The challenge of financing the US deficit

Transcription

1 The challenge of financing the US deficit The US deficit is growing rapidly, because of the tax reform... but also and especially because of the aging of the population By Bastien Drut, Senior Strategist at CPR AM. In December 2017, the United States adopted the Tax Cuts and Jobs Act (TCJA), which lowered taxes for corporations (in particular, a 35-21% cut in the corporate tax rate). corporate taxation and capital expenditure deductions) and for households (lower income tax). With regard to the federal state budget, the consequences of the TCJA reform will focus mainly on receipts: even taking into account the positive effects on activity, the CBO (Congressional Budget Office, a non-partisan agency linked to the Congress) assumes that the TCJA will significantly lower tax receipts. According to this institution, the legislative changes adopted in 2017 (of which tax reform is by far the main element) will reduce tax revenues by $1,700 bn over the period These legislative changes would increase the deficit by $242 bn in 2018, $292 bn in 2019, and $233 bn in Budget deficit projections done by the CBO (in $bn) Before the tax reform Net impact of the fiscal reform However, the tax reform is very far from being the only element that will deepen the deficit over the next decade. In fact, the US deficit is already on a rising trend since the beginning of 2016 because of the aging of the population, and in particular because of the very large increase in

2 expenditures related to Social Security and the Medicare program. These trends will accelerate in the years to come: Outlays related to the "Social Security" program (pension payments to pensioners or their spouses in the event of death but also disability pensions) are expected to nearly double over the next 10 years according to the CBO. Outlays related to the Medicare program (health insurance for the benefit of people over 65) will also become increasingly heavy and should also double over the next 10 years according to the CBO Rise of federal outlays compared with 2017 ($bn) Other outlays Net interest Medicare Social security As a result, and taking into account the sharp increase in debt service, the deficit will be multiplied by more than 2 between 2017 and 2028 according to the CBO's estimates, from $665 bn to $1526 bn. An increase in the deficit at this stage of the economic cycle is unprecedented It is unusual to see a large developed country embark on a program of massive tax cuts late in the economic cycle. Already at the end of 2016, Janet Yellen, who was then Fed chairwoman, had indicated that a "fiscal stimulus was no longer needed to bring the United States to full employment. In the March 2018 FOMC minutes, participants were generally skeptical and considered "the magnitude and timing of the economic effects of the fiscal policy changes as uncertain, partly because there have been few historical examples of expansionary fiscal policy being implemented when the economy was operating at a high level of resource utilization." In general, the deficit balloons during recessions (lower tax receipts, increased social benefits) and declines throughout the economic cycle, as the unemployment rate declines and tax receipts improve. The current cycle is thus atypical because, even before the fiscal stimulus was adopted, the deficit started to climb again while the unemployment rate was still falling rapidly.

3 US: fiscal deficit vs unemployment rate 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% federal deficit (% of GDP) US unemployment rate (R.) 12% 11% 10% 9% 8% 7% 6% 5% 4% 3% The question of the financing of the deficit arises for the future The rise of the deficit outside the recession period raises the question of its financing, especially since the effects of the Federal Reserve's monetary policy must also be taken into account. Since October 2017, the Fed has started not to reinvest all maturing securities it holds. Thus, the Fed will not reinvest $229, 270 and $ 182 bn in Treasury securities respectively in 2018, 2019 and The nonreinvestments of the Fed will significantly increase the amount of Treasury securities that non-fed investors will have to absorb. There is no imminent danger for the financing of the deficit in 2018 and According to the survey of primary dealers run by the Treasury, the deficit account for $820 bn in 2018 and $1030 bn in Taking into account the non-reinvestments of the Fed, it is therefore around $1050 and $1300 bn that non-fed investors will have to absorb respectively in 2018 and Assuming that net issuance of Treasury securities will be constituted of around 30% of T-bills, which is usually observed, the net issuance of long-term securities will be about $735 and 910 bn in 2018 and 2019: these amounts are far from unprecedented since the net issuance of long-term securities were close to $1000 bn in 2012 and even $1600 bn in In addition, demand at recent auctions has been strong, even for long-term and very long-term maturities. On the other hand, room for maneuver during the next recession will be very small because the United States would tackle it with an already very high deficit. The question of the financing of the deficit will arise all the more in the medium term as the foreign holdings of Treasury securities gradually erodes. The share of non-resident holdings is now at its lowest level since 2003 (44% of marketable debt): their foreign holdings are no longer increasing as fast as the public debt itself. The two countries (China and Japan) with the highest Treasury holdings have slowed down their purchases recently: China's holdings ($1300 bn in February) have stabilized since the beginning of Until 2014, China accumulated foreign exchange reserves to prevent the renminbi from appreciating too much. Capital outflows related to expectations of currency depreciation implied a fall in Chinese foreign exchange reserves from 2014 to The objective to stabilize the renminbi has led to a stabilization of reserves in China's current account

