SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION Please Note that the SPEX Crew will be taking a Mid-term break and will publish SPEX Issue 27 on 29th Oct. Keep reading! - Ben Lim, SPEX VP - A 500 Billion Message - Public or Private: Health Insurance in the UK - Malaysia Budget 2013: Some Questions Unanswered The Fortnight In Brief (25th September to 8th October 2012) US: Lower Unemployment Obamas Victory? The unemployment rate for September dropped to 7.8% after being held in the narrow range of 8.1 - 8.3% for the past 8 months. This is a significant boost to Obama's campaign, as Governor Romney has been lambasting Obama's failure in lifting the economy and even used it as a pillar of his own campaigning strategy. In the meantime, low supply in the housing market seems to be boosting prices, with the S&P/Case-Shiller home price index for 20 cities posting a 0.5% m/m gain for June. Asia Pacific ex-Japan: Improving Market Confidence The Asian Development Bank (ADB) adjusted their forecast for the Asian economies mainly downwards, except for Malaysia and the Philippines. Instead of the initial 6.6% expectation in July, the ADB is expecting Asia, excluding Japan, to grow 6.1% this year. The two largest Asian economies China and India have some of their projections sliced off due to domestic issues as well as weak export demand from their trading partners. China is expected to grow 7.7% - although still an impressive number - is stillbelow her 2011s astonishing 9.3% growth rate. Indias growth forecast fell from over 7% to the current 5.6%. However, with the recent news of improving US Purchasing Managers Index (PMI) from 49.6 to Septembers 51.5, market confidence in Asia has been on the rise. EU: Periphery Countries Back on The Hot Heat More austerity measures have been announced in Portugal and Greece, sending their citizens into a frenzy as measures become increasingly severe. Portugal has announced an additional tax rise of 4% on 2013 earnings while Greece will slash pensions, salaries, and healthcare as they bore a sharper than expected decline in output in order to secure rescue loans. The situation looks bleak as both countries are unlikely to reach their deficit targets in spite of the painful measures. ISSUE 26 8 OCTOBER 2012

IN COLLABORATION WITH

PROUDLY SUPPORTED BY

A 500 Billion Message

By Eugene Ong, Singapore Management University
This article looks at the cost of debt in the Eurozone, the importance of the European Stability Mechanism (ESM), and how it brings down the cost of debt in these ailing nations.

Standing by his word to do whatever was necessary to prevent a collapse of the euro zone, European Central Bank President, Mario Draghi, unveiled plans for the European Stability Mechanism1 (ESM). The ESM is an unlimited bond-buying program aimed at relieving high borrowing costs of struggling euro zone countries and is intended to replace the temporary funding programs such as the European Financial Stability Facility (EFSF) and the European Financial Stabilization Mechanism (EFSM). Despite being backed up by the ECB, it was initially opposed by the strongest nation in the EU Germany, until recent (12 September 2012) court rulings gave the green light but limited its contribution to 190 billion. Cost of debt in peripheral Europe The peripheral nations are running on deficits2 and as such, have to rely on borrowing from the private sector through bond issues to fund these deficits. However, with structural issues and depressing outlooks on their growths, investors are demanding higher interests to compensate for this risk. This increases the cost of debt for the already faltering nations. As the vicious cycle continues, these nations will eventually be shut out from raising capital from the private sector. Evident from Chart 1 below, the long-term bond yields3 of the peripheral nations have strayed upwards away from the average EU yields, with Greeces yield hovering at a staggering 24 percent as of July 2012. This is a stark contrast to a similar bond issued by Germany, which yields merely 1.3 percent in the same period. The peripheral nations will definitely not be able to sustain servicing debts at such levels.

