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  • Can We Use the Shiller CAPE Ratio to Forecast Country Returns? by Rich Shaner, CFA

    Originally written on Alpha Architect. Read Here Utilizing an Amended CAPE Ratio to Derive a Country’s Expected Return and Develop Portfolio Rotation Between Countries Sailesh S. Radha Journal of Portfolio Management A version of this paper can be found here Want to read our summaries of academic finance papers? Check out our Academic Research Insight category What are the research questions? We all became relatively aware of the CAPE ratio when Shiller predicted the 2000 internet bubble in his book “Irrational Exuberance,” then after he added a touch of robustness when he called the 2007 housing crisis(1) we all became intimately aware of it. Historically, the CAPE ratio, Shiller’s PE, has primarily be utilized over long periods of time and has expressed valuations as being undervalued, overvalued, or fairly valued. Similar to the paper previously covered by Tommi Johnson, Ph.D., in which CAPE is adapted to improve U.S. stock return forecasts, the author of this paper seeks to explore ways to sharpen the blade of the CAPE ratio to derive expected returns for countries in the MSCI Ex. USA World Index utilizing a measurement he calls, “Medium-Term Country Yield Forecasts” (CY-M). The research questions are as follows: Can we utilize CAPE with supplemental measurements to develop a yield forecast measure for the medium term? Can the Medium Term Country Yield Forecast be utilized to screen and rank countries to construct an international country rotation portfolio? What are the academic insights? Utilizing data from the MSCI All Countries World Index ex. USA (ACWX) for the periods 1969 though 2016 the author finds the following: YES, CAPE can be utilized as a medium-term yield forecast tool by amending and improving the metric via the addition of the country’s cyclically adjusted real exchange rate (RER 10)(2) with a country’s trailing five-year momentum. By combining these measurements with inverse CAPE (1/CAPE) the author developed what he calls the “Medium-Term Country Yield Forecast.” (CY-M)(3) YES, when ranking countries in quintiles by CY-M(4) over a 38 year period stretching from January 1980 through December 2017 the spread in the alpha between the top and the bottom quintile is an average of 14.30% annually. Why does it matter? CAPE was initially developed for the US Equity Market and has been widely utilized in various markets outside the United States as well. In the adapted CAPE ratio the author has developed, CAPE is utilized to garner an expected yield of foreign countries and is suited for analyzing medium-term (2-10 year) international investing opportunities. Typically international investing and choosing countries to invest in thas been complex and challenging for small and medium-sized investors. Because of this complexity managers have been turning to single country ETF’s to garner exposure to international markets. By utilizing the CY-M ranking system investment managers have a guide that they can utilize to effectively select which countries to invest in and have annual rebalance guidelines for where to effectively allocate capital in the MSCI World index countries. The author has also developed extremely helpful interactive charts of CY-M and images for you to utilize here. The most important chart from the paper: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Abstract The cyclically adjusted price-to-earnings ratio (CAPE), though originally derived for the US equity market, has now been calculated for various national equity markets outside the United States. In all its various adaptations, the measure has been used only to express valuations of those markets in terms of being overvalued, undervalued, or fairly valued. None of the adaptations of the measure have been used to derive finite equity return expectations from those markets. This article explores the approach of applying CAPE to develop a computable forecast measure, called the medium-term country yield forecast (CY-M), to express the medium-term real return expectations of national equity markets. In almost all of its past adaptations, CAPE has mostly been used to express only long-term (periods greater than 10 years) valuations of the equity markets, but the author here has explored its application in the medium term (periods between 2 and 10 years). Drawing conclusions from empirical studies on countries in the MSCI All Countries World Index ex. USA (ACWX) for the period 1969 through 2016, the author has amended the CAPE of a national equity market by coalescing it with the cyclically adjusted real exchange rate (computed in the same manner as CAPE) of the country and the long-term price return momentum (adjusted for inflation) of the market. The author also has applied CY-M derived from the adapted CAPE as a comparative measure to screen and rank countries in the ACWX to construct an international country rotation equity portfolio.

  • Medium-Term Country Yield Forecast (CY-M): A Smart Valuation Measure to Evaluate Countries

    Originally written on ETF TRENDS. Read Here Lack of A Valuation Metric to Evaluate Countries for the Medium Term To express forward-looking equity outlooks of individual countries using top-down valuation methods, managers and analysts alike use, apart from macroeconomic factors, the same fundamental metrics they use to screen individual stocks like the price-to-earnings ratio, the price-to sales ratio, the dividend yield, and the enterprise-value-to-EBITDA ratio, to name a few. Most of the outlooks derived from these metrics give investors a glimpse of how the country equity markets may perform in the short-term. However, there is definitely a lack of a unified metric that expresses the medium-term (three to eight years’ time frame) return expectations of a country equity market and that can be an addition to the toolbox for screening countries for country allocation while developing an international equity portfolio. Unified? Unified in the sense the metric should capture both the valuation of a country and its price return momentum. Modifying CAPE (or Shiller’s PE) to Develop a New Country Yield Forecast Measure CY-M In order to develop this unified metric, a yield forecast measure, which we call medium-term country yield forecast (CY-M), we explored many models to adapt CAPE (popularly known as Shiller’s PE) in order to derive