Statement at the Conclusion of the 2012 Article IV Consultation Mission to Saudi Arabia

Mr. Masood Ahmed, Director of the Middle East and Central Asia Department, made the following statement at the conclusion of the 2012 Article IV Consultation mission that visited Riyadh during May 14–26:¹

Economic performance has been exceptionally strong and the outlook remains buoyant. Oil production has been raised to ease pressures on global oil prices, and increased government spending coupled with accommodative monetary policy has supported continued acceleration in non-oil activity. Overall real GDP is estimated to have grown by 7.1 percent in 2011, with 8 percent growth recorded in the non-oil sector— the highest since 1981—and private sector growth at 8.5 percent. Saudi Arabia has provided important support to the global economy during a period of high global uncertainty, including through its actions in stabilizing the global oil market. Higher imports and increased workers’ remittances linked to the strong growth of the Saudi economy, together with expanded financial assistance have exerted a positive spillover and helped support other economies in the region and beyond.

Reflecting prudent economic management, the economy is likely to remain buoyant. On current trends, real GDP is projected to grow by 6 percent in 2012. The private sector is again expected to lead the way, reflecting the increased role of the private sector in the economy, a clear break from the past. Inflation is likely to remain modest at about 5 percent in 2012, but should be monitored carefully for signs that the economy is overheating. Fiscal and external surpluses are expected to remain very strong at almost 17 and 27 percent of GDP, respectively. However, given the current external environment and possible spillovers to global oil markets, the outlook is subject to some uncertainty.

Taking advantage of the strong state of the economy to advance the reform agenda and further strengthen institutions will help sustain growth in the years ahead. While there has been progress on diversification, the Saudi economy remains dependent on oil exports, and growth has been driven mainly by factor accumulation. Targeted government investment alongside product and labor market reforms can facilitate a more dynamic private sector and stimulate job creation for nationals. A strong and resilient financial sector also supports this process, with the 2011 Financial Sector Assessment Program (FSAP) Update providing a number of options that together with the ongoing implementation of Basel III will further strengthen risk management and promote capital market development.

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¹ In accordance with Article IV of its Articles of Agreement, the IMF holds bilateral consultations with its members, generally once a year. An IMF staff mission visits the country, gathers economic and financial data, and meets those responsible for the country's economic development and policies. Once they have returned to headquarters, the members of the mission draw up a report to be submitted to the Executive Board for review. Following this review, the Managing Director, as Chairman of the Executive Board summarizes the opinions of the Executive Directors, and this summary is forwarded to the country's authorities.

Source | International Monetary Fund - Blog NEWS | http://imf-news.blogspot.com/2012/06/statement-at-conclusion-of-2012-article.html

Slovak Republic—Concluding Statement for the 2012 Article IV Consultation Mission

Slovakia enjoyed one of the strongest recoveries in the region, reflecting its sound economic fundamentals and prudent policies. However, the economic outlook is clouded by spillovers from the euro area crisis. Policies should focus on mitigating risks and promoting growth. The government’s commitment to fiscal consolidation is welcome, but durable adjustment will require complementary reforms. Continued strong financial oversight is essential. Boosting employment is a top priority. The government’s economic program now being elaborated provides an opportunity to put in place the needed reforms to promote vibrant and inclusive growth.

1. The economy is expected to continue growing at a healthy pace. Buttressed by strong external demand, real GDP expanded by 3.3 percent in 2011—among the highest growth rates in the region—despite a sizable fiscal consolidation. Strong growth continued into the first quarter on the back of expanded auto production. Amid a worsened external environment, growth in 2012 is projected to slow to 2.6 percent. This relatively benign slowdown reflects strong trade linkages with Germany, continued external competitiveness, a still-moderate government debt ratio, and a sound banking system. Growth is projected to pick up to about 3½ percent over the medium term as the external environment strengthens and rising domestic demand closes the output gap.

2. However, risks to this outlook are mostly to the downside. Externally, an intensification of the euro area crisis would reduce demand for Slovak exports and increase bond spreads, reducing growth and weakening banks’ balance sheets. Working together with European partners in creating a more complete monetary union would help allay this risk. Domestically, a loss of market confidence in government’s commitment to fiscal consolidation would increase funding costs and result in tighter credit conditions. An early parliamentary approval of durable deficit reduction measures would reassure markets.

3. Policies should focus on mitigating risks and building a foundation for a strong and inclusive growth. Durable fiscal consolidation would put public finances on a sustainable footing. Continued strong oversight of the financial sector and close cross-border supervisory cooperation would maintain financial stability. Mutually reinforcing structural reforms to the labor market, education, and the business climate would boost employment and promote more inclusive growth.

Durable fiscal consolidation to promote sound public finances

4. The significant fiscal retrenchment in 2011 is welcome, but further adjustment will be needed to ensure debt sustainability. In 2012, adjustment stalled amid the election cycle and expenditure overruns, and the deficit is expected to remain broadly unchanged at 4¾ percent of GDP. In the absence of further fiscal consolidation, public debt ratio will remain on a rising trajectory and become increasingly vulnerable to shocks. Stabilizing the debt at 40 percent of GDP in the long run—a level that would leave room for the expected increase in ageing-related costs and other priority spending—would require a structural fiscal effort of about 2½ percent of GDP relative to 2011.

5. While the government’s deficit reduction plans are appropriate, policies should be prepared to let automatic stabilizers work fully. Though the details are still being worked out, it appears that the planned measures would be sufficient to lower the deficit to below 3 percent of GDP in 2013, while not unduly constraining growth. If growth turns out lower than expected, policies do not need to counterbalance the resulting revenue shortages, but should instead be allowed to operate automatically (for example, through higher unemployment compensation and social assistance), thereby limiting the effects on the economy. At the same time, if growth surprises on the upside, the higher revenue should be saved to facilitate the adjustment.

6. The focus of the planned adjustment mainly on boosting revenues is broadly appropriate. Following a sizable expenditure-based consolidation in 2011, the room for additional spending cuts without fundamental public sector reforms is limited, necessitating focus on revenue measures in the short run. These include shifting pension contributions from the second to the first pillar, introducing a progressive personal income tax, increasing the corporate income tax rate, extending the bank levy on corporate deposits to retail deposits, as well as broadening social insurance and income tax bases.

