Talking worth hearing: China

Tyler Cowen talks about the rise and fall of the Chinese economy: how they grew so fast, and why they're in trouble now.

~12 minutes

I like Tyler's insight that decades of high growth distorted the assessment of the risk/return of new investment projects, which is distinct (but compatible) from a decline in the marginal productivity of capital.

Sundry links

No time for writing this week, so I'm listing blog posts and articles that caught my eye recently:

1. Liftoff levers. John Cochrane is doing a fantastic job explaining how the Fed's reverse repo operations are supposed to work. Start with this post, and then read this other one.

2. A "new" working paper, by Katharina Knoll, Mortiz Schularick, and Thomas Steger, looks at global house prices in the really long run (1870-2012). From the abstract:

...house prices in most industrial economies stayed constant in real terms from the 19th to the mid-20th century, but rose sharply in recent decades. Land prices, not construction costs, hold the key to understanding the trajectory of house prices in the long-run. Residential land prices have surged in the second half of the 20th century, but did not increase meaningfully before. We argue that before World War II dramatic reductions in transport costs expanded the supply of land and suppressed land prices. Since the mid-20th century, comparably large land-augmenting reductions in transport costs no longer occurred. Increased regulations on land use further inhibited the utilization of additional land...

3. An Icelander goes to Cyprus and tells us why Cypriots keep cash worth 6% of GDP under the mattress.--Sigrún Davíðsdótti at A Fistful of Euros.

4. China's monetary and exchange rate framework under pressure.

           4.1 Huge FX inflows turn into small outflows, and the PBoC switches from draining renminbis to injecting them. To keep base money growing, the central bank has introduced new tools. By Gabriel Wildau for the Financial Times.

           4.2 Time to ditch the renminbi-dollar peg? The Chinese currency has depreciated and is hitting the central bank's target band.

           4.3 On the internationalization of the RMB, a colleague forwards several papers and reports
                 Paths to a reserve currency, at the Asian Development Bank Institute.
                 The rise of the redback, by HSBC.
                 Yuan is fifth world's payments currency, at the WSJ.
               
An important event to keep in mind is that the IMF is reviewing the SDR basket in 2015. China is under pressure to step up the internationalization of the renminbi, ahead of the basket review.

5. Dani Rodrik summarizes the results of his latest paper on de-industrialization.

Premature deindustrialization is not good news for developing nations. It blocks off the main avenue of rapid economic convergence in low‐income settings, the shift of workers from the countryside to urban factories where their productivity tends to be much higher.

Industrialization contributes to growth both because of this reallocation effect and because manufacturing tends to experience relatively stronger productivity growth over the medium to longer term. In fact, organized, formal manufacturing appears to exhibit unconditional convergence (Rodrik 2013), which makes it special and an engine of growth. Since low‐income countries tend to start with small manufacturing sectors, the dynamic within manufacturing initially plays a small role, overshadowed by the reallocation effect. But over time, the within‐manufacturing effect becomes a more potent force as the manufacturing sector becomes larger.Premature deindustrialization throws sand in the wheels of both engines (Rodrik 2013, 2014).

The consequences are already visible in the developing world. In Latin America, as manufacturing has shrunk informality has grown and economy‐wide productivity has suffered. In Africa, urban migrants are crowding into petty services instead of manufacturing, and despite growing Chinese investment there are as yet few signs of a real resurgence in industry. Where growth occurs, it is driven largely by capital inflows, transfers, or commodity booms, raising questions about its sustainability.  

In the absence of sizable manufacturing industries, these economies will need to discover new growth models. One possibility is services‐led growth. Many services, such as IT and finance, are high productivity and tradable, and could play the escalator role that manufacturing has traditionally played. However, these service industries are typically highly skill‐intensive, and do not have the capacity to absorb – as manufacturing did – the type of labor that low‐ and middle‐income economies have in abundance. The bulk of other services suffer from two shortcomings. Either they are technologically not very dynamic. Or they are non‐tradable, which means that their ability to expand rapidly is constrained by incomes (and hence productivity) in the rest of the economy.

I couldn't help but tie Rodrik's paper to that other paper by Pritchett and Summers, the one about regression to the mean of long-term growth rates. Growth is far from a uniform process. It tends to happen in fits and starts. Those who are projecting high growth rates of developing economies, based on past high growth rates, which in turn hinged on industralization, are probably going to be disappointed.

6. The translation industry.The Economist opines that translation is very hard for machines. Humans will need to stay involved, but technology will improve productivity.

A different question: Do improvements in translation bode well for language diversity in the world? How about the language learning industry? I see this as a race between technologies that allow machines to translate better, and technologies that allow humans to learn languages faster. The machines are winning, by a long shot. We're clearly on a path to better simultaneous translation capabilities. Soon we'll be able to listen to anything, anywhere in our native tongue, in real time. That means humans won't have to know more than one language. Learning languages will become a hobby, like dancing. (Sorry, parents, but you're wasting your money on Mandarin lessons.)

As for language diversity, I think a more important force than technology is urbanization. The lion's share of the world's languages are spoken by small, rural communities in developing countries. Urbanization increases the usefulness of majority languages, killing the minority languages. And urbanization will happen faster than the spread of cheap, simultaneous translation technology. At some point, however, the trend towards fewer and fewer languages will slow down, as simultaneous translation becomes pervasive.

Escaping China's currency controls: A "gambling" trip to Macao

Mainlanders looking to skirt the Chinese government's strict currency controls for a little high-stakes gambling need not look far after reaching the city of Macao.

