Friday, July 12, 2013

More evidence that China's rise is not inevitable

Some time ago, I wrote a post about three China predictions, in which I argued that China was likely to become the worlds largest economy due to some basic factors in its economy: it was growing in real terms, it had positive inflation and had a nearly fixed exchange rate to the dollar.  This means that in dollar terms the inflation China experiences counts toward its economy's size (unless you measure in PPP).

I also suggested that longer term, China would be surpassed, not only by India, but also again by the United States, which simply has better fundamentals.

Recently, there has been mounting evidence that China's rapid boom is coming to an end.  Today I saw this, which shows that the evidence is now so compelling that it is turning even the general media's narrative.  In the short term, China will likely take the steps necessary to keep the economy growing at a 5-6% rate.  Premier Li has already indicated that 8% is no longer the target (and with a declining workforce, is most likely unattainable).

These are growth rates to which India can aspire (it needs to make some structural changes in its economy).  Indeed, India has at times exceeded these levels and could do so again.

Meanwhile, the US can keep chugging along at 2-3% and remain larger than China on PPP terms for a very long time.

Good news for China, however, is that the absorbtion of cheap labor means it can focus more on quality of the labor, and on quality of life, as it moves up the income scale.  Bad news is, most countries fail when they get caught in the middle income trap of too many skills (and too high prices) for cheap work, but not enough skill for higher wages.

We shall see, but I believe that if you work or invest in businesses / industries that rely heavily on Chinese growth to function as an escape valve (or as the primary driver of growth), you have to be very concerned that many of the capital investments undertaken to capture Chinese market growth may be written off.  The risks are rising that this will happen.

The Federal Deficit: The REAL Reason the Fed will Taper

In the media, there has been much knashing of teeth over the scaling back of QE3.  Supposedly, the move to reduce purchases of US Treasury securities will lead to higher interest rates and from there to recession and then armageddon.  It is a delightfully linear thesis, which means it plays well in the media.  Ironically, much of the moaning comes from the same people who moaned about the introduction of QE to begin with (distorting the markets, perverting risk/reward, and eliminating price signals for investors).  So, QE is terrible, but withdrawal is worse.  One wonders what the addict is to do.

The Fed has maintained all along that factors in the economy overall would be dispositive, and highlighted unemployment (as part of the "dual mandate") as the main driver.  While labor markets have been improving (creating over 200,000 jobs per month for the past year and showing more strength this summer), there is another factor that is surely starting to come into focus: a dwindling supply of newly issued Treasury paper to buy.

A year ago, when the Fed started buying $45bn a month in Treasury securities, the Federal government was running a deficit of almost $100bn a month.  Thus, the Fed was buying about half of all newly minted securities, leaving the public (and foreign central banks) to buy the rest.

Due to several positive factors released in the monthly Treasury statement yesterday, including rising employment, higher corporate profits, higher rates of tax on incomes and the end of the payroll tax holiday driving higher revenues, and the sequester and the military drawdown leading to lower spending, the deficit is shrinking rapidly.  If CBO is right, the deficit will be about $640bn in FY2013, or $500bn less than the previous year.  (The same teeth knashers are suggesting that the economy is suffering from the withdrawal, though this doesn't seem to be true.  Makes you wonder how important all that "stimulus" really is.  I digress).

Were the Fed to keep purchasing at the same rates as before, it would purchase effectively 100% of new issuance, leaving no bonds for pension funds, and others looking to match assets with long term liabilities.

Indeed, to maintain this pace, the Fed would very soon have no choice but to purchase off-the-run bonds from prior periods of issuance.

This is why the Fed has moved off of the 6.5% unemployment figure that was its target for tapering before.  Mind you, reducing its purchases by half, to maintain its share of overall absorbtion of new Treasury issues will still leave a much smaller pool of assets for private parties.  In fact, if private demand reflects the $50bn or so the Fed was not buying each month in the fall of 2012, then the Fed would have to cut to zero just to maintain a large enough supply to feed the private market.

This is also why this is a great time for the Fed to "exit" or "taper" purchases.  Supply is more in line with private demand.  If the Federal government can manage a second and third round of sequester controls, along with some modest tax reform, the budget could realistically be in balance in FY2016.

Even if the deficit remains in the $200bn range, the Fed will have the option to sell some of its off-the-run bonds into the market to meet the demand of investors for bonds.  (With a balanced budget, the effective buyer could be the Federal government which could redeem the bonds at par).  All of which means that Bernanke might have been right all along.  There may be some capital losses associated with this.  But done moderately, the incredible interest generated by the portfolio will help to offset this.

Now, on the mortgage market side, things might be somewhat different.  However, again, as natural supply of Federal debt securities decline, investors looking for long term income will need to migrate to other asset classes with the most similar risk/reward characteristics: e.g. mortgage securities.

It will be fun to watch the knashers complain about how QE didn't really work, it just "got lucky" as policy was enacted as the economy was taking off on its own.