Eurozone's rebalancing challenge

Regaining external competitiveness dented by a decade of massive external capital inflows, asset price bubbles, and investment booms, is arguably the biggest challenge facing many of the beleaguered Eurozone economies. Martin Wolf, quoting two Goldman Sachs research papers, “Achieving fiscal and external balance”, points to the magnitude of this re-balancing challenge facing the peripheral economies.

To achieve a sustainable external position, Portugal needs a real depreciation of its exchange rate of 35 per cent, Greece one of 30 per cent, Spain one of 20 per cent and Italy one of 10-15 per cent, while Ireland is now competitive. Such adjustments imply offsetting appreciation in core countries. Moreover, with average inflation of 2 per cent in the eurozone and, say, zero inflation in currently uncompetitive countries, adjustment would take Portugal and Greece 15 years, Spain 10 years and Italy 5-10 years. Moreover, that would also imply 4 per cent annual inflation in the rest of the eurozone.

But the danger is that even if the required inflation environments can be sustained for long periods, the austerity policies being followed by these economies could choke off any growth and push them down a contractionary spiral. Spain's targeted fiscal correction by 5.5% of GDP over two years, with 3.2% adjustment proposed for 2012, from its fiscal deficit of 8.5% of GDP for 2011, is one of the biggest fiscal adjustments ever attempted by a large industrial country. Such severe austerity threatens economies with large unmeployment rates, debt-ridden banks, and fiscally constrained governments. Predictably, as with the case of Spain, the markets have reacted with alarm driving up Spanish bond yields and CDS spreads.

More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

Eurozone crisis in graphics

A series of excellent graphics from Paul Krugman that points to the underlying causes behind Europe's current crisis.

Contrary to conventional wisdom, surging public debt and fiscal irresponsibility was not the cause for the current problems, even among the peripheral economies. Greece was the only exception. The graphic shows how public debt to GDP ratios continued to decline across the PIIGS throughout last decade till the crisis struck.



However, in the aftermath of the Eurozone integration, there was a sharp surge in capital inflows from the core to the peripheral economies. Both demand and supply side forces drove these flows. On the demand side, the single currency and the resultant sharing of sovereign risk lowered the cost of capital for all these economies, thereby making debt available at cheap rates for the domestic industry.

On the supply side, this capital flow bubble was induced by the sudden decline in the sovereign risk of the peripheral economies (given their integration into a single currency union), the bright economic prospects and the potential for higher returns. Investors assumed that the biggest supporters of European integration, Germany and France, would never let a weaker eurozone country default on its obligations, for fear of derailing the political union of Europe. This belief enabled precisely such countries and their private financial institutions to borrow heavily at cheap rates. Predictably, these flows led the emergence of large current account imbalances.



The sudden influx of easy money led to a sharp increase in price levels and wages across the PIIGS economies. The economic competitiveness of these economies took a hit, especially in relation to the core area economies.



Despite the austerity programs under implementation in these economies, the debt-to-GDP ratios are not expected to come down anytime soon. The shrinking economies have contributed to the declines in interest rates.



Update 1 (28/2/2012)

Paul Krugman on what caused the Eurozone crisis,

At root, their problems are primarily caused by balance-of-payments rather than sovereign debt issues; they had huge capital inflows between 1999 and 2007, which led to inflation, and now they need somehow to regain competitiveness. But overlaid on this is a sovereign-debt crisis, which has forced them to seek aid — and the lenders are demanding harsh austerity in return, which is further depressing economies already suffering from severe overvaluation.

See also this set of graphics from Krugman. This shows the impact of austerity on Greece.

Examining Spain's twenty-plus unemployment rate

Among all the dismal macroeconomic indicators pouring out from the peripheral Eurozone economies, the biggest concern is the high unemployment rates. In an environment of fiscal austerity, high rates of unemployment rates have the potential to severely destablize the society. Nowehere is this a bigger concern than in Spain, which has the highest unemployment rate.



Though, this graphic from Zero Hedge is scary, as Ezra Klein points out, it may not be as depressing as it appears. The vast majority of kids in this age group are in school and therefore should not be considered as part of the workforce.



Historically Spain has had extrteme volatility in its labour market. Its unemployment rate surged since early 2008, mirroring its rise in the first half of the nineties. Ezra Klein writes,

Construction in Spain was a whopping 13 percent of employment during the housing bubble — far bigger than even the United States — which led to an especially big crash. Also, it’s much harder to fire workers in Spain (which in turn makes jittery employers more reluctant to hire in the first place) and much easier to use temp workers.

Temporary workers form 33% of the total employees in Spain, the highest among all major economies. A CEPR study of the labour markets in Spain and France finds that in case of the former, the cost of firing temporary labour is minimal whereas the cost of firing the permanent labour is very high. This temporary-permanent labour contract costs is an important structural imbalance in the Spanish labour market. It has echoes in India's own labour market policies.

