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Saturday, August 1, 2009

Is This Really a Global Recovery?

By Claus Vistesen: Copenhagen

China! China! burning bright

In a bubble, Day and Night

Is it Bust or is it Boom

That frames thy fearful asymmetry?*

Can you feel it? That calm and soothing feeling of low volatility and heaven bound risky assets driven by green shoots and second derivatives. Well, if you can't you are excused since neither can yours truly, or more precisely; he has a distinctly difficult time seeing from where people get the idea that we are headed for a broad based global recovery. However, beauty as always lies in the eye of the beholder and whichever way you look at it would be difficult to completely deny that the three key ingredients for a global recovery (and a resurgence of carry trade) in the form of low volatility, steadily climbing risky assets, and benign credit wholesale market credit conditions certainly seem to be present in ample quantities.

Now, while it is true that the level of volatility is still higher now than it was pre Q4-2008 and indeed pre August 2007 the trend so far this year has been inexorably down which reflects the perception that the worst may be over as well as the discourse of second derivatives and green shoots which has been with us throughout Q2 2009. With respect to equities they have equally begun to nudge up and are up some 5-10% from the beginning of the year in relation to Europe and the US. If you count from the trough reach some time during the first quarter this year, the increase would of course be bigger. The strength of the recovery discourse has taken many by surprise or perhaps more precisely, it has frustrated many. For example, I take note of the fact that two of the most astute macro traders (at least in my book) are feeling decidedly puzzled by the way the market is behaving at the moment. I cannot say that I blame them. For someone who take pride in being up to date in terms of macroeconomic data and analysis one would find it difficult to track the amount of bullishness which currently appear to have taken hold.

Now, I should immediately point out that I am not blind to the existence of the second derivative. I mean, I took calculus and I can also eyeball a graph in changes when I see one. My only gripe is that it only takes the faintest of scratch in the surface of the second derivative/green shoot glamour image to see that the fundamentals have not changed and moreover that the crisis has now moved its locus away from the US and right smack into the mainland of Europe in the form of significant downside risks in relation to Southern Europe and the ongoing mess in the CEE.

Yet, who is listening to a Danish student of economics anyway?

Consider consequently that the past couple of weeks brought us Bernanke's "exit talk" testimony to congress, news that a certain Mervyn residing at Threadneedle street would beat Bernanke to the exit, news that Russia is actually seriously considering issuing (and expecting foreign investors to bite) debt to cover its 2010 deficit, news that Hungary actually lowered interest rates despite, one could easily infer, an abyss of downside in the form of a plunging forint and a liability side denominated in Swiss francs, and finally Timmy's trip to China where it seems that the main message carried was one of reassurance that the US most certainly intend to vigilant towards the rising deficit.

We could add the Q2 GDP print in the US (preliminary) put up a much better figure, - 1% annualised, than expected which has so far been interpreted as a sign of recover although yet again I think that narrating this as a sign of an impending recovery is somewhat of a stretch. Meanwhile, Europe is heading straight for deflation and although I know that some economists, especially those of the old academic guard, consistently have been pointing to the benign effects of rigidness on the downside it is very important to remember that those same prices will need to adjust in key Eurozone countries absent a currency to bear some of the burden and thus price/wage rigidity may turn out to be a curse rather than a blessing.

Where is the Recovery?

The easiest way to approach this question is perhaps to point out where the recovery isn't and here I am talking about the OECD in general. Surely, we may succeed to avoid future cataclysmic events but the something has changed and new fundamentals are taking over. For example, I seriously doubt that many people have considered what it means for the global economy that the US economy will need to run an external surplus and I also think that most people have not yet realized the consequences of the unfolding mess in Europe and the Eurozone. On the other hand I have also stressed before how I am not, after all, a permabear in the sense that I do indeed see positive signs in emerging economies such as for example Brazil, India, Chile, Turkey, and China (although the latter is different for a number of reasons). I won't call this decoupling because evidently it isn't. To stay in the jargon I would rather call it re-coupling since this is essentially what it is and one key issue is the extent to which the new global economic system will help to even out the present imbalances and what consequences this, in some sense, inevitable rebalancing will have on surplus and deficit economies respectively. In this context and although one should always be careful in quoting onself, the following from an entry back in May still sums up quite well how I see the world at the moment;

We are very much still stuck in the mire and especially so in the context of the so-called developed OECD economies where it is difficult to see where any speedy recovery is going to come from. On the other hand the world is not made up entirely by the OECD edifice and it is exactly the potential for an asymmetric "recovery" and how global monetary policy might serve to transmit such a recovery which is the topic of this entry.

For the specifics of how I see the role of global monetary policy and global liquidity I recommend you to visit the actual post. However, it is worth noting that in a world where major global central banks are destined to keep rates low for an extended period it does not take much creativity to imagine the dynamics by which the global economy may potentially move forward driven by carry trade flows financed in the developed world seeking yield in whatever economies that might be able (and willing) to absorb the tide which is coming.

