Promising tax measures in the US and optimism among Japanese businesses

Macro Highlights - 10/5/2017

In short
  • Promising tax measures in the US and optimism among Japanese businesses
  • Focus on Russia and Brazil: Upturn, but persistent imbalances

Key Takeaways of the week with Lisa Turk, Economist, United States and Matthias van den Heuvel, Economist
  • The proposed tax cuts unveiled by the Trump administration will be used by the US Congress as a basis for building its proposed law. This has contributed to an upturn in confidence among investors
  • In Japan, despite business confidence being at its highest level for over a decade, prices and wages are still not accelerating…
  • …which should push the Bank of Japan to durably maintain its expansionist monetary policy

On Wednesday 27 September, the Trump administration revealed the key features of its proposed tax cuts. In line with previous proposals, the plan’s measures include cutting the corporate tax rate from 35% to 20%, reducing the tax rate for small businesses to 25% (currently subject to the individual tax system at 39.5%) or even allowing business investments in depreciable assets to be deducted immediately. For households, the government is proposing to simplify the tax brackets and raise the standard tax deductions from USD 12,600 to USD 24,000 for married couples. While the proposed measures also include removing certain tax deductions (e.g. partially eliminating the deductibility of interest for businesses), offsetting the drop in revenues to some extent, the specific information available on funding is still limited. It is now up to Congress to provide the details for a law that will have a chance of being adopted.

 Although few specific details have been released, this news has received a positive response from investors: 10-year Treasury yields climbed from 2.24% before the announcement to 2.32% on 2 October, the Russell 2000 index for small-cap companies has gained 2.3% since 26 September, and lastly, the dollar, based on the nominal effective exchange rate, has appreciated by 0.9% over the same period.

On the budget front, the Senate committee in charge of this has shown that it would be inclined to apply tax cuts. The Senate Budget Resolution publication for the 2018 tax year, which sets out the core features of the budget, includes a drop in revenues by USD 1.6 trillion from 2018 to 2027. Over the same period, the committee has also forecast a USD 5.1 trillion reduction in spending, making it possible to eliminate the deficit by 2026.  

This resolution will now need to be voted on by all the members of the Senate, before being reconciled with the House of Representatives’ resolution, before 8 December.

If, in line with our expectations, the tax cuts are adopted between now and the end of 2017 or early 2018 and the Federal Reserve resumes its monetary tightening in December, the dollar could appreciate again against the euro in the fourth quarter of 2017, climbing to 1.16, and the first half of 2018 (1.12 in the second quarter). The US yield curve could gradually flatten and we expect to see 2-year Treasury yields at 2.10% and 10-year Treasury yields of 2.85% by the end of the first half of 2018.

In Japan, the latest economic data indicate positive trends for growth. Despite being revised down, GDP growth was solid in the second quarter of 2017, with 0.6% quarter-on-quarter (versus 1% before the revision). On a positive note, domestic demand has contributed to this acceleration in growth, which was previously dependent on export performance. Alongside this, business confidence is up to its highest level in over a decade according to the quarterly Tankan survey published by the Bank of Japan (BoJ). Their confidence has been boosted by the yen’s depreciation (-9.3% year-on-year in September against a basket of currencies) and the robust level of global demand, which are helping drive the economic recovery. This optimism must also have been fuelled by the very solid profit margins recorded, up to their highest level for over 15 years (6.8% in the second quarter according to the Ministry of Finance). However, in line with our scenario, businesses are forecasting a slight deterioration in economic conditions over the coming months, notably due to the political and geopolitical uncertainty. Against this backdrop of dynamic growth, demand for labour among businesses is very high. In August, unemployment was at 2.8%, a 23-year low, while the ratio of job offers per applicant was up to 1.52, its highest level since 1973. This labour shortfall was one of the main issues raised by Japanese businesses in the Tankan survey.

However, Japan’s positive economic trends and labour shortfall are not yet translating into an acceleration in wages and inflation. Despite a significant increase in profits – up 60% between 2012 and 2017 – businesses are hesitating to increase wages and therefore their fixed costs due to the Japanese economy’s weak potential for growth. Illustrating this, the latest data show that wages for “regular” employees were up just 0.5% year-on-year in July. This weak level of wages is affecting inflation, which increased in August (0.7%), but is still well below the BoJ’s target of 2%. In addition, the increase in prices is linked almost exclusively to energy and food products, with core inflation coming in at just 0.2% in August. In this context, the BoJ has, in line with our expectations, kept its monetary policy unchanged following its meeting on 21 September. In addition, faced with weak inflationary pressures, it could once again put back its expected timeframe for inflation to return to its target at its next meeting on 31 October.  We still expect that the BoJ, among all central banks from developed countries, is likely to be the one that maintains a quantitative easing policy for longest. Furthermore, it should not raise its key rate in 2018. We therefore expect the Japanese yield curve to remain flat in 2018.

