Relevant and even prescient commentary on news, politics and the economy.

It’s pretty obvious how China can achieve its top economic priority of price stability

Premier Wen Jiabao made stabilizing prices China’s top economic priority for 2011. Amid the surge in world energy costs, this story didn’t make the front page. However, Chinese policymakers did take their time spent out of the limelight to allow the Chinese yuan to appreciate roughly 0.3% against the US dollar.

Chinese inflation is elevated and near 5% (4.9% is the official rate as of January 2011). I understand that China’s growth adjustment will take time; but if you’ve got unwanted inflation, then domestic policy is too loose (fiscal or monetary). And in this case, it’s the monetary policy that’s too loose – that goes for both currency and rates policies.

On the rates front: there’s a very frothy feel in domestic asset markets, specifically the property market. Low rates and easy money have sparked a(nother) property boom in China, one that policymakers are trying to tamp down. The Economist published a recent article to the point.

But it’s going to take much, much more than raising down payments and reserve requirements to shore up demand for risk assets. I mean, it really doesn’t take a genius to see that real rates are entirely too low. What’s the investment strategy here: nominal GDP is expected to grow at a 11% in 2011 (according to Economic Intelligence Unit, no link), while the lending rate is just 6.06%. There’s no rocket science here: money’s entirely too easy and inflationary pressures are there.

Furthermore, deposit rates are too low and capping domestic consumer demand. Rates need to rise.


On the currency front. Although there’s been some appreciation in the nominal currency, the yuan, Chinese policymakers only recently allowed their currency to fluctuate at all (again) on an annual basis (see chart below). Notice how the annual appreciation was near 0% spanning Q3 2009 to Q4 2010 (October). Since the central bank doesn’t fully sterilize the inflows of foreign currency from export sales, the depressed nominal rate on the yuan feeds through to the economy via inflation.


Inflation is rising, which is perking up the Chinese real exchange rate. In January 2011, the trade-weighted real effective exchange rate appreciated at a 4% annual rate (according to the JP Morgan Index). The real exchange rate takes into account the nominal rate plus shifts in the purchasing power of the domestic currency, as measured by relative price fluctuations.

The chart illustrates that the nominal exchange rate is now gaining traction on an annual basis, since the Chinese government halted its movement against the USD in 2009. I suspect that the nominal momentum will continue to grind upward throughout this year in order to temper some of the inflationary impetus coming from outside its borders (like Fed policy). But as I said before, it’s Chinese policy that’s too loose at home.

The problem is, that Chinese policymakers want to rein in accommodative policy without raising rates too much because they don’t want the currency to appreciate markedly and are unable to fully sterilize all the flows. Inflation results.

If Chinese policymakers question how to achieve their top economic priority, price stability, then the answer to this self-induced problem is pretty obvious: significantly raise rates and the value of the currency.

Rebecca Wilder

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According to the Setser Test, it’s unlikely that China reduced its Treasury holdings in November

According to the Treasury International Capital System (TIC) release, foreigners were net buyers of US securities in November, +$39 billion over the month. Of the $61.7 billion in long-term Treasuries net purchased (notes and bonds), private investors claimed $50.6, while official investors (central banks, sovereign wealth funds, etc.) accrued a smaller $11.1 billion. Over the last twelve months, foreign investors amassed $571 billion of the high-quality US securities: Treasury notes and bonds, agencies, and stocks, which includes the -$12 billion net sale of corporate bonds. Overall, it was a reasonably positive report, indicating that long-term asset sales are roughly in line with the current account deficit (chart to the upper left).

But the pundits follow the table on major foreign holders of US Treasuries. They note that the number 1 holder, China, reduced its holdings of Treasuries in November from just over $900 billion to just under. For some reason, investors and critics of the deficit alike are worried that when China is no longer named the US’ biggest stockpiler of Treasury securities, Treasury rates will skyrocket. Oh, the bond vigilantes.