[...] mainland authorities in recent months have been taking a closer look at the ways that gamblers dodge the official, 20,000 yuan limit on the amount of cash that a mainlander is allowed to take abroad (including Macao and Hong Kong).

One way around the currency rules begins with the purchase of an expensive watch or jewelry at a Macao pawn shop using a UnionPay debit card tied to a mainland bank account. UnionPay, China's state-run credit card company, bars the use of its cards in casinos but lets each card holder spend up to 1 million yuan every day at shops of point-of-sale machines, including pawn shops.

[...]

In the summer, Macao's streets are packed with mainlanders bustling from one casino to another. They also frequent the city's myriad pawn shops, which are overflowing with watches and jewelry. Gamblers use these pawn shops to obtain cash, so they don't flinch at steep price tags. After a purchase, a gambler-shopper quickly re-sells that expensive watch or piece of jewelry to the pawn shop for the same amount, less commission, and pockets the cash for later use in a nearby casino.

If it's so easy to skirt currency controls, why hasn't Beijing plugged this hole? My theory is that China allows the "Macao way-around" (as well as the "Hong Kong roundabout") as a sort of "safety valve"--the way pressure cookers have a hole built in, through which steam continuously seeps out. If China were really serious about currency controls, this low-tech evasion wouldn't happen.

Consider this: Now Beijing is getting upset that the money laundering/currency control evasion is getting out of hand. What do they do?

Under orders from Macao's secretary for economy and finance, Francis Tam Pak Yuen, a moratorium on new point-of-sale UnionPay machines in casino-attached jewelry shops took effect in July. The city's Office of Financial Information, meanwhile, and its Director Deborah Ng Man Seong are busy watching local casinos for signs of money laundering.
[...]
Yuen's moratorium order is expected to cap but not eliminate this pawn shop practice. It does not, for example, stop the use of existing UnionPay point-of-sale machines nor prevent casino operators from moving machines from one venue to another.

Doesn't sound particularly heavy-handed.

Macao provides other ways for "high rollers" from the mainland to evade capital controls. Read the whole piece, at CaixinOnline.

P.S. If you're interested in the topic of illicit financial flows in and out of China, check out the Global Financial Integrity website.

What caught my eye

1. Brazilians turn against the canarinha (for now).

2. Bad dreams about Russia, China, and World War.

3. What do cancer and unemployment have in common?

4. NBER papers: phasing out paper currency, and permanent changes to monetary policy.

1. "I want Brazil to lose," says a Brazilian. I seldom hear good things about the World Cup, which makes me think the event will be a positive surprise. (By the way, remember the comments in the months prior to London's Olympics?)

2. Russia strengthening ties to China. Perhaps it's WWI centennial fever, but I can't erase from my mind the idea of a China-Russia military alliance, against the "oppression," "bullying," etc. from the U.S.-Western Europe-Japan trio. Articles like this, on China supposedly following Japan's prewar blueprint, don't help put me at ease.

3. The odds of developing certain cancers decline with age, just like the odds of escaping unemployment decline with the length of the jobless spell, by Jim Hamilton.

4. Two papers from this week's NBER crop:

4.1 Costs and benefits to phasing out paper currency, by Kenneth Rogoff.

Despite advances in transactions technologies, paper currency still constitutes a notable percentage of the money supply in most countries.  For example, it constitutes roughly 10% of the US Federal Reserve's main monetary aggregate, M2.  Yet, it has important drawbacks. First, it can help facilitate activity in the underground (tax-evading) and illegal economy. Second, its existence creates the artifact of the zero bound on the nominal interest rate.  On the other hand, the enduring popularity of paper currency generates many benefits, including substantial seigniorage revenue.  This paper explores some of the issues associated with phasing out paper currency, especially large-denomination notes.

4.2 Has the financial crisis permanently changed the practice of monetary policy?, by Benjamin Friedman.

I argue in this paper that one of the two forms of hitherto unconventional monetary policy that many central banks have implemented in response to the 2007 financial crisis - large-scale asset purchases, or to put the matter more generically, use of the central bank's balance sheet as a distinct tool of monetary policy -is likely to become part of the standard toolkit of monetary policymaking in normal times as well.  As intended, these purchases have lowered long-term interest rates relative to short-term rates, and lowered interest rates on more-risky compared to less-risky obligations.  Moreover, their introduction fills a conceptual vacuum that has long stood at the heart of monetary policy analysis and implementation. By contrast, forward guidance on the future trajectory of monetary policy has been less successful.  Public statements by central banks about their actions and intentions will no doubt continue, but transparency for the sake of transparency is not the same as the deliberate attempt to shape market expectations for purposes of achieving specific monetary policy objectives. Finally, there is a conceptual component to all this as well.  In contrast to the last century or more of monetary theory, which has focused on central banks' liabilities, the basis for the effectiveness of central bank asset purchases turns on the role of the asset side of the central bank's balance sheet. The implications for monetary theory are profound.

What caught my eye

1. Japan's debt is on an explosive path, unless they have hyperinflation. That is not a literal quote from the article, just my takeaway from Ben McLannahan's piece on the FT.

No new ideas here: government debt keeps climbing, and it's not clear at all how they will stabilize it. But the quotes from some government, BoJ officials, and market participants, as well as some sentences in the article, were striking.

“A market crash is inevitable,” he says. “The only question is what measures we can take today to lessen the damage.”

"...gross central government borrowings equivalent to 24 years of tax receipts..."

"As Takehiro Sato, a policy board member, puts it, the more government debt a central bank buys, the greater the appearance of 'fiscal dominance' – where monetary policy essentially becomes a ruse to keep the state solvent.

