Its impossible to prove one way or the other, but Horner sent me a paper in the Oxford Review of Economic Policy, by Oxford’s Bent Flyvbjerg, with the rather alarming title “Survival of the unfittest: why the worst infrastructure gets built—and what we can do about it”, which suggests why we need to be so worried about infrastructure spending in China – aide from the fact that the numbers are simply huge.

In the paper Flyvbjerg looks at infrastructure projects in a number of countries (not in China, though, because he needed decent data) and shows how the benefits of these projects are systematically overstated and the costs systematically understated.  More important, he shows how these terrible results are simply the expected outcomes of the way infrastructure projects are typically designed and implemented.

It is not a very happy paper in general, but I am pretty sure that many people who read it probably had a thought similar to mine: if infrastructure spending can be so seriously mismanaged in relatively transparent systems with greater political accountability, what might happen in a country with a huge infrastructure boom stretching over decades, much less transparency, and very little political accountability?  Isn’t the potential for waste vast?

Who knows, but it seems that Beijing is increasingly worried about that possibility.  Here is an article from this week’s Caijing:

A golden but brief era for urban railway suppliers, builders and related companies across China appears to have ended in recent months.  Local governments nationwide have slashed infrastructure spending since last summer, and the urban rail business has slowed to a crawl after several years of rapid growth.

…NDRC imposed extremely tight regulations on the approval process for subway construction before 2008, said Jin Yongxiang, general manager of Beijing’s Dayue Consulting Firm, which advises subway projects.  Jin said “the situation took a 180 degree turn” in April 2009, when the State Council reduced the minimum capital requirement for urban rail projects to 25 percent. Levitra side affects: at that time, a NDRC source told Caixin, credit was loose and bank loans were easy to obtain.

“In some cases, the NDRC gave a nod to an urban rail project even if a local government had yet to meet the minimum capital requirement,” the source said.”With NDRC’s approval for subway projects, banks were willing to lend and would not hold city governments to the capital requirement.”  In some cities, though, enthusiasm for the urban railway building went too far.

For example, rail lines were built where few people live on the outskirts of the Hunan Province city of Changsha, said Wang Chengli, an urban transit professor at the city’s Central South University; levitra side affects.Today, exit gates for some of the city’s finished subway stations lead to farm fields.  Wang said Changsha authorities installed far fewer kilometers of track in the city’s center than in its suburbs – levitra side affects.Each project was approved by the central government, he added.

Zhang says China learned important lessons from the fast-track subway program.For example levitra side affects, he now thinks subways should never have been built in “many cities.”  “The only cities that should have built subways are super-large ones such as Beijing, Shanghai, Tianjin, Shenzhen, Wuhan, Nanjing and Guangzhou,” Zhang said.” Levitra side affects: provincial capitals such as Shenyang and Taiyuan can handle their transit needs with a single, light-rail line.”  Subways can be uneconomical in smaller cities.Zhang said final costs for many projects were often much higher than a local government’s estimate.

Little by little the claim repeated by so many China bulls – that you can never spend too much on infrastructure – is being eroded – levitra side affects.It is possible, it turns out, to waste a lot of money even on infrastructure, and if debt-fueled investment is being wasted in China, as I have been arguing for over half a decade, then without doubt debt must be rising at an unsustainable pace.Last week Bloomberg had this article levitra side affects, which suggests that even the official numbers, which show debt soaring, may be understating the reality:

Debt accumulated by companies financing local governments such as Tianjin…is rising, a survey of Chinese-language bond prospectuses issued this year indicates.It also suggests the total owed by all such entities likely dwarfs the count by China’s national auditor and figures disclosed by banks.  Bloomberg News tallied the debt disclosed by all 231 local government financing companies that sold bonds, notes or commercial paper through Dec; levitra side affects.10 this year. Levitra side affects: the total amounted to 3.96 trillion yuan ($622 billion), mostly in bank loans, more than the current size of the European bailout fund.

There are 6,576 of such entities across China, according to a June count by the National Audit Office, which put their total debt at 4.97 trillion yuan.That means the 231 borrowers studied by Bloomberg have alone amassed more than three-quarters of the overall debt. 

The fact so few of the companies have accumulated that much debt suggests a bigger problem, says Fraser Howie, the Singapore-based managing director of CLSA Asia-Pacific Markets who has written two books on China’s financial system.“You should be more worried than you think,” he said of Bloomberg’s findings – levitra side affects.“Certainly more worried than the banks will tell you.

There is more to the article.  For example Huang Jifa, in the investment banking division at ICBC, reportedly says that local government loans aren’t a problem because the projects will generate returns, even if not immediately.“ Levitra side affects: the money that Chinese local governments have borrowed is not like the money people borrowed in Europe or Greece,” Huang said in a Nov.24 interview – levitra side affects.“The Chinese government’s borrowed money is all invested; levitra side affects.Many projects will have returns.”

Maybe, but I am pretty skeptical.  The problem of course is that it doesn’t matter that many infrastructure projects in China have returns.  I am sure many do (as did many projects in Greece, no doubt).  What really matters is whether all the various projects in the aggregate are generating greater returns than the debt servicing cost, adjusting of course for all hidden and explicit subsidies.  If not, then debt levels must be rising faster than the economy’s ability to service the debt.

Here, by the way, is another interesting related article, from last week’s South China Morning Post.

Auditors have uncovered 530 billion yuan (US$84.21 billion) worth of irregularities with local government debt, the National Audit Office said on Wednesday.  An audit report, published on China’s central government website, reveals some of the problems investment analysts had believed to lay beneath the 10.7 trillion mountain of debt that local governments had amassed by the end of last year.

The report, conducted for the last year budget year, found problems including 46.5 billion yuan worth of “irregular credit guarantees”, 73.2 billion yuan worth of loans secured against irregular collateral, 35.1 billion yuan spent on stocks, houses and polluting plants and 132 billion yuan worth of expenditure not made by its approved deadline.

“A fifth problem is the fraudulent and underpayment of registered capital in financing vehicles, which amounted to 244.15 billion yuan,” the report said.  The local governments involved have been ordered to correct wrongdoings, but the clean-up work remains less than half done in some areas, the report shows.

Xinhua later added an update to the story in which they focused on the amount of the irregularity that had been recouped:

Nearly half of the misused funds uncovered in the auditing of China’s local government debts in 2010 has been recouped, authorities said on Wednesday.  Of the 530.9 billion yuan (about 84.3 billion U.S – levitra side affects.dollars) of misused funds uncovered for the year 2010, around 259.2 billion yuan had been recouped by Oct; levitra side affects.2011 levitra side affects, the National Audit Office (NAO) said in a report on the year’s auditing progress.

 …Violations of the management of local debts involved illegal guarantees for local debts, misdirected funds to capital, property and energy-consuming markets, and the operation of fake investment companies, the report said, adding that the governments have been moving actively to correct the irregularities.

This particular story is less important than the frequency with which we hear similar stories.  Every credit bubble in history seems to have been accompanied by a surge in accounting “irregularities”.  Irving Fisher explained why in the 1930s, and Hyman Minsky also indirectly showed why this might happen.  It is, I guess, a necessary accompaniment to out-of-control credit expansion.

I get many calls from investors and journalists on these debt-related topics, usually because they worry about the ability of specific borrowers and sectors to service the reported debt, and I always make the same response.  The debt will be serviced.  One way or the other it will be assumed by the central government through the banking system. 

But this is not the important issue.  The important issue is that it is clearly proving impossible to keep GDP growth levels high without explosive debt growth, and there are serious debt capacity limits to this kind of debt growth.  I have no idea where the debt will next show up, or what the next debt panic will be (I suspect this year it will be SOE debt), but I have no doubt that there will be more of these debt panics.  This is not an accident.  It is intrinsic to the way the development model works.

The problem, then, is not that there will be defaults.  The problem is that the only alternative to default is to service the debt, and this is what will cause the real damage to the economy.  If the economic benefits generated by the investment are less than the correctly-valued debt-servicing costs, as they almost certainly are, the difference has to be made up in the form of a transfer of resources from some sector of the economy.

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.

Only consume!

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. Levitra side affects: 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.

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. 

In that light, it was interesting to see this article in Wednesday’s South China Morning Post:

The Chinese government is planning new policies to boost domestic consumption, especially of vehicles and appliances, in a bid to offset the effects of sagging export demand, the China Daily reported on Wednesday, quoting a government official.  With tax rebates on vehicles and domestic appliances either having expired or due to expire, the government is working on new measures, said Huang Hai, former assistant minister of commerce and a member of the economic and trade policy consulting committee linked to the Ministry of Commerce.

These may include subsidies for families living in affordable housing that buy electrical appliances and for consumers planning to change cars, the paper said.  The newspaper also quoted a Ministry of Commerce spokesman as saying that the ministry was considering new programmes to expand consumption, with details to be announced next week. 

Huang also said over 10 government agencies, including the Ministry of Commerce, the National Development and Reform Commission (NDRC) and the Ministry of Finance, are expected to co-operate and propose concrete plans to boost consumption at a meeting slated for April.

“If at first you don’t succeed, try, try again,” WC Fields advised but, he added, “then quit.There’s no point in being a damn fool about it.” I don’t think this new attempt to boost consumption has any chance of succeeding, any more than similar polices did in 2009 and 2010. 

Sure, consumption of automobiles and white goods surged back then, just as you would have expected given the subsidies, and they will surge again no doubt, 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 – levitra side affects.In fact during both of those years consumption continued to decline sharply as a share of GDP.

The Financial Times version of this story makes a classic mistake:

China has ample room to stimulate consumption – levitra side affects. Levitra side affects: household spending accounted for half of gross domestic product two decades ago but dwindled to just 33.8 per cent of GDP in 2010, a record low for a major economy in peacetime.China is probably now at a turning point in that consumption is beginning to become a bigger force in the economy levitra side affects, but this will be a “longer-term process”, said Zhu Haibin, an economist with JPMorgan.

For years China bulls have been arguing that because the Chinese save so extraordinarily much money, there is plenty of room to stimulate consumption – just get them to save a little less.  The problem with this reasoning is that consumption is not low because Chinese households save a lot (they save in line with other Asian countries as a share of their income, and less than some).  It is low because household income is such a low share of GDP.

It isn’t about household savings

The only way to boost household consumption is either to redistribute income from the low-consuming rich to the high consuming poor, or, better yet, to redistribute wealth from the state to households.  Both of these have serious political implications that have to be resolved and are unlikely even to be addressed with consumption subsidies.  After five years of this argument, during which time consumption has plummeted relative to total savings, you would think they would start to abandon the idea that all we need to do to get consumption to surge is to reduce household savings a little.

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.

Nonetheless on Tuesday Xinhua has this to say about housing prices:

Sales of both new and existing homes in Beijing plummeted in 2011 as a result of the government’s efforts to cool down the runaway property market.  New home sales in Beijing dropped 18.4 percent to 90,605 units in 2011 from a year ago, the Beijing News reported Monday, citing data from the city’s housing regulator.

In terms of square footage, sales slumped 22.4 percent to 9.56 million square meters last year, falling below 10 million square meters for the first time in six years, the paper said.  Existing property transactions also plunged. Levitra side affects: sales in 2011 shrank 38.2 percent to 121,512 units, hitting a three-year low.  Monthly sales of existing homes have stayed below 10,000 units since April, the paper said.

Increased down-payment requirements and mortgage rates, as well as limits on home purchases, led to the declines, the paper said, citing Zhang Dawei, a chief analyst with Centaline Property.  Consumers will likely expect further price drops in 2012, as the government has reiterated that it will maintain the policies, Zhang said.  Property prices in Beijing are likely to fall 10 percent to 20 percent over the next six to 12 months, he said.

On a related note, on Tuesday, Li Yan, a young musician I know, called me up to ask me for some advice.  His parents, who come from and still live in a small town in Hebei province, wanted to buy him an apartment in Beijing, where he lives and works, because they were sure that in a few years the same apartment would cost an awful lot more.He wanted to know from me whether it made sense to do so – levitra side affects.He had heard prices are coming down rapidly and asked me whether he should tell his parents to wait – levitra side affects.Yes, I told him, wait.

I mention this story because Li Yan is a 21-year-old kid who has just started to become famous among Chinese youth for his wild antics and wilder music, and I suspect he thinks about and discusses finance and real estate as often as I think about and discuss life on Venus – levitra side affects. Levitra side affects: yet even he has heard that real estate prices are dropping.  Two years ago, of course, no one in China had any doubt that real estate prices can only go up.

This is an abbreviated version of the newsletter that went out two weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances.  While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs.  Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.

The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus.  It could boost disposable household income and household consumption by cutting income and consumption taxes, and as German household income grows relative to the country’s total production, the national savings rate would automatically drop and the trade surplus contract and eventually become a deficit.  Or Germany could engineer a massive increase in infrastructure spending.

If Germany doesn’t do either, and especially if it imposes austerity, there must be a surge in unemployment for many years within Europe as German excess capacity meets dwindling demand in peripheral Europe – buy vardenafil online.This surge in unemployment will force the peripheral countries into the unenviable choice either of absorbing that surge in unemployment themselves buy vardenafil online, or of forcing the unemployment back onto the core countries by abandoning the currency that is at the heart of their lack of competitiveness.

The historical precedents – and much of the commentary coming out of Germany – suggest that Germany will not take steps to reverse the trade surplus.  Countries that run large and persistent trade surpluses never seem to understand that their surpluses are mainly the consequences of domestic policies that generate additional domestic growth by absorbing foreign demand.

On the contrary, they usually insist that the surpluses are the consequences of domestic virtue, and they see no reason to give up being virtuous.  Surpluses, they seem to believe, are the way God rewards them for their enviable behavior, and as their surpluses decline – an inevitable consequence of the malaise affecting their trading counterparts – they actually try to limit the decline and do all they can do to prevent it from becoming a growing trade deficit.

