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.

Misery and Spending, Spending and Misery

Yesterday's post looked back with a broad and affectionate eye at the monthly trade and demand data for the world economy, concluding that  although here in the financial industry we are peering into the abyss, around us the world goes on pretty much as normal - people go on shopping, goods get made, shipped and sold. And when you total up all that quotidian coming and going it is strangely hard to notice that we're on the edge of a multiple crises.  Rather, the world economy looks pretty robust, trending (normalizing on IMF data) for global GDP growth of around 5%. 

In my experience, though the really big economic/financial crises shake the seismograph, they don't arrive like earthquakes out of the blue - rather, there's a steady and enduring stream of disappointment lasting usually years before the cashflow and balance sheet consequences become unendurable.  In the late 1990s, SE Asia's terms of trade were quietly falling apart for years, eroding cashflows and current accounts, before the consequences became clear in  1997/98. In the US, new home sales peaked in mid-2005 and spent the next three and a half years grinding relentlessly lower before finally bad debts (or rather, the attempt to 'insure' them by the CDS market) brought the Reaper's sickle to the banking system.  

It's not a rule, but it is a tendency. And so to today's topic: the danger implicit in a perceived collapse in consumer confidence. This, after all, is what is now dominating the headlines - just this morning we had the Nielsen global survey which concluded that we are at our most miserable since early 2009. Last week we had the Uni of Michigan US consumer confidence shocker also serving up the same conclusion. But because the really serious problems grind slow but grind small, I tend to view short-term movements in consumer confidence readings with considerable caution. Are they cause, or are they effect, or are they, indeed, anything truly measurable in the first place?

First, let's look at what is happening to measured global consumer confidence. To create this global index I've used subindexes in the US, Eurozone and NE Asia (including China), and as usual weighted them according to 5yr GDP averages. 

The first thing that strikes me is that although global confidence has certainly taken a knock, we're not really back at early 2009 levels. The Uni of Michigan may or may not be accurate in that story, but it's not one which yet has purchase in the  Eurozone  (105.1 in June 2011 plays 70.6 in March 2009), or in  NE Asia (97.2 in June plays a low of 81.7 in Jan 2009). 

Now let's look at the relationship between confidence and demand momentum.  Using the great statistical method of smoothing to a 6m purl and then eyeballing, it seems that usually there's a pretty good fit between the consumer confidence measured, and direct measurements of domestic demand. 

But one needs to go considerably beyond eyeballing the smoothed data to explore any seeming relationship. What we are looking for is evidence that a change in consumer confidence has a useful correlation between a change in domestic demand momentum - with no smoothing or averaging allowed. I've looked at the change occurring over three months (ie, the changes in both measures between, say, December and September) between 2000 and now. This shows there's a correlation coefficient of 0.24 between the changes in these two over 134 observations - sailing past the 1% significance test.  But the coefficient gets even stronger if you view consumer confidence as being a lagging indicator: it rises to 0.256 on a one-month lag, and 0.349 on a 2 month lag (this is its peak).

If you treat confidence as a leading indicator, however, the coefficient rapidly dribbles away to insignificance. 

The moral? Those surveys we're watching - the Nielsen, the Conference Board, the University of Michigan - they're more likely to be lagging indicators than leading.  Perhaps we're miserable because we're not spending, rather than not spending because we're miserable.  

But if that's true (and it's not a nice thought) it suggests there's a more powerful reason that mere transient misery why we're not spending, if we're not spending.   And so on we go, down the analytical trail. 

A Prelude to Possible Armageddon

'Be forward-looking'. Right now, I'd rather not. And that's not only cowardice speaking, but a claim that in times like these, the blazing inferno of our forthcoming possible catastrophes is at the very least likely to blind us to our present actual condition.  Today, and tomorrow, if I have time, I intend to look back - to establish at least where we stand, even if several of our paths onwards lead over the precipice.

What present itself in the data - even up to May and June data - is the sheer buoyant health of the world economy, and its sheer normality. Let's remember what's actually happening in world trade, and what's happening to world demand.

