Recent Political (and other) Cartoons

The Chinese Economy: A Drag on Australia in 2012?

One of the most interesting commentators on the Chinese (and global) economy is Michael Pettis. A consistent theme of his newsletter (which you can receive by asking him to send it to you!) is that many economic commentators don’t understand or at least downplay the significance of global imbalances and the concept of the balance of payments.

I’ve long argued to my students in the course Power in East Asia that Chinese purchases of US bonds are not a straight forward indicator of growing Chinese power (indeed I might have been a little more forceful than that). The belief that the Chinese could simply stop purchasing US bonds would require them to change their growth model and is not likely to happen anytime soon. But even if they did, it would not be the disaster for the US economy that many commentators seem to think.

Pettis writes:

One of the more absurd fears that still pops up every few months is the panic over the possibility that foreign central banks (i.e. the Chinese) might stop “lending” to the US government. If they ever decide to stop buying US Treasury bonds, the argument goes, US interest rates would soar and the US government would suddenly find itself unable to fund its fiscal deficit

…

Chinese “lending” to the US government is not a discretionary decision that they can choose or not choose to do – it is the automatic consequence of a growth model that requires a trade surplus to absorb domestic overcapacity – the idea that the US government needs foreign funding is based on a very fundamental misunderstanding of the balance of payments. The US government does not need foreign buyers for its bonds. On the contrary, it is in Washington’s best interest that foreign central banks sharply reduce their purchases of USG bonds.

He then explains why recent reduced purchases of US bonds have not led to an increase in interest rates.

US interest rates have very little to do with foreign purchases of US government bonds.

Why? Because foreigners do not fund fiscal deficits. They fund current account deficits, and as an accounting requirement the size of the current account deficit is exactly equal to the net foreign funding.　 Capital account inflows must exactly match current account outflows.

The direction of causality can go either way. If investment in the US is so high, for example, that it is impossible for US savings to supply the full demand (as occurred during much of the 19th Century), then the US must import foreign capital to make up the shortfall. The difference between domestic US investment and domestic US savings, of course, is equal to the net amount of foreign savings imported into the US, and is also equal to the US current account deficit. In this case soaring US investment causes the US to have a current account deficit and leads foreigners to fund this excess investment.

But as he then points out the direction of causality is not clear cut. While the CAD is equal to saving minus investment, rising ‘investment’ might be spurred by capital inflows, rather than the other way round.

But the direction of causality can also run the opposite way. Suppose foreign central banks have decided for domestic reasons (for example in order to generate domestic employment) to accumulate hoards of US government obligations and so run a trade surplus. This will cause a surge of net capital inflow into the US. In that case the US must run a current account deficit equal to the net inflow.　

There are several ways this can happen. One way is for the surge in foreign capital inflows to cause a sharp rise in what otherwise would have been unnecessary or unfunded investment – the real estate bubbles in Spain and the US might be obvious examples of this. Another way is for foreign savings to displace domestic savings, perhaps by funding a credit-fuelled consumption boom.　

But Pettis argues that in some ways this beside the point, what many commentators miss is the simple maths involved. Net capital imports equal a current account deficit. The real issue for the US and China at the moment is what happens if foreigners, particularly the Chinese stop buying bonds. Rather than cause interest rates to rise and a collapse of the economy, the result is actually beneficial for growth. This is because:

if there is a reduction in net foreign capital inflows there must also be a reduction in the US current account deficit.　

The results are not necessarily benign.

In Spain, for example, it will happen as a collapse in domestic demand and high levels of unemployment.

For the US, however, the result is likely to be better because reduced capital inflows will further reduce the value of the dollar leading to an increase in exports and therefore a rise in employment.

US interest rates on the other hand are likely to remain unaffected

First, the decline in US unemployment will result in a decline in fiscal expenditures since the main reason for fiscal expansion is to reduce unemployment. Second the reduction in unemployment and the increase in business profits will increase tax revenues. Lower spending and higher revenues means less borrowing, and so fewer foreign purchases of US government bonds will be matched by fewer US government sales of bonds.

Remember that saying that the US needs more foreigners to buy US government bonds in order to keep interest rates low is exactly the same as saying the US needs a bigger current account deficit in order to keep interest rates low.This cannot be true.