But this violates simple arithmetic.  Trade deficit nations have received capital inflows for many years from surplus nations as the automatic counterpart to their deficits.  If the surplus nations ever hope to get repaid – i.e.to reverse those capital flows – then it must be obvious that the trade imbalances must also reverse.

Spain buy vardenafil online, for example, can only support net capital outflows if it is running a current account surplus.  Germany can only receive net capital inflows if it is running a current account deficit. If Spain wants to repay its debt to Germany, and if Germany hopes to have its Spanish loans repaid, this can only happen if the former runs a current account surplus and the latter a current account deficit.

When should imbalances reverse?

The Germans, however, will argue that now is not the time for them to run a trade deficit, which would be the main way of running a current account deficit, presumably because their debt burden is rising, and so cutting taxes or increasing infrastructure investment will weaken their credit at exactly the wrong time.  They need to continue running surpluses for a few more years, they will insist, to protect themselves from the impact of the European crisis.

This is insane.  Countries cannot run surpluses forever, just as they cannot run deficits forever.  For debt not to build up to unsustainable levels in the deficit countries, both deficits and surpluses must ultimately be reversed.

When is the best time to do so?  Obviously the best time to do so is before the debt becomes unsustainable and there is a financial crisis.  If we have already passed that point, however, as we clearly have, when is the next best time to reverse the trade imbalances?

The answer should be obvious – right now.  If the present is not the right time to reverse European trade imbalances so as to allow the deficit countries to earn the wherewithal to support capital outflows, then when will it ever be the right time?  And by the way, as long as we are concerned about protecting German’s credit, if Spain cannot run a trade surplus, it cannot repay the debt it owes to Germany.  This also is just arithmetic.

This means that German reluctance to put into place policies that reverse the trade imbalances within Europe is illogical.  As the market has already indicated by its panic over European credit, German credit will be far more seriously damaged by defaults in the peripheral countries than by a cut in domestic income and consumption taxes, or by a surge in domestic infrastructure investment.

To make matters worse, it seems that not just debt prices but also credibility are in free fall.  Here is an astonishing quote from Christian Noyer, the Governor of the Bank of France and an ECB policymaker, according to an article in Saturday’s Telegraph:

“The downgrade [of France] does not appear to me to be justified when considering economic fundamentals,” Mr Noyer said in an interview with local newspaper Le Telegramme de Brest.  “Otherwise, they should start by downgrading Britain which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping,” he went on.

This was followed by the no less astonishing comments by François Baroin, French finance minister, who said: “The economic situation in Britain today is very worrying, and you’d rather be French than British in economic terms.”

Wow.This kind of fighting among countries is childish but unfortunately all too predictable given the historical precedents.  The English probably started the fight with some skeptical comments by Mervyn King, the Bank of England governor, about the health of the euro (not that he was wrong, just very indiscreet), but the French response has been a little out of control.

Aside from the fact that Mr – buy vardenafil online. Buy vardenafil online: noyer seems to have a limited concept of sovereign credit (France is not being considered for downgrading because of its explicit government deficits or its high inflation), these various statements should worry anyone who believes that the European crisis cannot be resolved without cooperation among European policymakers.  If they are so obviously squabbling, the skeptic in me wonders whether they really believe they can resolve the crisis, or whether they have already given up and are now preparing to assign blame.

Time to devalue the RMB?

There isn’t nearly as much (at least visible) antagonism and undermining behavior among Chinese policymakers, but I worry that there is nonetheless the same lack of logical thinking among them in regards to their “right” to a trade surplus – although at least they are not facing massive defaults in the countries to whom they have lent.  As China’s trade surplus declines dramatically, more and more people within the country are calling for interventionist steps to halt the decline, including depreciating the RMB, or at least halting its appreciation.

The rapid contraction in China’s trade surplus, they say, is evidence that China is rebalancing too quickly.  Already the Ministry of Commerce is issuing warnings.  This article is from Friday’s People’s Daily:

China’s trade will face ”very severe” conditions in the first quarter next year, a spokesman for the Ministry of Commerce said yesterday.  “The external economic climate will become very complicated next year, and net exports are set to slow,” Shen Danyang said.  “We will further accelerate reforms to achieve a better balanced trade and make overall trade remain a positive contribution to the economy. 

For trade to make a positive contribution to growth, of course, China must maintain a trade surplus – in a world of stagnant demand, only net demand from trade, that is a trade surplus, can contribute to growth.Trade deficits reduce demand, and I suspect that in spite of long insisting that the US trade deficit has not been negative for US growth, the Ministry of Commerce is unlikely to be as forgiving of a Chinese trade deficit.

But we would have to ask the same question of China as we would of Germany: if now is not the right time for China to run a trade deficit, when its reserves are sky high, when rebalancing the Chinese economy away from investment to consumption is more urgent than ever, when global imbalances have thrown the world into crisis, when will it ever be the right time?

Not next year, apparently; buy vardenafil online.There is developing in Beijing, I think, almost a panic about global economic prospects and the impact of the European crisis on China.  This panic is going make the rebalancing process harder than ever because a Chinese rebalancing almost necessarily requires a rapid slowdown in growth as investment decelerates sharply long before a rise in consumption can take up the slack; buy vardenafil online.Weakness in the export sector makes the slowdown all the more costly.

Certainly the focus of the very important central economic work conference that ended this week suggests that maintaining growth is the key. Buy vardenafil online: here is Saturday’s description in the People’s Daily:

China’s economic objective in 2012 will be to seek relatively fast growth while maintaining stable consumer prices, said a government statement issued yesterday, wrapping up the three-day central economic work conference.

“The theme of next year’s economic and social development is to make progress while maintaining stability, which means to maintain basically steady macroeconomic policy, relatively fast economic growth, stable consumer prices and social stability,” the statement said.

That sounds pretty reasonable.  However the Financial Times’ version of the story, perhaps not surprisingly, is a little more explicit:

China’s ruling Communist party wrapped up its most important economic meeting of the year with an agreement to focus on maintaining fast economic growth in the midst of what it described as an “extremely grim and complicated” global outlook.The annual three-day Central Economic Work Conference for top Communist officials sets policy for the coming year and this meeting clearly signalled that the leaders of the world’s second-largest economy are concerned about a slowdown in growth.

“Growth has replaced inflation as Beijing’s top policy concern,” said Qu Hongbin, co-head of Asian economics research at HSBC.“The economy is likely to slow further buy vardenafil online, calling for more aggressive easing measures.”  At the same conference last year, China’s leaders explicitly named taming inflation as the key policy goal for 2011.

The slowdown in growth is worrying an awful lot of people in Beijing and with all this concern, of course there is a lot of attention on trade policy.  Will the RMB appreciate or depreciate in 2012?  Within China many are going to argue that the rapid decline in the trade surplus, coupled with unmistakable evidence of flight capital, means that the PBoC should devalue the RMB.  Others within China will argue that debt levels and domestic imbalances are so worrying that the RMB should continue appreciating in order to speed up the pace of rebalancing.

If this were the whole extent of debate, it would be pretty easy to guess that the former side would win, but of course there is also international pressure.  Foreigners are going to argue that China’s maintaining a trade surplus will simply subtract from foreign growth, and given higher unemployment and lower growth in the US, Europe, and much of the developing world, China has no natural right to insist on a trade surplus at their expense.

With the trade environment getting worse all the time, I suspect that international pressure is ultimately going to decide the issue.  If China depreciates it will almost certainly set off furious retaliation – and remember, surplus countries always lose trade wars.  Deficit countries often win, at least in the near term.

his is an abbreviated version of the newsletter that went out two weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

But the PBoC move is qualitatively different from that of the others.  I think it is important to remember that changes in the minimum reserve requirements in China have more to do with managing the changes in underlying liquidity caused by net inflows and outflows to China than they have to do with changes in credit.  At any rate here is the Xinhua article on the subject:

The People’s Bank of China, the country’s central bank, said on Wednesday that it will lower banks’ reserve requirement ratio (RRR) by 50 basis points for the first time in three years in order to replenish liquidity in the country’s banking system as inflation eases. 

The latest cut, effective on Dec – levitra overnight.5, drops the RRR to 21 percent for large commercial banks and 17.5 percent for mid- and small-sized banks.An estimated 396 billion yuan (62.38 billion U.S; levitra overnight.dollars) in capital will be released into the market.  The move signals that the government is set to stabilize economic growth after easing inflationary pressures, although it is not yet known if the change will bring about a full-on move toward a looser monetary policy, analysts said.

I don’t think anyone was especially surprised by the direction of this move, although the timing was more aggressive than most expected – levitra overnight.It has been clear for a while now that China’s economy was slowing and we were pretty much expecting that Beijing was going to take action to spur credit expansion – which is really the only tool Beijing has to manage growth.

But the change in the reserve requirement usually has very little to do with credit growth, except possibly as a way for Beijing to signal its intentions.  For the past several years the main role of the reserve requirement hikes has been to soak up liquidity created by the monetization of the increases in the PBoC reserves (and, I suspect, to lower the funding cost for the PBoC, which would otherwise almost certainly run a negative carry).  When Beijing wants to affect credit expansion it does so mainly by administratively tightening or relaxing constraints on credit growth.

Since central bank reserves have not risen in recent months – in large part, it seems, because net speculative inflows have reversed (almost certainly because expectations of a stronger RMB have receded) – the PBoC may have decided that it needed to provide liquidity to the interbank market.  I suspect that this cut indicates that there were continued net outflows in November, perhaps even substantial; levitra overnight.We’ll know soon enough.

In fact the RMB continues to trade sharply down during intraday trading, only to be nudged up overnight by the PBoC fixing.  Three weeks ago in my newsletter I wrote extensively about this process and how it is probably a very good indicator of sentiment about RMB appreciation prospects.  From the data it seems that speculative capital is leaving China.

The combination of net outflows of flight capital and the sharp reduction in year-on-year inflation in October has left the PBoC feeling that they can afford to relax on the monetary side – even though, as I have long argued, inflation was bound to decline, but not because of traditional monetary tightening.

Growth is slowing

The more interesting question for most of us I think is whether in response to slowing growth Beijing will relax credit constraints in the near term.  Everyone who follows China closely knows about problems in the real estate sector, whose importance to growth in China should not be underestimated, but the growth weakness was across the board.  An article in last week’s Caixin lists the bad PMI numbers for October:

China’s manufacturing industry contracted, following a brief rebound in October, as the Purchasing Managers’ Index (PMI) dropped below the neutral level of 50 where it neither expands nor contracts, hitting a 32-month low in November.

 China’s PMI index for November was 48, down from last month’s 51 due to significant output contractions – levitra overnight.According to data released by HSBC and Markit on November 23, this was the largest single-month drop since March 2009. 

The output sub-indicator of PMI was 46.7, compared with 51.4 in October; levitra overnight.The number of new product orders decreased while the growth for export orders accelerated compared with the previous month.

article from the People’s Daily:

China’s manufacturing activities shrank for the first time in almost three years last month under dismal external demand, rising production costs and tight domestic liquidity for small firms.

The official Purchasing Managers’ Index, a comprehensive gauge of manufacturing activities across country slipped from October’s 50.4 to 49 in November, the lowest since March 2009. 

A reading below 50 indicates a contraction in industrial activities.  The drop was led by declines in new orders and new export orders, both of which scaled back more than 2 points and fell below 50, the China federation of Logistics and Purchasing, the index compiler, said today in a note. 

Also, most producers of raw materials and downstream products reported contracting activities, while manufacturers of consumer goods said their operational conditions still improved.

The numbers in the PMI report really aren’t good.  Every one of the important indicators are down, and I notice that my friend Mark Williams at Capital Economics is suggesting that year-on-year annualized growth in for the three months ending in October is barely above 7%.  He may be right.

Aside from the fact that it will probably take several months before any current change in credit policy will affect growth rates, I suspect that what really worries policymakers in Beijing is the speed with which Europe seems to be collapsing.  For two or three years I have been assuring my very skeptical Chinese friends that the problems in Europe were pretty substantial and would be extremely difficult to resolve, but I don’t think they really believed that it could degenerate like this.  The past two months, it seems, have been a real shock for Beijing and have forced some pretty rapid reconsideration of external conditions.

Exports are suffering

The impact of the European crisis is shown in the rapid contraction in shipping prices.  According to an article in Bloomberg.

The cost of hauling goods to Europe from China is falling faster than rates for deliveries to the U.S; levitra overnight.The price for shipments to Europe is down 39 percent to $511 per twenty-foot box since Aug.31, according to figures from Levitra overnight: clarkson Securities Ltd., a unit of the world’s largest shipbroker. Levitra overnight: that’s more than double the 18 percent slide in the cost to the U.S.West Coast, measured in 40-foot units.

 “European imports from China will be much, much lower going forward,” said Rahul Kapoor, a Singapore-based analyst at Platou Markets.“If you see falling freight rates, that would imply that European demand is falling off a cliff.” 

…While shipping rates were affected earlier this year by an expansion of the fleet that plies the Europe-China route, stable capacity since August shows the latest drop is a result of weak demand, Kapoor said in an interview today – levitra overnight.U.S; levitra overnight.deliveries are faring better than those to Europe, he said.

Earlier in the week Xinhua reported the results of a very gloomy survey among Chinese exporters:

A majority of Chinese exporters saw shipments to Europe decline in the past few months as the eurozone sovereign debt crisis weighed on external demand, according to newly released survey data.  About two thirds of nearly 600 companies surveyed from Nov.4 to Nov – levitra overnight.7 said their exports to Europe had dropped in the last few months, with 35 percent reporting significant falls, said Global Sources, a trade information provider, in a statement.

It said 22 percent of the firms reported exports remained stable and 12 percent reported growth in shipments.  Nearly 40 percent of the companies surveyed expected further decreases in exports to Europe in 2012, while 29 percent anticipated more shipments, said the statement.

