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The Shifting Mix of Global Saving
June 04, 2007

By Stephen Roach | New York

There is no glut of global saving.  Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP.  In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990.  At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world.  This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead.

There can be no mistaking the dramatic shift in the mix of global saving in recent years.  A particularly stunning change has occurred in just the past decade.  According to IMF statistics, in 1996 the advanced countries of the developed world accounted for 78% of total global saving.  By 2006, that share had fallen to 65%.  Over the same decade, the developing world’s share of global saving has risen from 22% in 1996 to 36% in 2006.  Put another way, the rich countries of the developed world – which made up 80% of world GDP in 1996 – accounted for just 43% of the cumulative increase in global saving over the past decade.  By contrast, the poor countries of the developing world – which made up only 19% of world GDP in 1996 – accounted for fully 58% of the cumulative increase in global saving over the 1996 to 2006 period, or approximately three times their weight in the world economy.  This wealth transfer from the poor to the rich – the exact opposite of that which occurred in the first globalization of the early 20th century – is one of the most extraordinary developments in the modern history of the global economy.

The United States, of course, stands out for extreme negligence on the saving front.  By 2006, America’s gross national saving rate – the combined saving of individuals, businesses, and the government sector – stood at just 13.7%.  That’s down from the 16.5% rate of a decade earlier and, by far, the lowest domestic saving rate of any major economy in the developed world.  Adjusted for depreciation – a calculation which provides a proxy for the domestic saving that is left over after funding the wear and tear on aging capacity – the US net national saving rate averaged just 1% over the past three years, a record low by any standards.  Over the  1996–2006 period, the US accounted for a mere 12% of the total growth in worldwide saving – less than half its 26% share in global economy as of 1996.  Elsewhere in the developed world, it has been more of a mixed picture.  The Japanese saving rate, while a good deal higher than that of the US, fell from 30.4% in 1996 to 28.0% in 2006.  By contrast, gross saving in the Euro Area held steady at around 21.0% over the past 10 years. 

Trends in the major countries in the developing world stand in sharp contrast to those in the developed world.  By now, it is well known that the large and rapidly growing developing economies of Asia have led the way.  Collectively, these economies have taken their gross domestic saving rate from 33% in 1996 to 42% in 2006 – enough to have accounted for 31% of the overall gain in global saving over this period, fully four and a half times their combined 7% share in the global economy as of 1996.  Nor can there be any mistaking the dominant role played by China in driving saving flows in the region.  According to IMF estimates, China’s gross domestic saving rate rose from 40.5% to 50% in 2004.  My guess is the Chinese saving ratio probably held near that level over the past two years; if so, that means China accounted for about 23% of the growth in global saving over the past decade, or three-fourths of Developing Asia’s contribution to the increase in world saving.  Elsewhere in Asia, the global saving impetus over the past decade has been small – for example, only 3% from the region’s newly industrialized economies (i.e., Korea, Taiwan, Singapore, and Hong Kong).  The Middle East is the only other significant source of incremental growth in global saving – accounting for 8% of the cumulative gain in world saving over the past decade, or one-third the contribution coming from China

Contrary to popular folklore, these trends in the mix of global saving are not a statistical aberration.  In particular, much has been made of the so-called flaws in the US Commerce Department’s estimates of the personal saving rate.  This criticism, which mainly focuses on the failure of government statistics to capture the capital gains pieces of saving arising from property and portfolio investments, misses a key point: National-income-based measures of saving were never designed to measure asset-based savings accruals.  Instead, they approximate the saving arising from current economic activity – in effect, measuring the difference between domestic expenditures and the income generated from current production.  As such, income-based saving gauges are agnostic over the possible existence of alternative asset-based sources of saving.  Should any such windfalls occur to individuals, businesses, or even government entities, there is no reason, of course, why there couldn’t be a shift in the mix between income- and asset-based saving.  That doesn’t mean the national-income-based saving construct is wrong – it just suggests that another source of saving has the potential to enter the equation.

