Outlook for Exit Strategies of Major Industrialized Countries
Koo, Bon-Kwan, SERI Quarterly
timing of exit strategy, post-economic crisis, emergency measures, fiscal stimulus, Federal Reserve, stimulus package
Amid growing expectations for an economic rebound, debate over the timing of an exit from the emergency measures implemented to overcome the latest crisis is flaring up. Views are divided into two campsi One focuses on the side-effects of prolonged use of the extraordinary measures. The other is concerned with the possibility of a double dip recession if the exit is too hasty.
In practice, major countries have already begun removing or withdrawing some of the peripheral emergency measures depending on their remaining usefulness. Nevertheless, they are taking a cautious approach in determining when to carry out aggressive exit strategies including hiking interest rates, wary of possible negative repercussions on their economies. Given such considerations, major industrialized countries (US, EU and Japan) are unlikely to embark on exit strategies in earnest until the second half of 2010 at the earliest.
NECESSITY AND SIGNIFICANCE OF EXIT STRATEGY
Discussion of Exit Strategy Heating Up
The global economic crisis, ignited by the worldwide financial crisis, is now easing, although the degree of progress differs among nations, depending on their situations. Among the largest economies China rebounded first in the first quarter of 2009, followed by Japan, which achieved positive growth of 2.3 percent in the second quarter, one step ahead of the US and EU industrialized countries. The US posted a 1 percent annualized GDP decline in the second quarter, a sharp improvement from the 6.4 percent drop in the first quarter, raising expectations that it could return to positive growth in the third quarter or soon thereafter. Backed by the positive upswings in Germany and France, expectations also are growing that the euro area could start recovering starting the third quarter.
The main reason that the economic crisis, considered the worst since the Great Depression, is showing signs of turning within a relatively short time is that major countries responded swiftly, fully recognizing the seriousness of the problem. For example, economic stimulus packages unveiled from the second half of 2008 to the first quarter of 2009 by about fifty countries totaled approximately US$3 trillion.1 This is a massive effort, equivalent to about 4.9 percent of the world's 2008 GDR The central banks of major countries also adopted a variety of aggressive financial support measures, including interest rate cuts and quantitative easing, to keep pace with the fiscal stimulus.
Without doubt, such measures were decisive in enabling an early recovery from the crisis. However, some of the extraordinary measures could bring serious side-effects if they are prolonged. On top of ultra-low interest rate policies, for example, governments and central banks supplied essentially an unlimited amount of funds to financial institutions and private companies by taking their assets as collateral for security. If this approach is protracted, it could lead to excessive liquidity and, eventually, cause a surge in inflation or disrupt the functioning of markets. The expansion of fiscal spending also could lead to the deterioration of fiscal balance and accumulation of government debt. If this results in an increase in issuance of government bonds and a hike in longterm interest rates, it could increase the cost of national debt and deteriorate the fiscal balance, thereby increasing the risk of national defaults.
Against this backdrop, the debate over the timing of exit strategies is heating up.: Some claim that as expectations are building about recovery, even though the crisis is in some sense still ongoing, an exit strategy should be executed promptly to preempt the side-effects from the emergency measures. Central banks and governments of major countries, however, are taking a prudent approach amid concerns that a hasty execution of exit strategies could lead to a double dip in which the economy slides back into negative territory after short-lived positive growth.
THE IMPORTANCE OF TIMING THE EXIT STRATEGY
History teaches that the timing of an exit strategy is crucial. If it is too hasty, it can bring a recovering economy back into recession. If it is too late, it can produce side effects that are difficult to overcome. Such occurrences are not all that rare in history.
First, there are some cases where hasty execution of an exit strategy triggered a relapse in a recovering economy. A good example is Japan's consumption tax hike in April 1997. It was imposed when the government misjudged and thought the Japanese economy had escaped the crisis. Even though the Japanese financial system had not healed from the collapse of the nation's 1990s bubble (the non-performing bond problem remained unresolved), the Hashimoto administration regarded the positive economic signs as indications that the crisis had ended. Therefore, the consumption tax was raised in April 1997, and the basic stance on fiscal policy turned toward retrenchment. Consequently, as the economic growth tumbled and financial defaults spread in the second quarter of 1997, Japan slid into a fullfledged financial crisis wherein Yamaichi Securities went bankrupt in November.
Another example was ending Japan's zero interest rate in August 2000. As the economy showed signs of recovery, the Bank of Japan (BOJ), which had lowered its rate to an unprecedented zero percent, lifted the policy to get back to a normal interest rate track, despite government opposition. The move resulted in another economic downturn.
