One Country, Three Economies
May 29, 2009
By Qing Wang & Steven Zhang | Hong Kong
This is an excerpt from Strategy and Economics: One Country, Three Economies: Play the Regional Disparity in China by Qing Wang, Jerry Lou and Steven Zhang, May 27, 2009.
One Country, Three Economies
There is large economic disparity among the regions in China. At the broadest level, China consists of three economies: the eastern area, which accounts for 64% of the national economy and consists of 11 provinces (including Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong and Hainan); the central area, which accounts for 26% of national economy and consists of eight provinces (including Shanxi, Jilin, Heilongjiang, Anhui, Jiangxi, Henan, Hubei and Hunan); and the western area, which accounts for 19% of national GDP and consists of 12 provinces (Inner Mongolia, Guangxi, Chongqing, Sichuan, Guizhou, Yunnan, Tibet, Shaanxi, Gansu, Qinghai, Ningxia and Xinjiang).
The income level among the three areas is quite uneven. In 2008, while GDP per capita in the eastern area was US$4,790, central and western areas were US$2,820 (or about 60% of the eastern area level) and US$2,500 (or about 50% of the eastern area level), respectively. The large regional disparity in income level becomes even more pronounced when the comparison is made at a provincial level. For example, Shanghai has the highest level of GDP per capita of US$10,440, or more than eight times of that in Guizhou province.
In fact, the regional income disparity in China is larger than both that among the states in the US and the country disparity in the Euro-zone. Specifically, the coefficient of variation (COV) - as a normalized measure of dispersion of a distribution - of provincial GDP per capita in China is 0.64. This is much higher than the COV of state GDP in the US of 0.39, and even higher than the country GDP per capita in the Euro-zone of 0.49.
The regional income disparity reflects several fundamental structural factors. First, urbanization tends to be much higher in the eastern area than in the central and western areas. Provinces with the highest urbanization such as Guangdong, Liaoning, Zhejiang and Jiangsu are concentrated in the eastern area, while the provinces with lowest urbanization such as Yunan, Gansu, Tibet and Guizhou are in the western area. Second, openness to external trade tends to be much higher in the eastern area than in central and western areas. Measured by exports as a percentage of GDP, eastern provinces such as Guangdong, Jiangsu and Zhejiang are 15-25 times as exposed to foreign demand as central and western provinces such as Qinghai, Gansu, Inner Mongolia and Henan.
When the Chinese economy was stricken by the global financial turmoil and economic recession, the shock impact varied significantly on different regions, depending on each region's initial conditions such as its economic structure in general and exposure to foreign demand in particular. We compared the growth rates of industrial value-added between 1Q09 and 1Q08 and used the difference as a gauge of the underlying shock impact from the crisis. It turns out that two types of provinces - which have either large direct exposure to foreign demand (e.g., Shanghai, Zhejiang and Fujian) or are major producers of natural resource commodities (Shanxi, Ningxia and Qinghai) - were most severely affected. While the impact on the former reflected a sharp contraction of external demand, the impact on the latter had largely to do with the collapse of commodity prices. On the other hand, the impact on regions that are less exposed to external demand or commodity-producing industries (e.g., Hunan, Guizhou and Anhui) has been substantially milder.
Three Economies, One Policy Stance
The crisis's impact on different regional economies in China varies. Mitigating the impact of the most serious crisis since the Great Depression in 1929-33 has entailed an unprecedentedly strong policy response. Ideally, the larger the negative impact on a region, the stronger the policy response should be. In another words, the policy response to the eastern provinces should be in principle stronger and more aggressive than that applied to the western provinces.
However, an equally strong and aggressive policy stance appears to have been applied across the regions in practice, independent of the shock impact of the crisis. As part of the Rmb4 trillion stimulus package, each provincial government is allowed to issue local government bonds. The proceeds from the bond issuances are to be used as ‘seed money' to help raise more funds - primarily in the form of bank loans - to finance investment projects undertaken under the stimulus plan. Therefore, the amount of local government bonds should be a good proxy for the strength of the local policy response, be it fiscal or monetary, to help the local economy, in our view.
In theory, there should be a positive correlation between the amount of local bond issuance and the magnitude of the negative impact each province suffers; however, such a relationship simply does not exist in practice. This pattern reflects the particular nature of the central-local government relationship in China, in our view. Compared to many other countries in the world, local governments in China traditionally have a much stronger interest in developing their local economies. In fact, academic literature considers this unique incentive structure as a key - albeit unorthodox - contributing factor to the success of China's economic reform. We think that the seemingly egalitarian approach in determining the size of policy support in coping with the crisis is a result of competition among provincial governments and intense bargaining between local and central governments, as every local government wants to seize this opportunity afforded by the global turmoil to give its own economy a boost through policy stimulus.
