BIS Does Us All a Favour

Nothing is more admired from a distance than quietly-maintained financial repression. We in the Anglo-Saxon world look out and envy the high household savings rate which deliver a seemingly endless supply of savings with which to finance sparkling new infrastructure and a manufacturing sector alive with the purr of new machinery. Why can't we be prudent like that?

The answer, of course, is that the corollary of financial repression is almost always an economy in which savings are allocated far more widely by banks or, worse, governments, than by capital markets. And in turn that tends to result in lower returns on capital, and, in time, more debt than in non-financially repressed economies.

We tend to forget this partly because it seems so counter-intuitive – how can all those hard-saving Japanese (or Dutch for that matter) end up carrying more debt that us financially-incontinent Brits and Americans?

But of course, most countries have very little idea about how indebted, in a relative sense, they are. Thus, even in the aftermath of August's financial panic, it is still uncommon to find Europeans who know that Europe is carrying a far heavier debt-load than the US.

So the Bank of International Settlements' work on debt levels is extremely valuable if only because it gives us the comparative data we simply don't yet know instinctively. Rather than simply trot out the usual government debt/GDP numbers, BIS has tallied up all debt of the non-financial sector – that's government, corporate and household debt.

You can find the results here, and they bear illustration. For example, they show that the average European economy is carrying a debt/GDP load 43 percentage points higher than the US.

But that's not Greece. For, out of 18 OECD countries surveyed by the Bank for International Settlements, Greece is the sixth-least indebted of the lot – indeed it's debt/GDP ratio is three quarters of a standard deviation below the average! I'm quite sure that Finland isn't prepared to learn that Greek debt/GDP levels are only three percentage points higher than its own. I doubt that France, the UK, the Netherlands will already know that, all-told, they are more indebted than Greece.

But whilst the individual readings are sometimes eye-opening - the US is the fourth-least indebted of OECD countries (so much for the 'hopeless case' rhetoric), there are other things to notice. First, although capital markets are currently pricing sharply for differences in debt-load, most of the developed world is clustered around 300-350% of GDP. In fact, there's an average debt load of 312% of GDP, with a standard deviation of 54 percentage points.

The world's debt-profile used to be neither so large, nor so clustered. Here's how it looked in 1980: the average debt/GDP was 167%, but with a standard deviation of 50 percentage-points – virtually the same spread as now, but on a much lower base. Then, the potential debt-problem nations were Japan (the perennial winner in this class), Canada, Sweden and the Netherlands. By contrast, we can clearly identify the prudent and financially cautious as . . . . Greece and Italy.

By 1990, Germany had won a reputation for debt-avoidance, but it was still joined at the bottom of the league by Greece and Portugal. Meanwhile, the average had jumped to 210% of GDP, with a standard deviation of 64 percentage points.

At the turn of the century, the average debt/GDP ratio had risen to 255%, with a standard deviation of 55 percentage points.

Is it too facile to attribute the noticeable convergence of debt levels to the globalization of capital markets and/or the convergence of interest rates which occurred in the years prior to the introduction of the Euro? It shouldn't be: after all, the logic of the single currency is that high net-saving countries (such as Germany) get higher bond-yields than their savings/investment balance ought to deliver; whilst countries that are investing far more than their domestic savings-flows could finance discover they have lower bond-yields than they might otherwise legitimately expect. In these circumstances, one should expect a convergence of 'financial thickening'. Unfortunately, the financial logic behind this goes no way at all to undermine the perpetual truth of banking – that no banking system can grow its assets by 30% a year without making dreadful errors. 

Anyway, as we watch the Euro Doomsday Machine go about its work of devastation over the coming months, bear these data-sets in mind, because they illustrate some of the truths that are at work in our lives. 

Shocks and Surprises, Week Ending August 26

The whole point of Shocks and Surprises is to spot how the consensus is likely to change by tracking where current assumptions and forecasts are being proved wrong.

