Friday, May 21, 2004

China Is Global Economy's 800-Pound Gorilla

China Is Global Economy's 800-Pound Gorilla
William Pesek Jr.

Traveling around Asia, it's hard not to view the region as a vast web of interconnected strings, all attached to China at the middle.

If you think that's an overstatement, consider this: Japan, by far Asia's biggest economy, is recovering from a 13-year malaise. And what are policy makers and investors here talking about? China and the specter of a slowdown in the world's sexiest economy.

That people here are more excited about a sudden drop in Chinese growth than a Japanese revival sheds light on the rising level of hysteria over China's outlook.

While the stakes of a Chinese slowdown are well known, it's not clear that global investors appreciate how difficult a task faces officials in Beijing. Much could go wrong with China's attempts to modernize its economy, and problems there could send shockwaves around the globe.

China is confident it can cool growth without a meltdown. That's music to the ears of Asian leaders counting on China to succeed in easing growth to about 7 percent this year from 9.1 percent last year. At least publicly, Asian and U.S. policy makers say China's chances are good. ...Link

And a related story: The Fed And Pavlov's Sheep

Thursday, May 20, 2004

Taming China's Runaway Economy

Taming China's runaway economy

...What’s the strategy for the future?
Yet, the hot topic among economists is how China should proceed with the next stage of economic development.

And the United States — the world's largest economy — has a big stake in the outcome.

Already, Washington has urged Beijing to loosen controls on its currency. ‘The problems of over-spending and excessive bank lending are issues of special privileges, and there is the greater problem of income distribution with the peasants as the neglected segment.’

During his recent visit to Beijing, U.S. Treasury Undersecretary John Taylor pressed China to adopt a "more flexible exchange rate,” arguing that it would "allow for smooth adjustments and prevent the kinds of 'hard landings' or 'boom-bust' cycles that...are so costly to any country.”

There is a pending move in the U.S. Senate to hold a hearing on China's exchange rate unless China acts "in 60 to 90 days.”

The United States incurred its biggest trade deficit with China last year, to the tune of $124 billion.

Some U.S. manufacturing and labor groups argue that the trade and job losses are due to the cheap Chinese currency that may well be undervalued by as much as 40 percent. ...Link

And a related story: India and China
Yet, another related link: BonoboLand

Tuesday, May 18, 2004

China And The US: The Great Unravelling Begins?

Well, here's another update on the highly possible pending global crisis. Some say Auerback is a little too bearish, but I have been following him for some time now, and he seems fair enough minded to me. I believe the times warrent the likes of Marshall, Roach and Xie. Even though the world is slowly advancing, she marches ever closer to the precipice of a great cliff. My bets are 2005, as are many - then watch out. Let's see how right I turn out to be.

The Great Unravelling Begins?
Marshall Auerback

...Today, by pursuing a more unilateralist foreign policy, the United States will have to absorb all of the costs without help from traditional allies. Its actions over the past 10 years (even before the Iraq war) have almost seemed calculated to lose the country as many friends as possible. The real risk is that the US now runs the risk of third world style debt trap dynamics on its own.

It is worthwhile pondering the risks facing the US economy today by re-examining the emerging markets’ crisis of 1997/98, whose parallel with today’s American economy grows more strikingly ominous. After 1995 the rise of the U.S. dollar and the depreciation of the Japanese yen and the Chinese Yuan led to a loss of export competitiveness in Asian economies whose currencies were effectively pegged to the U.S. dollar. The capital inflows exacerbated the real appreciation of the Asian currencies. The appreciation raised input prices relative to output prices, squeezing profits and hurting export growth. The Japanese recession reduced export profits. As a consequence of these external “shocks,” Thailand and Malaysia developed large and out-of-character current account deficits.

As manufacturing came under pressure, more and more investment went into the property market and the stock market. In Thailand, Malaysia, and Indonesia, asset bubbles began to blow out and the fringe of bad industrial investments also expanded. The rising inflow of foreign capital—mainly bank loans and portfolio capital rather than foreign direct investment—went disproportionately into unproductive activities with a high component of speculation. The continued fast growth rates (that supported the perception of an unchanging “miracle” in Southeast Asia) concealed a rise in the ratio of “bubble” to “real” growth, much as we see in the US today.

Right up to the eve of July 1997 the continued fast growth of the “miracle” economies of East Asia looked to be one of the certainties of our age. None of the four main crisis-afflicted countries (South Korea, Thailand, Malaysia, Indonesia) had had a year of significantly less than 5 percent real gdp growth for over a decade by 1996—Korea not since 1980, Thailand not since 1972. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Some estimates suggest that around 50 million of the combined over 300 million people of Indonesia, Korea, and Thailand fell below the nationally defined poverty line between mid-1997 and mid-1998. Many millions more who were confident of middle-class status felt robbed of lifetime savings and security. Public expenditures of all kinds were cut, creating “social deficits” that matched the economic and financial ones. Nature was pillaged as people fell back on forests, land, and sea to survive. Indonesia’s real gdp shrank 17 percent in the first three quarters of 1998, Thailand’s 11 percent, Malaysia’s 9 percent, and Korea’s between 7 and 8 percent. It took nearly two years to reach the bottom.

