The end of the end of the world

For manufacturing firms in developed countries such as the United States and the United Kingdom, the rise of China as a manufacturing base was seen as the end of the world.  With a seemingly endless supply of low-wage and diligent Chinese workers, manufactures elsewhere have been forced out of business and those that survived retreated to more high-tech products which were still beyond the reach of Chinese firms.  But the end is no longer nigh.  The bountiful supply of cheap labour has dried up and wages in China are rising along with demands for better working conditions.  Not only does this suggest the end of Armageddon for manufactures in developed countries but may also open up new business opportunities.

The industrialization of any economy whether it be Britain during the industrial revolution in the eighteenth century or modern day China involves the mass migration of workers from the agricultural sector into manufacturing.  The increase in productivity (the ability for workers to produce more in the same amount of time) generates a surge in wealth which typically first goes mostly to the owners of factories employing the cheap labour.  But there comes a point in time when the supply of workers from the countryside starts to fall off and firms have to compete more to keep workers which results in wages starting to rise.  This is crucial for the formation of a consumer society as workers gain spare cash to spend.  This is where China is positioned at the moment and it is a trend that is likely to pick up in the future. 

Along with the typical momentum involved with industrialization, demography is another factor that is adding to the upward pressure on wages.  Population growth is slow due to China’s one-child policy which limits the available pool of labour.  With most families only having the one child, parents are investing more in the education of their single progeny and this combined with the bright prospects for the Chinese economy mean that younger workers are aspiring to more than menial factory jobs.  The trade-off is that higher wages are required to attract and maintain employees.  

Rising wages are a boon for China as its new-found wealth begins to be dispersed to its citizens to a greater degree.  And higher pay for Chinese workers also offers some respite for competing firms - both in other low-wage countries and in developed economies.  Wages are now lower in other countries in Asia such as Vietnam and Cambodia.  This will attract factories to move there and help spread the benefits of industrialization. 

But a mass exodus from China is not expected.  China provides not only cheap labour but excellent transport links and suppliers of various components required for manufacturing which have been developed as China has become a key cog in the global supply chain.  Instead, China is expected to increasing replace workers with machines as pay rates increase further.  This will also be accompanied with a shift toward more high-tech products.  But this opens up the chance for big pay-offs for Western firms that can supply the machinery to Chinese factories as well as companies that can tap into the growing consumer market as employees get paid more. 

Doing business in China will still continue to present difficulties.  The Chinese government is doing its best to control the economy during this unprecedented surge in growth (for details, see Why China needs a slowdown) but that is like trying to steer the proverbial bull through a china shop.  The politics generated by a rise of China as a new power can also be problematic such as in the case of Japanese firms struggling with a nationalistic backlash over issues dating from over 60 years ago.  The growing pains involved in the coming of age of a country of 1.3 billion were never going to be easy but changes in the economy in China are offering up a new wealth of opportunities.

Where is all the money going?

Central banks in the world’s largest economies, the European Central Bank and the Federal Reserve in the United States, have recently announced plans for creating an unlimited amount of money.  A third central bank, the Bank of Japan, also has announced its intent to pump even more cash into the Japanese economy.  The funds from the central banks are used to buy bonds with the goal of pushing down interest rates (for details – see The Demand and Supply of Money).  The money received by those selling the bonds has to go somewhere.  But it is not always clear where the money will go.  Image pumping more and more jam into a donut – some of the jam will go where it is supposed to but the jam will at some point spurt out in unintended directions and make a bit of a mess.

The buying of bonds by the central banks will increase the prices of bonds and decrease the interest rates which mean that bonds will be a less attractive investment.  The shift of funds away from the bonds being brought by the central banks to other sectors of the economy is seen as an added benefit along with the lower interest rates.  It will help to reduce the borrowing costs of companies which would make them more likely to invest.  But the anaemic state of the economy suggests that such investment is still muted. 

Money has also moved from the bond market into shares.  This also has an upside due to what is known as the wealth effect – consumers will spend more when they perceive themselves to be wealthier (when their shares are worth more).  But any gains in the stock market due to this can only be temporary as the underlying value of the shares which depends on the profitability of the companies can only improve along with the economy.  This had not stopped the stock markets reacting vigorously to the perceived intentions of the central banks.

Considering the global nature of finance, the money does not only stay within the same country but spans the globe looking for the highest return.  However, the bond buying policies add to the colossal amount of funds that can potentially cause havoc in the economies which are their final destinations.  A flood of money surging into a country will increase the value of its currency while putting downward pressure on the currency in the country where the bond buying is taking place.  This dents the exports of the former while boosting the exports of the latter and the bond buying has been labelled as a protectionist policy at a time when sluggish economies make most countries desperate to boost exports.

