December 24, 2014 11:29 am

Causes and consequences of China’s contagious case of deflation

Monetary policy might not be enough and governments may be forced to step in, writes George Magnus
The 50 per cent fall in oil prices this year is self-evidently good news for all but oil-producing states, regions and companies. It also reminds us that the world economy is deflation-prone — both because of deficient demand in Europe, Japan and several big emerging markets and because China’s deflation, rooted in excess capacity, is structural and of growing significance.
A persistent and as yet unfinished slowdown in the country’s economic growth has been accompanied by the emergence of substantial overcapacity, a significant rise in non-financial corporate debt and a big drop in inflation. Between 2011 and November 2014, Chinese producer prices fell by 10 per cent — the annual change has been negative for 33 months — and the annual rate of consumer price inflation has fallen from 6 per cent to 1.4 per cent over the same period.

The ratio of output to capacity in many sectors — for example, steel, plate glass, construction materials, chemicals and fertilisers, aluminium, shipbuilding, and solar panel and wind turbine manufacturing — has fallen sharply. Last year it was about 70-72 per cent, and it is likely to have dropped further since. Property was the main beneficiary of the post-2008 investment and credit surge, accounting for about 16 per cent of China’s gross domestic product directly; it is now in a secular downturn. Inventories of unsold homes in many cities outside Beijing, Shanghai and Shenzhen have risen sharply to between 25 and 40 months of supply.
China’s nominal GDP growth has roughly halved since 2011 to 8 per cent this year, and the aggregate debt to GDP ratio has risen by 80 percentage points to 250 per cent. The increased burden of debt has been exacerbated by passive tightening from the rise in real interest rates.
These have doubled to 4 per cent, deflated by consumer prices; and surged from zero to 8 per cent, using producer prices. The share of interest payments in GDP has doubled to about 15 per cent. Although credit expansion is slowing, it is still running at almost twice the rate of nominal GDP, and much is probably sustaining excess capacity to avoid shutdowns and job losses.
The persistence of excess capacity will sustain China’s deflation, aided and abetted by a cosseted financial system, a closed capital account and financial privileges enjoyed by state enterprises. The escape from this environment is likely to be protracted, and perhaps even troublesome at times. The People’s Bank of China has been adding liquidity for some months, and recently cut interest rates for the first time in three years. It will doubtless continue along an easing path in 2015, but monetary balm is no substitute for capacity closure and debt restructuring.

The consequences of China’s deflation problems are ubiquitous and spilling into the rest of the world. Slower economic growth and a steady decline in the economy’s commodity intensity is already affecting commodity producers from Perth to Peru, with negative multiplier effects arising from lower revenues and reduced capital spending by resource companies. Moreover, as Chinese companies cut prices to clear excess supply, global competitive pressures intensify, forcing foreign manufacturers to do so too.

Further, the shift in China’s growth and its economic development model has led to an abrupt drop in import demand. After a fourfold rise between 2006 and 2012, imports have been treading water. At the end of 2014 they were about 15 per cent lower than at the start of the year. This is affecting not just commodity exporters but also Asian countries in China’s supply chains, and an array of advanced and emerging countries that have prioritised selling goods to China.

Additional deflationary pressures may yet be transmitted into the global economy in 2015 through depreciation of the renminbi. The combination of deflationary economic headwinds, looser monetary policy and a rising US dollar are likely to result in a weaker currency. The 50 per cent depreciation of the Japanese yen, so far, could yet be consequential, too. It is starting to lead to weakness in other Asian currencies, and it would be surprising if the renminbi were not allowed to weaken to compensate.

China’s structural deflation, along with factors such as excess debt and rapid ageing, will continue to have repercussions for monetary policy in advanced economies. Nine European countries, including Italy and France, are already experiencing mild deflation, and others may soon join them. Japan has won only a brief deflation respite from the fall in the yen, and by mid-2015 “lowflation” in the US and the UK could have dropped to zero.

The US Federal Reserve and other western central banks have failed to anticipate this deflation environment, persistently undershoot their inflation targets and appear powerless to reverse the trend. At some point, we will probably wonder if it is time for the anti-deflation baton to pass to governments.

