Is the end in sight or is the end nigh?
The consensus among investors and analysts these days is increasingly polarised between those who say we’re just about to turn the economic corner, and those who argue that the bottom is about to drop out of the world.
The first view is clearly wrong – and we’ve been hearing it ever since the crisis started in mid-2007. Yet the second argument isn’t any more realistic. Yes, things are pretty tough. Yes, they’re going to get worse. Yes, this is probably going to be the worst recession since the Great Depression – at least in the UK and US. But the key word is ‘since’. For all the problems we face, this is not a rerun of the Great Depression. There is a world of differences between then and now …
Not good, but better than it could be
The first is that the world is in very different shape to the world of the 1920s and 1930s. We often think of the Great Depression in isolation, but we need to remember that it followed shortly after the devastation of the First World War. That had a huge impact on the health of the global economy and on the ability and willingness of many countries to respond to the challenges of the Depression. It was like a patient, already severely sick, catching another life-threatening disease at the same time.
Secondly, if you look back before the Great Depression, rapid swings in output and severe prolonged recessions were more common than they have been in recent decades. Take a look at the chart below from Merrill Lynch.
It seems that recessions used to be significantly more frequent in America: there were 20 in 83 years up to 1940, compared with 12 in 68 years since then (including the latest one which isn’t shown).
What’s more, it looks as if recessions in the pre-depression era were typically longer (although there are all sorts of problems with comparing data across long periods of time like this, and it may well be that estimates for start and end dates are much less accurate for older recessions).
In other words, there’s a suggestion that the economy has changed substantially since then, making the boom/bust cycle less severe. There are plenty of possible reasons for this – but two very relevant ones are the absence of a gold standard (which lends itself to deflation) and greater willingness on the part of central banks and governments to intervene to boost the economy.
This second point is a very clear difference between 1929 and 2008. While many policymakers stood back at the start of the Great Depression (the most notable exception is Japan, which subsequently suffered less than any other developed economy), there seems little risk of that happening this time.
The Obama administration is already proposing a $775bn stimulus package for the US economy, but I suspect this could easily total three times as much over the course of the slump. That may be conservative: a recent study found that a government’s debts expand by an average of 86% after a financial system crisis such as this, partly due to lost tax revenues and partly due to huge public spending increases.
Bernanke has his finger on the button
Meanwhile, central bankers are both slashing rates and directly increasing the money supply. Of course, increasing the money supply alone isn’t the whole story: a central bank directly controls only M0 (currency in circulation plus bank reserves held at the central bank). Broader measures of money supply, such as M3, depend on how much of the base money is spent, saved, borrowed and lent.
In a deflationary recession, as people hoard more and spend and borrow less, broader money supply can contract even if the central bank increases the monetary base. And indeed, that’s what’s currently happening in the US, as you can see on the chart below.
My initial conclusion was that this means Fed is almost powerless in this kind of situation – that any prudent increase in M0 will do nothing to offset the contraction in the broader money supply. But I’m no longer sure: the more we see of Ben Bernanke’s actions – bearing in mind that he’s a specialist in the Great Depression who has explicitly blamed much of it on monetary policy mistakes – the more I suspect that he will expand M0 by as much as is needed to plug the gap, prudence be damned.
Whether a huge increase in public spending or a vast increase in money supply is the best course of action is a big question. But since I have no influence over these things, I’m more concerned about what will happen than what should happen.
I’m far from confident policymakers will act for the best. I’m sure there will be many unintended consequences. And we’re clearly in a nasty recession and probably headed for a spell of deflation. But increasingly I think the long-term risks lie on the side of inflation rather than deflationary depression.
China is not America
Once you begin comparing today with the Great Depression, the next step is often to compare China today with America then. And again, there are similarities. In both cases, you have a rising, increasingly-powerful country, exporting to the economies that used to dominate the world economy, who are running up ever larger debts with it. Today, we talk of China hoovering up US treasury and agency bonds; back then, the US was sucking in its trade partners’ gold reserves.
