Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

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Macro Letter – No 48 – 29-01-2016

Central Banks – Ah Aaaaahhh! – Saviours of the Universe?

Flash-Gordon-flash-gordon-23432257-1014-1600

Copryright: Universal Pictures

  • Freight rates have fallen below 2008 levels
  • With the oil price below $30 many US producers are unprofitable
  • The Fed has tightened but global QE gathers pace
  • Chinese stimulus is fighting domestic strong headwinds

Just in case you’re not familiar with it here is a You Tube video of the famous Queen song. It is seven years since the Great Financial Crisis; major stock markets are still relatively close to their highs and major government bond yields remain near historic lows. If another crisis is about to engulf the developed world, do the central banks (CBs) have the means to avert catastrophe once again? Here are some of the factors which may help us to reach a conclusion.

Freight Rates

Last week I was asked to comment of the prospects for commodity prices, especially energy. Setting aside the geo-politics of oil production, I looked at the Baltic Dry Index (BDI) which has been plumbing fresh depths this year – 337 (28/1/16) down from August 2015 highs of 1200. Back in May 2008 it touched 11,440 – only to plummet to 715 by November of the same year. How helpful is the BDI at predicting the direction of the economy? Not very – as this 2009 article from Business Insider – Shipping Rates Are Lousy For Predicting The Economy – points out. Nonetheless, the weakness in freight rates is indicative of an inherent lack of demand for goods. The chart below is from an article published by Zero Hedge at the beginning of January – they quote research from Deutsche Bank.

BDI_-_1985_-_2016 (4)

Source: Zerohedge

A “Perfect Storm Is Coming” Deutsche Warns As Baltic Dry Falls To New Record Low:

…a “perfect storm” is brewing in the dry bulk industry, as year-end improvements in rates failed to materialize, which indicates a looming surge in bankruptcies.

The improvement in dry bulk rates we expected into year-end has not materialized.

…we believe a number of dry bulk companies are contemplating asset sales to raise liquidity, lower daily cash burn, and reduce capital commitments. The glut of “for sale” tonnage has negative implications for asset and equity values. More critically, it can easily lead to breaches in loan-to-value covenants at many dry bulk companies, shortening the cash runway and likely necessitating additional dilutive actions.

Dry bulk companies generally have enough cash for the next 1yr or so, but most are not well positioned for another leg down in asset values.

China

The slowing and rebalancing of the Chinese economy may be having a significant impact on global trade flows. Here is a recent article on the subject from Mauldin Economics – China’s Year of the Monkees:-

China isn’t the only reason markets got off to a terrible start this month, but it is definitely a big factor (at least psychologically). Between impractical circuit breakers, weaker economic data, stronger capital controls, and renewed currency confusion, China has investors everywhere scratching their heads.

When we focused on China back in August (see “When China Stopped Acting Chinese”), my best sources said the Chinese economy was on a much better footing than its stock market, which was in utter chaos. While the manufacturing sector was clearly in a slump, the services sector was pulling more than its fair share of the GDP load. Those same sources have new data now, which leads them to quite different conclusions.

…Now, it may well be the case that China’s economy is faltering, but its GDP data is not the best evidence.

…To whom can we turn for reliable data? My go-to source is Leland Miller and company at the China Beige Book.

…China Beige Book started collecting data in 2010. For the entire time since then, the Chinese economy has been in what Leland calls “stable deceleration.” Slowing down, but in an orderly way that has generally avoided anything resembling crisis. 

…China Beige Book noticed in mid-2014 that Chinese businesses had changed their behavior. Instead of responding to slower growth by doubling down and building more capacity, they did the rational thing (at least from a Western point of view): they curbed capital investment and hoarded cash. With Beijing still injecting cash that businesses refused to spend, the liquidity that flowed into Chinese stocks produced the massive rally that peaked in mid-2015. It also allowed money to begin to flow offshore in larger amounts. I mean really massively larger amounts.

Dealing with a Different China

China Beige Book’s fourth-quarter report revealed a rude interruption to the positive “stable deceleration” trend. Their observers in cities all over that vast country reported weakness in every sector of the economy. Capital expenditures dropped sharply; there were signs of price deflation and labor market weakness; and both manufacturing and service activity slowed markedly.

That last point deserves some comment. China experts everywhere tell us the country is transitioning from manufacturing for export to supplying consumer-driven services. So if both manufacturing and service activity are slowing, is that transition still happening?

The answer might be “yes” if manufacturing were decelerating faster than services. For this purpose, relative growth is what counts. Unfortunately, manufacturing is slowing while service activity is not picking up all the slack. That’s not the combination we want to see.

Something else China Beige Book noticed last quarter: both business and consumer loan volume did not grow in response to lower interest rates. That’s an important change, and probably not a good one. It means monetary stimulus from Beijing can’t save the day this time. Leland thinks fiscal stimulus isn’t likely to help, either. Like other governments and their central banks, China is running out of economic ammunition.

Mauldin goes on to discuss the devaluation of the RMB – which I also discussed in my last letter – Is the ascension of the RMB to the SDR basket more than merely symbolic? The RMB has been closely pegged to the US$ since 1978 though with more latitude since 2005, this has meant a steady appreciation in its currency relative to many of its emerging market trading partners. Now, as China begins to move towards full convertibility, the RMB will begin to float more freely. Here is a five year chart of the Indian Rupee and the CNY vs the US$:-

INR vs RMB - Yahoo

Source: Yahoo finance

The Chinese currency could sink significantly should their government deem it necessary, however, expectations of a collapse of growth in China may be premature as this article from the Peterson Institute – The Price of Oil, China, and Stock Market Herding – indicates:-

A collapse of growth in China would indeed be a world changing event. But there is just no evidence of such a collapse. At most there is suggestive evidence of a mild slowdown, and even that is far from certain. The mechanical effects of such a mild decrease on the US economy should, by all accounts, and all the models we have, be limited. Trade channels are limited (US exports to China represent less than 2 percent of GDP), and so are financial linkages. The main effect of a slowdown in China would be through lower commodity prices, which should help rather than hurt the United States.

Peterson go on to suggest:-

Maybe we should not believe the market commentaries. Maybe it was neither oil nor China. Maybe what we are seeing is a delayed reaction to the slowdown in the world economy, a slowdown that has now gone on for a few years. While there has been no significant news in the last two weeks, maybe markets are only realizing that growth in emerging markets will be lower for a long time, that growth in advanced economies will be unexciting. Maybe…

I think the explanation is largely elsewhere. I believe that to a large extent, herding is at play. If other investors sell, it must be because they know something you do not know. Thus, you should sell, and you do, and so down go stock prices. Why now? Perhaps because we have entered a period of higher uncertainty. The world economy, at the start of 2016, is a genuinely confusing place. Political uncertainty at home and geopolitical uncertainty abroad are both high. The Fed has entered a new regime. The ability of the Chinese government to control its economy is in question. In that environment, in the stock market just as in the presidential election campaign, it is easier for the bears to win the argument, for stock markets to fall, and, on the political front, for fearmongers to gain popularity.

They are honest enough to admit that economics won’t provide the answers.

Energy Prices

The June 2015 BP – Statistical Review of World Energy – made the following comments:-

Global primary energy consumption increased by just 0.9% in 2014, a marked deceleration over 2013 (+2.0%) and well below the 10-year average of 2.1%. Growth in 2014 slowed for every fuel other than nuclear power, which was also the only fuel to grow at an above-average rate. Growth was significantly below the 10-year average for Asia Pacific, Europe & Eurasia, and South & Central America. Oil remained the world’s leading fuel, with 32.6% of global energy consumption, but lost market share for the fifteenth consecutive year.

Although emerging economies continued to dominate the growth in global energy consumption, growth in these countries (+2.4%) was well below its 10-year average of 4.2%. China (+2.6%) and India (+7.1%) recorded the largest national increments to global energy consumption. OECD consumption fell by 0.9%, which was a larger fall than the recent historical average. A second consecutive year of robust US growth (+1.2%) was more than offset by declines in energy consumption in the EU (-3.9%) and Japan (-3.0%). The fall in EU energy consumption was the second-largest percentage decline on record (exceeded only in the aftermath of the financial crisis in 2009).

The FT – The world energy outlook in five charts – looked at five charts from the IEA World Energy Outlook – November 2015:-

Demand_Growth_in_Asia

Source: IEA

With 315m of its population expected to live in urban areas by 2040, and its manufacturing base expanding, India is forecast to account for quarter of global energy demand growth by 2040, up from about 6 per cent currently.

India_moving_to_centre

Source: IEA

Oil demand in India is expected to increase by more than in any other country to about 10m barrels per day (bpd). The country is also forecast to become the world’s largest coal importer in five years. But India is also expected to rely on solar and wind power to have a 40 per cent share of non-fossil fuel capacity by 2030.

A_new_chapter_in_Chinas_growth_story

Source: IEA

China’s total energy demand is set to nearly double that of the US by 2040. But a structural shift in the Asian country away from investment-led growth to domestic-demand based economy will “mean that 85 per cent less energy is required to generate each unit of future economic growth than was the case in the past 25 years.”

A_new_balancing_item_in_the_oil_market

Source: IEA

US shale oil production is expected to “stumble” in the short term, but rise as oil price recovers. However the IEA does not expect crude oil to reach $80 a barrel until 2020, under its “central scenario”. The chart shows that if prices out to 2020 remain under $60 per barrel, production will decline sharply.

Power_is_leading_the_transformation

Source: IEA

Renewables are set to overtake coal to become the largest source of power by 2030. The share of coal in the production of electricity will fall from 41 per cent to 30 per cent by 2040, while renewables will account for more than half the increase in electricity generation by then.

The cost of solar energy continues to fall and is now set to “eclipse” natural gas, as this article from Seeking Alpha by Siddharth Dalal – Falling Solar Costs: End Of Natural Gas Is Near? Explains:-

A gas turbine power plant uses 11,371 Btu/kWh. The current price utilities are paying per Btu of natural gas are $3.23/1000 cubic feet. 1000 cubic feet of natural gas have 1,020,000 BTUs. So $3.23 for 90kWh. That translates to 3.59c/kWh in fuel costs alone.

A combined cycle power plant uses 7667 Btu/kWh, which translates to 2.42c/kWh.

Adding in operating and maintenance costs, we get 4.11c/kWh for gas turbines and 3.3c/kWh for combined cycle power plants. This still doesn’t include any construction costs.

…The average solar PPA is likely to go under 4c/kWh next year. Note that this is the total cost that the utility pays and includes all costs.

And the trend puts total solar PPA costs under gas turbine fuel costs and competitive with combined cycle plant total operating costs next year.

At this point it becomes a no brainer for a utility to buy cheap solar PPAs compared to building their own gas power plants.

The only problem here is that gas plants are dispatchable, while solar is not. This is a problem that is easily solved by batteries. So utilities would be better served by spending capex on batteries as opposed to any kind of gas plant, especially anything for peak generation.

The influence of the oil price, whilst diminishing, still dominates. In the near term the importance of the oil price on financial market prices will relate to the breakeven cost of production for companies involved in oil exploration. Oil companies have shelved more than $400bln of planned investment since 2014. The FT – US junk-rated energy debt hits two-decade lowtakes up the story:-

US-High Yield - Thompson Reuters

Source: Thomson Reuters Datastream, FT

The average high-yield energy bond has slid to just 56 cents on the dollar, below levels touched during the financial crisis in 2008-09, as investors brace for a wave of bankruptcies.

…The US shale revolution which sent the country’s oil production soaring from 2009 to 2015 was led by small and midsized companies that typically borrowed to finance their growth. They sold $241bn worth of bonds during 2007-15 and many are now struggling under the debts they took on.

Very few US shale oil developments can be profitable with crude at about $30 a barrel, industry executives and advisers say. Production costs in shale have fallen as much as 40 per cent, but that has not been enough to keep pace with the decline in oil prices.

