Asia’s Policy Trap
May 29, 2007
By Stephen Roach | New York
Asia is brimming over with foreign exchange reserves. While that cushions the region from a replay of a 1997-98 style crisis, it presents new challenges for Asian policy makers. Particularly worrisome are the excesses of a pan-regional liquidity cycle – complete with the risks of asset bubbles as exemplified by the current blow-out in domestic Chinese equities. Authorities both in Developing Asia and elsewhere in the world need to come up with a new policy framework – before it’s too late.
There is a striking twist to the current globalization. Unlike the globalization of the early 20th century when capital flowed from the rich countries of the developed world to the “settlement economies” such as Argentina, Australia, and Canada, the opposite is true today. In the current globalization, the incremental saving for the advanced economies of the developed world has been provided almost entirely by the transfer of capital from the poor countries of the developing world (including oil producers). The United States, with its massive current account deficit, is the major beneficiary of this “reverse Marshall Plan” – absorbing more than 70% of the world’s surplus saving over the past three years. With that transfer has come a huge build-up in foreign exchange reserves of the donor nations – especially those in Developing Asia. According to the latest estimates of the IMF, foreign exchange reserves in the developing economies of Asia are likely to exceed $1.8 trillion in 2007 – literally a six-fold increase from levels prevailing in 1999. Deeply scarred by the wrenching financial crisis of 1997-98 that was triggered by a paucity of such reserves, the emerging economies of Asia are collectively saying, “Never again.” But now they have subsequently erred on the side of excess reserve accumulation – quite possibly having gone too far in atoning for their mistakes of the past. The recycling of this capital – especially from Asia to the United States – has serious complications for the emerging economies of Asia. Lacking in well-developed capital markets, it has been exceedingly difficult for countries like China to sterilize the massive purchases of Treasuries and other dollar-denominated assets that are required to maintain pegged or “crawling pegged” parities with the US dollar. As a result, excess liquidity has seeped into Developing Asia’s domestic financial systems, pushing broad money growth in this region up to a 17% annual rate in 2006 – nearly three times the pace of money creation in the developed world. A similar overshoot has been evident in the expansion of bank credit. Here, as well, China is a particularly salient example. Despite multiple tightening moves by the People’s Bank of China over the past year, domestic bank lending was still surging at a 16.5% y-o-y rate through April – more than three percentage points faster than the pace of credit extension in early 2005. Not only does the Chinese central bank have ongoing and serious problems in mopping up the excess liquidity from incomplete forex-related sterilization, but also it continues to have great difficulty in achieving policy traction with a still highly fragmented network of branch banks. At the same time, embryonic banking systems continue to play a highly disproportionate role in the intermediation of total credit flows in the donor countries of Developing Asia. Here again, that’s especially the case in China, where the development of a domestic bond market has lagged and the banking sector still accounts for nearly 85% of total credit intermediation. In short, Asia, in general – and China, in particular – lacks the high-quality financial-market and policy infrastructure that is commensurate with its linchpin role as the world’s major provider of surplus saving. Senior leaders in Beijing concur on the urgency to address these shortcomings in the context of China’s broader control problems. The recent surge of money and credit is indicative of the concerns that recently prompted China’s Premier Wen Jiabao to characterize the Chinese economy as “unstable, unbalanced, uncoordinated, and unsustainable.” But it is the rapidly expanding Chinese equity bubble – with the domestic A-share index up more than 160% over the past year – that is today’s most visible manifestation of China’s control problem. Nor is this an isolated occurrence in Developing Asia. India’s Sensex Index has surged over 115% over the past two years, and the Korean KOSPI is up more than 70% over the same period. Sharp gains are also evident in the region’s smaller equity markets – especially Vietnam but also Taiwan, Malaysia, Pakistan, and Indonesia. To the extent that China is now the engine of Developing Asia, its liquidity management problems – to say nothing of trends in its currency and equity market – are emblematic of broader control problems afflicting the entire region. With limited domestic absorption, quasi-pegged currencies, and rapid accumulation of foreign exchange reserves, most of these surplus-saving economies are awash in excess liquidity. Lacking in alternative assets and, especially in the case of China, with largely closed capital accounts, domestic equities have absorbed a disproportionate share of the Asian liquidity binge. The result is a classic asset bubble – driven by the same speculative forces that have taken markets to excess for hundreds of years but, in this case, reinforced by the liquidity-prone currency regimes of surplus-saving economies. China’s equity bubble underscores a new and worrisome feature of its policy regime – a loss of control in setting currency expectations. By succumbing to the pressures of Washington-led China bashing, the renminbi