THE GLOBAL ECONOMY ENTERS 2011 WITH MODERATE GROWTH OUTLOOK
The global economy is poised for another year of moderately strong growth, but there are new uncertainties about inflation as a result of rising oil and food prices. The oil price spike could cost US consumers $60 billion, and thus reverse much of the income gain from reduced Social Security taxes. The uptick in food prices will add 1.5-2.0% to inflation rates in many developing countries and force their central banks to pursue tighter monetary policies. India has already raised interest rates several times. China has begun to tighten and will go much further in 2011. Other Asian and Latin American countries are following suit. The food price upsurge could fade during the second half of 2011 if agricultural conditions improve, but the low level of inventories will leave the markets vulnerable to any new supply shocks. The Federal Reserve will discount the impact of oil and food prices because the core inflation rate will remain close to 1.0%, but business and households will perceive that inflation is clearly on the rise. The European inflation rate has also risen above the central bank’s 2.0% target because of rising commodity prices and VAT rates, but it will focus on the fact that core inflation is close to 1.0%. Jean-Claude Trichet has naturally expressed concern about inflation, but the overwhelming goal of his monetary policy is to preserve the monetary union, so he cannot raise interest rates when Southern Europe is in recession. Bundesbank President Axel Weber said that inflation will peak at 2.4% in March and then decline.
THE UNITED STATES IS POISED FOR 3.5%-PLUS GROWTH IN 2011
The new optimism about the US economy has been tested by disappointing job growth in the December labor market report, but most analysts have discounted the data as an outlier. They took comfort from the fact that job growth during the previous two months was revised up by 70,000. They expect a similar revision for the December data. The Conference Board has also released its December Help Wanted Online index which indicates that there is pent-up labor demand. The report showed double-digit gains for a wide variety of job categories in the last year, including architecture and engineering, management, office and administrative support, computer and mathematical, and construction.
It will be essential for the economy to produce larger employment gains if the recovery is to be sustained. Total private non-farm payrolls have expanded by only 1.2%, or 1.35 million jobs, since last December. The economy still has a net job loss of 7.2 million since the recession ended. Temporary help service jobs have accounted for 23% of all the employment gains during the past year. The outlook for employment will depend upon the trade-off between the workweek and job creation. There was a gain in the workweek during the past year which was the equivalent of 1.9 million new jobs. If hours worked continue to rise at a 2.3% annual rate and the workweek is constant, the economy will start to produce 225,000 jobs per month.
The ADP employment report showed a job gain of 297,000 after three months in which the gains averaged only 67,000. The report also showed a breakthrough in hiring by small business. Firms employing fewer than fifty workers added 117,000 jobs compared to 144,000 for medium-sized firms (50-499 workers) and 36,000 for large companies. The uptick in small business hiring is significant because this sector has traditionally accounted for 60% of job creation, and has lagged during the past year.
The small business job data is very sensitive to new business formation and the ability of small firms to borrow. The rate of business formation peaked in the third quarter of 2007 and fell sharply for the next six quarters. It has since been holding steady, and thus could not offset job losses from small firms closing. Small businesses often rely on loans secured by residential or commercial real estate. The 30% decline in residential real estate prices and 40% decline in commercial real estate values have lessened the ability of small firms to use property as a form of collateral. Home equity loans have declined from 14% of all mortgage loans in 2006 to only 4% recently. Small business owners often use home equity loans to obtain capital.
A recent survey by the Federal Reserve Bank of New York tried to quantify the lending environment for small business. It found that 59% of small business owners in the survey had applied for credit and more than 75% received only some or none of the credit. A business loan had a denial rate of 69%. But the denial rate for the financing of a vehicle or equipment was only 30% because the borrowers provided collateral. It is very clear from the lending data that the real estate recession has not affected the economy only through wealth losses for the household sector. It has also had an impact on the ability of small business to borrow. A real estate recovery will therefore have a benign impact on employment growth through small business lending, not just through wealth gains.
There is now a broad consensus among forecasters that US output growth during 2011 will be 3.5%-plus. As a result of robust Christmas sales, analysts now expect consumer spending to grow at least 3.5% this year. Robust corporate profits and new tax allowances for investment should bolster equipment capital spending by at least 15%. Residential construction has declined to only 2.4% of GDP, so it cannot fall any further. As home sales improve, residential construction should be able to expand by 5-10%. Non-residential construction has been showing signs of bottoming and could record a gain of 2.0%. Federal spending is likely to grow 2%. State and local government spending could decline 2%. The export sector will benefit from a healthy global economy and the relative weakness of the US dollar. There was an improvement in the trade account during October and November which could boost real GDP growth by 1.5-2.0% during the fourth quarter. The resilience of final sales will bolster import demand again, but there will be only a modest deterioration in the trade account.
