BOJ, ECB, Fed: Three Ways to Lose Credibility

The collapse of ex-US confidence beyond anything justified by current economic data is just one early ramification of the dollar's strength. Nevertheless, it focusses attention back on central banks, and in particular on their perceived ability to exercise sufficient influence or even control on financial conditions to head off trouble.  In other words, it puts central bank credibility at a premium, at the same time as undermining it.

And in each major economy, the challenges to central bank credibility have evolved differently. But in each case, the risks of lost central-bank credibility are suddenly more thinkable, and more visible, than they were a few months ago. In fact, the threats to central bank credibility may themselves form a new category of risk to the global economy.

BOJ – Classic currency/bond market/financial system meltdown

The credibility of the Bank of Japan seems the most immediately fragile: it is horribly easy to envisage a situation in which a run on the yen forces up interest rates (in the mild version, to head off inflation; in the alarming version, simply to underpin the currency temporarily), which in turn destroys the value of JGBs held by financial institutions.
Just to put some figures on those holdings:
I) public sector debt makes up 22% of the total asset base of Japan's commercial banks, and are equivalent to just under 30%  of their deposit base.
II) Public sector debt account for 48% of insurance and pension assets, and are equivalent to 61% of total insurance and pension reserves.
III) Public sector debt accounts for 79% of Bank of Japan's assets, and equivalent to 141% of the deposits made with the bank, and are 2.36x the currency issue.

More generally, with public sector debt as a percentage of GDP having sailed past 200% approximately a decade ago, any significant and sustained rise in interest rates would threaten to overwhelm almost any imaginable plan for fiscal consolidation.

So what can be said for Bank of Japan.  Well first, this: that the underlying government debt situation is so extreme, and the ticking of the bond-yield bomb has been so audible for so long, that worries about the Bank of Japan's credibility have themselves developed a credibility problem. The reluctance to believe in the doomsday scenario in which Bank of Japan 'loses control of the situation' isn't simply a matter of recoiling from the horror – it is also testimony to the regularity with which the anticipation of Japan's doomsday has cost investors money.

The best chance of defusing this bomb demands: a) an economy which is growing in nominal terms  but also b) inflation which is sufficiently positive to help foster nominal GDP growth, by changing ingrained deflationary expectations), but sufficiently suppressed in both absolute terms and in volatility, to keep the bond market calmly accepting of a life of modest but sustained loss of value. Tricky, very tricky.

Before the latest devaluation of the yen, however, the trajectory for inflation suggested that BOJ's attempt to rise the inflation rate to around a steady 2%, excluding tax rises, was on course.

So the question now is: what impact is the devaluation of the yen likely to have on CPI? The most obvious impact is on the price of imported fuels: overall, energy has a 7.7% weighting in Japan's national CPI, falling to 4.6% if electricity is excluded, with the largest components being gasoline (2.3%) followed by gas (1.8%). In other words, every 1 percentage point fall in the yen vs the dollar would be expected to raise the CPI by 0.05 percentage points.

Now, in September, the yen declined on average by just under 4% against the dollar, and has fallen a further 2.5% in the earl days of October. Were this to be passed through entirely to gasoline and gas prices, the combined fall would be expected to raise the CPI index by 0.3% during those two months.
But this, of course, isn't what will happen, since a) oil prices have been falling as the dollar has risen; and b) the bulk of Japan's oil contracts will not be priced in spot terms either for the commodity or for the fx rate.  In both cases, in the short term this is likely to mute any inflationary impact from rising yen oil prices.

More importantly, oil remains quite a small part of the overall index weighting: the things which weigh most heavily on Japan's CPI are food (25.3%), housing (21.2%), transport (14.2%, includes oil) and culture/recreation (11.5%) - and for most of these, the pass-through from oil prices is likely to be very small.

ECB – The Discovery of Impotence 

Meanwhile, over at the ECB, Mario Draghi increasingly looks like an honest man getting used to public deception. Too personal? His problem is that ever since his July 2012 willingness to to 'whatever it takes' to save the Euro,  his ability to change expectations, and thus savings/investment behaviour is linked to whether he can make good on this claim.  There are two major problems which would seem to restrict the scope of 'whatever it takes'. The first is simply political: German opposition to quantitative easing seems entrenched, and to have resulted last week in Mr Draghi being unwilling or unable to quantify the size of his earlier stated plans for the ECB to start buying private sector assets in the aftermath of the ECB's latest policy meeting. 

 The second is legal: Article 21 of the ECB's constitution forbids 'overdrafts or any other type of credit facility . . . in favour of Community institutions or bodies, central governments, regional, local or other public authorities' and bans 'the purchase directly from them by the ECB . . . of debt instruments'.  On October 14th, the European Court of Justice will be hearing arguments from Germany academics on the legality of ECB's current bond-buying plans.  