has become a one-way bet to the upside versus the dollar. With the US Congress now more likely than ever to enact WTO-compliant, veto-proof sanctions on China, most market participants have concluded that a large upward adjustment in the Chinese currency seems more and more likely as the only way to avoid a protectionist endgame. The result has been a dramatic acceleration of hot-money inflows banking on a path of sharp RMB appreciation – in stark contrast with fixed currency expectations anchored by the once solid peg. This shift in expectations has amplified the trends noted above – leading to an accelerated pace of foreign exchange reserve accumulation, continued rapid growth in money and credit, and spillover effects in China’s domestic equity market. What Stanford professor Ronald McKinnon once labeled “conflicted virtue” – high-saving economies acquiring dollar-based claims on their creditors – is now in danger of becoming increasingly vicious (see McKinnon’s remarkably prescient 2005 book, Exchange Rates Under the East Asian Dollar Standard: Living with Conflicted Virtue, MIT Press). So what should be done to enable China and the rest of developing Asia to get out of this policy trap? In my view, a lasting resolution needs to satisfy three conditions: First, China needs to be more aggressive in taking actions to reduce surplus saving. That can only occur through a significant increase in domestic private consumption – a clear objective of China’s 11th Five-year Plan unveiled over a year ago. The sooner the consumption share of Chinese GDP starts to rise, the import share of this open economy will follow – reducing China’s trade deficit, a key component of its massive current-account surplus. China knows full well what it will take to boost domestic private consumption – namely, policies that establish and solidify a social safety net (i.e., pensions and social security) and thereby reduce the overhang of fear-driven, or precautionary, saving. Consumer cultures – especially for nations lacking in safety nets – don’t spring to life over night. The increasingly destabilizing financial signals currently coming out of China make it very clear that the time path of this transition now needs to be shortened by an accelerated pace of investment in safety-net institutions. Second, the United States needs to own up to the role it is playing in triggering destabilizing conditions in China and elsewhere in Developing Asia. The problem here is America’s unprecedented saving shortfall – a net national saving rate that averaged just 1% of national income over the 2004-06 period. The more the US relies on surplus savers from China and other Asian economies to fund its consumption-led growth, the more the destabilizing pressures of bilateral trade tensions will come into play – in economic, financial, and geopolitical terms. Relief of these tensions will require the US Congress to give up the ghost of promising a beleaguered American middle class that a bilateral RMB currency fix is the answer to all their problems. As I have stressed ad nauseum, it’s hard to be optimistic on this count. Unfortunately, there is no way out of the Asian trap if the US doesn’t disarm it. Third, Asia, in general, and China, in particular, need to establish a new policy anchor. As I noted recently, I don’t think it is an accident that China’s interplay between foreign exchange reserve accumulation and its equity market became increasingly destabilizing in the aftermath of the dismantling of the RMB-dollar currency peg in July 2005 (see my 21 May essay, “Policy Pitfalls in an Asset-Dependent World”). This single action, in conjunction with intensified pressure from Washington to do far more on the currency front, is the genesis of the hot-money inflows that are driving China’s foreign exchange reserves, domestic liquidity, and equity prices to excess. Chinese authorities need to be very direct and firm in re-establishing an explicit and transparent policy anchor – whether it is a price target, a money and credit target, or even a new currency target. With over $1.2 trillion in official currency reserves, China clearly has the ammunition to punish those who want to bet against a new policy target. With speculators increasingly eager to jump on the one-way RMB appreciation bandwagon, China may well need to take such actions in order to re-establish a credible policy anchor in the eyes of market participants. The rest of Developing Asia is very much beholden to the China fix. Linked to the real side of the Chinese economy through an increasingly integrated pan-regional supply chain, it is virtually impossible for the rest of Asia to decouple from any pressures that might affect the performance of China’s trade engine. Similarly, the fate of the RMB could well hold the key to currencies elsewhere in Developing Asia. If the Chinese currency moves sharply to the upside, other Asian currencies – with the possible exception of the Japanese yen – should be quick to follow. Conversely, if China reverts to more of a quasi-stable RMB, currency adjustments elsewhere in the region are likely to be stymied – thereby putting the onus on improved US saving as the main mechanism for a US current account adjustment. The Chinese equity bubble, in conjunction with mounting protectionist pressures in the US Congress, suggests that Asia’s current policy regime could be nearing a flashpoint. It is up to China and the rest of Developing Asia to put proactive policies in place that will enable it to escape this trap. Unfortunately, any such a resolution could well be for naught if Washington-led China bashing doesn’t back away from the brink..
Important Disclosure Information at the end of this Forum
How Sustainable is the Rebound?