The miracles led to the biggest financial bailouts in history. The imf mounted refinancing to the tune of US$110 billion, almost three times Mexico’s US$40 billion package of 1994–95 (the biggest in the imf’s history to that date). Yet the investor pullout continued through 1997 and 1998, the panic feeding upon itself. The fact that the collapse continued in the face of the largest bailouts in history suggests that something was awry with the imf’s bailout strategy, a matter of concern to countries elsewhere that might find themselves needing imf emergency funding in future.

The contractionary wave hit many other middle-income and low-income countries beyond Asia, particularly through falls in the price and quantity of commodity exports like grains, cocoa, tea, minerals, and oil. Russia’s renewed financial crisis and default in August 1998 triggered more contractionary shockwaves. Even countries that had diligently followed free market policy prescriptions (such as Mexico) were hurt as investors sold domestic currency for U.S. dollars in fear that any “emerging market” could be the next Russia or Indonesia. Brazil and some other Latin American countries in 1998 came perilously close to repeating the East Asian disaster.

This is what potentially lies in store for the US in 2004/2005. Obviously, Mr Greenspan will do all in his power to prevent this eventuality, but against a backdrop of Chinese tightening, a Korean central bank which is now exhorting its citizens to pay down debt and save more (despite a 20% national savings rate), and a natural tendency of East Asian toward continued neo-mercantilism (understandably brought about as a consequence of the events of 1997/98), the range of options available to the Fed are miniscule.

And protectionism is not much of a solution either, given that this would further highlight America’s limited range of policy options available. When foreign investors see a nation resorting to protectionism, they often interpret this as a sign of weakness, and accordingly seek out higher risk premiums, which the US can ill afford at this juncture. Protectionism also means in effect “biting the hand that feeds the US economy”, because to the extent that protectionism succeeds in reducing the imbalances in US trade, also reduces the increase in dollar savings held in the hands of foreigners. Assuming no change in their portfolio preferences away from US assets (a not entirely realistic assumption, as there may well be some form of retaliation which reduces the proclivity to hold dollars), there is in fact less foreign savings available then for them to disperse additional external financing requirements at the margin.

The greater the debt, the more deflation-prone the economy. A further complicating variable in the case of America is when too much of this debt is held by foreigners, many of whom are not well pre-disposed to the US today. That enhances the risk of capital flight, higher interest rates – in effect, reinforcing the deflationary vulnerabilities at the core of the US problem. Capital flight becomes an even bigger problem if there is nothing in the way of an external growth offset, which is clearly a problem in the event that China begins to slow dramatically, given the latter’s important secondary role as global locomotive. The great unraveling might therefore be rapidly coming upon us. ...Link

Sunday, May 16, 2004

Keynes' Bancor +

Ah... Here's a few other economists thinking seriously about the international financial architecture. They not only have adopted Keynes' Bancor scheme, but also give a brief history of why it is necessary. I couldn't agree more. Too bad some other heavyweight economists, like Roach and Xie, wouldn't go public with their endorsement of the Keynes and Davidson plans, to solve our massive global imbalances, they both keep writing about. We need many economists jumping on this band wagon if we are to have any luck in salvaging what's left of poor ol' capitalism.

We are at the point we are because too many economists of the classical school have believed far too long in false equilibrium and speculation models of currencies and markets, that clearly do not work - though they stubbornly hang on. We need base our thinking on new real equilibrium models based on balanced ppp's, as best can be figured. Then maybe we can advance.

I am not advocating a pegged system. In the past, the only pegging I advocated was for the rest of the world to peg the yuan higher if the Chinese wouldn't act themselves, since it is drastically too low, and hurting everyone - including themselves. As to the system, I advocate a truly balanced floating system, but one that is balanced by law and central bankers figuring the proper ppp's to make their proper buy and sell orders, as market makers, to maintain a true ppp equilibrium, and thus avoid the drastic dis-equilibriums and imbalances of the present system, caused by the liquidity preferences of speculators, and traders' hoarding and dumping of inventories - leads and lags.

Financial Globalization and Regulation
by Philip Arestis, The Levy Economics Institute of Bard College, and Santonu Basu, London South Bank University

...We maintain that credible and transparent regulation, to support and manage a genuinely international single currency is paramount. Under current international institutional arrangements, the International Monetary Fund (IMF) can easily undertake this function. This could be implemented with very little cost, in terms of finance, non-human and human resources. A revamped IMF can manage such operation in order to prevent major financial crises through credible intervention, and help country lending and borrowing in a transparent way. It should not be compelled to lend by powerful members or by borrowers who threaten to default, a most prevalent experience currently. This could easily be achieved by establishing a truly independent IMF. Indeed, such regulation may embrace those aspects suggested by Keynes (1980) in his International Clearing Bank (ICB) proposals for the post
second World War II international financial order.

