A silver lining and a dark cloud

Of course the last set of UK GDP figures were disappointing and everyone wishes that the recovery was robust. Clutching at straws, there is a silver lining. The rebalancing of the UK economy has been a constant topic for Mervyn King (and others) over the past three years.

Disappointingly, the UK’s trade deficit has hardly changed, despite the fall in sterling. If growth is stronger around the globe than it is in the UK, then the trade deficit might start to decline. Essentially the UK’s trade deficit is accounted for by three areas: tourism, cars and food.

Clearly rising food prices will make the trade deficit worse, but there is scope for some import substitution. Given the lags in production, this year should provide some relief.

We can be much more optimistic about tourism, which has the largest deficit of any sector of the economy. The squeeze on personal income and the value of sterling is likely to force more people to stay in the UK for holidays. The “staycation” is likely to be more prevalent. The weakness of sterling has meant that the UK (despite its weather!) has become a much more attractive place to have a holiday. Shops in central London could see a record year from foreign tourists as they snap up bargains.

In the automotive sector, I expect sales to be weak. The purchase of a car is easy to postpone. Imports could drop sharply. Exports might pick up a bit, but the main change could be the decline in imports.

The other factor that might come into play is that the psychology of UK managements might change towards exports. Hitherto UK and export demand has been weak. If export markets are perceived to have significantly stronger demand, then managements might focus more on exports. UK companies have tended to concentrate on improving margins rather than volume, but that could change if there are volume pressures in the UK.

That’s the silver lining, albeit a rather parochial one. The dark cloud is the political unrest in the Middle East and its catalyst. While one part of me wants to cheer the overthrow of despots, I am worried what might replace them. Iran is an uncomfortable example of one oppressor being replaced by another. A theocratic government in charge of Egypt would be an unsettling development for the Middle East.

Regime change is never easy. It would be nice to think that Egypt would become a properly functioning democracy. However, the examples of Iraq and Afghanistan show how difficult it can be to establish democracy in countries with little or no tradition of democracy.

It is very possible that we are entering a period of greater political instability in emerging markets. Rising food prices have been the catalyst for long-held grievance to erupt into the streets. Panic buying by governments of food stocks will only exacerbate the situation. No-one knows where this will lead.

Interestingly, the US and Western Europe are quite well placed. Except for exotic food stuffs, the US and the EU are largely self-sufficient in food. The economies will suffer food price inflation, but chronic shortages are much less likely. Also food is a smaller percentage of consumer expenditure in the developed world, so the squeeze on living standards is less acute.

Another dark cloud is whether rising food and energy prices will produce another recession. In the past large changes in relative prices of energy have been the catalyst for recessions. Coupled with food prices, it is also possible that the current rise in energy prices might engender a slowdown or recession in 2012 or 2013.

 

Why China will crash

All planning, economic and financial modelling tends to use a recent growth number and compound them out to the distant future. What forecasters tend to forget is this produces exponential growth. The higher the assumed growth number, the shorter the time in which the variable doubles in size. A short hand way of calculating this is to divide 70 by the growth rate. Hence, a 7% growth rate produces a doubling every 10 years. This is where it gets fun. To understand the ramifications, watch the video below and then think about China and the embedded growth expectations.

Odds and sods

Here’s a few things over the past few days:

Pushing bank capital ratios up to 20% is gaining some clout with David Miles adding his name. Bankers are desperately trying to resist yet more regulation. Here’s a thought: why not give bankers a choice, less regulation but much higher capital ratios? In my view, higher capital ratios is the only way to protect governments from implicit insurance for banks. It would also lessen the likelihood of liquidity crises. Obviously, this could only be phased in over a number of years.

Even Germany is feeling inflationary pressures. Import prices are rising at the fastest rate for 29 years. As if eurozone policymakers didn’t have enough on their plates. Germany will soon be pushing the ECB to raise interest rates. What the eurozone needs is higher German inflation, without higher interest rates. However, I can’t see the Germans putting up with negative real interest rates for long.  If interest rates rise in the eurozone, to state the obvious, the adjustment process for the periphery is going to be even more difficult.

