Markets Insight

March 19, 2014 7:05 am

China’s financial distress turns all too visible

Country’s economic change will have deflationary consequences

Investors have a lot to worry about without cause to fret about China, but now they have that too. Trend growth is slowing down, and markets have been shaken up by the actions of the People’s Bank of China (PBoC), which is trying to tame a virulent credit boom.

The incidence of financial distress is rising and becoming more visible. The recent drop in the renminbi, and the sharp fall in copper and iron ore prices are the latest high-profile manifestations of China’s changing outlook. These are not random developments or bad luck, but connected parts of a complex economic transformation with deflationary consequences for the world economy and skittish financial markets.

In the first two months of 2014, industrial confidence and output indices, retail sales, fixed asset investment, and credit creation were all weaker than expected. A slowdown in economic growth at the start of the year, coinciding with the Chinese new year holidays, is not unusual, but in each of the past two years, the government sanctioned faster credit growth and infrastructure spending to compensate. This time, those options are not available, or much riskier, because the government is trying to change China’s economic development model.

Change is mostly visible in finance, where market forces are slowly being brought to bear. The PBoC has announced the goals of full interest rate liberalisation by 2016, and of admitting private firms into the financial sector. It has introduced a two-way market in renminbi trading, and widened the trading band to plus or minus 2 per cent around a daily reference rate. These and other policy changes affecting shadow banking may already be damping the credit, currency and interest rate arbitrage behaviour of local banks, state enterprises and private companies.

Premier Li Keqiang confirmed a change in attitude last week when he said people should be prepared for bond and financial product defaults as the government proceeded with financial deregulation. He spoke in the wake of the country’s first corporate bond default and the failure of a significant steel mill to repay loans that fell due.

Slowing economic growth, chronic overcapacity and rising debt service problems in key industries are becoming more common, raising the risk of chain defaults involving suppliers and purchasers. Overcapacity recently prompted a senior executive in the Chinese Iron and Steel Association, Li Xinchuang, to say the problem was so severe it was “probably beyond anyone’s imagination”.

In an industry survey by the State Council, 71 per cent of respondents said overcapacity in iron and steel, aluminium, cement, coal, solar panels and shipbuilding was “relatively or veryserious.

Last week’s market scare, however, was focused on copper, which has fallen nearly 15 per cent this year, and by more than a third from its 2011 peak. Falling prices have embraced a swath of both ferrous and non-ferrous metals, sending ripples from Perth to Peru.

The underlying reason for the base metals shake-out is the mirror image of the prior boom, in which China’s voracious appetite raised its consumption to about 40 per cent of global production. Its per capita consumption is far higher than any other emerging country, regardless of income per head.

In short, what China gave producers and miners on the way up, it is taking away as the commodity composition and intensity of GDP growth tail off.

Large swings in market prices are happening also for murkier – and largely speculative reasons that hinge on the use of copper and ore as collateral for loans, and as a means of raising finance abroad and bringing it onshore to spend or lend. As the authorities clamp down on credit creation and shadow financing, falling prices, including that of collateral, will expose participants to losses, and markets to the risk of distress selling.

The transmission effects of lower prices into emerging markets and the global economy are most likely to prove disruptive, even if the positive real income effects for consumers eventually win out.

China’s economic transformation is happening regardless. Its leaders have choices only about how to manage it, and when to accommodate what is likely to be a painful adjustment. Sage advice would be to grin and bear it now, so as to avoid harsher outcomes later. But the political willingness and capacity to do so is unpredictable.

It is still possible that China will blink, raise infrastructure and housing spending and new credit creation, and lower bank reserve requirements and the renminbi. This would introduce a sharp twist to the underlying plot, but lead to a more dramatic conclusion.

George Magnus is a senior independent adviser to UBS and former chief economist

Politics & Ideas

The Economic Roots of American Retreat

Enduring a jobless recovery has discouraged many from supporting a robust U.S. foreign policy.

By William A. Galston

March 18, 2014 6:53 p.m. ET

A recent Pew Research Center survey finds that, by 56% to 29%, the American public says that it is more important for the United States to minimize its involvement in the Ukrainian crisis than to take a firm stand against Russian actions. Meanwhile, the latest NBC/Wall Street Journal poll finds that 57% of Americans believe the U.S. is still in recession.

These findings are related. To be sure, the American people are typically cautious about foreign entanglements, and 12 years of costly wars have intensified that caution. But something more is at work. As long as the economy remains troubled, the assertion that "it's time for nation-building here at home" will prevail against external challenges that seem less than existential.