The US belt-tightening policy under President Franklin D. Roosevelt's administration also yielded similar results. The Roosevelt government, which successfully dealt with the Great Depression in 1929, was buoyed by recovery in the economy and stock market in 1934-1936. To offset ballooning fiscal deficits caused by the New Deal policies, the Roosevelt administration imposed a tax increase in 1937 and tightened fiscal and financial policies. This, however, tipped the economy into a recession in 1 937 with stock prices plummeting and economic growth returning to negative territory.
In contrast to these examples, the prolonged implementation of Japan's ultra-low interest rate policy during the 1980s is a good example of an exit strategy that was too late and produced side effects that were difficult to cure. The Japanese economy, which had plunged into a deep recession due to the Plaza Accord in September 1985, started rebounding in the fourth quarter of 1987 on the back of financial easing measures, including lower interest rates. Due to concerns about a possible double-dip recession, the BOJ left the ultra-low interest rate unchanged at 2.5 percent for more than two years, until April 1989. By then, excessive liquidity had found its way into speculative property investments and stocks, creating an unprecedented asset bubble. The bubble soon burst, plunging the Japanese economy into a decade-long recession.
The lessons from the past explain why major governments and central banks today are taking a prudent approach to the timing of an exit strategy despite growing voices urging action.
PROSPECTS FOR EXIT STRATEGIES OF MAJOR COUNTRIES
This section takes a look at the current state of exit strategies in major industrialized countries and prospects for future implementation.
The United States
The US, the epicenter of the global financial crisis, used all possible fiscal and financial instruments to escape from it. On the fiscal side, the US has been implementing US$787 billion-worth of stimulus measures since February 2009. The Federal Reserve Bank (Fed),' virtually adopted a zero interest policy by December 2008 and pursued a quantitative easing policy (including a plan to purchase US$300 billion-worth of government bonds) to enhance the effectiveness of the monetary policy despite the zero interest rate. This marked a departure from traditional monetary policy centering on interest rate adjustment. In addition, the US also introduced liquidity supply programs and supplied more liquidity not only to financial institutions but to households and the private sector.
Such fiscal and financial policies contributed greatly to slowing down the downturn in the real economy and stabilizing the financial market. However, the expansion of the fiscal stimulus package led to a sharp deterioration in the US fiscal balance sheet and made a surge in government debt unavoidable. The increased issuance of government bonds heightened risk of a spike in long-term interest rates and raised concerns about rollover of government debt. In addition, a variety of liquidity supply programs that the Fed introduced has sharply expanded the monetary base.5 For now, the monetary expansion is limited to an increase in monetary base, as financial institutions remain reluctant to expand credit and thus keep the increased liquidity as reserve deposits at the central bank. However, once the credit crunch eases, it could prompt a leap in M2, leading to inflation and an asset bubble. Plus, the possibility cannot be ruled out that the increase in dollar supply could weaken the value of the greenback, which in turn could lead to an exodus of international capital and higher raw material prices.
Given such obvious risks, a partial exit strategy is already being implemented in the US, even as the debate continues between those who argue that it is time to withdraw the measures and those who declare "not yet." The amount of banks' reserve deposits fell to US$800 billion in mid- August from over US$900 billion in May, reflecting the Fed's partial withdrawal of liquidity support for financial institutions. When extending the duration of the liquidity programs, the Fed reduced the scale of some programs (e.g., the lowering of ceiling for TAF bidding to US$125 billion from US$150 billion). This can be interpreted as a part of an exit strategy.
Conditions, however, are not yet in place for fullscale implementation of exit strategies. Despite improvement in some real economy indicators, the unemployment rate" is likely to remain high for the time being, with the economic recovery likely to maintain a slow and steady pace. Financial institutions continue de-leveraging and shun credit supply by tightening loan-screening standards. Consumer prices are still declining compared to 2008, while inflation expectation is running lower than the Fed's target inflation rate. The capacity utilization rate stood at 69.6 percent (66.6 percent for the manufacturing sector) as of August 2009, indicating a large supply-demand gap and low inflation pressure. Given these considerations, the pressure for early implementation of exit strategies is not that high.
The time to implement the US exit strategy in earnest will be when these conditions turn around - after private-led economic growth is realized, financial institutions begin to provide new credit and inflation pressure becomes visible. With this in mind, the US is unlikely to aggressively implement an exit strategy including rate hikes until the second half of 2010 at the earliest.