For the second year in a row, China had the largest value of real estate transactions in the world. Of course there’s no property bubble in China. Pull the other one! You don’t increase lending by the equivalent of 50% of GDP over two years without producing a property bubble. In all likelihood, China will have record property transactions this year as well. Three strikes and you are out. Watch out for the first stages of a property collapse in 2012. Good article on real estate and why it causes problems for banks in FT.

Municipal bond funds suffer their 11th straight week of outflows. While concerns over insolvencies amongst municipalities and states might be overblown (Meredith Whiney’s figures have been widely rubbished), muni bond fund outflows are putting upward pressures on yields and crimping issuance. Along with the weak housing market, fiscal retrenchment at the state and municipal level is likely to be a significant drag on US economic activity this year.

Could political unrest in the Arab world be an exogenous shock for the global economy? Everyone has been surprised by events in Tunisia. The spread to Egypt is deeply concerning for stability. If unrest spreads to the Arab oil-producing countries, then the world may face another crisis, every bit as serious as the global financial crisis.

 

Crisis fatigue

I view myself as a realist rather than a pessimist. There’s an old aphorism: “it’s never as bad as it seems and it’s never as good as it seems”. I think it’s a good saying to bear in mind in the eurozone crisis. When you think about it, the eurozone has come a long way in a relatively short space of time. Several times it’s looked on the edge of imploding. Each time policymakers have been forced to adopt previously unthinkable solutions. From the tittle-tattle in the press it looks like we are being primed for an expansion in the EFSF. Spain is groping towards a solution to the caja problem, although the solution as currently configured is too small.

Markets don’t need a comprehensive solution, what they crave is some certainty that solutions will be found and that policymakers understand the issues. We may not be quite there yet, but progress appears to underway. An important barometer is the euro exchange rate. This seems to have stabilised and market participants, as reported in yesterday’s FT, seem to be more sanguine. Let’s hope that the urgency and momentum of policymakers doesn’t wane.

I still think that the interest rates of the rescue packages are too high and that the underlying competitiveness issue will fester away. The true catharsis of the eurozone may be postponed until the next recession.Given recent momentum in growth in Germany and in the US, this might be two years away.

The IMF are now sounding a warning on inflationary pressures. It is likely that this will be the theme for this year. Real interest rates are now far too low in emerging markets and there is the risk of a runaway asset bubble. Past history teaches that central banks are reluctant to raise interest rates until they are forced to, especially in emerging economies. I don’t see while this cycle should be any different. This suggests that asset markets should be underpinned by easy monetary conditions for the moment. However, later this year or more likely in 2012, central banks will be forced to move, assuming there is no decline in food and commodity prices. At first, markets will shake these rises off, but eventually they could produce the next down turn. So 2013 looks a plausible year for the next recession.

2013 also looks right from the perspective of the global political calendar. In 2012 there are the US presidential elections, the Chinese politburo elections and the Russian presidential elections. No politicians like to have an adverse economic environment in the run up to elections and potential political change, so it is very likely that policy settings will remain stimulative this year and into 2012.

Late in 2012, new administrations (especially in China) will have to grapple with the problems that have been deferred from previous years. Most notably these will be the US budget deficit and the Chinese credit boom. 2013 could be the year when the piper has to be paid.

We all know that the announcement of the world’s tallest building is a sure sign of hubris and impending collapse, but what about the announcement of the world’s largest city? China is proposing to create a city of 42 million people, twice the size of Wales. When you look at the extraordinary credit creation in China recently (equivalent to 50% of GDP in two years), you have to wonder whether China might be on the verge of the biggest bust the world has ever seen. Perhaps the world’s tallest building is not a big enough signal?

 

The British disease

Since WWII, the British economy can be characterised as being prone to inflation and having a structural trade account deficit. It looks like the UK is reverting to type. Inflation is high compared with other developed nations and the trade account is stubbornly negative. Why does the UK suffer from these twin problems? I’ve seen no research or comment on this, so I’ll attempt an explanation as I think the two are linked.