That, of course, has been precisely the story in the United States since the mid-1990s.  Yet a personal saving rate that moved into negative territory for two years in a row in 2005-06 – the first such development since the early 1930s – doesn’t necessarily paint a picture of an irrational American consumer.  Drawing freely from a steady stream of wealth effects from sharply rising asset values – first equities and, more recently, property – US households have, in effect, substituted asset-based saving for that which used to be derived from income generation.  These asset effects were hardly inconsequential.  During the heyday of the property bubble, net equity extraction from residential property rose from 3% of disposable personal income in 2000 to nearly 9% in 2005.  During that same period, however, the spending side of the US economy still needed to be funded on a cash-accrual basis – leaving America to run massive current account deficits in order to make up for the difference between asset-driven aggregate demand and production-driven income generation.  Unfortunately, what goes around often comes around: In a post-housing bubble climate, the asset effects are now swinging the other way – suggesting that national income-based saving measures are likely to become much more meaningful in shaping US aggregate demand than has been the case in a long time.

The world is not having an easy time sorting out this battle over the shifting mix of global saving.  For its part, the developed world seems more than content to maintain the status quo.  That’s especially the case for the US, which has long been drawing freely on the saving surpluses of others – and without having to offer up any concessions on the terms of external financing with respect to the dollar and/or long-term US real interest rates.  In the developing world, there’s greater tension over the current state of affairs.  Lacking in internal support from private consumption, externally dependent emerging economies have been more than content to use their saving flows to subsidize their currencies.  At the same time, most developing economies recognize full well that their growth models cannot be sustained without a drawdown in surplus saving and a concomitant increase in private consumption.  Nor do they believe they can sustain export-led growth dynamics ad infinitum without suffering serious protectionist pressures.  In a nutshell, this is the essence of the problem faced by the world’s dominant surplus saver – China

Saving is the seed-corn for future economic growth.  Without it, nations cannot invest in physical or human capital.  There are short-term Band-Aids that allow saving-short nations to make ends meet – mainly by borrowing from others and, from time to time, by unlocking value in under-valued assets.  The day will come, however, when surplus nations will begin to shift their focus away from functioning as lenders to the external world and turn, instead, toward providing support for internal needs.  The increasingly popular asset allocation shift into “sovereign wealth funds” (SWFs) is, in my view, an early warning sign of just such a change in focus.  Poor countries want more than undervalued currency regimes that dictate low returns in their massive portfolios of dollar-based assets.  They also want higher returns, which the SWFs are designed to achieve, but in addition they want internal absorption of surplus saving in the form of increasingly vigorous private consumption.  In the end, this is the only way the benefits of economic growth can be distributed fairly throughout the income distribution.  This is a key concern of many developing economies – especially China with its system of market-based socialism. 

The dramatic shift in the mix of global saving over the past decade is a big deal.  It drives the equally unprecedented disparity between current account surpluses and deficits – the crux of the global imbalances debate.  It also accounts for the gap between trade deficits and surpluses that is shaping the current protectionist debate in the US Congress.  In theory, of course, this shift in the mix of saving also has the potential to shape relative asset prices between debtor and lender nations.  Although those impacts have yet to take on serious proportions, I continue to suspect the risk of such a possibility is a good deal higher than that envisioned by the broad consensus of global investors.  

From the start, the concept of the global saving glut was very much a US-centric vision (see the March 10, 2005, speech of then Federal Reserve Board Governor Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit”).  From America’s myopic point of view, it believes it is doing the world a huge favor by consuming a slice of under-utilized saving generated largely by poor developing economies.  But this is a very different phenomenon than a glut of worldwide saving that is sloshing around for the asking.  The story, instead, is that of a shifting mix in the composition of global saving – and the tradeoffs associated with the alternative uses of such funds.  I suspect those tradeoffs are now in the process of changing – an outcome that is likely to put downward pressure on the US dollar and upward pressure on long-term US real interest rates.  If the borrower turns protectionist – one of the stranger potential twists of modern economic history – those pressures could well intensify.  Don’t count on the saving glut that never was to forestall these outcomes.. 


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United States
Review and Preview
June 04, 2007

By Ted Wieseman and David Greenlaw | New York, New York

Treasuries posted big losses over the past holiday-shortened week.  The market moved close to pricing out the possibility of any Fed easing on any timeframe in response to incoming data that continued to point to a big pickup in growth in the second quarter, after the weak first quarter showing that increasingly looks to have marked the trough of the mid-cycle slowdown.   Stocks moving to record highs certainly didn’t help either.  