7. However, complementary reforms are essential to ensure a durable fiscal consolidation. The planned shift of pension contributions brings with it increased future government pension obligations. We therefore welcome the authorities’ plans to combine it with a parametric reform of the first pillar. The reform should be underpinned by an actuarial analysis to ensure the system’s financial solvency. The proposed increase in direct taxes may reduce incentives to invest, underscoring the need for a more welcoming investment climate. The envisaged numerous changes to the tax system could raise collection risks, while the bank levy could discourage financial intermediation.

8. In the medium term, considerable savings could be achieved by improving tax administration and expenditure efficiency. Removing nonstandard exemptions and strengthening VAT administration could generate some 1½ percent of GDP in additional revenue. The planned unification of revenue collections would aid in this regard. International comparisons suggest that increasing efficiency in health spending could generate some 1¾ percent of GDP in savings. The planned reform of public administration could result in additional efficiency gains. The generated savings could be used to further reduce debt, to improve the quality of public sector outcomes, and to finance improvements to public infrastructure in less developed regions of the country.

9. The recently adopted fiscal responsibility legislation (FRL) is welcome, but there is scope to further strengthen the fiscal framework. The Slovak FRL is broadly in line with best international practices: it enhances transparency and accountability, covers a broad definition of government, and includes appropriate enforcement mechanisms. However, making the FRL fully operational requires anchoring the budget in a sound medium-term fiscal framework. Moreover, collecting and publishing in the budget financial information of public entities, including hospitals, would improve the monitoring of fiscal risks.

Strong oversight and cross-border cooperation to maintain financial stability

10. Slovakia’s banking system is sound. Strong fundamentals and effective supervision have helped the sector weather the crisis well. Banks are liquid, well-capitalized, and largely funded by domestic deposits.

11. Nevertheless, risks call for continued supervisory vigilance. The largely foreign-owned banking system is exposed to risks stemming from potential renewed stress in Europe and deleveraging by parent banks. Sizable holdings of Slovak government bonds leave banks’ balance sheets vulnerable to a widening of bond spreads. Close cooperation with home supervisors is essential to mitigate cross-border risks. Recent steps by the National Bank of Slovakia to strengthen bank capital and liquidity buffers are welcome.

12. A speedy resolution of nonperforming loans (NPLs) would support an expansion of credit. NPLs have been slow to come down, particularly in the corporate sector. Removing tax obstacles—such as allowing loan losses to be tax deductible in the year they were incurred—would reduce delays in loan write-offs and free up capital. In this regard, recent amendments to the Act on Bankruptcy and Restructuring would encourage timely restructuring and speed up NPL resolution by allowing creditors to take a more proactive role in bankruptcy proceedings.

13. Curtailing risks in housing lending would further strengthen banks’ balance sheets. The less-stringently regulated “other housing loans”—which are not subject to the regulatory limit on the loan-to-value (LTV) ratio and not financed by mortgage bonds—have surged, driving up the average LTV ratio. Subjecting all types of housing loans to the same LTV limit would ensure loan quality and help prevent excessive risk-taking.

14. Promoting deeper financial markets would bring economic gains by enhancing investment efficiency and broadening access to finance. This could be facilitated by further relaxing investment restrictions for the Pillar II pension funds and by developing a secondary market for government bonds.

Structural reforms for a vibrant and inclusive growth

15. Boosting employment should be a top priority.Unemployment remains in double digits, largely unaffected by the improvements in output. Effective implementation of the reformed Labor Code should help reduce unemployment over the longer run. Better-targeted vocational training through occupationally-oriented curricula, informed by cooperation with employers, would reduce skill mismatches. A sharper focus on market needs in tertiary education would spur innovation and increase productivity.

16. Addressing persistent regional economic imbalances calls for mutually reinforcing structural reforms. Regional development could be enhanced through policies to expand and improve infrastructure. Consideration should also be given to increasing employment incentives by differentiating labor costs by region according to the cost of living, including by supplementing future lower increases in minimum wages in less developed regions with means-tested social benefits and targeted reductions in social insurance contributions. Measures to enlarge the rental housing market, including by easing rental regulations, could help address shortages that inhibit mobility. Addressing lingering corruption and weak property and contract rights enforcement would reinforce ongoing efforts to improve business climate.

The mission would like to thank the authorities for their warm hospitality and cooperation.

Source | International Monetary Fund - Blog NEWS | http://imf-news.blogspot.com/2012/06/slovak-republicconcluding-statement-for.html

IMF Article IV Mission, Concluding Statement of the IMF Mission, May 29 to June 5, 2012

Much progress has been made in addressing Tuvalu’s economic challenges. The government has taken difficult decisions regarding spending, tax compliance is rising, and the new Policy Reform Matrix (PRM) process should streamline the process by which donors help the government reach its own priorities. The banking system is moving toward health, and public enterprises’ operations have shown improvement. All these steps are commendable, but a significant agenda remains to be implemented. To secure these gains and return Tuvalu to high growth, the government should build on these successes.

Economic Developments

A slow recovery is underway in Tuvalu, but there are important risks. GDP grew in 2011 for the first time since the global financial crisis, led by the private retail sector and education spending. We expect growth to rise slowly from 1.1 percent last year to 1.2 percent this year as the services sector continues to grow. Falling prices for imported goods such as clothing pulled inflation down to 0.5 percent in 2011, but the prices of domestically produced goods and services are also broadly stable. However, falling numbers of Tuvaluan seafarers, and the corresponding drop in their remittances, are hurting household incomes at a time when a strong, if weaker, Australian dollar is increasing imports. The possibility that seafarer income both does not recover and is not replaced by opportunities such as seasonal employment schemes is the biggest risk to long-term sustainable growth.

Even beyond employment, Tuvalu remains exposed to the difficult global environment.