THERE ARE FOUR MAJOR RISKS TO THE US OUTLOOK IN 2011
First, higher inflation could depress real income growth and thus constrain the upturn in consumer spending. The CPI increased by 0.5% during December because of a 4.6% gain in energy prices. The oil price in early January of $91 per barrel is high compared to a fourth quarter average of $85.03 and a 2010 average of $79.43. Food prices also rose at a 1.5% annual rate, which was the second largest increase since June 2009. During the past year, the CPI rose by 1.4% and was led by a 2.0% gain in commodity prices and a 1.2% gain in service prices. The core CPI excluding food and energy rose by only 0.6%, or the lowest rate of gain in fifty years. In 2011, energy prices could rise another 10% during the first half of the year. The USDA expects food prices to increase 2.0-3.0% for the year as a whole. Energy has a 9% weighting in the CPI and food has a 14% weighting. They could produce an annualized inflation rate of 2.8% during the first half of 2011. The Social Security tax cut should boost personal income growth into the 4-5% range during the first quarter, and thus help to compensate for higher inflation. Consumer spending could also be more resilient because the recent upturn was led by higher income households who have benefitted from the large gains in the equity markets since 2009. Those gains have continued in the new year. The top 20% of households now account for close to 40% of all consumer spending.
Secondly, the housing sector remains weak because of excess inventory resulting from foreclosures. It could take eleven months to sell the current supply of housing on the market compared to a long-term average of seven months. There are currently 3.9 million homes for sale compared to a long-term average of 2.5 million. Since 2006, 6.4 million homes have gone through foreclosure while 4.4 million mortgages are currently more than ninety days overdue or in foreclosure. The US should have a core housing demand of 1.6 million units per annum because of new household formation (1.2 million) and homes being destroyed by fire (400,000). The recession sharply curtailed the rate of household formation. As employment conditions improve, there will be a rebound which could bolster demand for new housing. The recovery will then become self-reinforcing by creating new construction jobs. During the recession, there was a loss of 2.1 million jobs in the construction sector, so there is ample potential for significant employment gains when the housing turn comes.
The third area of risk is state and local government spending. The Center on Budget and Policy Priorities estimates that state deficits will be $122.6 billion during the 2011 fiscal year and could be as high as $112.7 billion in fiscal 2012. The Obama stimulus program has so far provided $140 billion of assistance, but only $60 billion remains to help the states this year and this number will drop to $6 billion in fiscal 2012. The states with the largest projected deficits in 2012 in relation to their total budget are as follows:
The large deficits forced state and local governments to lay off 251,000 people in 2010 and 128,000 during 2009. State governments added 6,000 jobs last year, but local governments accounted for 257,000 jobs lost. There were 20,000 local government job losses in December, alone. The continuing deficits will require either new tax increases or spending cuts. The Illinois legislature has just approved a large increase in both personal and business taxes. It has been difficult for Illinois to reduce spending because of the influence of the civil service unions in the Democratic Party. They bankrolled the governor’s reelection campaign. States such as Texas and New Jersey will find it easier to reduce public spending because they have Republican governors or legislatures. The Republican Party in Congress is reluctant to provide new federal aid because it wants the state and local governments to reopen union contracts providing generous pension and health care benefits. The state and local government sector accounts for 19,407,000 jobs, or 14.8% of the total. It could easily lose another 200,000 jobs in 2011.
The municipal bond market has suffered from investor concern about deteriorating credit quality. Yields on 30-year triple-A bonds have risen above 5.0% for the first time since 2009. Municipal bond funds have experienced an outflow of $20 billion over the past ten weeks. The Vanguard Group has delayed plans to launch three new municipal bond funds.
The final area of risk is federal fiscal policy. The newly-elected Republican Congressional majority is determined to reduce federal spending. They will attempt to use the pending need to increase the fiscal debt ceiling as a form of leverage for obtaining spending cuts this year and next year. The Republicans now acknowledge that their original target for $100 billion of spending cuts is unrealistic, but they will probably strive for at least $50 billion of spending cuts. They are also talking about $2.5 trillion of cuts in discretionary non-defense spending over ten years. The markets could be apprehensive about the politics of the debt ceiling increase if the Republicans make outlandish promises to reduce discretionary spending.
In 1995 the debt ceiling impasse led to a government shutdown, but that was also because the administration and Congress could not agree on a budget or appropriation bills. The executive branch has a variety of options available for trying to circumvent attempts by the legislative branch to restrain the debt ceiling. The Treasury can draw down $200 billion of deposits at the Federal Reserve. It can sell $278 billion of mortgage-backed securities and student loans it acquired during the recent financial crisis. It can have the Social Security fund redeem bonds they hold ahead of schedule in exchange for a promise to be paid back later. As the trust fund holds $2.5 trillion of government securities, it could finance a prolonged period of government spending without a higher debt ceiling. The debt ceiling applies to gross government debt, including trust fund holdings belonging to the government. By reducing the amount of debt which the government owes to itself, the federal government can grow the net debt while staying within the gross debt cap. The current debt ceiling is $14.294 trillion while the total stock of government debt a few months ago was $13.384 trillion. The public owned $8.993 trillion while the government owned $4.5 trillion. The Republican leadership recognizes that shutting the government down would be unpopular, so the odds are high that it will strive to achieve some form of spending compromise with the administration. But if political theatre makes it impossible to achieve a compromise, the Treasury will be able to use the Social Security fund to avoid a government shutdown.