First-quarter growth was revised down a bit more than expected to +0.6%, but, as expected, all of the revision was attributable to an even larger downward adjustment in inventories into outright liquidation.   Final sales were left unchanged and final domestic demand were actually revised upward a half point.   After the sharp inventory drawdowns in Q4 and Q1 that subtracted an average of 1.1 percentage points from growth over the two quarters, a return to modest inventory rebuilding in Q2 looks set to add substantially to growth.   The accompanying pickup in industrial activity as the inventory cycle has turned has been clear in the sharp rebound in the ISM in April and a further small advance in May, to the best level in over a year.   The more positive Q2 inventory implications of the Q1 revision, combined with the better-than-expected April construction spending report (which pointed both to a smaller drop in residential investment in Q2 than we were expecting and an even bigger surge in business investment in structures), led us to raise our Q2 GDP forecast to +3.4% from +3.1%.   In addition to the strong ISM showing, this ongoing improvement in activity in Q2 received further support from a solid May employment report, which showed good gains in payrolls, hours, and aggregate earnings, rebounding smartly from the weak, weather-depressed April report.

Benchmark Treasury yields rose another 5 to 13 bp over the past week, a fourth straight losing week that has accumulated to a 26 to 37 bp backup in yields to their highs since last summer other than the 2-year, which is not quite through the January highs yet.   Continuing the trend seen throughout this sell-off, the 5-year led the way down, though in contrast to the prior three weeks, there was decent flattening of the curve on the week.

A substantial month-end index duration extension in May gave the long end some relative support.   The old 2-year yield rose 12 bp to 4.98%, the 3-year and old 5-year 13 bp each to 4.93% and 4.92%, the 10-year 10 bp to 4.96%, and the 30-year 5 bp to 5.06%.   There was minimal interest from final investors at the 2-year or 5-year auctions, and this ended up being a wise choice, as both new issues ended well in the red.   The new 2-year closed the week at 4.971% after being auctioned Tuesday at 4.886% and the new 5-year closed at 4.919% after being auctioned Wednesday at 4.818%.   TIPS performance was again very poor, as all of this ongoing market sell-off remained in real rates. The 5-year TIPS yield rose 13 bp on the week to 2.59% and the 10-year 8 bp to 2.57%, resulting in minimal changes in inflation breakevens relative to the respective nominal benchmark issues.

The market’s move over the past month toward pricing out Fed easing in response to accelerating Q2 growth saw a major further move in the past week — to the extent that almost all Fed easing has now been removed from futures prices.   The minutes from the May FOMC meeting contained nothing new or surprising, but they certainly did again reinforce that the Fed is firmly on hold — which the market finally actually believes.   In the shorter term, the fed funds futures market now sees almost no chance of a rate cut before year-end.   Three months ago at least two cuts were priced in.   The October fed funds contract lost 3 bp on the week to 5.24%, the November contract 5 bp to 5.23% and the December contract 7 bp to 5.215%.   Eurodollar futures losses were led by an average 19.5 bp plunge by the reds (June 08 to Mar 09).   The low rate Sep 08, Dec 08, and Mar 09 contracts all closed at 5.225%, pricing in a measly 13.5 bp in total Fed easing on any horizon relative to the 5.36% rate on the front month June 06 contract.   So unless the market’s willing to actually start pricing in Fed rate hikes, which seems quite unlikely at this point, the Fed repricing underpinning of the Treasury market’s recent collapse is probably nearing its end, and further weakness would more likely need to come from increases in rock-bottom term premiums.

Real GDP growth in the first quarter was revised down a bit more than expected to +0.6% from +1.3%, but importantly almost all of the surprise came from an even bigger downward adjustment to inventories than anticipated, pointing to stronger growth in Q2.   Inventory accumulation was revised down to -$4.5 billion (a 1.0 percentage point subtraction from growth) from +$14.8 billion (-0.3pp).   Final sales growth (GDP excluding inventories) was left unchanged at +1.6%, as a wider trade gap was offset by stronger domestic demand.   Indeed, final domestic demand growth was revised up to +2.5% from +2.0%, the best gain in a year.   The bigger-than-expected inventory correction in Q1 (coming after an even bigger inventory drag in Q4) sets the stage for a significant production recovery in Q2.   We look for a return to modest inventory rebuilding to add a bit less than a percentage point to second-quarter growth.