To counter the impact, Chinese exporters said they would accelerate rolling out new products, cut costs and invest more in research and development to improve product quality, according to the survey.  Meanwhile, 42 percent of enterprises planned to strengthen their presence in emerging markets including Latin America, the Middle East, Africa, East Europe and the Asia Pacific.

I don’t think there is a whole lot to say about this week’s numbers beyond what I have been saying for the past several months.  Nothing substantial has really changed.  China’s external account is worsening, and will continue to worsen since global imbalances have no choice but to adjust.  Growth in China is slowing but remains relatively rapid, and as unhealthy as ever, but there is little likely to be done to improve the quality of growth until 2013.  Beijing will continue veering back and forth between stomping on the credit accelerator and stomping on the credit brakes as the only way they can manage the economy.

This is an abbreviated version of the newsletter that went out two weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address. – levitra overnight

These should have never been considered surprising revelations since the historical precedents for investment-led growth “miracles”, of which there are many, are pretty clear.  Still, it was only in the past two or three years that the problem of wasted investment was widely acknowledged, although even here not universally.  A number of China bulls that fought most strongly several years ago against the idea that China was misallocating capital on a grand scale are still fighting the good fight.

I mention this because of an article that came out in last Friday’s South China Morning Post about China’s investment in the electric car industry.  The electric car industry was often Exhibit A in the argument that Chinese investment was in the aggregate rational and economically sensible.  This industry is clearly the industry of the future, the China bulls argued, and China’s massive investment in the technology, which would allow the country to dominate one of the key sectors of the future, showed why it was mistaken to complain about capital misallocation.  This kind of investment was actually very clever stuff.

I have to confess I was never comfortable with this argument, although criticizing investment in the electric car industry was always a little like punching a six-year-old child.  It is really hard to do it without looking like a heel, and inevitably someone points out that since the electric car industry is clearly the industry of the future, and since China is getting an early lead, it follows that this is a very smart investment for China.

But remember, even if the first two points turn out to be true (and if it is so obvious, why doesn’t everyone else do it?), the third doesn’t obviously follow.  The point is not whether or not electric cars will one day be an important business, and certainly not whether electric cars are a “good thing”.  What matters as far as this debate is concerned is

1)      Whether the total economic costs of investment are less than the total economic benefits, and

2)      Whether there is a mismatch in the timing of costs and benefits. 

The first point determines whether the investment is ever wealth enhancing, and the second determines whether or not in the medium term there is a worsening of the underlying imbalance.  This means that in discussing whether or not capital is being misallocated it is not enough to assert that electric cars will one day be an important technology.

Electric cars?

My problem with Chinese investment in the electric car industry had nothing to do with my superior knowledge of the prospects for the industry (I have none).  It had mostly to do with my basic instinct that risky high-technology ventures are not best funded and directed by companies, industries and policymakers who are historically weak in the technology sector, especially when they have no shareholder or budget constraints and have almost unlimited access to heavily-subsidized capital.  This seemed to me a recipe for wasted investment.

This is why the SCMParticle interested me:

Beijing is having a serious rethink over its ambitious electric vehicles policy.  The central government has assembled the top experts and policymakers on electric and hybrid cars at a meeting in Wuzhen, in Zhejiang province, this week.  One expert attending the meeting said the government was increasingly concerned about problems in the industry, including its cost-effectiveness, technological difficulties and the uncertain benefits to the environment, according to the 21st Century Business Herald.

It said Beijing was reconsidering its support for pure electric cars and may rethink how to spend the 100 billion yuan (HK$122.6 billion) fund set up to develop green vehicles – perhaps by shifting resources to hybrid cars.

Beijing is soon to release the final version of its long-awaited green car development plan, which has been under drafting by the Ministry of Industry and Information Technology since 2009 – side effects levitra. Side effects levitra: but there is now growing debate as to how to make best use of funding set aside to help develop the next generation of cars.

The central government announced its ambitious plan to develop a new generation of green vehicles – focusing on pure electric cars – two years ago.  However, in July, Premier Wen Jiabao wrote a long article in the Communist Party’s mouthpiece Qiushi magazine in which he said he was confused by the latest developments and the future of electric cars.  He also criticised the lack of co-ordination and planning of local authorities and warned against committing resources to premature technologies.”Whether electric cars will be a mature product, we don’t know,” he wrote.

A few days after this article appeared, BYD, the main maker of electric car in China saw its stock soar by 26% in a day.  Here is what an article in South China Morning Post said was the reason:

Shares in the Warren Buffett-backed BYD soared 26 per cent to a three-month high yesterday on hopes that new policies to steer mainland car buyers towards electric vehicles would help turn around slumping sales at the Shenzhen-based manufacturer of petrol and electric cars.

The rally came after the weekend publication of a directive signed by four government ministries encouraging 25 pilot cities, including major markets such as Beijing and Shanghai, to “actively study” exemptions for electric cars from license plate lotteries and auctions, as well as a host of other purchase restrictions.

The only way to make electric cars economically viable in China, in other words, is to put into place administrative measures that divert buyers, but as any economics student can tell you, these kinds of administrative measures simply shift resources from one sector of the economy to another without creating wealth.  In fact because they force consumers to choose something that they otherwise wouldn’t, they actually reduce overall wealth.

It is hard for me to be very optimistic that the success of electric cars in China will increase the wealth of the Chinese people.  It seems to me that investment in high-prestige areas like electric cars, solar panels, and so on for technologically backward countries with low worker productivity may be a little like investment in the space program or in the Olympics.  They may have positive political and even psychological returns, but on a strictly economic basis they reduce overall wealth and exacerbate domestic imbalances.

In that case for all the importance the industry might have one day, debt levels in China must continue to rise unsustainably.  The key to determining their economic impact of any investment must be the two points that I posit above. 

Is capital is being wasted?

First, the additional wealth that it creates for the economy must exceed the debt servicing cost to the economy of the investment, and of course the debt servicing cost must be the “true” debt servicing cost, in which interest rates are implicitly raised to an economically justified rate, and not the heavily subsidized rate that simply transfers part of the cost to the household sector.  If it does not, the domestic imbalances are exacerbated and debt rises unsustainably.

Second, even if over the long term the benefits justify the cost, if they do not do so over the short and medium term, then the imbalances are exacerbated for some period before they are resolved.  In and of itself this shouldn’t matter if we are concerned about long-term growth prospects, but in the case of an economy with serious domestic imbalances and the risk that these imbalances may derail the economy, it will matter.  To get to the long-term you have to go through the short and medium term, and disruptions in the short and medium term may eliminate the longer-term benefits.

Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect.  I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years.  The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis.  No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.

The fact that China is so poor is often proposed as an argument as to why this cannot also be the case for China, but of course this is a nonsensical argument.  Poorer countries with lower levels of worker productivity are less able, not more able, to absorb very high levels of investment.  This may seem counterintuitive at first, but only if you believe that there is a single optimal level of investment for every country regardless of its specific conditions.  If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.

This is why when so many analysts compare the per capita capital stock of China with that of the US or Japan, and then announce that this proves China has a long ways to go before it runs out of investment opportunities, I am always surprised, and even a little skeptical about their economic backgrounds.  This comparison simply does not make sense.

If it did, overinvestment crises would be largely limited to rich countries, not poor countries – something that is certainly not confirmed by history.  Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.

But I think there are more formal reasons to believe that China is misallocating capital.  Common sense suggests that when there is massive investment with

• very little accountability,
• severely distorted prices,
• an incentive structure that concentrates the benefits of investment in specific jurisdictions and over a short time period while spreading the costs throughout the national banking system and over the debt repayment period (which can be decades),
• no or very limited budget constraints,
• factional and regional conflicts, and
• shifts in responsibility as the instigators of the investment are promoted (often because of the positive impact of their own investment initiatives),

it would be a rare system in history that did not tend towards substantial capital misallocation.

Certainly the evidence on SOE investment suggests that this is indeed what happened.  A number of studies have suggested that if over the past decade you add up direct subsidies, the impact of monopoly pricing (which is of course simply a tax on households) and the interest rate subsidy, they total anywhere from six to ten times the aggregate profitability of the SOE sector.  This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.

The impact on ratios

This doesn’t prove that the same must be the case for infrastructure investment, real estate investment, and R&D initiatives, but the only relevant difference between SOEs and infrastructure, real estate and R&D investment, it seems to me, is that in the former case there is at least some way of accounting for results, whereas in the latter there isn’t.  And since in the former case the results are not encouraging, what are the conditions that limit wasteful investment in the latter?  There may be some, but I don’t know what they are.

But there are other ways to try to judge if there is likely to be massive capital misallocation.  We can deduce whether or not capital is being misallocated by determining what impact large-scale misallocation might have on various ratios.  We can then look to see if this is indeed happening. 

I would argue that if capital is being misallocated on a substantial scale over many years at least three things should happen.  First, GDP growth per unit of investment should decline sharply.  Why?  Because the costs of misallocation are pushed into the future as debt is serviced.  As these costs accumulate, they should reduce future GDP growth, and so as we get to that future we would need rapidly rising investment to generate the same amount of growth.

This certainly seems to be the case in China, especially over the past three years, during which time investment growth rates surged while GDP growth rates stayed more or less constant.  There are three complications with this argument, however. 

• It is not just investment that matters, especially for China, where the external account matters a great deal, so the relationship between rising investment per unit of GDP growth will have been severely understated in the 2002-07 period, when the current account surplus surged, and severely overstated in the 2008-10 period, when it declined.
• It is natural for the growth impact of rising investment to decline even if capital is not being misallocated, since the marginal benefit of additional investment will tend to fall anyway.  The fact that this is happening in China proves nothing.  Only the fact that it is happening much more quickly than in other cases would suggest that capital has been misallocated.

• If capital has been misallocated for many years, then GDP growth numbers in recent years are overstated, which places us in a circular position.  The declining impact of investment on growth is greater if we already know that investment has been misallocated.

The second ratio that would be affected by substantial misallocated capital is the debt level, and if capital is being misallocated debt should be rising at an unsustainable pace.  Why?  Because when liabilities rise faster than assets, by definition the increase in debt is unsustainable, and if debt-funded capital is being wasted, by definition the value of assets is rising more slowly than the value of debt.

Is debt in China rising at an unsustainable pace?  We can’t prove it one way or the other, but I think most analysts would agree that debt is rising incredibly quickly.  It may very well be that this is sustainable, but then it seems to me that this would imply an acceleration of growth in recent years, something we haven’t seen.  If the value of total assets is rising at anywhere near the speed of debt, in other words, it would seem to me that we have reached a point in which the growth impact of investment is higher than it has ever been in the past thirty years.  This is unlikely.  Debt almost certainly is rising faster than GDP or any other measure of the capacity to repay.

Third, if capital is being wasted, and the resulting losses are not showing up in the accounting for the investment, then by definition the losses must have been absorbed by some other sector of the economy.  In that case we should see their share of total wealth decline sharply as they are forced to cover the huge waste in investment.

Creating value

Is it possible to identify this sector in China and to judge whether or not this is happening?  Of course it is.  The sector that is responsible for absorbing the costs – transferred in the form of low interest rates, an undervalued currency, low wage growth relative to productivity growth, monopoly pricing, environmental degradation, and so on – is the household sector.  Has their share of total wealth declined?  Of course it has, especially in the past decade, when it has all but collapsed.

Now notice that with the exception of the studies suggesting that SOEs misallocate capital, this is all circumstantial evidence.  It is nonetheless pretty powerful circumstantial evidence, and I think it strongly confirms what both common sense and historical precedents suggest.  It doesn’t prove that capital is being misallocated in China, but it certainly suggests that anyone who isn’t at least seriously worried about this possibility is pretty credulous.

To go to the other extreme, I also worry about investment in social housing, which many China bulls insist thoroughly undermines the argument that China is wasting investment.  I realize that once again I am going to make an argument that may at first seem very controversial, but I suspect that as in some of the other “controversial” arguments, within a year or two this will be more widely accepted.  I say this because although it seems at first counterintuitive, the logic to me is quite compelling.

Is creating more social housing in China a bad idea?  To suggest that it may be wasteful sounds even more of a heel’s argument than to suggest that investing in electric cars is wasteful.  After all China certainly needs social housing, so how can it be wasteful?

The answer, of course, depends on what we mean by wasteful.  There is little question in my mind that lack of housing for the poor in China is a big problem, but we have to separate social, political and economic benefits.  In order to understand the impact of a significant increase in investment in social housing on China’s rebalancing and debt levels, only the economic impact matters.  I don’t doubt that there are huge social benefits to providing the poor with adequate housing, and there are also important political benefits to doing so, but are there economic benefits?

It depends.  If the economic benefits of providing cheap housing exceed the economic costs, then a surge in social housing investment is good for Chinese rebalancing, good for Chinese wealth creation, and good for Chinese debt servicing ability.  If not, it isn’t.

The economic costs are easy to understand.  They are the cost of servicing the debt associated with the investment at whatever the appropriate interest rate would be.  What is that rate?  Remember that if the nominal interest rate is lower than the nominal GDP growth rate, net lenders (households depositors) lose relative to net borrowers, and the imbalances in the Chinese economy get worse. 

This suggests that the correct debt servicing cost should be equal to the nominal GDP growth rate if we are concerned about rebalancing.  Chinese nominal growth rates are around 14-15%, but I would argue that since GDP growth is probably overstated if I am right about wasted investment, perhaps we can adjust the appropriate interest downward to 11-12%.

If we are indifferent to domestic imbalances and are only interested in wealth creation, then the “correct” debt servicing cost could be lower, but it would have to be equal to inflation, plus the cost of liquidity, plus some fairly high risk premium to account for the volatility around expected outcomes in China’s economy.  Of course we don’t know what inflation in China is.  CPI inflation last year was 5-6%, but most analysts believe it understates real inflation – side effects levitra.The GDP deflator is 9-10%. 