The boundaries are already blurred. Dealers talk about 'the BoJ trade' – buying bonds at auction from the finance ministry then flipping them immediately to the central bank to bag a few basis points of profit. One issue of 30-year bonds on February 6 was almost 90 per cent owned by the BoJ a month later. 'We are buying tonnes of JGBs; we are monopolising the market,' says Mr Sato."

"Claims of fiscal discipline are a 'charade', says Mr Bass. 'If you really look into next year’s revenues and expenditures, they’re spending Y23.3tn on debt service and Y31tn on social security, and getting Y50tn in tax. Before they even run the government they’ve already spent the money.'"

2. Big steelmaker in China stops production, awaits debt 'restructuring', at Caixin. This is the third default in China I hear about over the past couple of months: two in the steel sector, one in the solar panel sector. Who knows how many more are there. Plus, shadow bank lending apparently on the decline.

3. Life without Visa and Mastercard. The Russians say "no problem."

4. Uncertainty traps: intriguing paper. Ungated, early version (pdf).

5. This is an old piece (1993), by Mark Knutson, but I must admit I never read this account of Charles Ponzi's "remarkable criminal financial career." (pdf)

6. The 100th year anniversary of the Great War is approaching fast. I'm watching this 26-episode documentary by the BBC. So far I'm liking it. Speaking about BBC documentaries from the 1960s, earlier this year I enjoyed Kenneth Clark's Civilisation, an account of Western civilization through art, from the 6th century through modern times.

What caught my eye

1. Background to the Crimean conflict. Nice summary by BBC News.

2. Forty-four percent of Mexico's iron ore production is smuggled to China. (Does anybody know how large, or small, is China's real trade balance?)

3. Who is the eurozone's weakest link? Italian banks?

4. Felix Salmon on why bond buyers insist on lending to Puerto Rico under New York's law. It's not what you think.

5. Facebook drones, Google balloons.

Well worth reading

1. Chinaleaks:

Close relatives of China’s top leaders have held secretive offshore companies in tax havens that helped shroud the Communist elite’s wealth, a leaked cache of documents reveals.
The confidential files include details of a real estate company co-owned by current President Xi Jinping’s brother-in-law and British Virgin Islands companies set up by former Premier Wen Jiabao’s son and also by his son-in-law.
Nearly 22,000 offshore clients with addresses in mainland China and Hong Kong appear in the files obtained by the International Consortium of Investigative Journalists. Among them are some of China’s most powerful men and women — including at least 15 of China’s richest, members of the National People’s Congress and executives from state-owned companies entangled in corruption scandals.

I am surprised that this exposé has not received more attention in the U.S. media.

2. Rainfall risk and religious membership in the late 19th-century U.S.

Insurance among the members of religious organizations should be more valuable in communities facing greater risk, making membership in religious organizations more attractive in high-risk environments. We examine the link between rainfall risk and church membership as well as seating capacity across US counties in the second half of the nineteenth century. Our results indicate that church membership and seating capacity were significantly larger in counties likely to have been subject to greater rainfall risk. This link is present among the most agricultural counties and among counties with low population densities, but not among less agricultural or more densely populated counties. Among the most agricultural counties, a one-standard-deviation increase in rainfall risk is associated with an increase in church seating capacity of around 32 percent in 1890 and 65 percent in 1860.

Hat tip to Samuel Bentolila at Nada es Gratis (in Spanish).

3. The 30 most innovative countries in the world. Some surprising results.

4. Nice recap and update on Puerto Rico's fiscal mess. Other links on the same topic.

5. Emerging markets crisis: not all about tapering. (Originally linked to by macrodigest.com.)

China: Ripe for a sharp slowdown

(I prepared this piece for publication on Morningstar Advisor, my employer's bi-monthly magazine.)

In the years since the 2008 financial crisis China has posted impressive growth in gross domestic product (GDP), in spite of a lackluster global recovery. The country managed to do this by creating an investment boom, which in turn was powered by a surge in credit. Total debt, private and public, rose from 125% of GDP in 2008 to 215% in 2012. Corporations alone have racked up debt worth 111% of GDP.

A lot of that capital has been misallocated. China has built more ports, railways, smelting plants and residential complexes than it should have, given its productivity level. Because those projects will not deliver significant returns for a long time, if ever, bad debt is piling up. As a result, the balance sheets of Chinese banks are laden with dubious assets.

The official reported rate of non-performing loans (NPL) is less than 1%, which belies the actual quality of bank assets. Financial institutions use all kinds of maneuvers to inflate profits and dress up their balance sheets. In 2012 there was evidence of misclassification of dud debts as “special-mention loans,” which do not need provisioning but are expected to face difficulties. Loan officials enjoy substantial discretion in such classifications. More recently banks have introduced shady financial innovations. As an example, one instrument now on the rise are “trust beneficiary right investments,” according to a recent report by HSBC research. These quasi-loans circumvent the loan-deposit ratio requirement and the provisioning requirement that applies to regular loans. In one year, the balance of these trust rights has almost doubled for the largest Chinese banks, according to HSBC Research. The upshot is that balance sheets, especially those of mid-sized banks, are increasingly opaque.

Another type of fudging consists of rolling over loans that are in danger of falling behind schedule. This rescheduling of bad debt can be done directly in the books, by extending maturities. It also happens indirectly, by repackaging it as wealth-management products (WMP) offered to individual investors. WMP’s are sold by banks at much higher yields than bank deposits and have attracted a lot of buyers among small savers. They also have short maturities, which means that they are less reliable as a source of funding than traditional deposits. The groundwork for a bank run has been laid out.