the medium-term real returns expectations of national equity markets underlying the MSCI All Country World Index ex. USA (ACWX). CAPE, though originally derived for the US equity market, has now been calculated for various national equity markets, and in all its variations, the measure has been used only to express the valuations of those markets in terms of overvalued, undervalued, or fairly valued. However, none of those adaptations of the measure have been used to derive a finite equity return expectations of those markets. In almost all of its adaptations, CAPE has mostly been used to express only long-term (greater than 10 years) return expectations of the equity markets, but in our models, we have explored its application in expressing the medium term (between two and 10 years) return expectations. How to Develop the New Country Valuation Metric CY-M? While exploring the various models to develop CY-M, using a modified version of CAPE, we undertook an empirical study of the national equity markets underlying ACWX for the period 1969 thru 2017. In doing so, we identified various measures that could be coalesced into CAPE. In our empirical analysis and modeling, we departed from the usual price-multiple expression of CAPE by inverting the CAPE of each national market to its yield expression form, called inverse CAPE ( INV.CAPE), as the latter is more intuitive for investors to grasp. Why? It’s easier to explain a negative yield than a negative PE. In our analysis, we used rolling forward real (adjusted for inflation) returns over two-year through nine-year time horizons, all expressed in compound annual growth rate (CAGR) basis. Cyclically Adjusted Real Exchange Rate Among the measures we identified that could coalesce into CAPE, we found cyclically adjusted real exchange rate (RER 10) and trailing five-year price return momentum of national markets to have significant influence over their forward returns. The rationale for using the real exchange rate is intuitive – export-oriented economies depend on the relative price of export goods and services in the international market. The relative price of an exported good or service is a function of its native price and the exporting country’s nominal exchange rate, inflation level, and its long-run productivity. The real exchange rate, which encapsulates these factors into a single measure, is therefore potentially, albeit indirectly, the major driver of medium-term earnings of national equity markets. Five-Year Price Return Momentum The inspiration to coalesce trailing five-year price return momentum (5-YR MoM) with CAPE is based on findings put forth by DeBondt and Thaler in the paper “Does the stock market overreact?” In this paper, DeBondt and Thaler examined the future returns of past long-term outperforming and under-performing US stocks, where the out-performers and under-performers are measured using look-back windows ranging from three to five years, and concluded that performance of underperformers exceeds that of the outperformers. Zaremba explored the same idea with national equity markets in his paper “Investor Sentiment, Limits on Arbitrage, and the Performance of Cross-country Stock Market Anomalies.”, and he discovered that the phenomenon of long-term return reversal could be employed at the country level as well. S-CAPE (Smart CAPE) Good Predictor of CY-M Statistical analysis of the forward returns of countries underlying ACWX across the selected periods and their respective measures – INV. CAPE, RER 10, and 5-YR MoM – reveals that by blending RER 10 and 5-YR MoM with INV.CAPE we can define a smarter version of CAPE, called S-CAPE (Smart CAPE), which we discovered is a sound, robust measure that captures the medium-term returns expectations of any country outside the US. The analysis also discloses SCAPE, the modified version of CAPE, is reasonably a very good predictor of CY-M, the expected annual real equity returns (on a CAGR basis) over successive eight years, for all countries, both developed and emerging, in the index. Back-testing of international country rotation portfolios developed by selecting countries with high CY-Ms have yielded higher risk-adjusted alpha. The Plot of CY-M for Japan Let us look at Exhibit 1, which plots the trend of Japan’s CY-M over time. Along the bottom of the chart, the time periods advance on a monthly basis and the dates reflect the starting points of eight-year forecast time horizons, while the dates along the top reflect their respective endpoints. The vertical grid lines in the chart link together the ends of forecast horizon periods. Any point on the line chart is the compound average annual real return forecast for the succeeding eight years starting from the date listed on the bottom of the grid line and ending on the date listed on the top of the grid line. For example, as you can read from the exhibit, at the end of January 2018, CY-M for Japan is 9.57%, which means for the period starting from the end of January 2018 thru the end of January 2026, the expected real returns from the Japanese equity market is 9.57%. To summarize, this chart depicts the rolling forward compounded average annual equity-performance expectations (across eight-year intervals) of Japan on an inflation-adjusted basis, giving the investors a broad strategic cue on how to allocate to Japan in their international equity portfolios. This illustrative outline helps us understand how to frame equity expectations through CY-M at the country level. Exhibit 1: Medium-term country yield forecast (CY-M), Japan Source: BGA calculations, MSCI, and IMF. Notes: Data runs through January, 2018. The vertical lines indicate the forecast horizons, starting from the dates listed on the bottom x-axis and ending on the dates listed on the top x-axis. The country yield forecast model used is as of end of July, 2018. Country Rankings Here is the latest list of top two quintile countries ranked by CY-M: Quintile 1 Argentina, Colombia, Finland, Peru, Egypt, Indonesia, Spain, Japan, Israel, Czech Republic Quintile 2 Thailand, Malaysia, Austria, France, Sweden, Morocco, Turkey, Italy, Denmark For further details, visit the following Dashboard: Publications: A Yield Measure for Country Selection in the Medium Term Using Shiller’s PE A Global Country Allocation Framework: A New Paradigm for Constructing an International Fund-of-Funds ETF International Equity Investing: What is the best measure for country selection in the medium term?

