Trip Report April 15, 2019 / 04:29 pm UTC

Structural Themes at the IMF Meeting

By Mike Gallagher, Kevin Harris, Pedro Tuesta
  • Four key structural themes emerged from our discussions at the IMF/World Bank meeting: 
    1. The shape of the U.S./China trade deal;
    2. Whether China will be able to sustain the shift toward better quality growth; 
    3. How EMs can guard against the reversal of portfolio inflows; and 
    4. The future of the Eurozone (EZ).
  • Bottom line: There is some optimism that we are heading toward a U.S./China trade deal, but there is also apprehension that such a deal would be outside of the WTO framework. Some consider a soft landing for China’s medium-term growth achievable, though debate exists over the impact of deleveraging. On EM portfolio flows, there was no major breakthrough on the question of DM central banks taking account of their normalization action. Finally, forecasts of an H2 rebound in the EZ economy overshadowed concerns over how Italy will manage its public finances. 
  • Market implications: While the IMF meeting saw some realism on key structural themes, we feel that the discussions underestimate the impact of a bilateral U.S./China deal on global trade governed by WTO rules. Additionally, Italian debt risks were deemed to be tail risks, whereas we see them as a modestly likely alternative scenario. 

Figure 1: Chinese Bank Core Tier 1 Capital Ratios (%) 

Source: Continuum Economics, IMF 

Quality Growth in China

One of the structural questions raised at the Washington meetings over China is whether it can sustain the shift to better-quality growth in the coming years. The sense at the IMF meeting is that this could be achieved, but opinions vary over the confidence of such a soft landing path. Four key drivers of high-quality growth were identified: expanding the private sector domestically; boosting consumption as a share of GDP; modernizing fiscal and monetary policy; and sustaining deleveraging. 

On the first topic of expanding the private sector, the focus is on tilting the balance of investment and company growth toward the private sector and away from state-owned enterprises (SOEs). Such a rebalancing is seen as economically and politically feasible among IMF participants and would help boost productivity growth and hence cushion the slowdown in trend growth into the 2020s. 

On the second driver—enhancing consumption—the focus extends beyond the current VAT cut to help sustain consumption’s growing share of GDP on a multi-year basis. More needs to be done in the coming years to reduce households’ high precautionary saving rates. In this context, increased government spending on health, education and social transfers were regarded as key catalysts to reducing household savings and sustainably boosting consumption. 

Meanwhile, the view at the IMF meeting is that modernizing fiscal and monetary policy involves better and clear communication. For example, China currently uses a variety of monetary policy tools to guide the price and quantity of money, which allows short-term flexibility but restrains the growth of more market-based allocation of capital in the Chinese economy. However, there is an acknowledgment that progress on this front is likely to be slow, as the Chinese authorities are reluctant to significantly reduce policy control. 

Perhaps the greatest divergence of view exists on further deleveraging. The optimists feel that China can undertake select deleveraging in the shadow banking system (including the second-tier banks) which reduces vulnerability, but at the same time still allows overall credit/GDP to continue rising to sustain growth (Figure 1). The shift from manufacturing and investment to better-quality growth encompassing consumption/services and technology also allows this rebalancing to occur, as services and technology have lower credit intensity than the older industries. The pessimists worry that China’s debt/GDP ratio is already high by EM standards. While there is an understanding that this is a result of state involvement (SOE and local authority financing vehicle borrowing), pessimists worry that China’s credit growth will run out of steam. This would not facilitate a soft landing to 5.5% growth into the mid-2020s. 

U.S./China Trade 

The IMF is typically cautious in dealing with big-country divergences from international norms. Despite that reticence, the IMF has expressed hope that any deal reached between the U.S. and China would be multilateral—that is to say, it would fall under WTO rules and apply to other WTO members. However, that is not what the U.S. has intended from the outset and it is clearly not how the U.S./China deal will turn out. 

The U.S. has indicated that one of the final and most difficult issues, verification of compliance, is near resolution. Each side will establish an agency to monitor the other’s compliance with the agreement. That is not a multilateral arrangement: China has agreed to specific targets of specific U.S. exports, and there is nothing multilateral about that. The terms of the deal will apply only to the U.S. and China.

During briefings at the Spring Meetings, IMF officials also warned that the deal is not yet done, so markets may yet suffer a shock if a deal is not reached. That said, we have for some time expected talks to succeed and the good prospect of an agreement on verification addresses one of the final barriers to a deal.

Assuming an agreement is reached, one big market risk will be eliminated, but at considerable cost to the international system of trade rules. Some effort may be made after the fact to claim that the U.S./China deal is in the spirit of WTO principles (even though no such effort has been made so far), but in reality, the world’s two largest economies will have reached a bilateral trade agreement, ignoring international norms. We do not yet know what mechanisms will be agreed to in order to deal with (real or perceived) violations of the agreement, but it is hard to imagine the mechanism will fall within the WTO’s jurisdiction. 

It is entirely possible that a deal between the U.S. and China will not mean an end to the dispute over U.S./China trade. Tensions will still exist between the two countries. In addition, a trade deal between two WTO members that does not fall within the WTO framework is vulnerable to challenge from other members. WTO membership is a commitment to most-favored-nation treatment for all. A bilateral deal violates the spirit, and probably the letter, of WTO membership.

