Global Imbalances and the Chinese Economy

John Mauldin

Sep 17, 2015

If we don’t understand both sides of China’s balance sheet, we understand neither  – Michael Pettis
The most thought-provoking China analyst I know is Michael Pettis, author and economist, who is a professor at Peking University’s Guanghua School of Management as well as a rock music club owner and impresario. Conversations with Michael are always fascinating.

He has a fairly balanced take on China’s future, which is significantly different from most of what you read. That’s because he comes at understanding China’s problems in terms of balance sheets rather than macroeconomics. So five years ago he was telling us there was going to be a real debt problem in China because he understood the nature of balance sheets and China’s balance sheet portended further growth.

In his latest blog, which is today’s OTB, he ventures rather deep in the weeds in order to understand how of China’s balance sheet problems are now going to constrain its potential future growth. Let me quote the first few paragraphs:

With so much happening in China in the past month it seems that there are a number of very specific topics that any essay on China should focus. I worry, however, that we get so caught up staring at strange clumps of trees that we risk losing sight of the forest. What happened in July this year, and again in August, or in June 2013, or a number of other times, were not unexpected shocks and game changers. China is a dynamic and unbalanced economic system entering into something that we might grandly call a “phase shift”, or less grandly the rebalancing process, and that it is doing so with a great deal of debt structured in a highly inverted way. Anyone who sees China this way would have been able to predict not so much the specific shocks, panics, and credit crunches that we have experienced, but rather that we would of necessity experience a series of very similar shocks.

These debt-related shocks will occur regularly for many more years, and each shock will advance or retard the rebalancing process so that it a"ects the way future shocks occur. There are only a few broad paths along which the Chinese economy can rebalance, and if we can get some sense of the China’s institutional constraints and balance sheet structures, we can figure what these paths are and how likely we are to slip from one to another.

In order to get China right I would argue that above all we must understand the dynamics of debt, and of balance sheet structures more generally.

A China that slows down to “only” 3 to 4% growth is a China that buys materially less resources from around the world. My friend Barry Ritholtz published the following chart, which shows the amounts of raw materials that China buys as a percentage of world production. If debt fueled growth built around infrastructure and increasing capacity slows down, which if Michael is right it must, that is going to have significant impact on the prices of raw materials and on the stocks of those who sell them.

Let me issue a bit of a warning: the last month or so the essays in Outside the Box have been relatively brief and pretty easy to grasp, I think. This one is not in that vein. You will need to don your thinking cap on and focus a bit more than is normal for an Outside the Box.
While everybody gives lip service to how important China is, if you understand the underlying dynamics, China’s significance is even more impressive. My team at Mauldin Economics has created a very professional documentary on China, which you can register to watch for free right here.
I, along with a sizable portion of the American electorate, spent Wednesday evening watching the Republican primary debate, to see who would be the next candidate voted off the island. Who knew primary debates would morph into reality TV? I am absolutely fascinated by the process. And while the Republican Party holds my focus, I have to admit that what is developing for the Democratic Party is almost as intriguing. Next year’s presidential election is shaping up to be a surprise.
The biggest surprise so far is that 60% of Republican voters favor an outsider candidate with no real political experience. I thought that Ben Carson did well in the previous debate but wasn’t all that boffo. However, he has been climbing up the leaderboard, and I wouldn’t be surprised to see him atop it at some point in the cycle. Remember, however, that we saw a lot of people at the top during the last primary runs. It seemed everybody had their moment in the sun. An interesting thing about Carson is that so far the really big money hasn’t gotten behind him – it’s a lot of small donors who are carrying his campaign.
To the political junkies among my readers let me offer a link to a video conversation between Bill Kristol and Newt Gingrich on what these two seasoned political hands see in the presidential race on both sides. Newt is a friend, and I value our times together. I know this may seem strange, but I actually enjoy talking technology in history with Newt more than I do politics, although we can never avoid the latter topic. I have had a few discussions with him in the past month or so about the race, and it’s fun to watch him talk dispassionately about the process (now that the pain from four years ago is past, and he’s not running now). He is surprisingly more sanguine about Trump than I would have thought. I will admit that I am not.
One of the things that few people bring to the table like Newt does is that he not only understands the process of running for president, he knows all the candidates. I would be willing to take the over on the bet that he personally knows all of the Democratic candidates as well as the Republicans. For all the contrary press about him, he is a remarkably amiable and thoughtful man and a fascinating dinner guest. You can watch Kristol (whom I have never met) and Gingrich discuss the race here.
And speaking of conversations, I just got off the phone with George Friedman. We were talking over the immigration crisis in Europe, which will be the topic of my letter this weekend. George and Meredith will be staying with me next Monday night after they get back from Europe. (He was walking around Vienna in the evening as we talked). I am sure we’ll share another fascinating dinner.

George is nothing if not entertaining. I enjoy watching Meredith try to keep him on track. They make a remarkable team, whether writing about geopolitical events or working for the CIA in Africa back in the day. Great stories that I wish I could write about. You’ll just have to track him down one night and agree to an off-the-record conversation.
It’s time to hit the send button. Buckle in for some serious think time with Michael Pettis.
Your trying to get a handle on information overload analyst,

John Mauldin, Editor
Outside the Box

Global Imbalances and the Chinese Economy

By Michael Pettis

September 1, 2015

If we don’t understand both sides of China’s balance sheet, we understand neither

With so much happening in China in the past month it seems that there are a number of very specific topics that any essay on China should focus. I worry, however, that we get so caught up staring at strange clumps of trees that we risk losing sight of the forest. What happened in July this year, and again in August, or in June 2013, or a number of other times, were not unexpected shocks and game changers. China is a dynamic and unbalanced economic system entering into something that we might grandly call a “phase shift”, or less grandly the rebalancing process, and that it is doing so with a great deal of debt structured in a highly inverted way. Anyone who sees China this way would have been able to predict not so much the specific shocks, panics, and credit crunches that we have experienced, but rather that we would of necessity experience a series of very similar shocks.

