Corporate Japan's Cashflow Vs the Calls Upon It

This week's release of Japan quarterly balance sheet and p&l survey by the Ministry of Finance reminds us again of how difficult it is becoming to sustain Japan's public finances, even at a time when the corporate sector is managing itself conservatively and well.

The Good News

The quarterly survey gives us the most detailed insight available into how corporate Japan is managing itself: uniquely, one can conduct a Dupont analysis on what amounts to virtually the whole corporate sector. And it is striking how much good news corporate Japan can eke out even in a tough global economic environment. Sales were down 1% yoy in 2Q, and down 0.9% on a 12ma, but operating profits were up 14.2% yoy.

In terms of operating margins, the last year has been a story of a marginally difficult trading environment (COGS/Sales up 0.3pps yoy) offset by much-improved discipline (SG&A/Sales Down 0.7pps), achieved mainly at management level rather than simply by sacking personnel (Personnel Expenses/Sales ratio fell 0.2pps).  

Meanwhile, the multiple of sales per employee to total expenses per employee has risen steadily from the recent nadir of 4Q11 and continues to recover. This obviously will tend to sustain labour markets.

The trading environment makes it difficult, but with total assets down 2.2% yoy whilst sales were down 1% yoy, a slow and modest recovery in asset turns is being made. There is evidence of balance sheet discipline: bills and A/R were down 1.1% yoy, whilst inventories were down 5% yoy: together these accounted for a quarter of the fall in total assets.

Finally, the financial leverage ratio (total assets/equity) fell to 2.81 in 2Q12 from 2.86 in 2Q11, and the net debt/equity ratio fell to 62.6% in 2Q12 from 67.5% in 2Q11, with corporate Japan cutting its net debts by Y24.3 trillion during the year.

The net result is that both ROE and ROA have just about been restored to where they were before the earthquake/tsunami/nuclear crises disrupted the economy. A job well-done then? In the uniquely difficult circumstances corporate Japan has been facing, yes.

The Consequences and Cashflow

But in a way, that's the problem, as we can see when we look at the cashflows. With ROE and ROA in recovery thanks to generally improving Dupont ratios, the Japanese economy should be enjoying the cashflow results. And so it is: using change in net debt plus investment in plant and equipment as a cashflow proxy, corporate Japan's cashflow rose 57.1% yoy in 2Q12, and 32% yoy over the 12 months to June, to Y63.0tr.

But the cash is being spent, with investment in plant and equipment up 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

It is not just rising ROA which is responsible for that cash being spent:

1. Japan's capital stock is depreciating away: depreciation rose by 4.7% in the 12m to June. Simply to maintain current levels of capital stock demands re-investment of at least that much. To put numbers on it, depreciation allowances totalled Y8.53tr during 2Q, whilst investment in plant and equipment totalled Y8.3 tr. In the full 12 months, deprecation of Y36.66tr was answered by Y38.73tr in investment in plant and equipment. That investment accounted for 62% of cashflow.
2. Nonetheless, the amount of cash on corporate Japan's balance sheet, at 10.7%, is the highest it has ever been since the unwinding of the Bubble year's zaiteku financial games. Return on assets may be low at around 3.15%, but keeping cash on the balance sheet is even less attractive.

The result is that investment in plant and equipment is rising: 7.7% yoy in 2Q12, and 2% in the year to June. And the implication of that rising investment spending is that although corporate Japan is generating plenty of cash, it is generating rather less free cash. In the 12m to June, corporate free cashflow was Y24.27tr.

But there are plenty of calls on corporate Japan's free cashflows, so that Y24.27tr needs to be put into two contexts.

First, how that net paydown of debt corresponds to movements in the Japanese banks' balance sheets. This will allow us to infer what must be happening to cashflows from the non-corporate sector. Bank of Japan data tells us that in the year to June, bank deposits rose by Y13tr, whilst the loan-book expanded by Y4.5tr – a net deposit inflow of Y8.5tr. But since we also already know from the MOF's quarterly survey of balance sheets that the corporate sector cut their net debt by Y24.27tr (ie, were responsible for a net deposit inflow of Y24.27tr), it must be that everyone else (mainly government and households) cut their deposits by a net Y15.8tr.

This is important: excluding the corporate sector, Japan is running at a savings deficit. The data simply doesn't allow much room for a net flow of savings from the household sector any more.

Second, how does the corporate sector's Y24.27tr in free cashflow compare to the amount of debt the government needs to raise? Here are the sums: in the year to June, the amount of JGBs in issuance rose by Y21.5tr and the amount of short-term financial bills rose by Y4.86 trillion. In all, the government needed to sell Y26.36 tr of its debt. Essentially all of the corporate sector's free cashflow. . . . and then a little bit more.

