In China...in the US...and in Europe, policy meddling or the threat thereof hangs over markets...
IN A NEW paper from academics at the Hong Kong University of Science and Technology, authors Li, Liu & Wang lay out a clear exposition of the way that the Chinese institutional framework conspires to leach out profits from the predominantly private, cut-throatedly competitive, highly efficient, export sector, writes Sean Corrigan for the Cobden Centre.
In this way, it delivers an undue share to the state-owned or –controlled giants who occupy quasi-monopolistic positions 'upstream' in the largely non-traded, but also almost unavoidable sectors such as energy, metals, telecoms, logistics, finance, health, and education.
The paper lays out in some detail — in narrative, empirical and, inevitably, mathematically-modeled form — how this vertical separation helps perpetuate the 'imbalances' in China's top-heavy economy, by concentrating the bulk of the nation's impressive gains from trade in the hands of those whose activities are both investment-heavy and sensitive to the imperatives of the state, rather than to the needs of the ordinary consumer.
Moreover, Li et al also demonstrate a mechanism by which this 'commanding heights' strategy, one consciously adopted by the CCP so as not to lose control over the system as it became partially 'opened up' to the outside world, helps suppress the share of wages — and hence of domestic consumption — in the aggregate mix.
What the authors do not dwell upon is the further implication that the political aspect of this confronts the Party with an almost insoluble problem now that it is beginning to realize that the SOEs may represent not so much a bulwark of their rule, but a potential barrier to that progressive betterment of their subjects upon which their legitimacy as rulers depends.
It would be bad enough trying to steer resources away and strip privileges from these over-mighty entities were the problem just one of economics, but, given that the upper echelons of these giants are packed with senior party members, their boardrooms populated by red 'princelings' and politburo spouses, the knot assumes truly Gordian proportions.
In light of this engrained favoritism, it is also salutary to note just how badly even these vampire enterprises are doing in the current slowdown.
According to the official data, SOE profits fell 11.8% YOY in May, leaving the YTD total 10.4% below the comparable period in 2011. With revenues for the first five months up 11.3% from the previous year, this means operating margins must have fallen nearly 20%. In the export powerhouse of Guangdong, things were even worse (this time over the period Jan-April) as the SOEs there suffered an eye-watering 30.5% drop in income.
At the national level, return on sales is running at 5.1%, the lowest since the Asian Contagion, 28% below the WTO era median, and even 15% below the worst recorded in the LEH Crash itself. For reference, US manufacturers, absent much – if not all – trace of state support, just posted an 8.9%after-tax return on sales in QI, while miners recorded a figure of 16.6% and InfoTech one of 11.2%.
Note, too, that in such credit constrained conditions as persist in China at present, one must even doubt what exactly is meant by 'sales' – i.e., how much are accounts receivable piling up as vendor finance is extended and channels are stuffed in an attempt to massage the figures. One thing that is for sure is that the proportion of such 'sales' as was paid in hard cash is likely to be scant, indeed.
Not that we will ever know, now that the Party has officially banned all negative reporting ahead of the leadership handover (sic) and in light of (should that be 'in the obscurity of'?) its prohibition on local audit firms co-operating with the SEC and the PCAOB in the US in the latters' (belated) attempt to clear up a few trifling 'confusions' contained in the financials filed—and all too frequently not filed—by US-listed, Chinese corporates.
If any confirmation were needed of the dire state of play here, just look at the export figures from China's more developed satellites in the Pacific cluster, or consider the HSBC/Markit flash PMI which dipped again to a 7-month low, with China's own export orders sub-index hitting its lowest level since the dark days of early 2009.
Recent reports also suggest that the Big 4 banks have only managed to lend CNY25 billion in the first half of June (a system-wide monthly run-rate of less than CNY150 bln!) with deposits off by Y400 bln (which could require loan contraction of anything up to CNY300 bln) and this when many banks are already fully utilizing the new leeway granted them of paying 35bps over the official deposit rate.
No doubt the actual total will miraculously surge as month end (quarter end, in fact) approaches, but such window-dressing should not blind us to the fact that generic credit demand remains weak, or at least the rationally-fulfillable kind does. No wonder there are reports that the banks are being told to encourage another round of local government profligacy and hang the structural re-adjustments which policy has insisted the country needs.
The China slowdown has not yet run its course.
Over in the US, Blackhawk Ben has done what he knows best: perpetuated his violence upon the capital structure and pricing mechanism of the world's largest economy by extending the somewhat pointless Operation Twist until — well, basically, until he runs out of short-date paper to sell (though we would not put it past the man to issue Fed bills at that point in order to turn the whole of the US debt stock into nearer-money instruments and drain the system of every last drop of duration).
As regular readers will be aware, the momentum of money growth in the US has receded significantly from the rip-roaring pace which helped fuel the rebound at the back end of 2011, taking with it a good deal of the impulse behind the real economic upswing — regardless of the fact that corporate bond yields are again where they last were when the Fed first unleashed the demons of inflation, back in 1965.
