"If the US experiences a recession, might that not be good for China's exports? After all, China exports low-priced goods, and US households may consume more of these during a recession" - DuOo
You raise a good point. During a recession, consumption of luxury goods falls dramatically, while consumption of necessities may barely change. Thus depending on the kind of goods China is exporting, a US recession may not necessary hurt China's economy. I expect that a US recession will negatively impact on China, for two reasons:
1) There's a difference between low priced goods and necessities. Yes, demand for necessities is relatively resillient during a recession, but necessities are items like food and medicine. These are not the largest part of Chinese exports to the United States. Instead China's exports are mostly made up of consumer goods that, while (relatively) cheap, are not essential consumption items to US households.
2) China's exports are increasingly in the "luxury" and durable goods sector, which are highly vulnerable to the business cycle. There are very few cars, for example, that do not contain some parts that were made in China. An anecdote that I heard recently from a friend in the watch industry is that the mechanisms in nearly all "Swiss" watches are made in China. The watch is still assembled in Switzerland, so that it can still be claimed to be "Swiss" for marketing reasons, but much of the actual manufacturing is now taking place in China.
For these reasons, I expect that a US recession will negatively impact on China.
Showing posts with label Mainland economy. Show all posts
Showing posts with label Mainland economy. Show all posts
Tuesday, February 26, 2008
Wednesday, February 20, 2008
China's inflation... good news or bad?
Is inflation procyclical or countercyclical? In China now, the inflation rate is too high so that some people predict it could be a sign of recession. Can you explain? -Amy
At it's base, increasing inflation can be good or bad. Thinking of the standard supply and demand diagram: prices rise when there is either too much demand or too little supply. Too much demand would tend to reflect a rapidly growing economy, which is good; too little supply would reflect a slowly growing (or even shrinking) economy, which is bad.
In the case of China, it's hard to tell. Yes, prices are increasing at the fastest pace for 12 years, and inflation now stands at over 7%. But prices have been pushed up partly by the recent bad weather, which reduced supplies. Now that the bad weather is passing, its effect on inflation should diminish as well.
But there's another sense in which China's inflation is bad. Much of China's recent growth has come from growing net exports. China, the "world's factory," has churned out huge quantities of manufactured goods for world markets, where demand has been growing based primarily on low prices.
But China will not be the lowest cost producer of these goods for much longer. Price inflation directly drives up the price of exports, and the increasing value of the RMB increases the price when converted to other currencies still further. Additionally, the cost of producing goods in China is increasing rapidly, with migrant wages increasing and workers able to be more particular about their working conditions.
But lets not overstate the threat here. The effects I've outlined above are likely to slow that rate of growth of the Mainland economy. In future, more of China's growth will have to come from producing higher valued products, as they will no longer be the world's cheapest source of manufactured goods. But don't expect the economy to completely stagnate anytime soon.
At it's base, increasing inflation can be good or bad. Thinking of the standard supply and demand diagram: prices rise when there is either too much demand or too little supply. Too much demand would tend to reflect a rapidly growing economy, which is good; too little supply would reflect a slowly growing (or even shrinking) economy, which is bad.
In the case of China, it's hard to tell. Yes, prices are increasing at the fastest pace for 12 years, and inflation now stands at over 7%. But prices have been pushed up partly by the recent bad weather, which reduced supplies. Now that the bad weather is passing, its effect on inflation should diminish as well.
But there's another sense in which China's inflation is bad. Much of China's recent growth has come from growing net exports. China, the "world's factory," has churned out huge quantities of manufactured goods for world markets, where demand has been growing based primarily on low prices.
But China will not be the lowest cost producer of these goods for much longer. Price inflation directly drives up the price of exports, and the increasing value of the RMB increases the price when converted to other currencies still further. Additionally, the cost of producing goods in China is increasing rapidly, with migrant wages increasing and workers able to be more particular about their working conditions.
But lets not overstate the threat here. The effects I've outlined above are likely to slow that rate of growth of the Mainland economy. In future, more of China's growth will have to come from producing higher valued products, as they will no longer be the world's cheapest source of manufactured goods. But don't expect the economy to completely stagnate anytime soon.
China and the Industrial Revolution...
