US Labour Participation: Andrew Smithers and Lessons from Japan

The analytical debate about the fall in the US labour participation ratio essentially revolves around the degree to which potential pensioners are deferring or taking retirement in response to the impact of the great financial crisis. It's a genuinely important argument because on it turns estimates of likely potential growth rates and the size of the output gap (if any). Since these are key inputs into most monetary policy decision models, the stakes could hardly be higher.

Andrew Smithers' piece in the FT today  is the latest contribution. As I read it, the key message is that the fall in the participation ratio over the last few years paints an inaccurate picture of labour market slackness thanks to the way the US calculates the participation ratio. In most countries, the calculation is approximately employed + unemployed as a proportion of those of working aged – ie, aged 15-64. But in the US, the calculation is employed + unemployed as a proportion of all those aged over 15 years. So, naturally enough, as more people move into retirement, the US count of labour participation will fall. However, if you take the more accepted 15-64 participation ratio, you'll find that it has been rising quite steeply over the last few years.  In fact, the US labour participation ratio is not around 63% as claimed, but rather is slightly above 69%.  Smithers conclusion? There is less slack in labour markets than you might think, which means a) that the potential growth rate is commensurately lower and b) wage inflation will emerge sooner than you think. From which we must conclude that the Fed's room for sustained easing is less than we think – so sell bonds. 

Instinctively, or perhaps even ideologically, I'm sceptical, because: 

1. I'm convinced there must be a large cyclical element in the recent decline in the US participation ratio, which might be glossed as a large number of people reassessing what they want out of their lives in the wake of the financial crash;  
2. I see no good reason to hold on to the notion that people in non-labour-intensive employment will want to retire aged 65.  Take Mr Smithers, for example: I don't know how old he is, but if he joined SG Warburg in 1962, then it's a safe bet that he's a distinguished living exemplar of this point. The view of the inevitability, or desirability, of retirement aged 65 should be recognized as an extremely rare exception in any culture at any time, and one which there is no good a priori reason to expect to endure. If you doubt me, read Dickens.
3. I believe the essence of economics and economic growth is improvisation. This is why Goodhart's law is so crucial to any working economist, and more generally why one should always be sceptical of 'the economic data' (since by definition, it is measuring activities which are already superseded, or are in the process of being superseded).  In the case of demographics and labour markets,  we'll probably discover that the 'inevitability of demographics' turns out to be neither particularly inevitable nor specifically predictable.  Or put it another way: old age isn't going to be what it used to be.

Those are my prejudices, and, of course, they may be wrong.  But let's look at the experience of the country with the longest history of responding to an aging population:  Japan.  It is worth running Mr Smithers' charts for Japan over the long term to see how various measurements of labour participation have changed over time. 

First, let's have a look at the underlying demographic change – in particular, the rise of those aged 65+. This has been dramatic, rising steadily from 8.9% in 1980 to 25% in 2013. This compares to an US rate estimated at 13.7% in 2012. Not only is Japan's total elderly population greater, it also grew more rapidly, averaging a rise of around 0.6% of the population per year during the last 20 years, which is approximately double the rate at which the proportion of similarly-aged Americans is rising. 

Given this far more dramatic demographic aging, it surely should be expected that we would see commensurately more dramatic twists and turns in Japan's labour participation rates, on both bases of calculation, than we are seeing in the US currently. If, that is, the current fluctuations are indeed a product primarily of demographic change. 

The chart below measures changes in the labour participation ratio on both the 15-65 measure and the 15 and above measure. 

As one would expect, the shape is similar to what one sees currently in the US:  labour participation rises on the Aged 15+ count, but has fallen on the Aged 15-65 count. But it is not the similarities which are important, but the differences.  First, the decline in the Aged 15+ count is far less dramatic than one sees currently in the US, even though the aging was more rapid. The peak of participation on this count was in 1992, at 63.9% when the those aged 15+ accounted for only 13% of the population.  Since then it has declined by only 4.6 percentage points to 59.3%, even though the proportion of the population aged 15+ jumped 12 percentage points to 25%.  By contrast, the US participation rate fell from 63.4% to a low of 58.2%  - a fall of 5.2 percentage points -  between 2007 and 2010.  

Both the size of the fall, and its speed, are unlike anything seen in Japan.  It's too much, and much too fast.