As I have stressed on several occasions it is exactly this reshuffling of the global economy on the back of the financial crisis which is at the heart of the matter. One obvious consequence is thus that the global economy, at one and the same time, increasingly will be populated by an increasing amount of economies with the need (and desire) to deleverage as well as an increasing amount of economies dependent on exports to achieve economic growth. In wonkish terms, global economies will tend to move towards the same intertemporal preference for consumption and saving and since global intertemporal smoothing, by definition, occurs through current account imbalances it is not difficult to see how there is a constraint on many economies’ ability to smooth their consumption and saving decisions optimally in the case of a process of crowding in one end of the spectrum.

An obvious question here becomes; who, if any, will be the economies tilting the scale in the other direction through their ability to provide capacity (return) for other nations' desire to save more?

How are things in Emerming Market Land then?

Personally, I have tended to put my focus elsewhere than China most prominently because I think that the old narrative of the BRIC economies taking over the helm is not an adequate way to look at it. Essentially, I would put Brazil and India one one side and Russia and China on the other side since in the case of the latter they are about to grow old much before they become the economies so many people expect to become. Apart from Brazil and India I also see a fairly wide batch of emerging economies with the potential to do the heavy lifting as we move forward and I would include here economies such as Chile, Indonesia, Turkey, Morroco and a number of others. Much more than quibbling about the actual candidates here I want to emphasise the importance in realizing how this global realignment won't take place with the emergence of one single economy taking over from the US, but rather with a "basket" of economies/currencies driving the realignment.

Having said all this, it is pretty difficult to get around the fact that everything seems to be revolving around China at the moment. More specifically fears are growing that in an effort the counter the global recession and in a world where 6-8% growth rates are, in general, difficult to come by Chinese authorities as well as foreign investors are fuelling a bubble in China which may look like the one currently unravelling in e.g. the Baltics look minuscule [quote from Bloomberg and the FT]. Thus and even though I would argue that the analysis should have a different fundamental focus it is still cast in the perspective of, first China and then the BRICs in general.

The BRIC nations, which also include India and Russia, have the four best performing stock markets in dollar terms this year among the world’s 20 biggest, according to data compiled by Bloomberg. China’s Shanghai Composite Index has soared 85 percent in dollars while Brazil’s Bovespa Index rose 77 percent. India’s Sensitive Index, or Sensex, climbed 61 percent and Russia’s RTS Index gained 60 percent. The Standard & Poor’s 500 Index in the U.S., by comparison, is up 8.4 percent while Japan’s Nikkei 225 Stock Average rose 7.5 percent.

Investor appetite for emerging-market assets is building on speculation that countries such as China and Brazil will be among the first to recover from the worst global recession since World War II, said Vinicius Silva, New York-based emerging markets strategist for Morgan Stanley. “It highlights the fact that demand for emerging-market assets remain strong and that companies, particularly in the BRIC markets, are using the improvements in capital markets to raise capital,” Silva said.


Shares in Shanghai and Hong Kong tumbled on Wednesday as investors snapped up two newly listed mainland construction groups while selling down the rest of the market after reports that China’s central bank might rein in bank lending. Shares in China State Construction Engineering rose by as much as 90 per cent on their debut before closing 56 per cent stronger in Shanghai. China’s largest house-builder had last week raised Rmb50.2bn ($7.34bn) in the world’s biggest initial public offering since Visa raised $19bn in March 2008.

It is way beyond the scope of this post to open the box on what is really going on China. In terms of that topic I reserve the right to deal with it later and refer, thus far, to my styling on Blake above. However, I did like the recent analysis by Morgan Stanley's Qing Wang in which he talks about whether China is over-investing or over saving as well as the very relevant question of where the money would be spent were it not being used to finance the massive infrastructure investment program. Or, what is the opportunity cost of China's fixed asset investment program?

Given China's high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Since China maintains tight controls over outbound capital flows, about 70% of China's total offshore assets are in the form of official FX reserve assets as a result of investment made by a single-largest investor - the central bank. Moreover, we estimate that about 65-70% of China's official FX reserves are invested in US dollar assets, the bulk of which are US government bonds.

In response to this I ask the simple question. What is actually the capacity in China to create return on current and future investment of the magnitudes we are talking about both in the context of money supplied by domestic stimulus packages as well as foreign money thirsty for yield? Wang touches exactly upon this question as he questions just how much China can suck up. I would put it much more bluntly. China's capacity is declining and will continue to do so as we move forward as a result of the ageing which the one child policy is set to produce. This is really the missing story on China at the moment I feel and one story which could go a long way to differentiate the story. In this respect I do agree wholeheartedly with Michael Pettis when he says;

I have warned for a long time that it would be very difficult for China to make the necessary transition to a consumption-led economy quickly enough to accommodate the global adjustment taking place. Unless it is willing to see its economy collapse, there is simply no way China can reduce its negative net demand quickly enough to match the contraction in US demand and so avoid squeezing the hell out of the global tradable goods sectors. That is why policy coordination is so important, especially between China and the USD, and of course that is why I continue to be a pessimist. I do not think this policy coordination is taking place. I will write about this more later this week.