Economic value of social housing

Where does that leave the appropriate debt servicing cost?  I don’t really know, but probably still pretty close to 11-12% even if you don’t care about domestic rebalancing, and a hell of a lot higher than the 6-7% (or lower) at which local governments are likely to be able to borrow from the banks.

So much for the costs.  What are the economic benefits of social housing? There are, I would argue, two different components.  First, if social housing improves the productivity of labor, perhaps by giving better access to work and healthier living conditions, then this improvement in productivity is part of the economic value generated. 

Second, families that receive social housing have had an increase in their wealth (by lowering their expected housing costs).  This should boost their consumption and so create an additional source of demand that will drive economic growth.

If the combination of these two things – the annual increase in worker productivity and the additional annual spending that social housing releases into the economy – is greater than annual debt servicing cost, then the expected surge in social housing investment in the next few years will help rebalance the economy and will improve China’s ability to service its debt.  If not, then it won’t.

I have ignored one other factor, and that is the income redistribution impact.  To the extent that spending on social housing redistributes income from the average Chinese to the poorer Chinese, it should increase consumption somewhat, since the poor consume a larger share of income than the rich.  But there is a flip side to this.  The poorer the recipients of social housing are, the less they will contribute to economic growth and rebalancing because the lower their productivity and the less likely the consumption released by moving them into housing will justify the cost of the housing.

The point of all of this is not to say that social housing is a bad investment.  I am arguing, instead, that when analysts say that China can keep growing healthily at elevated rates for many more years because policymakers are planning to invest in social housing, they may be completely wrong because they misunderstand the impact of the investment. 

We shouldn’t assume that social housing expenditures are really a radically new form of economic growth that will replace the old form of growth driven by misallocated capital.  It could very well be the same kind of growth, in which case we are still stuck with the problem of worsening domestic imbalances (and so a declining consumption share of GDP and more reliance on exports and investment), and unsustainable increases in debt.  We have, in other words, resolved nothing as far as the underlying economic problem is concerned.

Analysts too easily argue that investment in social housing is China’s trump card that will guarantee sustainable annual growth of 8-9% or more for the next several years.  It isn’t.  First, there is almost no way social housing investment will be large enough to replace investment in manufacturing capacity, other real estate development, and infrastructure, and if there is a problem with the latter, it will continue.  Second, investment in social housing may itself be economically wasteful.  Certainly there is no reason simply to assume that, given the conditions that have encouraged capital misallocation for over a decade, calling the investment “social housing” will change anything.

This is an abbreviated version of the newsletter that went out two weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

Much of the latest issue of the newsletter, sent out two weeks ago, was on disaggregating the trading performance of the RMB to separate market sentiment from PBoC actions, but since this was pretty technical stuff I am not including it in this blog entry. This means that once again most of the current entry will be on Europe — a topic from which it is hard to escape.

In China economists are watching the spectacle in Europe, China’s largest export market, with rising dread.  Might European deterioration affect Chinese growth?  October and November tend to be very important months for Chinese exports, and so the prospect of a miserable Christmas in Europe is weighing heavily on Chinese exporters. 

But there isn‘t much China can really do about it.  President Hu left the G20 meeting in Cannes Saturday without committing China to very much, merely saying:  “We believe Europe has the wisdom and ability to solve the debt problem.”  At this point, however, regardless of the amount of wisdom floating around Brussels I think it is pretty unrealistic to expect a happy solution. 

We’re well past that stage.  By now, it seems to me, neither wisdom nor cooperation among world leaders is going to get us out of the debt and currency problems we face.  Rather than try to prevent a major disruption the policy goal now should be to engineer as quickly as possible the least disorderly and disruptive unraveling of financial markets in the peripheral countries.  And while it may help relieve frustration to excoriate European leaders for having made poor, we shouldn’t assume that there really is a set of “right decisions” that will lead us out of this mess.  I think there isn’t. 

In Athens, the refusal by New Democracy yesterday to join Pasoc in a coalition government indicates just how difficult political cooperation is likely to become, and how drastically political horizons have shortened.  What’s more, by forcing Papandreou to cancel the referendum just days after he announced it – in the face of white-knuckled threats from an enraged France and Germany – Athens has pretty much made clear just how desperate things are and how little room the leadership has to maneuver. 

Indeed the whole issue of sovereignty has become fuzzy.  Since France and Germany have basically exercised direct power over Greek’s electoral politics without assuming responsibility for solving Greece’s domestic problems, I can’t imagine that this won’t stoke even more resentment in Greece. 

But it’s worse than just an issue of fuzzy sovereignty.  Last week something new happened which cannot help but affect the near-term outlook.  By openly speculating for the first time on Greece’s leaving the euro, Europe’s leaders have ensured that there is almost no chance now of preventing it from happening, and sooner even than most pessimists expected. 

A country CAN leave the euro? 

Not that there ever really was much of a chance, in my opinion, to keep Greece in the euro, but I assumed that European leaders would do whatever they could to postpone the day of reckoning until after the major elections this and next year.  They would find ways, I thought, even if that meant putting more unemployment pressure on the middle and lower classes in Greece for another year or two.  

But now I don’t think Europe can postpone Greece’s exit much longer.  Statements by France and Germany may have transformed the dynamics of the crisis affecting Greece.  Here is an article from Friday’s Financial Times: 

In the frantic political seizure triggered by Athens’ abortive referendum plan, European leaders broke what was once the eurozone’s big taboo: that Greece could default and leave the eurozone.  The possibility has long been discussed in private, not least in Germany. But for the eurozone’s leadership – especially France – the avoidance of default and preservation of the euro’s integrity was a core goal of the seemingly endless series of rescue plans and negotiations to keep Greece from crumbling under the weight of its public debt. 

Only last week, Nicolas Sarkozy, the French president, said in a national broadcast that a Greek exit would be a “catastrophe” for Europe and the world.  The mood has now shifted dramatically, with Mr Sarkozy and Angela Merkel, the German chancellor, publicly discussing the prospect in public as they heaped pressure on George Papandreou, the Greek prime minister, to back away from his call for a plebiscite on the €130bn bail-out for Athens. 

Greece’s European partners were not just furious that they had not been consulted about the now abandoned referendum.They knew that with public hostility to the austerity imposed on Greece rising levitra dosing, the likely outcome was rejection by the Greek electorate, potentially triggering a Greek default and contagion across the eurozone.

In effect, Mr Sarkozy and Ms Merkel were forced to acknowledge that reality in order to bring home to Mr Papandreou, his government and the Greek opposition just how high the stakes had become.  “The question is whether Greece remains in the eurozone, that is what we want.But it is up to the Greek people to answer that question,” Mr Sarkozy said. Levitra dosing: the message from Ms Merkel was the same. 

By openly acknowledging that Greece could abandon the euro, Europe’s leaders may have set in motion events that will automatically force Greece to leave.  Here is the logic.  If Greece is ever forced to leave the euro, it will first have to redenominate domestic corporate and household liabilities into the new currency – let’s call it the drachma – or else domestic borrowers will be wiped out by the fall in the value of revenues relative to debt as the drachma immediately depreciates against the euro. 

But it doesn’t end there.  If a bank’s assets – its outstanding loans – are to be redenominated into drachma, then its liabilities, i.e.deposits, must be redenominated too, or else the balance sheet mismatch will bankrupt the bank. 

And there is where the problem lies.  As soon as any depositor realizes that bank deposits are likely to be redenominated into drachma, he will pull his deposits out of the banks so as to protect the value of his savings.  But obviously only a few depositors will be able to do this before forcing the bank into closing.  In order to prevent the resulting collapse in the banking system, the only thing Athens can do is to freeze bank deposits long before most depositors have had a chance to cash out. 

But depositors know this.  As the probability of Greece’s leaving the euro rises – and clearly it rose dramatically this past week – anxious depositors eager to prevent their deposits from being frozen and redenominated in a weaker currency know that they will have to speed up their withdrawal of deposits from banks.  And of course as anxious depositors withdraw their deposits, the likelihood of a banking crisis rises, and with it the likelihood of Greece’s being forced to freeze deposits and leave the euro.  

A Bagehot intervention? 

We are caught, it seems, in one of those self-reinforcing loops that almost always presage a collapse.  Rational behavior by individual agents leads towards a catastrophic event the threat of which reinforces the behavior. 

I don’t see any way to get out of this loop except with a Bagehot-style intervention – a very unlikely but immediately credible announcement by Germany and France that they are prepared to guarantee all deposits in the Greek banking system.  I call it a “Bagehot intervention”, but of course Walter Bagehot would never have recommended bailing out an insolvent borrower. 

Without a credible intervention this process almost always ends the same way.  There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro.  Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations.  Will Greece follow suit?  “If history repeats itself,” footballer Andrew Demetriou once pointed out, “I should think we can expect the same thing again.” 

And it probably won’t end there.  In my opinion the real risk for Europe in that case becomes a contagion of deposit withdrawal, not immediately, but at the first sign of trouble in their home countries.  As households from Italy, Spain, Ireland, Portuguese, and other vulnerable countries read every day about hardships faced by Greek families (and those, it will be noted, who trusted the authorities were the worst hit), what will they do? 

I know what many of my wealthy Spanish friends are already doing.  They are moving their deposits to safer havens.  I suspect that in other countries too anyone who can afford to withdraw money from the domestic financial system is at least thinking of doing so.  If this process accelerates it may be very hard to maintain domestic confidence in the local banking systems anywhere. 

If Greece gets worse in the next few weeks, Europe had already better have a plan about what steps it will take to defend banks in peripheral Europe.  Once Greece goes, even the least sophisticated households in other countries will know what the consequences for depositors will be.  Deposit withdrawals, after all, are one of the kinds of actions that different sectors of the economy will take to protect their interests in the face of a crisis, even though this behavior increases the likelihood of the crisis. 

This is simply part of the logic of sovereign financial distress – declining credibility causes stakeholders to act in ways that reduce credibility further.    What’s more, deterioration in the political process is part of financial distress at the sovereign level.  Remember, as Keynes pointed out back in 1922, that resolving these kinds of crises is always political – it is about which sector of the economy (or class) ends up paying for the adjustment.  

Workers can pay in the form of high unemployment and declining wages, the middle class can pay by having its savings inflated away, private businesses can pay in the form of confiscatory taxes and expropriation, creditors can pay through forced debt forgiveness, and so on, but ultimately someone must pay.  Politics becomes about deciding which groups will be forced to foot the bill.  Historical precedents suggest that political fault lines are likely to develop as different groups organizes politically to protect themselves. 

We will probably see this happen, for example, in Spain.  On November 20 Spain will hold elections.  For now it looks like the conservative PP will sweep out the Socialists and take nearly 200 of the 350 seats in Parliament.  This will give them a clear mandate and the power to enact any legislation they want.  

Unfortunately, as I suggested earlier in this newsletter, this doesn’t mean that they can resolve the crisis if only they figure out the “right decisions”.  Although it is unlikely they will mismanage the crisis to the same extent as the Socialists under Zapatero, who seemed to place a little too much importance on charm and cleverness over leadership, I am not sure there is a whole lot the PP will be able to do better than the Socialists.  

Both parties after all face the same problem.  They must drive the economy back into competitiveness, but aside from tinkering at the margins with tax and structural changes, really the only two ways Madrid can make Spain competitive is to drive wages down or devalue the currency.  The options for the PP, in other words, are the same as for the Socialists: either abandon the euro or accept extremely high levels of unemployment for the rest of the decade.  It is unlikely that any government facing those two options can maintain popularity for very long.

This is an abbreviated version of the newsletter that went out two weeks ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

; levitra dosing

We were discussing an article that recently appeared in the New York Times calling for a Chinese bailout of Europe.  According to the author, Arvind Subramanian, at the Peterson Institute, “Europe is drowning and needs a lifeline.”  That lifeline is effectively a bail-out package from China.

Bad politics

Although I agree with Subramanian that China should use current events to play a bigger and more decisive role in global finance, and I certainly agree that as a surplus nation it is very much in China’s interest provide financing to the eurozone, I am not sure it makes sense for China to do anything that actually helps Europe. 

In fact I found the article a little bizarre, but not at all out of step with the thinking in Europe; levitra do for men. I think the request for assistance from China and other developing countries shows how confused Europe’s leaders are and reinforces the claim made by Beth Simmons in her book (Who Adjusts) on the politics of the 1930s European debt crisis – levitra do for men. Simmons argues that one of the problems with a debt crisis is that when debt levels are perceived as being too high levitra do for men, major stakeholders are forced into behaving in ways that reinforce credit deterioration and exacerbate the debt problem.

This is well-known in corporate finance theory and explains why the risk of bankruptcy tends to grow slowly, and then suddenly spin out of control.  But Simmons focuses on sovereigns, not corporates, and argues that one of the major stakeholders, the political leadership, is part of the same pattern. 

Levitra do for men: as political horizons get shorter (in a crisis, governments tend to be unstable), leaders choose short-term fixes at the expense of medium-term solutions.  Levitra do for men: since they are unlikely to be in office to benefit from the medium-term improvement, they discount its effect at much higher rates than they discount short-term policies.  The result is that the crisis gets worse, not better.

This seems to be what is happening in Europe. In order to postpone the crisis, perhaps because of upcoming elections in a number of important countries, European leaders are choosing quick fixes at the expense of long-term European growth, and of course this will simply increase the probability and cost of a crisis.

Europe is capital-rich and in fact is a net exporter of capital. The reason peripheral European governments cannot get financing is not because there is a lack of capital or liquidity but simply because their solvency is questioned by investors, and correctly so in my opinion; levitra do for men.  Levitra do for men: they don’t need Chinese capital.  Levitra do for men: they need someone foolish enough to lend money to countries that probably won’t repay.