And this is when I really miss Brad Setser’s commentary (he is now at the National Economic Council). He noted time and time again, that the monthly TIC data tend to under-report the Chinese holdings, especially when they are shifting their portfolio holdings of US Treasuries up the curve. Well, that’s what the Chinese did in November: holdings of US Tbills dropped $21 billion, while longer-term note holdings increased a net $9.9 billion. (more after the jump)

According to Brad Setser, only in the annual survey of US portfolio holdings are China’s measured holdings of US Treasuries accurate:

This is actually a well established pattern. The past five surveys of foreign portfolio investment in the US have all revised China’s long-term Treasury holdings up (in some cases quite significantly) even as they revised the UK’s holdings down. The following graph shows the gap between Chinese long-term Treasury purchases in the TIC data and China’s actual purchases of long-term Treasuries– as revealed in the survey.

Brad Setser’s quote was from 2009, but the story hasn’t changed since. In the 2010 report for 2009 foreign holdings, the level of Chinese Treasury holdings was revised up from the TIC-implied level by near $140 billion, while that of the UK was revised down (by over 100 billion, I might add). Clockwork.

So let’s apply Brad’s test, I’ll call it the Setser Test, to see if China actually reduced US Treasury holdings in November, as the November TIC release suggests. (I highlighted Brad’s test in bold italics, RW is me). The test is listed in the middle of this post.

Brad: First, the TIC data should show a fall in China’s holdings, i.e. net sales of Treasuries.

RW: Yes.

Second, the TIC data should also show limited purchases of Treasuries through the UK.

RW: No. The UK bought near $25 billion in Treasury notes and bonds, which more than offset the drop in Chinese Treasury buying. In fact, if the TIC data is accurate, the UK is amassing a rather large stockpile of US Treasuries. This would be in sharp contrast with the average $48 billion balance of Treasury holdings since 2006 (Table 4 or 5 depending on the year)!

Third, the Fed’s custodial holdings should not be rising at a strong clip — as, given China’s size, it is hard to see how China doesn’t make up a large fraction of all custodial holdings.

RW: The Fed’s custodial holdings increased by a sizable $39 billion. More likely than not, this was due in part to Chinese activity.

So according to the Setser Test, it’s very unlikely that China reduced its Treasury holdings in November. In fact they probably increased their Treasury holdings, given the magnitude of the Fed’s custodial balance.

Rebecca Wilder

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Confusions and policies…let’s keep the players in mind all around

Chinese Confusions
by Paul Krugman

These days, China seems to play the same role in much of our discourse that Japan did two decades ago. We look at our own follies — which are immense — and then look at the Chinese, and ascribe to them all the virtues of foresight and determination we lack.

But just like the Japanese, the Chinese are human, and their policy makers are subject to the same kinds of confusion and inability to make hard choices that are part of the human condition. And Chinese macroeconomic policy is in the process of becoming a cautionary tale.

Basic economics says that by deciding to keep the renminbi undervalued, the Chinese put themselves under inflationary pressure; and sure enough, inflation is rapidly becoming a serious problem.

But political considerations seem to be ruling out all the reasonable responses. They won’t revalue, because that would hurt politically influential exporters. They’re reluctant to raise interest rates, because that would hurt politically influential real estate developers. They’re trying to impose quantitative limits on credit, but are finding that borrowers have enough influence to circumvent the limits. And now they’re trying price controls — which will inevitably come apart at the seams unless they do something about the underlying pressures.

It’s an edifying spectacle.

Now, schadenfreude should not lead to any complaceny on our part; China may be corrupt and unable to make sensible short-run choices, but in terms of fundamental inability to deal with long-term problems, we still have them beat hands down. Still, it’s worth remembering that all giants have feet of clay.

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China’s competitive devaluation

China took the world by surprise on Tuesday by raising bank lending and deposit rates for the first time since 2007. The story is, that restrictive monetary policy (i.e., raising rates) is needed to curb excessive lending, with an eye on mitigating inflation pressures. See this Bloomberg article to the point.