The main relevant elements of the ICB may be summarized: the establishment of a truly international central bank with the power to issue a single international currency, the Bancor in Keynes’s (op. cit., p. 72) terminology. The Bancor should be “fixed (but not
unalterable) in terms of gold and accepted as the equivalent of gold ….. for the purposes of settling international balances” (Keynes, op. cit., p. 72). The ICB should also be empowered to intervene in capital and financial markets to provide sufficient liquidity for the needs of international trade. National central banks would keep accounts with the ICB, so that normal banking “account clearing” can take place. The idea and the principles of the ICB are really very simple and are based on generalizing “the essential principle of banking, as it is exhibited within any closed system. This principle is the necessary equality of credits and debits, of assets and liabilities” (Keynes, op. cit., p. 72). Under these arrangements, the ICB “can with safety make what advances it wishes to any of its members with the assurance that the proceeds can only be transferred to the bank account of another member. Its problem is solely to see to it that its members behave themselves and that the advances made to each of them are prudent and advisable from the point of view of the Union as a whole” (Keynes, op. cit.,
pp. 72-73).

A revamped IMF, along the lines of the Keynes’ ICB would issue an International Clearing Unit (ICU) to serve as a medium of exchange and reserve asset. The ICB would issue ICUs in return for gold, dollar and other reserves of member central banks. ICUs should only be held by central banks, and in more general terms the ICB would operate as an institution which periodically would settle outstanding balances between central banks. The ICA would, therefore, be a “double-entry book-keeping clearing institution, providing overdraft facilities so that unused credit balances could be mobilized efficiently and effectively. It should be committed, along with member central banks, to guaranteeing one-way convertibility from ICU deposits to domestic money. ...Link

Friday, May 14, 2004

The Real Oil Problem

Newest BonoboLand Post - The Long Process of Salvaging Capitalism

Edward, we must take the other side of the argument into perspective also as posted by Marcelo. MIT economist M.A.Adelman has recently published in the current issue of Regulation just the opposite of Erdman's views. Now, which of these two views is correct, I have been unable to determine. There are hundreds of professional views on each side of this important issue. Whether it be Paul Krugman, or futures markets, etc., all these can be false signals of the psychology of the marketplace. I just don't know a way of determining the true answer, until the price goes through the roof. Any comment Chris?


M. A. Adelman is professor of economics emeritus at the Massachusetts Institute of Technology. He is the author of several books, including The Economics of Petroleum Supply: Selected Papers 1962–1993 (Cambridge, Mass.: MIT Press, 1993) and The Genie Out of the Bottle: World Oil Since 1970 (Cambridge, Mass.: MIT Press, 1995). More recently, he published “World Oil Production and Prices 1947-2000” in the Quarterly Review of Economics and Finance (Vol. 42).

Oil is not the first fossil fuel that conventional wisdom has identified as nearing exhaustion. Even before 1800, the worry
in Europe was that coal — the supposed foundation of their greatness — would run out. European production actually did
peak in 1913, and is nearly negligible today. Is that the result of exhaustion? Hardly — there are billions of tons in the
ground in Europe. But it would cost too much for the Europeans to dig it out. At a price that would cover cost, there is
no demand. Hence, the billions of tons of European coal are worthless and untouched. The amount of a mineral that is in
the ground has no meaning apart from its cost of extraction and the demand for it.

In 1875, John Strong Newberry, the chief geologist of the state of Ohio, predicted that the supply of oil would soon run out. The alarm has been sounded repeatedly in the many decades since. In 1973, State Department analyst James Akins, then the chief U.S. policymaker on oil, published “The Oil Crisis: This time the wolf is here,” in which he called for more domestic production and for improved relations with oil-producing nations in the Middle East. In 1979, President Jimmy Carter, echoing a CIA assessment, said that oil wells “were drying up all over the world.” Just last year, the New York Times reported that “oil reserves are expected to dwindle in the decades ahead,” while the International Energy Agency fore-according to “conventional wisdom,” humanity’s need for oil cannot be met and a gap will soon emerge between demand and supply. That gap will broaden as the economies of Europe, Japan, and several emerging nations grow and increase their energy needs. The United States is at the mercy of Middle Eastern exporters who can use the “oil weapon” to cripple the U.S. economy. Unless we increase domestic oil production radically or cut consumption, or nations like Russia quickly exploit recently discovered oil fields, the United States will find itself in an oil crisis.

