Sunday 30 November 2014

Chinese Malinvestment

Former White Elephant Investment: Pudong 1990 vs. 2010

We're in the midst of another round of Chinese 'Ghost City' malinvestment chatter in the news. Most recently, it was a report out of China citing an eye catching $6.8 trillion figure as the amount squandered.

The paper came from a couple of Chinese academics (Xu Ce and Wang Yuan) at the National Development and Reform Commission. As usual, I couldn't find the source material so I'll run through a couple of summary pieces in our media.

Here's  Jamil Anderlini at FT:
“Ghost cities” lined with empty apartment blocks, abandoned highways and mothballed steel mills sprawl across China’s landscape – the outcome of government stimulus measures and hyperactive construction that have generated $6.8tn in wasted investment since 2009, according to a report by government researchers...
Misallocation of capital and poor investment decisions are not the only explanation for the enormous waste in China’s economy. A significant portion of China’s post-crisis stimulus binge was simply stolen by Communist Party officials with direct responsibility for boosting growth through investment, according to separate estimates by Chinese and overseas economists. 
From Mike Bird at Business Insider:
The Chinese economy has wasted $6.8 trillion (£4.3 trillion) in investment during the last four years...
Even in the enormous Chinese economy, that's practically half of the investment between 2009 and 2013, the period covered by the investigation. This is likely to have pretty grim effects on Chinese economic growth in the years ahead.
This is sort of one of those sniff test statements. Does it really seem plausible? Recall this study that made the rounds a year or so back. The media typically summarized a summary of the study that they didn't bother to, or couldn't understand the nuances of; and drove conclusions far beyond the scope of the paper (which to my eye had already stretched their conclusions a bit given their own numbers).

In that paper, the authors make a claim (based on some weak assumptions) that 5.5 years of life were being lost, to Chinese living in the northern parts of the country, due to air pollution.

Again, an eye catching number. It seemed to fit the dominant China narrative. But the sniff test should have been, if you add 5.5 years to the life expectancy of northern Chinese how old would they then live? Beijingers would be living to 87+ years if they had the same air pollution levels as southern Chinese. Again, does that make sense? Of course not. Unless you're comfortable with the assertion that besides air pollution China does better at maximizes life expectancy then pretty much everywhere else in the world (in 2012 Japan's overall life expectancy was 1st in the world at 84.6 years).

So with this huge malinvestment number, the questions should be: what data were they using? and compared to what? And do two factors combine to produce the type of clear conclusions being drawn in the media?

The economist picks this apart pretty well here:
So how exactly do Mr Xu and Ms Wang arrive at their numbers? Their method is to compare China’s capital efficiency in the 1980s and 1990s with the past decade; they treat any decline in efficiency as evidence of wasted investment.
So, at a glance we can see that this is a fairly dubious way to seek the conclusions we're reading in the popular media. It's not to say that this study isn't useful. Measuring the diminishing returns to capital, or even parsing apart the theoretical divide between malinvestment and the more secular diminishing returns to capital you'd expect, would be incredibly useful. However, using the number derived from this method as a measure of malinvestment seems beyond an overreach.

At which point I notice that Paul Krugman has addressed this on his blog, better than I was going to.
What the paper does is look at the ratio of capital added to economic growth — the so-called incremental capital output ratio. It finds that the ICOR has been lower in recent years than it was in the past, and attributes all of the shortfall to waste. 
But what if there were no waste at all? What if China were simply engaged in capital deepening? What would we expect to see in that case? The answer is, exactly what we do see. The ICOR data say nothing at all about waste.
So again, this paper is looking at the capital efficiency in a more esoteric sense. The news papers a more literal sense. Playing on the ghost city, communist country narrative is all to easy. Which isn't to say that all investment is done 'efficiently'. Surely it is not. But the Chinese know that, and have been methodically going about remedying that over the past year.

Once again, I think Xi and the Communist Part of China have earned the benefit of the doubt on managing this process.