…On Friday, Moody’s placed 120 oil and gas companies on review for downgrade, including 69 in the US.

…The yield on the Bank of America Merrill Lynch US energy high-yield index has climbed to the highest level since the index was created, rising to 19.3 per cent last week, surpassing the 17 per cent peak hit in late 2008.

More than half of junk-rated energy groups in the US have fallen into distress territory, where bond yields rise more than 1,000 basis points above their benchmark Treasury counterpart, according to S&P.

All other things equal, the price of oil is unlikely to rally much from these levels, but, outside the US, geo-political risks exist which may create an upward bias. Many Middle Eastern countries have made assumptions about the oil price in their estimates of tax receipts. Saudi Arabia has responded to lower revenues by radical cuts in public spending and privatisations – including a proposed IPO for Saudi Aramco. As The Guardian – Saudi Aramco privatisation plans shock oil sector – explains, it will certainly be difficult to value – market capitalisation estimates range from $1trln to $10trln.

Outright energy company bankruptcies are likely to be relatively subdued, unless interest rates rise dramatically – these companies locked in extremely attractive borrowing rates and their bankers will prefer to renegotiate payment schedules rather than write off the loans completely. New issuance, however, will be a rare phenomenon.

Technology

“We don’t want technology simply because it’s dazzling. We want it, create it and support it because it improves people’s lives.”

These words were uttered by Canadian Prime Minister, Justin Trudeau, at Davos last week. The commodity markets have been dealing with technology since the rise of Sumer. The Manhattan Institutes – SHALE 2.0 Technology and the Coming Big-Data Revolution in America’s Shale Oil Fields highlights some examples which go a long way to explaining the downward trajectory in oil prices over the last 18 months – emphasis is mine:-

John Shaw, chair of Harvard’s Earth and Planetary Sciences Department, recently observed: “It’s fair to say we’re not at the end of this [shale] era, we’re at the very beginning.” He is precisely correct. In recent years, the technology deployed in America’s shale fields has advanced more rapidly than in any other segment of the energy industry. Shale 2.0 promises to ultimately yield break-even costs of $5–$20 per barrel—in the same range as Saudi Arabia’s vaunted low-cost fields.

…Compared with 1986—the last time the world was oversupplied with oil—there are now 2 billion more people living on earth, the world economy is $30 trillion bigger, and 30 million more barrels of oil are consumed daily. The current 33 billion-barrel annual global appetite for crude will undoubtedly rise in coming decades. Considering that fluctuations in supply of 1–2 MMbd can swing global oil prices, the infusion of 4 MMbd from U.S. shale did to petroleum prices precisely what would be expected in cyclical markets with huge underlying productive capacity.

Shipbuilding has also benefitted from technological advances in a variety of areas, not just fuel efficiency. This article (please excuse the author’s English) from Marine Insight – 7 Technologies That Can Change The Future of Shipbuilding – highlights several, I’ve chosen five:-

3-D Printing Technology:…Recently, NSWC Carderock made a fabricated model of the hospital ship USNS Comfort (T-AH 20) using its 3-D printer, first uploading CAD drawings of ship model in it. Further developments in this process can lead the industry to use this technique to build complex geometries of ship like bulbous bow easily. The prospect of using 3-D printers to seek quick replacement of ship’s part for repairing purpose is also being investigated. The Economist claims use this technology to be the “Third Industrial Revolution“.

Shipbuilding Robotics: Recent trends suggest that the shipbuilding industry is recognizing robotics as a driver of efficiency along with a method to prevent workers from doing dangerous tasks such as welding. The shortage of skilled labour is also one of the reasons to look upon robotics. Robots can carry out welding, blasting, painting, heavy lifting and other tasks in shipyards.

LNG Fueled engines

…In the LNG engines, CO2 emission is reduced by 20-25% as compared to diesel engines, NOX emissions are cut by almost 92%, while SOX and particulates emissions are almost completely eliminated.

…Besides being an environmental friendly fuel, LNG is also cheaper than diesel, which helps the ship to save significant amount of money over time.

…Solar & Wind Powered Ships:

…The world’s largest solar powered ship named ‘Turanor’ is a 100 metric ton catamaran which motored around the world without using any fuel and is currently being used as a research vessel. Though exclusive solar or wind powered ships look commercially and practically not viable today, they can’t be ruled out of future use with more technical advancements.

Recently, many technologies have come which support the big ships to reduce fuel consumption by utilizing solar panels or rigid sails. A device named Energy Sail (patent pending) has been developed by Eco Marine Power will help the ships to extract power from wind and sun so as to reduce fuel costs and emission of greenhouse gases. It is exclusively designed for shipping and can be fitted to wide variety of vessels from oil carrier to patrol ships.

Buckypaper: Buckypaper is a thin sheet made up of carbon nanotubes (CNT). Each CNT is 50,000 thinner than human air. Comparing with the conventional shipbuilding material (i.e. steel), buckypaper is 1/10th the weight of steel but potentially 500 times stronger in strength  and 2 times harder than diamond when its sheets are compiled to form a composite. The vessel built from this lighter material would require less fuel, hence increasing energy efficiency. It is corrosion resistant and flame retardant which could prevent fire on ships. A research has already been initiated for the use of buckypaper as a construction material of a future aeroplane. So, a similar trend can’t be ruled out in case of shipbuilding.

Shipping has always been a cyclical business, driven by global demand for freight on the one hand and improvements in technology on the other. The cost of production continues to fall, old inventory rapidly becomes uncompetitive and obsolete. The other factor effecting the cycle is the cost of finance; this is true also of energy exploration and development. Which brings us to the actions of the CBs.

The central role of the central banks

Had $100 per barrel oil encouraged a rise in consumer price inflation in the major economies, it might have been appropriate for their CBs to raise interest rates, however, high levels of debt kept inflation subdued. The “unintended consequences” or, perhaps we should say “collateral damage” of allowing interest rates to remain unrealistically low, is overinvestment. The BIS – Self-oriented monetary policy, global financial markets and excess volatility of international capital flows – looks at the effect developed country CB policy – specifically the Federal Reserve – has had on emerging markets:-

A major policy question arising from these events is whether US monetary policy imparts a global ‘externality’ through spillover effects on world capital flows, credit growth and asset prices. Many policy makers in emerging markets (e.g. Rajan, 2014) have argued that the US Federal Reserve should adjust its monetary policy decisions to take account of the excess sensitivity of international capital flows to US policy. This criticism questions the view that a ‘self-oriented’ monetary policy based on inflation targeting principles represents an efficient mechanism for the world monetary system (e.g. Obstfeld and Rogoff, 2002), without the need for any cross-country coordination of policies.

…Our results indicate that the simple prescriptions about the benefits of flexible exchange rates and inflation targeting are very unlikely to hold in a global financial environment dominated by the currency and policy of a large financial centre, such as the current situation with the US dollar and US monetary policy. Our preliminary analysis does suggest however that an optimal monetary policy can substantially improve the workings of the international system, even in the absence of direct intervention in capital markets through macro-prudential policies or capital controls. Moreover, under the specific assumptions maintained in this paper, this outcome can still be consistent with national independence in policy, or in other words, a system of ‘self-oriented’ monetary policy making.

Whether CBs should consider the international implications of their actions is not a new subject, but this Cobden Centre article by Alisdair Macleod – Why the Fed Will Never Succeed – suggests that the Fed should be mandated to accept a broader role:-

That the Fed thinks it is only responsible to the American people for its actions when they affect all nations is an abrogation of its duty as issuer of the reserve currency to the rest of the world, and it is therefore not surprising that the new kids on the block, such as China, Russia and their Asian friends, are laying plans to gain independence from the dollar-dominated system. The absence of comment from other central banks in the advanced nations on this important subject should also worry us, because they appear to be acting as mute supporters for the Fed’s group-think.

This is the context in which we need to clarify the effects of the Fed’s monetary policy. The fundamental question is actually far broader than whether or not the Fed should be raising rates: rather, should the Fed be managing interest rates at all? Before we can answer this question, we have to understand the relationship between credit and the business cycle.

There are two types of economic activity, one that correctly anticipates consumer demand and is successful, and one that fails to do so. In free markets the failures are closed down quickly, and the scarce economic resources tied up in them are redeployed towards more successful activities. A sound-money economy quickly eliminates business errors, so this self-cleansing action ensures there is no build-up of malinvestments and the associated debt that goes with it.

When there is stimulus from monetary inflation, it is inevitable that the strict discipline of genuine profitability that should guide all commercial enterprises takes a back seat. Easy money and interest rates lowered to stimulate demand distort perceptions of risk, over-values financial assets, and encourages businesses to take on projects that are not genuinely profitable. Furthermore, the owners of failing businesses find it possible to run up more debts, rather than face commercial reality. The result is a growing accumulation of malinvestments whose liquidation is deferred into the future.

Macleod goes on to discuss the Cantillon effect, at what point we are in the Credit Cycle and why the Fed decided to raise rates now:-

We must put ourselves in the Fed’s shoes to try to understand why it has raised rates. It has seen the official unemployment rate decline for a prolonged period, and more recently energy and commodity prices have fallen sharply. Assuming it believes government unemployment figures, as well as the GDP and its deflator, the Fed is likely to think the economy has at least stabilised and is fundamentally healthy. That being the case, it will take the view the business cycle has turned. Note, business cycle, not credit-driven business cycle: the Fed doesn’t accept monetary policy is responsible for cyclical phenomena. Therefore, demand for energy and commodities is expected to increase on a one or two-year view, so inflation can be expected to pick up towards the 2% target, particularly when the falls in commodity and energy prices drop out of the back-end of the inflation numbers. Note again, inflation is thought to be a demand-for-goods phenomenon, not a monetary phenomenon, though according to the Fed, monetary policy can be used to stimulate or control it.

Unfortunately, the evidence from multiple surveys is that after nine years since the Lehman crisis the state of the economy remains suppressed while debt has continued to increase, so this cycle is not in the normal pattern. It is clear from the evidence that the American economy, in common with the European and Japanese, is overburdened by the accumulation of malinvestments and associated debt. Furthermore, nine years of wealth attrition through monetary inflation (as described above) has reduced the purchasing power of the average consumer’s earnings significantly in real terms. So instead of a phase of sustainable growth, it is likely America has arrived at a point where the economy can no longer bear the depredations of further “monetary stimulus”. It is also increasingly clear that a relatively small rise in the general interest rate level will bring on the next crisis.

So what will the Fed – and, for that matter, other major CBs – do? I look back to the crisis of 2008/2009 – one of the unique aspects of this period was the coordinated action of the big five: the Fed, ECB, BoJ, BoE and SNB. In 1987 the Fed was the “saviour of the universe”. Their actions became so transparent in the years that followed, that the phase “Greenspan Put” was coined to describe the way the Fed saved stock market investors and corporate creditors. CEPR – Deleveraging? What deleveraging? which I have quoted from in previous letters, is an excellent introduction to the unintended consequences of CB largesse.

Since 2009 economic growth has remained sluggish; this has occurred despite historically low interest rates – it’s not unreasonable to surmise that the massive overhang of debt, globally, is weighing on both demand pull inflation and economic growth. Stock buy-backs have been rife and the long inverted relationship between dividend yields and government bond yields has reversed. Paying higher dividends may be consistent with diversifying a company’s investor base but buying back stock suggests a lack of imagination by the “C” Suite. Or perhaps these executives are uncomfortable investing when interest rates are artificially low.

I believe the vast majority of the rise in stock markets since 2009 has been the result of CB policy, therefore the Fed rate increase is highly significant. The actions of the other CBs – and here I would include the PBoC alongside the big five – is also of significant importance. Whilst the Fed has tightened the ECB and the PBoC continue to ease. The Fed appears determined to raise rates again, but the other CBs are likely to neutralise the overall effect. Currency markets will take the majority of the strain, as they have been for the last couple of years.