But does it matter just now if confidence in Mr Draghi's ability to deliver the ECB to full-blown quantitative easing gradually ebbs away? Arguably, it matters less that confidence in his promises of ECB largesse is now waning, than that it was present first in July 2012 ('whatever it takes') and again 2Q2014, since then it helped rally bond and equity markets. In the first instance, confidence in Mr Draghi's intentions helped cut the premium of 10yr BBB bonds from roughly 200bps to around 120bps; in the second, it helped push it down further, to around 95bps.   More dramatically, it was part of the circumstances which allowed the premium on 10yr Spanish bonds to fall from c500bps in July 2012 to  slightly more than 100bps now. Arguably, Mr Draghi's ability to buy time then was more important than the possibility that some of the currency in which he bought it may yet turn out to be lacking. 

In turn, this provokes the wider question of what quantitative easing can be expected to achieve in the first place. Whilst it seems likely that quantitative easing, and indeed the prospect of quantitative easing, can and does move asset prices in a way which can be very useful to extremely-stressed financial systems, it is altogether more uncertain that it can effectively change saving/investment decisions in a way which makes a clear impact on the economy. Studies by the US Fed found that the required internal rate of return demanded of corporate investment decisions were extremely 'sticky' and so likely to be surprisingly little encouraged by falls in short-term rates or even long-term bond yields. The results of this are there for all to see: years of quantitative easing in both the US and UK have brought forth expansions which are surprising mainly for their almost complete lack of normal cyclical 'accelerators', or indeed, of any noticeably cyclical structure.  

Fed – The Nostalgia for Normality

And this brings us back to the Fed, which now faces a challenge to its longer term credibility which reflects the curiously a-cyclical nature of the expansion currently underway: a nostalgia for 'normality' which seeks to re-instate a policy-making structure which simply is no longer available. Almost all commentary on the Fed's policymaking in one way or other amounts to attempts to re-interpret, re-state, or (most ambitiously) re-calculate the Taylor Rule conditions. When John Taylor first suggested the 'rule', it was simply put forward as a way of interpreting what had actually been the revealed policy of the Fed – that rate changes had been made to reflect deviations in both the actual rate from the targeted rate, and changes in the output gap (or, more loosely, how far actual output was deviating from potential output). In practice, this output gap was estimated by measuring the deviation over a long-term growth rate which had been stable enough to measure and extrapolate with confidence. 

The problem is that the financial crisis has left the economics profession profoundly uncertain as to the size of the output gap, and similarly unsure as to the potential growth rate of the US.   This ignorance and uncertainty was neatly illustrated by Friday's labour markets release: the 248k mom rise in non-farm payrolls suggested relatively buoyant growth, but the  shocking renewed fall in the labour participation rate suggested this growth was not drawing people back into the workforce as had been expected. If that is the case, the potential supply of labour must be smaller than appreciated (and so the output gap smaller than expected). But, finally, the market doesn't seem to be tightening, since since hourly wages were unchanged on the month.  As far as wages are concerned, it seems that even the mild upward pressure seen earlier in the year is abating. The paradoxes of the report point directly to the impossibility of using Taylor Rule metrics to structure monetary policy in current conditions. 

In these circumstances, the credibility issue the Fed faces is twofold: the the ability to make the right decision; and the ability to persuade the rest of the world that the FOMC knows why it is making it in the absence of a credible rationale. The worry is that the 'nostalgia for the normal' will tempt them to grab for a  solution which looks 'normal' – in this case, by raising interest rates – before any sort of cyclical normality is in fact re-established.

Northeast Asia Gets Ready to Cut Prices

Before the striking weakness of August's industrial data the region seemed to be avoiding the usual fate it meets when the dollar strengthens: export prices were not falling sharply, international terms of trade were holding up, underpinning margins, profitability and cashflow.  It was different this time.  But this week's industrial news from Japan and South Korea changes the picture for the worse: not only did industrial output slump in China (output rising 6.9% yoy only), Japan (output down 3.1% yoy) and South Korea (output down 2.8% yoy), but this slowdown was insufficient to stop inventory ratios blowing out.

The desire to cut inventory ratios, coupled with the accelerated depreciation in the yen, sets the stage for a renewed period of deflation coming primarily from Japan and South Korea. That pricing pressure is likely to radiate out to China and to Southeast Asia, and we're likely to feel its effects very soon.   

