Economic Base Case

I’ve been very busy for the last few days at work.

 Hopefully normal service will return next week but in the meantime, I take the following bullet points from our latest presentation to investors at work. 

I generally try to avoid making precise economic forecasts – it’s a way of making oneself look silly. But this represents my ‘base case’ on the economy for the next few years. What I think is likely to happen, rather than what I desire to happen. 

• The worst quarterly declines in GDP are behind us.
• Extraordinary fiscal & monetary policies have hopefully prevented a prolonged deflationary slide.
• Global growth will come from inventory re-stocking in the West and consumption/investment in the East.
• Capacity utilisation is at record lows, and still falling in Europe, the UK and the US – hence inflation is unlikely.
• Private sector capital expenditure is extremely weak.
• Fiscal policy expansion stop by late 2010/11, given large budget deficits and debt/GDP ratios and political pressure.
• Deleveraging by banks, companies and consumers is only just beginning. Corporate and household debt levels will fall and savings rates rise.
• Once the fiscal policy stimulus is withdraw, and the inventory restocking complete, the West is likely to dip back into recession by 2011.
• Bear Case: If deflation becomes more deeply entrenched (still a risk), then the (Anglo-Saxon)West faces a ‘balance sheet recession’ and a Japanese style ‘Lost Decade’.
• Bull Case: A strong upsurge in corporate investment could cause private sector GDP to start growing before the stimulus is withdrawn.

Replacing Kingman & the future of UKFI

So now that John Kingman has quit as head of UKFI, the body looking after our interests in the nationalised banks, the question turns to ‘who will replace him?’

The FT says:

Treasury insiders expect Mr Kingman to be replaced in the autumn by a senior banker or hedge fund manager.

Please no. Pretty please. If the Treasury is determined to get someone with private sector experience, and I can see the reasoning, why can’t we have an executive from a non-financial firm? You know, someone that understands about the real economy?

More generally we need to have a proper think about the role of UKFI. Should it’s mandate be to simply act as a custodian of our stake, aiming to off load them at a profit? Or should they be actively used as a tool of a new industrial policy? I favour the second option.

I don’t want RBS, Northern Rock et al used to ‘get the housing market going again’, I want to see them lending to firms with decent prospects. I want to see them providing finance to green technology start ups. They can play a role in rebalancing our economy.

The latest BOE figures show that, in June, lending to households rose 2.6% (year on year), lending to financial companies rose a staggering 34.6%, whilst lending to non-financial companies fell by 1.2%.

This has to be reversed.

 

China: Currency Manipulator?

I was reading this story on the BBC yesterday about US factories closing and moving to China.

In the small town of Cary, near Chicago, you can see American industry being dismantled in front of your eyes.

Doug Bartlett’s factory used to make electronic circuit boards. But orders collapsed as the recession took hold.

The factory shut in March with the loss of 87 jobs. Now the wrecking crew is in and the factory is being gutted.

“It hurts,” says Doug. “You hate to see the people laid off.”

Doug is selling off all the usable machinery. He blames the death of his business on unfair competition from the Chinese, accusing them of artificially devaluing their currency to undercut American goods.

“You have to stop the Chinese from cheating,” he says.

“We’re not only watching the dismantling of my company, we’re also watching the dismantling of the circuit board industry in the United States and the dismantling of American industrial might.”

This notion that ‘China is cheating’, is quite interesting. To be clear, the charge is that China is deliberately intervening in the currency markets to keep the value of the Renmimbi artificially low and hence Chinese exports competitive. The usual evidence for this is the vast stock of US bonds the People’s Bank of China (operating through SAFE – the State Administration for Foreign Exchange) has acquired over the last few years.

Two chroniclers of this saga are Brad Setser at the CFR and London-based macro trader Macro-Man.  

Danny Quah, Head of the Economics Department at the LSE and a man who certainly knows what he’s talking about, gave a strong argument against this received wisdom in a comment on a post here last week:

First, certainly SAFE buys considerable quantities of US dollars – but is that intervention? Or is it just the result of an after-the-fact imprudent faith in the continued strength of the US dollar? And remember it is not just China whose official coffers and portfolios fill to overflowing with US dollars. Japan comes a close second. And the UK, a surprising third, is estimated to hold nearly two-thirds of the amount China does in US Treasury bonds.

