Q&A on Asian Economies and their Place in the World

The good folks at Icfai University Press and specifically the editor of the magazine The Analyst have queried me to answer some question on the Asian economies and their ascend to the top position (or not) of the global economy and what this means. They have shipped me some questions, given me a deadline and below I provide some answers in Q&A format. Enjoy!

Question: History reveals that every international crisis leaves a lasting mark on the world, once the crisis is over and the difficulties it brought have been encountered, things tend to change. Similarly, do you think that the current global economic crisis must lead to a fundamental reassessment of how power and influence is expressed through the world?

I belive that the current financial crisis have accentuated what we already knew and what has been present in the data and the discourse for some time. Specifically I am talking about the idea that big emerging markets such as India, Brazil, China, Indonesia, Chile, Turkey etc have slowly but steadily taken over as the global powerhouses in terms of economic growth and thus it is also natural that they are gunning for more political and institutional power. When it comes to financial crises in particular the latest batch of proposals from the Obama administration to regulate the financial industry is another and more micro oriented theme which is a recurring event in the context of economic crises. Crises are often, in this way, catalysts for abrupt discrete changes in the economic and political environment.

Ultimately then I think that this fundamental reassessment of power and influence in the world (both politically and economically) have not been initiated by this crisis but it may be reinforced.

Question: As the Great Depression paved the way to World War II and to a new world order, how far the present crisis produce grave repercussions on the global economic order?

This intimately depends on how you define world order naturally. If I have to point towards the most enduring change which appears to have come on the back on this crisis it is the attitude to debt and long term sustainability of public finances. Those of us who have been interested in demographics and its effect on macroeconomic processes have long been waiting for (and predicting) the inflection point where the mismatch between expensive welfare systems and the increasingly broken demographic structure as as result of persistently below replacement fertility. In this way, the ability to take on debt today as a liability for the future and despite the theatricals on sovereign spreads and CDS on Greek and Spanish government debt, are in fact fundamentally driven by long term liability problems. For an excellent excursion into this topic in the context of Australia/New Zealand and beyond I warmly recommend this one by John Hempton.

Extrapolating to the idea of a new economic order this brings us into a fundamental dilemma. With every part of the national identity overlevered [1] and in need to rebuild their balance sheet most economies are looking to the last part of the identity to make up for the shortfall of savings; the external balance. The problem is that not everyone can export excess savings (i.e. run a current account surplus) at the same time. In my opinion this is where the big new emerging economies come in and despite by personal skepticism towards China pulling the world anywhere it remains obvious that those who can reasonably be expected to run sustainable net external borrowing positions (i.e. current account deficits) are exactly those economies mentioned above who are about to ascend as the new drivers of economic growth. If they don't, it is not easy to see where the growth is going to come from.

Question: The world financial crisis has been a defining moment in the ascension of emerging economies onto the international economic stage. Please comment.

Not really. In my opinion this goes back to the idea of decoupling from the US economy and how, before the crisis, many observers had their hopes pinned on the Eurozone (and the Euro) as well as Japan (and the JPY) to take over the baton from the US economy in steering forward global demand. In the context of Bretton Woods II this seemed a turkey shoot of an argument. Just de-peg from the US dollar and re-peg to the Euro and it is all engines go. Obviously, this was always going to be a mirage and essentially a smoke screen puffed up by those who have a fundamental desire to see the US economy fail and cave in on itself. So, why this detour in answering the question above?

Well, quite simply, the world "decoupled" for the US and indeed the advanced (G7) economies a long time ago.

From 1980 to 2008 the share of total world GDP made up by G7 economies declined from 51.33% to 42% and the corresponding figure for newly industrialised Asian economies rose from 7.17% to 21% and according to IMF this trend is set to continue. This is the real decoupling and it represents a major structural change in the global economy which goes far beyond the current financial and economic turmoil. Whether there will be anything particularly defining about the role of emerging economies as a result of the financial crisis is too early to say. A sovereing default in Greece or elsewhere in the Eurozone should increasingly make investors aware that global risk is not primarily present in emerging markets but actually right at the heart of the G7 and OECD edifice. Perhaps this will be a definining moment, but the general ascend of big emerging economies to the center of the world stage is not a product of the current turmoil.