In this context, Prime Minister S. Abe has decided to call early elections for 22 October, more than one year ahead of the initial schedule. He has announced that he needs voters’ support for his new plan, which aims to use the revenue generated by the VAT hike planned for 2019 to support the creation of childcare centres and children’s education rather than repaying government debt. He also plans to revise article 9 of the Japanese constitution, which defines Japan’s pacifist role. On the one hand, this decision has been motivated by his progress in the polls, in a context marked by the geopolitical crisis with North Korea. On the other hand, S. Abe is looking to take advantage of the upheavals affecting the opposition, the Democratic Party. The continuation of the economic recovery, for the sixth consecutive quarter, could help Prime Minister S. Abe to convince voters that his economic policies - known as Abenomics - based on fiscal and monetary stimulus and structural reforms, have successfully improved their living conditions. However, the latest polls show a confidence rating of 28% for S. Abe’s Liberal Democratic Party, compared with 13% for the new party of his nearest rival, Y. Koike. This progress in the polls by Tokyo’s governor is expected to fuel the political uncertainty over the coming weeks and could weigh on the yen.

All things considered, the expansionist monetary policy maintained by the BoJ and this uncertainty could lead to a depreciation of the yen, which is expected to reach 114 against the dollar in the last quarter of 2017 and 115 in the second quarter of 2018.


Lisa Turk, Economiste, Etats-Unis et Matthias van den Heuvel, Economiste


Upturn, but persistent imbalances

  • After contracting in 2015 and 2016, economic activity is growing again in Russia and Brazil
  • Strong disinflation and the central banks’ accommodative monetary policies are expected to continue to support private consumption…
    …but there are persistent structural imbalances, limiting the prospects for a sustained acceleration in growth. The political risk is high, with the presidential elections in the pipeline for 2018

One of the key factors behind the upturn in growth for emerging countries over the past 12 months has been the improvement in economic activity in commodity-exporting countries. More specifically, according to our estimates, nearly 75% of the emerging acceleration is attributable to Brazil and Russia. After being in recession territory for the majority of 2015 and 2016, real annual growth for these economies is now positive, with 2.5% for Russia and 0.3% for Brazil in the second quarter of 2017.

Despite depressed investment…


 For both Russia and Brazil, the fixed capital investment component was badly affected during this recession phase. Moreover, it is still penalising Brazilian growth today, compounding the situation marked by structural underinvestment. Investment represents just 18% of Brazilian GDP – and 21% in Russia – and is one of the weakest levels in the emerging world, significantly lower than Asian economies such as Korea (29%), China (44%) or Indonesia (33%). One of the reasons for this situation is the fact that Brazil and Russia are heavily dependent on commodity production. The dependence of these countries’ exports on commodities has grown even stronger: the percentage of commodities within Brazil’s goods exports has increased from 26% in 2002 to 45%, while the percentage of oil exports for Russia has climbed from 52% to 63%, with the percentage of manufactured products falling. According to Dutch Disease theory, commodity-exporting economies tend to promote investment in this sector to the detriment of the rest of the economy, contributing to their deindustrialisation and underinvestment.

Industry’s weighting within the Brazilian economy has fallen, down from 23% of GDP before the 2002 commodities boom to 18% today. In Brazil, this structural underinvestment – which is also linked to the country’s weak savings rate and relatively unfavourable business environment for investment[1] – has been reflected since 2004 in a very high level of production capacity utilisation in industry, which has contributed to the country’s high inflation environment. The downturn in commodity prices that began in 2011 has discouraged investment in this sector, which explains this sector’s very negative contribution to growth for the past few years. The country moved into a recession in 2014, pushing down the production capacity utilisation rate, which is still at a low point today.

With this lower production capacity utilisation rate and the persistently uncertain political environment, we do not expect to see a significant improvement in the outlook for fixed investments in Brazil. In Russia, the 

investment cycle has picked up again, but this is partly linked to exceptional construction projects. The stabilisation of business profits – nearly 50% of fixed asset investments are funded with equity – and the relative stability of oil prices that we are forecasting for 2017 do not seem likely to support any long-term acceleration for investments in Russia.

 …private consumption is picking up again

In these two economies, private consumption has been affected since 2014 by the credit crunch, the strong level of inflation following the depreciation of the rouble and real, and the (geo)political instability that has put pressure on both consumer and investor confidence. Private consumption is picking up again in these two economies and is expected to continue to be the main pillar for growth over the coming quarters faced with what we expect to be moderate inflation, following the sharp slowdown from the last few quarters, and its positive impact on real wages. In August, headline inflation came to 2.5% for Brazil and 3.3% for Russia, two all-time lows, below the official target of 4% set by the central banks.

