Thursday, January 26, 2012

The Economic Shift in the World Economy

I have started this post without a title, as I'm still trying to sort out which might be the best subject for a post. The slow motion car crash of the Euro is always tempting. Then there is the current state of China, which increasingly appears to be in trouble. Then there is the US 'recovery' or the latest discussions at Davos.

For the last point, an interesting perspective was aired at the forum in Davos, and it may be that it can tie together some of the many stories that are being discussed. This from Jeremy Warner of the Telegraph:

The contrast between Western gloom and Eastern optimism is again striking this year, and it is something that goes beyond the immediate challenges of the eurozone crisis.

According to forecasts aired by Indonesia's minister for creative industries, the total size of the world's middle class will more than double to 4.9bn by 2030, with 85pc of the growth occurring in the developing world. By then, some 65pc of this middle class will be in Asia.

Long term predictions of this sort are always going to be suspect, but few would disagree with the thrust of what the Indonesian minister is saying.
The article mirrors something that I wrote in 2009, in which I discussed the emergence of the Asian middle class, in contrast to the Western middle class whose spending power was in decline. I used the Tata Nano (perhaps a poor choice with hindsight) and SUVs as an example to illustrate the point. Whilst SUV sales were falling the Nano was the coming thing. The shift represented the move from wealth being concentrated in Western middle classes (the SUV), to a dispersion of the wealth to the East (the Nano), and with the Western middle classes moving down to meet the rising Eastern middle classes in the middle.

Another of the stories that I had kept in mind for a future post ties into the story of the decline of the middle classes in the West. It comes from the New York Times, and is an explanation of why the Apple iPhone is not made in the US (there is also a visual presentation of the argument here). It is a long article, but there are some points that are clearly made. The first is that it pops the fantasy that gripped the Western world; that the East would do all the clever work and that the East would simply be the cheap labour. Again, it has been a theme of this blog that this was just not going to happen. I have argued that all of the key services would, in the end, follow manufacturing.

The most interesting thing about the Apple story is that Apple still does have the design knowledge and experience, and this is still undertaken in the US. The problem is that there are so few jobs that this creates. Instead, the article argues persuasively that it no longer about the availability of cheap labour, but the flexibility of Chinese companies, and also the proximity to all key suppliers that makes manufacturing in China a compelling case. In addition, China has an army of engineers and technically trained staff, skilled manufacturing employees and so forth. The result is that Apple has a compelling case for manufacture in China. It is the underlying reason for why the middle classes of the US are being hollowed out. Those skilled jobs are going to China, for example the solidly middle class engineering jobs, and the skills of the US workforce must inevitably decline over time in relation to countries such as China.

It then just becomes a matter of time before the most highly paid jobs, such as those in design and marketing, likewise commence the move Eastwards, as the Chinese workers 'upskill', as Asian markets grow in relation to Western markets, and as the key skills to 'make stuff' become ever more concentrated in the emerging markets.The worrying element of this is that China has created a virtuous spiral. The more manufacturing it undertakes, the more compelling the case for manufacturing in China.

All of this appears, then, as a done deal. But is it?

To date, all of the massive growth in China has taken place in the context of 'state capitalism', in which China has carefully guided the rise in its economy with a combination of massive investment in state companies, and measures to ensure a competitive currency, and a policy of obtaining technology from the West through demands for technology transfers and outright technology theft. It is a story that is told in a recent Economist special report. But it is not just China that is following a state capitalism model, but as the report details, state capitalism is increasingly being endorsed around the world.

After all, who can argue that China's model has been a success to date? The real question is one of how long it might continue?

I am certainly having my doubts that it is a model that can be sustained. I recently used an analogy to explain to friend why I thought the Chinese model might now be in some trouble. When China first 'opened for business', the country was in a parlous state following the years of chaos characterised by Maoism. The first advantage was that China could almost do no worse. The second advantage that flowed from this is that, in terms of state capitalism, China could safely invest in infrastructure and almost guarantee a return. My analogy was that it was like throwing a dart at a dartboard from one foot away from the board, with the bulls eye dominating most of the board. As time has moved forwards, the person throwing the darts is moving steadily further away from the board, and the bulls eye is shrinking back to its normal size. It now takes skill to hit the bulls eye, and there are more misses than hits. Just one example of this in action is the case of cities being built but remaining unoccupied.

