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Tuesday, September 03, 2002


Anyone with any doubt that China is one of the contributory factors (not the only one) in global deflation should not miss this post from Andy Xie:

Incremental export to GDP ratio was at 54% in the first half of 2002, which is more than twice as high as export to GDP ratio last year at 23%. This clearly demonstrates that China's economy is export-led. Export momentum is still quite good, growing by 27.6% in July. Cyclically, China's exports are at most two months away from peaking, mainly due to the base effect. How quickly they decelerate depends on global demand. Roughly one third of China's exports goes to the US. Another one third goes to Japan and Europe. The US market has undoubtedly led China's export growth this year, contributing about 40% of the total growth. The other sources of demand for Chinese goods must have had much to do with the recovery of trade with the US. While it is difficult to estimate this US multiplier on China's exports, my guesstimate would put it at 1.5%. This would make 60% of China's export growth attributable to US final demand.

In addition to the impact of the global trade cycle, global redistribution of production to China appears to have elevated China's export growth potential. China's exports grew by 13.1% on average during the 1980s and 16.7% between 1990-97. Growth slowed considerably to 9.8% between 1997-2001. However, during this period, China's exports went through significant restructuring. It is now positioned to becoming the leading electronics exporter, while retaining the lead in light manufacturing products.
Massive FDI inflow has made this transformation possible. European and Japanese manufacturers have been shifting production to China to survive declining prices. China's export growth through such FDI comes from replacing production elsewhere and isn't dependent on final demand in the global economy. Assuming that there isn't significant final demand growth outside of the US, the structural shift of production to China accounts for 40% of export growth this year.

The above guesstimates would put China's export growth at 7% per annum in a flat global economy. For every one-percentage point of growth in the global economy, China's export rate should increase by about two percentage points. If the global growth rate is between 3-3.5%, China's export could sustain 13-14% annual growth rate. China has entered a new export boom, in my view.
Source: Morgan Stanley Global Forum

In case this all seems incredibly complicated lets just get some things straight: (i) China's exports are growing at a faster rate than growth in GDP, (ii) 40% of the growth in China exports comes from the US, (iii) this accelerated growth is not coming from new demand in the US, but from restructuring existing demand, ie China's exports would grow even in a stationary world economy, and (iv) this restructuring is taking place because products originating in China are cheaper, ie the global impact is deflationary, pushing prices down.

The lack of serious about economic numbers, which seems to be a permanent feature of how economic policy is conducted over there, is again making its presence felt.

The economic reform programme of Italy's ruling centre-right coalition suffered a setback on Monday when official figures showed a sharp rise in the public sector budget deficit in the first eight months of this year. According to data from the finance ministry, the deficit rose by more than 60 per cent from €22.2bn to €34.1bn (£14.1bn to £21.6bn) in the same period of 2001. The ministry blamed the increase largely on slower economic growth, which had depressed tax receipts. The figures represent a potentially damaging blow to the European Union's stability and growth pact, a cornerstone of Europe's monetary union. Like France, Germany and Portugal, Italy may find it impossible to meet deficit reduction targets agreed with the European Commission for this year and 2003 under the pact's terms.

Luigi Buttiglione, an economist at Barclays Capital, said there was a clear risk that Italy's deficit would next year overshoot the limit of 3 per cent of gross domestic product set by the EU's Maastricht Treaty. Almost as worrying, Italy's public sector debt, which stood at 109.4 per cent of GDP last year, could rise this year to 110 per cent or higher, recording its first increase since 1994. Although this would not disqualify Italy from eurozone membership, an increase in debt would go in the opposite direction to that stipulated by the Maastricht Treaty as a condition for eurozone entry in the 1990s.
Source: Financial Times

So let's get this clear, not only is the stability pact about to become what the Spanish call 'papel mojado' (in plain English find itself in tatters) as France and Germany are also queueing up to get permission to go outside the limits, but the whole Maastricht Treaty process is about, in the case of Italy, to be put in reverse gear. The agreement to bring down debt to GDP ratios was not simply justified by aesthetic values, Italy has a spiraling demographic process which is going to make the present public finance structure unsustainable if something major isn't done. And far from doing anything they're letting things get worse. Of course a certain amount of counter cyclical juggling would be in order if that was all this represented, but as I've said Italy's problem is as much structural as it is cyclical. At the same time if the Euro zone finance system is about to fail at its first test. What is this going to mean for the Euro?