First, let's remember that the last few years (since when?) have been a period of exceptional pricing and margins stability for most of Northeast Asia. Deteriorating terms of trade had been a way of industrial and trading life for most of Northeast Asia for as long as most managers can remember: between 1994 and 2011, terms of trade fell almost uninterruptedly for both Japan and S Korea; Taiwan held out a little longer and a little better, but was unable to escape, with a sharp and seemingly unstoppable slide between 1998 and 2011. However, since 2011, the pattern has been near-stability: between 2Q11 and the 3m to August, Japan's terms of trade fell only 5%, whilst they improved 1.7% for S Korea and rose 2.7% for Taiwan.

This new stability wasn't just the result of commodity price movements favouring Northeast Asia's industrial commodity-consumers – though that certainly helped.  But in addition, there had been no repeat of the bouts of savage deflation in dollar export prices experienced in 1997-2002, again in 2006 and once again, briefly in 2010. In its place has been a period of unusual pricing stability for NE Asian exporters. 

It is this stability which August's shockingly weak industrial data puts under threat. To recap:

• China's industrial output growth slowed to 6.9% yoy, on a monthly slip that was 0.7SDs below trend
• Japan's output fell 3.1% yoy, and was 1.3Ds below trend
• S Korea's output fell 2.8% yoy, and was 1.1SD below trend.

Now, this could perhaps be dismissed as a shared blip – and what's more, a blip in the month of the year which matters least as far as industry is concerned.  And it remains the case that momentum trends in G3 imports and Northeast Asian exports remain sufficiently robust to allow a yoy acceleration through the rest of the year (although perhaps slightly less than expected six months ago). It also remains the case that global domestic demand remains in reasonable shape.

However, the problem is that at least for Japan and South Korea, August's slowdown has left  both with an inventory problem which managements will want to address quickly (particularly in Japan).  Japan's inventory/shipment ratio has spiked up to the sort of levels seen in the immediate aftermath of 2011's triple disasters, and again in the angst-ridden period which brought PM Abe to office. Getting rid of these inventories will demand either further cuts in production, or significant price-cuts to get the inventories off the books. Since the end of August, the yen has fallen  more than 5% against the dollar, so the temptation simply to slash dollar prices will be hard to resist.

That then throws the pressure back onto Korea, where the inventory turnover ratio  (total inventories/sales) has been climbing since 2011, and in August reached record heights. 

And, of course, that pressure will also be felt in China.  China's August industrial data was awful too: not only did output growth slow to 6.9% yoy, but the slowdown in the topline crushed profits, which fell 0.6% yoy in August (if the data is to be believed). Once again, if China's data is to be believed, mainland companies have spent the last 18 months or so successfully protecting their margins, and this was still the case in August's slowdown.  However, as the chart also shows, China's margins are highly cyclical and tilted sharply towards the year-end. It is the fattening of these year-end margins which would be directly threatened by Japan and S Korea's efforts to offload inventories by cutting prices. 

Conclusion? It's price-cutting time for Northeast Asia: there will be bargins this Christmas.

The 'Fragile Eight' and Terms of Trade

Another day, another warning of possible global implosion. This time it's from the Geneva Group: as lofty a  bunch of European financial and economic practitioners as you're likely to come across. Entitled 'De-leveraging, What Deleveraging?' the report is for the most part a detailed explanation of why high levels of indebtedness can be dangerous. It also attempts to identify the difference between simple recessions and various types of debt-triggered disasters (an attempt which hinges on a touching faith in the ability to identify 'potential GDP'); and finally it focusses on the build-up of debt in emerging markets, warning of the possibility that the next financial crisis may be bubbling up in China and/or a group they identify as 'the Fragile Eight.'

The 'Fragile Eight' are: Argentina (129% debt/GDP in 2013); Brazil (121%); Chile; India (120%); Indonesia (65%); Russia (43%); South Africa (127%) and Turkey (105%).

In this article, I'm going to ignore China, and instead focus on the 'Fragile Eight'.  Or rather, I want to focus on one of the key factors which can turn an underlying fragility into a genuine crisis. the Geneva Group identifies three main types of crisis: banking crises; sovereign debt crises; and external crises, which they describe as an inability to rollover existing debt or obtain funding to cover current account deficits.  But each of these need a trigger - a shock which catalyses the crisis, of whatever type it may be. And in my experience, one key trigger which is almost always present, but which almost always gets ignored until it's too late, is a deterioration in a country's terms of trade - ie, a rise in import prices it must pay relative to the export prices it can command.

Big shifts in a country's international terms of trade really matter.  In terms of debt crises, they matter particularly because;
i) in practical terms, a deterioration in terms of trade usually results in a deterioration in underlying cashflows within an economy, which in turn  can expose latent financial vulnerabilities both to, and within,  a country's financial system;
ii)  since a country's terms of trade signal an international ability to price its goods and services, it is also a reflection on its potential growth rate. Put simply, if a country's terms of trade are rising, the world wants what it has to offer; conversely, if they are falling, the world's appetite for its goods and services are in relative decline.  And, of course, even though experience warns us that attempts to pinpoint a country's potential growth with any useful accuracy usually fail, a shift in the terms of trade is a useful indicator of which way the wind is blowing.

