End of the Industrial Super-Cycle

There’s an issue, or an unstated assumption, which underlies much of the current worry about the state and direction of the world economy. One way of appreciating it is asking the question: ‘How can the US economy still be expanding vigorously when its industrial sector is in such trouble?’

Consider the evidence. US industrial output has shown consistently negative momentum since 4Q14 and this shows few signs of reversing: in August output fell 0.4% mom, and the regional industrial surveys for September have been grim, with the Philadelphia Fed survey shocking at minus 6 , the Empire State manufacturing survey grim at minus 14.7, the Richmond Fed survey showing minus 5 (worst since January 2013), and the Kansas City Fed manufacturing survey showing minus 6.  At the same time, inventory/shipment ratios have risen to the highest levels since 2009, so far without improvement;  capacity utilization rates have tumbled from a high of 79% in November to 77.6% in August. Exports, meanwhile, have endured consistently negative 6m momentum trends since July 2014, and by July 2015 were falling 7% yoy.

Despite this, domestic demand indicators have remained on balance positive, and, in particular, labour markets have remained robust. In the face of the most dramatic trade/industry downturn since the great recession, 2Q GDP growth came in at 3.9% annualized, largely on the back of a 3.6% annualized rise in personal consumption.

The contradiction between what is happening in the industrial sector and the trajectory of the broader US economy shows up clearly in my momentum indicators.

This divergence between the industrial sector and the overall economy is fairly obvious in the US. What is less obvious is that something very similar is characteristic of the entire global economy.  

As the chart shows (*see below for details on these indicators), on a global basis, the industrial sector is clearly in trouble, but despite that, domestic demand momentum is not merely being maintained, it continues to accelerate slowly, as it has for much of the time since early 2014. 

It seems to me that the most important thing about this aspect of the global economy is to acknowledge that it is really happening, and has been happening for nearly a year now.  There is a deeply entrenched expectation that where the industrial sector leads, the rest of the economy must inevitably follow, from which it follows that a description of the industrial sector cycle is adequate to locate an economy’s current trajectory and potential.

Part of the reason for that is that economists (and everyone else) feel far more comfortable analysing the industrial economy than the services sector.  At the  most basic level, industrial output is far easier to count, movements in industrial prices are far easier to observe, balance sheets of industrial companies easier to take apart, all of which has allowed us a very good idea of how business cycles affect industrial companies.  Similar analysis of the services sector fails at the first hurdle - even counting the output is so uncertain that we rely on hard-fought and contestable conventions and inferences, rather than direct observation. As for pricing, inventories, capital involved. . . .

Historically, there have been good historical reasons for the expectation that where industry leads, the rest of the cycle will follow, and what’s more, over the last 20 years new life has been breathed into those reasons by China's rise.  Nevertheless, the expectation is, in philosophical terms, not necessary but only contingent - and it may be that as China has got richer, the contingency is passing. 

Consider how spending patterns in the US have changed. In 1950, spending on goods accounted for 60.7% of all personal consumption spending, with services accounting for only 39.3%. However, as incomes rose, so the proportion spent on services rose, until in the 12m to June 2015, the proportions were almost exactly reversed, with 67.2% of personal spending going on services, vs only 32.8% on goods. But even that exaggerates the importance of industrial sector supply, since two thirds of spending on goods is on ‘non-durables’ such as food and gasoline. In fact, spending on durable goods accounts for only 10.8% of US personal consumption spending.  This helps explain why a loss of momentum in the US industrial sector need not necessarily be pointing to a wider economic slump. 

Such a pattern should surprise no-one: as a society grows wealthier, so marginal demand shifts from the acquisition of goods to the consumption of services. 

One should expect to find this shifting pattern of demand not just in the US and Europe but, of course, in Asia too.  And given the extraordinary rise in material comfort in China over the last 20 years, one should expect a similar pattern of shifting demand there too.  Although we do not have the data to show this directly, the changing composition of China’s GDP makes it clear that this process is underway.

In 1995, secondary industries (ie, principally manufacturing) accounted for 46.7% of GDP output, whilst tertiary industries (ie, principally services) accounted for 33.6%.  By 2015, the ratios had changed so that tertiary industries accounted for 48.6% of output, whilst secondary industries accounted for 42.2%. But note that as far as domestic demand is concerned, China was also running at trade surplus of approximately 5.5% of GDP, suggesting that domestic demand for secondary industry products had probably sunk to around 36.7% of GDP. 

The shift in underlying demand is even clearer when one looks at marginal contributions to GDP: in 1995 tertiary industries accounted for about 29% of marginal GDP growth; in 2015 that had risen to 68%. 

This shift in Chinese marginal demand away from goods to services, although predictable, is nevertheless the signal that the forces which drove the commodities ‘super-cycle’ - the sudden emergence of demand for goods from a Chinese population transitioning from poverty to material decency -  are no longer the primary forces driving either the commodity cycle, the global industrial sector, or indeed, the world economy.  When China first started emerging from grinding poverty to mass material decency, it was predictable that the first priority for China's population was to acquire more 'stuff'. So it made sense to buy the stuff that made 'stuff' - hence the commodities super-cycle.

But as China's population has grown richer, its marginal demand has shifted from 'more stuff' to 'better services'. Crudely put, its the shift from a new shirt to a sharper haircut.  Unless industrial companies have factored in this slight slowdown in the rate of growth of marginal demand from China, the industrial sector will discover it cannot win the return on capital from its capex that it originally expected.  On the other hand, demand for services will continue to grow relatively unimpaired.

In these circumstances, disappointing industrial demand and all that goes with it can easily co-exist with continued growth of employment, and overall demand in the world economy. 

* (My global momentum indicators for the industrial sector and for monetary conditions take in data from the US, Eurozone, Japan and China; the global domestic demand indicator also includes data from the UK, S Korea and Taiwan. In each case, the indicator measures standard deviation movements from historic seasonal trends for key data. For the industrial indicator, this includes output, exports (local currency value and volume) and where possible indicators for inventory ratios and capacity utilization rates. For domestic demand, I include retail sales, vehicle sales, employment, wages, and selected other indicators where possible. For monetary conditions I include growth of monetary aggregates, movements of the currency vs the SDR, movements in real interest rates and changes in the shape of the yield curve. In each case, for global aggregates, countries are weighted according to 5yr average of US$ denominated GDP.   No single-figure indicator will be perfect, but I am confident that these are sufficiently information-rich to not be completely wrong.)

Cargo-Cult Companies - Japan's 2Q Duponts

The MOF's 2Q survey of private sector balance sheets and p&ls reveals this: more than ever before, corporate Japan's ROE depends only on the ability to source supplies cheaply, and there is little sign it wishes to change this business model or expand its reach. It is a cargo-cult approach, in which all depends on the vale of what washes up on Japan's shores.

On the downside, this confirms that Abenomics' hoped-for rejuvenation of the Japanese economy is nowhere to be seen. On the upside, in the short term, a devaluation of the Rmb will probably aid Japanese profits, rather than erode them as I initially thought.

The 2Q private survey presents a picture of extremes:

• the highest operating margins since my data starts in 1980; 
• the lowest asset turns since my data starts in 1980; 
• the lowest financial leverage since my data starts in 1980. 

At the moment, the gains in operating margins trump all else, raising ROE to 10.4% (just below the post-200 average) and ROA to 3.9% (1SD above the post-2000 average). So it is probably no surprise that as the key ratios which determine return on equity scale off in both directions to to previously unseen extremes, there is no sign of any change whatsoever in corporate behaviour.

And what does it all add up to? Operating profits growth running at just 7% yoy on a 12m basis, and investment in plant and equipment up just 5.5%, only just enough to cover the depreciation allowances claimed.