The second point is that Japan's experience places a huge question-mark over whether it is reasonable to accept 65 as a relevant age to start counting retirees.  After all, the participation rate calculated against a labour force of those aged 15-65 has now risen to no less than 83% currently in Japan, whilst on Mr Smithers' calculations,  on the same base of calculation, the US has yet to hit 70%.  The opportunity for extended working lives clearly has been grasped strongly in Japan, and if the US is anything like similar, there is simply no reason to believe that current levels of participation are anywhere near a ceiling. 

Finally,  Mr Smithers' conclusions about the  possible impact on labour market pressures of a higher-than-advertised participation ratio also finds no support from Japan's experience. At the same time as corporate Japan has evidently employed ever greater numbers of 'retired' workers, so it has persistently reported an oversupply of labour, and wage inflation has been almost completely absent. 

This is not to say that Mr Smithers will ultimately be wrong: he has long argued that the upper limit on Japanese labour numbers provides a tight constraint on Japan's GDP growth, since it simply is not possible to substitute capital for labour without accepting ever-diminishing rates of return.  And so far, the overall evidence from Japan bears him out. 

But in the case of the US right now, the evidence he provides is not strong enough to support strong conclusions. Demographics probably aren't the overwhelming factor in the recent decline in US labour participation ratios; there's no reason to believe that the 'real participation rate' is approaching a ceiling; and there's every reason to believe that improvisation will trump demographics in US labour markets for the foreseeable future. 

Japan: Capacity Constraints vs Expectations

It has been a grim week for Japanese industrial data: industrial output fell 2.3% mom in February, and the fall in the March JMMA/Markit manufacturing to 53.9, the most modest expansion since Sept 2013 hardly suggests a rapid rebound. Trade data for the first 10 days of March tells the same story (with exports up just 3.1% yoy in yen terms). These can perhaps be dismissed as showing transient weakness, possibly anticipating a collapse in demand because of the the 3pp rise in consumption taxes which took place this week.

The point of BOJ's quarterly Tankan surveys is to capture slightly longer-term trends. But the 1Q Tankan was also disappointing, with the Large Manufacturer's outlook index falling to just 8, which is the weakest for a year and which was a quite dramatic fall from the +17 recorded for current conditions. Even worse, the all-industry capex forecasts collapsed to 0.1% yoy for the coming year.

However, hidden away in the details was more encouraging news which raises the economy's chances of surfing through the cross-currents caused by the tax rises. Specifically:

• the diffusion indexes tracking supply-side constraints continue to suggest the potential for positive cyclical pressures. Large companies' readings of excessive employment minus insufficient employment came in at minus 6 (+2 for manufacturers, minus 12 for non-manufacturers); and this is forecast to improve over the next three months to minus 4 (+4 for manufacturers, minus 12 for non-manufacturers). 
• the diffusion index for excessive production capacity minus insufficient capacity came in at +2 (+6 for manufacturers, minus 3 for non-manufacturers), and this also is forecast to tighten over the next three months to +1 (+6 for manufacturers, and minus 3 for non-manufacturers). 

It's worth putting those in context: since 1995 the tightest reading for the employment diffusion index was minus 13 at the end of 2007, whilst the average has been +10.7. For production capacity, the best reading since 1995 was minus 2 – again in 2007 – whilst the average has been +9. So among the messages of the 1Q Tankan was this: Japan still has a (very slight) labour shortage, and no longer has a significant production capacity overhang.

 

Now this assessment is strikingly similar to the views underlying Bank of Japan's calculation of Japan's output gap (the difference between actual GDP and potential GDP).  BOJ's view that Japan is likely to close its deflationary output gap in the short to medium term looks plausible: quite possibly by the end of this year, Japan's domestic economy will supply insufficient  goods and services to meet domestic demand. (Incidentally,  the emergence of a sizeable current account deficit also suggests a domestic economy which is becoming cyclically, if not yet structurally, undersupplied.) If so, this would be the first time since before the financial crisis, and potentially for only the second sustained period since 1990. 

I have stolen the chart below from Bank of Japan's Outlook report published in October 2013, partly because it so closely echoes the Tankan findings, but mainly because it shows how distant is the memory of Japan being supply-constrained. 