The danger posed by these four risks is that US economists may have become too optimistic about the growth prospects in 2011. They have correctly abandoned fears of a double dip, but they may now be underestimating the constraints on growth from rising commodity prices, continued weakness in the housing sector, and state and local government budget deficits and job losses. The commodity inflation could erode real income growth before employment experiences a sustained recovery. The weakness of the housing sector could stall potential employment gains in a sector which lost over two million jobs during the recent recession, and should now be producing several hundred thousand new jobs. Weak house prices could also inhibit consumer borrowing again while stalling an upturn in lending to small business. Further job losses in local governments could offset the modest job gains occurring in the private sector and lessen the odds of employment growth achieving the 200,000 monthly rate needed to reduce unemployment. There is no danger of a renewed recession, but there is a risk that these negative factors could cause output growth to dip back into the 1.5-2.5% range during the middle quarters of 2011. If such weakness coincides with the end of the Fed’s quantitative easing program for political reasons, the stock market could correct 10% or more.
HOW US MONETARY POLICY HAS BOLSTERED BANK BALANCE SHEETS
The Federal Reserve has acknowledged that the outlook for the US economy is improving. The Fed’s latest Beige Book reported stronger retail sales and manufacturing activity in all regions. Fed Chairman Ben Bernanke has said publicly that real output growth this year should be in the 3-4% range. He continues to defend his policy of quantitative easing on the grounds that unemployment will decline slowly. The Fed’s Beige Book also acknowledged that the residential real estate market remains weak in all regions. The report noted that:
A majority of the Districts, including Boston, New York, Cleveland, Atlanta, Chicago, Minneapolis, Dallas, and San Francisco characterized local housing markets as weak and sluggish with little change from the previous reporting period. Kansas City noted further weakening, while Richmond received reports of both flat activity and further declines. The St. Louis District saw additional declines in existing home sales, but also cited increased new home construction permits. All Districts attributed slumping activity to concerns about the pace of economic recovery, especially in employment, while the Philadelphia, Atlanta, and Chicago Districts mentioned difficulty obtaining credit as another constraint on demand.
The Fed is concerned about the fact that the Case-Shiller Index is now showing renewed declines in home prices. If house prices continue to decline, there is a risk that both new wealth losses and increases in non-performing property loans could retard the upturn now occurring in consumer spending and bank lending.
There are signs that monetary policy is starting to bolster bank balance sheets. During the past year, banks have purchased $180 billion of government securities. During the fourth quarter of 2010, there was also a modest uptick of commercial and industrial loans. Consumer lending has begun to rebound as well. In the third quarter, lenders made more than 36 million consumer loans, up 3.7% from a year earlier. Home equity loans increased in October for the first time since 2008. J.P. Morgan has reported an upturn in its credit card business during the fourth quarter. The expansion of bank balance sheets will bolster the growth of the monetary aggregates after a long period of weakness.
As a result of private sector deleveraging, the only sector which has increased borrowing during recent quarters is the incorporated business sector. Its borrowing rose from $267 billion during the second quarter to $329 billion during the third quarter. The corporate sector appears to be using these funds to repurchase equity. Its equity buybacks rose from $215 billion during the second quarter to $368 billion during the third quarter. The corporate sector took advantage of a buoyant bond market to finance these share repurchases. The household sector reduced its borrowing by $232 billion during the third quarter while the non-corporate business sector repaid $163 billion of loans.
OBAMA APPOINTMENTS ARE A SIGN HE IS PIVOTING TO CENTER FOR 2012
The Obama administration has made three new appointments which could be important for economic policy. It has appointed William Daley as President Obama’s chief of staff, Gene Sperling as the new director of the National Economic Council, and Bruce Reed as Vice President Joe Biden’s chief of staff. All three are Washington pros. Mr. Daley is a former Commerce Secretary who played an important role in getting NAFTA through Congress seventeen years ago. He was recently a senior official at J.P. Morgan Chase. He is regarded as a player who could greatly improve the administration’s relationship with the business community. Mr. Sperling is a long-time policy wonk who ran the NEC at the end of the Clinton administration. He is pragmatic and generally conservative on fiscal policy. He authored a book called the “Pro-Growth Progressive.” He could play a useful role helping the White house to negotiate deficit reduction legislation with the Congress. Mr. Reed served in the Clinton administration and was executive director of President Obama’s deficit reduction commission. He is also pragmatic and was active in the Democratic Leadership Council, a group which promoted moderate-to-conservative views on economic issues. These appointments confirm that the president himself is very flexible and will move in a center-right direction to pursue his reelection. Left-wing Democrats will be disappointed, but they will support Obama in the end out of fear of an increasingly conservative Republican Party.
ENERGY AND FOOD PRICE INCREASES ELIMINATE RISK OF US DEFLATION
Despite the Federal Reserve’s concern about the risks of deflation, the US inflation rate will accelerate during the first half of 2011 because of rising oil and food prices. The oil price has risen because global demand grew by 2.6 million barrels per day during 2010 or more than twice the consensus forecast twelve months ago. Oil demand could rise a further 1.7 million barrels per day this year. Non-OPEC oil output rose by 1.0 million barrels per day last year, so the call on OPEC crude increased by only 500,000 barrels per day. OPEC spare capacity was 4.5-5.0 million barrels per day during 2010 and should hold close to that level this year. As non-OPEC output could soon stagnate, OPEC’s spare capacity could decline next year and fall to 2.5 million barrels per day by 2015. As supply is ample, there is no reason for oil prices to spike during 2011 from almost $100 recently, but the odds are high that prices could rise after 2012 as surplus capacity diminishes. The oil price should return to $90 per barrel before June.