Morgan Stanley's Eric Chaney is asking the same set of questions. The politicians are under pressure from electorates who have never really understood (because no-one has ever really taken the time out to explain the details to them) the Maastricht process, hence they are under real pressure to make light of the dilemena. Institutional Europe can take more distance. In today's post he states:

As the first real test of the Stability Pact occurs, it is crucial that governments take action to reduce their deficits, regardless of the short-term consequences on growth and employment. Since these institutions (the Commission, the ECB EH) are not directly accountable to EMU electorates, they can afford to give greater place to long-term credibility, vis-à-vis financial markets, in particular. Quite correctly, they stress that governments confronted with aging populations and large unfunded pension liabilities will be punished sooner or later if they give up pursuing rigorous fiscal policies when encountering their first post-EMU difficulties.

The Single Market and its logical postscript, the Monetary Union, were based on the forward-looking view that a deeper integration of European economies was critical for Europe's long-term political stability and constituted a convenient constraint to push through structural reforms. However, it was not sold as such to European electorates; instead, the EMU and the euro were presented to the layman as warranting more prosperity, stronger growth, lower unemployment and a more influential Europe. In other words, the implementation of the Stability Pact is as much a political issue as it is aan economic one.

Finally, one last point. Italy has just introduced an extremely draconian law to discourage all manner of immigration. The question could be asked as to whether a country where there is such a shortage of young people, and where there is such an acute problem of finding the resources to fund the long term retirement and health systems was in any position to implement such a law, even were it not totally ethically reprehensible?

This would be comic were it not macabre. It feels like someone's trying to make it to the Guinness Book of Records as with every passing day we seem to move one step back in time.

Tokyo shares skidded to a near 19-year low on Tuesday as banks, brokerages and high-tech issues crumbled amid growing concern over the global economy. The Nikkei 225 average fell 304.59 or 3.2 per cent to 9,217.04, its lowest level since November 1983. "The market was approaching fresh lows after falling in drips and drabs, and when it touched a new low it triggered more technical selling," said Tsuguya Onozuka, manager for equities at UFJ Tsubasa Securities.

"The fact that shares have fallen so far with so little news out there underlines how poor sentiment is right now. "Banks led the meltdown amid fears that recent falls in the stock market would result in heavy losses in their equity holdings and erode their already weakened capital base. The banking sector sub-index sank 5 per cent during the day. Mizuho Holdings, the world's largest bank by assets, tumbled 9.2 per cent to Y226,000, Sumitomo Mitsubishi Banking Corporation lost 8 per cent to Y556, and Mitsubishi Financial Group slid 6.9 per cent to Y740,000.
Source: Financial Times

This situation seems to be deteriorating by the day, and one senses that the Japanese government must act fairly soon. This is the easy part to foresee, the real question is what will they do? The most probable would seem to be to drive down the yen again in an attempt to refloat an export lead expansion, but then comes the question, how would the US respond? The point is that when things are only half bad, then sharing the pain seems acceptable, but as things get really bad, then no-one wants to be on the receiving end, but that only makes things worse for everyone. It's called a negative feedback loop I suppose. I'm not a marine engineer, but if I was I'd be asking how much more water all this can take before one of the bulkheads cracks and the water goes cascading on from one tank to the next.

So it's back to school - la rentree - for the international financial markets after the 'thin trading' season, and it's hard to see much cause for optimism. Japan is having great difficulty sustaining momentum, Euroland is getting into deeper and deeper water, and the latest bout of economic data from the US is hardly encouraging.

