Category Archives: Economics

Tango Down

You can’t deny that things are just not working out for Argentina these days. First, they had their hopes and dreams crushed earlier this summer after they lost against Germany in the World Cup. Obviously, soccer is just a sport. However, its also a way of life in most South American countries. So you can imagine how heartbreaking it must have been for the Argentinians.

To add insult to injury, recently, Argentina also defaulted on part of its sovereign debt. This means that it failed to meet its payment obligation to some of its creditors. Before we continue let me clear up two common misconceptions about sovereign defaults. The first one, is that it occurs when a country goes bankrupt. This is false. Default just refers to not being capable of paying or refusing to pay debt. The fact that Argentina defaulted on its debt was entirely its own decision as I will explain soon. Argentina still had money in its treasury to pay its debt off. Or it could have printed some money to do so; but it refused. The second misconception is that sovereign defaults are very rare occasions that only occur once in a million years when the economy or financial sector of a country is in shambles. This is partly true. Yes, financially troubled countries are more likely to default, but even developed countries can default too. The United States came close to defaulting in 2011 when Congress nearly refused to raise the country’s debt ceiling. The following list of sovereign defaults since 1961 shows that it can happen pretty often.

SIGSovereignDefaults2003

So why did Argentina default? You might have noticed from the table above that Argentina defaulted not too long ago in 2001. The story of Argentina’s most recent default can be actually be traced to its previous one. So lets go back to 1998 to get a better understanding of where we are today.

In order to control the hyperinflation caused by an economic crisis in the late 1980s, Argentina decided to peg its currency, the austral, against the US dollar in 1991. This lowered inflation and caused Argentina’s GDP to grow by nearly 50% between 1990 and 1998. Living standards rose and Argentina was labeled as one of the new emerging economies. However, not everything was as it seemed. Deep down within Argentina’s economy, a crisis was brewing. Argentina was spending a lot more than the revenue it was generating. Thus, the nation’s external debt kept on piling up. A financial crisis that occurred in 1997 in Asia slowed the Argentinian economy and reduced investor confidence in emerging markets such as Argentina. The final piece of the puzzle came when in 1999, Brazil devalued its own currency, causing the Argentinian austral to be less competitive against the currency of its neighbor.

After having enjoyed a honeymoon period during the early 90s, Argentina’s GDP declined by 3% in 1999 and the country entered a three-year long recession. Despite consecutive tax hikes and spending cuts by the Argentinian government, unemployment kept rising, the economy kept on shrinking and borrowing costs rose, making it harder for the the nation to finance its debt. The situation failed to improve as the people took the streets to protest and the IMF refused to keep lending to Argentina. By November of 2001, investors rushed to sell their australs, causing a run on Argentinian banks. Shortly thereafter, Argentina was forced to abandon the currency peg. Finally, on the last week of 2001, the Argentinian government defaulted on $132 billion of public debt. Here are a couple graphs that display how everything went insane in Argentina around 2000.

argentina-gdp-growth

Historical Data Chart

This is where our story truly begins. Until that date, Argentina’s $132 default was the largest in history. Despite cutting off the country from international capital markets, it stopped the Argentinian currency from entering hyperinflation and as the graph depicting Argentina’s GDP growth rate proves, it helped the country to enter a period of growth.  Argentinians are known for their kindness. That’s one of the reasons why their flag has a smiling sun on it. So, in 2005 and 2010, the Argentinian government offered new discount bonds to the holders of its defaulted debt. These bonds pad about 35 cents on the dollar of the original bonds. It was an offer that these investors could not refuse. If they did refuse, they got nothing. They had worthless bonds in their hands. If they said yes, they at least had something. Thus, 93 percent of bondholders agreed to the deal.

Who were the the remaining 7 percent, and what where they thinking? Well, they’re a group of hedge funds including Elliott Management and Aurelius Capital and they decided to take off their investor hats and become lawyers by going on a crusade to get the exact amount of money that they were originally owed. In other words, this was their reaction to Argentina’s proposal.

You see, the original bonds had a clause called parri passu, which means ‘equal treatment’ across all bonds. The holdout investors claimed that this meant that Argentina can’t pay back some bond holders and not the rest. Its a clever argument really. And its also risky. These investors could have taken the easy way out and received the discount bonds. But for years they’ve been going after Argentina to get their money back in its entirety. Its something that only a very determined and diabolical person would do. Paul Singer, the CEO of Elliott Management, the most aggressive hedge fund, fits that persona both characteristically and physically. I mean just look at him. He is a prime candidate to be the next Bond villain.

