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31-08-2014, 10:40 PM
China, its balance sheets, and us
Economic briefing Alan Mitchell Economics editor
970 words
1 Sep 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Alan Mitchell
"The relevant question to ask about the Chinese economy," says RBA governor Glenn Stevens, "is not really, 'What is the PMI doing this month?' – which is a huge obsession in markets and so on."
"The real issue is the financial part of the economy and whether they can manage that down."
Like other successful emerging market economies, China is trying to steer away from the dangerous shoals of financial crisis.
But China's problem is different to the external pressures placed on the other emerging market economies by the prospect of a return to more normal monetary policy in the United States.
They face the risk of at least a mild variant of what International Monetary Fund economists Bas Bakker and Leslie Lipschitz call conventional balance sheet crises: a sudden reversal of capital flows after a long period of strong inflows and a build-up of foreign currency debt.
China, with its capital controls and $US3.8 trillion in foreign currency reserves, seems immune from that kind of crisis. In fact, say Bakker and Lipschitz, China might welcome some capital outflow after the recent strong rise of its real exchange rate.
However, China is not immune from what the IMF economists call an insidious balance sheet crisis.
Insidious crises, they say, are triggered by internal imbalances and balance sheet vulnerabilities.
They typically occur when a combined credit, asset-price and construction boom becomes unsustainable.
"As growth slows and asset prices decline, many loans granted during the boom period (and predicated on unrealistic growth and price expectations) become problematic," Bakker and Lipschitz explain.Triggers for banking crises
"Nonperforming loans in the banking sector trigger a banking crisis.
"Given conventional bank leverage ratios, deposit protection, and political pressures, a widespread banking crisis almost inevitably elicits government direct intervention and a worsening of the fiscal accounts that is far larger than that due directly to the recessionary effects on government revenues."
As in the case of conventional, foreign debt-driven crises, the story usually begins with prolonged prosperity that dulls the sensitivities of investors and lenders to risk and rising vulnerabilities.
And, as the IMF economists tell it, this domestically generated crisis also emerges with the economy's natural evolution.
As both incomes and demand for goods and services rise, relative prices change.
The prices of internationally traded goods don't rise much because they are set primarily on global markets.
But the prices of goods and services that are not internationally traded ("non-traded" for short) are a different story.
Their prices are determined by domestic supply and demand, and an increase in demand has to be met by cranking up production, which can be expensive. The shift in consumer demand from motorbikes to cars to better housing and services such as healthcare and education is completely natural, and the change in prices needed to keep domestic production equal to the changing demand is part of that process.
The problem is when rising prices are built into investor expectations, and there is a debt-fuelled speculative boom with prices overshooting the levels needed to meet underlying demand, and we have a price bubble.
Asset markets are particularly prone to overshooting and bubbles, and domestic real estate is what the IMF economists call the "ultimate non-traded asset".Fuelled by credit
Unlike sharemarket booms, real estate booms always are fuelled by credit. That's how real estate market crashes turn into banking crises.
The shift in production from exports to goods and services to meet the new patterns of demand can create pressure on a government to support growth by throwing more fuel on the housing boom.
In China's case, the shift in demandto better housing and services is not just natural, it is long overdue.
It should have happened naturally. As manufacturers use up the pool of surplus farm labourers, wages rise. The consequent real appreciation of the yuan and the shift in income distribution from capital to labour should lead to increased consumption and lower saving. Higher household incomes shift demand toward non-traded goods and services, especially housing. In practice, the rebalancing of China's economy has involved the gradual dismantling of policies designed to boost saving and investment in export manufacturing.
It also became entangled with Beijing's macro-economic management response to the global financial crisis, which involved a massive expansion of investment funded through the state-owned banking system.
With China's financial and capital market regulations still limiting the returns on saving, private savings also poured into the real estate market.
By 2012 construction was running at more three times the level of 2003.
That, the economists say, represents a rate of expansion far above that in Japan in the mid-1990s, and comparable with that in Ireland in the 2000s.
Coupled with this construction boom has been an explosion of credit. Although bank credit has increased rapidly, other mechanisms of lending have proved much more expansionary, and "social financing" – the total amount of financing that the real economy can access via the financial sector – increased from 127 per cent of GDP in 2008 to 200 per cent in 2013.
Perhaps China will be the first country to have fully absorbed the lessons of insidious crises in rapidly developing countries, Bakker and Leslie Lipschitz say as the country's property market rocks ominously.
If not, China has a huge amount of economic ammunition to throw at the problem. But, even in the more optimistic scenarios, growth is likely to slow sharply.
In those circumstances, selling the budget may quickly become the least of Tony Abbott's problems.
In Australia, as in other economies in the Chinese supply chain, all bets – fiscal, political, and investment – would be off.