Judging from the last fortnight's Shocks and Surprises, it seems we may have got to the point where economists' assumptions (and by extension stockmarket pricing) are proving overly pessimistic. In my round-up last week I noticed that signals from the world's industrial economies were now more often surprising on the upside than shocking on the downside. The same was true this week, and particularly for Europe and the US – generally perceived as the most vulnerable parts of the world economy.

Take Europe: this last week gave us a rash of PMI readings for the Eurozone – readings which economists had by and large expected to show significant deterioration. Some did – France's manufacturing PMI, and Germany's services PMI, for example. But most simply didn't. Not only did the Eurozone Composite PMI, the Eurozone Services PMI, Germany's Manufacturing PMI and France's Services PMI turn out to be better than the range of surveyed expectations, but they almost all actually told a tale of market conditions which had improved during the month. The message was repeated outside the Eurozone, with British order books and consumer confidence readings beating both consensus and the range of expectations.

Something similar, but a little less dramatic, happened in the US, where durable goods orders jumped 4% MoM (and popped the S&P about 20 points) unexpectedly, where 2Q personal consumption growth was revised up from 0.1% QoQ to 0.4%, and where continuing unemployment insurance claims fell unexpectedly (a result obscured by a rise in initial claims generated by industrial disputes). On top of that, the Chicago Fed National Activity Index also came in far stronger than expected – though grazing the ceiling of the most optimistic expectations.

In all, then, the West produced 10 positive surprises, and only eight shocks. And the shocks weren't even difficult to predict – four of them stemmed from the wholesale collapse of German investor confidence tracked by the ZEW Survey. Frankly, ZEW need hardly have bothered: I could have told you that for free. (Indeed, I do.)

More worrying, and much more worth tracking, was the deterioration beyond expectations of Eurozone monetary aggregates. M3 rose only 2.0% YoY, vs an expectation of 2.2% and a range of expectation of 2.1% to 2.3%. Twenty basis points below expectations may not seem a big deal, but the details underlying it are horrible (repos up 20.1% YoY, money market institutions down 12.7%, private sector credit up only 1.9%). Moreover, as I explained here, Eurozone monetary velocity is flat on its back, so if Eurozone financial institutions no longer have the capital to buy or create financial assets, that strain will quickly show up in nominal GDP.

The economist in me worries about this a lot – so much so I'd be adding my weight to those consensus forecasts which are currently still proving too pessimistic.

If it has been a data-heavy week in the West, it's been data-light in Asia. Moreover, as far as China and NE Asia is concerned, there were few surprises. Almost all growth-related forecasts were about right: China MNI Business Conditions Survey, China HSBC Flash Manufacturing PMI , Taiwan IP, Taiwan commercial sales, leading/coincident indicators, Korea consumer confidence – all came in about as expected. That's the good news, the bad news is that the consensus expected stability or a modest continuing deterioration in conditions, and that's what happened.

Within that context, however, Hong Kong's trade data for July was a moderately unpleasant shock: not only did export growth of 9.3% YoY and import growth of 10.2% YoY undershoot expectations of 14.2% and 14.9% respectively (and the range of estimates too), but for both exports and imports, a MoM slowdown in the China-trade was to blame.

Foreign Banks in US Prepare for Armageddon

Sit down, I have a data-story to tell. 

You'll not be surprised to learn that it's extremely difficult to extract the sort of timely data about the state of Europe's banking system from the European Central Bank. But across the Atlantic, we have weekly updates about how foreign banks are managing their US operations, courtesy of the Fed.

And the results are a quite startling picture of how banks prepare for the absolute worst: being shut out of interbank markets, and being besieged by panicking depositors. More cautious by far than even in the aftermath of the Lehman collapse, more cautious than seems consistent with commercial banking operations, even. Indeed, the picture is so extreme that you need to know where you can check and follow the data for yourself: it comes from the US Federal Reserve's statistics page (here), Table H8, Pages 18 and 19 – Assets and Liabilities of Foreign-Related Institutions in the US.