  • Demography is Destiny – Part I

    With the world population having reached approximately seven billion, and continuing to grow about 79 million people each year,most of the growth in the recent years almost exclusively have been taking place in the less developed countries, which include the least developed, in Africa and Asia.[1] Out of the 48 least developed countries in the world, 33 of them are located in sub-Saharan Africa. According to UN estimates, by the year 2050, the number of people in sub-Saharan Africa may double and by the end of the century it may quadruple.[2] The estimates project population in sub-Saharan Africa to peak at around 1.6 billion, accounting for about 19% of the world population, in 2030 (see figures 1 & 2).[3]That projection puts sub-Saharan Africa way below Asia at 58% of the world population in 2030, but definitely higher than South America at 8% and rest of the world (see Figure 1 & Figure 2).[4] With the increasing presence of African population in the world demographic scene, Africa can potentially provide, investors world-wide, opportunities in the years to come to partake in its economic growth, if and when it takes off, and that growth shall derive its strength, at least to begin with, from its human capital progress. In the rest of this chapter, we’ll discuss in detail principles, analysis and the thesis that could be used by investment professionals – money managers, investment bankers, financial analysts and others – to dissect the demographic trends in Africa to arrive at a narrative– a narrative that will tell us what nations/regions in Africa have the potential, or not, to be the next generation of BRICs, the group of nations that have captivated investors around the world in the last two decades with a feel-good growth story, or to be the next East Asian growth miracle that peppered the few decades since World War II. Of course, there are those factors apart from demographics that need to be taken in to consideration before investment decisions are made, and those factors would be covered in detail in the remaining chapters of the book. Population vs. Development Relationship In the recent decades, discerning the relationship between population change and economic growth has become essential to explain the miraculous growth episode seen in East Asia from the 1950s to the early 1990s, and also that seen in Brazil, China and India the last two decades. But, the relationship has remained a subject of debate among economists and demographers for centuries. Till the turn of the century, the effects of population size and growth on economic development were at the heart of that raging debate. However, since the late eighties, age structure of the population has been thrown into the mix because of its proficiency in explaining recent growth episodes in East Asia. Age structure of the population is the distribution of the population across various age groups (see Figure 3). Prior to the age structure model becoming part of the debate, the opinion amongst demographers and economists were divided, and they were classified as Pessimistic Theory, Optimistic Theory, or Neutralist Theory. The pessimists, who traced their roots back to Thomas Malthus’s alarmist doctrines, held the opinion that population growth impedes economic development due to excessive burden placed on fixed resources and reductions in capital per worker and lower living standards. In the 18thcentury, Malthus theorized that in a world with fixed resources and weak technology progress would lead to insufficient food production leading to famine and starvation deaths. Even though those prognostications failed to come to pass, they remained very much in the debate till a few decades ago. However, during the last four decades or more the world’s population has more than doubled and yet the average per capita incomes have increased by more than two-thirds.[5]This cognizance led to the decline of pessimists, giving way to the so-called optimists. Optimists like economist Simon Kuznets and others while refuting the ideas of the pessimists believed that population growth is an economic asset, and it aids economic growth through increased stock of human innovation and gains from economies of scale. Julian Simon, an optimist, in his landmark book – The Ultimate Resources – revealed that growing demands of rising population on natural resources encourages technological progress resulting in the decline of their prices for the long-term. The Optimistic Theory gives more importance to technological progress and human capital progress than to physical and natural capital. The theory, while propounding the positive effects of population growth, also suggests that apart from population growth, there could have been multiple external factors in play for the consequences of population growth.[6] To summarize, Optimistic Theory debunks the Pessimistic Theory by asserting that population indeed adds pressure on fixed resources, but people are so resourceful and resilient that they tend to innovate under adversity.[7] Econometric analyses from numerous cross-country studies have revealed that when controlling for factors like country size, openness to trade, educational attainment, and quality of civil and political institutions, there is little evidence that population growth impedes or promotes economic growth, thereby supporting a neutralist view.[8] In other words, after controlling for the factors, the negative correlation between economic growth and population growth, as outlined by the Pessimistic Theory, disappears. Neutralist Theory has been the dominant view since the 1980s, and in line with that view, the policy makers has accorded population size and growth a marginalized position in national policy settings.[9]There are wide-ranging opinions amongst neutralist school of thought. While National Academy of Sciences (NAS) concluded in 1986 that “… slower population growth would be beneficial to economic development of most developing countries”, and whereas World Bank economist William Easterly suggested in his book – The Elusive Quest for Growth: Economists’ Adventures and Misadventures in the Tropics – that in some countries bigger populations can boost economic growth. Both Neutralist and Optimistic Theories take a broad approach on the relationship between population and development arguing that there is multitude of population-related factors that can have both positive and negative impacts on development.[10] The three views stated above had discounted the evolving age structure of a population, and which, as stated earlier is arguably as important as population. [1] Lilli Sippel et al., Africa’s Demographic Challenges (Berlin: Berlin Institute for Population Development, 2011), 6. [2] Ibid., 6. [3] Ibid., 6. [4] Ibid., 6. [5] David E Bloom David Canning and J. Sevilla, The Demographic Dividend: a New Perspective on the Economic Consequences of Population Change (Santa Monica: Rand Corporation, 2003), 15. [6] Ibid., 16. [7] M. Kummu, M. Keskinen and O. Varis, Modern Myths of the Mekong (Helsinki: Helsinki University of Technology, 2008), 108. [8] David E Bloom David Canning and J. Sevilla, The Demographic Dividend: a New Perspective on the Economic Consequences of Population Change (Santa Monica: Rand Corporation, 2003), 17. [9] Ibid., 18. [10] Ibid., 16. Figure: 1 Figure: 2 Figure: 3

  • China: Deciphering Fiscal Revenue

