This post draws significantly on M. Pettis.
The argument: If China's consumption (as a % of GDP) rises faster than investment declines, this will reduce China's current account surplus (decline in savings); and thus a reduction in the capital it exports. This means China recycles less of the worlds (and history's) largest surplus, it purchases less US treasuries which causes U.S. interest rates to rise.
Martin Feldstein wrote: "...change driven by Chinese domestic considerations, it could have significant impact on capital flows and interest rates."
As China re-balances, the savings rates will contract as a % of GDP. This will shrink the current account unless investment grows more slowly than savings, which is unlikely because a sharp reduction in investment would force a collapse in top line GDP. (Note - this means China will keep investment high to reduce impact of a slowdown AND will extend the period of slowdown in China once it happens).
The point that is wrong here is that a contracting surplus and less capital exports means higher interest rates. Conversely an expanding surplus and higher capital exports don't mean lower U.S. interest rates, though this did happen from 2004-2008. Rather, its the way in which the surplus expands or declines that will have a high affect on U.S. interest rates.
If the U.S. current account deficit rises due to surge in U.S. investment, than higher capital imports will not affect interest rates, because the supply of savings will be met by demand of savings. In fact, if the investment brings jobs, the increase income would lead to consumption and interest rates could rise.
If the current account deficit rises because of a reduction in net foreign consumption, then the drop in global demand for labor will create unemployment, growth drops, and either the government increases deficits to offset the decline or the fed encourages a surge in consumer financing - either way debt levels surge. Depending on the size of deficit or consumer financing, rates could do anything. More likely, they fall because of the weak growth and unemployment
In other words, interest rates don't fall because the U.S. is lucky enough to have foreigners lending them money.
Conversely - if China's current account deficit declines by recycling the surplus onto another country - Brazil for example - by stockpiling commodities, then the US current account is unchanged and the capital is imported from Brazil.
Lastly, if China's current account surplus is collapsed by a surge in Chinese consumption, then the U.S. deficit will decline. In that case, China would export less capital as Martin Feldstein explained. But a decline in the U.S. deficit would be expansionary, so less government bonds (or private borrowing) would be issued. In this instance, its not obvious that rates would rise or fall, though they would be responding to higher and the fiscal and monetary responses to growth.
Warnings about what happens if China stops buying government bonds are no different than warnings about what might happen when the U.S. closes its trade deficit. It all depends - if the deficit contracts because investment drops faster than savings that will be bad, and if Chinese consumers import more goods from the U.S. that will be good, regardless of the interest rates.
Thursday, April 14, 2011
On Containing Inflation
This post draws significantly from M. Pettis.
"Raising interest rates should encourage depositors to hold more money in their savings accounts." This is a very U.S. centric view of how financial systems translate changes in interest rates into changes in savings rates, via changes in household wealth.
It is hard to understand why China has such a high savings rate with such low real deposit rates. Negative real interest rates actually reduce household wealth by reducing the value of savings. Few households in China borrow and few households hold assets whose value benefits from declining interest rates (which is the opposite of the US).
So raising real interest rates (NOT NOMINAL) would in fact be inflationary by increasing household wealth, and thus reducing their incentive to save money.
Inflation reduces the value of household savings and reduces consumption, which is a self correcting measure for inflation.
The bad news is China's (Asian) financial system doesn't just counter act CPI inflation, it converts it into asset price inflation. This is a real concern in an economy that is likely misallocating capital. China's economy is dependent on expanding credit to fund investment. Raising interest rates by 25 (or 100bps since Nov?) are far too low to have a meaningful impact on credit supply. Reducing the flow of credit through PBoC sterilization, the flow of government deposits, Required Reserve Ratios, and reduced shadow banking credit, quickly translates into economic pain.
"Raising interest rates should encourage depositors to hold more money in their savings accounts." This is a very U.S. centric view of how financial systems translate changes in interest rates into changes in savings rates, via changes in household wealth.
It is hard to understand why China has such a high savings rate with such low real deposit rates. Negative real interest rates actually reduce household wealth by reducing the value of savings. Few households in China borrow and few households hold assets whose value benefits from declining interest rates (which is the opposite of the US).
So raising real interest rates (NOT NOMINAL) would in fact be inflationary by increasing household wealth, and thus reducing their incentive to save money.