Thinking About OPEC's Meeting

 Photo: Via. Google Search

OPEC's meeting concluded with a resounding shrug of the shoulders. At the end of the day it was the Saudi's decision. I had suspicions that they'd communicate price support at some level; but in hindsight why would they? At the end of the day, I can't think of any particular self interested reason for them to do so.

The interesting thing about this meeting, and given the complexity of modern finance, I was curious to see how price would react to OPEC's (the Saudi's?) communication; and specifically so. Forward guidance, is pretty well understood to be the dominant tool of central banks.

When credibly made the bulk of a centrals banks adjustment is done by markets inline with their expectations. So, if a central bank continuously targets 2% inflation and continuously undershoots it. The market prices in the undershoot. If a central bank announces the injection of funds on a short term basis, the markets price this in and money neutrally basically holds.

Would the Saudi's be able to achieve price support, simply by communicating a target? Would the world believe them?

We certainly saw markets react to OPEC's shoulder shrug, WTI quickly shot from $74 USD down to about $66, similarly Brent plummeted from about $73 to $70.  And I suppose we'll never really know if it's reaction would have been symmetrical (asymmetrically interesting to me).

Why would the Saudi's enable OPEC?

Had the production cuts been proportionately felt across OPEC members, it might make sense. If Russia had indicated that they would also be willing to curtail production in pre-meeting talks, then it might have made sense. But if the Saudi's have to bear the entire burden, why would they?

Vox's Brad Plummer outlines this point here. The key is probably in this Reuters article linked to in this article describing who would be bearing the brunt of that production decline:
With world markets awash in oil, Saudi Arabia embarked on a strategy of defending prices, which at the time were largely set by exporters rather than the nascent futures market. The kingdom slashed its own output from more than 10 million barrels per day in 1980 to less than 2.5 million bpd in 1985-86. 
Other producers failed to follow suit, however, both within the Organization of the Petroleum Exporting Countries and among new petroleum powers such as Britain and Norway. Prices fell into a years-long slump, leading to 16 years of Saudi budget deficits that left the country deeply in debt.
Plummer also links to this often cited look at government budgetary break even price of oil for OPEC countries. I still see this as apples to oranges.
OPEC breakeven prices
No only do I believe that the Saudi's along with the rest of the gulf states likely set budgets according to revenue more then they raise revenue according to their budget. But the ruling regime does not hold the tenuous position, politically or economically then the other major exporters (of course including Russia which is not in OPEC).

With both Russian and Mexican officials meeting with Venezuela and Saudi Arabia pre-OPEC this probably presented a crucial test of price support viability. Between Russia and the Saudi's a joint strategy, would have significant market power due to not just their high level of production (Russia at 10.5 mm/bopd and KSA at 11.6 mm/bopd) but also their relatively low consumption levels (Russia at 3.3 mm/bopd and KSA at 2.9 mm/bopd) in contrast with the USA who, despite a huge upswing in production remains a massive importer on global markets.  It's these net available exports that are the interesting barrels to me on the market place.

Russia's Part in all of This.

But it's hard to imagine Russia artificially reducing production (as opposed to some new projects becoming uneconomic at low price levels) with the sanction package biting down on the economy. This article estimates that effect of oil and sanctions at $90-100B and $40B respectively.

This could make for an interesting winter. As far as I can tell, besides an escalation of the war, Putin's only real leverage would be physically delivery (mutually destructive) and a huge stockpile of nuclear material and know how. That or Putin backs down physically and rhetorically.

Market Share... At Who's Expense?

With no price support OPEC (KSA) made a clear statement that it would let markets dictate things going forward. It was always a fractious bunch and with the only partner, with both the production levels and political leeway to do anything but maximize oil revenue (the Gulf Emeritus would have the ability, but not the gross quantities), unwilling to cut production. OPEC basically isn't.