Why did the Industrial Revolution (the original one, that started in Britain shortly before 1800) bipass China? See this link on Marginal Revolution.
Thursday, January 31, 2008
Exchange Rate Appreciation and Inflation....
" China is reported to be accelerating the appreciation of the yuan to combat inflaton instead of increasing its interest rates, in part because of expectations of further cuts in US interest rates. How does appreciation combat inflation?" - Jane
That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.
How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.
There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.
That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.
How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.
There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.
Tuesday, January 29, 2008
China.... consume or save?
"We're told that saving rather than consumption will ultimately lead to increased economic growth, as saving will encourage increased investment. However, some commentators insist that Mainland China take steps to increase domestic demand, which is the exact opposite. Why is that?" - Zheng
That's an excellent question! The issue with Mainland China is that it has developed very rapidly on the basis of ever increasing exports to the rest of the world. At the same time, the high level of domestic savings has financed increasing levels of foreign investment outside of China.
But this may be a fragile source of growth. There is growing resentment in some of the rest of the world as China's low-cost production drives foreign domestic producers out of business (irrational, in my view, since the rest of the world benefits on net from free trade with China), leading to increased talk of protectionism. (A by-product of China's massive trade surplus is its growing foreign currency reserves).
Also this makes China's continued development very dependent on the economic health of the rest of the world. Right now, with the US on the brink of recession, it is easy to see that this may not be in China's best interests.
Finally, and most importantly, China appears to be suffering from a serious imbalance. Why does the Chinese economy as a whole save up to 40% of total income (see here)- much higher than nearly any other economy? This suggests some structural problems that the Mainland Government would do well to try to rectify.
In sum, many commentators interpret China's high savings rate and massive trade surplus as symptoms that something is not right in the Mainland economy. It's the "something" that they'd like to see change, rather than the savings rate per se.
That's an excellent question! The issue with Mainland China is that it has developed very rapidly on the basis of ever increasing exports to the rest of the world. At the same time, the high level of domestic savings has financed increasing levels of foreign investment outside of China.
But this may be a fragile source of growth. There is growing resentment in some of the rest of the world as China's low-cost production drives foreign domestic producers out of business (irrational, in my view, since the rest of the world benefits on net from free trade with China), leading to increased talk of protectionism. (A by-product of China's massive trade surplus is its growing foreign currency reserves).
Also this makes China's continued development very dependent on the economic health of the rest of the world. Right now, with the US on the brink of recession, it is easy to see that this may not be in China's best interests.
Finally, and most importantly, China appears to be suffering from a serious imbalance. Why does the Chinese economy as a whole save up to 40% of total income (see here)- much higher than nearly any other economy? This suggests some structural problems that the Mainland Government would do well to try to rectify.
In sum, many commentators interpret China's high savings rate and massive trade surplus as symptoms that something is not right in the Mainland economy. It's the "something" that they'd like to see change, rather than the savings rate per se.
Thursday, January 24, 2008
Price Controls and Shortages...
One week ago, I discussed the likely consequences of the newly-introduced Mainland price controls here. I argued that "Price controls never have been, and in my view never will be, an effective policy to try to lower inflation." Previously, I've argued that price controls lead to shortages.
Well, guess what? From today's SCMP...
Worst-ever coal shortage sees stocks fall 40pc
Emergency measures taken as provinces ration electricity
The mainland has issued an emergency circular to ensure power supplies after an unexpected power shortage of nearly 70GW.
.....
In an effort to ease inflation, the State Council had announced this month that power producers would not be allowed to raise electricity prices in the short term, preventing them from passing on the rising cost of coal.
........
"It's a battle between power companies and the central government," said Great Wall Securities analyst Zhou Tao . "While coal prices are going up and an electricity price rise is ruled out by the government, the electricity companies are reluctant to buy much."
Electricity prices cannot be increased because of price controls, but the cost of generating electricity is rising due to rising coal prices. Profit maximising electricity producers respond by reducing the supply of electicity, resulting in power shortages.
The best response? Deregulate electricity prices, allowing these to move with the cost of production. The most likely response? Regulate coal prices, to reduce the cost of electricity generation. But this would not work: it'll merely result in shortages of both electricity AND coal, as profit maximizing coal producers respond to decreasing profit margins by decreasing the supply of coal.
