China reforms

I received a report from a well-known international broker after the China government released a detailed version of its reforms agenda. On the face of it, it looked radical. Somehow, I could not muster the enthusiasm for it since, on three key areas, the reform measures were vague: on reducing and eventually eliminating overcapacity, on local governments’ borrowing and funding problems (no right of taxation extended to them) and on the property sector.

In fact, in some relatively not-so-well commented areas, the reform measures were quite interesting. I mention a few of them here:

Transform the business registration system.

Gradually remove the administrative ranking of schools, research institutions, hospitals and other relevant entities. Promote the transformation of qualified administrative institutions into enterprises or community organizations.

Starting from its neighbors, China will quicken its pace of implementing the strategy of free trade area. Systems on market access, customs control, inspection and quarantine will be reformed. The mainland will also further open up and cooperate with Hong Kong, Macau and Taiwan.

I must concede that this statement about State-owned Enterprises (SoE) was also rather clear-cut:

The functions of different SOE will be clearly defined. For those in natural monopoly sectors, they will separate government from enterprise management and separate government from capital ownership, promote franchises and a government supervision system. Administrative monopolies will be further broken and competitive business will be introduced.

There was also the obligatory reiteration of capital account convertibility goal, market-based RMB exchange rate mechanism, interest rate liberalisation, etc. The last one should actually be, more specifically, ‘to free up bank deposit rates’. The rest of it, I am not sure, is really good for China. Not at this juncture and given the size of the credit bubble that exists in China.

Jamil Anderlini in the FT lends some perspective to the post-reform euphoria that has swept through international brokers looking for the next investment theme.

For those who have to endure the toxic smog of northern China, it often comes as a surprise to learn that Chinese environmental laws and emissions regulations are some of the most stringent in the world.

Over the past 10 years, Chinese leaders have insisted that cleaning up an environment devastated by decades of dirty, energy-intensive growth is a top priority.

But each year the smog thickens and the ecological destruction continues, as officials at every level ignore environmental laws and regulations in their jurisdictions in favour of rapid annual expansion of gross domestic product.

The contradiction between excellent environmental legislation and terrible pollution problems provides just one example.

Last week, the state council, China’s cabinet, and President Xi separately reiterated their commitment to reining in overcapacity in a wide range of industries, such as steel and cement. China’s leaders have been trying to tackle overcapacity in these sectors since 2004, but all have expanded rapidly and in some cases tripled their capacity since then.

The same is true for surging property prices. The government has tried to douse them since at least 2007 but they have soared instead.

Many of the goals mentioned at the close of the meeting on Tuesday have been part of the government’s agenda for many years, and were included in its 11th and 12th five-year plans, which came out in 2006 and 2011 respectively.

Reducing the economy’s reliance on investment and moving to a more service-oriented, innovation-led, consumption-based growth model have been central government policies going back eight years.  [Link – subscription may be required]

May be, just may be, this time, they are serious and might implement them. Even if only some get done, depending on which ‘some’ they are, China might make some good progress in its transition to the next phase of economic growth.

Nonetheless, one does not get the impression that the Communist Party is moving in the direction of loosening its control – of the economy, that is. One is not even murmuring about politics.

Immorality play – deciphering Krugmanomics

Good friend Srinivas Varadarajan of Mount Nathan Capital Management sent me the links to Larry Summers’ speech at the IMF Economic Forum on November 8 and two Krugman articles – one written before Summers’ speech and one after. I could not read the articles because I had exhausted my quota of ten free articles in New York Times for November. My friend kindly sent me the text of the articles. I read the Krugman articles and have not listened to the speech. At least not yet.

A quick summary of his articles is this:

Krugman would like to assign the task of containing bubbles in asset prices to regulatory policies and that monetary policy should focus on full employment and price stability. The implicit objection, perhaps, is that monetary policy is too blunt a tool to contain asset price bubbles. It is a different story that the Federal Reserve has neither used its regulatory powers nor monetary policy levers ever to contain bubbles.

As is normal for Krguman, he sets up a strawman to knock it down. He engages in polemics and not well-reasoned arguments. Here is a sample:

There are many economic commentators who take rising leverage, asset bubbles and all that as prima facie evidence that monetary policy was too loose; some argue that the Fed kept rates too low for too long after the 2001 recession, some argue that interest rates were too low over the whole period from 1985 to 2007.

The trouble with this line of argument is that if monetary policy is assigned the task of discouraging people from excessive borrowing, it can’t pursue full employment and price stability, which are also worthy goals (as well as being the Fed’s legally binding mandate). Specifically, since the US economy shows no signs of having been overheated on average from 1985 to 2007, the argument that the Fed should nonetheless have set higher rates is an argument that the Fed should have kept the real economy persistently depressed, and unemployment persistently high – and also run the risk of deflation – in order to keep borrowers and lenders from making bad decisions. That’s quite a demand. [Link]

The problem with this line of argument (aren’t we getting tired of repudiating this obvious non-sense?) is that it is not black or white. The Fed not only did not do anything to contain bubbles forming; it actively encouraged the formation of asset bubbles because it believed (and still does believe) in the transmission from asset prices to the real economy.

