As the global recession deepens, the Chinese authorities have recently announced that plans to ‘reinvigorate’ key industrial sectors including steel, autos, shipbuilding, petrochemicals, textiles, non-ferrous metals, equipment manufacturing, IT, light industries, transportation and logistics would be implemented. The primary purpose of these plans is to protect ‘advanced productive capacity’ in general and the market share of leading enterprises and brand names in particular. To this end, the Chinese government has vowed to adopt “a combination of well-coordinated measures, including intensifying the technological transformation of enterprises, promoting mergers and reorganizations, shutting down backward production facilities, developing major products, innovating major technologies, and apportioning key development projects” (cited from NDRC’s work report to NPC, March 5, 2009). Boosting Demand versus Reducing Supply In our view, the importance of these ‘reinvigoration plans’ appears not to have been fully appreciated by market observers. Perhaps in part being misled by the word ‘reinvigoration’, many market observers have typically associated these plans with the overall economic stimulus plan that aims to boost domestic demand with the objective of offsetting weakness in external demand and absorbing excess production capacity. We, however, interpret these ‘reinvigoration plans’ differently and believe that they are actually supply-side policy adjustments, the primary purpose of which is to effect a government-guided, orderly production capacity retrenchment. Here’s why: First, the reinvigoration plans apply to almost all key sub-sectors of the manufacturing industry, ranging from upstream to downstream and heavy to light industries. To ‘reinvigorate’ such a wide range of industrial sectors by boosting demand is equivalent to boosting aggregate demand, in our view. However, the Chinese government has already had a separate domestic demand-boosting spending package in place featuring massive investment in infrastructure, affordable housing and so on. So, it is highly unlikely that the primary purpose of the reinvigoration plans is to support the relevant industries from the demand side, in our view. Second, from the perspective of macroeconomic management, expansionary macroeconomic policies to boost demand are appropriate if the economic downturn is deemed cyclical and thus temporary. If, however, the negative demand shock is large and permanent, demand-boosting measures will only serve to perpetuate the inevitable production capacity retrenchment instead of helping to ‘iron out’ the short-term fluctuations, the conventional objective of discretionary macroeconomic management. It has become increasingly clear that the negative shocks to the Chinese economy stemming from the current global recession are much more serious and lasting than those experienced during either the Asian Financial Crisis in 1997-98 or the global economic downturn in the aftermath of the internet bubble bursting in 2001-02. We believe that the Chinese authorities have by now appreciated the seriousness of the current crisis. In this context, the ‘reinvigoration plans’ are part of the authorities’ systematic effort to downsize the existing production capacity, as a complement to the demand-boosting measures, one purpose of which is to help buy time for this supply-side adjustment. Third, we believe that the authorities’ recent adjustment of the spending composition under the original Rmb4 trillion stimulus plan signals a shift in the balance between demand-boosting and supply-reducing measures toward the latter. Compared with the original plan, the revised plan substantially reduces the spending on ‘hard’ infrastructure projects (e.g., railways, highways, airports, ports), which helps to absorb the excess production capacity of heavy industries and boosts the potential supply in the long run, and correspondingly increase its spending on ‘soft’ infrastructure such as medical, healthcare, cultural and education. Of particular note, the spending related to ‘innovative structural change projects’ has increased sharply, a substantial portion of which is earmarked for potential expenses related to sectoral consolidation amid the supply-side adjustment, in our view. Implications These plans – when implemented – are expected to create both winners and losers within the same industries and thus likely have profound market implications. Chinese policymakers – like their Japanese and Korean counterparts – have traditionally given much credence to industrial policies whereby the bureaucrats play an important role in determining resource allocation and strategic development for various industries. The policymakers tend to rely on the ‘visible hands’ to accelerate supply-side adjustment which, in their view, may turn out to be a lengthy and ‘disorderly’ process if the job is left with the ‘invisible hands’ to handle. In fact, industrial policies have always been an important part of Chinese macroeconomic management, and their purpose is to facilitate a supply-side adjustment, as a complement to conventional monetary and fiscal policy, which works from the demand side. The rationale behind this interventionist approach adopted by Chinese policymakers is that since China is still a developing