It seems logical to argue that countries that have structural trade account deficits should suffer from structurally weak currencies. The counterpart to a trade deficit is that trading partners accumulate currency and liabilities from the deficit countries. The liabilities in the deficit currency increase relative to the quantity of goods that the country produces and the assets that it has available for sale. Hence, other things being equal, this should produce inflation (the value of money declines relative to goods and assets) and weaken the currency, intensifying inflationary pressures.

If I had access to all the data providers that I had when I was working, I’m sure that I would be able to prove this statistically. However, if we think anecdotally, the UK fits into this pattern. The trade account has been generally negative and the currency weak since WWII.

The US is also an interesting case. It is suffering from lower than average inflation despite a chronic trade account deficit. However, inflation is systematically under-reported in the US because of its use of hedonic adjustments and judicious changes in the mix of components. Over the past 20-30 years inflation in the US has been higher than in Japan or Germany, two nations with structural trade surpluses.

The eurozone is also an interesting example. Within the eurozone, the deficit countries suggest that even without currency devaluation, this interaction of external liabilities and internal goods and assets produces inflationary pressures.

If we think of Spain, a trade deficit with Germany means that Germany is accumulating claims on Spain. Spain does not produce enough tradable goods to redeem those claims, so the scarcity of Spanish tradable goods may lead to some inflation in those goods. However, because of competition in the tradable goods sector this is likely to be a minor effect. More likely is that some of those claims will be redeemed against real estate in Spain. Indeed, this seems to be the more likely avenue of inflationary pressure.

It is this imbalance between the supply of liabilities and the production of goods (and assets) that is at the heart of the linkage between structural trade deficits and higher inflation. This is another reason to believe that the eurozone has some fatal structural flaws that doom it to failure.

We can also think of this in terms of final demand in an economy. By definition, economies that have structural trade deficits have domestic demand in excess of domestic supply. Other things being equal, this ought to produce upward pressures on inflation. This may be disguised if the price of tradable goods is weak. This has been the case over the past 15 years as China has ramped up production and increases in productivity has outweighed increases in input prices. Recent events seem to suggest that this process is coming to and end.

What about China? It has a massive trade surplus, but is suffering from rising inflation. It could be argued that China would be suffering even greater inflation if it weren’t for the trade surplus. Indeed, if it weren’t manipulating its currency, then inflation would be much lower. As emerging economies tend to have higher inflation, it is plausible to argue that the trade surplus has pushed down inflation by suppressing domestic demand.

Returning to the UK, the structural trade deficit has been indicative of excess domestic demand (recently fuelled by an increase in borrowing) producing inflationary pressures. This has been compounded by sterling weakness. Indeed, it is interesting to note that the decline in the exchange rate has been cited as one of the main drivers of higher than expected inflation by the Bank of England. If domestic production is unable to take advantage of rising import costs through substitution, then inflation must emerge.

Looking back over history, it is easy to see that the decline in the sterling exchange rate in the 1970s caused inflationary pressures. The strength of sterling in part of the 1980s as a consequence of North Sea oil helped to push inflationary pressures down. The stability of sterling in the late 1990s and early 2000s ameliorated inflationary pressures. However, now that North Sea oil production is declining, downward pressure on sterling has resumed and with it, inflationary pressures have surprisingly strong.

Unless this structural problem in the UK is addressed, the UK is doomed to a weak exchange rate and higher than average inflation. Recent trade statistics suggest that without a change in economic policy, the UK will not achieve the desired rebalancing of its economy.

The first issue the UK faces is that its economy is relatively open and large enough that it is one of the first economies that other countries want to export to. It has very efficient retail distribution. For instance, if an exporter wants to access UK supermarkets, it only needs to deal with four companies to gain access to the vast majority of consumers. In clothing, a handful of companies account for the vast majority of sales. The UK economy is also large and diverse enough that it can be attractive for high value, niche products as well.

One policy option might be to try to raise trade barriers in some way. However, this would be extremely difficult with the UK’s membership of the EU and WTO. It would also be inflationary as low unit cost imports would be replaced by high unit cost domestic production. So this appears to be a non-starter as a policy option.

A better policy would be to in some way incentivise export production. Another common feature of countries with a structural trade deficit appears to be underinvestment, particularly in areas that would produce export earnings. The UK has been plagued by under-investment since the 1950s.