30.00 Germany 25.00 Italy Spain Greece 15.00 France Ireland Portugal EU (27 countries)

28.0 26.0 24.0 22.0 20.0 18.0 16.0 14.0 12.0 Average of Japan, U.S. and U.K. Ireland Greece Spain Italy

20.00

Portugal
Euro area (17 countries)

10.00

10.0 8.0 6.0

5.00

4.0 2.0

Jan-05

Jan-01

Jan-03

Jan-07

Jan-09

Sep-01

Sep-03

Sep-05

Sep-07

Sep-09

Jan-11

Sep-11

Figure 1: 10-year government bond yields

May-12

May-08

May-09

May-10

May-11

Source: Statistical data from Eurostat

Figure 2: Unemployment rate in EU, US, and Jpn

Copyright 2012 SMU Economics Intelligence Club

May-12

May-02

May-04

May-06

May-08

May-10

0.00 Jan-09 Jan-10 Jan-11

0.0

Sep-10

Sep-08

Sep-09

Sep-11

Jan-12

Deep structural issues faced by these nations are also alarming. Where Germany faces a healthy unemployment rate of 5.5 percent, at least two out of ten are unemployed in Spain and Greece (as of April 2012), as seen in Chart 2 above. The rest of the peripheral nations face unemployment rates in excess of ten percent. On the contrary, the average unemployment rates in the U.S., U.K. and Japan are at a healthier rate of 6.9 percent during the same period. This exacerbates the current deficit situation as shortages in jobs translate into lower tax revenues and higher unemployment payouts; all of which adds on to the already blown up budget deficits1 by widening the gap between a governments revenue and expenditure. How does ESM reduce bond yields? In short, these struggling nations require capital to plug their growing deficits. This is why markets reacted favorably to the announcement of the ESM and the eventual approval by the German courts. Despite being aimed at unlimited purchases of short-term debts in primary markets, its consequences are far reaching. Most obviously, yields2 on short-term bond issues in countries subscribing to this aid will be significantly depressed. Insufficient compensation in the form of interests for the risks involved in lending money to troubled nations will cause it to be less attractive relative to existing debt instruments in the market, depressing demand for such bonds. On the other hand, simply increasing interest payouts will add on to the financial burdens of the troubled nation. To entice investors to invest in these bonds, interest rates have to increase adequately. With the ESM bailout mopping up the excess supply of short-term bonds, bond rates need not be raised while the issuing nation is able to fund its deficits from each issue. Best of all, funds from the ESM may not necessarily be utilized because the mere announcement of the availability of such funds, acts as a deterrent against investors demanding higher rates. To fund deficits and correct long-term structural issues, the peripheral nations should ideally issue bonds with longer tenures. However, the ESM will only be buying up short-dated bonds. Though not directly lowering the yields of long-term bonds, the ESM program will inevitably bring down long-term yields. As short-term bond yields are set to decline, investors seeking higher returns will more likely to invest in longer tenure bonds instead. This shift in demand will result in an increase in long-term bond prices and thus, lower yields. The impacts of the ESM announcement was almost immediately felt by the financial markets as The Spanish Treasury recently sold 860 million of 10-year bonds at an average of 5.7 percent compared to a yield of 6.6 percent in the beginning of August. At the point of issuing the bonds, the Spanish government is still undecided about seeking aid from the ECB although most in the market believe that Spain would eventually be left with no choice but to seek bailout. Whats so different about ESM? Several of the ECBs past efforts such as the temporary EFSF and EFSM have been focused on tackling the symptoms and not the deep-rooted cause by attempting to fund the deficits in distressed nations, yet the ESM program is no different. The only difference is the powerful message behind this permanent mechanism, reinforcing the ECB and Mario Draghis commitment to do whatever it takes to prevent a collapse in the euro zone. Aligning an ailing nations structure to increase competitiveness while narrowing severe budget deficits requires time, capital, commitment and discipline. With the ESM program, the ECB seeks to buy these nations necessary time and also provide sufficient capital to fund immediate liabilities and stimulate growth. Whether the ESM is buying more time for a slow and painful death as argued by many economists, or a well thought master plan that will eventually turn things around, ultimately rests on the decisions made by fiscal policy makers. To qualify for 3 Copyright 2012 SMU Economics Intelligence Club