For each of the Fragile Eight, I have looked at movements in the Citi Terms of Trade Index since the beginning of 2006, and tracked where September's index is relative to the long term average, and also at the change during the last 12 months.  In both cases, I'm interested in both the extremity of the current position, and in the speed at which changes have happened.  In order to capture this, I have expressed the current deviation in terms of standard deviations from the post-2006 average.

This table reveals the Fragile Eight are not as coherent a group as the Geneva Report assumes.
i) For Turkey, Russia and India, the story told by the terms of trade are either positive or neutral, with the implications for improved cashflows that implies. These are the the Not-So-Fragile Three.
ii) Conversely, there are two, and possibly three, clear losers. Brazil is the biggest loser both in terms of how far from the post-2006 average September's position  has fallen (2SDs below) and the speed at which this fall has occurred (2.3SDs over the last 12 months).  South Africa and Indonesia also look like major losers, with Indonesia's terms of trade currently 1.7SDs below its l/t average, and South Africa's 1.4SDs below. Of these two, however, South Africa looks the more vulnerable, because it starts with a much higher leverage (127% of GDP vs Indonesia's 65%), and because Indonesia's terms of trade appear to have virtually stabilized over the last 12 months, whilst South Africa's has deteriorated quite sharply (down 0.5SDs).
iii) Finally, whilst both Argentina and Chile are suffering a modest deterioration in terms of trade, the current position and the speed which which current deterioration has arrived look relatively unexceptional.

Finally, it is worth remembering that terms of trade are a global zero-sum game: one country's terms of trade loss is another country's terms of trade gain.  What may yet prove the most important factor in the world's cycle is the unusual strength and resilience in terms of trade which developed markets are now showing. This phenomenon embraces not just the US and Europe, but also most of Northeast Asia, including economies who's histories have for years or even decades been suffered incessant terms of trade problems.  More on that later. . . .  

Eurozone - Expansion Despite Policymakers Best Efforts

There are very good reasons why the Eurozone is identified as a major drag on the world economy: its policymakers have managed to distil a formula of strategic policies which are fundamentally toxic.  The mix tightens fiscal policies whilst at the same time demanding bank recapitalization, all within a single-currency framework which imposes on approximately half the continent the wrong international pricing for locally-produced goods and services.  The resulting slide towards deflation isn’t an accident, it is policy (sometime referred to as ‘internal devaluation). To that must be added a studied lack of enthusiasm for supply-side reforms, and in certain cases (Italy, Spain, Portugal at least) an inherited public sector debt problem which, without a return to vigorous nominal GDP growth, must eventually end in default.

None of this is news to those outside the policymaking environs of the EU.  What is more surprising is that the Eurozone continues to grow at all (albeit 2Q GDP was virtually unchanged qoq, annualizing to just 0.1%), and might be expected to accelerate mildly over the coming year. And yet embedded in the misery, there are developments which would, in other circumstances, herald a cyclical recovery.  The good news shows up in rising productivity of the two key factors of production: capital and labour.

The first chart attempts to identify directional trends in return on capital by considering nominal GDP as an income from a stock of fixed capital. Movements in that capital stock are estimated by assuming a 10yr depreciation of all gross fixed capital formation (as identified in quarterly national accounts). The chart shows a pattern in which capital stock has been shrinking since the beginning of 2013, and is currently now shrinking around 0.6% a year in nominal terms.  Since nominal GDP is currently rising at approximately three times that rate, asset turns are rising sharply, which in turn generates a rise in return on capital.

This cyclical dynamic of capital spending stalling sufficiently to allow a rise in asset turns is a familiar feature of economic cycles, and the corollary of rising asset turns is, of course, a resurgence of investment spending. The problem is that elsewhere in the world,  in this cycle the gap between return on capital rising and capital stock beginning to be replenished has been extraordinarily long.  For example, in the US, the ROC directional indicator bottomed out in 2Q99, and recovered to its pre-crisis levels by 3Q10, but it took until 2Q11 for capital stock to stop shrinking.  And then the recovery has been exceptionally muted: by 2Q14, although the ROC directional indicator was at its highest since the early 1980s, capital stock was growing at only 2.1% yoy.   One can guess at the reasons for this relative dislocation between ROC and capital spending: a fundamental lack of medium-term commercial confidence; an underlying deflationary expectations; a failure financial intermediation. Whatever the reason, ROC may be rising, but it seems obviously premature to expect any sort of sustained recovery in Eurozone investment spending.