The only thing I would add is that this is not simply a question of correcting US-China imbalances, but a more more deep rooted issue in terms of fundamental drivers of international capital flows and the future supply of net capacity.

Moving on to safer ground I recently did a lengthy analysis on Chile in which I concluded that the economy was one of to watch for relative good news in relation to the financial crisis. Recently, we learned how Chilean banks booked a healthy US 959 million profit in the first half of 2009 and although this number is useless in itself I think that it is pretty obvious from digging into the specifics (see article) that although Chile financial sector has seen its share of losses, the picture is a lot less dire than elsewhere. In fact, if we look at one of graphs that I showed in my analysis of Chile, we see that financial services have held up remarkably well during the financial crisis (see also here), no doubt due to strong underlying fundamentals as well as a very aggressive policy reaction from the central bank.

Generally, analysts and local observers in Chile are beginning to notice green shoots with increasing regularity and unlike the ones observed in Europe or elsewhere in the OECD I am more confident that the ones in Chile are going to be long lived although 2009, in all likelihood, will be a tough year when the chapter is closed. The following quote is from Bloomberg;

Chile’s economy may be starting to recover from its slump as extra government spending spurs growth, Finance Minister Andres Velasco said today. Velasco has spent more than $4 billion this year on tax cuts and extra outlays. He will pull $8 billion from Chile’s offshore savings funds in 2009 to help pay for the stimulus as well as to plug the budget deficit caused by slowing growth and lower receipts from mining.

Chile is facing the deepest recession since 1999 after revenue from exports declined and a virus ravaged its salmon farming industry. The economy shrank faster than forecast in the first half and probably contracted in the second quarter from the first, the central bank said on July 8.

“These policies have effects, but they don’t occur overnight, they don’t happen in one month or one quarter,” Velasco said. “We have to continue working, we have to keep a cool head and at the same time be prudently optimistic.”

Now, Velasco has a distinct interest, of course, in spinning the story in a certain way but until evidence surfaces to the contrary I am willing to buy this story. More generally, the influence of China also pops up in the context of copper prices where many suggest that a large part of the recent increase in Copper prices (and indeed commodities) owes itself exactly to the stimulus money from China. As a side note on this, it seems that the link between rising Copper (and commodities in general) is being increasingly linked to a story of stockpiling in China and then of course, what will happen when China decides that it has had enough. This was a story I picked up on in my analysis of Chile (picked off from Macro Man) and it appears to be gaining traction as an actual analytical explanation.

Elsewhere in Latin America, Morgan Stanley's Latam analyst on Brazil Marcelo Carvalho simply throws in the towel, as it were, devotes an entire note to the link between Brazil and China and what this means for the economic growth of the former. As will come as no surprise Carvalho notes the strong link between Brazil's economic performance and commodity prices and since China certainly seems to be driving the latter, if not directly, then through its effect on overall global sentiment then the rampant growth in China may add positively to the outlook in Brazil.

Moving the perspective up a further notch and as a concluding remark on my, admittedly, selective tour of the emerging market edifice I will leave you with the recent general statement from Morgan Stanley's Manoj Pradhan;

The strong worldwide rally in risky assets since March reflects not just the relief that the worst is likely behind us, but also anticipation of a return to growth for most economies. Much is expected from Emerging Markets, particularly from Asia ex-Japan, which is expected to outperform the rest of the world. Markets and investors realize, however, that not all EM economies are alike, and some will show output growth that is lower than the 1.3% growth our global team expects from the G10 economies in 2010.

Thanks for nothing might be your immediate response here and although I agree that this is extremely general it does sum up the main discourse at the moment whether you agree or not.

Bottomline - What to Watch?

The answer to this question depends on your perspective of course but it seems abundantly clear that if the locus of the financial and economic crisis has moved from the US to the shores of Europe and in particular Eastern and Southern Europe, the corresponding locus of the recovery has moved to Asia (ex-Japan) and most forcefully China. I think it is important to understand how and why these two discourses may co-exist as we move forward.

I believe it is obviously clear that the global economy is not heading for a quick rebound here, but it is equally as clear that some economies will be able to post growth rates that are much above the mean of what the OECD is able to. In this way, one key theme to watch is how this difference is transmitted through to the global economy e.g. in the form of carry trade flows but also in the form of an evolving process by which some economies begin, and go through, their inevitable adjustment and rebalancing phase.

In this specific context I have to be more than a little bit skeptical about the capabilities of China. This is not out of an inherent disdain towards the country but, on the contrary, because I fear that China may ultimately succumb to all those hopes and subsequent load pinned on her shoulders. In this sense I think, although I acknowledge that I have presented no formal analysis to back it up, that the recovery is some way to really materialize and that it may just ultimately be bust and not boom that frames China's economy.


* Apologies to William Blake; and of course to Macro Man for encroaching on his territory.