Corn and soybean prices have risen because the USDA has recently lowered its estimates of output growth this year. The USDA estimates that global output of soybeans will be 255.5 million tonnes compared to 257.8 million previously. It lowered yield estimates in both the US and Argentina. It also lowered estimates of corn production to 816 million tonnes because of lower yields in the US and Argentina. There was a slight reduction of estimates of wheat production as well because of severe rains in Queensland, but the change was only one tonne.
The USDA forecast of rice output was lowered slightly, but output will still be 3% larger than last year and set a record. As a result, Asian rice prices softened during December and do not appear to be vulnerable to the supply shocks in other food commodities. In 2008, by contrast, there was a spike in the price of rice as well as corn, soybeans, and wheat.
The price of copper has risen to new highs during the past month while other base metal prices have been firm. There is strong demand from the emerging market countries while output is increasing slowly. The core CPI inflation rate remains subdued, but commodity prices are driving the PPI higher. The PPI rose 1.1% in December because of oil and food prices. In the year as a whole, it rose 4.2%. The PPI for intermediate goods increased 0.4% during December and 4.6% during the year as a whole. The goods inflation rate in the US has been subdued for some time. It is likely to move higher this year and boost the core inflation rate to at least 1.5% by year end.
EUROPE’S ECONOMY CONTINUES TO BE A TWO-TIERED ONE
The European economy finished 2010 enjoying healthy growth momentum in the north and continued signs of weakness in the south. The euro area December purchasing managers’ index was revised up to 57.1 from 56.8, which is the highest level since April. The output index rose to 58.4 from 55.8 in November. The new orders index rose to 58.1 from 55.6 in November. The German index was at 60.7 compared to 58.9 the month before. France was at 57.2 while Holland was at 57.5. Italy rallied to 54.7 from 52.0 the previous month. Spain was at 51.5 while Greece continued to be weak at 43.1. Ireland benefitted from its tradable goods industries and rallied to 52.2. The PMI service data for December showed greater geographic divergence than the manufacturing data. The headline composite index was at the 55.5 level that was set in November. Germany rose to a new high of 59.2 while Spain, Greece, Portugal, and Ireland slumped. The German economy is clearly the European growth leader. Its real GDP grew by 3.6% during 2010. The Germany ZEW survey (economic sentiment) rose strongly to 15.4 in January from 4.3 in December. Most economists had expected the index to increase to only 7.0.
Germany has now retraced 73% of the GDP decline which occurred during 2008-09 compared to 42% for the euro area and zero for countries on the periphery. Germany’s success has reflected robust exports and an upturn in capital spending. In 2011, the euro area is likely to grow at a 1.7% rate while the German economy will probably grow 3.0%. France will follow at 1.6% and Italy at 1.4%. Sweden also outperformed with a growth rate of 5.6% resulting from a rebound in consumption, investment, and exports. Sweden should expand a further 3.3% this year. Germany has been a major winner from trade with China. Total exports have nearly doubled since 2008. Germany’s auto sales at Daimler and BMW have grown from 160,600 autos in 2009 to 310,000 in 2010. VW’s sales, which are largely produced within China, rose from 1.402 million to 1.950 million. VW has the largest market share of all foreign auto companies in China.
Europe continues to debate the debt servicing challenges facing Spain, Portugal, Ireland, and Greece. Senior EU officials would like to increase the amount of money the stabilization fund can loan and possibly have it purchase government debt. The fund currently has a nominal size of €440 billion, but can only loan €250 billion. As a result of German caution, there was no consensus at a recent meeting of eurozone finance ministers, so the issues will have to be addressed by heads of government in March. German decision making is hindered by the fact there will be several lander (state) elections this year, and the Free Democratic Party has been critical of helping Southern Europe. Meanwhile, the ECB purchased an additional €2.3 billion of debt in the peripheral countries in early January.
The European Union issued a proposal to allow the restructuring of bank bonds when financial institutions get into trouble. There had been discussions about such an action with the Irish banks at the time Ireland received an aid package, but the European Central Bank vetoed the idea because of concern about financial contagion. The opposition Fine Gael Party, led by Enda Kenny, has been advocating restructuring of bank bonds if it can form a government after the Irish elections likely to occur in March. The fact that the EU raised the issue will encourage Fianna Gael to pursue a restructuring of bank debt, but it will not act unilaterally. The ECB has so far been reluctant to discuss restructuring of bank debt because of concern about the potential contagion effects, but there is strong support for the idea among academics and some officials in the EU. What remains to be seen is whether any proposal for Ireland will then be applied to Greece, Spain, and Portugal.
The markets are very focused on the funding needs of European governments and banks this year. It is estimated that Spain will need to sell or refinance €205 billion of government debt in 2011 while Portugal will have to sell or roll over €37 billion of government debt. Both countries have recently had successful auctions, so market apprehensions have diminished somewhat. The European Central Bank has been intervening in the markets and currently holds over €76 billion of government securities in the peripheral countries. The Portuguese banks will have to refinance €500 million of liabilities during the first two months of the year. The Spanish banks will have to refinance €600 million of liabilities in March and April. Portugal will probably have to rely on the European Central Bank to fund its commercial banks while Spain’s larger banks still have reasonable access to the private markets. Moody’s is threatening to downgrade Portugal again while there is a risk that the country could be forced to hold an election this summer which would expose divisions over its new fiscal austerity. The Spanish banks are far stronger than the Irish banks because the central bank compelled them to establish larger loan reserves after Spain joined the monetary union. Private analysts estimate that Spanish banks may still need €75 billion of new capital to achieve a 12.5% core equity ratio.
