As I have been saying, 2010 will be an interesting year in the markets, and this week only supports my contention. Many bearish voices are suggesting a correction is coming, but we have been hearing this since March of last year. Nonetheless, something bearish is afoot, as the world wrestles with the continuing ramifications related to recovering from the worst economic collapse since the 1930s. Here is where we are this week.The risk aversion following the 2-day slide in the markets has supported safe haven currencies such as the dollar and the yen, sending commodities lower. Amid this backdrop and in the absence of any key economic report, the major averages may fight to hold key support levels. - World Daily Markets Bulletin The factors contributing to this bearish influence are global in scope, and they offer insight into just how interrelated all the global markets have become, and, as we will see at the end of this article, how one less-discussed factor just might be a prime mover in the market of today.China, the driver of today's economic recovery, is so "hot" it is tapping the brakes on its rapidly growing GDP, which hit 10.7% in Q4. China announced it would begin reducing liquidity in its markets. The announcement of this "normalization" process immediately and negatively impacted the global equity and commodity markets, but positively affected the U.S. dollar and Japanese yen. One might argue that this relationship is typical, and so it is, but now factor into that the possibility that China has a larger problem with its developing housing bubble. Housing prices have jumped some 70% in the last two years. Put that together with an over-stimulated economy, a government that is putting on the monetary brakes, and you now have one huge market (China as a whole) acting as a drag on the global economy.Fine, China is China, and we know that its debt-free and rapidly growing economy is influencing the global markets, but what about our markets right here in the U.S.? We have mixed economic data indicating our recovery is happening, but it is not quite solid in its footing. Q4 corporate earnings for the most part have been strong, but some would argue that is true only because of major cost-cutting and tighter inventories.
Showing posts with label China. Show all posts
Showing posts with label China. Show all posts
Are the Chinese capital controls optimal?
China is currently amassing large foreign reserves while imposing internally capital controls. Does this make sense? Wouldn't an economy that has the ability to create such surpluses want to participate more fully in world markets? One should not forget that these foreign reserves are accumulated thanks to a positive trade balance and a fixed exchange rate, not thanks to a particularly well functioning capital market in China. In fact, the financial sector in quite under-developed in China, and most households have access to nothing more than simple bank accounts.
Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis build a model where the central bank has access to world market, but domestic households not. This enables the central bank to impose a different interest rate than the world interest rate, but it steady-state it is best to replicate an open economy: accumulate reserves and issue domestic debt at the world interest rate. If the economy grows rapidly, though, you want to have a higher interest rate domestically while imposing capital controls, that is, one needs to prevent arbitrage. But then, intertemporal substitution needs to happen through international reserves, as households cannot do it.
What is intriguing here is that we have a situation where open markets are welfare inferior to restricted ones with a reserve accumulation policy. Usually, we think that free markets would work best, especially as here there is no moral hazard, systemic risk, or other distortion. The reason is that borrowing constraints are binding as the economy converges towards steady state, and it cannot provide adequate intertemporal allocation in open markets. The central bank needs to help, and needs to differentiate interest rates to do so. That can only happen with capital controls.
Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis build a model where the central bank has access to world market, but domestic households not. This enables the central bank to impose a different interest rate than the world interest rate, but it steady-state it is best to replicate an open economy: accumulate reserves and issue domestic debt at the world interest rate. If the economy grows rapidly, though, you want to have a higher interest rate domestically while imposing capital controls, that is, one needs to prevent arbitrage. But then, intertemporal substitution needs to happen through international reserves, as households cannot do it.
What is intriguing here is that we have a situation where open markets are welfare inferior to restricted ones with a reserve accumulation policy. Usually, we think that free markets would work best, especially as here there is no moral hazard, systemic risk, or other distortion. The reason is that borrowing constraints are binding as the economy converges towards steady state, and it cannot provide adequate intertemporal allocation in open markets. The central bank needs to help, and needs to differentiate interest rates to do so. That can only happen with capital controls.
Inter-provincial risk sharing in China
Despite widespread claims, China is still far from a capitalist economy. There is still a considerable amount of command-and-control, and the state-owned enterprises still comprise a large and heavily subsidized sector of the economy. One aspect of a command economy with a (still) poor finance and insurance sector is that it can enforce some sharing mechanism to alleviate the consequences of local business cycle shocks or offer some redistribution across geographical regions. Such mechanisms are also in place in Western economies, mostly implicitly (for example, a national unemployment insurance) and when it is explicit, it leads to tensions as some always pay and some always receive (examples: Canada, Bolivia). Anyway, back to China.
Julan Du, Qing He and Oliver Rui find that the state-imposed fiscal channel of redistribution during the business cycle has a relatively minor impact: it dampens business cycle fluctuations by only 9%. A much larger impact comes from movements in labor, which is actually surprising as the state actively impedes such movement with an internal passport system and undocumented workers face major hurdles for public services. Still an in all, there is very little inter-provincial smoothing going on. I would have expected the central government to do a much better job in this case.
Julan Du, Qing He and Oliver Rui find that the state-imposed fiscal channel of redistribution during the business cycle has a relatively minor impact: it dampens business cycle fluctuations by only 9%. A much larger impact comes from movements in labor, which is actually surprising as the state actively impedes such movement with an internal passport system and undocumented workers face major hurdles for public services. Still an in all, there is very little inter-provincial smoothing going on. I would have expected the central government to do a much better job in this case.
Understanding Chinese household savings
It is not a secret that the Chinese are saving like crazy. The big question is why their savings rate is the highest in the world and it was addressed before on this blog (more below). The explanation that this would have to do with life-cycle considerations as the population ages (with few children) has by now been largely dismissed. So can explain it?