So the question of whether the China buys US bonds or not is more dependent on the Chinese growth model of running current account surpluses.

… this is hard to predict since it is based more on political factors than economic ones.　 China’s current account surplus has contracted quite dramatically in the past four years, not because of domestic rebalancing, of course, but because of forced foreign rebalancing, and there are many who think the trade balance may actually go into deficit next year.　

Pettis thinks it is unlikely that China will slow export growth anytime soon because of the view that this would be a disaster.

Huo Jianguo, head of the Ministry of Commerce's research unit, was much more explicit. Last week he warned about the consequences of slow export growth.

China needs annual export growth of at least 15 per cent to ensure stable economic expansion as the rate of domestic investment cools, the head of the trade ministry's think-tank said in comments published yesterday. "We just can't tolerate the simultaneous fall in investment, consumption and exports," Huo Jianguo, head of the Ministry of Commerce's research unit, told the Shanghai Securities News. "A growth rate of 15 per cent [in exports] is basically a benchmark and any growth below that would start to affect employment."

Beijing has pledged to stabilise exports and boost imports next year to balance trade as part of efforts to bring equilibrium back to the economy and insulate it from the effects of deteriorating external demand.　 Many international economists believe China's growth has been fuelled by a reliance on investment spending, creating asset bubbles and overcapacity problems that pose more serious structural challenges than shifting external trade conditions. But Huo said concerns about falling exports were growing.

"In fact, the investment-driven model of 2009 has changed, exports are playing an incremental role in overall growth - so when export growth eases, people get nervous." Huo noted that at least 80 million jobs are related to exports - many of them held by migrant workers and therefore vital for social stability.

This is likely to lead to an increase in trade tensions. Remember the basics of global trade: not everyone can run a trade surplus. If the US and countries like Spain in Europe want to run a surplus or reduce their deficits, this will mean that China, Japan and Germany etc will have to reduce their surpluses.

Chinese and German trade surpluses must be matched by deficits elsewhere. Chinese and German export success must be matched by a willingness of other countries to buy their products. Now in an ideal world, a country’s trade surpluses would lead to increases in the value of its currency. In Europe this can’t work for individual members of the Eurozone and between the US and Asia equilibrating mechanisms are restricted both by Asian currency policies and perceptions of the US as a safe haven for capital.

Pettis then turns to the growing costs of debt service in China caused largely by excessive infrastructure investment. Growing debt is a real problem for China.

As we saw in the last debt crisis, a decade ago, debt-servicing costs are only manageable in China thanks to financial repression – i.e. extremely low lending rates funded by even lower deposit rates -- which implies a huge transfer, equal to several percentage points of GDP annually, from household savers to corporate and government borrowers. Households, in other words, typically clean up banking messes.

…

The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.

The solution of increasing consumption in China is often seen as a relatively simple phenomenon that will occur over time, almost as a matter of course. But recent years have seen decreases not increases in consumption. (although see here for an alternative view)

Indeed, one of the growing narratives by the Gillard government and particularly Treasurer Wayne Swan is the opportunities created by China that go beyond the mining boom. Swan argues that the growth of the Chinese middle class will create an export bonanza for Australia.

Of course, the mining boom is only one part of a much bigger and evolving story about the influence of China's rise on the world. The China story is not just a mining story; it's also a story of its dynamism and the spectacular growth we're seeing of its middle class. China's rapid growth is delivering hundreds of millions of people into a burgeoning middle class.

It's important here to distinguish between the complex and subtle process of ‘middle classing' and the simple process of ‘urbanising'. Some of China's many millions of internal migrants have achieved lifestyles that qualify as middle class, but the vast majority have not, at least not yet. It is the present and prospective shift of China's current working class and working poor into empowered consumers that will mean so much to Australia.

This, according to Pettis, might be a longer-term project than Swan seems to think.

Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010.　

Policies aimed at boosting consumption by offering incentives to purchases household goods and cars will no doubt increase spending on these items but …

since those subsidies were ultimately paid for by the household sector, the policies did not translate into an overall surge in consumption because there was no net increase in household wealth. In fact during both of those years consumption continued to decline sharply as a share of GDP.