I have previously noted that Japan's private sector savings surplus looks to be in terminal decline. Indeed, from what we know now, it is rather surprising that it managed even the Y15.72tr surplus recorded in the year to June. What our ramble through the corporate sector's balance sheet reminds us, though, is how precarious the balance now is, even at a time when the corporate sector is managing its operations and balance sheets well during a difficult environment.

It raises the question quite urgently: unless corporate Japan is willing to stop re-investing, and thus see its operational asset base shrink, can we expect it to continue to finance Japan's fiscal deficits? And if not the corporate sector, who?

US Fretting: Reasons to be Fearful

What's driving the US private sector savings surplus higher? Using Google Insight to track what the US has been worrying about, we can describe the tide of worries so far in 2012.

• Iran's nuclear ambitions (peaked end-Feb)
• The possibility of a Chinese hard landing (peaked end-April)
• Eurogeddon (plateaued in June, retreating now)
• Next up . . . Fiscal Cliff

I have previously (here ) stressed that part of the reason for the US's 'soft patch' has been an unexpected re-emergence of financial caution:

'After falling pretty much uninterruptedly since 2009, the US Private Sector Savings Surplus (PSSS) rose 0.5 percentage points yoy in 1Q, and based on the data currently available looks to have risen by a further 2.4 percentage points yoy in 2Q. If this is correct (and it's unlikely to be dramatically wrong), then the US PSSS is at its highest level since 1Q11 on a 12m basis.A rising PSSS simply means that households and corporations are consuming (and investing) a smaller proportion of their income (and profits). And this in turn saps domestic demand, and acts against those fundamental forces which should be sustaining the domestic cycle.”

But the crucial question is: what is driving this renewed US financial caution? We have already ruled out monetary policy, because bond yields remain far below anything 'fair value' models would suggest – when that happens, private sector saving surpluses normally dwindle, not burgeon. One way of shedding light on this question is to track what the US population has been searching for on Google, using Google Insight. Four things which have been repeatedly said to be panic-worthy are the Euro Crisis, China's slowing, Iran's nuclear ambitions, and the approaching fiscal cliff. But which, if any, are responsible for the bouts of caution?

The answer, as the chart shows, is 'each of them', but at different times. 

 In fact, there is a clear sequence at work.

1. During January and February, the Google data suggests the US's main worry was about Iran's nuclear ambitions. Concern about China was rising, but this was probably offset by a retreat in concern about the Euro.
2. Throughout March, concerns about Iran largely evaporated, worries about China stabilized, and concerns about the Euro crisis continued to melt away.
3. Beginning in April, concerns about China mushroomed, and 'China crisis' became the dominant search-term out of these four, peaking at the end of the month. At the same time, concern about the Euro was staging a muted comeback.
4. By May, concern over China's slowdown was still sharp, but it was first rivalled, and then surpassed, by worries about the Euro. In retrospect, it is not difficult to link these concerns both with the rise in the private sector savings surplus, or even the 6.3% mom fall it the S&P500. In short, May was given over to fretting about external economic threats.

5. In June, although worry about China and Iran had fallen away, the Eurozone's crisis dominated US search enquiries virtually all month. Not until late June did its salience start to retreat.
   6. Throughout the first six months, the threats most likely to have triggered a rise in financial caution were exogenous. But quietly a domestic financial issue was working its way up the worry-agenda: the set of worries about politics and policy captured by the phrase 'fiscal cliff'. As the chart shows, the interest shown in this by Google searchers began to rise in late June, and by mid-July seems to have become - on this measure at least – the most fretted about topic of these four.

Meanwhile, concerns about the Eurozone, about China and about Iran's nuclear ambitions, have retreated in importance: latest data suggests that concern about China and Iran are around their lowest levels so far this year, whilst Euro-worries are around their average level for the year so far.

Is this good news or bad news? Neither really. 

The attitude towards China seems level-headed: the economy is going to slow, after all, but this isn't necessarily disastrous (see here) and certainly isn't unpredictable, so in the absence of accidents it seems unlikely it will offer another 'worry-peak' any time soon. Conversely, one wonders what it would take to ease concerns about the 'fiscal cliff'? If one is unable to answer that question, this could be sustained as a focus of economic and financial anxiety for months to come. 

But finally, and most obviously, both the Euro and Iran harbour, in their different ways, the capacity to shock and appal economic imaginations at any time during the rest of the year.   