The peripheral European countries are now paying long-term interest rates which will be unsustainable unless they can greatly bolster their growth rates. There is a large gap between their long-term borrowing costs and projected growth rates. If we use IMF forecasts for growth, the gap is 11.6% in the case of Greece. Next is Ireland at 6.6%, followed by Portugal at 5.5%, Spain at 3.4%, and Italy at 2.0%. Many investors continue to believe that Greece and Ireland will have to restructure their debt because of high borrowing costs. The German press reports that there is discussion about having the financial stabilization fund lend countries money to repurchase their debt at discounted prices. As Greek debt sells at a deep discount to its nominal value, such an action would help to reduce the country’s debt levels without requiring a formal restructuring.
In a recent European tour, Chinese Vice Premier Li Keqiang promised that China would support Spain by purchasing €6 billion of Spanish government debt. As a result of the tour, Chinese and Spanish firms signed $7.9 billion of business deals. Sinopec is also about to take a 40% stake in the Brazilian subsidiary of Spain’s Repsol in order to participate in Brazil’s major new oil discoveries. China regards Spain as a potentially valuable partner in developing Latin American business. China has also taken advantage of Greece’s problems to make a large investment in the country’s ports. Europe is now China’s largest trade partner, so China is constantly searching for ways to gain more influence on European policy. It wants Europe to declare China a market economy and end an embargo on arms sales. Spain does not have as much influence as Germany, France, and Britain on these questions, but as Europe’s fourth largest economy it is more important than the other countries facing financial problems.
Estonia joined the monetary union on January 1st. Estonia achieved this goal after many years of a currency peg to both the deutschemark and the European currency. It also came after Estonia suffered a very severe downturn during 2009 in order to maintain the peg. Its real GDP fell by 13.9% and unemployment rose to 18%. Estonia’s real GDP recovered by 1.8% during 2010 and will probably grow by over 4.0% this year. Latvia and Lithuania also suffered severe downturns to maintain their currency pegs. Real GDP fell by 18% in Latvia and 14.7% in Lithuania. But neither country is likely to join the monetary union for several years.
CONCERNS ABOUT INFLATION BECOME PROMINENT IN CHINA
China’s economy probably grew at a 9.0% annualized rate during the fourth quarter. Fixed investment and exports remained robust. The government’s efforts to suppress real estate speculation have not prevented housing starts and sales from remaining resilient. The purchasing managers’ index fell to 53.9 in December from 55.2 suggesting growth in the manufacturing sector is moderating. The new orders index fell 5.0% while the export orders index was flat. The weakness of domestic orders suggests that government efforts to curtail bank lending may have dampened domestic spending during the final weeks of 2010.
The central bank is imposing a tighter monetary policy because of concern about inflation. It was at 4.6% in December and is widely expected to climb higher in 2011. The central bank has raised reserve requirements again to 18.5% for large banks, imposed administrative guidance on property lending, and hiked interest rates twice. The loan target for 2011 will be 7.2 trillion RMB compared to 7.5 trillion RMB in 2010 and a de facto gain of over 10 trillion RMB because of banks selling loans to trust companies. The problem is that interest rates are still low in relation to inflation, so there is little incentive to restrain spending. Surveys indicate that 45% of homebuyers in Shanghai paid in cash during the second half of 2010. The central bank will need to increase deposit yields to 5.0% from 2.5% in order to discourage speculative cash withdraws.
The primary cause of higher inflation is food prices while there has been a modest uptick in other goods prices as well. The inflation rate in the service sector has risen sharply because of wage gains resulting from labor shortages. The Chinese press is carrying stories that the coastal provinces need ten million more workers. The growing labor scarcity reflects a sharp slowdown in the growth rate of the labor force because of the one child policy introduced during the 1970s. China’s population growth rate has declined from 1.42% per annum during 1980-88 to 0.5% currently. The labor force is projected to expand from 803 million this year to 819 million in 2017, and then begin a gradual decline after 2018. Labor demand, by contrast, is projected to rise to 837 million workers by 2017. Migrant workers are the critical swing factor for employers in the coastal provinces. As a result of strikes during the second quarter, their pay rose nearly 40% last year. It will probably grow at a 20-30% rate for the next five years.
The government has so far tolerated wage inflation because of a desire to redistribute income and boost consumption, but the wage gains will at some point pose a challenge to China’s growth model. The model was built on productivity significantly exceeding wage growth and boosting profits. The robust profits pushed China’s investment share of GDP to 48%. If profits now contract, China’s investment could also decline. Japan’s experience during the 1960s and 1970s could be a role model for China. In Japan’s high-growth era during the 1960s the wage share of value-added fell to 50% from 60% during the 1950s. As the rate of urbanization slowed and the labor market tightened, wages took off and their share of value-added rose to 68% by 1980. There was a squeeze on profit margins which dampened the stock market until Japan entered a new bubble era during the mid-1980s.