Inflation reduces the value of household savings and reduces consumption, which is a self correcting measure for inflation.
The bad news is China's (Asian) financial system doesn't just counter act CPI inflation, it converts it into asset price inflation. This is a real concern in an economy that is likely misallocating capital. China's economy is dependent on expanding credit to fund investment. Raising interest rates by 25 (or 100bps since Nov?) are far too low to have a meaningful impact on credit supply. Reducing the flow of credit through PBoC sterilization, the flow of government deposits, Required Reserve Ratios, and reduced shadow banking credit, quickly translates into economic pain.
Monday, April 11, 2011
The China Dream
This post draws significantly on Edward Chancellor's white paper "China's Red Flags"
Past manias and financial crises have shared many characteristics. Below is a list of "leading indicators" of financial distress.
1. Compelling Growth Story - usually associated with some new technology or exciting prospects for a particular economy.
2. Faith in the competence of authorities -examples include the Fed in 1920s and the "Greenspan put".
3. A general increase in investment - capital is mis-pent during periods of euphoria. J.S. Mills said "panics do not destroy capital, the merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works."
4. Surge in corrpution
5. Easy Money - Low rates lead investors to chase higher yields and riskier assets. Bagehot said "John Bull can stand many things, but he cannot stand two percent"
6. Fixed currency regimes - which generally lead to too low rates and large capital inflows. The EMU lead to property and consumption booms. Asian crisis of 1997 is similar.
7. Rampant Credit Growth - liabilities are contracted that cannot be repaid (NPV of a project cash flows is less than the stock of debt). Sharp deviations of credit growth from past trends and lagging credit growth tends to be a leading indicator of financial distress.
8. Moral hazard - the belief that authorities won't let bad things happen. Irresponsibility is not punished.
9. Financial Structures Become Precarious - Investments do not generate enough income to finance the loans (Ponzi Scheme). As a result, the market becomes vulnerable to what otherwise might be considered insignificant events.
10. Dodgy loans are securitized by collateral. Real Estate busts are generally worse because they are associated with real economic activity (construction).
Past manias and financial crises have shared many characteristics. Below is a list of "leading indicators" of financial distress.
1. Compelling Growth Story - usually associated with some new technology or exciting prospects for a particular economy.
2. Faith in the competence of authorities -examples include the Fed in 1920s and the "Greenspan put".
3. A general increase in investment - capital is mis-pent during periods of euphoria. J.S. Mills said "panics do not destroy capital, the merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works."
4. Surge in corrpution
5. Easy Money - Low rates lead investors to chase higher yields and riskier assets. Bagehot said "John Bull can stand many things, but he cannot stand two percent"
6. Fixed currency regimes - which generally lead to too low rates and large capital inflows. The EMU lead to property and consumption booms. Asian crisis of 1997 is similar.
7. Rampant Credit Growth - liabilities are contracted that cannot be repaid (NPV of a project cash flows is less than the stock of debt). Sharp deviations of credit growth from past trends and lagging credit growth tends to be a leading indicator of financial distress.
8. Moral hazard - the belief that authorities won't let bad things happen. Irresponsibility is not punished.
9. Financial Structures Become Precarious - Investments do not generate enough income to finance the loans (Ponzi Scheme). As a result, the market becomes vulnerable to what otherwise might be considered insignificant events.
10. Dodgy loans are securitized by collateral. Real Estate busts are generally worse because they are associated with real economic activity (construction).
Saturday, April 9, 2011
Earnings Forecasts Versus Cyclically Adjusted Earnings
12 month S&P 500 earnings peaked in the third quarter of 2007 at $90 per share. So, from the third quarter of 2006 to third quarter of 2007, 12 month earnings peaked, and began to subsequently decline. During the first quarter of 2009, the 12 month earnings bottomed at a staggering $7 per share. Based on forward estimates, 12 month earnings are supposed to surpass the 2007 peak in the third quarter of 2011. This is the fastest recovery according to Robert Schiller and S&P.
The gap between projected 12 month profits and the 10 year average annual earnings is set to widen to the most since 1951.
Following the credit crisis, profits tumbled 92%, but will have recouped their peak in 50 months. That compares to 52 months following the dot.com bubble when earnings dropped by 52%. Following the great depression, profits did not recoup their 67% losses for 19 years.