While restrictive monetary policy is needed, raising rates is not the only tool available to policy makers: China could allow their currency (CNY) to appreciate. With support from the fiscal sector, a broad CNY appreciation would improve prospects for global growth ex China via import demand. Instead, the higher domestic rates may crimp domestic demand, perhaps reducing inflation, but contemporaneously lowering import demand.

In my view, China’s move yesterday should be viewed as competitive devaluation: reducing domestic prices in order to capture a competive edge. The currency war, as so-called by Brazil’s finance minister, Guido Mantega, is afoot; and China just confirmed its participation.

Textbook economics says that a central bank cannot have it all: independent monetary policy, a fixed exchange rate, and open financial markets (the impossible trinity). China has a fixed exchange rate (currently, it’s effectively pegged to the USD, see chart below) with tightly monitored capital markets. This means that the Chinese economy effectively matches the “easy monetary conditions” of its counterpart, the US. Monetary policy in China is too loose.

Going forward, further accommodative monetary policy in the US will likewise loosen policy further in China; inflation pressures will be even more robust. But, large-scale asset purchases on the part of the Fed will likewise weaken the USD, which is positive for US exports and negative for US import demand.

All in all, policy makers in China are looking at the USD move with tunnel vision. If the CNY maintians its current trajectory (effectively flat), then any shift in relative prices based on the recent (or future) rate hikes will reduce the CNY real exchange rate (all else equal, of course) – that’s competitive domestic devaluation.

The table has already been set.

Chinese policy makers have slowed the nominal appreciation. Think about what could be if the CNY had maintained its 2005-2008 trajectory, where the CNY appreciated against the USD nearly 20%. Using the compounded annual growth rate (CAGR) over the same period, where the CNY gained 0.5% on a monthly basis against the USD, the month-end September CNY would be valued 11% higher against the USD than it is now.


They slowed real appreciation, too. The real appreciation of the CNY against its trading partners – the real exchange rate accounts for both nominal appreciation and price differentials across countries – slowed from an average 0.4% monthly gain spanning the period 2005-2008, as measured by the CAGR, to just 0.05% since then. (I use the JPMorgan real exchange rate index, but the BIS makes similar data available free of charge.)

The Chinese authorities are fully aware of the economic value of external demand (exports). The media will say that China’s trying to “cool” domestic inflation by raising domestic bank rates; but that’s not the full story. In my view, what they’re really trying to do is to “cool” domestic inflation in order to shift relative prices and depreciate the real exchange rate, all to gain a competitive advantage in global goods markets.

Rebecca Wilder

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A Conversation with George Soros

With thanks to Felix Salmon for arranging the invitation.

There’s an episode of House where he has to get rid of one of the people for his new team.  By the end of the episode, the sharpest person in the group has said everything that we would have expected to hear from House—and is therefore summarily dismissed, since hearing one’s own opinions being spoken by someone else is less useful than being challenged.

I had a similar feeling with George Soros’s conversation last Wednesday morning with Chrystia Freeland, sponsored by Reuters and held in the NASDAQ building that, er, graces Times Square. So what follows isn’t everything Soros said so much as what he said that either (1) you wouldn’t already know from reading this blog or Paul Krugman or (2) added details or touched on an interesting issue.

UPDATE: Krugman finds another similarity between himself and Mr. Soros.

The Recent Crisis and Its Causes

Soros declares that there was twenty-five to thirty (25-30) years of a “Super Bubble,” which has now burst.  It seems from the discussion that Soros believes the SuperBubble was worldwide.  Recovery is being hindered by some policies—Germany’s talk about austerity was especially mentioned—by Soros sees strong hope in the Trade Shift that has accompanied the crisis. He noted that the “global economy is a lot better than the US economy,” and that he expects to see it continue growing even if the U.S. (or Europe, due to the German leadership, or even both) fall into a :double-dip.” (In this he is arguably more of an optimist than many.)