In practice, expectations entrenched over such a long time are unlikely to be overturned simply because the facts change. The process of changing expectations sufficiently to alter economic, commercial and financial behaviour is likely to be long and frustrating – the initial 'shock-value' of Abenomics was prized at first specifically on the hope that it might short-circuit this process of expectation-rebuilding.   That 'shock-value'  might not have dissipated entirely without result: that, perhaps, was the  underlying message from March's Shoko Chukin SME confidence index hitting the highest point since 1989.  

Nevertheless, as a guide to what we might expect, it seems realistic to take as our baseline what happened in that period between roughly 2006 and mid-2008 when large companies thought they had insufficient production capacity, and unsufficient labour. What happened to: company capital spending; labour markets; and inflation? 

Capital Spending Using the MOF's quarterly survey of private sector balance sheets & p&ls as our guide, there was a vigorous response to the threat and then emergence of a shortage of capital stock during this period.  Following years of negligible growth or actual shrinkage in spending on plant and equipment, as supply constraints began to emerge, spending rose 9.6% in 2004, 8.5% in 2005 and  14.7% in 2006 before being choked off in 2007 and subsequently.  It hasn't recovered: corporate spending on plant and equipment last year was a mere 68% of what it had been in 2007!  

On the basis of the tightening supply-side constraint on productive capacity, it seems reasonable to expect that the dire 0.1% yoy forecast of capex spending will be revised sharply higher in the coming quarters. 

Labour Markets This strength did not carry through noticeably to labour markets, however.  There was a stabilization in employment, but growth never got much above 0.6% yoy during the years of undersupply, and there was no noticeable or significant rise in wages. Rather, these were precisely the years when companies managed to push up the sales/expenses multiples of employees to highs of around 8.3x previously seen only in the immediate aftermath of the bubble years.  In short, employers reacted to a perceived shortage of labour by raising the productivity of their employees and booking the profits.  The moral is that it will take more than the perception of labour shortages to push up wages sharply. Not only is there no sign that this is taking place now, there is little reason to expect it to arrive any time soon. 

Inflation and Inflationary Expectations Finally, it is worth querying something that seems obvious – that the short bout of supply-side constraints did very little to move inflationary expectations, or, indeed to significantly mitigate deflationary tendencies in Japan. True, the CPI's downward drift was not significantly interrupted. However, there were signs that at the corporate level, there was a scaling back of deflationary expectations. Specifically, during 2006 to 2008, 15+ years of sharp corporate deleveraging, measured either by total assets/ equity, or by net debt/equity were both halted, and replaced by a short-lived bout of mild re-leveraging!  Although mild, this was also unprecedented in post-bubble corporate Japan: it almost amounts to a rush of blood to the head.

Conclusions?    Looking past the weakness of current data, and the likelihood that the tax rises will produce more such data in the short term, it does look as if for only the second time since the bubble years, Japan is hitting genuine supply-side constraints.  On the positive side, this forms a genuinely encouraging background for a capital spending cycle in a way which defies the current dire data. Quite possibly, it will also see a reversal in long-standing develeraging behaviour by corporate Japan. But the hopes that the cycle will be driven by gains in labour markets, specifically through significant wage rises, are unlikely to be realised. 

Eurozone Credit - A Squeak of Life for Italy and Spain?

Over the last few weeks, a crop of data from Italy and Spain has surprised consensus and broken trend positively: last week that included Spanish mortgage markets and Italian consumer confidence; before that we'd had surprises from Italy's industrial output, sales and orders surprised, and its current account deficit was small enough to break trend. In addition, Spain's exports are beginning to pick up sequentially once again.  Italy and Spain are not the most obvious places to look for signs of commercial life in the Eurozone. So what is happening?

The headlines of the Eurozone Feb money data were unremarkable – M3 growth of 1.3% yoy was exactly as expected, and in any case is hardly striking when compared against a base of comparison which is rapidly becoming easier.  But it was nonetheless a strong figure, with the 0.2% mom rise 1.2SDs above historic seasonal trends.