Put simply: If the people do not believe we are strong at home, they will be reluctant to support a policy of strength abroad, reducing the ability of the U.S. to serve as the guarantor of global security. 


By prevailing economic standards, the Great Recession ended in mid-2009. But there are good reasons why average Americans don't see it that way. Although inflation-adjusted gross domestic product exceeded its late 2007 peak by the second quarter of 2011, the number of jobs has not regained its prerecession level.

At the beginning of economic recoveries, hiring has typically trailed production increases. After the first seven downturns following World War II, the resumption of hiring didn't kick in until two or three months after production rose.

But then things began to change. After the 1990-91 recession ended, the lag between hiring and production stretched to 10 months; after the 2001 recession, it increased to 16 months. The current three-year gap between the start of recovery and the revitalization of employment has no precedent in the postwar era. Something fundamental has changed in the relationship between economic growth and employment gains, and the American people sense it.

There is another reason so few Americans believe that the recession has ended: The standard of living for most people has eroded. Median household income declined by 1.6% in 2008 and 2.6% in 2009. But after the official end of the recession, it continued to fall—by 2.3% in 2010 and 2.5% in 2011before stabilizing in 2012. Analysis of more recent data by Sentier Research indicates that median household income grew only marginally in 2013.

The bottom line: As of the end of 2013, median household income was 4.7% lower than in June 2009, the official end of the recession; 6.2% lower than in December 2007, the official beginning of the recession; and 7.5% lower than in January 2000. Median household income today is barely higher than it was a quarter-century ago, in 1989.

Underlying these troubling household statistics is a fundamental shift in the structure of the U.S. economy. For decades, wages constituted about 55% of total national income. In the wake of the Great Recession, that measure has dropped to 50%. Total compensation, which includes benefits, averaged 66% during the same period. It has now fallen to only 61%. Meanwhile, the Bureau of Economic Analysis reports that after-tax corporate profits, which oscillated between 5% and 7% of GDP from 1980 through 2000, have surged to an all-time high of 10%.

During the Cold War, Americans were sustained by the belief—and the fact—that we were all in it together. And we were: In 1967, according to the Census Bureau, the top 5% of the U.S. population received 17% of national income, and so did the middle fifth. Nearly two decades later, in 1984, little had changed: The top 5% of Americans received 17% of national income, the middle fifth, 16%.

Today in the post-Cold War era, Americans have less reason to feel the we're-all-in-this-together sense of national purpose. The top 5% receives 22%, the middle fifth only 14%. If average Americans no longer believe that the economy works for them, it's hard to argue with them.

Although both political parties are split, many members of each party continue to believe in a U.S. that is engaged overseas not only economically and diplomatically, but also militarilynot to invite conflict, but to deter the kind of aggression we have seen in recent weeks.

Yet our political leaders cannot sustain the country's leading role without the support of the American people, who will not be willing to shoulder that burden unless they have a chance to improve their lives and enhance opportunity for their children. Their loss of confidence is the largest obstacle to a foreign and defense policy that reduces aggression and increases security around the world. For America's national leaders who still support such a policy, rebuilding a growing economy whose fruits are widely shared is Job One.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved

Deconstructing the U.S. Economy: The Non-Recovery

By: Eric Sprott

We are now in the 5th year since the “officialend of the Great Recession (the National Bureau of Economic Research (NBER), which officially dates U.S. recessions, said the recession ended in the second quarter of 2009), but it hardly feels like a recovery. Nonetheless, the media, sell-side economists, central bankers, the IMF, etc. all claim that the U.S. economy is now firmly out of the woods.

President Barack Obama said in his State of the Union speech that he believes 2014can be a breakthrough year” for the U.S. economy and the IMF, which raised its forecast for U.S. GDP growth in a report titledIs the Tide Rising?”, now predicts growth of 2.8% in 2014.1

However, a closer look at the data suggests that things are not improving and that the U.S. economy remains frail. Many point to the unemployment rate as a sign that things are getting better. Indeed, it has been declining steadily for many years and now stands at 6.7%. However, what many seem to forget is that the unemployment rate is declining for the wrong reasons.

Yes, the U.S. has been adding new jobs, but a large share of the decline in the unemployment rate can be explained by discouraged workers leaving the labour force.2 This effect can be seen in the falling participation rate. Many argue that this decline in the participation rate is structural and is caused by population aging. This explanation is superficial and misleading.

