Oil and Bonds
Apr 18, 2006
Stephen Roach (New York)
In the macro realm, bad things usually come in pairs. The confluence of yet another surge in oil prices and a long-overdue back-up in bond yields has piqued my interest in that regard. Crude oil prices are back near $70 and bond yields are at important thresholds -- closing in on 2% in Japan, 4% in Europe, and slicing through 5% in the US. My concerns stem less from a partial analysis of each development and more from the potential interplay between them. The combined impacts of these two factors raise the odds that a tipping point for an unbalanced global economy could well be close at hand.
I continue to believe that the American consumer is the weak link in the global daisy chain. The combination of rising long-term interest rates and higher oil prices puts an unmistakable squeeze on discretionary income -- the last thing overly-indebted, saving-short US consumers need. The higher gasoline prices arising from the recent back-up in crude oil markets unleashes a classic negative income effect on the consumer that, by Dick Berner’s reckoning, could knock about $60 billion, or 0.6%, off disposable personal income this summer (see his dispatch in today’s Forum, “Risks for the Consumer”). At the same time, higher US bond yields could unleash a negative wealth effect -- taking a toll on a housing market that is already moving lower and also acting to constrain mortgage refinancing activity and household sector equity extraction. For a US consumer who remains chronically short of labor income but who drew support from more than $600 billion of annualized equity extraction in late 2005, that could be an especially tough blow. In this increasingly interconnected global economy, America’s problems quickly become the world’s problems. Other consumers will also feel these impacts -- albeit to a varying degree, depending on their sensitivity to oil prices and interest rates. But the US, as the world’s heretofore most resilient and dominant consumer, could well be the lightning rod for a broader array of global impacts. The combination of negative income and wealth effects is not only a double whammy for the American consumer, but it could also be an equally tough blow for the global producer. Trade linkages will quickly bring America’s rapidly expanding external supply chain into the equation, especially the top three exporters to the US -- Canada, China, and Mexico. Collectively, these three countries accounted for fully 42% of total US imports in late 2005. But it would also be the case for the next tier of America’s import sourcing -- Japan, Germany, the UK, and Korea -- which collectively account for another 20% of US imports. With America’s imports of tradable goods currently standing at a record 37% of goods consumption, any pullback in US discretionary spending spurred by the confluence of income and wealth effects could have very powerful global ripple effects. Trade impacts should not be measured solely on the basis of who ships the most to the US. Equally important is the export dependency of America’s suppliers. On that count, China’s exposure is especially worrisome. Exports currently account for nearly 35% of Chinese GDP, and of that amount, fully 40% go to the US. China is also heavily exposed to oil. Its oil consumption per unit of GDP is literally twice that of the average developed economy. While a subsidy structure limits the direct impacts of higher oil prices on Chinese consumers, that simply means the pressures bear more on the fiscal finances of the central government. Consequently, the confluence of rising oil prices and bond yields hits China with a double whammy of its own. Needless to say, if that leads to a slowing of Chinese economic growth -- an outcome that is also consistent with the objectives of the government’s latest five-year plan -- collateral damage on China’s major trading partners would be expected. That would especially be the case for its Asian neighbors such as Taiwan, Korea, and Japan. Participants in China’s new and increasingly far-flung commodity supply chain would also be affected; that would include Brazil, where exports to China have increased five-fold since 2000, and Australia, where the growth in Chinese exports has accounted for fully 34% of the cumulative increase in overall exports since 2000. Globalization cuts both ways -- it reinforces trade-dependent growth on the upside but also exacerbates adjustments on the downside. Still, there is another channel of macro transmission effects that must also be considered in sorting through the combined impacts of rising oil prices and bond yields -- the global liquidity cycle. World financial markets have drawn extraordinary support from the unusually accommodative monetary policies of the world’s major central banks over the past five years. This has played a key role in driving the global property boom, which has benefited a broad array of economies around the world -- especially the US, the UK, Spain, Australia, and New Zealand. At the same time, the developing world has also benefited from this