A collapse in equity markets will puncture confidence and this will undermine growth prospects globally. Whilst some of the malinvestments of the last seven years will be unwound, I expect CBs to provide further support. The BoJ is currently the only CB with an overt policy of “qualitative easing” – by which I mean the purchasing of common stock – I fully expect the other CBs to follow to adopt a similar approach. For some radical ideas on this subject this paper by Professor Roger Farmer – Qualitative Easing: How it Works and Why it Matters – which was presented at the St Louis Federal Reserve conference in 2012 – makes interesting reading.

Investment opportunities

In comparison to Europe– especially Germany – the US economy is relatively immune to the weakness of China. This is already being reflected in both the currency and stocks markets. The trend is likely to continue. In the emerging market arena Brazil still looks sickly and the plummeting price of oil isn’t helping, meanwhile India should be a beneficiary of cheaper oil. Some High yield non-energy bonds are likely to be “tarred” (pardon the pun) with the energy brush. Meanwhile, from an international perspective the US$ remains robust even as the US$ Index approaches resistance at 100.

US_Index_-_5_yr_Marketwatch

Source: Marketwatch

Is the ascension of the RMB to the SDR basket more than merely symbolic?

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Macro Letter – Supplemental – No 2 – 11-12-2015

Is the ascension of the RMB to the SDR basket more than merely symbolic?

  • Chinese rebalancing towards domestic consumption changes the balance of trade
  • China’s largest trading partner remains the EU, making a US$ peg sub-optimal
  • SDR currencies offer the best liquidity for intervention or speculation
  • International investment will be dramatically enhanced by full convertibility

I’ve changed my view of the importance of the RMBs inclusion in the SDR. Initially I thought this a purely symbolic action but, having discussed the issue with several economists and ex-Central Bankers (including one from the PBoC) I believe this a logical move towards free convertibility of the RMB.

For many years the RMB has been pegged to the US$. During the early part of this century it rose relative to its neighbours. This was not such a great imposition on the economy since annual GDP growth was still in double figures.

After the great financial recession of 2008 things changed. New economic policies focused on increasing domestic consumption. At the same time the Chinese economy began to slow dramatically as a result of over-investment, especially in primary industries, meanwhile, the benefits of cheap labour, which had driven China’s mercantilist expansion during the past 25 years, showed signs of fatigue.

After 2008, the US embarked on aggressive quantitative easing which eventually began to foster new domestic employment opportunities – in turn leading to a recovery of the fortunes of the US$. Earlier this year the PBoC devalued the RMB albeit to a small degree.

If you were the PBoC what would you do?

China is rebalancing towards domestic consumption at a pace which would be almost inconceivable in any other country. The implications of this shift include an increase in imports and a structural adjustment in the momentum of the trade surplus. China is moving on from simply being the world’s manufacturer to become a trading nation. A freely convertible currency would reduce frictions in trade and encourage foreign direct investment. The downside to this regime change is the volatility of the exchange rate.

At $3.5trln the PBoC has the largest foreign reserves of any Central Bank. This has primarily been a function of their peg against the US$, although they have actively sought to diversify in to EUR and even the “barbarous relic” gold. During the last 18 months the bank has drawn down on some of those reserves (they peaked at $3.9trln in May 2014) as it managed a devaluation versus the US$ which has fallen from RMBUSD 6.05 in January 2014 to RMBUSD 6.49 today (8-12-2015).

Has the benefit of the US$ peg now run its course? During the period of strong – export led – growth, China was under significant international political pressure to allow the RMB to rise against the US$. The perception is that they resisted international interference, but over the last 20 years the RMB has risen by around 30%. Nonetheless, market commentators immediately seized on the devaluation – especially since August – as a sign that the Chinese were engineering an export led recovery at the expense of the US. This 2013 paper from the Bundesbank – China‘s role in global inflation dynamics suggests there may be some substance to these concerns:-

The overall share of international inflation explained by Chinese shocks is notable (about 5 percent on average over all countries but not more than 13 percent in each region). This suggests that monetary policy makers should take macroeconomic developments in China into account when stabilizing domestic inflation rates; (ii) Direct channels (via import and export prices) and indirect channels (via greater exposure to foreign competition and commodity prices) both seem to matter; (iii) Differences in trade (overall and with China) and in commodity exposure help explaining cross-country differences in price responses.

Nonetheless, the authors note that, between 2002 and 2011, the “supply shock” from cheap Chinese goods explained only 1% of changes in consumer prices outside China, whilst the “demand shock”, from rapid Chinese, growth accounted for 3.6% of changes in global consumer prices. 95% of the variation in global inflation were due to non-Chinese factors.

As the Trans Pacific Partnership comes into effect, China needs to embark on a series of bilateral trade agreements. After the US, its largest trading partners are Japan, South Korea, Taiwan, Germany, Australia and Malaysia, however, as a currency trading block the Euro Area is preeminent.

There are two alternatives to a US$ peg, the first is to manage the RMB effective exchange rate, but this would be expensive due to the multiple currencies involved, the second option is to peg the RMB to the SDR basket. Both politically and economically this acknowledges China’s position as the second largest economy. It also heralds another incremental change in perception about the pre-eminence of the US$ as a reserve currency.

The RMB will be included in the SDR from October 2016. As the Chinese administration moves towards free-convertibility it is likely that they will start by widening the degree to which the currency can fluctuate. By managing the RMB versus the other SDR currencies they can take advantage of the liquidity these currencies provide and the lower volatility that the SDR basket has relative to its constituents. This will also allow the PBoC to intervene to stem the largest speculative currency flows. Table below shows the annual level of trade by region (2011):-

Region Exports Imports Total trade Trade balance
 European Union 356 211.2 567.2 144.8
 United States 324.5 122.2 446.7 202.3
 Hong Kong 268 15.5 283.5 252.5
 ASEAN 170.1 192.8 362.9 -22.7
 Japan 148.3 194.6 342.9 -46.3

 

Source: China National Statistics Bureau

Capital Flows

Trade is one aspect of China’s development, the other is capital; the Kansas City Federal Reserve Macro Bulletin – Global Capital Flows from China – takes up the story:-

In 2014-15, China experienced five consecutive quarters of capital outflows for the first time since 2000, and the annual volume of outflows is at a record level. If growth expectations continue to soften, this trend may continue in the near future.

China has been an active investor in Africa and other resource-rich regions, but, as its competitive advantages from labour dissipate, external investment will become far more important. Another reason to allow full convertibility.

Technical issues and challenges

The two requirements for joining the SDR are; being a larger exporter – which is no issue for China -and having a freely accessible currency. They still have some way to go on the latter, but China now has more than two dozen swap lines with foreign central banks, has promoted offshore trading and abolished quotas for foreign central banks and sovereign wealth funds investing in mainland bonds. 

RMB fixing – the PBoC as a participating SDR central bank, must provide the IMF with a daily fix. Currently there is a gap between domestic and the offshore RMB rate, closing that gap will be an operational challenge.

SDR currencies are weighted based on trade and reserve status – Marc Chandler – China And The Pull Of The SDR – elaborates:-

Given China’s export prowess, it suggests the yuan should be a major currency in the SDR. However, as a reserve asset, it is very small. The IMF estimates the yuan’s share of reserves at a minuscule 1.1%.

For more on the technical aspects of the SDR this paper from Europacifica – The RMB in the SDR and why Australia should care offers more insights.

In October China issued its first Treasury bill on the international market. Here is how it was reported by the FT – China completes first London debt sale:-

Spencer Lake, global head of capital financing at HSBC, one of the banks that arranged the sale, called the transaction a milestone in the internationalisation of the renminbi, noting that it was the first debt offering in any currency from the PBoC outside China.

“This strategic move demonstrates the clear commitment by the Chinese authorities to grow the offshore bond market and the confidence in the City of London as a leading renminbi hub for future activities,” he said.

“The PBoC bond will give a genuine boost to liquidity, market confidence and provide investors with the quality that they demand.”

Who will buy the non-performing loans?

Another reason China may want to move towards free convertibility is to encourage foreign investment. An article from Zero-Hedge – One Analyst Says China’s Banking Sector Is Sitting On A $3 Trillion Neutron Bomb explains:-

If one very conservatively assumes that loans are about half of the total asset base (realistically 60-70%), and applies an 20% NPL to this number instead of the official 1.5% NPL estimate, the capital shortfall is a staggering $3 trillion. 

That, as we suggested three weeks ago, may help to explain why round after round of liquidity injections (via RRR cuts, LTROs, and various short- and medium-term financing ops) haven’t done much to boost the credit impulse. In short, banks may be quietly soaking up the funds not to lend them out, but to plug a giant, $3 trillion, solvency shortfall. 

Conclusion

I believe the inclusion of the RMB in the SDR is more than simply symbolic. It will allow the PBoC to move away from a US$ peg, widen it trading bands and balance its currency more effectively relative to its main trading partners. PBoC Intervention can be generally confined to SDR currencies which, due to their high liquidity, will be the cross-currency pairs of choice for speculators.

China versus India – Currencies, Reform and Growth

400dpiLogo

Macro Letter – No 31 – 06-03-2015

China versus India – Currencies, Reform and Growth

  • India announced a reformist budget, short on detail but market friendly
  • The PBoC cut interest rates again but are still behind the curve
  • Chinese and Indian Real-Estate prices continue to decline in real terms
  • INR/CNY exchange rate will move higher

Last month PWC – The World in 2050 – produced a long-term forecast for economic growth in which they predicted that India could become the second largest economy in the world by 2050 in purchasing power parity (PPP) and third largest in market exchange rate (MER) terms. Putting the scale of world economies in to perspective they say:-

China has already overtaken the US for the number one spot, and will remain as the world’s largest economy in 2050. India could narrowly overtake the US for the number two spot by 2050. However, the gap between the third largest economy and the fourth largest economy will widen considerably. In 2014, the third biggest economy (India) is around 50% larger than the fourth biggest economy (Japan). In 2050, the third biggest economy (the US) is projected to be approximately 240% larger than the fourth biggest economy (Indonesia).

The prospects from the BRIC economies are mixed. Russia is entangled in the geo-politics of the Ukraine and its economy has suffered from falling energy prices as this article from Chatham House – Troubled Times: Stagnation, Sanctions and the Prospects for Economic Reform in Russia explains. Meanwhile Brazil, still reeling from the stagnation of 2013, looks set to head into a fully-fledged recession exacerbated by high, wage-squeezing, inflation resulting from the near 30% decline in its currency. The prospects for India and China are much better.

India

Last week Arun Jaitley, India’s finance minister, announced a budget which he described as “a quantum jump”. Among other things, he intends to:-

  • Implement an RBI inflation target
  • Maintain a national government budget deficit of 4.1% of GDP in cash terms
  • Target a budget reduction to 3% of GDP in 2017-2018
  • Increase Spending on road construction and power generation
  • Streamline subsidies and accelerate the de-nationalization of state industries
  • Introduce a harmonised goods and sales tax, by April 2016, to replace state and federal levies – potentially adding 2% to GDP by creating an India-wide “common market”
  • Rationalise direct-taxation – cutting corporation tax but closing loopholes, abolishing a wealth tax in favour of an income tax surcharge on higher earners

This amounts to a decidedly reformist agenda, although the speech was light on detail. It removes several barriers to investment in India, although the issue of reform of land laws remains unresolved.

China

Meanwhile, last Saturday, the People’s Bank of China (PBoC) cut interest rates. This is the third accommodative move in as many months. Their motivation appears to be three-fold:-

  • Stimulate Credit Growth.
  • The fall in credit as measured by “total social financing” -13.5% y/y in January 2015 versus a +17.5% in January 2014. This may also allow SOEs and SMEs to service existing debt acquired during the indiscriminate credit expansion of 2009.
  • Alleviate Falling inflation.
  • The inflation rate has declined by 1.7% since Q4 2014. Lending rates are only 20bp lower over the same period. In other word a “real” tightening of 1.5% has occurred.
  • Stem Capital Outflows.
  • The capital and financial account deficit hit a decade high of $91.2bln in Q4 2014. This is a sharp deterioration, in 2013 the capital account surplus for the year was $326.2bln

This action may still not be sufficient to re-invigorate the Chinese economy. It fuels hopes for further accommodation later this year. This could take the form of lower interest rates, additional liquidity, reduction in bank reserve requirements or some form of fiscal stimulus. Last year the Chinese government budget deficit was 2.1% of GDP, there is plenty of room for manoeuver.

