All eyes on Germany as Europe looks to a year of change

Chinese authorities move to boost the country’s flagging economy

Sir John Redwood


Volkswagen, in common with other German carmakers, faces dual challenges: falling sales in China and the prospect of regulatory and technological changes © Bloomberg


During rough times in share markets late last year the FT fund held 15 per cent in cash and was at the bottom end of the permitted range for share investments. This gave it some protection against the falls.

Coming into the new year, I put money into China and some into Germany, where I had sold out months ago ahead of the economic and trade problems encountered by those countries.

I also added to investment in the new economy following the sell-off in technology in December, this time through an exchange traded fund (ETF) that invests in general digital companies. I anticipated a January rally which has duly materialised, with good bounces in some of the most hard-hit markets and sectors. The fund is up nearly 4 per cent so far this year.

My policy of holding nothing in the Eurozone last year worked well. I added something in Germany because it had fallen more than most last year as people came to understand the way its economy was going to be slowed by the effects of tighter money on the world car market. The negative effects of trade wars on an economy that has a particularly large dependence on manufacturing exports have shown through. Sales into China have been weak.

The German car industry could also be on the wrong end of the technical and regulatory challenges to conventional car production and sales. Governments are forcing a switch to electric from petrol and diesel. EU emissions regulations have caused some impediments to car sales. New companies are emerging that meet changing customer demands and companies with established brands are rushing to adjust their products and approach, incurring costs as they do.

There were two immediate triggers for my purchase of some German shares. The first was the decision of European authorities to cut a deal with Italy over its budget. One of the biggest risks to euro investment was temporarily removed when they decided not to try to do to Italy what they did to Greece and Cyprus and squeeze the country by withholding liquidity through the Central Bank.

That would have been deeply damaging to markets. The second trigger was the big deflation of prospects for Germany brought on by poor third-quarter GDP figures showing an actual decline in activity, and poor forward-looking indicators as well. This hit German shares and leaves the market ready to think about how reflationary action might come to the economy’s rescue. The country still has some strong brands with revenue potential.

I remain nervous in the longer term, because there is no clear path to full political union such that German taxpayers stand behind poorer countries and weaker banks elsewhere in the Eurozone.

The position I have bought is quite small and based on what I hope is a temporary undervaluation of German strengths within a weak Eurozone. This issue in popular form will be part of the background to the European elections in May, when challenger parties look likely to do much better than traditional pro-EU establishment parties in many countries.

In Germany itself, the AFD and the Greens seem set to take seats from the CDU and SPD, which have slumped to new lows of support. The AFD will not be keen to extend more credit and grants to the rest of the euro area. The May elections matter both because the European Parliament now has more powers as a co-legislator to the European Council, and because it will influence the personnel chosen for the new Commission to be formed after the results.

The traditional centre left and centre right pro-EU blocs together may fall short of half the total seats in the European Parliament for the first time, while challenger governments such as Italy, Hungary and Poland will be choosing commissioners with different views from the establishment.

My purchase in China follows a halving of the Shanghai Composite stock index from the peak of 2015. The background has been a slowing in the Chinese economy, which seems to have worsened towards the end of 2018. While the official figures pick up a small deterioration in overall GDP growth, western companies dealing with China report a deeper slowdown.

The Chinese authorities have responded with a policy to get more loans and equity money into private sector businesses to allow them to expand. There have been tax cuts to boost consumption and a further expansion of loans to local authorities undertaking infrastructure investment. They have cut the reserve ratio requirements for banks, encouraging more expansion of credit. I suspect they will do more of this until the Chinese economy picks up pace. This should be positive for Chinese shares.

Technology was hit late last year because people had made big profits on it and wanted to reduce their risks. Some of the large US companies also had their own bad news to report as sales slowed. I did not take any evasive action for the fund, so a good year for this section of the portfolio was rounded off with a bad final quarter.

There were regulatory pressures that now require these companies to spend more for the same amount of business. Despite this, they still look well set to benefit from consumers who like digital solutions to their problems.

The fund has a substantial position in smaller technology companies through ETFs in robotics, cyber and digital, as well as in the larger stocks through Nasdaq. It looks as if the decline of many traditional businesses stuck with shops on the high street, advertising on mainstream television and labour-intensive ways of delivering service will continue in the face of intense digital competition.