These debt-related shocks will occur regularly for many more years, and each shock will advance or retard the rebalancing process so that it affects the way future shocks occur. There are only a few broad paths along which the Chinese economy can rebalance, and if we can get some sense of the China’s institutional constraints and balance sheet structures, we can figure what these paths are and how likely we are to slip from one to another.

In order to get Chinas right I would argue that above all we must understand the dynamics of debt, and of balance sheet structures more generally. Four years ago one of my clients sent me a research report by Standard Chartered in which their China analyst warned that while Chinese debt levels were still negligible, there was a chance, small but no longer insignificant, that credit growth could speed up sharply and debt eventually become a significant constraint for policymakers.
Things were fine for now, the analyst seemed to suggest, but it was possible that Beijing could mismanage its way into a debt problem.

The overwhelming consensus at the time was that China’s growth model was healthy and sustainable, and would generate GDP growth rates for the rest of the decade that were not much lower than the roughly 10% we had seen during the previous three decades. My client sent me the report along with the comment that the sell-side was finally recognizing that the Chinese economy was at risk. A leading analyst who had long been part of the overwhelming bull consensus was, he said, finally beginning to understand the Chinese economy and the problems it faced.

I wasn’t so sure. It seemed to me that those who understood the Chinese growth model would have also understood that its overreliance on investment to fuel growth, combined with the structure of its credit markets, extremely low interest rates, and wide-spread moral hazard, made soaring debt almost inevitable, and that debt was already constraining policymaking.

To suggest that this might happen only if the new administration – that of Xi Jinping – mismanaged the process suggested to me that the analyst did not really understand the self-reinforcing relationship between rising debt and slowing growth, and was underestimating how difficult it would be for the new administration to break out of this process. It was going to happen almost no matter what Xi’s administration did, and his administration would be very unfairly blamed for incompetence. At the time the research report was written there was an aura of invincibility about policymaking in China, so that warning about possible future policy mismanagement seemed like perfunctory prudence. But every “growth miracle” ends up follow the same credibility path, with what once seemed an unending stream of sophisticated and dedicated leaders at every level of policymaking suddenly and unexpectedly becoming an administration of clunky, incompetent bureaucrats, as foolish as the rest of us. When the miracle country outperforms expectations year after year during the expansion phase, we assume that brilliant policymaking is the cause, rather than– more appropriately, as I will explain– inverted balance sheets. When this same balance sheet inversion subsequently causes the economy sharply to underperform expectations during the contraction period, our admiration for policymakers quickly turns into contempt for their incompetence, usually tinged with bitterness that our forecasts turned out so magnificently wrong.

There is a very big difference between acknowledging that China has a lot of debt and understanding how debt and debt creation are embedded within the financial system, but the Standard Chartered economist, like most, assumed that the former implied the latter. In June the NBR’s journal for Asian economic research, Asia Policy, put together a roundtable to review Nicholas Lardy’s book, Markets over Mao. I was one of the five analysts who were asked to participate. Lardy is one of the best informed and most knowledgeable of the economists covering China. In my review I praised his book for the quality of its analysis, and it well deserves that praise.

But there was a fundamental disagreement in how he and I interpreted the data, and this disagreement extends to the majority of analysts covering China. Lardy believes China is in reasonably good shape economically and concludes with optimistic growth forecasts. Based on the same data and absorbing much of his analysis and interpretation of that data (I have been reading Lardy for many years) I expect growth to slow sharply. The current consensus for China’s long-term growth, I think, is around 6-7%. Lardy has said “China could grow at roughly 8% a year for another 5 or 10 years.” I believe, however, that without a massive and fairly unlikely transfer of wealth from the state sector to the household sector, the average Chinese GDP growth rate under Xi Jinping cannot exceed 3-4%.

So why do we disagree? I suspect that we disagree for the same reason I disagreed with the Standard Chartered analyst, who saw an unsustainable debt burden simply as an unlikely but possible result of policy mismanagement. We disagree, in other words, not on the fundamental data but rather in our understanding of debt dynamics and the constraints the balance sheet can place on an economy’s “fundamental” operations.

As I see it there are at least two important disagreements here. The first is about the impact of balance sheet structures on exacerbating volatility. Neither Lardy nor the Standard Chartered analyst spent much time discussing how the balance sheet might affect growth. For me, however, this has been and continues to be a key component of the Chinese economic “miracle”, and indeed also of every previous growth miracle. As I said in my review:

Rebalancing is often harder than expected, in other words, not just because of opposition by vested interests, but more importantly because highly inverted balance sheets cause policymakers to overestimate potential growth during the miracle years. But when growth during the rebalancing phase contracts more than expected, the same balance sheet inversion that exacerbated the expansion phase will also exacerbate the slowdown, especially as declining credit quality reinforces, and is reinforced by, slower growth.

I made a similar argument two weeks ago in a Wall Street Journal OpEd about why it is so important that Beijing maintain its credibility, which is the only way of ensuring that China’s substantial balance sheet mismatches can be managed and rolled over:

History suggests that developing countries that have experienced growth “miracles” tend to develop risky financial systems and unstable national balance sheets. The longer the miracle, the greater the tendency. That’s because in periods of rapid growth, riskier institutions do well. Soon balance sheets across the economy incorporate similar types of risk.

…Over time, this means the entire financial system is built around the same set of optimistic expectations. But when growth slows, balance sheets that did well during expansionary phases will now systematically fall short of expectations, and their disappointing performance will further reinforce the economic deceleration. This is when it suddenly becomes costlier to refinance the gap, and the practice of mismatching assets and liabilities causes debt, not profits, to rise.

Financial distress can be worse than a crisis

The second misunderstanding is about why “too much” debt matters. For most economists, the main and even only problem with too much debt is that it might lead to a financial crisis, and that the fear of crisis undermines confidence and so can cause spending to drop. But while these are important problems, these analysts are mistaken in limiting their concerns to these two issues. While a financial crisis is certainly a risk, the damage debt does to an economy occurs long before any crisis, and for debt to be terribly damaging to an economy’s long-term growth doesn’t even require a crisis.