The S&P500 has traded at an average of 15.7x reported annual profits since 1900, according to Robert Schiller (show this with data). Estimated earnings for 2011 are $95.21. $95.21 x 15.7 values the SP500 at $1,491.
The 10 year inflation adjusted average earnings is for the SP500 is $60 (research this). If earnings are $95.21 in 2011, they will be 59% higher than the inflation adjusted average earnings over the past ten years. The only other times since 1951 where forward earnings have approached that level was in December 2006 and August 2000, at the peaks of profit and economic expansion (research this).
The SP500 cyclically adjusted PE is currently 22 (or 24 times; research this?). The historical average for the cyclically adjusted PE is roughly 15.5 times , which is in right on top of the average PE versus annual reported earnings (nick - research this).
The gap between projected 12 month profits and the 10 year average annual earnings is set to widen to the most since 1951.
Following the credit crisis, profits tumbled 92%, but will have recouped their peak in 50 months. That compares to 52 months following the dot.com bubble when earnings dropped by 52%. Following the great depression, profits did not recoup their 67% losses for 19 years.
The S&P500 has traded at an average of 15.7x reported annual profits since 1900, according to Robert Schiller (show this with data). Estimated earnings for 2011 are $95.21. $95.21 x 15.7 values the SP500 at $1,491.
The 10 year inflation adjusted average earnings is for the SP500 is $60 (research this). If earnings are $95.21 in 2011, they will be 59% higher than the inflation adjusted average earnings over the past ten years. The only other times since 1951 where forward earnings have approached that level was in December 2006 and August 2000, at the peaks of profit and economic expansion (research this).
The SP500 cyclically adjusted PE is currently 22 (or 24 times; research this?). The historical average for the cyclically adjusted PE is roughly 15.5 times , which is in right on top of the average PE versus annual reported earnings (nick - research this).
Wednesday, April 6, 2011
The Cost of Low Interest Rates
This post draws heavily on M. Pettis.
What is the cost of the transfer of wealth from households and savers to banks?
Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. (Appendix 1 - the case for and against nominal interest rates equal to nominal GDP).
Assuming IR are 75% of nominal GDP, then China's 14% average growth rate means nominal IR should be 10.5%, versus the actual 6% lending rate. This means interest rates are at between 350 and 800 basis points too low. If we add the excess bank spread (estimated at between 150 and 250 bps) we can say that at the very low end, nominal IR are 500 basis points too low.
That means that 5% of GDP is transferred from Households to Businesses every year. Lets show some numbers for context.
In 2009, total bank deposits in China were RMB64 tr; 60% of those deposits belong to households (rough guesstimate); RMB64 tr * 60% * 5% = RMB 1.9 tr. That represents 5% of GDP.
Of course, households are not only paying to subsidize banks, they pay to subsidize manufacturing investments, real estate investments, infrastructure investment, sterilization bills, PBOC borrowing - investments that have negative NPVs without the subsidy. (Capital misallocation).
Even if banks are insolvent, China can protect itself from illiquidity because the government controls funding and interest rates. In the past, China could grow its way out, despite declining relative consumption (and a rising savings rate and rising trade balance), because of the growing world economy. As long as debt levels in deficit countries could rise to counteract adverse unemployment effects the world (US) has no problem absorbing the trade surpluses.
Things are different now
Unemployment is high in deficit countries. Debt levels are being forced down. China must reduce its dependence on trade and investment by increasing the share of household consumption. Household consumption is dependent on household income, so as/if household income is taxed away by banking costs - it will be impossible for household consumption to surge.
The result is for total GDP to drop sufficiently where household consumption takes on a larger share. Japan is the example of this, where consumption growth declined to 1-2% annually as households were forced to subsidize insolvent institutions through repressed interest rates and undervalued currency. In Japan's case, total economic growth has been less than consumption growth as China rebalances its economy.
Appendix 1
Against - historically, developing countries have not had nominal interest rates equal to nominal GDP. When IR < Nominal GDP, then providers capital get less than their share of growth. In China, households are providers of capital, businesses & govenment are users of capital (they use it for FGF) = transfer of wealth. (Note, is the savings rate an independent variable that forces down interest rates; or is the savings rate a consequence of low interest rates and other policies that "tax" households and "subsidize" production - Think of it this way - policies that tax households and subsidize production forces more production than consumption, which forces up the savings rate).