With the US Federal Reserve lifting the threat of a bigger credit and money squeeze, markets can make a bit of headway before we get to the next set of worries. A trade deal between presidents Trump and Xi would also help and is possible. The purchases are so far doing well, but I need to keep an eye open for any relapse.


Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing.


The Coming China Shock

For years, China has defied the widely held view that political openness is necessary for long-term economic development. But recent macroeconomic developments now suggest that the country's exceptionalism is nearing its expiry date, with potentially devastating effects for the global economy.

Arvind Subramanian , Josh Felman

chinese investor investment map


CAMBRIDGE – In September 2018, we argued that China’s economic and foreign policies were defying the “laws” of economics and geopolitics, and warned that the situation could not last. Since then, our assessment has been borne out, and our concerns have deepened.

Until recently, China had been able to pursue a unique development path, owing to the government’s far-reaching control over the economy (and society more generally). But those days are over. The country’s internal debts are mounting to unsustainable heights, and domestic investment levels have passed the point of diminishing returns and are veering toward negative territory.

Moreover, China’s strategy of fostering exports, promoting industrial “national champions,” and expropriating foreign technology has crossed the threshold of what the West, especially the United States, is willing to tolerate. Chinese President Xi Jinping’s Belt and Road Initiative is showing all the signs of imperial overreach. Not only does the BRI’s lending far exceed participating governments’ borrowing capacity, but its loan terms have become increasingly onerous – indeed, usurious – as Harvard University’s Ricardo Hausmann recently observed.

Back in September, we saw some discontinuity in China’s economic performance as inevitable. Even if the country was not heading for a full-blown crisis, we believed it would almost certainly experience some combination of rapidly decelerating growth and a sharply depreciating exchange rate.

That prognosis has since become even more likely. With global economic growth and exports declining, China’s economy is on track to slow further relative to the 6.4% growth recorded in the fourth quarter of 2018. The double-digit average achieved from the 1980s until recently has never seemed more distant.

In response to the current global slowdown, the Chinese government has decided to loosen restrictions on private and public borrowing. But this will merely aggravate the country’s debt and overinvestment problems. Or, as a famous Chinese saying goes, it is akin to “drinking poison to quench one’s thirst.”

Even without these macro developments, China’s defiance of well-established findings in development economics was never going to last forever. The economists Douglass North, Daron Acemoglu, and James A. Robinson have shown that long-run economic development tends to rely on strong state institutions and open political systems, because these are necessary to foster competition, investor confidence, dynamism, and innovation.



In the chart above, the upward sloping line represents the positive relationship between political and economic development. As the notable exception to an otherwise robust relationship, China has long posed a problem for this theory. With its closed political system, it should not be anywhere near as rich as it is.

In the 1990s and 2000s, the West made a gamble that China would cease to be an exception and would veer toward normalcy by adopting more open and democratic political institutions (as indicated by the dotted blue arrow). As a practical matter, that bet translated into Western policies to facilitate China’s rise, and decisions by US firms to transfer manufacturing capacity there.
But under Xi’s leadership, China has instead become less open (as shown by the red arrow). And, as Nicholas Lardy of the Peterson Institute for International Economics shows in a new book, its economy has also shifted back from a private-sector-driven growth model to state capitalism.

In other words, systemic political and economic changes are making China even more of an exception, thereby increasing the odds that its return to normalcy will come in the form of a sharp deterioration in economic performance (the downward dotted black arrow). There is no telling precisely when that correction will happen. But the more China defies the rules of economic development, the more likely it becomes.

Unfortunately, any discontinuity in China’s economic performance would have a seismic effect on the rest of the world, because it would lead to a significant weakening of the renminbi. In fact, China itself might engineer a depreciation of its currency in order to promote its exports and cushion the inevitable fall in domestic demand, particularly its investment component.

Such a scenario would have a tsunami-like impact on global currencies. Other major Asian countries would respond by pursuing their own devaluations to maintain their competitiveness, and Europe and the United States would experience sharp deflation as their currencies strengthened in kind.

For a historical comparison, consider that in the 1930s, the US dollar and British sterling depreciated by about 40% over four years, while the French and German currencies remained broadly stable (measured against gold). Like the US and Britain in 1929, just before the Great Depression, today the major Asian economies that would be affected by a Chinese currency shock account for around 30% of world trade.