The problem for China is not excessive saving, given that they save at about the same rate as other Asian countries. Instead the real problem is that household income is such a low share of GDP.

This means that the only way to boost consumption is redistribution from rich to poor or from the state to households.

When we add in the possibility of a continued decline in house prices throughout China, we may start to feel some kind of wealth effect dragging consumption growth down even further as a share of GDP, although I am not sure I am too worried about that. The housing boom seems to have mainly benefitted speculators, and I don’t think that it translated into a significant increase in consumption when housing pieces were on their way up. In that case it shouldn’t matter too much on the way down either, although it is better to wait and see what happens.

In the case of houses, prices are definitely falling in China, according to Pettis.

So it is debt that is the big problem, but past options used to 'solve' earlier debt problems are probably not available again.

This time however I really doubt that the debt crisis can again be resolved by financial repression, since household wealth is already far too small a share of GDP, and expected GDP growth prospects much lower than in the past. Remember that if GDP growth slows sharply, the only way households can continue permitting that their share of GDP declines, as it has for the last thirty years, is if household income growth drops to zero or even goes negative.

Slower growth and an already-low share of GDP will mean that it will be politically very difficult to force households to clean up the mess another time. Add to this the problem of illiquidity in the banking sector, which is going the become an increasing problem over the next few years as borrowers have trouble repaying loans and will require more-or-less permanent ever-greening, and I think there will be much greater appetite for a real liquidation of bad debt.

Australia is vulnerable to these potential problems in China and Australians are increasingly dependent on the Chinese Communist Party managing a rapidly growing, but increasingly unbalanced economy! But lots of people have thought that the Chinese growth model was unsustainable before, so I wouldn't take too large a bet on it collapsing.

Although given the reasonably high percentage of equity (shares) in my super accumulation fund I am in a way betting on Chinese growth continuing for a little while at least. Over the longer-term it is likely that China will continue to demand resources from Australia. It's the medium-term - the next 2-4 years that worries me.  

If you wanted to short the Chinese economy - that is a take abet against continuing high levels of growth in China -  then shorting Australian resource stocks would be a good strategy.

For what it's worth I think the Chinese authorities are likely to be able to cover up problems for a little while yet. Next year, however, is another betting opportunity.

Debt Denouement?

Debt is the major problem facing the world economy at the moment. But it's not as clear cut as many commentators make out. The recent focus has rightly been on Europe and on the sovereign (public) debt crisis.  (See here and here and here and here for earlier posts on debt).

For Australia there are two types of debt to worry about directly and another type indirectly.  Indirectly Australians need to worry about the reactions of European and American policy-makers to their public debt problems.

As many commentators have recently pointed out, contractionary fiscal policy in a time of economic stagnation, fear and credit anxiety is likely to lead to - surprise, surprise - contraction. To think otherwise is slightly ridiculous. The real question is whether the decline in the price of sovereign debt is worth more to getting the economy back on track than attempting to support growth with limited fiscal resources. 

Directly, Australians need to worry about their own foreign and household debt. Both are private forms of debt and are of course related. Households have borrowed from the banks, who have sourced some of their funding from overseas lenders. The balance of offshore borrowing by the banks has improved since 2007, but it is still very important as the banks keep telling us when they decide not to pass on the full weight of RBA interest rate cuts.

A post from Leith van Onselen covers the possible negative impact of rising household debt for younger Australians.

Last week, the Reserve Bank of Australia’s (RBA) Bulletin noted how high housing costs are disproportionately affecting younger Australians:

Median housing debt-to-income ratio for Australians under 39 years of age has risen 29 per cent in the six-year period to June 2010, compared to the 20 per cent rise for the oldest Australians in the same time.

The increases leave younger Australians with a median housing debt of 333 per cent of household income or more than double the 159 per cent for the over-60 crowd…

“The increase in the cost of housing has affected younger households, whether renters or purchasers, more than other age groups”, said the report…

Now the Galaxy Australian Debt Study has found that younger Australians are more stressed about repaying debt than any other generation:

People aged between 24 and 35 topped the debt anxiety list, with nine in 10 concerned about making debt repayments.