Spain's problems can be traced to a real estate bubble and a private consumption boom. Paul Krugman captured Spain's problems succinctly,

There was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

An examination of the macroeconomic indicators highlights Spain's vulnerability. Since the mid-nineties, the Spanish debt-to-GDP ratio has declined gradually to just 36.1% in 2008. However, it has since ballooned to 60.1% in 2011. Gross capital formation has declined from 29% of GDP in 2008 to less than 23% in 2010. Tax revenues as a share of GDP has fallen from slightly below 14% in 2007 to just above 8% for 2009. Since 2007, the structural balance, or output gap, has widened from just above 1% to more than 7% in 2011. Strained by the depressed economy and the resultant fall in revenues, the fiscal balance slipped from a surplus of nearly 2% of GDP in 2008 to a deficit of 9.3% in 2011. If macroeconomic indicators are any reflection, since 2009, the Spanish economy has fallen off the cliff.

The austerity is likely to worsen the situation. However, given its high unemployment rates and the adequate fiscal space available, Spain should be following expansionary policies till recovery takes firm hold.

China and US - Contrasting paths to structural imbalances?

In many ways, China and US are classic examples of how both free-market capitalism and statist capitalism, through contrasting routes, have produced severe macroeconomic imbalances that have brought the later to its knees and threatens the former. The graphic below insightfully captures the respective problems of the American and Chinese economies.



It was unbridled financial market liberalization and sustained expansionary monetary policy, which fuelled massive property and financial asset bubble and debt-financed household consumption binge, that is the source of much of America's current woes. Notional household income share of the GDP rose on the face of the twin bubbles. Households spent as though there was no tomorrow, running savings down to the bottom. Finally when the bubble burst and the recession took hold, households faced the brunt of the slowdown and even after four years, recovery remains uncertain.

In China, the policies enacted in late nineties, in response to bankruptcy problems facing state-owned companies and banks, looks set to have much the same impact in not the distant future. Beijing assumed tighter control over interest rates and exchange rates, keeping them artificially low to finance cheap loans to businesses and government agencies and increase external competitiveness so as to drive its preferred export-led and infrastructure investment driven economic growth model. This period also coincided with the government abandoning the communist era policies of life-long employment and liberal social safety nets, thereby forcing households to increase their savings to meet educational, health care and housing needs for themselves and their children.

These policies amounted to a huge transfer of wealth from the households to businesses, both government and private, and government agencies. Banks and state-owned companies staged excellent recoveries. But all this was at the cost of households - household consumption, already among the lowest at 45%, fell to just 35%, and savings rate rose sharply to about 40%.



As the Times and the FT point out in two excellent essays, this model worked well so long as the export markets were vibrant and the infrastructure deficit was filled, and the government was able to control the supply and price of credit and thereby keep cost of capital artificially low. As the two primary growth drivers weaken, as is happening now, and the unregulated shadow banking system assumes an increasingly dominant role (it now supplies more credit to the economy than the formal banking system) thereby weakening Beijing's ability to control credit, the sustainability of this growth model becomes doubtful. The sliding property market which financed a major share of the investment spending, especially by local governments, is yet another source of concern.

George Magnus writing in the FT has this to say about China's rebalancing strategy from an investment-centric and credit hungry model to one built around consumption,

"It involves a redistribution of income from capital and profits to labour and wages; radical changes in the role of the exchange rate, interest rates and capital markets; and strategies to counter the high propensity to save by households, corporates and central government. It is also politically divisive because power and economic privilege have to be wrested from party elites, state enterprises and banks, and given to new beneficiaries such as private companies, households, college graduates and rural migrant workers."

It is increasingly inevitable that China can sustain its high growth rates only if its domestic consumers can step into the space being vacated by the traditional growth engines. The question is whether Beijing has the stomach to embrace the required structural reforms to enable this transition?

The desirability of an expansionary credit-driven recovery?

Even as the debate rages about how best to achieve recovery, there is the issue of what should constitute recovery. Though there cannot be much argument about the need to bring down unemployment rates to the pre-recession lows, the need to restore the other macroeconomic parameters (notably those related to financial sector and household consumption) to its pre-recession peak is questionable.

Roger Farmer, an ardent advocate of the superiority of quantitative easing over fiscal expansion and a strong believer of the self-fulfilling effect of market confidence, writes,

"Housing wealth in the US has fallen by 34% since its peak in 2006, and is still declining. The stock market fell by almost 50% from its 2007 peak and remains down by nearly a third. This enormous loss of wealth caused a large and persistent drop in consumption demand, which has led to an increase in unemployment... A quantitative-easing policy in which a central bank buys risky assets can prevent price fluctuations and restore the value of financial wealth...