It would not be enough to just encourage investment. Some deficit countries have higher investment rates but investment has been directed towards real estate, which has little or no use as an export good. Investment incentives would have to be directed towards productive capacity and not leak to the real estate sector.

In essence, the UK has to rediscover a mercantilist policy mix without excessively distorting the whole economy. Incentives to invest in productive capacity and for overseas companies to relocate productive capacity to the UK should be a major plank of policy.

However, the real trick would be to grow productive capacity in high valued added areas. A broad brushed investment incentive would favour high capital intensity, low value added investment. This would leave the UK vulnerable to swings in the exchange rate. Obviously, if the trade deficit disappeared due to investment incentives, then sterling would suffer less structural weakness and might even rise. A rising exchange rate would be problematic for high capital intensity, low value added industries and any policy that favoured these would be self defeating.

So what to do? My suggestion would be to improve the attractiveness of the UK as a place to do business. Unfortunately, recent public policy has tended to be the opposite. The government needs to sit down with industry leaders and work out how it can make Britain more attractive as a place to do business.

The second area it needs to address is education and skill shortages. In education, there needs to be more focus on the skills that are vital to a knowledge and high value added economy. I would focus on the basics such as maths, science and literacy, but I would also encourage design and creative subjects. Additionally, I would have some training in economic, how to run a business and personal finance.

The third thing I would do is to encourage areas where the UK appears to have a competitive advantage. For instance, pharmaceuticals, aerospace, instrumentation and electronics appear to be areas where the UK has successful companies. Ask companies in these areas what they need to be even more successful. Some modest tax incentives might be appropriate, but many would probably say better support from governmental bodies and export finance.

Fourthly, I would make it easier to access finance for start up and for small and medium sized businesses. However, any government support would need to be focussed on industries which might help our trade balance. Too many enterprise schemes have been used as tax dodges in real estate and the consumer sector. Ensuring backing for the right type of company would not be easy. Carte blanche cheque writing is not the answer. The Department of Trade and Industry would need to have some re-staffing with some venture capital types.

Let’s hope our leaders won’t let a good crisis go to waste. Unfortunately, I think policy is getting sidetracked by ridiculous ideas like extended paternity leave, which only makes the UK less competitive.

 

With friends like this…

…who needs enemies. Barroso typifies the economic illiteracy, political blindness and arrogance of the EU political elite. So it’s all Ireland’s fault is it? What utter tosh. Sure there’s been incompetence and fraud but at its heart is the unworkable mechanism of the euro. Savvy commentators having been warning for years about this. I fear that there will be a political upheaval as popular anger grows over the harsh terms of the bailout. The interest cost is just too high. The spread over the cost of funds is criminal.

Recapping the cajas

No details, but recapitalising the caja system in Spain would be a significant step towards resolving the eurozone crisis. If Spain can gain credibility then, at least, it would slow the spread of the crisis. In fact, the eurozone authorities should do everything in their power to help Spain as it could provide a fire-break. It still doesn’t solve the competitiveness problem. A bold move would be to cut wages and personal mortgage principals by a similar amount in conjunction with a bank recapitalisation. The other thing I would do is create enterprise zones with tax incentives to encourage relocation of companies that could contribute to exports.

OTC under-collateralisation

“…this saga highlights something banks have long preferred to conceal: namely the wider level of under-collateralisation in the OTC derivatives market. Last year, Manmohan Singh, an economist at the International Monetary Fund, calculated, for example, that if market participants posted sufficient collateral to cover all OTC deals properly, they would need an extra $2,000bn (or about $100bn per big dealer). The TABB consultancy has reached similar conclusions. And while banks dispute this data, these numbers are sobering; particularly since OTC business is now moving on to clearing houses – where collateral will be mandatory.”  Gillian Tett in today’s FT.

Yet another reason to believe that profits in the derivative business are fraudulent.

Hooray, someone has said it!