The second problem with the Chinese model is that it requires the acquiescence of trading partners. The special report points out the increasing queasiness of key trading partners when faced with effectively subsidised state giants entering into international markets. The Economist article is perhaps an exemplar of a growing backlash against the state capitalist model. For example, it points to the spreading influence of the model, and the more the model spreads, the more problematic it becomes. The more companies that face competition from these state supported enterprises, the more there will be complaints to policy makers of unfair competition. There are two approaches to such complaints. One is restriction of trade, and the other is to respond in kind. In either case, the model will start to break down. The former is (I hope) self-explanatory, but response in kind will just lead to a fight that neither side will win.

I am reminded of a long while ago. I remember commenting on another Economist article (sorry, I cannot find it now) that argued that the cheap products being manufactured in China should be seen as a wonderful benefit for the West. The article argued how this kept down inflation, and provided a better standard of living to the West. They mentioned the problem of currency keeping prices as low, but thought that the benefits derived from this were positive (this is my best recollection of a long, long while ago). I do remember that I argued at the time that this subsidy of Chinese goods might appear to provide benefits, but at the cost of hollowing out their competitors in the West. I see the state capitalist model is going to raise the same issues, but this time with China's trading partners increasingly jaded about China, and with a growing sense of frustration as the impacts of the emerging market growth becomes ever more plain to see.

I am not sure that the acquiescence can continue for much longer.

Another side of the story is that of Chimerica. The funding of Western states in order to continue trade imbalances is coming to an end. It has not ended, but the limits of the model are becoming apparent. Also, the costs of the model are becoming apparent. This leaves a tough period of transition. For example, the problems of the Euro area will eventually land on the doorstep of China and the other emerging markets. This is going to take place at a time which, in the case of China, will be when the problems of the state capitalist model are starting to make themselves felt. China's property bubble is bursting, and there are signs that the Chinese economy is rapidly slowing. This from Ambrose Evans-Pritchard, who discusses proxies for the state of the Chinese economy before saying:

So how did China pull off an economic growth rate of 8.9pc in the fourth quarter?

Beats me.

I strongly suspect that the trade and power data reveal the true state of China’s economy.
There clearly was a pick up in early January but I stick to my view that China has inflated its credit bubble beyond the limits of safety – an increase of 100pc of GDP in five years, or twice US credit growth from 2002-2007 – and that Beijing cannot continue to gain much traction with this sort of artificial stimulus.

Indeed, the extra boost to GDP from each extra yuan of credit has collapsed, according to Fitch Ratings.

There are several points that can be taken from the discussion that I have presented. The first is that, as was predictable, a major shift has taken place in the world economy, and the price of the shift has been the diminishing of the Western middle classes, and the rise of the middle classes in the emerging economies. This is being noticed, and it is finally being understood. The success of the model has relied on the acquiescence of the Western world, but the continuing acquiescence is doubtful. Set against this, the stage of development of China in particular, has seen a virtuous spiral develop. However, that virtuous spiral might be upset by the consequences of the gross mis-allocation of resources that are becoming apparent. Whether the over investment in real estate by banks and provincial and city governments, or ever more questionable infrastructure investment and investment in more and more industrial capacity, this has potential to be a drain on the Chinese economy.

It is a complex situation. It is difficult to predict how it might unwind. However, the one certainty is that some kind of change is on the horizon. The pain being felt by the middle classes of the Western world will be addressed by politicians, and there is no sure way to know how they will finally respond. Of one thing, I am increasingly certain. The acquiescence of the West to a system that is destroying the wealth of the West is coming to an end.

Note: I have used the expression emerging economies but they have, in most senses already emerged. Please excuse my use of this convenience. Also, as ever, my focus is perhaps too much on China, which is simply because it is one of the countries I watch most closely.

Tuesday, January 17, 2012

Debt and Economic Structure

In my post today, I am going to talk about the principles of structural debt reliance in an economy. It is (I hope) going to illustrate, in principle only, why so-called austerity causes a downwards spiral in an economy, and why denying the need for reductions in government borrowing are a fallacy. It is deliberately simplistic, but I hope that it will nevertheless make the point.

In order to illustrate the point, I will use a notional company that makes office 'widgets'. I choose this type of company as its products have broad applications (as all organisations use office supplies to some extent). We will imagine that our notional company makes 1000 widgets per week, and is a private company. At the starting point of the example, the government is borrowing money, but not excessively. Our widget company is supplying many organisations with their products, and they are a company in reasonable shape. Amongst their many customers are various government organisations, and these organisations purchase on average 200 widgets per week.

