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©2004 Monetary Authority of Macao The Causes and Effects of Deflation in Macao Vong Lap Kai Abstract Macao has entered a deflationary era since the second half of 1998 as the economy started a recession in 1996. The change in consumer prices, a widely known measure of inflation or deflation, moved from a rate as high as 8.56% in 1995 down to a record low of -3.2% in 1999 within a period of three years. Deflation remains in Macao despite that the economy has bounced back to positive growth after 2000. Based on a framework that depicts the relationship of change in consumer prices with various endogenous and exogenous factors, this paper tries to explain why deflation occurs in theoretical sense and in the practical situation of Macao. It is found that deflation in Macao is more closely related to the prices of imports as well as the asset prices. Studies of price convergence between Macao and its neighbouring cities and supply side reasoning for the decline in consumer prices would enrich the explanatory power of price movements in Macao. - 85 - 1. Introduction There has recently been a concern over deflation in Macao when the inflation rate as measured by the change in consumer price index has turned into negative values since the second half of the 1998. It is widely believed that the decline in consumer prices has been closely related to the autonomous price adjustments after the economy slid into recession in the aftermath of the burst of property price bubble and the 1997 Asian financial crisis. Since the domestic currency is linked to the Hong Kong dollar at 1.03 under the Currency Board Arrangement (CBA), the Monetary Authority does not have the autonomy in implementing monetary policy to combat the decline in consumer prices, while it has to leave local interest rates following the movements of its Hong Kong or US counterparts. Contrary somewhat to the standard economic theory which states that an economy would usually find its output drop during deflationary periods, the economy of Macao has achieved positive growth alongside with deflation since the year 2000. Although the output of Macao grew by double-digit rates in the past two years, deflation only dropped at a slow pace from a record high of 3.2% in 1999 to 1.56% in 2003. As Macao is a small open economy, its economic performance is extensively driven by external economic factors. The price declines in the past six years could therefore be attributed to the disinflation found in the world’s leading economies. The United States and the European Union, the two largest merchandise export destinations of Macao, had experienced low inflation until 2003. China, Japan, Hong Kong and other major import sources of Macao had also seen stable price trends. The main objective of this paper is to layout a framework that can help explain the general price movement of Macao. Special attention is also paid to the determinants and problems of deflation in the local economy. Section 2 will define inflation, deflation and - 86 - disinflation and the differences between them. A brief theoretical explanation of the causes and costs of deflation will also be discussed. Section 3 will briefly describe the movements of the consumer prices in the past few years and how consumer prices are calculated in Macao. Based on the discussions in Sections 2 and 3, a model is constructed in Section 4 to locate key variables which affect local price levels. Section 5 will explain policy options available to combat deflation for the authorities. The final section concludes. 2. Inflation, Deflation and Disinflation Inflation, deflation and disinflation refer to different behaviours of the general price level. Inflation refers to a sustained rise in the general price level; deflation means falling general level of prices whilst disinflation represents that the inflation rate is positive but declining over time. In understanding these three concepts, it should be borne in mind that prices are measured at aggregate level rather than at one particular market or industry because there will always have sectors where prices move in either relative or absolute terms against the general price trend. As to the measurement of the general price level, there exist two popular methods: gross domestic product deflator (GDP deflator)-based and consumer price index (CPI)-based. The GDP deflator is a broad index of prices in the economy whereas the CPI measures the price level of a broad basket of consumer products and services. The CPI is widely employed in the globe but has certain shortcomings. Most notably, it tends to produce upward bias. The reasons are as follows: first, consumers do change their spending patterns, but the Laspeyres CPI does not permit the substitution possibilities. Second, shifts to lower price discount outlets are not reflected adequately in this index. Third, the CPI does not take qualitative improvements into account where better-quality products would ask for higher prices. As a result, Ariga and Matsui (2003) argue that the change in CPI in Japan appears to have an upward bias of at least half percentage point. - 87 - Let us assume that an economy is at steady state whereas the aggregate demand (AD) and aggregate supply (AS) intersect at P* (price) and Y* (output) (Chart 1). A rise in the aggregate demand then shifts the aggregate demand line to the right to AD’, intercepting the aggregate supply line at a higher point and pushing prices up to P’. This usually happens when an economy is booming with widespread shortages of both labour and materials. The business sector cannot respond to the excess demand by expanding sufficiently real output, resulting in a situation where