China I

Key to this shift has been the growth of bilateral relationships.  He noted obliquely that these developed in part because many governments—most especially the Chinese, who have been “the great beneficiary of globalization”—do not want to change their capital controls, but sees them as facilitating the new paradigm. He expects that the next move will be that Hong Kong (with the HKD remaining independent of the RMB) will become as London did in the 1960s and 1970s, the intermediary of choice for the growing market (now China, then Europe).

There is a strong need to increase Chinese domestic demand, which he rightly expects is being partially facilitated by the recent wage increases. While there is a need to shift from the previous US-Chinese symbiotic relationship (essentially, bonds for exports), Mr. Soros is “not sure there will be” further advancement in that relationship without greater domestic Chinese consumption. He declared that the Chinese economy has become “the motor” of the world economy, but also noted that it is a smaller motor, so the world economy is not moving so fast.

Currencies

In that context, he was asked by a gentleman from Fidelity Capital if it is time to move from the USD to a “basket” as the World Reserve Currency. (As regular readers know, this is an issue near and dear to my heart.) Stating the obvious, Soros noted that having “a more neutral currency” (which may not be an exact quote) would be helpful in correcting the imbalances, which are largely due to the dollar being the International Reserve Currency. He agreed that a basket Reserve Currency would improve the market. (I—and I suspect David Beckworth—might agree that it would provide for easier remedies, but I’m not convinced it would provide for a better market, since arbitrage opportunities and issues of asymmetric information would be more likely to skew outcomes.)

China II

Soros is very sympathetic to the Chinese people themselves.  He notes that they work hard but that their labor is harnessed to an undervalued currency to the benefit of the State. He described the Chinese mercantile system as being “State Capitalism,” which he calls a “very powerful” model, while also noting that it is not so good as the previous “International Capitalism.” Since he noted that “International Capitalism”; is synonymous with “the Washington Consensus,” this leaves him having damned China with very faint praise.  (Though, in fairness, he is even more negative about Russia, which he described to Jim Holt as an example of unsuccessful State Capitalism, whose success or failure is primarily driven by the price of oil. He also sees a real possibility of China developing into an Open Society—another point on which he is rather an optimist.)

Where he is not positive about China is its Real Estate market, which is skewed in part due to the political structure. The Chinese version of mercantilism allows government officials to own three (3) properties, which has been a very good way for those workers to get rich through selling and “trading up.”  The primary solution to this bubble, he believes, would be initiating a property tax, which would produce a carrying cost on properties and therefore mitigate the speculative aspects of the bubble. (Soros essentially notes that, as with the United States, labor is overtaxed and capital undertaxed in China.  Since China has excess productive labor, the benefits flow to the state.  Implicitly, the U.S.’s excess produced the differential model discussed above, which worked well for both parties for some fifteen (15) years.)

But all is not  bread and roses in Soros’s view of China.  An Indian journalist sitting next to me asked the obvious question: Has being a democratic country “hamstrung” India as compared to China? Soros came back to his key theme of the need for growth in Chinese domestic demand, noting that the Indian economy is more stable precisely because there is now domestic growth—growth that will be facilitated in China only as that State evolves both politically and economically. He noted that the Chinese people, to date, have been willing to accept limits on their individual freedom for its benefit in growth, but he does not see other countries being willing to accept such limits on their own freedom to support China’s growth.  If I ever had any doubt that Soros is a more devoted Popperian than I, it was eliminated in that moment.

Other Powers, and Some That Might Be

Soros spoke positively of Turkey (Dani Rodrik may have a counterpoint), negatively of Germany (from a policy perspective; when asked by a reporter from Crain’s what we will look back on and see as stupid, he replied that “fiscal rectitude, from a timing point of view, is wrong.”), and generally positively of the Euro, declaring in response to a question about Ireland and Greece that “If anybody would leave [the Eurozone] it would be Germany.”