Second, perhaps more critical, as you saw from my blog post

http://dq6bn.blogspot.com/2008/11/where-in-world-is-asian-thrift-and.html

it is not just China that has been running large bilateral surpluses against the US (and thus resulting from whatever rate the RMB has gotten to, through SAFE’s actions). The EU and the oil-exporting countries have seen bilateral surpluses against the US of about the same magnitude and dynamics as China’s – it has got to be a strain to say that those trade surpluses against the US derive from SAFE’s interventions to keep down the RMB.

I’m starting to change my view on this one. I have long been firmly of the view thhat the Chinese model was dependent upon exports and so ‘currency cheating’ made sense as a model. John Ross is doing a good job of persuading me that exports are not the driver of growth, whihc combined with Danny’s argument’s above force me to reconsider.

This debate the issue of ‘cheating’ is more than a economic argument. It is also a political issue. 

WASHINGTON, Jan 21 (Reuters) – President Barack Obama is committed to pressing China on its currency practices, which are a major concern for the both United States and the global economy, U.S. Treasury Secretary-designate Timothy Geithner said on Wednesday.

Geithner was asked at his Senate Finance Committee confirmation hearing whether he thought China’s “manipulation” of its currency remained a serious concern.

“I do believe it is a significant issue,” he told Sen. Jim Bunning, a Kentucky Republican who has sponsored legislation to press China to move a more flexible exchange rate policy.

“As I said earlier, I believe it is important for the United States and the global economy that our major trading partners operate with a flexible exchange rate system and that market forces determine the level of those exchange rates,” Geithner said.

The issue is of course more complex than the simple ‘is China cheating’? As Danny Quah has noted talk of ‘excessive Asian savings’ is perhaps a Western Centric term. It is unusual to blame the lender in a debt crisis and not the borrower. We don’t hear as much talk of ‘Excessive Western Consumption’.

Could the same argument not be made on this issue? We hear a lot of talk of ‘Chinese currency manipulation’ but less complaints that ‘the US has been running an ever widening deficit for the best part of 30 years (with notable exceptions in the Clinton period), they can’t complain that someone is still buying their debt’.

I’m increasing moving towards a policy of ‘blame global imbalances’. I think that Asia (and the petro-states amongst others) have saved too much, they have been too reliant on exports and maybe as part of an export dependence and high savings they have ‘influenced heavily’ the value of their currencies.

But the flip side of that is that the West has spent too much, been too reliant on consumption as a driver of growth and gotten into too much debt.

Both sides are to blame and an argument as to who started it is entirely irrelevant. The agenda now must be a way to find a more balanced version of global growth.

The Tories in Action

Go read Paul.

A taster: 

57 jobs are going, along with all the deflationary impact that has upon our local economy, and the services that will suffer.  They are going  because this Conservative council relies for its direction on the word of a finance organisation shown to be wholly incapable of doing its job, and which has accepted that the views, used by the Chief Executive to justify the council’s approach, need tighter regulation to stop them being used in precisely this damaging way.

The alternative might have been to look at the council’s own balance sheet. 

But that would have given the Tories the wrong answer.

A bigger rental sector

This story strikes me as good news.

The UK is set to experience a boom in American-style mass-produced rental homes as part of proposals by a consortium that meet a government call for greater institutional investment in the residential market.

Aviva insurance group,is to launch an investment fund with as much as £1bn to buy and rent out swaths of new-build residential property in partnership with CB Richard Ellis property consultancy and a big US residential manager.

The venture will order purpose-built residential blocks of 100 units or more in south-east England to rent out, mainly near big transport hubs and on significant regeneration sites that have stalled because of the economic downturn.

The partners have based their strategy on a US model of large-scale, multi-family rented housing. They say that it will be the first of its kind for the UK, providing thousands of homes for the private rental market, which is dominated by amateur landlords and buy-to-let investors. Rental property is a much bigger business in the US and across northern Europe.

I’d prefer the State to be building more public housing but this seems to me to be a  good start. As I’ve said before (here and elsewhere) I’d prefer house prices to be lower. Developing a bigger, and better run, rental sector can only help.

I know I’ve got at least two readers that know more about the issues here than me. Curious for their thoughts.

China’s Growth: The Debate Continues

John Ross has left a detailed response in the comments to this post.

Worth a read.

