Tag Archives: public finances

Chile: Latin America’s Wunderkind

Posted on by emmuser
2

Chile’s finance minister, Felipe Larraín, swung through London this week with a contingent of business people in tow to celebrate ‘Chile Day’ on June 27. The event was aimed at promoting the country as an investment destination. Given Chile’s strong institutions and envy-inducing macroeconomic performance, they certainly have a lot to celebrate. Mr. Larraín stopped by the London School of Economics for a public airing of his marketing pitch and managed to impress your resident blogger.

Why is Chile the economic envy of the region?

Highest sovereign credit rating in Latin America

  • Fitch upgraded Chile’s rating to A+ in February 2011, citing the country’s ‘structural strengths’ and ‘very strong institutional framework.’
  • Moody’s upgraded Chile’s rating to Aa3, the fourth highest investment grade, in June 2010, around the same time that it cut Greece’s rating to junk.
  • Ratings agencies are notoriously behind the curve, but Moody’s move came as a positive surprise in the wake of Chile’s ‘financial resilience’ to the devastating February 2010 earthquake.

First South American member of the OECD

  • Chile became the 31st member of the OECD’s club of advanced economies in January 2010.
  • In welcoming Chile, the organisation noted Chile’s  ‘prudent tax policies’ that gave it the leeway for stimulus measures to weather the global financial crisis as well as the country’s ‘groundbreaking’ pension reforms in the early 1980s.

Solid public finances

  • The country has one of the lowest public debt levels in the world at less than 10% of GDP at the end of 2010. This is a sharp contrast from the lofty levels in most advanced economies.
  • Chile needed $8.4bn in financing for reconstruction efforts after the earthquake. Officials showed an admirable political willingness to raise taxes – something the far-more-indebted US has shown no stomach for – as well as issue debt, rather than tap its sovereign wealth fund.
  • The government issued a global peso bond for the first time in history in July 2010: US$520Mn in 10-years at a yield of 5.5%.
  • Chile has a fiscal rule to help maintain fiscal discipline by insulating public spending from short-term copper price fluctuations and the business cycle. See this recent IMF paper on the rule.

Strong institutions

  • Chile has the strongest institutional quality in Latin America and ranked 28th out of the 139 countries surveyed globally in this category, according to the latest Global Competitiveness Index, due to transparent policymaking and low levels of corruption.

Balanced growth

  • For a small open economy, Chile has surprisingly strong domestic demand. The ratio of consumption (private + government) to GDP in 2010 was 70%, which is in line with that in many advanced economies as well as with bigger emerging markets, such as Turkey.
  • Consumption showed considerable resilience during the global financial crisis. As seen in the graph below, consumption is the only GDP component that has positively contributed to growth every year in the 2007-10 period.

Source: Banco Central de Chile

  • Export-led economies, such as the Czech Republic and Hungary, where export-to-GDP ratios exceed 70% of GDP, are more vulnerable to downturns in world trade and contracted more sharply than Chile during the global financial crisis.

No impending danger of overheating or a sudden stop in capital flows

  • Gross capital inflows are strong, at 16% of GDP in Q1 2011, but are driven by FDI, making the economy less vulnerable to a sudden stop in capital inflows. FDI is generally considered less prone to reversal than foreign inflows into equities and debt securities.
  • Bank lending to the private sector – at around 10% y/y – is growing at a measured pace, much slower than in many other countries in the region (eg. Brazil, Colombia, Peru).

BUT….

Fate is largely tied to China

  • Those who think a hard landing is on the way in China should be wary about Chile.
  • Asked what an abrupt China slowdown would mean for Chile, Mr. Larrain artfully dodged the question and simply said he doesn’t expect such a scenario.
  • China bought about a quarter of Chile’s exports in 2010 and Asia as whole accounts for about half of exports, a higher percentage than in Argentina or Brazil.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

Chile is still copper country

  • The country’s exports are not very diversified and copper continues to dominate, leaving the economy vulnerable to any downturn in global demand for the metal.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

Fitch Raises Hungary Ratings Outlook: Odd Timing

Posted on by emmuser
Reply

Fitch raised the outlook on Hungary’s sovereign credit rating to ‘stable’ from ‘negative’ on June 6, making the ratings agency appear out of touch with events on the ground. The long-term rating on Hungary’s foreign currency debt currently sits at ‘BBB-‘, one notch above ‘junk’ status, and the outlook improvement makes a rating downgrade in the near-term less likely.

Fitch positively revised the outlook due to ‘increased confidence’ that Hungary will cut the budget deficit below 3% of GDP by 2012. Where is this confidence coming from? They point to fiscal measures detailed in the latest convergence programme (submitted annually to the European Commission) and to structural reforms announced by the government in February 2011 (see chart below) to justify the revision. However, the ‘increased confidence’ is baffling since these reforms are so far mostly words that are not yet backed by action.

Parliament has not yet passed the vast majority of these promised reforms. In fact, the government has not yet submitted most of the draft legislation, making an outlook upgrade appear premature. The situation would be similar to me pledging to run a marathon and winning a participation medal just for registering.