On balance it seems optimistic to expect US financial caution once again to retreat whilst the Fiscal Cliff still looms, and the Euro and Iran hang around, perhaps waiting for their turn again in the limelight.    

Fear Itself

The relative insouciance of non-Europe financial risk prices in the face of the Eurozone's grinding catastrophe may partly be owing to the time non-Eurozone financial institutions have had to tiptoe quietly away from direct involvement. But there's another reason too: all over the world, the anticipation of Europe's financial crisis finally getting completely out of hand is stopping businesses investing and hiring, and in turn that is stopping households spending. In short, everywhere in the world, private sector savings surpluses are on the rise once again.

And this is despite the fact that bond yields remain far below 'fair value' – a pricing which in the past has been effective in discouraging excessive saving, whilst encouraging corporate investment. Fear itself is financing the retreat in financial risk pricing.

This unanticipated new surge in private sector savings surpluses was noticeable first in the US, partly because the US reports its data early, but also because the rise defied other usually reliable cyclical indicators. When we search for the reasons behind the 'soft patch', this is what we discover: during 1Q12, the PSSS jumped to 7.5% of GDP, up from 4.5% in the same period last year. The change was just big enough to inflect the 12m curve upwards.

In the Eurozone, the story is less clear-cut (and less securely accounted for by official data). However, my best estimate is that during 1Q the Eurozone's PSSS climbed to 5% of GDP, up from 4.5% in 4Q11 and 4.8% in 1Q11. This is only a fractional rise, but it occurred during a time when the Eurozone's financial system was still feeling the short-term relieving effects of the ECB's Long-Term Refinancing Operation. Throughout the first quarter the fall in European CDS rates reflected the momentary retreat of the Eurozone crisis – they fell from a peak of around 632bps in early December 2011 to a low of around 365 in late March.

But of course, the crisis is back. Currently CDS rates are around 480bps, and every survey of European consumers, businesses or investors tells the same story of dramatically collapsed confidence. So we can assume the Eurozone private sector savings surplus is also surging. And whilst we cannot yet make the calculations (because we don't know the details of what's happening on the fiscal side), the result isn't in doubt. During March and April this year, the Eurozone's current account showed a Eu10.36bn surplus, compared with a deficit of Eu3.95bn in the same period last year.  

What about Asia? The quarterly charts tell us that during 1Q, surpluses in both China and Japan were in smooth retreat: China's 12m surplus fell to 3.5% from 3.9% in 4Q11, whilst Japan's fell to 5.2% from 5.9% in 4Q11. In both cases, this fall underpinned Asian domestic demand (consumption and investment spending) whilst moderating the (still positive) inflow of cash into Asian financial institutions.

But as with the Eurozone, it seems very likely that this is now reversing. We can see this in the trade data: China's trade surplus during 1Q was a very modest US$1.15bn, compared with a very modest deficit in US$706mn in the same period last year. However, during the next two months the surplus burgeoned to US$37.12bn, up 34% yoy, even as domestic demand indicators continued to soften. In Japan, the fall of the PSSS during the past 12 months has been more dramatic than in China, but as the next chart shows, that fall has already stopped on a 12m nominal basis. The chart runs to the end of April, but May's trade data suggests the stasis is continuing. So too do the downturns in Japan's domestic demand data (starting mid-May).

We can therefore observe that a non-cyclical upturn in private sector savings surpluses emerged in the US during 1Q, spread at first moderately and more recently fiercely to the Eurozone in 2Q, and is now arriving in both China and (to a lesser extent) Japan. Since this is happening against the background of extremely low global bond yields – yields far lower than 'fair value' and thus historically likely to discourage net savings – it's reasonable to assume this change in behaviour is a response to collapsed confidence.

This change in financial behaviour has markedly different financial and economic effects. For the financial system, the private sector's private sector savings surpluses represent accelerated net inflows of cash into the system. Because, by definition, the banks cannot recycle this into private sector credit, this cashflow must go to buy either government debt or foreign assets. Such forced buying of government debt can be expected to depress yields and consequently risk pricing.

But those private sector cashflows are only generated by deferring spending on consumption and investment. The non-cyclical savings behaviour in turn becomes precisely the motive factor stripping demand from the world economy and tipping it into a cyclical downturn.

Whilst Europe's national political leaders evidently consider 'protecting the Euro' a more important goal than securing national economic survival, there's no reason the rise in Europe's private savings surpluses

should abate. But if financial institutions and financial centres in the US and Asia have in fact spent the last couple of years quietly quarantining Eurozone financial institutions, the best hope of abating the rise in private sector savings surpluses is probably for Europe's crisis to come to its head sooner rather than later.  Since, outside the Eurozone, it's fear itself which is now doing the damage.