In this context, a one-size-fits-all policy approach becomes an inevitable outcome: while the strength of Chinese authorities' anti-crisis policy responses is determined with respect to the adverse situation in those regions that have been hardest hit by the ongoing crisis (e.g., Pearl River Delta and Yangtze River Delta), the regions will likely benefit from a policy response applied equally across them. In another words, despite de facto three economies there is only one policy stance, meaning that the policy boost is appropriately supportive for some regions but super-accommodative for others.
Diverging Regional Growth Trends
Different regions in China will likely demonstrate a pronounced divergence in growth trends during this global economic recession. The impact of global economic recession on different regions inside China is quite uneven, reflecting each region's initial conditions such as its economic structure in general and exposure to foreign demand in particular. At the same time, the policy responses will be largely non-discriminative across regions, with the stance being determined by the adverse situation of the regions hardest hit by the crisis. In this context, the policy support received by those regions that have been less affected by the global recession may more than offset the negative impact of external demand shocks such that their regional economy could do substantially better than China's macroeconomic situation would suggest.
We rank China's 30 provinces by their potential economic performance amid the current global recession by factoring in not only the initial negative impact of the external shocks on the local economies but also the policy support received by each region. Eastern provinces such as Fujian, Zhejiang, Shandong and Guangdong will likely be among the regions that would be most negatively affected by the current global recession, while Guizhou, Hainan, Jilin and Sichuan will likely be among the least affected regions, by our estimate.
Our ranking of economic performance by region seems broadly consistent with the recent passenger car sales, which is a useful proxy for households' purchasing power and consumer confidence, and cement consumption, which is a good proxy of local construction activity.
Looking ahead, with potentially diverging regional growth trends, the firms that have disproportionally large business exposures to a region will likely find their performance critically tied to the performance of the local, instead of national, economy. Identifying those firms that are well positioned to benefit from the regional economies expected to substantially outperform the national economy will likely become an important investment theme, especially when uncertainty surrounding the overall macroeconomic outlook diminishes.
Beyond the near term, the current global economic turmoil and the Chinese authorities' policy response should serve to help narrow the regional economic disparities that have widened in the past decade, and thus are a source of considerable tension in China's economic and social development; this bodes well for a more integrated nationwide market and balanced growth in the long run.
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Deleveraging the American Consumer
May 29, 2009
By Richard Berner & David Cho | New York
American consumers have begun what looks like a long process of deleveraging their balance sheets and rebuilding saving, aimed at restoring a more sustainable balance between household debt and consumers' ability to carry it. One measure of sustainability is the debt service ratio - household payments of interest and principal on debt in relation to disposable income. By that metric, courtesy in part of lower interest rates and our expectations for a recovery in income, consumers are already about one-quarter of the way through the process. Of course, consumers' ability to carry and service debt depends on current and expected income and wealth - both financial and tangible, largely in housing. Indeed, the unprecedented plunge in employment, and thus income and wealth, triggered the consumer retrenchment that emerged last summer. Hopes are now high for a recovery in income, further progress in trimming debt service, and thus for improvement in consumer spending.
What makes the current experience unique, however, is that those shocks to income and wealth occurred just when rising leverage made consumers most vulnerable. In fact, leverage ratios such as debt to assets or mortgage debt to owners' equity in real estate paint a much grimmer picture than does the debt-service ratio: Mortgage debt in relation to tangible assets jumped by 500bp in the year ended 2008, while such debt in relation to owners' equity soared by 2,760bp, both to record highs. By those measures, the deleveraging process likely will stretch out over several years. Either way, we think that the coming decrease in leverage and increase in saving will mark a sea change in consumer behavior, with critical implications for lenders and financial markets.
Calibrating consumer deleveraging. In this note, we attempt to quantify the deleveraging process. We use the household debt-service ratio as a key analytical metric for assessing deleveraging, because it captures the influence of changes in both debt and interest rates on debt service. It is important to note, however, that while lower interest rates are today making debt service more manageable, rising rates will eventually make it more challenging even as stronger income growth unfolds.
Our research strategy consists of two steps. First, we establish what might be a sustainable level of consumer debt service in relation to income; a rough estimate is 11-12%, which might be associated with debt in relation to income of 80-100%. Then we use base, bull and bear scenarios to estimate how long it might take to approach those ratios under different circumstances. To link household debt and debt service to our economic scenarios, we estimate equations to describe the growth in mortgage and non-mortgage consumer debt, taking account of the factors that drive originations, repayments, refinancing and defaults. We build on our earlier work on credit losses and deleveraging at lenders to try to achieve internal consistency between the economic scenarios and losses and to incorporate the feedback to growth in debt (see Credit Losses, Deleveraging and Risks to the Outlook, May 4, 2009).