In fact one can easily make a case that while a financial crisis may be spectacular, it nonetheless limits the damage caused by excessive debt by forcing a recognition of the losses, only after which does the system begin to allocate capital efficiently. Until this happens, the adverse impact of debt on growth can persist for decades. A case in point is Japan. Japan never had a financial crisis or a banking sector collapse, but from 1990 to 2010 the amount by which its share of global GDP has declined, substantially more than 50%, far exceeds the damage caused to any other country by a financial crisis. Or consider the heavily indebted countries of Europe, like Spain, Italy and Portugal, who have avoided crises, but only in a way that makes it hard to believe that they are better off economically today than they might have been had they suffered a financial crisis in 2009 or 2010.

In my review of Lardy’s book I try to explain why debt constrains growth, whether or not it leads to a crisis:

The second way liability structures can constrain growth, while often poorly understood by economists, is actually well understood in finance theory. An economic entity will suffer from “financial distress” if debt has risen so much faster than expected, or growth is so much lower than expected, that economic agents become uncertain about how higher debt-servicing costs will be assigned to different sectors of the economy. This uncertainty forces these agents to react in ways that unintentionally but automatically intensify balance sheet fragility and reduce growth. This uncertainty is intensified if the debt burden rises and falls inversely with debt-servicing capacity, which almost always happens when economic growth is highly credit-intensive, and which seems to be happening in China.

Because this seems so counter-intuitive for many people, it bears repeating. The problem with too much debt is not just that it might cause a crisis. The problem is, first, that debt may be “inverted”, i.e. structured in a way that systematically enhances volatility, which means good times become better and bad times worse. This automatic leveraging-up of volatility has seriously adverse impacts on long-term growth. Second, when debt levels are higher than expected and growth lower (one of the nearly inevitable consequences of highly inverted balance sheets), if this divergence causes uncertainty about how the debt servicing will be resolved, the uncertainty itself forces agents to behave in ways that automatically reduce growth and increase balance sheet fragility further.

Lardy’s response to my discussion of debt indicates, I think, just how much disagreement there is here and how easy it is for most economists to misunderstand what I think are the relevant issues – although in fairness it should be noted that he is responding to five separate reviews, and so this is unlikely to be his full response:

Contrary to Michael Pettis’s assertion, the book does give some attention to the liability side of the Chinese economy. I note the huge buildup of debt starting in the fourth quarter of 2008 and analyze the challenges this debt poses for financial stability. But in Markets over Mao I point out that China differs in several critical respects from other countries where rapid debt buildups have precipitated financial crises.

To begin with, China’s national saving rate, reflecting the combined savings of households, corporations, and the government, approaches 50% of GDP, significantly higher than any other economy in recorded history. Like households, countries that save more can sustain higher debt burdens. Second, the vast majority of this debt is in domestic rather than in foreign currency…Thus, its debt does not involve any significant currency mismatch, a major contributor to many financial crises. Third, the majority of this debt has been extended by banks, and China’s systemically important banks are financed entirely by deposits rather than through the wholesale market…Finally, the government has enormous scope to further increase bank liquidity should that become necessary. Other factors, too numerous to list here, also suggest that a banking crisis is far from certain in China.

Lardy is not actually disagreeing with anything I said. In fact I fully agree with him that a banking crisis is unlikely, and have written many times that while it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse. This doesn’t mean however that China’s debt burden is irrelevant.
A system of interlocking balance sheets

Japanese GDP growth, after all, did indeed collapse as it was forced to rebalance its debt-laden economy, and this collapse in growth has lasted an astonishing 25 years, with, as I see it, still no end in sight. I would argue that Japan’s debt structure explains the 25 years of low growth and will ensure many more years of low growth. During the first wave of excitement over “Abenomics”, for example, I wrote on this blog and elsewhere that just trying arithmetically to work through the consequences on the country’s debt burden of the success of Abenomics made it hard for me to see how Abenomics could possibly succeed in generating inflation and real growth without an explosion in its current account surplus that the world would not be able to absorb.

It was precisely because of China’s debt dynamics that I began arguing in 2006-07, and contrary to consensus, that China’s growth model was unsustainable, that its debt was rising too quickly and could not be reined in without a significant drop in growth, and that China had urgently to rebalance. The same logic made me argue in 2008-09 that China’s adjustment was going to be brutally difficult and would entail at least a decade of GDP growth that could not exceed 3-4% on average. And yet I have always also argued that China’s banking system, because of an implicit guarantee by Beijing, is very unlikely to collapse, and if one excludes things like the credit crunch in June 2013 or this month’s stock market panic, we are unlikely to see a financial crisis unless GDP growth – and with it credit growth – remains at current levels for another 3-4 years at most.

This, for some reason, has been very hard for most economists to grasp – for example the most common “refutation” of my argument and that of other skeptics by so-called “China bulls” is nearly always something along the lines of “He has been predicting a crisis for six years and it still hasn’t happened”. At first I assumed that these bulls were being – perhaps understandably given how poorly their forecasts had performed – defensively dishonest, but I quickly realized that the same argument was being made by people I respected a great deal who were incapable of  such a defence.

It wasn’t dishonesty, I realized, but a failure to understand the economy as a dynamic system in which a)imbalances could persist and grow for many years before eventually rebalancing, b)the more rigid the institutional structure of the economy, the deeper imbalances were likely to get, c)the longer they persisted, the more disruptive the rebalancing was likely to be, and the less significant the “trigger” that set it off, and d)there are many ways rebalancing can occur, and the way it actually occurs depends on institutional constraints and rigidities. These economists seem to find it difficult to understand that an economy can have a very unbalanced debt structure, with debt growing at an unsustainable rate, so that there will be a significant reduction in future growth, but a crisis is only one of the ways, and not the only way and certainly not imminent, that this reduction in future growth can happen. It is only when debt is subject to a &ldquo ;sudden stop” that a crisis can be inevitable, but in many if not most cases there is no crisis.