Making matters worse, trade is much more important to the global economy today than it was 90 years ago. In 2017, merchandise exports accounted for 20-25% of global GDP, compared to just 8% in 1929. That means a depreciation in Asian currencies would have a significantly greater global impact than the dollar/sterling devaluation of the 1930s. Thus, a China shock could potentially dwarf the competitive currency depreciations of the early 1930s – one of the darkest economic periods in recorded history.

One way or another, China’s continued defiance of the “laws” of macroeconomics, geopolitics, and economic development will hasten its inevitable return to normalcy. When that happens, the world had better brace itself.


Arvind Subramanian, a former chief economic adviser to the government of India, is a senior fellow at the Peterson Institute for International Economics and a visiting lecturer at Harvard’s Kennedy School of Government. He is the author of Eclipse: Living in the Shadow of China’s Economic Dominance.

Josh Felman is Director of JH Consulting.




Some Dark Clouds on the Horizon for the U.S. Economy

By Matthew C. Klein

Some Dark Clouds on the Horizon for the U.S. Economy
Photograph by Christopher Burns


By most accounts, the American economy is doing well. Jobs continue to be added at a robust pace, wage growth is accelerating, and the stock market has largely recovered from its late 2018 swoon. Yet a few recent pieces of data highlight potential trouble spots.

Most obvious is the sharp slowdown in retail sales observed at the end of last year. CreditSights notes this could be a false signal not matched by some private-sector estimates:

Some Dark Clouds on the Horizon for the U.S. Economy

But they also point out that the weak retail sales numbers fit with the sharply declining willingness of U.S. banks to make consumer installment loans:

Some Dark Clouds on the Horizon for the U.S. Economy


Banks are also tightening standards on commercial and industrial loans for the first time since 2016. Back then, growth slowed sharply and the industrial economy went into an outright recession.

Consumer confidence has also taken a hit recently. Chart via CreditSights:

Some Dark Clouds on the Horizon for the U.S. Economy

That could fit with the modest increase in the number of Americans filing claims for unemployment insurance since September.

The latest figures from the Federal Reserve Bank of New York’s Consumer Credit Panel also have a few warning signs. After years of steady growth since the trough in 2010, the number of new credit accounts opened by American consumers peaked at the end of 2016 and has now dropped by 6%.

Worryingly, this seems to be a lagging indicator: The number of credit inquiries peaked at the end of 2015 and is now down more than 20%. This measure of consumer credit demand has been declining ever since the Fed began raising its interest rate target and is now even lower than it was during the worst of the financial crisis.

Chart via Torsten Sløk of Deutsche Bank:

Some Dark Clouds on the Horizon for the U.S. Economy

As he puts it, “Both the level and the trend in this chart are somewhat worrying.”

Data on U.S. freight traffic is another potential area of concern. This chart from John Kemp demonstrates the scale of the slowdown.

None of this is to say that a recession is imminent or that the Fed will soon be lowering interest rates and restarting its bond-buying programs. The data do suggest, however, that the relatively fast pace of U.S. growth in 2017 and 2018 may be difficult to sustain this year without significant policy stimulus.


Brexit: Between a Border Poll and a Backstop

In Brexit negotiations, the Irish question is proving the most difficult to answer.

By Ryan Bridges

 

 
A border is coming to the British Isles – just where, though, is not yet certain. This weekend, the leader of the Irish Republic’s nationalist Sinn Fein party called for Northern Ireland to begin preparing for a border poll and a united Ireland. Sinn Fein has been making such calls ever since the Brexit referendum, but only recently have they gained some credibility. The United Kingdom’s imminent departure from the European Union is poised to disrupt the trade and regulatory harmonization that has made the illusion of a united Ireland – and thus the Good Friday Agreement – possible. If the U.K. leaves the EU’s customs union and single market as promised, or leaves the EU without a withdrawal agreement, a border somewhere between the U.K. and the EU is inevitable. The decision of where to place that border will reshape the British Isles and their relationship to the Continent.
 
The Backstop
The Irish Republic and the EU have been adamant that there cannot be a border in Ireland, arguing that it would undermine the Good Friday Agreement. (That agreement brought a near-total cessation of the civil war between republicans, who seek a united Ireland, and unionists, who wish to remain part of the United Kingdom.) So they proposed the so-called Irish backstop. The backstop would effectively keep Northern Ireland in the EU’s single market, while both Northern Ireland and Britain would remain in a customs union with the EU “unless and until” they reach an agreement that removes the need for the backstop. (The EU’s preference was for the backstop to apply only to Northern Ireland, but the British government insisted on this U.K.-wide format.) Northern Ireland’s Democratic Unionist Party has fiercely opposed the backstop and any other solution that would treat Northern Ireland differently from Britain. The DUP’s objection would matter less were it not for the fact that British Prime Minister Theresa May’s government depends on the party’s support for a functional majority.