China and India as economic dynamos

Before delving into the details of monetary policy in each country, it is worth taking a broad overview of the Chinese and Indian economies from a global perspective.

The table below shows the major economic regions of the world ranked by population: –

Country GDP-YOY Interest Rate Inflation Rate Jobless Rate Debt/GDP C/A Population
China 7.30% 5.35% 0.80% 4.10% 22.40% 2 1360.72
India 7.50% 7.75% 5.11% 5.20% 67.72% -1.7 1238.89
EA 0.90% 0.05% -0.30% 11.20% 90.90% 2.4 334.57
USA 2.40% 0.25% -0.10% 5.70% 101.53% -2.3 318.86
Brazil -0.20% 12.25% 7.14% 5.30% 56.80% -4.17 202.77
Russia 0.70% 15.00% 15.00% 5.50% 13.41% 1.56 143.7
Japan -0.50% 0.00% 2.40% 3.60% 227.20% 0.7 127.02

 

Source: Trading Economics

India and China stand out as the engines of economic growth. They have a combined population of more than 3.5bln. On a GDP per capita basis both countries have far to go. Indian GDP/Capita is $1,165 and China $3,583, compared to Euro Area $31,807 and USA $45,863. However, as PWC say in their report, the gap between the rich and these relatively poor countries is likely to narrow in percentage terms significantly by 2050.

Here are some more statistics which help to show the similarities and differences between the two economies:-

Criteria China India
Age structure 0-14 years: 17.1% 0-14 years: 28.5%
15-24 years: 14.7% 15-24 years: 18.1%
25-54 years: 47.2% 25-54 years: 40.6%
55-64 years: 11.3% 55-64 years: 7%
65 years and over: 9.6%(2014 est.) 65 years and over: 5.8%(2014 est.)
Median age total: 36.7 years total: 27 years
male: 35.8 years male: 26.4 years
female: 37.5 years (2014 est.) female: 27.7 years (2014 est.)
Population growth rate 0.44% (2014 est.) 1.25% (2014 est.)
Birth rate 12.17 births/1,000 (2014 est.) 19.89 births/1,000 (2014 est.)
Death rate 7.44 deaths/1,000 (2014 est.) 7.35 deaths/1,000 (2014 est.)
Net migration rate -0.32 migrant(s)/1,000 (2014 est.) -0.05 migrant(s)/1,000 (2014 est.)
Urbanization – Urban 50.6% of total population (2011) 31.3% of total population (2011)
Rate of Urbanization 2.85% annual (2010-15 est.) 2.47% annual (2010-15 est.)
Major cities – population Shanghai 20.2mln                                                            BEIJING (capital) 15.6mln (2011) NEW DELHI (capital) 22.6mln                                        Mumbai 19.7mln (2011)
Infant mortality rate 14.79 deaths/1,000 live births 43.19 deaths/1,000 live births
Life expectancy at birth 75.15 years 67.8 years
Total fertility rate 1.55 children born/woman (2014 est.) 2.51 children born/woman (2014 est.)
Infectious diseases degree of risk: intermediate degree of risk: very high
Literacy – age 15 (can read and write) total population: 95.1% total population: 62.8%
male: 97.5% male: 75.2%
female: 92.7% (2010 est.) female: 50.8% (2006 est.)
School life expectancy 13 years 12 years
Education expenditures NA 3.2% of GDP (2011)
Maternal mortality rate 37 deaths/100,000 live births (2010) 200 deaths/100,000 live births (2010)
Children under weight <5yrs 3.4% (2010) 43.5% (2006)
Health expenditures 5.2% of GDP (2011) 3.9% of GDP (2011)
Physicians density 1.46 physicians/1,000 population (2010) 0.65 physicians/1,000 population (2009)
Hospital bed density 3.8 beds/1,000 population (2011) 0.9 beds/1,000 population (2005)
Adult Obesity 5.7% (2008) 1.9% (2008)

 

Source: Index Mundi

From a Chinese perspective the main elements which stand out in the table above are:-

  • Slower birth rate, aging population and lower fertility rate – according to the UN China’s working age population will decline by 16% between now and 2050
  • Higher literacy, especially female literacy
  • Lower mortality rate and higher health expenditure

For India, improvements in education, sanitation and healthcare are key factors.

Indian Monetary Policy

The Reserve Bank of India (RBI) cut their key Repo Rate in December 2014. Despite falling oil prices they have left this rate unchanged as the effects of the currency devaluation of 2013 work their way through the economy. This is an extract from the RBI Bulletin – February 2015:-

On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:-

  • keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 7.75 per cent;
  • keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liabilities (NDTL);
  • reduce the statutory liquidity ratio (SLR) of scheduled commercial banks by 50 basis points from 22.0 per cent to 21.5 per cent of their NDTL with effect from the fortnight beginning February 7, 2015;
  • replace the export credit refinance (ECR) facility with the provision of system level liquidity with effect from February 7, 2015;
  • continue to provide liquidity under overnight repos of 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75 per cent of NDTL of the banking system through auctions; and
  • continue with daily variable rate term repo and reverse repo auctions to smooth liquidity

They go on to defend their hawkish stance on inflation:-

The upside risks to inflation stem from the unlikely possibility of significant fiscal slippage, uncertainty on the spatial and temporal distribution of the monsoon during 2015 as also the low probability but highly influential risks of reversal of international crude prices due to geo-political events. Heightened volatility in global financial markets, including through the exchange rate channel, also constitute a significant risk to the inflation assessment. Looking ahead, inflation is likely to be around the target level of 6 per cent by January 2016.

Their growth forecasts are also cautious:-

The outlook for growth has improved modestly on the back of disinflation, real income gains from decline in oil prices, easier financing conditions and some progress on stalled projects. These conditions should augur well for a reinvigoration of private consumption demand, but the overall impact on growth could be partly offset by the weaker global growth outlook and short-run fiscal drag due to likely compression in plan expenditure in order to meet consolidation targets set for the year. Accordingly, the baseline projection for growth using the old GDP base has been retained at 5.5 per cent for 2014-15. For 2015-16, projections are inherently contingent upon the outlook for the south-west monsoon and the balance of risks around the global outlook. Domestically, conditions for growth are slowly improving with easing input cost pressures, supportive monetary conditions and recent measures relating to project approvals, land acquisition, mining, and infrastructure. Accordingly, the central estimate for real GDP growth in 2015-16 is expected to rise to 6.5 per cent with risks broadly balanced at this point.

Since this report GDP data has surprised on the upside and the Indian Finance Ministry even suggested their own forecast could be revised to 8.5% – this is how the Wall Street Journal reported it, last week:-

India is in a “sweet spot,” the report said: Inflation has eased, international investors are bullish on India and the government in New Delhi has a strong mandate for change.

If the Modi administration continues improving the business environment and reducing government interference in the prices of food, fuel and other basic goods, the survey said, India’s GDP eventually could experience double-digit growth. That would give the country more resources to help its poor and provide opportunities for its young, growing middle class.

The combination of a relatively weak currency, declining inflation, accelerating growth and a structural reform package, from a government with a strong mandate from its electorate, are a heady cocktail. The RBI underpins these developments by holding back on interest rate cuts. The INR has taken this to heart as the chart below shows. It is still dangerous for the RBI to aggressively cut interest rates – the moderation in inflation needs to feed through to inflation expectations – but inward foreign direct investment could lead to a steady appreciation in the INR over the next couple of years. I wait for technical confirmation of this trend which could see at least a 61.8% correction of the 2011/2013 range (44-68) around USDINR 53:-

USDINR 5 yr

Source: Barchart.com

Chinese Monetary Policy

The Peoples Bank of China (PBoC) announced an interest rate cut last Saturday, lowering the one year rate to 5.35% from 5.6% previously. A PBoC official stated Deflationary risk and the property market slowdown are two main reasons for the rate cut this time,” The PBoC press release was somewhat drier:-

The one-year RMB benchmark loan interest rate and deposit interest rate will both be lowered by 0.25 percentage points, to 5.35 percent and 2.5 percent, respectively. At the same time, the upper limit of the floating range for deposit interest rates will be raised from 1.2 to 1.3 times the benchmark level in support of market-oriented interest rate reform. Adjustments are made correspondingly to benchmark interest rates on deposits and loans of other maturities, and to deposit and loan interest rates on personal housing provident fund.

This is the second rate cut in four months. They also introduced a Standing Lending Facility to create better liquidity:-

To implement the decisions adopted at the Central Economic Work Conference as well as the requirements of the 2015 PBC Work Conference and PBC Money, Credit and Financial Market Work Meeting, to improve the central bank’s liquidity support channels for small and medium-sized financial institutions, to address seasonal liquidity fluctuations in the run-up to Spring Festival, and to promote stable functioning of the money market, the PBC has decided, based on the reproducible experience from the pilot Standing lending Facility (SLF) program participated by the branch offices in ten provinces (and municipalities), to introduce SLF operations in branch offices nationwide. As a result, the PBC branch offices will provide SLF on collaterals to four categories of local legal-entity financial institutions, i.e., the city commercial banks, rural commercial banks, rural cooperative banks, and rural credit cooperatives.

This followed on from a cut to Bank Reserve Requirements announced on February 5th:-

The PBC has decided to cut the RMB deposit required reserve ratio for financial institutions by 0.5 percentage points, effective from February 5, 2015. Furthermore, in order to enhance the capacity of financial institutions to support structural adjustment, and to beef up support to small and micro enterprises, the agricultural sector, rural area and farmer, and major water conservancy projects, the PBC has decided to cut the RMB deposit required reserve ratio for city commercial banks and non-county level rural commercial banks that have met the standards of targeted required reserve reduction by an additional 0.5 percentage points, and cut the required reserve ratio for the Agricultural Development Bank of China by an additional 4 percentage points.

The continued pegging of the RMB – within tight parameters – to the US$ means that China is a beneficiary of the rising US$, but this is something of a double-edged sword since the currency appreciation has been damaging for Chinese exporters. The slowing of the Chinese economy over the last few months and PBoC action has heralded a much needed weakening of the CNY rate as this chart shows:-

USDCNH Oct 2012-March 2015

Source: Barchart.com

The PBoC rate cut will probably not be the last action to stimulate economic activity, being pegged to a currency which has been steadily rising on a trade-weighted basis whilst maintaining a substantial interest rate differential is a difficult long-term operation even for an economy as closed to international capital flows as China. The BIS – Assessing the CNH-CNY pricing differential: role of fundamentals, contagion and policy released this week, discusses some of these issues in greater detail, here is the abstract:-

Renminbi internationalisation has brought about an active offshore market where the exchange rate frequently diverges from the onshore market. Using extended GARCH models, we explore the role of fundamentals, global factors and policies related to renminbi internationalisation in driving the pricing differential between the onshore and offshore exchange rates. Differences in the liquidity of the two markets play an important role in explaining the level of the differential, while rises in global risk aversion tend to increase the differential’s volatility. On the policy front, measures permitting cross-border renminbi outflows have a particularly discernible impact in reducing the volatility of the pricing gap between the two markets.

A weaker RMB would help China more than devaluations have aided other emerging market countries since most of China’s debt is denominated in their own currency, however, a major factor acting as a drag on economic growth is over-investment. At more than 50%, China has the highest level of investment as a percentage of GDP of any major economy – in the UK, by contrast, investment amounts to less than 20%.

