The IMF Increasingly Agreeing with the Global Imbalances Analysis of the Economy

As Beijing slowly unlocks from its 60th anniversary celebrations – the streets are still relatively empty but more and more people are going out, although my local Starbucks still hasn’t reopened, forcing me to go elsewhere for my hardcore caffeine fix – a lot is still going on in the rest of the world. Both the US and the IMF have come out with releases that help us to pick through the problems that China and the world are facing.

Before discussing these releases, let me make a quick digression to an event that a lot of people have been asking me about. Two weeks ago China Construction Bank announced that it would rollover 24.7 billion yuan in bonds that it had “purchased” from its AMC, Cinda, for another 10 years. Bank of China and ICBC, which sit on 473 billion yuan worth of AMC bonds, will probably do the same when their AMC bonds come due.

What does this all mean? Remember that as part of the recapitalization of the banks after the NPL fiasco of 10-15 years ago, the AMCs (asset management companies) were created to purchase and liquidate the bad debt. There is a big argument as to whether or not they took out all the garbage loans, but at any rate they bought a lot of bad debt and, since they had no assets of their own, paid for them with issues of medium term bonds, which they exchanged in two tranches. One tranche was for 100% of the face value of one portion of the bad loans they took on, and the other was for 50% of face of the rest of the bad loans they acquired.

The problem of course is that these bad loans were worth a lot less than either 100% of face or even 50% of face. In fact they have been liquidated at a rate of about 20% of face. This leaves the AMCs bankrupt and unable to repay the bonds, so when they came due the bonds were simply rolled over. There is a sort of comfort letter from the Ministry of Finance (its exact value is in dispute), so the banks have been able to get away with treating the bonds as money good. The point of all this is to remind us that all the .losses for the earlier spate of bad loans, even assuming that all the bad loans were identified and cleaned up (which I doubt) have not been resolved.

Someone (the banks? The Ministry of Finance?) will eventually have to pay up. If the process is allowed to drag on for many years, I suspect that the banks will pay out of retained earnings, but since retained earnings at the banks consist primarily of the very wide spread between the lending rates and the interest rates that banks are allowed to pay depositors, ultimately this means that households will be forced to recapitalize the banks. If there is a short term problem, however, perhaps leading to a crisis of confidence in the banks, I suspect that the MoF (unless debt at the sovereign level in the mean time becomes a problem) will explicitly guarantee the bonds or take them directly on the government balance sheet.

US unemployment picture is ugly

To return to the rest of the world, unemployment in the US is not getting better. Yesterday the Labor Department released figures that showed the US unemployment rate climbing to a fresh 26-year high of 9.8% in September. According to an article in the Financial Times:

Official figures on Friday showed that non-farm payrolls dropped by 263,000, making it the 21st consecutive month that the US economy has shed jobs. The data were worse than even the most grim expectations, as economists predicted a 175,000 drop in payrolls, and followed a decline of a revised 201,000 jobs in August when the unemployment rate was 9.7 per cent.

Although I think most economists are expecting that US economic growth in the third quarter was a fairly healthy 3%, as far as China is concerned it is not the future growth in the US economy that matters so much as future growth in US consumption. A jobless recovery in the US, if that is what we get, probably means that dragging household consumption will not be the engine of US growth, and even less will it be the engine of Asian growth, which it was for so many years. Any Asian and Chinese recovery predicated on a revival of out-of-control US consumption is likely to be disappointed.

On Thursday the IMF released its World Economic Outlook, which was mildly positive on the global economy, arguing that “the recovery has started, financial markets are healing, and in most countries growth will be positive for the rest of the year as well as in 2010,” although in line with the US employment report it worried that “the pace of recovery is expected to be slow and, for quite some time, insufficient to decrease unemployment” (later in the report they say “the current rebound will be sluggish, credit constrained, and, for quite some time, jobless”). The report also argued that because most of the “recovery” has been based on public spending and, I guess especially in Asia, gearing up capacity without much regard for demand, an economic recovery was likely to be slow and risky.