The first chart suggests the difficulties foreign banks now have in accessing US money markets, or perhaps just expect to have. Traditionally, foreign banks in the US have raised money in the US, and channelled back to other overseas offices (head office, usually). At the beginning of 2008, this net lending back home was running at US$445b, but in the immediate aftermath of the interbank breakdown of 2008 this net lending dwindled to US$135 billion (Dec 08). The traditional patterns revived, and by the beginning of 2010 the net lending to o'seas office amounted to US$398 billion.

No longer: the pattern of funding has reversed spectacularly. Between the end of 2010 and the middle of August this year, those overseas offices have net repaid US$571 billion to their US operations, and are currently funding them to the tune of US$174 billion. US$200b of that money has arrived since June. It is as if US money markets were no longer open to foreign banks, or at least potentially no longer open to foreign banks, so they have to rely on funding from their head office.

It's even more remarkable when you realize this reversal of funding is taking place against the backdrop of a sharply weakening dollar.

The second chart is even more extreme, and it maps the staggering build-up of cash holdings by foreign banks in the US. Foreign banks' holdings of cash are now equivalent to 103.4% of their entire deposit liabilities. That's right, foreign banks in the US are now in a position to pay out every depositor they have in full, and still have cash left over. Cash holdings now amount to just under half these banks' total assets.

In short, the way foreign banks have restructured their balance sheets in the US suggests one of two possibilities. Either the Fed has demanded it of them, or their head offices want at least to preserve their US operations if Armageddon hits at home.

Flow Essentials: Scaffolding for the Cycle

Today I publish my Flow Essentials booklet for 2Q for the US, the Eurozone, China and Japan. It tracks those fundamental ratios which are scaffolding for my view on the cyclical state of these economies, and their likely near-term future. The pdf file can be downloaded here.

The charts look at return on capital, labour productivity, banking system leverage trends, private sector savings surpluses/deficits, and terms of trade. They also look at the changing relationships people and their money (liquidity preference), and between money and the economy (monetary velocity).

I believe how these ratios and indicators change tell us a great deal about what's really happening in these economies, above and beyond the noise of the monthly data-tide. Moreover, they uncover cyclical potentialities and perils which would otherwise be largely hidden. Given the extreme financial risk-aversion we're currently suffering, and the underlying economic scepticism and/or fear they reflect, an examination of the roots of the world's leading economies' business cycles feels unusually timely.

Here's what they reveal:

In the US, the charts shed a light on the profound divorce between current cyclical indicators, and financial fears. If you look at what's happening to the factors of production, it's pretty clear that both ROCs and labour productivity growth are still very positive – having survived the 1H downturn with ease. But – and this I find astonishing, if only in retrospect – something profound happened in 2Q. For the first time in 12 quarters, the US private sector ran a savings deficit during 2Q. This deficit was equivalent to 0.9% of GDP, and compares to a surplus of 6.1% in 2Q10, and a 12m savings surplus of 4.3%.

In one sense, this is a shocking reversal of cashflows – for the first time since 2Q08, the US private sector has had to attract a cashflow from the financial system in order to maintain its current level of consumption and investment. And it's no illusion: precisely during the same period, the US banking system's net foreign liabilities increased for the first time since the end of 2008 – precisely what you'd expect if the banking system were having suddenly to find cash, rather than allocate it. Against this background, the weakness of the dollar is hardly surprising.

But in another sense, this is merely a restoration of normal seasonal patterns, after three years interruption-by-crisis. I calculate the PSSS using non-seasonalized data for the current account and the fiscal deficit, and it's those seasonalities which caused the 2Q plunge into deficit. We can be almost certain that a surplus (probably declining) will be resumed in 3Q and 4Q, and that the equilibrium between the US private sector and foreign savers will be effected on easier terms as the year wears on.

The other factor which is very striking is the way monetary velocity has collapsed back almost to levels seen during the worst stretches of 2009. I am inclined to believe that this represents the continuing substitution of deposits for 'riskier' financial assets – nonetheless, the less-efficient allocation of savings that implies must surely be a drag on growth. Looked at in a positive light, however, it seems unlikely that monetary velocity will fall much further – which in turn argues that nominal GDP growth is probably bottoming out just about now (at around 3.7% YoY).