But there are also substantial differences. The US was a highly-developed country, already the world’s largest economy – and very much a consumer economy. Consumption accounted for over 70% of GDP – higher than it is today, as you can see in the chart below.
Back in the 1920s, consumer credit arrived for the average American for the first time, sparking an orgy of overspending that left consumers tapped out and overindebted by 1929 (just like today). Firms who had built their capacity to serve these consumers and others in Europe suddenly faced a severe problem of overproduction as consumers retrenched.
China certainly faces the second problem – it has overinvested to feed Western demand. But it doesn’t have the exhausted consumer that the US had then and has today. In short, in 1929 America was the epicentre of both shocks. Today, China is only dealing with one side of it.
Clearly that’s not a great situation either. But differences such as these mean that simply suggesting that “America in 1929 = China now” doesn’t necessarily lead us to useful conclusions – especially as China has plenty it can do to support its economy. Obviously, investment in manufacturing is going to fall away quite substantially. But – perhaps in contrast to the US in the thirties – there are very obvious ways for it to be replaced with other investment.
China is at a far lower level of development, relative to the rest of the world, than the US was then. There’s enormous scope for investing in transport infrastructure, mass-market housing, cleaning up the environment, building up the health, education and social security system – the list goes on. Measures that improve the welfare safety net and increase people’s sense of security should also bring down the savings rate and boost consumption. This will be a long-term shift and can’t be brought about in mere months, but it points the way to future growth for China once this crisis in over.
Time to grow lending
China is also in the enviable position of being one of the few countries that doesn’t need to deleverage. While debt ratios rose ever higher in the West in recent years, in China, the opposite happened. Take a look at the chart below from Tao Wang of UBS.
Wang argues that while much of the world has to curb borrowing, China can try to step up lending. And this seems to be part of the government’s plans: apart from cutting rates, it also announced in early December a package of measures aimed at the financial sector. These included ensuring that liquidity remains adequate, providing loan guarantees for small and medium-sized businesses, increasing consumer and farmer loans and allowing more companies to issue bonds.
The fact that the Chinese government still exerts more control over its domestic economy than most others, should also help here. In the UK, banks have treated Gordon Brown’s instructions to lend more with contempt; it’s harder to see that happening in China. Similarly, state-owned enterprises can be pressured to keep investing and keep people employed.
November’s data suggest that lending already seems to be picking up, as you can see in the chart below of year-on-year growth in Chinese bank lending. This graph is probably going to be a pretty important one for monitoring China’s economy over the next year.
Increased lending in a downturn isn’t necessarily great for bank balance sheets and thus for shareholders in the banks. I’m already sceptical about the levels of non-performing loans in Chinese bank loan books and this doesn’t make me any more enthusiastic about buying into them. But it will help to reduce problems in the broader economy.
I still think China will grow significantly more slowly than most economists are officially forecasting, especially in the first half of the year. But once you combine the huge coming US stimulus package with what China can do for itself and the differences between 1930s and now, suggestions that we’re heading for Great Depression II with China bearing the brunt of it seem excessive.
Tough times for India
Oddly, while there are rightly a lot of questions about the risks to China, none of the forecasts that I see for India seem to take account of the serious downside risks for that economy. I’m certainly not expecting a depression there either – but I fear the slump is going to be worse than most people expect.
There’s an assumption that since India’s exports are a smaller percentage of GDP (around 20-25% versus 35-40% for China), it should be less affected by conditions in the rest of the world than most of Asia. But it’s not just exports that matter in GDP, but the value-added part of exports – ie the extra value added to imports in the country before re-export. To show how important this is, note that Hong Kong, Malaysia and Singapore have a simple exports to GDP ratio of more than 100%.
As you can see in the chart below from Jonathan Anderson of UBS, when we look at value-added (the green bars), the situation changes and the difference between China and India is much smaller.