Lardy of course is far more sophisticated than most economists covering China, but while he says that he “does give some attention to the liability side of the Chinese economy”, he mostly notes that there is a significant amount of debt, before going on to explain why he thinks a banking crisis is unlikely. He misses what I think are the most important aspects of China’s liability side, however, for example: the extent and nature of the balance sheet inversion and how it will exacerbate the economic contraction and convert refinancing risk into unexpected increases in debt, rather than unexpected increases in profits, as occurred during the expansion phase; or whether the reinforcing relationship between unexpectedly high debt and unexpectedly low growth will create enough uncertainty about how debt servicing costs will be allocated that it forces financial distress costs onto the economy.

These are the reasons debt matters, not just whether or not debt must lead to crisis, and the failure to address these reasons is, I think, typical of the kind of attention most economists give to debt, in China and elsewhere. It perhaps explains why economists have such a poor track record in predicting economic reversals – the models they implicitly use make it hard to understand and quantify a dynamic rebalancing process.

It is neither enough to note the amount of debt a country has or to speculate on the probability of a debt crisis. What matters is the systemic role of debt in generating economic activity, the feedback processes that are embedded in debt structures, and the uncertainty that may arise about the resolution of debt-servicing costs. To summarize, there are at least four important issues to consider:

  1. It is possible to structure an economy in such a way that excessive debt creation is not a “choice”, not even a bad choice, but is instead the automatic consequence of institutional constraints within the economy, and in fact it is very rare that a country experiencing many years of “miracle” growth hasn’t created such constraints. This is why it should have been possible to see well over a decade ago that China’s excessive indebtedness was inevitable. Economists who warned of the possibility of a deterioration in the balance sheet, but who thought nonetheless that China could avoid this outcome without a major restructuring of its growth model and a significant reduction of its growth rate, were always fundamentally mistaken. Excessive debt levels were never a “possibility”. They were a necessity as long as the growth model had not been fundamentally transformed.

  1. The structure of the balance sheet, by which I mean the types of mismatches between assets and liabilities when debt levels are high enough, can systematically enhance volatility, so that periods of expansion, real productivity growth, or benign global conditions can result in many years of growth that exceed expectations. This comes however at a cost. First, the same balance sheet structures that enhance growth during the expansion phases will cause growth to slow much faster than expected during the contraction phases, and second, enhanced volatility always reduces value, although not always perceptibly at first, because it increases gapping risk. This process is perhaps counterintuitive to those who think all economic activity is driven by fundamentals, but is well understood by traders and investors, who know how it works in margin buying, leveraged positions, and derivatives that directly quantify leverage and gapping risk.

  1. Apart from enhancing volatility, high debt levels can adversely affect growth any time there is uncertainty about how debt servicing costs will be resolved, i.e. to which sectors or groups they will be explicitly or implicitly allocated. This uncertainty will affect the behavior of any sector of the economy to whom the costs might be allocated, in the form of either direct taxes, indirect taxes (e.g. inflation or depreciation), appropriation or expropriation, or wage and consumption suppression. These sectors, all of whom will alter their behavior in order to protect themselves from bearing the costs of debt, comprise most of the economy, including foreign creditors, small business owners, savers within the banking system or in other forms of monetary assets, workers, wealthy owners of financial and non-financial assets, the agricultural sector, importers and exporters, the mining sector, and many others. The wealthy might take their money out of the country, for ex ample, and creditors might shorten maturities and raise interest rates, business owners might disinvest, the middle class might dis-intermediate savings, workers might organize, local policymakers may engage in protectionist activity, borrowers might invest in riskier projects, banks might reduce the scope of their lending to the most protected sectors, etc. The point is that it is a mistake to assume that the only or main cost of excess indebtedness is a financial crisis.

  1. The balance sheet can embed strong feedback mechanisms within the economy that make it almost impossible to predict the growth of debt. The balance sheet mismatches that during the expansion phase could be refinanced in ways that created unexpected profit, can easily lead to rising debt instead as the mismatches become harder to refinance or require government guarantees.

This is why I would argue that once a country’s balance sheet reaches a certain critical point, any analysis is fundamentally mistaken if it simply acknowledges the existence of a great deal of debt, or sees a debt buildup as unlikely, or as the consequence of bad policy, when already institutional constraints make it a necessary corollary of growth.

Debt was already a problem in the Chinese growth model more than ten years ago (and is a problem in several advanced economies too, who are going to find it nearly impossible to grow out of their debt burdens without implicit or explicit debt forgiveness). Those analysts who do not understand why this is the case probably do not understand why the balance sheet will continue to be a heavy constraint on Chinese growth and will underestimate the difficulty of the challenge facing Xi Jinping and his administration, which means among other things that they will be too quick to criticize Beijing for failed policies when growth drops below their projections.

But to understand this requires probably a fundamentally different way of understanding economics. The economy is a dynamic system made up, as Minsky said, of interlocking balance sheets, and the way economic growth, exogenous shocks, debt dynamics, income distribution, and every other dynamic process is intermediated from balance sheet to balance sheet depends both on the structures of the balance sheets and on other institutional constraints that characterize each economy. For those doing “empirical” economics, multiple regression and various kinds of multivariate analysis will no longer march down the royal road of mathematics but will rather be relegated to one of the side-streets, for occasions in which the economy is expected to be heavenly, and in which, as David Byrnes sang, nothing ever happens.

Instead when we do math we will prefer to think in terms of options, probability theory, and lots of simple algebra, all of which are well suited to understanding both how debt can disrupt an economy in a predictable way and how the threat of that disruption can itself also disrupt the economy in a predictable way. Unfortunately this will make forecasting very difficult – at least the current variety of forecasting, as in: China’s GDP will grow by 6.84% in 2016, 5.93% in 2017, 5.77% in 2018, and 5.02% thereafter.

But losing these types of forecasts is not much of a loss. When nothing happens, these forecasts are often quite accurate. When something happens, however, they are always wholly useless, an obvious such case being growth forecasts for China both during the unexpectedly large fiscal stimulus in 2009 and 2010, and later, just as it reached the end of its period of growing imbalances and began the reversal process, around 2011-12.