A previous victim has been Brazil where the value of its currency, the real, climbed to above R$1.6 against the US dollar in July 2011 after having dropped briefly to below R$2.4 against the US dollar at the end of 2008.  The volume of its exports has suffered as a result and the Brazilian economy has slowed.  A strong currency is also a problem in Japan where the central bank followed the lead of central banks in Europe and the United States with its own bond buying plans with one eye on its currency.  The Japanese yen is still close to its record high of around Y76 against the US dollar which was reached in October 2011. 

In the old economic textbooks, the value of currencies would be dictated by the relative competitiveness of different economies.  More competitive economies would be able to export more and the funds drawn in from overseas as a result would increase the value of the currency.  The opposite would hold true for less competitive economies and the system of global trade would trend toward equilibrium as a higher currency would make more competitive economies less so and vice versa.  However, the flow of money across borders now overwhelms the flow of goods and it is the cash that is sloshing around in the global financial system which dictates movements in the currency markets. 

These funds are often completely separated from the reality of the underlying economy and the same forces that push the overall system to equilibrium are not at work as would be the case when trade in goods dominates.  This combined with the ability for cash to be moved almost instantaneously has profound and often chaotic effects on the global economy and our understanding of the economy still lags behind these new circumstances – a humbling reality for any economist.

The Demand and Supply of Money

Economists love the idea of demand and supply.  It is one of the basic concepts we use to describe almost everything.  Yet, thinking about demand and supply with regard to money may seem strange.  Money is something that everyone wants more of and there is never enough of the stuff.  But with central banks across the globe printing more money but banks and companies being cautious about using the bundles of money they have, there is plenty of it around but no one wants to spend it.

The supply of money has been on the rise due to the policies of quantitative easing which central banks have used to try to revive sluggish economies.  The central banks have been creating money from nothing to buy bonds in an attempt to push down interest rates so as to prompt firms and households to borrow more. 

Typically, an increase in the money supply will result in inflation as more money chasing the same number of goods pushes up prices.  But much of the extra cash is being hoarded by banks and companies who are too scared to put it to use.  On the other hand, consumers are being squeezed with downward pressure on wages for those that manage to hold onto their jobs.  Any extra money for households is typically being used to pay off debt after a borrowing binge in the build up to the global financial crisis. 

Central banks have tried to boost the demand for money by lowering interest rates.  It may sound like a bizarre concept but the interest rate is the price of money as it is the cost involved in obtaining cash that is not yours.  The interest rate is determined by the demand and supply for money in a market environment.  That is, an abundance of savings (excess supply) will push down the interest rate while lots of borrowing (excess demand) will have the opposite effect.  In practice, interest rates are also influenced by central banks that set the interest rate, which acts as a base rate for the interest rates on different types of debt, to keep inflation within a target range – typically inflation of around 2.0%. 

The global financial crisis in 2008 and 2009 can be seen as the result of interest rates deviating from what would have been appropriate.  There were massive inflows of savings from China in the banking system in the United States as the Chinese government built up foreign currency reserves which were in US dollars and invested in US government bonds.  This kept interest rates artificially low and resulted in increasing levels of debt as companies, households, and even the government took advantage of cheap borrowing.  Fingers have also been pointed at the US central bank, the Federal Reserve, for not acting faster to clamp down on the excessive borrowing by increasing the interest rate.  But it proved difficult for even the Federal Reserve to end the debt fuelled party – the results of which have only become obvious with hindsight. 

But now interest rates cannot be low enough.  The central banks have set the interest rate close to zero but this is still too high to prompt companies to borrow considering that it is unclear whether investments will generate profits given the uncertainty that clouds the global economy.  Central banks have tried printing more money through quantitative easing which is another way of pushing down interest rates which firms actually pay when borrowing.  While this new cash has helped somewhat in this regard, much of the money has gone elsewhere – some to stocks which has helped to boost the share market but some of the funds have headed overseas with undesirable effects (but more on this in my next posting).

The nitty gritty of economic is not for everyone, and while it may not be that interesting (Your Neighbourhood Economist cannot work miracles), hopefully the workings of the economy will make a little bit more sense (and please comment or email if you would like to know more).

Why China needs a slowdown

The rise of China will be the most momentous shift in economic power of a generation and it is only a matter of time until China will be the largest economy in the world.  For a long time, the concerns regarding China have been over its relentless rise and how its insatiable appetite for raw materials has pushed up commodity prices.  But the world economy has become dependent on China as an engine of growth as economies in Europe and elsewhere stumble.  So the worry now is not about China expanding too fast but China not expanding fast enough as sluggish global demand begins to hurt China’s economy and the Chinese government is not acting to maintain the previous hectic rate of economic growth.