His key point about the Euro is one that is often found in the literature of financial crises, including the previous Great Depression: there is a European Central Bank, but there is not a central Treasury. But this appears to be de facto being remedied by the Solvency Crisis, with “back-up funds” being developed and used.  Soros noted a key distinction that is often missed in discussions: there was not a crisis of the EUR, but rather a European banking crisis, which was exacerbated by policy disagreements between France and Germany. (Germany won, though his view of whether this victory will be relatively Pyrrhic is left as an exercise.)

Again, he looks to the Chinese as an indicator, who started putting their money—you know, that 4 Trillion RMB stimulus and the revenues that have followed it—into the EUR as soon as it reached around 1.20.  The Chinese bought the EUR, the Chinese bought Spanish bonds, the Chinese stabilized the market.  The Chinese did something no one else can do for them—bought another currency on the open market.

And this is the key to understanding Soros’s attitude toward Japan. You think this is easy, realism? The Japanese are correct to worry about their currency, Soros notes, because, while the RMB is the strongest currency in the world, you cannot own it because of capital controls that the Chinese government maintains because they do not want to have both rising wages and an appreciating currency in their export-based economy. Accordingly, per Soros, any appreciation of the RMB “has to be done in an orderly manner.” In the meantime, the Japanese did the only thing they could.

U.S. Politics

Mr. Soros was by no means a fan of the Obama Administration. Echoing Glenn Greenwald, he notes that the Obama Administration should have corrected the excesses, the abuse of power, of the Bush Administration. Despite this (and what follows), Soros believes Obama “may well be elected to a second term.”

As a matter of handling the banks through the crisis, Mr. Soros noted that the Administration should have injected Equity into the banks, but notes that he believes the Obama team found this politically unacceptable. The result is that the government effectively nationalized the banks’s liabilities and “allowed” them to “earn their way out of that hole,” through practices such as increasing consumer credit card rates.

(My memory of the events is somewhat different, since part of what the Fed received for its TARP funds were warrants on those banks—warrants that have subsequently been sold and counted as if the revenue against the original loans to make them appear more “profitable” in the eyes of several bloggers and financial journalists [including, for instance, Robert]. But certainly there was no AIG-like structure imposed, no U.S. equivalent of Northern Rock, no matter how much saner than would have been.) 

To no one’s great surprise, Mr. Soros does not believe that Mr. Obama is “anti-business.”

The biggest fault he found with the Administration’s approach to the crisis is that they depended on the “confidence multiplier” to make recession shallower and shorter than it otherwise would have been. The problem with a confidence multiplier is, of course, that when the results do not match the expectations, the “multiplier” becomes a disappointment, and therefore a drag on expectations going forward. Mr. Soros described this as what happened.

If this scenario is true, then the decision not to ask initially for a $1.2T stimulus, with a chance to end up with a better mix and higher absolute amount of actual stimulus funding, will go down as the tombstone for the Administration, not “just” a spanner in the possible continuation of the Administration’s economic team (h/t Mark Thoma on Twitter).  But, hey, the recession has been over for more than a year, so things are getting better, with the upcoming elections more resembling the signpost of 1982 than 1932.  At least in some timestream.

Gold

This one was pulled all over the place, so it should come as no surprise.  Gold is, per Mr. Soros, the only active “bull market” right now.  He is also not optimistic about the ending of that market. Gold is “the ultimate bubble”—may be going higher, but is certainly not safe and is not going to be forever.

Mr. Soros admits a similar attitude toward oil, but at least there the commodity has intrinsic value. As Vincent Fernando, CFA, notes, owning something other than gold at least gives you the possibility of “productive assets.”