My work provides a new and coherent approach to macroeconomics that explains how a lack of confidence can lead to persistent unemployment. It supports the purchase of equities by central banks to reduce asset-price volatility, restore the value of wealth, and prevent a future market crash...

The Great Recession did not turn into Great Depression II because of coordinated action by governments around the world. Although fiscal expansion may have played a role in this success, central bank intervention was the most important component by far. Quantitative easing works by increasing the value of wealth."

The underlying assumption behind Prof Farmer's hypothesis is that normalcy can be achieved only with a restoration of the pre-crisis financial asset values. The same assumption drives the logic of those advocating expansionary policies - somehow consumers will start to buy, businesses will invest, and banks will lend, thereby restoring normalcy in economic growth, and this in turn requires adequate time so that market confidence will revive and asset values will regain their old highs.

The logic behind monetary accommodation is to buy some time so that the forces of economic growth can be catalyzed into action. It is hoped that if market expectations can be shaped, it could pave the way for growth - investments, jobs, and consumption - which in turn would restore asset values to the pre-recession era standard.

Expansionary policies, especially on the monetary side - like maintaining ultra-low interest rates for an extended period of time - have the potential to generate and amplify existing distortions. One manifestation of this is the deepening divide between the bigger firms and the small and medium businesses in the US. While the former have continued to access credit at ultra-low interest rates and pile on record profits, the later have been badly squeezed in the credit markets. Risk averse banks have been wary of lending to these companies, who are the predominaty actors in creating jobs in the US economy. The result

Another example is the phenomenon of the existing TBTF institutions getting even bigger and more riskier riding on the back of the favorable policy regime. In fact, as Nassim Nicholas Taleb and Mark Spitznagel have argued persuasively in a recent article, the US Treasury and the Fed, as part of TARP and the numerous other unconventional monetary policies, have transferred an astonishing $2.2 trillion to the major American banks and this figure is estimated to reach $5 trillion by end of the decade. They write about how banks, despite their recklessness, were bailed out by the US government.

"Banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.

Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level."

Banks benefitted immensely from the prolonged period of access to ultra-low interest rates, blanket credit guarantees, collateral standards dilution, and massive capital injections. At the height of the crisis, the Fed backstopped bank losses by becoming the lender, insurer and even purchaser (buying up illiquid and risk-filled mortgage backed securities to prevent values plummeting) for the entire financial system.

As the crisis expanded and the strains started showing on some of the largest financial institutions, it became increasingly evident that their failure would have catastrophic consequences on the economy. So the momentum gathered to provide all possible liquidity support and even direct bailouts, if need be, so as to contain the spread of systemic risks. The underlying premise was that it was mainly a liquidity crisis (and not a solvency one), and if the banks were given enough time, market confidence would be restored, asset values would recover, and balance sheets will be repaired.

It can be safely argued that this strategy worked, and the balance sheets of the biggest banks have recovered considerably from the depths of 2008-09. However, unfortunately, this relatively quick recovery has blanked out all institutional memory of the lessons from the sub-prime crisis. Apart from some cosmetic changes, financial markets continue merrily with limited regulation.

The same old unhealthy practices, ones that led to the build-up of systemic risks in the first place, are back along with the driving force behind these trends - distorted incentives of traders, executives and managers. Executive compensation is back to the halcyon days of the pre-crisis era. The big financial institutions have gotten bigger and enjoy the benefits of a market place where even as their smaller competitors are credit constrained, they themselves have access to capital at utlra-low rates for an extended period of time. It clearly appears as though nothing has changed, and the cycle looks set to repeat, with the markets in wait for the next bubble to inflate.

In a recent post about the Eurozone crisis, Tyler Cowen had written that though the Eurozone governments had on paper a balanced budget, their commitment to a single currency was a massive naked put, relative to their GDP, which was not internalized into the national budgets. Similarly, the growing sizes of the TBTF institutions and the resultant concentration of risks, is a very large naked put by the US government in favor of its TBTF institutions, one which is unfortunately not reflected in the US government's fiscal balance. Only when disaster strikes and the bailout checks have to be signed, the true magnitude of the fiscal commitment becomes obvious.

Finally, there is the impact of the extraordinary monetary accommodation in the US on the world economy, especially the emerging economies. The massive stocks of easy money sloshing around poses great threats to financial market stability. For a start, it can trigger off destabilising capital inflows into emerging economies and undesirable sharp currency appreciation. However, these flows can quickly reverse, leaving currencies and equity markets battered.

The aftermath of the sub-prime mortgage crisis presented a great opportunity for regulators to clamp down on the several unhealthy business practices in financial markets that were primarily responsible for the mess. However, that window of opportunity is almost gone. And more worryingly, the market conditions that has emerged in the aftermath of the crisis may be perpetuating or even amplifying many of the worst offending excesses.