I repeat: PRICE CONTROLS DO NOT WORK.
Well, guess what? From today's SCMP...
Worst-ever coal shortage sees stocks fall 40pc
Emergency measures taken as provinces ration electricity
The mainland has issued an emergency circular to ensure power supplies after an unexpected power shortage of nearly 70GW.
.....
In an effort to ease inflation, the State Council had announced this month that power producers would not be allowed to raise electricity prices in the short term, preventing them from passing on the rising cost of coal.
........
"It's a battle between power companies and the central government," said Great Wall Securities analyst Zhou Tao . "While coal prices are going up and an electricity price rise is ruled out by the government, the electricity companies are reluctant to buy much."
Electricity prices cannot be increased because of price controls, but the cost of generating electricity is rising due to rising coal prices. Profit maximising electricity producers respond by reducing the supply of electicity, resulting in power shortages.
The best response? Deregulate electricity prices, allowing these to move with the cost of production. The most likely response? Regulate coal prices, to reduce the cost of electricity generation. But this would not work: it'll merely result in shortages of both electricity AND coal, as profit maximizing coal producers respond to decreasing profit margins by decreasing the supply of coal.
I repeat: PRICE CONTROLS DO NOT WORK.
Friday, January 18, 2008
China vs. India
China and India share many similarities. Both are rapidly developing, relatively poor, huge economics who are together changing the shape of the world economy. But they have some fundamental differences, and their economic growth is occuring in radically different sectors. According to Marginal Revolution, that's mainly down to different labour laws. Read more here.
Thursday, January 17, 2008
Chinese Price Controls...
Prices are going up in Mainland China, so the Government has enacted price controls. From today's SCMP editorial...
"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."
The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.
"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."
The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.
Wednesday, November 21, 2007
Too expensive at half the price.... Mainland equities.
I've talked repeatedly here about China's equities bubble (for my last installment, see here). But here's another piece of the puzzle. Bloomberg reported on November 5 that on its first day of trading in Shanghai, Petro China tripled in value, and became the most valuable company in the world by market cap- much larger than any other oil company, even though several of these have significantly higher revenues, oil reserves, and other assets.
Or consider this table published in mid-October. Of the 25 most valuable companies in the world by market cap, 8 were Chinese, while only one Japanese company, Toyota, makes the list- even though Japan is the world's second largest national economy, and many Japanese companies are global brands, with a strong global presence.
Focusing on financial institutions on the same list, there are 4 Chinese companies on the list, and only three from the rest of the world.
Yes, China represents a great opportunity for future growth and therefore future profits. But this great?
Or consider this table published in mid-October. Of the 25 most valuable companies in the world by market cap, 8 were Chinese, while only one Japanese company, Toyota, makes the list- even though Japan is the world's second largest national economy, and many Japanese companies are global brands, with a strong global presence.
Focusing on financial institutions on the same list, there are 4 Chinese companies on the list, and only three from the rest of the world.
Yes, China represents a great opportunity for future growth and therefore future profits. But this great?
Tuesday, November 20, 2007
How Rich is China?
A recent article in the Financial Times (thanks to Marginal Revolution for the pointer) suggests that some soon-to-be released numbers will show that living standards in China are 40% lower than had previously been believed.
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Of course it remains to be seen what is really in the data when it is released, but let me clarify what this news is about. When we measure GDP across countries, we do so at market prices. We're left with nominal GDP, which is a measure of the market value of production in the economy over a period of time (typically a quarter or a year).
But to make that number meaningful, we need to adjust it to real terms. So we also construct real GDP, where we measure the total value of production if prices had remained at the same level as in some base year.
But what if we wish to compare GDP across countries, as a means of comparing the standard of living across countries? We have real GDP in China measured in Chinese RMB, against US GDP measured in USD, for example, which are not directly comparable.
One simple approach would be to just use the market exchange rate, but that may not be ideal for several reasons. First exchange rates are highly volatile. It is not uncommon for nominal exchange rates to fluctuate by 10-30% in a single year, while underlying living standards change very little! But more importantly, the cost of living can vary radically across countries. Some countries may experience high incomes (and therefore high GDP: total income = total output), but also high costs, while other countries may experience the reverse. We therefore need to filter out any systematic differences in the cost of living to get an accurate idea of comparable living standards.