As a capitalist economy with a communist government, China has the best of both worlds.  Rampant entrepreneurism, which Your Neighbourhood Economist has always associated with Chinese people (positive racial stereotyping?), has resulted in wealth creation on a massive scale and dragged millions out of poverty.  Yet, the communist government maintains a level of control over the economy to help the country through a period of unprecedented growth.  As such, the government stepped in when the global financial crisis hit in 2008 with a colossal economic stimulus worth 16% of GDP over two years.  It may seem a strange notion for a communist government to be propping up a capitalist economy but it is the best way for the communists to provide higher income for its citizens and maintain their grip on power.  And a strong central government helps to keep much of the messy politics out of the way (for an example of politics getting in the way - One step forward and two steps backwards)

Yet, as the global economy weakens, China itself is in the midst of a significant economic slowdown but the government has held back from throwing its full weight behind another economic rescue mission.  The Chinese government has the capacity for further action as it does not have the debt of governments in other large economies.  Punters in the media have suggested that it is the change of the top government posts that has resulted in the leaders in China being distracted.  Others have pointed to the possibility that more of a stimulus would not have any further effect.  But Your Neighbourhood Economist would argue that the Chinese government is smarter than that and still has the capacity to generate growth in the economy.

It is not that the Chinese economy wouldn't get a boost from more stimulus but that such measures would create more problems than it would solve.  The economy in China is like a weightlifter on steroids – more steroids would typically help to lift heavier weights but too much can cause severe damage.  Investment is the steroids that have been driving the Chinese economy.  Investment is typically what fuels any economic expansion.  Companies build factories and shops if there are products to make and sell but this will only happen if consumers have enough money to buy the goods.  So investment surges when an economy is booming but companies will stop investing if times turn bad.

Companies in China not only provide goods and services for the 1 billion people that live in China but also export products for retailers across the globe.  As such, investment in China has reached unprecedented levels - around 50% of GDP compared to around 15% in the United States.   Much of the stimulus package in 2008 went toward spending on infrastructure and was combined with lower interest rates and increased lending by state-owned banks.  A bit more of the same has been tried in 2012 but without the same fervour. 

The leaders in China could try more of the same but a further boost to investment may result in one shot of steroids too many.  That is not to say that it would not have an effect but rather than the effect would be to exacerbate imbalances in the Chinese economy.  Investment that outpaces growth in the economy risks not only being a waste of money but distorting the development of the economy.  Excessive spending to build factories which end up producing goods that no one wants will result in bad debts.  Spending on infrastructure is another possible form of investing but this also needs to expand along with a growing economy so as to go to areas where it is actually required rather than roads to nowhere.

Considering that global banking system got in trouble following a period of debt fuelled expansion, Your Neighbourhood Economist hopes that lessons have been learnt and that the Chinese economy is not pushed to expand too rapidly.  But only time will tell – stay posted.

One step forward and two steps backwards?

Economics can often provide solutions to problems while the study of politics can be about why the solutions are not always easy to implement.  This could be seen as a bias interpretation but the changes in the fate of Spain over the past month could possibility be an example.

The interest rates on Spanish government debt tumbled at the beginning of September following the announcement of plans by the European Central Bank (ECB) to buy an unlimited amount of bonds of indebted countries in Europe (refer to “Whatever it takes”).  This should have been the beginning of the end of the debt crisis in Europe.  But the mood turned sour as Spain once again hit the front pages of the papers as politicians in Madrid and in the region of Catalonia positioned themselves amidst the changing political landscape.  As a result, the Spanish government is having to fight to stay in the Eurozone as well as trying to hold the country together. 

The ECB made a bold stand in its willingness to stand behind countries like Spain who suffer from excessively high interest rates as a result of concerns over a possible breakup of the Eurozone.  If the ECB makes good on its pledge to do “whatever it takes” to save the euro, investors have less to worry about and renewed buying of Spanish bonds should help bring down the interest rates on the government debt.  But in practice, the best laid plans do not always work out.

The backing of the ECB required countries to submit to supervision from the EU and the IMF which makes the help offered by the ECB less attractive.  Losing control of their own affairs is a fate that those in power do not welcome and the Spanish government is holding off on asking for help from the ECB.  But the daunting nature of the economic problems in Spain suggests that help from outside is inevitable.  Real GDP in Spain is expected to shrink by 1.5% in 2012 and 0.7% in 2013 according to the IMF while the government debt continues to increase.  The Spanish government is expecting to borrow 207.2 billion euros in 2013 which is more than its plans for 186 billion euros in new debt in 2012.  An examination of Spanish banks this week suggests that a further 60 billion euros are needed to stabilize the banking sector and some of these funds may have to come from the government.

