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  • hard landing vs stimulus

    this article is written by a famous economist in china, whose name is Xie guozhong. in this article, he expresses that both china and america want to
    get some changes, but it's difficult for both of the two countries to reach their aims. talk about it if you have any interest on it.


    The following article was written last Monday and is in the current issue of Caijing Magazine. The basic point is that (1) the bounce since Nov 08 that was driven by technical factors and stimulus hope is over, (2) bad corporate and economic news, much worse than expected, would weigh on markets, (3) markets could bounce again only after the 4Q08 corporate and economic news are digested, and (4), while another bounce in 2Q-3Q0 is possible, it would still be a bear market rally. The global economic contraction may stop in 2H09. But it wouldn't be the beginning of another growth cycle. Indeed, with so much monetary and fiscal stimulus, we may get stuck with stagflation through 2010. Only structural reforms in the US and China could start another growth cycle and bull market. Happy CNY! Andy


    Hard Landing vs. Stimulus



    By now a barrage of economic and corporate data is showing unequivocally that the global economy is in a hard landing. The US lost over half a million jobs in both November and December 2008, and the unemployment rate surged to 7.2%, the highest since 1993. For 2008 as a whole the US lost 2.6 million jobs, the highest since 1945. The chances are that the US GDP contracted by 1.5-2% in the fourth quarter of 2008 alone.



    China's economy has tumbled since October 2008. The leading signals were tumbling export orders from Europe and Japan in September 2008. The industrial consumption of electricity may have declined by around 10% in the fourth quarter of 2008 from one year ago, compared to mid-teen growth rate before; auto sales probably declined by 10%; home appliance sales probably dropped more; property sales came to a standstill; and even department store sales may have fallen. Supermarket and hyper mart sales probably rose by low single digit. Millions of migrant workers have returned home from the coast due to factory closures. The chances are that China economy went into a hard landing in the fourth quarter of last year too.



    Only demand side data from consumption-driven economies like Australia and the UK add information to what we know from China and the US. The situation in export economies like Japan and Germany reflects entirely what's going on elsewhere. The rapid contraction of their manufacturing is quite self-evident from the global situation. The demand side situation in the UK is even worse than the US's. I have argued for years that the property bubbles in Australia and the UK were bigger than in the US, possibly twice as big. Australia could cushion the blow by devaluing its currency, as it is a small economy and has a large export sector. The UK doesn't have a large export sector anymore and mostly depends mostly on capital inflow. Hence, devaluation wouldn't work for it. The UK is facing a catastrophe like no other.



    There are three forces driving the global hard landing. First and foremost is the bursting of the global asset bubble. Roughly 100% of global GDP in paper wealth has evaporated. The negative wealth effect on demand is roughly 5%. Minus 3.5% trend growth rate for the global economy, the wealth effect alone should cause the global economy to contract by 1.5% in 2009. As the wealth loss is mostly permanent, i.e., the high asset value before was a bubble and the current level is normal, the 1.5% contraction represents a permanent loss.



    The second force is the slowdown or reduction in bank lending. Governments around the world blame the recession on banks' unwillingness to lend. They may be barking up the wrong tree. Lack of capital could be a major factor in their unwillingness to lend. But, with government capital injections, capital is not a major issue anymore, unlike six months ago. The main impediment to lending expansion is the credit worthiness of the borrowers. They have less collateral due to asset devaluation and less revenue due to recession. Ceteris paribus, banks would be less willing to lend to them. The credit contraction is part of the adjustment after the bubble burst. Banks lent too much and bankrolled the bubble. It is not surprising that they would contract afterwards. Governments should not hope to revive the economy by pressuring or incentivizing the banks to lend. As a corollary, interest rate cuts won't be so effective in stimulating demand.