Unionists and others in Britain see the backstop as nothing short of an Irish and EU plot to seize a piece of the United Kingdom as the price of Brexit. Northern Ireland wouldn’t be under the control of the Irish Republic, but it would be forced to apply the EU’s customs and regulations without a voice in shaping them. Ireland and the EU argue, however, that the backstop is about preserving the status quo and avoiding the need for a border between the two territories that could incite violence.

The EU is not especially thrilled to be in this position – the backstop is the biggest obstacle to securing an orderly Brexit, though not the only one – but it has been loath to pressure Dublin to abandon its stance. For Brussels, the only outcome worse than a no-deal Brexit would be abandoning a small member state on an issue that state views as existential just to reach a deal with London. Brussels fears this would send a signal to other small EU member and prospective states with potential territorial disputes (particularly Baltic and Balkan countries and Cyprus) that Brussels cannot be relied upon to defend them.

As for Ireland, on the surface, its dogmatic insistence on the backstop looks like a contradiction: If what Dublin fears most is a border, and failure to reach a deal ends in a border, why not yield? Agreeing to a five- or 10-year limit would at least kick the can down the road. But there is a difference between a border that arises as a result of failed talks – talks that Ireland and the EU are confident would have to be picked up sooner than later – and a border that arises with Ireland’s acquiescence. If Dublin admitted in principle that it could accept a border with Northern Ireland, it fears that such a border would emerge and would be permanent, crushing the centuries-old dream of a united Ireland. A border resulting from a disorderly Brexit, on the other hand, is seen as temporary; implementing the backstop would likely be the EU’s first condition to start talks on an EU-U.K. trade agreement.

It’s a position that works in principle but is explosive in practice. In a January survey by the Irish group Red C Research, 70 percent of respondents in the Irish Republic opposed a hard border. The government in Dublin has struggled mightily to explain what it would do in the event that there is no withdrawal agreement. After months of insisting there were “no plans” for a border, the Irish deputy prime minister said vaguely in mid-January that a border “could be at sea.” This presumably meant in the Irish Sea, not between the British Isles and the Continent. Irish Prime Minister Leo Varadkar referenced the latter idea during a private meeting with opposition party leaders, saying that all goods from the U.K. and Ireland could be checked at Continental ports – an outcome he said must be “avoided at all costs.” At the World Economic Forum’s meeting in Davos at the end of the month, however, Varadkar took his hardest line yet, saying a no-deal Brexit would result in “customs posts,” other physical infrastructure and “possibly a police presence or army presence to back it up.”

In trying not to inflame tensions at home, the Irish government is alienating the EU. To this point, Dublin has held outsize influence in Brexit negotiations because it had EU backing, but it risks being crushed between the U.K. and the EU if it refuses to control the EU’s external borders in a no-deal Brexit. The EU has two overarching objectives that would be put at risk in a disorderly Brexit: protecting the interests of a member state over a non-member state and protecting the single market. If the Irish Republic fails to defend the single market, the EU would be forced to choose between its objectives – and it would choose the single market. This would effectively mean that the Irish Republic would be expelled from the EU trade area and forced into a bloc with the United Kingdom. Ironically, escaping this bloc would be all but impossible without reaching a resolution with the U.K. or unilaterally installing border checks – it would essentially be Ireland’s Brexit. For a nation that has historically looked to Europe for allies in resisting English domination, being trapped in such a bloc with the U.K. would be a significant strategic failure.
 
The Poll
Ireland’s last option might just be a border poll. Under the terms of the Good Friday Agreement, the secretary of state of Northern Ireland is to call a referendum on union when it appears likely that a majority would support a united Ireland. (The agreement allows polls to be held every seven years until it passes.) The imprecision of this language was never a serious concern, because a majority always seemed a generation away. Belfast-based pollster LucidTalk said polls have historically shown support for remaining in the U.K. in the low-to-mid 50s when undecideds are removed.
 