The EU, like the US, injected significant stimuli to its flagging economy, adopting euro200 billion-worth of measures in tandem with an expansionary monetary policy through a variety of means, including rescue financing, interest rate cuts, and quantitative easing, all aimed at escaping from the economic and financial crisis. As a way to promote quantitative easing, the EU employed two instruments - a fixed rate-based capital supply operation (a method of supplying the total amount of bidding, conducted since 2008) and a Covered Bond purchases (effective temporarily for one year from July 2009 to June 2010). At the same time, to run capital supply operations more smoothly, the EU expanded the list of qualified collaterals for the European Central Bank (ECB) and eased the credit rating requirements.8
Such economic stimulus packages and monetary easing policies played a positive role in preventing a deeper plunge in the real economy and stabilizing the financial market. However, the fiscal policy has widened fiscal deficits and could constrict the economic recovery. Given that the EU population depends more on social welfare benefits such as unemployment benefits than people in other parts of the world, they are very sensitive to fiscal deficits. Considering that an increase in fiscal deficits could lead to a reduction in social welfare benefits, it is possible that the increase in fiscal deficits may not spur consumption. This is one of the reasons why the EU is taking a passive approach to economic stimulus through fiscal spending. Given this, there is a possibility that, unlike in other countries or regions, the EU will implement an exit strategy for fiscal policy before that for monetary and financial policy.
The ECB would be in charge of an exit strategy for monetary policy, but an early implementation of an exit strategy would seem highly unlikely. Consumer price inflation remains negative, implying no upward pressure on consumer prices, and the pace of economic recovery is slower than in other regions. Another factor backing this assertion is that despite quantitative easing measures, the credit crunch continues in the EU, with corporate and household lending still stagnant.
In addition, it will not be easy for EU member countries to keep pace with each other in the implementation of their exit strategies since their rate of recovery and the degree of pressure on consumer prices differ. The probability is high that ECB's interest rate hike will come after the Fed's. This is because euro appreciation against the dollar has already hindered economic recovery in the euro area and the region is unlikely to want to add more fuel to the strengthening euro by raising interest rates earlier than the US.
The Japanese government mobilized about ?25 trillion of budget resources from August 2008 through March 2010 to combat the global recession.10 In addition, it introduced or expanded a variety of measures to facilitate the supply of liquidity to the corporate sector, including the emergency guarantee system, the "safety net loan system," and the crisis response loan system. In step with government policies, BOJ cut the policy interest rate and supplied liquidity to the market through quantitative easing measures.
Backed by these policies, the Japanese economy returned to positive growth in the second quarter of 2009, and the extension of loans by financial institutions has maintained a slight but steady rise. Plus, commercial paper (CP) interest rates have also stabilized with the amount of corporate bond issuance increasing steadily, suggesting a great improvement in corporate fund-raising environment and a stabilization of the financial system. The increase in the government's fiscal spending, however, has further worsened the government's already-weak fiscal situation. This resulted in an increase in the issuance of government bonds, raising the possibility for an increase in long-term interest rates and further deterioration of the government's balance sheets. Being aware of this risk, Japan's Liberal Democratic Party (LDP) presented medium-term plans to attain fiscal soundness. This, however, has become meaningless as the LDP lost its control of parliament. Considering that the newly-elected Democratic Party under Yukio Hatoyama has not yet established a concrete fiscal soundness plan, an exit strategy for the fiscal sector is unlikely to be implemented for the time being.
As suggested by the remark of BOJ Governor Masaaki Shirakawa, "When introducing extraordinary measures, every central bank agonizes over how to end them," the BOJ likely implemented the quantitative easing policy while keeping an eye on an exit strategy. The BOJ placed a time limit on most of emergency measures and thereafter adjusted the date of expiry as and when necessary. Even when implementing the quantitative easing since September 2008, the BOJ aimed at keeping the growth of overall money supply stable and steady. These corroborate the assertion that the BOJ made an effort to keep an eye on the exit.
In view of the fact that the size of the central bank' s government bond and CP repo operations as well as the size of CP purchases are declining at a rapid pace, Japan can be seen as implementing the crisis response strategy along with a partial exit strategy at the same time. The time-limited crisis response measures will be automatically terminated once their necessity becomes less apparent. The government's financial measures, particularly those related to corporate financial support, will also be carried out on a time-limited basis,
Japan's exit strategy is likely to come in full force after 201 1, one step later than in other major countries in Europe and the US. First, this reflects the fact that there will be no inflation concern arising from excessive liquidity, at least for the time being in Japan. Indeed, Japan is likely to face deflation rather than inflation due to the output gap that is now estimated at around 8 percent of GDP. Second, the painful scars brought by hasty implementation of exit strategies in the past will give pause to an exit strategy until the BOJ is confident that the economy is on a path to sustainable recovery. However, there is a possibility that the timing of an exit strategy could be brought forward if global inflation concerns make international cooperation more imperative. This, however, would be a very exceptional case.
Considering past failures in implementing exit strategies and the situation prevailing in the major industrialized countries at present, exit strategies, despite their necessity, are likely to be implemented cautiously and prudently. In the G20 Meeting of Finance Ministers and Central Bank Governors held in September, the US Treasury Secretary Timothy Geithner said, "Traditional errors committed in past in times of economic crisis were that the governments responded to the crisis too late with insufficient policies and applied the brakes too early. We should never repeat these mistakes again." This indicates that the timing of exit strategies will be determined very prudently.