the ESM funds, other than facing precarious conditions, ailing nations have to subscribe to strict follow-up conditions with regards to fiscal actions and spending. The lack of fiscal unity poses as a hazard in multilateral risk sharing through the ESM. If bailout funds were dispensed without any fiscal discipline requirements, individual nations can and will always seek to further its national interests at the expense of the other euro nations in the absence of a governing body (to keep such nations in check). The conditions attached to the ESM bailout can be seen as another effort by the ECB to fortify this unity, as this increases the discipline and commitment levels of these nations after receiving aid, thereby minimizing moral hazards. The ECB and the individual governments are aware of what needs to be done. But this has only won half of the battle. Executing these measures is the other half. The ones who will eventually feel the pain of sharp budgetary cuts are its citizens, which explains their resistance to such changes and ultimately impeding the progress of structural reforms. While there is no doubt that the ESM program may not address the underlying issues, it sends a resounding message to the world about the ECBs commitment to the euro zone in hopes of reviving investors confidence. The effectiveness of the ESM program will be clearer once Spain and Italys bailout decisions are announced. The European Stability Mechanism (ESM) is an international organization that provides financial assistance to members of the Eurozone in financial difficulty. It was established as a permanent firewall in the Eurozone in place of the two existing temporary facilities, European Financial Stability Facility and European Financial Stabilization Mechanism.
1

Budget deficits defers from trade deficits. Trade deficits occur when a country imports more than it exports whereas a budget deficit refers to the government spending (e.g., welfare payouts) more than it earns (e.g., tax revenue).
2

Bond current yields are not exactly a bonds interest rate. It is derived from the annual coupon payment divided by the price paid for the bond. If a bond is bought at par, the yield is equal to the interest rate. If it is bought at a discount (price below par), the yield of the bond is higher than its coupon rate and vice versa for a premium bond situation. Therefore, bond yields are inversely related to its price.
3

Sources: Financial Times, Eurostat, and Bloomberg

4 Copyright 2012 SMU Economics Intelligence Club

Public or Private: Health Insurance in the UK

By Leslie Tay, Hong Kong University
Health insurance offers protection against the risk of ill health, diseases and accidents. In this paper, we discuss why health insurance may be sub-optimal in the private market. We then proceed to evaluate if the National Health Service (NHS) does a better job in insuring her people against ill health. We conclude with the principles that should guide future health care reforms. Sub-optimality of private health insurance The demand for health insurance is driven by the risk of illness and the risk of delayed or incomplete recovery which create losses from both medical cost and the loss of productive time during treatment. The supply of health insurance, however, is sub-optimal, as the five conditions for the efficient supply of insurance are not met. The probability of illness is not independent when faced with a contagious disease. The probability is not less than one for people suffering from chronic or congenital diseases. Developments in genetic testing, which can improve knowledge of future health problems, create more uninsurable conditions. While the probability of illness is estimable, the probability of the cost of treatment (over a long period of time) is often not as medical technology advances quickly. Private health insurance faces the problem of adverse selection and moral hazard 1. The former problem arises because insurance companies do not have perfect information about insurees, thus giving potential insurees an incentive to hide information to get a better premium. This creates unstable equilibriums within the insurance market as companies respond with either a pooling equilibrium, which drives healthy insurees away, or a separate equilibrium, which creates sub-optimal coverage for healthy insurees. The latter problem occurs because both the probability of illness and treatment cost are endogenous to the insurees. Third party payment problems also occur when doctors, knowing that insurees do not face a constraint on medical treatments, overprescribe for their own financial benefits. This leads to overconsumption of health care, as private costs are zero while social costs are positive. Benefits of the NHS There are two basic problems with private health insurance- incomplete coverage and overconsumption. The NHS can be considered more effective than private insurance if it solves these two problems and does not create unintended effects (spill overs) arising from public health service. The NHS is essentially a universal benefit. Everyone is entitled to free medical services regardless of contributions. NHS, funded by taxation, is a form of insurance even though it is not governed by actuarial principles as it offers protections against the risk of ill health. Coverage is complete under the NHS since taxation is compulsory for every working adult, thus pooling the risks of both the healthy and unhealthy, young and elderly, solving the problem of adverse selection. The NHS is also better able to cover illnesses that are not idiosyncratic, chronic and congenital. Unlike a profit-driven insurance company, where the supply of insurance requires the actuarial premium to cover at least the markup and expected losses, the government is more interested in improving health and social utility is taken into account. The government also has a wider financial scope for covering these diseases. Lastly, under the NHS, doctors are given salaries (Fig. 1) and are not paid fee-for-service. This removes third party payment problems since doctors no longer have the financial incentives to overprescribe or encourage costly treatments. 5 Copyright 2012 SMU Economics Intelligence Club