Strong performance at the Tuvalu Trust Fund (TTF) has brought closer the point where it will begin to recapitalize the Consolidated Investment Fund (CIF). But a reversal could hurt the TTF, depriving the government of necessary support. Proceeds from licensing and joint ventures have improved the government’s revenue prospects, but further strengthening of the Australian dollar could negate these gains. On the other hand, a rapid weakening of the dollar could cause prices of imported goods to rise quickly. In the current fragile environment, this would present serious difficulties for Tuvaluan households.

Policy Discussions

Fiscal Policy and the Global Environment

The global crisis led to two linked problems in Tuvalu. First, high spending has drained the government’s assets just as the TTF was hit by poor returns. Second, falling seafarer employment hurt household incomes. Both have been aggravated by the strong Australian dollar, which reduced U.S. dollar-denominated earnings for seafarers and the government.

Now is the time to build on last year’s successful measures to bring the budget under control. Steps taken to bring down TMTS costs, and the decision to approve no new scholarships this year were difficult and commendable. Thanks to these steps, improved tax compliance by the private sector, and a large one-off Australian grant, the CIF will not be exhausted in 2012¹. But budget support next year will be tied to implementing PRM measures. Raising the TCT rate is an important step, but raising compliance among PEs – currently none of which pay TCT – will be crucial both to bring deficits down in the future and for securing budget support from donors. The next step for direct taxes is to follow through with penalties for noncompliance, including nonfinancial ones such as passport suspension. On subsidies, returning TMTS referrals to a committee of doctors should begin to bring costs down. The authorities should also continue to coordinate with donors to ensure scholarships remain at a sustainable level and bring CSOs transparently on budget. Public wage increases should also be tied more closely to inflation. Finally, new joint ventures should be signed with care, and only after verifying that market-based borrowing by NAFICOT does not endanger concessional assistance from donors.

Going forward, expenditure should be reoriented toward supporting social goals and growth. The PRM rightly focuses on primary education and streamlining health expenditure. More support for training, for example by enrolling women and broadening the curriculum at TMTI and by determining priority areas for awarding scholarships, will improve Tuvalu’s ability to send productive workers abroad, as will taking more advantage of seasonal labor schemes in Australia and New Zealand. Cuts to capital expenditure should not postpone needed infrastructure improvements, and Outer Islands projects should be clearly prioritized and financed by the FTF’s unspent balances rather than relatively scarce government resources.

These and other ongoing efforts will also help Tuvalu deal with the challenging global environment. Smaller budget deficits will allow the government’s assets to be rebuilt while better training and more opportunities for Tuvaluan workers, in New Zealand and increasingly in Australia, will help cushion the blow of declining seafarer demand. The new objective-based asset allocation of the TTF should be implemented with a strong bias toward protecting Tuvalu’s asset holdings, both of the TTF and the TNPF, from risky conditions in global financial markets.

Supporting Private Sector Growth

Raising incomes will also depend on creating a better business environment. Some results are already visible from public enterprise reform: collections at TEC are up and TMTI is on a better footing. But further improvements are undermined by overlapping arrears with the government, which PEs cite as a reason not to pay taxes. However, improvements at the banks are encouraging, as they will grant more Tuvaluans access to credit and increase capacity to support new businesses.

Continuing to implement the PE reform agenda is key to supporting growth. Addressing tax arrears and poor customer payment culture is especially challenging in small countries. Improved accounting procedures should help sort out the net position of unpaid government supplier payments to PEs and PE tax arrears, but more important in the long run will be ensuring both parties make all payments on time and transparently. The effort to commercialize PE operations is also paying off with improved risk management at the NBT and higher collections at TEC. In the long run, this will increase the flow of dividends to the government, easing fiscal pressures, and reduce PE overdrafts at the NBT, freeing capital for lending.

The financial system has made significant strides, and progress seems likely to continue. The improved focus on credit quality and financial position of the DBT and NBT are encouraging. In particular, the DBT has begun to clean its balance sheets by writing down uncollectible loans. As the NBT’s risk monitoring capabilities improve, it should begin to do the same. On the other hand, delinquencies from small loans at the TNPF are a concern of unknown magnitude: to ensure the Fund’s continued financial health, the authorities should seek to have its actuarial viability assessed, and also amend the law to encourage retirees to take annuities rather than lump-sum withdrawals.

Government interference in the economy should also be reduced. As they return to health, the DBT and NBT should gradually be allowed to set their own rates, at least in areas, such as lending to businesses, where they are already effectively in competition. Installing a new and fully professional board at TEC to ensure the company’s independence will show that Tuvalu is serious about improved PE management. Finally, the unfortunate situation at TCS presents a very difficult problem with no easy solution. Private companies are already taking over TCS’ traditional business of supplying the Outer Islands. To facilitate this transition, the government should coordinate with businesses both in Funafuti and the Outer Islands to ensure that they have sufficient credit and freight capacity to ensure all Tuvaluans have access to retail goods.

Source | International Monetary Fund - Blog NEWS | http://imf-news.blogspot.com/2012/06/imf-article-iv-mission-concluding.html

IMF Executive Board Concludes 2012 Article IV Consultation with New Zealand

On June 6, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with New Zealand and considered, and endorsed, the staff appraisal without a meeting on a lapse-of-time basis.²

Background

The New Zealand economy continues to grow at a modest pace. Output grew by 1 percent in 2011, as elevated export commodity prices and favorable agricultural conditions helped offset the adverse impact of large earthquakes in Canterbury in late 2010 and early 2011. Continued aftershocks have delayed earthquake-related reconstruction. Domestic demand has remained soft as households and businesses continue to deleverage amid a weak housing market and an uncertain outlook. Elevated rates of unemployment, currently above 6 percent, and spare capacity have helped contain inflation.

The Reserve Bank of New Zealand (RBNZ) lowered the policy rate in March 2011 by 50 basis points to cushion the impact of the February earthquake. Since then, it has kept the policy rate on hold given the deterioration in the global economic position, subdued domestic activity, and the expected impact on future domestic activity of the strong exchange rate.

