After his departure from UBS, Andy Lees went radiosilent while setting up his own research company, AML Macro. We are now happy to be able to bring to our readers' the occasional report from Lees, who has traditionally been one of our favorite macro analysts, and whose insights are usually months ahead of the maintstream.
Emerging Markets Unable To Continue The Heavy Lifting
AML Macro Limited
In the last few days we have seen reports suggesting Brazilian household debt and service payments are weighing on growth, that Southeast Asia’s commercial credit is approaching its pre-1997 financial crisis peak of 75% GDP, and that South Korea’s household debt has reached 164% of disposable income compared with 138% in the US at the start of the housing crisis. Chinese debt rose 15% in excess of GDP last year from 191% to 206%. Its corporate cash flow is around 50% of profitability whilst loan growth is way in excess of the banks’ return on equity meaning the growth is dependent on a continual supply of new capital to the banks. Over the last few years whilst the developed economies have struggled to reduce their debt relative to GDP – (the most successful of the major economies has probably been the US which has taken non-financial sector debt down from a high of 253.15% GDP to 248.18% GDP) – the developing economies have taken advantage of cheap funding to inflate their debt levels dramatically, leaving the global debt position worse than in 2007.
Brazilian households spent 21.3% of their income paying debt in November, close to the record 22.6% in October 2011, and double the 10.6% in the US. Household debt has doubled since 2005 to 44.6% of annual income as households have borrowed to buy cars and household goods etc. Default rates are now at 30 month highs, weighing on economic growth. Falling unemployment and interest rates have unleashed unprecedented demand from Brazil’s growing middle class in recent years, encouraged by tax breaks and credit incentives, but rising prices are now leading to a drop in real wages making the accumulated debt unsustainable. Late last year the IMF released a report entitled Non-Financial firms in Latin America: A Source of Vulnerability? It suggested that rising corporate debt levels are increasing the risk of firms becoming exposed to a funding shock. Leverage has risen since the Lehman crisis, with the increase in debt burden evident from the rising debt-to-sales ratio. As West LB says of Brazil, “I think these numbers show the exhaustion of a growth model based on consumption. The government will have to find other ways to stimulate the economy”.
South Korea’s household debt ended 2012 at KRW959.4trn. Debt reached 164% of disposable income in 2011 compared with 138% in the US at the start of the housing crisis. The quality of the debt is also deteriorating according to the Samsung Economic Research Institute. The president needs “measures to stymie the rising danger of a massive default crisis”. Hi Investment says the government will have to bear most of the cost of the overdue loan and mortgage payments, which will worsen the budget deficit and government debt. With debt reaching dangerous levels, South Korea desperately needs to boost exports otherwise growth will slump lifting default rates. Even before we consider the implications of the currency war, where is South Korea going to export to as economy after economy has reached their debt limits. Increasingly, because of insufficient productivity growth, the only possible buyer of their goods is going to be the Fed or some other central bank with printed money.
Reuters reports that Southeast Asia’s heady growth in recent years has been debt fuelled, and is beginning to resemble the unsustainable mid-1990’s boom. Authorities are shy to raise rates as they want to maintain growth as long as possible, and presumably they know as well as anyone, the risks to the outstanding debt if the economy slows. Growth is strong across the region. Whilst the credit intensity of the economies is not as pronounced as China’s, commercial credit as proportion of GDP for the region’s 5 largest economies – Indonesia, Malaysia, Singapore, Thailand and the Philippines – is approaching its pre-1997 crisis peak of 75%. It suggests a few more years of credit-fuelled growth will make a repeat of a 1997 financial crisis a distinct possibility. Presumably an early unwind of QE by the Fed would bring forward this date.
China’s ability to keep sustaining growth by running imbalances with the rest of the world has not only pushed the developed economies’ debt to unsustainable levels, but it is reaching its limits with the emerging markets as well. Unfortunately China won’t be able to continue running imbalances as the rest of the world simply cannot afford to buy its exports. The cumulative global misallocation of capital means world productivity growth is simply not strong enough to sustain the scale of growth the world has been used to.
China’s total factor productivity growth has slumped since 2007, requiring nearly 1/3rd more capital relative to GDP than in 2007 to achieve a 35% lower growth rate. The excess capital thrown off has slumped with its current account surplus falling from 10.7% GDP to 2.6% GDP. With the developed economies already choked by debt, China redirected its surplus capital through a change in the terms of trade to those commodity producing countries that could afford it, but the consequence has been soaring emerging market debt levels. For China to maintain GDP growth given its declining productivity growth, it will have no choice but to consume down its current account surplus and stock of FX reserves. If countries haven’t got sufficient productivity to take on more debt, they are certainly not going to be able to pay down existing debt unless the social and political system is strong enough to accept the austerity it would infer. Instead China will have to accept freshly printed money from the Fed or some other central bank rather than the assets it thought it had gained access to.
