Poor’s said that Argentina’s decision constitutes a default.63 In the post-war era, Argentina has defaulted on its debts on eight different occasions, including two in this century. That is why investors tend to be wary of Argentine debt, pricing it accordingly. The current default came about because Argentina was not able to sell a sufficient volume of short-term paper to fund repayment on maturing debt. Argentina subsequently chose to postpone repayment. S&P noted, “Following the continued inability to place short-term paper with private-sector market participants, the Argentine government unilaterally extended the maturity of all short-term paper on August 28. This constitutes default under our criteria.” Given that Argentine bonds are priced very cheaply, it appears that investors were already expecting default or something similar. If investors expected the economy to grow at a reasonable pace, then there would be greater optimism about the ability to service debts. It is the lack of growth, driven in part by a lack of investment, that continues to spook investors.