If European leaders hope that China will lend large amounts of money directly to those borrowers, I say good luck to them but they shouldn’t expect too much.  Levitra do for men: why should China lend to someone who won’t repay?  But if Europe is asking China to lend into a fund that is effectively guaranteed by Germany, then there shouldn’t be much Chinese reluctance.  In that case however I would have to wonder why Europe needs help from foreigners. Germany has little difficulty in borrowing on its own.

This is absurd.  Levitra do for men: europe needs growth, not capital, and importing capital means exporting demand, which is now the world’s most valuable resource. Increasing unemployment cannot possibly be the solution for Europe – especially when Spain just announced yesterday that unemployment was up to 21.5%.  Levitra do for men: but I guess postponing the crisis is more important than medium-term growth if you are looking to get reelected in the next year or so.

Financing gaps

One of the members of the forum then asked if I was saying that all such interventions are value destroying, pointing out that foreign intervention, led by the IMF, in South Korea in 1998 was generally seen as positive for the country.  (This, as an aside, is more akin to the Suez canal crisis mentioned by Xiang than anything that is happening today in the US or Europe.)

My response:

The role of the IMF is to bridge balance of payments gaps (at least its original role). The problems of Europe are internal debt crises levitra do for men, not balance of payments gaps. In fact Europe as an economic entity is a capital exporter and has no trouble financing itself externally.

I guess we also have to make a distinction between a liquidity crisis and a solvency crisis – levitra do for men. I would argue that Korea suffered a liquidity crisis in 1997 (and Mexico in 1994, for that matter) because of its severely mismatched and inverted balance sheet.  Since the only thing that could repair the balance sheet was US dollars, it needed external help – levitra do for men. The adverse trade impact of that external help was presumably less than the adverse impact a sovereign default would have had.

I admit that I may be overly hasty in saying that what Europe is experiencing is a solvency crisis – like that of Mexico in 1982 – in which case additional foreign borrowing is likely simply to postpone the eventual debt restructuring/forgiveness while ensuring many years of stagnation – levitra do for men. It will not reduce the threat of default.

Of course if I am wrong, and European governments are not at all insolvent but simply illiquid, the liquidity should be provided by European governments; levitra do for men. Korea needed the IMF to supply dollars, because it experienced a dollar liquidity crisis, but if Spain etc.are simply experiencing liquidity crises, and not solvency crises, it is euro liquidity they need, not dollars, yen or RMB, and asking for foreign loans will have trade consequences.

To put it in different terms, if California experiences a solvency crisis, it should default and restructure its debt. If it experiences a liquidity crisis in which it is unable to bridge a short-term financing gap, I would argue that it should not turn to the IMF or to European or Chinese central banks for funding but rather to the US government, or more likely to its creditors; levitra do for men. In fact California would not even be allowed to go to the IMF.

That is one of the problems with Europe.  Levitra do for men: is it a single country, in which case Spain is just the European California and should not turn to the IMF or foreigners, or is it a bunch of separate countries anyone of which can go to the IMF, in which case the IMF should be able propose currency devaluation as one of its conditions for lending?

In the end this is Germany’s crisis to resolve, not China’s.  Germany has benefitted tremendously from the euro.  Nearly all of its growth in the past decade can be explained by its rising trade surplus which, given monetary policy driven almost exclusively by the needs of slow-growing and consumption-repressed Germany, came at the expense of the rest of Europe.

If the Germans want to save Europe, they must reverse their polices and start running large trade deficits even if that comes with slower growth.  If not, the euro will break apart and peripheral Europe will almost certainly default on its obligations to Germany.  Levitra do for men: either way Germany loses.

And why do I say that Germany benefitted from the euro at the expense of peripheral Europe?  For one thing, take a look at the table below provided to me by Chen Long.  It shows the top ten trade deficit countries for each of the indicated years.  I have colored each of the spendthrift, deficit-loving countries of peripheral Europe red, and all the thrifty, deficit-hating countries green.

Notice that peripheral Europe in red shows up quite a lot – mainly thanks to Spain and Portugal and to a lesser extent Italy, in 1991 and 1992.  In total they show up around twelve times during the decade, with an average rank of roughly six.

Surplus and deficit

But notice that Germany shows up every single year among the leading deficit countries – with an average rank of around four, which makes it worse than the average for Spain, Italy and Portugal.  Toss in Austria, a country with policies that mirror that of Germany, and the “virtuous” countries of Europe turn out in the 1990s not to have been much more virtuous than the vicious ones.  They turn up fourteen times instead of twelve and have bigger deficits on average.

I know this isn’t a very scientific analysis.  Germany is much bigger than the other economies and so a smaller deficit in GDP terms will nonetheless show up as a larger deficit in nominal terms.  But it is interesting that before the adoption of the euro, thrifty hard-working Germany managed to run quite a lot of trade deficits.

Now take a look at what happened in the next decade to the top ten leading deficit countries.  Once again the spendthrift, deficit-loving countries of Europe are colored red.

Pretty surprising, right?  First off, notice that there is no green.  It turns out that Germany and the thrifty Europeans largely learned to love thrift only after the euro was established.

Red countries, on the other hand, are everywhere.  Although I am sure to be excoriated by some, not least by my French mother and her family, for including France among the spendthrifts, altogether they show up 42 times, with an average rank of around five.  Their performance in the decade after 2000 turns out to have been abysmal compared to their performance in the decade before 2000.

The data for leading trade-surplus nations tell a similar story.  In the decade before 2000, Germany shows up in the top twenty trade surplus countries only once, in 1990.  But in the decade after 2000, Germany is the second biggest trade surplus country every single year except in 2001, and again in 2010, when it ranked third.

Among the spendthrift countries, on the other hand, France shows up in the top ten trade surplus countries every single year from 1992 to 2003, after which it drops off forever to become one of the major deficit countries after 2005.  Meanwhile, surprisingly, presumed wastrels like Italy are actually in the top ten trade surplus countries every year from 1993 to 1999, while little Ireland managed to put in four showings in the top twenty trade surplus countries in the 1990s.  In the decade after 2000, however, they too became major deficit countries.

So how do we explain the European crisis?  One theory is that the European crisis was caused by the moral turpitude and spendthrift habits of lazy Europeans along the periphery, in sharp contrast to the hard-working and thrifty countries of the center.  According to this theory it is unfair to demand that Germans clean up the mess. 

If you believe this theory, you are going to have to explain what happened in 2000 that turned thrifty Italians, French and Irish into spendthrifts, and that turned ordinary Greeks, Portuguese and Spaniards into even worse spendthrifts.  You will also have to explain why spendthrift Germans in the 1990s suddenly morphed into the stolid, thrifty creatures of legend.

An alternative theory is that the imbalances were caused by internal policies – perhaps the creation of the euro and the gearing of monetary policy to German needs at the expense of the periphery? – which led to the severe internal imbalances.  These imbalances created employment growth in the countries that suppressed consumption, and forced the countries that didn’t to choose between debt and unemployment.  Of course since the latter countries had no control over monetary policy, the choice was largely made for them by the ECB with its excessively low interest rates, and their debt levels surged. 

I find this alternative theory a lot easier to understand, and if it is true it places responsibility for saving the euro squarely in Germany’s hands.  The only way to save the euro (and incidentally to prevent Germany’s banks from being forced to absorb huge losses on peripheral European debt) is for Germany to spur consumption and investment enough to reverse the current account surplus.  Only this will allow peripheral Europe to grow and to earn the euros needed to repay the debt.

Betting the future

Before closing I wanted to mention one last thing, perhaps more as a joke than as an opinion on anything substantial.  I spent last week at a conference in Melbourne.  As I was coming back I noticed at the airport a huge billboard advertising Ernst & Young.

It seems to be the fashion among large financial institutions to advertize how globalized they are by relaying some “astonishing” fact about the world and implying that if you hung out more with them you wouldn’t find the fact astonishing at all.  Ernst & Young’s astonishing fact was presented this way:  “Fact or fiction?  China’s estimated economy will reach $29 trillion by 2020.”

If they had been more straightforward, and simply posited that China’s economy would be $29 trillion by 2020 I would have cheerfully guessed “fiction”.  I assume by the way that they mean constant dollars otherwise the whole exercise is pointless.  China’s nominal dollar GDP in 2020 is inordinately sensitive to dollar inflation between now and then.

Since it is China’s “estimated” economy, however, that is supposed to reach $29 trillion, I was unsure of how to respond.  I suppose it is a fact that someone somewhere has made that estimate, but since every other possible estimate has also probably been made, I am not sure I would want to make a big deal of this particular one unless I believed it to be accurate.  Anyway how can an “estimated” economy reach any number?  Maybe a grammarian should have check the ad before it went up.

At any rate I did the math, and it turns out that China has to grow by roughly 16% a year in constant dollar terms to reach $29 trillion in 2020.  I guess if you think China will grow in real RMB terms by 9% a year, and that inflation in China will be more than 5% a year, and that the RMB will appreciate by 4% a year, and that dollar inflation will be around 4% a year, you can get to the $29 trillion, but it seems a stretch – especially the assumption of real RMB growth of 9% a year while inflation and the RMB are appreciating together by 9% a year. 

I would like to make a $100 bet with Ernst & Young.  I bet that in constant dollars China’s GDP will be much closer to half that number.

This is an abbreviated version of the newsletter that went out last week.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

The biggest problem with the debate, I think, is the muddled thinking and half-baked arguments that characterize each side.  For example many of those who believe China is cheating on trade go through complicated exercises to prove the currency is undervalued and should be sharply revalued.  

The currency may well be undervalued, but a significant rise in the RMB, especially if it is countered domestically by an increase in credit at lower real rates, might actually make the global imbalances worse and, more worryingly, cause China’s debt burden and capital misallocation to rise.  This would make China’s eventual adjustment far more difficult. 

The focus should be on shifting China’s economy towards the more labor-intensive and efficient sectors, and an appreciating RMB might actually make things worse, especially if it encourages hot money inflow.  It is much better, I think, for China to raise interest rates than to raise the value of the RMB. 

The other side’s arguments are even more muddled.  The US-China Business Council, for example, issued a release on October 12 that exemplifies one of the major misunderstandings on trade. I realize that the USCBC is primarily an advocacy group, and so their arguments are aimed at supporting a position rather than adding to the debate, but I wonder if making arguments that are so easily refuted helps their cause. 

Here is what the USCBC said in their October 12 release. 

USCBC believes that the currency legislation passed yesterday by the US Senate will do more harm than good.USCBC continues to advocate that China needs to move faster toward a market –determined exchange rate; passing tariff legislation on imports from China will not get us closer to this goal and will hit the pocketbooks of American households at a time they least can afford it.  Limiting imports from China would not mean an increase in US employment or lower the trade deficit; we’ll just shift our imports to another overseas supplier; levitra doses. Levitra doses: if this is intended to be a jobs bill, it is a jobs bill for Vietnam, Indonesia and Mexico. 

For their first point, we should be clear.  Tariffs will hurt the pocketbooks of American households as consumers, but not as workers.  If there is a positive impact on employment, under conditions of high unemployment households are likely to be better off, not worse off, if there is a resulting contraction in the trade deficit, even if the cost of consumption rises.  This is just arithmetic. 

So the key question is whether actions taken by the US can cause the trade deficit to contract and with it US unemployment.  This is where their second point comes in.  The USCBC says there will be no domestic employment impact – which also means that it will cause no contraction in the current account deficit – because any reduction in exports from China will merely shift the US trade imbalance to countries like Vietnam, Indonesia and Mexico. 

Others make the same argument.  David Pilling, for example, someone with whom I usually agree, in Thursday’s Financial Times says:

Even if Chinese exports do become less competitive, jobs are unlikely to flock to high-wage economies such as the US.Rather they will tend to go to other low-wage ones such as Bangladesh, Vietnam, Indonesia and Mexico. 

But no.  As I have pointed out many times, this argument is wrong for at least two reasons.  The first reason is the implicit claim that there is no overlap between US production and Chinese production – it assumes that the US produces, or can produce, none of the things that China exports.  This is clearly and demonstrably false. 

The second, and much more important, reason is that this argument implicitly assumes that changes in trade flows only have first order impacts – in other words if a Chinese textile exporter loses his American client to a Mexican exporter, there will be no further economic impact on the US trade account.  This, of course, is nonsense. 

Let us assume for a moment that 100% of any reduction in US imports from China results in an equivalent increase in US imports from Mexico and none of it from an increase in US production.  This is very unlikely but I am willing to concede the point for the sake of argument. 

Trade is global, not just bilateral 

Lucky Mexico, right?  But the story of course doesn’t just end there.  Why do Mexicans want to increase their exports – just so that they can rank higher on the export league table?  No, of course not.  They want to increase their exports so that they can increase their own incomes and so consume more at home. 

Since Mexico’s own current account will be determined by the gap between domestic savings and investment, depending on how much excess capacity and unemployment there is in Mexico, the increase in Mexico’s exports will be more or less matched by an increase in Mexican imports.  After all a surge in Mexican exports to the US should cause Mexican wages to rise, Mexican unemployment to fall, Mexican interest rates to rise, and the peso to rise.  

All of these things will increase household income and so increase domestic consumption and domestic investment in line with the increase in domestic production, and this will require additional Mexican imports.  Some of these additional Mexican imports will come from the US, and some from some other country, but the other country from which Mexico imports more will then go through the same process.  Ultimately many countries’ trade accounts will be affected, and the net impact will be an increase in US production. 

The key (and indisputable, since it is just an accounting identity) point is that if China’s trade surplus falls and Chinese net purchases of dollars decline correspondingly, the US current account deficit must decline by an equal amount.  There are many ways this can happen, some good and some bad, some directly and some through changes in the trade balance of other countries, but it must happen. 

To claim otherwise shows a marked inability to understand the balance of payments mechanism.  What we really should be debating is how to accomplish this shift in trade in a way that is optimal for China, the US, and Mexico.  Denying that it will happen really doesn’t help. 