The fact that we are moving to currency wars would seem to be a tacit acknowledgement that this is now the case; the game has changed from one of absolute growth to one of relative growth within a productivity constrained world. A recent report highlighted that since 2005 global liquids (oil) production excluding ethanol has risen by just 2.2mbpd, leaving a significant shortfall against the previous trend. Over the period exports had fallen by 1.9m bpd and “available net exports”, defined as global net exports minus China and India’s combined imports, fell from 40m bpd in 2005 to 35m bpd in 2011, helping to explain stagnant global GDP growth, particularly outside the US. A simple extrapolation of the trend would imply that by 2030 China and India would be consuming 100% of global net exports. This is not going to happen, but it highlights that China and India’s growth is becoming increasingly expensive to achieve as there is simply not the global scale of productivity needed to drive the kind of numbers we need – (http://www.resilience.org/stories/2013-02-18/commentary-the-export-capacity-index). With the oil sector’s expenditure now 1.5 times cash flow, the oil price may not be sucking capital from the rest of the economy, but clearly the oil companies are.
In 2007, developed economies’ debt reached its limit relative to GDP. Five years later the world is reaching the same constraint. The misallocation of capital has taken on global proportions with emerging market debt soaring relative to GDP. Whilst China has some small capacity to boost growth a little further, Japan clearly does not, and increasingly neither does Asia as a whole. Asia’s trade surplus (inclusive of India and Japan) has swung from a surplus of USD38.8bn in October 2007 to a deficit of USD12.7bn. Whilst international savings as measured by world FX reserves are still rising rapidly suggesting a surplus of capital being created, the picture is somewhat different when the Swiss foreign currency reserves are removed.
Asia’s (inclusive of India and Japan’s) trade deficit.
Japan’s income surplus is being consumed to finance its trade deficit, with the result that its international reinvestment rates are falling. Rather than Toyota NA reinvesting in plant and equipment, its income stream is being consumed by Japanese households who can no longer produce sufficient to sustain their own consumption, let alone pay down their debt. The consequence has been a USD162bn fall in Japan’s net foreign investments between 2009 and 2011 and a fall in the US gross investment ratio down to 15.48% GDP. In Japan itself the budget deficit is consuming more than half the gross savings, leaving people to question whether the net investment ratio is actually positive at all. The fact that Abe has targeted 2% inflation, the currency is falling and the BOJ is aggressively buying bonds to finance the budget has simply facilitated what would otherwise have been imposed by the markets as the current deficit increasingly means that Japan can no longer fund its own consumption, and therefore that consumption, or domestic investment, must gradually be priced out one way or another.
QE can only be described as genuinely effective if it lifts productivity sufficiently for debt to fall relative to GDP, which has clearly not been the case, at least not yet. Instead it has supported GDP, but at the cost of adding to debt and to the misallocation of capital, ie it has added to the scale of problems we face. It has only been successful in the sense that we have been blinded to the damage it is doing, which is in declining investment ratios in the developed world and collapsing return on investment in China. That’s not so bad if we can keep pushing back the day of reckoning. The difficulty arises when the damage becomes immediate, such that the government can no longer fool us into believing that everything is ok; the opportunity cost of strong future growth turns into an immediate loss of economic output, rising unemployment and deteriorating living standards.
In an interview on CNBC – (written up on zero hedge) - Stanley Druckenmiller highlights that since 1994 US entitlement spending has risen from 50% of federal outlays to 67%, and will rise by a further USD700bn over the next 4 years as demographics kick in. At the moment the market is blind to the damage it is doing, but as Stanley says a simple normalising of interest rates back to where they were before QE, would add an extra USD500bn a year to the government’s interest bill, somewhat putting the USD85bn sequester into perspective. He also reminds us of the irrationality of the financial markets by highlighting that the Greek bond market was perfectly fine until February 2010, but within 2 weeks it had collapsed.
The fact that we are moving to currency wars seems an acknowledgement that we are reaching the limits again. The fact that Brazil’s economy is choking from its debt-fuelled growth, or that people are now starting to talk about “the rising danger of a massive default crisis” in South Korea, or that Southeast Asia’s credit is approaching its pre-1997 peak of 75% GDP, suggests that we are getting close to the point where debt has once again reached its limit relative to GDP and the lost opportunity cost is about to become a real cost once again. With this in mind, whilst EU politicians may offer an extension to those countries missing their budget targets, do the financial markets still have the ability to facilitate that extension? Can sterling avoid its decline turning into a rout?
Some of the emerging market debt is relatively small and the necessary rebalancing of the economy should be relatively easy to achieve, but even if it is only a cyclical limit as oppose to the structural limits of the developed economies, it is coinciding at the same time and will add to the global problem. As data on world GDP growth would suggest, it is not just Brazil where the numbers show “the exhaustion of a growth model based on consumption”.
World GDP Growth