U.S. manufacturing barely grew in August after a sharp setback a month earlier, a report said on Tuesday, stoking worries the economy's already weak recovery may stagnate more in coming months. The Institute for Supply Management (ISM) said its closely watched index of factory business conditions was unchanged in August at 50.5, posting a seventh month of growth but coming in below expectations for a rise to 51.6. Any reading above 50 signals growth, while one below 50 indicates contraction in a sector that makes up roughly one-sixth of the U.S. economy. In what ISM said was a cause for concern for manufacturers the rest of the year, the new orders index fell in August to 49.7 after having tumbled more than 10 points in July to 50.4. That showed new orders, a key source of future growth, declining for the first time since last November.
Source: Yahoo News

Wall street took the news badly and continued the downward trend that started at the end of last week. Of course the stock markets may be just as influenced by the continuing war talk about Iraq or the ongoing probes into entities like Citicorp, so its impossible to read to much into this. But the continuing attrition in the job market, and the stop-go expansion in manufacturing leads me, like Steven Roach, to keep asking how long the American consumer will carry on the weightlifting exercise. Certainly it's far from clear how any of this is going to move forward in the short term, but my own personal feeling is that in the absence of any real expansion push the dangers of falling back into recession are as present as they ever were.

The latest news and economic data from Tokyo continue to cause concern. Yesterday the Nikkei average dropped 1.67 percent or 159.10 points to 9,362.53 after touching in one moment an 18 year low at 9,269.10. On November 10, 1983, it closed at 9,244.24.In part this downward movement is provoked by uncertainty concerning the immediate outlook in the US (and now in Europe judging by the latest survey data on August manufacturing). In part the fall is a reaction to talk of plans for large scale tax cuts, when it is absolutely clear that reducing government debt has to be high among Japan's priorities. And in part the move is a reaction to the continuing doubts about the real health of the Japan business sector as evidence accumulates that all is not what it seems.

It is hard to identify precise tipping points for Japan's agony, but in the past I have pointed to one indicator - a Nikkei below 10,000, for its feedback effects on the value of bank assets - as a possible candidate. Every day the Nikkei stays below that level marks one more day in which Tokyo moves a little bit nearer to the brink. Another possible candidate is obviously government debt, which continues to increase rather than decrease. My view is that no-one really has a firm, agreed figure for the value of Japan government debt as a percentage of GDP. In part this depends in what you count as debt. However for a long time now a widely quoted figure has been stuck at 130%. Well in this piece from the Reuters on Yahoo News they suggest the value is now 140% (remember with deflation the real value of debt automatically rises), so perhaps the stakes just went up.

It was only a matter of time until we fell this low," said Masanori Hoshina, head of global portfolio marketing at BNP Paribas. "Part of our weakness lies in concerns about the cloudy economic outlook in the U.S. But the key problem is that there are still no signs of a sustainable economic recovery in Japan," he added. Data on Friday showed the Japanese economy grew at a faster-than-expected 0.5 percent in the April-June quarter, but industrial production fell unexpectedly for the second straight month in July and other data showed deflation worsening. Declines in prices make it harder for Japanese companies to service their mountains of debt, adding to pressure on banks. High government debt levels are also a worry. "With a public debt of around 140 percent of GDP, the Japanese government doesn't have many cards left up its sleeve," said Hiroshi Nishiyama, senior portfolio manager at SG Yamaichi.

Against such a backdrop banks were pummelled. Mizuho Holdings Inc, the world's largest bank by assets, plunged 7.23 percent to 231,000 yen and was the highest traded issue by value on the first section of the Tokyo Stock Exchange. Rival UFJ Holdings Inc slipped 4.18 percent to 252,000. Japan's megabanks have large holdings of stocks on their books and falls in the stock market eat into their capital base, increasing fears of financial instability.

Another notable loser was Tokyo Electric Power Co Inc (TEPCO) , which extended its losing skid to six straight sessi ons and was down 1.46 percent on the day at 2,360. Shares in Japan's biggest power utility have come under heavy pressure since it said last week that it may have failed to accurately report cracks in its reactors. Traders say that a string of recent scandals in corporate Japan has helped undermine market sentiment and depress trading volume in recent weeks.