There is more.  Pilling in his Financial Times article provides some other very common arguments as to why US trade intervention will have no effect on US employment, and I think these arguments are also wrong, or at least more complicated than he makes out.  He says: 

Many items supposedly made in China are just assembled in China.A report by the Asian Development Bank Institute in 2010 found that, of the estimated $178.96 wholesale cost of an iPhone, the value of assembly work in China accounted for only $6.50; levitra doses. Levitra doses: most of the manufacturing cost comprises high-precision components made not in low-wage economies, but in high-wage ones such as Japan and South Korea. 

Since June 2005, when the renminbi was first unpegged, the Chinese currency has appreciated 30 per cent against the dollar.The real rate of appreciation is greater given higher Chinese inflation – levitra doses. Levitra doses: we should not be surprised that this has failed to do the trick.The yen virtually doubled in value within two years of the 1985 Plaza Accord levitra doses, with little impact on Japanese exports. 

The iPhone example in the first claim always seems to come up, but of course it would only be relevant if iPhone-like products consisted of all, or at least the bulk, of China’s production of tradable goods.  

Do they?  Perhaps they do, in which case the claim – that there is too little Chinese pricing component in China’s exports for a revaluation to matter – may well be plausible, but to the extent that it is true it also means that there would be no cost anyway to China of revaluing the RMB.  Revaluing would not affect China’s export competitiveness one whit. 

Of course if this true, China should quickly revalue even without US pressure.  After all why worsen China’s terms of trade and give up control of monetary policy if there is no positive employment impact of currency intervention?  Simply to annoy the US Senate? 

The fact that China isn’t immediately revaluing in a massive way, I suspect, suggests that no one in China buys this claim. The iPhone is probably a very atypical example of Chinese exports or of products aimed at import substitution (which, let us not forget, are just as relevant to the debate over trade intervention as are actual exports). 

The second argument is more complicated and perhaps more confused.  The experiences of Japan after 1985 and China after 2005 are often used to prove that exchange rates don’t matter to trade imbalances.  In both cases, after all, rising current account surpluses followed currency appreciation. 

Of course, and again, if anyone in China (or Japan, for that matter) really believed that the level of the currency is unrelated, or even inversely related, to the size of the trade surplus, the conclusion would be all the more urgently in favor of appreciation.  If raising the value of the RMB really does give China the same or a bigger current account surplus, then why not do it immediately?  There would be nothing but positive benefits for China. 

Getting the logic right 

The answer, of course, is that currency does indeed matter, but it is not the only thing that matters.  In both cases – Japan after 1985 and China after 2005 – the currency appreciation was matched by a significant expansion of domestic credit and a reduction in real interest rates.  

As I have often argued, repressed interest rates are an even greater cause of the current account surplus than a repressed currency.  If China forces up the RMB but then lowers real interest rates even further, the combination could easily cause the current account surplus to rise, but at the expense of more capital misallocation in China – as Japan’s experience in the 1980s amply demonstrated. 

Bloomberg recently had an interesting article on Friday showing just how this relationship between credit and the international competitiveness of the tradable goods sector works: 

China has taken on General Electric Co; levitra doses.(GE) and Western peers that control the $70 billion wind-turbine market, striving to repeat its 2010 coup when the Asian nation sold more than half the world’s solar panels for the first time. 

Armed with at least $15.5 billion in state-backed credit, China’s biggest windmill makers Sinovel Wind Group Co – levitra doses.and Xinjiang Goldwind Science & Technology Co.won their first major foreign orders in the past year.They plan to set up plants abroad, including China’s first in the U.S., easing entry into markets for delivering machines that can weigh 750 tons each. 

…Sinovel, Goldwind and China Ming Yang Wind Power Group Ltd – levitra doses.(MY) have disclosed at least $15.5 billion in loans and credit lines since May 2010 to aid their international expansion from CDB and Industrial & Commercial Bank of China (601398) in statements and filings.  Goldwind and Sinovel announced plans to raise as much as 10.5 billion yuan by selling bonds. Levitra doses: goldwind disclosed its move in June, and Sinovel announced regulatory approval yesterday. 

As part of Sinovel’s biggest European deal, CDB will provide debt financing to its Irish partner, Mainstream Renewable Power Ltd.A-Power plans to raise $260 million in debt from Chinese lenders for its Texas wind park, it said in May.  CDB is offering a yuan-denominated loan for Florianopolis- based Desenvix’s 34.5-megawatt project at an interest rate about four percentage points lower than what’s available through Brazilian banks, though hedging the yuan currency risk might offset that discount, Desenvix’s Antunes said.

Aside from suggesting that there is indeed some overlap (wind turbines and, as the article mentioned elsewhere, solar panels) between Chinese exports and US production, the main point here is that it is possible to change relative competitiveness not just be adjusting tariffs or the value of the currency, but even more importantly by adjusting local financing costs, especially for capital-intensive products. 

I hope I am not cherry-picking weak arguments, but I think every article I saw opposing the Senate bill used one or more of these three arguments.  In general there are altogether too many muddled arguments in favor or against trade intervention.  It is even possible for someone like Guido Mantega, Brazil’s finance minister, to take major interventionist steps all the while decrying the rise of currency and trade wars. 

The truth is that I am very pessimistic about the evolution of trade over the next few years.  I expect further sharp deterioration in the international trade environment and the continuation of trade and currency wars.  Part of the reason for my pessimism is the dishonesty or muddle-headedness of both sides of the debate, and this cannot but lead to grandstanding, unrealistic expectations, and more fighting.  

If we are going to do better, at the very least we need to accept two pretty straightforward claims that both basic trade theory and economic history confirm pretty overwhelmingly: 

1. Trade intervention is bad for global growth, and the world would be poorer, not richer, if international trade collapsed.
2. Diversified economies with high unemployment and large current account deficits generally benefit, at the expense of their trade partners, from trade intervention; levitra doses.Surplus countries, by the way, have almost no real ability to retaliate.  In fact it is very hard to find a significant counterexample in history, in which an increase in tariffs or a devaluation of the currency did not cause employment growth for a diversified country with a large trade deficit.  I, for one, haven’t found any, but I find it easy to remember cases in which trade intervention resulted in relative outperformance.  

If trade warriors refuse to accept the first claim, and free traders refuse to accept the second claim, I really don’t see how we can possibly arrive at a globally optimal outcome.  Trade will continue to contract as deficit countries discover that trade intervention indeed works, just as Keynes claimed that it would, to shift the unemployment burden of adjustment from deficit countries to surplus countries. 

This argument, by the way is not just about China and the US.  It is just as much about Germany and deficit Europe; levitra doses.And it is no closer to being understood there either.

This is an abbreviated version of the newsletter that went out last week.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

How do interest rates normally affect the savings and consumption rate?  The consensus view, of course, is that there should be a negative correlation between interest rates and consumption.  In other words when interest rates rise, households should save more and so consume less out of current income. 

Why?  One reason may be that savings are simply postponed consumption, and we are willing to postpone consumption if we are paid enough to do so.  The more you pay me to save in the form of a high interest rate, in other words, the more I save out of current income, and so the less I consume.  The same thing happens, by the way, when rising interest rates cause the cost of consumer financing to rise, and so discourage the use of credit cards.

There is another reason why this may be the case.  Typically we associate rising interest rates with falling stock, real estate and bond prices.  If most of our wealth consists of those three kinds of assets, then higher interest rates should be associated with a decline in our wealth, and because we feel poorer, we reduce our consumption rate.

In both cases rising interest rates are assumed to bring declining consumption and higher savings.  This relationship seems to be supported by the data in many countries. 

I am nonetheless a little uncomfortable with the first explanation – that as you increase the reward for postponing consumption, households save more.  I find it hard to believe that people really think this way about savings, and if they did, it seems to me that unless there were an enormous preference for liquidity, in any country in which deposit rates were negative in real terms (i.e – buy levitra on-line.households are paying, not getting paid, to postpone consumption) consumption rates should rise to 100% or more. 

This certainly isn’t the case.  In China, for example, deposit rates are seriously negative and have been negative for many years, and yet the household savings rate is nonetheless very high.  In fact it seems that, as a rule, countries with repressed interest rates have higher, not lower savings rates. 

What’s more, I have seen US historical data that suggests that when interest-rate declines have coincided with falling, not rising, stock and real estate markets (as they have recently), the savings rate usually rises rather than declines.  In other words households care mainly about their wealth, not about the reward for postponing consumption. 

Which explanation is more correct matters a lot for Chinese monetary policy.  We tend to be so US-centric when we think about economics – including, unfortunately, most Chinese economists – that we automatically assume that because raising interest rates in the US will reduce consumption and so limit inflation, it must also be the case in China – buy levitra on-line. 

Even very prestigious newspapers, citing prominent economists and research analysts, assure us that in order to fight inflation the PBoC raises interest rates.  Here for example, is what the Financial Times said three months ago: 

China has raised interest rates for the fifth time in eight months, indicating the country’s leaders are still focused on taming politically sensitive inflation, despite evidence that the world’s second-biggest economy is slowing – buy levitra on-line.Benchmark one-year lending rates will be raised 25 basis points to 6.56 per cent from Thursday, while one-year deposit rates will go up 25 basis points to 3.5 per cent, the central bank said on Wednesday.

The rise suggests that inflation is likely to have accelerated to a three-year high of more than 6 per cent in June, well beyond Beijing’s comfort zone.  Buy levitra on-line: the government is scheduled to announce the inflation figure next week.

Here is Xinhua, on the same day: 

The interest-rate hike will help check high inflation and the June CPI data will be 6.2 percent, Lu Zhengwei, chief economist for the Industrial Bank, predicted. 

…Guo Tianyong, a professor with the Central China Finance University, said the move is necessary as it can help correct the negative interest rates and manage inflation, but it can also slow economic growth and precipitate inflows of speculative hot money. 

A quick Google search uncovers thousands of articles and OpEd pieces that make the same point.

The empirical evidence

But for many years I have strongly disagreed with this claim that raising rates is a way of combating inflation.  If it is the wealth effect, and not the consumption-postponement effect, that really drives changes in savings and consumption rates, then raising rates would only reduce consumption if there were a negative correlation between interest rates and wealth, as there clearly is in the US. 

Is there a negative correlation between the two in China?  Probably not.  Most Chinese savings, at least until recently, have been in the form of bank deposits.  In a financial system in which deposit rates are set by the central bank, the value of bank deposits is positively, not negatively, correlated with the deposit rate.

Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines.  In that case, rising rates should be associated with rising, not declining, consumption and with higher, not lower, inflationary pressure.

I want to repeat this because I think it is a very important source of confusion.  In the past few years the consensus on China has dramatically changed, and as a result many of the things I used to discuss which once sounded so strange and “contrarian” (I hate that word) – discussions for example about the unsustainable increase in Chinese debt, the role of financial repression in undermining household income growth, the nature of the Chinese growth model – are now pretty widely held. 

But it is still very rare to hear anyone acknowledge that while raising interest rates in China may be a very good thing – because it reduces the capital misallocation on which Chinese growth is highly dependent – it does not reduce inflationary pressure.  It increases it.

Needless to say that is why I found the Nabar paper so interesting.  My argument had always been a conceptual argument based on balance sheet principles, but Nabar has tested the correlation.  He went out and measured changes in consumption as a function of changes in the real deposit rate.

And he finds in fact, in line with my conceptual argument, that higher real rates really are associated with lower savings and higher consumption.  Here is what he says:

Although a large body of research has examined the determinants of household saving in China, little attention has been directed to interest rates and their impact on saving decisions.  Bank deposits are currently the primary saving vehicle available to Chinese households.

The return households earn on these bank deposits could therefore potentially influence household saving behavior in a tangible way.This research assesses how interest rates affect household saving decisions using a panel dataset that covers China’s 31 provincial-level administrative units over the period 1996–2009.

The main findings are as follows. 

• Panel estimates suggest that household savings respond strongly to a change in the real interest rate – buy levitra on-line. Buy levitra on-line: a one percentage point increase in the real rate of return on bank deposits lowers the urban household saving rate by 0.6 percentage points.

• A comparison of the relationship across sub-periods shows that the association is stronger in the later period, 2003–09, relative to the earlier period, 1996–2002.The relationship is robust to the inclusion of variables that proxy for other influences on saving such as life cycle considerations and self-insurance against income volatility.  

• The evidence also indicates that when the return on alternative investment is high (for example when real property price growth is relatively strong), a decline in the real return on bank deposits does not have as negative an impact on household portfolios.  

The results suggest that China’s households save to meet a multiplicity of needs – retirement consumption, purchase of durables, self-insurance against income volatility and health shocks – and act as though they have a target level of saving in mind.An increase in financial rates of return, which raises the return on saving, makes it easier for them to meet their target saving.Financial reform that boosts interest rates could therefore have a strong effect on current tendencies to save. 

I think this is a very important point.  For one thing it confirms the claim that financial repression also represses consumption growth, and so is one of the factors at the heart of China’s economic imbalances – in fact I would say it is the main factor.

It also says that monetary policy may have very different consequences from our hidden assumption that it works the same way in China as it works in the US.  In the US if the Fed wants to lower inflationary pressures, it raises interest rates to reduce household wealth, to raise the cost of consumer financing, and otherwise to put downward pressure on demand by reducing consumption.

In China however when the PBoC raises the interest rate it has limited effect through the cost of consumer financing (consumer finance is negligible in China) and it actually increases household wealth.  This means that raising rates is more likely to encourage inflation than to reduce it. 

And since real interest rates have actually declined in the past year, lower real rates help explain why inflation may have already peaked, and why it is coming down.  In fact this may be why financially repressed countries can have both rapid monetary expansion and limited inflation, as they typically do.  Inflation itself, by lowering real rates, can reduce inflationary pressure.  It is self-correcting – at least until households begin withdrawing deposits and spending the money simply because the cost of holding money is too great.