As in the US, so in the Eurozone the cyclical growth factors were actually improving during 1H – ROC was rising gently albeit not yet to pre-crisis levels, and this was allowing a modest expansion of capital stock. There is much better news from labour productivity: real output per worker, adjusted for capital per worker, is now rising for the first time in recent Eurozone history, so labour markets are likely to be more resilient than might immediately be suspected. However, deleveraging is painfully slow, with bank private sector LDRs only dribbling down to around 105% (vs c82% fdor the US). Over 10% of gross foreign liabilities have quit the Eurozone banking system, with the result that even a reasonably large private sector savings surplus (about 5%) isn't delivering sufficient cash to allow much lending-growth. Added to which, monetary velocity has flatlined in Europe now since the end of 2008, with no sign of a pickup. As a result, with deposit growth slowing to under 4%, it seems unlikely Europe's nominal GDP growth will outpace that of the US any time in the near future.

For all the handringing and introspection, the story told by China's fundamental ratios is one of more of the same. Most ratios are disappointing, but not so much as to precipitate either a crisis or a major policy change. Thus, ROC is probably slightly worse in 2011 than 2010, whilst growth of capital stock is probably slightly higher in 2011 than in 2010. Monetary velocity is flatlining, as it has been for 18 months now. Terms of trade continue to decline, albeit gently.

Together the unaddressed inefficiencies are undermining China's cashflows – China's 12m PSSS probably declined to around 5.6% in 1H11 from 6.3% in 1H10 – but the pace of decline makes no dent at all in the financial sector's cashflows. In fact, by July, the banking system's LDR had fallen to 66%, which is actually down from 66.5% in July 2010. This underlying liquidity was, of course, sucked out of the system by PBOC's repeated raising of reserve requirements: once these were taken into account, the banking system's effective LDR was shunted up to just under 84%, it's highest rate since early 2004. The stress, though, is entirely policy-induced. China's real cyclical challenges are political, rather than financial or economic. (That probably makes them more real, more consequential, not less).

There's a challenge in interpreting the ratios for Japan. That challenge is first to separate out the impressive early recovery from the March 11 catastophe, from the real lasting damage done to Japan's economic infrastructure, and then secondly, to remember that even had March 11 not happened, Japan's economy would in any case be only in a mediocre position to prosper cyclically.

The disasters of March have taken a sharp toll on the factors of production: the rise in ROC was abruptly snuffed out, and previously sharp-gains in labour productivity were scaled back. Monetary velocity also collapsed. We can expect all these to bounce back to some extent during the rest of the year. But other problems cannot be attributed to March 11: for example, the unabated collapse of terms of trade – the effects of which are excacerbated by the rise in the Yen. This is also reflected in the slow decline of the private sector savings surplus, which started well before March 11, and has continued after it. The real problem is that this economy still looks fundamentally deflationary, and whilst monetary velocity will probably bounce back in 2H, there remains no reason to think it will or can return to pre-2008 levels. In which case, the long-term contraction of nominal GDP must be expected to continue in the medium to long term.

Finally, there's no real encouragement anywhere for operating margins: terms of trade have fallen sharply everywhere. In the Eurozone and Japan, they have fallen right back to the previous lows of 2008. Things aren't quite so bad in the US and China – but in both cases, comparisons are going to get tougher throughout the rest of this year.  

Shocks and Surprises - Implications

Looking back at the Shocks and Surprises of the last couple of weeks, there's what might be called a Broad Surprise: actually, the evidence from the world's industrial economy is, by and large, surprisingly good. The trade cycle continues to flow practically unabated: over the last two weeks we've had positive surprises from China's trade numbers, Taiwan's trade numbers, and this week Taiwan's export orders. Europe's trade numbers were pretty much as expected. The only negative trade shock has come from Singapore – which is too small to be truly representative. We've also had leading indicators rising in the US and also in China.