Question: To what extent will emerging economies remain the drivers of global economic growth in 2010?

To a very large extent I would argue. In 2010 the IMF estimates (in their October 2009 Outlook) that the world economy will resume growing at an annual rate of 3.1% after having contracted by -1.06% in 2009. Breaking this up on the major advanced economies (G7) and developing and emerging economies the IMF estimates that the former will grow by 1.7% and the latter by 5.1% in 2010. Yet this difference does not tell the whole story. Consider then the fact that measured in US dollars (current prices) the share of world GDP made up by the G7 as well as the emerging and developing economies was 53.8% and 30.7% respectively. Yet still, and out of a total estimated value of 2010 world GDP growth at trn 3.267 USD the G7 is expected to contribute to this with only trn 1135 USD while emerging and developing economies are expected to contribute with trn 1674 USD.

More generally, this is a tendency we should expect to continue. Consequently and while global GDP forecasts into 2014 are quite fickle, forecasts by the IMF has the current price value of total world output (in USD) rising from trn 60.429 USD in 2010 to trn 74.660 USD in 2014. Out of these trn 14.165 USD, the G7 and the emerging and developed world are expected to contribute with trn 4886 USD and trn 7871 USD respectively.

In this way and I hope that my readers will forgive me the excessive arithemetic; if we take the IMF's forecast to heart, emerging markets are definitely going to be the main drivers of global headline GDP growth in 2010 and beyond.

Question: As the evolving international order is going to be Asia centered and polycentric for a variety of reasons. Do you think that India is ready to play a larger role to ensure stability, security and peace in the world?

I sure hope so. A lot of the future stake of the global economy is pinned on India, China, Brazil, etc to develop and evolve both politically and economically. India already plays a very big role in the global economy, but is somewhat dwarfed (in terms of attention at least) by China. However, I believe this will change. Despite some well described and severe issues with a growing gender gap (which is also an issue in China) India is set to enjoy a much more stable and slow demographic transition into old age than China who will age very quickly due to its one child policy.

In this sense I forsee that India will slowly but surely take over from China as the big global emerging economy powerhouse. However, and beyond the obvious political responsibility this entails it also comes with an economic ditto. Thus, one of the biggest problems with China is that she will never be able to run a respectable external deficit that would resolve and alleviate global macroeconomic imbalances. A deliberate mercantilist policy and the effects of the one child policy which strips the economy of the capacity to suck up its own (let alone foreign) savings are two crucial factors here. In my opinion we have one shot to correct these global imbalance and much will hinge upon India (and the rest of the emerging pack) here. Specifically, India must ensure that the demographic transition is kept in check from below as well as, currently, from above. By this I mean that Indian must ensure that it does not fall into a fertility trap with total fertility rates lingering below 1.5 children per woman. Secondly, India should shy away from mercantilist policy. Standard economic theory tells us that external borrowing is not an ill if matched by a sound and long term oriented investment policy as well as capacity in the economy proxied by a large share of young to mature workers out of the total population.

Especially the argument on preventing fertility to fall too far and too rapidly is quite politically incorret at the current juncture with climate and overpopulation (still) dominating the discourse. However, it is crucial in my opinion that we are able to differentiate the debate to look at both sides of this coin. Otherwise, India and the rest of us will regre it.

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[1] - (investments, consumption and the government)

Random Shots

Watching, monitoring, and analysing the economy and her markets is as much about tracking discourses (and how they change) as it is about perusing data material on various leading and lagging indicators. And thus, as I am still knee deep into putting the last touch on my thesis [1] I thought that I might as well move in with some random shots at what just might (or might not) be a subtle change of discourse in the context of the areas of the economy I am interested in.

