China doesn’t need to deleverage

MoneyWeek reports on why inflation will return sooner than people think.

(emphasis mine)
[my comment]

Why inflation will return sooner than people think
By Cris Sholto Heaton Jan 12, 2009


Is the end in sight or is the end nigh?

The consensus among investors and analysts these days is increasingly polarised between those who say we're just about to turn the economic corner, and those who argue that the bottom is about to drop out of the world. [I am in "the bottom is about to drop out of the world (because of hyperinflation)" camp]

The first view is clearly wrong — and we've been hearing it ever since the crisis started in mid-2007. Yet the second argument isn't any more realistic. Yes, things are pretty tough. Yes, they're going to get worse. Yes, this is probably going to be the worst recession since the Great Depression — at least in the UK and US. But the key word is 'since'. For all the problems we face, this is not a rerun of the Great Depression. There is a world of differences between then and now …

Not good, but better than it could be

The first is that the world is in very different shape to the world of the 1920s and 1930s. We often think of the Great Depression in isolation, but we need to remember that it followed shortly after the devastation of the First World War. That had a huge impact on the health of the global economy and on the ability and willingness of many countries to respond to the challenges of the Depression. It was like a patient, already severely sick, catching another life-threatening disease at the same time.

Secondly, if you look back before the Great Depression, rapid swings in output and severe prolonged recessions were more common than they have been in recent decades. Take a look at the chart below from Merrill Lynch.



It seems that recessions used to be significantly more frequent in America: there were 20 in 83 years up to 1940, compared with 12 in 68 years since then (including the latest one which isn't shown).

What's more, it looks as if recessions in the pre-depression era were typically longer (although there are all sorts of problems with comparing data across long periods of time like this, and it may well be that estimates for start and end dates are much less accurate for older recessions).

In other words, there's a suggestion that the economy has changed substantially since then, making the boom/bust cycle less severe. There are plenty of possible reasons for this - but two very relevant ones are the absence of a gold standard (which lends itself to deflation) and greater willingness on the part of central banks and governments to intervene to boost the economy.

This second point is a very clear difference between 1929 and 2008. While many policymakers stood back at the start of the Great Depression (the most notable exception is Japan, which subsequently suffered less than any other developed economy), there seems little risk of that happening this time. [With helicopter Ben on the case? no kidding.]

The Obama administration is already proposing a $775bn stimulus package for the US economy, but I suspect this could easily total three times as much over the course of the slump. That may be conservative: a recent study found that a government's debts expand by an average of 86% after a financial system crisis such as this, partly due to lost tax revenues and partly due to huge public spending increases.

Bernanke has his finger on the button

Meanwhile, central bankers are both slashing rates and directly increasing the money supply. Of course, increasing the money supply alone isn't the whole story: a central bank directly controls only M0 (currency in circulation plus bank reserves held at the central bank). Broader measures of money supply, such as M3, depend on how much of the base money is spent, saved, borrowed and lent.

In a deflationary recession, as people hoard more and spend and borrow less, broader money supply can contract even if the central bank increases the monetary base. And indeed, that's what's currently happening in the US, as you can see on the chart below. [see my entry on how deflation creates hyperinflation]



My initial conclusion was that this means Fed is almost powerless in this kind of situation — that any prudent increase in M0 will do nothing to offset the contraction in the broader money supply. But I'm no longer sure: the more we see of Ben Bernanke's actions — bearing in mind that he's a specialist in the Great Depression who has explicitly blamed much of it on monetary policy mistakes — the more I suspect that he will expand M0 by as much as is needed to plug the gap, prudence be damned. [I agree and it is scary]

Whether a huge increase in public spending or a vast increase in money supply is the best course of action is a big question [Answer: No, it is completely insane] . But since I have no influence over these things, I'm more concerned about what will happen than what should happen. [same here]

I'm far from confident policymakers will act for the best. I'm sure there will be many unintended consequences [hyperinflation]. And we're clearly in a nasty recession and probably headed for a spell of deflation. But increasingly I think the long-term risks lie on the side of inflation rather than deflationary depression. [correct, but a lot sooner than even you think]

China is not America

Once you begin comparing today with the Great Depression, the next step is often to compare China today with America then. And again, there are similarities. In both cases, you have a rising, increasingly-powerful country, exporting to the economies that used to dominate the world economy, who are running up ever larger debts with it. Today, we talk of China hoovering up US treasury and agency bonds; back then, the US was sucking in its trade partners' gold reserves.

But there are also substantial differences. The US was a highly-developed country, already the world's largest economy — and very much a consumer economy. Consumption accounted for over 70% of GDP — higher than it is today, as you can see in the chart below.



That's very different to China today. In contrast to the overconsumption/underinvestment problem that America had after a debt-fuelled consumer-spending boom in the 1920s, China very clearly has an underconsumption/overinvestment problem. Domestic demand is too weak, while investment in manufacturing to meet export demand has been too high.

Clearly that's not a great situation either. But differences such as these mean that simply suggesting that "America in 1929 = China now" doesn't necessarily lead us to useful conclusions — especially as China has plenty it can do to support its economy. Obviously, investment in manufacturing is going to fall away quite substantially. But — perhaps in contrast to the US in the thirties — there are very obvious ways for it to be replaced with other investment.

China is at a far lower level of development, relative to the rest of the world, than the US was then. There's enormous scope for investing in transport infrastructure, mass-market housing, cleaning up the environment, building up the health, education and social security system — the list goes on. Measures that improve the welfare safety net and increase people's sense of security should also bring down the savings rate and boost consumption. This will be a long-term shift and can't be brought about in mere months, but it points the way to future growth for China once this crisis in over.

Time to grow lending

China is also in the enviable position of being one of the few countries that doesn't need to deleverage. While debt ratios rose ever higher in the West in recent years, in China, the opposite happened [This is the key point of this article]. Take a look at the chart below from Tao Wang of UBS.



Wang argues that while much of the world has to curb borrowing, China can try to step up lending. And this seems to be part of the government's plans: apart from cutting rates, it also announced in early December a package of measures aimed at the financial sector. These included ensuring that liquidity remains adequate, providing loan guarantees for small and medium-sized businesses, increasing consumer and farmer loans and allowing more companies to issue bonds.

The fact that the Chinese government still exerts more control over its domestic economy than most others, should also help here. In the UK, banks have treated Gordon Brown's instructions to lend more with contempt; it's harder to see that happening in China. Similarly, state-owned enterprises can be pressured to keep investing and keep people employed.

November's data suggest that lending already seems to be picking up, as you can see in the chart below of year-on-year growth in Chinese bank lending. This graph is probably going to be a pretty important one for monitoring China's economy over the next year.



Increased lending in a downturn isn't necessarily great for bank balance sheets and thus for shareholders in the banks. I'm already sceptical about the levels of non-performing loans in Chinese bank loan books and this doesn't make me any more enthusiastic about buying into them. But it will help to reduce problems in the broader economy.

I still think China will grow significantly more slowly than most economists are officially forecasting, especially in the first half of the year. But once you combine the huge coming US stimulus package with what China can do for itself and the differences between 1930s and now, suggestions that we're heading for Great Depression II with China bearing the brunt of it seem excessive. [Agreed. The conventional wisdom on China is dead wrong.]

My reaction: The single key point to take away from this article is that China's leverage ratios were falling in recent years as the US went on its subprime binge. That loan to gdp chart alone really drive this point home nicely.

(Sorry for those of you who were waiting for my big entry on China, but I need one more day to work on it)

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