Conclusion

I’ve left out a few things, including the roundelay that resulted when one journalist attempted to discuss Mr. Soros’s firm’s holdings in a company he said he didn’t the firm owns. But in general the feeling one gets when presented by Mr. Soros the person is that he is an optimist, perhaps incurably so. Things are rough, and they will probably continue to be rough for a while, but in the longer term, things are getting better for all.

I’m guessing he won’t be speaking at The March to Keep Fear Alive.  But Mr. Colbert—let alone his predecessor at the Washington Monument—would do well to book him as a guest.

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China and use of coal

Reader benamery 21 comments on US energy consumption from a previous post at Angry Bear on a better picture of what drives energy consumption in China. The NYT article used air conditioning and shopping malls as one metaphor for the good life that the Chinese are striving for, but he would advise caution for those wanting to Americanize our image of China at least in the short term (decades).

Residential air conditioning is only 2.8% of U.S. energy consumption (including electrical system losses at 31.5% system efficiency), and the average occupied square feet is a LOT bigger than a Chinese apartment. A/C isn’t the U.S. energy monster, that’s the private automobile. A/C uses less energy than residential space heating (5%) or water heating (3.0%) or appliance use (9.4%). It takes on importance from an energy perspective because it drives electricity PEAK demand (not total energy consumption) in large parts of the country.

A look at another lifting from comments by sparaxis at Oildrum from China Energy Group at Lawrence Berkeley National Laboratory.

It’s useful to look at how coal is used in China to assess what future demand may look like. Unlike the US, less than half of China’s coal is used for power generation, so while important, electricity demand is not the sole driver of coal demand.
China uses almost half as much coal for coking to drive its huge iron & steel industry, so that portion of demand will depend on the outlook for steel, half of which is now used in buildings and infrastructure.
Also unlike the US, China devotes a lot of coal use to district heating (“other transformation” in the graph) in the northern cold climate zones, and that portion is expected to grow only modestly as building reforms increase the efficiency of heat use in buildings.
For direct end-use of coal, that is almost all in industry, particularly the cement industry (residential use has fallen to about 80 million tonnes).
Given many saturation effects driving both construction and end-use of electricity by 2020, we don’t see coal continuing its dramatic rise of the last few years. 2010 probably marks the peak of cement production.
Under a depletion curve defined by China’s declared 189 billion tonnes of reserves from the 2003-2005 National Resource Survey, China is currently on what I call a “sharp peak” production profile that could reach 3.6 to 3.8 billion tonnes, but not for long.
The units in the following graph are in China’s standard measurement of “tonnes of coal equivalent” where 1 tce = 1.37 tonnes raw coal.


China Energy Group at Lawrence Berkeley National Laboratory

Other publications include:

The China Energy Primer

China’s Coal: Demand, Constraints and Externalities

Energy Use in China: Sectoral Trends and Future Outlook

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Increasing internal demand in China for goods needs more thoughtful analysis

A shift to more internal demand for China might not benefit the US in ways we think it will. One such area is the impact of increased demand for resources and energy. And another is where the jobs are.

China Puts Up More Money to Build Solar Capacity

The government-owned China Development Bank has just made its third massive loan to one of the country’s solar energy makers, bringing its total commitment about $17 billion. The combined size of the loans is large enough to allow China to double the global manufacturing capability for solar wafers and cells. The latest recipient of the government’s largess is Yingli Green Energy Holding Co. Ltd. (NYSE:YGE), which today announced that had received an aggregate line of credit from the China Development Bank worth about $5.3 billion. In April, Suntech Power Holdings (NYSE:STP) and Trina Solar Ltd. (NYSE:TSL) received loans of $7.3 billion and $4.4 billion, respectively.

The NYT points to energy use, efficiency, and China (Rdan…the emphasis is on global warming but needn’t be):

Already, in the last three years, China has shut down more than a thousand older coal-fired power plants that used technology of the sort still common in the United States. China has also surpassed the rest of the world as the biggest investor in wind turbines and other clean energy technology. And it has dictated tough new energy standards for lighting and gas mileage for cars.

