Archive for January, 2007
A series of news items (see here and here and here and here among hundreds of other ones) have been recently written on the Chinese stock market “bubble” and investors’ “frenzy” (a 130% surge in 2006 and more upward pressure in January), on its risks and on the concerns of the Chinese authorities about such a “bubble” getting out of hand and then bursting.
The key issue is why we observe such a stock market “bubble” and investors’ “frenzy” in China now? In my view the main explanation, one that has not been discussed so far and that I find the most likely one, is that such a bubble is indirectly related to the Chinese policy of effectively fixing its exchange rate to the US dollar (the rate of upward crawl of the RMB is at such a snail’s pace that we have an effective peg on China).
This policy has led to forex intervention of the order of about $250 billion a year in 2005 and 2006 (see the recent work by Brad Setser Casson Rosenblatt on this). Since only 70 to 80% of such intervention was sterilized (according to sources close to the PBoC) this intervention led to a sharp increase in 2006 of base money and credit. The Chinese authorities tried to control such monetary and credit growth via administrative controls on credit and by tightening reserve requirements on the banks while, at the same time, maintaining very low deposit rates and very low interest rates on the sterilization bonds. But monetary, liquidity and credit growth have been substantial in spite of these controls.
One would have expected that such large monetary growth would lead to goods price inflation. But in China a series of factors (elastic labor supply and slow real wage growth, administrative controls on prices, bumper crops) have kept goods inflation low. Instead, as in many other countries, the excess liquidity created by the forex policy has led to asset inflation. This asset inflation took first the form of a housing bubble; but with some credit controls being binding the existing housing bubble seems to show some signs of cooling off. Also, with deposit rates so low and capital controls, the 50% of GDP savings of the Chinese needs to go somewhere. And increasingly, the liquidity created by the fixed exchange rate is now going into the stock market.
So the fixed rate regime is an indirect cause, through liquidity and credit creation, of the equity market frenzy and bubble. And with deposits rates and sterilization bond rates being so low, increasingly the hot money – that is flowing into China because of the leaky capital controls on inflows – is going directly into the stock market, thus feeding the bubble frenzy. This also implies that, as long as China maintains a fixed peg, it will not be able to regain monetary policy autonomy and credit policy independence and will not be able to control the bubble in the stock market.
I have recently written a paper on why China should move to a more flexible exchange rate regime (available here for RGE Premium subscribers; see here a brief summary of this paper). The paper clearly discusses how the Chinese exchange rate policy has led to a loss of control of monetary and credit policy and has fed the investment, credit and asset bubbles – including now the stock market bubble – that are overheating the Chinese economy.
As the Chinese authorities correctly worry now, the bursting of this bubble could lead to a financial and real hard landing. What they do not seem to grasp yet is that such bubbles are direct consequences of their exchange rate policy. Unless they move away from their effective peg towards a more flexible exchange rate, these asset bubbles will fester and the risk of a hard landing will increase. Administrative actions to control this stock market bubble will be as ineffective as the mostly failing administrative controls on credit and investment. What China needs to do to control its stock market bubble is a more flexible exchange rate regime.
The first estimate of US Q4 GDP growth came at a better than expected 3.5% (in previous blogs – see here and here – I discussed why several analysts and myself originally expected a much lower figure for Q4 and did consequently revise upward our forecasts). While the headline is strong it is important to [...]
Davos’ WEF may be the congregation of the world’s globalization elites but, a little paradoxically, this year some of the main themes discussed in Davos is that of the growing income and wealth inequality, the middle classes anxiety about job security, trade and globalization, the rising backlash against globalization and what to do about it to prevent trade and asset protectionism and a retreat from globalization. I myself recently wrote a presentation on this topic (available here to RGE Premium subscribers) and I was one of the panelists in a Davos session where these issues were discussed (see here and here and here and here for some news reports on this Davos debate). The same issue of the challenges that globalization entails have been discussed in recent month by a wide range of thoughtful analysts including Martin Wolf, Larry Summers, Ben Bernanke and many others.
Globalization has, in the long run, beneficial effects for individual countries and the global economy. Over the last 50 years the countries that join and integrated themselves in the global economy have done well and those that did not join the globalization train have tended to lag behind. But the current backlash against globalization derives from the fact that trade and globalization creates both gainers and losers; the net gains are positive but losers will rightly resist change that makes them worse off.
Gainers include skilled workers in advanced economies whose jobs cannot be easily outsourced, Chinese, Indian and other emerging market workers who are joining the global economy and whose incomes are rising, owners of scarce resources such as commodities, owners of real and financial capital and financial assets in general.
But the list of losers is also quite long: unskilled workers in advanced economies, skilled workers whose jobs can be outsourced, anxious middle classes whose real wages have grown less than productivity and whose jobs are not as secure as in the past; middle income countries (such as Mexico, South Africa, etc.) whose competitiveness is threatened by the rise of China and other Asian low cost low wage producers; poor farmers in China, India and other developing countries whose relative and absolute poverty may be increasing; Africa that has not enjoyed yet the benefits of globalization.