May 29, 2007
By Richard Berner | New York
US economic growth is reviving from a first quarter trough. To be sure, statisticians likely will likely revise first-quarter growth down by a quarter of a percentage point to about 1% — perilously close to stall speed. But incoming data suggest that the inventory correction that began last fall is ending, and that somewhat stronger gains in domestic final demand and lean inventories have promoted a production snapback. More important, growth in some previously-soft areas of final demand appears to be picking up, offering hope for a lasting revival. Yet, with several headwinds to growth still evident, just how sustainable is the rebound? And what are the downside and upside risks? As we see it, both the fundamentals and incoming data suggest that the revival is sustainable. In addition to renewed inventory accumulation, several factors are fueling the unexpectedly strong second-quarter result: A resilient consumer, a less-intense decline in housing activity, and improvements in capital spending, net exports, and in government outlays. That 3% spring pace probably isn’t sustainable, however, courtesy of the likely fallout from soaring gasoline prices and a deeper summer housing downturn. And if those two headwinds intensify, they would pose downside risks. But in my view the odds of growth slipping below 2% again have receded dramatically; indeed, there are some upside risks to growth. The analytics of the rebound are critical to that assessment. Four key themes underpin our fundamental case for a resilient economy that shows improvement later this year as the housing recession fades. First, we think gains in jobs and income will be strong enough to support both moderate gains in consumer spending and a rise in thrift. Second, we believe that booming growth abroad will promote a sustained improvement in net exports and thus output and jobs for the first time in two decades. A key reason is that overseas growth has become less dependent on what’s happening in the US economy and is increasingly driven by domestic demand abroad. We think improving US net exports may add up to half a point to US growth and will help promote global rebalancing (see “The Decoupling Debate: US Implications,” Global Economic Forum, April 16, 2007). In addition, we believe that corporate capital spending discipline in recent years implies that “pent-up” demand will support business investment outlays (see “Explaining the Capex Conundrum,” Global Economic Forum, April 23, 2007). And finally, financial conditions are still supportive of growth. Incoming data through the first quarter validated only two of those four themes. Job and income gains have been sufficient to promote solid gains in consumer outlays. To be sure, growth in nonfarm payrolls has slowed significantly in 2007, from a monthly average pace of 189,000 last year to just 129,000 in the first four months of this year. And on balance, we expect further deceleration in coming months. But wage gains outstripped inflation in the first four months of this year despite the rise in energy costs, and together with solid growth in nonwage income, promoted a 4.6% annualized improvement in real disposable income in the three months ending in March — more than double the pace of real spending over the same period. In addition, in my judgment, financial conditions remain supportive of growth. Mortgage and corporate borrowing rates have risen by 20-30 bp and lenders have tightened mortgage-lending standards since the start of the year. But the backup in real rates reflects strong global growth rather than tighter credit, in my view, and credit availability outside mortgages has if anything improved (see “The Conundrum Unwinds,” Investment Perspectives, May 24, 2007). And higher stock prices and a weaker dollar have offset the impact on financial conditions of developments in mortgage markets since the start of the year. In contrast, support for the other two themes was missing last quarter. Despite evidence of stronger than expected growth in many of our major trading partners, US net exports were a drag on growth in the first quarter. US exports contracted at a 1.2% annual rate in the first quarter, with industrial supplies, capital goods, and services all declining. And imports, especially of petroleum products, soared as US refinery shutdowns hobbled domestic supply. But the upturn in March capital goods bookings and ISM respondents’ April reports of firmer orders overall and for exports signal that a gradual improvement lies ahead. Likewise, business capital spending rose at a tepid 2% annual rate in the first quarter, following a 3.1% decline last fall. But nondefense capital goods orders and deliveries both rose at a double-digit annual pace over the three months ending in April, production of business equipment grew at a 9.3% annual clip over that time frame, and the ISM respondents’ April reports of firmer orders signal that a gradual improvement lies ahead. The fundamentals combined with encouraging data are strong evidence for the sustainability of the current rebound. But two significant headwinds likely mean that summer growth won’t be as strong as that in the second quarter. First, the housing recession still has further to run. True, housing starts have improved in each of the past three months, likely contributing to a less-intense decline in residential construction in the second quarter, and new, single-family home sales jumped by 16.2% in April, hinting that a rebound in housing activity may finally be at hand. Don’t count on it. Housing demand does appear to have bottomed, but even that conclusion is hardly rock-solid, because two housing headwinds still loom ahead: First, lenders continue to tighten lending