However, help from the ECB may be on the way as the Spanish government is making moves in the right direction and is in the process of implementing many of the policies that would be required of it if the country needed assistance from the ECB.  This may be crucial as the Spanish prime minister Mariano Rajoy has remained firm in his stance that he will not accept conditions being imposed from outside.  Yet, if the prescribed policies had already been put in place, the outside help need not require any further harsh measures.  But the policies of austerity have resulted in protests in Spain so the government is treading a fine line and the possibility of turmoil is never far away but at least efforts towards a solution are in the process of being made. 

The political difficulties of cutting government spending and raising taxes would be more than enough to deal with.  But the tough measures taken by the government have triggered another crisis – the perennial issue of secession in Spain.  Catalonia which is centred on Barcelona is both the wealthiest region in Spain as well as the region which has the most debt.  Its prosperity means that Catalonia provides more tax revenue to the central government in Madrid than it receives in government spending.  But, at the same time, the regional government in Catalonia has had to ask Madrid for just over 5 billion euros as investors will no longer lend the region any money.  This contraction has been jumped on by politicians in Catalonia who want to push for independence for the region and a snap election for the regional government in Catalonia has been called for November which is being seen as a proxy referendum on the possibility of secession.   A crisis is always a good opportunity for politicians to push for change even if it adds to the mayhem.

But such is politics.  Politicians must keep voters happy to stay in their jobs while others will take their opportunity to grab for power.  But this is not always conducive to action.  It is no coincidence that the ECB has been able to make bold policy shifts while governments in the various countries in Europe (including Germany) have been squabbling on the sidelines.  The messy politics in democracies can get in the way of doing what is required.  If only economists ruled the world!

“Whatever it takes”

This is the bold pledge made by the governor of the European Central Bank (ECB), Mario Draghi, in reference to what the Europe’s central bank is willing to do to help stop countries leaving the euro.  This statement of intent was made at the end of July but investors had to wait until the beginning of September for the details of how far the ECB was willing to go.  And the ECB has brought out the big guns to prove its resolution but it remains to be seen whether the full might of the ECB will be enough.

The central part of the new policy was that the ECB would purchase an unlimited amount of bonds of indebted countries suffering from high interest rates.  The fact that the ECB has set no limit on funds available for bond purchases is meant to stop investors selling bonds of European governments in the expectation that the interest rates will rise (interest rates get higher if bonds are sold off and their price falls).  If the ECB is always ready to buy bonds, the price of bonds is less likely to fall and this will create an environment where other investors will be motivated to also buy. 

And in theory, it is a good time to buy.  The worries that a breakup of the Eurozone will prompt governments to default on their debt have prompted investors to sell off the bonds of countries such as Spain who are expected to have difficulties in paying their bills.  If the fears of default can be soothed, the prices of bonds will seem cheap.  So, the ECB is betting on its ability to calm the nerves in the market and could actually make a profit on its buying of bonds.

This new stance is not without its problems.  The help for troubled countries from the ECB is not unconditional and governments must agree to reforms to the economy which would be supervised by the EU and the IMF for the ECB to buy their bonds.  Spain is seen as a prime candidate for this support but the harsh reality of having to submit to orders from others has made the government reluctant to seek assistance. 

 

The ECB could be caught in a dilemma if a country does not toe the line after having their bonds propped up by the ECB despite having signed on for reforms.  If the ECB stops its bond purchases for such a country, default would be highly likely and this is exactly the result that the policy is intended to stop.  There are concerns with the ECB along with the EU and the IMF having control over governments which have been democratically elected by their citizens.  While an undesirable outcome of the sovereign debt crisis, the greater power of these unelected bodies is the result of governments being unable to sort out the problems themselves. 

But perhaps the biggest concern is the slim possibility that that the unlimited firepower of the ECB will not have enough punch.  Pessimists may bet against the ECB to test its resolve.  There are numerous parties which are unhappy with the new position taken by the ECB.  In particular, policies makers in Germany have made public their displeasure and this will grow with the amount of funds which the ECB uses to buy up bonds increases.  Investors will also second-guess the efforts of countries receiving support as to whether they will stick to what is expected of them by the ECB.  The policy of the ECB has been compared to a bazooka – if you have a big enough gun, no one will mess with you.  But there is the smallest chance that even a bazooka may not be big enough faced with an army of doubters.  

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.

 

This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.