  

US Savers Turned the Screw in 1Q

• US Cyclical Factors including ROC and Real Labour Productivity Remain Sharply Positive
• But Deleveraging Accelerated Again in 1Q, Pushing Up Private Sector Savings Surplus , and and Pushing Down Loan / Deposit Ratios
• Renewed deleveraging is anomalous, and is not reflected in asset prices or straightforward risk measurements
• Renewed deleveraging is anomalous at a time of exceptionally bad bond-market value
• So the Growth Risk for the Rest of the Year Remains on the Upside

We now have quarterly GDP numbers for the world's major economies, so it's time to start tracking movements in the fundamental ratios which structure the world's business cycles, starting with the US.

Our view based on these ratios for 4Q11 were (in this piece)as follows: “. . . by our estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, we believe that the net develeraging of the economy which started in 2008 is now complete. We do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.”

How much of that is still right? The good news is that returns on both capital and labour continue to rise, at an accelerating pace – the best underlying news for a sustained business cycle upswing.

ROC is still climbing, and this continues to fire major capital investment spending: in nominal terms, total fixed capital investment jumped at an annualized pace of 20.8% during 1Q. In real terms, private capital spending rose only a miserable 1.4% annualized - but there seems to be an unaccounted seasonal factor at work depressing the 1Q investment numbers, since this was the best 1Q reading since 2006. Overall, nominal capital stock is probably growing around 1.2% a year – still less than half the c4% yoy nominal GDP growth, so we should expect ROCs to continue to rise along with asset turns.

Real output per worker, adjusted for capital stock per worker, also accelerated mildly to 3% during 1Q, an inflection from from 2.8% in 4Q10 which should be enough to sustain improvements in the labour market. 

As far as margins are concerned, the US international terms of trade have held steady since they bottomed out in December 2011: since then export prices have risen 2%, whilst import prices have risen just 1%.

All of this suggests the US cycle should be in buoyant good health. But it doesn't seem to be: the 2.2% annualized GDP growth recorded in 1Q was lower than I expected, and a retreat from the 3% of 4Q11. And there's probably more on the way, since the GDP data disappointed even before the 'soft patch' began to show up in the data for April and May's economy.

I have previously explained the origins of that 'soft patch' in the industrial sector, using changes in momentum of output, domestic demand, inventory and export demand. I think that analysis is both correct and useful . . . . but also incomplete.

For the big disappointment of 1Q is that deleveraging had not stopped, as I expected. Rather, it re-started and re-intensified – and it is that which so far is the decisive factor in the US recovery. One can capture this by two counts. First, the private sector savings surplus jumped to 8% of GDP in 1Q from 5.2% in 4Q11. There are strong seasonal factors at work, but nevertheless, that jump was sufficient to push up the 12m ratio to 4.7% of GDP, from 3.8% during calendar 2011. This is the only quarter since 2009 that the PSSS has risen significantly. 

Second, the same story is written in the banking system's balance sheet: during 4Q11 banks' loan to deposit ratio stood at 81.8%, and was rising gently, having seemingly bottomed out in 3Q11. But by early May 2011, the ratio had fallen again, to 80.8%, with deposits rising US$153bn since the beginning of the year, compared to a rise of only US$70bn for loans. 

Awaiting Eurogeddon, it may seem obvious that caution must reassert itself. But, of course, the timing doesn't fit. More, reawakened caution was not obviously reflected – and frankly, still is not obviously reflected – in US financial asset prices. During 1Q, most measurements of risk were in retreat: 5y bank CDS rates declined to average 201bps in 1Q12 from 252bps in 4Q11, whilst the capital risk premium on 10yr Treasuries (spread between 10yrs and 10yr TIPs) widened modestly in a way which usually signals improving risk tolerance.

More, US Treasuries became ever more expensive relative to the fair value you would expect in an economy growing 2.2%, CPI inflation of 2.82% and a Fed Funds target of 25bps. Historically, as the chart below shows, when Treasuries represent such astoundingly bad value, one expects Private Sector Savings Surpluses to start to dwindle. But rather, the opposite happened.

In conclusion, we really do not know what has provoked re-invigorated deleveraging in the US during 1Q12 - for the time being it remains anomalous. Unless or until a workable explanation is found, we should expect precisely that it will be an anomaly, which is likely to be corrected in the coming quarters. If so, the upside risks to US growth during the rest of 2012 continue to look greater than the downside risks.  

ECB Loses 86% of the Eurozone's Current Account Deficit

What is one to think about the Eurozone's revision of absolutely fundamental data which evaporates 86% of the zone's current account deficit for the last two years? That is what has the European Central Bank has unveiled today, revising down the 2010 deficit from Eu42.16bn to Eu6.79bn, and the 2011 deficit from Eu29.49bn to Eu 3.21bn.

Although these are some of the biggest revisions of major macro-numbers I've seen for a while, they are curiously inconsequential, because what ails the Eurozone is nothing to do with cashflows, and everything to do with balance sheets. Probably the most serious medium term consequence is on the credibility of the institution itself - it is, after all, meant to making policy at least partly on its seemingly unstable  monitoring of the Eurozone economy.

What is the basis of the revisions, and what do they do to our understanding of the underlying cashflows of the region? At the moment, the ECB says simply that the huge 2010-11 revisions are 'mainly owing to revisions for income on direct investment'. The ECB's notes strongly imply that these revisions are related to revisions for the Eurozone's net direct investment position generally. Those revisions led to the ECB cutting its statement of the Eurozone net foreign direct investment liability position, by Eu 69bn to Eu 1,224bn as of 3Q11. But that's far too small a shift in the underlying capital position to produce such a dramatic improvement in the Eurozone's current account cashflows.

For now, the exact justification for the revisions remains mysterious. What it means, however, is that in 2010 official data now shows the Eurozone with a current account deficit of 0.3% of GDP, rather than 1.8% of GDP. In 2011, it had virtually no deficit at all (0.1% of GDP) rather than the 1.3% deficit previously recorded. Europe's savings and investment are now virtually balanced, apparently. Moreover, the private sector savings surpluses must correspondingly have been better than previously thought (around 5.8% in 2010 and falling to around 4.1% by 3Q11).

Fundamentally, it doesn't contradict what we already know: that the Eurozone private sector is generating substantial savings surpluses, which are fetching up as positive cashflows into its banking system. Those cashflows (deposits in minus loans out) amounted to Eu218bn in the 12m to February, and cut private sector net debt to Eurozone banks to Eu 376bn. All that cash inflow, and more, has been used by Eurozone banks to buy foreign assets: in the 12m to February, Eurozone banks' net foreign assets rose Eu262bn to Eu934bn.

In other words, every measure concurs: the crisis of the Eurozone is generating substantial net outflows of capital from the region. So here's a final note from the ECB's data-release: at the end of 2011, gross external debts of the region amounted to Eu11.3tr, or about 121% of GDP. Those debts had fallen Eu126bn in the last three months of the year.

One Day the EU Will Apply to Join Turkey

I've spent the last couple of months an investment bank in Bahrain which had (past tense) an ambition to ally the surplus capital of the Gulf region to the financing opportunities presented by the historic emergence of Turkey and its near neighbours. To my mind, that was (and is) a hugely inviting prospect. Istanbul is one of the few cities that can claim to be the centre of the world, and right now hosts an alliance of demographics and growth that I remember from the great Asian emerging markets of 20 years ago. The long and short of it is that Turkey is a country of 74+mn, with a median age of 28.5 years, a per capita income averaging around US$10,300. Over the last decade its real GDP growth rate has averaged 5.3%, but it's been a rough old journey, with a standard deviation of 4.4%.

Growth, opportunity and volatility – what's not to like for an emerging market investor?

Right now, it looks as if 2012 will be another rocky year, with investors needing to take a view on how far Turkey overheated last year, how quickly it is rebalancing its economy between domestic demand and exports, and how much appetite world markets have to keep financing Turkey's investment spending. My sort of questions, in other words. (Incidentally, I expect the usual suspects will markedly underestimate the capital appetite for Turkish risk at this point: the key datapoint being the 110% jump in FDI – the world's stickiest money – last year).

My starting point is, as usual, to run the Flow Essentials charts to get to the underlying ratios Turkey's economic growth and financing depends on. Start with estimated growth of capital stock and the direction of ROC. My assumption is that when you've got a rapidly expanding banking system (loan growth of 42.3% last year) you must have significant misallocation of resources, disguised temporarily by inflation (up 6.5% on average in 2011, and rising sharply, to 10.6% YoY in January). But even using deflated numbers, on my count capital stock is growing around 8.6% pa (or 16.5% nominal), but ROC was no worse than flat last year.

And this was borne out by the monetary velocity reading, which again was no worse than flat.

This was a genuine surprise: the expected misallocation should have shown up far more starkly on these charts.

