China: Accepting the landing

There is apparently a saying in the UK’s Parachute Regiment that after you have jumped out of the plane you simply have to accept whatever landing you get.

Friday, February 5th 2016, 10:12AM

by Andrew Hunt

While we might hesitate to liken China’s great credit boom of 2009-2014 as being akin to jumping out of a plane – although there certainly was an element of there being a leap into the unknown – it is clear that China’s economy is landing at present. As to whether the landing will be soft or hard, we are minded to side with George Soros’s comments at Davos, “namely I do not so much expect a hard landing in China, I am observing it”. We estimate that China’s industrial complex is in a recession and that, despite 5% or more service sector growth, aggregate GDP growth is currently around 3.5%. Potentially, this rate may go lower in 2016 and this will definitely count as a hard landing for the PRC.

The question for the rest of the world’s policymakers is, of course, what to do about this turn of events – should they merely accept the landing or try to find some form of cushion. Although the press seems certain that something must be done, we are less certain that this is the case. Perhaps the Bank of England should not delay its rate hikes simply because China is slowing, perhaps the FOMC should stay on its tightening course, and perhaps the Reserve Banks of Australia and New Zealand should not ease.

By way of an example, we can recall that just before commodity prices cracked, the Chilean economy was clearly overheating and suffering from a large current account deficit, consequences we believe of the inflationary effects of the large capital inflows that had occurred between 2005 and 2012. However, following the ‘Tapering Tantrum’ of mid-2013, and the first signs of an approaching possible crack in commodity prices, the Chilean authorities took the opportunity offered by the decline in capital inflows to raise interest rates, reduce domestic credit growth and depress domestic demand. In fact, we believe that the authorities correctly identified that the world was changing as China began its first ‘wobbles’ and that as a consequence their export receipts (and therefore national wealth) were about to come under pressure. Therefore they acted so as to oblige their population to alter their own spending behaviours accordingly. Hence, Chile was among the first of the Emerging Markets to suffer a (near) recession but the positive result of this aggressive policy stance was a sharp reduction in the current account deficit that we would argue left the economy better able to ‘cope’ with the commodity price storm that was to follow.

Indeed, the fact that Chile has managed to contain its current account deficit even after a near 20% fall in its export revenues (in USD terms) is an impressive performance. Had the country not done this, but instead attempted to support its level of domestic demand and incomes via countercyclical policy measures (as the financial markets might have wanted...), then not only might its economy have become still more distorted but its current account deficit might well have trebled and the CLP become another crisis currency. Instead, by holding domestic demand flat as exports declined, Chile’s economy has remained relatively stable and the real GDP data has actually been quite creditable over the last year as a result of the decline in the current account deficit.

Nevertheless, many are arguing that if the China Crisis continues to unfold in the way in which we suspect, policymakers in the rest of the world should respond despite Chile’s example. However, we should also note that countercyclical policies only really work by either getting the private sector to borrow “demand power” from their expected future incomes (i.e. by generating domestic credit growth), or by governments borrowing from their future expected tax receipts (i.e. a large budget deficit), or by in effect stealing demand from another country via a currency devaluation.

Unfortunately, in the current weak global trade environment, which has already witnessed too many competitive devaluations, the opportunity to steal market share from other countries would seem to be relatively limited. Certainly, those that have tried this approach have not met with much success. This therefore only really leaves the private or public sector tapping / borrowing of future expected incomes to fund current expenditure route.

However, any conscientious policymaker should only allow anyone to borrow from the future if they believe that future income trends will really be better than current ones (is this one of the factors that is holding back credit growth in Japan currently?) but if China and North Asia’s problems are likely to be long-lived, as we believe that they will be, then we must ask whether global real income trends will be better in the future? Given that China probably accounted for more than a third of global growth between 2009-2013, if China does enter into another post devaluation 5-6 year slump (as it did following its previous devaluation in 1994), one could question the wisdom of assuming that incomes will be high enough in the future to warrant borrowing from them today.

Moreover, there is a danger in being the ‘last man standing’. If a country does have significant domestic demand growth within the current global environment (either as a result of circumstance or policy), then there is clearly a risk that it will become a magnet for both global capital flows and all those inventories of unsold consumer goods that are currently residing in Emerging Market and US warehouses. The result of such a situation would likely be a very large current account deficit that was financed for a while by ‘hot money flows’ but which would ultimately prove destabilising for the economy. Already, the UK as well as potentially NZ and Australia seem to be at risk from such a scenario.