The writer is a senior independent economic adviser to UBS

Heard on the Street

Combing Through the Coming Year’s Emerging Risks

Shifting Monetary Policy, Other Factors Will Help Shape 2015

By Richard Barley

Dec. 25, 2014 11:42 a.m. ET

Emerging-market investors have faced testing times in 2014. Bonds, currencies and stocks have been volatile. The Russian ruble crisis is just the latest shock, and may yet dominate the start of 2015. But deeper challenges still loom.

First, growth isn’t what it used to be: Between 2005 and 2009, emerging-market growth outstripped that in the developed world by 5.5 percentage points on average, according to International Monetary Fund data. Over the next five years, that gap is forecast to be just 2.8 points.

True, expected emerging-market growth of 5% next year is still healthy, compared with 2.3% for advanced economies. But the slower pace will still have implications for those countries that have failed to recognize shifting growth patterns and adjust their economic models accordingly.

Second, monetary policy in the developed world is shifting. The U.S. Federal Reserve, while remaining “patient” on raising rates, is on the road to tightening. The European Central Bank and Bank of Japan are heading in the other direction. But the vast majority of emerging-market liabilities are denominated in dollars, UBS points out: U.S. interest rates will have a bigger effect than those in Europe or Japan.

Third, the fallout from the plunge in oil and commodity prices will continue to reverberate, with Brent crude down more than 40% this year. Not only will it divide countries into winners and losers—broadly, commodity consumers versus producers—it may also change capital flows. Data on this is hard to come by. But to the extent that flows of petrodollars from oil exporters have found their way into emerging stock and bond markets, there could be less support in 2015.

Fourth, some high-profile defaults may test sentiment. Ukraine’s bond debt may yet be restructured, and Venezuela looks headed for trouble. That should only be a minor headwind, however. The problems facing these countries aren’t new, and defaults shouldn’t be a surprise.

More troublesome problems may lurk in the corporate debt market, particularly in Russia if sanctions continue to cut companies off from international capital markets. Corporate debt has been one of the big growth areas for emerging markets as investors have hunted for yield.

Russia looks almost certain to face a tough 2015; political risk in Brazil and Turkey could also cause concerns. But if emerging markets sell off as a whole, investors should be looking for opportunities. Countries such as India and Mexico that are reforming their economies may get caught in the downdraft of volatility, although would offer a chance to add exposure.

That reflects the fact that “emerging markets” is increasingly an inadequate label for a diverse set of economies. They are still vulnerable to some common factors, as the market appears hard-wired to treat them as homogeneous. But with each passing year, smart investors will be rewarded for treating them more as individual nations than as an asset class.

The Productivity of Trust

Ricardo Hausmann

DEC 23, 2014            

CAMBRIDGE – The Nobel laureate economist Paul Krugman once quipped that “Canada is essentially closer to the United States than it is to itself.” After all, most of its citizens live in a narrow band along the more than 3,000-mile-long border. Most Canadians live closer to more Americans than they do to other Canadians.
The same can be said of corporations and governments. Most firms are closer to the government than they are to other firms: they interact with government rules and agencies more than they do with the rest of the business community. The quality of that interaction and its evolution over time is probably the most fundamental determinant of a country’s potential for growth and prosperity.