The nominal effective exchange rate has appreciated by around 30 percent since its trough in early 2009. The appreciation reflects the effects of higher export prices, positive interest rate differentials, and, although currently volatile, some increase in global risk appetite since end-2011.

Reflecting the slow recovery, past revenue and spending decisions, and accrued earthquake-related spending, the fiscal deficit in 2010/11 reached a record high of 9¼ percent of GDP on an accrual basis. Net government debt increased to 20 percent of GDP by mid-2011 from a low of 5½ percent in 2008.

The current account deficit in 2011 remained low at 4 percent of GDP, well below the 8 percent level in 2005-08, reflecting terms of trade gains, weak domestic demand, and low world interest rates. Net external liabilities have declined, but remain high at 72 percent of GDP at end-2011.

The banking sector remains sound. Bank profits are strong and nonperforming loans have fallen to less than 2 percent of total loans. Capital adequacy has improved since 2007, with the Tier 1 capital ratio reaching 10 percent in September 2011. Banks have made steady progress in lengthening the maturity profile of their wholesale funding since 2008 and increasing the share of retail deposits, but the total stock of banks’ gross external liabilities remains above 70 percent of GDP and loan-to-deposit ratios remain high.

The pace of New Zealand’s economic recovery is likely to remain modest. Output growth should pick up somewhat to 2⅓ percent in 2012 as earthquake reconstruction spending gains pace, although the size and timing of this spending is still uncertain. Growth is projected to rise to 3¼ percent in 2013, led by reconstruction. The key risks to the outlook are largely on the external front and on the downside, related to emerging weaknesses in the global economy and a possible upheaval in the global financial system.

Executive Board Assessment

In concluding the 2012 Article IV consultation with New Zealand, Executive Directors endorsed staff’s appraisal as follows:

Outlook and risks. The pace of New Zealand’s economic recovery is likely to remain modest. Output growth should pick up somewhat in 2012 as earthquake reconstruction spending is expected to gain pace, but the size and timing of this spending is still uncertain. High household debt is likely to weigh on the growth of private consumption as households will need to save to strengthen their balance sheets. The spare capacity and elevated unemployment will contain wage and inflation pressures in the near term. The risks to this outlook are on the downside and largely external, stemming mainly from emerging weaknesses in the global economy and a possible upheaval in the global financial system. The flexible exchange rate would provide an important buffer against shocks.

Monetary policy. The current accommodative monetary stance is appropriate. If the recovery remains on track and downside risks dissipate, monetary policy will need to tighten gradually to contain inflationary pressures. However, if the global recovery stalls or international capital markets are disrupted, the RBNZ has scope to cut the policy rate and provide liquidity support for banks.

Fiscal policy. The planned deficit reduction path strikes a balance between the need to contain both public and external debt increases while limiting any adverse impact on economic growth during the recovery. The authorities’ plan to return to budget surplus by 2014/15 should put New Zealand in a better position to deal with future shocks and the long-term costs of aging. Moreover, it will relieve pressure on monetary policy and thereby the exchange rate, helping contain the current account deficit over the medium term. New Zealand’s relatively modest public debt gives the authorities some scope to delay their planned deficit reduction path in the event of a sharp deterioration in the economic outlook.

External vulnerabilities and the exchange rate. New Zealand’s large net liabilities present a risk. Despite recent improvements, the current account deficit is projected to increase over the medium term as earthquake reconstruction activity gains pace and global interest rates normalize. To contain this increase and limit a further buildup of foreign liabilities over the longer term, the New Zealand dollar would need to be weaker than its current level. However, part of its current strength may dissipate over time with the eventual tightening of policy rates by major central banks. Increasing national saving, including through the planned fiscal deficit reduction, would reduce external vulnerability.

Financial sector issues. Banks remain sound, but they are exposed to highly leveraged households and farmers and rollover risks associated with large short-term offshore funding needs. While New Zealand’s bank regulatory norms are more conservative than in many other countries, the authorities should assess on an ongoing basis the balance between banking sector vulnerability versus efficiency to minimize the risk that systemically important banks pose to the economy. Options to strengthen prudential norms if needed could include setting banks’ capital requirements above the Basel III minimum or raising the core funding ratio more than the planned 75 percent to reduce short term external debt further. The RBNZ’s continued work on the costs and benefits of macroprudential measures is welcome, as is the authorities’ intention to implement key features of Basel III in early 2013.

Source | International Monetary Fund - Blog NEWS | http://imf-news.blogspot.com/2012/06/imf-executive-board-concludes-2012_19.html

The “EUR/USD” Currency Trading Pair: Woulda, Coulda, Shoulda… [Guest Article]

By Tom Cleveland , 24^th Nov 2010 , forextraders.com 

The world of foreign exchange has had its own version of a reality series appearing center stage on every trader’s monitor for the past decade. The “EUR/USD” currency pair is the highest volume traded pair, the most visible, and with a short history since the Euro never existed before 1999. Perhaps, it was a thought in the minds of many European officials and discussed at cocktail parties for years, but its creation and the battle for supremacy that commenced was a direct frontal assault on the globe’s leading reserve currency, the greenback, right from the start.


Shades of Marlon Brando claiming, “I could have been a contender!” seem most appropriate at this juncture, since the ascendancy of the Euro for the past ten years was finally tested in 2010, as many felt it would be back when its formation became a done deal. The pricing trends presented in the following chart tell the compelling story, one for the history books and definitely worthy of a Hollywood script or TV series at the least:

When the Euro was finally introduced as a regional “experiment” to put European economies on par with its primary competitor, the United States, it followed a long history of star-crossed attempts to legislate currency exchanges by governmental proxy, rather than submit to the vagaries of global market forces. The Bretton-Woods accords brought us the “adjustable peg” system after World War II to complement the Marshall Plan rebuilding of Europe.

Attempts to peg currencies to a Gold standard collapsed in 1968, giving way to a floating-rate system, but Western Europe tried once again to stabilize its currencies as a group by inventing “the Snake”. By 1979, the serpentine solution was replaced by the European Monetary System, or EMS (does anyone remember the “Ecu”?), doomed to failure from the start.