We've also had positive surprises from US industrial production, and capacity utilization. Perhaps it's in this context we should also note the positive surprises coming from US labour markets, UK wage settlements (?), and the surge in Japanese machinery orders.

Can we really dismiss all these as just lagging indicators in a world economy which is currently being mugged by a collapse in financial confidence and the vanities of Eurozone politicians? Should we ignore what we know of the structural foundations of this cycle: that pretty much everywhere outside China asset turns, labour productivity, and ROCs are rising, but that the resulting positive cyclical impulse is being moderated and governed by households bent on mending over-extended household balance sheets?

In the short to medium term, the answer to that question will turn largely on developments in credit markets. Will the stockmarket losses of the last fortnight scupper deposit growth in the months to come, as the ability to substitute one set of financial assets for another is lost? And if this source of M2 growth is lost, will banks' ability to create/buy financial assets collapse with it? And finally, even if the supply of credit is maintained, how long will today's presumed collapse in loan demand persist?

For the next few weeks, I daresay we'll see Shocks and Surprises enough from real economy readings. But the ones that will need close watching are the Shocks and Surprises from the world's monetary systems.  

Shocks and Surprises, Week Ending August 19

Sometimes the worst shocks leave an imprint on the stockmarket charts. This week it happened on Thursday when the Philadelphia Fed business outlook survey diffusion index collapsed to minus 30.7, from plus 3.2 in the previous month. This was off the charts, being way below anyone's surveyed expectations, and the worst reading since March 2009. The S&P had opened very weak, and promptly lurched down again on this news, and at the time of writing hasn't recovered. So dramatic and thorough-going was this fall – huge falls in all the subindexes – the Philly Fed accompanied it with something that was almost an apology: 'The collection period ran from Aug 8 to Aug 16, overlapping a week of unusually high volatility in both domestic and international financial markets.'

The Philly shocker was presaged earlier in the week by the Empire State Manufacturing survey, which at minus 7.72 was also far below consensus, and which told a sorry sale of dwindling work backlogs, new orders and inventories. Finally, the 3.5% MoM fall in sales of existing homes wasn't foreseen, but its shock-value was mitigated by housing starts and building permits data which was very much as expected.

Since this week will be remembered in the US (and probably elsewhere) for Philadelphia's contribution to financial panic, it's pretty certain that we'll forget that this week also delivered some positive surprises from the US. Yes, no-one had expected industrial production to rise 0.9% MoM, but it did (thanks mainly to a 5.9% MoM increase in auto-production), and no-one had expected capacity utilization rates to climb to 77.5% either. In other environments, the news that capacity utilization was running at its highest levels since 3Q2008 might have been noted and remembered for its likely impact on the investment cycle.

For form, I should also mention the surprisingly positive 0.5% MoM rise in the US' Leading Indicators. But there's a big caveat to this: the surprise was generated almost wholly by rises in M2, stockmarkets (yes!), and the steepening of the yield curve. So there's no doubt what next month's Leading Indicator is going to look like. Be warned.

At its highest level, I take the politico/diplomatic news from the Eurozone as being genuinely trivial. A Merkel/Sarkozy meeting produced ever-more fantastic declarations of dedication to maintaining the existence of the Euro Doomsday Machine. There comes a point at which these statements seem not merely incredible or ill-advised, but actually bonkers. I reached that threshold this week. Meanwhile, the Doomsday Machine continues its work: poor numbers from Eurozone 2Q GDP (up 0.2% QoQ) were as expected, as were trade and current account balances. However, Germany's 2Q GDP falling to just 0.1% QoQ, on a fall in net exports, and slower household consumption and construction spending was a shock. Since Germany is thought to be the Western economy best positioned to benefit from global growth, its unexpected slowdown is troubling confirmation that global growth really isn't what we took it to be.

Europe held one rather limp surprise: UK average weekly earnings actually rose 2.6% YoY in the past three months! Does that make anyone feel better? Thought not.