Still, leverage must have been rising sharply, and banking data tells us that banks' loan/deposit ratio rose from around 80% at the beginning of the year to 89% by the end of the year, and that this had been financed at least in part by an increase in foreign liabilities from a net US$16.74bn at the beginning of the year to around US$20.4bn by the end of the year. But once again, one would have expected the rise in leverage of the banking system, and is escalating exposure to the jitters of its foreign liabilities to be more extreme. Run the numbers, and it turns out that only 9% of the rise in the loan book was funded by the net increase in foreign liabilities – slightly less than the 11.2% that was funded by banks' running down their holdings of domestic securities.

But in the end, we cannot escape the fact that even if Turkey's rapid 2011 growth has been driven by rather less inefficient resource allocation than we had expected, and even if the financing of the growth was rather less reckless than it might have been, Turkey's growth was still powered by a major private sector savings deficit. In fact, I estimate that that deficit came to 8.7% of GDP in 2011.

And here is the rub: judging how far and how fast that savings deficit is being corrected this year is surely the key to potentially one of the most exciting turnaround stories of the year.

Yesterday Turkey reported that it ran a current account deficit of US$5,998mn in January, slightly down from US$6,565 mn in December, and US$6,022mn in January 2011. Nonetheless, this was taken as a slight disappointment (consensus had expected a deficit of only US$5,500mn for the month), because the monthly improvement was only approximately half the improvement of the trade balance. The surplus on 'invisibles' amounted to only just over US$1bn, which was 24.1% less than in January 2011. Part of the reason for this, no doubt, was the stalling of the tourism trade: tourist arrivals rose only 0.6% YoY in January – no doubt reflecting Europe's straitened economic circumstances.

So far so gloomy. However, what matters for Turkish financial markets right now is the extent to which, and the pace at which, it winds back the private sector savings deficit which ballooned to around 9% of GDP last year. Movements in the current account are a crucial part of this calculation, and here the news is distinctly better.

In nominal terms, the 3m private sector savings deficit hit bottom in May 2011 at Tkl 33.99bn, and has since moderated. That progress was continued during January. In the three months to end-Jan, the PSSD improved to Tkl 26.57bn – only Tkl 2.38bn above where the balance was the same period last year.

Private sector savings surpluses and deficits usually have a distinctive seasonal pattern (as do current account balances, and government fiscal balances) so we can also assess how current changes in private sector savings flows compare to 'normal' conditions. And, as the second chart shows, when judged on this basis, Turkey's private sector savings cashflow position continues to improve, with the pace of improvement having picked up noticeably in the three months to both December and January.

Bond Yields and Saving Behaviour in the US

What relationship, if any, consistently holds between interest rates and private savings behaviour? Do savings really go up when interest rates go up? And can excessively high savings ratios be brought down by keeping interest rates low? If so, what rates, and how low? And if savings rates stay high regardless does that mean we're in some sort of liquidity trap?

I should probably have had this down decades ago when I first encountered an ISLM graph, but the truth is that I've never met anyone in the market who actually uses ISLM analysis. Or mentions it.

Instead I have focussed on private cashflows and savings behaviour, usually looking at private sector savings surpluses and tracking their impact on bond yields. For emerging markets, this is often crucial: the most powerful financial dynamic bar none in emerging markets is what happens to government bond yields when a private sector savings deficit flips over into a surplus, or vice versa. In these cases, the cashflows are easy to trace: if an economy develops a savings surplus, then on a net basis, the private sector is dumping cash into a financial sector which, by definition, can use it to buy only government bonds or foreign assets. Hence bond prices rise and yields fall. Easy money.

Even in the massively-open and highly disintermediated financial system of the US, traces of the relationship remain.

Interesting though this is, it's hardly a complete theory linking bond yields with savings behaviour. Nor would one expect it to be: if private sector savings surpluses and deficits were the only determinant of bond yields, the world wouldn't have so many fixed income economists (and professional Fed watchers). And the financial world would never had heard of 'fair value models' for bond yields.

So let's look at those models. In my experience these fair value models regress and regularly recalibrate from three factors:

• policy rates
• inflation rates
• growth rates

A movement, or an expected/forecast movement in any one of these will change what the model signals to be the 'fair value' of a bond.

Anything that regresses and recalibrates enough will end up looking like it has useful explanatory power. Here's how my simple fair-value model of US bond yields compares with what actually happened over the last 21 years. It's not a superb fit, and even if it was, that would be testament simply to the power of serial recalibration rather than the theory it allegedly sets out to test.