The IMF seems increasingly to be agreeing with the “global imbalances” analysis of the economy, probably to the dismay of China and other surplus countries. Early in the report it says:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand and imports.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. To accommodate the shifts on the demand side, there will need to be changes on the supply side.

Surplus countries must consume more

The interesting thing for me was this focus on surplus countries. Although there does seem to be an economic rebound, the report says, the recovery will be weak unless countries with large trade surpluses step up domestic demand. To keep growth up, surplus countries like China must boost domestic spending, and appreciate their currencies. This pretty tough claim will probably not make Beijing, Berlin or Tokyo very happy, although it does chime with US views on global trade imbalances. In their own words:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand—notably emerging economies in Asia and elsewhere and Germany and Japan.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. In these economies, private consumption and investment are unlikely to pick up the slack that will be left by diminishing fiscal stimulus, given that household incomes and corporate profits will be subdued and balance sheet repair will be under way for some time, implying higher saving rates.

The authors of the report do not seem terribly optimistic about the prospects for a sustainable spurt in surplus-country domestic demand in the near term (“This process of rebalancing global demand will be drawn out.”) but I am not sure, perhaps because the IMF is after all a very politicized institution, that they specify the trade consequences. They acknowledge that there will be a problem with expected increases in savings in one part of the world conflicting with high savings elsewhere, and they don’t seem very optimistic about prospects for a surge in investment, but it seems to me that they shy away from working out how this will happen and how the pain will be distributed (through the trade account, I would argue).

What about overinvestment?

In a section in Chapter 4 of the report entitled “Do Precrisis Conditions Help to Predict Medium-term Output Losses?” there was an interesting discussion about the relationship between output losses associated with a crisis and pre-crisis investment levels. On especially commented on section had this:

The prominent role of investment and capital losses suggests that the level and evolution of precrisis investment would be good predictors of eventual output losses. Indeed, regression results provide strong evidence that economies with high precrisis investment-to-GDP ratios, measured as the average investment-to-GDP ratio during the three years before the crisis, tend to have large output losses.

In contrast, the investment gap, defined as the deviation from its historical average of the investment-to-GDP ratio during the three years before a crisis, is not statisti­cally significant. We return to potential interpretations of these results later in this section, but it is worth mentioning that the precrisis investment share is particularly robust as a leading indica­tor, even after controlling for the level of the current account balance. This suggests that countries that have high investment rates tend to experience larger output declines follow­ing banking crises, irrespective of whether the investment is financed by foreign or domestic savings.

For those of us who worry about China’s having recently increased its already-excessively-high investment rate, this passage was an uncomfortable read. In addition for people like me, who believe strongly that the very process of misallocated investment will act as a damper on future consumption growth (and I think this is becoming much more widely accepted, or at least discussed, in policy circles), the combination of warnings over overinvestment and pleas for more consumption from trade surplus countries is deeply worrying. By the way, for a short and quick view of why I think consumption won’t grow, you can check a recent debate held by the New York Times on the subject of Chinese consumption growth.

So what about all this excess investment? The State Council recently made a lot of noise about its determination to curb excess capacity. Here is the Financial Times version of the story:

China has issued a stark warning about the risk from rising overcapacity in the economy, saying it could hamper recovery and lead to a surge in non-performing bank loans. The State Council, the country’s cabinet, issued a new plan to combat overcapacity in seven industries, barring new aluminium smelters for three years and criticising “blind expansion” in parts of the steel and cement industries.

The cabinet statement, which came late on Tuesday evening in Beijing, follows a crescendo of warnings from senior officials. It also outlined measures to restrict manufacturing of equipment for “green” industries of wind and solar power. China’s economy has rebounded sharply in recent months due to an investment boom – much into infrastructure – fuelled by increased public spending and a surge in lending by the state-owned banks.

But over the past three months many government officials have begun to publicly warn that the credit binge could create overcapacity in heavy industry, which could produce a new round of bad bank loans.