How do we do that? Well, we need detailed price data on similar items sold in different countries. We compare GDP not at market exchange rates, but at PPP (or "purchasing power parity") rates, that seek to adjust for differences in the cost of living.
And that's where this revision in mainland GDP is reputed to come from. Apparently prices in mainland China that have been used for making the PPP adjustment have been poorly measured in the past, and the result is a systematic understatment of the cost of living.
I'll be following this story with interest....
Monday, November 19, 2007
Benford's Law... and Testing Economics Data
I earlier posted a link on Benford's law, the idea that most data series are likely to have many more observations starting with the digit "1" than "2", and more starting with "2" than "3", etc. The idea was that to get from "1" to "2" requires a 100% increase in magnitude, while getting from "2" to "3" requires only a 50% increase in magnitude.... and so on.
Well, the undercover economist has more... the same principle can be used to assess whether economic statistics are accurate.
Suspician of the accuracy of statistics has a long history. Benjamin Disraeli famously commented that there are three kinds of lies.... "lies, damned lies, and statistics." But maybe this is not fair. At a minimum, most statistics should satisfy Benford's law.
I can think of an excellent application. Many people are suspicious of the macroeconomic numbers generated by Mainland China, especially at the state level. A simple test of whether they're made-up or not would be to see whether the series satisfy Benford's Law.
Of course this would not be a fall-proof test. What if the numbers really were made up, but by statisticians who knew about Benford's law?
Well, the undercover economist has more... the same principle can be used to assess whether economic statistics are accurate.
Suspician of the accuracy of statistics has a long history. Benjamin Disraeli famously commented that there are three kinds of lies.... "lies, damned lies, and statistics." But maybe this is not fair. At a minimum, most statistics should satisfy Benford's law.
I can think of an excellent application. Many people are suspicious of the macroeconomic numbers generated by Mainland China, especially at the state level. A simple test of whether they're made-up or not would be to see whether the series satisfy Benford's Law.
Of course this would not be a fall-proof test. What if the numbers really were made up, but by statisticians who knew about Benford's law?
Wednesday, November 14, 2007
Mainland Futures...
There's a new feature that may be introduced shortly that may have a profound effect on mainland equities. I've argued before that Mainland Chinese equities represent a bubble, and that one day it must burst. One reason why it's lasted so long is that there are no instruments available for investors in the mainland to short equities. Thus people who think that the market is overvalued remove their money from the market, but can do little more. Investors who remain are by definition optimists, who believe that the market will continue to rise- otherwise they wouldn't invest in the first place!
In an economy where the number of new investors is growing at incredible rates (remember those reports about hundreds of thousands of new equity accounts being opened every day?), there's no stortage of optimism.
But now that pie cart may be about to be overturned. From today's South China Morning Post:
"The imminent launch of index futures in the mainland is increasingly spooking investors who fear it could herald a sharp correction in a market that has almost doubled this year."
The response?
"The mainland's stock benchmarks slipped for a fourth day yesterday as investors braced for the introduction of a system that will allow big funds to bet on a market decline. The losses contrasted with a rebound in the Hong Kong market."
So mainland investors may be able to short mainland equities soon, and that's enough for the market to drop? Chalk that up to additional evidence of a bubble...
In an economy where the number of new investors is growing at incredible rates (remember those reports about hundreds of thousands of new equity accounts being opened every day?), there's no stortage of optimism.
But now that pie cart may be about to be overturned. From today's South China Morning Post:
"The imminent launch of index futures in the mainland is increasingly spooking investors who fear it could herald a sharp correction in a market that has almost doubled this year."
The response?
"The mainland's stock benchmarks slipped for a fourth day yesterday as investors braced for the introduction of a system that will allow big funds to bet on a market decline. The losses contrasted with a rebound in the Hong Kong market."
So mainland investors may be able to short mainland equities soon, and that's enough for the market to drop? Chalk that up to additional evidence of a bubble...
Wednesday, October 31, 2007
The Collateral Damage of Trade....
Yesterday I posted on the link between trade and disease. Trade results in other risks as well... like creating racial offense from poor translations!