In 2Q sales rose 1.1% yoy (1.4% 12ma) whilst operating profits jumped 20.5% yoy (7.4% 12ma), and as a result, margins rose to 4.81% (vs 4.52% in 1Q), and 4.3% on 12m. These are the fattest operating margins for Japan since my data begins in 1980.

The reason for the rise in margins is simply an improvement in corporate terms of trade, with the cost of goods sold ratio falling 0.9pps qoq to 76.4%, the lowest since at least 1980 (although on a 12m basis, the 77.3% ratio was matched in 2Q11). There is no further improvement in SG&A /Sales, with the ratio rising slightly to 18.8% (vs 18.2% in 1Q and 18.7% in 2Q14). And there was practically no further improvement in the sales/expenses per employee ratio, as sales per employee fell 3.1% yoy whilst expenses per employee fell 3.4% yoy. 

Both asset turns and financial leverage continue to decline to new lows. Total assets rose 5.2% yoy and 5.9% 12ma whilst sales rose 1.1% yoy and 1.4% on a 12ma, so annualized asset turns fell to 0.87, from 0.95 in 1Q and 0.91 in 2Q14. On a 12m basis, asset turns fall to 0.906x, the lowest since 1980s.

Whilst total assets rose 5.2% yoy in 2Q, shareholders’ net worth rose 6.5% yoy, so financial leverage fell to 2.63, or 2.66x on a 12m basis: again, the lowest since 1980 at least. The cash portion of that net worth continues to rise, up 8.6% yoy in 2Q, equivalent to 11.4% of total assets, or 11.3% on a 12 basis - the highest proportion since 1992 in the immediate aftermath of the zaiteku financing bubble years.  Those cash holdings strip 4.5 percentage points from return on equity, cutting it to 10.4% from the ex-cash ratio of 14.9%. 

US Capital Goods Winter Thaws in July

There was enough in July’s capital goods data to remove most of the clouds which have hung over the investment cycle for the last six months. In July capital goods (nondef ex-air) orders jumped 2.2% mom, whilst shipments rose 0.6% and inventories fell 0.1% mom. The orders recovery was broadly-spread: autos rose 4% mom, computer/electronics rose 2% mom, machinery rose 1.5% and electrical equipment rose 1.3%.

The result is that the book/bill ratio recovered back to 1 for the first time since January, and the inventory/shipment ratio fell to 1.73x, also the lowest since January. Although this does not entirely remove all threats from the capital goods cycle, it does suggest the immediate pressures have been relieved.

In particular, inventories of capital goods have been kept essentially flat since September 2014, and with the inventory/shipment ratio now a full standard deviation lower than the post-2010 trend, any significant recovery in end-demand stands to be amplified by a rush to re-stock supply channels.

Still, for the capital goods sector, 2014-15 was a long long winter, and even July’s results are not stellar. In particular the book/bill ratio is still a full standard deviation below the post-2010 average. More, although orders rose a revised 1.4% mom in June and a further 2.2% in July, it still leaves the dollar total down 3.3% yoy and 6.6% below the 2010-2014 growth rate.  Similarly, although shipments rose 0.9% mom in June and 0.6% in July, in dollar terms they were up only 0.5% yoy in July and are 5.3% below the 2010-2014 trend.

China and Commodities - The End of the Beginning

I suspect the market is wrong about China, and wrong about its likely appetite for industrial commodities in the coming year - most likely the bottom has already been and gone.

To start with two things which should be obvious: the Caixin manufacturing PMI for August, which apparently managed to panic markets when it fell by 1.7pts to 47.1, is produced by Markit.  China’s industrial data is insufficiently consistent to allow the tests, but where one can measure - Europe, UK and the US - there not the slightest scintilla of meaningful correlation between movements in Markit’s PMIs and movements in industrial output. I do not doubt these indexes power to move markets, but their information content is right up there with astrology: they are not even wrong.

The second thing which I think is obvious is that China’s willingness to devalue the Rmb is a correction of a quite serious monetary policy mistake made last year, and was a necessary precondition to re-liquefying the economy. There are clear signs that PBOC is now grasping the opportunity, adding 150bn yuan in open market interventions this week, the largest since Chinese New Year’s temporary 205bn yuan injection, and compared with the average weekly rise of just 6bn yuan during the last three months.  On top of that, the week has seen PBOC extend 110bn yuan in medium-term loans to 14 financial institutions, and also pump $48bn into China Development Bank and US$45bn into China Exim Bank.

China has finally granted itself the conditions under which it can reflate the economy, and it looks like the central bank is finally making an attempt.  If it succeeds, then the track record suggests that eased monetary conditions will be able to restore momentum in both the industrial sector and in domestic demand.

If so, this is the end of the beginning of China’s cycle, rather than the beginning of the end.

In which case, the current panic in commodity markets looks misplaced, since Chinese demand for industrial commodities is more likely to stabilize and/or rise during the coming year than to disappear.  In fact, that trajectory may already be emerging in the relevant data, such as  imports and inventories. 

The place to start is with the volume of China’s imports of industrial commodities. For those commodities which are no longer growing, imports topped out early in 2014, since when they have been either stagnant or falling. But by July, that peak is beginning to pass out of the base of comparison, with the result that yoy falls are beginning to moderate and will continue to do so, even if the recent signs of modest growth disappear.  In July, imports of four out of the six major industrial commodities showed a yoy rise in volume terms.  

1. Crude Oil: up 29.3% yoy, and up 10.4% ytd
2. Refined products: up 28.5% in July, and up 0.9% ytd
3. Iron ore: up 4.3% yoy in July, and down 0.1% ytd 
4. Copper: up 2.9% yoy in July, and down 9.4% ytd
5. Coal:  down 7.7% yoy in July, and down 34.1% ytd
6. Steel Products: down 13.9% yoy and down 8.9% ytd

We can also get some clues from Australia’s trade patterns: during June exports to China rose 3.4% yoy, although in the year to June exports to China were down 17.7% ytd. Now, looking at commodities: in A$ value terms: 

1. Iron ore down 10.9% yoy in June and down 32.1% ytd
2. Coal: up 13.7% yoy in June and up 1.7% ytd
3. Copper: down 21.4% yoy in June and down 24.2% ytd

The message is similar: although the market is soft, the later data suggests things are moderating, not getting worse.

There’s more to this moderation than simply a base of comparison effect. In addition, the inadvertent tightening of monetary conditions during 2H14 and early 2015 squeezed working capital hard enough to make China’s companies in turn squeeze their supply chains (hence the toll on Northeast Asian suppliers) and cut inventory holdings. There are a variety of measures of China’s inventories, but most agree that commodities inventories have fallen, quite sharply. Of the three separate measures of iron ore inventories, two find them down 26.8% yoy in July, and one finds them down 29.5%. Rebar inventories are down 3.4% yoy, and hot rolled coil inventories are down 8.2%. Coal inventories at China’s ports are also down 10.9%.

It is more difficult to construct wider inventory totals, but producer goods seem to have been falling steadily and consistently since 2008. That fall has moderated significantly over the last year, but still, by June, inventories of producer goods were down 7.5% yoy.  It is even more difficult to reconstruct an inventory series for durable goods generally, but my attempt suggests inventories of durable goods peaked in September 2014, have fallen 18% since then and were down 0.3%yoy in June.

This combination of falling import demand and falling inventory holdings of industrial commodities is consistent with what one would expect after a prolonged period of unusual monetary discipline. What would be consistent with a relaxation of that discipline would be, at the least, a willingness to stabilize inventory holdings, which with even steady underlying domestic demand, would result in a resumption of rising demand for industrial commodities. 