standards, and the impact of that restraint has in my view only begun to appear. Moreover, builders have yet to correct fully the mismatch between housing demand and supply. With unsold new homes representing at least 6.5 months’ and more likely 7.2 months’ supply, renewed declines in starts are likely. For example, to return inventories to the 5-5.5 month level by year-end probably requires a 20% (not annualized) cut in one-family housing starts from April’s level. The upshot: The intensity of the housing recession is fading, but it is far from over (see “The Housing Mismatch,” Global Economic Forum, May 25, 2007). In addition, gasoline prices have soared well beyond where we expected they would peak just a few weeks ago, further menacing consumer discretionary spending power and consumers’ willingness to defend their lifestyles. In early May, we thought regular unleaded gasoline would peak at about $3/gallon, but prices have climbed by another 25 cents (see “Gasoline Prices: Déjà vu,” Global Economic Forum, May 4, 2007). Apart from normal seasonal factors, each penny/gallon costs consumers about $1.3 billion in extra outlays. The good news: Wholesale gasoline quotes have slipped by about a dime in the past week, hinting that prices may have peaked as the impact on supply of refinery shutdowns may be abating. Even if prices have peaked and decline slightly in June, however, the hike in prices over the December-June period will have cost consumers about $82 billion at an annual rate (after allowing for normal seasonal increases). The more sedate rise in food quotes has also hurt (recalling that food accounts for nearly 14% of consumer budgets, compared with just 3.3% for gasoline); I estimate the drain on consumer budgets from these two factors will have totaled $120 billion or 1.2% of disposable income. Surprisingly, according to a recent special survey from the University of Michigan’s Survey Research Center, “Consumers have faced the recent spike in gas prices for the first time without being overwhelmed by fears of an impending economic calamity.” The Center, which is responsible for the well-known monthly canvass of consumer sentiment, argues “it is this newfound resilience of consumers that will help to stabilize the economy and maintain positive economic growth during the year ahead.” It does seem that attitudes and spending are holding up well considering the jump in gasoline prices, and consumer fundamentals otherwise are supportive. But other surveys, like an Associated Press poll last week, are less positive; forty-six percent of respondents said that the jump in gasoline prices is causing “serious hardship.” Time will tell, but I view the runup in gasoline (and food) prices as a significant headwind for consumers. I think the risks for financial markets are now evenly balanced. Market participants have priced in the near-term growth improvement, so signs of weaker growth could trim real fixed-income yields and pressure risky asset prices. Investors expect the Fed to remain on hold through 2007 and anticipate only modest ease through early 2009. That is in line with our baseline view. While stronger growth is thus in the price, market participants do not expect either higher inflation or any chance of Fed tightening. That’s also in line with our view, but it’s important to contemplate the risks to such a scenario. As I see it, the combination of rising gasoline quotes and a renewed, intense downturn in housing activity would pose significant downside risks to US growth. But consumer resilience and upside risks to global growth imply some parallel upside potential to growth in the US economy. In that context, investors should pay close attention to inflation risks, including the threat that rising protectionist sentiment could turn into legislative action in the Congress.
Important Disclosure Information at the end of this Forum
NDRC Launches New Administrative Effort to Curb Investment
May 29, 2007
By Qing Wang | Hong Kong
Key Points Conclusion: The National Development and Reform Commission (NDRC), China’s powerful economic planning agency, launched a new effort to curb investment in energy-intensive sectors through administrative measures. I expect investment growth in these sectors targeted by NDRC to slow significantly in the coming months. Instead of viewing this move as the onset of a new round of campaign-style administrative tightening to tackle the risk of a generalized economic overheating, I think these measures represent the authorities’ renewed effort to specifically help achieve the government’s ambitious energy-conservation target. What's New: The NDRC issued an “urgent notice” last Friday, May 25, instructing local governments to stop the renewed “blind” expansion of energy-intensive sectors including steel, electrolytic aluminum, copper metallurgy, iron alloy, calcium carbide, coke, cement, coal and electricity sectors. This is the first major package of administrative tightening measures since August 2006. Implications: This renewed effort by the Chinese authorities to curb investment through administrative measures underscores the challenge to effective macroeconomic management in China. Investment growth in these targeted sectors would slow significantly in the coming months, in my view. However, experience suggests that the impact of administrative measures tends to be short-lived. In view of the authorities’ stated preference for market-based policy measures, I interpret these administrative measures as largely playing a damage-control role. The authorities will likely follow up with market-based initiatives. Details NDRC Launches New Administrative Effort to Curb Investment The National Development and Reform Commission (NDRC), China’s powerful economic planning