powerful upsurge in the global liquidity cycle; emerging market debt and equity have led the charge in the global asset performance sweepstakes over the past three years. This has enabled developing countries such as Mexico and Brazil to ride the tailwinds of falling interest rates and all but eliminate their foreign indebtedness. Needless to say, this has been a truly liberating experience for economies long buffeted by all-too-frequent crises. Yet what central banks giveth, they can always taketh. All three major central banks — the Federal Reserve, the European Central Bank, and the Bank of Japan — are now on the tightening side of the policy equation, the first time they have been collectively engaged in taking away the global punch bowl in about 15 years. The Federal Reserve has raised its policy rate in 15 consecutive meetings of the Federal Open Market Committee. Unlike the Fed, which may now be nearing its ultimate objective, the ECB and the BOJ have only just begun the process. Thus far, the impacts of this policy normalization campaign have been largely confined to the short end of the yield curve -- thereby having little bearing on those segments of real economies, such as homebuilding, capital spending, and consumer durables, that are more sensitive to rates at the longer end of the maturity spectrum. The recent back-up at the long end of global yield curves underscores the growing risk of a serious challenge to that immunity. To the extent the normalization at the short end of the global yield curve is finally accompanied by normalization at the long end, a decisive turn in the global liquidity cycle could well be in the offing. Rising oil prices could compound the problem. The oil-related hit to discretionary incomes of oil-consuming nations is the functional equivalent of an added withdrawal of excess liquidity in a world that is now on the other side of the monetary policy cycle. This underscores what I believe could well be the thorniest aspect of the outcome -- the potential nonlinearities of the interplay between a turn in the liquidity cycle and rising oil prices. This is where macro is at its weakest. We are trained in the art of partial analysis. We have rules of thumb that are helpful in gauging the impacts of fluctuations in oil prices. We have different models that attempt to assess the impacts of swings in interest rates. But we lack a unifying “general equilibrium” framework that pulls it all together. Sure, Nobel Prizes have been awarded to brilliant theoreticians, such as Stanford’s Kenneth Arrow, for making important progress in deepening our understanding of the conceptual context of this problem. Large-scale econometric models have also been designed to deal with so-called spillover effects from one sector to another -- in some rarer cases, from one country to another. But these tools just don’t cut it in today’s Brave New World. Liquidity cycles and asset bubbles have gone to excess, while oil prices are in uncharted territory. Meanwhile, the globalization of trade and capital flows has redefined the cross-border linkages that will ultimately shape the outcome. Sadly, we are better equipped to deal with the macro of yesteryear. I am coming around to the view that nonlinear “threshold effects” -- the macro equivalent of the tipping point -- will probably play an important role in unmasking the endgame in today’s liquidity-driven unbalanced world. The breaking point in this case will probably be determined by a combination of economic and psychological factors. That’s because the sustainability of America’s current account deficit -- by far, the most serious imbalance in today’s unbalanced world -- is critically dependent on the confidence that foreign investors place in dollar-denominated assets. If that confidence were to falter for any reason, the subsequent venting of the pressures stemming from the massive US external deficit may be swift and severe -- with important spillover effects on other markets and wealth-dependent economies around the world. I honestly don’t know if the bond market and oil prices are now at thresholds that could spark such pyrotechnics. I suspect it could take something more in the 5.5% to 6% range for yields on long Treasuries to qualify as a full-blown tipping point. Even so, a 5% bond yield and $70 oil are much closer to that possibility than has been the case in a long time. Moreover, it’s important to note that this confluence of forces is not occurring in isolation -- it is playing out in the increasingly ominous context of a post-US-housing bubble shakeout and an increase in protectionist pressures. Courtesy of a more-than-ample cushion of excess liquidity, an unbalanced global economy has endured an extraordinary array of destabilizing developments in recent years. This had led to excesses in many segments of world financial markets -- especially in some of the riskiest markets, such as emerging-market debt and equities. Investors are now taking liquidity-induced resilience in the global economy for granted. Maybe Iceland was the canary in the coal mine after all.