As for the Saudi's motivation, it may be a fight for market share by way of undercutting the more expensive marginal barrels on the market. From OPEC's official release:
"world oil demand is forecast to increase during the year 2015, this will, yet again, be offset by the projected increase of 1.36 mb/d in non-OPEC supply.  The increase in oil and product stock levels in OECD countries, where days of forward cover are comfortably above the five-year average, coupled with the on-going rise in non-OECD inventories, are indications of an extremely well-supplied market."
If the Saudi's are going for market share the obvious play to target is the rapid build up in tight oil production in the US. Not only is it fairly expensive (estimates oscillate in aggregation, to say nothing of the wide variation in per well/per location costs) but it's also typified by relatively steep decline rates.

How This Might Impact The US

You have to remember that once the investment in discovery, drilling, and establishing the production infrastructure, not in maintaining existing infrastructure and production. With increasing decline rates on each well any interruption in those initial capital outlays result in a much steeper drop in oil production.

Tyler Cowen links to this article by William Watts on Marketwatch that makes an interesting point:
At the same time, analysts have also noted that for many shale producers, a large chunk of production costs - acquiring acreage, contracting wells, etc. - have already been spent. As a result, the more important figure might be "half-cycle" production costs which analysts at Citi last week pegged at between $37 to $45 a barrel"
Eric Lee who is one of the Citi analysts on the report in Platts:
a “full capex cycle” shale project might have a per barrel cost of $70/b or more, but one that is a “half cycle” project, where a lot of the costs are already sunk, could be down into the high 30’s. Overall his conclusion is that a $70 basis WTI price could slow the roughly 1-million b/d growth rate in shale by 25%. “It looks like you would need about a reduction in rigs of 40% to 50% to really flatten production growth, and to do that you’d need about $50 oil,” he said. Overall then, the impact of the price fall on US production growth will be “soft.” (Morse noted that Citi has not changed its robust projections for higher US output.) 
I couldn't find the Citi report. It would be interesting to see how they got to these numbers. But we'll have to settle with for the author's synopsis. I'd be pretty curious to see the timeframe the author is speaking of. Certainly that full capex cycle number increases in importance as time rolls.

Bottom Line

I effectively read this as OPEC being no more. If there was a deal to be made, it would have been made between Russia and the KSA. There's an alliance to watch for. Maybe not until sanctions end. Maybe if sanctions intensify. Maybe never.

The things I'll be watching beyond the price of oil: Russia/Euro sanction negotiations, Russia in the Middle East (and Iran), Chinese oil consumption.

Monday 24 November 2014

A Suprise Monetary Policy Development in China.

Chinese Monetary Policy

It's been an interesting set of events over the past week at the PBOC where a surprise monetary policy move last Friday jump started markets and was a welcomed surprise for me. With a 40 basis point cut on the one year and a rise on the deposit rate ban (the bank sets a target, currently 3% and banks are allowed to offer rates within a ban around this target) from 10% to 20% this move is a nice measured step down the liberalization path.

A New Direction for the PBOC?

Chinese monetary policy has long been exceedingly interesting and exceedingly boring. Most of the intrigue stems from it's complete lack of substance, direction, or really anything. I've been curious about when/if the role of monetary policy would expand as the ambitious transformation program takes hold in China.

We've all heard countless discussions about how there is a need to increase consumption levels relative to investment levels in order to establish a sustainable growth trajectory. Of course this is true at some level. In our western way, we typically preech doom and gloom and the coming cliff of 'whatever's around the corner'. This doesn't appear so for China (in my minority view). Yes growth is decreasing and debt levels are rising. But like the structural reform package there remains alot of low hanging fruit. Monetary policy seems to hold promise.

The economist has a good outline of the bank here:
Sudden shifts in the value of the yuan always bear the central bank’s fingerprints, but are infrequently explained. The motto for the People’s Bank of China (PBOC) should be: “If you know what we did, we must have done it wrong”.
... Yet real interest rates have climbed to more than 8% for industrial companies, since the prices at which they sell their wares are actually declining. That, in turn, makes debts much harder to service than anticipated. Cutting interest rates while enforcing capital rules to prevent banks from issuing a gusher of new loans would be a better way to rein in debt.
Reducing that real debt burden is consistent with standard monetary policy of adjusting the base in accordance to more standard aggregate goals like inflation, employment, and GDP levels. Moves have been made this year, in targeted moves, in an attempt to re-allocate funds. Sectoral specific cuts in the reserve requirement ratio to encourage lending in the agriculture and smaller sized businesses was welcome. But beyond this, the PBOC still often fell into more fiscal styled actions (like the program with the Development Bank mentioned in the Economist article above).