too much money is chasing too few goods. Chart 1: Demand-Pull Inflation P AS P’ P* AD’ AD Y* - 88 - Y’ Y On the contrary, deflation may stem from either demand or supply shock. For example, when an economy is undergoing a recession, consumers would probably reduce their spending as the risk of losing their jobs increases. This would characterise an adverse demand shock whereas consumers demand lesser quantity of products at each given price level. These can be represented by a shift of AD to the left (AD’), driving down the output of the economy (Y’’), while at the same time lowering the general price level (P’’) (Chart 2). Another cause of deflation would be a supply shock such as lower import prices or technological advancements which bring down the unit cost of products or services. This is also illustrated in Chart 2 where the AS line shifts to the right (AS’), resulting in a higher output Y** and lower price P**. Meanwhile, demand and supply shocks could happen at the same time, resulting in a new equilibrium of Y’ and P’. Chart 2: Demand and Supply Shocks Induced Deflation AS P AS’ P* P’’ P** P’ AD AD’ Y’’ Y* Y’ Y** - 89 - Y Like inflation, deflation is a concern of an economy. Since wages are normally set in nominal terms, deflation would raise real wages if the business sector is unable to reduce nominal wages. This would lower companies’ profits and may result in higher unemployment and deterioration in overall economic conditions. If businesses are able to reduce nominal wages, households would have their incomes cut, leaving fewer financial resources to repay existing debts that are set in nominal terms. Under normal circumstances, Fisher (1930) suggests that nominal interest rates tend to fluctuate up or down in response to expectations about future inflation. In other words, nominal interest rate is equal to real interest rate plus expected inflation. This Fisher equation means that expected decline in inflation would trigger a drop in nominal interest rate. However, nominal interest rate has an effective zero bound. Once the nominal interest rate is cut close to zero percent, continuous drop in consumer prices or sustained deflation will cause the real interest rate to increase. Deflation could also reduce bank earnings as Fisher (1933) argues in his debt deflation theory. Deflation increases the real value of debts while trimming the value of collateral for loans. The resulting deterioration in both business and household balance sheets, accompanied by a higher real interest rate, works to weaken loan demand and could lead to increases in loan defaults. As a result, deflation would affect adversely the banking sector. Banks would then either raise financing charges (finance premium) or reduce lending as default risk rises, resulting in further drop in aggregate demand. 3. Consumer Prices in Macao Like most other countries in the world, Macao regularly compiles the CPI as a key measurement of inflation. The CPI calculation is based on the consumption pattern derived from the results of the Household Budget Survey. There are three types of CPI in Macao: the Composite CPI reflects the consumption price changes for the general population in Macao; within which, CPI(A) relates to 54% of the households with an - 90 - average monthly consumption expenditure of MOP3,000 to MOP9,999, while CPI(B) relates to 26% of the households with an average monthly consumption expenditure of MOP10,000 to MOP19,999. The CPI basket contains 555 items of goods and services resembling the consumption pattern in a typical household. These items are further grouped into ten different categories. Each category is assigned a weight which represents a proxy for the share of expense in the total expenditure of a household. The component and weight of each category in composite CPI basket are given in Table 1. Price information is collected from 782 outlets on a regular basis, including supermarkets, municipal markets, Chinese restaurants, department stores, boutiques and travel agencies, etc. The total number of prices used to calculate CPI is around 4,831 per month. Table 1: The Components of Macao Composite CPI Categories Weights Foodstuffs and beverages Clothing and footwear 31.35 5.26 Rent and housing expenses 29.93 Tobacco and alcoholic beverages 1.23 Household goods 3.22 Health 2.42 Transport and communications 9.81 Education and leisure 10.89 Other goods and services Total 5.89 100.00 Source: Statistics and Census Service of Macao. - 91 - In line with international practices, the CPI is calculated using Laspeyres methods, which allow direct comparison of indices in subsequent years to that in the base year. It is also noted from Table 1 that “foodstuffs and beverages” and “rent and housing expenses” are the two biggest components which jointly represent 61.28% of all items in the composite CPI basket. Thus, it is not surprising to see that price movements in these two items have profound effects on the inflation rate as measured by the changes in consumer price index. During the period between 2001 and 2003, the accumulative decline of 6.7% in “rent and housing expenses” represented 33.2% of the overall decrease in the composite CPI whilst “foodstuffs and beverages” accounted for another 24.7%. However, the biggest price drop (by one fourth) was witnessed in “clothing and footwear” during the period. Unlike “rent and housing expenses” and “foodstuffs and beverages” which are more often consumed locally due to higher time costs for consuming outside Macao, “clothing and footwear” are influenced more significantly in price by similar goods in the neighbouring cities as time costs are of relatively little concern. The rapid drop in prices of this category can hence be attributed