The financial system may be reaching a breaking point. Twice in 2013 the interbank interest rate spiked above 10% when the central bank initially provided less funds than the wholesale loan market initially expected. Each time the liquidity crisis could have set off a domino of defaults, resulting in a systemic solvency crisis. Both times the central bank saved the day, pouring more money into the system, and allowing the economy to keep investing, borrowing, re-financing and accumulating bad debt. China is unable to stop this merry go-round.

Stories of financial excess seldom have a happy ending, as Carmen Reinhart and Kenneth Rogoff documented extensively in their book “This time is different.” It is hard to characterize the end of an episode of financial excess, because so much depends on how debt was accumulated in the first place. A financial crisis, in particular, may or may not occur, depending on monetary and fiscal responses by policymakers. But at a very minimum history suggests that China’s economic growth should decline sharply as the economy starts deleveraging, whether a hard landing happens or not.

China optimists not only downplay the possibility of a crisis, but make five-year projections of growth between 6% and 7%, just a notch below the current 7.5% pace, and much higher than what a deleveraging China would allow: most likely below 4%. Some of these high-growth projections depend on two arguments. At best, I find that they overestimate China’s strengths. At worst, they are completely irrelevant.

The first argument is that the level of China’s total government debt, which includes central, provincial, and local jusrisdictions, is modest. Direct obligations stand at just under 40% of GDP, using recent data from China’s National Audit Office. That is a modest amount by the standards of most large countries in the world. But if one adds explicit and implicit guarantees the figure rises to a less flattering 60%. Even at that level, optimists might say, China’s government has less debt than those of most advanced economies. Beijing, the argument goes, has plenty of room to bail out its financial sector and cope with a recession if a financial crisis strikes.

Problem is: healthy public finances did not help the U.S., Spain, or Ireland to dodge the 2008 crisis. In 2007, U.S. general government debt was a modest 64% of GDP, according to the International Monetary Fund's World Economic Outlook database. Spain’s and Ireland’s were 36% and 25%, respectively. Japan in 1991, arguably a better parallel to present-day China, had government debt of just 66% of domestic output, and still suffered a 20-year malaise as a consequence of the excesses of the 1980s. The level of government debt does not predict the occurrence of a banking crisis or a real estate crash.

The second argument is that China can rely on a strong external position. China’s debt is presumed to be mostly domestic, i.e. denominated in renminbi and held by Chinese investors. That is less true than what the official numbers show. Over the last couple of years a significant share of China’s “shadow financial system” has been taking advantage of low interest rates on the dollar to borrow abroad and speculate in the property market at home. To circumvent capital controls, that external borrowing is disguised as export revenue or foreign direct investment, so it does not show up in the official statistics as what it really is: short-term external debt. Estimates of this debt are hard to come by, but ballpark guesses are terrifying. According to Bank of America, in the first four months of 2013 China’s actual trade surplus, after removing fake exports, was one tenth of the official number.

Not only is China’s current account surplus smaller than it appears, but the country is more vulnerable to flows of “hot money” than generally recognized. When quantitative easing in advanced economies goes in reverse, capital will leave China, pulling the rug under property prices.

What China’s ultimate fate will be is highly uncertain. Bad debt, rampant speculation and the unregulated shadow financial system could precipitate a sudden collapse. Alternatively, Chinese authorities might be able to reign in credit growth and engineer a gradual reduction of investment growth. I certainly hope for the second outcome. But one thing I have little doubt about is, as China deleverages one way or another, GDP growth over the next five years will be substantially lower than what most people seem to expect.

Well worth reading

1. John Cochrane discusses the Nobel lectures. The part about Shiller is particularly good.

2. Why Abenomics will disappoint, by Martin Wolf at the FT. My takeaway is that Japan should drive up final consumption by transferring income from the corporate sector to the household sector, and that raising the consumption tax will not accomplish that.

3. Capital ratios of European banks.

4. China's actual GDP growth rate might be 1.5 to 2 percentage points lower than the official figure. Article in the WSJ blog, with data from Capital Economics.

Well worth reading

1. Corruption perceptions. The 2013 results are in. Changes from 2012:

Biggest deterioration*: Syria, Spain, Gambia, Mali, Guinea-Bissau, Libya, Yemen, Mauritius and Eritrea.

Biggest improvement*: Myanmar, Laos, Senegal, and Brunei.

*I list countries with an absolute change of the corruption score of at least five points, with the exception of South Sudan, which did not have a score in 2012.

2. A new measure of U.S. GDP, by Aruoba, Diebold, Nalewaik, Schorfheide, and Song.

GDP can be estimated by measuring either expenditure or income. Since a penny spent is a penny earned, both methods should give the same answer, but there is substantial measurement error in both estimates. This column presents a new method of measuring US GDP that blends these two estimates. According to the new measure, GDP growth is about twice as persistent as the current headline measure implies. The new measure also makes the current recovery look stronger, especially in 2013.

3. Educating the economists of the future. What's wrong with Econ 101, by Matthew Klein at Bloomberg.

4. I enjoyed this interview with Richard Thaler by Douglas Clement at The Region. 

Take quantitative models, quantitative investing strategies. I think what we’ve learned—especially in the last five years or so—is there’s essentially one quantitative model. 

I don't agree with Thaler's assertion that every economist thinks that interest rates in ten years will be substantially higher than they are today.

5. Why high land prices in China are not (necessarily) a bubble, by Joseph Gyourko. The land price index that Gyourko has constructed is available here.

Well worth reading

1. Forward interest rates and monetary tightening, by Jim Hamilton at Econbrowser. This is a nice refresher of forward interest rates, and an application of the Gurkaynak-Sack-Wright data set (xls).