    This blog post was originally published on Seeking Alpha by Sailesh S. Radha on October 29, 2012 There have been lot of questions raised over the years about the quality of economic data coming out of China in terms of reliability of the data collection methods, quality control, the statistical techniques it employs, data compatibility with the western methodologies and reporting systems, government influence in data reporting, and the reporting standards. Many of those questions may be legitimate, and some may be due to the misconception the rest of the world has about China, arising primarily from its opaqueness to the rest of the world. Moreover, the Chinese government manages its messages very tightly in order to advance its political legitimacy in the eyes of the Chinese people and the rest of the world. On July 26, Wall Street Guru Dr. Ed Yardeni of Yardeni Research Inc. in his morning briefing to his clients emphatically confirmed that the Chinese economy is in a significant slowdown based on some year-over-year analytical tax revenue charts IMRA had developed for Yardeni Research from the June fiscal report, Chinese Ministry of Finance released in early July. Here's what Dr. Yardeni said in his morning briefing: Recently, lots of doubts have been raised about the accuracy of official economic measures released by China's government. Debbie and I don't doubt that the quality of much of the data is questionable. We regularly update our China chart book and try to assess the big picture as best we can using all the available data as a whole. We are constantly on the lookout for more data to add to our chart book…. I recently asked our consultant, Sailesh Radha, to work on China's official tax revenues. He found the latest official release in Chinese and used Google's translation utility to read it…. The data were released by the Ministry of Finance on Tuesday of this week and outlined in a story appearing in the English version of The data confirm a significant slowdown in Chinese economic growth during the first half of this year: (1) Tax revenues rose only 9.8% y/y during H1-2012, down from 29.6% over the same period a year ago. Growth rates were down across all 11 major revenue sources. (2) Personal income taxes actually declined 8.0%. A year ago, they rose 35.4%. Corporate income taxes rose 17.3%, but that was down from 38.3% a year ago. (3) Revenues from property transactions took a hit. The ones from "Land Value Increment" rose 14.7% vs. 91.1% a year ago. "Deed" revenues fell 9.9% after rising 27.5% a year ago. Albeit he was right in his assessment of the economy, and was suspicious of the quality of data emanating from the Ministry of Finance, I believe that he jumped too quickly to his conclusion, which was based solely on the year-over-year analysis of the headline tax revenue and its major sources. The rest of this article examines the elucidations why analysts and strategists should be very cautious handling Chinese fiscal revenue data in their analysis, and in discerning the state of the Chinese economy using them. In illustrating the reasons, I would be using the recently released September report as well as the third-quarter's year-to-date report (a cumulative report covering the three quarters of this year) released by the Ministry of Finance to comprehend the various sources of the Chinese fiscal revenues as well as their taxation system. My experience in parsing the Chinese monthly fiscal reports on their Ministry of Finance (MOF) website has been harrowing so far primarily for the following reasons: a. The monthly fiscal reports show up only on the MOF's web-page in Chinese and you are at the mercy of the translation tools that web browsers provide (I used the chrome browser), as the translations are messy and half-baked. You will literally spend hours analyzing the translated reports to get the numbers for the various tax sources, and moreover, cross verification is impossible, as the media only reports the headline numbers and the numbers for some of the major tax-revenue sources. The Chinese National Bureau of Statistics only reports annual numbers for government finance, and not the monthly numbers. But, it would have been nice if it reported the monthly numbers because the bureau presents all its data in English and in a comprehensible tabular format. It also gives you an option to view all the data in Excel. b. The report that is released in March every year combines the numbers for January and February, and I am yet to ascertain the reason behind it and I believe it could be because of the extended Chinese New Year holidays in January. As a result, fiscal numbers for the month of January and February are not available on a standalone basis. In fact, if you go back few years, sometimes December values are missing for many of the tax-revenue sources. c. Of late they have begun to publish year-to-date reports every quarter, and sometimes that data is presented in a tabular format. In fact, you can look at the table at the end of latest year-to-date third-quarter report referred to earlier, even though the column headers as well as the name of the revenue sources are in Chinese. The norm is that data are reported by the MOF on an absolute basis as well as on a year-over-year basis for every month (barring January and February, as they are combined), and for some of the months, year-to-date reports are also published. For some revenue sources, year-over-year declines/increases from the prior year are also reported. In some of the reports, data relating to some revenue resources are never reported at all. So, the reports lack uniformity in presentation and content. As you can see from the reports, piecing together the fiscal revenue data to obtain the complete and a thorough picture is excruciating. The Chinese government employs the five-year plans to provide broad outlines of the fiscal policy stance that would be maintained in the following five years to achieve its economic objective in that time period. It uses tax reforms primarily to fine-tune tax policies enacted prior, to enhance the existing ones, to mobilize revenue, and to respond to new economic shocks. Ever since China started its market reforms and began opening its economy, a series of major watershed tax reforms were enacted in the eighties and in the early nineties. According to the Chinese Ministry of Finance, the series of reforms that began in the early eighties and ended sometime in the early nineties, focused on transitioning from a single tax system adopted in the traditional planning economy into a multi-category of taxes, multi-state and multi-level tax system, based on turnover tax and income tax and with mutually assorted other category of taxes. In 1994, the Chinese government again undertook a major tax reform with the aim of establishing the socialist market economy system through fair and just taxation by reforming the turnover taxes and income taxes. If you look at Fig. 1, since the 1994 tax reforms, tax revenue had rapidly increased in China at an average annual rate of 12.9% till 2006, with the annual growth rate of GDP in the corresponding period at 9.9%. As a result, tax revenue as percentage of GDP has grown steadily at an annual rate of 2.3% since the reforms. Since 1994, numerous tax reforms, structural tax reduction policies, and revenue mobilization programs have been undertaken as means of managing economic stability (see Table 3), including the major tax reforms that were undertaken since 2005 (Table 4 and Table 5). Numerous tax reduction programs and tax reforms were enacted as part of the fiscal stimulus to counter the global recession of 2008. With all those reforms, now the total number of taxes in China totals 19 (see Table 1). As of 2010, turnover tax revenues constituted 58.8% of the total tax revenues, income tax 26% and the rest 5.2% (see Fig. 2). As part of the 12th Five-year plan, many more tax reforms are envisaged (see Table 2). Table 1: Classification of Chinese Tax System Source: Ministry of Finance, People's Republic of China and IMF. Table 2: Current and Anticipated Major Tax Measures during the 12th Five-year Plan Source: Ministry of Finance, People's Republic of China and IMF. Table 3: Tax Incentives as a Fiscal Policy Tool