But even as Beijing imposes the world’s most rigorous national energy campaign, the effort is being overwhelmed by the billionfold demands of Chinese consumers.

Aspiring to a more Western standard of living, in many cases with the government’s encouragement, China’s population, 1.3 billion strong, is clamoring for more and bigger cars, for electricity-dependent home appliances and for more creature comforts like air-conditioned shopping malls.

Chinese cars get 40 percent better gas mileage on average than American cars because they tend to be much smaller and have weaker engines. And China is drafting regulations that would require cars within each size category to improve their mileage by 18 percent over the next five years. But China’s auto market soared 48 percent in 2009, surpassing the American market for the first time, and car sales are rising almost as rapidly again this year.

An older generation of low-wage migrant workers accepted hot dormitories and factories with barely a fan to keep them cool, one of many reasons Chinese emissions per person are still a third of American emissions per person. Besides higher pay, young Chinese are now demanding their own 100-square-foot studio apartments, with air-conditioning at home and in factories. Indeed, one of the demands by workers who went on strike in May at a Honda transmission factory in Foshan was that the air-conditioning thermostats be set lower. [Rdan…the mandate is 79 degrees F.]

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Chinese Yuan


The economic headline this morning is that China has agreed to allow the yuan to appreciate.

The announcement is being credited with about a 1% higher opening for the stock market and numerous pundits are claiming this will make a significant difference.

But this has happened before and it had little impact. From 2004 to 2007 the yuan appreciated some 20%. But the net impact was about a 1% rise in the price index for US imports from China and essentially no impact on the US trade deficit with China.So why should anyone expect a different reaction this time?


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China’s not the answer for the Eurozone

by Rebecca

“Go long whatever Chinese consumers buy and go short Chinese capital spending (construction) plays. Consistently, go long tech/short material stocks.”

That is the first sentence of a BCA Research report’s executive summary on China equity strategy (link not available). Rather than a global equity strategy, I’d like to put this into an economic growth context via trade…and with Europe.

Go long Eurozone economies selling to China? Is China the panacea for Eurozone growth? Short answer is no, but we’ll attend to that later. Even if the euro wasn’t selling off against the majors, China’s domestic demand is robust and export income is flowing into the Eurozone – but to where?

The chart below illustrates the dynamics of annual export growth to China for the top 6 countries of the Eurozone measured by GDP in 2009: Germany, France, Italy, Spain, Netherlands, and Belgium. Presumably, the bulk of China’s export demand would flow to these countries.

Since the Eurozone’s annual export growth to China bottomed out in May 2009, many of the Eurozone economies (some not shown in chart) have registered, on average, double-digit monthly export growth to China: Belgium 49% Y/Y, Germany 25%, Spain 16%, Greece 19%, Ireland 22%, Netherlands 39%, and Portugal 49%. Only Finland saw its monthly average export income drop over the same period, -10% Y/Y.

(A note of clarification: the statistics in the chart are monthly Y/Y growth rates, while the statistics in the paragraph above represent the average monthly Y/Y growth rate spanning the period May 2009 to March 2010. All of this data can be downloaded from Eurostat, EU27 Trade since 1995 by CN8).

But 75% of the Eurozone’s exports to China flow from just three countries: Germany, 54%, France, 11%, and Italy 10% (average Jan 2009 – Feb 2010 and see table below). This makes sense, given that Germany, France, and Italy are the three largest countries in the Eurozone.

However, compared to the size of their economies, Belgium and Germany are the true beneficiaries of China’s external demand, not Spain, France, nor Italy. And this trade data is truncated before the record decline of the euro.

The table above relates each country’s share of total Eurozone exports to China to its share of Eurozone GDP. I’d say that Belgium is doing quite well compared to its larger neighbors, +2.5% spread on a 3.8% share base. But Germany’s out of this world, 26.9% spread on a 26.8% share base. Spain, France, and Italy are faring poorly, as their spreads are wide and negative.