This is an abbreviated and much edited version of the newsletter that went out two months ago.  Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at, stating your affiliation, please.  Investors who want to buy a subscription should write to me, also at that address.


Looking for the lifeboats

Which investments work best when markets decline?

MORE investors fear the American stockmarket is overvalued than at any moment since 2000, according to Robert Shiller of Yale University. Recent research by Deutsche Bank, meanwhile, suggests that government bonds are as expensive as they have ever been. So it makes sense for investors to consider what assets they should buy to hedge against a sudden plunge in the value of equities or bonds.

New research by AQR, a fund-management group, looks at the ten worst quarters for global equities and government bonds between 1972 and 2014. On average, equities lost more than 18% during such quarters while bonds, a less volatile asset, lost 3.9%.

These two asset classes are often seen as complementary: the classic “balanced” portfolio comprises 60% equities and 40% government bonds. Shares are riskier and benefit from economic growth; bonds are safer but their value is eroded by inflation. The AQR numbers show that government bonds do act as a useful hedge for equities, earning an average return of 4.8% in the quarters when shares plummeted. That is good news: both assets may look overvalued but they are unlikely to fall in tandem.

But government bonds were not the only asset to do well; commodities and, in particular, gold, also produced positive returns. Corporate bonds were of little help: they lost value, relative to government bonds, when equities fell (see chart).

When government bonds fall, equities are less consistent as a hedge: they gained ground in only six of bonds’ ten worst quarters. Nevertheless, thanks to their phenomenal performance in the second quarter of 2009, when the post-crisis rally got going, equities delivered an average positive return of 3.5% in bad bond quarters. Commodities also gained ground. Although it does not feature in AQR’s table, cash would have delivered a small positive return during sell-offs. But the current return on cash is close to zero, making it less appealing as a hedge.

What about hedge funds? In the past, these high-charging vehicles claimed to be able to prosper in good times and bad. Proper hedge-fund indices did not begin until 1990, so do not cover the full period. Even so, their record in the eight bad equity quarters since then has been disappointing: an average loss of 5.2%. A lot of hedge funds are exposed to the stockmarket.

AQR suggests that this may not tell the full story. There are a number of asset-picking strategies that have been shown to work over time. A combination of five of those strategies (value, momentum, carry, defensive and trend-following) would have produced very good returns during past stockmarket sell-offs.

Since many hedge funds operate variants of these strategies, it might seem odd that the overall industry numbers are not as good. However, the AQR composite figures do not allow for trading costs or fees. Its numbers are also the result of back-testing, a process that can produce marvellous results but is nonetheless flawed. Test enough strategies on past data and you are bound to find a few that work brilliantly. This would be so even with a truly random series, such as winning lottery numbers. There is no guarantee that such strategies will be as successful in future.

Is AQR’s exercise worth attempting at all? Many investors take a philosophical view. First, they are unlikely to predict the exact timing of the next market plunge; if the signs were obvious, they would have sold already. Second, long-term investors should ignore short-term market falls. Crashes may come and go but in the long run, asset prices will rise. American equities overcame both the bursting of the dotcom bubble and the 2008 financial crisis to reach record peaks earlier this year.

But the challenge for investors this time may not be a sudden collapse like 1987’s Black Monday. It could be a long slow decline, like the air leaking out of a deflating tyre. The obvious case study is Japan, which was the first rich country to grapple with deflation and zero interest rates.

Japanese equities are still at just half the level of the end of 1989, despite many promising rallies in the interim; bond yields have been stuck at very low levels since the late 1990s.

At least Japanese investors had the option of buying foreign assets as a way of escaping the doldrums in their home market. But the conditions they faced may now set in across the developed world.

Emerging markets were the big hope, but even they have let investors down in recent years.

The options are narrowing.

Fraud, Fools, and Financial Markets

Robert J. Shiller

Bernie Madoff

NEW HAVEN – Adam Smith famously wrote of the “invisible hand,” by which individuals’ pursuit of self-interest in free, competitive markets advances the interest of society as a whole.

And Smith was right: Free markets have generated unprecedented prosperity for individuals and societies alike. But, because we can be manipulated or deceived or even just passively tempted, free markets also persuade us to buy things that are good neither for us nor for society.
This observation represents an important codicil to Smith’s vision. And it is one that George Akerlof and I explore in our new book, Phishing for Phools: The Economics of Manipulation and Deception.
Most of us have suffered “phishing”: unwanted emails and phone calls designed to defraud us.

A “phool” is anyone who does not fully comprehend the ubiquity of phishing. A phool sees isolated examples of phishing, but does not appreciate the extent of professionalism devoted to it, nor how deeply this professionalism affects lives. Sadly, a lot of us have been phools – including Akerlof and me, which is why we wrote this book.
Routine phishing can affect any market, but our most important observations concern financial markets – timely enough, given the massive boom in the equity and real-estate markets since 2009, and the turmoil in global asset markets since last month.
As too many optimists have learned to their detriment, asset prices are highly volatile, and a whole ocean of phishes is involved. Borrowers are lured into unsuitable mortgages; firms are stripped of their assets; accountants mislead investors; financial advisers spin narratives of riches from nowhere; and the media promote extravagant claims.
But the losers in the downturns are not just those who have been duped. A chain of additional losses occurs when the inflated assets have been purchased with borrowed money. In that case, bankruptcies and fear of bankruptcy spawn an epidemic of further bankruptcies, reinforcing fear. Then credit dries up and the economy collapses. This vicious downward spiral for business confidence typically features phishes – for example, the victims of Bernard Madoff’s Ponzi scheme – discovered only after the period of irrational exuberance has ended.
Epidemics, in economics as much as in medicine, call for an immediate and drastic response.
The response by the authorities to the Great Crash of 1929 was small and slow, and the world economy entered a “Dark Age” that lasted through the Great Depression of the 1930s and the Second World War. The 2007-2009 financial crisis portended a similar outcome, but this time the world’s governments and central banks intervened promptly, in a coordinated fashion, and with an appropriately high volume of stimulus. The recovery has been weak; but we are nowhere near a new Dark Age.
For that we should be grateful. Yet some now argue that the fiscal and monetary authorities should not have responded so quickly or strongly when the 2007-2009 crisis erupted. They believe that the primary cause of the crisis was what economists call moral hazard: because risk-takers expected that the authorities would intervene to protect them when their bets went awry, they took even greater risks.
By contrast, our view (supported by plenty of data) is that rapidly rising prices usually reflect irrational exuberance, aided and abetted by phishes. The irrationally exuberant were not thinking of the returns they would garner if the authorities intervened to maintain the economy and the flow of credit (or, in extreme cases, moved to bail out their bank or enterprise). Such possibilities were a marginal consideration in the euphoria preceding the 2007-2009 crisis: those selling at inflated prices were making profits; and buyers “knew” they were doing the right thing – even when they weren’t.
The reluctance to acknowledge the need for immediate intervention in a financial crisis is based on a school of economics that fails to account for the irrational exuberance that I have explored elsewhere, and that ignores the aggressive marketing and other realities of digital-age markets examined in Phishing for Phools. But adhering to an approach that overlooks these factors is akin to doing away with fire departments, on the grounds that without them people would be more careful – and so there would then be no fires.
We found out many years ago, to the world’s great regret, what happens when a financial epidemic is allowed to run its course. Our analysis indicates that not only are there endemic and natural forces that make the financial system highly volatile; but also that swift, effective intervention is needed in the face of financial collapse. We need to give free rein to fiscal and monetary authorities to take aggressive steps when financial turmoil turns into financial crisis.