 
But the question has changed since Brexit, because remaining in the U.K. now entails leaving the EU. In December, LucidTalk asked Northern Irelanders how they would vote in a referendum on a united Ireland in the event of a no-deal Brexit. Fifty-five percent of respondents, including 11 percent of unionists, said they would certainly or probably vote to leave the United Kingdom. Removing undecided respondents pushes the figure up to 57 percent. Sure, this is just one poll, but 56 percent of Northern Ireland’s voters backed “remain” in the 2016 referendum. And the findings make some sense: The threat of a border spurs moderate republicans who have otherwise preferred to avoid the disruption of a border poll to come out strongly in favor of one, while neutral voters like those who support the Greens or the Alliance Party, who would likely be the decisive votes in a border poll, are fiercely in favor of a united Ireland over a no-deal Brexit, according to LucidTalk’s findings. (Both the Greens and Alliance lobbied for “remain” in the Brexit referendum.) It’s also notable that the 2017 Northern Ireland Assembly election, the only one since the Brexit vote, marked the first time in Northern Ireland’s almost 100 years of existence that unionists failed to reach a majority.

Our assessment from the jump has been that there will be a withdrawal agreement, and that is still the likeliest scenario. It’s in the interests of all sides, and failure would be devastating – and not just economically. But should a no-deal Brexit appear imminent, it is faintly conceivable that public outcry in Northern Ireland could trigger a border poll. The EU may then temporarily exempt the Irish Republic from enforcing customs and regulatory checks to allow time for the poll. More conceivable in the event of a disorderly Brexit, London, Dublin, Belfast and Brussels – and potentially Washington – could assemble in a slightly depoliticized atmosphere to determine how to safeguard the Good Friday Agreement. The likeliest solution would resemble the Northern Ireland-specific backstop that the EU initially proposed, entailing checks in the Irish Sea between goods traveling from Britain to Northern Ireland.

Whatever happens next, the Irish Republic and Northern Ireland must play their cards carefully. Thus far, all sides have prioritized political concerns over economic ones, but that may change once the economic consequences are impossible to ignore. In that case, Ireland, Northern Ireland, or both might find that they’re expendable.

China’s Urban-Rural Divide

Differing paces of consumption growth explain some of the media Sturm und Drang around Chinese consumers, but also hint at potential problems ahead

By Nathaniel Taplin

Booming consumption growth among rural Chinese households is being bolstered by government subsidies.
Booming consumption growth among rural Chinese households is being bolstered by government subsidies. Photo: Andy Wong/Associated Press


In the U.S., disaffected rural voters helped elect President Trump. In China, where people this week are celebrating the new year, the urban-rural divide is a bit different: Rural residents are suddenly doing a lot better growth-wise than their urban peers.

That helps explain some of the panicky sentiment around Chinese consumers right now. Upscale Western brands such as Apple —which recently blamed China for slowing sales—target upper-middle-class, urban Chinese. Unless Beijing enacts pro-market reforms to shore up its urban economic engines, bubbly rural spending may not be enough to keep overall consumption growing rapidly. That would remove a key safety net for the economy and risk a “middle-income trap” for China.

Urban China is retrenching thanks to a heavy mortgage-debt overhang, a legacy of Beijing’s previous big stimulus effort in 2016. Urban real per capita consumption, which in 2016 was growing roughly in line with incomes, slowed to a pace 1 to 2 percentage points behind incomes in 2017 and 2018. In rural China, the pattern has been the opposite: Consumption was growing more than 3 percentage points faster than income by mid-2018.



Even though rural Chinese account for only a quarter of total household consumption, they drove around 40% of consumption growth last year, according to Gavekal Dragonomics.

This boom appears to be the result of a surge in government subsidies, rather than organic growth. Eliminating poverty is one of “three tough battles” identified by President Xi Jinping for broad policy support. As a result, central-government spending on poverty alleviation has shot upward, hitting almost 90 billion yuan ($13 billion) in 2017, roughly double 2015 levels, according to the Economist Intelligence Unit.

Loans from state-owned banks such as Agricultural Development Bank of China targeted at the poor have shot up, too, and local governments have also boosted spending.

Rural poverty alleviation is an admirable goal, but may not be sustainable without sparking more debt problems. Rural consumption growth had already started tailing off by the end of last year.

Unless urban households take up the slack, consumption looks likely to weaken further in 2019. A big income-tax cut will help. But if Beijing really wants to keep consumers on an even keel, it needs to revive private-sector animal spirits with real reforms—and a trade deal with the U.S.