The construction spending report for April also pointed to somewhat stronger final domestic demand in the quarter, with a smaller than expected drag from a residential sector and a sharper acceleration in business capital spending. Overall construction spending rose 0.1% in April, marking a third straight gain.   Within residential activity, the key components that feed into GDP – new single and multi-family homebuilding – fell just 0.3% after being unchanged in March, pointing to a smaller drop in residential investment in Q2 than we had previously estimated.

We now look for a 12% decline.   Meanwhile, nonresidential spending is on fire, surging another 1.5% in April for a 30% annualized surge over the past three months.   After some softness over the prior couple quarters, business investment in structures appears to be roaring back in Q2.   We look for a 15% advance in this component of business investment in the second quarter.   Combined with the major recent improvement in capital goods orders and shipments that point to a significant pickup in equipment investment as well, we see overall business investment in Q2 on track for a gain near +10% after zero net growth over Q4 and Q1.   This pickup in business capital spending, smaller drag from housing, and big boost from inventory rebuilding should more than offset a significant slowdown in consumer spending — we look for consumption to slow to +2.0% in Q2 from the 4%+ gains seen in Q4 and Q1 — to drive a significant pickup in growth.   Incorporating the positive impacts of the Q1 inventory swing and the upside in construction, we upped our Q2 GDP forecast to +3.4% from +3.1%.

Confirmation for this ongoing improvement in activity in the second quarter was provided by strong results from the key early May data releases, employment and ISM. Nonfarm payrolls rose 157,000 in May, with improved weather helping the solid rebound from the weak April report.

Job gains were led by healthcare, leisure, government, and business services, while a surprising flat reading for construction, with the residential components only down marginally, also helped.   Manufacturing and retail were weak areas.   Other details of the report were also positive.   The unemployment rate held steady at a near cycle low 4.5%.

The average work week ticked up to 33.9 hours, leading to a sizable 0.5% rise in aggregate hours worked.   This gain in hours, along with a 0.3% rise in average hourly earnings, combined for a 0.8% surge in aggregate weekly payrolls, a proxy for wage and salary income.   Even after what’s likely to be a sharp rise in the PCE price index in May, this should lead to a healthy gain in real wage and salary income for the month.

Meanwhile, the headline ISM composite diffusion index posted a small further gain in May to 55.0 on top of the sharp rise in April, reaching the highest level in over a year as factory sector activity has rebounded after the sharp inventory correction seen in Q4 and Q1.   Upside in the key orders (59.6 v. 58.5) and production (58.3 v. 57.3) gauges offset a dip in employment (51.9 v. 53.1).   Upside in exports seems to be providing key support to orders, with the export orders index jumping to a three-year high.   The end of the auto sector recession — with the big rise in assemblies in April, the motor vehicle sector is on track to make a material positive contribution to Q2 growth — also is likely playing an important role in the recent improvement in factory sector conditions.

The economic calendar is fairly quiet in the coming week. Main data focus will be on chain store sales results Thursday and the trade report Friday. There have been early indications from some companies that May chain store sales might have seen a sizable rebound after a dismal April, with help from more normal weather after unusually cold temperatures stymied early spring clothing sales.   We’re certainly wary that these positive early anecdotal reports may not apply industry-wide in the face of the series of record highs for gasoline prices set through the month.

May motor vehicle sales released Friday were disappointing, and there was a significant mix shift toward cars and away from trucks, so the spike in gasoline prices seems to have been felt in that sector of retail sales at least.   The trade report, given that it is for the first month of the quarter, could have a significant impact on Q2 GDP estimates.   We currently have net exports making a marginal positive contribution to second-quarter growth.   Prior to the late week data, investors will be most closely watching a speech by Fed Chairman Bernanke on “Housing and the Economy” on Tuesday morning as part of the annual International Monetary Conference.   This gathering of central bankers from around the world has in the past been a significant market mover, though with the appearance of so little doubt at this point about the medium-term policy paths major central banks are likely to follow, there is probably a lot less room for any surprises this year than in previous years.   Other data releases due out include factory orders Monday and revised productivity.