The widget company actually likes to supply these government organisations, as they have one particular advantage, and that is that they are government organisations. From this flow many benefits to our widget supplier. They pay on time, and most importantly, they seem to pose no credit risk. This in turn has benefits in, for example, raising finance, as the credit provided to the government is seen as rock solid. Overall, the widget company likes to supply to the government, and even hires a sales specialist who has knowledge of government procurement to help build this area of the business. Our widget maker starts to notice the growth of their business with government organisations, with government spending increasing over time. The money being spent by the government is increasingly funded through borrowing, not through taxation.

Our widget maker sees government sales creeping progressively upwards, moving steadily from 200 widgets a week, up to 300. At the same time, there are steady increases in sales from the other purchasers of widgets. With the ongoing growth in the business, our widget maker makes some new hires, and invests in new plant. The demand for their widgets is growing steadily, and they are struggling to meet the new demand for 1200 widgets per week, and will soon be turning down orders unless they invest. On current growth rates, they feel confident to invest in capacity for 1500 widgets per week. In order to grow their business, they visit their bank, and have a persuasive story of steady growth, reliable customers, and a growing stream of revenue with which to repay the loan for the new capacity. The loan is granted, and our widget company invests in expansion. All the while government borrowing is steadily increasing and the overall size of debt growing.

All is going well for our widget company, and then there appear to be tremors in financial markets. For many years, government debt has been growing, and concerns are starting to be raised about the degree of borrowing by the government. Words such as crisis start being used, and yields on government debt are rising. Raising new debt is becoming more difficult and expensive. There is talk of government cutting borrowing, and cutting services. Our widget maker is concerned, but not that concerned until the cuts to government expenditure start to be implemented. The number of widgets sold to government departments stops growing, and then starts to decline. The government sales specialist explains that the cuts by the government are limiting the spending of departments on new widgets, and that some of the government organisations are disappearing entirely.

Sales to government organisations start to fall back to the original 200 per week. It is a blow, but it is not that big a blow that our widget manufacturer cannot survive. After all, it was not just the orders from the government that were growing, but also the sales to businesses. They may have over-invested in new capacity, and repaying the financing of that capacity will be more difficult but not impossible. Time moves forwards, and the cuts of the government are starting to bite. Our widget maker once again becomes concerned. Whilst the government widget purchases have stabilised at the original 200 per week, the company notes declines in orders from some private customers. Also, some of his private customers are becoming tardy in paying their bills, and this is hitting cash-flow. The company is finding that sales overall are falling back towards the 1000 widgets per week, and they need at least 1100 sales per week to cover their cost of finance.

They are in trouble, and their cash flow is starting to be a problem for meeting their bills. They are themselves making late payments. They do not understand what is going on. After all, they had a diversified customer base, and were not reliant only on the growth in government orders to finance their expansion. However, they were unaware that many of their customers, just like themselves, were also supplying the government and like themselves grew (in part) through growth in government orders. And then there were the companies that supplied the companies that were supplying the government. And then there were the companies that supplied the companies that supplied the companies that supplied the government. In each case, they all see a deterioration in their revenue as government cuts bite, and each sees a negative impact upon their business.

The companies that are direct suppliers to the government are hit hardest. They are the ones now being tardy with paying their invoices. This tardiness impacts down the supply chain, with some companies not being paid for their products and services as companies start to fail. Our widget maker is now in trouble and is one of those companies. Their own suppliers are complaining about late payments, and are starting to restrict any new credit to the widget supplier. As credit from suppliers starts to disappear, and with now negative cash flow, our widget supplier is going bust. When the inevitable happens, the workers are laid off, and the bank takes a hit to its balance sheet. The liquidators sell off what remains of the plant and anything that might have value for creditors. The laid off workers look for new work, but with so many companies laying off workers, new work is difficult to find.

The laid off workers are unemployed, and they therefore tighten their belts. There is no money available for many things they had enjoyed before. For example, they would regularly go out to restaurants, but this is now completely unaffordable. It is notable that, whilst many restaurants are still in business, many restaurants are also going bust. It is not just restaurants, but other businesses that are closing the doors, such as shops, and hair dressers. And the shopfitters, and the wholesalers are also being hit. Yes, some businesses are still doing well, but the numbers of bankruptcies over a multitude of sectors are steadily rising. Even where businesses survive, they are often downsizing. Unemployment is climbing fast.

At this point I will stop. It is clear that this is a self-reinforcing downwards spiral. The managers of our widget business were, in all regards, perfectly competent business people and  managed their company in a sensible and responsible way. The market gave them positive signals, and they responded. As business people, they did everything right.