China appears to be the panacea for just a handful of countries, most notably Germany and Belgium. But alas, it’s no panacea for the Eurozone, not even for Germany. Unfortunately, the Eurozone’s fragile developed colleagues, the US and UK, are.


The shares illustrated in the chart are calculated for year 2009.

Markets anxiously await China’s every move; but according to the April 2010 IMF World Economic Outlook, China ran the largest current account surplus across the IMF member countries – $284 bn in 2008 – the 20th largest as a share of GDP. That kind of saving is NOT going to get the global economy back on its feet in full very quickly. China is not the answer for Europe.

The Eurozone, in particular, is paying close attention to non-Eurozone (16 countries adopted the euro as their currency) growth alternatives. I leave you with an excerpt from a nice FT article on Europe’s true woes – fiscal austerity measures – featuring the research of Wynne Godley and Rob Parenteau:

Many years ago, he [Wynne Godley] also criticised the institutional arrangements of the European Monetary Union. Writing in The Observer in August 1997, he noted that members of the eurozone were not only giving up their currencies but also their fiscal freedom. Within the union, a government could no longer draw cheques on its own central bank but must borrow in the open market. “This may prove excessively expensive or even impossible,” he warned.

He went on to caution that without a common European budget, there was a danger that “the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression that it is powerless to lift”.

China is not the answer: not for Europe; not for the US; and not for the UK.

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Get ready for a little EM inflation

Today I was thinking about tightening cycles in emerging markets; and more specifically, about that in China. Because let’s face it, China matters. China matters to the rest of Asia via competition for export income. China matters to Europe via competition for jobs. China matters to Brazil via domestic production via imports. China matters.

The inflation pressures are building in key emerging economies, especially in the BIICs (Brazil, India, Indonesia, and China) – see this previous post regarding my new acronym, and this article at the Curious Capitalist (curiously posted just shortly after my post), which leaves my omitted “R” but relays the intuition behind the second “I”.

Although the inflation is not prevalent in any BIIC except India, really, I wanted to comment about why it will build…quickly.

First round, the construction of consumer prices is heavily weighted toward food and energy costs across the BIICs. Indonesia, India, and China are highly susceptible to food price shocks (either driven by shortages or demand growth). Expect this as a first-round driver of inflation as the global economy recovers further. It’s already happening.

Second round, the BIICs are growing quickly and nearing, or are already at, potential. Annual industrial production growth has recovered or surpassed its pre-crisis rate in China, Brazil, and India, 19%, 16%, and 17%, respectively. This is expected, given the drop-off in world trade (an illustration can be found from this May 2009 pos), but unsustainable as the output gap closes.

Third round, interest rate differentials. This year, the BIICs’ central banks are expected to raise policy rates. In fact, Brazil, China, and India have already boosted reserve requirements. But with US rates expected to stay low for an “extended period”, international interest rate differentials will change and monetary flows will shift. Capital inflows can lead to inflation if not properly sterilized.

To date, inflows are not properly sterilized, as evidenced by the ongoing accumulation of reserves and rising money supply growth (again, I refer you to my previous post on M1 growth rates.

The chart above illustrates the one-year-ahead nominal interest-rate differential between the 2yr forward government rate for each respective BIIC country versus the 2 yr forward US Treasury rate. The forward differentials for China and India are on a steady upward trajectory, while those for Brazil and Indonesia are simply steady. I believe that this appropriately represents the sterilization efforts and monetary policy management on the part of the BIICs’ central banks: more managed in Brazil and Indonesia, not as much in China and India.

So where does this analysis leave us? With a very interesting policy mix in the emerging market space. In fact, in my view this is the riskiest part of the emerging market cycle: the recovery. If policymakers get this wrong, we could see a lot of price action, final goods and assets alike, on the horizon.

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