Asset Markets

Indian Real-Estate

With relatively high short-term interest rates and uncertainty still hanging over the market due to the currency devaluation of 2013, Indian Real-Estate transactions have been sluggish. In 2014 residential sales were down 30% y/y across India’s seven major cities. A growing inventory of unsold properties is weighing on the domestic banks. Real-Estate accounts for around 13% of Indian bank lending. With non-performing loans on the rise, lower interest rates would be very welcome for the banking sector. The chart below shows the age of property for sale and the length of time these properties are taking to sell in the major cities – a region which accounts for around 70% of India’s property development:-

Unsold Indian Property - Frank Knight

Source: Knight Frank

The National Housing Bank – a subsidiary of the RBI – publishes an index of prices. With an inverted government bond yield curve (1yr 7.83% vs 10yr 7.68% – 4-3-2015) and a substantial over-hang of inventory, it is not surprising that prices are struggling to make much real upside even in the best areas:-

NHB - Price Data

Source: National Housing Bank

A new government initiative called the Smart Cities Project was launched last year with $1.2bln of funding for 2015. Long-term, this will help to deliver the housing and infrastructure India needs, but, near-term, Real-Estate is an asset class which remains supressed. Many apartment buildings stand empty and whilst real prices have not declined significantly, market activity remains very subdued. I do see value developing; there will be an opportunity to invest over the next couple of years as the economy responds to structural reforms.

Demand will emanate from urbanisation and an increase in high and middle income workers returning to India – after all, the “quality of life” for skilled workers returning home is compelling. A working paper from the Peterson Institute – The Economic Scope and Future of US-India Labor Migration Issues looks at the positive impact of both temporary and permanent Indian labour on US markets, they go on to raise concerns about recent US immigration policy:-

…but US immigration data show that India is by far the most important partner country for both permanent and temporary US employment-based migration: Indian nationals account for about half of all US employment-based permanent migration (e.g., green cards) in recent years.

…The prospects of a US-India totalization agreement for social contributions/taxation as part of an FTA are evaluated. A TA is likely to result in indirect economic losses to the United States from the loss of payroll taxes paid but never claimed by temporary Indian workers in the United States. The substantial political and economic quid pro quo that India would have to commit to in order to incentivize the United States to negotiate a TA would be daunting and seems likely to diminish the attractiveness of an FTA to India.

This 2012 paper from the Institute for European Studies – India’s Returning Elite Knowledge Workers is an excellent insight into the inward migration of skilled workers to the major cities of India’s North East. Here is a summary of the “Brain-Gain”:-

India’s rising independence in the last decade as an economic actor constitutes new issues in global governance for a large skilled workforce. What once constituted a ‘brain-drain’ for Indian actors that emigrated to the Global North (EU and US economic powers), is now resulting in a ‘brain-gain’ for the sending countries. India, as a representative power of the emerging Global South, has been a leader in creating cross-border social networks for entrepreneurship through ties between the Indian expatriate community and local entrepreneurs in industries that are enticing Western agents. 

This dissertation project investigates how the ‘brain gain’ of high-skilled entrepreneurs of Indian origin has transformed the landscape of infrastructure and social relations within emergent Global South cities in India based upon elite trans-migrant imaginaries of home. India’s growth as a global power attributed to cross border diasporic networks of Indian transnationals has given rise to a generation of permanently returning migrants to India’s cosmopolitan cities. This paper explores the movement of transnational Indian elites returning from the United States and Europe to postcolonial India. Through ethnographic interviews in Silicon Valley, California, I attempt to understand why social and technological entrepreneurs of Indian origin, those who see their return as a new venture or idea, are returning to accommodate a hybridized Western lifestyle within an Indian socio-cultural context. These entrepreneurs are transforming the peripheries of the cosmopolitan global city through the gated communities where they reside and Special Economic Zones where they work toward developing new business and change in India. By examining the narratives and everyday life of elite diasporic returners in their newfound ‘home’ spaces, I question (a) what are the principle motivations that guide entrepreneurs to return to India (b) whether the cosmopolitan Global South city can function as a hybrid ‘home’ and (c) in locating ‘home’ by transforming their spatial and temporal relationships, how are power relations constituted.

Chinese Real-Estate

Shanghai Real-Estate has risen by 650% since 2000 and by 85% since the last peak in 2007, although nationwide the increase in the period from 2008 to 2013 was a more moderate 20%. The driving force behind this price increase has been urbanisation. In the past 12 years 220mln people have move from rural to urban districts in China. A large number of these new, often unskilled, city dwellers have been employed in construction. It is estimated that 27% of urban Real-Estate is unoccupied. This explains the recent downturn in Chinese Real-Estate prices as this chart of newly built housing shows:-

china-housing-index

Source: Trading Economics and National Bureau of Statistics of China

In January the decline was -5.1% versus -4.3% in December and -3.7% in November 2014. Price drops were recorded in 64 of the 70 major cities, compared to 66 in December. Declines are not evenly distributed: the average price of new homes in the country’s four first-tier cities rose for the second consecutive month. The existing housing market is also more buoyant for first-tier cities, rising for the fourth month in a row. In second and third-tier cities prices continue to decline.

Writing in the FT – How addiction to debt came even to China Martin Wolf describes the problem overhanging the Chinese property market:-

China’s huge credit boom has several disquieting features. Much of the rise in debt is concentrated in the property sector; “shadow banking” — that is lending outside the balance sheets of the formal financial institutions — accounts for 30 per cent of outstanding debt, according to McKinsey; much of the borrowing has been put on off-balance-sheet vehicles of local governments; and, above all, the surge in debt was not linked to a matching rise in trend growth, but rather to the opposite.

This does not mean China is likely to experience an unmanageable financial crisis. On the contrary, the Chinese government has all the tools it needs to contain a crisis. It does mean, however, that an engine of growth in demand is about to be switched off. As the economy slows, many investment plans will have to be reconsidered. That may start in the property sector. But it will not end there. In an economy in which investment is close to 50 per cent of GDP, the downturn in demand (and so output) might be far more severe than expected.

Despite this relatively sanguine appraisal of the prospects for the housing market it is worth pointing out that 75% of Chinese individual net worth is tied up in Real-Estate – by way of comparison, in the US the figure is 28%.

Chinese Real-Estate may recover at some point, probably in response to wage growth – currently running at around 8% in real terms, buoyed by state mandated minimum wage increases (13%) and strong growth in private manufacturing (12%). For the present I expect Real-Estate prices to continue to decline. This will eventually exert significant downward pressure on private domestic consumption – an impediment to the policy of “re-balancing”.

Indian Equities

Indian equities have performed strongly due to the currency devaluation, high inflation and relatively strong economic growth. Money supply has moderated in response to higher interest rates but is still sufficient to encourage asset market speculation. The chart below covers the period up to January 2014 but the double digit expansion has continued during the last year:-

India_Money_supply

Source: RBI

The currency devaluation of 2013 has fed through to higher inflation but the fall in oil prices has narrowed the current account deficit, whilst exports have held up well. This, among other factors, has supported a rise in stocks, despite the RBI’s hawkish stance:-

BSE_1yr

Source: Bigcharts.com

The SENSEX Index is trading on a current P/E ratio of 18.52. This is still in the lower half of the 5 year range (16.5 to 24). With growth prospects likely to be revised higher, I believe the market will continue to exhibit strong performance over the coming year.

Chinese Equities

The Shanghai Composite performed strongly in Q4 2014 as markets became cognizant of the PBoCs dovish policy shift. Government policy is also supportive, with the continued development of Free Trade Zones remaining high on their agenda. The Jamestown Foundation – “Hope” versus “Hype”: Reforms in China’s Free Trade Zones provides more detail and suggests they may fail to realize their early promise:-

After a year of the Shanghai pilot FTZ, three new FTZs are now being established in the major sea-port cities of Guangdong, Tianjin and Fujian (South China Morning Post, December 13, 2014). Fujian is the closest mainland province to Taiwan, Tianjin specializes in international shipping and related sectors and Guangdong is adjacent to Hong Kong and Macao and is close to Southeast Asia. However, the troubles of the Shanghai FTZ—despite the personal high-level support of Premier Li—suggest that these new FTZs will face an uphill battle in expanding the grounds of economic liberalization in China.

Most Promises Stand Unfulfilled

China’s slowing growth has led many foreign companies to consider scaling back their expansion plans, and the Shanghai FTZ has failed to deliver on the promises of reform that appear necessary to justify foreign companies’ high hopes for a better future business environment in China.

Bi-lateral Free Trade Agreements are also being contemplated. This paper from ECFR – The European interest in an investment treaty with China explores one with the EU:-

Like the EU, China is a global player. Trade and investment talks cannot be viewed in isolation of moves with third parties. Chinese economic agents – from SOEs turning into multilateral firms, to sovereign funds or more dispersed private actors – are in a decisive phase of capital internationalisation as China maintains a large current account surplus.

Recent trade data, however, paints a vulnerable picture in the near-term. This was the data for January, admittedly a notoriously volatile period as it precedes the Chinese New Year: –

  • Imports -19.9% – forecast -3.2%
  • Exports -3.3% – forecast +5.9%
  • Crude oil imports -41.8%
  • Iron ore imports -50.3%
  • Coal imports – 61.8%

Another factor impacting the stock market is credit and money supply growth, M2 grew 12.2% in December 2014 down from a high of 13.6% in 2013, however it has regained upward momentum in the last couple of months:-

China M2 - Cato

Source: Cato, John Hopkins University and PBoC

 

Unless it can be reversed, this declining trend will act as a drag on economic activity. Nonetheless, the stock market has surged ahead – note the dramatic increase in volume traded – anticipating the effect of the PBoC policy shift:-

Shanghai_Composite_1_yr

Source: Bigcharts.com

A longer-term chart shows that the market has some distance to go until it reaches its old highs:-

china-stock-market 8yr

Source: Trading Economics

The Shanghai Composite is trading on a P/E ratio of 16.33. This is undemanding but the risk of China unpegging and devaluing their currency is a significant risk for the international investor.

Conclusions and Investment Opportunities

Bonds

I have not made much mention of the government bond markets in China or India: it is not because one cannot invest in these markets but due to the relative difficulty of accessing them and their uneven liquidity. They both offer a real yield – China 2.63% and India 2.57% for 10 year (4-3-2015). Both markets are attractive.

Real-Estate

Both China and India are suffering from an overhang of unsold property but the overvaluation is more pronounced in China. India has the additional advantage that interest rates have more room to fall in the event of a sharp downturn in economic activity. India has a younger population and its skilled ex-patriot workers are returning in significant numbers. The Chinese market will take longer to clear. Neither market has finished correcting yet.

Equities

On a price to earnings basis the Shanghai Composite (16.33 times) offers better value than the Sensex (18.52 times) however there is a real risk that the “internationalisation” of the RMB leads to its decline against the US$. The Sensex is making new highs whilst the Shanghai Composite is trading higher after a major correction from the 2008 highs. This is not to suggest that India is trouble free, however, it has more room to grow given its per capita GDP, and less signs of over-investment. Corruption is an issue in both countries but the Chinese administration’s efforts to root out officials who have “feathered their nests” is likely to act as a drag on growth. Indian reform is principally concerned with reducing bureaucratic impediments to the functioning of free markets – closing tax loopholes, reducing state interference in competitive processes and so forth.

The key for growth in both China and India is the inward flow of foreign capital. On January 29th the UN – Global Investment Trends Monitor – announced that China had become the leading destination for FDI in 2014 ($128bln) for the first time since 2003, however, its growth rate was an incremental 3%. India, by contrast, saw FDI surge by more than 26% to $35bln – this follows a 17% rise in 2013. This trend will continue, accelerated by the reforming zeal of the incumbent regime.

Indian and Chinese interest rates will decline, but Indian rates have more room to fall. Chinese and Indian stocks will rise but, with the currency devaluation behind it, Indian stocks – despite their higher P/E ratio – look better placed to rise.