This surprise sent me back to the Eurozone banking data, where  to my profound surprise, I also found signs of life – something I had discounted owing to this year's forthcoming ECB stress tests.  In particular, loans to the private sector, though they inched down 0.1% mom and were down 3.6% yoy, are now beginning to moderate the extremely negative trends of the last five years.  Thus although Feb's private sector loans fell marginally, this was fully 1.3SDs better than the average Feb fall of the last five years.  Nor is this a one-off, there have been gains vs trend in each of the last six months, leaving the 6m momentum at 0.7SDs above trend – this is the highest it has been since August 2011, and it is still rising sharply.

The problem is that the underlying trend is so sharply negative that even these new levels of outperformance will still leave overall lending contracting quite sharply this year.  If the outperformance of the last six months is maintained throughout the year, private lending lending will end up falling 2.9% in 2014, with loan book down Eu305bn. That's better than the 3.6%, or Eu395bn contraction of 2013, but still a fall. So what we have is simply a moderation of the pace of contraction, not a reversal – a second-derivative change, not yet a change in direction. 

But the Eurozone encumbrances an impossibly diverse set of economies, so we should expect the overall moderation of trend to incorporate substantially diverse credit trends.  Perhaps the overall modest improvement is hiding substantial improvement in individual economies? The first cut tells us that the improvement vs trend in lending to the private sector is found mainly in the Big Four economies of Germany, France, Italy and Spain, which account for just over two thirds of the Eurozone loan book. There the first break into positive momentum came in mid-2013,  with a sharp acceleration during four months to February. By February the 6m deflection above trend was running at 1.04SDs, and the loan book was contracting by 1.9% yoy. 

It's a different tale for the rest of the Eurozone, where the nadir of contracting lending came only in September 2013, and where the 6m trendline broke into positive territory only during February. For these economies the loan book was contracting 6.9% yoy in February. The improvement in current trends means little for them: loans fell 5.6% in 2013 and are likely to fall 5.4% again in 2014.  

Looking more closely at the Big Four:

• The biggest 6m deflection against trend by far is from Spain (1.2SDs). There, pace of decline of credit has been essentially held steady since June 2013. Even so, on current trends, it still seems likely the total loanbook will contract by a further 8.3% this year (vs 9.6%  in 2013). 
• The second largest recovery against trend is found in France, where in February the loan book for corporations and h'holds actually expanded by 0.9% yoy, and 0.6 Sds above trend. Again, however, the underlying trend is sufficiently grim to make any significant credit growth this year unlikely – current trends would suggest a growth of 0.4% (vs 0.8% in 2013). 
• By February German loan growth was running at 0.3% yoy, and the 6m momentum trendline was 0.3SDs above reasonably negative historic trends.  On current form, we can expect no loan growth in 2014 in Germany (vs 0.2% in 2013). 
• Finally, Italy's loan book was down 2.7% yoy and was only 0.2SDs above trend. However, interestingly, the improvement in current trends would cut that fall to just 0.2% yoy in 2014, which represents a modest recovery from the 4.1% yoy fall in 2013. 

A very rough summary, then, is that there is no significant loan growth in either Germany or France, and recent data gives no grounds for expecting any in 2014.  Recent data, however, gives us evidence that there is already a significant moderation of negative trends in Italy,  and that conditions in Spain, though grim, are no longer deteriorating.  Perhaps the fact that the Eurozone's credit vice is no longer intensifying its grip on these economies is allowing a squeak of commercial life.  Meanwhile, credit conditions remain essentially unchanged, and sharply negative for 'The Rest'. 

US Capital Goods Book to Bill - On the Brink

The 1.3% mom fall in Feb's orders for capital goods (non-def ex-air) threatens to snuff out a re-tooling cycle which, though currently feeble, has been the best bet for a swing factor to push 2014 GDP growth above the 2.7% of current consensus.

The arrival or absence of a proper capital goods cycle is the crucial swing factor for 2014 US GDP. In 2013, non-residential investment added just 0.31pps to the average GDP growth of 2.6% - ie, it accounted for just 12% of US GDP growth. This is a significant underperformance: since 2010, nonresidential investment accounted for 30% of US GDP growth, on average. It is also an underperformance which, if corrected, could be expected to add 0.3-0.5pps to 2014 GDP growth. As a result, the monthly durable goods orders data is currently among the most important in the world.