4 surplus has been significantly reduced recently, making it unlikely that foreign exchange reserves will increase. In addition, recurrent rumors suggest that the Chinese authorities would stop purchasing Treasury securities, particularly because of the deterioration in US public finances on the one hand, but also more political considerations in the context of commercial renegotiations. Japan's holdings ($1060 bn in February) are being eroded, possibly because FX hedging costs have risen sharply with the rise in short-term interest rates, which makes Japanese investors less likely to buy US securities. Under these conditions, the domestic sector excluding the Fed has had more and more to buy Treasury securities in recent years and it will have to do it even more in the future, which will imply some interest rate adjustments. The money market reform in October 2016 implied that money market funds had to absorb around $220 bn of Treasury securities (of short maturity) between the end of 2015 and the end of Households and mutual funds, too, increased steadily their Treasury holdings over the last quarters. The change in the investor base is likely to put upward pressure on long-term rates. An IMF working paper ("Government Bonds and Their Investors: What Are the Facts and Do They Matter?", 2012) estimated that a 10 percentage point decrease in the non-resident ownership rate implied an increase in long-term interest rates from 30 to 40 basis points. For the US Treasury, one way to counter this might be to increase its net issuance to more T- bills and to decrease its issuance of long-term securities Breakdown of US Treasury holdings ($bn) Foreign - official Foreign - private Fed Domestic holdings 0

5 USD vs share of non-resident holdings Real effective exchange rate share of non-resident holdings (R.) 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% Empirically, the share of non-resident holdings has been negatively correlated with the US dollar. In the medium term, a significant depreciation of the dollar would allow a return of non-resident investors. The US deficit is growing rapidly, which is unprecedented at this stage of the cycle. This comes from tax reform... but also and especially from the aging of the population. Pension funding and senior health spending will continue to drive the public deficit inexorably over the coming decade. The financing of the deficit in 2018 and 2019 will not pose a real threat, but difficulties could appear during the next recession. This is all the more true as the Fed gradually is shrinking its balance sheet and as foreign holdings are stagnating, implying that domestic investors outside the Fed will be increasingly more solicited. These developments are likely to gradually exert upward pressure on long-term rates. May, 2018 Information: All comments and analyses reflect CPR AM s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or investment research. CPRAM is therefore not bound by the prohibition to conclude transactions of the financial instruments mentioned in this document. Any projections, valuations and statistical analyses herein are provided to assist the recipient in the evaluation of the matters described herein. Such projections, valuations and analyses may be based on subjective assessments and assumptions and may use one among alternative methodologies that produce different results. Accordingly, such projections, valuations and statistical analyses should not be viewed as facts and should not be relied upon as an accurate prediction of future events. Past performances are not constant over time and are therefore not a reliable indicator of future performances. About CPR Asset Management: CPR AM is an investment management company certified by the French Financial Markets Authority, an autonomous and wholly owned subsidiary of Amundi Group. CPR AM works exclusively in third-party

6 investment management (for institutional, corporate, insurance, private banking, fund management, and wealth management clients). CPR AM covers the main asset classes, including equities, convertibles, diversified investments, interest rates and credit). CPR AM in figures (End- December 2017) More than 46 billion in AuM - More than 100 employees, more than one third of whom are involved in investment management. CPR ASSET MANAGEMENT, limited company with a capital of Portfolio management company authorized by the AMF n GP boulevard Pasteur, Paris - France RCS Paris. _AM cpr-asset-management