Which is perhaps what is also signalled by freight rates. The Baltic Dry index ended July at 1,131, up 50% yoy, and slightly more than double the Feb 2015 low.  Since the end of July, it has dropped to 1,014: the average price since 2011 is 1128, and the current price is 0.3SDs below that average.  Interpretation? The index was anticipating some pick-up in demand, and still is, although it now has slight doubts. Perhaps it too places its faith in Markit’s PMIs.

China Post-Dollar Policy - Coordination or Frustration?

With faultless timing, the BIS’s Financial Stability Board published its once-every-five-years peer review of China, assessing the authorities’ administrative ability to foresee, recognize and react in a timely manner to financial instability. Its message? That whilst great strides had been made, there are still a plethora of regulatory agencies with mandates sufficiently loosely drawn that their efforts sometime overlap and nullify each other.

Or, as they put it: ‘Enhancing inter-agency coordination and developing an integrated risk assessment framework will promote a common understanding of objectives and risks, which will in turn facilitate joint policy actions and public communication.’

Whilst the FSB was focussing on the agencies with a claim to oversee various parts of China’s proliferating financial sector, they could have extended their review to highlight the way the different agendas of the Ministry of Finance and PBOC have hampered effective monetary policy development in the run-up to the stockmarket collapse and subsequent yuan devaluation.

The tension between the two arises because government has 3.6tr yuan deposits with the central bank, amounting to 11% of its total assets, or, excluding fx reserves,  about a third of the implied domestic assets of PBOC. By raising or lowering those deposits, the Finance Ministry can affect private sector liquidity: when it lowers its deposits, it pumps money into the private sector; when it raises deposits, it takes money out of the private sector.

Over the last year, the average monthly movement of these deposits (addition or subtraction) has come to 373bn yuan.

During the same time period, the average monthly addition/subtraction to liquidity made by PBOC has been 85bn yuan. But open market activities are not the sum total of PBOC’s interactions with the domestic economy. We can estimate those by looking at the change in PBOC’s total assets, minus the change in the fx reserves kept on that balance sheet.  Currently, these implied domestic assets amount to 11.28tr yuan, and they increased by 2.71tr yuan, or by 32%, in the year to July, with the average monthly addition/subtraction coming to 418bn yuan.

As we can see, the Finance Ministry has a swing factor averaging 373bn yuan a month, and PBOC has a total swing factor of 418bn yuan.  Those are big numbers, and if deployed in a consistent and coherent way, they could have a serious impact on domestic liquidity.  But they are also so similar in size that they each separately could frustrate and cancel out each other’s policy intentions.

So what’s actually happening?  The following chart shows the 6m momentum change vs in government deposits and PBOC’s implied domestic assets, expressed in SDs vs historic seasonal trends.

And what it captures is that the default position over the last year has been for PBOC and Ministry of Finance actions to pretty much cancel each other out.  During the second half of 2014, as the dollar began to rise and China’s foreign exchange reserves began to fall, PBOC responded by rapidly expanding their domestic assets. This was a reasonable response to the tightening of conditions implied by the forced-march rise of the Rmb. But the impact was negated by the rise in government deposits made by the Finance Ministry - what PBOC put in, the Finance Ministry took out. 

Early this year, when it was clear that the economy was in worse shape than anticipated, the Finance Ministry abruptly changed its tactics, running down its deposits in PBOC, with the effect of pumping liquidity into the domestic economy.  Unfortunately, just at that time PBOC also changed its policy, cutting back sharply on the growth of domestic assets: 72% of the rise in domestic assets made in the year to July was made during between July 2014 and Jan 2015.  Result? Both policy initiatives were cancelled out once again. 

The hope is that, with monetary policy no longer constrained by the need to shadow the dollar, both PBOC and Finance Ministry can agree on coordinating a mutual approach to fiscal and monetary policy which can be sufficiently accommodating to make a positive impact on the economy. The data for July - the latest available - hints that something like this may yet emerge.

China Devalues - More Consequences

The government's reasons for launching the reform will decide the yuan's exchange rate in the future. If it's economic, then depreciation will continue because the dollar is expected to become stronger. If it's political, depreciation will not last.

- Xu Gao, chief economist of Everbright Securities

A lot hangs on that observation: a modest devaluation and/or sustained depreciation could help China’s economy a lot. A chaotic devaluation triggering capital flight and undermining the stability of the deposit base would be disastrous.

Whilst markets fret about the potential negative consequences of China’s devaluation, it is easy to forget that it does at least go some way towards correcting a major  policy mistake - the unwillingness to ease monetary policy in the latter part of 2014 to offset the tightening impact of keeping the Rmb effectively tied to the soaring dollar. July’s stockmarket collapse pointed very strongly to the need for a more dramatic about-turn in monetary policy than had previously been tolerated, and August’s devaluation, if nothing else, achieves that.

What is more, by releasing the de facto dollar peg, China in theory gains the freedom finally to operate a monetary policy which serves the cyclical needs of the domestic economy. And although China’s has a more positive inflationary dynamic than consensus is prepared to admit, there is no doubt that more accommodative monetary conditions stand the best chance of improving the purely cyclical economic dynamics.

So far this year, PBOC edged only half-heartedly towards loosening policy, which began to bear similarly modest fruit in May, June and July’s monetary data. In particular, July’s ‘surprisingly good’ money and credit data  - M2 up 13.3% yoy, new bank lending of Rmb 1.48tr - need substantial qualification The attempt to prop up the stockmarket inflated both bank lending and M2 growth whilst simultaneously diverting credit away from the ‘real economy’. (See this for explanation).  And the tepid loosening seen in May, June and July gets a substantial boost by from August’s devaluation.

Historically, where changes in China’s monetary conditions have led, domestic demand and industrial momentum have usually followed soon. Whilst July’s industrial momentum was weak to an extent which offset June’s relative strength, and July’s domestic demand data was just plain weak, in both cases,  the 6m momentum trendlines, although in negative territory, are inflecting up. It is a fair bet that this modest upward inflection will be maintained into August and probably beyond.

And in addition, prior to the devaluation we were already looking at a modestly rising CPI (and thus falling real interest rates).  Unless accompanied by destabilizing capital flight, the devaluation raises the likely inflation outlook, rather than depressing it into a possibly deflationary scenario.  (Nb, this is not the view of consensus, which is looking for inflation of 1.5% in 3Q, 1.8% in 4Q and a fairly steady 2% in 2016. Thus the 1.6% yoy rise in July’s CPI was not expected.

Even before the impact of Rmb devaluation is taken into account, those CPI forecasts look too low to me: I’d be looking at 1.8%-1.9% in 3Q15, 2.3%-2.6% in 4Q15, rising to 2.9%-3.4% in 1Q16 and 3%-3.7% in 2Q16.

But the improvement in China's monetary conditions will also have an impact on global monetary conditions. Indeed, it will accelerate an upward inflection point which had already arrived in June.

My monetary conditions indicator track what I believe to be the four key things one needs to know about an economy’s money: how much of it there is;  what happening to its domestic price;  what’s happening to its international prices; and what’s happening to its time-value. For my global monetary conditions indicator, I weight for the US, Eurozone, China and Japan according to 5yr dollar GDPs average.  The key thing to know is that conditions have been tightening since 2Q14, reaching their nadir in 2Q15, since when they have been in tentative recovery.  That recovery gathered pace in June and July, and China’s Rmb depreciation will almost certainly accelerate that recovery significantly in August.  More, during the early part of this year, monetary conditions were deteriorating in the US, China and even Japan, and easing only in the Eurozone.  By August, my estimate is that they will be improving in China, in the US and in Japan, whilst deteriorating slightly in the Eurozone.  Overall, however, the upward inflection point has already arrived.