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Risks for the Consumer
Apr 18, 2006
Richard Berner (New York)
Consumers went on an unsustainable spending spree over the past quarter, and a spring “payback” is likely. Compared with just 0.9% in the fourth quarter of 2005, we estimate that real outlays accelerated to a 5.5% annual clip in the quarter just past, or well in excess of the sturdy 4.1% annualized gain we reckon for first-quarter real spendable income. Of course, much of the winter spending acceleration reflected two one-time events — a rebound from the hurricane-induced energy shock last fall and a warm-weather-induced January discretionary spending surge. The spring payback is in fact already underway; over the past three months, we estimate that spending has already slowed to a more sustainable 2.9% annual rate. More important for the resilient American consumer, significant hurdles lie ahead that could depress the pace even more. Among them: Soaring gasoline prices, rising interest rates, and decelerating housing wealth will all test consumers’ mettle and threaten the immediate outlook for consumer spending. The likely jump in gasoline prices over the second quarter would sap about 0.6% from discretionary consumer spending power. Consumer borrowing costs on both mortgage and other forms of debt are rising. And it appears that housing demand and home price growth are cooling off sharply. But strong income and job growth in my view will sustain both moderate spending gains and a gradual increase in the saving rate. Here’s why. Notwithstanding my belief that consumers are unlikely to permanently retrench, I don’t want to dismiss any of these three challenges out of hand. Most important in my view, gasoline quotes are rising sharply again, and the price peak is likely six weeks away. After tumbling some 70 cents at the pump from their post-Hurricane Katrina peak to $2.25/gallon in December — a factor that boosted discretionary income in that period — retail gasoline prices have retraced more than half that decline, hitting $2.73/gallon in the week ended April 10. A further rise to $3/gallon by Memorial Day seems highly likely, which alone would add some $60 billion to consumer energy bills and drain about 0.6% from discretionary income. Driving this latest price surge are three supply shocks: First, US refineries scheduled heavy spring downtime for maintenance that was deferred following the hurricanes, so distributors have drawn down gasoline inventories by 5% in the past nine weeks. Second, the final phase-in of US environmental regulations (the Tier 2 Vehicle and Gasoline Sulfur Program, begun in January 2004), and the decision by many refiners to phase out the use of methyl tertiary butyl ether (MTBE) as an emissions-reducing additive in 2006 has increased the demand for scarce ethanol as a substitute and boosted prices. The ethanol-laced fuel is also more difficult to handle, adding to costs. Third, notwithstanding apparently ample crude supplies, a flaring in geopolitical risks, especially regarding Iran, has elevated the level of crude prices by about $7/bbl in the past several weeks. I assume that gasoline quotes will rise further through the end of May and then drift back below current levels as refinery runs increase, the ethanol squeeze begins to ease, and refineries begin the traditional post-Memorial-Day transition from gasoline production to other fuels. However, I’d be the first to concede that in tight markets a further supply disruption could push prices higher, and given the uncertainty surrounding both supply and demand, the price path over the next few months is likewise cloudy. Rising interest rates represent a second challenge for consumers. I expect that higher interest rates will eventually affect consumer spending through four separate and familiar channels: The cost of borrowing for big-ticket durables will increase, higher rates on both mortgage and non-mortgage credit will boost household debt service, and, other things equal, rising rates will depress equity values and home prices and thus stock-market and housing wealth as supports for spending. Despite a 375 basis-point (bp) rise in the Federal funds rate and in the prime loan rate, however, there is not a lot of evidence that rising rates are having much influence on any of these channels — so far. One reason is that lenders don’t make consumers pay market interest rates. For example, auto finance company loan rates have risen 200 basis pints since the Fed began to tighten, but at 5.4%, such rates are now even lower than mortgage rates. And finance companies have recently been extending loan maturities and loan-to-value ratios to offset the effects of higher rates. More subtly, most retail chain stores routinely still offer one-year or longer zero-interest rate loans on consumer durables. Credit card lenders just as routinely still offer “teaser” loan rates — say, 0% for the first eighteen months — to attract new accounts. Likewise, official estimates of debt service in relation to income or the broader “financial obligations ratio” (FOR) compiled by the Fed likely