Rallying Risky Assets no More?

The first interesting piece that got my attention was the coverage by FT Alphaville's Tracy Alloway of this week's musings by JPMorgan and UBS about whether the recent dip in risky assets (and subsequent rally of the buck) is a decisive turning point or merely a blip à la Dubai.

In terms of a change in discourse there is not much in the way of one as e.g. JPMorgan's equity team concludes;

We advise adding to positions on weakness and would revisit this view if jobless claims were to move back towards 500k, if Greek default becomes a reality or if manufacturing leading indicators roll over.

Now, this appears as full out frontal bid on equities to me since if jobless claims were to move into the 500ks it would not, I presume, happen overnight as well as a de-facto Greek default would constitute, an ex-post, post mortem on an equity market in shambles as it would surely wreck havoc even in the initial stages. As for the leading indicators they are of course, by nature leading and thus this may be the figue leave JPMorgan can cling on to if and when they decide to back pedal on this bullish strategy. More generally, UBS is quoted of pointing to three sources for the recent dip in risky assets and thus immediate source of a sudden correction. The first is the growing worry by part of Chinese policy makers of the bubblicious state of the economy and thus the incipient signs of monetary tightening. The second relates to the recent barrage from Obama against the financial sector and especially, I assume, the declared war against proprietary trading which has been the source of fat profits for the likes of Goldman, illuminati, Sach, Morgan Stanley and other of their ilk. Finally, there is of course the growing unease in the market place with the unfolding mess in the Eurozone where Greece is still taking center stage teetering on the brink of a bailout in the form of either and IMF led representation or an internal agreement with the EU.

While I certainly agree that those factors represent sand in the otherwise smoothly running machine of excess liquidity driving the rally in risky assets I tend towards a more straightforward source of a potential correction. Consequently, and for all the stimulus and inventory driven growth we are currently observing I think that final demand at the end consumer as well as the willingness and capabilities of companies to ramp up investment will disappoint thoroughly to the downside. The need to rebuild balance sheets and deleverage across all sectors of the real economy will trump the current positive discourse. It is ironic in this sense that the current flurry on government deficits (especially in the Eurozone) represents exactly the inflection point reached by many OECD governments with respect to the need to decisively rein deficit spending in order to put in a reasonable effort at covering future age related liabilities (as the principal although not only reason). In short; it is really difficult to see from which sector in the real economy we are likely to see a recovery to confound the current expectations in the market.

Yet, as is clear from the latest equity research from the good equity analysts at JPMorgan and UBS the discourse is still fixed on recovery. My bet though is that it will change at some point in 2010 in line with the lack of response from the real economy in taking over from stimulus driven growth, but of course; when it comes to the movements of stocks ... I am not the right one to as. Really, I am not! 

Speaking Truth on Japan

Meanwhile in Japan it was interesting to note the comments by economist at the BOJ Kazuo Momma who managed to pinpoint with surgical precision what exactly Japan's current woes are in terms of macroeconomic dynamics;

(Quote Bloomberg)

Japan’s economy is far from achieving self-sustained growth as the export-led recovery fails to spur spending at home, according to Kazuo Momma, the Bank of Japan’s top economist. “The risk that the Japanese economy will fall off from a cliff is small, but there is still a long way to go,” before the expansion becomes sustainable, Momma said in Tokyo today. “Even if the global economy continues to recover, the spread of that to capital spending and the labor market will be limited.”

The key thing to notice above and beyond the real economic effects in the form of entrenched deflation and low growth is the failure of the momentum from external demand to reach the domestic economy. Perhaps more than anything this is the defining characteristic of the Japanese economy and, I would argue, export dependent economies in general. Consider also that the discourse on Japan to large extent has been solidly anchored in the expectation that  the strong momentum of the export related activities would eventually lead into a positive feedback loop with domestic activity. This has so far closely resembled the well known perennial wait à la Beckett and it is worth I think to ask what exactly underlies this disconnect in the economy. In this sense, I thought it interesting that Mr. Momma and thus the BOJ moved in with such a decisive recognition that something seems thoroughly broken in terms of the ability of the domestic Japanese economy to gain traction. 