Anat Admati in today’s FT is arguing that banks shouldn’t be looking to pay (or increase) dividends at the moment. Instead they should continue to build up their equity base. I wholeheartedly agree. The only way to get round the too big to fail problem and the implicit insurance that the state provides is to have much larger equity cushions. Tongue in cheek, I have suggested  before that they should have an equity to assets ratio of 20%. Mr Admati is suggesting 15% to 30%. He would also remove the tax subsidy that debt provides. Excellent, let’s do it. It could be phased in like Basel III. Removing excessive leverage and the illusion of high ROEs through leverage would be hugely beneficial. It will mean that NIMs will have to rise over time as it would be economically stupid for banks to earn below their cost of capital.

The other useful thing to do would be to get managers to act more like partners in investment banks. John Kay’s article yesterday explained how the financial system has become corrupted over the past 25 years. Why shouldn’t employees have an “earn in” and then an “earn out” similar to a partnership structure? This would reduce the mega bonus problem in the sector. The other useful thing that could be removed is the increasingly pernicious “winner takes all” system that investment banks operate.

The other issue that no-one seems to be addressing is the fictitious nature of much of the declared profits in the financial sector. Long dated contracts where there are extremely skewed returns like credit default swaps are highly problematic to value and pushing MTM valuations through the P&L is ridiculous. Also fees associated with any contract where a bank takes a capital risk need to amortised over the life of a contract not taken up front. This needs to be applied to ALL contracts where there is a capital risk.

America’s problem

If you want one chart to sum up the biggest challenge facing US policymakers and, by extension, the global economy, this is it. US net savings are negative. To put it another way, the US is depleting its capital stock.

If the US wants to grow faster and earn its way out of its debt problem, it will have to invest more. I’ve not looked at the most recent figures, but the last time I looked corporate America was investing less than depreciation.

Because savings must equal investment on a global economy scale, the savings gap for America has been closed by foreign savings inflows (mainly Asia and our old friend China). If the US ramps up investment to improve long-term growth then it can be financed in three ways:

1. Foreign capital inflows. This has sustained the US in the low and negative savings era. An increase in capital inflows, however, means the trade deficit will, by definition, increase. This could be self-destructive as it might cause a crisis in confidence in the dollar and reduce capital inflows, which would push up interest rates, choking off investment. A dollar crisis would “solve” the deficit problem, but at the cost of a recession, which would probably be global.
2. Reduce government dis-saving. This is a fancy way of saying “cut government expenditure”. The private sector (personal and corporate) are running a savings surplus, so it follows that it is the government that is the main cause of negative net savings through the large budget deficit. Budget cuts large enough to produce say 5% net saving as a percentage of GDP would entail reducing the budget deficit by around 8 percentage points. Budget cuts of that magnitude would cause a severe recession.
3. Increase private sector savings. Corporate sector savings are already at very high levels, so it would be down to the personal sector to increase its savings rate. The Nov. 2010 savings rate was 5.3%. The 1980s average was 8.6%. If consumers were to increase their savings rate to the 1980s average (still not enough to get back to positive net savings overall BTW), then it would knock approximately 230bp off GDP growth. Again, a recession would result. Given the importance of consumption to US GDP (approx 70% of GDP), the multiplier effect would suggest that it would be a severe recession. A table of US savings rates is shown below.

So there you have it. If the US wants to grow faster, it will have to increase its investment rate. To avoid a balance of payments and currency crisis it will have to significantly increase domestic savings, either through cutting government expenditure or increasing personal savings (or probably both). In the latter scenario a recession is virtually unavoidable. In the former scenario, a recession is also very likely. While I don’t think a recession is likely this year, 2012 or (most likely) 2013 is plausible.

It’s a competitiveness problem

Even if the EFSF is expanded to €2,000bn, it won’t solve the competitiveness problem. The only way out is a simultaneous cut in wages and haircut on personal sector debt. Anything else is sticking plaster. Ambrose gets the message.

Bootle highlights the absurdity of Chinese economic policy

I missed this yesterday, but, hey, I’ve got to point it out.

More pictures of empty cities in China

Some more satellite pictures of empty cities in China.

The Age of De-leveraging

Have a look at this presentation.

Smart money looking for China bust

Serious money looking for a Chinese bust.