agency, has launched a renewed effort to curb investment in energy-intensive sectors through administrative measures. On Friday, May 25, the NDRC issued an “urgent notice” instructing local governments to stop “blind” expansion of energy-intensive sectors including steel, electrolytic aluminum, copper metallurgy, iron alloy, calcium carbide, coke, cement, coal and electricity sectors. The NDRC stated that the output growth of the majority of energy-intensive sectors was over 20% YoY in 1Q, as the tight energy supply situation has eased, “making it more difficult to achieve the energy-conservation target.” But This is Unlikely to be the Onset of A New Round of Campaign-style Administrative Tightening NDRC’s move came in the wake of the PBOC’s unprecedented announcement of a three-pronged package of measures regarding FX and monetary policy. Moreover, this is the first major package of administrative tightening measures since August 2006. Clients may wonder whether this does not signal the onset of a new round of the campaign-style, heavy-handed administrative measures that were implemented to tackle the risk of a generalized economic overheating in early 2Q 2004 and last summer, respectively. I think not. It appears that this policy package is more focused and the message is being delivered with somewhat of a less urgent tone. Specifically, this new NDRC announcement differs from the package of administrative measures introduced last summer in several aspects. First, while last year's policy package was aimed at addressing the "blind investment" in all sectors (with an emphasis on energy-intensive and sectors facing overcapacity), this package is only targeting the energy-intensive sectors. Second, in the latest announcement, NDRC is demanding strict enforcement of the policy measures introduced last summer instead of initiating new ones. Third, while last year's package was jointly announced by the NDRC (the lead agency), Ministry of Land & Resources, the Environmental Protection Agency, the Bureau of Production Safety, and China Banking Regulatory Commission, the current package was announced in the name of NDRC alone. Fourth, a very tight reporting deadline (i.e., one month) was set for local governments in last year's announcement, but no deadline has been specified in the latest one. I therefore think this new policy announcement represents the authorities’ renewed efforts to help specifically achieve the government’s ambitious energy-conservation targets. The government’s11th Five-year (2006-2010) Plan set the objective of reducing the energy consumption per unit of GDP by 20%, or averaging a 5% reduction per year. The government failed to achieve this target in 2006 and vowed to redouble its efforts this year (see Stephen Roach’s note “Unstable, Unbalanced, Uncoordinated, and Unsustainable,” Global Economic Forum, May 19, 2007). I believe it is against this background that the NDRC launched this new administrative effort. Significant But Likely Short-lived Impact I expect investment growth in these sectors targeted by the NDRC to slow significantly in the coming months. However, the impact of these administrative measures is unlikely to last long, in my view. As the Chinese economy becomes increasingly market-oriented and sophisticated, the effectiveness of administrative measures – albeit still being resorted to frequently – has weakened appreciably over time. In particular, local authorities, who are often the sponsors of large investment projects and whose interests are not necessarily aligned with those of the central government, do not have a strong incentive to follow through with these austerity measures imposed by the central government. Thus, the impact of these administrative measures, which fail to alter the underlying economic incentive structure, tends to be rather short lived, however decisively they are implemented initially. Experiences from the last two rounds of administrative macro-controls are a case in point. Heavy-handed administrative measures were introduced in early 2Q 2004. As a result, fixed-asset investment (FAI) growth was brought down sharply, but it bottomed out by early 3Q and started to climb strongly by early 2005. The impact of the most recent round of administrative tightening lasted for an even shorter period of time. The FAI growth rate started to decline in July last year and had bottomed by December and since early this year has staged a strong rebound. Awaiting Market-based Measures Several senior government officials stated late last year that, going forward, the authorities would prefer market-based policy measures to manage the macro economy. In its 1Q Monetary Policy Report, PBOC also stressed the need to maintain policy stability and continuity, which we interpret as suggesting that no consensus has been reached on the need for heavy-handed administrative measures to address the risk of a generalized overheating (see “China Economics: 1Q Monetary Policy Report: Be Prepared for Rate Hikes,” May 15, 2007). How should we then interpret this new administrative effort by the NDRC? I would consider it as a damage-control move to buy time before the NDRC is ready to roll out a comprehensive reform of the pricing mechanism for a wide range of natural resources-based products, including water, fuel, electricity, natural gas, and coal in the coming months. Although we do not have the details of this reform package, the direction of the reform would be to normalize the prices of these products, which have been kept too low, and to encourage energy conservation and environmental protection through market-based measures.
Important Disclosure Information at the end of this Forum
What Is the Risk to China’s Economy If the A-share Market Bubble Bursts?