The news is less bad for the second factor of production: labour. The cyclical dynamic plays out in much the same way as it does for capital: in the early stage of a recession, employment falls sufficiently to allow labour productivity (deflated by changes in capital per worker) to rise. When productivity begins to rise, labour markets begin to recover.  And here the trends in the Eurozone are slightly encouraging: real output per worker, adjusted for changes in capital per worker, are rising at approximately 1.7% yoy (output per worker up +0.6% yoy, capital per worker down c1% yoy). And in response, employment in the Eurozone is actually rising, by around 0.5% yoy in 2Q. This rise in employment is currently concentrated in two economies: Spain (up 2% yoy) and Germany (up 0.8% yoy). However, there is no reason not to expect this employment gain to be maintained, and gradually strengthened. In both the UK and (to a lesser extent) the US, the sustained rise in employment, backed by rises in labour productivity (deflated by capital stock) has been the key to the sustained and generally non-cyclical expansions currently underway.   And this is the key, the Eurozone’s recovery, though tepid, is unlikely to show signs of becoming self-supportingly ‘cyclical’ any time soon. 

Two final charts illustrate the point. The first is of the Eurozone’s private sector savings surplus: this I estimate at approximately 5.2% of GDP in the 12m to 2Q. The private sector savings surplus shows, of course, the balance between private investment and savings, and self-evidently, strong changes in the balance of these decisions are a key dynamic of investment cycles. Hence in 2008-2009 the financial crisis produced a very sharp jump in the PSSS from a savings surplus of around 0.7% at end-2007 to a high of 6.6% in  1Q10. The current dynamics are not similarly cyclical – since 4Q12 the surplus has wandered between 5% and 5.6% of GDP, and is currently drifting downwards, to around 5.2%: savings and investment decisions show no signs of dramatic movement.

The private sector savings surplus is also a measure of the fundamental vector of flows of cash between the private sector and the financial system – a savings surplus ends up as a net flow of private sector cash into the financial system, whilst a deficit will have to be funded by a flow of cash from the financial system to the private sector (for example, by bank lending and a rising loan/deposit ratio).  In a bank-dominated financial system, the positive flow of cash associated with a savings surplus will accumulate in bank deposits, and thus in the money aggregate M2.  It is therefore crucial to determine how effectively the banking system can recycle these savings back into the economy. One measure of this is monetary velocity (GDP/M2).  And as the chart shows this is showing a small but continuing decline.  Consider what this means: in the 3m to July, M2 grew at 2.3% yoy, and if monetary velocity continues to fade whilst monetary growth remains stable, nominal GDP growth must sink below the 1.8% achieved in 2Q14.

The ECB plainly understands the impact of the continuing inability of the Eurozone’s financial institutions to improve its recycling of private savings flows.  However, there is little evidence that even a fully committed policy of quantitative easing can reverse this fall in monetary velocity. In the US, all the Fed’s quantitative easing, coupled with a convincing expansion, has not yet managed to reverse the fall in monetary velocity. In the UK, quantitative easing has not stopped the long-term decline of M2, and, of course, in Japan, monetary velocity has been falling virtually without interruption since 1993.  The message seems to be that central largesse cannot make commercial banks into efficient recyclers of private sector savings – it can only attempt to overwhelm that inefficiency with sheer scale.

Where does this leave the Eurozone as a contributor to global growth in the short and medium term? Surprisingly, perhaps, leaves us with grounds to expect that a modest expansion can be maintained, despite the slowdown of 2Q, simply on the basis that rising labour productivity in the absence of net positive capital spending, will allow for a modest but sustained rise in employment, which in turn can provide some modest expansion in demand.   But there are two caveats: first, there is no reason to expect any obvious acceleration in pro-cyclical behaviour; second, there is no reason to expect that nominal GDP will match levels of M2 growth any time soon; and third, there is no reason to expect that any relatively modest steps towards quantitative easing by the ECB will succeed in inducing any pro-cyclical behaviour in the short to medium term. The Eurozone will remain a drag on world growth, but in the short to medium term, probably not more so than we are currently used to. 

This is an excerpt from the Shocks & Surprises Global Weekly Summary for the week to 19th September. Please email me if you would like to see a copy.

Bulletin of Broken Dreams - With Two Grounds for Hope

'Let's go'
'Yes, let's'
They do not move as the curtain falls. 

It is nearly midsummer, so time for taking stock of how the first half of the year has developed. Musing over this, it struck me that the hopes and expectations commonly held at the end of 2013 have receded so rapidly that even recalling them requires an imaginative effort.  