The prolonged recession affecting the Russian and Brazilian economies has led to an underutilisation of production capacity (negative output gap) and this situation can still be seen today. This factor is expected to keep the upside pressures on core inflation in check, enabling the central banks to continue with their key rate cut monetary policies over the coming months and to support the credit market. The continued rate cuts in Russia and Brazil, combined with the increase in the Fed Funds rate in the US, which we are forecasting for December 2017, could reduce the appeal of the yield spread for bond assets from these countries. Furthermore, even if these currencies are below their level according to the equilibrium effective exchange rate approach, a fresh outbreak of (geo)political risks could push them towards more depreciation, increasing imported inflation and forcing the central banks to deviate from their accommodative monetary policies.

Potential for growth is still limited…

Despite the economic upturn seen in these two economies, Russia and Brazil still have structural imbalances, limiting their potential for any significant, long-term acceleration in growth. In Russia, the dependence on oil – we estimate that a 10% change in the price per barrel would have an impact of around 1.0% on GDP growth –, the non-optimal redistribution of oil revenues and the weak demographics are limiting the country’s level of potential growth that is around 1.0-1.5% according to the OECD and our estimates. Over time, Russian growth is therefore expected to align itself with this level, indicating that the second quarter’s acceleration in growth to 2.5% is more a catch-up phenomenon than a long-term upturn in activity. The downturn in industrial production and leading manufacturing indicators in Russia seems to support this scenario for a normalisation of growth. The Brazilian economy is expected to continue with its slow convergence towards its potential growth, which we estimate at 1.5-2%, in 2018.

More specifically, in Brazil, real annual growth moved back into positive territory at the start of 2017, supported by the upturn in private consumption and net exports. While the last few quarters have been turbulent, with D. Rousseff’s impeachment and the political developments surrounding the Temer administration, the Central Bank of Brazil’s credibility has improved. Maintaining a restrictive monetary policy despite the slowdown in growth has made it possible to bring domestic inflation down and anchor inflation expectations, while reassuring international investors, as shown by the real’s appreciation since 2016 and the stability of foreign direct investment. Following its sharp deceleration that began in 2016, inflation is expected to remain close to the central bank’s target due to the negative output gap and high unemployment affecting the Brazilian economy. The deterioration in the job market and the slowdown in nominal wage growth highlight the fragility of domestic demand. This is also reflected in net exports, with their positive contribution to growth linked primarily to the weak level of imports. These elements are set against a backdrop of significant political uncertainty and a deterioration in the country’s public accounts, which is likely to undermine confidence among consumers, industrial operators and investors. Although it has continued to increase since 2014, the Brazilian government has once again raised its primary fiscal deficit target, from 2.1% of GDP in 2017 and 1.8% in 2018 to 2.4% and 2.2%. Fiscal expenditure levels are still very high. Alongside this, the country has a nominal fiscal deficit representing 9.4% of GDP – one of the highest in the emerging world – while public debt has increased rapidly in the past few years, climbing from 52% of GDP in 2014 to almost 75% today. These developments highlight the need to continue with the fiscal consolidation process that began at the end of 2016 with the adoption of a law freezing real government spending for the next 20 years. The reform of the social security system – which represents 42% of government spending – is crucially important in this environment. However, in addition to facing resistance in Congress due to its unpopularity, it has seen various postponements on account of the political developments affecting the Temer administration. This reform is particularly necessary in a country that is characterised by an ageing population and one of the lowest retirement ages among all OECD countries. The upcoming elections in 2018 could result in this being put back again or a watered-down version being adopted, which would raise questions about the government’s ability to effectively manage its fiscal deficit, putting the country’s sovereign debt rating under pressure.

 …with a clear political risk

There is also a political risk for Russia: in August, the US approved and even reinforced the sanctions that had been put in place against it under the Obama administration. The presidential elections will be taking place in March 2018. In Brazil, the general elections in October 2018 are expected to see a political reshuffle. Indeed, the presidential elections will be accompanied by the renewal of the 513 members of the Chamber of Deputies and 54 of the 81 Senate members. The outcome of the elections is increasingly uncertain because Lula, the leading candidate in terms of voting intentions for the first round, has been named in the political scandals from the past few months. Between now and then, the political uncertainty looks set to continue. The current president, M. Temer, faced a fresh indictment at the end of September for obstructing the course of justice and participating in a criminal organisation.

[1] Brazil is ranked 123rd in the World Bank's "Doing Business" index, while Russia is 40th.


François Léonet, Economist, Emerging Markets