One way to look at a current account deficit is that it represents both a lack of saving by the domestic sectors (very true in the UK, Australia and NZ at present) and an implied transfer of current domestic incomes to the rest of the world. In a national income accounting sense, a current account deficit is known as a ‘withdrawal’ from the circular flow of income but if incomes are lower as a result of the deficit, the sustainability and wisdom of any form of domestic credit boom that leads to a weaker current account balance must be questionable.
Of course, in his ‘General Theory’, Keynes suggested that a short term boost could be given to an economy by the government borrowing money and then burying it, so that other people could dig it up and then spend the funds (which as Keynes pointed out, is just what gold mining is anyway...). He did of course then go on to say that it would be better in the longer term to pay people to dig productive assets such as roads and other productive forms of infrastructure and ‘capital stock’.

We would certainly agree that if either the private sector or the public sector were to borrow during times of slow growth in order to invest in more productive assets, this might well lift realised future incomes and therefore be beneficial for the economy over the longer term. Rather than ‘bridges to nowhere’, countries should build useful infrastructure and invest in R&D, education and other productive assets. The latter is of course fine in theory but in practice we have found over recent years that increases in private sector borrowing tend to end up financing another housing boom that adds little to real wealth creation, while most expansions in public sector administration frequently seem to add little to long term productivity growth either directly or through their ‘multiplier’ impact on the number of coffee shops around the government buildings.....

For several years now, economists have been wringing their hands over the decline in productivity growth that has occurred in the Western world and while we suspect that some of this is simply the result of simple bad luck, sub-optimal education policies, a corporate sector that is too focused on financial rather than real world engineering and the legacies of the GFC, we also suspect that much of the slowdown in reported productivity growth is simply the result of a compositional shift in the supply side of many western economies. So much of the growth in the West and elsewhere over the last 10-20 years has been focussed on the low productivity growth sectors of construction, low value-added services and public sector activities rather than the productivity growth generating traded goods sectors (i.e. manufacturing and higher end services) that trend sustainable growth rates have suffered in those economies that do not have rapid rates of population growth.

At the risk of perhaps trivialising the argument, we could argue that the proliferation of coffee houses may have provided the UK hospitality sector with 7% nominal growth last year (and therefore a very significant contribution to aggregate GDP growth in the near term) but the over-reliance on this low productivity growth sectors will likely have been to the detriment of achievable trend rates of growth. Consequently, we would argue that while governments could in theory this year choose to attempt to allow their economies to borrow ‘spending power’ from the future through running easier monetary or fiscal policy regimes, they should only do so if the type of spending that these policies create is itself likely to raise long term incomes so that the countries can afford what they attempt.

To their credit, Chile evidently decided that it could not afford to offer a countercyclical response to the commodity crash and as a result it has contained its current account deficit, the currency has drifted lower rather than collapsed and domestic inflation rates have remained below 5% in year on year terms. In contrast, Japan attempted to ‘hide’ its structural deficiencies during the late 1980s and 1990s with both private and public sector credit booms but the result has been a stagnant economy over the last 20 years and the prospect of further income-sapping austerity ahead as the ‘bill’ for the previous credit booms falls due.

In 2009, as the world economy teetered in the edge of the precipice, there probably was not time to think about the type of growth that they could achieve in the near term – they just needed ‘something’. However, the various short term focused policy responses of 2010-13 (i.e. QE X+1) contributed to the lacklustre global income trends and to the over-reliance on global / Chinese credit that have led us to the point that we find ourselves operating at today – China has probably reached the end of an immense credit cycle, North Asia and the US are loaded with inventories and Japan is facing the realisation that Abe-nomics has not worked and that fiscal austerity may be what is next. European growth has benefited from the impact of lower oil prices but even those cannot be relied upon to sustain growth indefinitely.

Therefore, the policy choices facing politicians today are either more short term policy stimulus that merely creates more problems in a year or two hence; facing up to reality Chile style; or finally doing what they should have done in the early 2000s and seeking to find ways to boost real income and value added growth through suitable supply-side policies.

In a market sense, if they choose the latter we will become optimistic over the longer term, although there may well be some form of continued financial market stress in the near term as the world comes to term with the new regime. However, if policymakers simply choose more of the same old ‘QE-style response’, we suspect that market behaviour may be the reverse: in the near term there may be a further ‘relief rally’ but in a couple of quarters or so we would probably find that sentiment would be deteriorating once again.

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Andrew Hunt International Economist London

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