Currency

Risks for the RMB are on the downside whilst for the INR they are on the upside, the trend is underway:-

CNY-INR-2 yr

Source: Exchangerates.org.uk

The second arrow of Likonomics and the Chinese property market

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Macro Letter – No 18 – 29-08-2014

The second arrow of Likonomics and the Chinese property market

  • The Chinese rebalancing towards domestic consumption continues
  • The shadow banking system is being forced into the light
  • But a slowdown in the property sector poses a potential risk to economic reform

Seven Lucky Gods

The Japanese “Ship of Happiness” containing the seven lucky gods – originally of Chinese and Indian origin

Source: onmarkproductions.com

Back in March I anticipated a stimulus package to avert too dramatic a slow-down in the Chinese economic rebalancing, process: –

By a number of conventional measures China has reached the Ponzi stage. Total debt has increased from $9trln in 2008 to $23trln in 2013 (250% of GDP). Private sector debt has increased from 115% of GDP in 2007 to 193% in 2013. Measures of the multiplier effect of debt to GDP suggest it now takes 4 RMB of debt to create 1 RMB of GDP growth. The Chinese authorities attempts to slow bank lending have led to a significant expansion of shadow bank credit. Much of this lending is to sub-prime borrowers.

Recent action by the PBOC suggests they are now targeting the illusive shadow banking sector. Last week they drained 50 bln RMB via reverse-repos…after strong growth in 2013 the PBOC may be inadvertently engineering a “Minsky Moment” – when asset prices collapse – but the Third Plenum focus on market based reform would suggest this is not the intention…

Since then the PBOC has been actively steering the Chinese “Ship of Happiness” towards more tranquil waters by, among other measures, reducing bank capital requirements. Highlights of China’s Monetary Policy in the Second Quarter of 2014 updates the recent timeline:-

 On April 22, the PBC decided to cut the reserve requirement ratios for county-level rural commercial banks and county-level rural cooperative banks by 200 and 50 basis points respectively, effective from April 25, 2014.

On June 9, the PBC decided to cut, effective from June 16, 2014, the deposit reserve requirement ratio by 0.5 percentage points for commercial banks (excluding those that were subject to the deposit reserve ratio reduction on April 25, 2014) that have complied with prudential requirements and have reached the required ratios in their lending to the agricultural sector, rural areas, and farmers, and to small and micro enterprises. In addition, the RMB deposit reserve requirement ratio of finance companies, financial leasing companies and auto financial companies was cut by 0.5 percentage points.

This change in reserve requirements has dampened the extreme volatility of short term repo rates. Lower volatility and lower rates fuel risk-taking; bank credit surged in June by RMB1970bln – up 90% on June 2013.

Meanwhile, the government, in pursuit of President Xi’s “Chinese Dream”, embarked on a mini-stimulus package – estimated in the local media at around RMB10tln. This has reignited the stock market but begs the question “How can further stimulus solve the problem of excessive liquidity?” The Business Insider – China Unveils ‘Mini Stimulus’ To Boost Its Slowing Economy described it thus: –

“The State Council is responding to the growth slowdown by announcing tax breaks for SMEs (small and medium enterprises), speeding up investment in railways and rebuilding urban shantytowns,” HSBC economists Qu Hongbin and Sun Junwei said in a report Thursday.

“This time the package is small in scale, but it is more targeted and involves reforms on financing to secure funding,” they said. “So this should help China to smooth growth without exacerbating financial stability risks.”

The tax breaks for “small and micro” companies will be extended until the end of 2016, the State Council said in a statement on the central government website.

It also said 6,600 kilometres (4,100 miles) of new railway lines will come into operation this year, 1,000 kilometres more than in 2013.

The plan will also see the creation of a railway fund that will receive between 200-300 billion yuan ($32-$48 billion) each year, the statement said.

… “These measures show that Premier Li’s government aims to stabilise short-term growth with policies which can enhance efficiency while avoiding future financial troubles,” Bank of America Merrill Lynch economists Lu Ting and Sylvia Sheng said in a report Wednesday.

“We believe these measures are the right policy responses to the ‘fiscal cliff’ as a consequence of the anti-corruption campaign, and we think markets will overall welcome them.”

There have been nine reported cases of Trust Fund defaults in the five months to May which matches the total during the whole of 2013, however, several shadow banks are being merged and acquired by licensed banking institutions. Meanwhile, the China Banking Regulatory Commission (CBRC) is helping to ease the pain of rebalancing for the banking system. Caixin – Banks Start Using New Loan-To-Deposit Ratio on July 1looks at the detail: –

Starting July 1 banks in China are using a new method of calculating the loan-to-deposit ratio, a change that the regulator and analysts say will allow for more loans to be extended.

The China Banking Regulatory Commission (CBRC) announced on June 30 the new set of rules for figuring the ratio, which is capped by law at 75 percent, meaning that banks cannot lend out more than three-quarters of the deposits they accept.

A CBRC official has said the regulator will consider adjusting the way the ratio is calculated to allow for more lending. That includes broadening the range of deposits to include “relatively stable” funds.

The new rules differ from the old ones in both loan and deposit calculations, the announcement shows.

Six types of loans can now be excluded from the formula. They include loans linked to the central bank’s re-lending program and proceeds from the sales of a special financial bond that raises money to support small and micro businesses. Loans made using money raised from bonds that investors cannot redeem for at least one year are also excluded under the new rules.

These loans all have clear and stable sources of funding and thus do not need to be matched with general deposits, the regulator said.

Why ease conditions when M2 is growing at 14.7%, M1 at 8.9% and M0 at 5.3% (June 2014)? I believe the easing of conditions is due to official concern that risk in the financial system is substantially understated. This article from the Wall Street Journal  – Risky Business in China’s Financial System – highlights some of the issues: –

Is China heading for a financial crisis? Some risk indicators have risen markedly over the past twelve months: Interbank rates are more volatile, with liquidity shortages increasingly common; there have been a few minor bank runs; and the country experienced its first corporate default in recent history earlier this year.

Loans and Booms - China vs Crisis countries-page1

Source: Oxford Economics, Haver Analytics and Wall Street Journal

Moreover, though official figures suggest that just 1% of loans are non-performing, bank balance sheets likely aren’t as healthy as they seem.

Evidence from a range of countries suggests that credit booms – as China experienced from 2009-‘13 – result in substantially higher levels of non-performing loans (NPLs). A more realistic assumption that 10%-20% of total loans might go bad implies total NPLs of RMB6-12 trillion (US$1-1.9 trillion). The higher end of the range would suggest a bad-asset problem comparable in scale to the one that followed the U.S. subprime loan crisis.

The author goes on to discuss the importance of the shadow banking system. Then he asks: –

What might trigger a crisis in China? The drift downward in property prices could accelerate as the economy cools, leaving substantial oversupply. Property and land are often used in China as collateral for loans, so a sharp fall in house prices would damage bank balance sheets; liquidity would dry up; and institutions with high rollover needs might struggle to find funding.

Higher interest rates also would increase debt-service payments, and banks could see their deposit bases erode as corporate deposits shrink. The growing importance of the shadow-banking system would likely exacerbate these effects.

Such a crisis would have major economic implications not only for China but — through financial and trade linkages – for the whole world. The Oxford Economics Global Economic Model estimates that, in such a scenario, Chinese gross domestic product would grow less than 2% in 2015, and world growth would drop as low as 1%.

Of course, that’s a worst-case scenario, and odds of it happening are only about 10%. With China’s overall government debt relatively low and foreign exchange reserves at an all-time high, authorities have the means to intervene on a large scale if necessary.

Still, as long as interest on deposits is capped by the government, Chinese savings will continue to be invested in riskier and higher-yielding products, adding to distortions in the financial system.

That means the risk of a financial crisis will remain until the government introduces reforms to the financial sector, and manages its way out of the credit boom in an organized fashion.

The deleveraging of the credit boom and reform of the financial sector are the second and third arrows of Likonomics – named after the economic policies of Premier Li Keqiang. Even getting to the second arrow will be difficult given a housing bubble which shows signs of bursting.

Housing, the Achilles heel

Recent official data shows house price declines in 55 out of 70 cities in June vs May and 35 out of 70 cities in May vs April. Sales volumes as measured by floor space are down 9.4% in the first seven months of 2014 vs the same period last year.

The FT – Property bubble is ‘major risk to China’ puts the Chinese government’s dilemma in perspective: –

The government itself has an enormous incentive to keep pumping the bubble up, since all land is technically owned by the state and land sales made up 60 per cent of local government’s budgetary revenues last year, according to estimates from JPMorgan.

Since 2008 land prices have increased fivefold, triggering corresponding asset price rises, but even as prices soared and supply mushroomed, demand for housing and office space pretty much kept up – until this year. More than 90 per cent of households already own at least one home and, for those urban households that own apartments, nearly 76 per cent of their assets are in real estate, according to Gan Li, director of the Survey and Research Center for China Household Finance.

At 90% Chinese home ownership is ranked sixth highest in the world (2012 data). It is slightly lower than Singapore but well above the levels in UK (66.7%) and USA (65.2%). Here is a table from Wikipedia . However, it has been estimated by the China Household Finance Survey  that empty homes make up more than 20% of the housing stock. Of these, the vast majority are investment properties.

Meanwhile the first arrow of Likonomics – a tempering of monetary stimulus – put in place since the great recession, has been accompanied by a swath of anti-corruption policies. President Xi reaffirmed his commitment to anti-corruption measures in a speech on 29th June on the eve of the 93rd anniversary of the founding of the Chinese Communist Party.

Michael Pettis – The Four Stages of Chinese Growth describes the overall reform process being undertaken by the Xi government. The entire essay is a brilliant insight into the economic development of China since 1978 and looks closely at the “social capital” deficit which, if left unaddressed, might undermine the Chinese economic miracle of the last 30 years :-

The second liberalizing period. What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.

But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.

Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform, environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.

Many of the Third Plenum measures are focussed on a root and branch reform of the property development industry. This post from Investing in Chinese Stocks – RMB 8.7 Trillion in Land Finance At Risk provides some fascinating insights, into the dangers these reforms pose to the property development industry: –

A strict audit of 15 trillion in land sales is going to uncover dirt in many Chinese cities. Already, according to the article below, 9 cities have been found to have violated regulations governing land finance, including Shangluo, Hengyang, Neijiang, Xingtai, Huzhou and Suqian. Recall how land finance works:

Chinese local governments sell land to developers who build homes and commercial centers. The revenue from land sales pays for development of supporting infrastructure, everything from roads and subways to schools and parks. Land sales also finance local government debt which exploded after 2008. In the post-2008 economy, developers rushed to build property amidst a real estate bubble and when the government moved to restrict activity in first- and second-tier cities, developers poured into third- and fourth-tier cities and repeated the model. However, developers have run ahead of many local governments. In areas where there are true ghost cities, support infrastructure such as schools and hospitals have not been built. If the real estate bubble bursts and land sales fall, local governments will need to find another revenue source or they may be unable to finance the infrastructure that generates GDP growth and supports the local real estate market, and they may even face a debt crisis in some of the worst hit areas. This ignores all the potential issues with indebted developers, plus overproduction and bad debts in other sectors of the economy.

84 major Chinese cities have borrowed 8.7 trillion, backed by revenue from land sales. If cities have violated regulations or violated the law in their use of land finance, things could quickly come to a head in areas where the governments are borrowing to survive, which is already the case in some cities. The conclusion to the article is a good summary:

“Mortgage financing using state-owned land, borrowing money to promote urban development and stimulating economic growth, this economic growth model is not sustainable, it can very easily bring about hidden volatility in the capital markets and macroeconomic development.” Wang Jianwu told reporters, the key to solving the problem is for the local government to gradually adapt to the “new normal,” get rid of “land hormone” stimulus, while local governments also need to shift from the dominant role of economic development to servicing economic development.

Yet again, the anti-corruption probe lines up with the leaderships vision of economic reform. By squeezing local governments’ ability to borrow through land sales, the shift towards a rebalanced, market-based economy can proceed more quickly.