China Devalues - Some Consequences

What Happened: People's Bank of China devalued the Rmb, setting the rate 1.9% lower on August 11, and a further 1.1% the next day - the biggest fall for the Rmb since the 33% devaluation in the first week of 1994, and seemingly an abandonment of prioritising early inclusion in the SDR over the needs of the domestic economy.

Why It Matters:  This is an important development both for China (its economy and politics), for the rest of Asia, and for the world economy.  Let's take them separately. For China, the decision to devalue marks the abandonment of two linked policy goals. First, and most obviously, it is an acknowledgement that the economic sacrifice made in demonstrating sufficient stability for the Rmb to be included in the SDR at an early date, is proving too burdensome.  Or, to be blunt, it acknowledges the error of allowing the Rmb to be dragged up with the dollar last year, without an aggressive easing in other areas of monetary policy.

Second, and less obviously, it marks the end of the carefully assembled illusion that sufficient foreign reserves and a sufficiently conservative set of banking policies could allow China to escape indefinitely from the monetary policy trilemma (the one which makes a fixed currency, open capital account and independent monetary policy an unstable triad).  Both of these mean that a serious policy re-think is now inescapable.

Politically for China, the stockmarket's fall followed by the predictable devaluation of the Rmb demonstrates two things: first, it tells the Party that it cannot control the Market; second, it tells the Chinese people that the Party cannot control the Market.  Given that the Party treasures control above all else, this represents a genuine political crisis.  So in short, this is a moment of profound challenge and, ultimately change, for China's political economy.

For Northeast Asia, the problem is very simple: China accounts for just over 70% of Northeast Asia's combined exports. If China is devaluing in order to maintain its export position (a subsidiary aim, with the principal aim being to raise utilization rates in an economy which has been driven by the growth of capital stock), then export prices will be cut for every other Northeast Asian trading partner and competitor. The deflation which so far has been largely confined to commodity markets, will spread more rapidly to Asian manufactures, starting now.  Within Northeast Asia, Japan is the most obviously vulnerable, having tried for two and a half years to ginger up its economy via devaluation. China has just trumped that strategy.

For the rest of the world, there is the uncomfortable fact that in dollar terms, during the five years to 2014, China accounted for 54% of the total growth in GDP for the G7 and BRICs combined.  Or put it another way, between 2010 and 2014, China's dollar GDP grew 71.5%, whilst the rest of the G7 and BRICs expanded just 9.8%.  Depending on how far China ends up devaluing, those numbers are going to change, and quite possibly dramatically.

And finally, and again obviously, China's devaluation is likely to trigger a whole new round of Asian-sourced deflation in the traded goods sector. Bond markets have made their initial reaction, western monetary policymakers will be re-casting their sums.

What Happens Next?   
We shall see. At present, Chinese sources are glossing the devaluation merely as an extension of China liberalizing its economy. Whilst one can't rule out completely that the end-result may yet be that, it defies belief that this is the motivation. Rather, for the reasons given above, this is a moment of profound challenge for China's policymakers, and how the various tensions, problems and opportunities will play out is, for now, anybody's guess.

China Devalues - The Trilemma Bites Both China and Japan

The announcement today of a sharp devaluation of the Rmb is a capitulation to strategic necessity which a) had already been quietly seen on the OANDA fx site since July 31st, though not, curiously on Bloomberg and b) was the inevitable outcome of the failure of the Xi Jingping Put.

To repeat: 
"The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma.  In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression.  The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing. 

"In short, the choices have suddenly got both hard and urgent."

There are immediate consequences to think about.

For China,  there are two fundamental questions:
1. The Communist Party has discovered that it cannot control the market.  Given the unrivalled importance that maintaining control has in the Party's list of priorities, what does that mean for the future of the market in China?
2. The Chinese people have discovered that the Party cannot control the market. What does that mean for the economic choices to be made by China's households and companies?

For the rest of Asia, there is one very obvious question: what happens now to Japanese policy. Those of you who subscribe to my  Shocks & Surprises Global Weekly Summary will have read on its front page this week:

"In Asia, Bank of Japan’s monetary policy board meeting produced no new initiatives, but commentary from the bank’s governor which bordered on the complacent. In fact, Japan’s momentum indicators for domestic demand and the industrial sector are now flagging in a way not seen since the election of PM Abe. If one of the outcomes of China’s stockmarket collapse is a depreciation of the Rmb, Bank of Japan could yet discover new vulnerabilities in the Japanese economy."

To be plain, about 71% of Northeast Asia's exports come from China, and given the weakness of Western demand,  a 1.9% devaluation in the Rmb will quickly result in a 1.9% fall in the dollar price of China's export prices, which will inexorably be followed by matching falls elsewhere in Asia's export prices. Any Asian country which has been relying on devaluing its way back to competitiveness with China will feel the pressure. So there's more policy initiatives to come - and not leas from the Bank of Japan.

China's July Money Data - Rescue Funding

China’s July monetary data gives a coherent, if slightly complicated, picture of the attempt to staunch the financial bleeding from the stockmarket’s fall.  In total, it describes a rapid emergency financial re-intermediation by the banking system, whilst at the same time shows the financial system in total withdrawing funding from the real economy.  The hope must be that July’s data shows merely Part 1 of the rescue, with the crucial bit of Part 2, as yet unseen, being the banking system being willing to restore funding to the ‘real economy.’

The key data is the discrepancy between the Rmb1.48tr in new bank lending made in July - 1.7SDs above historic seasonal trends, and the strongest since June 2009 - and the miserable Rmb589bn in new bank lending recorded in the monthly aggregate financing series. Since the point of the aggregate financing data is to track financing made to the ‘real economy’, we are left to conclude that the difference between the two measures of banks lending - 891bn yuan of it - represents bank lending to non-bank financial institutions. The rescue funds, in other words.

In the short term, the good news is that the money lent to rescue financial institutions has been recirculated right back to the banks, with deposits rising 2.17tr yuan during July.  The less-good news for now is that:

• the banks are not lending that back into the ‘real economy’. Not only was lending to the real economy down at just 589bn yuan in July, the lowest since October 2014, but in addition, banks withdraw a net 331bn yuan of bankers’ acceptances during the same month. The net effect must be a sharp squeeze on corporate working capital. 
• the second bit of bad news is that the rise in deposits is accompanied by a sharp fall in liquidity preference (M1/M2) to a new record low as speculative and transactional demand for money is dulled by financial and economic uncertainty. 

China's Reserves - Hong Kong's Part in Their Downfall

Between the end of August 2014 and the end of June 2015 China’s foreign exchange reserves fell by US$275bn.  Where did the money go?  Probably more than half of it was accounted for loans being repaid to Hong Kong’s banking system: latest data shows that Hong Kong’s net lending to China fell by US$91bn between September 2014 and April 2015.   The huge inflow of Hong Kong bank lending, which saw loans to China rise from a low of US$122bn in September 2012 to a high of US$342bn in March 2014, went sharply into reverse just as the US dollar began to strengthen in the second half of 2014.

Part of the reason for this withdrawal is doubtless a change in perception of risk as the dollar strengthened.  But heightened risk aversion is not the only story: Hong Kong’s own liquidity situation has been sufficiently compromised that retrieving capital from the mainland was almost certainly a commercial necessity.

The reason is that Hong Kong is no longer generating the private sector savings surpluses which historically  have funded the build-up of net foreign assets in Hong Kong’s banking system.  Whilst a savings surplus results in the private sector piling cashflow into the banking system, which by definition can only be invested in government debt or foreign assets.  By contrast, a savings deficit results in cash flow from the banking system back to the private sector, with the banks able to generate the cash only by selling government or foreign assets. 