Fairfax Media Management Pty Limited
Document AFNR000020140831ea910000n
Economic briefing Alan Mitchell Economics editor
970 words
1 Sep 2014
The Australian Financial Review
AFNR
English
Copyright 2014. Fairfax Media Management Pty Limited.
Alan Mitchell
"The relevant question to ask about the Chinese economy," says RBA governor Glenn Stevens, "is not really, 'What is the PMI doing this month?' – which is a huge obsession in markets and so on."
"The real issue is the financial part of the economy and whether they can manage that down."
Like other successful emerging market economies, China is trying to steer away from the dangerous shoals of financial crisis.
But China's problem is different to the external pressures placed on the other emerging market economies by the prospect of a return to more normal monetary policy in the United States.
They face the risk of at least a mild variant of what International Monetary Fund economists Bas Bakker and Leslie Lipschitz call conventional balance sheet crises: a sudden reversal of capital flows after a long period of strong inflows and a build-up of foreign currency debt.
China, with its capital controls and $US3.8 trillion in foreign currency reserves, seems immune from that kind of crisis. In fact, say Bakker and Lipschitz, China might welcome some capital outflow after the recent strong rise of its real exchange rate.
However, China is not immune from what the IMF economists call an insidious balance sheet crisis.
Insidious crises, they say, are triggered by internal imbalances and balance sheet vulnerabilities.
They typically occur when a combined credit, asset-price and construction boom becomes unsustainable.
"As growth slows and asset prices decline, many loans granted during the boom period (and predicated on unrealistic growth and price expectations) become problematic," Bakker and Lipschitz explain.Triggers for banking crises
"Nonperforming loans in the banking sector trigger a banking crisis.
"Given conventional bank leverage ratios, deposit protection, and political pressures, a widespread banking crisis almost inevitably elicits government direct intervention and a worsening of the fiscal accounts that is far larger than that due directly to the recessionary effects on government revenues."
As in the case of conventional, foreign debt-driven crises, the story usually begins with prolonged prosperity that dulls the sensitivities of investors and lenders to risk and rising vulnerabilities.
And, as the IMF economists tell it, this domestically generated crisis also emerges with the economy's natural evolution.
As both incomes and demand for goods and services rise, relative prices change.
The prices of internationally traded goods don't rise much because they are set primarily on global markets.
But the prices of goods and services that are not internationally traded ("non-traded" for short) are a different story.
Their prices are determined by domestic supply and demand, and an increase in demand has to be met by cranking up production, which can be expensive. The shift in consumer demand from motorbikes to cars to better housing and services such as healthcare and education is completely natural, and the change in prices needed to keep domestic production equal to the changing demand is part of that process.
The problem is when rising prices are built into investor expectations, and there is a debt-fuelled speculative boom with prices overshooting the levels needed to meet underlying demand, and we have a price bubble.
Asset markets are particularly prone to overshooting and bubbles, and domestic real estate is what the IMF economists call the "ultimate non-traded asset".Fuelled by credit
Unlike sharemarket booms, real estate booms always are fuelled by credit. That's how real estate market crashes turn into banking crises.
The shift in production from exports to goods and services to meet the new patterns of demand can create pressure on a government to support growth by throwing more fuel on the housing boom.
In China's case, the shift in demandto better housing and services is not just natural, it is long overdue.
It should have happened naturally. As manufacturers use up the pool of surplus farm labourers, wages rise. The consequent real appreciation of the yuan and the shift in income distribution from capital to labour should lead to increased consumption and lower saving. Higher household incomes shift demand toward non-traded goods and services, especially housing. In practice, the rebalancing of China's economy has involved the gradual dismantling of policies designed to boost saving and investment in export manufacturing.
It also became entangled with Beijing's macro-economic management response to the global financial crisis, which involved a massive expansion of investment funded through the state-owned banking system.
With China's financial and capital market regulations still limiting the returns on saving, private savings also poured into the real estate market.
By 2012 construction was running at more three times the level of 2003.
That, the economists say, represents a rate of expansion far above that in Japan in the mid-1990s, and comparable with that in Ireland in the 2000s.
Coupled with this construction boom has been an explosion of credit. Although bank credit has increased rapidly, other mechanisms of lending have proved much more expansionary, and "social financing" – the total amount of financing that the real economy can access via the financial sector – increased from 127 per cent of GDP in 2008 to 200 per cent in 2013.
Perhaps China will be the first country to have fully absorbed the lessons of insidious crises in rapidly developing countries, Bakker and Leslie Lipschitz say as the country's property market rocks ominously.
If not, China has a huge amount of economic ammunition to throw at the problem. But, even in the more optimistic scenarios, growth is likely to slow sharply.
In those circumstances, selling the budget may quickly become the least of Tony Abbott's problems.
In Australia, as in other economies in the Chinese supply chain, all bets – fiscal, political, and investment – would be off.
Fairfax Media Management Pty Limited
Document AFNR000020140831ea910000n