* An energy price-related jump in the nondurable goods component should reinforce the previously reported gain in the durables category, leading to a further 1.0% climb in overall factory orders in April.   Meanwhile, inventories are expected to be up 0.4%, with the I/S ratio slipping to 1.24.

* We expect Q1 productivity to be revised down to +1.1% and unit labor costs up to +1.8%.   The GDP data showed a modest downward adjustment to the relevant measure of output, while the labor market figures pointed to slightly lower hours worked than originally assumed.   This should net out to a 0.6 percentage point downward adjustment to productivity growth in Q1 (relative to the originally reported reading of +1.7%).   On a year/year basis, we now see productivity running at +1.0% through Q1.

Meanwhile, compensation is likely to be revised sharply higher in Q4 and a bit higher in Q1.   This change, together with the expected productivity adjustments, implies a significant upward revision to unit labor costs over the past couple of quarters.   Indeed, the year/year rate appears likely to be pushed up by a full percentage point (to +2.3%). And it’s worth noting that this calculation is distorted by a timing shift in the accounting for stock option exercise and bonus payments, which actually points to a much higher year/year growth rate in Q2.

* We look for the trade deficit to narrow $0.8 billion in April to $63.1 billion, with exports up 1.6% and imports gaining 0.7%.   On the export side, almost all of the gain should be accounted for by a sharp rise in capital goods.   Industry data point to a significant gain in aircraft exports, and factory shipments figures indicate a solid rise in other capital goods, led by semiconductors.   A correction in gold after last month’s odd spike should be the largest negative offset.   On the import side, Energy Department data point to good gains in petroleum products, with upside in both volumes and prices, which should extend the sharp rebound in this category seen in March.   A pickup in inbound cargo through the key West Coast ports points to some underlying strength in consumer goods imports, but we expect this to be offset by a correction in the volatile drugs category after a huge gain posted last month.


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Infrastructure: Making a New Beginning
June 04, 2007

By Chetan Ahya, Tanvee Gupta & Deyi Tan | Mumbai

High level of infrastructure deficiencies

Indonesia’s infrastructure investments have fallen sharply, to around 2.5% of GDP in 2006 from more than 6% of GDP in the pre-crisis (1997-98) period.  Indonesia’s infrastructure spending is one of the lowest in the region.  According to the 2006 World Economic Forum survey of 125 countries, Indonesia was ranked 89th on basic infrastructure provision, compared with 60th for China and 38th for Thailand.  In 2005, Indonesia’s infrastructure spending was 2.1% of GDP, compared with 9.0% in China, 3.6% in India and about 10% in Vietnam.  Rising infrastructure deficiencies are deterring business entities and adversely affecting the quality of urban life.  According to the World Bank, around 40% of Indonesian households are not connected to an electricity network, about 80% of households are not connected to piped water supply, and 45% of the population does not have access to sanitation.

What explains low spending so far?

Fiscal constraints in the last few years have resulted in low budget allocations for infrastructure.  Since the 1997 crisis, the government has been very conscious of managing public finances in a prudent manner.  In fact, the government had kept capital spending in check to reduce public debt as a proportion of GDP.  The share of development expenditure has declined to 29% in 2006 from 50% in the mid-1990s.  The public debt-to-GDP ratio had fallen to 33% as of end-2006 from 57.5% in March 2003.  While public spending has been low, attracting private sector participation has also been limited during this period, as it entails the difficult task of bringing about major changes in the government’s policies, the institutional and regulatory framework, and the public sector’s managerial skill sets.  According to World Bank estimates, the private sector currently contributes 20-25% of total infrastructure investments in Indonesia.

Government is adopting a new approach

Major macroeconomic adjustments are behind us.  The macro environment is improving, and the overall GDP growth trend is accelerating.  Apart from this favorable macro background, Indonesia is specifically addressing the infrastructure sector problems by attempting to move away from a structure where decisions on policies and investments were made by a select few individuals on behalf of the government in an ad hoc manner.  This structure allowed greater opportunities for rent-seeking activities and ignored the principle of fiscal sustainability while promising government support to attract private sector participation.  The new approach aims to facilitate the transition to a structure where decisions are taken by institutions in a relatively transparent and credible manner.  Indonesia has, over the last five years, initiated a number of measures to improve the overall institutional framework of governance and reduce rent-seeking and corruption within the public sector.