Feb's 1.3% mom fall was bad enough, but when taken in conjunction with the 0.5% mom rise in shipments, it threatens the tepid cycle already underway. It means that the nominal level of orders have once again very nearly fallen to the level of shipments. The orders/shipments ratio is a sort of crude book-to-bill ratio: in normal expansionary time, the ratio is comfortably over 1, but when it falls below 1 one can be fairly certain that the cycle is turning down. February's results have cut this ratio to 1.01, down from the 1.04-1.06 range which normally prevails in expansions. We're not yet there, and there's still time for things to improve, but it puts us on the brink of a capital goods downturn.

The sectoral details were also bad: machinery fell 1.5% mom, communications equipt fell 2.7%, electrical equipment fell 0.9% and computer products fell 0.5%. In the key machinery sector, although shipments rose 1.6% mom sa, when one strips out the seasonal adjustment, there was no growth at all in yoy terms. 

It is astonishing that the cycle could be about to peter out, because there are many excellent reasons to expect an acceleration of capital investment. First, a strengthening is long overdue. For every country I look at, I estimate changes in capital stock by depreciating all fixed investment over 10yrs, and I generate a signal for directional changes in return on that capital by expressing GDP as a product of  that capital stock (a sort of asset turns measure). On this basis, ROC in the US is currently about as high as during the peak of the early 1990s, but capital stock is still growing only 1.8% a year in nominal terms even though gross private fixed capital formation grew by an annualized 5.3% in 4Q13.  By historic standards, the recovery has been both feeble and late, and a rebound is well overdue. 

This is broadly confirmed by monthly industrial data, which shows that capacity utilization rates have recovered to 78.8% in February. This is half a standard deviation above the post-2000 average, and approaching the 79%-80% levels which formed the pre-crisis plateau during 2005-2008. Since there's no obvious disequilibrium between industrial supply and demand which might trigger any downturn in the short-term, utilization rates are likely to continue to grind higher, in the absence of accelerated capital spending. 

This may not be a problem for individual companies, but it is for the economy as a whole.  For the number of people employed rose by an average 1.7% yoy in 2013, which meaning that capital per worker is virtually static, as is output per worker deflated by capital per worker.  Plainly, the lack of investment is now a ceiling to productivity rises, and thus to the potential GDP growth rate. 

After all this, it is worth repeating: Feb's data puts the US capital goods cycle on the brink of a reversal. All things considered this is not only depressing, but counterintuitive.  The odds must remain good that March and subsequent months bring better news. 

Japan's Happy SMEs?

In Japan, large companies and their SME suppliers co-exist in a symbiosis which is traditionally deeply uncomfortable for the smaller party. And so it continues.  In calendar 2013, large companies (Y1bn+ in capital) accounted for 43% of Japanese sales and, with OPM of  4.8%, took for 55% of corporate profits.  Meanwhile, small companies (Y10-100mn in capital) accounted for 38% of sales, but with OPM of 2.8%, took only 29% profits.  Because small companies form the the protean industrial substructure which support Japan's giant companies, they also are first to know when conditions change. This is why the Shoko Chukin SME business confidence index tends to be closely watched.  

In March the index jumped 2.9pts to the highest levels seen since 1989. On the face of it, this is extraordinary: in the very near future consumption taxes will rise to 8% from the current 5%, and although there has been no noticeable rush to shop before prices rise,  there is nevertheless a common worry that demand will take at least a temporary hit after prices rise.  And yet not only did the index for non-manufacturers rise 3.7pts (vs 2.2pts for manufacturers), but in addition, the biggest bounces in sentiment came precisely from retailers (up 5pts), wholesalers (up 4.5pts) and truckers (up 6pts). These are exactly the sectors which stand to be worst hit if tax rises bite into domestic demand.

At this point, the most important thing to realize is that this index is not seasonally-adjusted, and that SME confidence always jumps in March, which is the end of the fiscal year.  I do not know why the end of the fiscal year cheers SME spirits so much, but the track record is unequivocal: in the last five years, the monthly gain in March has averaged 3.8pts – rather more, actually, than was achieved this year. The chart below shows that regular March bump.  It also shows that it doesn't usually last – we can expect to see most if not all of the gain reversed in April.