Riccardo Cristadoro and Daniela Marconi make the point that we really need to look at households, as firms or the government have not increased their savings rate sufficiently. Using panel data, they notice that the savings behavior differs markedly across provinces. And one aspect that does as well vary across provinces is the provision of social services and the access to credit. Thus they tie the high savings rate with the need to build up precautionary savings. This corroborates my previous posts about increased idiosyncratic risk and the reform of the public pension system.
Riccardo Cristadoro and Daniela Marconi make the point that we really need to look at households, as firms or the government have not increased their savings rate sufficiently. Using panel data, they notice that the savings behavior differs markedly across provinces. And one aspect that does as well vary across provinces is the provision of social services and the access to credit. Thus they tie the high savings rate with the need to build up precautionary savings. This corroborates my previous posts about increased idiosyncratic risk and the reform of the public pension system.
How is China now planning its economy?
Since 1978, China has undergone a fundamental and very successful reform from a planned economy towards a market economy. But one should still keep in mind that this is still an autocratically governed country where technocrats call the shots at all levels. China is still working with five-year plans and the economy is still tied to administrative goals. SO how does economic planning work in China nowadays?
Gregory Chow offers some insights, in particular on how this planning has recently become more important due to the global economic crisis. Administratively, policy is guided by the five-year plans, which interestingly have recently included new sections on welfare and management of society, making apparent some worries about the adverse effects of market economies and rapid development (or democracy when people can complain?). The remarkable part of these plans is that explicit targets are set, and policy is in a major way oriented towards these targets. Of course, the government still controls directly a considerable number of state-owned enterprises. And it has the traditional tools of policy in a market economy at its disposal to influence the rest of the economy. These policies are coordinated at all levels thanks to the very central nature of government.
In some sense it would also be good for market economies to also set some targets for policy. In fact, this is what politicians should be arguing about and then let technocrats put policy in place to achieve these targets. I would not mind targets like putting a man on Mars by 2020, making sure everyone in covered by health insurance by 2015, get 50% of commuting kilometers on public transportation, or defense expenses being completely dedicated to defense (and not attack) by 2015, for example. In fact, the World Bank has well-defined targets for developing economies. In do not see why this should not be applicable for developed ones. At least it would make governments capable of rallying support for some goals and be explicitly accountable.
Gregory Chow offers some insights, in particular on how this planning has recently become more important due to the global economic crisis. Administratively, policy is guided by the five-year plans, which interestingly have recently included new sections on welfare and management of society, making apparent some worries about the adverse effects of market economies and rapid development (or democracy when people can complain?). The remarkable part of these plans is that explicit targets are set, and policy is in a major way oriented towards these targets. Of course, the government still controls directly a considerable number of state-owned enterprises. And it has the traditional tools of policy in a market economy at its disposal to influence the rest of the economy. These policies are coordinated at all levels thanks to the very central nature of government.
In some sense it would also be good for market economies to also set some targets for policy. In fact, this is what politicians should be arguing about and then let technocrats put policy in place to achieve these targets. I would not mind targets like putting a man on Mars by 2020, making sure everyone in covered by health insurance by 2015, get 50% of commuting kilometers on public transportation, or defense expenses being completely dedicated to defense (and not attack) by 2015, for example. In fact, the World Bank has well-defined targets for developing economies. In do not see why this should not be applicable for developed ones. At least it would make governments capable of rallying support for some goals and be explicitly accountable.
Why is the Chinese savings rate so high?
The current global imbalances, at least those between the US and China, are only possible because China is currently saving a historically high share of its income. Various theories have been advanced to explain this surge in the savings rate: 1) Economic reform has increased household-level uncertainty and thus precautionary savings. 2) Forces have shifted from consumption-oriented households to savings oriented businesses. 3) Demographics and the life-cycle combined with the growth in income lead currently to high savings rates because savings change through the life cycle and thus fluctuations in the dependency ratio become important.
As Carl Bonham and Calla Wiemer point out, the savings rate has not been uniformly high and is in fact consistent with the changes in the dependency ratio. The savings rate increased through the 1980s to peak at 41.9% in 1995, then "bottomed" at 37.7.% in 2000, before surging back to 51.4% in 2008. The current global imbalance occurs in part because, unlike before, investment rates are restricted by policy, and stand at 43.5%. A modest decrease in the savings rate can rebalance things.
To test the three theories against these staggering numbers, Bonham and Wiemer use a structural VAR and determine the latter one is the most important, while the others cannot be dismissed. I am not particularly fond of VARs to test theories, they should rather just describe the data, but the evidence is quite compelling in this case. Of particular interest is that one can forecast the savings rate, as the dependency ratio is quite predictable. And this forecast shows that Chinese savings rates have peaked last year and will decrase quite significantly over the next decade. If true, this should reduce considerably the pressure on China to do something about current imbalances.
As Carl Bonham and Calla Wiemer point out, the savings rate has not been uniformly high and is in fact consistent with the changes in the dependency ratio. The savings rate increased through the 1980s to peak at 41.9% in 1995, then "bottomed" at 37.7.% in 2000, before surging back to 51.4% in 2008. The current global imbalance occurs in part because, unlike before, investment rates are restricted by policy, and stand at 43.5%. A modest decrease in the savings rate can rebalance things.
To test the three theories against these staggering numbers, Bonham and Wiemer use a structural VAR and determine the latter one is the most important, while the others cannot be dismissed. I am not particularly fond of VARs to test theories, they should rather just describe the data, but the evidence is quite compelling in this case. Of particular interest is that one can forecast the savings rate, as the dependency ratio is quite predictable. And this forecast shows that Chinese savings rates have peaked last year and will decrase quite significantly over the next decade. If true, this should reduce considerably the pressure on China to do something about current imbalances.
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