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“James Bond. Allow me to introduce myself. My name is Ernst Stavro Blofeld. They told me you were assassinated in Hong Kong”

So how have these hedge funds fared over the past decade? Not so successful actually. They attempted to sue Argentina in the past and failed. When it seemed that suing wasn’t working, they turned to seizing Argentinian assets. Not financial assets though, they targeted physical assets. In 2012, Elliott Management seized a frigate belonging to the Argentinian navy off the coast of Ghana as partial payment for the money that it was owed. But this tactic failed as well when Elliott Management were forced to hand the frigate back. I don’t know what is funnier, imagining hedge fund pirates taking over a ship in Armani suits, or that the fact that this ship is still used as a frigate in the Argentinian navy when it clearly belongs in a museum.

The holdouts made their breakthrough in 2012 when a lone judge in New York named Thomas Griesa ruled that the holdouts were correct about the parri passu clause, and that Argentina couldn’t pay the exchanged bonds without paying the holdouts too. To put the pressure even more on Argentina, Judge Griesa ruled that if Argentina refused to pay the holdouts, it would prevent any financial institution from facilitating the payments Argentina maid to the exchanged bondholders. This decision put Argentina in a tough situation because if it didn’t pay the holdout bonds, it would default on all the exchanged bonds, even thought it was willing and able to make the payments. I’m sure this was Paul Singer’s reaction after Judge Griesa’s decision.

Time went by, insults were thrown and meetings were held, but both sides could not come to an agreement by July 30, which was the deadline that Judge Griesa had placed on Argentina. Hence, Argentina defaulted. Besides stubbornness, there were several other reasons for why Argentina refused to pay. Firstly, their foreign currency reserves were running low. At the time of the default, Argentina only had $29 billion in foreign currency reserves. If they paid the holdout investors, then their reserves would reach critically low levels and would greatly effect their monetary policy in the future. The second reason is that Argentina had another clause in their exchange bonds called RUFO ( Rights Upon Future Offers). This clause forbid Argentina from offering any new future bondholders a better deal, without also extending the same deal to exchanged bondholders. In other words, they would have to pay the exchange bondholders the same full amount on each bond just as they would pay to the holdouts. If Argentina broke this clause, they would have been liable to pay the exchanged bondholders approximately $120 billion.

Although the holdouts failed to get what they wanted, they are still searching for ways to shake some cash out of Argentina. On August 11th, a federal court in Las Vegas gave NML Capital, one of the holdout creditors, the right to investigate the US-based companies of an Argentinian businessman named Lazarao Baez.  Mr. Baez is under investigation in Argentina for allegedly embezzling $65m from government contracts. By looking into Baez’s activities, NML hopes to perhaps recover some funds through a court order and to humiliate Argentina for not paying its debts. I think that after defaulting 8 times in its 200 year history, Argentina is impervious to financial humiliation.

So what happens now? Will Argentina’s economy crash again like last time? Not really. This default occurred for obscure legal reasons as opposed to financial reasons. Of course it will continue to cut off Argentina from international capital markets, making it harder for Argentina to borrow, but they were still in that situation anyway. Argentina’s economy will continue to be in stagflation, with negative growth and high inflation. I think they’re used to it by now. Finally, because Argentina’s external debt and GDP is so low compared to the global economy, this default will not have a large effect on global markets.

Historical Data Chart

Nevertheless, I feel bad for the people of Argentina. They’re forced to suffer due to the mismanagement of an incompetent government and the greed of a group of rich hedge fund managers. I think there’s only one man who can solve this problem. The one man that all Argentinians turn to when they are desperate for something miraculous to save them at the last minute…Lionel Messi.

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BONUS: If you follow this blog regularly, you would know by now that I like to simplify complicated concepts by using humor and various real life examples. I think it gives a chance for people who are not familiar and not interested in these topics to understand and enjoy reading about these issues. Lets be honest, sovereign debt defaults, hedge funds and RUFO clauses are not the most interesting subjects in the world. As a bonus, I’ve added a video of Felix Salmon, a Reuters reporter, who tries to explain the story of Argentina’s default in even simpler ways than me …by using Legos and action figures. Enjoy.

“This situation thrust upon the Argentine people is also a form of violence. It is a financial missile, which also costs lives”
– Cristina Fernandez de Kirchner, President of Argentina

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Europhoria No More

In 2011 and 2012, the Eurozone was on the brink of destruction. Investors were preparing for a Greek exit from the Eurozone and some experts were even questioning the very existence of the European Union. However, in two years, much has changed. Today, the possibility of Greece leaving the Eurozone or of Cyprus becoming insolvent seems like a distant memory and after two years of being in recession, the Euro area has finally generated positive growth. The growth is slow, but is nevertheless positive.