For - the "sample" of developing countries have closed or sticky capital accounts - which are used to repress currency value to protect trade; these countries also systematically repress interest rates.
On average, nominal IR are 75% of nominal GDP with wide dispersion around the mean.
What is the cost of the transfer of wealth from households and savers to banks?
Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. (Appendix 1 - the case for and against nominal interest rates equal to nominal GDP).
Assuming IR are 75% of nominal GDP, then China's 14% average growth rate means nominal IR should be 10.5%, versus the actual 6% lending rate. This means interest rates are at between 350 and 800 basis points too low. If we add the excess bank spread (estimated at between 150 and 250 bps) we can say that at the very low end, nominal IR are 500 basis points too low.
That means that 5% of GDP is transferred from Households to Businesses every year. Lets show some numbers for context.
In 2009, total bank deposits in China were RMB64 tr; 60% of those deposits belong to households (rough guesstimate); RMB64 tr * 60% * 5% = RMB 1.9 tr. That represents 5% of GDP.
Of course, households are not only paying to subsidize banks, they pay to subsidize manufacturing investments, real estate investments, infrastructure investment, sterilization bills, PBOC borrowing - investments that have negative NPVs without the subsidy. (Capital misallocation).
Even if banks are insolvent, China can protect itself from illiquidity because the government controls funding and interest rates. In the past, China could grow its way out, despite declining relative consumption (and a rising savings rate and rising trade balance), because of the growing world economy. As long as debt levels in deficit countries could rise to counteract adverse unemployment effects the world (US) has no problem absorbing the trade surpluses.
Things are different now
Unemployment is high in deficit countries. Debt levels are being forced down. China must reduce its dependence on trade and investment by increasing the share of household consumption. Household consumption is dependent on household income, so as/if household income is taxed away by banking costs - it will be impossible for household consumption to surge.
The result is for total GDP to drop sufficiently where household consumption takes on a larger share. Japan is the example of this, where consumption growth declined to 1-2% annually as households were forced to subsidize insolvent institutions through repressed interest rates and undervalued currency. In Japan's case, total economic growth has been less than consumption growth as China rebalances its economy.
Appendix 1
Against - historically, developing countries have not had nominal interest rates equal to nominal GDP. When IR < Nominal GDP, then providers capital get less than their share of growth. In China, households are providers of capital, businesses & govenment are users of capital (they use it for FGF) = transfer of wealth. (Note, is the savings rate an independent variable that forces down interest rates; or is the savings rate a consequence of low interest rates and other policies that "tax" households and "subsidize" production - Think of it this way - policies that tax households and subsidize production forces more production than consumption, which forces up the savings rate).
For - the "sample" of developing countries have closed or sticky capital accounts - which are used to repress currency value to protect trade; these countries also systematically repress interest rates.
On average, nominal IR are 75% of nominal GDP with wide dispersion around the mean.
How to Clean Up a Bank
This post draws heavily on MPettis:
How to Clean Up a Banking Crisis
Reduce accumulation of NPLs by keeping borrowing rates low. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount. By lowering rates, central banks able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did by repressing deposit rates. Households pay for this in the form of low returns on their savings. (appendix 1 - alternative investment opportunities are also affected when savings rates are held too low).
Direct equity injection, when financed by government borrowing at low (suppressed) interest rates is also passing the cost to savers. If other banks provide the financing, then suppressed lending and suppressed deposit rates have the same effect as above.
Lending Spread - provide the banks a wide spread between lending and deposit rates that allows them to rebuild their capital through profitability. This is a second "tax" on households
(the first is through deposit rates) that subsidizes profitability of the banks.
These three mechanisms are how households and other savers clean up banking problems. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.
How much does it cost?
How to Clean Up a Banking Crisis
Reduce accumulation of NPLs by keeping borrowing rates low. Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments. Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount. By lowering rates, central banks able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers. But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did by repressing deposit rates. Households pay for this in the form of low returns on their savings. (appendix 1 - alternative investment opportunities are also affected when savings rates are held too low).
