Lots of macro news from China over the last two weeks as the government stepped up efforts to boost liquidity in the economy. What is less covered by media is a piece of report (http://www.ft.com/cms/s/0/27a221be-57e4-11e1-b089-00144feabdc0.html#axzz1nRDRRp1F) about its management of its large foreign exchange reserve – the country reduced holdings of US treasury while increased holdings of mortgage securities, in anticipation of QE3. As I understand it, the mortgage securities are mainly agency securitized mortgage bonds – high investment grade but yielding a bit higher than the US treasury.
Well done, SAFE!
Balance sheet recession has happened across the developed world and is due to continue. It is true even in the US, the most dynamic economy in the world, although central bank printing money – quantitative easing – slows the speed of balance sheet contraction and tries to give more time for the economy to recover. To “grow” out of the already high amount of debt is extremely challenging, with Japan being the case in point. One reason is that asking a high-consuming country to increase savings rate is difficult. Another reason is that reducing real exchange rate by reducing labor cost is often politically unpopular. And finally, the implicit future liability of the American economy – onerous future pension payments – requires a significant amount of political bargain and negotiation which may go beyond imagination, to reduce it back to sustainable level.
Therefore, “financial repression” has become an increasingly popular term – savers subsidizing borrowers with the aim to stimulate inflation that reduces the real cost of servicing debt. As much as a way to “grow” out of debt at the aggregate level, it is a way of wealth redistribution between economic sectors. It sounds unfair, but faces less political obstacles than reducing wage by firing people aggressively or forcing savings rate to increase by reducing bank lending. In a financial repressive world, people may still be able to hold on to their jobs, which helps contain social instability, but may gradually see the decline of their real income – but only gradually. It appears less painful than a sudden drastic crisis, at least psychologically. Financial repression has been used by many developing countries with high inflation (not hyperinflation by the way); and now it is used by the developed economies as well.
And SAFE was right to figure this out and capture its effect by jumping onto the yield buying spree. Low interest rate that subsidizing borrowers clearly benefits home buyers and the housing market, and ultimately boosts the mortgage bonds. The Obama government has shown its unwillingness to write down mortgages and determines to support the domestic housing market, probably until the inflation comes back and the market is able to supports itself again. In the mean time, the treasury yield will remain low, while the yield on mortgage bonds may not significantly jump (ie. perceived quality not deteriorate) given government support in the market. Given such outlook, shifting one’s capital from US treasury to US mortgage bond should not be a bad idea. And SAFE is indeed doing it.
Another paradoxical and very important fact is that, when foreign central banks anticipate QE3 and start to do trades that should benefit from the policy, the Fed actually needs less firepower (e.g. using less of its balance sheet) to implement the policy. That is because the foreigners are now helping the Fed to support the domestic housing market.
Well done, Fed.
It is very dangerous for economists to predict short-term market movement – as demonstrated by the January rally while many economists were pessimistic at the end of 2011 about the European economic outlook in 2012. They are unable to validate their predictions until there is significant correction in the market. The tricky thing is, from investors’/traders’ point of view, short-term volatility does help one to make money; when the correction comes, it is claimed to reflect investors’ “taking profit”. To put it simply, to make money is to ride on the right wave. Paradoxically, the right wave is hard to detect ex-ante, as claimed by EMH believers and many investors.
It is somewhat validated by the fact that many investors did miss the January rally. Those who preferred cash to equities apparently missed the rally. Even those who were fully invested in equity may still have underperformed the market index (at least in January) as many dynamics persistent last year got mysteriously reverted in January. Hungary and India -two of the worst performers last years- saw sharp rise in their equities and currencies in January. And major European indices hit new high against huge risk of economic recession. People cited many reasons for the rally, including central bank intervention and better US employment data.
All is convincing, ex-post.
I wishfully hope, as one who is keen to study fundamentals, the medium-term market return should conform to economic dynamics. To be self-relieved, I have to distant myself a bit away from the market volatility, including the January rally. Put it in another way, maybe I shouldn’t have written this blog entry. 🙂
Reading a book about Japan’s recession over the past two decades, I was interested to see the Japanese companies having large incentive to repay/reduce the debt on their balance sheets. It was in line with the interest of shareholders and creditors as most of these companies still enjoyed strong positive cash flow thanks to strong foreign demand for their products. Therefore, repayment is just an issue of time. However, such deleveraging effect has significantly postponed the recovery in the Japanese economy.
This prompted me to look at the loan growth in China, particularly the lending situation of SMEs. Arguably, one should expect that SMEs are most vulnerable amid economic recession/slowed growth, as they don’t receive state/local government guarantee over their debt position. That implies that lending to SMEs should normally face larger setback than lending to big companies in the current hard situation.
The lending data published by the Chinese central bank (http://www.gov.cn/gzdt/att/att/site1/20120130/782bcb8883ce109072d001.pdf) a few days offers an encouraging sign: the growth of 18.6% in the outstanding loans to SMEs in 2011 outpaced the growth of 14.0% in the overall outstanding loans, implying robust borrowing needs of SMEs which are sensitive to growth dynamics in the economy. That stays in significant contrast to the current lending environment in developed countries like the UK and the situation ten years ago in Japan.
OK, to be fair, interpretation of Chinese economic data always inevitably involves multiple layers of quality check. For one thing, alongside the loan breakdown by company size, the central bank release also mentions the maturity breakdown – effectively shorter maturity- which indicates strong short-term liquidity needs and relatively weak long-term financing needs. Interestingly, I haven’t seen the intersection of the above two dimensions, e.g. what does the short-term liquidity needs of SMEs look like? And what about SMEs’ long-term borrowing needs, an important indicator of people’s confidence about the economy? For another thing, it is often tricky to analyse SME lending as there could be grey area of defining who is SME and who is not. This could end up lending to red-tapes which are legally classified as SMEs but enjoy soft budget constraint (eg government guarantee) that are not normally enjoyed by SMEs.
But still, the data looks as if China has yet to reach the edge of crisis. At least I hope so.
I know people are keen to raise the topical issue of “black-market” lending in China, particularly when there is great need to remove the regulatory obstacles to SME financing. I will be keen to look for some data before coming back to the issue.