In 4Q14, Hong Kong generated a private sector savings deficit of HK$56.4bn, equivalent to 9.2% of GDP, and this was followed by a HK$47bn deficit in 1Q15, equivalent to 8.2% of GDP. Now, Hong Kong’s private sector savings position is highly seasonal, with large deficits usually seen in 4Q, usually recovering to an offsetting surplus in 3Q.  However, the deficits of 4Q14 and 1Q15 were big enough to leave the 12m position as a modest deficit of 1.5% of GDP.    

The trade and government budget deficit/surplus for April-June are now in, so we can see the extent to which the underlying savings situation is developing.  Hong Kong’s reported a June budget deficit of HK$11.3bn, bringing the fiscal balance for 2Q  to a deficit of HK$15.92n, equivalent to an estimated 2.8% of GDP. Meanwhile, with June’s trade balance showing a deficit of HK$45.8bn, the 2Q deficit came to a deficit of HK$115.4bn, which implies a 2Q current account balance of approximately HK$8.4bn.  

Taken together, this suggests that Hong Kong produced a private sector savings surplus of HK$24.4bn, equivalent to 4.4% of GDP. This represents something of a recovery, as it compares with a 2% surplus in 2Q14, and a 8.2% deficit in 1Q15. However, on a 12m basis, the SAR is still running on a modest private sector savings deficit (equivalent to about 0.9% of GDP). Whilst this is hardly disastrous for Hong Kong itself, and implies little in the way of currency pressure or interest rate premiums to the dollar, it does mean that the now ‘normal’ conditions for Hong Kong is that it no longer produces a savings surplus that can  be re-invested in the mainland. Rather, Hong Kong’s underlying savings balances require that it sells down a modest portion of its accumulated foreign assets, which effectively means repatriated capital from the mainland. Hong Kong, in other words, is no longer a net source of capital for China in its own right, but rather is one of the factors generating capital outflow from China

Story of the Day - US Factory Orders & Japan Cash Earnings

Two things stood out from the day’s data:

1. The 1.8% mom rise in US June factory orders
2. The 2.4% yoy fall in June's cash earnings for Japanese workers

US June Factory Orders The 1.8% mom rise in June’s US factory orders allowed some slight improvement to the underlying ratios which influence short-term industrial dynamics, but without really making inroads on the underlying inventory and book/bill problems. With shipments up just 0.5% mom, the book to bill ratio rose 1.3% mom to the best since March - but even so, it remains 2.3% lower than in June 2014, and slightly below a 10yr average which includes, of course, the Great Recession. Meanwhile, inventories rose 0.6% mom (with no change in unfilled orders) whilst shipments rose 0.5%, so there was no improvement in the  inventory/shipment ratio, which returned to the highest since February, and is 1.1SDs above the 10yr average. Neither of these ratios are so bad they demand an urgent re-thinking of economic policy, but equally, whilst they remain unaddressed, they compromise short-term industrial prospects in the US.

Japan June Labour Cash Earnings  The 2.4% yoy fall in June’s labour cash earnings (for companies with more than 5 employees) and the 3.3% yoy fall in average earnings for all employees, makes quite clear that Japanese employers are not in the business of passing on competitive benefits of devaluation to their employees. For the wider measure, June’s payment fell 1.9SDs below what one normally expects in June. And June is an important month, because it is one of the two large bonus months of the year: last year, June accounted for 11.6% of total annual earnings, with only December being more important (representing 14.5% of earnings).  

With increasingly little in the way of monetary policy dynamics to offer immediate extra support, it’s difficult to be optimistic about the short-term trajectory of domestic demand. And that policy lacuna will become more important if the brunt of China’s stockmarket failure is borne by a sharp weakening of the Rmb (which seems a logical expectation).  At that point, Japan’s policymakers will be faced with the possibility that two and a half year’s worth of sharp competitive devaluation against its biggest Asian trading partner/competitor have not brought the benefits to Japan’s domestic economy which they could have expected. 

The Failure of the Xi Jinping Put

Since 12 June, the Shanghai Composite index has fallen by just under 29%, and the Shenzhen Composite has fallen by 33%.  Measuring in terms of market capitalization, the Shanghai Composite crash has cut 12tr yuan off capitalization, whilst the Shenzhen has cut 10tr yuan from capitalization.  China’s nominal GDP is currently around 64.4 tr yuan, so the combined loss of capitalization from these two markets alone is equivalent to slightly more than a third of annual GDP.

There are two chief methods by which such a crash is transmitted to the domestic economy: first, by a negative ‘wealth’ effect, and secondly, by its impact on those credit institutions which had been financing the run-up and the impact on their clients. To the extent that these two effects can be separated, the second is the most important. Probably no-one, including those inside China’s banking system, really knows the extent to which recent bank lending has been used to finance stockmarket positions. However, the really explosive phase of China’s stockmarket frenzy started in November, and between November 2014 and May 2015, new bank lending amounted to 6.84tr yuan.

Even at the latest valuations, Shanghai and Shenzhen index levels are approximately 50% above end-Oct 2014 levels, soon paper that leaves plenty of scope for margin positions to be paid down without catastrophic pain. But of course, that’s not how margin-position finance works - their very essence is leverage and concentration of positively correlated risk. We can very confident that at least some financial institutions will be in deep trouble, and it be a brave analyst who asserted that none of those risks would develop into systemic threats.

The need to respond to this market disaster finally brings into focus the traditional monetary policy trilemma which Beijing has successfully finessed over the last decade. The monetary policy trilemma is that it is in theory impossible at the same time to pursue a currency target, an independent monetary policy (or, to put it another way, to use monetary policy as a purposeful and effective instrument of economic policy) and to maintain a free capital account.

Over the last 10 years or so, China’s preference was to allow financial repression sufficient to fund an extraordinary growth in the stock of fixed capital, whilst keeping the currency weak enough to allow it to find overseas markets for the resulting surplus production. In response, once-strict capital controls were gradually eroded (both officially and unofficially) as investors sought to buy the undervalued currency, and in response, China both amassed nearly US$4tr in foreign reserves, whilst partly sterilizing the capital inflow by raising reserve ratios on Rmb deposits from 7.5% in 2006 to a peak of 21.5% in 2011.

This strategy was not able to remove the trilemma, but it took the sting out of it, by granting policymakers time to react to changing conditions.  But what was gained in policy-flexibility was lost in policy-clarity. Essentially, different financial system actors were independently free to pursue policies which were not necessarily complementary.

That fundamental lack of policy clarity was publicly visible only times of economic stress, when PBOC’s monetary policy were abruptly overturned by State Council decisions - the most obvious example being the credit-splurge mandated at end-2008/early 2009.

It is in this strategic context that China’s stockmarket collapse can be understood. During the first half of the year, policy aims included;
i) maintaining a stable Rmb in order to hasten the day when it is included in the IMF’s SDR;
ii) loosening capital controls whilst sequencing a gradual liberalization of banking and financial markets;
iii) ensuring a sufficiently loose monetary policy to allow nominal growth to sustain the sort of growth previously financed via the financial repression which was in the process of being dismantled.

Even in the best of circumstances, these divergent priorities would bring the policy trilemma into sharper focus. But the trilemma has become increasingly urgent owing to the extraordinary strength of the dollar (and thus the Rmb) between October 2014 and May 2015: the priority of maintaining stability in the Rmb meant there were strict limits on the ability to loosen monetary policy aggressively enough to maintain economic momentum, whilst all the time, the sequencing of loosening capital controls meant the policy mismatch became increasingly obvious.  The initial response was logical: ignore the trilemma and buy time by selling foreign reserves (which fell US$238bn between August 2014 and March 2015), and inject cash back into the financial system by cutting reserve ratios by 2.5pps to 17.5% by end-May, with each percentage point cut releasing approximately 3tr yuan back to banking markets.   In addition, PBOC put in place schemes extending finance to banks on the basis of specified lending criteria.