The formulation of the Euro seemed to many as just one more failed attempt at market manipulation, but once national currencies were disbanded and destroyed, there was no going back. However, the one ringing comment at the time was, “Would German bankers raise interest rates on everyone if there was a crop failure in Spain?”, an opinion that political forces would meet their match when market realities prevailed.

Fast forward to the end of 2009. After nearly recovering its pre-recession strength, news headlines began to foretell that there were significant debt problems in Greece, the weakest member state in the European Union from an economic perspective. When the crisis fully broke, the Euro had descended from its once lofty perch of .60 down to .18. Forex market trading of the Euro when introduced commenced at a similar value, then dropped to .85 where most analysts thought it should rest, but from late 2000, the Euro marched in a constant upward trend to .60 in 2008.

Talk of replacing the U.S. Dollar as the world’s number one reserve currency has all but disappeared from forex news discussions. The greenback, battered and humbled, has regained some of its pride as the exchange rate nestled into the .30 to .40 trading range. Persistent debt problems in Europe and related deficit issues is the U.S. will more than likely prevent either currency from dominating the other for some time.

The basic issue for Western democracies, the developed countries of the world, is how to stimulate domestic growth in their native territories when all eyes are fixed on Asia and developing countries for growth prospects. Growth will produce tax revenues that will reduce deficits and strengthen national currencies. Sounds simple enough, but no one wants to swallow the medicine.

President Obama’s bipartisan committee on reducing the deficit recently released their preliminary proposals, none of which were supported by the political powers that be. Marches in London protest proposed measures there as well. Economic war will be upon us if major financial solutions are not immediately forthcoming.

Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2010/11/eurusd-currency-trading-pair-woulda.html

Guest Article: The INR-USD Exchange Rate – Will the Rupee Depreciate?

By Ashutosh Gupta, Vice President of Investment Research and Chief Transition Officer, Evalueserve and
Surbhee Sirohi, Manager in the Investment Research group, Evalueserve .
May 2011.

The USD-INR exchange rate is an important indicator of investor sentiment and can significantly impact not only the fortunes of individual firms and sectors but also the government. While this exchange rate has been very stable overall for the last five years, there have been periods of significant volatility. For example, USD-INR moved from 40 to 51.50 from March 2008 to March 2009. We believe there is a significant downside risk to USD-INR exchange rate and will explore some of the risk factors here:

•  Inflation is at an all-time high; the Consumer Price Index (CPI) increased by 10.88% in 2009 and by 13.19% in 2010. The monetary policy changes to control inflation have been ineffective. We believe this is because inflation is being driven primarily by structural supply side challenges such as lack of agricultural infrastructure, low crop yields, low organized retail penetration, and lack of import buffer for staples such as pulses where India is one of the main producers worldwide.

Figure 1 depicts the percentage change in the consumer price index (CPI) over the last ten years.

Figure 1: Inflation – Percentage Change in Average Consumer Prices (2000–10)

Figure 2 highlights the comparison of yields for select crops.

•  India as one of the fastest growing economies should be a favoured destination for investment. Nevertheless, it witnessed a decline in Foreign Direct Investments (FDI) in 2010, making it the only BRIC country where this happened. This is troubling as FDI is an important indicator of investors’ faith in a country’s long-term prospects. Foreign Institutional Investment (FII), which provides short-term portfolio investment money inflows, has been buoyant, but these funds are volatile by nature and are prone to “flight risk”, something that happened during the financial crisis. Most countries prefer FDIs to FIIs. India in 2010 experienced a decline in FDI although FDI increased globally (see Figure 4).

• Recent widespread corruption scandals have reinforced the negative perception of governance deficit in India. This, combined with regulatory and tax uncertainty, will deter foreign investors. For example, several global firms who invested in India’s telecom sector have had to write off billions of dollars of their investments.
• A major source of foreign currency inflows to India is remittances; India received USD 55 billion in remittances during 2010. The Middle East accounts for a major share of this inflow and the current turmoil in the region may negatively influence it.
• The combined central and state government deficit has stubbornly stayed around 10% of GDP. Another major concern is that India imports about 70% of its oil and efforts to increase the production capacity of petroleum and natural gas domestically have not been very successful.
• India’s current deficit is about 3%, the level it reached during the crisis of the 1990s. A current account deficit is not bad by itself for a growing economy if it helps build important long-term productive assets. Unfortunately, some of this money already seems to be feeding speculative real estate activity instead. This is exacerbated by the fact that the more volatile FII money (and not the more stable FDI) is funding the current account deficit.

• The United States (US) economy seems to be on the path to recovery. It is very likely that the improving US economy will draw more funds at the expense of emerging countries. This can already be seen in the FDI inflows, which increased by 43% in 2010.

After studying the various demand and supply factors for the Rupee, we have arrived at three likely scenarios:

First Scenario – Rupee Depreciation

This scenario is likely to occur if oil prices continue to rise or if FII money “exits” because of a crisis of confidence. Based on past evidence, even a relatively orderly outflow of USD 15 billion of FII money over a year could result in the INR depreciating by 22–30%. This would imply an exchange rate in the range of INR 55–60 to USD 1. It could get even worse if the flight of capital were to take place over a shorter period. This would imply a higher cost of petrol, diesel, and petroleum products in India, leading to even higher food prices and Consumer Price Index. The current account deficit would balloon and the rising inflation could create a vicious cycle.

Second Scenario – Rupee Appreciation

This scenario is likely to occur if the FII money continues to flow in and FDI levels improve. An appreciating Rupee will make imports cheaper and lead to better managed deficits and inflation. The flip side is that Rupee appreciation would erode India‟s cost advantage in the export sector especially the booming ITES sector and likely invite government intervention. This is what happened just before the onset of the 2008 financial crisis when the USD-INR touched 39 and the Indian government repeatedly intervened in the currency markets to halt the Rupee appreciation.

Third Scenario – Status Quo

This is the most benign scenario. The exchange rate continues to move in its current range and slowly appreciates over the long term as the economy continues to develop and India strengthens its position in the global markets. The government‟s efforts to improve agricultural infrastructure bear fruit in the longer term and inflation declines. Exchange rate fluctuations do not cause any major disruption in the trade environment.

