Whilst the world watches Europe, it is missing the Chinese slowdown

The official Chinese GDP data show economic growth of 8.1% in the year to end March, as always a little above the recently-reduced official target of 7.5%. There is though a considerable degree of scepticism over this number (in 2007, the GDP data series were described as “for reference only” by Li Keqiang, who becomes Prime Minister in November) as other data series are much weaker. Power output (a data series likely to be accurately measured and very significant in a manufacturing-based economy) rose by only 0.7% over the same period, car retailers are reporting a huge build-up in inventories indicating a fall in consumer confidence, and sales of bulldozers are down by 51% compared with a year ago which indicates weakness in construction. These are worrying figures.

In the very worst of the global economic crisis in 2008/09, China embarked on a staggeringly large investment and infrastructure spending programme in a bid to maintain demand in the economy in 2009 and 2010 whilst they hoped that the rest of the world would sort out their banking crises and associated problems. They were hoping that by the time their own stimulus programme had run its course, the rest of the global economy would have regained its poise and would once again provide the strong consumer demand for Chinese exports. With the US also spending heavily, the world did come out of recession in 2009, and 2010 was also a reasonable year. However Western consumer confidence has not recovered and consumer spending has not returned to make the recovery self-sustaining – and the eurozone’s problems have only made things worse. So the hoped-for recovery in Western demand for Chinese exports has not occurred.

Worse still for the Chinese, the enormous stimulus they delivered has had two serious negative consequences. First was a house price boom in the major cities of China, as the extra spending engendered confidence that Chinese growth would continue to be strong, interest rates were held at low levels and banks were strongly encouraged to lend. In 2011 the authorities became concerned about this and sought ways to reduce the flow of credit for speculative house purchases. Secondly, the infrastructure projects that were built were brought forward from plans for several years hence, and so there are now many entire “ghost” towns built with roads, houses, and shops where nobody lives or works – the infrastructure of China is now years ahead of its current stage of economic development and the demand for that infrastructure. In economic terms the returns from much of the investment boom China undertook have been very low or possibly zero.

China’s economy is now hugely imbalanced with consumer spending just 35% of the economy. Contrast this with the UK and US where consumer spending represents nearly 70% of the economy. If China’s growth story is to be sustained it will need to produce its own consumer demand rather than rely on the Western consumer, and a major rebalancing between investment spending and consumer spending is required. Wages have been growing very quickly, but the Chinese love to save and encouraging them to spend has so far proved difficult. Ironically, whilst the West’s problems are an unaffordable welfare state system and a crumbling infrastructure, China currently has too much infrastructure and not enough of a welfare state. The cost of healthcare in China is very high and pension provision is poor – a stronger safety net might encourage Chinese workers to hold lower savings and go on a mini-consumption boom.

China’s economy is slowing more dramatically than the official data show; commentators have been assuming that in this situation, further economic stimulus would be the policy response. Such a stimulus should not however be a repeat of the government-directed investment spending. Instead to be effective, more subtle policies aimed at boosting consumption are required. Until then, whilst the world watches the Eurozone fall apart they may be missing the problems that are emerging in China. Chinese and Asian equities are the preferred asset class over the next decade, and long term investors should be seeking a heavy exposure in their portfolios. Over the next few months however, there remains scope for investors to be disappointed with Chinese economic developments, and a better buying opportunity is likely to emerge.

 

Dear Diary – possible reflections of some of those at the G8 meeting

The G8 meeting achieved nothing, despite the sense of crisis in the markets. The communiqué was bland and meant different things to different people. Below are what the leaders may well have really thought  about the summit.

Barack.  Re-election chances continue to drop – only 6 months to go. Have to say that Angela has some backbone, kept going with the German Nein all weekend long despite all of us ganging upon her to open her wallet. Played at being best buddies with Francois, the new boy in our club – it keeps David and Angela on their toes. Anyway he and I do have a lot in common, the rich should be paying a whole lot more towards getting us out of this mess, and it shouldn’t be the ordinary Joe who takes the hits all the time. Europe really worries me though – if it all blows up this summer, it could send our economy back into recession just about election time and I’ll be a very young ex-President.