to Manage Economic Shocks Source: Ministry of Finance, People's Republic of China and IMF. Table 4: Recent Major Structural Tax Reductions Source: Ministry of Finance, People's Republic of China and IMF. Table 5: Main Tax Reforms for Revenue Mobilization (since 2005) Source: Ministry of Finance, People's Republic of China and IMF. Now to the point of Dr. Yardeni's conclusion and his thought process - it is perilous to opine on the state of the Chinese economy based on year-over-year analysis of the headline tax revenue numbers and the major tax revenue sources alone, without ascertaining and analyzing the underlying fiscal dynamics that are transpiring within the economy. The primary reason being, China as you can see (from Tables 2, 3, 4 and 5), albeit a blue-chip emerging country, is in a constant state of flux on the fiscal front attributable to: reassessment of fiscal policy every five years through the five-year plans, constant tweaking and improvisation of the existing tax system through tax reforms, constant improvisation of tax collection systems, recent spate of tax-revenue mobilization programs and constant addition and withdrawal of tax incentives to counter new economic shocks. If you look at Fig. 3, the positive correlation between tax revenue as percentage of GDP and annual GDP growth rates, as was evidenced in the time period 1998 through 2006 (as see in Fig. 1), has been broken or does not exist anymore in the time period 2006 through third quarter of 2012. The economy so far is growing at an annual rate of 7.7% (based on the recent third-quarter GDP update); however, tax revenue is exhibiting higher growth rates and is currently around 22.7% of the GDP, compared with around 19% at the end of last year. The breakdown of this relationship alone underlines the need for analysts and strategists to do a thorough analysis of the fiscal report to make a confident judgment on the direction of the economy. Any judgment devoid of any such analysis is perilous to say the least. My point here is, considering the underlying fiscal fluidity, one has to thoroughly understand the premises behind the increase or decline of revenue from each individual tax source, before using them to determine the pulse of the economy. Let's review the latest September fiscal revenue report as well as the third-quarter report: 1. If you look at Fig. 4, total fiscal revenue rose ¥826 billion ($132.270 billion) in September, ¥40 billion more than in August, and ¥78 billion more than that recorded in September last year. Fiscal revenue as you all know is the sum of tax revenue and non-tax revenue. Non-tax revenue, which includes special program receipts, charge of administrative and institutional units, penalty receipts and others, posted a total of ¥147 billion in September, while tax revenue came in at ¥678 billion (see Fig. 5). 2. Fiscal revenue for the three quarters ending September 30, 2012, recorded an all-time high of 25.6% of the GDP, with the tax revenue recording an all-time high of 21.9% after a previous high of 19% of the GDP recorded at the end of 2011. Domestic VAT (5.4%), CIT (4.8%), business tax (3.3%), and import VAT and consumption tax (3.2%) round up the top spots among the various tax-revenue sources. For the same time-period cumulatively, non-tax revenue sized up at 3.7% of the GDP (See Fig. 6). The elevated growth of fiscal revenue and tax revenue (as discussed earlier) compared with the below-expectations GDP growth rate of 7.7% (saar) so far this year is very disconcerting. 3. When viewed on a year-over-year basis using Fig. 7, there were some sore spots in the September numbers - import VAT and consumption tax revenue recorded a decline of 5.3%, corporate income tax recorded a -11.1% and personal income tax, a decline of 5.7%. The decline in corporate income tax revenue is in line with the declining industrial profits as discussed here (and here). However, the decline in personal income tax revenue is a surprise for an economy growing at 7.7% (saar), but if you look closely at item number four in Table 4, threshold for IIT was raised to ¥3,500 from ¥2,500 on September, 2011. So, logically the numbers for September are influenced by that tax code change last year apart from the slowing economy. The most distinguishing aspect of that chart is the through-the-roof year-over-year growth of 52.8% recorded by non-tax revenue, which has driven the fiscal revenue to grow at an impressive 11.9% compared with the milder growth rate of 5.8% for the tax revenues. Export tax rebate (a form of subsidy) registered an impressive 36.2% growth, and is a good real-time indicator that tracks the Chinese exports. In September, business tax revenues registered an impressive growth of 26.5%. It indicates, after ascertaining that there were no changes in the tax code, the non-manufacturing sector is doing better than the manufacturing sector, whose VAT tax revenues posted a growth of measly 10.4%. The abnormal growth of non-tax revenue is also reflected again in Fig. 8, which records the quarter-over-quarter growth of the tax revenues and the fiscal revenues for the first three quarters of this year. The local governments, facing sluggish tax income due to the slowdown are looking for new sources of revenues to meet spending goals, and non-tax revenues with flexibility in assessment and supervision have become a major source of income. The decline of import VAT and consumption tax revenue by 5.3% signifies challenging economic conditions at home as well as abroad. We should not discount the fact the price levels are also declining - in September, CPI of China rose 1.9% compared to 2.8% for the same period last year. Tax revenues as you know are function of the tax base, which is also influenced by the price levels. Applying year-over-year analysis to data gleaned from the monthly as well as the quarterly fiscal report for smaller items like vehicle purchase tax, deeds (stamp tax), land appreciation tax, and other items listed in Table 1 under behavior taxes and resource taxes are definitely useful in gauging the strength of the various sectors in the economy - consumers, financial markets, property market, and the housing market. Barring vehicle purchase taxes, the rest of the small items are also known as "local small taxes." 4. Figures 9, 10, & 11 are year-over-year analysis charts derived from the year-to-date Chinese fiscal revenues report covering the first three quarters of this year. If you look at Fig. 9 and Fig. 10, all sources of revenue have posted a decline this year on a year-over-year basis compared to the same time-period last year. The year-to-date fiscal revenue has registered a year-over-year growth difference of -18.6% (see Fig. 8) compared to that from the same time-period last year, tax revenue (-18.8%), VAT (-12.9%), consumption tax (-6.9%), business tax (-11.9%), import VAT and consumption tax (-29.9%), CIT (-21.1%), IIT (-42.8%) and non-tax revenue (-19.3%). Personal income tax revenue with a growth difference of -42.8% is an outlier suggesting that a weaker economy as well as the structural tax reductions in the individual incomes taxes (discussed in Table 4) to promote income among low-income groups have acted as a double-whammy on the personal income tax revenue. Similar conclusions were drawn from the September report as well. Likewise, the growth difference of -21.1% for the corporate income tax revenue and -29.9% for import VAT and consumption tax revenue confirm slowdown of the manufacturing sector and the domestic economy respectively (including declining inflation), as was confirmed by the September numbers. The fiscal revenue has done better than the tax revenue for the first three quarters of this year, and that means non-tax revenue, which has a significantly lower share of the fiscal revenue than the tax revenue, has registered