Figure 1: NHS Practitioner Salary in Source: Pay in the NHS

Drawbacks of the NHS The NHS is not free from moral hazards since the private marginal cost of health care remains at zero. Fortunately, unnecessary treatments are often non-urgent with long waiting time. Long waiting time, a private cost, has an unintended effect of reducing moral hazards. Nonurgent treatments per month are limited by the rationing of resources, which are usually given lower priority. To that extent, the introduction of waiting list targets since the late 1990s have created a perverse incentive for hospitals to give priority to non-urgent treatments, which may be unnecessary, thus exacerbating moral hazards. The NHS can also be seen as an over-provision of health insurance, since the NHS covers a wide range of health-care services including cheap treatments and checkups. It was argued that there was little consumption smoothing benefit in covering these low cost and predictable health treatments since the utility derived from insuring them were small. These treatments were also usually self-insurable, thus the NHS has an effect of reducing the incentives to save and increasing the burden of the state. Final comments The NHS has solved non-coverage problems but has failed in reducing moral hazards. The UK, however, has been able to match other industrialized nations in terms of health measures like infant mortality and life expectancy despite being a low-spending nation on health care. We shall conclude with 3 principles that should guide future UK health reforms: i) Role of private insurance: We should not be quick in rejecting private health insurance. The take-ups for private insurance have been increasing especially for costly necessary non-urgent treatments. Moral hazard problems within private insurance have also decreased with the introduction of co-insurance and deductibles. Coinsurance2: Co-payment for health services can help reduce the moral hazard problems and over-insurance related to free medical treatment under the NHS. As Gruber, author of Public Finance and Public Policy, argues, The optimal health insurance policy is one in which individuals bear a large share of medical costs 6 Copyright 2012 SMU Economics Intelligence Club

ii)

within some affordable range, and are only fully insured when costs become unaffordable. iii) Spill overs: The increase in efficiency and cost-savings in insuring the country against poor health have been matched by a decrease in X-efficiency3 from the public provision of health care (Fig. 2). It was found that 87% of respondents to a survey chose long waiting time as an area that NHS needs improvement. Management problems and the quality of public health care have to be addressed by increasing competition and better monitoring. The introduction of quasimarkets since 1990s and public bodies like National Institute for Clinical Excellence (NICE) are steps in the right direction.

Figure 2: Changes in waiting time and number of operations Source: The Patients Association

Moral hazard occurs when a person chooses to undertake risks because he/she will not feel the cost that could incur. Moral hazard often takes place after a transaction has taken place and when actions are unobservable.
1 2 Co-insurance

refers to the spreading of risk between the insuree and the insurer.