Into this environment emerged a stockmarket frenzy. This rapidly became at the very least a useful tactical adjunct by which the policy trilemma could once more be finessed. Specifically, an irresistibly-booming domestic stockmarket to which the authorities could gradually grant foreign access would generate a predictable capital inflow which would allow the pursuit of the Rmb’s inclusion in the SDR to be maintained with rather less negative stress on domestic monetary policy.  In addition, of course, growing the stockmarket’s role as an allocator of savings is consistent with the broader policy of a phased dismantling of the structures of financial repression.  As time went on, it even became possible to imagine, or at least hope, that the wealth-effect alone might mitigate the dour economic consequences of monetary policy settings.

The crash not only wipes out that way of finessing the monetary policy trilemma, but by generating a whole new generation of yet-to-be-calculated bad loans and savings-destruction, it makes it a whole lot worse, a whole lot sharper, and a whole lot more urgent to recognize. 

This is why an almost full-deck of policy measures were announced in the hope of shoring up the market. What one might call the Xi Jinping Put consisted not only of last weekend’s 25bp cut in deposit and lending rates, and a 50bp cut in deposit reserve ratios for commercial banks stretching to a 300bp cut in RRRs for finance companies and non-bank companies, but also the State Council unveiling a draft law to remove the 75% loan-to-deposit ceiling for commercial banks, and official draft guidelines allowing the official pension fund to invest up to 30% of its net assets in equities.

But so far the Xi Jinping Put has failed: on Tuesday, the Shanghai Composite rallied 5.5%, but gave back the entire gains on Wednesday. By end-Friday, the market was down 13.8% from Tuesday’s highs, and - as is usual at this stage of a crisis - the hunt is on for ‘market manipulators’ to blame.   Most probably it failed because at some level the market recognizes that whilst the trilemma is unresolved, the Xi Jinping Put cannot be definitive.

One way to see this is to ask: ‘what is missing from the package?’  One thing which is conspicuous by its absence is PBOC injecting money into the market. Weekly totals of PBOC’s open market operations show that from end-April to mid-June PBOC was entirely absent from the market - its net injections of liquidity were . . . zero. Only in the last weeks has PBOC injected cash into the market, adding a paltry Rmb35bn in June 25th auction, and Rmb50bn in the July 2nd auction. 

Rather, the job of supplying liquidity to the private sector has been quietly subcontracted out to the Ministry of Finance, which has almost entirely checked the usual seasonal growth of the deposits it keeps in PBOC. In the 3m to May, central government’s deposits in PBOC were down 7.4% yoy , doing this, effectively releasing approximately 250bn yuan of cash to the private sector directly, although the opportunity-benefit in the form of reduced treasury takings will be higher.

So what happens now? The logic of the situation is that the damage inflicted on the financial system will force a clarity of policy which finally over-rides the deep desire to ignore the monetary policy trilemma.  In short, monetary policy can become truly expansionary, in which case there is a sacrifice to be made either of the short-term stability of the Rmb, or the phased dismantling of capital controls and other structures of financial repression.  The alternative is that the damage to the financial system is unrelieved by monetary policy, but policies to open the capital account and sustain the stability of the Rmb are maintained. Almost certainly that will now entail a hard landing. 

In short, the choices have suddenly got both hard and urgent.

Innocence & Experience & 'The Wealth Effect'

One of the popular and current rationales for why the US economic expansion has never quite developed the normal panoply of cyclical accelerators is that the ‘wealth effect’ of a surging stockmarket has been far less than previous calculations suggested.

The observation is important, because as of March 2015, the US household sector was keeping 31.1%  of its total financial assets in equities or mutual funds, compared with only 19.5% in bank deposits & credit market instruments. In fact, the proportion kept in equities and mutual funds is the highest since end-2000.

Now, the S&P500 has attained a CAGR of 14.7% over the last six years, and as it has done so, the amount of wealth households have tied up in the S&P has risen from $8.2tr in 1Q2009 to $21.56tr in 1Q2015.

How much is that? Well, in the national accounts, compensation of employees currently runs at $9.477tr pa, and it is growing at about $380bn pa.  Given the tally of of equities and mutual funds held by households, it would require a rise in equity values of just 1.75% a year to generate that $380bn pa pay rise.   Or put it another way: the $13.36tr rise in the value of households’ equity and mutual fund investments is equivalent to just over one and a half year’s worth of average employees’ compensation during the same period.

So how households’ do with that new wealth plainly matters, a lot, to the economic cycle.

Looking through the literature on why the wealth effect is failing, I’m struck first by the certainty which allowed economists and econometricians to assume that ‘the wealth effect’ would be stable over time.  I’m also struck by the absence in the literature of any reference to the permanent income hypothesis  (the idea that a person will adjust his spending according to the his life-time income expectations  - or alternatively that his spending pattern will itself reveal that life-time income expectation).

It seems to me very likely that the proportion of the ‘stockmarket wealth’ a person is prepared to spend will not be stable, but rather will be informed by (and reveal) his underlying expectations about the likely volatility of those holdings.  If a person’s long-developed experience is that the stockmarket only goes up, he is likely to spend a higher proportion of the gains than if his experience has led him to believe that a significant portion of it is likely to be given back in the near future.  In other words, people will only ‘believe’ a portion of the increase in their wealth. How much they ‘believe’ it, will depend on their recent experience.

Now these ‘beliefs’ are likely to be developed as a result of long experience, and are likely to change over time as those experiences change. Here’s a  very simple (primitive, even) model: the ‘belief’ in the secure return of stockmarket investments is formed over a 10yr period, with more recent years having greater weight than in previous years. In the chart below, I’ve averaged a straight-line declining balance of years, so the change in the most recent year has 100% weight, the year before than 90%, the year before 80% etc.

What this chart suggests is that very sharp stockmarket falls may have a strong and long-lasting negative impact on people’s beliefs about what proportion of a stockmarket’s subsequent gains can be ‘believed’. And in turn, those beliefs may be incorporated into permanent income calculations, and hence spending/saving decisions.  Thus in 1999, the experience of the previous 10yrs would have led to an expectation of ‘safe’ gains of 11.1%, during a year in which the S&P rose 19.5%.  By contrast, in 2014, the previous 10 years would have taught that only 5.7% gains were ‘safe’, and any excess gains were unlikely to be factored into spending/saving decisions. Adjusted for the changing base, one would thus expect the impact on consumer spending of a rise in the stockmarket in 1999 to be approximately double what it was in 2014. 

If expectations are formed over a long period of time, no-one should expect ‘wealth effects’ from the stockmarket to be stable. But they might, given more investigation along these lines, be not entirely mysterious. 

Meanwhile, the other insight into how households actually think about their ‘wealth, or financial situation, is revealed in the household saving rate.  One would expect that when lengthy experience has led households to believe more strongly in the security of their stockmarket gains, their saving rate would decline; when they become more sceptical, one would expect the savings rate to rise. And, in general, this does appear to be the case. 