Concern about the Chinese housing market has even attracted the attention of the Kansas City Fed – China’s slowing housing market and GDP growth – they cover many of the issues already discussed but also look at the longer term impact of demographics: –

Looking further ahead, the real-estate sector will need to adapt to the inevitable decline in demand caused by demographic change. The share of China’s population from 24 to 30 years old, the age group needing to purchase their first home, has declined from 13.4 percent in 2000 to 10.7 percent in 2010. The share of the working age population (15 to 59 year olds) has declined to 68.7 percent in 2013 after peaking at 70.1 percent in 2010, reversing the upward trend of the prior two decades.

…Taking both the short- and long-term factors into account, the real estate sector’s recent slowdown is likely to continue as housing activity stabilizes at a lower growth path. While this adjustment could provide certain long-term benefits, it will generate significant downward pressure on China’s near-term growth.

For a rather more sanguine view of the current situation this policy brief from The Peterson Institute – Is China’s Property Market Heading toward Collapse? Provides a broader historical context, highlighting the fundamental differences between China today and USA in 2008 or Japan during the 1990’s: –

 The fears about China’s property market are likely overblown. First, China’s private housing market is young. It did not exist until 1998. Over the last 16 years, the property sector has seen large swings in both prices and levels of investment. Cyclical downturns have resulted from macroeconomic conditions, credit restrictions, and the government’s attempts to curb either the overheating or overcooling of the sector. This cyclicality is a good thing to the extent that investors tend to avoid making one-way bets on either price appreciation or depreciation, and thereby it works to prevent excessive speculation. Largely owing to limited financial innovations, market developments, and punishing taxes, China’s property market is still less leveraged than is typical in more developed economies. Developers have lowered their debt-to-asset ratios since 2009 and Chinese buyers must offer down payments of at least 30 percent before they can apply for mortgages.

Second imposed more than four years ago to discourage property purchases for investment purposes. Indeed, at the time of this writing, some 30 Chinese cities have started to ease these property curb policies, which were designed to prevent excessive speculation. In addition, the government could also liberalize its urban household registration system, or hukou, to allow migrants to purchase houses and thereby encourage them to settle in their cities permanently.

In the medium term, the government can take a number of other steps, such as reintroducing an urban public housing program in large cities, funded by a property tax, to address income inequality and encourage an increase in rental properties. To reduce banking sector risk, the government could encourage banks to issue covered bonds to reduce the risk of maturity mismatch of their mortgage assets. Furthermore, diversifying property developers’ sources for finance through real estate investment trusts, or REITs, would also reduce their reliance on bank financing. China should also improve its data collection to take into account the quality, location, and other important features of property transactions.

More important, demand for urban properties is expected to remain high over the next decade. It is estimated that another 200 million people could join China’s urban areas by 2023. In this sense, China’s property market bears no resemblance to Japan in the early 1990s or the United States in 2008. As long as urbanization continues and appropriate policies are adopted, this property market downturn should prove to be merely cyclical, and a major correction is unlikely to take place.

The authors expand on the positive long-term factors which support the Chinese property market but remain cognisant of the risks of a near-term bursting of the property bubble. Chinese property has risen 64% since 2010, eclipsed only by Hong Kong where prices are up 94%. Rental yields are 2.66%, higher than Singapore at 2.41% but well below Japan at 5.53%. However, some comfort may be drawn from indications of the rise of zero down payment mortgages – if these become widespread the property bust may be deferred.

Private capital flight

This brings me to another issue which affects the global economy. If 76% of the net worth of Chinese city dwellers is tied up in real-estate, how will they diversify their investment risk? Many of the wealthiest Chinese families have already moved a substantial portion of their net worth abroad. This trend is likely to continue unless the government imposes capital controls. What is the likely impact on domestic asset prices?

A recent article from The Diplomat – Chinese Investors Fuel California Housing Bubble gives an interesting perspective to the debate. Chinese nationals only account for 11% of the foreign buyers of real-estate in the San Francisco area but their marginal impact is significant. Chinese demand is being fueled by uncertainty over domestic Chinese housing policy and fears about the stalling of economic growth:-

As Mark McLaughlin, CEO of Pacific Union, a prominent San Francisco real estate firm, told local CBS affiliate KPIX, “it’s added a demographic of buyers who, generally, take a long-term view. They’re not sellers in the next five to seven years.” Chinese buyers are sitting on much of this property as housing in the Bay Area becomes increasingly scarce, causing its value to skyrocket. The Case-Shiller home price index, released in May, saw Bay Area home prices jump by 23 percent compared with  a year ago.

That may be just the beginning. On average, San Francisco real estate cycles take about five to seven years to run their course from recovery to collapse. The current surge in prices began in early 2012. Home values have shot up 50 percent since then; during the last surge, the prices peaked at 54 percent. Chinese money is likely to add pressure to the current bubble.

Of course Chinese buyers have been evident in many prime real-estate locations including Manhattan, London and Sydney. Earlier this month Wang Jianlin, China’s richest man, invested $HK12.5 bln in Australian real estate including a AUD900 mln resort on the Gold Coast.

A recent article from the Wall Street Journal – The Great Chinese Exodus looks into the migration trends of wealthy Chinese: –

…A survey by the Shanghai research firm Hurun Report shows that 64% of China’s rich—defined as those with assets of more than $1.6 million—are either emigrating or planning to. …The elite are discovering that they can buy a comfortable lifestyle at surprisingly affordable prices in places such as California and the Australian Gold Coast, while no amount of money can purchase an escape in China from the immense problems afflicting its urban society: pollution, food safety, a broken education system. The new political era of President Xi Jinping, meanwhile, has created as much anxiety as hope.

…Last year, the U.S. issued 6,895 visas to Chinese nationals under the EB-5 program, which allows foreigners to live in America if they invest a minimum of $500,000. South Koreans, the next largest group, got only 364 such visas. Canada this year closed down a similar program that had been swamped by Chinese demand. …Beijing makes a crucial distinction between ethnic Chinese who have acquired foreign nationality and those who remain Chinese citizens. The latter category is officially called huaqiao—sojourners. Together, they are viewed as an immensely valuable asset: the students as ambassadors for China, the scientists, engineers, researchers and others as conduits for technology and industrial know-how from the West to propel China’s economic modernization.

…Still, the sheer volume of China’s outbound travel these days, and its massive economic impact, gives it new leverage. In the global market for high-end real estate, Chinese buying has become a key driver of prices. According to the U.S. National Association of Realtors, Chinese buyers snapped up homes worth $22 billion in the year ending in March. Australia called a parliamentary inquiry to find out whether local households were being priced out of the market by Chinese money. (The conclusion: not yet.)

Without fee-paying Chinese students, many colleges in the postrecession Western world simply wouldn’t be able to pay the bills. Chinese students are by far the largest group of foreign students on U.S. campuses, and their numbers jumped 21% last year from the year before—to 235,597, according to the Institute of International Education. Their numbers are increasing at a similar pace in Australia. In England, there are now almost as many Chinese students as British ones studying full-time for postgraduate master’s degrees. …The Chinese government has no desire to slow the flow of students. Its attitude is simple: Why not have the Americans or Europeans train our brightest minds if they want to? President Xi’s own daughter went to Harvard.

Provided the domestic housing market doesn’t collapse and the Chinese authorities resist the temptation to impose capital controls, Chinese buyers will continue to support prime real-estate markets globally. However, this is a risk which needs to be monitored closely.

Conclusion and investment outlook

In order to understand China you need to study its history, this recent essay by The Economist – What China Wants – is an excellent introduction. China has witnessed several long-term “Cycles of Empire” over the past three millennia as this Moneyweb interview with David Murrin – China’s fifth reincarnation as an empire system and its link to Africa. Explains:-

It’s unique in that it is the fifth, could be sixth if you go back far enough, incarnation of a 500 year empire cycle. They’re now 120 years into that cycle so they’re really about the stage where they burst forth onto the world. Every one of China’s cycles has been bigger than the one before, so when people say it didn’t actually ever have influence outside its borders, look at the last incarnation at the peak of the 14th century. Their trading system reached the shores of Africa, they controlled the Indian Ocean, they controlled the whole or parts of the Pacific.

The opportunity to rebalance the Chinese economy has come at an opportune time, with the US in a slow, but steady recovery from the great recession. Moderate US growth is helping Chinese exports to rebound as this article from the China-United States Exchange Foundation-  China-US Trade Boosted by Moderate Growth in the US Economy explains: –

The United States’ economic recovery, albeit moderate, is good for overseas exporters. During the first seven months of the year, Chinese exports of good to the US increased by 6.3% over a year ago, while its global export growth was 3.0%. The US market performed twice as good as the global market. In July alone, exports to the US shot up by 12.3%, contributing 2.1% to China’s global export growth. 

However they recognise the need to maintain good trade relations with the US:-

According to China Customs statistics, Chinese imports worldwide increased by 1.0% during the first seven months of the year. Imports from the US, however, increased by 5.0%, far outperforming its global imports.

Perhaps the greatest risk to the Chinese administration, as it seeks to rebalance the economy, is a collapse in the housing market. So far, the rebalancing has proceeded without a major catastrophe. Chinese stocks remain cheap on a P/E basis (SSE current P/E 10.59) and forecasts for 2015 factor in little earnings growth. The chart below shows the Shanghai Composite vs the S&P500 since August 2010.

Shanghai SE Composite vs S&P500 2010-2014

Source: Yahoo finance

The S&P 500 has risen close to 100% whilst the Shanghai Composite has fallen by 30%. By comparison, the Chinese real-estate index is up 64% over the same period. This chart from the Peterson Institute shows the under-performance of stocks relative to housing:-

China House Prices vs Stock Market and Bank Deposits - CEIC Data Peterson Institute

Source: CEIC, Peterson Institute

A dramatic slow-down in European growth may justify the low valuation for the Shanghai Composite, as may a reversal in the fortunes of the US stock market, nonetheless, on a relative value basis, Chinese stocks look attractive. I believe the US economy will continue to perform, though not so strongly as of late. The ECB will avert an implosion of the major European economies “whatever it takes”. In this environment China will find, quantitatively fuelled, export markets to cushion the pain of domestic reform. Chinese stocks will outperform Europe, and may well outperform the US, over the next couple of years.

The second arrow of Likonomics – a deleveraging of the credit bubble – looks likely to be postponed.

China – rebalancing and the risks to world growth

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Macro Letter – No 8 – 28-03-2014

China – rebalancing and the risks to world growth

  • China’s exports collapsed last month – is this a trend or will the rebalancing be less painful?
  • Will a slowdown in Chinese growth tip its major trading partners into recession?
  • What would 4% Chinese GDP growth mean for developed markets?

After a period of double digit GDP growth during the last decade, China has slowed to a still respectable 7 to 8% range. Behind the scenes, however, the new administration is attempting to steer the world’s second largest economy away from export led expansion towards a more balanced mix of production and consumption. China embarked on economic reform in 1978. After several decades of mercantilist policies the adjustment process will inevitably be beset by squalls and stormy weather.

Overinvestment

Back in 1992 Hyman Minsky published a paper entitled The Financial Instability Hypothesisit discusses the three stages of credit expansion during an economic cycle: –

Hedge Finance – where borrowers have sufficient cash-flows to meet repayment obligations

Speculative Finance – where borrowers can repay interest but not principal

Ponzi Finance – where borrowers have insufficient cash-flows to meet interest or principal obligations

By a number of conventional measures China has reached the Ponzi stage. Total debt has increased from $9trln in 2008 to $23trln in 2013 (250% of GDP). Private sector debt has increased from 115% of GDP in 2007 to 193% in 2013. Measures of the multiplier effect of debt to GDP suggest it now takes 4 RMB of debt to create 1 RMB of GDP growth. The Chinese authorities attemptes to slow bank lending have led to a significant expansion of shadow bank credit. Much of this lending is to sub-prime borrowers.