May 29, 2007
By Qing Wang | Hong Kong
Summary & Conclusions As the A-share market continues to rise rapidly despite historically high valuations, fears of serious consequences from a potential burst of the stock market bubble have intensified greatly in recent weeks. However, on examination of household and corporate exposure to the stock market, we conclude that the negative ‘wealth effect’ on consumption would be moderate and financing conditions for corporate investments would be unlikely to deteriorate significantly should the A-share market plunge by 30% from current levels. The potential impact on the banking sector is much more difficult to gauge, given the paucity of data. However, our stress test suggests that the impact on banks’ balance sheets would – while significant – likely be manageable. In sum, we believe that the direct economic impact would be manageable in the event of such a burst. Hence, the fear of a complete economic meltdown in China as a result of a potential burst of the stock market bubble is unwarranted at the current juncture, in our view. Nevertheless, a major correction of the A-share market could well result in significant contagion to global markets, as seen during February’s short-lived correction. However, to the extent that any such global sell-off were driven by concerns about a stock-market-correction-triggered-recession in China’s real economy, it would likely prove overdone, in our view. If, however, the stock market continues rising rapidly from current levels, we think the risk of a much more serious impact from a potential stock market correction will heighten significantly. Fears of a Stock Bubble Burst As the A-share market continues to rise rapidly despite historically high valuations, fears of serious consequences from a potential burst of the stock market bubble have intensified greatly in recent weeks. Investors are especially concerned about the potentially serious real economic impact of a negative ‘wealth effect’ on household consumption, the financing channel for corporate investments and banks’ balance sheets. We address these concerns by analysing the exposures of the household, corporate and banking sectors to the stock market. We look at a scenario under which the stock market plunges by 30% in a relatively short period of time. Based on investor feedback, this is the order of correction that could trigger serious concerns over implications for the wider Chinese and global economies. Since the paucity of data prevents us from conducting a thorough or precise simulation of such a scenario, we rely on officially published data and make several rather extreme assumptions with a view to gauging how bad things could get. Therefore, this exercise should be viewed as a ‘stress test’ rather than an attempt to forecast with any accuracy the outcome of a potential stock market correction. Moderate ‘Wealth Effect’ on Household Consumption A typical concern about the fallout of a major stock market correction is the impact of the negative ‘wealth effect’ on household consumption. Households that hold stocks directly or indirectly through mutual funds feel poorer when the stock market falls. This can result in a decline in current consumption. We estimate that, although Chinese households had about Rmb25.5 trillion of financial assets (i.e. about 108% of GDP) by end April 2007 (Exhibit 1), only about 20% (Rmb5.2 trillion) are in the form of stock holdings. Headline stock market capitalization stood at about Rmb16 trillion at end-April, but only about one-third of this is actually ‘marketable’ – i.e. available for investment by retail investors. The rest remains held by a small number of large shareholders (mostly the State). In another words, household exposure to the stock market is much smaller than that suggested by headline stock market capitalization. Were the stock market to plunge by 30% from current levels, the value of households’ stocks would, ceteris paribus, shrink by 30% to Rmb3.6 trillion. With the value of other assets unchanged, total household financial wealth would decline by Rmb1.6 trillion or about 7% of GDP. To determine how such a decline in household financial wealth might affect consumption, we need one important parameter – the ‘marginal propensity to consume out of wealth’ (MPCW). Given the extreme difficulty of estimating this figure for China, due to poor data quality and availability, we use estimated MPCW for the US as a proxy. Most academic research puts the MPCW for stock wealth in the US at around 4% (see How Large Is the Housing Wealth Effect? A New Approach, NBER Working Paper No. 12746, December 2006). In other words, for every US$100 decline in stock wealth, it is estimated that US consumers lower their consumption by US$4. We view this US parameter as a high end figure for China, given US households’ greater propensity to consume in general and the highly-developed financial markets in the US – which make it much easier to translate financial gains into cash income. Based on a MPCW of 4% and a loss of financial wealth equivalent to 7% of GDP for Chinese households, a 30% plunge in the stock market would cause GDP growth to drop by 0.2 percentage points as a result of the negative ‘wealth effect’. While such a reduction in the GDP growth rate would be material for many low-growth countries, the impact would be quite moderate by China’s double-digit growth standards. Note that China’s propensity to consume out of wealth may be considerably smaller than that of the US, hence the actual impact on China’s GDP growth could be substantially smaller than the 0.2% delivered by our scenario. We think this may explain in part why we have not seen a major consumption boom despite a surge in the stock market since mid-2006. We believe another factor that helps explain the seemingly small ‘wealth effect’ on consumption has to with households’ perception of financial gains as unsustainable. Both consumption theory and empirical research suggest that consumption is more responsive to permanent gains in personal financial wealth. In view of rampant speculation in the domestic A-share market, it is quite possible that many investors are discounting a considerable proportion of their rapid financial gains as temporary. No Serious Challenge to Corporate Investment Financing As regards investment, the theoretical counterpart to the ‘wealth effect’ on consumption is the ‘Tobin’s q theory’. According to this theory, a firm will invest if the stock market’s valuation of new capital addition (or investment) to the firm is higher than the actual replacement cost of the capital. Tobin’s q is the ratio of market valuation of the capital to its actual replacement cost. When q is greater than one, investment is worthwhile and encouraged. For example, if a firm has an investment project that costs Rmb10 million and the completion of the