According to our analysis, during the next two years the probability of the first scenario (depreciation of Indian Rupee by 20%) is the highest (about 50%) while the other two scenarios have an equal probability of approximately 25% each. In other words, there will be pressure on the Rupee unless steps are taken to fix structural issues described in this article. The Indian government and RBI are well aware of this risk and are definitely hoping for the third scenario, in which India essentially grows its way out of trouble over a couple of decades and where they only have to intervene occasionally to smoothen out excess volatility. As Subir Gokarn, a deputy governor of RBI recently said, “Intervention is not costless, it simply transfers the cost from one constituency of the economy to another.”

Full whitepaper available from this link. 

Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2011/06/guest-article-inr-usd-exchange-rate.html

Guest Article: The Shell Game: Currency Forecasting Basics for the Rest of Us.

By Dee Mason, money.co.uk, 24/ Aug/ 2011.
  

Moving from country to country, while still having monetary responsibilities to my native country, has meant that I have had to keep some of my attention on currency forecasts and how much my current paycheck was actually worth in my hometown. Over the course of the last three or four years, it has basically felt like a game of financial Frogger, as I find it continually necessary to weigh whether transferring, converting, or saving my funds in their various and sundry currencies is wise or foolhardy. For those of us who live this sort of peripatetic lifestyle, and there are many of us, attempting to predict the ebb and flow of our money can be a truly daunting task. Currency forecasting, the act of predicting the value of a currency over time, is by no means an exact science, and if you flip between network news coverage on any given night, the information will vary wildly from program to program and expert to expert. So what is a world traveller to do? Your best bet is to familiarize yourself with at least the basics of currency forecasting, so that when you are planning to take advantage of that great ski deals in Switzerland package you stumbled upon online, or are moving from your teaching job in Sri Lanka to your new job in France, you do not find yourself completely broke. As not everyone is adept at math and, let’s face it, currency forecasts are highly educated guesses at best, the information below is meant to help you understand and interpret the currency fluctuations you see and hear about, at a basic level.

How It Works

Currency forecasting occurs via two different models – fundamental analysis and technical analysis. Like pretty much everything science and/or math based, fundamental analysts and technical analysts continually argue about the pros and cons of both methods. If you are flipping between channels, websites, or programs, and getting different information from each one, it is often due to a difference in the analytical style of the expert commentator.

Fundamental Analysis

Fundamental analysis requires a lot of, well, analysis. Traders who utilize fundamental analysis examine models produced by banks and other financial institutions around the world. These models analyze everything from interest rates to purchasing power to assets from each market. Fundamental analysts compare the various models, and the external cultural and political factors that could be affecting the various markets, in order to predict the path of the currencies involved. For those of us concerned with exchange rates, fundamental analysis addresses the gross domestic product of the countries, inflation, productivity, and unemployment to determine the value of one currency against another.

Technical Analysis

Technical analysis does not use models. Instead, it focuses directly on the trading systems of each market, examining monetary trends over time, via a combination of chart examination and mathematics. When dissecting the available data, traders using technical analysis will examine support and resistance lines, which determine the general rate at which prices within a currency pair will trade. They also use technical indicators to study the economic stability of a currency. Technical indicators are, in essence, reports of a particular economy generated daily or hourly. They also follow trends, literally the movement of a particular currency pair, and pay attention to whether the currencies are moving down, up, or some other direction altogether. For those of us who are not full-time traders, or quantitative analytical political scientists, the technical analysis model is rather more useful, as it allows us to examine a particular currency, as opposed to the movement of an entire market or economy. When it comes to exchange rate forecasting, the technical analysis model focuses on patterns and the flow of money between businesses and consumers within a particular market. Online trading sites such as Forex, TD Waterhouse, and Etrade UK make it possible for the average person to have some idea of the ebb and flow of one currency against another. These sites continually update charts and trends, and with a bit of practice, a layman, can glean a great deal of information from the available data.

The Rest of Us

Now that you have some idea of what to look for, hopefully your next experience of moving from country to country and currency to currency will feel less like a leap of faith, and more like an educated guess. Even if your interest in following currency trends is only passing at best, having some understanding of what you hear and read about your money is useful. The next time you are planning a move, take a good look at your current currency versus your potential new currency. Having a functional knowledge of your own money’s worth will go a long way to increasing your comfort level wherever you choose to live.

 

End of article. 

Source | The Currency Forecasting Blog (CFB) | http://currency-forecasting.blogspot.com/2011/08/guest-article-shell-game-currency.html

Finland—2012 Article IV Consultation Concluding Statement

Despite strong fundamentals and a track record of good policies, Finland’s near-term outlook is threatened by intensifying external strains. Economic activity in the euro area is expected to weaken markedly in 2012 on the back of financial sector deleveraging and fiscal consolidation in several European countries. Spillovers to Finland could be significant given its highly open economy and trade and financial linkages with Europe. Thus, the key immediate policy concern is to cushion the downturn, including through a nimble fiscal policy, while mitigating any lingering vulnerabilities. Financial integration and complexity have created new risks and test supervisory abilities, not least in light of Finland’s close linkages with other Nordic financial markets. In the longer run, Finland faces challenges from a rapidly aging population, slowing productivity growth, and eroding competitiveness.

Economic situation

1. After the deep recession of 2008-09, the Finnish economy rebounded robustly in 2010 but stalled at the end of 2011. The recovery was supported by a strong surge in domestic demand, propelled by rising consumer confidence, low interest rates, and renewed wage growth, although exports never regained their previous vigor. As the euro area sovereign debt turmoil intensified, dwindling demand from trading partners dragged the economy to a standstill in late 2011, despite overall growth of about 3 percent for the year. Activity in the first quarter of 2012 was slightly stronger than expected, but weak investment suggests weakening growth in the near term. Albeit still adequate, competitiveness has worsened significantly in recent years, with contracting export market shares and a small current account deficit in 2011, the first in nearly two decades.

