19th October 2014
This blog is a sort of exhale after the market mayhem that began just over a week ago – though in fact the downswing began in mid-September – followed by an intriguing idea proposed by friend and former colleague, Jon Anderson, who runs Emerging Advisors Group. Although he is ‘subscriber only’, he’s given me permission to summarise his notion that China’s credit boom amounts to nothing short of stealing with some limited implications for the economy, but bigger ones for banks.
Market mayhem globally
After all the brouhaha in markets, it’s a chilling thought that after several days of significant declines, you’d have been better off in bonds this year than in stocks. This wasn’t in the script at all. According to Morningstar’s index returns year-to-date as of 17th October, you’d have preserved your capital in short-term government or corporate bonds, but made over 5% in mortgage bonds or inflation-protected bonds, and between 12-15% in long-term corporate or government bonds. If you have been in equities, you’re now losing money year-to-date on almost every market index. The only stand-outs with good, double-digit returns have been China’s Shanghai Composite, after a being a dog for so long, and India’s Sensex. You would be up if your managers had been long Indonesia, and the Philippines, and frontier markets such as Egypt and Pakistan.
But the chances are that most of us are out of pocket, clutching the comforting narrative that the last few days of mayhem were an ‘overdue correction’. Most equity markets, after all, haven’t experienced a meaningful correction since July 2011. I’m not sure how comfortable we should feel. For starters, this correction could go on. But whether it does or doesn’t, we’ve been warned…
Central bankers to the rescue
True, markets ended on a cheerier note on Friday, and the price action was quite revealing as traders focused on a couple of significant verbal interventions by central bankers. On Thursday, in the US, James Bullard, the Chief Executive of the Federal Reserve Bank of St Louis Federal told Bloomberg TV that the Fed should continue to buy assets for the time being, that is, to not end QE this month, www.valuewalk.com/2014/10/james-bullard-fed-consider-delaying-end-qe/. Instead, in the face of falling inflation expectations, the Fed should wait and see and defer a decision to end QE at its December meeting.
Here in the UK, on Friday, the Bank of England posted a speech up on its website by Chief Economist, Andy Haldane, known as the Twin Peaks speech. You can read it here: http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech764.pdf. In fact you should read it because there’s a lot of very interesting material in it about why the UK economic recovery is both encouraging and deeply disappointing. Reasons to be despondent focus largely on the continuing dysfunctional state of the labour market that you see in many areas except the headline rates of unemployment and employment. But Andy Haldane hit the headlines for saying that ‘the mark-down in global growth, heightened geo-political and financial risks and the weak pipeline of inflationary pressures from wages internally and commodity prices externally’ implied that interest rates could ‘remain lower for longer’ than he expected three months ago.
Equity and other risk markets, of course, drool at the hints and suggestions of central banks persisting with zero rate policies, even if QE itself is no longer the major driver in the US and UK. Meanwhile, the ECB is still being egged on in financial markets, so to speak, to go beyond its private asset purchase programme to full-blown sovereign QE, despite the fact that bond yields in most of Europe are already in the basement.
The D word
With CPI inflation hovering around 1.6% in the US in September, falling to 1.2% in the UK, and slumping to 0.3% in the Eurozone, the major concern has been about the risk of deflation. Most think this is principally a Eurozone issue, since a) several countries are already experiencing an outright decline in the price level, and most of the rest are a smidgeon away and b) the Eurozone typifies the standard description of deflation as a chronic deficiency in aggregate demand.
In the US and UK, outright deflation looks unlikely at the moment. In the US, for example, food, housing and medical care costs are rising at around 2-2.5%, education and communication costs are rising at about 1.5%, but clothing, transportation, recreation, energy and commodity costs are falling by around 1% compared with a year ago – and the full impact of falling energy prices has yet to work its way through. In the UK, the ONS advises that prices for housing and household services (including rents and utility bills) have been ‘the main contributor to the rate of inflation for almost two years and currently account for a third of the rate’. Without these, the rate of inflation would have been 0.8%, rather than 1.2%. So, ‘unlikely’ deflation seems alright so long as the economic growth can be sustained, and importantly, if we assume that wages and salaries will start to rise, sooner or later.