But conventional wisdom “knows” many things that are not true. There is not, and never has been, an oil crisis or gap. Oil
reserves are not dwindling. The Middle East does not have and has never had any “oil weapon.” How fast Russian oil output
grows is of minor but real interest. How much goes to the United States or Europe or Japan — or anywhere else, for that matter
— is of no interest because it has no effect on prices we pay nor on the security of supply. ...Link
And continue following the argument: BonoboLand

Thursday, May 13, 2004

Hubbert's Peak Goes Global

"I can't say that I agree with this article, but Paul Erdman is a respectable economist - a bit bearish though. I believe Chris may be interested enough for a few comments, so I am posting. With China adding considerably to global oil demand, and certain royal families in Arabia switching contracts from U.S. interests to Russia, and China's new pipeline to Russia, it bears noting. China's new appetite for oil is most evident in her choice of vehicles. The SUV has become her newest craze of the new wealth generation. According to NOVA 25% of all new vehicles sold in China are SUV's. She seems to have developed America's appetite for extravagance. This adds to her massive industrial demand for oil and energy, thus adding considerable weight to the argument."

Why the coming oil crisis will last

Commentary: Why the coming oil crisis will be structural
By Paul Erdman

-- Before considering the effect of surging global demand for energy on the price of crude, I would like to discuss the potential structural change in the supply of oil.

In 1956, M. King Hubbert, an American geophysicist working at the Shell Oil research laboratory in Houston, came up with a startling prediction: Oil production in the United States would peak in the early 1970s, signaling the beginning of an irreversible decline in the domestic output of crude petroleum. This event would be merely the precursor of a peaking out of oil production on a global scale, signaling the onset of the end of the Age of Oil.

Almost every energy expert on earth rejected this thesis out of hand -- until the early 1970s when, indeed, exactly that happened. Output of crude oil in this country peaked in the year 1970, and it has been falling ever since.

This event has since become known in industry circles as "Hubbert's Peak." Despite its fundamental significance where the future of our oil-based economy was concerned, for decades it turned out to be a scientific thesis that remained generally unknown. For those who had heard of it, it was derided as just another of those crackpot "end of the world as we have come to know and love it" theories that are usually espoused by gold bugs or other doomsday prophets of the same ilk.

That has now changed. Its acceptance by the academic world is evidenced by the recent publication of two books dealing with this subject:
"Hubbert's Peak: The Impending World Oil Shortage" by Kenneth. S. Deffeyes, professor emeritus at Princeton University and a former colleague of Hubbert at Shell.

"Out of Gas: The End of Age of Oil" by David Goldstein, vice provost and professor of physics at the California Institute of Technology.

These scientists have applied the same methodology developed by Hubbert in his analysis of the outlook for American crude oil output to world oil production. They have come to the conclusion that global output of crude oil now also is on the verge of peaking out and that when this happens, contrary to all expectations, the amount of crude of oil flowing into the world market will most probably begin fall by somewhere between 5 and 10 percent annually.

This conclusion runs contrary to all previously held expectations, for two reasons:

1. It was assumed that rapid new discoveries of oil reserves would continue well into the 21st century, ensuring that the future supply of oil would continue to stay well ahead of demand, just as it had during the entire 20th century.

2. Aside from the impact of new discoveries, given the amount of crude petroleum known to have been in the ground when we first started to pump it -- roughly 2 trillion barrels -- were we to continue to pump oil and consume it at the rate we are doing now, we will not have pumped the last drop for at least another 40 years. And it is only at that point where the so-called supply crisis will occur.

Those who subscribe to Hubbert's theory tell us that both of these expectations are dead wrong:

1. As regards new discoveries, they point out that the last great oil field, the Ghawar field in Saudi Arabia with reserves of 87 billion barrels, was discovered 45 years ago. Since then geologists have scoured the earth searching for major new fields -- to no avail. The largest remaining unexplored area is the South China Sea, which is considered by geologists to be promising but not spectacular.

But as Goldstein points out: "Let us suppose for one euphoric moment that one more really big one is still out there to be discovered. Even if we were to stumble onto another 90-billion barrels field tomorrow (the equivalent of another Ghawar field) Hubbert's Peak would be delayed by a year or two, well within the uncertainty of the present estimates of when it will occur. It would hardly make any difference at all."

2. Regarding timing, the bell shape of the history of crude oil output dictates that the supply crisis will begin in earnest not when the last drop of oil has been pumped out of the ground sometime in the hazy future, but rather when we have used up half the oil that existed, not all of it. Once we have reached that halfway point, existing oil fields will start to become exhausted faster than the new oil fields can be tapped. The rate at which oil can be pumped out of the ground will then start to decline.

This, as Goldstein points out. is the essence of the bell-shaped curve hypothesis. There is a growing consensus that the crucial turning point in output will probably occur in the second half of this decade, in or around 2007.

The crucial remaining question is: how fast will the gap then grow between supply and demand? All other things being equal, the decline side of the curve will be a mirror image of the initial increase. But of course there will be mitigating factors, such as energy conservation measures or the development of substitutes to oil as a primary energy source, ranging from hydrogen to nuclear to solar.