While China's main concern should certainly be on the structural reforms mentioned above, monetary policy can and should play a central role. With the fiscal stimulus pumps set to push the infrastructure and investment based spending that risks exasperating the current imbalance, the government needs to be wary of turning on the fiscal taps.

The danger with monetary policy is that the financial system has long been set to push funds towards the SOEs that risk compounding problems as well.

I have been curious to see when the PBOC would begin more traditional monetary policy because I believe that this will indicate the state of progress in the financial system in the CPC's eyes. This is an important step.

Central to the reform package outlined at last year's Third Plennum (previous posts, here and here) was the notion that funds need to find their way into the hands of small and mid sized firms. Consumption habits would benefit from the liberalization of deposit rates. The ability for micro sized entrepreneurs to gain access to a larger pool of assets, akin to our small business lending facilities at our banks, would again push the reform goals in a manner that would also balance out bank portfolios and reduce dependence on the more murky portions of China's shadow banking sector.

A Surprise Move and More to Come?

PBOC's surprise move friday, described here, after big days Friday and Monday in Shanghai, Shenzhen and Hong Kong, it is clear that the markets hadn't price this move in. Perhaps more surprisingly, articles like this one are popping up discussing the likelihood of another rate cut:
"Top leaders have changed their views," said a senior economist at a government think-tank involved in internal policy discussions. 
The economist, who declined to be named, said the People's Bank of China had shifted its focus toward broad-based stimulus and were open to more rate cuts as well as a cut to the banking industry's reserve requirement ratio (RRR), which effectively restricts the amount of capital available to fund loans.
This is one aspect of the low hanging monetary fruit, and I believe is under appreciated in the most reports on China. Let's not forget that their falling economic growth is falling. It's not negative. Let's also not forget the scale of transformation going on here.

Over the past 5 years, due to both internal and external factors exports have fallen in importance. Chinese consumption of natural resources have fallen as the infrastructure mega projects that defined years of growth have taken a less prominent role in growth. Industrial and manufacturing weakness have been present for the past few years. All set against a background of a weak global economy.

Despite all the wisdom of the all the western experts, one thing must be noted: the scale of this purposeful transition has never been achieved before. Transitions are usually painful and externally imposed.

And of course, despite all the wisdom of all the western experts, another thing must be noted: the scale and uniqueness of China's success (as outlined by Summers & Pritchett here along with my thoughts). Leaves me with the feeling of: who better to attempt this restructure?

Assuming that the internal allocation mechanisms are improving, consistent with the rest of the reform agenda (I don't think we have any reason to believe they aren't), then reductions in the reserve requirements, liberalization of deposit rates, and a fall in official bank rates towards more western levels are an 'easy' path to a more standardized monetary policy regime.

This should be entertaining to watch unfold.

Sunday 23 November 2014

Thoughts on a Book: Don't Even Think About It

Don't Even Think About It

I had this book by George Marshall recommended to me recently. It's written by an environmentalist involved in the PR game. The author takes man made climate change as his base assumption. From there he seeks an answer to why no one cares about it enough to make any changes. Essentially it asks why people ignore it. My summary would be: energy consumption is awesome. People will justify it's consumption in whatever manner works or them. Simple as that.

I find this approach useful. The eco movement struggles on two fronts: convincing people that there is a problem and then convincing them to implement a solution. But they never truly recognize how much people enjoy consuming energy.