According to the government’s timetable, most of the legislation – including that laying out a National Employment Programme, a new disability pension system and a new Public Procurement Act – are slated for July. At that point, we can better discern whether the government is really committed to fiscal reform. Up until now, the government has resorted to temporary stopgap measures to contain the budget deficit, such as the de facto nationalization of the private pension system and the imposition of ‘crisis’ taxes on certain sectors, which will do nothing to help the country’s long-term fiscal sustainability and will likely hurt it.

Shockingly, investors continue to give Hungary the benefit of the doubt.

Local Government Woes: Next Leg of the Crisis?

Posted on by emmuser
Reply

The global economy has returned to growth, but that doesn’t mean the crisis is in the rearview mirror.  A major legacy of the first stage of the crisis is the scar left on public finances. Public debt burdens in both emerging markets and advanced economies have soared in recent years, and they have already reached a boiling point in the euro zone periphery. Mark Horton of the IMF explores the reasons behind the fast build-up in public debt in the paper Fiscal Policy Issues after the Crisis.

Governments worldwide are now in belt-tightening mode. However, financial troubles at the local government level could undermine such efforts. More importantly, defaults by local governments could slow economic growth and/or threaten financial stability. Adding to the uncertainty, local government finances tend to be harder to track than those of central governments, but they are still important for gauging a country’s overall economic health.

Case of the United States

Local governments, like the federal government, suffered a contraction in tax revenue during the recession, and they are now having trouble slashing services fast enough to keep pace with the fall in revenue. This has led to wider budget deficits and higher debt levels. A major concern is that states – those most in trouble include California, New Jersey, Ohio – will cut aid to local governments.

A dangerous snowball effect could develop, whereby rising debt levels induce higher borrowing costs, which in turn makes it more challenging for local governments to service their debt. Inadequately funded pension liabilities are adding to their woes. Rather than raising taxes and irking voters, local governments may instead opt to default. So far, no major city has done so, but there are fears that this could soon change.

How worried should we be? Meredith Whitney, a prominent analyst known for looking beyond the Wall Street consensus, has predicted that dozens of US cities will default on their muni bonds. “Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy,” she said in a recent interview. Warren Buffett, the oracle of Omaha, has joined Ms. Whitney in expressing concern. See here.

Others say such fears are overblown. See Larry Swedroe of CBS MoneyWatch. Much of his counterpoint to Meredith Whitney seems to rely on looking at past defaults and extrapolating what happened to the future (eg. in previous defaults in Orange County and NYC, bondholders were made whole so they will be this time around too), which doesn’t seem like a particularly strong argument. Bloomberg columnist Joe Mysak also goes on the offensive against Whitney. Most of the column seems to be unsubstantiated vitriol against Whitney, except for the quotes he took from a Fitch report. “Debt service is generally less than 10 percent of a state or local government’s budget, and in many cases much less…. so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).”

In response to fears of default, there were large net outflows from muni bond funds in late 2010/early 2011, as seen in the graph above. According to estimates from the Investment Company Institute, inflows returned to positive territory in May. Some have taken this as a sign that all’s well with muni bonds, but that remains to be seen.

Case of Hungary

The United States is not an isolated case. Financial troubles at the local level are one of the obstacles facing Hungary as it attempts to bolster public finances. Cutbacks by the central government have added to local governments’ fiscal burden. Hungary missed meeting its general government budget deficit target of 3.8% of GDP in 2010 owing to a higher-than-expected deficit at the local government level.  By end-2010, local governments had accumulated debt amounting to over 5% of GDP.


Local government debt accounts for only a small share of Hungary’s total public debt, which topped 80% of GDP in 2010. However, it has some dangerous, potentially systemic implications. In the latest Financial Stability report, Hungary’s central bank warned that local government debt poses a risk not only to public finances, but to the health of the banking system as well.

By the end of 2010, banks’ exposure to municipalities exceeded HUF 1,000 billion (EUR3.7bn, US$5.4bn), accounting for 5% of total bank loans.  As the central bank notes, “Credit risks are further aggravated by the fact that a large portion of municipality bonds were issued with a few years grace period, during which the borrower pays interest only, without servicing the principal. Once the grace periods expire, monthly installment burdens increase which, according to our estimates, may increase the expenditures of local governments by up to HUF 25-30 billion at the system level in the coming years.”  The fact that 60% of local government debt (bonds and loans) is foreign currency-denominated (mostly Swiss francs) has added to solvency concerns.

In Hungary, there is not much data on local governments’ fiscal situations, which makes it challenging to evaluate. This is the case in many countries.

Case of China

Even before the global financial crisis, analysts worried that debt-laden local governments in China, if allowed to default, posed a risk to macroeconomic and financial stability. See this blog post from World Bank economist Louis Kuijs which details the issue: China’s local government debt—what is the problem?

A recent news report from Reuters suggests regulators are finally moving to address the problem. The central government is reportedly set to pay off some of local government loans, but banks would also take part of the hit. However, China expert Michael Pettis says that while it’s good that authorities are recognising and quantifying the problem, it doesn’t address who will ultimately foot the bill for the losses.