    The third force is the inventory cycle. When commodity prices were rising, wholesalers and manufacturers were hoarding inventories either as a hedge against rising prices or for speculative profit. At the peak of commodity speculation in 2007 the shipping cost for iron ore tripled from the level in 2006. A major reason was that the sellers in the spot market refused to unload the cargo in anticipation of price appreciation for iron ore. The daily shipping rate was effectively supported by the expectation of iron ore price appreciation. I am giving this example to illustrate how strong inventory demand was. When prices turned around in mid-2008, wholesalers and manufacturers tried to run down their inventories, which depressed final demand. The dramatic collapses of steel price and shipping rate, for example, were driven by this force.



    All three forces are still at work in the first quarter of 2009, i.e., the rapid pace of economic contraction will continue. Financial markets have not fully priced in the magnitude and length of the recession. This is why the barrage of bad economic and corporate news is weighing down stock market everywhere. During the rapid globalization period the shares of corporate earnings and tax revenues in global GDP surged, led by the financial sector earnings and China's government revenue. Of course, the other side of the coin was declining share of labor income and diminished consumption power of workers. Rising household borrowing, backed up by rising asset prices, sustained the growth trend for a decade. Naturally, as the bubble bursts, the ensuing economic downturn affects corporate earnings and tax revenues first. As businesses try to cut costs to recover their profits, they lay off workers, and the laid-off workers cut consumption, which causes the second round of economic contraction. Obviously, this vicious cycle could go further than necessary without government stimulus to cushion up demand.



    This is where the announced stimuli by China and the US could play a major role in stopping economic contraction. Stock markets hit major bottoms in November 2008: S&P 500 hit 750, and Hang Seng 11,000. S&P 500 bounced up by 22% and Hang Seng 42% afterwards to their recent recent peaks. The slowdown in leverage reduction initially drove the bounce. The optimism over the impact of the stimuli announced by China and the US drove markets further up in December 2008 and continued into the first week of January 2009. Markets have been coming down in response to the bad economic and corporate news. The downward trend may last for one or two months until the bad economic news are digested. In 2009 markets will fluctuate on the hope for stimulus impact and the fear of worsening economic situation.



    The first positive kick for the global economy will come from the inventory cycle. We don't know how much de-stocking is contributing to the current contraction. There are good evidences that the current inventory cycle is quite dramatic.



    The Baltic Dry Index ('BDI') that measures the average shipping cost in global trade was under 2000 for two decades before 2003, surged above 5,000 in 2004 on strong Chinese demand for resources like iron ore, declined to around 2,000 in mid-2005, skyrocketed again in 2007, peaked at 11,400 on May 30th 2008, and has collapsed dramatically afterwards to the low 800s or over 90% decline. In the long run, the Baltic Dry Index is determined by the ship building cost and fuel price. In the short term, the shipping capacity is fixed, and demand drives shipping cost. When demand is below shipping capacity, shipping cost drops to operating cost-fuel plus labor costs, i.e., fixed cost cannot be recovered.



    The dramatic rise and fall of the BDI partly, if not mostly, reflects the speculative demand, even though classified as inventory demand. When the Fed cut interest rate in August 2008 in response to the Sub-prime crisis, it launched another wave of speculation in commodity market. It spooked the users into hoarding inventories to hedge against price rise. For example, many steel producers had legitimate fear of iron ore price escalating and scrambled for more inventories. Of course, rising iron ore price drove up steel price, which caused steel users like automobile companies to store up more steel. When the recession brought down commodity prices, everyone had the incentive to sell or use the inventory. That force exacerbated the downturn. It was probably the most important force in bringing down the global economy in October 2008.



    Before the middle of 2009, de-stocking would be finished and re-stocking may kick in. That extra source of demand may give the global economy a significant kick. I wouldn't be surprised that the BDI double or even triple from the current level by then. East Asian economies experienced a similar force in the fourth quarter of 2008. De-stocking was actually the most important source of contraction in early 1998. Like now, the reversal of price expectation and the rising capital cost incentivized manufacturers and distributors to run down their inventories as low as possible.