Second, by not curbing bubbles, did the Federal Reserve really help the cause of stable and full employment?

He argues for a negative real rate of interest and this is his proposed route to getting there:

One way to get there would be to reconstruct our whole monetary system – say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom – whether it’s a bubble or driven by expansionary fiscal policy – to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations. [Link]

The problem with this line of argument – about creating inflation – is that they do not know what they will get. There is no roadmap; there is no precedence. There is full scope for the law of unintended consequences. Hubristic Krguman should become a more humble Krugman. That might not restore economic growth to America but at least restore sanity to policy debates.

One key point that Krugman writes in his piece is this:

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’s answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest. And this hasn’t just been true since the 2008 financial crisis; it has arguably been true, although perhaps with increasing severity, since the 1980s. [Link]

Unintentionally, Krugman might have stumbled on to something here. The world economy ran out of organic forces of growth by the time it entered the 1980s and since then has sustained itself on debt and debt-fuelled bubbles in different parts of the world with increasingly inequitable consequences. What the world experienced in the twentieth century second half was an aberration and not the norm. It was not seen in the first nineteen centuries and hence it is a mistake to presume that such economic growth  – seen at best for half a century if not less – is the world’s birthright.

Even if the source of growth shifted to the East, it would not be feasible to achieve what the West did because that growth model is resource intensive (and that is not just about crude oil) and hence unsustainable when bigger and populous countries embrace it. By its sheer nature, it is prone to result in military conflicts too.

Of course, there is another reason why the West would be unwilling to support economic growth in the East – even if the resource intensive model were sustainable – and that is the loss of geopolitical dominance that comes along with loss of economic growth.

What is the answer? There are no easy answers. Unlike PK and LS, one should not pretend to have answers. Acceptance of lower growth is the answer at least until some technology (resource) frontiers are crossed and growth can resume sustainably.

In an article on slowing global trade, FT cites Paul Krugman stating the reasons for global trade slowdown:

Yes, the relationship between trade and GDP was changing as many of the factors that had driven globalisation over the past three decades were “receding in the rear-view mirror”, he said. But that was not necessarily cause for angst. “Ever-growing trade relative to GDP isn’t a natural law, it’s just something that happened to result from the policies and technologies of the past few generations,” he wrote. [Link]

It is a pity that Krugman is unable to link what he wrote about the factors driving globalisation receding into the rear-view mirror with economic growth itself.

Further, it is the ultimate irony that Krugman should write this:

OK, this is still mostly standard, although a lot of people hate, just hate, this kind of logic – they want economics to be a morality play, and they don’t care how many people have to suffer in the process.

It is the policy of stimulus that appears to be an immoral play, as it benefits the rich and the Wall Street at the expense of Main Street, pensioners and old people who live on savings without, at the same time, giving any hope or jobs to the young.

Krugman should listen to the interview that Stanley Druckenmiller gave CNBC on the day the Federal Reserve chose not to taper in September. He should read Andrew Huszar’s article, ‘Confessions of a quantitative easer’.

Krugman concludes his article referring to the final remarks of Larry Summers in his speech. BTW, by the time I finished this blog post, I had finished listening to Larry Summers’ speech. You can find it here.

LS concludes his speech by saying that we should be concerned about a policy agenda that has monetary policy doing doing less with monetary policy than was done before and doing less with fiscal policy than was done before and taking steps whose purpose is to cause to be less lending and borrowing (and less?) inflated asset prices.

Well, I am not quite sure what policy alternative that LS would approve of and one that has no unpleasant, long-lasting and inequitable side-effects. At the very least, those who propose such never-ending stimulus should ring-fence their policies and the macro-economy from financial market speculation.

Capital controls should be back on the agenda. Short-term capital gains should be brought back and pegged at 30% for gains realised within twelve months and the rate of tax should taper to 0.0% only for gains realised after five years. Financial Transaction Tax should be introduced and so should super-normal profits tax. All these revenues should be used to support the bottom of the pyramid that their stimulus policies would not end up supporting in any case.

These modern Keynesians should remember that the original Keynes favoured capital controls as he batted for maximum policy autonomy.

If they do not supplement their stimulus measures – allegedly aimed at full employment – with anti-speculation measures, then they are really batting for the rich and the elite (because they are the only ones who benefit from asset bubbles) and that is an immorality play.