Nonetheless, the conclusions which we can draw from this model are remarkably similar to those wrested from doubtless far more sophisticated models produced by our august Wall Street friends. And so are the conclusions are drawn by comparing actual bond yields with 'fair value' yields. What screams out in retrospect is that during 2004-2008 bond yields were far lower than 'fair value'. And from there it is but a step to conclude that the chief reason for that was that policy rates were set too low for too long, and, moreover, were expected to be kept too low for longer still. The graph serves as the charge-sheet against Alan Greenspan. And as it looks as if the same thing is happening again now (bond yields far lower than 'justified' by likely economic growth and inflation), we might eventually find it thrown into evidence against Ben Bernanke at some later date.

What the chart is saying right now is simple: bond yields are simply too low, making bonds an unattractive investment. Let's put it even more bluntly: who in their right minds would save to invest in bonds right now? At which point, we get to ask (and answer) an important question – regardless of the absolute nominal bond yield, does sufficiently 'bad value' in bond yields usually dissuade saving, and do sufficiently 'generous' bond yields usually encourage saving?

And I think we can answer than question empirically with a simple 'Yes'.

Consider the relationship between the deviation of bond yields from fair-value, and movements in the private sector savings surplus. The chart below illustrates it well, and that's not just because I've fiddled the axes. More importantly, the correlation between sequential movements in these two during the last 87 observations passes the 1% significance level quite easily.

For those of us interested in recent US economic history, and in global savings/investment imbalances, this chart is pretty irresistible, as it links the descent into major private sector savings deficit during 1997-2000 and again in 2005-2007 with bond yields being somehow maintained at levels which actively discouraged saving. When yields rose (relative to 'fair value') savings deficits were trimmed and reversed.

And now? Bonds represent absolutely rotten value, and as long as this is the case, the US private sector savings surplus will continue to decline, boosting US consumer demand at a pace slightly exceeding those of private sector income growth (widely defined).

One more thing: there is absolutely no sign of a Keynesian 'liquidity trap' anywhere on this chart.

Will China Implode? Not Just Now

So to recap, the world economy was swinging along nicely, despite the collapse in confidence, when it ran across  three potential catastrophes:

1. The possibility that the US recovery is stalling (a complex nexus of causes and effects which includes the impact of a profoundly divided political establishment on economic and financial confidence); 
2. The existential crisis of the Eurozone;
3. The possibility of a hard land for China. 

Today I'm going to look at the third - China.

(But first, note that the debt crises in the US and Europe are actually historic reflections of each other. The US Treasury market was a war-child - between 1861 and the end of the Civil War in 1865 government debt  mushroomed from US$65 million to US$2.756 billion. Out of desperate need to finance a war to finally settle the historic States/Federal political question, was born a single dominant Federal debt market. We watch now as that debt market becomes hostage to precisely the same question of State/Federal rights and powers (which is what, ultimately, the Tea Partiers are on about). Meanwhile, over in Europe, the attempt to try and retain a full fiscal panoply of State Powers whilst sharing a single currency has delivered bankruptcy to at least one State, and probably more. The result, more likely than not, will be the construction of a single dominant Federal debt market.)

I remain sanguine about China's immediate future.  This is not, I hope,  because I don't recognize China's problems, or the threat they pose. But for the most part they are not new. Take, for example, the worry about the debts of local government financing platforms. Now, there is no doubt that they are far bigger than they have been, and far bigger than they should be - whether you accept the National Auditor's lowball figure of around 9.5 trillian yuan, or the higher estimates, which range up to around 14.5 trillion yuan.  But in the end, these debts represent the accumulated fiscal deficit of provincial and lower levels of government. Since in China taxes flow upwards to Beijing, but responsibilities flow downwards to the regional authorities, how to finance these layers of government has been a perennial problem for China for as long as I can remember. Indeed, I'd say that how to finance lower-tiers of government has been the problem for China, possibly exceeded only by problems of water and agriculture (to which, of course, it is linked).  Monetising this problem away was the underlying reason why China used to be inflation-prone , and which ultimately brought Zhu Rongji to power in the 1990s.  About his first act was to re-set the split of China's tax-take between national and provincial governments. Anyway, here's the big bad secret which China's (not) been hiding all these years - if you're fiscally squeamish look away now. . .

