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Friday, January 02, 2009

The Second Great Depression Wends Its Way Forward in December

And lands in China.

Well China isn't quite in Great Depression mode yet, but manufacturing activity - which forms the core of the Chinese economy and accounts for 43% of all activity - is already very close to a technical recession, and phew, it wasn't very long ago that the Chinese economy was registering double digit growth. So the turn around is gigantic. The "close to technical recession in manufacturing industry" call comes from the people over at CLSA Asia-Pacific Markets, who compile the China purchasing managers index, and they base their judgement on the fact that their Chinese manufacturing index has now been registering contraction for five consecutive months.

Now for those of you who are new to the world of Purchasing Manager's Indexes (PMIs), welcome. Basically these indexes are very useful, since they give you a "just in time" point of reference to tell you what is actually happening. These are composite indexes - measuring things like current output, new orders (both domestic and export), employment and input prices. They are not perfect, but they are reasonably accurate - the fit which you can get between composite PMIs (manufacturing and services combined) and GDP is often attractively good - and in a country like China where the main data we get is year-on-year (which in a critical moment of rapid change like this one is virtually useless) it is very hard to see what is happening. The Shanghai-based Industrial Bank estimate, for example, that GDP growth in China will be 5.6% in Q4 2008. But what does that data point - if accurate - tell us? That the economy is slowing fast, well we already knew that. But just how fast? Well GDP was 9% in Q3 - down from 10.1% in Q2. So the deceleration is very rapid, but did the Chinese economy actually manage to contract in Q4? I doubt it, but it may do in Q1 2009, although the only way we would really know would be if the National Statistics Office published quarter-on-quarter seasonally adjusted numbers, which as far as I can see they don't. Indeed only a small group of highly developed economies actually take the trouble to do this, and you don't even find all EU member countries doing it yet, although Eurostat (thank god for Eurostat) do require such data from members (but those of you who ever get round to checking will see there are still blanks for some countries in the Eurostat quarterly releases).

Hence you can see why, in the case of somewhere like China, the PMIs are very, very useful, for those of us who would like to try and follow what is happening as it actually happens.

As for the PMI itself, China’s composite manufacturing index contracted for the fifth consecutive month in December as recessions in the U.S., Europe and Japan bit deep into demand for exports - indeed China's exports fell year on year for the first time in seven years in November. The CLSA China Purchasing Managers’ Index registered a seasonally adjusted 41.2, compared with a record low of 40.9 in November. On such indexes any reading below 50 reflects a contraction.

Despite the apparent small improvement in December the current output index actually fell sharply, and was down to a record low of 38.6 from 39.2 in November, so production was falling, and the index was basically nudged up slightly by other factors, such as the measure of new orders which rebounded to 37 from 36.1, driven by a rise in export orders to 33.6 from a horrific 28.2 in November. However, according to the report, Chinese manufacturers reduced the size of their workforces at a series record in December, and the employment index has now contracted for five consecutive months, to hit 45.2 in December.

So where exactly are we? Well we aren't (quite) in the Second Great Depression yet, but the situation is deteriorating, and rapidly. Manufacturing output is now contracting at quite a sharp pace, while it was rising in the first half of the year at something like a 15% year on year rate. In a useful summary of the Chinese situation back in November, Nouriel Roubini defined a hard landing in China - which he felt was coming - as follows:

There is thus now a growing risk of a hard landing in China. Let us be clear what we mean by hard landing. In a country with the potential growth of China, a hard landing would occur if the growth rate of the economy were to slow down to 5-6% as China needs a growth rate of 9-10% to absorb about 24 million folks joining the labor force every year; it needs a growth rate of 9-10% to move every year about 12-14 million poor rural farmers to the modern industrial/manufacturing urban sector.

This is more or less the consensus view of what we used to think a hard landing would mean in China, but I think the latest data already take us beyond that. I think there is now a real risk of a technical recession in the more or less classic sense of two consecutive quarters of negative growth (let's say that the risk is 50-50 at this point), and of serious economic and financial dislocation following in the train of this (btw, just how quickly can you burn your way through $1.7 trillion in reserves, it will be an interesting experiment I think).

Brad Setser (further down the same link) has long been more cautious on China, being sceptical about the impact of a dramatic slowdown in exports (and even more importantly in export oriented investment) on an export driven economy, but those of us who have been closely watching other export dependent economies like Germany and Japan over the last decade and a half were surely not quite so sceptical. However even Brad himself is clear that the possibility of an export downturn feeding its way back into the domestic economy - via some sort of negative feedback process - is real enough:

But the real key to forecasting China’s future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly. And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

The $1.7 trillion question is, then, just why China is so export dependent? Doubtless there are many factors at work, but one of these is, I am almost sure, China's very special demographics (30 years of one child per familiy policy), and the special problems that these present in the context of building a sustainable national pensions system at the same time as the population pyramid inverts. Obviously the absence of a credible pension system has to be one of the factors influencing the strong desire to save which we are seeing in China. Economics Nobel Franco Modigliani also thought this, and specifically addressed the Chinese saving puzzle in his last published paper:

China's per capita income ranks below 100th in the world. Its saving rate, however, has been one of the highest worldwide in recent decades. In this paper, we attempt to explain the seeming paradox within the framework of the Life-Cycle Hypothesis developed by Franco Modigliani. The key LCH variables are income and population growth. Our results based on data we put together from official sources show that income growth has been the dominant factor behind the dramatic increase in China's saving rate, as predicted by the LCH. Demographic structure and inflation also had significant impact on the fluctuations of the saving rate.
The Chinese Saving Puzzle and the Life-Cycle Hypothesis - Franco Modigliani and Shi Larry Cao

By Way Of Brief Conclusion

Well basically, the conclusion here is that there is no conclusion, at this point at least. But I would draw attention to two potential points of interest for all you "economy watchers".

Firstly, a couple of months back my fellow blogger Doug Muir drew our attention to a very interesting point being made by US economic historian Scott Reynolds Nelson:

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

At the time of reading this I thought to myself hmmmm! This isn't that simple, but he is on to something. Basically I think no two (or does that make it now three) Great Depressions are ever really exactly alike. I certainly think the resemblence between what is going on now and what happened between 1929 and 1933 is more than passing (especially for the sequencing, of which more in another post), but evidently there are elements of the 1873 one too, and Scott Reynolds puts his finger on some of them, especially in the context of surplus to requirement investment and large capacity overhangs. So my best guess is that what we have is a hybrid, and that what is now happening in China is the best example of the underlying dynamics behind that other great depression that hit our grand- (or great grand) parents and that may well be now about to come back to hit us, boomerang style.

Which brings me to my second point, the Smoot-Hawley Tariff Act, which, as wikipedia explain, was signed into law on June 17, 1930, and raised U.S. tariffs on over 20,000 imported goods to record levels. After the act was passed, many other countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. Many economists now regard the Smoot-Hawley Act as having been the principal feedback catalyst for the severe reduction in U.S.-European trade, and which took it from the 1929 high down to the depressed levels of 1932 and which thus accompanied the start of the Great Depression. And here, in the spectre of a repeat performance comes just the danger we face in the wake of the dramatic contraction which is now underway in China.

It is my personal guess that the first major issue to face Barack Obama as President of the United States may well be what to do about China, and especially what to do about a China which lets - as I now suspect they may well do - the yuan float, in order to see it float DOWN as the economy unwinds. If this does indeed happen then Obama will really have to struggle to hold back the protectionist pressure I think.