Even when being carried out, exit strategies will be implemented on a step-by-step basis according to the situation facing each measure, rather than abruptly all at once. Witness the fact that major countries are already partially implementing exit strategies in the financial sector. From this perspective, exit strategies can be divided into passive and active categories as shown in the following table.
From this viewpoint, a full-fledged exit strategy, including the absorption of liquidity and hike in interest rates, is likely to come in the second half of 2010 at the earliest. This forecast is based on the fact that even if the economy turns upward, it will take several quarters for the economy to gain momentum through autonomous growth by private consumption and investment, rather than through fiscal spending. Another factor behind this forecast is that it may also take some time before consumer price pressure surfaces.
Moreover, considering that major countries are likely to place a higher priority on economic recovery than fiscal soundness for the time being, full-fledged exit strategies for the fiscal sector will come only after 201 1 at the earliest.
Without a doubt, the necessity of an exit strategy cannot be overemphasized. However, if excessive emphasis leads to misjudgment by governments or central banks, it could drive the world eeonomy, which is now bottoming out from the worst recession in 100 years, back into a double dip. Such a scenario must be avoided. To this end, international cooperation should be promoted further, if necessary. In this light, an exit strategy will remain as one of the world's central issues of discussion into the first half of 2010.
Posts-Crisis and Exit Strategies
The world's economies are starting to recover from the economic crisis that began in 2007. As they do so, the debates on when and how to withdraw stimulus measures and what the post-crisis picture will be are gaining intensity and momentum. Perhaps East Asia, which is at the head of the pack coming out of the crisis, provides the ideal subject for such debate.
The increase in the government's fiscal spending, however, has worsened the government's alreadyweak fiscal situation.
Now that signs of recovery are sprouting a year after the global financial meltdown, debate is percolating over when to exit rescue policies. As history has shown, timing is crucial. Being too early or too late threatens another downturn or a burst of inflation. Fledged exit strategy measures such as the absorption of liquidity and interest rate hikes are likely to come in the second half of 2010 at the earliest in carefully measured steps. The US and EU will likely precede Japan.
1 This is a simple sum of the figures revealed by the governments of major countries, including the US' US$787 billion, the EU's euro200 billion, Japan's ?7.5 trillion (excluding ?5.6 trillion released on April 10, 2009), and China's CNY5.6 trillion (including CNY4 trillion for infrastructure investment, plus a variety of tax cuts and subsidies). In some cases, it could contain the numbers of the plans that were slated already for 2009 and 2010. Japan's plans in particular, contain the figures of non-fiscal measures. Given these, there is a substantial gap between the figures released by major governments and the actual amount of fiscal spending.
2 The exit strategy herein refers to the measure of removing a variety of emergency and extraordinary policies taken to overcome the financial and economic crisis after the Lehman Brothers collapse in September 2008 and getting them back to normal polices.
3 The FRB started lowering sharply the policy interest rate (the target rate for the federal fund) beginning in mid-2007. The central bank has virtually adopted a zero interest rate policy by cutting it to 0 to 0.25 percent on December 16, 2008.
4 The White House Office of Management and Budget predicted that US government debts will shoot up to US$23.3 trillion in 2019 from US$10 trillion in 2008, with its share in GDP rising from 70.2 to 101.9 percent.
5 The monetary base doubled to US$1.6662 billion in July 2009 from US$832.4 billion in June 2008.
6 After surging to 9.4 percent in July 2009, the jobless rate will likely exceed 10 percent in early 2010. A fast turnaround is unlikely in 2010.
7 The scope extended from euro-denominated securities issued in euro regions, towards dollar/pound/yen-denominated securities, euro-denominated syndicate bonds issued under the UK law, and payment guarantee subordinated bonds.
8 The limits on the credit rating of the collaterals are eased to "over BBB-" from "over A-."
9 The primary reason behind this is the Growth and Stability Pact of the EU that limits the expansion of public debts and fiscal deficits.
10 Although the economic stimulus packages released by the Japanese government amounted to roughly ?132 trillion, the actual amount of fiscal measures is estimated at about ¥25 trillion.
KOO Bon-Kwan is a research fellow at SERI. His current research focuses on Japanese Economy and Japanese Industry Structure. He holds a PhD in Business Administration from Sung Kyun Kwan University. Contact: email@example.com…
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Publication information: Article title: Outlook for Exit Strategies of Major Industrialized Countries. Contributors: Koo, Bon-Kwan - Author. Magazine title: SERI Quarterly. Volume: 2. Issue: 4 Publication date: October 2009. Page number: 13+. © Not available. Provided by ProQuest LLC. All Rights Reserved.
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