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!
As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.
Monday, October 29, 2007
Froth and Bubbles....
"What should China do to try to reduce excess liquidity and inflation" - Qin
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China is increasingly exhibiting the signs of an overheating economy. Asset prices are incredible (literally, in my view; see here for my earlier views), and domestic price inflation has increased to 6.5%, with increasing signs of further rises to come.
What can China do about this? Let's start with the standard prescriptions: a contractionary policy, using either fiscal or monetary policy. On the fiscal side, this could take the form of either a tax rise or a government spending cut. Given the chronic state of many parts of the mainland government sector (for example, health care), a spending cut seems out of the question. Further, a significant tax rise is likely to result in increasing compliance issues, so may not be desirable either.
That leaves us with monetary policy, which has already been tried with limited effect. In part that is because any increase in interest rates is being offset by an increasing money supply due to growing foreign reserves. When Beijing prevents the RMB from appreciating by buying USD assets, it increases the money supply by an offsetting amount. The scale of this is almost impossible to sterilize, so the net effect is actually an expansionary monetary policy, in contrast to the contractionary one that is required to stabilize the economy.
My conclusion is that ultimately, stabilizing the economy in China will require the rate of money supply growth to fall. A significant appreciation of the currency would certainly help, as this would reduce the growth rate of foreign reserves, and the corresponding injection of currency into the economy. An alternative would be to encourage increased capital outflows, so that the current rate of appreciation of the currency could be maintained with less official intervention.
Based on the rapid appreciation of the RMB earlier today, maybe the mainland authorities are opting for more rapid currency appreciation, although one day is hardly a trend! In sum, any action by Beijing to try to slow the money supply brings with it significant economic risks. But doing nothing and hoping for the best may bring even greater risks.
China's Growing Reserves....
"China has accumulated huge USD reserves. How might these affect the US in future?" -Arun
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
China currently holds official reserves of approximately 1.4billion USD, mostly in USD denominated assets. The source of these growing reserves is official activity in the foreign exchange market, as Beijing seeks to control the value and stability of the Chinese currency. The end result is that the United States government is becoming increasingly in debt to the Mainland Chinese government.
In thinking about the effects of this growing reserves mounting, the are two possibilities that I would focus on. First, in principle, China could seek to use these holdings of debt to try to influence US policy positions. For example, suppose the United States were to increase protectionism by imposing punitive tariffs on China's exports. China could threaten to throw the foreign exchange market and the fixed income market in the United States into disarray by dumping huge quantities of USD assets on the world market.
I do not think that this is a likely outcome. Such a threat would not be in China's best interests. The very threat of wholesale selling would significantly drive down the value of a significant part of the Chinese government's balance sheet, imposing real costs on China. The only reason for making such a threat would be in the hope that the US would alter its behaviour so that China would never need to carry through with the threat. But the United States would never be willing to be seen to bow to Chinese pressure, as the political cost domestically would be too great. So a threat to sell is neither credible nor optimal for China.
The second effect of the growing debt mountain is that in the longer term, the United States is like any other debtor, and China like any other creditor. Future income in the United States will flow in increasing amounts to creditors in China and elsewhere, at the expense of future prosperity of US citizens. However, I want to be careful not to overstate this: even if all of China's reserves were in USD, at current US Tbill rates of about 5%, this amounts to a flow of $70Billion USD per year- or just 0.5% of current US GDP.
Sunday, October 7, 2007
Sports, sentiment, and cycles....
I can't sit here, as a native-born Kiwi (New Zealander) and not make a comment on the shocking result in the Rugby World Cup in the early hours of the morning, HK time. Completely against expectations, the world's top rugby team, and the most successful in the history of the sport, lost to France in the quarter-finals. There are many things I'd like discuss (like the refereeing), but I'll leave that to the experts. The fact is, based on current form, the All Blacks (as the NZ team are called) should have won by a large margin.
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Let me first address the apparent contradiction of the top team failing to win the World Cup, and then get on to the macroeconomic implications of sports, and implications for China.
