Tuesday, 28 April 2015

China – Playing Catch Up

Many expect the Chinese economy to misbehave but it is more likely that China will grow out itself out of trouble

China is growing up in front of our eyes and there is an expectation that, like any adolescent, it will get into trouble before fulfilling its promise.  Naysayers predict that China’s growth spurt has left it with a number of issues that must be worked through before it can get any bigger.  Yet, China has a good head on its shoulders in the form of the Communist Party which will do all it can to keep the economy buoyant.  While the years of stellar growth are likely over, it need not mean that the Chinese economy will be held back.

Big trouble in (not so) little China?

The spectacular rate of growth achieved by China over the past decade could never continue forever.  Quite the opposite, the rapid expansion would have been harmful if it had been maintained and a slower pace of growth is actually a preferable outcome.  This is because much of the economic growth had been fuelled by investment – construction of new factories to sell cheap goods overseas along with the expansion of megacities in China to accommodate an influx of workers from the countryside. Normally, investment accounts for around 10% to 15% of GDP in most developed countries but reached 50% of GDP in China. 

This building frenzy could not continue especially when it is becoming more difficult to make money and some investments would be wasted on pointless projects.  It is the examples of this, empty apartment blocks and overly lavish public spending, that pessimists point to as evidence that China has gone too far.  With large amounts of bad debt expected to result from these poor investments, the financial sector is expected to take a big hit and drag the whole economy down with it.  The argument is basically that China has gotten too big for its boots and will need to shrink.

Growing up is never easy

Your Neighbourhood Economist would instead argue that China has a similar problem to what he had when he was growing up.  His mother would buy Your Neighbourhood Economist clothes that were too big for him in the knowledge that he would grow into them.  It is ungainly to be sporting oversized gear and this seems to be similar to the phase China is going through.  This is partly because China had been expanding so quickly that any investment needs to be put up in a hurry.  There is also the added complication of spending getting out of hand as regional politicians try to impress their bosses in the Communist Party.

Yet, China, like a much younger version of Your Neighbourhood Economist, still has a lot of growing to do.  Some of the ill-fitting parts of the Chinese economy may be put to better use as its citizen will continue to migrate toward the cities in search of work.  China has also learnt lessons from its investment binge with the central government shifting emphasis from economic growth to other benefits of greater wealth such as a cleaner environment and a more efficient bureaucracy.  Local officials are being brought into line through a crackdown on corruption and concentration of power within the Communist Party.

Along with changes to policy, the Chinese government also has the resources to deal with any past mistakes.  With both domestic savings and government reserves at high levels, there is plenty of money around if needed.  And, with an eye firmly fixed on keeping the economy growing, the Communist Party would not be as timid compared to Western governments in terms of stepping in and shoring up the banking sector if needed.  China is also moving away from investment as the driver of its economic growth and consumption is expected to pick up the slack (albeit with growth at a slower pace).

Growing while you watch

Your Neighbourhood Economist has seen the change in China with his own eyes.  In a visit 15 years ago, the Pudong area across the river in Shanghai seemed like a ghost town but one that had been freshly built with a scattering of skyscrapers.  Now, Pudong is anything but quiet and the pace at which new buildings continue to go up is testament to China’s growth.  It also shows that it you build it (in China at least), they will (still) come.

Thursday, 16 April 2015

Monetary Policy – where has the magic gone?

The European Central Bank tries to cast another spell to save the Eurozone but its magic has been stolen

Monetary policy is like magic – you have to use tricks to get people into believing what you want them to believe.  Both magicians and central banks apply various devices to convince their audience that they can pull off amazing feats.  A bit of showmanship can be crucial in creating an aura of the fantastical when your powers are actually rather limited.  Central banks have pulled this off in the past but quantitative easing by the European Central Bank is more likely to show that it does not have any rabbits left to pull out of the hat.

Trying to work magic

Your Neighbourhood Economist likes to look back fondly to an era when central banks had the financial market enthralled with their mastery of all things economic.  This admiration was won the hard way in the 1980s by bringing double-digit inflation back to more manageable levels and ushering in an era where the booms and busts seemed to have past.  But central banks have been taken down a notch by their inability to revive the economy after the global financial crisis. 

Slashing of interest rates has not worked as high levels of debt meant that no one wanted to borrow. Upping the ante, central banks tried pumping money into the financial system through quantitative easing.  The effect on the actual economy due to quantitative easing also looks to be limited at a time when there is already a lot of spare cash in the financial system.  Financial markets were buoyed by quantitative easing but a side effect has been the potential for heightened volatility in the financial markets

With few other options seen as viable, quantitative easing has gone from an unconventional measure to the mainstay policy for central banks despite questions over its usefulness.  The European Central Bank has been slow to try its hand at quantitative easing even though the Eurozone economy was struggling more than most.  This was because Germany (who had initially done well despite its neighbours being in crisis) was firmly against the central bank in Europe printing cash to buy government bonds.  It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself) that the European Central Bank to override this opposition.  

No more magic left

The European Central Bank has been put at a disadvantage considering that the other big central banks have already tried to work their magic through quantitative easing.  Investors are becoming harder to impress having already seen central banks pull off similar tricks.  To maintain the wow factor, quantitative easing has needed to get bigger and bigger.  The central bank in Japan pledged to double the money supply within two years but had to offer up even more cash when its initial plans proved to be lacking. 

The European Central Bank cannot compete on scale as it has to perform magic with one hand behind its back due to the political constraints within the Eurozone.  Any extra boost using the element of surprise was also dented by the protracted process as the European Central Bank and Germany squabbled publicly over quantitative easing in the months before the policy was launched. 

The fractious politics in Europe has sapped power from the central bank who had previously been the main shining light in saving the Eurozone.  Political squabbles have highlighted the limited power at the disposal of the European Central Bank.  It is like a magician who is being sabotaged by their own assistant – it will take more than magic to escape this spell.