What can one conclude? That stockmarket investments are not money in the bank, and repeated warnings that prices can go down as well as up are understood, albeit that belief is moderated by experience over an unknown length of time. If that time is lengthy, as one would expect, then the impact of a sharp fall in equity values, or a series of sharp falls, will compromise the ‘wealth effect’ of subsequent rises for years to come.  In 1999 the S&P rose 19.5%, and households perhaps ‘believed’ that 11.1% of the rise in wealth would stick, and could thus be spent. In 2014 the S&P rose 11.4%, but households perhaps believed that only 5.7% of it would stick.  And one other thing. . . given a fair wind and no catastrophes (how I wish!) the wealth effect of a rising stockmarket is likely to gradually recover, but only as the disasters of 2008 recede from memory.

US 1Q Stumble : A Bigger Hit to Profits

Observations and Conclusions
What is one to make of the state of US GDP growth after the stumble to 0.2% annualized of the advance estimate for 1Q?  The immediate causes for the slump are known and have been tracked here repeatedly for the past few months, including: the unexpected rise in the personal savings rate, the opening up of a supply/demand disequilibrium in the industrial sector, the deterioration in inventory ratios both for manufacturers and wholesalers and the stalling of capital goods spending.

Some of those are clearly transitory disruptions generated by a completely unexpected shift in relative prices, notably the fall in energy prices. And in at least two cases, the most recent monthly data suggests that there is some reversion to previously-experienced ‘normality’ is already underway. For example, it is likely that the fall in petroleum prices gave households an unexpected windfall which they initially banked rather than spent. This ratcheted the personal savings rate  from 3.9% in November to a peak of 5% by February, but this retreated to 4.6% in March. The dynamic may now be changing but even so, personal savings jumped 16.2% yoy in 1Q, whilst personal spending growth slowed to 3.5% in 1Q from 4.1% in 4Q14.  Secondly,  by February, the unexpected climb in manufacturers’ inventory/shipment ratio which had taken it from 1.3 in September to 1.36 in January seems already to have peaked, falling to 1.35 in February.

Whilst we can watch some of these transitory dynamics develop and begin to resolve themselves, the1Q stumble reveals deeper weaknesses which cannot be resolved so quickly.

Those weaknesses show up when we subject the US economy in 1Q to a Dupont-style breakdown in an attempt to identify factors affecting growth, return on capital and cashflow.

The core problem is that there is more to worry about than merely 1Q’s stagnant topline growth (nominal GDP was stagnant). In addition, the first quarter saw stagnation in the previously-improving terms of trade, and an unexpected and unwelcome return to deleveraging strategies.

The result is that even though household savings rates and tallies rose, the private sector savings surplus for the economy as a whole almost certainly sank into deficit in 1Q. This is an unexpected result which strongly indicates that corporate profits must have been hit hard during 1Q, with asset turns, margins and leverage all contributing to a fall in return on capital. And whilst one should certainly expect some topline relief in 2Q, there seems no good reason to expect either a further boost to terms of trade, or an early willingness to change leveraging/deleveraging behaviour.  The logical conclusion from that is that the current weakness in the capital goods cycle is unlikely to reverse sharply in the near future, and consequently that the business cycle is similarly unlikely to bounce in the near future. At present, consensus expects a rebound to 3.1%  annualized growth in 2Q: the risk to that consensus, I’m afraid, is probably on the downside.

Let us look at these components one by one.

ROC and Capital Stock. The 1Q stumble has, of course, hurt the ROC directional indicator (generated by expressing GDP as a flow of income generated by a stock of fixed capital, with that stock estimated by depreciating gross fixed capital formation over a 10yr period). That downturn has now lasted two quarters, which is the longest fall since the financial crisis. Despite this, the indicator remains at historically very high levels (better than anything achieved in the 1990s) and capital stock growth is still extremely muted at just 2.6% yoy.  The current deterioration is only a modest decline from a propitious starting point, so unlikely by itself to be sufficient to be itself the cause of further deterioration. 

This does not necessarily point to a new slowdown in the capex cycle since a) there is usually a lag between the downturn in the return on capital indicator and a clear downturn in investment spending and b) the ROC indicator remains at historically very high levels. However, this two-quarter fall in the ROC indicator is consistent with the uninterrupted decline decline in capital goods orders seen since August. 

For labour, the data makes easier reading: in yoy terms, the number of employees rose 2.3% yoy and real GDP rose 3% yoy, so output per worker rose 0.7% yoy in real terms. Perhaps surprisingly, this is the highest yoy rise since 4Q13. With capital per worker rising 0.4% yoy, output per worker adjusted for changes in capital per worker still showed a rise of 0.3% yoy. This is hardly inspiring, but is probably sufficiently positive to maintain positive momentum in labour markets.

The rise in output per worker has been running ahead of capital per worker now almost uninterruptedly since 2010. However, it is worth noting that even now capital per worker also rose 0.2% qoq and 0.4% yoy, which is the highest it has been since the Great Recession.  In the immediate future, this combination of rising output per worker (deflated by capital per worker) and (probably) still rising capital per worker is likely to sustain both labour markets.

Terms of Trade.  Difficult this: the improvement in terms of trade which accompanied the fall in petroleum prices was sustained between July 2014 and January 2015, and lifted them by 5.5%.  Such an improvement should have resulted in improved trading and profit margins for companies, and for households, reduced energy bill. Both should have improved cashflows into the financial system.  If it did, what happened to that money? Also note that in 1Q15, that that improvement stalled, which will have removed that stimulus (if any).

Leverage and Money. When we look at banks’ loan/deposit ratio we can see precisely what happened: the extra cashflow was banked. A relatively modest rise in bank loan/deposit ratios which emerged in 2Q14, fractionally reversing a decline in the ratio virtually uninterrupted since the financial crisis. The LDR rose from a low of 74.8% in April 2014 to a peak of 76.2% in October 2014. But there it peaked, and retreated very modestly to 75.6% in March. In short, the trading gains from the rise in terms of trade were banked (as the rise in the personal savings rate suggested) and the timid releveraging of early 2014 was snuffed out. 

The same story materializes when we look at the relationship between money and the economy. Two things are evident. First, in 1Q the recovery in liquidity preference (M1/M2) which had been quite dramatic since 2008  flattened out in 1Q15, suggesting a reduced transaction and speculative demand for money - consistent with a reduced eagerness to spend money. Second, the decline in monetary velocity (GDP/M2) which had been arrested during 2014’s brief flirtation with re-leveraging, bit back again with a vengeance in 1Q.  In plain terms, when falling energy prices delivered a windfall from trading margins (companies) or budgets (households), those gains were banked in deposits not spent (hence souring trends in liquidity preference and monetary velocity), which in turn reduced 1Q GDP.

Private Sector Savings Surplus

But now we come to a conundrum: all this suggests cashflows should have been very positive, and that the private sector would have generated a rising savings surplus in 1Q. But unless there is a sharply more positive current account position reported than seems likely from Jan-Feb data, this simply didn’t happen. Rather, the currently available data for federal debt and likely current account balance point to a small deficit (US$20.6bn) in 1Q, sharply reversing the $186.8bn surplus achieved in 1Q14, and cutting the surplus to a meagre 0.3% of GDP for the 12m to 1Q15.

How could this possibly be consistent with the rest of what we think we know about the economy? There are two potential sources of savings surpluses: household savings and corporate profits. Since we know from the personal income and spending data that household savings rose sharply during 1Q, assuming the 1Q estimate of the PSSS is not badly awry, the numbers must point to a far sharper downturn in corporate profitability than the ROC directional indicator suggests. This is, of course, consistent with the sharp downturn in orders of capital goods, and the way export growth has stalled in recent months.  

There is a further implication: movements from private sector savings surpluses to deficits generally tend to put pressure on bond yields and fx rates. 