Elsewhere on Japan I also took note of the veritable tableau d'horreur in the context of the estimated fiscal outlay in the coming years. Consequently, recent numbers from the ministry of finance suggest that Japan will up the its bond issuance by as much as 16% moving towards 2013. Concretely, the butcher's bill is estimated to total 51.3 trillion yen in the year starting April 2011, 52.2 trillion yen in the fiscal year of 2012 and 55.3 trillion yen in the fiscal year of 2013. Naturally, former minister and now opposition member Yoshimasa Hayashi was quick to slam on the critique simply noting that it was unclear whether the new DPJ led government was worried at all about the fiscal conditions of Japan's economy. Specifically Mr. Hayashi worries about 10 year yields which I reckon is the right time horizon for when this could really turn out sour for Japan; (quote Bloomberg) ... 

The deteriorating fiscal position has raised concern that bond investors may start to demand higher yields for holding Japan’s debt. The yield on the 10-year government bond rose half a basis point to 1.31 percent at 2:28 p.m. in Tokyo. It hasn’t exceeded 2 percent in more than a decade.

Finance Minister Naoto Kan said yesterday that the government’s mid-term fiscal strategy to be released by June will help to maintain investors’ confidence. “We need to keep yields around the current level by maintaining markets’ trust in our fiscal health,” he told parliament. S&P’s downgrade of the outlook for Japan’s debt to “negative” indicates it may cut the local-currency rating for the first time since 2002. National Strategy Minister Yoshito Sengoku called the warning a “wake-up call.”

Before we start comparing Japan with Greece et al though there is little doubt that demand will be there for the securities since we can be pretty sure that the BOJ will be provide the bid through quantitative easing. However, in a longer term perspective and with largest debt to GDP ratio as well as the oldest population in the world one does not have to be a macroeconomic literate to see how this cannot go on forever. However, as long as Japan remains a net external lender the problem is one of accounting really and with its own independent central bank the show can go on for quite a while. Moreover, the likely side effect on the JPY makes it an almost attractive route to follow by Japan in the sense that a long waited depreciation of the JPY (if it comes) will not only strengthen the export sector but also provide some welcome inflation to the economy.

Wither the Euro (as a "reserve" currency)?

Perhaps the most interesting headline coming in on the wires in the beginning of the week was this Bloomberg piece running under the header that the Euro is losing its allure as a reserve asset.

Investors are pulling cash out of Europe at a record pace as central banks slow euro purchases, jeopardizing its status as a substitute to the dollar as the world’s reserve currency.

Last year, policy makers loaded up on euros, while analysts at Barclays Plc in London and Aletti Gestielle SGR SpA in Milan predicted central bankers would make good on threats to reduce the greenback’s dominance. Now the euro is down 8.4 percent since Nov. 25 in its fastest slide in 10 months amid concern that cash-strapped countries like Greece won’t pay their debts. Billionaire investor George Soros said Jan. 28 that there’s “no attractive alternative” to the dollar.