But the odds seem overwhelming that none of this will happen in time to head off an energy crisis that will dwarf anything we have ever experienced.

Editor's note: The author of this series has equity positions in three major international oil companies: ChevronTexaco, ConocoPhillips, and ExxonMobil.

Economist and author Paul Erdman is a columnist. ...Link

Wednesday, May 12, 2004

Wild Card Impact On S.E.Asia Growth

After searching around the web for pertinent and balanced information about China's possible direction and impact on the global economy, I came across Daniel Lian's post at Morgan Stanley. The entire post has many tables and other useful information. Daniel extends Stephen Roach's "Wild Card" scenario by assessing the other S.E.Asian countries' possible growth potential, while factoring in a China soft or hard landing, oil and the Fed. I would further add the currency wild cards to the play, i.e., the dollar - euro - yen - yuan. I don't have much to add at this time. It looks like anyone's game, in any direction, at this point.

Daniel Lian

...Bottom Line: 2004 Realistic, Major Risks Lie in 2005
Risks to Southeast Asia growth have heightened as a result of a firm resolve by Chinese policy makers to engineer a slowdown, and the increased risk of a hard landing in 2005 given that, thus far in 2004, no slowdown appears evident. Most significantly, there appears to be a confluence of three wild cards: surging oil prices, the China slowdown, and the onset of a Fed tightening cycle.

Despite the global wild cards, our Southeast Asia economic forecast remains quite robust. Our 2004 and 2005 Southeast Asia growth forecast (Exhibit 10) has been largely based on our global, China, and Northeast Asia growth expectations. A probable upward revision in growth forecasts for China and Northeast Asia for 2004 should benefit global growth and in turn buoy Southeast Asia growth assuming other threats – energy, rate hikes, China hard landing, and “secondary” global demand weakening – are unlikely to exert a significant economic impact over the remainder of 2004.

The same cannot be said for our 2005 forecast. This is because the main China risk – the timing and mode of the slowdown – lies squarely in 2005, not 2004. The risk of a China hard landing in 2005 clearly is not fully factored in our 2005 Southeast Asia forecast. While our global forecast looks quite benign for 2005, it is largely due to our belief that global demand cannot be permanently salvaged by the Fed and global central banks’ easy liquidity stance. If the world does experience a full-fledged China hard landing in 2005, a full “blown-away” energy crisis, coupled with aggressive Fed tightening and “secondary” global demand weakening due to the triple wild cards, Southeast Asia growth could be under further threat next year.

Tuesday, May 11, 2004

Attacks From The Periphery

Marshall Auerback

A precise warning from a bear - is it plausible? I tend to think we are on very shaky ground.

...The great paradox is that equity investors need to be shaken up further in order to calm the bond markets and thereby reduce the threat of systemic stress. A few more days like yesterday and perceptions will grow that the declining “wealth effect” from a falling stock market will reduce the need to tighten precipitously. In fact, a further horrendous slide in the stock market might actually shift market sentiment back in the direction of ease, which would in turn resume the process of dollar decline and thereby afford Asian central banks the chance to offer a lending hand by placing a bid under the bond market in order to preclude a crash in the greenback. The Fed and their political masters are praying that the pressure for monetary restraint will fall away naturally, via more moderate business growth and inflation signals, and that will keep the bond market vigilantes passive.

Of course, if the bond market vigilantes continue to run rampant, this creates distinct potential for the nightmare scenario: bond yields keep spiking higher, as the Fed's credibility continues to decline amid robust economic activity reports and a widening gulf between the presumed neutral and actual Fed Fund rates. In turn, the higher yields ultimately crash the stock and commodity markets, and those developments let out a ton of steam from the bond pressure cooker. But by turning down equity values in a big way (20%? 25% 30? more?), the bond yield spike will also turn the big, slow ship of housing demand and prices downward for the first time, and that change will pick up momentum over time and will prove impossible for the authorities to arrest. If this doesn’t set the stage for a massive credit revulsion, it is hard to imagine what will. The credit bubble may burst at that stage and with it, the eruption of much more systemic risk, the barest outlines of which are seen from the periphery today.

BonoboLand - Three Quotes That Tell It All

BonoboLand - Three Quotes That Tell It All
By Edward Hugh

Stephen Roach is back on form. Yesterday's MS GEF post contains three quotes which just about sum everything up.

"I am still in the soft landing camp insofar as the trajectory of the China slowdown is concerned. However, I would be the first to concede that what is soft for China — something like a halving in industrial output growth over the next year — may not seem that way for the rest of the global economy or world financial markets."

Exactly. Then there is the oil price shock problem. I couldn't tell you where the price shock sets in, but Roach's guess seems as good as any that are on the table. And remember, any China slowdown may not be accompanied by a pro-rata reduction in oil consumption: so we may get the worst of both world's.

"In my view, however, the “true” shock probably comes with $50 oil. A sustained increase to that level for 3-6 months would represent in excess of a 70% surge above the post-2000 average — on a par with full-blown oil shocks of the is only guesswork at this point as to whether developments in the Middle East spiral out of control in a fashion that would push petroleum prices up to that ominous level."

Then there is the US deficit problem and the possibility of fiscal tightening accompanying interest rate tightening.

".........the impacts of the coming Fed tightening will coincide with a shift to fiscal restraint, as tax cuts hit their maximum; moreover, a monetary tightening will also exacerbate the downside of the home mortgage refinancing cycle — heretofore a powerful source of incremental growth in consumer purchasing power. As I see it, those developments, in conjunction with the negative impacts of higher oil prices, paint an increasingly worrisome picture for the US economy in 2005."

All in all a very hard call. Which makes you wonder why all those 'consensus analysts' seem so convinced.........

Monday, May 10, 2004

Global Wild Cards

Stephen Roach

...There can be no mistaking the powerful upturn in the global business cycle that began in mid-2003. The key question all along has been one of sustainability. In retrospect, the old policy multipliers worked after all — certainly better than I gave them credit for. But, then again, the Authorities injected a stimulus the likes of which of the modern-day world economy had never seen. Alas, now it’s payback time. For a still unbalanced global economy, that payback could be especially severe. Put oil, China, and the Fed into the equation — all deflationary forces — and the endgame starts to look downright treacherous. The rapidly escalating undercurrent of geopolitical angst only compounds the problem. All that leads me to conclude that this confluence of global wild cards could make the current rebound in the global economy one of the shortest on record.

And check this out - Edward Hugh

Saturday, May 08, 2004

BonoboLand - Does Deleveraging Equal Deflation?

BonoboLand - Does Deleveraging Equal Deflation?
Check out all the comments at BonoboLand above.

I don't mean to pour water on others' fires, but global shipping figures at GeoHive show China and S.E. Asia to be a much larger influence on global markets than many have thus far stated, including Andy Xie. As Stephen Roach stated global trade is now 25% of global GDP, and these figures clearly show China and S.E. Asia to be a very powerful player in the global trade marketplace, far beyond mere commodities, luxury goods, and such. I believe Marshall Auerback comes closer to nailing down the true global picture, although Xie's older post should be taken very seriously.

I'll post some of Marshall's article and urge reading the link to the entire post. I also urge reading Karol Gellert's article on Fisher's debt deflationary spiral, as she interpreted it for a college paper.

The “inflation/deflation” debate has been ongoing virtually since the start of the 21st century. Rising commodity prices, rapidly recovering economies (in both America and Asia, notably China) and the ongoing generation of one mini-bubble after another, particularly in the US, has until recently shifted the collective weight of investment opinion toward the great reflation trade. The basis of the Great Reflation Trade, as we have repeatedly identified, lies in an unqualified conviction the government can and will, "by any means necessary" to quote Governor Bernanke's seminal November 2002 speech, drive the economy, corporate profits, asset prices higher – all to ward off the prospect of a Japanese style deflation emerging on American shores.
As we all know, by the late 1980s Japan had an asset bubble. It was accompanied by a private debt bubble. By 1991 the asset bubble began to burst. But the outstanding debt, fixed in nominal Yen, did not go away. Even though the Bank of Japan took policy rates to zero and even though the fiscal balance went from a 3% of GDP surplus to a 10% of GDP deficit, the Japanese economy stagnated.

Stagnation in the Japanese economy has widely been attributed to the burden of private debt built up in the 1980’s. Faced with greatly reduced collateral, private firms and households reduced expenditures and sold assets to reduce their debt burden. This in turn reduced aggregate demand.

As the 1990’s progressed, matters got worse in Japan. Unemployment rose. Low inflation gave way to outright price deflation. The economy fell into two successive recessions with little recovery between them. Again the attempt by firms and households to reduce high debt is widely cited as the cause of the greater economic weakness of the 1997-2002 period.

During the latter part of the 1990s, firms did finally begin to significantly reduce their debt. This can be attributed to the emergence of a debt deflation dynamic that emerged at the time. Deflation raises the de facto real interest rate, even if policy rates are zero, and it raises the real debt burden. Private economic agents recognised this. They moved to reduce debt and their actions contributed to recession and more price deflation. Together high debt and price deflation threatened a debt deflation spiral. Asset prices, including equity prices, kept on falling in this environment, even though short tem interest rates were zero.

How close are we to this debt deflation dynamic in other parts of the world today? Certainly, events over the past week have engendered a rapid reversal in investor psychology away from inflation. Abrupt falls in base metals, commodity-based currencies (notably the Australian and Canadian dollars), gold and silver, have all contributed to a revival of fears which predominated during the 2000-2001 period, in which “deflation”, brought about by ongoing deleveraging pressures, was said to be the major underlying threat to the global economy.