Money matters

I have been a bit sluggish in posting here. One goes through these spells every now and then. No matter what we write, stocks keep going higher every day without fail. Either one feels stupid or powerless or, I guess, it is a bit of both. No amount of analysis, history and potential risks matter. The only thing that matters is free money. Financial markets have been getting plenty of it.

Five years after the crisis, central banks are still cutting rates. The European Central Bank cut rates on November 7. Apparently, it was hotly discussed in the policy meeting and that members of the Monetary Policy Committee from the Bundesbank dissented. Draghi had to use his casting vote.

There is plenty of reassurance – strenuous ones – in the speeches of the current Fed chairman and the chairwoman-to-be on how long they can keep interest rates low.

From the chairman on 19 November 2013:

In particular, even after unemployment drops below 6-1/2 percent, and so long as inflation remains well behaved, the Committee can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.

To the extent that this third factor–a perceived reduction in the Fed’s commitment to meeting its objectives–contributed to the increase in yields, it was neither welcome nor warranted, in the judgment of the FOMC.

When, ultimately, asset purchases do slow, it will likely be because the economy has progressed sufficiently for the Committee to rely more heavily on its rate policies, the associated forward guidance, and its substantial continued holdings of securities to maintain progress toward maximum employment and to achieve price stability.

In particular, the target for the federal funds rate is likely to remain near zero for a considerable time after the asset purchases end, perhaps well after the unemployment threshold is crossed and at least until the preponderance of the data supports the beginning of the removal of policy accommodation.

Five days before him, the Vice-Chairman (Ms. Janet Yellen) spoke at her confirmation hearing in front of the Senate Banking Committee:

We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve’s goal of 2 percent and is expected to continue to do so for some time.

For these reasons, the Federal Reserve is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation and reliance on unconventional policy tools such as asset purchases. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy.

Neither of them, for all their commitment to transparency, addressed the question of why they feel compelled to continue with these policies fully five years after the crisis occurred. Hence, follow-up questions hardly came up:

Could it be that monetary policy is not the answer and, worse, could monetary policy be creating more problems, even as it is not solving existing problems?

Nor did they, in the interests of transparency, choose to address the issues raised by Andrew Huszar. He was a former Fed Staffer who oversaw the implementation of Quantitative Easing (asset purchases by the Federal Reserve). Of all platforms, he wrote in the Wall Street Journal that the quantitative easing programme had been a feast for Wall Street:

Even when acknowledging QE’s shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces). The implication is that the Fed is dutifully compensating for the rest of Washington’s dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street’s new “too big to fail” policy. [Link]

Kevin Warsh, a former member of the FOMC, politely called Quantitative Easing (QE) an untested and incomplete policy experiment. He said that long periods of free money do not augur well for long-term growth or financial stability.He goes on to discuss the winners and losers that the Fed policy creates, international consequences of its policy and the obligations the Federal Reserve carries as the issuer of international reserve currency, etc.

The blog Cyniconomics has an interesting re-interpretation of Kevin Warsh’ polite article. Well worth a read. It is really not for laughs, though.

Another polite article (perhaps, too polite) is that of Mohamed El-Erian who just cautions that investors should opt for greater portfolio differentiation and that Wall Street should not deviate too much from the Main Street. More forthright comments from him might not have really been heard, anyway.

Today, FT reported that the Bank of England might not raise interest rates as soon as the 7% unemployment rate was reached. What a surprise?!

Hence, what Yours Truly wrote in MINT two weeks ago is a message that likely fell on deaf ears – both that of policymakers and that of investors.

Malaysia budget

It has been a while I posted. Was busy with a country report on Singapore that I had to write for Dr. Jim Walker’s Asianomics. Completed it. Learnt a lot about Singapore in these three weeks, as much as I had learnt, perhaps, in my fourteen years of living here. I do not think that this record is something to be proud of.

While engaged in that talk, had to write a comment on the Malaysian budget for another client. The budget document was simple. The first two pages were dedicated to the praise of the Lord. Did not know that the country wanted to become a developed nation by 2020 with a per capita GDP of USD15,000.00. It was fascinating to get a pee into the politics behind subsidies reduction in that country. It is the same in most developed countries. The Malaysian Prime Minister invoked diabetes to remove subsidies on sugar. He is bringing in a Goods and Services Tax from April 2015. Before he could do so, he gave away a lot of income  tax reliefs. One got the impression that there was serious intent on fiscal consolidation without follow-through in action. Must be familiar to readers in several countries.

The higher capital gains tax on foreigners speculating in Malaysian property was a rare case of fiscal populism and prudence combined.

The good thing about the document was that it was easy to read. It was not lengthy. It stated the growth assumptions upfront. There are still some things that MoF in India can learn from this budget document, even if serious and sincere fiscal consolidation cannot be one of them.

You can find some interesting articles (pre-budget) here, here and here. The budget document is here.