understate the financial strength of the typical consumer. Fed research shows that three compositional factors in credit-card lending explain the entire rise in the overall FOR (see “Financial Obligations: Misleading Metrics?” Global Economic Forum, January 27, 2006). And market rates will increase debt service gradually. For example, my colleagues David Greenlaw and Ambika Bisla recently concluded that the potential payment shock from rising rates on existing adjustable-rate mortgages in the near term was quite small because the bulk of the ARMs outstanding would not reset for at least another couple of years (see “Home Sweet Home,” Global Economic Forum, December 17, 2005 and “Gauging the Payment Shock,” MBS Perspectives, November 4, 2005). With roughly $330 billion of ARMs resetting in 2006, a 200 bp adjustment in the index would boost annual debt service by about $6 billion — or less than 0.1% of household disposable income. Moreover, given the dramatic flattening of the yield curve, many ARM borrowers are refinancing their loans into fixed-rate mortgages. Rising rates may eventually take their toll on equity prices and equity wealth. But for now investors believe and I agree that rates and equity values are rising in tandem because global growth is strong. As evidence, virtually all of the 50 bp backup in nominal global bond yields since February has been in real terms; inflation compensation has gone up only slightly. Rising real rates that accompany strong growth should not hurt equities; so long as the Fed contains inflation, in my view, that stance is unlikely to cause lasting damage to risky assets. The housing wealth story could be a sterner test of consumers’ mettle. With ample signs that higher home prices and higher interest rates are depressing housing affordability, demand has cooled. Housing starts haven’t slowed as rapidly, and rising inventories of unsold homes speak to a growing mismatch between supply and demand — a mismatch that will surely lead to slower growth in home prices. However, I continue to believe that, barring a surge in interest rates, the deceleration will be relatively gradual. Moreover, while housing wealth plainly matters for consumer spending and the share of income that is spent, in my view the influence is smaller than most believe, and thus the fears that a sharp slowing in home prices will trigger retrenchment are overblown (see “Housing Wealth and Consumer Spending” and “Housing, Mortgages and Consumption: Comparing Australia, the UK and the US,” Global Economic Forum, October 7, 2005 and March 3, 2006). Most important, I think that hearty income gains will swamp the impact of these three challenges. The combination of stronger job growth and rising wages has over the past year gradually contributed to accelerating wage and salary income. Despite rising energy quotes, in March a proxy for such income in real terms picked up to 3.2% — a six-year high — and to a 5.1% annual rate over the past six months. More is coming: With job opening rates — a measure of pent-up demand for hiring — at five year highs, I think job growth will remain healthy. Moreover, dwindling slack in labor markets points to further firming in wage growth (see “Will Labor Markets Tighten Further?” Global Economic Forum, April 3, 2006). Indeed, such income is probably growing faster than official statistics suggest. My colleague Ted Wieseman notes that total withheld income and payroll taxes surged by 9.8% in the first quarter compared with last year, or at least 350 bp ahead of any wage income measure or proxy (see “Tax Time,” Global Economic Forum, April 13, 2006). Finally, nonwage income gains are picking up again: Interest, dividend, and proprietors’ income are all rising at a pace between 6% and 11%. It’s worth noting that a 6.5% gain in disposable personal income would equal a rise of $610 billion — dwarfing the headwinds discussed here. Ironically, some pessimists seem to have given up on consumer retrenchment (but note Steve Roach’s “Oil and Bonds” in today’s Global Economic Forum). Given the three challenges outlined above, however, we expect that a period of relative softness in consumer spending lies immediately ahead. The deceleration likely will cap Treasury yields for now, may give the Fed a reason to pause in its tightening campaign, and promote a slightly weaker dollar. In the event, the pessimists and even consensus seers will probably conclude that the long-overdue slowdown has arrived. We think they will be wrong again: The deceleration should be temporary, as the headwinds turn out less threatening than feared, and income gains reassert their primacy over spending trends. As always, risks abound, but I’ll concede that today they seem a little more demanding. The energy test is the most immediate and could be the most daunting of these consumer challenges, but in combination, all three could have serious consequences for discretionary wherewithal and spending. We don’t expect it, but a surprise surge in inflation could be a catalyst, undermining consumer purchasing power, pushing up interest rates, and depressing housing wealth.