So my take on global warming: yeah there's an issue that we should be addressing, but until we have a replacement for all of that awesome energy we consume, we won't address it. Simply put, people know there is a problem, and don't care enough about it to do anything about it. I say 'know' there is a problem because the evidence is so overwhelming. I say that no one (even among those that 'know' there is a problem) do anything about it, because all you have to do is not consume the products, and everybody consumes the products.

This book doesn't necessarily conclude similarly, but that narrative is woven into the story line. Not surprisingly my viewpoint aligned with Daniel Kahnemen (of 'Thinking, Fast and Slow', which would be on my short list of my favorite books):
"No amount of psychological awareness will overcome people's reluctance to lower their standard of living. So that's my bottom line: There is not much hope..."
I liked that this book wrestled with the basic idea that people don't care enough about climate change/global warming to sacrifice anything close to what's needed. I take this as fact, and so I don't often find discussions and books on the topic terribly interesting.

My base assumption, for anything in life, is that people are idiots. And while I say it that way for effect, I think it's obviously true. Of course, the follow up question should be: How do you define idiots? And the answer, for the most part, comes from the aforementioned Daniel Kahnemen and Thinking, Fast and Slow. We simply aren't wired optimally for this world we've created. And yet, we're incredibly confident that we are. I call that idiocy. I also spend alot of time trying to identify and address my own idiocy.

We're built for reflexive decision making meant to keep us alive, healthy, and happy in the now.

Climate change is the perfect problem to demonstrate this. It's a long run problem. Sure we have pretty solid evidence that current weather phenomenon are being magnified by these long run trends. But our brain is wired to construct a narrative to explain things that inconvenience us in the now. These events are far away, it could be natural cycles, there have been hurricanes/tornados/droughts always, who's to say these are any worse?

And I think this is the key, that this book points out (alright, alright, I take some liberty with the interpretation), but is a bit light on in it's conclusion: it's not about getting the message out, everyone basically knows what the problem. Sure they say they don't, but they do.

It's like evolution. Everyone basically knows it, but accepting it doesn't matter enough to people to go through the mental work to sort out the cognitive dissonance of competing religious/science, consumption/science world views.


Where this book is lacking, in my opinion, is it's failure to address the vast difference in energy consumption across borders. The book reads like it was written by a rich white guy to inform the debate in countries populated by rich white people. There isn't anything wrong with that. But that discussion is an extension of the "energy consumption is awesome" line of reasoning that I think is entirely lacking in the typical discussion. While it's present here, how do you not it extend it beyond borders?

Parse out some relevant stats on India's energy consumption habits (or lack thereof), as described in this article:
“India is going to use coal because that’s what it has,” said Chandra Bhushan, deputy director of the Delhi-based Center for Science and Environment, a prominent environmental group. “Its strategy is ‘all of the above,’ just like in the U.S.” 
Each Indian consumes on average 7 percent of the energy used by an American, and Indian officials dismiss critics from wealthy countries. 
“I don’t want to use the word ‘pontificate’ when talking about these people, but it would be reasonable to expect more fairness in the discussion and a recognition of India’s need to reach the development of the West,” Mr. Goyal said with a tight smile.
Being rich is awesome. Rich people consume lots of energy. Poor people want to get rich (since being rich is awesome). One result is that they will need to consume more energy. Therefore, as current options are, that increase in energy consumption will exasperate climate change dynamics. There is no way around that. Particularly given that the vast majority of people are incredibly poor (from my Canadian lens of reference).

So again, if we accept that we need to consume less energy derived from fossil fuels. And if we have no economically viable option to replace that energy with renewable/clean energy. Then we, by definition, need to reduce energy consumption levels.

Since, really poor people consume so much less energy then rich people, and if you accept (as I do) that poor people getting richer (and enjoying all of the benefits that accompany that) should be our greatest hope, than we can't expect them to bear the burden of that reduction.

Therefore, the burden would fall on rich people to carry the burden of marginally lower consumption rates that would still be far beyond the reach of those billions of poor people increasing their consumption levels.

How is this not fair/realistic/obvious? But we can't even bring our own energy consumption levels down from their ridiculous heights. We've made strides to clean it up a bit and we pat our selves on the back for some stagnation/reductions (instead of admitting that the economic meltdown and terrible job we've done implementing rebound policy was the cause).