Yu Yongding wrote a commentary for China Daily on the need for structural changes in China’s economy to sustain growth. He is president of the China Society of World Economics and a former member of the monetary policy committee of the central bank. He states the following:
China’s progress over the past three decades is a successful variation on the East Asian growth model that stems from the initial conditions created by a planned socialist economy. That growth pattern has now almost exhausted its potential. So China has reached a crucial juncture: without painful structural adjustments, the momentum of its economic growth could suddenly be lost. China’s rapid growth has been achieved at an extremely high cost. Only future generations will know the true price. The country’s investment rate now stands at more than 50 percent—a clear reflection of China’s low capital efficiency. There are two worrying aspects of this high rate. First, local governments influence a large proportion of investment decisions. Second, investment in real estate development accounts for nearly a quarter of the total. Some local governments are literally digging holes and then filling them in to ratchet up the GDP. (China Daily, December 23, 2010)
China has taken new steps to promote wider international use of the renminbi. It has announced that the Bank of China will allow US customers to trade the currency. This policy will expand the offshore market beyond Hong Kong. The next day the government also announced that it will allow Chinese companies to use the renminbi to make foreign investment or takeover bids. Chinese companies are now far more aggressive at making foreign investments than ever before, so this development will help to facilitate the process. China began to promote the renminbi as a global currency recently by allowing 70,000 companies to use the currency for trade. As a result of this policy change, trade settled in renminbi totaled $51 billion between June and November 2010 compared to zero eighteen months ago.
The renminbi is still not fully convertible, so there are limitations on its potential role as a reserve currency. As China now has $2.85 trillion of foreign exchange reserves, the odds are increasing that the renminbi will become fully convertible by 2015. When it does, the renminbi is likely to emerge as a rival to the US dollar in the East Asia region. Malaysia has already announced plans to purchase renminbi for its currency reserves, but other countries have lagged because the market for renminbi-denominated assets is still very undeveloped.
Treasury Secretary Tim Geithner made a speech on US-China economic relations in early January in preparation for the pending visit by Chinese President Hu Jintao. As in the past, he encouraged China to pursue a more flexible exchange rate policy. The Chinese press is reporting that the renminbi will be revalued 5% this year after a 3% gain during 2010. It also should be noted that the renminbi will appreciate another 4-5% in real terms because of China’s inflation rate rising above 5%. The Chinese are very cautious about permitting rapid exchange rate appreciation because they are aware of this inflation differential and the upward pressure now occurring on wages in the country’s major export zones.
The Asian Development Bank has published a report on China’s role in the global trading system. The report examines the impact of the iPhone on the US trade deficit. The report describes in great detail China’s role as the final link in a global assembly process spanning many countries. According to the report, only $6.00, or 3.6% of the $178.96 cost of the iPhone, accrues to the Chinese economy. The rest goes to overseas suppliers of components. The largest foreign beneficiaries are Japan (33.8% market share), Germany (16.8%), Korea (12.8%), and the US (6.0%). The report explains why Japan has a trade surplus with China and why currency appreciation will have only a limited impact on China’s competitive position. As China is an assembly point in a global supply chain, currency valuation would protect its competitive position by reducing import costs.
JAPAN’S STOCK MARKET AND ECONOMY FOLLOW DIVERGENT PATHS
The Japanese stock market led global markets during the fourth quarter after a long period of underperformance. The MSCI Japan index rose by 12.6% in US dollar terms compared to 6.5% for the Asia ex-Japan index. The Tokyo stock market benefitted from improving confidence about the US economy and the hope that this will bolster the dollar-yen exchange rate.
Japanese firms have succeeded in restoring profit margins to 2007 levels despite the fact that sales are still 15% below pre-crisis levels. Firms did this by squeezing costs, especially wages. The average monthly cash earnings of regular employees rose by only 0.8% year on year in the first ten months of 2010 after falling 3.3% in 2009. The pressure on wages in a deflationary environment explains why consumption has been stagnant for fifteen years. The government gave a boost to consumption during the past few quarters with “ecosubsidies” for autos and appliances, but these subsidies have now ended. As a result, real GDP will contract during the fourth quarter after a gain of 4.5% during the third quarter.
Bank lending declined by 2.1% year on year in December. The use of credit lines at banks is also at its lowest level in six years. The Bank of Japan will try to stimulate credit growth with a ¥5 trillion quantitative easing program this year. It will purchase government debt, commercial paper, corporate bonds, exchange-traded funds, and REITs.
Prime Minister Naoto Kan realigned his cabinet in order to evict some weak ministers and appoint a new trade minister who favors Japan joining the Transpacific Partnership that is being promoted by the US. The TPP is a very divisive issue in Japan because of concern about farmers facing more competition from rice imports. The corporate lobby supports the TPP because of fears that Japan is falling behind other countries, such as Korea, in pursuing bilateral or regional free trade agreements. He also appointed a new economics minister, Mr. Kaoru Yosano, who is very hawkish on fiscal policy and wants to move quickly to reduce the country’s large deficit. As there is no consensus on this issue, it is unclear how effective he will be.