2. A summary and critique of Summers' "great stagnation" hypothesis, by Stephen King at the FT. King makes an important distinction between "supply side" and "demand side" theories of the stagnation. Tyler Cowen already pointed the discussion in that direction a few days ago.

3. NBER working paper by David Dollar and Benjamin Jones, on the link between China's institutions and its "unusual" macroeconomic performance.

China presents several macroeconomic patterns that appear inconsistent with standard stylized facts about economic development and hence inconsistent with the standard neoclassical growth model. We show that Chinese macroeconomic patterns instead appear consistent with an environment where state control of factor markets can promote aggressive output goals. We consider the micro-institutional features that can sustain this behavior, emphasizing the hukou system and state control over capital allocation, and present a simple model built on these features. The model can explain several puzzling facts about the Chinese economy, including its unusually low labor share and unusually high saving and investment rates. Interestingly, the model also shows that free-market reforms can initially take the economy further from global macroeconomic norms.

4. John Hussman on his usual crusade to show that we should expect meager returns from U.S. equities. I find his charts persuasive--until he starts trying to show that the Philips curve is incorrectly specified, or that there is a tiny correlation between unemployment and the stock market. (I don't disagree with the theses, but with the methods.)

20130925 Links: Germany's economic model, China's urbanization, U.S. corporate profits

1. Martin Wolf (FT) and Evans-Pritchard (The Telegraph), railing against Wolfgang Schäuble and Germany's wrong-headed virtuous model. (Evanst-Pritchard's rant is quite colorful.) Wolfgang Münchau looks at the implications of Merkel's victory for European crisis management.

2. The farmers left-behind by China's urbanization:



3. Scary chart by John Hussman (a lot more at his weekly commentary):

20130924 links: Why the poor don't work; Ben Stein; China's outlook; the German election

1. Why the poor don't work, by Jordan Weissmann in The Atlantic (hat tip to Tyler Cowen at MR).

2. Wikipedia's profile of Ben Stein (not flattering, overall).

3. China's hazardous outlook, by Michael Pettis on Bloomberg.

4. Results of the German election in Berlin. The wall's still there:

The black line is a "very rough approximation" of the Berlin wall's route.

From the an entry by Michael Steen on the FT blog "The World":

This is a map, courtesy of the Berlin returning officer’s website, of the constituency votes in Berlin. Blue is the Christian Democratic Union of Angela Merkel and purple represents the Left party, which was formed from the remnants of the communist SED that ruled East Germany as well as leftwing defectors from the centre-left SPD, shown in red. (The Greens are, um, green.)

The starkness of the division should make for depressing reading by anyone studying Germany’s reunification, but it also reflects some basic economic truths. The most gentrified parts of eastern Berlin are the only ones where the Left party did not win the constituency vote.

Although Germany’s east-west differences have reduced since 1991 (partly thanks to large fiscal transfers) the east still lags the west in income, wealth and employment. That also explains why support for what could be considered protest parties tends to be higher in the east. This was illustrated separately in Sunday’s election in the higher numbers of people voting for the new eurosceptic Alternative for Germany party in the east compared to the west.

Links 20130729: Argentina property market; India's macro situation; China's gov't debt

• Housing bust in Argentina, via Bloomberg News. Plus evidence of real estate bubbles in Chile and Colombia.

“The main issue in Argentina is that the real estate market has historically been transacted in dollars so when you make it impossible for people to source dollars liquidity gets disrupted,” said Bret Rosen, managing director of research at Jamestown Properties LLC in New York.Fernandez’s foreign-currency curbs effectively put home purchases out of reach for many Argentines because they would be forced to buy dollars on the black market for 60 percent above the official rate. Sales in Buenos Aires plunged 34 percent in the first five months, the biggest decline since the 2001 financial crisis that culminated in the government’s $95 billion bond default, according to the Buenos Aires Notary College.

• A little overview of India's short-term macroeconomic situation, via Bloomberg News.

• China's National Audit Office to audit government debt, via BBC News. I wonder what the NAO will publicly say, once the audit is finished. Not the whole truth, of course.

20130606 Links

1. Top ten contributors to global growth; 2. Reorienting China; 3. Will India get downgraded to junk status?

********************************************************************************************************************************************************************************************************************************************************************************************************************

1. Emerging and developing economies already make up about 50% of the world's GDP at purchasing power parity. Their large size, and continued higher rates of growth than in advanced economies, have catapulted EMs to the top of the chart of main contributors to world growth. For the period 2012-17, the top contributors to world GDP growth are projected to be (in brackets, rank in 2002-07):

1. China (1)

2. U.S. (2)

3. India (3)

4. Russia (4)

5. Brazil (6)

6. Indonesia (11)

7. South Korea (9)

8. Mexico (10)

9. Japan (5)

10. Turkey (8)

Canada and U.K., which were in the top ten in 2002-07, get dropped.

Source: Financial Times, accessed on June 5, 2013.

2. IMF paper by Lee, Syed, and Xueyan on consumption and investment in China. Abstract:

This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates. If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.

I am not surprised that the authors find evidence of excessive investment, but the insight that private consumption is heavily dependent on investment in the western provinces is new to me. And this has an important implication: if eventually investment growth slows down, as almost certainly it will, total domestic demand will slow down, regardless of how much rebalancing occurs away from investment and towards consumption.

3. S&P revised India's outlook to 'negative' on April 25, 2012. Fitch did the same in June of the same year. Moody's keeps the outlook as 'stable.' All three major agencies give India the lowest of the investment-grade ratings: BBB- (Baa3 in the case of Moody's).

