Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Puerto Rico’s Coming Fiscal Adjustment (Still Too Big)

by Brad Setser Thursday, March 30, 2017

About two weeks ago, Puerto Rico’s oversight board approved Puerto Rico’s revised fiscal plan. The fiscal plan is roughly the equivalent in Puerto Rico’s case of an IMF program—it sets out Puerto Rico’s plan for fiscal adjustment. Hopefully it will make Puerto Rico’s finances a bit easier to understand.*

I have been a bit slow to comment on the updated fiscal plan, but wanted to offer my own take:

1) Best I can tell, the new plan has roughly 2 percentage points of GNP in fiscal adjustment in 2018 and 2019, and then a percentage point a year in 2020 and 2021. The total consolidation is close to 6 percent of GNP (using a GNP of around $65 billion, and netting out the impact of replacing Act 154 revenues with new tax)—see page p.10 of the revised plan, and my past posts on Puerto Rico’s fiscal math.**

2) The board adopted a more conservative baseline. Puerto Rico’s real economy is projected to contract by between 3 and 4 percent in 2018 and 2019 and by 1 to 2 percent in 2020 and 2021. I applaud the board for recognizing that the large fiscal consolidation required in 2018 and 2019 will be painful. The risks to the growth baseline—and thus to future tax revenues—should be balanced. There though is a risk that the board may still be understating the drag from consolidation. If Puerto Rico is currently shrinking by 1.5 percent a year without any fiscal drag, and if the multiplier is 1.5, then growth might contract by 2 to 3 percent in 2020 or 2021.

3) While creditors have complained that Puerto Rico isn’t doing enough, I worry that there is still too much consolidation too fast: Puerto Rico’s output is projected to fall by another 10 percentage points over the next five years, which would make Puerto Rico’s ten year economic contraction as deep as that experienced by Greece.

Sadly, this is a realistic outcome if you combine five to six percentage points of consolidation, a multiplier of 1.5 (especially as much of the consolidation is offsetting a fall in federal funding) and negative trend growth. There is a real risk that the coming contraction generates further outmigration, undermining the basis for any eventual recovery. Puerto Ricans are not required to stay on on-island. A shrinking population ultimately means a shrinking tax base.

4) The overwhelming majority of the adjustment is the result of the need to offset the exhaustion of pension assets and the loss of federal health care funds, not the result of projected debt service (the primary surplus in the plan is between 1 and 1.5 percent of GNP). Basically, Puerto Rico tried to avoid a draconian consolidation after its 2007 slump through running down pension assets (and for a while running up debt) and by taking advantage of Obama era policy changes—but now has run out of rope.

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China’s Estimated Intervention in February

by Brad Setser Monday, March 27, 2017

The proxies for Chinese reserve sales show very modest sales in February. Foreign exchange settlement (which includes the state banks) shows $10 billion in sales, and only $2 billion counting forwards. The PBOC’s balance sheet shows similar changes—foreign reserves fell by $8.5 billion and foreign assets fell by $10.6 billion. No wonder the (fx) market is no longer focused on China.

The fall off in foreign exchange sales is particularly impressive given that China didn’t have its usual trade surplus in February, for seasonal reasons (China’s trade often swings into deficit during the lunar new year). Modest reserve sales alongside a monthly trade deficit imply that the pace of capital outflows fell.

The only analytical problem is that the fall in pressure on the renminbi is a bit over-determined.

Controls on outflows were tightened. For real, it seems. That likely helped.

And the yuan was stable against the dollar, broadly speaking. There continues to be a correlation between movements in the yuan and the pace of outflows.

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Just How Much Money Should the Border-Adjusted Tax Raise Be Expected To Raise?

by Brad Setser Friday, March 17, 2017

I have a new paper out with David Kamin of New York University Law School—it will be formally out in Tax Notes in a couple of weeks, but given that there is a live debate on the topic, we are posting it in draft form now—and the New York Times had a related editorial linking to it earlier this week.

So this is a joint post with David Kamin.

Our paper makes two arguments.

1) Even with fairly optimistic assumptions about long-term growth and long-term interest rates and the persistence of “excess returns” from U.S. direct investment abroad, the U.S. cannot sustain trade deficits of approaching 3 percent of GDP over the long-run. The CBO’s estimates for long-run growth and the long-run nominal interest rate on the U.S. debt stock imply a sustainable long-run trade deficit of about 1 percent of GDP. That would generate maybe 20 basis points of GDP in permanent revenue. If the excess returns (“dark matter”) on U.S. foreign direct investment go away, the U.S. would need to run a small trade surplus—and the border adjustment would lose revenue over the long-term.

As a result, realistic projections of revenue from a border adjustment should show that revenue falling considerably and, possibly, entirely disappearing over the long-term.

Remember the border adjustment acts as a tax on imports (imports are not deductible as a cost) and a subsidy for exports (a portion domestic wage and other content of exports is effectively rebated, as exports are not considered revenues while domestic wages are considered expenses, creating a tax loss). So it only generates revenue in net if the revenue collected on the border adjustment on imports exceeds the revenue lost on the export rebate.