project will increase the overall market value of the firm by Rmb12 million, it makes sense for the firm to carry out this investment as it creates an additional Rmb2 million of market value. As such, a booming stock market encourages investment; conversely, a plunge in stock market prices tends to lead to a contraction in investment. However, we believe that even a 30% correction in the stock market from current levels would be unlikely to have much of an impact on fixed-asset investment in China. First, we argue that the value of Tobin’s q in China is always substantially greater than one regardless the performance of the stock market, mainly reflecting the low replacement cost of capital goods in China. The financing costs of investment projects (e.g. the interest rate on the bank loans) are kept substantially below the market-clearing level. The binding constraint on investment decisions is usually not the cost of capital but the availability of bank loans. Reflecting low interest rates, there is always strong demand for investment, generating the tendency for over-investment. While a booming stock market should drive Tobin’s q far above one, a 30% decline in the stock market from current levels would by no means take it below one, in our view. Put another way, we do not believe Tobin’s q is a binding consideration when investment decisions are made in China. Second, as a source for investment financing, the amount of capital raised from the stock market remains very small. In 2006, only slightly over 2% of total financing for fixed-asset investment came from the A-share market (Exhibit 2). Although this ratio has more than doubled in the first four months of this year, it is still less than 5%. This suggests that, even if stock market financing became shut off completely in the wake of a correction, corporate investment financing conditions would not deteriorate significantly, as long as other channels of financing remained open. Manageable Impact on Banks’ Balance Sheets A 30% plunge of the stock market could cause major damage to banks’ balance sheets, if the banks have large exposure – direct or indirect – to the stock market. In order to safeguard the quality of their assets and meet relevant prudential requirements, the banks might respond by raising their lending standards, squeezing overall bank lending and negatively affecting real economic activity (e.g. consumption and investment). Since the China Banking Regulatory Commission (CBRC) prohibits Chinese banks from lending to investors to purchase stocks, no published official data are available on banks’ direct exposure to the stock market. It is likely that in some form bank money has found its way into the stock market. However, pinning down an exact figure is almost impossible. Anecdotal evidence suggests that, since mid-2006, when the A-share market started to take off, some households have increased their overall leverage ratio through conventional household loans (e.g. mortgage loans) to invest in the stock market. That said, any attempt to estimate banks’ real exposure to the stock market is largely guesswork, in our view. In light of this, we take a ‘stress test’ approach to gauging how much damage could be done to the banks in the event of a major stock market correction. For the purposes of this analysis, we assume that bank customers have leveraged up substantially with money borrowed from the banks. To this end, we make some rather arbitrary and extreme assumptions. First, we assume that all the diversion of banks’ lending into the stock market is carried out by the household sector, given that the banks should have tighter and more regular monitoring of the usage of bank lending by their corporate clients. Second, we assume that 50% of all new bank loans made to the household sector since June last year have been diverted to the stock market in one form or another. This is, of course, an arbitrary assumption – but we think this 50% is likely to be on the high side of the potential range, and hence conservative. Third, we assume that a 30% plunge in the stock market would turn this lending into non-performing loans (NPLs). The amount of new bank lending to the household sector between June 2006 and March 2007 was Rmb634 billion. Assuming that 50% of this amount has been diverted to the stock market and turns into NPLs as a result of a major stock market correction, this would create Rmb317 billion of NPLs. This would account for only about 1.3% of total outstanding loans extended by all financial institutions combined as at end-March 2007. This stress test suggests that the impact on bank balance sheets of a 30% plunge in the stock market would be manageable, even assuming that substantial hidden leverage has been taken on by the household sector with money borrowed from the banks since June last year. This moderate impact is not surprising, given that only about 17% of total bank lending is extended to the household sector in China – a lower proportion than in many other countries (e.g. the ratio in the US is about 45%). Naturally, we cannot rule out completely the possibility that the corporate sector may also have diverted some of the funds borrowed from the banks into the stock market. However, based on feedback from market participants and officials, we suspect the amount involved is not very significant at this stage, especially given that the overall growth rate of bank loans to the corporate sector has been generally stable at 14-15% YoY since last year. Potentially Significant Social Implications The social implications of a 30% plunge in the stock market could be large, however. Most retail investors entered the stock market at a relatively late stage of the current stock market rally (i.e. between late 2006-present). A major market correction could therefore hurt a large number of retail investors disproportionately. This could have significant social implications. In regions where the market economy is less developed and the notion of self-risk-management in a market economy has not been widely accepted, discontented retail investors who incur large losses as a result of a stock market correction could feel let down by the government, leading to incidences of social instability. We believe these social implications feature importantly in the authorities’ assessment of various potential consequences stemming from a major stock market correction. Significant but Likely Short-lived Contagion Effect A major correction of the A-share market could well result in significant contagion to global markets, as seen during February’s short-lived correction. However, since the negative impact on China’s real economy would be manageable, the contagion effect would likely be short-lived, in our view. In particular, to the extent that any such global sell-off were driven by concerns about a stock-market-correction-triggered-recession