One Dark Age is one too many.

lunes, septiembre 21, 2015



The two Mexicos

With its combination of modernity and poverty, Mexico provides lessons for all emerging markets

“IN ESTABLISHING the rule of law, the first five centuries are always the hardest.” For much of the past two decades, that quip by Gordon Brown, a former British prime minister, has seemed not just dour, but wrong. Buoyed by China, by trade growth and capital inflows, by talk of new middle classes and the bottom billion, it was easy to forget old truths about how hard it is for poor countries to become rich. A breezy assumption took hold: that emerging markets would surely follow the likes of South Korea and Taiwan on the path to wealth.

That view of development has crumbled of late, along with emerging markets’ growth rates.

China, the locomotive to which many are still hitched, is slowing. Russia, South Africa and Brazil are in reverse gear. Their currencies drop with every fall in commodity prices; they will no doubt weaken further if the Federal Reserve raises American interest rates in a meeting due to end after we went to press. Trade is growing more slowly than global GDP, a trend that seems unlikely to reverse soon. All of this makes the trajectory taken by the East Asian tigers seem ever more exceptional.

A more realistic model of development is Mexico, a country that has parlayed its considerable advantages into patches of modernity but has singularly failed to eradicate poverty nationwide.

Some of its disappointments can be laid at the door of specific policies. But they also reflect the difficulties countries face throughout the emerging world.

Duet for one
Mexico has a lot going for it just now. Its economy is tied to America’s rather than China’s: in a week it sells more exports to the world’s largest consumer market than it does to China in a year. Once dependent on oil, it has Latin America’s largest and most sophisticated industrial base, exporting more cars than any country except Germany, Japan and South Korea. For two decades its macroeconomic management has been impeccably orthodox. Recently, it has thrown open its oil industry to private investment, and has tackled private monopolies. A vibrant Mexican middle class prospers along an industrial corridor running from the American border down to Mexico City. Its political system is essentially stable.

Yet despite decades of reforms—at times half-hearted, at times full-throttled—Mexico has failed to bridge the gap between a globalised minority and a majority that lives in what Enrique Peña Nieto, the president, admits is “backwardness and poverty”. Since 1994, when Mexico joined the North American Free Trade Agreement, income per head has grown by an annual average of barely 1%. About half the population remains stuck in poverty; another quarter risks slipping back into penury. Lawlessness, corruption and conflicts of interest prevail among the police, courts and politicians supposed to care for the marginalised.

Mexico’s duality shows that getting macroeconomic policy right is necessary to success, but not sufficient. The difficulties it still faces are a cautionary tale. The first lesson, and easiest to learn, is the centrality of urbanisation. Cities offer people opportunities to prosper that cannot be found in the countryside: about 120,000 people in Asia are migrating to cities every day, for example. But unless cities provide transport, power, sanitation and security, they will fail to fulfil their economic potential. Violent, drug-related crime stalks Mexico’s scruffy barrios, where city-dwellers live. In South Africa the lack of public transport obliges slum-dwellers to take expensive minibus-taxis to work. Cities in Pakistan and the Philippines are plagued by blackouts. Slums ought to be every moderniser’s priority. They are where most people live, and where jobs, schools and technology are closest to hand.

Roads and rails
The second is the importance of infrastructure, and not just in the cities. Many of the foundations of the modern Mexican economy were laid a century ago, in the form of roads and railways tying its industrial heartland to its ports and the northern border. That leaves swathes of the country unconnected. Centralisation breeds anomalies: beach resorts often buy their seafood in Mexico City’s wholesale market, hundreds of miles from the coast. Yet linking up parts of a country is not easy. It takes both investors willing to bear risk and also politicians prepared to take on the status quo. In India, for example, plans for big infrastructure projects have been frustrated by squabbles over land and a dearth of long-term financing.

A third lesson from Mexico is the need to bring the informal economy into the light. Small, unregistered firms provide employment to most of the labour force, but are shunned by banks and anxious to remain below the taxman’s radar. That saps the domestic economy. In the past decade and a half, while the productivity of the biggest Mexican companies has grown by 5.8% a year, that of the smallest has plunged by 6.5% a year. This problem is as prevalent in Mexico’s changarros, where tacos sizzle alongside every bus stop, as it is in the shops and stalls of India, where only 2% of food and grocery retailing is in the formal sector. Electronic invoicing, which creates digital trails for the taxman, and mobile banking, which brings poor people out of the cash economy, both offer promise.