But the lack of income formation, aka wages and salaries, is a serious weakness, and not just in the US and UK. Some central bankers and economists persist with the belief that the tightness of the labour market, evidenced by headline employment and unemployment numbers, will soon give way to rising wages and salaries, necessitating an early, if not immediate, rise in interest rates. In other words, spare capacity is steadily being eroded, they say, and the best time to contain the inflationary implications is before they appear.
The trouble is that this reasoning has been around for a while, shows few if any signs of being validated, and ignores crucial structural shifts taking place in the demand for and supply of workers with different levels of skill and education, courtesy of advanced technologies, robotics and automation. At the top end of the skill spectrum, if anything there’s excess demand and no problem with income formation. At the bottom end, opposite conditions prevail, aided and abetted by the supply of workers falling out of the squeeze on middle-wage-paying occupations and functions.
So, whether the risk of system-wide deflation grows or not, with all the risks this poses to debt sustainability and equity and risk asset valuations, hinges on whether we can keep growth going at a reasonable clip. And this is most likely why the IMF’s World Economic Outlook, released two weeks ago sparked such alarm. On one level, the IMF and many private forecasters are fairly comfortable with the US and the UK economic performance prospects, hopeful about Japan’s, not overtly concerned about a China still growing at 7%, and still optimistic that emerging markets can contribute significantly to global growth.
But the WEO’s subtitle was ‘Legacies, Clouds, Uncertainties’. It worries about the consequences of an eventual change in the US monetary regime (the Fed starts to raise policy rates), low trend growth in developed economies (investment and labour market hysteresis), high probabilities of a Euro-Area recession and deflation, declining trend growth in emerging markets (lack of reform), and a dark side to China’s economic transition (growth slump).
The IMF baseline forecasts, like those of most private sector forecasters, governments and central banks, openly acknowledge past errors but are predicated on the view that if we just wait long enough, we will return to equilibrium. But what if there is no equilibrium? What if the long-awaited improvements in investment, productivity, wages, inflation and so on simply don’t happen, or happen soon?
Equity markets just had a reminder that they shouldn’t take this return for granted. Central banks might still calm things down from time to time, but it’s also time for them to step aside. Central banks should put pressure on their political masters to pull their proverbial fingers out when it comes to policy-making, demand management, and supply-side reforms, allowing them to restore some kind of normality to the cost of capital and the financial system. If we persist with nothing but the central bank crutch for markets, we should really fear future mayhem.
Credit kleptocracy in China
Among the many things that perplex and intrigue China watchers and thinkers is China’s credit boom, which has already propelled non-financial, largely corporate and local government, to around 250% of GDP, up 100% over a decade. The widest published measure of credit, total social financing, which probably understates credit availability, is slowing down. But at 15% growth in the year to September 2014, it’s still growing not that much less than two times nominal GDP.
Jon Anderson of EM Advisors Group has a fascinating report out (subscriber only) in which he develops a particular theme about the credit boom that leads to the conclusion that enormous amounts of loans have been made to agents and entities that haven’t spent the proceeds. Jon’s best explanation? A massive money laundering scheme in which funds have been, in effect, stolen. He has allowed me to summarise his argument, and, whatever we may think, it’s worth thinking about (some additional comments of mine in italics).
He concludes that the downswing in credit expansion has to be allowed to continue, and probably will, but the impact of unwinding a ‘virtual’ credit boom on the real economy will be limited, while the impact on banks is significant.
The first thing that Jon finds ‘wrong’ about China’s credit boom is that it hasn’t resulted in any of the economic and financial conditions that other EM have experienced. In fact, looking at China against his universe of EM, he finds no strong evidence of overheated domestic demand, a bottom-left-to-top-right construction boom (except in 2009-10), external deficits, a significant rise in non-deposit bank funding, or bubbles in either equity or home prices. There’s no question about the scale of credit expansion, but it’s not obvious where it’s gone. It’s not gone into the broader economy, or into asset markets, hoarding, capital flight, or US dollars.