Angela.  Re-election chances continue to drop – only 16 months to go. Well, that goes down as one of the most miserable weekends of my life. I know I’m still at the top of Barack’s European speed-dial, but it was horrible to watch him buttering up Francois. At heart though neither of them believe in balanced budgets and sound money like I do; they just want the money and public expenditure to keep on flowing and keep their supporters sweet. I am now only really left with David as a true right-of-centre ally in Europe; at least he is backing our drive for a political union as the best option to save the monetary union. Even so, he joined in with the others that Germany must spend lots of money we don’t have and let the ECB print and cause inflation – I was totally alone on this but stood my ground.

I thought it was a pretty smart idea to take 3 hours off from our discussions to watch the Champions League Final – it would be 3 hours not having to defend sound economic principles and a chance for Germans to show the football world how good we are (again) – but it didn’t work out. Bayern lost (on penalties – Germans never do that) and the symbolism was so awful – a team of foreign imports on huge salaries from the part of London inhabited by investment bankers, managed to overcome the bulk of the German national team, who were so strong, courageous and disciplined, and from Munich, the most successful centre of the German export industry. Worst of all that photo of us all watching the game has gone viral thanks to Twitter.

David. Re-election chances starting to drop – though still have 36 months to go. Politics is a rum old game. Who would have thought that a British Conservative Prime Minister would be telling the nations of Europe that their best (and only) hope was to move toward a full-on political union led by Germany? Yet George keeps on telling me that really is the best hope for our economy until the next election. Maybe, but it would be terrible for Britain’s influence with the US and China if Europe was truly one country with an elected President. I really can’t see it happening though, but I just don’t know if that is a good or a bad thing. That photo should do me the world of good with all the ordinary footy supporters in the country though – not many Posh Boys really like association football. Like Angela I had to be grovel a bit to Francois.

Francois. Chances in the parliamentary elections in 4 weeks definitely on the up. Life is amazing right now. Two weeks I was M. Normal, a French Socialist leader that had never had responsibility for anything in my life except for other Socialists, and now the President of the United States of America is telling me and the others what wonderfully interesting ideas I have. Also quite a nice feeling for Angela and David to have to be extra nice to me right now – I shall make good use of that back home in the next few weeks ahead of the elections.

Mario. Politicians are so transparent, always worrying about their election prospects.

Vladimir. Why are these guys so afraid of elections? Everyone’s beating up on Angela. I reckon she needs a good friend like me, and then just maybe we can get Germany to see Russia as their best European ally, instead of always looking westward.

An open letter to the voters in Greece

Congratulations! Your votes in the general election last week have humiliated the two main parties which have dominated Greek politics over the last 30 years. Traditionally they have between them garnered 2/3 of your votes which has meant that one or other of them has always been in power. They have failed you miserably, by i) permitting many of your fellow citizens not to pay the taxes levied by government, ii) making up for it by creating swathes of public-sector jobs where everyone receives two extra months pay each year to compensate for the fact that they do have to pay taxes, iii) tolerating corruption across most parts of the economy, iv) persistently running large budget deficits and borrowing heavily from anyone who will lend to them, and v) fiddling the figures to hide this from you.

Pasok and New Democracy, the two parties which signed up to the bailout package with its attendant further austerity, between them only managed 1/3 of the vote this time round and so even together they do not have a majority in parliament, under the system which so favoured them. 2/3 of your votes went to small parties which said they would not accept more austerity. Sadly, I have to tell you that these other political parties are not explaining the reality to you either. In recent weeks opinion polls have shown that around 70% of you want an end to austerity and to remain as members of the Eurozone, and so this is what these parties have had as their campaign platforms. Clearly this would be a good outcome for you if it could be brought about, but unfortunately this is not an option that is available.

The harsh truth that no one seems to have told you yet is that you have to choose between further austerity whilst staying in the euro and coming out of the euro with only a bit more austerity. The euro is a club for economies which wish to organise themselves along German lines – it requires real control of public finances and does not tolerate desires for pay increases which have not been earned through productivity improvements. Your economy, whilst it has been straitjacketed within the euro, has become hopelessly uncompetitive. This now requires that you go through a devaluation process and your only choice is whether this devaluation is internal or external.