Sunday, September 01, 2002


It seems a preoccupation with bubbles and their aftermaths is all the rage. This weekend a number of emminent economic lumineries have been huddled in closed session for the annual Jackson Hole symposium organised by the Kansas Federal Reserve. Apart from Greenspan's scarcely credible observation that bubbles are difficult to identify in advance, there was his rather more credible acknowledgement that once in motion they are extremely difficult to halt without risking even more damage from the remedy. But talk of bubbles has to bring us right back to the housing market and in particular to the UK, Australia and Spain, if the housing price index which appears in this timely piece on the economist global site is anything to go by:

FOR all the newspaper space devoted to stockmarkets, households around the world have far more of their wealth tied up in property than in shares. American households' shareholdings briefly surpassed the value of their houses in the late 1990s. Now they have about $11 trillion-worth of shares (held directly or in mutual funds), compared with almost $14 trillion in housing. In other countries, housing is even more important. In rich countries as a whole, individuals own $23 trillion in equities, but perhaps $40 trillion in property.

Almost everywhere, house prices continue to outpace inflation. The exceptions are Japan, where house prices are now in their 11th year of decline, and Germany, where prices have been more or less flat since 1992. Britain has risen to the top of the house-price inflation league, with prices up by over 20% in the year to July, double the pace of a year ago. Australia, Canada and Spain have also all seen price gains of at least 10%. Average house-price inflation in America has slowed to around 7%, from 9% in mid-2001—a rise, still, of more than 5% in real terms. American house prices have risen by more in real terms since 1997 than in any previous five-year period since 1945. The National Association of Realtors says that house-price inflation has accelerated strongly in many cities in the second quarter. New York, Washington DC and Los Angeles all saw rises in median house prices of 18-22% over a year earlier.

There are reasons to think that the increased interest in property as an investment is here to stay. Yet there is also a big risk that investors, burnt by the stockmarket, are now overinvesting in housing. The market for housing is almost as prone to irrational exuberance as the stockmarket. And a housing bubble is more dangerous than a stockmarket bubble, because it is associated with more debt. A steep fall in house prices would harm the global economy far more than a slump in share prices. The best gauge of whether house prices are overvalued is the ratio of house prices to average disposable income—the equivalent, as it were, of the price/earnings (p/e) ratio for shares. In America and Britain, this ratio is now close to its peak of the late 1980s, and the ratio is flashing red in some cities, such as London and Washington, DC. In Ireland and the Netherlands, the ratio is at a record high.

All this means that house prices might continue to rise for a while yet. But the higher they climb, the more households' debt will swell. The real housing bubble in America and Britain is not the rise in house prices, but the growth in mortgage debt, which is at record levels in relation to incomes. The optimistic view is that, with interest rates at 40-year lows, households can afford to borrow more. Still, home buyers may be underestimating the true cost. Interest rates are low because inflation is low. But that means that borrowers can no longer rely on inflation to erode their debts, as it did in the past. At the very least, households hoping that ever-rising house prices will provide generous nest eggs are likely to be disappointed. At worst, the risk is that prices in many countries may take a tumble. Falling house prices, massive debts and low inflation: now that really would be an unpleasant cocktail to contemplate.

Allen Sinai was also at pains to make a similar point at the Jackson Hole get-together according to this report from Yahoo News:

"We are looking at the biggest stock asset deflation since the 1930s," economist Allen Sinai of Boston-based Decision Economics Inc. said after the invitation-only meeting ended. "It's severe and significant, it is some $7 trillion of loss, maybe $7-1/2 trillion of lost net worth to Americans in equities, so far offset by an increase in residential real estate asset wealth,"

Sinai said he sees some dark parallels between the stock-price run-up in the 1990s, which led to companies using debt excessively, and to home-price surges that has led homeowners to leverage themselves with more debt and to flock to real estate purchases after bailing out of stocks. "It's a bit of the gold rush, tulip craze, dot-com psychology," he said, referring to buying behavior in real estate markets. "That's what I mean by bubble-like ... I'm very concerned about that as a risk to the economy."

Sinai is very concerned about it and me too. It's still too early to say how this one will end, but it certainly doesn't look either stable or sustainable. The happiest outcome would be a stronger recovery in the broader economy producing a rise in interest rates and a consequent adjustment downwards in house prices, which as well as being a function of earnings must also be a function of monthly repayment schedules. But failing this, and right now the possibility of a strong recovery doesn't seem too evident in the short term, it remains to be seen for exactly how much longer there will be buyers coming up to the plate to pay next months higher prices. Remember this increase is speculative to the extent that people are investing in housing since they believe that the prospects of a continuing rise make today's prices realistic. If that confidence disappears, then what happens next?