BNP Paribas: Ready for Deflation?

The grinding process of deflation is on the horizon but, while this may cause difficulties for the global economy, corporations can use financial instruments to minimise risk as BNP Paribas's Paul Mortimer-Lee, Luigi Speranza, Clive Banks and David Slater explain to Steve Dunkerley.

The global economy is witnessing unprecedented times and faces years of uncertainty, according to Paul Mortimer-Lee, global head of market economics at BNP Paribas. All companies, he says, should be planning for the future now. "There is a massive global shortfall in terms of output," he says. "Unemployment is rising, wages are frozen and pay levels are set to remain the same. It is hard to see where the inflationary fears are coming from. We expect pressures towards deflation over the coming one-to-two years," he adds.

"The underlying economic concerns are simple: deflation is on the way and all companies should be planning ahead now if they wish to mitigate their risks."

If governments and regulatory authorities catch inflation quickly enough, he says, it can be dealt with. "Yet it is difficult to deal with deflation. Given the choice, UK authorities would go for inflation." However, BNP Paribas sees a deflationary future. "You don't get runaway deflation," says Mortimer-Lee. "It is more of a grinding process. And for sure, the tide is coming, slowly but surely, and it will come in. It is unavoidable."

Luigi Speranza, head of inflation economics at BNP Paribas, highlights that central banks need to tread a fine line because expectations can fluctuate quickly. At the moment inflation expectations are well anchored, but as inflation grinds lower this could change suddenly. "This can affect behaviour," he says, "with the risk of a deflationary spiral."

A deflationary spiral, a situation where decreases in prices lead to lower production, which in turn leads to lower wages and demand, which then leads to further decreases in price, is considered a worst-case scenario for national economies. The "Great Depression" is regarded by many as a deflationary spiral and no one wants a repeat of that.

European policy making

Speranza says a protracted period of falling core prices is the most likely outcome in the Eurozone. "There has been only a modest decline in core inflation to date," he says. "Core inflation is 1.5% below its cyclical peak of 2%, but we expect to see a three-quarter percentage point fall each year for the next couple of years."

The problem with European policy makers, he adds, is that while the aggressive quantitative easing methods adopted in the UK have been successful to date, the policy is a taboo in Europe. "It is a taboo because of what happened with the Weimar Republic in Germany," he says. As a result of First World War reparations, the German government's approach was to print money. This caused a loss in confidence and rampant hyperinflation. Yet the Japanese lesson of not acting quickly enough is there for all to see. Its 1980s recession took a decade to overcome.

It is clear that there is a theoretical divide between the Anglo-Saxon tradition and the Germanic, yet it is Germany that is facing the biggest problems (exacerbated by an upcoming election). Half the banking losses in the EU economy are expected to come from the German banking system, yet radical change appears some way off. "The German government aims at stabilising the employment situation by subsidising cuts in working hours to avoid job losses," says Mortimer-Lee.

But this could well be a mistake. The bad news for the next British Chancellor, according to Mortimer-Lee, is that "the UK is the basket case of Europe." He continues: "There are few economies in a worse state than the UK, particularly in terms of the fiscal situation. The next Chancellor, whoever he or she is, will have a terrible job on their hands. They will have to cut spending and increase taxes. They will be very unpopular."

The problem facing CFOs, contends Clive Banks, head of derivatives and FX, European Corporates at BNP Paribas, is one of uncertainty. "For organisations," he says, "if deflation exists, it means they will lean towards delaying investment, as values will drop and the break even point will be that much further off."

Yet despite this deflationary economic forecast, he says that few companies have done a lot of work on the major impacts of either inflation or deflation. "This generation of finance directors has not lived through these sorts of problems," says Banks. "And may not know what their balance sheet and cashflows look like in a non-benign environment. There are many factors to take into consideration, since revenues and costs behave in different ways. Not to mention rents behave differently to wages and the fluctuating costs of raw materials. And there can be large timing differences in price adjustments. Balancing them all in an inflationary or deflationary economy or economies will prove difficult."

Protection versus premium

"For Mortimer-Lee, there is only one short-term risk, and that is definitely deflation. Although, if the authorities aren’t careful, their efforts to curb deflation could lead to inflation at a later date."

BNP Paribas offers a range of products that can help corporate clients avoid the worst of the impact. It has witnessed an increase of corporate clients in the market for inflation-linked derivatives, particularly those from the real estate, utility and retail sectors, who are exposed to inflation risk in their corporate liabilities or cashflows.

The company offers a number of risk mitigation tools to corporates, from "vanilla" swaps to volatility options to match the dynamics of underlying flows. The swap will typically be agreed over a set number of years and based on a notional amount (representing the figure on which the inflation and the fixed rate payments will be paid). The swap is tailored to fit an exposure and can, in most instances, be a more suitable route than an inflation-linked bond (or "linker").

In order to reduce the likelihood of being locked into a hedge, higher premium products, such as range accruals, caps and floors, may offer the necessary protection from volatility. In terms of linkers, to date the overwhelming majority of issuers of these bonds have been government organisations. Corporates have tended to issue fixed-interest debt and utilise the swaps market to handle inflation.

New IAS 39 exposure draft

One further complication for corporates comes in the form of accounting standards, in particular, IAS 39. To date IAS 39 has meant that inflation swaps do not qualify for hedge accounting and thus can introduce unwanted volatility into the P&L.

In July the International Accounting Standards Board published an Exposure Draft relating to the re-classification and measurement of financial instruments. It proposes that rather than the current complex classification system, there would instead be just two measurement categories: fair value and amortised cost, along with a single classification system for all financial instruments, including financial contracts with embedded derivative features. This would, effectively, place all financial instruments on a level playing field and may mean that the hedge accounting constraint on use of inflation derivatives is removed.

"The detail is undoubtedly complex," says Banks, "yet the underlying economic concerns are simple: the inflation outlook is highly uncertain and all companies should be planning ahead now if they wish to mitigate their risks."

This uncertain outlook is reflected in an increase in the market price of volatility. David Slater, head of inflation trading explains that volatility of inflation is now trading at double the level of interest rate volatility, whereas historically it has traded at closer to 60% (see graph). Whether you believe in deflation or inflation, we will be living outside the bands of low inflation we have enjoyed in recent years.

Mortimer-Lee agrees: "It is not about inflation at all, it's about deflation." And it is deflation, according to Mortimer-Lee, that governments and chief financial officers should be preparing for right now. Don't say you haven't been warned.

Paul Mortimer-Lee, global head of market economics at BNP Paribas
Luigi Speranza, head of inflation economics at BNP Paribas
Clive Banks, head of derivatives and FX, European Corporates at BNP Paribas
David Slater, head of inflation trading at BNP Paribas
Volatility of inflation trading at double the level of interest rate volatility