The internal devaluation process means that you can stay in the euro but that you regain competitiveness via cutting the costs in your economy. This means reducing both the quantity and price of labour and in quite significant terms, both in the public and private sectors. This is difficult and very painful and will take several years, but that is the price you will have to pay if you wish to remain as part of the euro. Latvia is a recent model of how this approach can work.

The external devaluation process means that you come out of the euro, and bring in a New Drachma as your currency, which is then allowed to float freely. Many economists estimate that it would immediately fall by about 50%, which would double the value of all your euro-denominated debts, so it would make sense to default on all such debts. You will become poorer but competitive overnight and you can start to rebuild your economy from a lower base –  you will still require a little austerity as even without paying interest on all its debt, your government is still running a deficit, and there will be no one prepared to lend to them, so some further cuts are required. In the first year or two there will also be very high inflation, which will reduce your real standard of living as the costs of imported goods soar. Iceland is a good recent example of this approach.

It appears that you will soon get another chance to vote – I hope that this is the clear choice presented to you by your politicians. The second option is I believe, by far the better of the two.

With best wishes,

Jeremy

From Heroes to Zeroes – 21st Century Central Banking

At the beginning of this century, the reputation of Central Banks in the West was at its apogee – over the previous 20 years inflation had been wrung out of the global economy by maintaining interest rates consistently higher than the rate of inflation. If inflation threatened to rise too sharply then raising rates by a few hundred basis points was sufficient to choke off consumer demand (since their mortgage repayments formed such a significant part of their disposable income) and slow the economy and inflationary pressures. Once this had been achieved, often requiring a quick recession, rates could be cut again and the restoking of consumer demand would reignite the economy. In short, it was apparent that Central Banking that had as its main target the control of inflation could be successful at only a small cost to growth. Politicians found themselves able to give up their desire to control interest rates for electoral purposes and give independence to their Central Banks. Central Bankers became Heroes!

The recession in the US following the bursting of the internet bubble and fears for the US economy following 9/11 however, saw the Fed cut US rates right down to 1% in 2002 and hold them there until 2004. 1% interest rates were much lower than seen in previous cycles and in hindsight were responsible for a massive inflation of the US housing market. Whilst the internet bubble was essentially financed by equity, since the new companies had no cash flow, the housing bubble was financed by debt. Debt-financed bubbles we now know inflate far further than equity-financed bubbles and then burst in a far more devastating fashion. Central Banks meanwhile, focussing only on the Consumer Price Inflation targets did not spot the bubble in the debt markets and so did not increase interest rates sufficiently to manage things better.

Following the 2008 meltdown in the global financial system and subsequent recession, Central Banks found that even interest rates that were effectively set at zero no longer helped to boost consumer demand. This was for two reasons, first consumers realised that they had already got too much debt and no longer wished to borrow more, even with low interest rates and secondly the all economic agents (banks, companies and consumers) had lost confidence in the future growth prospects of the economy that they did not want to lend, borrow or spend.

The Central Banks went back to their old textbooks to search for policy tools when interest rates can no longer be reduced and discovered Quantitative Easing (QE) which pushes money into the financial system in an effort to boost the demand for financial assets and thus stimulate the real economy. Many Zeroes of dollars, euros, yen and pounds have been created in this way. QE has almost certainly worked in the sense that economic growth in 2009, 2010 and 2011 would have been much worse without this policy, but it has not been enough to boost growth back onto a sustainable path. Worse still, repeated applications of QE seem to be less effective at doing this than the first effort. The scale of these interventions has brought forth much criticism of Central Banks in the US and the UK for creating the risks of hyperinflation from the creation of so much money. In Europe where monetary orthodoxy of the Bundesbank is enshrined in the ECB’s mandate, the Central Bank is criticised (outside Germany) for not doing enough to support the Eurozone economy.

For politicians, who are policy-constrained by huge fiscal deficits and debts, the only hope is that Central Banks solve their problems, but whilst Central Banks have the tools for fighting inflation, they do not have the tools for fighting deflation. They have done what they can (zero interest rates and QE) but have little more to offer bar providing liquidity to keep troubled banks alive and adding more zeroes to the money supply. The Age of the Heroic Central Banker is now behind us.