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China
Apr 18, 2006
Andy Xie (Hong Kong) and Denise Yam, CFA (Hong Kong)
“The easing of the liquidity situation among property developers has reduced the deceleration pressure in the economy”. We are upgrading China’s 2006 GDP growth forecast to 9.5% from 7.8% on faster lending growth: The loans to non-financial sector rose by Rmb1.26 trillion in 1Q06 compared to the government target of Rmb2.5 trillion for the full year. Funding inventory accumulation in the property sector appears to be the main driver for the excess loan growth. It eases the slowdown pressure in the economy in the short term, in our view. Additional tightening is not likely: The changing lending terms appear to be the main factor in boosting lending. The loan-to-value ratio for lending against properties as collaterals has been raised substantially. Banks are also more liberal in accepting shares as collaterals. There appears to be purposeful easing in China’s lending policy. It would be contradictory to tighten macro policy while lending policy has eased. The odds of a property hard landing are rising: Household demand for mortgage peaked in 2004 and remains sluggish. The current loan growth mainly supports property production. The disconnect makes a property hard landing likely in 2007 or 2008. China’s lending accelerated considerably in 1Q06. New loans to the non-financial sector were 50% of the full year 2006 target, and 70% more per month than in 1Q05. Easier lending terms seem to be driving the lending acceleration, which suggests purposeful easing. The lending acceleration mainly benefits property developers that were facing liquidity problems due to sluggish sales last year. The property industry has directly contributed 15% of China’s GDP growth over the past five years and its multiplier effect is more than 2. The property sector may contribute 25-35% of the revenues of local governments directly and indirectly. Easier lending terms are drivers of the lending acceleration. Loan-to-value ratio for lending against property as collateral has increased. Shares are more acceptable than before as collaterals. The changing lending terms suggest purposeful easing in China’s financial policy. Tightening at macro level is not likely, we believe, as it would contradict the financial policy. The easing of the liquidity situation among property developers has reduced the deceleration pressure in the economy. The Chinese economy has been decelerating since 1H04, as reflected in electricity consumption, even though the announced GDP growth rate has not changed much. As China’s GDP data is of low quality, our GDP upgrade should also be interpreted as directional and symbolic. The direction of change reflects our view. The level merely reflects our attempt to estimate the data that the government will announce. China may be in a macro trap. Expectations of further Renminbi appreciation have kept China’s interest rates very low, which has led bubble elements in the economy to expand. Liquidity is more abundant than desirable. The 7-day interbank repo rate is at 1.6%, still too low for an economy growing at a double-digit rate. The expanding bubble makes China’s economy appear invincible as the low cost of capital allows bad businesses to survive. But the risk of hard landing rises with the expanding bubble in the economy. Property is by far the biggest macro risk. The financial support for property production is not matched by household demand for properties. Mortgage loans increased by Rmb240 billion in 2005 compared to Rmb422 billion in 2004. Total consumer loans (including mortgage loans) increased by Rmb43.1 billion in 1Q06, down 32.3% YoY, and only account for 3.9% of the total non-financial-sector loan growth in 1Q06. The data do not suggest a change in the sluggish trend. The lopsided allocation in financial capital for property construction despite unmatched demand suggest that the odds of a hard