This book doesn't really address this, and I think is the worse for it. Someone explain to me how you'd justify telling really poor people who consume way less energy then us, to consume less. I've yet to hear a logical argument.


So the basic argument that most environmentalists face (or think they face) is two fold: explaining the problem, and getting buy in on a policy set that addresses the problem.

The eco-movement's problem (to me) is that often they think the first part of that problem is objective. It's the future, it's not objective, and it's not uniform. Pointing to past data and saying: therefore, in 40 years this will happen. Is a guess, by definition. Which is fine, but not at least acknowledging that is problematic.

The other issue is a bit more subtle: a). environmentalists often conflate not buying into their second argument (policy changes, future predictions, etc.) with not buying into the first argument (that there is a serious issue) and b). they often don't have any real answer to the second problem that is at all feasible (thus taking things back to point a).

This book reinforced my habit of ignoring conversations on this topic that don't, as a central topic, address how awesome consuming energy is.

Monday 17 November 2014

Cold Shouldering Putin and Opec's Big Meeting

A couple of interesting developments over the weekend at the G20's in Brisbane with Putin bailing out early got me thinking about end goals and strategic thinking. Naturally, with thinking about Russia comes thinking about oil. With thinking about Oil comes thinking about the Saudi's and the up coming OPEC meeting.


The interesting thing about all of this is trying to parse out the end goals of key players. So we'll start with the G-20 and work our way back. While everyone has basically condemned Russia's behaviour in Crimea and eastern Ukraine, Cameron, Abbot and my own Canada's Stephen Harper lined up to get their very public digs in. My question is why? Ok, maybe 'why' is the wrong question. These statements are meant to play to their domestic audience, to make everyone feel like they are doing their part, standing up to the bully, etc. etc.. I get that. But perhaps questioning what these types of statements might actually accomplish is appropriate.

Is Putin going to say: "oh I didn't realize Stephen Harper doesn't want me in the Ukraine... shit, get me a phone and we'll pull funding/troops/tanks/whatever out... my bad". Or do you think he's more likely to dig in? Putin remains popular, ibut that popularity is dropping according to numbers cited from Leada in this article which also shows that the average rating out of 10 given to Putin by Russians was 7.33 (this in a time of capital flight, economic sanctions, tanking crude prices, and invasion of a non-threatening neighbour). Might backing him in a corner, help him drum up domestic support the old fashioned nationalistic (ie. they are bullying Russia... and so we bomb) way? I don't know. And Putin probably doesn't either. But I wouldn't bet that he'd opt for a passive reaction to blustery headline grabbing. When his constituents are convinced his current path is a positive one.

Also remember, that although many of the big multi-natinoal companies have dollar denominated debt that sanctions will prevent being rolled over; they and Russia in totality itself aren't too bad on this front. Also remember that since the Ruble has tanked, and oil is priced in USD this acts as a slight mitigant to price declines domestically. 

This article from the telegraph gives us a great summary of events in this post (found after I started).

I think they overstate the case that the global economy needs Russia more then Russia needs the global economy. But there is truth in it. Especially as fall turns to winter and the importance of energy supplies grow. I think the EU is feeling a bit more confident in their position as Brent trades near 5 year lows. Is that sustainable?

A potentially interesting bit in this article is the discussion on how prepared Russia is to hunker down. Alluding to the national sacrifice historical narrative, it does seem like Putin has a better chance of talking his Russian electorate into a winter of sanctions then Merkel would have talking her's into a self imposed winter of intermittent supply or inflated prices on their natural gas. Should Putin decide to retaliate in this manner (notice that Merkel didn't work as hard as the leaders mentioned above to grab headlines while still maintaining a critical position).

Despite letting the Ruble float (and subsequently tank), Russia has significant reserves (over $400B USD) and was wise to not stand it's ground so early. It won't be a couple weeks or likely even a couple of months until economic pressure is so significant that Putin is forced into backing down. It may turn into a battle of popular political will between a sanctioning euro population and a sanctioned Russian population. Here's hoping it doesn't come to that.