First, the link between G3 demand and NE Asian exports is as tight as it has ever been, and, what's more, so far as we can tell, both have been interruptedly buoyant now since the middle of 2009.  Looking at G3 import data in dollar terms, by May US imports were rising 20.7% YoY, Eurozone imports were up 32.6% YoY, and Japan's imports were up 27.5% YoY. Overall, then, G3 imports were growing 26.9% YoY. What's more, sequential momentum remained positive, with the MoM growth in the three months to May rising 0.8 SDs faster than the historic seasonalized average, and the 6m of this momentum indicator riding at 0.92 SDs.  This is not immediately signalling the developed world economy is dangerously anaemic.

And, of course, NE Asia's exports machine is answer the call: by May NE Asia's exports were growing 14.8% YoY (China up 19.3%, Korea up 22.4%, Taiwan up 9.5%, and even Japan  managed a 1.8% YoY rise, despite the worst that earthquakes/tsunamis/nuclear accidents could throw at them. By June, my best guess is that NE Asian YoY export growth will come in again around the same (China up 17.9%, Korea up 13.6%, Taiwan up 10.8% and, based on the first 20 days, Japan up 9.2%). As the chart below shows, there's been a downward inflection in the 6m momentum trendline, but we're still ranging deep in positive territory.  And that's despite the multiple catastrophes suffered in the region's second-largest industrial economy.

Up to May and June, then, if you had to choose a description of the world economy judging from its trade data, it would be fair to use words like buoyant, or - if you're determined to be a grizzled pessimist - steady.

So it should be no surprise that you'd probably end up using much the same vocabulary if you looked at domestic demand data.  A word about how I do this. In each country, I look at what I consider to be the obvious monthly data-points for domestic demand: retail sales; auto sales; labour markets (employment and wages); construction and, where possible, service industries activity.  For each of these indicators, I develop the seasonalized historic expectation and measure monthly deviations from that pattern, expressed in terms of standard deviations.  For each country, I will then take a flat average of those deviations. When looking across countries (ie, for NE Asia, or for Europe, or for the world) I weight according to a 5yr average of dollar GDPs.

Here's how the situation looks up to May:

This ought to ring some bells: momentum accelerating throughout 4Q10 and 1Q11, followed by a sharp fall-off in April and May, with the beginnings of a recovery visible in June (probably - we've only partial data so far).  On a 6m trend basis, we have the same thing we saw in the trade data: an inflection point downwards in April, but still defiantly positive underlying sequential momentum. (Details: for 6m to June, the US is up 0.49; Europe is up 0.21; and NE Asia is up 0.05. For June itself, the relative strengths (on the data we have) are almost exactly reversed - ie NE Asia is up 0.78; Europe up 0.13; US down 0.26). 

Once again, one would conclude from this data that although the world economy's future may turn out to be catastrophic for several popularly identifiable reasons, its OK so far. (As the man said as he flew past the 30th floor window on the way down.)

Naturally enough, when an economist goes to the considerable trouble of constructing these indicators, he likes to use them to get a quick grab on likely GDP growth.  In the case of this demand model, the newly-normalized model (yes, shameless, I know) runs to an r-squared of 0.9 over the last 12 years when regressed against the IMF's global GDP result.  Last year, the IMF says the world economy grew by 5.01%, whilst this demand indicator suggested 5.2%. This year again, it's again telling us to expect the world will grow by around 5.2%. 

Unless, of course, the immediate future is dreadful.  Which it might be - it demands no highly-developed imaginative powers to envision it.  But as you ponder the possible trajectories, do at least remember that for all the analytical ink spilled, and for all the weaknesses already printed in the world's data, during 1H 2011 the world was growing quite nicely at a clip of around 5%.  

Back and Utterly Off-Topic

In the Cotswolds this weekend for two remarkable events. First, a party the like of which I shall probably never have again. Thanks N & E - you astonish.

Second, the extraordinary 'Heracles to Alexander' exhibition at the Ashmolean. If you are in England, or can get to England, go and see this before it closes on August 29. When I was very young I queued for hours, and then struggled to avoid being crushed in order to see the Tutankhamun exhibition.  But I really think this one is the more amazing, the more stunning. Dazed partygoer that I am, I remain amazed.

Delay not a moment: clear your diary and book your tickets today.

Lamentation

Unhappy the man who spends his weekend moving into a new computer, only to discover on the morrow that all his xl file links need re-building.

Britain's Private Sector : Net Creditors!