country that is trying to catch up with the more advanced ones as fast as possible, the government should aggressively implement the policies that have been proven to be a success in other countries (e.g., Japan, Korea, Singapore) instead of adopting a laissez faire approach to allow the market mechanism to work on its own, which tends to be slow. In practice, the effectiveness of industrial polices in facilitating supply-side adjustment is mixed. During booming years, when most industries are profitable, it becomes very difficult for the authorities to enforce the industrial policies. During downturns, when the profitability and survival of large SOEs are under threat, policymakers tend to be more determined and aggressive in carrying out these policies by forcing consolidation of the industry in general and closure of ‘smaller and inefficient producers’ in particular. If history is a guide, large, state-controlled companies that have close relationships with and strong influence over policymakers tend to be the winners and will likely emerge stronger out of the supply-side adjustment. Reflecting the official intervention in the context of implementing industrial policies, the supply-side adjustment tends to take the form of exiting the industry by a number of small-scale, non-state-owned enterprises such that the overall industrial profit margins are protected. The average annual growth rate of overall industrial profits during 2001-02 declined by about 40 percentage points from the peak level reached in 2000. The decline appears to have been mainly due to a slowdown in volume growth, while the profit margin squeeze was rather moderate. What’s Next Details of these sectoral ‘reinvigoration plans’ are expected to be released in the coming months. When announcing these ‘reinvigoration’ plans initially, the authorities already provided the general principles and broad elements of these plans. The plan for each sector typically consists of three broad categories of measures: i) boosting demand; ii) consolidating existing production capacity; and iii) upgrading production technology. We believe that production capacity retrenchment is the primary objective that will lead to concrete policy action. Mergers and acquisitions in the context of industrial consolidation will likely pick up significantly in the near term. While this supply-side adjustment will likely depress investment in the short run, it should help to solidify the dominance of industry leaders in the longer run by protecting their profit margins and market shares.
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Show Me the Money
March 13, 2009
By Joachim Fels & Manoj Pradhan | London
In a nutshell: With G10 official interest rates approaching zero and several major central banks engaged in various forms of quantitative easing (QE), we think that money supply is a key indicator to watch in order to gauge whether monetary policy action will find traction. A closer look at the data suggests that conventional and unconventional monetary easing has in fact started to lift money supply growth in major economies, which we see as an important intermediate step towards economic stabilisation later this year and recovery in 2010. True, velocity – the speed at which money changes hands, defined as the ratio of nominal spending to money supply – has declined, but this is normal in the early stages of monetary expansion simply because monetary policy affects the real economy with a lag. Moreover, we show that velocity has often continued to decline even during past economic recoveries. Thus, we disagree with the popular notion that monetary policy cannot find traction as long as velocity keeps falling. Pushing hard on rates… While there is a legitimate debate over whether central banks are pushing on a string, there is no doubt that they are pushing very hard. Within the G10, official interest rates are virtually zero in the US (0-0.25%) and Japan (0.1%) and just 0.5% in the UK, Canada and Switzerland. In the euro area, the refi rate still stands at 1.5% after last week’s cut, but the effective overnight interest rate (EONIA) between banks trades close to the 0.5% floor set by the ECB’s deposit rate. Thus, the GDP-weighted G10 policy rate now has a zero handle. The weighted G10 policy rate is likely to drop further as we expect more rate cuts in the euro area, Japan, Australia, New Zealand, Sweden, Norway and Switzerland in the next few days, weeks or months. …and QE: Moreover, as we discussed in more detail in “QE2”, The Global Monetary Analyst (March 4, 2009), several major central banks including the Fed, the ECB, the Bank of Japan and the Bank of England are engaged in various forms of quantitative easing, which has led to an explosion of excess reserves held by banks with these central banks. The explosion of bank reserves has pumped up the monetary base – consisting of cash in circulation plus bank reserves held at the central bank – in these four countries, as we have illustrated. In the US, the monetary base has more than doubled over the past year, while it is up by 40% in the euro area and 30% in the UK over the same period. The monetary base is also called ‘high-powered’ money, because our fractional reserve banking system allows banks to create many times the dollar amount of deposits from