More specifically, the government has taken significant measures during 2005 and 2006 to improve the environment for private sector participation in infrastructure.  Key measures to improve the Public-Private Partnership (PPP) investment environment include: (a) revamping the regulatory framework by unbundling the functions of policy maker, regulator, contractor (awarding contracts), and operator; (b) providing explicit subsidy compensation to state-owned enterprises (SOEs) in the case of the electricity sector; (c) reforming the land acquisition law; and (d) setting up a risk management committee that focuses on sustainability issues arising out of government support to PPP-based infrastructure projects.

Inflexion point has already occurred

We believe that the inflexion point in infrastructure investment trends has already occurred.  The government’s balance sheet has been restructured, with public debt to GDP falling below 40% in 2006 from 100% in 1999.  In addition, the government is making an effort to gradually change the mix of public expenditure in favor of development spending.  We believe that this itself is beginning to provide some acceleration in infrastructure spending.  In 2006, infrastructure spending grew 49% YoY, we estimate.  Moreover, private sector participation is likely to increase modestly, particularly in the roads sector, in response to continued efforts to reform the PPP-related institutional framework.  In the telecom sector, private sector participation has already grown significantly.

Infrastructure spending to rise to US$23.5 billion by 2010

We expect the government to continue its efforts to implement reforms in the infrastructure sector with the same vigor as witnessed in the last two years.  Indonesia’s infrastructure investments could increase to US$23.5 billion (4% of GDP in 2010) from US$9.1 billion (2.5% of GDP) in 2006.  The key sectors where we expect infrastructure spending to rise are roads (absolute increase of US$5.6 billion by 2010 over 2006), electricity (US$4.5 billion), and telecom (US$3.1 billion).

Which sectors will benefit?

In addition to the broad macro gains in terms of improvement in overall efficiency, we expect the following sectors to benefit from the likely pick-up in infrastructure investments: (a) toll road operating companies, (b) construction and engineering companies, and (c) mining companies.  Within mining, we expect coal-mining companies to benefit from a pick-up in demand.  In line with the long-term targeted primary energy mix, a number of new electricity plans are likely to use coal as fuel.  For instance, the government recently unveiled its plan to develop 10,000 MW coal-fired power plant projects by 2010, which would result in a doubling of domestic coal consumption, to 80-100 million tons per annum.  Even if the government manages to achieve 50% of its target, this would result in a significant increase in domestic coal consumption, we believe.

For a detailed analysis of Indonesia’s infrastructure sector, please see Building a Foundation for Reviving Infrastructure, June 4.


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Novice, Naive or Super-Speculative
June 04, 2007

By Qing Wang | Hong Kong

Summary and conclusions

The same liquidity story that kept the insolvent banks afloat for so many years is being used by some mainland investors as an argument for the sustainability of the current stock market bubble. We think that the effectiveness of the policy measures taken by the authorities to cool the market depends on which type of mainland investor is dominant — broadly speaking, the novice, ‘naive’ or super-speculative investor. The novice is unaware of the risks; the naive investor underestimates the risks; and the super-speculative investor plays with the risks. The Chinese authorities appear to be taking a trial-and-error approach, which we expect to feature three elements: education (for the novice), communication (for the naive), and ‘no salvation’ (for the super-speculative). Last week, the Ministry of Finance raised the stamp duty on stock transactions. We view this as yet another communication effort from the authorities to signal their discomfort with the frothy stock market.

If the stock market continues to rise as rapidly as it has done in the past few months, we’d expect the authorities to escalate their efforts to cool off the ‘irrational exuberance’. However, we see considerable risk that the market may eventually evolve into a game of ‘chicken’ between some super-speculative investors and the government.

If the higher stamp duty fails to have a meaningful impact, we would expect further and stronger policy measures. We maintain our view that the risk to China’s economy is manageable if the A-share market bubble bursts at current levels. Going forward, if the authorities fail to rein in stock prices, we think the associated risks will rise substantially.