But the ubiquity of informal firms also points to a final lesson—the corrosive effects of a general lack of trust. Without enforceable laws and contracts, public services that make taxes seem worth paying and a political establishment that serves the national interest, the only institution that most people can rely on is the family. As Mr Brown hinted, it can take generations to build institutions that enable people to trust arm’s-length transactions. But it is not impossible. Witness the confidence now invested in Mexico’s and Brazil’s central banks, or South Africa’s tax authorities.

Even the boldest reformer could not rapidly resolve all of these problems. This is the less cheering message of the two Mexicos: for all but a handful of countries, the road to prosperity is hard and long. But Mexico’s successes also demonstrate that it does exist. Even if the gains must be measured in decades, perseverance eventually brings rewards.

Wall Street's Best Minds

Emerging-Market Woes Are Greatly Exaggerated

Though currently out of favor, China and other markets can re-emerge as investment bright spots.

By Zachary Karabell      

In August, equity markets finally displayed the volatility that many had been anticipating.
Other asset classes, including currencies, high-yield and emerging market bonds, and, of course, energy and commodities, had roiled throughout the year. But equities had been largely immune—until the past month.
The selloff was attributed widely to accelerating worries about the tenability of China’s economic growth, and how its sharp deceleration would negatively affect global economies. For more than a decade, skeptics warned that China’s economic model, dependent on exports and state spending on infrastructure, was on the verge of a hard landing. But over the summer, those concerns began to emanate from China itself, and its domestic equity markets began to crash. Although those markets are largely unconnected to global markets, global equities began to sell off hard, as investors worldwide began to question whether China’s day of reckoning had arrived.

Other factors played a part for sure: low volumes in the normally slow summer month of August; a high level of algorithmic and program trading; the ongoing question about when the Federal Reserve will begin to raise short-term rates. But the China question looms largest, especially because as China goes, so goes global growth.

So, will China slow so much that global growth is imperiled? If the answer is ‘yes’, then, indeed, we should be very concerned about the stability of emerging markets, and the viability of international bonds and financial assets that are exposed to those trends (which is most of them). But there are strong reasons why the answer could be ‘no’.

Two billion and Counting
When our children and grandchildren look back at the first 15 years of the 21st century, it is likely that the addition of billions of people to the global middle class will be a dominant theme.

And that China—and its string of double-digit growth years—was the anchor. As hundreds of millions of Chinese moved from the countryside to newly constructed cities, China’s appetite for raw materials fueled a global economic boom. From Chile to Brazil to swaths of sub-Saharan Africa to Indonesia and Southeast Asia, more than a billion people in turn benefitted from China’s growth.

China also became a market for high-end finished goods: turbines, semi-conductor equipment, locomotives, airplanes, and tempered steel. China’s trading partners prospered, from Germany to Japan to South Korea to the United States. In fact, the only large country that grew almost entirely on its own internal steam was India, which, lagging China’s impressive trajectory, was powered by its domestic market.

China also reaped benefits from the globalization of supply chains, becoming the low-cost global producer for Europe and the United States. At the same time, it became a highly desirable market for U.S. and multinational companies looking to tap China’s burgeoning middle class consumers.

Businesses such as Apple, Kentucky Fried Chicken, Federal Express, and Wal-Mart all gained from China’s growth.

China’s growth resulted not only in the creation of a new Chinese middle class several hundred million strong, but also a global middle class several billion strong. That is why the prospect of a severe China slowdown is of such concern to so many.

Because so much of the world has changed so dramatically and so quickly is the very reason why this train of global growth will be so difficult to derail. It may face challenges in the year ahead, but the momentum is powerful.

Think about it. The last time there was global concern about the viability of emerging market economies was the Asian currency crisis and the meltdown of the Russian ruble in the late 1990s. Many countries, ranging from Latin America to Asia, had autocratic, inept governments with high levels of foreign debt and few reserves.

Today, much of the world has democratically elected governments that are accountable for economic growth and prosperity. Brazil, for instance, may be facing recession and scandal, but its democratically elected government knows that if it cannot enact meaningful reforms to enlarge the middle class, it will lose its mandate to govern. In addition, over the past decade, many of the countries that have advanced from China’s rise have not squandered their profits.

Instead, they have bolstered their reserves and invested in infrastructure and education—perhaps not as much as they could or should have, but incomparably more than 20 years ago. They have strengthened their foreign reserves, and many have favorable current account balances, all of which better positions them to weather storms and downturns than was the case in the late 1990s when their high debt made them vulnerable to the ebbs and flows of international credit and finance.

Today, many countries are overly reliant still on the export of raw materials and oil. That is a real weakness in light of China’s diminished appetite and the efficiency evolution sweeping the planet that translates into less demand.

But that reliance is offset by the surge in consumer demand within those countries. In fact, the growth of domestic consumer economies is perhaps the strongest reason to suspect that even a significant China slowdown does not portend a general financial and economic crisis. India is the most compelling example of a vast non-Western economy that is surging because of its own internal middle class market, rather than reliance on exports or commodities. It is not alone: countries such as Nigeria and the Philippines, and to a large extent Indonesia, which have a combined population approaching half a billion people, are exhibiting similar dynamics (despite Nigeria’s former dependence on oil exports and Indonesia’s extensive commodity boom and bust).

Although the commodity bust and China’s shifting economic mix have been and will continue to be unsettling, and at times painful, these are positive adjustments for the world. They move the next stage of global evolution away from selling stuff and digging stuff and towards billions of people using stuff. They move the world away from selling to the highest bidder or to the one with the largest appetite for metals and oil and towards a world ever-more grounded on billions of people striving to create a better life for themselves and their families.

To believe that we are on the brink of a significant global crisis, therefore, is to believe that several billion people in the world formerly known as ‘developing’ cannot make the transition that a billion people in the developed world already have. It is to believe that they are both incapable of good governance, and unable to craft a formula for their own wellbeing. That may, of course, be true, but if it is, our worries will be more substantial than what asset classes to invest in and how much.

Karabell is head of global strategy at Envestnet, a leading provider of wealth management technology and services to investment advisors.


Ray Dalio


Fed Can’t Solve Housing Puzzle Alone

Looser lending standards, not the Fed’s decision to hold rates at zero, may be more important for home sales.