the monetary base through lending to, or acquiring assets from, non-banks. Watching the Ms: Initially, rather than creating new deposits through lending and asset purchases, banks, on aggregate, have chosen to ‘sit’ on much of this cash and hoard reserves at the central bank. Hence, the monetary base has grown more rapidly than money supply measures such as M1, M2, M3 and M4, which include cash in circulation and various forms of deposits that non-banks such as private households or companies hold with banks, but not the excess reserves that are part of the monetary base. By definition, this implies that the so-called money multiplier – the ratio of the monetary base to the broader monetary aggregates – has fallen. More recently, however, money supply growth has started to accelerate in several major economies, including the US and the euro area. In the US, the 12-month growth rate of M1 has picked up from close to zero last summer to 13% recently, and M2 growth has doubled to some 10%. In the UK, M4 growth is running at an 18% clip, though this is mainly due to the growth in deposits held by non-bank financial firms. And in the euro area, where broad M3 growth is still accelerating, M1 growth has picked up from nil to 6% recently. Over the next few months, we would expect a further acceleration in money supply growth in industrialised countries as banks are using more of their excess reserves to buy safe government bonds (paying governments with deposits, which these use to finance higher public spending), and as the Fed and the Bank of England will buy more assets in the open market. Note that the latter activities will directly increase deposits and thus money supply only if the sellers of the assets are non-banks. If the sellers are banks, it is banks’ reserves held with the central bank and thus the monetary base that will increase in the first round. Banks may then either hoard these reserves, or they may start to buy other assets from, or make loans to, non-banks, which would then increase the other monetary aggregates. Focus on M rather than C: As we have argued before, we view this pick-up in the Ms as an important intermediate step towards a bottoming of the global economy later this year and a recovery in 2010. Thus, we will monitor money supply developments closely over the next several months and report regularly on them in this publication. Note that we are less concerned about the deceleration in credit aggregates (loans to the private sector) because we view credit growth as lagging rather than leading the cycle. We explored this in more detail in a recent note (“Credit Confusion”, The Global Monetary Analyst, February 4, 2009), where we showed that money supply tends to lead the real economy, while loan growth tends to lag, especially in upswings. Velocity is falling, but so what? A common response to our argument that rising money supply growth is good news is that velocity is falling and thus a rising money supply has no impact on the real economy. This is another way of saying that monetary policy is pushing on a string. Let’s take a closer look at this argument. To this end, recall that the velocity of money is defined as the ratio of nominal spending – usually proxied by nominal GDP – to money supply. We illustrate the velocity of money supply, M1, along with the growth rates of its two components, M1 and nominal GDP, for the US, the euro area, Japan and the UK. A few points are worth noting: • First, at least in the last few recessions, velocity has also fallen, so there is nothing unusual about the drop in velocity in the current recession, except that it has been particularly pronounced. Velocity usually drops in a recession because monetary policy eases rapidly and M1 growth thus accelerates, while nominal GDP growth still declines. It is a well-known fact that real output and prices react to monetary actions with a lag. Thus, it shouldn’t come as a surprise that monetary stimulus in response to the onset of recession leads to a drop in velocity. • Second, the sharp increases in M1 growth during recessions were typically followed by a pick-up in nominal GDP growth, thus ending the recession. Again, money leads output and prices (combined into nominal GDP in our charts). But interestingly, velocity typically kept falling well into the economic recovery. In the US, velocity picked up in the later stages of the recovery. But in Japan, the euro area and the UK, velocity has kept trending down during the 1990s and 2000s. This of course reflects the fact that money supply growth has consistently exceeded nominal GDP growth. But in our context, the crucial point is that, contrary to what many people tell us, a further decline in velocity should NOT stand in the way of an economic recovery. Bottom line: Conventional and unconventional monetary easing has boosted the monetary base in major economies. This has started to translate into a pick-up in money supply growth, a fact we deem more relevant than the continuing decline in loan growth, which is usually lagging the cycle. Moreover, past experience, including the Japanese one, suggests that the recent decline in the velocity of money should not stand in the way of a bottoming of the global economy later this year and recovery in 2010.
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