Do you remember when China's Third Plenum was going to usher in a new and energetic phase of reform in which an improved capital allocation would lay the foundations for a shift towards consumption-led demand and rising return on capital?  What we have got is a tremendous amount of political energy diverted into an anti-corruption campaign and a host of mini-measures aiming to fine-tune the economy to ensure that the same old broad GDP targets are met . . . anyhow, it seems. That Xi Jinping may turn out to be China's Brezhnev remains an awful possibility. 

Do you remember when Abenomics was going to rejuvenate Japan? The core of that strategy was a hope that sufficiently dramatic policy initiatives from both the central bank and the government could fundamentally re-order Japanese expectations – which is to say household and corporate financial and economic behaviour. So far the devaluation of the yen has produced a mild and belated upturn, but close examination of corporate behaviour shows no deviation whatsoever from the tactics and strategies hard-learned during deflation. It is still not clear that what 'third arrow' policies will be adopted, but currently it seems that the most that can be hoped for is a snail's pace  scaling down of corporate tax rates paid for by closing other tax breaks.  It seems unlikely to fundamentally change corporate expectations or behaviour. 

There were, perhaps, no great expectations of the Eurozone, except that a pickup in the rest of the global economy might mitigate the damage done by policies aimed only at extending the Euro's half-life as a viable currency.  Nothing has changed there, except a quiet backsliding on measures to underpin a banking union, and a quiet backsliding on some of the excesses of the destructive fiscal compact. Voters turned in unprecedented numbers to elect members of the European Parliament opposed in a variety of ways to the EU institutions' agenda. But it seems likely the new head of the European Commission will be a man who's main qualification is a lifetime's unthinking and unbending devotion to 'the project'.

So our anticipation of reforms which might help re-boot the global economy were ill-founded and are probably best forgotten. Despite all that, the outlook for the world economy has actually improved, and will probably continue to improve during 2H, even if the reasons are altogether more mundane (see previous comments on prospects for G3 imports and NE Asian exports). 

At the centre of this is the US recovery, which continues to accelerate without really threatening to reach escape velocity. Two indicators give a pretty clear visual idea of where we are: employees' willingness to quit their jobs; and small businesses' intention to expand capex.  Both are grinding higher, but at such a slow pace that there's no short or even medium term likelihood of reaching their pre-crisis cruising altitudes any time soon. The quit rate is a good indicator of how employees think about the state of  labour markets – the higher the quit rate, the greater the quitting employee's confidence that an alternative job awaits. Latest data shows it has risen to 1.8%, which is up from the 2009 lows of 1.3%, but  still far off from the 2.2%-2.3% sustained pre-crisis. In other words, we're halfway there.  The small business capex intentions rate is self-explanatory: pre-crisis it typically ran at about 31%-32%; during the crisis it bottomed out at around 17.5% and has since recovered to 24%.  In other words, just as with the quit rate, we're about halfway there. 

And there is an unexpected second factor allowing encouragement: it seems that Britain has stumbled on a form of recovery driven by a rise in employment which probably reflects human ingenuity responding to dire necessity. It seems wrong to credit any of Britain's policymakers with discovering this course – indeed, there is little sign they understand how and why it is happening.  And since such a supply-led recovery is a genuine novelty to Britain's policymakers, there's still every chance that they will snuff it out by tightening monetary policy in order to head off a 'overheating' which exists nowhere outside London's property market.  Nevertheless, if it is allowed to live, a supply-led recovery can be extremely durable, and it has been born and already reached its early years without the benefit of productivity-enhancing investment spending or any significant supply of credit. 

It is also possible that Britain's labour-led recovery may be replicated elsewhere in parts of Europe where there are few other grounds for hope – Spain for example. 

But the problem is that almost everywhere the world's cycle remains hostage to a financial system which, for varying reasons, remains profoundly dysfunctional. The key measurement here is monetary velocity – or GDP / M2.  It is worth taking a moment to imagine what this measures. M2 can be seen as the cash and bank deposits of households and corporations. A new deposit can be created essentially in only two ways: either they represent the balance sheet result of a new bank loan; or alternatively, it can represent what happens when you liquidate a real asset (a house, a diamond necklace) for cash.  The bank's function is to act as an intermediary to allocate those deposits to a purpose sufficiently productive to allow it to pay interest.  If monetary velocity is falling whilst M2 is growing, it means either that the banks are not distributing the savings at all, or they are allocating them extremely badly. 

It's still happening virtually everywhere. In the US, monetary velocity has sunk to lows not seen since at least 1959 (when my data starts), even as M2 rises to around 6.5%. The reason; in the 12m to May, deposits in US banks have risen by $783bn, but their loan books have risen only $324bn, which has cut the loan/deposit rate by 2.5pps to 75.6%. 