Under any of the three scenarios, we think the 11-12% debt-service and 80-100% debt-to-income ratios might be attainable by 2011. That may sound extraordinarily rapid, but bear in mind that it will be anything but painless, as evidenced by key metrics in the deleveraging process, such as growth in debt, sustainable spending growth and the personal saving rate. Our baseline scenario is consistent with an 8% contraction in mortgage and consumer credit between 2009 and 2011, real annualized personal spending growth of 2-2.5%, and a personal saving rate of 5-5.5% by 2010 and 6% by end-2011. But we believe that over a longer time period, consumers will boost their saving rate to 7-10%, reflecting limited growth in household assets and correspondingly still-high leverage ratios.
Across the bull, base and bear scenarios, the debt and debt-service ratios appear to be quite close. However, through mid-2010, that reflects two opposing forces in numerator and denominator. For example, in the bear case, the level of debt service is falling faster than in the base or bull scenarios, reflecting reduced credit demand, bigger charge-offs and lower interest rates. However, disposable income in the bear case is also considerably lower, resulting in little discernable difference in the ratios until 2H10 and into 2011. Then, the differences in credit growth and, to a lesser extent, in interest rates begin to deviate from those in disposable income.
Dissecting the influence of rates and debt on debt service. Against that backdrop, it's instructive to separate the decline in debt service into its two constituent parts, namely interest rates and debt. In the current climate of historically low mortgage rates that have fostered a mortgage-refi boom, intuition suggests that declining rates greatly reduce debt service and let consumers who lock in those low rates off the hook, at least for several years. And there is no question that consumers who swap ARMs for fixed-rate loans will be immunized from the coming back-up in mortgage rates as the Fed slows its program of mortgage and Treasury purchases and the economy recovers.
However, our analysis suggests that most of the decline in the debt-service ratio in these scenarios is the result of declining debt rather than of refinancing it. Even with a ‘lock in' effect that shields many borrowers from rising rates, the impact of the decline in rates we foresee accounts for only about 34bp of the further 200bp decline in the debt-service ratio (DSR) we expect by 2011. That 34bp decline will give consumers a windfall of roughly US$40 billon annually in each of the next two-and-a-half years. (Alert readers will note that David Greenlaw estimates that if 30-year fixed-rate mortgage rates declined to 4.5% and stayed there, the savings would amount to about US$100 billion. Indeed, under those circumstances, our methodology implies a DSR decline of 80bp or savings of US$92 billion at an annual rate.). That's important for looking beyond 2011: In order to keep the debt-service ratio from rising significantly when interest rates rise to more normal levels, consumers will need to reduce debt further in relation to income from the upper end of the 80-100% range. Unless nominal income growth moves well past 6%, this is consistent with the longer-term increase in the personal saving rate to 7-10% that we expect.
Pushback on the sea change. Notwithstanding our logic and metrics, we appreciate that it's dangerous, especially in the depths of recession, to argue that consumer behavior is changing for good. Indeed, the assumption about saving behavior is a lightning rod for the differences between more optimistic forecasts of growth and ours; the optimists seem to believe that when the fog of uncertainty lifts and wealth rebounds, consumers will go back to their spending and borrowing ways.
Economic theory can shed some light on the issue. Many modern macro models blend a mix of ‘life-cycle' and ‘rule of thumb' consumers, with the proportions dictating the dynamics of saving behavior. ‘Life-cycle' consumers respond to changes in income and wealth in deciding on spending and saving, while ‘rule of thumb' consumers spend most of their current income. For the latter group, the dramatic decline in overall wealth over the past seven quarters has little bearing on spending, which instead will rise or fall in line with current income. It appears that optimists are assuming that a combination of rule-of-thumb behavior and a build-up of some pent-up demand for goods and services in recession means the saving rate won't rise much and that spending will grow in line with income.
But the swings in wealth have been unprecedented in the current downturn, and a broad-based and persistent decline in housing wealth is outside the experience of virtually all homeowners, let alone the sample period for most macro models. Many rule-of-thumb consumers, who likely are lower-income earners, are also homeowners; the Fed's Survey of Consumer Finances shows that 41.4% of respondents in the bottom-income quintile and 55.2% in the second-lowest quintile owned homes as of 2007, and they have counted on home equity as collateral for borrowing. Moreover, the decline in asset values has far outstripped any reduction in liabilities, leaving even ‘rule-of-thumb' consumers more leveraged although debt-income ratios peaked at the end of 2008.
As a result, we believe that three powerful forces are pushing consumers in a new direction: Housing wealth is unlikely to rebound quickly, reflecting the still-sizeable imbalances between supply and demand, made worse by rising foreclosures. Second, the legacy of the financial crisis likely has made many consumers and lenders more risk-averse, not just temporarily but in a more lasting way. And new financial regulation will further restrain the availability and increase the cost of credit.
Both voluntary and involuntary changes. Some of the behavioral change we see is voluntary and prudent, reflecting wealth losses and recession-induced uncertainty. Unprecedented wealth losses and prospects for slow revival are prompting ‘life-cycle' consumers to save more, and uncertainty around the outlook for income has made all consumers more cautious. In contrast, some of the change is involuntary and immediate, as defaults, the credit crunch and income losses squeeze consumers. The recession and the credit crunch have promoted defaults, less access to credit, and a squeeze on income for ‘rule of thumb' and liquidity-constrained consumers.
These changes are likely to depress the growth of credit even as some credit-sensitive parts of the economy, notably housing demand, are now stabilizing and begin to recover later this year. To be sure, the influence of the credit crunch on homebuying and consumer spending that reduced the growth in household debt is beginning to ebb. But if consumers are boosting saving to pay off existing debt, and lender write-downs and charge-offs are slowly bringing down the outstanding amounts, then declines in consumer debt outstanding are likely to continue in our moderate recovery scenario.
Thus, in our baseline scenario, we expect overall household credit to decline (annual average basis) by 8% from 2009 to 2011. To cross-check our forecasts of growth in outstanding debt with those at the industry level, we compared ours with those of our banking analyst, Betsy Graseck. Betsy expects that consumer and mortgage credit combined on bank balance sheets will shrink by 4% during this period. But because banks hold only about one-third of such credit, and more severe losses in MBS and ABS securities imply a decline of about 10% in the remaining two-thirds of outstandings, we think that our baseline estimate of -8% for the sum of loans and securities is reasonable.
Changes in regulation reinforce the process. Beyond write-downs and consumer and lender caution, we believe that appropriate stepped-up regulation and enforcement of existing rules covering the financial services industry and financial markets will also restrain the growth of credit over time. We have no way to quantify these developments, but we suspect that for the next three years, the credit card bill of rights and increased oversight of the mortgage origination and distribution process will limit loan growth.
Costs and benefits of deleveraging. Consumer deleveraging will entail both costs and benefits. Leveraged losses will hurt both lenders and consumers, the latter as foreclosures and bankruptcies rise. Adjusting to a new austerity will be painful for many, even in recovery. But less leverage will leave lenders and consumers better able to withstand financial and economic shocks, promoting financial and economic stability. And by boosting domestic saving, the deleveraging process should over time further reduce America's external imbalances, a critical need when global investors are fretting over America's fiscal sustainability.
Implications for lenders and financial markets. Consumer deleveraging and its aftermath imply a lower trend in loan growth, less leverage in total but a continued migration of debt back onto balance sheets, and thus lower absolute income and peak ROEs. Betsy Graseck estimates that median ROAs and ROEs for the banks under her coverage will reach 1.35% and 15.7% in 2012, down by 12bp and 223bp, respectively, from the prior peaks. Adjusted for risk, and over an entire credit cycle, however, returns to consumer lending likely will be higher than before: With balance sheet capacity still scarce, better pricing and more careful origination should dramatically reduce the future peaks in charge-offs relative to the current cycle. Indeed, Betsy believes that reintermediation and relationship-driven origination should help banks with strong customer acquisition, service and support organizations. For financial markets, the new equilibrium may mean lower securitization volumes and a continued move to less complex debt issuance.
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The Global Liquidity Cycle Revisited
May 29, 2009
By Joachim Fels & Manoj Pradhan | London
Reality check: One of our key macro themes for 2009 has been the emergence of a new global liquidity cycle powered by massive monetary stimulus, which should help to support asset markets, end the recession and prevent lasting deflation (see "A New Global Liquidity Cycle", The Global Monetary Analyst, January 14, 2009). A little more than four months later, it is time to review the evidence that has accumulated since then and discuss whether the theme is likely to have staying power for 2H09. In short, our conclusion is - yes, it is.