The 27th could be a watershed moment. Hopefully we get some clarity on the strategic vision of the organization, or more specifically, the Kingdom of Saudi Arabia going forward. While this article does a great job of outlining the challenges faced by each of the major oil exporting countries. I think it doesn't fairly capture KSA's position. This graph that it cites from the Economist is a nice visual summary:


Like Russia, KSA has significant reserves ($745B in Sept.) so a downturn can be weathered. But articles like these assume all budgets are made independent of revenue. That doesn't seem likely in all cases (particularly KSA), where it seems more likely that they say: "hey look at all this money we're going to have, lets spend a bunch of it".

Aramco's Manifa project involves building of artificial islands to harness onshore drilling efficiencies in shallow waters.
One of Manifa's 27 Man Made Islands
At any rate, the Saudi's  legacy oil production is some of the cheapest in the world. The billion dollar question of course is what the composition of Saudi production is now, and will be going forward. By the end of this year Manifa is supposed to be producing 900,000 bopd. That's not nothing. The scale of the project, and subsequent cost might (must) impact cashflow considerations. If their production remains the cheapest in the world, they might just go for market share.

Conspiracy theories abound about the motivation behind the OPEC's willingness to crater the price of oil. It's certainly helping economies around the world, particularly a country like China where through their structural reform the addition of nearly (5.7 million bopd this October x $100 vs. $80) $100 million dollars daily has been great. From another angle, the western bloc of countries imposing sanctions on Russia couldn't have had the oil markets help them much more.

Regardless of whether they will enforce or lower the production quota, hopefully we get some direction. I suspect that markets will be on the move shortly after the Nov. 27th meeting. Similar to FED announcements I suspect forward guidance on price support would have a huge impact immediately. Perhaps there will be an asymmetrical move with the opposite announcement, but I also suspect the market is pricing in continued low prices.

We'll just have to wait and see.

Saturday 1 November 2014

Regression to the Mean: Chinese Economic Growth in Context

The latest study making it's rounds about Chinese economic growth is this paper by Larry Summers and Lant Pritchett: Asiaphoria Meet Regression to the Mean.

I have to admit to being underwhelmed by this paper. Much smarter people then I seem to be quite impressed like Tyler Cowen here. My reaction is fairly simple: Of course Chinese growth is unsustainably high over some undefined time horizon but what in this paper wouldn't have applied in 1990, 1995, 2000, 2005, and 2010?

Perhaps the author's intent is to be obvious and non-specific (this paper still has plenty of useful info in this context), but why has this become the new 'it' study on China? (mood-affiliation?)

The paper makes three basic claims:

1. Growth rates are typically persistent and low.
2. Developing world growth rates are highly volatile and regress back to global means aggressively.
3. The Asian giants (China and India) should include a rapid regression to the mean as a realistic possibility.

None of which I really disagree with. But in the conclusion there is this:
India and even more so China are into essentially historically unprecedented episodes of growth. China’s super-rapid growth has already lasted three times longer than a typical episode and is the longest ever. The ends of episodes tend to see full regression to the mean, abruptly.  
It is impossible to argue that either China or India have the kinds of “quality institutions” that have been associated with the steady dynamic of growth in the currently high productivity countries. The risks of “sudden stops” are much higher with weak institutions and organizations for policy implementation. China and India have very different modalities of this risk, but both have tricky paths to continued prosperity. 

Again, it's not that I disagree with any of this. In fact, I would say that these are almost self evident truths. But my issue is that this paper doesn't wrestle with whether China's "historically unprecedented" episode of growth does in fact mean that 'this time is different'. I believe that the author's would agree that progression towards the "quality institutions" found in successfully transitioned countries promotes growth, and that neither China nor India posses sufficiently developed institutions, would they not then conclude that this represents an opportunity to avoid said regression?