Nevertheless, if March's bounce is a fiscal year-end phenomenon, it has peaked still higher than any since 1989.  And when one looks at how the various aspects of corporate experience and expectations are changing, it does seem that SMEs perceive real improvements in their operating environment, measured on a yoy basis. One particularly striking result is that SMEs now see the capacity situation as favourable (albeit by the narrowest of margins). For an economy which has routinely reported excess capacity for decades, this is rather startling. In addition, financing conditions, which have historically also always been seen as unfavourable, have nudged up to nearly neutral.  The profits situation is still seen as marginally unfavourable, but this is a far better reading that in March 2013.  Finally, SMEs are also seeing the first signs that the margin squeeze imposed by the depreciation of the yen is beginning to relax very slightly.  

Conclusion? March's reading isn't the breakthrough it seems, but nevertheless the index is grinding higher on the back of a slow improvement in business conditions:  maybe Japan's SMEs are catching some trickle-down from the gains finally being enjoyed by exporters as the J-curve impact of the yen devaluation  finally begins to emerge. 

US Taper and Foreign Investors - Part 2, Wary and Tactical

Last month, I wrote about how net foreign investment in long-term US instruments recorded an unprecedented US$133bn capital out flow during 2013 – something that has only happened once before in post-Cold War financial history. Since changes in fundamental financial behaviour are rare, it raised the question of whether this was merely a trading response by international investors to the prospective end of the Fed's taper, or whether it represented a fundamental re-assessment of the role of US dollar markets in the global financial system. The stakes could hardly be higher.

We now have data from January, which extended the trend: in January, net long-term foreign capital inflows came to just $7.3bn, which is $20bn less than in January 2013, and which takes the 12m net outflow to $157bn.

But closer inspection of the composition of this shortfall reveals that the origin and targets of the outflow are not as simple as merely a reaction to Fed's tapering. And as a result, the strain put on the dollar, and and dollar asset markets, is probably less than it appears. Finally, there is also evidence that insofar as the exodus from US bond markets is motivated by the announcement of Fed tapering, the exit has been tactical rather than strategic.  Overall, the detail belies the impression that the world is quietly removing itself from the dollar-standard.

The first surprise is that despite the headline deficit, there has been no foreign net selling of domestic US securities. Rather, in the 12m to January, foreign investments cut their buying of US domestic securities by $567bn yoy to just $15.4bn – a massive drop in buying, but not actually net selling.  The collapse in net buying was shared by both private investors (down $311bn yoy to just $16bn net buying in the 12m to Jan), and official investors (down $255bn yoy to a net $0.6bn sold in the 12m to Jan).  What pushed the entire balance into deficit was a net selling not of US securities, but rather of securities of foreign companies and institutions floated and traded in the US – there was net selling of $173bn of these securities!

So foreign net buying of US domestic long-term securities fell by $567bn to just $15.4bn: what were the major portfolio changes? As expected, the main driver was a reluctance to buy new treasuries: on a 12m basis, net buying fell $350mn yoy to just $10.5bn in the 12m to Jan.   But the biggest actual net selling was in equities: foreign investors sold a net $52.1bn in the 12m to Jan,  compared with net buying of $110.5bn in the same period the previous year. This is consistent not just with caution in bond markets, but also modest profit-taking in equities.  Foreign investors bought $53.6bn of agency bonds (down $72.7bn yoy), and $3.4bn of corporate bonds (up $18.6bn).

The combination of bond caution and profit-taking in equity markets looks much more like a tactical trading strategy than a wholesale decision to exit US asset markets.  And this suspicion is bolstered by a further detail: at the same time as foreign investors were cutting their holdings of US securities, they were building up unprecedented levels of deposits in  the US banking system.  (To be precise these are banks' liabilities to foreign investors – since they cannot be either bonds or equities,  I am assuming they are deposits.) To put some numbers on it: in the 12m to Jan, foreign investors sold a net $157bn, but raised their deposits in US banks by $541bn.  The change in behaviour from the previous year is stark: in the year to Jan 2012, foreign investors had bought a net $528bn in securities, but raised their deposits in US banks by just $79bn.

Now take a look at the chart below, which tracks 12m changes in foreigners' net purchases of US securities, and net deposits in US banks. The first thing to notice is the offsetting relationship between changes in holdings of securities and bank deposits which seems to have been fairly consistent since 2011.   Since then, when purchases of securities have dried up, bank deposits have risen, and conversely when securities buying is booming, bank deposits run down.  The most obvious explanation for this is simply that foreign investors are tactically trading in and out of securities markets without at the same time trading in and out of the US financial system, or the US dollar.  Which perhaps explains why the lack of impact on the dollar from the net sales of US securities.