In the Eurozone, the decline in monetary velocity has slowed, but only because M2 growth has slowed so fast that nominal GDP has yet to catch up:  by April M2 growth had slowed to just 1.9% yoy, and unless positive momentum is restored, it will sink below 1% by the end of the year. Deposits in Eurozone banks fell by 0.8% yoy in April, or by Eu 95bn, whilst banks' loans books shrank by 3.3% yoy, or Eu402bn during the same period.  Such contraction managed to cut 2.7pps off the loan/deposit ratio, but it still stands at  104.7%. 

Where will it stop? US banks' pre-crisis loan/deposit ratio topped out in early 2008 at just over 102% - they are now 75.6% and are still falling. UK banks' ratio peaked out in late 2007 at 117.9% and have fallen to 92.6% and are still falling. Eurozone banks' stood at around 123% in early 2008, and have come down only to 104.7%.  They have a very long way to go. The Eurozone has a very long way to go. 

Britain's monetary velocity also continues to fall as banks continue to deleverage: in the year to April, banks' loans to the private sector fell £68bn whilst deposits rose £14.5bn, cutting banks' LDR by 3.4pps yoy to 92.6%.  

Where else are monetary velocities falling? Practically everywhere one looks: Japan, China, S Korea, Taiwan,Hong Kong etc. Perhaps the baleful truth is that in a global economy which is dominated by global capital flows, no economy entirely escapes unscathed when the developed world's banking systems are dysfunctional.  

Ever since encountering the idea in John Greenwood's Asian Monetary Monitor (then of GT) in the late 1980s that a universally-distributed system of money market mutuals might allocated capital more effectively than commercial banks, it has seemed to me that commercial banks are a fundamentally unnecessary form of commercial activity. It has also been my belief that something like that must arise out of the ashes of this crisis. We are waiting. 

NE Asia's Inventory-Related May Export Blip

The surprisingly weakness of NE Asia's May trade data is the result of a long-maturing unwanted inventory build up meeting Chinese financial constraints, and is happening despite the emerging improvement in underlying Western demand.  It's a temporary phenomenon which is likely to be answered later this year by a sharper-than-expected rise in NE Asian output and exports. 

The positive momentum which has been building quietly for months in both Northeast Asia exports and G3 imports, has taken a blow from May's NE Asia trade data.

• China's exports rose 6.9% yoy, which was only 0.1SD above historic seasonal trends; 
• S Korea's exports fell 0.9% yoy, which was 0.5SDs below historic seasonal trends; 
• Taiwan's rose 1.3% yoy, which was 0.7SDs below historic seasonal trends; 
• Japan's 20-day data points to a likely fall of 6.5% yoy in dollar terms, a full SD below trend. 

Taken together, this suggests NE Asia's exports rose only 2.8% yoy in May on a monthly movt which was 0.3SDs below historic seasonal trend. This is a considerable disappointment, and is a noticeable check to the build-up of momentum which had been emerging.

But it is an unusual weakness, because it is centred almost exclusively in inter-Asian trade. Thus, the real weaknesses in China's exports were in HK down 38.7% yoy, Asean down 5.4%, S Korea down 5.2%, Japan down 1.1%. But exports to the EU jumped 13.4% yoy and to the US exports rose 6.3%.

For S Korea, exports to Asia fell 6.5% yoy, with China down 7.5% and Asean down 9.1%, whilst exports to the EU jumped 23.8% yoy and rose 7.6% yoy to the US.
For Taiwan, the weaknesses were in Thailand down 8% yoy, Singapore down 3.6%,  S Korea down 0.2% whilst Japan rose only 2.6% and mainland China +3.1%. Meanwhile, exports to the UK rose 19.6% yoy, to Germany rose 9% and to the US rose 1%.

The check to inter-Asian trade is also the reason why, though exports were weak, they were much stronger than imports: China's imports fell 1.7% yoy on a monthly move which was half a standard deviation below historic trends; S Korea's imports rose just 0.3% yoy, which was 1.2SDs below trend; Taiwan's imports fell 2.3% yoy,  which was 1.7SDs below trend. Result? Northeast Asia's trade surpluses have burgeoned even as trade volumes slowed noticeably.


Now growth of G3 imports and NE Asian exports usually move in lockstep and have done so for years, with NE Asia's exports growing slightly (and predictably) faster than G3 imports. It is most unusual for them to underperform G3 imports, as the chart below shows – and when it happens it's normally a signal that Western demand is about to slow.  Yet it's happening now, at a time when the performance and prospects for G3 imports are the strongest they've been for two years, and accelerating.