On this side of the Channel, we're so used to international comparisons finding we're the most feckless, drunken, ineducable, absent-mindedly pregnant slobs that we sort of assume we must also be the most financially irresponsible deadbeats too. Particularly when compared to our clean-living near-neighbours, who we view as Germanically cautious like Mrs Merkel, or Catholicly-financially-repressed like all those Italians who are still living with their mothers past the age of 40. No wonder they can save, if they're still lapping up Mama's pasta.

It was also the message we got when Mr Soros bounced sterling out of the ERM back in 1992: 'You can't come in here dressed like that, sonny.'

Like many caricatures there's a painful element of truth. Back in the mid-2000s, the UK private sector was in net debt to its banks to the tune of around Eu350 billion, whilst the Eurozone's private sector owed a net  Eu 900 billion or thereabouts.  In other words, the Brits owed a net Eu 5,720 per head of population, which was more than double the Eurozone's Eu2,735 per capita net debt. Feckless or what?

But the mid-2000s isn't where the story stops. By the later 2000s, even the Brits got a bit worried about carrying so much debt, so even at the peak of late-2007, the net debt per capita had expanded to only Eu 6,854. But over the Channel, the party really started only in 2005, and by 2007, the Eurozone per capita net private bank debt had risen to Eu 4,475. Catching up!

And then, when the crisis hit, the Brits reacted hard and fast, repaying an astonishing net Eu 540 billion between October 2007 and March 2011. And now? The latest figures (for March 2011) show we're now in credit to the tune of Eu 116 billion, or Eu 1,880 per head.  By contrast, across the Channel, our Eurozone counterparts, though they have repaid Eu 815 billion since their peak net-debt of September 08, still find themselves net debtors to their banks of approximately Eu 1,643 per head.

And as a corollary, the British bank loan /deposit ratio has fallen to around 95% (from a 2005 peak of 121% - what was the FSA thinking of?), whilst the Eurozone LDR is still  running around 105% (dribbling down from a 2006 peak of 117%).

None of which is to imply that we Brits aren't the slack-jawed morons you can find sicking-up on the streets of Manchester/Newcastle/Cardiff on any night of the week.   It's just that, rather surprisingly, it turns out we can afford it.  So I'm off for a martini.

Spain Still Has a Fighting Chance

In January this year I was invited to a CapitalWeek conference in Beijing to talk on the likely trajectory of Europe's financial crisis. Recall, if you can, those carefree days of January when Portugal could get 10yr money for sub-7%, Ireland for 8% and change, and even Greece's bonds sometimes dipped below 11%. Well, Europe was a bit off my geographic focus, but it seemed important, so I hashed out a simple methodology, under which I calculated a hurdle rate for nominal GDP growth, which, if a country hit it, it could stabilize its sovereign debt, but beneath which, the already-heavy debt burdens could only grow. That hurdle rate was essentially debt/GDP multiplied by market rates for 10yr sovereign debt.

Working out the likely trajectory then became a matter of judging whether it was plausible that a country could hit its nominal GDP hurdle rate any time in the foreseeable future.  Here's how it looked (then) for Portugal:

Back in January, you had to believe that Portugal could sustain nominal GDP growth of 6.2% to work down its sovereign debt burden.  Since the introduction of the Euro, Portugal has only very rarely managed that hurdle rate of nominal GDP growth, and it was inconceivable to me that it was going to do so any time soon. So the conclusion was obvious - sooner or later, the sovereign debt burden would break Portugal.  As it subsequently has. And as this reality sank in, so bond yields rose and pushed up the hurdle rate - at today's yields, it stands at 8.5%. Anyone think Portugal's going to grow at 8.5% nominal?

On this methodology, there were other victims: Greece (obviously),  Ireland (less obviously), and . . . Italy (I'm afraid).

But Spain - the current focus of market attention -  was a close call. It had a hurdle rate of only 3.7% - well within its recent historic experience, and, with a 20%+ unemployment ratio, damned easy if you closed the gap with potential output. And the curious thing is,  even though Spain is under the market cosh, the hurdle rate has risen only to 3.9%, whilst its 1Q GDP rose by a nominal 2.6%. More, since its capital stock is contracting by around 2.8% a year, Spain's ROA must be climbing structurally - which suggests short/medium term cyclical support. Here's how it looks now:

My conclusion is this: even if/when the People's Party is going to spend the next weeks finding stacks of IOU's down the back of the municipal sofa, Spain's sovereign debt has still got a fighting chance.