Rugby teams have different styles of play. Some are flamboyant, occasionally producing amazing results, but in the long run are likely to disappoint (like hedge funds); others play excellent, exciting rugby, win more often than not, but sometimes suffer major lapses (like equities); and others are dead boring, able to grind out a modest return under most circumstances, but fail to inspire in the long run (like bonds).
Of these three types, I'd characterise the All Blacks as the top equities fund of world rugby. For over 100 years, they have out-performed all other funds across all asset classes on average, but they've had significant set-backs along the way, in particular failing to win some crucial games at world cups! But maybe that's just a result of the structure of the world cup. To win, a team must beat three competitors on three consecuative weekends in sudden-death matches. Winning two by a large margin is irrelevant if you lose the remainder.
Consider the analogy of investing. Suppose your objective was to have the highest return in three consecuative pairwise comparisons with randomly selected alternative funds. Would the top equities fund win? There's a good chance of that if all the competitors were also equity funds. But the probability drops as the investment strategies of the opposition diverge from equities. For example, equities may have out-performed bonds consistently for as long we we've had data (and have now started out-performing hedge funds as well), but I'd expect equities to beat bonds in three consecuative periods (months, say) with a probability of less than 50%, since bonds consistently outperform equities in a falling market.
Of course that doesn't completely explain the Rugby World Cup: with one victory in 5 world cups, the most dominant team is running at a lowly 20% success rate! But at least it's a start.
The semi-finals of the cup include England (bonds) versus France (hedge fund) and the winner of South Africa (equities)/Fiji (hedge fund) versus the winner of Scotland (underperforming bonds)/Argentina (inexperienced hedge fund). As with investments, it's impossible to be sure what the outcome will be.
But lets get on to the macroeconomics of sport, since this is supposed to be a macroeconomics blog! New Zealand has a small population that is completely rugby obsessed. This obsession starts at birth, and aflicts nearly all members of the population, whether they've ever picked up an oval ball or not. Perhaps more so than in any other country, the performance of the national rugby team affects the mindset, optimism, and outlook of the population.
So what happens when the national team losses unexpectedly? National mourning and stunned disbelief. But maybe more. How about a recession?
Remember that expectations and optimism play a major role in the consumption and savings decisions of consumers. In the case of New Zealand, the current phase of the business cycle would suggest that this is particularly so. As with the United States until recently, the economy has been booming, largely on the basis of the "feel good" factor. This has fueled increases in house prices to historically unprecedented levels, which has in turn fueled large increases in consumption spending and investment (in new houses), driving the economy to new heights. The end result is unsustainable, with the current account deficit at worse than 8% of GDP, and record household debt levels.
This ponzi scheme of inflated real estate prices driving excessive consumption must at some point come tumbling down. Could a shock to expectations, in the form of the worst ever performance of the All Blacks at a world cup trigger such a correction? Time will tell.
Coming closer to home, the Chinese market is a "bubble of bubbles" according to some commentators. Hype about the coming olympics may be helping to drive up asset prices above fundamental levels. What happens when the olympics is over, especially if China fails to impress with a record medals haul? It's the final straw that breaks the camel's back, and the smallest pin that bursts the largest bubble....
Friday, October 5, 2007
China is a "Bubble of Bubbles".... and Ben is to Blame....
Thursday, October 4, 2007
Do bubbles slow economic growth?
"Will the presence of bubbles not slow economic growth in real economy? In China at the moment, investing in real assets may appear relatively unattractive compared with investing in equities, based on recent returns. Also, some SOE have been prosecuted for using funds earmarked for real investments to speculate in the markets instead. In the long run, is this bad for economic growth?"- Mattias
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
You raise a very important point. When asset prices are increasing very rapidly, firms may be tempted to divert funds from real investment to investing in equities instead. Such activity will lower overall investment, and therefore the capital stock in the long run, and must eventually reduce economic growth.
Clearly this is not an equilibrium: asset bubbles do not last forever, and when they come crashing down, firms who have engaged in such behaviour will experience substantial real consequences.
In the case of state owned enterprises, Chinese authorities are correct to try to prevent such speculation, for two reasons. First, if equity investment by SOE's has become widespread in China, then those same SOE's may face potential large losses, and may require bailing out when the bubble bursts.