It may seem hypocritical to decry the dangers of massive debt build-up, and then to warn when the process of paying down such debt appears to have commenced in earnest. As always, however, context is very important. The Japanese experience demonstrates that debt repayment against a backdrop of a huge financial bubble that has burst can be highly deflationary, especially if there is no offsetting monetary or fiscal stimulus. Of course, a crucial distinction has to be made between the experience of Japan, where the monetary authorities took firm steps to burst their asset bubble, in contrast to the Fed which, for all its talk about being “vigilant about inflationary pressures”, has done nothing but talk about electronic printing presses and helicopter money to lift asset prices and the inflation rate to avert debt deflation.

The dynamic between debt and price deflation was best analysed by Irving Fisher in the early 1930’s during the great depression. Fisher argued that the great depression was the result of two economic events – the emergence of high private debt in the 1920’s and the onset of significant price deflation in 1929. He referred to these as the debt disease and the dollar disease. Price deflation swells the real value of the dollar and thereby the real burden and cost of private debts. If private debt is low (no debt disease) price deflation is not disastrous. But if private debt is high, price deflation sets off a vicious downward economic spiral which Fisher called debt deflation. Because the onset of price deflation raises the real burden of debts, firms and households shed assets and reduce expenditures in order to pay down debt. But these acts of liquidation by all economic agents push prices yet lower, which in turn raise the real debt burden further. Fisher emphasised: the more economic agents individually try to repay their debts, owing to consequent price deflation, the more they owe.

The crowded nature of the Great Reflation Trade amongst the leveraged speculating community, and the subsequent process of exiting it against a backdrop of huge international debt build-up, manifests elements of this Fisherian dynamic. The massive declines seen in the precious metals, bond and forex markets over the past few weeks, show how fast and destabilising market conditions can be when all begin to rush for the exits simultaneously.

The “man in the theatre” said to have yelled “Fire” this time around is China. For months, Chinese authorities, led by Premier Wen, have been making increasingly hawkish comments to the effect that China was committed to using “effective and very forceful measures” to slow growth. This culminated with last week’s Bloomberg story reporting that Chinese banks have been asked to stop lending. The story cited a loan officer at the Pudong Development Bank (amongst others) as saying, “We have already been told to suspend all our loan business…It’s a decision from the very top.” ...Link

Thursday, May 06, 2004

The Coming Profit Shock - China

Asia Pacific: The Coming Profit Shock

Andy Xie (Hong Kong)
{Important related story}Does Deleveraging Equal Deflation? Auerback

China’s slowdown should have a greater impact on profits than on volumes. China’s investment surge has created temporary bottlenecks and inflated commodity prices. Also, the investment bubble supercharged China’s consumption, especially demand for luxury goods, artificially inflating profit margins for such products.

The unit import price for minerals/metals rose by 57% between 1Q02-1Q04, while the volumes rose by 81%. The price change was global and, hence, redistributed income from consumers, and downstream industries to upstream ones. In other words, it has acted as a global tax.

As China cools its investment bubble, most of the price gain in commodities would be reversed, removing the inflation tax and, hence, reversing the profit gains of the upstream industries that we have seen in the past two years.

The Commodity Linkage

China’s imports are one-third those of the US, but grew by more than that last year. About half of China’s imports are raw materials and equipment for capital formation. Another one-third are components for export processing. Thus, China’s slowdown should mainly affect these two sectors.

Because construction of infrastructure, property and factories dominates China’s investment, any investment boom would trigger massive increases in imports of minerals and metals. China accounts for roughly for 70% of the global incremental demand for hard commodities.

As China’s fixed investment accelerated from 13.1% in 2001 to 43% in 1Q04, the demand for such commodities skyrocketed. The greater impact, however, was felt in prices. China’s unit cost of imports for such commodities rose by 57% during 1Q02-1Q04. A similar increase also occurred in 1993.

The main reason for the rapid price rise is that China’s investment occurs whenever there is liquidity and is not sensitive to price, as local governments just want to see capital formation. Thus, a liquidity boom can push up commodity prices very rapidly. However, when the liquidity tide recedes, the process reverses, i.e., the investment doesn’t react to cheap commodities, and, therefore, the price correction undershoots.

There is an argument that the demand recovery in the US, Europe and Japan would offset China’s weakness. This argument does not work for two reasons, in my view. First, the interest rate-sensitive or commodity-intensive sectors (i.e., housing and autos) were never weak during the economic downturn, because the Fed cut interest rates more aggressively than in the past. Thus, the current economic upturn in these economies has not boosted commodity demand that much.

Second, the incremental demand for most commodities has come from China. This is why commodity prices correlate closely with China’s investment cycles. It would be surprising if this linkage didn’t work this time. Further, China’s current investment bubble this is much bigger than the one 10 years ago in absolute volume. Thus, the reversal for commodity prices should only be more dramatic.