As key drivers of the revision and possible future downgrade, the analysts at S&P wrote in June 2012: "The outlook revision reflected at least a one-in-three chance of a downgrade in the next two years if India's external position continues to deteriorate, its GDP growth prospects diminish, or if progress on fiscal reforms remains slow." I was not able to read Fitch's report, but in an April 2013 interview of CNBC with Art Woo, the agency's director of sovereign ratings, he said it was more likely than not that India would be downgraded, citing slower growth and the deterioration of public finances.

The odds are against India, I'm afraid. Since 2012:Q1, GDP growth has slowed further, the current account deficit has become wider, and the government deficit has shrunk only marginally. The IMF projects GDP growth (p. 153) to rise from 2012 to 2013, but so far we have not seen this improvement. The IMF also projects the government primary deficit to shrink marginally in 2013, but the total deficit to remain unchanged, as a % of GDP. The current account balance, at -4.1% over the 12 months to 2012:Q1, has declined to -5.1% as of 2012:Q4. And, although there are some big changes underway, but I get a sense that the latest wave of reform will amount to a marginal change, rather than a Big Bang, as it has been dubbed.

In my opinion, the most likely scenario is: at least one agency downgrades India by the end of 2013. Second most likely scenario: the downgrade happens in 2014.

20130605 Links

1. Singapore: LNG trading; 2. Hong Kong's property bubble; 3. Remembering Tiannanmen.

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1. LNG futures in Japan: When? By reading this article about the market for liquefied natural gas (LNG) in Singapore, I realized that a futures market in this commodity does not exist even in Japan.

Stephanie Wilson, managing editor of Asia Power at Platts, said: "There is certainly a growing demand for them but as yet, we don't have any LNG futures traded on an exchange. It is something that will probably happen in the next couple of years. I know in Japan, they are talking about launching a futures contract as early as 2015 as they deregulate their energy industry. Whether or not it will bring down the price of LNG, certainly these guys need something to hedge against now that the market is becoming more volatile." 

In the meantime, Singaporean authorities are thinking about creating a secondary market for LNG. Right now, all Singaporean buyers get their supply from one company, the British BG Group. But:

EMA's latest proposal calls for a competitive licensing framework that would see Singapore buying LNG on demand and reduce its concentration risks of only buying from one supplier.
For the moment, LNG buyers in Singapore have to work with BG Group to get their supplies and are not allowed to re-sell it to anyone else domestically. 

A secondary market might solve this rigidity. 

Ravi Krishnaswamy, vice president of energy and environment at Frost & Sullivan, said: "In the future, what EMA is trying to do is to allow the buyers to on-sell the gas using the domestic pipeline network to other interested parties especially if they have excess supply. This also in a way tries to help the buyers who may not have a need for all that capacity in that point of time to hedge the risk with respect to the take or pay contracts."

I can see how the current market is too rigid. Buyers of LNG have to buy exactly as much of the stuff as they  think they need, or buy more of than they need and store it, but they can't hedge against the price risk, because there are no futures contracts (I don't know if there is market in forwards). My question after reading the article is: Can Singapore sell more importer licenses, or does BG's license have an exclusivity clause attached? Either way, a secondary market is surely a improvement.

2. Property bubble talk in Hong Kong.

The risk of a property bubble persists despite an easing of prices following government restraints, Financial Secretary John Tsang Chun-wah warns. 

For some apartments continue to change hands at unusually high prices. 

A 636-square-foot flat at Kingswood Villa in Tin Shui Wai sold yesterday for a similar-size high of HK$3.99 million, or HK$6,274 per sellable square foot. 

Prices of subsidized flats are also soaring. A 426-sq-ft unit at Wo Ming Court in Tseung Kwan O went for an estate record of HK$3.55 million, or HK$8,333 psf. 

Tsang, meanwhile, was telling the Legislative Council's financial affairs panel that secondary home prices continue to stay soft, though the number of transactions has picked up slightly on the back of a huge inflow of capital and a relatively low interest rate. 

And a bubble cannot be ruled out while quantitative easing by the United States continues.

3. Remembering Tiannanmen, but not on mainland China. (This will probably get EconWeekly censored in China.)

Every year, Hong Kong residents gather in droves for the annual vigil to commemorate the Tiananmen democracy protests. More than marking the brutal crackdown in Beijing 24 years ago, the event here increasingly symbolizes disaffection with rule by China. 

Tens of thousands of people gathered Tuesday evening at a large park in the former British colony. They turned the park into a sea of flickering light as they held candles aloft to remember those killed when their protests in central Beijing were crushed by the Chinese military on June 4, 1989. Commemorations of the crackdown are suppressed everywhere else in China. 

(...) 

In Beijing, there was no sign of large-scale protest, but some people answered a call by activists to wear black to work in remembrance. As in previous years, many pro-democracy activists themselves were not allowed to leave their homes to mark the anniversary. On the country's lively social media, searches for words including “commemorate” and “6_4” were banned, and the candle emoticon was removed. 

(...) 

When Hong Kongers poured into the streets in 1989, their sympathy with the protesters in Beijing had more to do with fears about impending Chinese rule -- then eight years away. Now it's about current problems that include corruption, a leader viewed by many as inept and tin-eared, and a yawning wealth gap that has stifled the aspirations of the city's large middle-class.
And “of course it also expresses the anger of people over the Chinese government messing with our democratic reform,” said pro-democracy legislator Lee Cheuk-yan. 

Mike Yip, a sales consultant attending the vigil, said people were dissatisfied with the lack of reform. 

“Everybody understands we can't change anything in the short term but we hope that slowly there will be changes,” he said. 