landing for the property sector and the economy are rising. Lending Acceleration Eases Decelerating Pressure Local currency loans to non-financial sector accelerated considerably in 1Q06. They increased by Rmb1.26 trillion, compared to the full-year target of Rmb2.5 trillion and the increase of Rmb2.35 trillion in 2005. The loan target would have suggested Rmb 650 billion growth in 1Q06. The extra growth of Rmb605 billion is equivalent to 3.3% of 2005 GDP, suggesting that it would have a big effect on the economy. Even though it is customary for banks to front-load lending early in the year, the amount of loans made as well as the growth in monetary aggregates in 1Q06 was still far above expectations/ Micro anecdotes suggest that easier lending terms are responsible for the acceleration. The loan to value ratio for lending against property as collateral has increased substantially. In some cases, it has gone up to 100% from 50%. Shares have also become more acceptable as collateral. Easier lending terms appear to reflect purposeful easing from the conditions set during the tightening in 2004 by the relevant authorities. Therefore, the above-target lending should not trigger another round of tightening. Otherwise, the authorities should not have eased in the first place. There are two possible explanations for what has happened. The state-owned banks are preparing for IPOs this year. They have incentives to increase lending to support their IPOs. If this is the main incentive, lending growth should taper off in 2H06. The other possible reason is that local governments want to support property developers that were facing liquidity problems in 2H05 due to sluggish sales. The property sector may contribute directly and indirectly 25-35% of the revenues of local governments. If this is the main factor behind the lending acceleration, the trend may not even ease in 2H06. The lending target for 2006 has to be pushed up to accommodate this factor. Chances are that both are relevant factors. The lending trend could ease somewhat in 2H06. But the lending target will likely be exceeded by Rmb400-500 billion for the year, which could push up GDP growth rate by 1.5-2 percentage points. Economic Deceleration May Pause China’s economy has been decelerating since 1H04 as reflected in the electricity consumption trend. Electricity output grew by 15.4% in 2003, 14.9% in 2004, 13.3% in 2005, and 11.2% in Jan-Feb 2006. The deceleration has been mainly due to lending moderation. As China’s banking system has a substantial amount of surplus liquidity, lending acceleration has always been a possibility, as long as it has the sanction of the relevant authorities. This appears to be the case so far this year. The revival in lending has eased decelerating pressure on the economy. Many property developers were facing liquidity problems in 2H05 as sales were sluggish. The increased lending has re-liquefied them, allowing them to continue their construction projects. Also, local governments appear to have increased borrowing for resettlement costs. The increased resettlement compensation led to a revival of property sales in March 2006, owing to demand from the resettled residents. The property industry contributes up to one-third of China’s GDP growth directly and indirectly. Local governments may receive 25-35% of their revenues from the sector through land sales, taxes, and other channels. Local governments are incentivized to increase property production regardless of current sales, as much of their revenue is generated when property projects are launched. We are raising our 2006 GDP forecast symbolically to 9.5% from 7.8% to reflect the change in China’s financial policy. We do not believe that there will be another round of tightening in response to the loan growth surge. The easing of the lending terms could not have happened without the support of the relevant authorities. Tightening against it would be contradictory to government policies.