Big purchases such as a first home were largely to blame for the stress, with 55 per cent of people in this age group nominating rising rents and mortgage repayments as their biggest financial concern, according to the Galaxy Australian Debt Study…

“While most Australians are trying to be financially responsible, it is worrying that people aged 25 to 34 appear to be feeling the greatest strain,” Matthew Strassberg, senior adviser at Veda, the debt investigation company which conducted the survey.

The survey also found 15 per cent of people in this age group were likely to apply for more credit over the next six months, compared with 9 per cent in the remainder of the population.

This is where it can all go wrong, Mr Strassberg said.
“It is concerning that there are people struggling with their current debt levels but are turning to more credit as the answer, potentially edging closer to a debt spiral,” he said.
“While people can have large credit commitments, the debt spiral begins when a person starts slipping behind on payments and seeks yet more credit as the solution.”

The bi-annual Galaxy survey reveals Australians are facing unprecedented levels of debt stress as 82 per cent of the population worry about meeting debt repayments, up from 75 per cent in September 2010…

The research also suggested one in five Australians were struggling to pay off their credit commitments.

As a means of coping with the stress of debt, 87 per cent of consumers have chosen to cut back on everyday spending and lifestyle, 49 per cent have cut back on groceries and 35 per cent received assistance from family or friends…
“Borrowing from family and friends is common, so is wanting to access superannuation early.

That more people are worried about repaying debt now than in September 2010 is interesting given that the official ratio of household debt to disposable income has fallen over the past year, from 154% in September 2010 to 151% in September 2011. Perhaps the reasons for the rising anxiety levels have to do with:

1. Housing prices falling. 90% of household debt relates to mortgages. And with home prices now falling, households are losing the ability to simply sell-up, repay outstanding debt, and walk away.
2. The economic (employment) outlook is far less certain, owing to the slowing domestic economy (outside of mining) and overseas concerns (including Europe and China).

With the baby boomers starting to retire, and needing to liquidate their housing assets to fund retirement (remember: they own roughly half of Australia’s housing assets, including 57% of all investment properties), the question beckons: will younger Australians be in the position to buy these homes from the boomers at current prices?
From the above studies, the answer is doubtful.

The phenomenon of high debt and the consequent need to

In an article I wrote a couple of months ago I considered three structural changes that were affecting the Australian political economy.

The first structural change is the long-running shift away from manufacturing towards services and the more recent revitalisation of the mining sector. This has come, to some extent, at the expense of manufacturing and important service industries such as tourism and international education. 

The second structural change - and the one I'm focused on in this post - is the shift away from debt-financed consumption and rising housing prices to a higher rate of saving – generally considered under the description deleveraging or more simply the paying off or consolidation of debt.    

Perhaps we should call this the end of an earlier structural change that began with financial liberalisation and gathered pace as credit markets expanded over the 1990s and kept going until 2007 when the music stopped and not everyone found a chair. The growth of household debt as a percentage of disposable income grew rapidly over the 1990s and 2000s rising from: 

48% in September 1990 to 156.7% in June 2007 to 150.8% in September 2011.

Debt for housing is 89.7 % of total household debt.

Investor housing debt is 29% of total household debt.

Interest payments as a percentage of disposable income reached a high of 13.4% in June 2008 to a low of 9.3% in June 2009 to 11.4% in September 2011.(see Structural Shenanigans for graphics)

So ... household debt remains at high levels and the inability to continue to grow debt even further undermines an important source of growth over the past 20 years. 

Think about it.

The growth that occurred after the recovery of the 1990s recession was augmented, buttressed and sometimes driven by the expansion of household debt by around 100% of disposable income. 

If we were to have the same favourable conditions over coming years this would mean that household debt as a percentage of disposable income would have to go to 250% of income. 

The question I often ask myself at times like Christmas is how much debt could I get into. Now not owning a house means that this would probably be unproductive debt spent on expensive dinners and wine and presents. 

But regardless of what I spent it on, at some point the debt burden becomes too much to service and I either have to pay it off, reschedule it or declare bankruptcy. Extrapolate this task across households across the economy and you can see why a major source of growth has at best stabilised and at worst gone into reverse.

This is the change that may matter most of all for Australia in 2012 as households save more and the "paradox of thrift" exacerbate the impacts from overseas. 