Deposits in insolvent banks versus investment in bubbly stock market

Those who argue for the sustainability of the current bubbly stock market in China often draw an analogy to China’s recent past. Until a few years back, and before they were restructured and recapitalized, the largest state-owned commercial banks — saddled with a huge amount of non-performing loans — were technically insolvent. However, Chinese households still put the bulk of their financial assets in these banks in the form of deposits. One key reason is that these banks, though insolvent, were still liquid. In the same vein, the bulls argue that, despite its stretched valuation, the fast rise of the A-share market is sustainable because there are plenty of new funds flowing into the stock market. If abundant liquidity could keep insolvent banks afloat for so many years, why can it not keep the bubbly stock market rising?

This argument fails to take into consideration one key difference between depositing one’s money in insolvent banks and investing it in a stock market — that is, that the principal of bank deposits are guaranteed, explicitly or implicitly, by the government, while that for stock investment is not. In today’s Chinese stock market, mainland investors collectively appear to have chosen to ignore this important difference. Indeed, if you don’t draw this distinction, the same liquidity story that used to keep the banks afloat might indeed be able to sustain the stock market. However, this begs the question whether the investors are novice, naive, or super-speculative?

Three broad types of investor

Chinese retail investors have been opening on average nearly 0.3 million investment accounts per day in recent months, and the total number of accounts has reportedly reached over 100 million. Some are buying stocks simply because they are numerically cheaper (i.e., Rmb2 per share is considered a lot cheaper than Rmb5 per share) without looking at their basic financial indicators (e.g., the P/E). Given these anecdotes, one is tempted to conclude that these investors are simply new to investing in the stock market, and have little idea of the associated downside risks.

While some mainland investors see the downside risks of investing in a bubbly stock market, they may subscribe to the notion that the government will provide some form of implicit guarantee and bail them out if the bubble were to burst. From the perspective of such ‘naive’ investors, while there are downside risks, they are small as they believe that the government would provide similar protection as to their bank deposits.

Some investors are perhaps super-speculative and reckon that: a) Beijing would take strong policy measures that risk pricking the bubble. They argue that the government has a relatively low tolerance of systematic financial risk and the attendant impact on the real economy stemming from a burst of the stock market bubble; and b) more importantly, the government has more-than-adequate financial capacity to repair any damage wrought by a bubble burst. On the latter point, China’s holding of the largest amount of FX reserves in the world give it a considerable cushion against negative shocks, domestic or external. The super-speculative investors are essentially betting that, as the stock market bubble grows bigger and the potential systematic risk becomes more serious, the government will become increasingly eager to prevent a market crash. They too argue that the government would bail out investors, especially given its financial capacity.

Three-pronged strategy: Education, communication and ‘no salvation’

The effectiveness of the policy measures taken by the authorities to cool the stock market depends on the type of investor dominating the market, in our view. Novice mainland investors need to be educated. If ‘naive’ investors dominate the market, the government’s job is also relatively straightforward: to convey an unambiguous message to the tens of millions of investors that neither the principal nor the return on their stock investment is guaranteed. If, however, the super-speculative investors run the show, the task of cooling the stock market is more difficult. We think it could turn into a game of ‘chicken’. To guard against moral hazard, the government would likely have no choice but to refuse to provide salvation in the event of a burst bubble.

A trial-and-error approach?

It is difficult to make a distinction between the three types of investor, as they tend to demonstrate similar behavior patterns in practice. And some investors may be initially ignorant, become increasingly naive over time, and eventually transform themselves into super-speculative investors. The government appears to be taking a trial-and-error approach.  The strongly worded official circular issued by China Securities Regulator Commission (CSRC) on May 11, 2007, which urges for “strengthening education of investors about the risks related to investing the stock market” is clearly an effort targeted at the novice investor. We view the recent policy moves by PBoC (i.e., asymmetric rate hikes) and MoF (i.e., raising the stamp duty on stock transactions) as part of the authorities’ communication effort to signal their discomfort with current market levels.

If these policy signals fail to dampen the ‘irrational exuberance’, we think the government would likely strengthen its communication strategy, with a view to conveying a more explicit and forceful message warning investors against counting on a bailout if the bubble bursts. This could be done via additional asymmetric rate hikes and a stamp duty increase.

If, however, all these attempts fail to produce a material impact on the market, the government may be forced to take more resolute actions (e.g., the introduction of a capital gain taxes) to effect a major market correction, thereby hoping to stop super-speculative investors in their tracks.