There is a significant risk that the Democratic Party will suffer major losses in Japan’s local election in April. The government’s current approval rating is below 30%. The government will also have to form a coalition with smaller parties to get a two-thirds vote in the lower house of the Diet to approve its budget. These parties were formerly allied with Democrats, but broke off over the issue of the US military base in Okinawa. If the Democrats cannot find coalition partners, they could be forced to call an election in June.
The government passed a cabinet resolution endorsing its FY 3/12 budget. General account expenditure is projected to be ¥92.4 trillion. Tax revenue is projected to be ¥40.93 trillion while special account surplus funds are expected to be ¥7.9 trillion. These estimates produce a total fiscal deficit of ¥44.298 trillion, or a level similar to last year’s. Japan’s large deficit will finally push the ratio of public debt to GDP over 200%. The markets remain unconcerned about the public debt because it is 95% owned by local investors while a rising household savings rate and a large corporate financial surplus are keeping the current account in surplus.
FOOD PRICE INCREASES DRIVE INFLATIONARY FEARS IN EAST ASIA
There is growing concern in other Asian countries about inflation. The recent uptick in food and oil prices could drive inflation higher because the food share of the CPI in many Asian countries is in the 30-40% range. Indonesia’s inflation rate could rise as high as 7.6%. The Thai inflation rate could rise to 4.5%. The Philippines inflation rate could be 3.6%. The Malaysian inflation rate could increase to 2.9%. The Korean rate could exceed 3.0%.
Korea has just raised interest rates to 2.75%, two months ahead of the market consensus. If the Korean economy rebounds, concern about inflation could provoke the central bank into raising interest rates another three or four times. Thailand has also raised interest rates to 2.25% As core inflation could rise from 1.4% to 3.0% over the next six months, the odds are high that the central bank will tighten three or four more times. Indonesia has been reluctant to raise interest rates because of concern about currency appreciation, so it has increased bank reserve ratios from 5% to 8%. As inflation pressures could intensify because of commodity prices, the central bank will probably raise interest rates by the second quarter while trying to restrain the currency with capital controls.
India has recently experienced another surge of food prices to 18% year on year. The government is also threatening to turn food inflation into broad-based inflation by promising to index minimum wages for changes in food prices under the National Rural Employment Guarantee Act. The risk of food inflation nurturing wage inflation will force the Reserve Bank to raise interest rates further despite the recent volatility of industrial production. Most Indian economists believe that inflation will decline later this year because of a good monsoon, but India will remain vulnerable to changes in global commodity prices.
EXTREME FLOODING DIMS AUSTRALIA’S GROWTH PROSPECTS IN 2011
Australia has been rocked by severe flooding in the state of Queensland. It greatly disrupted coal mining and paralyzed the capital city of Brisbane for a few days. Queensland accounts for about 20% of Australia’s economic output while the coal industry accounts for nearly half of globally-traded coking coal. The output losses from the flood appear to sum to $6 billion, or 0.5% of Australia’s GDP. If all of these losses accrue in the first quarter, it could reduce output by 1.5% and cause total real GDP to decline for the first time since the fourth quarter of 2008. The floods also impacted farms producing 27% of Australia’s fruit, 30% of vegetables, 44% of cotton, and 93% of sugar. The loss of these crops will drive up food inflation during the next few quarters. Prior to the floods, Australia appeared to be poised for 3.7% output growth this year and 4.0% in 2012. Business investment will rise by 13-14% both this year and next year because of a mining boom. The terms of trade are close to a post-federation high. Retail spending has been erratic because of household caution, but unemployment has declined to 5.0%. The Reserve Bank will therefore be willing to raise interest rates again after the economy recovers from the flood. The floods have temporarily weakened the Australian dollar, but its great vulnerability is the prospect of further monetary tightening in China which might dampen growth forecasts for 2012 and 2013.
CANADIAN ECONOMY EXPECTED TO UNDERPERFORM US IN 2011
The Canadian economy is likely to grow by about 3.0% in the year ahead compared to 3.5% in the US. Canada outperformed the US in the early stages of the recovery. Output and employment returned to pre-recession levels after only eighteen months. Final domestic demand grew by 4.3% during the past four quarters compared to 2.4% in the US. Canada suffered a deterioration in its trade account equal to 2.1% of GDP while the US trade account improved by an amount equal to 1.0% of GDP. In recent months, there had been a slowdown of retail sales and homebuilding which could cause domestic final demand to rise by only 2.4% this year. The government has also imposed new restrictions on mortgage lending in order to slow the rapid growth of consumer debt. The upturn occurring in the US economy should bolster Canadian exports and cause the trade account to reverse some of last year’s decline. There was a large gain in manufacturing employment during December because of this new optimism. Canada will also boost investment by reducing its corporate tax rate to only 15% next year. The Canadian dollar has rallied because of this benign outlook and could restrain the export recovery. The Bank of Canada is concerned about the exchange rate, but the resilience of the US economy could cause it to tighten monetary policy again by the third quarter.
LATIN AMERICAN AUTHORITIES INTERVENE IN THE CURRENCY MARKETS
Latin American countries continue to express concern about the danger of exchange rate appreciation. In 2010, the central banks accumulated $93.7 billion of new forex reserves, which is double the level from 2009 and triple the level from 2008. Total reserves were $553 at the end of 2010 compared to $243 billion in January 2007. Chile announced that it will be prepared to spend $12 billion on intervention this year. Brazil has imposed new restrictions on the foreign exchange activity of banks.