Second, the diversion of investment funds into equities increases the overall demand for equities, and puts upward pressure on asset prices, contributing to the size of the bubble. Any steps by the mainland government that limit the size of the bubble are wize in my view.... I would prefer to see other and more aggressive steps taken by the government as well.
Thursday, September 20, 2007
Controlling China's Inflation
China's inflation rate has increasing, and recently hit 6.5%- the highest level in 10 years. The mainland Government has responded to inflation in the past by gradually increasing interest rates in small increments, with limited success. But now it's bringing out the big guns. From today's South China Morning Post....
"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."
It then goes on, more ominously, to reccommend....
".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."
Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.
The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.
Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.
So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.
When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.
Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.
The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.
So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.
The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.
The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.
For my earlier take on price level targeting in China, see here.
See also this column by Thomas Palley in the Guardian.
"Beijing has issued price-control measures for consumer products, which include a freeze on prices.... the government would not change any of the prices of products and services it controlled for the rest of the year. The government administers a vast array of prices, including those for land, transport, utilities and fuel."
It then goes on, more ominously, to reccommend....
".... price-monitoring systems for food, electricity and medicine, and an emergency response system to address any big price fluctuations..... [L]ocal governments should increase minimum wages as soon as possible to make up for inflation."
Let's boil down the problem of increasing inflation to its elementary economic components. Ultimately, any increase in prices is due to a mis-match between supply and demand. At existing prices, demand exceeds supply across a wide range of goods and services, so producers respond by raising their prices, to maximise their profits. But price increases will likely lead to demands for higher wages, as workers seek to maintain their real wages, which firms will in turn pass on to consumers via higher prices, causing a wage-price spiral.
The government's solution to this problem is to try to limit this process by preventing price rises across the range of goods and services whose prices they control. By definition, they may be able to control these prices, but this is a small front in the overall battle against inflation. And ultimately price controls are futile in this battle.
Price controls are nothing new, but they have never been very successful. Even the United States had price controls over the 1971-1973 period, and while the inflation rate fell from 6% to 3-4% over during the freeze, it shot up to 11% in 1974 when the price controls were removed. That's because the fundamental source of inflation had not been addressed.
So that's one black mark against price controls: they fail to work, except in the short run. But there's another more fundamental reasons to dislike price controls. They cause the price system to break down.
When we as consumers decide what we'd like to consume, the price provides an important input into our decision making process. We tend to skimp on high priced goods, but consume relatively more of low priced goods. Because the prices reflect the resource costs of providing the goods, this is efficient. Our consumption decisions reflect the fundamental cost of providing goods and services, reducing resource wastage in the economy.
Now the Government decides to delink the price from the cost of provision across a range of goods and services. Rational consumers will respond by consuming more of these relatively cheap goods and services. The government will need to respond to this increase in demand by stepping up supply- even though it may be making a loss on each unit of output that it is now providing. Thus valuable resources will need to be diverted from some alternative use to increasing the supply of the price controlled goods.
The alternative is that the goverment fails to increase the supply of price-controlled goods, and instead allows demand to outstrip supply. The end result of this would be shortages, and the likely establishment of black markets where the goods are sold at their true economic value, away from government control.
So if price controls are futile, what can the Government do to try to lower the inflation rate in Mainland China? Ultimately they need to lower the demand for goods in the economy. That requires that the economy cool off, and the break-neck rate of economic growth slow.
The appropriate channels for achieving the required economic slowdown are what we would label a "contractionary monetary policy"- for example, raising interest rates abruptly, by more than the increase in inflation, to ensure that real interest rates rise. Or allowing the currency to appreciate more quickly, so that foreign demand for domestic goods slows, and and domestic demand for foreign goods (which are now cheaper) increases. These steps would deal with the fundamental imblance in the Mainland economy, and ensure that demand moves back into line with supply.
The alternative- a partial price freeze- is like a partial stop bank in the path of a swollen river. Yes it might keep the water out for a while, but ultimately it just won't work.
For my earlier take on price level targeting in China, see here.
See also this column by Thomas Palley in the Guardian.
Wednesday, September 19, 2007
China's Air Pollution...
Two brilliant minds, Adam Posner and Gary Backer, weigh in on China's air pollution, here and here.
Thanks to Freakonomics for the link.
Thanks to Freakonomics for the link.
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