to three factors: first, the increasing popularity of lower price discount outlets; second, the rising cross-border consumption in the neighbouring Zhuhai and third, the longer sales period by major clothing outlets owing to fiercer competitions. Consumer prices had traditionally recorded positive changes since the statistics were made available to the public in the 1980s. The continued growth of Macao’s economy as well as the general inflationary situations in the globe had kept local inflation above the zero boundary. The upward trend of inflation had also helped to build a spur in asset prices especially in the real estate sector. The inflation rate accelerated in the early 1990s and ran up to a peak of 9.0% in October 1995. It then subsided in response to the economic slowdown due partly to the macroeconomic control measures implemented by the People’s Republic of China since July 1993 to cool down the overheated economy especially in the southern part of the - 92 - country. The inflation rate fell further to negative values after the 1997 Asian financial crisis when asset prices across the broad fell abruptly. The loss in devaluation of assets in the aftermath of this crisis pulled back further the economy to negative growth of 4.6% and 3.0% respectively in 1998 and 1999, raising the unemployment rate and cutting deep the pockets of households. The adverse demand shock came into play and caused the general price level to fall. Inflation started to fall below the zero mark and hence deflation emerged since the second half of 1998. The fall in consumer prices could be attributed to the autonomous price adjustments to the demand shock as well as external influences. It is noted that major import sources of Macao including Mainland China, Hong Kong, Japan and other Asian economies all experienced declining prices, creating so-called “imported deflation” in Macao. The changes in consumer prices remained in negative territory though the unemployment rate has been improving and the economy recorded double-digit growth in 2002-03 after the liberalisation of the gaming industry. - 93 - Chart 3: Movements in the Consumer Price Index, 1994-2003 (%) 12 10 8 6 4 Year-on-year monthly rate Average rate in the latest 12 months 2 0 -2 -4 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Source: Statistics and Census Service of Macao. 4. A Price Model for Macao According to the discussions in Sections 2 and 3, four independent variables can be identified to estimate the movements in consumer prices. They are: Unemployment (U) – jobless rate, lagged by one year, is selected as a proxy for the business cycle, which reflects the cyclical effects on consumer prices. Change in nominal effective exchange rate (NEER) – this variable is included in the model to show the imported inflation effect on domestic prices. Nominal credit growth (NCG) – this aggregate, lagged by one year, serves to represent the rise and fall of the asset price and its effect on rental and housing expenses. The lag - 94 - reflects the typically slow and staggered response of rental contracts to property price developments. Effects of the 1997 Asian crisis on asset prices (D) – this enters the model as a dummy variable that tries to incorporate the effects of asset devaluation after the crisis. The model, which is resemblance to the one developed in Schellekens (2003), can be mathematically represented by the following equation: π t = β 0 + β1U t −1 + β 2 NEER + β 3 NCGt −1 + β 4 D + β 5 (1) whereas π t denotes the change in GDP deflator at time t.1 However, the unit root test on the data between 1988 and 2003 shows that the unemployment rate is not stationary whilst NEER, NCG and π are stationary (when only a constant is included) at their levels and significant at 10%, 10% and 1% respectively.2 The unemployment rate is subsequently dropped from this model and Equation (1) is rewritten as below: π t = α 0 + α1 NEER + α 2 NCGt −1 + α 3 D + α 4 (2) Fitting this model using annual data between 1988 and 2003, Equation (2) can be rewritten as: π t = 4.46 − 0.80 NEER + 0.23NCGt −1 − 5.21D (2.28) (-2.38) (2.51) 1 (3) (-1.99) The reason why GDP deflator is chosen over CPI is that CPI does not exhibit stationary property under the unit root test but GDP deflator does. Since the changes in GDP deflator resemble those of CPI, GDP deflator is chosen as a proxy for the headline inflation in the model. 2 The unit root tests produce mixed results. While the Phillips-Perron (z) test shows that NEER is stationary at 10%. NCG and GDP deflator are only stationary at 10% and 1% in the Dickey-Fuller test. This is probably due to the short length of time series. - 95 - The t-statistics are in parentheses and the results of the estimations are summarised in Table 2. Table 2: Regression Results Regression Statistics Multiple R 0.888557 R Square 0.789534 Adjusted R Square 0.736918 Standard Error 3.144334 Observations 16 ANOVA df Regression Residual Total Constant NEER NCG D 3 12 15 SS 445.07 118.6421 563.712 Coefficients 4.458372 -0.79637 0.234132 -5.20886 Standard Error 1.958812 0.335073 0.093314 2.619278 MS 148.3567 9.886838 T Stat 2.276059 -2.3767 2.509067 -1.98866 F Significance F 15.00547 0.000231 P-value 0.041976 0.034973 0.027455 0.070033 Lower 95% Upper 95% 0.190487 8.726256 -1.52643 -0.06631 0.030817 0.437447 -10.9158 0.498056 The coefficient of determination of this model was close to 0.80, implying that about 80% of the change in prices can be explained by the three variables in Equation (3). All coefficients are significant at the five-percent level and have the predicted sign. In terms of qualitative explanations, the model reveals that local deflation can be explained by nominal effective exchange rate, nominal