But notice also that this pattern is new: prior to the crisis, there was no obvious offsetting relationship between securities purchases and bank deposits – both tended to move in the same direction both in and out of the dollar financial system.  This suggests an underlying change in the overall pattern of foreign investor behaviour in dollar markets, with a far greater sensitivity to market conditions and a far greater willingness to trade. The pre-crisis willingness simply to pile rather indiscriminately into dollar assets has been modified.

And, finally, this is reflected in overall investment patterns (of securities and bank deposits). Whilst the 12m to Feb 2014 still showed an overall inflow of $383.2bn, the total has been in steady and unspectacular decline since 2011.  In 2011 the net inflow was $754bn; in 2012 it fell to $563bn, and in 2013 it fell again to $394bn.  This is clearly a different pattern of behaviour from the steady pre-crisis build-up, or the rout  experienced during the crisis. A willingness to hold dollars remains, but that willingness is less enthusiastic than before, and evidently more qualified by tactical trading opportunities than before the crisis.  The world's investors have not abandoned the dollar, but the relationship has changed.

China: Tactical Reversal

China’s strategic economic aims remain unchanged, but the tactics deployed to achieve them have reversed. This reversal of tactics will make a direct impact on the rest of Asia, and if pursued sufficiently hard, on the rest of the world too. 

Last year, China’s revealed policy was to tolerate rapid overall credit growth to accommodate a ‘stealth liberalization’ of interest rates via the ‘shadow banking’ system, whilst letting a steady rise in the Rmb to do the heavy lifting in the fight against inflation. Now that policy has reversed, with accelerating interest rate reform, a continuing roll-back of the ‘shadow banking’ experiment, and the resulting financial squeeze mitigated via a weaker Rmb. 

The implications for the rest of the region depend on how aggressively this policy reversal is pursued. At its simplest, it means China will be a tougher competitor in export markets. At the limit, a sharp depreciation of the Rmb could result in China exporting deflationary pressures to the rest of Asia and to the rest of the world, acting in much the same way as Japan’s post-1995 yen devaluation. 

Four developments in China over the last couple of weeks demand a reassessment of assumptions about strategy and policy.  The four developments are:
i) the belated but almost ritualistic repetition of annual targets for growth, trade, inflation and money supply, unchanged from 2013;
ii) the announcement of CPI and PPI numbers significantly below those targets;
iii)  weak industrial, domestic demand and financial data for the first two months of the year; and
iv) an unexpected fall of the Rmb against the dollar, accompanied by PBOC doubling the daily trading band to 2% either side of a daily fixing, from the previous 1%.

Taken together, they point us to a changed understanding of China’s reform efforts, and a recognition that if the strategic aims remain the same, a U-turn in tactics is underway.

Let us first consider the announcement of formal economic targets for 2014 made by premier Li Keqiang in his work report to the National People’s Congress: GDP target of about 7.5%, CPI around 3.5%,  M2 growth of around 13%, trade volumes  to grow by around 7.5% and 10mn more urban jobs to be created, all accompanied by a ‘proactive fiscal policy and prudent monetary policy.’  The key point about these targets are that they unchanged from last year: for all the emphasis on reform at last November’s 3rd Plenum, Li Keqiang’s underlying message is that for the time being need have no macro-economic consequences at all.

This runs directly counter to the view that whole point of reform was to overhaul systems of political and financial patronage in order to discover a less-inefficient allocation of resources. Such a re-allocation of resources implies at the very least a transitional period of economic volatility, which in turn implies a toleration of slower growth in the short to medium term.  Now that Li Keqiang has nailed his colours so firmly to the mast, those assumptions are fatally undermined.

At this point, it may be worth quoting an editorial in the CCP’s Global Times, which appeared right at the end of the NPC: 'Do officials at provincial and township levels have the same determination as the top leadership in carrying out comprehensive reforms? To be honest, society is not as confident as officials at the top.  Reforms are bound to intrude into the interests of certain groups, and redistributing those interests is risky. Some senior officials are not able or willing to undertake the risks.