X-inefficiency is the difference between efficient behavior of firms suggested by economic theory and their observed behavior in practice. It occurs when technical efficiency is not achieved due to a lack of competition.
3

Sources: Public Finance and Public Policy (2 nd Edition), Economics of the Welfare State (4th Edition), Public and Private Choice in UK Insurance (Working Paper 98/19), The American Economic Review, Journal of Public Policy

7 Copyright 2012 SMU Economics Intelligence Club

Malaysia Budget 2013: Some Questions Unanswered

By Lee Guo Jun, Singapore Management University
It is a budget widely expected to shore up support from Malaysians as the Malaysian general elections loom. The Malaysian government plans to splash out RM252 billion (S$101 billion) in the year 2013, aimed at boosting private investment, strengthening education and training, increasing innovation intensity and production, reducing national deficit, and improving the well-being of the rakyat (people in Malay). Despite reduced external trade due to the US experiencing sluggish growth and the EU still uncertain in its future, Prime Minister Najib Abdul Razak announced that the 2013 budget aims to ride on the increase in domestic consumption and investment as main sources of growth, with the economy poised to grow by 4.5% to 5.5% in the year 2013. This article zooms in on the budgets 5 th focus on improving peoples welfare and discusses its potential effectiveness on addressing the nations welfare problems. Figure 1 below illustrates how the budget will try to achieve some of these aims.

Figure 1: Selected Allocations in Budget 2013 Source: Malaysiakini.com

Among the highlights from the Muslim nation are a 1% cut from income tax rate of individuals earning an annual income of up to RM50,000, a ten-year tax holiday1 for private operators and entrepreneurs in the oil and gas industry, building 123,000 units of affordable houses and increasing the monthly income limit for loans to increase the number of Malaysians owning their first residential property, and a cool RM500 for households with income of RM3,000 per month and below, and RM250 for unmarried individuals earning RM2,000 per month and below. Despite a very generous budget allocation with more focus on citizens and budding entrepreneurs, pertinent questions to the Malaysian economy and her peoples welfare remained unanswered. Through the Bantuan Rakyat 1 Malaysia (BR1M) scheme, the budget projects that about 4.3 million households and 2.7 million unmarried individuals will benefit from the cash handouts, with the amount totaling up to RM3 billion. While a one-off boost in household income may aid low income families with purchasing necessities in the short run, it would not be possible 8 Copyright 2012 SMU Economics Intelligence Club

to narrow the poverty gap in the long run. Consumer price index 2 for January to August 2012 may be under control (hovering at 1.2%) thus keeping food prices low, but wages are still depressed due to immigration of foreign workers competing for low-skilled jobs with the local labour force. An increase in wages however, needs to be complemented by an increase in labour productivity to boost output per worker. Otherwise, the increase in labour costs would be transferred from producers to consumers, hurting low income families even more in the form of higher prices. Furthermore, some of the cash handouts serve a more political purpose rather than an economic one. For instance, the budget offers a RM200 cash rebate upon purchase of a smartphone for youths aged 21-35 years old which has left many analysts scratching their heads. But it is important to note that the national budget targets demographic groups that could potentially swing the votes to the governments favour. According to Today, a Singaporean newspaper, unmarried individuals above 21 years old consist of the bulk of 3 million newly registered voters who are set to vote in the next election a number that could easily swing state governance from one party to the other. Another concern would be how the government plans to rein in federal government debt 3, which hit a historic high of 53.7% of GDP for the year 2012 (see Figure 2 below). With global trade experiencing a slowdown and Malaysias major trading partners heavily affected, the government cannot solely depend on an excellent trade surplus to service debt and keep the government deficit in check. In the United States, Mitt Romney, the US presidential candidate, emphasizes the provision of tax cuts to the middle income group but at the same time reduce the number of tax exemptions and holidays issued to private operators to keep the government deficit4 from ballooning. Prime Minister Najib Abdul Razak however believed that it is important to attract foreign multinational companies to invest in the oil and gas industry by providing them a ten-year tax exemption, effectively closing down what could have been a major source of tax revenue to reduce government debt in the next ten years.