We appear to have been left with the worst of all worlds. The regulators have failed to seize the opportunity. The market conditions in the aftermath of the crisis works towards making the big institutions even bigger. And amidst all this, the credit markets remain seized up and the economy continues to show no signs of any recovery.

Rebalancing China's savings-investment imbalances

One of the biggest macroeconomic challenges for the world economy in the years ahead lies in the manner in which China's economic growth is managed as its economy moves into the next stage of growth.

Over the past decade-and-half, China's spectacular economic growth has pulled hundreds of millions of Chinese out of poverty and provided the engine for global economic growth itself. This growth was was driven by a massive export-led industrial and infrastructure investment boom, that channelized the very high domestic savings rate and huge foreign direct investments.

Whenever, economy threatened to slowdown the government further boosted its fixed investment share of the GDP. In fact, the decline in exports during the recent global recession, the government increased the fixed-investment share of GDP from 42% to 47%, and increased further in 2010-2011, to almost 50%. Nouriel Roubini who feels that such growth is unsustainable, describes the results

"No country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Commercial and high-end residential investment has been excessive, automobile capacity has outstripped even the recent surge in sales, and overcapacity in steel, cement, and other manufacturing sectors is increasing further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors."

The only way out of this is to prune down investments and increase domestic consumption, which remains the lowest among any major economy. I have blogged earlier about China's savings paradox (massive savings, when interest rates are so low) which has generally been attributed to the uncertainty Chinese feel about their income and the market-oriented nature of Chinese reforms. It has been argued that an extensive social safety net, universal medical insurance, reduced cost of higher education, and expansion of public services would lower the uncertainty and get Chinese consumers to spend more.

However Roubini feels the challenge goes beyond this, and requires more fundamental structural changes. He argues that these structural factors contribute towards a massive transfer of wealth from households (through their savings) to corporate sector. It is natural that domestic consumption was just 35% last year, since the share of GDP going to household sector is less than 50%, again among the lowest in all major economies. These structural factors and their impacts are

1. Low interest rates - means that the returns for savings are very low, and corporates enjoy negative real rate on their borrowings. This constitutes one of the biggest direct transfer of spending power from savers to borrowers or households to corporates.

2. Artificially deflated exchange rate - Works in two dimensions. One, it increases export competitiveness. It encourages businesses, already benefitting from artificially suppressed wages and lower cost of capital, to over-invest in facilities for exports. A build-up of imbalances and excesses in export-oriented manufacturing is the result. Two, it lowers import competitiveness. Therefore, domestic consumers are prevented from enjoying cheaper imports and are forced to pay higher prices to buy lower quality domestically manufactured goods. This adds an inflationary dimension to the consumers spending, thereby reducing their real effective purchasing power.

3. Low rate of corporate taxation - This too keeps the cost of production artificially low. Higher taxes would generate higher revenues, which could be used to fund a comprehensive social safety and welfare system, besides expanding the coverage of public services. This also would dis-incentivize over-investments, apart from transferring wealth from coporates to governments and then to consumers.

4. Low wage growth - Labour repression, with policies like the household registration (hukou) system and overt arm-twisting of labor groups, have kept labour wages low. Businesses benefit by way of lower cost of production, whereas workers do not get to share proportionately the gains of higher economic growth.

5. Repressed financial markets - This is one of the most under-stated and less discussed issues, and a critical determinant of how China addresses its structural challenges. Greater depth and breadth to its financial markets would provide much higher returns to savers, who could then use it to increase their purchasing power. It would also provide a more efficient channel for the Chinese government to raise resources and invest their surpluses.

Roubini has some doomsday predictions for the Chinese economy,

"But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan. Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible."

In this context, the findings of a recent NBER working paper by Barry Eichengreen and others on economic slowdowns in fast-growing economies is instructive. They use international data since 1957 and find that

"International experience suggests that rapid-growing catch-up economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve on or soon after 2015. Our estimates suggest that high growth slows down when the share of employment in manufacturing is 23 per cent; while current data on employment shares in China are not readily available, observation and extrapolation suggest that China is nearly there. Our estimates similarly suggest that growth slows when income per capita in the late-developing country reaches 57 per cent of that in the country that defines the technological frontier, a level that China is likely to reach only somewhat later... Most provocatively, slowdowns are more likely and occur at lower per capita incomes in countries that maintain undervalued exchange rates and have low consumption shares of GDP."

They find that countries which are more open to trade are able to maintain higher growth rates for a longer period of time. However, higher old-age dependency ratios make growth slowdown more likely, and China will have a higher old-age dependency ratio in the not-too-distant future.