Excess liquidity surges to a new record-high... Back in January, the available data indicated that the new liquidity cycle was only in its infancy. Our favourite metric for excess liquidity - the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K') - had only started to tick up slightly for the G5 advanced economies (the US, euro area, Japan, Canada and UK) and was still declining for the BRICs aggregate. Now, our updated metrics, which include data up to March 2009, confirm that a powerful liquidity cycle is underway, with excess liquidity surging to a new record-high both in the advanced and the emerging economies. Thus, the jump in excess liquidity over the past two quarters has more than fully reversed the preceding decline in excess liquidity, which had foreshadowed the credit crisis.
...and further increases are likely in the coming quarters: The surge in excess liquidity reflects both rapid M1 growth in response to monetary easing, and the outsized declines in GDP in most economies over the past couple of quarters (recall that the growth rate of excess liquidity equals the growth rate of M1 minus the growth rate of nominal GDP). Looking ahead, further growth in excess liquidity appears likely, though probably at a slower pace. We expect M1 growth to remain strong or even accelerate further, reflecting the active quantitative easing in the US, UK, Japan and euro area that is underway and still has further to go. At the same time, we expect global GDP to bottom out soon, so that the real economy will start to ‘absorb' some of the additional money that central banks are printing. Yet, further growth in excess liquidity appears likely in the foreseeable future as central banks are far from done with quantitative easing, and we deem a V-shaped economic recovery to be unlikely.
Asset markets supported: We have argued repeatedly over the years that the ups and downs in excess liquidity have been key drivers of past asset booms and busts. The bond market rally of the early 1990s was led by a build-up of excess liquidity and gave way to a bear market for bonds in 1994 as excess liquidity evaporated. The equity bull market of the late 1990s was also accompanied by a build-up of excess liquidity, culminating in the dotcom bubble which burst early this decade as excess liquidity turned down. The mother of all credit and housing bubbles was also fuelled by the surge in excess liquidity that started in 2002, just as the downturn in excess liquidity in the G5 from 2006 onwards and in the BRICs from mid-2007 foreshadowed the crisis of 2007/08.
This time around, it doesn't seem to be any different. Risky assets such as equities, credit and commodities have rallied over the past few months as excess liquidity has surged. The ‘wall of money' has dominated the (justified) concerns about the outlook for corporate earnings and the implications of deleveraging in the financial sector and the private household sector. Whether the rally in risky assets can continue remains to be seen - our European and US equity strategists are cautious and our EM equity strategist Jonathan Garner has become less bullish recently. In any case, our analysis suggests that there is plenty of liquidity around - and more coming - to support asset prices.
Global bottoming is near: Also, our view expressed in January that the massive liquidity injections by central banks would find traction and help to end the recession in the course of this year appears to be on track. Most economic indicators suggest that the global economy will bottom out soon, though we continue to think that any recovery during 2H09 will be rather anaemic. While the bank lending channel remains impaired, easy monetary policy has been affecting the global economy through several other channels, including asset markets, inflation expectations and cross-border money flows into countries pegging to the dollar, such as China (for more detail on these channels, see "Money Talks", The Global Monetary Analyst, May 6, 2009).
Deflation fears dispelled: Finally, decisive monetary action has in fact helped to dispel the fears of lasting deflation that were so widespread around the turn of the year. Market-based measures of inflation expectations have increased significantly from very low levels back to more normal levels over the past several months. In our view, however, inflation expectations still look too low and could move substantially higher once markets start to focus more on the potential implications of the monetisation of government debt that is currently underway. Sure, hyperinflation is a tail event, but one that cannot be dismissed lightly against the backdrop of massive central banks' balance sheet expansion and rapidly rising public sector debt (see "Could Hyperinflation Happen Again?" The Global Monetary Analyst, January 28, 2009).
Sovereign risk = inflation risk: Indeed, there are some signs that, over the past week or so, investors have started to worry about inflation risks. While the headlines have been dominated by concerns about sovereign risk and potential sovereign downgrades, we find it interesting that the accompanying rise in nominal bond yields has been almost entirely due to a rise in breakeven inflation rates, rather than real yields. This makes sense as the risk of a sovereign default for countries such as the US, where government debt is denominated in the domestic currency, is virtually zero. If needed, the central bank will simply be instructed to print more money to service the debt. Thus, sovereign risk in these cases is really inflation risk, and should be reflected in rising breakeven inflation rates.
Bottom line: Reviewing the evidence to date, we conclude that the new global liquidity cycle, which started late last year, is alive and kicking. Excess liquidity has surged, asset markets have rallied, the global economy looks set to bottom out, fears of lasting deflation have been dispelled, and inflation risks are on the rise. With quantitative easing still in full swing and the economic recovery in 2H09 expected to be rather anaemic, we believe that there is no early end in sight for this liquidity cycle.
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