Not surprisingly, as inflation has risen and deposits rates lagged during the past year, much of the evidence suggested that contrary to Beijing’s announced plans, consumption was likely to be declining as a share of GDP.  I have said many times that when they finally published the 2010 data in the China Yearbook 2011, I would expect to see consumption drop from 35.0% in 2009 to 34% in 2010 and perhaps another point lower in 2011.

On Friday my associate Chen Long told me the yearbook had in fact just been published, and he sent me the data.  Our expectation turns out to have been right.  Household consumption for 2010 is reported to be 33.8% of GDP. 

Here is the full data:

Aside from the extraordinary decline in the consumption rate, it is interesting to see what happened to the trade surplus.  At 6.4% of GDP in 2010, it is extremely high, but well off its record levels in 2007 and 2008, when as a share of global GDP China’s trade surplus may well have been the highest in modern history.  Notice that as it declined from its peak, investment surged. 

This is just what we would have expected.  The negative growth impact of the sharp drop in China’s trade surplus may have forced GDP growth rates to nearly zero, and the sudden and violent expansion in investment was necessary as the counterbalance to keep growth rates high.  Changes in the declining consumption share of GDP have had very little impact on changes in GDP growth.  And it continues to decline.

PS: I often mention my central bank seminar as a fascinating class in which some of the brightest students at Peking University debate and analyze monetary and credit conditions in China in a way that impresses even real central bankers.  The Soros-funded Institute for New Economics Thinking has asked them to provide a blog outlining their deliberations, and you can find here their first few reports examining debt levels in China. Its in early stages, but keep an eye on it. These guys are very smart.

This is an abbreviated version of the newsletter that went out last week.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.

– buy levitra on-line

What’s more, given how bad the markets were this week, it’s tempting to write excitedly about what the sharp drop in the prices of stocks, commodities and currencies is now telling us – cost of levitra.I am not sure however what to say because I don’t believe that there was ever any chance of global growth returning for several years, and of course, to put it as politely as I can, I never believed in the emerging-markets decoupling theory.I have been arguing for the past three years that the 2007-08 crisis is not even close to being over because all the major capital and trade imbalances that have helped cause the crises afflicting much of the world remain in place.

In the US, there has been some rebalancing as private debt levels have come down sharply, but we still have a long ways to go. Cost of levitra: i expect that consumption growth will remain weak and unemployment high for several years, and it is probably only with a hardening of trade sentiments that growth will return to the US.If the US pushes hard to close the trade deficit by enacting measures that are either directly protectionist – raising tariffs or restricting foreign purchases of US government bond purchases, for example – or indirectly interventionist – more monetary expansion or a consumption tax, for example – like the UK after 1930-31, when it too went protectionist, we might see the economy revive a little more quickly.

Of course while closing the US trade deficit creates growth for the US, it does so by allowing the US to grab a greater share of its domestic demand, and in the short run this doesn’t help the rest of the world at all – cost of levitra.On the contrary, it would be devastating for the surplus countries.None of this is being made easier by the sharp contraction in the growth rate of international trade reported by the WTO on Friday. Here is the Financial Times on the subject:

The WTO on Friday revised down its estimate for growth in global goods trade in 2011 to 5.8 per cent from an already cautious forecast of 6.5 per cent and warned that the risks were “firmly rooted on the downside”.

Meanwhile, an estimate of commerce compiled by the Netherlands Bureau for Economic Policy Analysis, a Dutch think-tank, showed growth in goods trade grinding to a halt over the summer, threatening to start contracting for the first time since it went into freefall during the global financial crisis in 2008-09.

As limited as the US adjustment has been so far, for the rest of the world it has been worse; cost of levitra.In China the huge investment–consumption imbalance has only gotten worse since the crisis, and there is little chance that we will see much action until 2013 at the earliest; cost of levitra.Unfortunately the longer we wait the higher debt levels will be, especially NPLs, and the more difficult the adjustment will be.

In Europe the only consequences of the debt crisis have been rising debt ratios in peripheral Europe as the afflicted countries refinance at high interest rates while GDP growth goes negative, a hardening of German attitudes towards acknowledging their own role in creating the crisis, and an increasingly destabilizing political environment.In November, for example, the right should sweep out the ruling Socialists in Spain, but after a year or two the electorate is going the realize that the right can’t do anything about the crisis either, so we will be left with both major parties seriously discredited.

Since the crisis we have seen consumption growth in the US and peripheral Europe drop sharply as households deleveraged. Cost of levitra: of course we have also seen real estate investment in both regions drop sharply.The only mitigating trend was the surge in developing-country investment cost of levitra, with China driving that surge to astonishing levels, which created some additional global demand to counterbalance the decline in all the other major sources.

So where will increased global demand come from? It won’t. Cost of levitra: for individual countries of course there is one source of increased demand, but this additional demand comes automatically at the expense of their neighbors, and we call that trade war.

Before returning to the topic of trade and currency wars I wanted to discuss a related topic.As one European country after another finds its access to bond markets blocked, hopes are rising that the developing world might step in and relieve the crisis by buying the bonds that European investors and official entities are unwilling or unable to buy; cost of levitra.And why not? After all, the BRICs alone have between them over $4 trillion in reserves.This can fund a lot of deficits.

Send in the BRICs

The latest frenzy over a developing-country rescue was set off when the Financial Times reported last Monday that the Italian government had announced that China might buy a boatload of Italian bonds:

According to Italian officials, Lou Jiwei, chairman of China Investment Corp, one of the world’s largest sovereign wealth funds, led a delegation to Rome last week for talks with Giulio Tremonti, finance minister, and Italy’s Cassa Depositi e Prestiti, a state-controlled Italian officials were in Beijing two weeks ago to meet CIC and China’s State Administration of Foreign Exchange (Safe), which manages the bulk of China’s $3,200bn foreign exchange reserves – cost of levitra.Vittorio Grilli, head of treasury, met Chinese investors in Beijing in August.Italian officials said further negotiations were expected to take place soon.

The next day Brazilian finance minister Guido Mantega pumped up the frenzy even further when he said senior officials of the BRICs nations would meet in Washington this week to figure out a rescue plan for Europe. Cost of levitra: some people suggested he may have gone further than he should have, but Dilma Rousseff didn’t completely back down from his comments.According to an article in Wednesday’s Financial Times:

Although she stopped short of proposing a solution involving only the “Bric” emerging nations, which aside from Brazil include Russia, India and China, she said if Europe could present a viable framework for a rescue package, her government would support it; cost of levitra.“Brazil will always be willing to participate in any international effort cost of levitra,” Ms Rousseff told reporters in Brasília.

Brazil is clearly trying to make grand statement; cost of levitra.After all it would be the first time in history that developing countries had put together a financial rescue package for Europe, and that has to be pretty exciting.

Not what it seems

But right away there were rumblings that suggested that, once again, the market was not thinking through its position – cost of levitra.There is little chance that any BRIC rescue is likely to happen cost of levitra, and if it does, it would be bad news for Europe, not good.

First off to spoil the party was India, whose response to the announcement that it was going to help rescue Europe was a bit like that of a man being congratulated for having been chosen to “volunteer” to charge into a burning building to rescue the portrait of Chairman Kim.“Uh, not so fast” they said, “We gotta talk.” According to the Financial Times:

Brazil had sprung the suggestion of the leading developing nations coming to the rescue of the eurozone on its fellow Bric countries, India’s finance ministry said on Wednesday – cost of levitra.R.Gopalan, secretary in the department of economic affairs at the Indian finance ministry, told the Financial Times that Brazil had “thrown” its proposal at the grouping only days before it is to meet in Washington on September 22.

On Tuesday, Guido Mantega, Brazil’s finance minister told reporters that officials from the leading emerging market economies would meet next week to discuss potential joint action to help the crisis-hit eurozone.

“The idea has been thrown at us by the Brazilian finance minister,” said Mr Gopalan; cost of levitra.He declined to say what measures India might consider to assist the eurozone but said his country would wait to see what was discussed at the talks in Washington, which are to include ministers from Brazil, Russia, India, China and South Africa.

Just in case there was any doubt, former Prime Minister Lee Kuan Yew chimed in, saying on Thursday that Singapore had no plans to participate in a bailout; cost of levitra.“We’re in no position to rescue the Europeans by buying their bonds.Nor do I think buying their bonds will necessarily rescue them,” 

And China? Aside from the chance to get in some finger wagging, they didn’t seem too eager either; cost of levitra. Cost of levitra: premier Wen, at the World Economic Forum meeting in Dalian, explained what helping out meant.According to an article in the People’s Daily:

Premier Wen Jiabao said on Wednesday that China is ready to increase its investment in debt-ridden Europe, and urged the European Union (EU) to recognize China as a full market economy.”European countries are facing sovereign debt problems and we’ve expressed our willingness to give a helping hand many times. Cost of levitra: we will continue to expand our investment there,” Wen said while addressing 1,500 business leaders and government officials at the opening of the World Economic Forum, known as the “Summer Davos”.

Wen said that he reiterated China’s support to European Commission President Jose Manuel Barroso in a recent phone call.However, he added that “EU leaders and the leaders of (Europe’s) major countries must look at Sino-EU relations from a strategic viewpoint – cost of levitra.” Cost of levitra: based on WTO rules, China’s full market economy status will be recognized by 2016.If EU nations can demonstrate their sincerity several years earlier, it would be the way a friend treats a friend,” he said.

Perhaps not surprisingly, the article in the South China Morning Post was a little more forthright and suggests not that China is softening its position but perhaps hardening it:

Premier Wen Jiabao yesterday spelled out China’s demands for helping the US and Europe overcome their financial and economic difficulties in remarks seen as a shift in China’s attitude towards the developed economies.

Speaking to 1,500 delegates at the opening of the annual World Economic Forum event in Dalian , Wen delivered a message that was both polite and clear; cost of levitra.While the US and Europe could count on China’s continued financial support cost of levitra, China also had “hopes” from them, he said.

“Countries must first put their own houses in order,” Wen said.” Cost of levitra: developed countries must take responsible fiscal and monetary policies. Cost of levitra: what is most important now is to prevent the further spread of the sovereign debt crisis in Europe.” Wen’s biggest hope for Europe, which is struggling with a growing debt crisis, was recognition of China at the World Trade Organisation as a full market economy.

…“For quite a few times, China has offered its help by increasing our investment in Europe,” Wen said without giving examples.”Up to now, we still believe Europe can pull through its current difficulty and we are still ready to expand our investment there,” he said.”But China also hopes that European leaders will muster the courage to appreciate the strategic importance of the Sino-European relationship, such as recognising China’s status as a fully fledged market economy,” he said.

Later during the forum Zhang Xiaoqiang, vice-chairman of the National Development and Reform Commission, the country’s top economic planning agency, said that Beijing is willing to buy euro bonds from countries involved in Europe’s sovereign debt crisis “within its capacity” – cost of levitra.How much capacity does it have? That wasn’t made clear.

Does Europe need the BRICs?

So there you have it.Something substantial might happen, or it might not.

My guess is that nothing will happen except a few token gestures aimed mostly at generating positive headlines and boosting confidence. Cost of levitra: why? Because if Germany, with its superior understanding of the politics of the EU and greater dependence on European demand, while enjoying the benefits of information asymmetry, is not willing to buy Spanish and Italian bonds, it would be pretty foolish for the BRICs to step into the breach, and the BRICs pretty much know this. Cost of levitra: their idea of “helping” Europe, I suspect, consists of buying German bonds, not those of Italy and Spain.

In which case how does it help? Not a lot, and in fact it will make things worse for Europe.This is because more foreign investment will not help Europe.Local governments, it turns out, are suffering from a classic case of skewed incentives, in which actions that benefit individual players like the governments of Spain, Portugal or Italy in the short term may hurt Europe as a whole.

Why won’t BRIC purchases help those countries overall? In the short term it would seem that a country having trouble funding itself at manageable interest rates should welcome any major new investor no matter his provenance – cost of levitra.Every large buyer is a valuable resource, especially if it is large enough to restore confidence to the markets and spur other investors.

But we have to remember that foreign investors are not the same as domestic investors – cost of levitra.Any net increase in foreign purchases of euro-denominated local government bonds has an impact far beyond the short term funding impact – cost of levitra.It also affects the trade environment.

This impact is an automatic consequence of the way the balance of payments works.Today Europe runs a current account surplus.By definition this means that far from being starved of capital, European savings exceed European investment, and it exports the excess to the rest of the world.

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd; cost of levitra.European governments are unable to fund themselves not because Europe needs foreign capital.It has plenty – cost of levitra.They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem.What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus; cost of levitra.In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

How would this happen? There are many ways, but the most obvious is that as foreign central banks sell large amounts of dollars to buy euros, the euro strengthens against the dollar; cost of levitra.As this happens, European manufacturers become less competitive globally and their exports drop.

Foreign investment creates its own adjustment

This would cause a rise in European unemployment as those manufacturers are forced to fire workers – cost of levitra.It would also cause total European savings to decline as total production drops more quickly than consumption. Cost of levitra: remember that savings is simply the difference between production and consumption.In other words as more foreign savings enter Europe, one consequence might simply be less European savings, which is hardly likely to resolve the solvency problem.

Of course there are other ways Europe could adjust.Europe could prevent a rise in unemployment if all of the new foreign funding was used to fund direct investment.Every dollar given to Spain by the BRICs, in other words, would have to be matched by a one-dollar increase in Spanish infrastructure spending; cost of levitra.Might this happen? Of course not.Given the need for transfer and welfare payments cost of levitra, it is very unlikely that Spain in this example would transfer the additional money to a new investment project, and anyway if it did it would not solve the original problem of selling bonds to finance its day-to-day needs.