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Capital Is No Longer Flowing Uphill

by Brad Setser Wednesday, March 15, 2017

So report Emine Boz, Luis Cubeddu, and Maurice Obstfeld of the IMF —the net financial outflow from emerging markets that characterized the pre-crisis global economy is no more. Capital isn’t exactly flowing downhill, e.g. from rich, advanced economies to poorer emerging economies. The aggregate current account of the emerging world is close to balance.

But the basic flow of funds is not from one set of advanced economies (Europe, Japan, the Asian NIEs) to another set of advanced economies (U.S., UK, Canada, Australia). It is no longer uphill.

In my view, there is both more and less than meets the eye here.

Less, because Asia’s surplus hasn’t actually changed much from the pre-crisis period. China’s surplus is a bit smaller after its 2016 stimulus. But the surplus of the NIEs is bigger than it was before the crisis (I do not quite understand how the NIEs can be considered advanced economies for discussions of the global flow of funds but be judged against the reserve adequacy standards for emerging economies—but that is a topic for another time). Japan’s surplus is back to roughly it pre-crisis level — and the rise in Japan’s surplus in 2016 has partially offset the fall in China’s surplus. The split within East Asia between “emerging” and “advanced” is a bit arbitrary. All the major east Asian economies are importers of resources and exporters of manufactures.

Emerging Asia is still in aggregate an exporter of savings to the world. Especially if India and others in South Asia are excluded, or if the NIEs are included.

More, because the relatively constant surplus in emerging Asia means there has been a giant swing in the aggregate current account balance of the commodity exporters. One proxy is the aggregate current account balance of the former Soviet Union, Latin America, the Middle East, and Africa. These regions of the world ran a surplus of $300-400 billion before the global crisis and a similar surplus in 2011 and 2012. They now run a deficit of similar size.

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On the Cost of Holding Reserves. Sometimes It Is Not That High

by Brad Setser Monday, March 13, 2017

A few quick reactions to Tony Fratto’s argument that the cost of holding foreign exchange reserves acts as a natural limit on exchange rate manipulation. The cost of holding reserves is the cost of so-called sterilization—issuing short-term domestic currency debt to offset (in technical monetary policy sense) or to fund (in a financial sense) the purchase of a typical reserve portfolio of say 3 to 5 year Treasuries and similar euro-denominated assets.

1) The cost of holding reserves is often the highest in the countries that need reserves the most. They tend to have high domestic interest rates, so the “negative carry” on reserves is significant. Turkey for example. Or Brazil (though Brazil’s central bank has made money on the appreciation of the dollar against the real from 2014 on, with the capital gain on its dollar reserves offsetting some of the negative carry). The high apparent cost of reserves in countries with high nominal rates is one reason some countries—like Turkey—have found creative ways to limit the fiscal cost of reserves. Turkey allows its banks to borrow from abroad and place the borrowed foreign currency on deposit at the central to meet the banks domestic reserve requirement (the Reserve Option Mechanism).

2) The cost of holding reserves conversely isn’t much of a constraint in “savings glut” countries with low domestic interest rates. Taiwan for example. That is one reason why reserves are a ridiculously high level relative to GDP (about 80 percent of GDP). Or Switzerland. The Swiss National Bank is taking tremendous amounts of foreign exchange risk (so there would be large capital gains or losses from moves in the franc-euro exchange rate, or given the composition of its reserves, in the dollar-euro exchange rate), but its actual interest bill isn’t a constraint. Negative rates on sterilization instruments and positive rates on Treasuries should result in positive carry. The fiscal cost of holding reserves also isn’t a constraint in Japan, though Japan hasn’t been intervening recently. The Ministry of Finance funds its reserves with essentially zero rate notes. The “carry” on reserves is one reason why Japan’s government is actually, according to the IMF, receiving more in interest income than it pays out of interest on its debt.*

3) The cost of holdings reserves did not prove to be a constraint on China either, back in the pre-global crisis days when China really was intervening at a rapid clip to block appreciation of the yuan. China’s reserve to GDP ratio rose from around 15 percent of GDP (2000) to around 50 percent of GDP in 2007 (if you counted all of China’s shadow reserves in 2007 and 2008).

China’s fiscal cost though was limited by China’s relatively large stock of base money. Base money is a zero interest rate loan to the central bank, it is very cheap funding. And it was further limited by China’s ability to shift the costs onto the backing system: China stopped selling expensive sterilization bills, and instead sterilized by raising the required reserve ratio in the banks. And the rate of remuneration on the reserves was kept low. Other countries no doubt have used the same trick.