Add to this rising income and wealth inequality in the US, Europe, Japan, China, Latin America and other emerging markets: rising inequality as the share of capital/profits in income is rising and that of labor is falling; rising inequality as highly skilled workers real incomes are rising and that of lower skill workers are falling; rising inequality of wealth as financial and real wealth is concentrated and becoming more concentrated with returns to financial assets being high.
How much of these changes are due to technological change rather than trade and globalization is an open debate. But the distinction between technology and trade is becoming fuzzier as technological change that allows to have global supply and production chains or that allows offshore outsourcing of services (more generally the growth of trade in tasks) is effectively a form of international trade and it sharply fosters it. So, the distinction between the two is becoming fuzzier.
As there is general agreement that trade and asset protectionism and a severe backlash against globalization would be dangerous and lead to loss of global growth and welfare, the issue is what policy actions can be taken to prevent a reversal of globalization.
This morning I was in the panel on the 2007 global economic outlook together with Laura Tyson, Jacob Frenkel, Min Zhu and Montek Ahluwalia. I was the only one who expressed some concerns about a US hard landing that could take the form of a growth recession or an outright recession. However, other panel members agreed [...]
I am off today to Davos for the World Economic Forum (WEF). I will blog regularly this week on the issues debated at this gathering. In the meanwhile an op-ed that I have written together with Jonathan Schmidt, the Director and Head of the Global Agenda at the WEF, has been published in an number [...]
Gillian Tett, the sharp Financial Times editor who covers derivative instruments, structured finance and the explosion of credit in financial markets, reports on a senior banker telling her how leverage ratios of 50 or more are currently easily reached in financial markets: “He then relates the case of a typical hedge fund, two times levered. That looks modest [...]
I recently discussed the factors – weather and price discounts – behind the growth rebound in Q4. One of the side effects of the unseasonably warm weather was the sharp drop in oil prices. This fall in oil prices is a positive shock that boosts real income and spending. I expect that the recession in housing will continue throughout 2007: even in Q1, real residential investment may fall at an annualized rate of 15%. Still, as discussed before, the unseasonably warm weather in December temporarily boosted housing starts and this boost would continue in January unless the weather becomes colder soon.
It is possible that these and other temporary factors may lead to a growth rebound in both Q4 and Q1. But that would incorrectly lead analysts to argue that the 2006 slowdown is over. I see fundamental weaknesses of the economy persisting into all of 2007 and leading to a hard landing this year. Before considering these weaknesses, it is worth considering the factors that may lead in Q1 to the continuation of the temporary growth rebound of Q4.
Among the hard landing pessimists, David Rosenberg – U.S. economist for Merrill Lynch – is very thoughtful. While he is – like me – pessimistic about 2007 he has recently argued that a series of six factors may keep Q1 growth better than expected. These factors include: “a delayed boost to retail sales as consumers use their holiday-season gift cards, the upcoming introduction of Microsoft’s Vista operating system (which is shifting the timing of some capital spending plans), the late Chinese new year (which influences the timing of exports), government spending patterns and distortions introduced by the weather. Another reason is the decline in energy prices, which is giving a lift to real income.”
Of these six factors I see low oil prices and the unseasonably warm weather as the most important ones that may temporarily boost growth to 2.5% in Q1. Many speak of the “gift cards” effect but this is most likely small in size and limited to January. The introduction of Vista is tricky: it is not clear whether this new product will be very successful and whether major corporations will adopt it in early 2007. The Chinese New Year effect is also relatively small in size. While the spurt in government spending – especially military – that Rosenberg predicts for Q1 is in part conditional on the “surge” in Iraq being implemented.
So data in January and part of February may positively surprise on the upside. But I expect that the factors that are drag on growth will reassert themselves by March and certainly Q2. These elements of weakness include six factors: 1. the housing recession that is nowhere near the bottom with the next leg of this contraction deriving from the ongoing mess in the subprime segment of the housing market and from increased employment losses in housing once completions fall off; 2. the increased spillover – with a lag – of the housing recession to non-residential construction; 3. the continued weakness of the auto sector – especially the Detroit Big Three – in terms of both sales and production; 4. the relapse of manufacturing in late Q1 and Q2 with the manufacturing ISM moving again below 50 and manufacturing job losses continuing; 5 the continued weakness of real corporate investment; 6 the spillover of lower housing wealth, higher housing debt servicing costs and lower mortgage equity withdrawal to consumption as households still have negative savings and are highly indebted.
So I expect that the US slowdown will resume by the end of Q1 and accelerate in Q2 and the rest of 2007. Some of the slowdown factors are subject to lags that are at times hard to predict. But the hard landing drivers will assert themselves over the next two quarters, as I will flesh out in detail in future blogs.
In my blog yesterday I discussed how the unseasonably warm weather affected consumption and economic activity – including stronger housing activity – in Q4: “warmer weather means that construction sites that would close in the winter stay open”.
