Download The Causes and Effects of Deflation in Macao

©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.
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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
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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.
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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*
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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**
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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
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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.
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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
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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.
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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
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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.
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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.
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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
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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
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affect
local
consumer
prices.
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