The article in the South China Morning Post adds some color, and a partial explanation of why all these angry statements about preventing excess capacity over the past few years have had so little effect:

In unusually blunt wording, the cabinet also pointed its finger at local authorities. “Some regions have acted illegally. We are once again seeing cases of illegitimate approvals, of construction starting before it has been approved, and of construction starting even as the approval process is underway,” it said.

The cabinet’s strident warning about overcapacity underscored why officials have been circumspect about the economy, repeatedly saying that it has shown signs of recovering from the global financial crisis but is still not on solid ground.

It is hard to give up investing

The truth is everyone in the world is against the creation of “excess” capacity, but as long as Beijing has in place policies that explicitly subsidize investment and production, it will take an awful low more than fulminating against wasteful investment to eliminate it. I would argue that wasteful investment is the automatic consequence of policies that lower the cost of capital to “unreasonable” levels, implicitly socialize risk, and otherwise subsidize producers in the name of boosting employment.

Since Beijing has very explicitly chosen to attack rising unemployment in the short term – probably wisely, although also probably more ferociously than was optimal – there is little they can do to prevent a massive rise in wasteful investment. You cannot take an economy with the highest investment rate in history, and already massive waste, and very quickly force investment rates up even higher, without also increasing waste. The problem with all this wasted investment, of course, is that someone must pay for it, and that “someone” will undoubtedly be Chinese households, who will then almost certainly go on to disappoint us by failing to splurge on consumption.

And are they really serious about tackling excess capacity? Here is what Bloomberg said in an article earlier this week about the shipping industry:

China and South Korea’s support for shipbuilders may add to a glut of capacity, slowing a recovery in freight rates and vessel prices. The world’s two largest shipbuilding nations have taken steps this year to aid shipyards and safeguard jobs as customers delay or scrap orders amid tumbling world trade. That support will likely ensure more vessels enter service, even as lines mothball and scrap existing ships because of a lack of cargo.

“The Chinese and Koreans, in particular, will make sure that these ships come,” Philip Clausius, chief executive officer of lessor First Ship Lease Trust, told a conference in Singapore yesterday. The “daunting number” of ships that “will hit the market over the next three, four, five years will make the recovery a rather slow and painful one.”

China’s bid to become the largest shipbuilding nation by 2015 may also worsen the glut as it competes for market share, said Matthias Umlauf, senior economist at HSH Nordbank AG. The world’s shipyards have dry-bulk ship orders with a combined capacity of 64 percent of the existing fleet, according to data compiled by Bloomberg.

China has “the chance to become the world’s largest shipbuilding nation and they will not let this chance go,” said Umlauf. “They will support their national champions and that will definitely add to the overcapacity situation.”

As I have said many times before, I don’t see how pressures to increase savings in the US and other trade-deficit countries will not conflict with pressures in China, Germany, and other trade-surplus countries to maintain policies that force up savings rates, especially if sustainable global investment rates decline. The only outcome, I think, is increasing trade tensions. In that light, today Bloomberg reported a very worrying escalation of the conflict:

The two largest groups representing U.S. companies in China said the Asian nation has enacted a series of policies discriminating against foreign investors and imports. The U.S. Chamber of Commerce and the U.S.-China Business Council said in testimony today that Chinese contracting rules, technical standards and licensing requirements were protectionist. Chinese officials have made the same charge against the U.S. following President Barack Obama’s imposition of tariffs on Chinese tire imports.

Both organizations have previously defended China, calling it a large and growing market for U.S. exports and lobbying to fend off legislation aimed at punishing China for currency policies and government subsidies. The criticisms of the two U.S. groups reflect mounting tensions that economists said could spark a spiral of retaliatory measures between the countries.

“There are growing indications that China’s movement toward a market economy has stalled,” Jeremie Waterman, senior director for China at the U.S. Chamber of Commerce, testified to a hearing at the U.S. Trade Representative’s office today. “The voices of protectionism in both countries are on the rise.”