People start to feel pessimistic about their spending capacities and if growth slows further then we could end up in a negative spiral. 

Another reason why people are feeling pessimistic is that the value of assets has fallen significantly since 2007-08.

The fall in the share market may matter more in Australia than elsewhere because more Australians have their super invested in shares than anywhere else. 

As a matter of interest, the third structural change causing anxiety in the community is a tentative shift towards a less pollution-intensive economy through the establishment of a carbon price and support for renewable energy through a variety of schemes and policies.

The first two structural changes are long-running and largely unavoidable without significant and perhaps costly policy interventions, which could cause more problems than they fix.

The third involves a greater level of immediate political choice. But government has the ability to encourage a shift towards a more diversified, future oriented economic structure.

And though policy change associated with this is likely to have only a minor impact in the short-term, the way that debate has polarised the community has added to negative perceptions of the Gillard government.  

Next year should be an interesting year. But just as problems could occur it's also possible that Europe will sort out its mess, China will gradually begin to shift from high investment to higher consumption. If the Communists can manage the Chinese economy through another period of global crisis then maybe everything will be hunky dory in 2012. 

Let's hope that those focused on vulnerabilities and negative spirals (like me) are wrong and the boomers are right for at least one more year.

Recent Political Cartoons (and a few others)

Renewable Electricity Generation in Australia

Renewable Sources of electricity production have been growing rapidly in recent years, but the contribution of solar still remains minuscule as I reported here a little while ago. I imagine most people would be quite surprised by the figures.

The Clean Energy Council has just released a report on the state of Clean Energy in Australia.

Though the news reports laud the achievements we still have a long way to go before we can call ourselves a clean energy country.

Most of our renewable contribution to electricity production (remember that electricity and energy are two different concepts with the former a component part of the latter).

Basically about 10 per cent of our electricity generation is accounted for by renewable sources.

So what are these renewable sources. Most important of course is hydro power, which has benefited from high rainfall, allowing more run-off and hence more electricity generation. Wind is obviously next most important and most of the most significant proposed increases in renewable generation are wind projects.

Solar accounts for very little of this. Indeed Solar in total accounts for 2.315% of 9.64%, which equals 0.22% of total electricity generation.

Undoubtedly, solar installations have been increasing rapidly.

But the benefits of generous state schemes to pay households for solar contributions to the electricity grid are only available to those able to afford solar systems on their roof tops. This means poorer households and renters gain no benefits and have at the same time seen significant increases in electricity costs.

Although there is debate about the reasons for electricity price increases, there is no doubt that electricity prices have increased. The CEC reports that "Electricity prices in Australia have risen about 30 per cent over the last four years." The CEC argues:

There are several factors behind the recent price rises. By far the largest is the need to
replace and upgrade the ageing poles and wires of the national electricity grid, some of
which have been in service for more than 40 years. Recent estimates suggest that more
than $130 billion will be necessary to upgrade the network over the next decade, growing
to $220 billion over 20 years.(1) Research indicates that these network costs will cause price
rises of up to 66 per cent in NSW and Queensland by 2015.(2) Similar increases are likely in
other states and territories.

Other reasons for power price rises include the increasing cost to generate electricity with
both coal and gas along with the increased use of energy-intensive appliances such as
air-conditioners and flat-screen televisions, which increase peak demand for electricity
and overall costs.

1 K Orchison, Coolibah Pty Ltd, Powering Australia, 2011, page 19.
2 P Simshauser, T Nelson, T Doan, AGL,The Boomerang Paradox Part 1: how a nation’s wealth is creating fuel poverty, The Electricity Journal, 24(1), 2001,
pages 72-91. 

They are rather more sanguine than others about solar rebates: 

According to analysis prepared for the Clean Energy Council by ROAM
Consulting in 2011, the combined cost of both small and large-scale renewable energy
comes to approximately $78 per year for the average Australian household. This works
out to $1.50 per week. By 2020 the cost of renewable energy is expected to make up
between 4 and 7 per cent of the average household power bill.(3)

3 J Riesz and J Gilmore, ROAM Consulting, The True Costs and Benefits of the Enhanced RET, 2011, page iii