Some of my best friends are central bankers

It’s not that I have anything against central bankers, I mean some of my best friends are central bankers, but… I just don’t want them in charge of regulating individual institutions.

Paul Myners, who I have a lot of time for (and Tom has even more), is making a lot of sense. Talking about the Osborne’s planned reforms:

“They have misjudged the competence and culture of the Bank of England,” Lord Myners told City A.M. “The Bank is a very academic institution. It is not actually about doing things.”

OK, Myners is a government minister but he’s not the only one saying this.

According to a senior City banker with ties to Tory politicians, there is indignation at Mr Osborne’s suggestion that “markets regulation could be combined with the Takeover Panel and Financial Reporting Council to streamline the number of regulators and create a powerful markets regulator”.

Both bodies have significant standing in the City and the banker said the Tory plan was unveiled with no prior consultation with those bodies.

“No conversation was had by anybody in the Tory party with one of those bodies,” he said.

“It has severely damaged the ‘thinking man’s view’ of the Conservative party in the City,” he said.

Today Sir Andrew Large, former Deputy Governmor for Financial Stability of the Bank, writes:

To my mind the architecture of which institution does what is secondary, yet the Conservatives appear to have fallen into the trap of thinking that altering the architecture will deliver a better outcome. The fact is there is no perfect supervisory architecture.

…

So I am not convinced that to split the FSA and put supervision squarely into the Bank is wise or necessary, or that it will deliver a better result than the improvements under way. Changing architecture involves real risks and the burdens of migrating roles. Besides this, the consumer improvements suggested by the Conservatives do not require splitting the FSA in two. Finally, is this the right time to experiment – for the second time in 12 years – with the architecture?

 

Yesterday, to underline the point about the Bank being ‘bookish’ rather than ‘market savvy’ , MPC Member Andrew Sentance made some comments on quantitative easing, minutes after the successful auctioning of £5bn of gilts.

His remarks raised expectations in financial markets that the Bank might be ready for a sustained pause in its injections of cash into the economy through the purchase of government bonds.

Scott Thiel, head of European fixed income at BlackRock, said: “This is one of the biggest single gilts transactions of all time, and the Bank jolts the market with significant market-moving information only minutes after the deal has been sealed.”

Mr Sentance’s comments irked government officials. One said: “The problem with the external members of the Bank of England is that they live in this cocooned, separate world and do not consider how they might move the markets.”

Like I say, some of my best friends are central bankers but…

Anger: Found

I asked where the anger had gone?

Charlie found it.

Taken altogether, what all of this means is that Goldman’s profit announcement is a giant “fuck you” to the rest of the country. It is a statement of supreme privilege, an announcement that it feels no shame in taking subsidies and funneling them directly into their pockets, and moreover feels no fear of any public response. It knows that it’s untouchable and it’s not going to change its behavior for anyone. And it doesn’t matter who knows it.

There are going to be some people who say that some of this stuff isn’t government subsidy so much as ordinary government contracting. After all, do we criticize Boeing for making airplanes or Electric Boat for making submarines during a war? If we don’t do that, then why should we be pissed about Goldman making a profit underwriting TARP repayment stock issuances, or Treasuries?

When Hopi met Jon…

Go and read Hopi’s interview with Jon Cruddas.

Excellent piece of journalism and full of interesting thoughts.

“If you thought that you had dis-invented the laws of economics, you had these self correcting mechanisms which that meant that you could guarantee growth, then there was no reason to contest the central institutional arrangements for this positioning because it would guarantee trickle down …

…you could retain that coalition which retains power. Doesn’t necessarily change the country but it gives you an armlock around the political system at Westminster.”

This continued economic growth meant there were enough resources to keep an election winning coalition together, even if an ever increasing number of voters were dissatisfied or disillusioned. But this era of growth stopped suddenly last year.

“The music stops, middle of last year. Growth is no longer guaranteed.”

It follows from this, that the abrupt end to the politics of growth signals the end of the New Labour era. If Blairism was about taking the economic success of free market capitalism and spreading the proceeds more equitably, then what does the movement do when those funds are suddenly and sharply withdrawn?

“…The contrast is not just the Blair Brown period, but the way the Blair Brown period was forged in the context of a benign climate. …also contrast growth with austerity. A politics of scarcity contrasts with a politics of growth. That creates huge challenges to the party.”

China’s Growth: The Debate

I thought I’d managed to leave China behind last week but Michael Pettis has such a good post up, that I’ve been inspired to return to the subject.