2. The financial sector has remained generally sound despite the turbulence in the euro area, but vulnerabilities persist. Bank capital ratios are comfortably above minimum requirements and non-performing loans are manageable. However, banks’ operating profits have declined amid weakening interest income and increased competition for retail business. Moreover, the Finnish banking sector is highly concentrated with a majority of assets controlled by subsidiaries of foreign Nordic banks, with attendant large exposures to the latter. These factors contribute to sizable spillover and deleveraging risks for banks owing to the financial strains in the euro area, though direct exposures to periphery countries remain minimal. Credit growth, while slower than before the crisis, is faster than in the rest of the euro area. The insurance and pension fund sectors are weathering well the ongoing crisis, but their solvency margins—though still relatively high—have been reduced.

3. The housing and mortgage markets appear relatively stable, albeit vulnerable to high and rising household debt.Household balance sheets have been made riskier by fast increases in indebtedness as a share of disposable income during the last decade. However, default rates have remained low, even if they could deteriorate if unemployment were to perk up markedly. In any case, highly-leveraged households could be forced to curtail their consumption, particularly when current low interest rates return to more normal levels given the dominance of floating rate mortgages, with a negative impact on activity. After some retrenchment in 2009, house prices returned to their pre-crisis growth path. In real terms, they are now comparable to those prevailing at the 1990s peak, though still broadly in line with fundamentals, according to various analyses.

4. The fiscal position deteriorated sharply during the acute 2009 recession, and while consolidation has now begun, the costs of population aging loom large. In 2011, the budgetary stance tightened by around 1 percent of GDP in structural terms, but weakening growth still put the headline deficit at ¾ percent of GDP and gross debt ended 2011 at 48½ percent of GDP. Over the longer run, aging costs for the general government are estimated to rise by about 5 percent of GDP, adding to fiscal pressures.

Outlook and risks

5. The mission expects GDP growth to decelerate markedly to around ½ percent in 2012 before picking up again in 2013. Negative growth in the middle of the year reflects weak consumption and investment, marred also by continued sluggish exports. Though activity should start to recover late in 2012, volatile financial market conditions and to a lesser extent structural fiscal consolidation (also in trading partners) will be a continuing drag. Accordingly, output will fall further below potential in 2012 and inflation will moderate. The supply potential of the economy may have been significantly curbed by the crisis as low investment has taken its toll. Potential growth may also be hindered by the recent deterioration in competitiveness.

6. Risks to the outlook are tilted to the downside, with heightened uncertainties. In the short run, they primarily relate to uncertainty about financial market developments, with possible tensions for bank funding leading to deleveraging and tighter credit, as well as spillovers from a deeper and more protracted slowdown in the euro area than now projected. Similar negative impacts could derive from a significant reduction in Finnish real estate prices or continued competitiveness erosion. In the longer run, persistence of expansionary monetary conditions in Finland, along with repercussions from safe-haven inflows into the financial system, may overheat the economy and fuel asset price bubbles. Limited expansion of working age cohorts in a rapidly aging population could also constrain potential growth.

Policies

7. Against this background, Finland must address existing vulnerabilities and long-term sustainability issues, while paying due attention to short-term growth. Financial sector policies should include efforts to maintain capital at the levels envisaged under Basel III while more emphasis should be given to liquidity provisioning. Fiscal policy must strike a delicate balance between supporting economic activity and addressing the sustainability gap. Further structural reforms should be implemented to spur potential growth, while wages should rise in line with productivity, thereby preventing more declines of competitiveness.

Financial sector

8. The mission recommends improving capital and liquidity buffers and continued vigilance to mitigate risks of potential interruptions of bank funding from abroad. Finnish banks already meet in their core Tier 1 ratios the minimum capital and conservation buffer requirements envisaged under Basel III, but not all credit institutions satisfy the leverage ratio requirement. Furthermore, compliance with Basel III liquidity requirements will entail some additional effort as regards the asset composition of the liquidity buffer and the size of long-term stable funding. Indeed, the Finnish banking system is largely funded through foreign sources and wholesale markets. Hence, banks could benefit from gradually building capital buffers and shifting asset composition toward more highly-liquid instruments. These objectives should be accomplished in measured but steady steps over the medium term to avoid fostering pressures for deleveraging.

9. The mission commends the authorities’ efforts to bolster supervisory practices. Improvements are being implemented along the lines of the 2010 FSAP recommendations. New liquidity standards have been introduced. The authority of the FSA to impose fines on credit institutions was extended in 2010, while further legislative changes are expected in 2012-13 in line with the EU harmonized framework for supervisory sanctions. Top-down stress testing capacities are also being augmented and work is ongoing to strengthen the analysis of the consolidated risk profile of complex financial groups.

10. Nonetheless, the mission underscores the necessity of enhanced supervision of nationally systemic banks and reinforcement of macro-prudential tools.

• Heavy concentration in the Finnish banking sector implies high contagion risk from systemic banks. Contagion analysis based on balance sheet inter-linkages indicates that a few institutions act as liquidity hubs, thus rendering them systemically important for the integrity of the financial system. In this regard, the mission regards as beneficial closer supervision and possibly more stringent prudential requirements for nationally systemic banks, such as additional capital buffers, higher liquidity provisions, and topped-up contributions to the Deposit Guarantee Fund.

• With a majority of loans tied to depressed Euribor rates, interest margins tightened. Very low rates over a prolonged period may encourage risk-taking by banks to increase short-term profits, including by accelerating credit expansion, ultimately with adverse impact on financial sector health. We advise that supervisors scrutinize carefully bank risk-taking behavior. Plans to define national competencies for macro-prudential supervision are a recent important step in this respect. The mission similarly welcomes the in-depth survey of vulnerabilities related to the housing and credit markets as well as publication of standard definitions to calculate the loan-to-value ratio (LTV) and the planned introduction of countercyclical capital buffers. These steps should be complemented by granting the FSA authority to make LTV ceilings binding and implementing a national loan registry to guard against excessive borrowing.

11. The mission also notes that the effectiveness of supervision and crisis resolution mechanisms can be further buttressed. Memoranda of understanding (MoU) complying with best international practice have been signed with foreign (mainly Nordic and Baltic) supervisors and supervisory colleges have been active. Nevertheless, these MoU are not binding, which hampers enforcement actions, and consideration should be given to strengthen their legal status. Similarly, enhancing mutual sharing of supervisory information could facilitate preparedness in host and home countries. We recommend that joint contingency planning with other national authorities for cross-border resolution be advanced, containing the risks to Finnish subsidiary activities, with ex-ante burden-sharing guidelines defined to limit contagion. The mission shares the authorities’ preference for a common bank-resolution framework at the EU level, but advocates formulating national or regional plans in the interim. Until such frameworks are fully operational, ring-fencing the activities of Finnish subsidiaries remains advisable.

Fiscal

12. The short-term fiscal stance is broadly neutral, while substantial adjustment is envisaged through 2015, though measures still have to be identified. The mission projects the general government (GG) structural surplus to remain roughly unchanged in 2012. Over the medium term, the government program aims to set the central government (CG) debt-to-GDP ratio on a declining path and reduce the CG deficit from 3 to 1 percent of GDP between 2011 and 2015 (end of the government’s term). However, attaining this goal would require measures beyond those already identified, as, under current policies and macroeconomic assumptions, we forecast the CG deficit to stay above 1½ percent of GDP by 2015.

13. The mission endorses the authorities’ 2012 and 2013 fiscal stances. The budget for 2012 provides for virtually full operation of automatic stabilizers, leading to an increase in the headline deficit, thereby supporting domestic demand. This is desirable because the outlook for near-term growth is weak and activity appears below potential. On the other hand, the long-term fiscal sustainability gap is estimated at about 4½ percent of GDP, owing to the impact of population aging on public expenditures. Thus, the mission concurs that a broadly neutral 2012 fiscal policy is appropriate, avoiding pro-cyclical withdrawal of support to the economy while preventing damage to long-term sustainability prospects. Similar considerations suggest that the authorities’ planned moderate structural tightening for 2013 is adequate too, provided economic activity rebounds as projected. Given the unusual downside risks surrounding the recovery, the authorities should nevertheless stand ready to loosen budget policy if growth underperforms considerably.

14. The mission also supports the medium-term consolidation goal. Over this longer horizon too, fiscal policy must balance the conflicting objectives of supporting growth and making progress toward closing the sustainability gap. Hence, the mission recommends a gradual structural adjustment, of about ½ percent of GDP per annum, which is broadly consistent with the authorities’ 2015 goal for the CG, eliminates the sustainability gap in 10 years, and allows for steady reduction and eventual disappearance of the output gap by 2017.

15. But we stress that such consolidation should be implemented flexibly to avoid harming growth. If growth falters significantly below potential, automatic stabilizers should be allowed to operate fully and further structural consolidation delayed until a recovery has taken firm hold. It may also be preferable to substitute part of the headline tightening with structural measures that significantly improve fiscal sustainability but only modestly impact activity, such as increasing the retirement age and boosting productivity in public service provision. The need for immediate fiscal consolidation is also lessened by the authorities’ strong track record in budget discipline. Despite the sustainability gap and high spreads in a number of other euro area countries, financial markets still regard Finland as low risk. Hence, rollover risks are marginal. Finally, postponing additional adjustment is unlikely to contravene the EU fiscal compact, since under the baseline macro scenario the GG structural balance has a substantive margin above the ½ percent of GDP deficit threshold.

16. Measures that directly reduce the impact of aging on public expenditures or broaden the tax base should form a key plank of medium-term adjustment efforts.

• The mission notes that, with a rapidly aging population and associated increase in health care costs, priority should be given to measures aimed at restraining growth in demand for health- and long-term care. By the same token, the generosity of the social and unemployment benefits system could be further moderated, notably by additional tightening of the unemployment and disability pipelines to early retirement as well as increases in the statutory minimum and maximum retirement ages, contributing to an increase in the effective retirement age.

• With an already high revenue ratio, the mission believes there is little scope for further increases in the tax burden. Hence, revenue measures should focus on broadening the tax base, reducing, if feasible, relatively high marginal labor tax rates, and shifting from labor taxation to less distortionary consumption- and property-based taxation. In this connection, the mission supports the one percentage point increase in the standard VAT rate and the energy tax hike, but also advocates reducing the number of items on reduced VAT rates. The mission endorses the authorities’ plans to lower mortgage interest deductibility, which subsidizes home ownership and promotes indebtedness by households, potentially heightening vulnerabilities of the financial system. Hiking property tax rates, which are low by international comparison, would provide municipalities with a more stable source of revenue, reducing their dependence on highly cyclical corporate taxes.

17. The mission encourages reform of the fiscal framework, especially for local governments (LG), to facilitate attainment of sustainability. Increased attention should be given to contain rapid expenditure growth in LG, for example by moving toward expenditure ceilings for municipalities and by smoothing their revenue stream with the aim of avoiding pro-cyclical spending peaks and troughs and thus strengthening long-term budget planning. Additional mergers of municipalities would pave the way for economies of scale.

Structural reform and other

18. With the looming decline of working age cohorts due to aging, policies should encourage greater labor force participation and productivity to enhance growth. Apart from increasing the minimum and maximum statutory retirement ages, the mission recommends that labor market policies and benefits be adjusted so that activation takes place earlier. Moreover, we note the OECD recommendation that public R&D expenditures be refocused on basic research rather than direct support to business R&D. The mission also points out that tuition fees and more reliance on loans rather than grants for students would likely improve the cost effectiveness of higher education. Additionally, the large productivity differential between manufacturing and services should be reduced by opening the service sector to more competition. Similarly, opening the health care sector to competition could improve efficiency and help contain the buildup of aging pressures.

The mission is grateful for the high quality and openness of the discussions and for the cooperation and hospitality received from the Finnish authorities and private sector.

Source | International Monetary Fund - Blog NEWS | http://imf-news.blogspot.com/2012/06/finland2012-article-iv-consultation.html