an impressive growth this year (also see Fig. 8). Fig. 11 provides year-over-year analysis of the various tax sources for this year as of end of third quarter, while Fig. 12 reflects the year-to-date fiscal revenue collection in yuan for the same time-period. From the above analysis, we can appreciate that in order to obtain apples-to-apples comparison using year-over-year analysis for comparing tax revenue across two consecutive years is very challenging to say the least, considering the fact we have to be cognizant of all the changes in the fiscal policies that have taken place in the time-period. Using the fiscal revenue data to do historical trend analysis, across years or across different time-periods, to predict the trends in the economy as a whole is futile, considering the questionable quality of data and the fluid nature of fiscal policies in China. In order to obtain an instantaneous pulse of the economy at a given point in time, it is imperative that apart from doing a year-over-year analysis, we apply refinements to the analysis by overlaying causal elucidations that accompany the headline elements as well as the individual sources of fiscal revenue in the fiscal reports. It is not a surprise that fiscal policies change every year and from one five-year plan to another, as China is an emerging economy, and is long ways from maturing. So naturally, the fiscal reforms and tax revenue mobilization programs are ongoing phenomena. The key principles of Chinese tax reforms in the recent years have been: More simplified taxation system Broader tax collection basis Lower tax rates Stricter tax collection The two elements outlined above - number two and number three - as well as the recent spate of revenue mobilization programs (as outlined in Table 5) may explain the disconnect between GDP growth rate and the increasing share of tax revenue as percentage of GDP as discussed earlier and outlined in Fig. 1. The whole discourse so far has focused only on year-over-year analysis. However, month-over-month analysis is also feasible and could be a better option, as the underlying fiscal conditions are more stable on a monthly basis than on an annual basis. But, the biggest challenge in doing the month-over-month analysis is the need to construct a database of monthly raw values, before applying the month-over-month computations and not forget the monthly numbers for January and February are combined into one. Instead in the year-over-year analysis, the year-over-year values are already provided alongside the raw data by the Ministry of Finance. In spite of all caveats, the monthly as well as the quarterly fiscal reports house a ton of information that can throw tremendous amount of light on the underlying Chinese economy. Disclosure: I am long GXC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

  • Exit Of The Periphery From The Eurozone Is Inevitable

    This blog post was originally published on Seeking Alpha by Sailesh S. Radha on 19th December 2012 As the euro crisis muddles along with no end in sight, let's analyze the journey of the eurozone so far since the great financial crisis of 2008, and the subsequent downward spiral of the eurozone periphery set in motion by the Greek socialist government's revelation in December 2009 that the Greek budget deficits were twice what were previously estimated. The Greek crisis, on the heels of the Irish economic crisis, spread like a wild-fire across Europe and has left in its wake Portugal, Italy, and Spain, in a state of financial and economic panic. Albeit the panic assumed different proportions in those countries called the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) or the periphery as a group, its gust had the potency to draw the eurozone's core - Germany, France, Netherlands - in to the center of the storm. The fiscal crisis in Greece set off alarm bells across the eurozone, especially the periphery, on the fiscal front. They then triggered a series of backlashes from the bond vigilantes, who forced sovereign governments of the peripheral nations to pay up more to hold their debt, triggering a crisis of confidence that percolated through their banking and financial systems. Of course, I haven't said anything that you did not know, but what has been lost in the current turmoil is the root cause of the crisis. All the discourse amongst the policy makers and the perquisites imposed by the troika of ECB, IMF and EU on the countries in the periphery to tackle the turmoil have solely focused on austerity measures to put the fiscal balances in order, and largely to preserve the monetary union. The irony is that none of the recommendations have emphasized reforming the flawed macro-economic fundamentals of the periphery, which have been asymmetric to that of the core ever since the establishment of the eurozone. The asymmetric macro-economic fundamentals of the periphery, which have been put to test by the recent crisis, are threatening to rupture the eurozone as the one-size-fits-all coordinated monetary policy has been ineffective so far, as it has failed to manage the persistent current account imbalances of the countries in the periphery Lending by eurozone core to the periphery As you can see in figure 1, German banks have retrenched their lending to the PIIGS from a peak of €917 billion ($1,218.63) in Q2 2008 to a €383 billion ($ 508.956) in Q2 2012. The German exposure was about 37% of its GDP at the peak in Q1 2008 compared with the 15% at the end of Q2 2012. Similar has been the case with French as well as the Dutch banks too (see figure 2 and figure 3). In the case of the French banks, the exposure dwindled from 52% of the GDP at the peak to 22% at the end of Q2 2012, while the Dutch banks' exposure dwindled from 63% of the GDP to 19%. With the year-over-year declines in the banking exposure to the PIIGS hovering between 25% and 35% in these countries, the periphery has been experiencing the classic case of "sudden stop" with inter-bank lending virtually coming to a halt. As a result of the "sudden stop," the slack in private lending has been picked up by ECB, the lender of last resort, the sovereign governments in the periphery, the duo of European Commission and IMF, and the bloated TARGET2 balances. The total exposure of banks from core eurozone countries Germany, France, Netherlands, Austria and Belgium to PIIGS dropped from €2.6 trillion in Q1 2008 to €1.0 trillion in Q2 2012 (see figure 4). ECB Lending The global recession of 2008 morphed into a crisis of confidence as well as a banking and debt crisis for the countries in the periphery, pushing Europe into another round of recession. In order to prevent the banking and debt crisis from spreading from the periphery to other peripheral and core nations of the European Union, the ECB stepped in to fill the liquidity gap left behind by the sudden withdrawal of private capital - as cross-border private lending as well as inter-bank lending had dried up. In January 2008, ECB lending to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) in the form of Main Refinancing Operations and Longer-Term Refinancing Operations amounted to about €100 billion. As of end of October this year, ECB lending to the periphery has ballooned to around €1 trillion including lending by the individual National Central Banks via Emergency Liquidity Assistance (ELA). The lending also includes the 36-month Longer-Term Refinancing Operations conducted by the ECB in two installments - one at the end of December, 2011, and the other at the end of February, 2012. ECB allotted €489 billion to 523 banks in eurozone in the first installment and about €530 billion to 800 banks in the second installment. Figure 5 summarizes the ECB lending to the peripheral nations. In the figure, the numbers for Greece include the ELA lending of €122 billion by Bank of