'When the public points their fingers at interest groups that stand in the way of reforms, they usually mean civil servants and SOEs. Actually, when reforms are carried out, they will touch upon the interests of nearly all Chinese people. The opposing voices will eventually mount for the govt.'

The reiteration of the usual economic targets also looks like a promise that the boat is not to be rocked too violently. And it is this light that we must look at the other three developments. First, the industrial, demand and financial data for Jan-Feb clearly shows a slowdown is underway. Industrial production growth slowed to 8.6% yoy (from 9.9% in the same period in 2013), and exports fell 1.7% yoy (vs a rise of 23.6% in the same period of 2013);  for domestic demand, urban fixed asset investment slowed to 17.9% (21.2%), and retail sales slowed to 11.8% (12.3%); for finance, bank lending growth slowed to 14.2% yoy in Feb, and the monthly addition of total aggregate financing fell to Rmb 938.7bn yuan in Feb vs Rmb 1.066tr in Feb 2013.  Although market reaction to these numbers was severe, it is worth trying to put the weakness in context: the chart expresses the 6m momentum trendline for industry (output, exports, electricity generation), domestic demand (retail sales, urban investment, auto sales, real estate conditions, passenger traffic), and monetary conditions (money growth, real interest rates, yield curve and currency movements). It confirms the slowdown, but also emphasises that, so far, the volatility remains, in Chinese terms, unspectacular.

Unspectacular, but this loss of momentum is still a threat to the Li Keqiang’s ‘normal’ targets, and so demands some sort of policy response.

This is where the next two developments come in.  February’s CPI inflation retreated to 2% yoy, the lowest since Jan 2013, whilst PPI fell minus 2% yoy, the most disinflationary since July 2013.  With money growth slowing, China’s 3.5% yoy CPI target for 2014 looks likely to be undershot: the trends of the last five months suggest inflation falling to around 2% for the whole year, at spending most of the second half of the year below that rate.  So the 3.5% CPI target starts to reinterpret what a ‘prudent monetary policy’ might be.

Consequently, there is room to allow, or encourage, a depreciation in the Rmb to offset the tightening discipline in China’s broadening banking markets. For all the current unease about likely credit problems emanating from China’s ‘shadow banking’ system, it is worth remembering how and why its growth was tacitly encouraged last year.  The rise of the ‘shadow banking system’ can also be seen as an experiment in banking reform, amounting to a ‘stealth liberalization’ of China’s interest rate regime, since trust loans and entrusted loans both escaped PBOC’s interest rate regime.  China’s banks began to price credit whilst still conforming the formal policy-demands of PBOC, ensuring that there was no sudden diversion of resources away from the traditional recipients/beneficiaries of bank credit.

Whilst this allowed the experiment to be undertaken without disadvantaging core political clients, it also meant that total credit expanded fast –  formal bank loan-growth rose 14.1% in 2013, but I estimate the stock of aggregate financing rose by 17.3%.  Clearly, the heavy-lifting of inflation control was not being done by the banking system, formal or shadow: rather, that work was done by allowing the Rmb to rise unspectacularly but uninterruptedly.  During 2013, the Rmb rose 2.8% against the US dollar, and about 3.5% against the SDR.  The combination was evidently successful in taming inflation whilst maintaining economic growth.

And it is this tactical solution which is now being reversed. With formal interest rate reform now clearly fast-tracked over the coming two years (PBOC chief Zhou Xiaochuan: 'We will let the market play its due role in interest rate liberalization. That's for sure’), the ‘stealth liberalization’ no longer has a role to play, and can be wound back. Just as its expansion meant an overall loosening of credit conditions which needed to be disciplined by a strengthening Rmb, so the wind-down of the shadow banking system tightens credit conditions, and this can be at least partly offset by a depreciation of the Rmb, particularly given benign inflation trends.  And so the combination of relaxed inflation prospects, foregrounding of interest liberalization and a determination that the current slowdown should not develop into something more threatening, reveals the change in policy.

For the rest of Asia, a weakening Rmb is a direct step-up in competitive pressures, since China now accounts for just under 59% of total NE Asia exports, and a weaker yuan will encourage China's exporters to cut prices to win market share and improve cashflow.  Those of a nervous disposition will remember what happened when after the sharp devaluation of the yen post-1995 – at the beginning of which Japan accounted for about 51% of total NE Asia exports.