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Getting Puerto Rico’s Fiscal Baseline Right

by Brad Setser Friday, March 10, 2017

Developments in Puerto Rico are accelerating. The long-run fiscal plan is really a critical component of PROMESA—as it is intended to be a guide both for Puerto Rico’s annual budget and for any debt restructuring. I want to offer a few quick comments on the Ernst & Young report, and the most recent letter Puerto Rico’s oversight board sent the governor:

1) Puerto Rico probably isn’t going into (over?) its pension cliff and the health care cliff with a $1 billion primary fiscal surplus (the primary fiscal balance is the revenues minus non-debt expenditures). The Ernst and Young report suggests that spending is likely understated (unlike in past years, when the standard problem was that tax revenues were typically overstated). The oversight board seems to agree: “the Board has concluded that the Government’s FY17 expenditures could be understated by an amount ranging from $60 to $510 million, with a cumulative impact much greater over the next ten years. The Government’s liquidity projection is further understated by $300 million in FY17.” The implication alas, is that when Puerto Rico loses $1 billion in pension financing (as its pension assets will soon be depleted) and $1.5 billion in health care financing (as the Affordable Care Act grant will soon run out), it will face substantial fiscal deficits even in the absence of any debt service. The fiscal math I walked through on Monday still I hope works, but the likely starting point is worse.*

2) The oversight board recommends lowering the nominal growth forecast for the next few years, and being more cautious in the medium-term. The implied real economic contraction is now over 3 percent in both 2018 and 2019. That I fear is the unfortunate reality: one clear lesson from Greece is not to imagine away near-term pain. I would though be interested in seeing more explicit treatment of how the magnitude of the proposed near-term fiscal adjustment is contributing to the fall in growth.

3) In standard macroeconomics, a fiscal consolidation only depresses short-term growth. The economy eventually bounces back to potential. I worry though that in Puerto Rico near-term consolidation will reduce long-run potential (hysteresis) for one simple reason: lots of Puerto Ricans will respond to the ongoing contraction by migrating off-island, permanently weakening Puerto Rico’s economy.

4) The enormous uncertainty around Puerto Rico’s future fiscal bargain with the federal government (Medical funding is the most significant aspect of this, but in my view the interaction between Puerto Rico’s system of tax and the federal corporate income tax is also part of the bargain) impedes any quick restructuring agreement. Any deal that Puerto Rico strikes with its creditors before its future Medicaid funding and corporate income tax treatment is settled leaves the downside risk with the residents of Puerto Rico.

One last point: The oversight board’s web site has become an essential source of information on Puerto Rico remarkably fast.

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The January U.S. Trade Data

by Brad Setser Wednesday, March 8, 2017

Over the last year, U.S. import growth stalled. Capital goods imports did nothing—in part because of weakness in non-residential investment. And consumer goods imports were flat.

That appears to have changed. Real consumer goods imports were up 9 percent year over year in January. Real capital goods imports were up 7 percent (table 10 in the trade data release).

To be sure, the January trade data can be a bit funky. As Bill McBride of Calculated Risk notes, the timing of China’s lunar new year plays havoc on the United States’ own seasonal adjustment. But the ISM import index suggests February won’t be much different.

Of course, there are different ways to interpret the recent strength in imports.

Import growth can reflect an acceleration in demand growth that is also supporting strong growth in domestic activity (China right now?).

Or it can mean that more of a given amount of demand growth is bleeding out to the benefit of the rest of the world, leaving the “home” economy short demand — slowing the economy (U.S. from 2001 to 2004?).

In practice it is often a bit of both. See Neil Irwin.

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Puerto Rico’s Daunting Fiscal Math (My View)

by Brad Setser Monday, March 6, 2017

An applied economics question:

A country with no independent monetary policy, undergoing a ten-year slump that has reduced its real GDP on average by over a percentage point a year, needs to do a fiscal consolidation of roughly 10 percentage points of its GDP. How much does output fall?

The example is not entirely hypothetical.

Puerto Rico isn’t a country, but rather a territory of the United States. It is a part of the U.S. monetary and currency union—though it isn’t completely a part of the U.S. fiscal union (Puerto Ricans—and firms based in Puerto Rico—generally do not pay federal income tax). Puerto Rico’s gross national product (GNP) is down more than 14 percent since 2006 (the last data point is 2015, and the Government Development Banks’s high frequency indicator shows a further decline in 2016). GNP is the relevant measure—GDP is clearly inflated by the tax games played by firms operating in Puerto Rico. And the oversight board has asked Puerto Rico to show the impact of closing a $7 billion (just over 10 percent of GNP) fiscal gap through austerity. More on that later.

The answer—fairly obviously, I think—depends on your view of the fiscal multiplier. The Fed is raising rates: directionally it will be hurting, not helping. There is no monetary offset. If you use a multiplier of around 1.5 (well justified on the basis of recent analysis*) GNP should fall by roughly 15 percent.

That is huge, and it seems unreasonably large. But it is a function of asking for an unreasonably large fiscal adjustment in an economy that lacks the capacity to offset fiscal consolidation through monetary easing. Greece’s experience though shows that a massive fiscal consolidation can produce a massive fall in output. There is plenty of empirical cause to worry.

The Fiscal Gap

So why is the financing gap—$7 billion on average over ten years—so big?

That to me is the interesting bit.

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