When Hong Kong was handed back to China in 1997, it was allowed to keep its own political system and Western-style civil liberties such as freedom of speech until 2047. 

Residents can vote for some of their legislators, while others are chosen by business and other special interest groups. They've never been able to choose their leader, who during British colonial rule was dispatched from London. Since China retook control, the leader, now known as chief executive, has been chosen by a committee of mostly pro-Beijing elites.

20130603 Links

1. China's exchange rate; 2. Nigeria's banking system; 3. The Fed indirectly caused low interest rates.

1. Is the renminbi overvalued? Charles Dumas at the FT thinks so.

Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.  

Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolonged “investment-led” slowdown. 

China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per cent of GDP, much of it debt-financed, has left it with high prices for real estate and industrial commodities. These assets with low-to-negative yield are also the most sensitive to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble, high nominal and real interest rates make these asset prices vulnerable. 

Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue the yuan and cushion the rebalancing of the economy away from excessive capital spending. But it would also drain away bank deposits, threatening a major domestic asset sell-off as well as bank insolvency. 

[Emphasis added.]

I am most worried about a spiral of: flight of savings away from Chinese banks, rising interest rates, a property crash, and household and bank insolvencies.

2. Nigeria's banking system has recovered. To me, not following the Nigerian economy closely, it was news that the country suffered a banking crisis in 2009. In any case, the IMF has published a report that says that banks have recovered just fine, although (of course), substantial risks remain. Selected paragraphs from the executive summary:

1. The Nigerian economy has experienced domestic and external shocks in recent years, which resulted in the 2009 banking crisis. However, the economy has continued to grow rapidly, achieving over 7 percent growth each year since 2009. The performance of financial institutions has begun to improve, though some of the emergency anti-crisis measures continue to be in place. The success in maintaining financial stability after the crisis, and in the face of major external threats, reflects the decisive and broad-based policy response by the government and the Central Bank of Nigeria (CBN).  

2. Following the crisis, the authorities took a comprehensive set of remedial measures. Substantial liquidity was injected; a blanket guarantee for depositors, as well as for interbank and foreign credit lines of banks, was provided; the Asset Management Company of Nigeria (AMCON) was established to purchase banks’ nonperforming loans (NPLs) in exchange for zero coupon bonds and inject funds to bring capital to zero; regulations and supervision were strengthened and corporate governance enhanced; and the universal banking model was abandoned and banks instructed to establish holding companies or divest their nonbank activities.  

3. As a result, Nigeria avoided economic collapse and economic growth resumed. The challenge now is to build on these achievements, so that vulnerabilities can be mitigated and growth placed on a sustainable and enduring path. 

(...) 

5. The financial system continues to suffer from weak governance, including some non-transparent ownership structures, deficiencies in financial reporting, and endemic perceptions of corruption. These weaknesses were highlighted by failures and severe undercapitalization of several banks, contributing to banking sector consolidation from 89 banks in 2005 to 20 in 2012. The federal government’s fight against corruption has resulted in an improvement in perception of the extent of corruption as indicated, for instance, by Transparency International in 2011. However, corruption continues to be a significant problem, including in the court system and other public authorities.  

6. Despite significant progress in recent years, the regulatory and supervisory framework has gaps and weaknesses: (i) Nigerian financial institutions operate under a framework of laws, regulations, circulars, and guidelines that are not all well-understood, and do not seem to provide a coherent overall framework; (ii) further enhancements are still needed in bank supervision and resolution, particularly with regards to at least one weak bank, and to cross-border supervisory practices; and (iii) the extensive agenda ahead for supervisors and regulators will pose serious capacity challenges.  

7. The development and regulation of non-bank financial institutions require further reforms. The insurance sector needs better enforcement of compulsory insurance; improvements in product disclosure standards; and resolution of small unprofitable companies. The 2004 pension sector reform was helpful, but coverage remains low. Legacy funds’ assets are yet to be transferred to Pension Fund Administrators. Although the Nigerian Securities and Exchange Commission (SEC) has made progress, more reforms are needed to further enhance oversight of the capital markets. The SEC has been without a Board since June 2012, jeopardizing its proper governance and functioning.  

(...) 

9. Access to finance is an important constraint to Nigeria’s development. There is negligible intermediation to small and medium-sized enterprises (SMEs) by the formal financial sector. While the microfinance sector has undergone significant changes, it remains characterized by numerous small, financially weak and ineffective institutions. 

3. Bringing perspective to QE. David Beckworth points out that the Fed, yes, bought a lot of government debt in 2010-11, but they also allowed their share of Treasury debt balances to drop in 2008-09. In his view, the Fed is indirectly responsible for the ultra-low interest rates. If I understand him correctly, the Fed did not respond adequately to the spike in demand for money balances in 2008-09, and that that failure is behind the low interest rates.

David asks "Why are interest rates so low?"

The most obvious answer is that the monetary policy of the Federal Reserve is keeping them low. Many observers point to the Fed’s large-scale asset-purchase programs as the reason for the low interest rates. Others point to the Fed’s forward guidance on interest rates that says the target federal-funds rate will remain in the exceptionally low 0–0.25 percent range for some time. These observations have led some to conclude that the Fed is not only creating a drag on the economy with its low-interest-rate policies, but is also making it easier for Congress and the president to avoid tough budget choices and enabling large government deficits by reducing the Treasury Department’s financing costs. 