China’s GDP data remain a puzzle. The relationship between electricity consumption and GDP has shifted massively. China’s electricity consumption grew by 67.8% and GDP by 45.1% between 2001-05, implying the elasticity of electricity consumption to GDP at 1.2. The elasticity was 0.8 during the preceding 10 years. The structural changes in the economy are unlikely to be so fast to explain such a big change. A more plausible explanation is that China’s GDP growth rate was substantially understated between 2002-05. Hard Landing Risk Is Rising Again The current round of stimulus is again towards the production side, and the property sector in particular. Demand for property is not picking up at the same pace. Indeed, financial data continue to show sluggish property demand. For example, mortgage lending increased by Rmb240 billion in 2005 compared to Rmb422 billion in 2004. Consumer lending (including mortgage lending) increased by only Rmb43.1 billion in 1Q06, down 32.3% YoY, which suggests that the sluggish trend has not changed. There are three possible explanations for the sluggishness in mortgage lending. First and the most popular one is that Chinese households are using cash to purchase properties. What's hard to explain is why it happened in 2005, and not before. There are no radical changes in the economy that could explain the sudden change in trend. Second, the sales data may be suspect. As presales account for most of property sales, when the sales are counted is open to interpretation. It is possible that some cities have been smoothing data, i.e., understating the sales in the previous years and overstating the sales last year. Third, some local governments have accelerated resettlement and increased compensation. Local governments may have borrowed directly with resettled land as collateral for resettlement cost. While the resettled families use cash to purchase properties, the debts are on the balance sheet of the government companies. Whatever the causes for the sluggish mortgage demand, it would suggest that China’s housing demand has peaked. However, property construction has been and is still rising at over 20% YoY in volume. Massive oversupply is a distinct possibility in 2007-08. As property under construction carries a market value of 30% of GDP upon completion, it would be the most important macro factor in determining China’s landing in this cycle. Macro Tightening May Not Work China’s tightening in 2004 prevented an imminent hard landing. The current round of stimulus has increased the hard landing risk again. In particular, if exports slow down together with property, a hard landing is almost inevitable. The latter of course depends on the US’s property market and is out of the control of the Chinese government. Macro tightening, such as increasing deposit reserve requirement, is not useful. The banking system has so much excess liquidity that the increase would not drain away sufficient liquidity to slow down loan growth. Further, the Renminbi appreciation expectation keeps China’s interbank interest rates 300 basis points or more under the LIBOR rate, i.e., the surplus liquidity situation is unlikely to go away as long as expectation remains for further Renminbi appreciation. A far more effective measure would be to tighten lending terms again. Loan-to-value ratio for collateral-based loans could be cut again. In particular, the ratio should be below 50% for land and shares. This would slow down loan growth but would cause more surplus liquidity in the banking system and, on the other hand, increase China’s trade surplus. The expectation for further Renminbi appreciation appears to have put China in a macro trap. Unless the government manages to suppress the appreciation expectation quickly, the bubble elements in China’s economy may continue to expand and cause a hard landing in the next two years. The central bank is making it easier for capital to leave the country to diminish the appreciation expectation. For example, the effective US$ deposit rate for onshore is 300 bps above that for Renminbi deposit, which at least discourages deposit switching from Renminbi into US$. Moreover, the terms for US$ purchase by Chinese households were just eased to facilitate deposit switching back into US$ from Renminbi. The central bank also loosened the restrictions on domestic funds to invest in foreign assets. This could have a major effect if the government is willing to tolerate the scale of this activity to rise to US$100 billion quickly. But, Chinese government always wants gradualism and is unlikely to escalate this sector so fast. One quick solution is to appreciate the Renminbi to the long-term expected value quickly. The market is expecting China to appreciate the currency gradually at 2-3% per year over the next two years. I believe that this is a reasonable expectation. China’s political system is deeply conservative and is against shock therapy of any kind. We remain convinced that China needs a change in its development model, which has been based on the government mobilizing resources to increase capital formation, which in turn fuels export growth. Rising export revenues provide the financial resources for further government-led capital formation, leading to concentration of wealth and income, insufficient consumption, rising social tension and intensifying friction with major trading partners (see our report, “Time to Change”, February 27, 2006). Sustained strong growth in exports and loan-driven investment in the recent months is worsening China’s imbalances. We continue to long for the appropriate policy adjustments that will shift growth from exports and investment to domestic consumption, and from the coastal to inland rural areas. Before we see convincing improvements in social security, education and healthcare systems, employment conditions for migrant workers (lifting minimum wages) and an uplift in household wealth that will unleash China’s consumption potential, GDP growth could be strong, but not of the desired quality and sustainability. A change in the external environment could solve China’s problem. If the US housing market drops by 10-20% quickly, it would derail China’s exports, which would diminish the market expectation for China’s currency appreciation. Such an external shock works because it diminishes China’s growth prospect, which is not a desirable outcome for China. In summary, unless something extraordinary takes place, the macro trap that China is in will last. The trap makes the Chinese economy invincible, as it decreases the cost of capital so much to prevent bad businesses from going under. But the bubble elements in the economy continue to expand in this trap. And the hard landing risk continues to rise.