If the West was mired in misery this week, could we at least see some positive surprises from Asia? Well, this was not a week for economic data from China, and what was released was, even though there was no survey to determine consensus, unsurprising. Unsurprising, but could have been worse. The MNI Flash survey of business sentiment in China deteriorated mildly, but in the detail there was a surprising recovery in new orders (best since May), and a financial position subindex which, though bad, was slightly less bad than lasts month. Since the MNI tracks loads of SMEs, I personally hadn't expected this very marginal improvement. The China Conference Board Leading Economic Indicator also rose 1% in June, higher than the 0.6% in May and 0.3% in April: consumer expectations, loan growth and new export orders, apparently helped the rise. I'm sceptical – this survey has a short track record, which includes major revisions.

This doesn't mean that there wasn't something worth noting: Taiwan's export orders, for example, came in very slightly stronger than expected at 11.1%,, but with the problems afflicting the electronics sector, and the slowdown in Taiwan's exports recently, there was every chance this data-point would disappoint – and it didn't. No surprise, then, but certainly a minor relief. This minor relief was offset, however, by Singapore's trade data, which showed non-oil domestic exports down 2.8% YoY - a modest positive YoY had been expected.

Finally to Japan, which surprised nicely with a 2Q GDP result which showed a fall of only 0.3%. This probably wasn't worth cheering too much, since a rise in inventories contributed 0.3 pp to the overall growth, and in any case the sharp fall in Japan's terms of trade flattered the GDP number. When you add back the trading losses (which are counter-intuitively obliterated by the deflators for exports and imports), Gross Domestic Income (rather than Product) fell by 0.8% QoQ. Which, I should say, was about consensus.

What do we take from this week's Shocks and Surprises? I think there are two main lessons. First, the West, and particularly Europe, is slowing. Second, that the perception that it's all bad in the US is actually wrong – the message is more subtle than the cacophony of fear and panic can allow. Third, that perhaps surprisingly, the world's trading environment, and with it China, continues somehow to teeter without falling, yet.

Optimism

The last day of my holidays must be devoted to optimism - after all, on the very day it started, market collapses wrecked my peace of mind, and quite possibly the future I had imagined for myself. With the future so radically uncertain, optimism is indispensable.

Part of my holiday reading has been Kevin Kelly's 'What Technology Wants'. Kelly coined the term 'the technium' to describe the interface of human creativity and technology. He argues that the exponential emergence of the technium is nothing more or less than evolution accelerated.  And like evolution, the technium has its own inherent biases which will tend to influence how (and how fast) it evolves, although, of course, its evolution will also be subject to accident and, perhaps, some element of human constraint. Despite the title, the book is less about technology per se than about evolution. Technology, like just like humanity, is a process, or tendency, not an entity.

I highly recommend it, not least because of its underlying optimism. Right at the very root of the whole technology story is the thorough-going rejection of Malthusianism in all its forms.  The huge and wonderful irony about Malthus is that he formulated his wretched views at the precise moment when technology had finally achieved the sort of take-off speed which would prove him repeatedly, relentlessly and tirelessly wrong ever since.  For me it is a truism: if an argument is basically Malthusian, then it's certain to be wrong.

(Take, for example, the threat of 'peak oil'. I imagine that somewhere in the 17th century, there were a bunch of worriers fretting about 'peak charcoal', armed with forecasts of charcoal demand intersecting 30 years hence with the limit - the total possible forest-covereage of Britain, perhaps.  

Anyway, here's a cause for optimism - a passage by Julian Simon, former Uni of Maryland professor of business administration, quoted in the book:

These are my most important long-run predictions, contingent on there being no global war of political upheaval: 1) People will live longer lives than now; fewer will die young. 2) Families all over the world will have higher incomes and better standards of living than now. 3) The costs of natural resources will be lower than at present. 4) Agricultural land will continue to become less and less important as an economic asset, relative to the total value of all other economic assets. These four predictions are quite certain because the very same predictions, made at all earlier times in history, would have turned out to be right.

I wonder how many of these we have forgotten to believe?