And indeed this morning it was reported that housing starts and building permits were up in December due to the warm weather. Under the headline Housing Starts in U.S. Unexpectedly Climb on Growing Sales, Warmer Weather Bloomberg reported that:
Housing starts in the U.S. unexpectedly rose in December as sales improved and the weather turned unseasonably warm….
“The housing market has reached stabilization, but I would not be surprised to see some weaker numbers going forward,” said Phillip Neuhart, an economist at Wachovia Corp. in Charlotte, North Carolina. Favorable weather allowed some builders to get an early start on projects, “pushing the headline number up,” he said. …
Unseasonable warm weather may have contributed to the strength in starts last month, economist said. Last month was the warmest December since 1957, according to the National Climatic Data Center in Asheville, North Carolina. The government boosts the December figures in order to compare it with other months because it assumes harsher winter weather stalled some projects. “Given the warm weather in December, the seasonal factor was probably too large and therefore overestimated construction,” Drew Matus, a senior economist at Lehman Brothers Holdings Inc. in New York, said before the report….
So before analysts and commentators get excited about these housing starts numbers they should consider the entire flow of recent news about housing that have come out this week. If you look at this flow the bad news overwhelm the good ones and suggest that the housing market – unlike what is argued by the consensus – is nowhere near its bottom.
Here is below a list – as complete as I could find – of very recent headlines on the state of the housing market.
They add up to 19 bad/bearish news and only 3 good news, specifically higher housing starts, homebuilders’ sentiment slightly up (but still very poor) and Lennar (a major homebuilder) being more optimistic about 2007 after posting a large loss for Q4.
Conclusion: do not be misled by the warmer weather. The housing market is nowhere near to be bottoming out if you look at the full set of news about this market.
And here is some recent commentary on the housing recession:
Home-loan house of cards ready to fall. The collapse of the subprime credit market may come this year, with a major subprime lender going broke. The repercussions will haunt us for years.
As discussed in my previous blog the reason why I and other forecasters originally underestimated the Q4 growth has mostly to do with the resilience of real consumption during Q4. Most other components of aggregate demand were either falling (residential investment, inventory change) or possibly falling or rising weakly (equipment investment, non-residential structures). The real strength was in real consumption that is estimated to be running at about 4% real growth in Q4.
So the main issue is whether this consumption spurt was due to temporary factors or is rather signal of a more structural resilience of consumption. In my view two factors boosted consumption on a temporary basis in Q4.
First, major retailers sharply cut prices for many consumer products – especially electronic goods and appliances – early in the holiday season (some even before Thanksgiving). That boosted the sales of these goods to annualized rates of 30% to 40% in November and December. But most of this sales boost may prove to be temporary and driven by intertemporal substitution. For example, since most of those who wanted to buy a flat-screen TV at sharp discounts did so in the holiday season, such sales may sharply drop in Q1 and ahead as those large discounts have been phased out. So, the important macro question is how much of the Q4 price discounts stole demand from Q1 and Q2 of 2007 back to Q4 of 2006. If this effect was large – and economic studies suggest that such intertemporal elasticity of substitution for temporary changes in prices is large – the Q4 consumption boost could be temporary.
Second, consider the role of weather in economic activity and consumption in particular. That effect depends on the particular activity but, on net, warmer weather in a cold season has a positive effect on economic activity and demand. Yes, sales of winter apparel suffered because of the warm weather; and yes the output of utilities would be lower (as the December figures that came out today showed) when the weather is too warm as less gas and electricity is demanded and produced.
But the rest of economic demand and supply is supported by warmer weather as bad weather creates disruptions to both supply and demand. On the supply side, warmer weather means that construction sites that would close in the winter keep stay open; and disruptions of production from winter storms (see the Denver case recently) are less pronounced. On the demand side, colder weather keeps households at home where they spend less than they would if they would go to a shopping center, to a restaurant or to out-of-home entertainment. Moreover the warm weather, by pushing down the demand for heating oil, has led to a temporary fall in oil prices and thus a temporary boost to real incomes and consumption.
As Goldman Sachs put it in a recent note to its clients: “Warm weather has probably helped some of the recent indicators, and should provide a notable boost to January payrolls in areas such as construction employment. But a ‘payback’ is likely when temperatures return to seasonal norms.”
Then, if this interpretation of Q4 consumption growth and faster supply activity is correct, a Q4 rebound of growth relative to Q3 would not be a signal that the US growth slowdown of 2006 has been successfully reversed but could rather means that it was temporarily halted by temporary factors.
And the implications would be, as I will argue in a forthcoming blog, that the US economic slowdown of 2006 may continue in 2007 regardless of the temporary Q4 2006 growth rebound.
Commentators on my blog and other fellow economists recently have asked me two questions: 1. Do I still believe that the US will have a hard landing in 2007? 2. Do I still hold to my October forecast of a near stall for the US economy in Q4? I will provide a detailed answer to [...]