One of the benefits of negotiations within the WTO framework is that smaller economies and minor trading partners take part in trade openings between large economies. That benefit is an incentive to general WTO membership. One set of rules and one set of tariffs (mostly) applies to all. A bilateral trade deal between the world’s two largest economies reduces that benefit and undermines the incentive for WTO participation. 

We do not mean to argue that further devolution is the likeliest course for global trade rules. It is clear though that the odds of devolution increase with the signing of a U.S./China trade deal. Devolution, which makes international trade and finance more costly, is also a risk inherent in Brexit and in downside scenarios for Italy. 

Guarding Against EM Capital Outflows

Capital flows had been a thorny issue for multilateral organizations in general and the IMF in particular, as controlling capital flows falls mainly on the purview of central banks, which are the primary contact for the IMF in each country. Capital flows have many positives but also create many disturbances to local markets, especially when they distort the price of main assets; including the exchange rate, the interest rate and the overall price of the economy. Therefore, policies to reduce those impacts were developed, and these policies were in focus last week.

To understand where we are now, let’s give a bit of history. Capital flows are a relatively new issue, especially in EMs. Before the 1980s, external crises were mostly in the current account; therefore the usual recipe was to have the right mix of monetary and fiscal policies while using the exchange rate as stabilizer. 

As capital flows developed, the financial account developed a life of its own, and the recipe grew to include a monitoring of debt ratios—first public debt, and over time including corporates. There was also a monitoring of international reserves. Many “safe ratios” developed but there was always the discussion of how much was enough.

Now the idea is that domestic authorities will be responsible for dealing with capital flows and that the focus ought to be on inflows, as controlling capital outflows is considered as having many negatives outweighing any short-term positives. Initially, “administration of flows” was frowned upon, but as flow volatility increased and exchange rate movements started to behave as a shock amplifier rather than a shock absorber, the orthodoxy allowed for the control of inflows to smooth exchange rate movements and let the real exchange rate find its equilibrium. The difficulty in assessing these efforts are mostly tied to the fact that the actual equilibrium exchange rate is not observable.

The 2008 financial crisis brought a distinct reality; even if EMs adopted the right policies, the large amount of flows still affected emerging currencies. New policies arose, including the building of significant reserves that went well above the usual ratios and allowing EM central banks to use proactive FX intervention, including financial tools like FX futures and tying the timing of the inflows to the cycle (e.g., whether the flows will overheat an economy at the end of the expansion cycle). The difficulty of the task is clear and now the discussion is whether the IMF is responsible for warning large countries to mind the impact of the spillovers from their policies, as they could be sources of spill backs of capital flows. The possibility of spill backs has grown because now emerging countries represent a much larger part of the global economy (60%), as compared to the previous episode of tightening before the global financial crisis (40%).

The main implication for market analysts and investors for EMs is that while a country “doing the right thing” will help to manage capital inflows, it may not be enough. Analysts and investors have to consider the impact of spillovers from the major DM central banks as they start to normalize from ultra-easy monetary policy. Conversely, for DM analysts and investors, the growing possibility of spill backs from EMs will be a rising concern for potential safe-haven flows.

EZ Mid-Cycle Slowdown With Italy Over the Horizon 

The greatest focus on the EZ at the IMF meeting was on the cyclical situation. While uncertainty exists whether this is more than just a mid-cycle cooling of EZ growth, most participants believe H2 will likely see an improvement in growth trends due to a rebound in the German car sector and less domestic turbulence in France and Italy. A view also exists that financial markets are underestimating 2019 stimulative fiscal policy, which in Germany is estimated to be around 0.6% of GDP on a cyclically adjusted basis. 

Some officials also point toward lower U.S./China trade uncertainty helping to reduce EZ business uncertainty. However, this misses the risk of increasing U.S./Europe trade tensions to EZ growth as Trump switches his attention from China to Europe and given the new dimension of tariff threats surrounding Airbus and Boeing.

Italian budget concerns were over the immediate horizon. A sense exists that German Chancellor Angela Merkel’s desire for Italy to support a German candidate for EU Commission president after the May European parliamentary election will ensure an uneasy calm prevails on the political and budgetary front. While research has been done on the growing “doom loop” risks between banks and Italian sovereign debt and banks, it is not yet known whether this will become an issue in 2019, 2020 or subsequent years (Figure 2).

While our core scenario remains for an Italian political, budgetary and economic muddle-through, it is worth noting that one of the major rating agencies downgrading Italy to junk would trigger our downside Italy scenario. This could set off a chain of adverse feedback loops. Global investors would reduce BTP holdings, both reflecting the rating decision and fearing other rating agencies following suit. In turn, this may hurt the Italian government’s market access, which is critical given its large gross refinancing needs. Fears over the eventual inability of Italian banks to use Italian government bonds as collateral at the ECB would also raise fears over a second huge EZ crisis. In Washington, this type of scenario was regarded as a tail risk well over the horizon, whereas we attach a 15% probability to such a chain of events. 

Figure 2: Banking System Holding of Domestic Government Bonds (%)

Source: Continuum Economics, IMF 

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I, Mike Gallagher, the lead analyst certify that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further certify that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.