Greece, backed by inferior collateral than that accepted by ECB in general. The size of the entire ELA facility today stands about 234 billion (see figure 6), and factoring that into the total number from figure 4, and as said earlier, the total lending by ESCB (European System of Central Banks) should undeniably be more than €1 trillion. Figures 7 through 11 will reveal the size of the ECB lending to various peripheral countries. Flight of Deposits and collapsed lending Of the peripheral countries, Greece, Ireland, and Spain, have seen a massive exodus of deposits (see figures 12 and 13), partly from German, English, and French banks reducing their exposure to them, and in large part from the flight of investors pursuing safety. Spain has seen its deposits dwindle from €1.7 trillion in June 2011 to €1.5 trillion, at the end of October 2011, a decline of €237 billion. On the other hand, Greece has seen its deposits erode by €83 billion euros since the current crisis raised its ugly head in December 2009. Likewise, Ireland has seen its deposits erode by €23 billion euros since August 2009. However, as you can see from figure 12, core countries like Germany, France, and Netherlands are experiencing steady growth of bank deposits in spite of the crisis. The flight of deposits from the periphery coincides with the growth of deposits in the core countries, creating a fragmented credit system and a dualistic banking system in the eurozone, and thus, dampening the ECB's current ultra-slack monetary stance. With the flight of deposits, the cost of credit in the peripheral countries is rising, crippling the already strained credit system there. As you can see figures 14 & 15, lending has collapsed in Spain, Ireland, and Greece. ECB's monetary policy By applying Taylor's rule to the countries in the periphery and the core, and despite the deluge of liquidity pumped by the ECB, we can gather that the current ECB target rate is too tight for the periphery, while being lax for the core group. As you can see in figure 16, Taylor's rule suggests that the ECB target rates historically have been incongruent to the macroeconomic conditions of the two individual clusters considered separately. In other words, one size policy does not fit the economic circumstances of the disparate countries in a monetary union. Considering the fact that the current crisis in the eurozone has created a divergence between the core and the periphery, it raises the question - how long can the ECB be accommodative toward the periphery, without harming the economic interests of the core of the eurozone. Incongruity of fiscal policy as well as monetary policy with macroeconomic conditions in the periphery The bond vigilantes have forced the sovereigns in the periphery to undertake austerity measures, and with the ECB's current monetary stance, despite infusion of abundant liquidity, being tight for the conditions there, both the fiscal policy as well as the monetary policy as a result are running counter to the macroeconomic conditions in the periphery. The conditions set forth by the troika as part of bailout programs are grounded on principles of austerity, whereas the order of the day should have been comprehensive macroeconomic reforms supplemented by austerity measures. Ever since the existence of the European Union, the nations on the periphery have been running current account deficits with the core nations. And therefore all the prescriptions provided by the troika, in addition to austerity measures, should have been centered on labor reforms emphasizing productivity and wage reduction in the periphery. To be added to the list of prescriptions should have been the depreciation of the currency, which is impossible in the current scenario, considering the coordinated monetary policy that is threading through the peripheral nations as a result of being in a monetary union. Unless efforts are not made to restore balance to the current account, the periphery will never see resurgence again and will continue to muddle along in the quagmire as we have seen in the last few years, and that too only with the aid of boundless ECB liquidity. The ECB liquidity programs have given an opportunity for the core countries to set their financial books in order by reducing their financial exposure to the periphery and thereby setting the stage for transformation of the eurozone with minimum disruptions. The economic and financial divergence between the core and the periphery has reached a critical stage now. The policy makers in the EU and ECB now should be emphasizing through the current liquidity programs, maybe, an orderly bifurcation of the eurozone into two groups - one containing the core nations and the second containing the periphery including Portugal, Ireland, Greece, and Spain (Italy for all purpose would remain in the core). So far when the circumstance were good, the core nations were reaping the benefits from the union to some extent at the expense of the periphery, but since the crisis, the core led by Germany have not been happy campers for having to undertake the burden of bailing out the economically downtrodden brethren from the periphery. The divergence on the economic front has spilled over in to the political realm widening the breach even further. An orderly bifurcation rather than that forced by the markets would be the best long-term solution to the crisis in the periphery For each of the countries in the periphery, the only way out of the current quagmire is through economic reforms aided by independent fiscal and monetary policy. The fiscal belt tightening going on in these peripheral nations is not helping alleviate the macroeconomic problems in these countries at all. As discussed earlier the underpinnings of austerity measures solely promote fiscal balance, and restoration of normalcy to the eurozone at the earliest, and not rectifying the macroeconomic flaws in the periphery. Since the coordinated monetary policy is not conducive for comprehensive macroeconomic reforms, independent monetary policy should be the way forward, but for that to happen the periphery will have to exit the monetary union. Labor reforms are the first that should be undertaken in order to promote productivity in the economy by removing labor market rigidities and welfare programs that thwart job creation and limiting cross-border labor migration. The wage structure in these countries needs to be rationalized to the national standards rather than the EU standards, thus promoting job growth. The peripheral nations have to depart from the euro currency, so that their new currency would operate at an optimum efficiency, which would eliminate current account imbalances and reduce the growth rate of sovereign debt. With the population growth rate at below replacement levels, the classical Solow's growth model would reveal that the long-term growth rate of the countries in the periphery would be governed purely by the rate of growth of productivity and human capital growth. Conclusion The rupture of the eurozone is inevitable due to the economic imbalance between the periphery and the core, but the rupture can be managed in an orderly fashion with the help of ECB. Doing so in an orderly manner will eliminate all uncertainties and minimize financial and economic losses. The ECB's quantitative easing has helped the core countries to manage their exposure to the periphery, and the policy makers should use this as an opportunity to stage the reformation of the eurozone rather than it being forced on them by the markets. Irrespective of how the rupture transpires, for long-term investors, exposure to country ETFs like EWP (iShares Spain Country ETF), having an exposure to financials of 50%, and EIRL (iShares Ireland Country ETF), should be kept at bare minimum Disclosure I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