In one thing has our esteemed Chairman succeeded, viz., he has made equities as cheap as they have ever been compared to bonds. Witness the gap between the earnings yield on the S&P500 and the BAA corporate bond of almost 2% points in bonds' favor! Equity risk premium, please phone home.
Jigging the arithmetic slightly, this gives us a long-term, real earnings growth factor (rEGF) of minus1.8% per annum, fully 2.7 standards below the 1980-2012 mean. More telling, however, is the fact that this datum also lies 1.4 standards lower than it normally does in relation to the current growth in private sector GDP — a benchmark which, you may not be surprised to learn, has displayed almost exactly the same median value of 3.2% over the past three decades as has the rEGF.
The fact that a disparity of 4.6% between the two has opened up could imply that market participants have seen through the fraud of ludicrously suppressed bond rates (and, arguably, are also somewhat skeptical of long term growth in what is still an overly stimulus-dependent economy).
Thus, the Fed is keeping the stock market supported, but only at the expense of just about every other rational means by which to allocate capital. We should be thankful that the political environment is not conducive to its undertaking anything more far-reaching in its effects than tinkering with a yield curve which — given the intense desire to park flight capital in something deemed to be relatively safe — would probably have remained flatter than normal in any case.
Charting these waters in investment terms is therefore none too easy. The US is decelerating, right on schedule, but is not yet actually declining. So, while we may be in for a steady diet of mild disappointment, it is hard to identify a specific trigger which could tip the real world into the abyss — at least not before most of the alternative destinations for one's capital have been sent plunging into its Stygian gloom first.
That said, while there are one or two more heartening signs — e.g., that household deleveraging (and default) has already stretched to 20% of household income; that dips in the gas price are seemingly filtering through into abstention from consumer credit; that the ratio between non-residential fixed investment to housing has gone from a four-decade low to an all-time high, though the proportion of net private investment in potentially productive equipment and structures is still a very paltry fraction of the sums consumed annually, either privately or by the ever-open maw of the state.
Until a genuine end to what has been a generation-long decline in provision for the future (interrupted only briefly by the euphoric waste of the Tech Bubble), we cannot wax too lyrical about America's longer term prospects, cheap energy or no.
All of which brings us wearily back to Europe where the only question remains when and if the Germans will blink and start writing checks to all their neighbors and, if so, what conditions will they apply to their long-delayed largesse.
So far, Frau Merkel is sticking to the only strategy that she can — of insisting that future aid is tied to the construction of budgetary oversight, reduced national sovereignty, and the implementation of labor market reforms which, at one and the same time, calls the bluff of the likes of M. Hollande while paying lip-service to her own countrymen's obvious unwillingness to pay for what they view as their counterparts' indolence or improvidence.
How long this can last is an open guess. Certainly, the markets — suffering a paroxysm of fear on Monday, when Spanish Bonos hit 7.29%, 588bps over German Bunds and Italian BTPs touched 6.17%, 476bps over — have since recovered what is either a measure of poise, or a slug of undiluted wishful thinking (according to taste) with Spain back at 6.55%, 500bps over, and Italy at 5.68%, 412bps over.
A gauge of how much this relies on the assumption of a 'Ja, endlich, wir bezahlen!' emanating from Berlin can perhaps be had by noting that German 10-year CDS still stand at a lofty 132bps, juxtaposed to the Aa3 pairing of Japan and Chile and that Bunds have seen their 50bps yield discount to Treasuries dwindle to a single figure difference in the past several weeks of bail-out speculation.
Perhaps the real lesson is to be had from the Baltics where drastic 'internal devaluation' has accompanied genuine 'austerity' in the form of government cut backs stretching from 10% in Estonia, to almost 20% in Lithuania, and near 40% peak-to-trough in Latvia. As a result, of the bitter medicine swallowed there, private GDP is now on the rise, with growth rates of 0.9%, 4.9%, and 3.9% annualized over the past six months in Estonia, Latvia, and Lithuania, respectively.
Ireland and Portugal, to give them credit, have seen something similar occur, with the state's slice of the pie shrinking 13% in the first and 15% in the second, but Spain has barely managed a 5% cumulative cut and Italy is already well on its way back to unchanged from the peak, despite all Mario Monti's protestation about his performance in trimming the excesses of the past.
'Austerity' which not only forces those who have become dependent upon the state to go out and seek other ways of making a living, but confiscates more of their and their private sector neighbor's earnings when they do so, by imposing swingeing increases in taxes (and so pushing down marginal returns to labor and capital at just the wrong moment), is, as we have said before, a very luxurious form of achieving budget balance, indeed. Aimed, as it is, not so much at reinvigorating individual endeavor as at minimizing the reduction in the reach and importance of the state, this is truly a policy prescription to satisfy neither those who would apply Keynes' soothing nostrums, nor Austria's much tougher love.
THAT is what is 'self-defeating' about such measures, not the simple fact of trying at last to live within one's means and to re-orient one's activities more to wealth creation than wealth destruction – as we fear the unfortunate citoyens de L'Hexagon—the French—are about to discover under their newly installed, traditional left-wing, tax-and-spend, New Dealer leadership.
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