It seems to me that, while this paper describes the rate of change of GDP (and by proxy development) it doesn't give the level of GDP (and of course by proxy the level of development).

And this isn't me talking about how wise and efficient autocracy can be. To me, the greatest contribution to these unparalleled growth rates is just how effectively the CCP pre-Deng destroyed the economy. Talking about levels seems paramount. And I think GDP per capita adds that context to the discussion.

When you think of the most relevant cultural/economic performance parallels to China, you probably think Japan, Taiwan, and Korea. China, of course, is unique in it's sheer size. But what is lost on people is it's uniqueness in it's absolute poverty. China was one of the poorest countries in the world when this growth phase started and has merely (and miraculously) risen to near middle income territory. But where were the rest of these countries in per capita terms when they "regressed to the mean"?

Japan '70: $15,162 (regressed to: 3.4% growth)
Korea '91: $9,591 (regressed to: 4.42% growth)
Taiwan '94: $11,932 (regressed to 3.48%)

How about the Per Capita GDP at the start of these phases?

Japan '59: $7,752
Korea '62: $1,123
Taiwan '62: $2,263

By Contrast corresponding Per Capita Chinese GDP:

China '77: $178
China '91: $495
China '13: $3,583

Per capita GDP Data World Bank WDI 2013 Data Set. All numbers reported in constant 2005 USD. Growth numbers from S&P paper.

So here's an assumption that I'll make and not provide adequate data to cover: moving away from centralized autocratic control of a country/economy produces favourable economic results with diminishing marginal returns. Think of wealth enhancing policy as a continuum; at 0 you have North Korea and at 10 you have, well an argument, but lets just say above 7 you have a large group of market based economies with some mixture of liberal democratic institutions. This of course excludes countries abnormally dependent on exporting natural resources (I'm looking at you Norway).

Now in an unscientific approach that assumes my under-supported assumption, what would best proxy a countries location along that continuum? In my opinion it's the per capita wealth or GDP measurement. In a manner as simple as Summers and Pritchett (S&P) arguing that countries regress back to the GDP growth mean. Therefore, China starting at say a 0 or 1 on the 'wealth enhancing policy continuum' might be at a 3 or 4 now. Countries that successfully regressed to the mean maybe did so around 6 or 7. Of course this isn't rigorous. But intuitively I think it's not a bad framework to use.

I'll try to come back to this at a later date and try to flush things out at a later date in more detail because I think it's often overlooked, particularly in China and India's case because the aggregate size of their economies are so much larger then any other country (at their stage in development has ever been). These countries, on per capita terms, are very, VERY poor (India in '13 had per capita GDP of $1,165). If per capita is any sort of proxy of how much "low hanging fruit" is available to propel growth, then the slow move along the development continuum results in the possibility of sustained abnormal growth levels (which China has already demonstrated). Judging by the many headlines you ready about the need for/lack of/inability to produce reform in China, I have to assume it's fairly well accepted that the long hanging fruit is out there and fairly obvious.

I think China is doing a good job of sustainably harvesting that low hanging fruit. And their ability to do so sustainably in an unprecedented manner over the past three decades should give experts a bit more pause when making recommendations with any confidence. Everyone agrees on the direction of reform. The speed and the end result (just because the CPC wouldn't want to hit a 10 on the democracy index, it doesn't meant they don't want to go from a 3 to a 5) are a debatable, as the CPC is in rarified economic growth air, shouldn't we consider that they aren't idiots and might have some insight?

This isn't saying that China WILL continue growing rapidly. As S&P allude to in their paper, developing countries growth rates are extremely variable. I interpret this as: though there are a much greater quantity of growth promoting possibilities, there is a certain symmetry in growth destabilizing risks. This of course comes from a guy who is endlessly fascinated and impressed with the abnormally amazing economic performance of China (and to a lesser extent India) described in this paper by S & P. While the current regime inherited a low base to grow from, they've been able to avoid that highly variable growth rate and the expected regression to the mean.

Let's hope that L & S can repeat this same paper in another 5 years time.