Likely Near-Term Trajectory of the Cycle

Two of the three factors affecting return on capital seem unlikely to be helpful in the near term. First, last year’s jump in the terms of trade is unlikely to be extended or repeated, and this is likely to compromise margins and cashflows. Second, it is difficult to find a good reason to expect the current deleveraging will be once again be reversed in the near term.  There is, however, a third factor which should improve: the energy price windfall isn’t getting any bigger for households, but conversely, spending/savings patterns are likely to revert to normal (which means more spending). The net impact is probably neutral to positive for on household spending. 

But if corporate profitability has already been hit more than is immediately obvious (which seems to be the lesson from the private sector savings deficit), then the removal of terms of trade gains and sustained deleveraging will put more pressure on the capital goods cycle. And that, of course, puts pressure on the dynamic of the business cycle, and consequently on the prospects for a 2Q rebound.

The Hong Kong Connection: Postscript

The role played by Hong Kong's banks in the outflow of capital from China over recent months has a further consequence which is worth pointing out clearly. Very regularly, when faced with unexpected surges in China's trade balance, analysts scrutinise trade flows between Hong Kong and China particularly closely, looking for (and often finding) evidence of over-or-underinvoicing for exports and imports. 

The point to make is this: even if this succeeds in inflating China's overall trade surplus, if at the same time it inflates Hong Kong's trade deficit, then that will erode the very private sector savings surplus upon which Hong Kong relies to fund (or even maintain) its net bank lending to China.  In this symbiosis, the trade money flows to China, but that generates a demand by Hong Kong's banking system to claw it back by cutting credit lines to China. 

It didn't always work this way: when Hong Kong had a regular major savings surplus, or when net lending to China wasn't virtually the whole of Hong Kong's net foreign lending, the relationship would have been contingent, mild and even effectively non-existent. But that's not the case anymore: if China swells Hong Kong's trade deficit, Hong Kong will (must) get the money back by cutting lending to China. That's the symbiosis.

China's Capital Outflow: The Hong Kong Connection

A squeeze on lending to Chinese banks by Hong Kong’s banking system has been a primary, and perhaps even dominant factor in the capital outflow which has eroded China’s foreign reserves over the last six months.  Net foreign currency lending to China by Hong Kong’s banks contracted by HK$555bn (US$71.5bn) in the four months to January 2015 - a fall of 21% over those four months. So far, though, there has been no reciprocal significant withdrawal of Chinese bank liquidity from the Hong Kong dollar market.

The core fact needing explanation are these:  between the end of August 2014 and the end of March 2015, China’s fx reserves dropped by US$238.8bn, despite having recorded a US$67.021 bn current account surplus in 4Q, and a US$123.8bn trade surplus in 1Q15.  In 4Q14 China recorded a capital and financial account deficit of US$30.5bn, and the deficit was certainly much larger than this in 1Q15.

How was Hong Kong involved in those outflows? Was it a beneficiary of deposits moving from China to Hong Kong, or was it a protagonist, clawing back credit previously extended to China? More, has the decrease in China’s foreign exchange reserves meant any alteration in the extent to Chinese banks’ involvement in Hong Kong’s money markets?

We can find the answers in the changes in the net external position of Hong Kong’s banking system, and specifically the net position with China, both in Hong Kong dollar markets and in foreign currency markets. Within this, it is the foreign currency position which matters most,since the Hong Kong dollar position accounts for only about 22% of Chinese entities deposits in Hong Kong’s financial system.

Looking at the foreign currency position (which includes the Rmb position),  liabilities to Chinese banks rose by HK$138.6bn and to non-banks by HK$36.5bn in the four months to September, whilst foreign currency claims on Chinese banks fell by HK$379bn, and by HK$2.5bn to non-banks.  Overall, this means that Hong Kong banks’ net claims on Chinese entities diminished by no less than HK$554.8bn (US$71.5bn) in the four months to January. That’s a fall of 21% in the net position in four months!

Crucially, HK$515.8bn of that withdrawal from Chinese positions was attributable to closing positions with Chinese banks, with loans to Chinese banks being withdrawn far faster than Chinese banks raised their deposits: foreign currency claims on Chinese banks fell by HK$379bn, whilst liabilities to those banks rose by HK$136.6bn.  What is more, it is plain that the withdrawal of net foreign currency loans by Hong Kong banks has (so far) been specific to Chinese banks: to net lending to foreign banks (including China) fell by HK$99bn only in those four months, whilst net loans to foreign non-banks rose by HK$44.3bn.

Why have Hong Kong’s bankers cut their China loans? There are at least two ways to look at this. Most obviously, Hong Kong’s banks may have cut their risk profile with Chinese banks in response to concerns about China’s economic slowdown and the deteriorating credit quality.  

(One interesting question is: do China’s banks themselves share this perception of increased risk, and if so, will (are?) Chinese bankers taking a similar view of their customers’ prospects?  Given the concerted efforts made by banks to improve their abilities to assess risk and price for it, one would expect so.

For example, this week the results of a survey of 200 bank branches in 12 cities by Rong360 found no banks were offering first-time buyers the 30% discount on mortgage rates recently allowed by the government, or were giving discounts on second home loans, despite policy relaxations by central bank.  Rather, a majority of the banks were charging rates above the benchmark rate.  There were a couple of bankers’ quotes accompanying the report which bear repeating: 'It's difficult because our margins are already squeezed, there isn't much differentiation in the market, so our focus is on how much our capital costs are.'  Another: 'Banks look for good investment return, so they'd rather invest in the stockmarket.')

But there is a second reason: Hong Kong’s economy is no longer producing savings surpluses which need to be re-invested in foreign assets.  Historically, the massive build-up of net foreign assets of Hong Kong’s banking system have been a result of a massive sustained private sector savings surplus. Between 1990 and 1994 this averaged 6.6% of GDP, but in the  pre-handover boom years before 1997 this deteriorated into a private sector savings deficit of around 5% of GDP. That deficit was swiftly and dramatically rectified: from 1999 to 2009 the savings surplus was back, averaging onwards 8.4% of GDP. 

However, over the last three years, there has been a further reversal, with minor savings deficits emerging: there were deficits of 1.1% of GDP in both 2012 and 2013, followed by a surplus of 0.8% in 2014 which has probably dipped back into a deficit of around 1.4% in the 12m to 1Q2105. (Caveat - the 1Q15 result in the chart below is an estimate only.)

A sufficiently sophisticated financial system will, of course, find ways to finesse these underlying cashflow dynamics in the short to medium term. However, the erosion and disappearance of Hong Kong’s private sector savings surplus has capped the overall amount of net foreign assets Hong Kong’s banking system carries. The current US$288bn in net foreign assets is, for example, lower than the amount carried in 2007. 

Moreover, the dramatic concentration into China assets which mushroomed so dramatically after 2010 means that if cashflow concerns dictate that asset holdings have to be cut, then unavoidably it will be Chinese assets which are offloaded.

So far, Chinese banks have not really responded to the withdrawal of foreign currency lines from Hong Kong’s financial system by scaling back their own position in Hong Kong.  Indeed, so far this has had made almost no impact on Hong Kong’s HK$ banking liquidity, to which China is a major supplier. Taking the position in Hong Kong dollars,  between Sept 2014 and Jan 2015, HK$ liabilities to mainland banks fell by HK$9.3bn to HK$112.7bn, whilst HK$ liabilities to Chinese non-banks rose by HK$10.5bn to HK$205.4bn. However, HK$ claims on Chinese banks rose by HK$768bn and Chinese non-banks they rose by HK$9.32bn.  On a net basis, the total net HK$ exposure of Hong Kong banks to the mainland went from a net liability (deposit) of HK$73.1bn in Sept 2014 to HK$64.1bn in January 2015.  In the scheme of things this is a relatively minor change drop in China’s provision of HK$ liquidity to the system.