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On a Wing and a Prayer
Apr 18, 2006
Serhan Cevik (from Washington)
Avian flu, with the potential to develop into a pandemic, is spreading around the world. Throughout the history of human societies, infectious diseases have resulted in significant mortality and socio-economic disruptions (see Jared Diamond’s excellent book, Guns, Germs and Steel, New York: W. W. Norton, 1997). Despite medical advancements, the unknown nature of an emerging disease still brings fear and speculation and therefore, even without a pandemic, may result in economic and social disruptions. Today, we are going through such a phase of ‘discovery’ with the highly pathogenic form of avian influenza known as the H5N1 virus. Influenza is not an unfamiliar disease, as there have been, at least, 10 influenza pandemics — all lethal but some more severe than others — over the last three centuries. The worst episode was the 1918 Spanish flu pandemic that killed between 50 million and 100 million people — almost 1% of the world’s population at the time — in less than a year. The scale of human suffering becomes clearer when we compare it to military deaths of 8.3 million over four years on all fronts during World War I. And now, as the new virus spreads around the world, some experts argue that a mutated strain of H5N1 capable of human-to-human transmission could be even more fatal. The mutation of the lethal strain into a human pandemic may have unpredictable repercussions. The first known bird-to-human transmission of the H5N1 virus happened in Hong Kong in 1997, infecting 18 people and killing six of them. Since its re-emergence in Asia towards the end of 2003, more than 45 countries in Europe, the Middle East and Africa have reported outbreaks of the deadly virus, in most cases involving wild birds and poultry. According to the World Health Organisation, the current epidemic of avian influenza has so far infected 194 people and killed 109 of them. Even though the fatality rate of 56.2% is shockingly high, all the evidence to date suggests that the H5N1 virus has not yet mutated into a strain capable of transmission between humans and that intimate contact with diseased birds is the main source of human infection. Nevertheless, since humans have no acquired immunity against this virus, the risk of spreading to new territories and becoming endemic is not negligible and could create serious social and economic disturbances, especially in developing countries. It is difficult to forecast the impact of an influenza pandemic on the global economy. Even if all the countries effectively contain the current pandemic killing mainly wild birds and poultry, the threat to humans will remain intact. Pandemics may be rare, but they are also recurring events. Indeed, the authorities are already warning about the risk of a second wave. Given the unpredictable nature of influenza viruses, it is impossible at this stage to determine the trajectory of biological and geographical progression. But we know for sure that a pandemic, depending on its severity, could endanger millions of lives and have severe economic repercussions. For example, the SARS virus — infecting 8,096 people but killing only 774 of them — resulted in output contractions in several countries. Therefore, an influenza pandemic, with a higher rate of fatality, could cause a marked decline in economic activity and increase risk aversion in financial markets. Developing countries are far more vulnerable to a human pandemic. Given the small share of poultry in GDP and exports, the direct economic impact of avian flu has so far been limited in all the countries reporting outbreaks. However, poultry is a vital source of nutrition for the poor in developing countries who usually have chickens in their backyards to supplement their income and food consumption. Culling of these animals is a considerable shock to low-income groups and might also have fiscal costs. Furthermore, containment strategies may not necessarily be enough to prevent the emergence of a human pandemic and therefore economic and financial fallout in the future. As investors get anxious and seek ‘safe havens’ for their assets, we would see a decline in economic activity as well as in capital flows to emerging markets. The fear factor alone would be enough to bring a downturn in tourism — one of the main sources of hard-currency earnings in the Middle East and North Africa region — and consequently deterioration in external accounts.
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