Figure 1, shows the contribution to the total participation rate for various age groups. As shown in Figure 1, since January 2005, the participation rate has fallen by 2.9% (from 65.8% to 62.9%). Of this decrease, 1.3% and 4.7% were driven by the 16-24 and 25-54 age groups, respectively. The rest was offset by a 3.1% increase in participation by the 55+ cohort.

Note: Sum of individual components adds up to total participation rate. Source: Bloomberg, Sprott Calculations 

This is reflective of a deep problem, as it suggests that baby boomers are failing to make ends meet and have to work for longer or even come out of retirement, and that the future workforce, those in their prime working years, are leaving the labour force.

Interestingly, without the “3% contribution” from the 55+ cohort, the labour force would have fallen below 60% for the first time since 1971, a period when the participation rate was starting to expand, driven mainly by women entering the workforce.

But that’s not all; many of those in their early 20s, seeing how hard it is to find a job, are staying in college for longer, amassing outrageous levels of student debt in the process. This is obviously not a sustainable solution. Delinquency rates on student loans (the bulk of them insured by the U.S. Government) are now at all-time highs (Figure 2). Most of these student loans have been securitized and sold to investors with the Government’s stamp (sound familiar?).

Source: Bloomberg, Sprott Calculations 

For all the rest (ages 25-54), the participation in the labour force has also been declining, although at a slightly slower pace. Nevertheless, the average U.S. consumer is still worse off than it was before the Great Recession. Real disposable income per capita (Figure 3) is lower than it was at the end of 2005 while, over the same period, health care costs have increased from 10.0% to 11.5% of GDP (Figure 4), thereby reducing funds available for discretionary spending.

Source: Bloomberg, Sprott Calculations

Source: Bloomberg, Sprott Calculations

Not surprisingly, lower disposable income and discretionary spending levels for the average American are reflected in declining retail sales growth (Figure 5 shows the year-over-year growth rate in retail and food services sales).

Source: Bloomberg, Sprott Calculations 

Moreover, since the summer of 2013, when the Federal Reserve lost control of the bond market (see our articleHave we lost control yet?”, June 2013)3, we have seen a clear deterioration in demand for credit dependent purchases. Since these purchases are mostly made on credit (mortgages, car loans), increases in interest rates have made them unaffordable to many customers. Thus, because of the large and sudden increase in interest rates, housing sales have slowed significantly, as can be seen in Figure 6. Similarly, car sales growth has been on a declining trend since it peaked in mid-2012 (Figure 7).

Source: Bloomberg, Sprott Calculations 

Source: Bloomberg, Sprott Calculations 

On the supply side, things do not look rosy either. The U.S. composite PMI has been more or less flat for the past 3 years (Figure 8) and has suffered a sharp decline since its August 2013 peak”. Other indicators, such as the durable goods new orders have been growing at a declining pace (Figure 9).

Source: Bloomberg, Sprott Calculations 

Source: Bloomberg, Sprott Calculations  

To conclude, numerous indicators of the state of the U.S. economy point to a non-recovery:
  •  The participation rate is low and supported by baby boomers working more or coming out of retirement. 
  •  Students (the future labour force) are defaulting on their loans in record amounts
  •  Disposable income is still below its pre-recession level
  •  An ever increasing share of disposable income is being spent on health care, crippling discretionary spending.
  • Higher interest rates are further depressing discretionary spending (home and auto sales). 
  •  All of which is resulting in anemic business and economic activity.

Claims that the U.S. economy is suddenly rebounding have been made before. They are misleading at best and fallacious at worst. It would not be surprising to see further deterioration, which would force central planners to initiate additional unconventional intervention (i.e. Quantitative Easing).


Wow! In a recent Bloomberg article, Andrew Gracie, an executive director at the Bank of England (BoE), was proposing that in the event of a bank failure, regulators could suspend derivatives contracts affecting the failed bank on a global basis.4 He further argues that “The entry of a bank into resolution should not in itself be an event of default”. In other words, the solution proposed by the BoE to deal with a bank that fails and that has entered in a mountain of derivatives contracts is to suspend the market.

But this misses the point. As usual, regulators try to patch things up instead of proposing true solutions. What they are effectively proposing is to suspend reality, yet again, and pretend that there are no problems. This is even worse than suspending mark-to-market! How ironic that the same regulators who allowed this to happen are the ones who ask the market to suspend reality.

2See the January 2013 Markets at a Glance,“Ignoring the Obvious”: