Tuesday 25 March 2014

Russian Sanctions: Until China is onboard what's the point?

Just killing some time on a layover in Seattle (enroute to the Philippines for some vacation time) and this article on Bloomberg caught my eye.

It brings up a point that needs to be reconciled in order to effectively sanction Russia. Namely, the Chinese response.

The article makes a few key points that don't appear to be fully considered in the wider discussion.

Regarding the push to authorize export crude oil from the US in order to put pressure on Putin:
The U.S., even after the shale boom, must import 40 percent of its crude oil, 10.6 million barrels a day that leaves the country vulnerable to global markets.
Regarding China's past flurry of oil deals with Russia:
China already has agreed to buy more than $350 billion of Russian crude in coming years from the government of President Vladimir Putin. The ties are likely to deepen as the U.S. and Europe levy sanctions against Russia as punishment for the invasion of Ukraine.
Quoting Nicholas Redman from IISS:
“For Russia, there was an idea that Europe was something close by and it worked and it was desirable to emulate,” Redman said. “Over the years, on multiple fronts the attractions of the European model fell. It’s almost a civilizational choice the Russians have made to turn away from Europe, to stress their Eurasian rather than their European identity.”
So the obvious points: What oil is the US going to export (ie. why would Putin concern himself with the exports of the largest (more or less) importer int he world)? How steep of a discount would Putin have to entice a significant Asian demand shift? Would China risk their current rash of deals (and future supply) to enforce western sanctions? Can Putin sell the politics of a short term price discount for export diversity in the long run?

To me these questions seem to put Putin back in the driver seat. I always considered Germany and China as the two key participants to give sanctions any chance. While it seems like Merkel and the Germans are at least vocally supportive (I'm skeptical on their willingness to actually go through with them) the Chinese are noticeably staying out of this.

Another element to consider is if the west proceeds with sanctions against Russia with the knowledge that China will not back them, how this impacts future sanction participation by China and similarly developing countries.

I assume Iran is watching this round of sanction talk closely. If China balks here, will India participate in the next round of Iranian sanctions should they renege on whatever nuclear agreement gets put fourth? You have to assume the liklihood is significantly reduced. Of course if India balks on those sanctions, what do you think the reaction from China will be?

I might be looking at that all wrong. And perhaps all of this is getting hashed out behind closed doors. But significant economic sanctions still seem like a bluff to me.

That being said, Putin putting boots on the ground and actually occupying Crimea throughout this ordeal was also a surprise. So what the hell do I know?

Friday 21 March 2014

Chinese Reforms Update

Life has kept me away from the blog here but what a few weeks it's been.

China's Rorschach Reforms

Announcement after announcement, data point after data point, all providing 'evidence' for arguments as diametrically opposed as reform success to a hard landing (and everything in between).

Here are a few of the highlights:

Broadening the Yuan trading bound: The People's Bank of China (PBoC) has always set the rate at which Yuan can be exchanged for USD.  Until 2005 they maintained a hard peg (the rate is x and only x). Accepting a trading band of +/- 0.3% doesn't sound like a huge move but that 2005 action allowed some flexibility for the market to at least indicate the desired rate direction. 2007 brought the band to 0.5% and 2012 to 1%. Also, during this period, the Chinese currency appreciated significantly (graph below). The announcement this March was a doubling of the bound to 2%.

You can see that the Yuan/USD has largely been a one sided trade, meaning that the market almost by consensus believed that the Yuan was undervalued at 2005. 2014 and the 2% band marked an interesting occurrence, the markets pushed the Yuan value lower.

Directions aside, the liberalization of the Yuan is a key piece of the re-balancing reform we've heard so much about. While the appreciation since 2005 has eaten into the financial repression that has aided domestic producers to sell their excess production or domestic investment abroad (a below equilibrium exchange rate would result higher then socially optimal production levels). The undervalued Yuan also ate into domestic consumers purchasing power.

Notice that this imbalance encourages over investment and under consumption. Key items that the re-balance need to address. With the recent depreciation, the market is suggesting that perhaps the government won't get a free re-balancing lift from exchange rate liberalization but having the market find the right level will encourage help ensure that external balances don't encourage internal imbalances. This alone makes is encouraging.

Bankruptcies: With over investment embedded in the Chinese economy (via financial repression) it's quite reasonable to expect that the re-balance reform will render firms on the frontier of economic viability, insolvent. So for me, perhaps the most interesting reform development to watch will be how the Chinese economy handles unwinding these firms. Or put another way, how does Chinese internalize all of the uneconomic investment.

That Li Keqiang understands that bankruptcies are inevitable, and recognizes the magnitude of the problem is encouraging. However, the scale of this problem is yet to be revealed. Because of China's very low level of capital stock at the beginning of this growth phase it seems logical that despite the presence of financial repression high investment levels of investment, despite being sub-optimal in the current period were easily internalized and became economic with growth. However, at some point the marginal returns of this over-investment tipped into the uneconomic territory.

When did this happen? Has this happened? In which industries has it occurred? In which industries will it occur in the future?  These are the billion Yuan questions that reforms should answer for us. They are also the questions that will impact the effectiveness of reforms, and determine how the reforms should evolve going forward.

Capital Market Liberalization: China has unveiled a pilot program that should facilitate the issuance of preferred shares by certain market segments. From Reuters:
Analysts have widely predicted the first preferred shares to be included in the trial will be shares in Chinese banks. Sources told Reuters last week that major state-owned banks, which are among China's biggest index heavyweights, have already prepared share tenders. 
The second group of listed firms include those which intend to acquire or absorb their counterparts by issuing preferred shares, while the third group covers those which aim to use preferred shares to replace existing ordinary shares, the CSRC said in the statement published on its microblog.
Again, pushing market influence. Again, stopping well short of 'ideal' (which gives the critics ample room to wonder: why not extend this to x industry? why not offer x channels to debt?) but a clear first step in the direction indicated by the Chinese government in their reform outlines and a move consistent with the consumption/investment re-balance plot line.

The market allocation of resources, in my opinion, is by definition socially optimal in the vast majority of cases (particularly in determining consumption and investment habits). Thus, to my eye, this is by definition a step in the right direction (I accept that there is plenty of room for disagreement on this point). Increasing the market's influence on what is deemed a good investment, and what is 'over-investment' is a positive. That this reform seems to be incentivizing consolidation is a bit troubling. But, if this helps internalize the over-investment described above, then it might still be net positive.

Perhaps the more important benefit is that this is a positive step towards giving households access to a wider range of investment opportunities. I'm having a hell of a time finding data on the composition of household savings but this article from the Epoch Times cites a PBoC report, "Surveys conducted by The People’s Bank of China show that Chinese residents prefer saving their money in banks rather than investing in stocks, bonds, and real estate." I'd really love to read through this report but I'm having a hell of a time finding it or any more information on how households are allocating their savings.

If this is correct, and it does line up anecdotaly with the little bit of knowledge I have on the subject. But Chinese households are largely under invested in the stock market and as liberalization allows increasing numbers of companies to tap into debt markets, and an increasing number of financial institutes are able to fund these companies, and as an increasing number of products are offered to households to give them exposure to this type of equity, then I think they'll you'll see a serious shift to equities.

How far away is that? Again with the billion Yuan questions, but this does appear to be consistent with that direction.

Thursday 6 March 2014

Poll shows most Albertans favour renewable energy over coal... so what?

I love stories like this one from the Edmonton Journal:

A shocking result, people would rather have renewable energy produce their energy then coal. SHOCKING! I wish they'd link to the questions asked when stories rely on surveys. Of course, with framing effects and what not you can skew results in whichever direction you want. Then maybe authors would no the worthwhile surveys to report on and the worthless surveys to ignore.

For example how was the price point question asked?:
Commissioned by the Canadian Association of Physicians for the Environment, the poll also found that two-thirds of Albertans are willing to pay higher prices for electricity generated by wind and solar power, and that a majority are convinced there are negative health effects related to burning coal. 
For example, had the previous question been:  Burning coal has been found to contribute to four of the five leading causes of mortality in Alberta: Heart disease, cancer, stroke, and chronic lower respiratory diseases. Are you concerned by the negative health effects related to burning coal?

Then followed by: Would you be willing to pay a slightly higher price for your energy if it were to come from renewable non-polluting sources?

We don't know if that was the case, but you get the point.

But that all isn't even what makes me laugh.

Of course everyone wants renewable energy. It just isn't economically feasible YET. It will be someday. But it's not there yet. Even if you favor more government support, you'd probably want to support a carbon tax that would make non-renewables less economically competitive.

These are nuanced question topics that require aren't black and white. I don't find survey's like this provide any useful information. The more detail or prior knowledge you need to answer a question, the least likely the results of a survey based on these questions becomes.

'We should stop consuming fossil fuels' that's a legitimate position, but in and of itself it doesn't offer any value because it doesn't indicate how. To do so would require a) a plan to replace fossil fuels in our daily lives, or b) a plan that people will actually follow to change our daily life so we don't require fossil fuels.

At the end of the day my guess is that solar will be all that we need in 15-20 years time. I'm guessing some tinkerer (I'm hoping it's from some poor country) finds a breakthrough on energy storage that enables all renewables to breakthrough. Everything will probably scale up at first depending on when this break through happens. I remember reading Ray Kurzweil's The Singularity Is Near and bought into his reasoning on this.

As we nano-size processes the process most likely to utilize this trend is likely to be solar. Every time the sun is out our houses covered in solar power generating paint will be feeding into our smart grid that stores enough power for those cloudy days when our cars with solar power generating bodies run to our office buildings constructed from high efficiency solar power generating materials.

If someone called me asking if I'd prefer living in that world to one powered by non-renewables, I'd be inclined to say YES!... But so what?

China: Reform Progres

President Xi Jinping, centre, and Premier Li Keqiang arrive for the National People’s Congress opening session
Photo Credit: Associated Press
This post is motivated by Li Keqiang's recent speech, some recent Chinese Monetary Policy adventures, and a book I read last night: Avoiding the Fall: China's Economic Restructuring by Michael Pettis.

The theme here is restructuring. China needs to promote balanced growth. China needs to increase consumption. China needs to stop relying on debt fueld investment. We've all heard the headlines. 2014 should give us a good indicator of both the willingness to reform and the direction that policy makers will take it.

Premier Li and his forward guidance.

Two key numbers: Li identified targets of GDP growth at 7.5% and household consumption growth at 14.5% (China overshot GDP by .2% and undershot on HCG by 1.4% in 2013).

Following these statements Li reiterated the government's support for Investment, even stating (from this FT article), "We will take investment as the key to maintaining stable economic growth".

Interpretation of an interpretation is always a bit, well, of questionable value. But it'll be curious to see whether they will set a key target (aimed to reduce investment share) or if they will use it as an active discretionary fiscal policy tool to aid in the re-balance (which could easily be counterproductive).

If they actively target a path towards balancing the consumption/investment shares of GDP then this will, almost by definition reduce GDP growth significantly (via falling investment growth, perhaps even to negative growth). This is why the 7.5% target described earlier is a bit puzzling. Not too sure how you can have both.

Which turns me to Pettis's Avoiding the Fall.

The basic thesis of Pettis's book is that GDP growth MUST fall. The mechanism by which it will fall is not determined, nor is the timing of the fall. However, the debt servicing capacity will be reached at some point in the not so distant future (Pettis suggests as early as two or three years from now) in which case a hard landing will be forced on China.

Conceptually, framing this with an accounting identity is probably the easiest. So we have a basic GDP equation

GDP = Consumption + Investment + Government + Current Account

Alright, so remember:

- In a close economy Investment = Savings. But of course we aren't in a closed economy.
- If Investment exceeds Savings then that balance shows up as a Current Account surplus (or vice versa) which is simply the net exports. (ie. GDP that isn't consumed domestically but is consumed in foreign markets).

Now, a couple of items unique to China according to World Bank Data:

- Savings (Investment) increased from an already high 37% of GDP to 51% from 2000 to 2012
- Household Final Consumption dropped from an already low 47% of GDP to 35% from 2000 to 2012
- By comparison world averages were 22% and 60% respectively in 2012.

So the rebalance math is simple: Consumption growth > GDP growth > Investment Growth

So the trillion RMB question is how you get a relatively high GDP growth rate out of an economy that has manufactured it's growth via an expanding investment share of GDP. And this is a question that get's infinitely more complex when that investment portion is fueled by debt. Which is a key component of Pettis's argument.

A sense of urgency?

The main reason that the status quo can't last economically is Pettis's assumption that Chinese investment has at some level been misallocated, and is likely increasingly so. Pettis broadly describes misallocated investment as investment who's impact on GDP exceeds the economic wealth generated by it. This follows logically from his discussion on financial repression which I fully agree with.

Financial repression describes the subsidization of one sector at the expense of another. In this case, the simplistic description is that Chinese savers are given very low return on their assets (and few other avenues to preserve wealth) in order to provide very low rate loans to borrowers. These borrowers, with their below market debt can invest in projects that at the margin would not be economic. The longer this set up exists, the argument goes, the greater the number of uneconomic projects being undertaken.

Financial repression isn't necessarily all bad though. When a country has a very low existing capital stock the funneling of funds towards it's growth does not necessarily lead to economic missalocation (the China Development Bank story here shows the value). Countries like Japan and South Korea have utilized this method of development effectively in the past and have found themselves in the rarefied class of countries that blasted through the middle income trap.

While I might disagree, or at the very least remain agnostic, about the scale of misallocated investment I don't for a second doubt significant capital has in fact been misallocated. The Chinese government must implicitly accept this notion as well, or re-balancing would not then be required (if the economic worth of investment met or exceeded the capital outlay, then the project would be a good investment).

My divergence from Pettis's view is along the lines of timescale and urgency. I don't quite have my head around why dead limit capacity would form such a cliff. I agree that uneconomic acivities will have to be recognized at some point. I also agree that a slowdown in economic growth is inevitable. But a hard landing? I'm not convinced.

In order to avoid a hard landing, China needs to focus on two key items: recognizing and unwinding the loss generating debt and increasing the consumption share of GDP.

Chinese Loan Growth:

In January China's loan growth was shown to be the largest since the stimulus spending of 2009. What did this mean? Was it one of the many annual abberations caused by the Lunar New Year? Was it a bullish signal that the supply side is ramping back up? Was it another hail mary thrown onto the increasing mountain of debt that we hear is fueling China's growth?

February's numbers indicate another huge growth in loans. More of the same? Oliver Barron's article on Forbes illustrates the contradictory nature of some of the data:
Many of the data points released over the last two months have signaled a domestic slowdown, including the January manufacturing PMI reading at a six-month low of 50.5 and the February HSBC Flash PMI reading of 48.3, a seven-month low (a reading below 50 signals contraction). However, this data was somewhat puzzling as it contrasted with a 10% yoy growth in exports in January and a 23% yoy rise in new yuan loans, both of which suggest a relatively well-off economy.
His interpretation of these incredible loan volumes is something much simpler. And a strong indication that China's reform policy is pushing forward, while offering another indicator pointing towards a general slowdown:
As it is now emerging that the strength of bank loans can be partly attributed to off-balance sheet loans coming back on balance sheet, then the actual demand was actually much weaker than the headline figures suggest and the slowdown is confirmed.
IF this is the shadow banking system being rolled onto the balance sheet of Banks that is a solid first step towards the proper recognition of their magnitude, and also an indicator of how potential losses will be dealt with.

In the late 90's in the wake of the Asian financial crisis China addressed high levels of non-performing loans at the four state owned commercial banks by effectively transferring them out into state backed asset management companies. Is something like this possible now? It's hard to say but if we can get those assets out of the shadow banking sector and back onto the big banks balance sheets we'd at least know the scale of the problem.

 Interest Rate Liberalization:

Interest rate liberalization is typically a key to unwinding financial repression. Those incredibly high household savings rates now increase household income and capital is allocated more conservatively which reduces investment going forward.

Bloomberg reports on the progress here:
The People’s Bank of China moved toward freeing up interest rates in July by removing a floor on the rates banks can charge for loans. Three months later, the central bank started a “loan prime rate” based on weighted average costs charged to the best clients by nine major Chinese lenders and in December, it allowed banks to sell negotiable certificate of deposits with yields set by the market.
This, in conjunction with the deposit insurance indicated in the article, as well as the forward guidance on pushing for market determined interest rates should go along way to clear up current imbalances.

Hopefully, deregulation will also allow the entrance of other formal banks to cater to the many business, as described in this BBC article that are paying exorbitant rates:
Zhou Feng, the 30-year-old boss, told me that without the high-interest loans from shadow banks he couldn't take on large orders. He usually pays 24-30% for these loans, which in his case are usually for just three to five days, and give him much-needed cash.


The reason for my optimism on China is twofold.

The first, and most important, reason is that there is alot of low hanging fruit. I've stressed on this blog previously the need to disentangle the aggregate macro picture from the more nuanced micro environment. The main reason that China has been able to produce the spectacular growth numbers that they have is quite simply that they started from such a small base.

The second, and almost equally as important, is that for whatever reason. The Chinese government has done an excellent job at choosing policy through this period. Was every choice the right choice? I wouldn't think so no. But this growth story could have gone off the rails at any number of times where the 'experts' would have acted incredulously that anyone had thought this wouldn't be the case.

I was only 12 when the '97 Asian financial crisis hit, but I can only imagine that a similar line of reasoning to Pettis's could have been made. Obviously, the continuation, or even acceleration of these policies have likely compounded the problem, but still.

Or imagine asking yourself in 2006 what would happen to China's export economy if the entire developed world had a complete financial meltdown and fell into an economic recovery that bordered, and continues to border on stagnation.

No, I'm going to need to see something materially change (for example a walk back on the plenum reforms), my benefit of the doubt goes to the Chinese government.

Wednesday 5 March 2014

Ukraine: Likelihood of Effective Russian Sanctions

Gallery Russia Ukraine gas row: Russian Gas Supplies Through Ukraine Turned Off
Photograph: Sean Gallup/Getty Images
I'll go ahead an predict that we'll see a deescalation militarily in Ukraine in an empty rhetoric filled new cycle about the 'strength' and/or 'weakness' of various countries and various presidents.