Other studies suggest that China’s export value added may be higher, up to 18%. But even using this, you can see that the difference between China and India’s export exposure is less than investors often assume. This chart dates from 2007, but the situation is unlikely to have changed much since then – indeed, given the evolution of China’s manufacturing industry towards sectors such as electronics which have a relatively low domestic value-added, the total is more likely to have dropped than risen.
Even more importantly, focusing on exports also ignores the extent to which the Indian economy has been buoyed by easy money. Credit-fuelled investment has been a key driver of India’s growth, just as in China – and getting loans is likely to be much harder there over the next year or so, especially given the amount of cash that companies have been raising from international markets (around 40% of funding last year).
The Satyam scandal will be bad for confidence
And we saw a worrying hint of what else could happen this week. As you may already have heard, the founder and chairman of Satyam, the country’s fourth-largest software firm, resigned after admitting doctoring the company’s accounts on an enormous scale for years.
The scale of the deception is pretty staggering: the firm’s claimed operating margin of 24% has turned out to be just 3% and the supposed $1.1bn of cash on its balance sheet is just $78m. Satyam’s shares have plummeted by 87% and given that the outsourcing sector is one where trust is extremely important, the firm’s future is in doubt.
This is shocking because Indian firms are supposed to have relatively sound corporate governance by emerging market standards. Had this happened in a Chinese firm or an Indonesian one, the shock would have been much less – but in India it’s a very big deal.
Looking at the extent of the boom in India and the way it’s been fuelled by easy credit, I’d be surprised if this is the last corporate scandal or disaster. Without having any specific firms in mind at present, I can easily foresee all sorts of problems emerging in real estate, in finance and in big industrial groups as finance dries up.
I’m not suggesting that Indian firms are going to be worse in this respect than Chinese ones – I’d expect them to be better. But the shock in India will be a bigger blow to confidence, just because it will be more unexpected.
Turning to the markets …
| Market | Close | 5-day change |
|---|---|---|
| China (CSI 300) | 1,918 | +5.5% |
| Hong Kong (Hang Seng) | 14,377 | -4.4% |
| India (Sensex) | 9,407 | +5.0% |
| Indonesia (JCI) | 1,417 | +4.5% |
| Japan (Topix) | 855 | -0.5% |
| Malaysia (KLCI) | 919 | +2.8% |
| Philippines (PSEi) | 1,985 | +6.0% |
| Singapore (Straits Times) | 1,806 | -1.3% |
| South Korea (KOSPI) | 1,181 | +2.0% |
| Taiwan (Taiex) | 4,503 | -1.9% |
| Thailand (SET) | 459 | +2.0% |
| Vietnam (VN Index) | 313 | 0.0% |
| MSCI Asia | 82 | -1.7% |
| MSCI Asia ex-Japan | 286 | -5.7% |
Asian equities were mixed last week. The biggest loss was in the Indian indices, dragged down by the Satyam scandal. That story overshadowed most other corporate news, but in Indonesia, Bumi Resources slumped more than 30% after announcing plans to buy three smaller coal miners for what many analysts see as inflated prices.
In the credit markets there were small signs of improvement. The iTraxx Asia credit default swaps (CDS) indices continued to tick down for both investment grade and riskier debt (credit default swaps are contracts that bet on the risk of a company defaulting on its debt and a higher CDS index implies that markets are pricing in a higher risk of default.) Interbank lending rates are also falling after the usual end-of-year liquidity squeeze that results from accounting rules and the part-closure of many markets over the holiday season.
However, economic data continued to be very weak. Taiwan’s exports fell by a record 41.9% year-on-year in December. In China, power generation fell by 9.1% y/y in the same month. Korea’s central bank cut rates to a new low of 2.5% after a run of very weak indicators, including a 14.8% y/y fall in manufacturing output in November.
In Thailand, by-elections for the seats of 29 MPs barred from politics by the consitutional court seem to have strengthened the new government of Abhisit Vejjajiva. His Democrat-led coalition provisionally won 20 seats to the opposition’s nine, extending its majority to 48 seats.