Bottom line

If the stock market continues to rise as rapidly as we have seen in the past few months, we should expect the authorities to escalate their efforts to cool off the stock market. There is a considerable risk that the stock market may eventually evolve into a game of chicken between some super-speculative investors and the government. We maintain our view that the risks to China’s economy are manageable if the A-share market bubble bursts at current levels (see China Economics: What Is the Risk to China’s Economy If the A-share Market Bubble Bursts? May 28). Going forward, if the measures fail to rein in the surge of stock market prices, we think that the associated risks would rise substantially.


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Middle East/North Africa
Deriving Liquidity
June 04, 2007

By Serhan Cevik | London

The explosive growth in derivatives may be a saviour or the biggest bubble in history. The continuing strength of the global economy reflects structural changes as well as financial innovation and accommodative monetary conditions. Indeed, while real interest rates have risen in recent months, global liquidity remains abundant enough to keep credit spreads low and risk appetite high. But what is behind this ‘wall of liquidity’ building a new risk culture all around the world? The original source may have been the behaviour of central banks in the post-2001 period, but monetary easing can no longer explain the evolution of risk aversion. What we have witnessed is the effect of secular gains on the inflation front and a self-reinforcing cycle of liquidity-driven capital flows. And we think that the recycling of current account surpluses may hold the key to the puzzle. Take, for example, the rise of petrodollar liquidity and ‘excess’ savings in Asia. The cumulative current account surplus of oil exporters and emerging Asian economies surged from 0.6% of global GDP in 2002 to 1.7% last year, leading to an unprecedented accumulation of foreign assets (see Pumping Money, May 22, 2007). No wonder, with such an unusual liquidity cushion, investors have started chasing returns in ‘exotic’ markets and through highly leveraged positions. One of the most revealing indicators of the new risk culture is the explosive growth in derivatives that may well turn out to be a saviour or the biggest bubble in history.

The global derivatives market grew by 25,935% since 1987 to US$415 trillion last year. Globalization is not just about outsourcing production operations to countries with lower labor costs, but also involves greater financial openness. In the last two decades, the world economy has indeed experienced a wave of financial integration, leading to lower home bias and the emergence of innovative instruments. For example, according to the Bank for International Settlements, the outstanding notional amount of exchange-traded and over-the-counter derivatives contracts increased from US$1.6 trillion in 1987 to US$5.7 trillion in 1990 and then surged to US$71.9 trillion by the end of the decade. That may look like an astonishing growth, but it is nothing compared to what has happened in the years of abundant liquidity. The latest survey shows that the global derivatives market grew at an annual rate of 68.5% to US$297.7 trillion in 2005 and US$415.2 trillion at the end of last year. In other words, the global pool of structured financial products ballooned from 8.7% of global GDP in 1987 to 246.1% in 2000 and then to 789.2% last year.

Greater risk-taking, not just hedging, through derivatives has become a source of market liquidity. In 2006 alone, the outstanding volume of derivatives contracts increased by US$117.5 trillion — more ten times the size of the US economy. Under normal circumstances, financial innovations lead to efficiency improvements and risk diversification, which of course make financial markets more resilient against abrupt fluctuations in asset prices. However, although the net level of risk exposure is much less than what gross figures suggest, derivatives have evolved into an instrument of greater risk-taking, not just hedging, as investors chase ‘excess’ returns in a world of low real interest rates. And when hedging instruments become a platform for leveraged speculation, there is no longer the embedded ‘insurance’ feature and potential losses (as much as gains) could be amplified throughout asset markets around the world (see The Curse of Alpha, November 16, 2006). Therefore, while appreciating the value and advantages of financial innovation, we are also concerned about the explosive growth in complex derivatives that could suddenly turn from being an instrument of risk disaggregation to the biggest risk bubble in history.

Carry trades are vulnerable to the risk of chain reaction in financial markets. Even though emerging countries (as a group) are now net exporters of capital, the inflows of private capital in search of higher returns have remained unabated. Unfortunately, despite stronger economic fundamentals and structural progress, the overwhelming size of capital flows may still lead to exchange rate misalignments and asset price bubbles in emerging markets (see Carried Away, September 27, 2006). And that makes all the financial systems vulnerable to changes in global risk appetite and thus to the sudden unwinding of leveraged positions.


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