in China’s real economy, we think it would likely prove overdone. Higher Stakes Going Forward We think the risk of a much more serious impact from a potential stock market correction will heighten significantly if the stock market continues rising rapidly from current levels. Should the value of households’ stock holdings double from current levels to 40-50% of GDP, the potential negative ‘wealth effect’ on consumption would increase and the negative impact of a major stock market correction on consumption and overall growth would become more significant. More importantly, with potential returns from investing in the stock market substantially and persistently higher than those from traditional investment activity, not only households but also the corporate sector could be tempted to leverage up with money borrowed from the banks to invest in the stock market. It would then become increasingly difficult for bank regulators to enforce relevant prudential rules and prevent diversion of legitimate bank lending into the stock market. Were this to happen, banks would eventually become more exposed to the stock market. The impact of a major stock market correction would then be magnified by the credit channels of the banking system. The resulting damage on the real economy would be much larger, especially given the banks’ dominance in financial intermediation in China. Going forward, we advise paying close attention to any sign of investors’ increasing their hidden leverage with money borrowed from the banks. We believe that the credit channels of the banking system will be the main transmission mechanism through which the impact of a potential stock market correction would be spread to the rest of the economy
Important Disclosure Information at the end of this Forum
Mind the Gap
May 29, 2007
By Serhan Cevik | London
Inflation will remain low in the near future, but risks are now on the upside. Judging from the behaviour of inflation over the last year, Israel is an exceptional country with strong economic growth and deflationary readings. Consumer price inflation moved from 3.8% in April 2006 to -1.3% last month. Not only is this well below the lower bound of the central bank’s target range, but it has also come through at a time of low interest rates and above-trend growth. Mysterious? Not really. There is one simple fact behind this intriguing phenomenon, and that is the shekel’s realignment towards its fair value against the dollar. After years of undervaluation, the shekel’s appreciation has led to a wave of deflation, because of the high and immediate pass-through effect on the prices of imported goods and services and, more importantly, in non-tradable sectors using pricing schemes linked to the exchange rate. For example, housing prices denominated in dollars dropped by 6.2% over the last year. Since the housing sector has a 22% weight in the consumer price index, it is not surprising to see the headline inflation rate in deflationary territory, even if we ignore pass-through and spillover effects on other sectors of the economy. However, although inflation is likely to remain low in the near future, upside risks are now becoming more pronounced, in our view. As the shekel stabilizes, underlying pressures will start dominating inflation dynamics. Our projections (as well as the consensus estimate) suggest that the annual rate of change in the CPI will stay in deflationary territory in the comings months, mainly because of base effects stemming from the shekel’s appreciation. Even though fundamental improvements in the Israeli economy still support the shekel’s valuation, it is likely to stabilize around the current level and have a diminishing influence over domestic prices. This is why we have argued that underlying pressures resulting from sustained growth in domestic demand will start dominating inflation dynamics. Indeed, consumer price inflation excluding items influenced by the exchange rate has already diverged from currency-driven items in the CPI. According to the Bank of Israel’s estimates, the “domestic” component of the CPI recorded a 4% year-on-year increase in the first quarter of the year — even above the upper bound of the target range, whereas the “imported” component (including currency-linked items and energy prices) showed a 4.6% drop. These figures confirm our view that the strength of the global economy and accommodative monetary conditions in Israel have pushed GDP growth beyond the trend growth rate and thereby led to higher inflation (excluding the currency pass-through effect). The Israeli economy is now expanding at a rate that is faster than its potential. After four years of strong growth, Israel’s economy shows no sign of slowdown. According to preliminary figures, real GDP growth remained at an annualized rate of 6.3% in the first quarter of this year, just a bit lower than 7.3% in the previous quarter. While exports of goods and services are still one of the leading engines of growth, the most interesting story coming out of the latest national accounts is the shift in the composition of growth towards domestic demand. Consumer spending grew at an annualized rate of 11.8% in the first three months, up from 4.9% in the preceding quarter and an average of 4.8% in the whole of last year. And within the private consumption component of GDP, spending on durable goods is the key driver, recording an astonishing 95.1% annualized increase in the first quarter. With low interest rates and sustained improvements in the labour market, the rise in domestic demand should not be a surprise. However, the continuing pace of above-trend growth in domestic demand also means that the Israeli economy now faces inflationary pressures stemming from a ‘positive’ output gap. The central bank’s current monetary policy stance is highly accommodative, in our view. With short-term interest rates at an all-time low of 3.5% and consumer price inflation excluding currency-linked prices running at 4%, there is little doubt that the current stance of monetary policy in Israel is highly accommodative. Therefore, even if we assume an improvement in the economy’s potential growth rate, the prevailing growth dynamics still confirm our view that inflation risks are now on the upside.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Dean Witter Asia Limited and/or Morgan Stanley Dean Witter Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Dean Witter Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").
Global Research
Conflict Management Policy
This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html
Important Disclosures
This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International plc, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Dean Witter Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.
Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.
|