So what's happening? What's happening in Qingdao Port's bonded warehouses gives a big hint. There, the inspectors are on the trail of allegedly fraudulent receipts for inventories of metals,  which are used as collateral to borrowing from Chinese and foreign banks.  There are suspicions that the same stock of inventory has been pledged for multiple loans. This is not what's surprising – frankly, one assumes this is standard operating procedure, with the only person pretending not to know being the banking officer authorising the loan. No, what's important is that the scandal has surfaced now, telling us, as it does, that the loans have defaulted.  The story, then, is that financing conditions are tight – so tight that inventories are being liquidated in order to raise cash.  

It's difficult to get the data to prove this is what's happening generally in China, but perhaps the weekly iron ore inventories tell the correct story: inventories built up sharply during the latter part of 2013 and the first half of 2014, but now appear to be peaking.

If this is the position in the mainland, then it is hardly likely that Taiwan's mainland operations are exempt from the practice or the financial pressure. And if so, one would expect less enthusiasm among Taiwanese suppliers to load their mainland operations with more supplies. 

South Korea provides the clearest example of a long-maturing build-up of inventory which is now reaching its peak. S Korea's inventory turnover index is a near-cousin of the more popular inventory/shipment ratio. As the chart shows, this ratio has been rising steadily since late 2009, and by April this year had reached a new peak. At some point, Korean companies will wish to stop that build-up: the trade data suggests that by May that point had been reached.

The one NE Asian country which quite clearly doesn't have an inventory problem is Japan, where conservative balance sheet management is sufficiently ingrained to provide a vigilant patrol on inventory levels. 

Conclusion? After waiting years for a pick-up in Western demand, and allowing inventories to build-up as they do so, Northeast Asia's industrial base has given up waiting, and, partly under pressure from China's financial constraints, have started liquidating those inventories just as Western demand is finally beginning to return.  For NE Asia this is resulting in a blip in trade. If Western demand continues to emerge, however, it is likely to be revoked later this year with accelerated production and inter-Asian trade. 

Japan 1Q Duponts: What's Changing, What's Not

The easiest bull argument to make for Japan in the Abenomics era has been that if the economy can generate some nominal topline growth, whether achieved by currency depreciation or by a successfully aggressive monetary policy, or simply by overturning deeply ingrained deflationary expectations, then the resulting rise in asset turns would power a spectacular rise in return on capital.

The MOF's quarterly survey of private sector balance sheets and p&ls shows  accelerating topline gains and also sharp upturns in ROE and ROA, but for not for the reasons expected. Topline gains there have been – sales rose 5.6% yoy in 1Q - but corporate Japan's response has been to prioritize continued deleveraging over re-investment, and to focus profits-generating efforts on wage control.

Investment in plant and equipment rose 7.4% yoy, a sharper rise than expected, and the strongest since 2Q12. However, in absolute terms, the Y12.231tr spent on plant and equipment was rather less than the Y14.485tr fall in net debt during the same period, and only slightly more than the Y10.569tr in depreciation expenses. Whilst the rise in investment spending is of course to be welcomed, it is probably not the turning point in corporate behaviour which Abenomics is looking for.

Gains are certainly being made in ROE & ROA: operating profits rose 18.8% yoy whilst net worth rose only 4.3%,  which pushed ROE for the quarter reached 3%, the highest it has been since 1Q08.  Similarly, with total assets rising only 1.8% yoy, it was the strongest quarter for ROA since 1Q07, and the best on a 12m basis since mid-2008.

At the core of this was an improvement in operating margins: sales rose 5.6% yoy whilst operating profits rose 28.8%, which pushed OPM to 4.5%, the highest since the bubble years, with the 12m rise similarly spectacular.

How did it  happen? On a 12m basis, OPM rose 68bps yoy to 3.98%. This happened despite cost of goods sold actually rising by 7bps during the same time: the whole of this was counteracted by a 75bp fall in SG&A.  And drilling down further, the whole of that was accounted for by a 79bp fall in personnel expenses/sales to 12.6%. 

Essentially it boils down to this: on a 12m basis, sales per employee rose 7.2% yoy 12ma, whilst total expenses per employee rose only 5.5%. This took the multiple of sales/expenses per employee to 7.94x in 1Q14, and to 7.71x on a 12m basis.  As the chart shows, this multiple is still below its pre-crisis peak, and we should expect corporate Japan to continue to strive to raise this ratio, even if this means that wage growth is suppressed beneath inflation rates. 

The rise in sales also lifted asset turns (sales/assets) mildly, but at only 0.952x this remains extremely low by any standards, including Japan's own recent history – the average since 2000 is 1.03x.   Balance sheet management remains remarkably conservative, with financial leverage falling to a new low of 2.7x, with net debt falling 2.6% yoy, and net debt/equity falling to a new low of 55.2%. There is no sign of any change in this aspect of corporate behaviour.