Well well, what a difference a couple of jitters in Southern Europe makes. Now, before we get ahead of ourselves in terms of the long term significance of the Euro's recent slip I think this abrupt change in discourse on the Euro is a good testament to the difficulty many have in understanding exactly what these so-called global imbalances are. This may sound arrogant as I imply here that I do actually understand, but I find it extremely difficult to see how people who hitherto believed in the Euro as a the new dominant global currency can suddenly shift position on the back of trouble in Greece, Spain et al. I mean, surely and if you had cared to look and listen the structural difficulties of the Eurozone and the obvious inability of the EUR/USD to move about in the 1.50s/1.60s and thus act as the main vessel of rebalancing were there for anyone to see. Well not quite and while the coup de grace from George Soros is significant in itself I think it worthwhile to think back to the heaty days when Bernanke lowered rates as an initial response to the subprime fallout (and the ECB momentarily raised) and thus where the Eurozone was hailed as the new engine of the global economy to take over from an ailing US economy. Some of us tried to dimiss this nonsense but it appears that it takes near default along the periphery, before it really hit the main wires. So let me be quite clear here. The Euro is not an alternative to the Dollar in so far as goes rebalancing of the global economy which would entail the Eurozone being a relatively large and sustained net external borrower. In fact, given the troubles in Spain and Greece the real challenge is how the Eurozone can become a net surplus region and thus reduce the borrowing of key member countries.

Bubble Trouble in China

This one is hardly news and neither has there been much of a change in discourse as it has been some weeks now that Chinese authorities little by little have started to voice concerns over the growing tendencies of overheating in the Chinese economy and property sector in particular.

China’s “real worry” is asset bubbles as capital flows into an economy awash with money and the nation emerges from the crisis into a “boom time,” central bank adviser Fan Gang said. Moves by the central bank this year to curb liquidity were “timely and necessary,” Fan told a forum in Beijing today. “Although globally we’re still talking about the crisis, China and some developing countries now are facing another boom time.”

Stocks fell in Asia and Europe today on speculation that Chinese policy makers will do more to cool the world’s fastest- growing major economy after two reports showed a sustained rebound in manufacturing and rising prices. Excess liquidity is a “problem” as low interest rates and slower growth in the U.S. and Europe encourage money to flow into China, said Fan, the academic member of the monetary policy committee.

One economist and long time China observer, Andy Xie, that I tend to lean on is much more out spoken on the current risks in China as well as a recent report by BNP Paribas sees  decisive turning point already in 2010 as tighter liquidity conditions begin to bite;

China’s property market “bubble” is set to burst as the government curbs credit growth and clamps down on speculation, according to independent economist Andy Xie As bank lending slows, “it’s very difficult to see this demand continuing,” Xie, formerly Morgan Stanley’s chief Asian economist, told Bloomberg Television in Hong Kong today. Tougher property policies may lower 2010 sales volumes 10 percent, compared with an earlier forecast for growth of as much as 5 percent, BNP Paribas said in a report today.

I agree in the main. The key however is timing and just how far China may run here. It may be longer than many imagine, but I agree with the fundamentals of the argument. Xie apparently thinks that 2010 will see a significant correction. I have no reason to disagree, but a bubble in China (in general) may run a long time before she runs out of steam. Having said this though, recent bits and pieces of information that I have been fed from the ground in China by my "contacts" strongly suggest that a breaking point is near. One key ingredient here according to a property insider in China is that almost all of the stimulus money currently being poured into the Chinese economy (which is a lot) is going into property and needless to say, this cannot run forever.

More generally, a full blow out of the Chinese property sector in e.g. some of the most bubbilicious parts of the real estate sector would constitute a severe dent in the expectations of a global recovery driven from Asia. Perhaps this more than anything suggests why it is important to keep a weary eye on port side property in Shanghai and elsewhere even if you are not in the market for a condo.

A Change in Discourse?

Whether there has really been a change in discourse in some parts of the market as per reference to the points mentioned above or whether I am just preying on a well worn narrative to take some random shots I will leave it for the reader to decide. In general, the ball is still rolling on the recovery discourse but with events in the Eurozone and a Chinese economy looking set to fall short of the promises to pull forward the global economy things might change sooner rather than later. To this I would add the fundamental and lingering trend of deleveraging in all real sectors of the economy which ultimately means that self sustained growth will disappoint thoroughly to the downside and this I hold to be quite certain and not just a random shot.

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[1] - Which I will present here in due course.