The Consumer Linkage

The investment bubble has exaggerated China’s income growth. As income growth in bubbles tends to be concentrated among a few people in the center of the bubble, China’s demand for luxury goods has been rising rapidly over the past two years. While the secular trend is positive, China’s demand for such goods would likely stagnate or even decline in the coming quarters.

Luxury automobiles, for example, have seen very rapid sales growth. While there is a secular growth trend in the size of China’s wealthy class, the bubble has exaggerated its ranks and purchasing power. Hence, auto demand has grown rapidly while prices have been high. As China’s bubble deflates, this industry has to sell to less wealthy people, but with much more capacity. A major price war is looming, in my view.

Another example is the consumption of Chinese tourists in Hong Kong. Shanghai and Beijing account for most of the big Chinese spenders in Hong Kong. But their purchasing power has been exaggerated by the property boom in their cities, partly funded by Hong Kong and Taiwan investors purchasing properties there. Thus, Hong Kong’s retail sales to Chinese tourists partly reflect Hong Kong investors buying Shanghai and Beijing properties. In other words, it is Hong Kong money coming back. When the property bubble deflates, this flow will also diminish.

The Regional Linkage

Asian trade has been reorganized in the past five years with China replacing others in the OECD consumer market, and other Asian economies supplying equipment and consumer goods to China. China/Hong Kong accounted for half of the export increase of other East Asian economies in 2001-03. What it means is that East Asia can only grow when China grows. This change is inevitable as it reflects the relative competitive advantages of the economies. However, it also means that East Asia’s business cycle correlates with China’s and with the US’s only indirectly through China.

Equipment demand is the most obvious linkage. China’s equipment imports, especially from Japan, grew by over 40% in value last year. The growth will likely be in single digits or worse in the coming six quarters.

The most important linkage may be profits from selling goods and services inside China. Korean, Taiwanese and Japanese companies have done an outstanding job of turning China into a market as important as their home markets. In the long term, this strategy could work well. However, their profits in China have been exaggerated by the bubble.

China’s credit surge has been the most important source of profit growth for Asian companies in the past two years, either through higher commodity prices or stronger Chinese consumption. The reversal would come as a negative profit shock. The market still underestimates this effect, in my view. ...Link

Sunday, May 02, 2004

The Failure of Monetary Control

This article by D'Arista bears understanding as a policy prescriptive for a stop-gap emergency serious financial soloution. It is by no means a final structural solution, but could suffice as a band-aid to hold capitalism's hand until real international financial architecture reform may be considered. Jane has also offered real architecture proposals in the past, but Paul Davidson still offers the wisest course of real structural reform, yet this proposal also warrants our near term attention.

Jane D'Arista

...Rebuilding effective monetary transmission mechanisms

While the once-powerful effects of reserve requirements have atrophied, they remain a promising tool for reviving effective monetary control. But a reserve management system that could be readily adapted to recent and future institutional changes requires
three key operational features: it must extend monetary control to the entire financial sector; apply reserve requirements to financial firms’ assets; and expand the central bank’s eligible holdings by using repurchase agreements as the primary tool of open market operations.

Reserve requirements can and have been applied to all financial firms in asset-based systems and narrow versions of such systems have been employed successfully to influence the allocation of credit in several advanced economies (U.S. House of Representatives, 1972). If used as a broader tool of monetary control, asset-based reserve requirements would enhance stability by tightening the linkage between the central bank and all lenders, investors and borrowers in their national markets.

Under an asset-based reserve system, the central bank would be authorized to engage in repurchase agreements to buy or sell any asset held by financial institutions - bank loans, mortgages, bonds, stocks, foreign deposits, etc. - when there is a change in overall credit or in holdings of one or more of these assets relative to target growth rates. The central bank’s repurchase agreement would be held on the liability side of its balance sheet and would be matched on its asset side by the reserves it creates for financial institutions. The balance sheets of financial institutions would show a reverse placement: they would hold non-interest-bearing reserves on the liability side of their balance sheets and noninterest- bearing repurchase agreements with the central bank as assets.

By creating liabilities for financial institutions, asset-based reserves would remedy a fundamental flaw in the existing model that can slow or even halt recovery in a recession. Under the current system, the amount of reserves held by banks as assets governs the
amount of deposits they can create by lending. When borrowers spend loans extended by banks, they redistribute the deposits created by those loans throughout the financial system. But if banks are too risk averse to lend, the central bank ends up pushing on a string as it creates “excess” reserves for deposits that never materialize – a condition that intensifies deflationary pressures.

Under the proposed asset-based reserve system, the central bank would distribute reserves in the form of non-interest-bearing liabilities that will spur the financial sector to acquire earning assets even in a downturn. Additions of these cost-free liabilities might
also encourage cancellations of non-performing loans and debt securities by providing incentives for the financial sector to replace them with earning assets. This would channel liquidity directly to households and businesses, helping avoid the stagnation that
develops when financial institutions are unwilling to make new loans and investments and cannot cancel debts for troubled borrowers without jeopardizing their own survival. ...Link