As you can see, between 1995 and 2009, Guangdong and the Yangtze Delta can lay claim to fiscal respectability.   But most of the rest of China can't. The capital region (Beijing-Bohai) has finances which, were it not the capital, would be among the most disastrous in the nation - but we can perhaps give it a pass on account of its unique position in China. But the Industrial Northeast, which ran a fiscal deficit of over 12% of provincial GDP in 2009, has a distinctly rust-belt fiscal legacy. And in the Central Provinces - China's heartlands - the deficit was running at near 8% of GDP in 2009. In short, the fiscal position of China's provincial governments is a mess, and has pretty much always been a mess.

So although the situation is now news, it's not exactly new. Nor are the ways in which it has been solved. First, the central government rebates the vast majority of taxes back to lower levels of government. And secondly, local governments supplement their budgets by land sales and by using near-deniable near-provincial-sovereign financing platforms.  When times are tough, or when provincial countercyclical spending has been particularly ferocious,  there will be an extended tussle about who, ultimately, gets to pick up the tab.

With a bit of luck we will not be witness to the grisly infighting which will eventually produce a settlement.  But we can be pretty sure that it's a question of 'who's going to pay', rather than 'where on earth are we going to get the money from', because we can track the underlying cashflows of the whole China economy via the private sector savings surplus. And here is my estimate of it, up to June this year:

The key point of this chart is that although the private sector savings surplus is in decline, it's still massive at around 5.6% of GDP, or 2.4 trillion yuan a year. And that surplus is effectively the net cashflow into China's financial system after the banks have done all the lending they can do to the private sector (which for these purposes includes the local government financial vehicles). There's nothing for this money to go on except either central government debt, or foreign assets. This persistent deluge of cash into the banking system is the reason why China's banking system has a collective loan/deposit ratio of only 66%. It's the reason why bank lending can growth at mid-teen levels persistently even though the government has commandeered and disabled 20%+ of the deposit base as reserves.  And, of course, it's also the reason why China isn't going to run out of financial or fiscal options any time soon.

US Bond Markets, and the Novelty of Saving

The truth is, the US financial community isn't used to their economy running a private sector savings surplus - which is hardly surprising because until the financial crisis came along, it hadn't run one since the early 1990s. One result is that there are plenty of people in the US financial industry who don't instinctively understand the link between that surplus and cashflow/balance sheet movements in the banking industry.

Two strands of recent popular economic contention illustrate the point. First, when the Fed stops hoovering up government debt (sometime in June), will that result in a major bond correction? Second, now surveys show US loan conditions beginning finally to ease, are we about to see banks forced into selling off their bloated portfolio of government securities in order to fund new private sector credit?

Behind both worries lurks the same (probably unanswerable) question: why is US government debt trading above its fair value, with 10yr bonds changing hands at around 3.2%, rather than nearer the 4% that underlying conditions (policy rates, inflation, growth) would imply?  Will either of these two near-term worries upset the apple-cart.

Once again, I turn to the US private sector savings surplus.

The key point about the private sector running a savings surplus is that it represents the direction of cashflow between the US private economy and the financial system. If there is a surplus, then the financial system, after it's done all the lending and investing it can with the private sector, remains a net receiver of cash, day in, day out. And since by definition it can't deploy that cash in new private sector lending, it must necessarily end up buying either government debt or foreign assets.  When there is a deficit, by contrast, the financial system faces an urgent need to generate the cash it needs to give to a private sector which otherwise would have to make its own adjustments. And what are the two main ways for banks to raise cash? Liquidate its government bond position and/or take on net foreign liabilities. 

So when we look at the emergence of a private sector savings surplus in the US since mid-2008, we can understand why  holdings of securities have jumped by just under half a trillion dollars, and why, at the same time, net foreign liabilities of the banking system have shrunk by just under US$700 billion. What else could possibly have been expected?

Whilst the private sector continues to run a savings surplus, these flows will - must - continue, regardless of the curtailment of the Fed's buying, and/or the improvement of credit conditions.

For those worrying about the fair value of US government bonds, then, the question should be: how long will the US private sector continue to throw off surplus savings.  There are two techniques for determining this. The first is to model the numbers line by line. So far as I can tell, no-one on the Street is doing that (and neither am I, before you ask). The second is to eyeball the trend. This gives you two alternative answers. First, if the steep decline seen in 1Q is maintained (which, I suspect, can be translated as 'if oil prices continue to rise') then the US will get through its surplus by mid-2012.  If, on the other hand, the more modest trajectory of normalization seen over the last two years is extended, the surplus will endure until around mid-2013.  My guess? Even by mid-2013 the US will still be running a savings surplus, and the rest of the economy will adjust around that fundamental choice. Quite simply, it's what defines the 'New Normal'.

Luckily, by that time, less unorthodox economists than myself will be explaining it far better than me, and the Street will understand it instinctively.