Recent action by the PBOC suggests they are now targeting the illusive shadow banking sector. Last week they drained 50 bln RMB via reverse-repos. Below is a chart of Chinese loans; after strong growth in 2013 the PBOC may be inadvertently engineering a “Minsky Moment” – when asset prices collapse – but the Third Plenum focus on market based reform would suggest this is not the intention: –

Chinese loans

Source: Macrobusiness.com.au

Whilst the shadow bank loans have been reigned in, credit formation is still progressing. This is consistent with target M2 growth of around 13%.

There are signs of official policy beginning to bite. In January a coal mining company (Zhengfu Energy) was saved from defaulting on loans by a government engineered bailout, however, in sea-change, China witnessed its first corporate bond default this month (Shanghai Chaori Solar) and a real estate developer (Zhejiang Xingrun Real Estate Company ) was allowed to default on $567 mln of debt to a consortium of 15 banks.

This week the HSBC PMI index recorded 48.1 the fifth month of decline. Meanwhile domestic consumption is growing but the rate of retail sales growth has been easing: –

China retail sales 2010 - 2014

Source: Tradingeconomics.com

China’s transition towards domestic consumption is still remarkable. It is testament to the ability of the state to direct policy.

Reform Agenda

The new administration under President Xi has a clear agenda as this article from the China – United States Exchange Foundation explains:-

First and foremost, Xi’s economic reform agenda wisely addresses some of the country’s most serious economic problems. The new leadership unambiguously aims to tackle them in a forceful manner. 

Second, Xi not only took control of all the supreme institutions in the party, state, and military during the latest political succession, but he also now chairs the newly established National Security Committee and the Central Leading Group on Comprehensive Deepening of Economic Reform. The lower levels of the Chinese government have also established leading groups on economic reform headed by party secretaries and governors or mayors. All of these provide institutional mechanisms through which Xi and his team can more effectively implement reform policies.  

Third, Xi has been supported not only by experienced economic reformers in the top leadership but also by a group of world-class financial technocrats, including Harvard graduate Liu He and Stanford-trained Fang Xinghai. Recently, Ma Jun, Deuteche Bank’s former chief economist on greater China, was appointed as chief economist of the People’s Bank of China. Huang Yiping, former chief economist of emerging Asia for Barclays, also joined the advisory team to the top leadership.  

Finally, the timetable for the bold reform agenda reflects President Xi’s political calculations to stabilize the Chinese economy before the fall of 2017, when the party leadership will experience another major turnover (because of age limits, 5 out of 7 members of the Politburo Standing Committee will retire that year). Xi needs to consolidate power for his second term by unequivocally succeeding in implementing his economic reform agenda. 

If the aim is to rebalance the Chinese economy by 2017 draconian action is required in the near-term. The US economy is stronger than it has been since the crisis of 2008/2009. The Eurozone whilst vulnerable is in better shape than it was in 2011/2012. From a global perspective the developed economies are better placed to absorb the shock of a China slowdown.

So how will China reform? This short article from AJISS – Analysis of the Third Plenary Session and the Outlook for the Future – suggests a number of areas for focus but highlights the areas where doubts exist about the administrations ability to deliver, they conclude on an optimistic note: –

As noted above, expectations are low that the Xi Jinping administration will undertake radical reforms, but a more careful examination of the Decision reveals a number of praiseworthy policies: private capital will be permitted to participate in state-financed investment projects, the percentage of money paid into the public treasury from state-run company earnings will be boosted in order to step up social security funding, and the system of land ownership will be further reformed to increase individuals’ share of capital gains from land. As long as a growth rate of about 7% can be sustained, the combination of these partial reforms should be reasonably effective in extending the lives of the current political and economic systems. The most likely scenario for the near future is that the Communist government will maintain the present political and economic systems by seeking out compromises with rising economic elites, rooting out corruption and implementing income redistribution policies to partly alleviate popular discontent.

All these reform policies are relatively long-term in nature, but if financial markets begin to meltdown, it should be remembered that China is a command economy and can implement bail-outs more swiftly than in most democracies.

Last month the China-United States Exchange Foundation published the following article – Coming Out of the Shadows: Why China Needs a Lehman Moment – which goes to the heart of the dilemma facing the Xi government:-

If we agree that the Chinese state has the financial means to restructure the shadow banking system (which has assets equivalent to 60 percent of GDP), then the challenge is to design a market-based approach that will liquidate zombie borrowers quickly (Zhengfu Energy is a classical zombie borrower).  Investors (mostly wealthy private individuals in the case of shadow banking) must pay a steep price for their failure to perform due diligence (so far, no private individual has lost money investing in products channeled through the shadow banking system).   Granted, the widespread practice of cross-collateralization (borrowers guaranteeing each other’s debt) is likely to trigger chain defaults if one zombie borrower goes under.  But this is an unavoidable price to pay.  Beijing would be far better off in the long run if it opts for intense short-term pain. 

This week, in response to the recent publication of the Work Report, the China- United States Exchange Foundation – The Second Arrow of Likonomicsdescribed the process of Likonomics:-

1. A cautious manner to economic stimulus measures.

2. The deleveraging of financial sectors.

3. Structural reforms of the Chinese economy.

Essentially this process begins by allowing the market to gain prominence but this is only the first arrow: –

Likonomics is different from laissez-faire economics, and it is not a stress test for the Chinese economy. The Chinese government does not alternatively choose between small and big government ideas, but leaves market issues to the market, and government responsibilities to the government. It re-clarifies the role of the market and the role of government in economic and social development. 

If increasing the role of the market and reducing administrative interventions is the first arrow of Likonomics, then the second arrow is clearing lines of responsibility and the role of government in reform, as explained in the new government work report. 

First of all, the Chinese government will become the active regulator of reform, to ensure that the Chinese economy avoids upheavals. The report clearly states that the reasonable range for the Chinese economy in the future will be a GDP annual growth rate of around 7.5%, M2 growth of 13%, and CPI at 3.5%. These indicators are consistent with those of 2013, but the expectations of growth and inflation were lower than 2011. It means the Chinese government has abandoned hard targets on economic growth and inflation, allowed some of the indicators to cross the line, and accepted the fact that China’s economic growth started to slow down. However, the emphasis of the reasonable range means that the Chinese government will carefully assess the situation of the economy and provide crisis intervention if necessary. The clarity of the reasonable range will help stabilize the outlook and enhance market confidence in the Chinese economy. 

Most market commentators are beginning to predict slower growth for China in 2014 and beyond. I think this expectation is mainly based on past experience of Chinese stimulus. The new administration is adopting a different approach. Whilst the economy may stall in the near-term I believe the government can and will intervene aggressively to avoid a widespread crisis.

For a wonderfully argued contrary view Micheal Pettis – The impact of reform on growthsums up what should happen in a genuine reform process.

I believe that a large part of the objective of this economic reform is political in nature. President Xi has already shown himself to be a more centralist leader than China has witnessed in many years. The imbalance of the Chinese economy presents an opportunity to return power to the center. This article from Jamestown Foundation – Xi invokes Mao’s image to Boost his own Authority helps to put the Third Plenum economic policies in a wider context:-

Xi’s carefully calibrated rhetoric is thus geared toward appeasing Chinese who want a continuation of economic reforms as well as conservative elements within the Party who agree with Deng’s judgment that “if we abandon the standard of Mao Thought, we are in fact negating the party’s illustrious history” (People’s Daily, March 24, 2010).  Indeed, in his now-famous internal talk last December on drawing the right lessons from the collapse of the Communist Party of the Soviet Union (CPSU), Xi noted that the CPSU made a fatal error in denigrating Lenin and Stalin. As a result of forsaking their founding fathers, Xi pointed out, “[latter-day Soviet party members] were wallowing in historical nihilism.” “Their thoughts became confused, and different levels of party organizations became useless,” he said. (Radio Free Asia, May 24; Deutche Welle Chinese Service, January 25, 2013).

For a different, but complimentary, view of the current political shift within China, this article from The Diplomat – Why Chinese Study the Warring States Period – provides a fascinating perspective: –

The Chinese leadership is working toward achieving three main goals:  The leadership wants to prevent the emergence and mitigate the existence of the conditions that plagued the political arena of the Warring States era. Specifically it wants to maintain stability, foster unity and reduce the risk of division, as well as mitigate competition. The leadership also wants to continue developing a more prosperous economy and a strong military. And the military must remain committed to supporting the leadership’s agenda, namely bolstering the ruling regime’s legitimacy, protecting sovereignty, defending territorial integrity, and ensuring the state’s overall survival. Finally, unlike the Qin leaders who emphasized the rule of law, the current leadership most likely will continue promoting a code of behavior to cultivate obedience and order. If these trends continue along the current trajectory – in other words, there are no internal and/or external disruptions to the existing trajectory – the Chinese leadership should be able to create a relatively stable and more prosperous and unified state system supported by a strong military capable of ensuring the survival of the current Chinese state system.

The Warring States Era took place between 475 and 221 BC. It was a period regional power struggles which ended with unification under the Qin dynasty. From a military perspective China has already become the regional hegemon in Asia-Pacific. A united country is essential if it is to build on this position.

Chinese Imports

But what about the near-term impact of a China slowdown on financial markets? For the remainder of 2014 and probably the first half of next year China’s economic activity will be difficult to forecast, but it is reasonable to anticipate further signs of weakness. This will impact its major trading partners. Countries which rely on Chinese imports may begin to experience shortages or higher prices – although these may be offset by a weakening in the RMB. The chart below illustrates this, however, it is a new trend and the first sign of RMB weakness for many years.

USD-CNY 2009-2014

Source: Yahoo Finance

Countries which export to China are likely to find the environment more challenging, especially those which supply commodities and basic materials.

Here is a table of China’s principal trading partners from 2011.

Region            Exports         Imports                Trade balance

EU                          356.0              211.2                     +144.8

USA                       324.5               122.2                    +202.3

ASEAN                  170.1               192.8                    -22.7

Japan                    148.3               194.6                    -46.3

S.Korea                 82.9                 162.7                    -79.8

Brazil                    31.8                  52.4                      -20.6

India                      50.5                 23.4                     +27.1

Russia                   38.9                 40.3                     -1.4

Taiwan                  35.1                  124.9                   -89.8

Source: National Bureau of Statistics of China

Exporters in Taiwan, South Korea and Japan are clearly vulnerable to a Chinese slowdown but there are other export countries which have significant exposure.

Here is a selection of countries for whom China is a substantial export market:-

Region                              Percentage

Vietnam                                25.8%

Japan                                    21.3%

United States                       19.0%

Australia                               18.4%

New Zealand                        16.4%

South Korea                         15.6% (2012 est.)

Russia                                    15.5%

Brazil                                     15.3%

Indonesia                              15.3%

Malaysia                               15.1%

South Africa                         14.4%

Saudi Arabia                        13.5%

India                                      10.7%

Source: CIA Factbook

The fall-out from a China slowdown is likely to be broad-based. For these countries it will temper inflationary forces and support lower interest rates. Whilst the initial impact on stocks may be negative, the expectation of lower domestic interest rates will be positive. Slower growth in China will reduce growth globally, prompting developed nation central banks to adopt stimulative monetary policies in order to avoid recession. This in turn will support equity markets both in developed countries and, through international investment flows, emerging markets.

Conclusion

Chinese growth may slow further in 2014/2015 from current levels of 7.5% towards 4% but I believe the government will then intervene aggressively to reverse the decline once it has achieved its political agenda. China’s main trading partners will not escape the impact of this slowdown unscathed, although it will affect countries which export to China more directly.

Within China sectors such as health care, retail and IT will benefit from the great rebalancing. Commodity export countries such as Australia will continue to find the environment challenging. The Chinese administration will use the slowdown to assert its authority in regional disputes around the South and East China Sea. In the process it will once again test the resolve of any US military response.

For developed markets slower Chinese growth will temper inflationary concerns. Once this spills over into slower developed country growth I expect further quantitative easing – this will support asset prices for stocks, bonds and real estate both domestically and internationally.