Our widget maker was directly exposed to government cuts, but was also indirectly exposed. As the borrowed money flows through an economy, the structure of the economy shifts to the consumption of that money. In some cases, as in the case of our widget maker, the shift in structure is readily apparent. In other cases, the shift in the structure of the economy is less apparent. For example, the small sandwich shop near the widget maker's factory that is doing good business as a result of the increase in the labour force in the widget maker. For example, extra staff may have been taken on to service the increase in business from the widget factory.

When we imagine the many interlinked ways that an economy restructures to service the debt founded consumption, it does not come as a surprise when we see countries such as Greece slide into a downwards spiral as government cuts borrowing and expenditure. It is the only possible outcome. There are those that propose the opposite course of action, which is to increase borrowing and expenditure, but the logic of this is that the economy will simply structure more deeply into servicing the debt based consumption. It will, undoubtedly, delay the problems, but only at the cost of more pain when the ability to accumulate yet more debt finally comes to an end.

Even if only holding debt accumulation at the current rate, the problem remains that the debt is accumulating, but the structure of the economy will remain the same; it means that the problem of a debt based structure is left unchallenged. One day, the economy must restructure away from the debt accumulation as infinite debt accumulation is not possible. There will always come a point at which the debt burden becomes too much, or where markets finally perceive that it is unsustainable.

When an economy structures around debt accumulation there is no painless fix. It is simply unreal to imagine that a restructuring away from debt accumulation might be undertaken without the period of the downwards self-reinforcing spiral. It absolutely must happen. The only question is to ask how much of the economy is rooted in debt consumption, how fast and deep the cuts will be. There are, of course, some things a government might do during this painful period, such as retraining, and other ideas to try to ameliorate the pain. However, there is no avoiding that the painful restructuring is the only way that the economy can move back onto a sustainable path.

Sunday, January 15, 2012

The EU Downgrades

This will be quite a short post. It has been impossible to miss the news from last Friday about the downgrades of several EU countries by Standard and Poor's (S&P):

Ratings agency Standard & Poor's downgraded the government debt of France, Austria, Italy and Spain on Friday. But it kept Germany's at the coveted AAA level.
The downgrades deal a blow to the eurozone's ability to fight off a worsening debt crisis. All told, S&P cut its ratings on nine eurozone countries.
The rating agency ended France and Austria's triple-A status. It also lowered Italy's and Spain's by two notches and did the same for Portugal and Cyprus. S&P also cut ratings on Malta, Slovakia and Slovenia.
"In our view, the policy initiatives taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone," S&P said in a statement.
France's downgrade to AA+ lowers it to the level of U.S. long-term debt, which S&P downgraded last summer.
S&P had warned 15 European nations in December that they were at risk for a downgrade.
The way that the press have reacted is as if this is some kind of shock, even though the potential for a downgrade has been been trailed, as is mentioned in the quote above. S&P's statement about why they made the downgrade can be found here. It has also had an impact on the rather dubious Euro bailout fund, with this from the WSJ:

Standard & Poor's Ratings Services on Friday said it had stripped triple-A ratings from France and Austria and downgraded seven others, including Spain, Italy and Portugal. It retained the triple-A rating on Europe's No. 1 economy, Germany.
The downgrade to France, the bloc's second-largest economy, will make it harder—and potentially more expensive—for the euro zone's bailout fund to help troubled states, because the fund's own triple-A rating depends on those of its constituents. The downgrades also speak to how deeply the concerns over countries on the euro zone's periphery have penetrated its core. Worst-case fears weren't borne out: France avoided the two-notch downgrade S&P had warned of last month.
So, is this really news? In some senses 'yes', and in some senses 'no'. The most interesting thing about the ratings agencies is that they are supposed to look into the future and make assessment of asset risk, but they nearly always seem to play 'catch up' with the reality on the ground. Even the most casual browse of the financial news would have told anyone that the problems of the Euro were spreading from the so-called periphery into the so-called core. The S&P downgrade is, as always seems to be the case, just playing catch-up.

However, it is news in the sense that it has real impacts. The first impact is on the bailout mechanism, as mentioned in the WSJ article. However, another impact is upon European banks. I expected to find a raft of headlines to this effect, but a search of Google News did not turn up what I expected (perhaps my keywords were not right, and I missed the articles). In particular, those banks that hold the sovereign debt of the downgraded countries will see further erosion of their already (in many cases) strained balance sheets. The only example I found discussing this point was curiously in reference to Japanese banks:
France’s loss of its AAA rating probably won’t have any immediate effect in Japan as domestic banks’ holdings of French bonds aren’t large, Azumi said in Tokyo yesterday, according to Kyodo News.
It is now an open secret that the ECB has been bailing out European banks in the hope that they will in turn use the money to purchase European sovereign debt. This from Wolfgang M√ľnchau in the FT:
And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.
Regular readers will know that I do not agree that the bailout was a 'good thing', but I quote this as it as it makes the point about the indirect purpose of the bailouts. I have mentioned before that there are large chunks of debt coming due in the next couple of months, and funding these chunks of debt may be a severe problem. I used this chart from the Economist before, as it paints the picture well:

When bank balance sheets are already under strain, the question is what they might do with all of the money that the ECB is pouring into their balance sheets. The new Basel accords are demanding higher levels of capital, and the ratings of assets will impact upon their compliance. The question is this; with their balance sheets already strained, when the periphery debt looks ever more dangerous, and the core debt is now being recognised as high risk, why on earth would any bank actually purchase high risk European sovereign debt?

The problem is this, that in the topsy-turvy world of banking regulation the ratings agencies really matter. They are, of course, completely hopeless in their assessment of risk, but they nevertheless have major impacts. However, it does occur to me that there is the possibility that the bailout of the banks by the ECB might come with strings attached, in backroom deals, that as a quid pro quo, the banks agree to continue to purchase dubious Euro sovereign debt. I can only speculate on this but, if such an agreement has taken place, it is a great way to increase the contagion. It really is kicking the can down the road.

Furthermore, as many (including myself) argued, the establishment of the Euro bailout fund would spread the problems into the Euro core, as countries such as France were already in a position of having too high levels of debt. A long time ago, I discussed the problem of who would be left to do the bailing out when every country was racking up too much debt. The context of the discussion was the US, if I remember correctly, but the same applies here. It has long been the case that any bailout is being funded by countries borrowing more money to enact the bailout. They are not using a net credit position to bailout, they are just borrowing more on the basis of having a better credit position than the bailee. However, when they are in a position of having too much debt themselves, they start to tip their own creditworthiness into the danger zone. Again, using your own fragile creditworthiness to support the less creditworthy is another case of kicking the can down the road.

The problem with such can-kicking is that it ratchets up the final consequences of the crisis. I have argued against the idea of contagion before, as the problem was not one that might be compared with a contagious disease, but more like a cancer that is destroying from within each country. However, the actions of trying to avert a major crisis are genuinely creating contagion. It was in the early points of the crisis that I suggested that contagion was the wrong metaphor for the problem, but it now seems appropriate. I am genuinely puzzled at what is going on. It just seems that policy-makers must actually see that they are in a hole, but they continue to keep digging it deeper.

It is not as if I am alone in questioning the endless successions of bailouts. Again, it does not take long to find voices expressing concern. What on earth do those who are enacting the policies think the end of the game might look like? Do they really believe that, for example, that one year from now that the Euro crisis will have ended, that sovereign debt problems will have disappeared, and that Europe will be on the road to economic recovery? They must, surely, have some kind of belief that this will be the case, and this must be why they continue to try to 'solve' the crisis? However, if they were to stop digging their hole for just a moment, the absurdity of this idea becomes apparent.

The crisis is getting ever larger, not diminishing. The fact that the ratings agencies are downgrading is just a belated indication of the reality of the situation, and just highlights exactly how bad things have become. When such clueless organisations have finally accepted the depth of the crisis, then it must be very, very bad indeed.

Note: A longer post than intended...


Just after I completed the post, I found this in the Telegraph:

Use of the European Central Bank's three-year funding programme is expected to exceed €500bn in February when lenders are offered their second chance to access its new long-term refinancing operation (LTRO), according to Credit Suisse.
Last month, banks borrowed a total of €489bn using the LTRO, which has effectively seen the ECB take on the role of providing a large part of the funding required by several eurozone banks.
Analysts at Credit Suisse point out the ECB's willingness to provide an increasing proportion of the short and longer-term funding required by eurozone banks has led to a widening gap in the size of its balance sheet versus those of the Bank of England and the US Federal Reserve.
The ECB's balance sheet has risen in size to close to 30pc of eurozone GDP from just over 20pc before it launched the LTRO. By comparison, the Bank and Fed's balance sheets are both worth just under 20pc of domestic GDP.

And later:

The ECB's decision to increase its exposure to banks has effectively seen it provide the "bazooka" markets had been urging it to use to help stem the debt crisis.
Spanish banks that borrowed money using the LTRO are thought to have used most of it to buy Spanish government debt, leading to a lowering in yields.
Interesting, is it not? It still does not discuss the problem of the downgrades for the bank balance sheets, but it is there in the subtext. I still suspect my Google News search was looking for the wrong key words, so if anyone has seen an article on the effect of the downgrades on bank balance sheets, a link would be welcome.