  • Spain: The Fiscal Problems Of The Autonomous Regional Governments

    This blog was originally published on Seeking Alpha on 21st October 2012 by Sailesh S. Radha On Friday, Balearic Islands and Asturias joined the autonomous regional governments of Andalusia, Canary Islands, Castile-la Mancha, Catalonia, Murcia, and Valencia (see Fig. 1) in asking help from Madrid's newly created Regional Liquidity Fund (FLA), an €18 billion credit facility to provide affordable financing to the fiscally ailing regional governments. With an increasing number of the 17 regional governments seeking help from Madrid, the liquidity fund is being pushed to its limit. The fiscal woes of the regional governments came to the forefront when Valencia sought a bailout in July from the Spanish state for €4.5 billion, followed by Catalonia in August for €5 billion, to meet their debt obligations. The Mediterranean regions of Valencia and Murcia subsequently requested similar aid, although on a smaller scale. Early in September, Andalusia declared that it would have to seek help from Madrid to tide over its fiscal woes; various estimates put the amount at about €5 billion. Only Madrid, La Rioja, and Galicia out of all the regions have ruled out tapping the FLA. Data from Spain's Central Bank, Bank of Spain, puts the outstanding debt of all the 17 regions to €150.6 billion as of Q2, 2012, with the total debt of Catalonia, Valencia, Madrid, and Andalusia constituting 65% of the total (see Fig.2). The total outstanding debt of all the autonomous regions in terms of debt-to-GDP ratio is about 14% of the Spain's total economic output, while Catalonia and Valencia stand at 22% and 20.8% of their outputs, respectively (see Fig. 3). If you look at Fig. 4, the total outstanding regional debt as of Q2, 2012 registered a 107.3% increase from €72.6 billion at the end of 2007, when the global recession hit Spain. With Spain mired in a banking crisis, a second recession in three years, an unemployment rate of more than 25% and an increasingly unsustainable national debt burden, the autonomous regions' accumulation of huge debts and deficits have for all purposes put Madrid now on a path of full-blown bailout from the eurozone's permanent bailout fund, the European Stability Mechanism (ESM). The question now is when? In 2011, the collective budget deficit of all the regional governments was reported at 2.9% of Spain's GDP, and that is about one-third of Spain's overall national deficit of 8.5%, and way above the 1.3% target set by Madrid. How did the autonomous regions get to this point? If you look at Fig. 1, it's no coincidence that the Mediterranean regions such as Catalonia, Valencia, Murcia, and Castile-La Mancha are in dire straits. They were the beneficiaries of the real-estate boom which took off when Spain joined the euro, and went bust abruptly in 2008. During the decade-long boom years, the coffers of the regional governments raked in unprecedented revenues from enhanced property sales and building permits, VAT collection from consumer spending, and income tax collection from immigrants who came to work on construction sites. But, the problem was that the regions instead of establishing strong counter-cyclical fiscal policies, based on sound financial management principles, threw caution to the wind and went on a spending binge. They hired public employees who cannot be fired, provided increasingly expensive healthcare, especially for the growing elderly population, built massive white elephant infrastructure projects, airports (Valencia has built an airport at which a single plane is yet to land), gleaming government buildings, public swimming pools, and so on and so forth. And so when the great recession hit Spain in 2008, tax revenues dried up while the spending commitments remained. The subsequent widening of their fiscal balances forced the regions to look to international markets to fund the shortfalls. General administration, the institution that caters to providing public services to the regions including social services, health, education, and infrastructure, racked up a monumental debt of about €83 billion in more than 4.5 years since the end of 2007 (see Fig. 4). But, the eurozone crisis that began in the periphery following the great recession of 2008 finally hit Spain, the eurozone core, early this year. This served to enhance the risk premium on Spain's sovereign debt, and so, along with all the economic woes ailing Spain, all the Spanish autonomous regions have been locked out of the international markets from financing their widening deficits. As you can see in Fig. 5, the year-over-year growth of regional debt since 2007 peaked at the end of 2010 at 32.8%, and then declined to a year-over-year growth of 17% at the end of last year, reflecting the strain in the international debt markets in funding the fiscal imbalances of the regions. With a devolved quasi-federal structure in Spain, the autonomous regions are responsible for 1/3 of the overall national public spending, which are financed primarily by their tax revenues and the rest, about less than 20% of their spending, is funded by the Spanish state tax-revenues. With the regional tax revenues drying up after the real estate bust, a bloated spending overhang is remaining from the binge days. And with Spain in the throes of a second severe recession in three years, the regions have increasingly become cash-strapped and looking to the Spanish State to bail them out. As you can see in Fig. 6, among the regions on the Mediterranean where the real estate boom was dominant, Catalonia, Spain's largest regional economy, about the size of Portugal's, is the hardest-hit from the bust - with its debt rising precipitously to €43.9 billion in Q2, 2012 from €15.8 billion at the end of 2007, about slightly less than a twofold increase in more than four years. Similarly and to a lesser extent, Valencia and Andalusia registered a meteoric rise of €9.5 billion and €8.3 billion, respectively, in the same period. Fig. 7 captures the contrast of the debt-burden of the regional governments before the great recession of 2008 and after: The total regional debt grew at an annual rate of 7.1% in the boom days from 1995 to 2007, and then grew at an annual rate of 21.3%, a threefold increase. Since 1989, when the "Washington Consensus" was evolved between the U.S. Treasury department, the IMF, the World Bank and the G-7 countries, counter-cyclical fiscal policies were prescribed as a core component of macroeconomic stabilization programs. They were applied numerous times in the nineties during various episodes of sovereign debt crises in Latin America, arising from boom-bust scenarios akin to the one playing out in Spain right now. The irony is that Spain, a player in the G-7 fold that prescribed the counter-cyclical fiscal policies during those episodes, failed to apply those principles to its renegade regions. Over and over again, it seems to me that lessons learned from prior crises are quickly forgotten, and what used to be a phenomenon of the emerging and under-developed world, is recently being repeated very often in the northern side of the North-South economic divide. Is the U.S. government listening? The fiscal indiscipline that has brought Spain to the doorstep of a full-blown bailout is slowly spilling into the political realm, with various autonomous regions clamoring for complete fiscal devolution from the Spanish State, and some- like Catalonia- even clamoring for self-determination. The rampant unemployment currently running more than 25% among the unemployed youth can turn out to be a lethal mix with the political discontentment that is brewing in some of the regions. We have to wait and see. Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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