This understanding, however, runs up against three inconvenient facts. First, the Fed has not been dominating the Treasury market. At the end of 2012, the Fed held only 15 percent of all marketable Treasury securities, roughly the same share it has held over the past decade. This means that the largest-ever run-up of public debt was financed mostly by individual investors, their financial intermediaries, and foreigners. Second, the Fed’s forward guidance on interest rates is itself shaped by the Fed’s forecast of the economy. The Fed, then, is not independently shaping the future path of interest rates, but is responding to what it thinks will happen to the economy in the future. Finally, long-term interest rates on safe government debt across the world have fallen: Very similar sustained declines in government-bond yields have occurred over the past four years in the United States, the United Kingdom, Germany, and Japan, as the graph below shows. It is far easier to explain these declines as a function of a weak global economy than to attribute them to an overactive, all-powerful Fed.

David moves on to say that

The proximate reason, then, for the low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets. Households, for example, continue to hold an inordinately high share of money-like assets, including Treasuries, in their portfolio of assets.
Households’ high share of safe assets should not be surprising given the spate of bad economic developments over the past five years: the Great Recession, the euro-zone crisis, concerns about a China slowdown, the debt-ceiling dispute of 2011, and the more recent fiscal-cliff talks. The immediate effect of these developments was to create uncertainty about future economic growth and raise the demand for money-like assets. This elevated broad money demand not only has kept interest rates low, but also has prevented a robust recovery from taking hold.
While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

Simplifying, the two opposing views implicit in David's discussion are: 1. The Fed bough a lot of Treasury debt, thus keeping their prices high and yields low; 2. There was an independent rise in the demand for money, motivated by expectations of slow growth and by increased risk, and the Fed failed to counter expectations of depressed nominal spending.

I admit that I have not articulated a full-fledged response to David's views, but here hare a few thoughts:

1. The Fed's balances of Treasury debt do not matter for the determination of interest rates as much as the marginal purchases of treasuries, and the announcement of (possible, not even actual) future purchases.

2. Risk perceptions and risk aversion probably played a big part in the surge of money demand in 2008-09. The Fed did step in to assuage the markets. Although the Fed did fall short of targeting nominal spending, it is not clear to me how NGDP targeting would have been more effective than the policies that the Fed actually followed in regards to mitigating the rise in risk perception and risk aversion.

3. The Fed's policies in 2008-11 did probably suffer from the "pessimism problem," and it was not until 2012 when they got around it by targeting the unemployment rate. And it might have been better if they figured that out sooner. But can the Fed, really, steer the real economy one way or another, by buying more treasuries? Why would it make any difference if the Fed targeted NGDP instead of targeting the unemployment rate? In my opinion, the announcement of an intention to keep interest rates low for a long period of time had an effect on the prices of financial assets, but it made a difference on the real economy mostly by removing some uncertainty and instilling a bit of confidence. Having an objective, well-defined target was important, but the choice of target (NGDP, unemployment, employment creation, output growth, what have you) was secondary.

Here's David's blog post, and here is his recent piece on the National Review.

20130530 Links

1. Expected income growth in the U.S.; 2. Rising rates in Canada?; 3. Property speculation in China.   ***************************************************************************************************************************************************************************************************************************************************

1. Income growth expectations and forecast consumption growth.

A research note at the Chicago Fed. Conclusion:

This article documents the decline in aggregate consumption during and after the Great Recession. It also explores the relationship between the decline in consumption and the decline in consumers’ expectations about their future income. The analysis uses microeconomic data from the Michigan Surveys of Consumers to study expected income growth. These data show that expected income growth declined significantly during the Great Recession for all age, income, and education groups. It is the worst drop ever observed in these data, and it has not yet fully recovered to prerecession levels. Furthermore, we show that expected income growth is a strong predictor of actual future income and consumption growth. For this reason, forecasts of near-term consumption and income growth using these data suggest sluggish income and consumption growth over the next year.

2. Wage gains and higher expected inflation in Canada: The end of the easing cycle?

Yes, consumer price index (CPI) inflation last month ran at an ice-cold 0.4 per cent on a year-over-year basis, the slowest rate since the 2009 recession. Yes, even so-called “core” CPI inflation (a measure that excludes the most volatile components such as food and energy, which is not only a more reliable measure of the underlying inflation trend but is the ultimate guide for Bank of Canada interest rate policy) is a thin 1.1 per cent, dangerously close to the bottom of the bank’s inflation target range of 1 to 3 per cent.

And yes, all of this would typically spur the central bank to action to bring inflation back toward the happy middle of its target range – meaning, typically, rate cuts to lend a hand to a clearly sluggish economy. 

Yet the central bank continues to indicate that its next rate move, whenever that will be, will most assuredly be up, not down. It sees that there are a host of temporary factors that have kept consumer prices down – most recently a dip in fuel prices – that may not last. 

And, perhaps more strikingly, it sees the wage growth 

Statistics Canada reported Wednesday that Canada’s average weekly wages rose 3.1 per cent in March from a year earlier, matching the pace of February. Those numbers are the highest since last fall, and coming back to back, they make a solid case that wage inflation is gaining speed in this country, as economic growth picked up in the first quarter.

3. Property speculation in China.

In the latest effort to cool the property market, local governments were urged to implement a 20 percent personal income tax on capital gains from property sales, if a homeowner sells the property within five years of its purchase and the property is not the only one owned by the seller.

The authorities in major housing markets such as Beijing, Shanghai and Guangdong said in late March that they would implement the policy, which led to a sharp decline in secondhand home sales in those markets.

Although Li said that other local authorities are only expected to carry out the personal income tax policy on a "selective" basis, he pointed out that the country may tax the possession of multiple properties in the second half, if current policies continue to push up housing prices and worsen the market environment.

"The mismatch between supply and demand has been growing for years," Li said.