Figure 2: Federal Government Debt as a Percentage of GDP Source: Malaysiakini.com

Dato Seri Najib Abdul Razak, who is also the Finance Minister for Malaysia, announced that RM200 million will be allocated to the soon-to-be established Graduate Employability Taskforce to strengthen the employability of unemployed graduates, through provision of soft 9 Copyright 2012 SMU Economics Intelligence Club

skills training and on-the-job training in private companies. Ensuring that graduates will be hired by private companies not only raises the average level of skill within the labour force, but also stems the outflow of skilled labour to countries like Singapore, Hong Kong, and the United Kingdom in search for jobs. Despite the good intention to prevent skilled labour from leaving Malaysias shorelines, the amount allocated to improve the skill levels of unemployed graduates is questionable. Malaysias close neighbor, Singapore, spent $750 million on the Skills Programme for Upgrading and Resilience a budget allocation 9 times higher for a total labour force that is slightly more than a quarter of Malaysias labour force of 11 million people. While some may argue that effectiveness is not entirely dependent on the size of investment, it is easy to be skeptical of the governments commitment when RM3 billion worth of cash handouts will be distributed next year instead of going towards improving labour productivity in Malaysia. Despite claims by members of the opposition party claiming that the national budget is akin to an election budget aimed at preserving the governments power at the top, this author believes that the budget would steer Malaysia away from its relatively large dependence on external trade, focusing on the pillars of private consumption and investment. Handing cash rebates to low income individuals and families however, do not address the root cause of the increasing income gap. Thus, the Malaysia government should place more emphasis on the citizens welfare in the long run, such as introducing policies aimed at improving labour productivity at a larger scale instead of only graduates. Even if the Malaysian government believes that budget 2013 would shift the looming general elections to their favour, this author believes that true victory is only achieved when short-term happiness is traded for long-term prosperity.
A temporary reduction or elimination of tax payments, also referred to as tax abatements, tax subsidies, or tax reduction programmes.
1 2 Measures

changes in price levels of consumer goods and services purchased by households.

Government deficit occurs when government expenditure exceeds the revenue that it generates.

Sources: Malaysiakini, Star Online, Today

10 Copyright 2012 SMU Economics Intelligence Club

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capital ization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents Shane Ai Changxun (Vice President, Publication) changxun.ai.2010@smu.edu.sg Singapore Management University Singapore Herman Cheong (Vice President, Operations) Wq.cheong.2011@economics.smu.edu.sg Singapore Management University Singapore Fariha Imran (Marketing Director) Farihaimran.2010@economics.smu.edu.sg Singapore Management University Singapore Randy Lai (Editor) Tw.lai.2010@smu.edu.sg Singapore Management University Singapore Lee Guo Jun Guojun.lee.2010@economics.smu.edu.sg Singapore Management University Singapore Eugene Ong Eugene.ong.2009@business.smu.edu.sg Singapore Management University Singapore Ben Lim (Vice President, Publication) ben.lim.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming (Publications Director) jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Vera Soh (Liaison Officer) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Seumas Yeo (Editor) Seumas.yeo.2010@smu.edu.sg Singapore Management University Singapore Leslie Tay Leslie.tay@hku.hk Hong Kong University Hong Kong, PRC

Everything in this document and/or in this website is copyrighted by law and cannot be used without the written permission of its owner/publisher. It is forbidden to make digital copies or reproductions, however you may however use the information as reference material and it may be physically printed for personal use. You may also quote parts of the content of this publication, digitally or physically, if the source and author is clearly stated, together with the copyright information. All views expressed in this publication are the personal opinion of the researcher(s), do not constitute a buy or sell recomm endation on any instruments, and in no way reflect the opinions, views, or thoughts of SMU and other abovementioned universities, and unless specified, of any other student clubs. All logos and/or images on these pages belong to SMU and the respective third party copyright and trademark owners. SPEX, affiliated clubs and the covering researcher accepts no liability whatsoever for any direct or consequential loss arising from any use of this document or further communication given in relation to this document. SPEX is the brainchild of current New York University undergraduate Mr. John Ang, further developed by SMU students for the benefit of both SMU and non-SMU students.

11 Copyright 2012 SMU Economics Intelligence Club