The next thing he finds odd is that although the liabilities of households, listed companies, and industrial enterprises have gone up as a share of GDP, these ‘normal’ borrowers only account for about a third to two-fifths of the aggregate rise in debt to GDP. The principal recipients, he argues, have been tens of thousands of newly-created LGFVs (local government finance vehicles) and related construction, developer and infrastructure firms, most of which are only 5-6 years old and don’t fall under any normal corporate reporting or regulatory channels. These entities were created for the express purpose of taking on debt to implement, often single project, infrastructure and construction programmes. (Remember that China’s response to the Great Financial Crisis was a stimulus programme of 16% of GDP, predominantly via credit creation).
Now the plot becomes interesting, because while these recipients unquestionably gorged on credit, it isn’t clear what they did with their credit balances. Reported construction activity has soared in relation to GDP, but Jon asserts that he can’t find any evidence that the same surge in intensity applies to cement and steel usage, or electricity, iron ore, copper and aluminium demand. He also says that typical EM credit booms see credit growth outstrip deposit growth by a fair margin as borrowers raise funds abroad and leverage, but in China deposits have kept pace with credit because these same recipients of much of the credit are also responsible for the growth in deposits.
Pulling ends together, the most likely explanation for a boom in reported construction, way in excess of what was actually being built, along with the the biggest borrowers also being the biggest depositors, is embezzlement on a huge scale. (This certainly resonates with President Xi Jinping’s resolute and robust anti-graft campaign, see below). And if you want a high profile example of how this has manifested itself, you could look simply at the case of former security chief, Zhou Yongkang, who is under investigation for corruption. Earlier this year, Chinese media reported that the authorities had seized close to $15bn in assets from 300 of Zhou’s family members and associates, the bulk of which was in the form of deposits and domestic and foreign securities (http://reut.rs/1k97qcL).
So, leaving the politics aside, the bottom line here for investors is equivocal. Since a lot of the credit in the credit boom never went into the real economy in a material fashion, unwinding the credit expansion (as is now happening slowly) should not lead to a major pinch on the downturn in economic growth. Jon also says that the much commented upon credit intensity of investment-fueled GDP should also be reconsidered because investment includes the frenetic and fake construction activity that’s a fiction. Ergo, capital discipline has been better than suggested by the rising capital-output ratio.
(I’m having trouble with this bit: if fake projects are all accounted for in the investment data, then either China’s GDP is also a fiction since the rise in investment didn’t happen as reported, or we shouldn’t have a seen a rise in the intensity of fake projects in relation to GDP. In any event, residential property investment growth has been falling sharply since 2011, bouncing only briefly in the first half of 2012 in response to a stimulus programme. And it is difficult to overlook home price inflation, rising vacancy rates, and significant housing inventory overhang in Tier 2 to Tier 4 cities. Also debt financed infrastructure that is duplicative or uncommercial in terms of returns and debt servicing is fact).
Bottom line, China can carry on growing at a decent clip even while credit growth slows down a lot. But growth will have to slow down to, say 5-6%, we should expect a big shake-out and bankruptcies among the recipients of the credit gorging extending to trust and other non-bank lenders, and banks and other lenders will be left to deal with the consequences of a significant rise in bad debt and NPLs. (We reckon China can manage financial instability better than in the West before the GFC because all the important financial players are state-owned, but it’s asking a lot for this not to permeate the real economy and jobs, or not to result in renewed financial repression, which is the cornerstone of the economic model which China is trying to change. Not good for the rebalancing agenda).
So there you have it… Jon’s virtual credit boom… in a nutshell.
While there are different ways of interpreting the economic data, there is a strong narrative in Jon’s theme that resonates with President Xi’s anti-corruption campaign, which I’ve looked at here: www.georgemagnus.com/chinas-economy-is-bound-up-with-xis-anti-corruption-campaign/ I also recommend a read of a recent op by Minxin Pei, as he considers the scale of theft associated with the construction and infrastructure boom, notes the networks of corruption that have permeated the Party and state, and wonders not so much whether China is changing, but the uncertainty as to how it’s changing mobile.nytimes.com/2014/10/18/opinion/crony-communism-in-china.html?referrer=
There’s no question that President Xi’s leadership has had to focus on endemic corruption as integral to the task of implementing economic reform, and restoring the Party’s legitimacy. But quite where this all leads, and whether it makes successful and durable economic reforms more or less likely is a moot point. The focus on Party purity, anti-graft, anti-democracy, and ‘traditional culture and values’ is a bit of throw-back, and doesn’t sit comfortably with unbridled optimism.