    Adding to the upward force of re-stocking, the impact of stimulus will probably be felt in the second half. Obama's stimulus plan is likely to be $750 billion over eighteen months. The quickest part of the plan is $350 bn or 2.5% of GDP tax cut. Even though the Obama stimulus plan initially focused on investment, it is now mostly about tax cut to support consumption, because it is the only way to boost demand quickly. The US government doesn't have the machinery to boost investment quickly. Targeting investing areas, identifying projects, and establishing implementation organizations will take a long time. Even though excessive consumption has got the US economy into trouble, it has to boost consumption again to stabilize the economy.



    China doesn't have the US's problem. It has a vast machine comprised of government agencies, state owned enterprises, and private contractors to implement investment projects quickly. Hence, the easy short-term fix is to issue fiscal bonds and pump the money into the investment machine. Many railroad and highway projects were started in early 2008. By the middle of 2009 some stimulus impact should be felt by the economy. Even though China's economic imbalance is excessive investment and insufficient consumption, the economic stimulus is still to boost investment, because China has the machinery to do it and doesn't have the personal income tax base to do what the US is doing.



    What I am portraying is that there will be an economic rebound in the second half of 2009, but it is not sustainable. Inventory re-stocking is obviously a temporary force. The stimulus that China and the US are implementing will not address the structural imbalance within or between them. Indeed, the stimulus prolongs the unbalanced growth model that got us into trouble in the first place.



    Some may ask why not. There is a popular theory that China and the US have effectively become one economy, and the imbalance between the two is not a problem. As long as China is willing to buy the US treasuries, that 'China produces and the US consumes' could be a lasting equilibrium. But, even if China's willingness to buy treasuries remains intact, the US and China block is not self contained. In particular, if the 'China produces and the US consumes' block tries to grow fast, oil price will surge, which will suck money out of the axis and bring it down. The property-***-credit bubble in the China-US axis burst because high oil price sucked too much money out of it. Like an old motorcycle, it can't go fast anymore.



    This is why I believe that the bounce in the second half of 2009 would be unsustainable. Stock markets are being weighed down by bad economic and corporate news now. In two to three months, they may smell economies improving in the second half and start to rally again. However, the rally may fizzle out in the third quarter, as the economic pickup was merely a bounce and not sustainable. In 1999 East Asia recovered first on inventory re-stocking and then was on export surge, as Europe and the US's economies were strong. Now the whole world is weak and can't export out of its problems.



    It takes time for the global economy to find a new and sustainable growth path. The necessary changes are that the US expands production and China expands consumption. Neither is easy. And it takes time to implement changes to achieve the desired objectives. Institutional inertia is hard to overcome. The US is stimulating consumption again to boost its economy because it has the system to do it. And China is stimulating investment again because it has the system to do so. It requires in-depth changes to their political economies for them to move in different directions. The time-consuming nature of structural reforms is why the sustainable economic recovery will take time.



    The combination of inventory cycle and stimulus may give us a 'playable' bounce between the second and third quarter of 2009. 'Playable' is a market jargon that refers to a bear market rally that lasts for several months. The bounces that we have seen are all very short lived and not considered playable. There may be a 'playable' bounce in 2009. But, markets will fall again on bearish economic expectation about 2010. Indeed, the bear market is likely to last through 2009 and most of 2010. Bull market will come back only when China and the US have done sufficient structural reforms to create a sustainable growth cycle.

  • #2
    just a FYI, Xie guozhong is Andy Xie, Senior Vice-President, Morgan Stanley; currently, Managing Director, Morgan Stanley Dean Witter Asia.


    We used to discuss all his articles back in the old CDF days.
    “the misery of being exploited by capitalists is nothing compared to the misery of not being exploited at all” -- Joan Robinson

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    • #3
      Originally posted by xinhui View Post
      just a FYI, Xie guozhong is Andy Xie, Senior Vice-President, Morgan Stanley; currently, Managing Director, Morgan Stanley Dean Witter Asia.


      We used to discuss all his articles back in the old CDF days.
      Thanks for the background.
      J. J. Ogershok, Jr.

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      • #4
        Andy Xie got kicked after someone leaked an overly frank e-mail about globalization and how S'pore got to where it is by, according to Mr. (dr?) Xie, laundering money for the region.

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