But this is not the Weltanschauung – the worldview – that permeates private-sector discourse, especially the views expressed by most chambers of trade and industry and business associations around the world. Business organizations often hew to Ronald Reagan’s dictum: “Government is not the solution to our problems; government is the problem.”
It is a great sound bite: short, recursive, and somewhat poetic. Unfortunately, it is also dangerously misleading. After all, even if government were the problem, then changing what it does must be part of the solution.
The truth is that markets cannot exist without governments, and vice versa. Governments are essential to the establishment of security, justice, property rights, and contract enforcement, all of which are essential to a market economy.
Governments must also organize the provision of infrastructure for transportation, communication, energy, water, and waste disposal. They run and regulate health-care systems and primary, secondary, tertiary, and vocational education. They create the rules and provide the certifications that allow firms to assure their customers, workers, and neighbors that what they do is safe. They protect creditors and minority shareholders from miscreant managers (and managers from impulsive creditors).
Saying that governments should get out of the way and let the private sector do its thing is like saying that air traffic controllers should get out of the way and let pilots do their thing. In fact, governments and the private sector need each other, and they need to find better ways to collaborate.
The problem is that in many countries, both developed and developing, the current relationship between the private sector and the government is often dysfunctional. Not only is it characterized by deep distrust, but the broader society does not find a closer relationship to be either legitimate or in the public interest, and for good reason.
The private sector often engages with the government in order to make itself more profitable. After all, maximizing profits is what CEOs are supposed to do. And the government has ways to help: It can force suppliers to sell their inputs more cheaply, repress workers’ wage demands, protect the final market from competition by imports or new entrants, or lower their taxes.
But these schemes make firms more profitable by making their suppliers, workers, and customers poorer. Accepting such demands makes the government rightly illegitimate in the eyes of the rest of society, which cherishes higher priorities than redistribution in favor of the already rich.
Outcomes would be very different if the focus of the relationship were productivity rather than profitability. Productivity improvements, by lowering costs, allow firms to pay their workers and suppliers better, reduce prices for consumers, pay more in taxes, and still make more money for their shareholders. A focus on productivity is win-win-win.
Governments can do many things, in a variety of areas, to raise productivity. Fresh produce requires a cold-storage logistic system, a green lane at customs, certification of good agricultural practices, and sanitary permits. Tourism depends on sensible visa requirements, convenient airports, road signs, hotel construction permits, and the preservation of cultural sites and coastlines. Manufacturing requires dedicated urban space that is adequately connected to power, water, transport, logistics, security, and a diverse labor forcé.
All of these productivity-boosting inputs require institutions that teach and extend industry-relevant knowledge and skills. None of them appears in the World Bank’s Doing Business indicators or the World Economic Forum’s Global Competitiveness Index. And yet, without these public inputs, the industries that depend on them cannot succeed.
That is precisely what happens in the absence of a sound and legitimate basis for cooperation between the government and the private sector. The result is inadequate provision of public goods that raise productivity and make everyone better off.
To create such a basis for cooperation, many countries need a new compact between the government and the private sector. This will not be possible if business groups insist on putting taxes at the center of the discussion. Instead, they should focus on measures that raise productivity.
More broadly, business groups should seek only those government policies that are unambiguously in the public interest. Demands that are perceived as greedy erode legitimacy and, ultimately, effectiveness. In this context, watchdog NGOs dedicated to scoring the public-interest value of what business groups ask for from the government could facilitate trust.
Perhaps most important, business associations do their members a disservice by seeking to impose on them a single voice. Doing so usually leads to a focus on policies that are preferred by all members – such as lower taxes – instead of measures that are important to the productivity of each member. Just as monopolies are bad for markets and politics, business representation in the private sector would benefit from more competition.

11:22 am ET Dec 23, 2014

Inflation Reading Misses Fed’s Target for 31st Straight Month

By Eric Morath

Robust economic growth and strong hiring supports the expectation that the Federal Reserve will move to raise short-term interest rates next year, despite inflation trending below the central bank’s target.

Most Fed officials expect to start raising short-term rates from near-zero in 2015, with many of them pointing toward the middle of the year. Fed Chairwoman Janet Yellen said last week that Fed officials anticipate raising rates as long as unemployment continues to fall, and they are confident inflation will over time move back toward their 2% goal.

The latest inflation readings, however, show prices trending away from that goal.

The price index for personal consumption expenditures, the Fed’ s preferred inflation gauge, fell 0.2% in November and was up 1.2% from a year earlier, the Commerce Department said Tuesday. That shows an easing from last month’s annual reading of up 1.4%.

The PCE price index has undershot the Fed’s target for 31 straight months.

Even when excluding food and energy, inflation is decelerating. So-called “core” prices were up 1.4% in November from a year earlier. That’s a slowdown from October’s annual reading of 1.5%, which itself was revised down from a previously reported 1.6% gain.

The new inflation numbers alone likely won’t change views inside the Fed, but if core inflation continues to decelerate, that could be a worry.

Ms. Yellen acknowledged last week that falling energy prices will hold down headline inflation, “and may even spill over, to some extent, to core inflation.” But, she said, officials “see these developments as transitory.”

Continued strong hiring and output growth should reassure officials at the central bank that the economy can handle tighter monetary conditions, even if inflation continues to undershoot their goal.

The economy expanded at a 5% rate in the third quarter—the best gain in more than a decade—and the unemployment rate fell to 5.8% in November from 7% a year earlier.

A fall in energy prices, while dragging down overall inflation, helps consumers in the form of cheaper gasoline and supports broader economic growth.

“Having to spend less on gas and energy…it’s like a tax cut that boosts their spending power,” Ms.  Yellen said.