Unpleasant Facts and Other Musings

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.

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

Michael Pettis recently posted an interesting piece on the Shanghai market.  He makes the following points.

1. In markets, there are fundamental or value investors, arbitrage traders and speculators. Speculators react to information about supply and demand, as well as the expected short term impact of fundamental information. Value investors buy assets in order to capture the profits generated by these assets over a longer time frame.
2. In the Shanghai market, transaction costs are too high for more relative value traders.  Trustworthy fundamental information is too scarce, predicting government action is too important [This isn’t too different from the US market over the past crisis] and valuations are usually too high for fundamental or value investors to participate. This means that speculators dominate the market.
3. Without value investors buying when the market is cheap and selling when the market is expensive, the market will be more volatile.

After giving many examples of how the Shanghai market trades on non-economic information, he concludes:

“A market driven almost exclusively by speculators, and with little to no participation by fundamental or value investors, is not a market that pays much attention to long-term growth prospects.  It is driven largely by fads, technical factors, liquidity shifts, and government signaling.

So what does this year’s crash in the Shanghai stock market tell us?  It might be saying something about the impact of the European crisis on export earnings.  It might suggest that liquidity in the system is being driven into real estate rather than into stocks.  It may reflect contagion and nervousness about the fall of stock markets abroad.

But we should be cautious about reading too much into it.  In fact attempts by Beijing to hammer down real estate bubbles in the primary cities without addressing underlying liquidity expansion may simply push asset price bubbles elsewhere, and this could easily cause a surge in the Shanghai stock markets.  But this should not then be interpreted as signaling a surge in the economy.

Shanghai’s markets will go up and down, but they are not driven by investor evaluation of long-term growth prospects.  China does not yet posses the tools to make such evaluation useful, so be careful about reading too much into the stock market numbers.”

This does not mean that the Shanghai composite is useless. It means that it is a combined measure of liquidity and government intervention.  If the fund managers who speculate on government policy or liquidity are successful in making money, then the market is giving useful information. The information may be slightly different from other markets (although even developed world markets are more focused on the next few quarterly earnings than on growth prospects 5 to 10 ears out), but it is still important.  It is particularly important for those who think that China’s recent growth during the downturn is unsustainable because it is built on real estate speculation and government spending without a clear way to transition back to a more normal convergence style growth. A sharp fall in equity prices is one of the indicators of a tighter monetary policy (or that a tighter monetary policy is finally having an impact), and further extreme moves could be signs of an actual deflationary unwind. Any stock market move has many causes, but it definitely gives us useful information.

A – H share premium on top, Shanghai A Shares normalized to Jan 3^rd, 2010 on bottom. The premium of the Shanghai A shares over the foreign traded H shares is another measure of the relative excess liquidity in China’s market compared to the rest of the world. Source: Palantir.