credit growth and the 1997 crisis. - 96 - 5. Policy Options in Combating Deflation Sustained inflation and deflation are both regarded as undesirable economic phenomenon. Deflation, in particular, could hurt consumption sentiments since households expect that they can consume more with the same amount of money in the future. The banking industry would suffer from an adverse effect on its collaterals in its loan portfolio and the increased cost of nonperforming loans as the surge in real debt could possibly lead to higher loan default risks. Given the visible cost of deflation, it is always desirable for the authorities to prevent it from happening for a prolonged period. In the real world, central banks or monetary authorities normally set their inflation target above one and below two percent. Once an economy falls into the deflation trap, prices would be slow in turning up again as consumption contracts. Business would then experience a profit squeeze on lower sales, followed by a decline in wages, and hence consumption would drop further. The problem may be exacerbated if the banking system is undergoing difficulties with a rise in bad debts. In such a situation, efforts to boost base money would have limited effect if the additional liquidity largely ends up as banks’ excess reserves. Macao faces a challenge in the current deflationary period. This is especially the case because Macao operates under the CBA where local interest rates have to follow the movements of Hong Kong rates. Besides, the nominal interest rates are now close to zero. These two factors leave no room for expansionary monetary policy to stimulate economic activities. In a situation where monetary response is insufficient or inadequate, fiscal policy seems to be the only vital apparatus in addressing the deflation problem. Sustained deflation is very often a problem of expectation where people expect prices to fall. What needs to be done is to reverse this expectation and let them believe that prices would rise in the future. The fiscal policy can be used in combating deflation in two ways. First, fiscal policy can be devised to boost the aggregate demand. The stimulus - 97 - should be targeted to have a wider effect at the aggregate level, addressing the problems in credit and asset channels which could increase the prices of goods as well as assets. Second, structural reforms can also be extended to an economy to facilitate reallocation of resources, allowing a more rapid disposal of bad assets. This coincides to what has been pursued by the Monetary Authority of Macao which requires banks to increase their provisions on nonperforming financial assets. The fiscal stimulus, accompanied by the structural reforms, would help raise the long-term return on capital eventually and dim the possibilities of prolonged deflation. 5. Concluding Remarks Macao has entered a deflationary era since the second half of 1998 due to an adverse demand shock triggered by the devaluation of asset prices. The deflation has continued until now, even though positive economic growth has been recorded since 2000 with the years 2002 and 2003 showing spectacular two-digit growth. It is explained in this paper that the enduring deflation for the small open economy in a period of economic growth can be possibly explained by imported deflation and that the prevailing CBA and nearzero interest rates leave little room for expansionary monetary policy. Certainly, deflation is undesirable to an economy because it impinges on the balance sheets of both households and business corporations. Under the CBA setting, fiscal stimulus and structural reforms could be devised as anti-deflation strategies. In addition, the resurgence of inflation in the economies of Macao’s major trading partners would lessen deflationary pressure in the near future. Finally, it is believed that prevailing cross-border consumption by Macao residents should have a major bearing on local prices. It would therefore be useful if further research can be conducted to look into the details on how the price convergence between Macao and its neighbouring cities can - 98 - affect local consumer prices. References Ariga, K. and M. Kenji (2003), “Mismeasurement of the CPI,” NBER Working Paper No. 9436, January. Bernanke, B. and H. James (1990), “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Approach,” NBER Working Paper No.3488, October. Bordo, M.D, and A. Redish (2003), “Is Deflation Depressing? Evidence from the Classical Gold Standard,” NBER Working Paper No. 9520, March. Buiter, W.H. (2003), “Deflaton: Prevention and Cure,” NBER Working Paper No.9623, July. Clouse, J., D. Henderson, A. Orphanides, D. Small and P. Tinsley (2000), “Monetary Policy When Nominal Short-term Interest Rate is Zero,” Federal Reserve Board Finance and Economics Discussion Series, November. Eggertsson, G. (2003), “How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible,” IMF Working Paper 03/64, March. Fisher, I. (1930), The Theory of Interest, the Macmillan Company. _______ (1933), “Debt Deflation Theory of Great Depressions,” Econometrica, Vol. 1, 377-57. International Monetary Fund (2003), Deflation: Determinants, Risks and Policy Options Findings of an Interdepartmental Task Force. - 99 - N’Diaye, P. (2003), “Determinants of Deflation in Hong Kong SAR,” IMF Working Paper 03/250, December. Reifschneider D. and J.C. Williams (1999), “Three Lessons for Monetary Policy in a Low Inflation Era”, Federal Reserve Board Finance and Economics Discussion Series, September. Schellekens, P. (2003), “Deflation in Hong Kong SAR,” IMF Working Paper 03/77, April. Yates, T. (2002), “Monetary Policy and the Zero Bound to Interest Rates: A Review,” ECB Working Paper No. 190, October. - 100 -