There is a third way.As workers are fired because the European manufacturing sector becomes less competitive, European governments could borrow even more money to cover the transfer payments or otherwise give them jobs.This is really just a variation on the above cost of levitra, but the conclusion is a little different.It suggests that any net increase in foreign purchases of European bonds will be met by a more-or-less equivalent increase in the amount of government bonds issued; cost of levitra.This, of course, does not help Europe in the aggregate, although it may temporarily help the governments issuing those bonds.

As the above cases show, the increase in foreign investment would simply be matched either by an equivalent reduction in domestic savings or an equivalent increase in domestic debt to counteract the rise in unemployment – cost of levitra.Rather than ease the burden, in other words, foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt. Cost of levitra: the BRICs, in other won’t help Europe by buying Italian bonds.They will simply help the Italian government at the expense of Europe generally.

The second way that the BRICs can help is by funding direct investment in infrastructure and manufacturing capacity throughout Europe – cost of levitra. Cost of levitra: if the infrastructure is economically viable, European wealth will grow faster than European obligations to the BRICs and everyone can be better off. Cost of levitra: of course this solution eliminates the possibility that the BRICs will simply buy government bonds.

One way or the other I am unable to see any way in which Italy’s great hope of Chinese bond purchases can leave Europe better off.It is easy nonetheless to see why desperate governments welcome official money from the developing world with their trillions in reserves.European savers are increasingly refusing to provide financing, and so any alternative source of funding is seen as a godsend.

But we must remember that although the afflicted European governments will benefit in the very short term from the help of foreign investors, the adverse impact on European manufacturers and on European savings overall more than makes up for it – cost of levitra.An increase in foreign funding creates slower growth and, with it, the need to increase fiscal deficits in order to prevent a rise in unemployment.

Turning to foreign sources of capital will only aggravate the problem from which Europe already suffers.Even assuming that developing countries are willing to take on risks that Europeans find prohibitive cost of levitra, their help will not improve prospects for Europe.On the contrary cost of levitra, it will hurt growth prospects and make the ultimate resolution of the debt crisis more difficult than ever.BRICs should be exporting more demand, not more capital.

It is important that the desperate short-term funding needs of certain governments do not lead to an overall worse outcome for Europe.If Europeans do not want to fund credit-impaired European governments, they should not ask foreigners to do so.Slower growth and foreign debt will not help resolve the problem of insolvency. – cost of levitra

Europe’s travails in particular can’t be good for exports.  What’s worse, it’s now pretty much official that the euro will fail soon enough.  We have this on no less an authority than Angela Merkel.  Here is what Thursday’s Financial Times says:

Angela Merkel, German chancellor, declared on Wednesday that “the euro will not fail” after the country’s powerful constitutional court rejected a series of challenges to the multibillion-euro rescue packages agreed last year for Greece and other debt-strapped members of the eurozone.

In a passionate restatement of Germany’s determination to defend the common currency, the chancellor welcomed the court’s judgment as “absolutely confirming” her government’s policy of “solidarity with individual responsibility” – prices levitra.

No, I didn’t misread the article.  I just have a very different understanding of the logistics of a denial.  Last year, for example, I wrote on my blog about ferocious denials by both Spain and Portugal that they would need any official help in funding themselves.  But according to one of my favorite British television comedies, Yes, Minister, an official denial means something very different from what is intended.  “The first rule of politics,” Sir Humphrey, the wily civil servant in the show, insists is: “never believe anything until it is officially denied.”

That’s why, citing Sir Humphrey, I was pretty sure that both Spain and Portugal would need to be bailed out.  As long as they remained within the euro, I was convinced that there was no politically acceptable adjustment mechanism that would allow them to continue funding their debt in an orderly way.  One way or the other they would have to be bailed out or default, and probably both, with the first happening a few times before the second.  In the end the denial confirmed the bail out.  Sir Humphrey usually knows how such things actually work.

So of course Merkel’s denial struck me as especially interesting.  I don’t want to sound too glib or too jokey, but I wonder if there has ever been a forced devaluation that wasn’t preceded by ringing assertions from presidents and central bank governors that under no circumstance would the currency ever devalue. 

What is all the more interesting is that I recently discovered that the quote “never believe anything until it is officially denied” doesn’t originate with the writers of the British TV comedy.  Apparently it can be traced to at least as far back as Otto von Bismarck, who was born not too far from where Angela Merkel grew up.  Never believe anything until it is officially denied, the Iron Chancellor warned us.

 An interesting proposal

 So if Germany’s Iron Lady is now denying that the euro will fail, can its failure  be far off?  It depends I guess on what we mean by failure.  If any important reversal in the structure and membership of the euro is a failure, then it will almost certainly fail, but I suppose there are many ways the euro project can be transformed without quite calling it a failure.

 At the end of last month Hans-Olaf Henkel, for example, the former head of the Federation of German Industries, had an interesting OpEd in the Financial Times.  In his piece he says:  

Having been an early supporter of the euro, I now consider my engagement to be the  biggest professional mistake I ever made.But I do have a solution to the escalating crisis.  

…Instead of addressing the true causes, politicians prescribe painkillers – prices levitra.The euro patient suffers from three discrete diseases: as a result of the financial crisis, many banks are still unstable; the negative effects an overvalued euro has on the competitiveness of the “south”, including Belgium and France; the huge level of debt of some eurozone countries; prices levitra.It would be misleading to proclaim there is an easy way out – prices levitra.But it is irresponsible to maintain there is no alternative – prices levitra.There is.  

The end result of plan “A” – “defend the euro at all cost” – will be detrimental to all.Rescue deals have led the eurozone on the slippery path to the  irresponsibility of a transfer union – prices levitra. Prices levitra: if everybody is responsible for everybody’s debts, no one is.Competition between politicians in the eurozone will focus on who gets most at the expense of the others.The result is clear: more debts prices levitra, higher inflation and a lower standard of living.The eurozone’s competitiveness is bound to fall behind other regions of the world.

 As a plan “B” George Soros suggests that a Greek default “need not be disorderly”, or result in its departure from the eurozone.But a Greek default or departure from the eurozone implies risks too high to take – prices levitra.First in Athens, then Lisbon, Madrid and perhaps Rome, people would storm the banks as soon as word got out. Prices levitra: a “haircut” would not improve Greece’s competitiveness either.Soon, the Greeks will have to go to the barber again. Prices levitra: anyway, we now talk also about Portugal, Spain, Italy and, I am afraid, soon France.

 That is why we need a plan “C”: Austria, Finland, Germany and the Netherlands to leave the eurozone and create a new currency  leaving the euro where it is.If planned and executed carefully, it could do the trick: a lower valued euro would improve the competitiveness of the remaining countries and stimulate their growth – prices levitra.In contrast, exports out of the “northern” countries would be
affected but they would have lower inflation. Prices levitra: some non-euro countries would probably join this monetary union.Depending on performance, a flexible membership between the two unions should be possible. 

I think Henkel is right, although I think the likelihood of Europe’s adopting his Plan C is pretty small.  Still, it is interesting to consider why he  might be right.  

As I see it, we cannot continue with the existing currency arrangement.  Countries like Spain (I am reverting to my habit of calling all the deficit countries “Spain”  and all the surplus countries “Germany”) simply will not adjust quickly enough as long as they maintain the euro, and we are going to watch their economies contract and their debts grow until finally the electorate has had enough and  forces a radical change in strategy .

Much if not most of peripheral Europe will then leave the euro and default, and Germany will have to eat the losses on its outstanding (and growing) loans.  But why wait?  The longer we put off the reckoning the worse it will be for peripheral Europe and the greater the losses that Germany will have to swallow.  So shouldn’t Germany simply force Spain to leave the euro now?  

Damned either way

The problem is that if Spain leaves the euro and returns to the peseta, it will be caught in a downward currency spiral like the ones suffered by Mexico in 1982 and 1994 and Korea in 1997.  In both cases the currency plunged by far more than the amount of its theoretical overvaluation.  This happened because a substantial portion of Mexican and Korean debt was denominated in foreign currency.  Of course once Spain revives the peseta, it will be in a similar position – with a lot of its debt denominated in euros, which will become a foreign currency.  

What does external debt have to do with the extent of the devaluation?  Quite a lot, it turns out.  Mexico and Korea (and a host of others examples) remind us that when a country is forced to devalue, the amount of the devaluation is not necessarily in line with estimates of the amount of overvaluation.  

I would argue that Spain probably suffers from 15-20% overvaluation, but once Spain returns to the peseta the peseta will not devalue by that amount.  It will devalue by at least 50%, and probably a lot more.  Why?  Because of the self-reinforcing relationship between the currency and external debt.   

It always works the same way when a country with a lot of external debt devalues its currency.  As the peseta devalues, Spain’s external debt will rise in tandem since it is denominated in the appreciating currency.  Since Spain is already believed to be overly indebted, as the debt rises relative to domestic assets, Spanish credibility will decline quickly and financial distress costs will rise.

 But of course as credibility declines and defaults rise, the peseta will drop even more as investors flee the currency and as domestic borrowers with euro-denominated debt try to hedge the currency risk.  This will go on in a self-reinforcing way until the currency has been crushed.  In the end, for Spain to leave the euro would probably cause its external debt to more than double – perhaps even triple – as the peseta falls; prices levitra. Of course it will be  forced into default within days or weeks. 

This, by the way, is not an argument for Spain to  stay in the euro.  If Spain stays in the  euro we will still arrive at default, but much more slowly, and mainly at first through a grinding away of wages and economic growth over many, many years and a gradual building up of debt as Germany refinances Spanish debt at interest rates that exceed GDP growth rates.  The default will occur anyway, but only after years of high unemployment. 

This is why I think Henkel’s proposal makes sense.  Rather than have Spain leave the euro, Germany can leave the euro.  The new German currency would automatically appreciate and the euro would depreciate, but without the terrible debt dynamics, the adjustment in the currency value would be much closer to the theoretically correct adjustment.  The relative adjustment would probably be in the 20% range rather than in the 50% range. 

Of course German banks would still have a problem.  Their deposits would be in the form of the new German currency, and a lot of their loans – all those to Spain, for example – would be in the depreciating euro, and so they would take large losses.  But at least the losses will be less – and more importantly the process will be more orderly – than if Spain simply leaves the euro and defaults. 

One way or the other Germany is going to take a pretty big hit.  It is a complete waste of time trying to figure out how to avoid it.  It would be far more constructive to resolve the problem as quickly as possible in as orderly a manner as possible, and as any good Minskyite would tell you, that means we have to pay special attention to the balance sheet dynamics.  That’s why I think Henkel’s proposal is an interesting one. 

Of course the really interesting thing about Henkel’s proposal (at least to me) is to figure out what decision France would make if something like this happened.  If France remained within the euro (i.e.“peripheral” Europe in Henkel’s scenario), the possibility of a United States of Europe would be forever dashed, but it would almost certainly be replaced with a two-entity Europe – the United States of Germany and the United States of France, or perhaps, for those who like 19th Century monetary history, the new Zollverein and the new Latin Union. 

Not so stunning 

Meanwhile, still in Europe, and in a country not likely to join either entity, the Swiss National Bank decided to get very serious about the currency wars.  Here is the Financial Times again: 

The Swiss National Bank stunned financial markets on Tuesday by setting a ceiling for the Swiss franc against the euro in an attempt to prevent the strength of its currency from pushing its economy into recession.

The central bank said it would set a minimum exchange rate of SFr1.20 against the euro.The SNB action came after previous measures to weaken its currency proved ineffective as the worsening eurozone crisis prompted a flight to safety by investors, boosting haven  

Analysts said the move raised the stakes in the global currency war as countries vie to protect their exporters and, by removing a release valve for investors looking for a haven from current market turmoil, could heighten instability on financial markets. 

I am not sure how stunned to be about all of this.  As I see it this is pretty much part of the expected evolution of international financial arrangements.  The world is seriously deficient in demand compared to capacity and every country is going to try (has already tried) to capture as large a share of that demand as it can.  This means every country is going to try aggressively to export capital or limit capital imports. 

But of course it doesn’t work that way.  If capital-exporting countries want to increase capital exports in order to acquire a bigger share of global demand, and capital-importing countries want to limit or reverse capital imports, something has to give way.  This is basically what we mean by trade and currency wars. 

And what’s bizarre to me is that in this muddled environment there are an awful lot of people, including some very respectable economists, asking that Asians help Europe out by funding their fiscal deficits.  China and other Asian central banks, they say, should buy European bonds, especially the bonds that no one in Northern Europe wants to touch.  

But do they understand what this means?  If Asian central banks increase their flows to Europe – by buying more government bonds, for example – Europe will be transformed from a net capital exporter to a net capital importer, and with that Europe’s small trade surplus will reverse itself and become a trade deficit.  

This means slower growth for Europe – Germany needs a trade surplus to generate growth and Spain’s trade deficit is so high that it cannot afford any further deterioration.  Is it really a good idea to trade slower growth for another year or two in which Europe can further build up its debt burden? 

The Swiss have clearly made their decision.  They do not want any more foreign capital inflow and are trying to eliminate or at least reduce it by capping the rise in the Swiss franc.  It probably won’t work.  I guess now by having converted the currency into a one-way bet I assume that we are going to see massive speculative inflows into the Swiss franc on expectations that inflows will eventually force the SNB to revalue. 

And one way or the other inflows must show up as a deterioration of the trade account.  My guess is that in a few weeks or months the SNB is going to have to use more forceful measures to stop speculative inflows. 

This is just a harbinger of things to come.  As I discuss in the piece I wrote for Foreign Policy last week, no one wants any part of the exorbitant privilege that comes with the ability of foreign institutions to acquire your currency.  Countries will continue trying desperately to export capital to each other while continually crying foul at attempts to force them to import capital.  The currency wars will roll on. 

This is an abbreviated version of the newsletter that went out last week.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address. – prices levitra