Brazil’s growth rate rose to 8.1% year on year in November. Retail sales are booming while industrial production has been weak because of rising import penetration. The current account deficit widened to 2.5% of GDP from 1.5% in 2009. The strong exchange rate has restrained import prices and held the total inflation rate at 5.9% compared to 6.2% for the service sector. The central bank will raise interest rates again to combat inflation. The new government is still formulating a strategy to restrain public spending.
AFRICA ENTERS 2011 IN GOOD SHAPE, BUT RISKS REMAIN IN REGION
It is estimated that real GDP in sub-Saharan Africa grew by 4.75% during 2010 compared to 1.7% in 2009. If South Africa is excluded, real output growth in the region was 5.8%. After falling sharply during the global financial crisis, exports rebounded to a level 13.6% above pre-crisis volumes in March 2010. The largest gains were for metal and mineral exporters as well as oil producers. After declining by 12.3% in 2009, FDI rebounded by 6% to $32 billion in 2010. The World Bank estimates that FDI flows could rise to $40.8 billion in 2011 and $51.8 billion in 2012. South African growth during 2010 was only 2.7%. There was an uptick in consumer spending, but private investment was sluggish. The corporate sector has been cautious because of the strength of the rand and uncertainty about the government’s economic policies. President Jacob Zuma is generally indecisive and has taken actions to placate the leftwing of the ANC which destroy jobs. The ANC Youth League has also been calling for the nationalization of the mines. The outlook for the resource sector in Africa continues to be positive. Ghana is now an oil producer. Zambia hopes to boost copper output to a record one million tonnes over the next few years. Gold production is increasing in Mali, Burkina Faso, and the DRC. Some countries continue to suffer from political conflict. The president of the Ivory Coast has refused to surrender power after losing a recent election. President Robert Mugabe of Zimbabwe wants to hold an election which he could again attempt to rig. Southern Sudan will become a new country later this year, but must still resolve some border issues with the north.
WILL EFFECTIVE IRANIAN SANCTIONS BE IMPOSED IN THE NEAR FUTURE?
The US government will soon attempt to impose sanctions on Iranian oil exports. Iran produces approximately 4 million barrels per day (including 600,000 from natural gas liquids) and consumes 1.8 million barrels per day at home. The US will seek to obtain Saudi help in boosting oil output in order to compensate for lost Iranian supplies. As Saudi Arabia wants to prevent Iran from becoming a nuclear power, it will help the US effort to impose sanctions. As sanctions on Iran could reduce OPEC capacity by 2 million barrels per day barring a dramatic gain in Iraqi output, they will probably encourage at least a moderate uptick in the oil price in 2012.
WHY CAPITAL CONTROLS ARE BECOMING ACCEPTED IN GLOBAL FINANCE
The World Bank’s new global forecast for 2011 notes that domestic demand in the developing countries accounted for 46% of global output during 2010. The World Bank remains positive on the outlook for the emerging market countries. It also endorsed the principle of developing countries using capital controls to manage the impact of global financial flows on their exchange rates and domestic asset markets. The report notes: “Capital inflows into some middle income countries have placed undue and potentially damaging upward pressure on currencies. Many of these inflows are short-lived, volatile, and sometimes speculative in nature. Left unchecked, such flows can lead to abrupt real appreciations and depreciations that are out of line with underlying fundamentals and can do lasting damage to economies.”
The IMF issued a report in November 2010 which was also sympathetic to the idea, albeit emphasizing that the controls should have a light touch and be temporary. The IMF report acknowledged that it had to be more flexible about judging capital regulatory policies because of the growth in surplus liquidity on a global basis. It said:
No presumption is made here that capital account liberalization is a goal in itself in all cases, but rather that a broader range of tools and advice, contemplating both the elimination and imposition of controls, may be more appropriate for domestic and systemic stability. It is recognized that international capital flows are only a type of financial flow—the type that crosses borders—and that the overall approach must fit in a broader vision of macro-prudential regulation and supervision.
The first major test of the IMF’s support for capital account liberalization was the East Asian financial crisis in the late 1990s. Emerging markets then recovered and capital flows helped to magnify the gains. The global financial crisis of 2008-09 provoked new concerns about the growth of global liquidity. The Fed’s decision to embark upon a policy of quantitative easing then ensured that developing countries would become concerned about excessive volatility in capital flows and distortions in their exchange rates and asset markets. During the past six months, many developing countries—Brazil, Thailand, Indonesia, Taiwan, Korea—have attempted to use capital controls to manage the impact of capital flows on economies. As it has a currency board, Hong Kong cannot impose capital controls, so it tried to offset their impact by imposing a special 5-15% stamp tax on property transactions. The goal was to discourage high turnover speculation in property. Turkey surprised the markets by lowering interest rates while increasing reserve requirements to dampen exchange rate appreciation despite a booming economy. The policy change has created concerns about overheating and caused the exchange rate to fall 10%. These actions suggest that governments are going to be more interventionist in managing capital flows than at any time during the past decade. Countries will want to maintain access to the international capital markets but they will want to do it on terms that do not compromise other policy objectives.
©2011 David Hale Global Economic, Inc
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