Direct equity injection, when financed by government borrowing at low (suppressed) interest rates is also passing the cost to savers. If other banks provide the financing, then suppressed lending and suppressed deposit rates have the same effect as above.
Lending Spread - provide the banks a wide spread between lending and deposit rates that allows them to rebuild their capital through profitability. This is a second "tax" on households
(the first is through deposit rates) that subsidizes profitability of the banks.
These three mechanisms are how households and other savers clean up banking problems. The bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry. This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.
How much does it cost?
Tuesday, April 5, 2011
The Way Financial Systems Allocate Capital
This post draws heavily on M. Pettis.
Every financial system is capable of periods of capital misallocation, and this almost always seems to happen during periods of very low interest rates and rapid money expansion, but some financial systems do this more extravagantly than others.
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems.
In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors. This system generates tremendous growth for underdeveloped economies where economic value is easy to identify. Identifying economic value in developed (particularly with respect to infrastructure) economies is more difficult
In that case these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change.
The other type of system, in which the problem of systematic capital misallocation is much reduced, is one in which banks decide for themselves the kinds of activities they fund, and their shareholders and depositors bear both the rewards and risks of their capital allocation. These kinds of banking system are much more prone to instability, but they are also much more efficient at allocating capital over the long term. In part this is because there is a fairly robust mechanism for recognizing and liquidating poor investment. In the former system, because risk tends to be socialized, there is no obvious mechanism, besides that of an omniscient and disinterested credit committee, for identifying and correcting misallocation.
The prestige of the Anglo-Saxon model soared in the past two decades precisely because its biggest competitor for prestige, the Japanese banking system, collapsed so spectacularly in the 1990s.
In practice of course there is no pure example of one financial system or the other, but as the statement above suggests it is pretty safe to say that Japan during its growth period, and the countries that copied the Japanese model, are closet to the extreme version of the former. The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem.
Every financial system is capable of periods of capital misallocation, and this almost always seems to happen during periods of very low interest rates and rapid money expansion, but some financial systems do this more extravagantly than others.
As I see it there are broadly speaking two very different conceptions of the role of a country’s financial systems.
In one, banks act largely as fiscal agents for the government or the economic elite, accumulating savings and deploying capital into projects usually selected for promotion by those elites. Since banks are in the business of taking risk, and since rapid credit expansion is inherently risky, the only way to guarantee financial stability is to extract much or all the risk from the banks and imbed them elsewhere. In practice the only “elsewhere” big enough is the state. In this kind of banking system the state typically socializes credit risk and passes losses onto taxpayers or depositors. This system generates tremendous growth for underdeveloped economies where economic value is easy to identify. Identifying economic value in developed (particularly with respect to infrastructure) economies is more difficult
In that case these kinds of financial systems inevitably run into the problem of capital misallocation. It doesn’t matter if at one point they do a great job of allocating capital and generating real growth. As long as the same allocation process is maintained, it seems, at some point they begin to overinvest. Perhaps this is because the economic sectors that benefit most from the regulatory, credit and economic subsidies, not surprisingly, become increasingly powerful within the political system and increasingly reluctant to allow the system to change.
The other type of system, in which the problem of systematic capital misallocation is much reduced, is one in which banks decide for themselves the kinds of activities they fund, and their shareholders and depositors bear both the rewards and risks of their capital allocation. These kinds of banking system are much more prone to instability, but they are also much more efficient at allocating capital over the long term. In part this is because there is a fairly robust mechanism for recognizing and liquidating poor investment. In the former system, because risk tends to be socialized, there is no obvious mechanism, besides that of an omniscient and disinterested credit committee, for identifying and correcting misallocation.
The prestige of the Anglo-Saxon model soared in the past two decades precisely because its biggest competitor for prestige, the Japanese banking system, collapsed so spectacularly in the 1990s.
In practice of course there is no pure example of one financial system or the other, but as the statement above suggests it is pretty safe to say that Japan during its growth period, and the countries that copied the Japanese model, are closet to the extreme version of the former. The current Chinese financial system, even more than Japan, is clearly one in which the purpose of the financial system is to act as the state’s fiscal agent and in which banking stability is guaranteed by the state. It is also clearly one in which capital misallocation can become a huge problem.
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