Last week John Ross had a go at Pettis for questioning the merits of China’s economic system.

As John has outlined in a long series of posts, he fundamentally believes that the key to long term economic growth is investment and that China is successful because, by directly controlling investment it can control growth.

There might be something in this, certainly for developing economies. But as Chris has argued it may be the case that governments in developed countries have less control.  In other words the Chinese model, which is similar in some respects to the South Korean and Japanese route to prosperity, can succeed in increasing GDP from a low base but doesn’t work in an advanced economy. If true, then this would undermine the argument of tjhose who claim that the UK, for example, could learn a lot from China.

On this very topic, an email landed in my inbox this morning from a broker in Hong Kong:

 Next year, more and more analysts will start to question when, like Japan and S.Korea before ,  China’s semi-capitalist or authoritarian capitalist system becomes too ossified with job done in building up native industry.

There will be more and more focus, too, in the wake of the $1 trillion plus surge in bank loans, on China’s already hefty weight of NPLs—finance /economic  hernias or worse ahead? !! 

NPLs = Non-performing loans.

As I said last week, China can continue growing because, despite exports being down and domestic demand being weak, it can keep increasing investment (or fixed capital formation). This has collapsed in the West where private companies have little desire to invest during a recession and where even if they did want to then they would find it difficult to raise the finance. In China however state owned companies are ordered to invest and state owned banks required to lend to them.

What we really have here are two issues – one long term and one short term, but both linked. The long term issue is the one referred to above – can China keep growing by investing. John Ross would point to the amount of people living in poverty and the lack of infrastructure in much of the country and say yes. But surely we eventually hit a point when simply investing more and more is not enough. One can only add so much to capacity.

In the long rule, many argue, that China needs to consume more domestically. In other words Chinese workers need to save less and spend more. This would not only provide a driver for growth other than investment/exports but would also help to address the global imbalances that have plagued the economy over the past decade.

But in the short term there is the issue of how sustainable current Chinese economic actually is.  This is where Pettis comes in. He received an email from a fund manager which casts light on some of the ‘investment’ currently driving Chinese growth:

I don’t know how much you travel around China.  Tom and I do a fair bit, and most recently we were in Guiyang.  I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc.  But what we saw over there is rather hard to fathom.  It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land. 

Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen.  They built sprawling new government buildings about a 20-minute drive north of town.  And then the residential high rise projects started going up.  From driving around the area, Tom and I figured well over 100 20+ storey buildings.  

What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town.  Every building we got close enough to see was either incomplete/under construction, or empty.  Our tone gradually went from “Haha, another one!” to “Oh my God, another one.”  We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon.  The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction. 

 The fund manager asks:

What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy.  Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment?  If they can prevent a crash, then maybe it’s all worth it ? 

(SOE = State Owned Enterprises).  

Pettis answers at first with a good discussion on the nature of debt (with a plug for Minsky) before saying:

So to get back to the original question, will we see a crash, or a steady slowdown?  My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on. 

This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to.  There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment.  This is not a note of optimism, by the way.  As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly. 

Grim stuff for China, but for me the really interesting stuff comes at the end, and neatly ties together the short and the long term issue:

China needs to increase domestic consumption for stable internally driven growth.  You can’t increase domestic consumption if you’re buying real estate.  So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy.  You really do wonder how long the Chinese will keep up this level of “pump priming”.  If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity. 

In other words China’s current policies are delaying a shift to a more sustainable model.

In the end this the question on China. On the one hand John Ross believes that the investment driven, state directed growth can not only be used during the transition from developing to developed economy but can continue from that point onwards. People such as Michael Pettis disagree. They worry that in the long term the model won’t work and in the short term it may be pushed to its limits.

For what’s it worth, I lean more towards Pettis. I do think that there should be more government involvement in the economy. The industrial policy agenda that I’m keen on would involve the government helping private industry to grow. It would involve government loans to firms in key sectors and it would necessitate much closer co-operation between government, industry and unions than we have currently.

But I don’t take it as far as arguing for the nationalistion of vast chunks of the economy. I recognize that there are times (such as in the UK transport and housing sectors currently) where private industry is failing to invest when it should be investing. I’m more than happy for the government to step in. But I also recognize the potential danger of the Chinese approach of investing simply for investing sake.