Unpleasant Facts and Other Musings

Arnold Kling complains about vague fed policy.

Everyone is acting as if in order to maintain the Fed's independence, the Fed must be allowed to be vague about its targets, vague about how it might achieve those targets, secretive about how it thinks its actions influence those targets, and ad hoc in its approach to deciding when to take action. I would suggest re-examining such assumptions.

"My suggestion is that, if you get asked those questions, just say we're examining nontraditional methods and there are many different ways in which we can address the issue. I would be as nonspecific as you know how to be. The major reason is that I don't think we will know until we start to address the issue." - Greenspan in 2003, discussing what the Fed might do as interest rates approach the zero bound

A paper on the Chinese housing market (See FT, econbrowser, MR for more details) highlights that its market has gone up almost 800% since 2003 Q1. In contrast, the Shanghai A share market and Chinese real GDP are both up about 90% since Q1 2003.

 While the paper highlights a potential bubble, What is more interesting to me is from the chart the FT takes from the paper.  They find that the market is being taken over by Central State Owned Enterprises (SOEs).  These SOE developers have been driving up the price of the housing market, paying on average 27% more for similar properties.  

 

It is worrisome to see SOEs start to dominate an economy that was growing precisely because they had reduced the impact of SOEs in their economy. A large part of their convergence growth can be attributed to their switch from a communist towards a neoliberal system. A good rule of thumb is that the smaller the impact of SOEs, the richer the area. The trend of decreasing SOE employment has been a positive driver of China’s economy since the Asian crisis in 1998*.

In China’s response to the crisis, workers at state owned enterprises have stabilized and even increased slightly from its bottom in 2008.

During an economic downturn, it makes sense that the transition from SOEs towards the private sector would slow down. However, if there is a crisis and a resurgence of SOEs, then that could be one more reason to be worried about China’s long term future.

 

 

*The causation can also be said to go the other way, as decrease in SOEs is also due to China’s liberalization of the economy which allowed private companies to force SOE’s to privatize or be uncompetitive.

The CBO released their Long-Term Budget Outlook for 2010! This may be a weird thing to get excited about, but I was looking through their 2009 outlook and wishing that I could work with an updated version.

Key quote:

“Keeping deficits and debt from growing to unsustainable levels would require raising revenues as a percentage of GDP significantly above past levels, reducing outlays sharply relative to CBO’s projections, or some combination of those approaches. Making such changes while economic activity and employment remain well below their potential levels would probably slow the economic recovery. However, the sooner that long-term changes to spending and revenues are agreed on, and the sooner they are carried out once the economic weakness ends, the smaller will be the damage to the economy from growing federal debt. Earlier action would require more sacrifices by earlier generations to benefit future generations, but it would also permit smaller or more gradual changes and would give people more time to adjust to them.”

Key chart:

In order to make sense of the above chart, the difference between the extended-baseline scenario and the alternative fiscal scenario needs to be understood.  The extended base-line scenario assumes that taxes and revenue change as is expected in the current law.  The alternative fiscal scenario assumes things that are likely but are not scheduled under the current law, such as no Medicare physician payment cuts and the AMT tax relief (See Table 1-1 in the report for more details).

My main complaint about this approach is that the least likely aspect of alternative fiscal scenario is also one of the most important: that it assumes that the tax cuts from 2001 and 2003 are not going to be allowed to sunset. This can be partially corrected for by using the revenue from the extended baseline-scenario and spending from the alternative fiscal scenario.  We find that the primary deficit (Deficit before including interest payments) will be -1.4% in 2020 and -3.1% of GDP in 2035.  Incorporating in the interest payments from the alternative baseline scenario (The actual interest payments will be higher due to a larger debt build up), that means that the total deficit will be -4.5% in 2020 and -7% in 2035.

I’ll end with a CBO table that informs us that the sooner the deficit is brought under control, the better:

A lot of models of the economy use the stock market as a leading indicator. That is why it can be very silly to turn around and use these models in order to figure out where the market is going*. Perhaps more subtle forms of this type of mistake are why economists are generally not known for being good traders. However, there are interesting micro-relationships within the market that correspond to economic activity in interesting ways. One of these is the relationship between consumer discretionary stocks and consumer staples stocks vs. nominal US personal consumption expenditures.

Right now, the market seems to be pricing in a slightly lower nominal growth rate than it did pre-crisis.

*These models can be useful insofar as it helps tell a trader that the market has an incorrect macro view, but that is another story.

China is changing its RMB exchange rate policy. Here are the key quotes:

In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

...

In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

I can think of a few reasons why they are choosing to do this now.

1. By promising action right before the G20, it allows them to avoid this contentious issue and instead make the developed countries focus on their debt problems.

2. They have been trying to moderately tighten their policy in other ways, so this move is a natural extension of their policy that as an added benefit placates members of the international community.

3. They figured that because everyone is now worried about the Euro, they could change to a basket and have a smaller effect on the markets than if they implemented this policy while everyone was already selling the dollar.

4. Due to recent currency movements, they are worried about export competition from manufacturing in the Euro-zone more than they are about US competition. This move could be a medium term move to strengthen the Euro.

Of the above reasons, #1 and #2 are pretty obvious and are generally well known. #3 seems like it could be true, while for #4 to be correct the reference basket of currencies would have to be changed pretty drastically.

It is worth noting that while the language does not imply revaluation, but as long as the forward rates are pricing in some type of revaluation (and the only time they don't seems to be when there is a liquidity shock and people are forced to exit their positions) the last time the PBOC used similar language the RMB appreciated pretty steadily for a few years. However, this steady appreciation encouraged speculation in RMB based assets, driving up the real estate bubble that China is presumably worried about now. If they let (encourage) the RMB be priced to steadily appreciate at a similar rate again that would imply that either they haven't learned their lesson or that the party has decided that they cannot let the real estate bubble collapse anytime soon and are desperate to keep it going.

I thought that it would be worth looking into the demographics of China.  It would be nice to actually quantify its effect a bit more closely.  Luckily, I found a paper that did just the type of analysis that I was looking. David Bloom and Jeffrey G. Williamson wrote “Demographic Transitions and Economic Miracles in Emerging Asia”, published in April 1998. They used demographic and economic data from 1965 through 1990 to generate estimates on the impact of a demographic dividend.  They measured the impact of the growth of the population, the growth of the working age population (15 through 65) and other common variables on per capita GDP growth.  I took the average of the coefficients in table 4 to do a country specific analysis of China and India.  On average, the growth of a working age population helps per capita GDP growth by about 1.7% for every additional percent growth in working population, while every percent growth in the total population hurts per capita growth by 1.4%.

Without a demographic Dividend, China’s GDP growth would be marginally lower:

The demographic dividend’s effect (blue line) is disappearing, and will go negative after 2015. The orange line measures the total impact of population on GDP, combining the dividend’s effect on per capita income with the overall population change.

For India, their demographic dividend is mainly in the future.

India’s overall GDP growth will slow down with their general population growth, but their per capita GDP growth will be benefiting from a demographic dividend for quite some time.

This analysis relies on coefficients from 1965 through 1990, so the impact of the elderly is not going to be properly quantified.  There were no countries facing an abnormally large elderly population that expected benefits from the government. When the Bloom & Williamson paper separated out the youth dependency and elderly dependency ratios, they found that an elderly population actually added marginally to growth (Which makes some sense since unlike with youth the elderly population is marginally productive).  However, after economies have had to deal with the potential fiscal crisis due to their aging population the effect might be found to be quite a bit more negative.

I suspect that some measure of this nature might be helpful in separating out convergence growth from demographic driven growth. Unfortunately, the nature of the demographic dividend is that the dividend occurs during convergence, so a simplistic analysis can only explain so much.  

Data: April 2010 IMF WEO database was used for PPP GDP data. The 2008 UN World Population Prospects database (medium variant projections) was used to get the age structure of China and India.

I thought that I would put yesterday's China convergence comment in some context.

I was thinking about a very good Scott Sumner post* where he looks at whether or not China can be called a free market success.  He discusses how China moved from a communist system towards a mixed system, and in countries with Confucian cultures the level of involvement of State Owned Enterprises (SOEs that are monopolies, not SOEs that compete on the open market like many of Singapore's) is correlated to their absolute wealth. Within China, the prevalence of SOEs in a region is correlated with that region's growth.

China is converging to a certain level of wealth which is limited both by how free its economy is and the amount of resources available.  If Beijing is already 2/3rds as rich as South Korea (and Seoul itself) on a PPP basis**, there is reason to think that the level of convergence might soon slow down as China is closer to reaching its equilibrium convergence level than people think. Of course, Matthew Yglesias points out, if people continue migrating from less free areas of rural China (where the prevalence of more SOEs mean that the natural convergence level is even lower) into China's richer cities where they will work in industry and services instead of agriculture, then the impact of slower growth in the richest areas might not impact the overall economy too much.

China's future growth path is very important because if they aren't growing fast enough in normal times it will be more difficult to deal with the inevitable volatility.  China's current policy is generating a lot of loans that many people think will turn into nonperforming loans. These NPLs could be less significant if China grows enough, since there are less bad loans in a well performing economy and the bad loans that do exist will be smaller relative to the economy. If China's growth slows down because it is closer to convergence than people think (and because their working age population is no longer growing and the market for their exports might not expand as quickly as it has in the past), then the resulting NPLs could end up being a very serious issue.

All of this suggests that there are a few things that are very important to track when figuring out China.

1. Some measure of how mixed an economy they are relative to comparable economies. In the heritage index China is closer to Vietnam than South Korea, though part of it is because of how the index is calculated.

2. A measure of China's demographics. Luckily, demographics are one of those indicators that are known far in advance so this data doesn’t need much tracking. The chart below shows the changing working age population of the BRICs countries from the UN’s World Population Prospects 2008 revision database (Medium Variant).  From this perspective, India is much better positioned than China.

3. Measures of China’s internal migration.  If they ever change their policy on migrant workers from rural areas, it could be a sign that the party is going to keep going for a while longer.

4. The prices of China’s property markets, to see when NPLs will become a big deal. Changes in China’s monetary policy might lead changes in the property market (which might be tracked via the relative prices on China’s commodity market), since property markets are less liquid and therefore react more slowly to changes in fundamentals. Another potentially useful indicator is the Shanghai market.

5. The state of the rest of the world, since China’s exports depend on a healthy global economy.

This list is by no means exhaustive, except I did mention “the rest of the world” as a single data point to be tracked.

 

 

*Yes, again. If he is going to keep being relevant I’m going to have to keep linking to his posts.

**If GDP counted construction activity by migrant workers and the official population numbers of Beijing excluded them, then Beijing might have a long way to go before their PPP GDP per capita approaches South Korea’s level.

Beijing's 2009 GDP (PPP) per capita: $17,063