No News from Japan

Sometimes no news is more telling than one might initially think and although it was hardly earth shattering for the market that the BOJ chose yesterday to keep its main benchmark rate sitting at 0.1% it does highlight the extraordinary difficulties Japan currently face in terms of sparking its economy back into some kind of forward momentum.

(quote Bloomberg)

The Bank of Japan held interest rates near zero and said it remains committed to fighting deflation as gains in the yen risk stunting the recovery from the country’s worst postwar recession. “I hope that price declines will be overcome as soon as possible,” Governor Masaaki Shirakawa told reporters in Tokyo after his board kept the overnight lending rate at 0.1 percent. “It will take time before we can see prices rising to favorable levels,” he said, adding that the central bank will maintain an “extremely accommodative financial environment.”

Japan’s credit rating outlook was lowered by Standard and Poor’s today, highlighting concern that the world’s biggest public debt will lead to higher borrowing costs in a country already facing falling prices and a strengthening yen. Finance Minister Naoto Kan said today that the BOJ can do more to battle deflation, and people with knowledge of the matter have said it may consider expanding an emergency loan program or increasing purchases of government bonds. “It’s highly probable the central bank will come under pressure to ease policy further as the economy loses steam,” said Teizo Taya, a former central bank board member and now adviser to the Daiwa Institute of Research in Tokyo. “The bank will likely consider expanding the lending facility, while it will try to avoid increasing bond buying as much as possible.”

The statement by the governor Shirakawa really tells it all and one can only second his hope that price declines will soon hit the shores of Japan. Yet, this seems more and more unlikely which is also why the BOJ seems to be moving straight back into full out QE mode at the same time as its peers are set to try, albeit with great difficulty, to restore some kind of normal monetary conditions over the course of 2010. 

The BOJ consequently seems to be silently conceding that it will have to cooperate tightly with the MOF in trying to bring some kind of momentum back to Japanese soil. In this concrete case it will mean keeping open the taps to create a bid for the steady flow of Japanese government bonds.

(click on graphs for better viewing)

The core-of-core index has now fallen since January 2008 with the total accumulated decline in the core nominal price level of 6.8%. Now, I don't need, I think, to spell out what this implies for debt and growth dynamics in Japan which just seem to perennially stuck at the moment.

The problem for Japan is really that it is fighting a losing battle on two fronts. Firstly, and quite as most observers would expect Japan is having great difficulty in terms of building up domestic demand (see graph here). Secondly however and much worse; conventional wisdom would have that as the risky assets began to fly back in March 2009 and as the global economy showed the first tepid signs of emerging from the death bed so should the JPY weaken and Japan ride, through the carry trade effect, the global upturn on exports. Yet, this has not been the story so far and while Japan indeed is exporting a lot to service the runaway train China, the new found reluctance of the JPY to react to global risk sentiment is preoccupying.

Measured against the Euro and using the period 2004 to 2009 (more or less) as the base average value the JPY is now 10% and 17% stronger against the Euro and the Buck respectively.

Finally, to add injury to insult S&P moved in Monday with a nudge as it threathened to downgrade Japan's sovereign debt rating less it gets its fiscal book on the mend. As a mitigating factor S&P mentions Japan's strong net external position which acts as an important dam towards the rising flood of public sector debt. Yet, unless Japan succedes in pushing the JPY down on a sustainble basis against its main competitors this dam will break sooner rather than later. Needless to say that if the BOJ decides to abide completely from the implied domestic pressure to continue funding deficit spending, S&Ps hands will be effectively forced. One thing is for sure as Societe Generale's chief Japan economist Takuji Okubo is quoted by Bloomberg;

"The market should be braced for the BOJ keeping its current rate unchanged for a very, very long time".

Indeed, and thus as the big talking point in the rest of the world remain fixed on exit strategies and the need (and peril) of fiscal consolidation Japan continues to be stuck in the mire. My own personal feeling is that it might very well be the BOJ leading the pack of global central banks rather than the other way around, but for now the fact that there is no news from Japan is exactly what makes it news.