By Spencer Jakab
Data on existing-home sales for August are due Monday, and Thursday will bring a reading on sales of new homes for the same month.Data on existing-home sales for August are due Monday, and Thursday will bring a reading on sales of new homes for the same month. Photo: David Paul Morris/Bloomberg News

“There has never been a better time to buy a home.”

That phrase, or variations on it, can be found in thousands of advertisements from real-estate agents and home builders. While impossible to disprove without the benefit of hindsight, it is safe to say the slogan’s prominent use at the peak of the housing boom was unfortunate. Maybe it was even used during the Lyndon Johnson administration, which was the last time the U.S. homeownership ratio was so low.

With that in mind, it is worth asking whether the Federal Reserve’s decision last week to keep interest rates near zero for a bit longer will give a fillip to home sales. Monday’s data on sales of existing homes for August and Thursday’s release of new-home sales for the same month should shed light on where things were headed before the Fed meeting.

Both have been looking up but remain low historically. Existing sales are closer to normal. July’s annualized figure of 5.59 million was the best since before the crisis and 62% higher than five years earlier.

New-home sales, meanwhile, hovered near their postcrisis high of 507,000 single-family units and have enjoyed a much sharper bounce. Still, they are only around half their pre-housing-boom level on a population-adjusted basis.

Lower mortgage rates might help but are just part of the puzzle. According to an index of housing affordability maintained by the National Association of Realtors, affordability in July sank to the lowest level since 2008. But then, according to the same measure, affordability peaked between 2011 and 2013. Not only were sales of both new and existing homes lower then, but a large chunk of existing sales were to investors rather than individuals.

Equally important though tough to quantify is the ease of getting a mortgage. The Mortgage Lender Sentiment Survey conducted by Fannie Mae in August indicated a significant loosening of conditions.

A case of sales recovering as affordability dropped suggests that, within reason, interest rates take a back seat to credit conditions and pent-up demand. The Fed may not have to worry as much about sabotaging the housing recovery when it finally raises rates.

Up and Down Wall Street

Federal Reserve Is Now Central Bank to the World

Yellen & Co. defer rate liftoff as global turbulences offset low headline jobless rate..

By Randall W. Forsyth 

Bloomberg News

While the U.S. retreats from its role of the world’s policeman, the Federal Reserve evidently has becoming willing to take up the mantle of central bank for the world.
Citing “recent global economic and financial developments,” the Federal Open Market Committee voted to maintain the near-zero interest rate policy that was put in place during the throes of the economic crisis in December 2008.
In so doing, the U.S. central bank evidently was in accord with major international authorities, notably the International Monetary Fund and the World Bank, which had urged the Fed not to raise its interest rate target for fear of worsening the turmoil in emerging markets.
The Federal Reserve did so even as it acknowledged the U.S. economy is expanding at “a moderate pace.”
In addition, it took note in its latest policy statement, as it did previously in late July, of “solid job gains and declining unemployment.” Indeed, last month’s jobless rate of 5.1% was just a hair above the FOMC’s year-end projection of 5.0% and its longer-run projection of 4.9%.
Inflation, however, continues to fall short of the Fed’s 2% target (which uses the personal consumption deflator, not the more familiar consumer price index). And the Fed sees the risks posed from abroad posing downside risks to prices and the economy. Here’s the key sentence from the FOMC statement:
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
Which translates to the Fed keeping rates lower for even longer than previously projected.
Arguably more important than the Fed’s current unchanged interest-rate target is that its policy-setting further reduced its year-end rate outlook not only for 2015, but also for 2016 and 2017, by about a quarter percentage point each.
Based on the so-called dot plot graph of the projections of the members of the Fed’s Board of Governors and the 12 Fed district presidents, the median call is for just one quarter-point hike, from the current 0-0.25% range, this year. Previously, the dot plot called for two such moves before the end of 2015.
For 2016, the median year-end forecast of these Fed officials calls for a fed funds target of 1.5%. And for end-2017, the median forecast is 2.5%. Only by 2018 do the Fed officials see the fed funds reaching what they see as its long-run equilibrium rate of 3.5%.
Not only is that a long ways off, the monetary solons previously have had to rachet down their dots steadily. Indeed, four of the group of 17 (there are two vacancies among the seven Board Governors and 12 district presidents) expect no increase at all in 2015.
Indeed, one of the dot plotters called for a negative fed funds rate for end-2015 and 2016. Sub-zero policy rates have been adopted abroad, notably by the European Central Bank, but never by the Fed.
That said, one-month U.S. Treasury bill rates dipped into negative territory Thursday, an interesting curiosity. Much more important was the steep drop in the Treasury two-year note yield, the coupon security most sensitive to Fed expectations. In the wake of the Fed’s rate decision, the two-year note yield dropped to 0.69% from just over 0.80%--which doesn’t sound like much but it’s a big move when rates are close to zero. And it was the clearest indication of the market’s assessment that the Fed will be lower for longer.
What also should be clear is that currency exchange rates—not just interest rates, the traditional target for central banks—have become a major transmitter for monetary policies. That should not be entirely surprising in a world where the major central banks’ administered rates are at or near zero—or even below zero in some cases.
The dollar’s exchange rate is the purview of the U.S. Treasury, and the Fed is careful not to tread on the former’s territory. But Yellen also took note of the effect of the turmoil in currencies and global markets with regard to their impact on U.S. growth and inflation.
To give such high importance to events abroad is extraordinary, and perhaps without precedent.
It is also ironic that the U.S. central bank is taking on increased influence in international economic affairs while China, the world’s No. 2 (and ascendant) economy, is going through the throes of a significant slowdown, which is roiling many of the world’s other emerging economies, especially commodity producers. At the same time, America’s ability to influence geopolitical events has been ebbing.
Whatever the reason, the Fed signaled that U.S. short-term interest rates will remain historically low, even as Fed officials think the domestic economy is doing pretty well. While economists can debate the propriety of that policy, investors should incorporate that reality into their portfolio decisions.