How did the Eurozone manage this turnaround? Well, we can all thank the European Central Bank (ECB) for this. In July of 2012, ECB President Mario Draghi announced that the, “ECB would do whatever it takes to preserve the Euro.” In addition with this speech, the ECB extended the maturities on the loans it gave to European banks (called Long Term Refinancing Operations) and announced a new program (called Outright Monetary Transactions) where for the first time, it promised to purchase the sovereign bonds of financially troubled nations, given that they agree to implement certain fiscal reforms (tax hikes, spending cuts, etc.).

The ECB used a tricky monetary maneuver called sterilization to make sure that LTRO didn’t increase the European money supply the way FED’s QE did and until today, no country in the Eurozone has actually applied for a bailout through Outright Monetary Transactions. However, the mere existence of these programs created a sense of security in the Eurozone and they helped reduce the sovereign bond yields of Eurozone nations that had been inflicted by the crisis. For you bond newbies, the lower the interest rate on a bond, the less riskier it is deemed by the market. The graph below does a good job in visualizing Spanish and Italian bond yields in relation with ECB actions.

whatever_it_takes

In fact, one could argue that the sovereign bond yields of periphery Eurozone countries have dropped too low. For example, on the day that I have written this post, 10-year Spanish government bonds are yielding 2.68% whereas 10-year German bonds are yielding 1.27% . That means that the spread between the country with the highest unemployment rate in the developed world and the safest economy in the Eurozone is less than 2%. Back in August of 2012, that spread was about 6%. Even when Apple issued 10 year bonds in April of this year, their bonds yielded 3.45%. I think its safe to say that the markets have treated periphery Eurozone nations rather kindly.

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Despite the irregularities in the bond markets, its hard to deny that the Eurozone has been in a honeymoon period for the last two years. However I realized that something is rotten in the state of Denmark, France, Italy, Spain, and all the other Eurozone countries (that was a Shakespeare joke. Read a book people). when a couple of months ago, I got a phone call from my good friend Mario Draghi.

Mario Draghi
“Buddy, I need your help with something. Come on over quick. Party at Merkel’s place afterwards.”

Even though I had a very busy schedule, I couldn’t say no to one of my oldest friends. So I decided to take the trip down to Frankfurt. Here I am outside the ECB.

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I’ve lost count of how many times I’ve been there but I still have to go through security. Its so annoying. Anyway; when I walked into his office, Draghi seemed worried. He told me that the Eurozone is on the brink of negative inflation, otherwise know as deflation. The ECB’s target inflation rate has been 2% for the past several years. However, as the graph below shows, Euro area inflation has been below 1% since November of last year. In fact, just last month, several European countries including Greece, Cyprus and Hungary observed negative rates of inflation.

euro-area-inflation-cpi (2)Even those of us who haven’t received an education in economics have been told to fear inflation. However, deflation can be just as bad, if not worse. I’m pretty sure I explained this in a previous post but deflation has two main negative impacts. First of all, deflation discourages spending. Why should a sensible person purchase something today if he knows that it will be cheaper and more affordable tomorrow. This situation might seem profitable for an individual, but if everyone acts this way, then spending will decrease and the economy will come to a halt. Secondly, inflation has the ability to ease the cost of borrowing. Imagine that I take on a loan. Because of inflation, the amount of money I borrowed becomes less valuable. However, the amount that I borrowed stays the same. Thus, it becomes easier for me to pay back my loan. In cases of deflation when a currency gains in value, the exact opposite happens and debt becomes harder to pay off.

Due to the austerity measures installed in many Eurozone countries following the debt crisis, the Eurozone economy is barely expanding. Draghi fears that deflation could push the Eurozone economy back into recession. One of the reasons that Draghi had his hands tied was because he had already lowered interest rates to nearly 0%. Yet, he was failing in spurring inflation. That was where I stepped in to give Draghi some advice. On June 5th, Draghi listened to everything I had to say and held a press conference. The cameraman zoomed in on Draghi so I didn’t make the shot but I was sitting right next to Draghi during the press conference.

Firstly, I realized that European banks were parking their money at the ECB. Thus, I urged Draghi to set the ECB deposit rate to a negative figure. Negative deposit rates can encourage banks to take their money out of the ECB and perhaps lend it to consumers and companies because they would actually be losing money for depositing their cash at the ECB. This would spur growth and much needed inflation. Draghi followed my advice and lowered the deposit rate to -0.1%. He also lowered the headline inflation rate to 0.15% from 0.25%

Secondly, in the final hours of our meeting, we came with an idea to initiate a new financing program called Targeted Long Term Refinancing Operations (TLTRO)  where banks can borrow money from the ECB equivalent to as much as 7 percent of their outstanding loans to non-financial corporations and households. The loans will be given for 4 years. However, if these institutions don’t lend out the money they get from these loans, we will cut their maturities to two years.

Finally, I told Draghi to always have an ace of spades in his back pocket, in case the worst comes to worst. That ace of spades, would be outright bond purchases, just like Quantitative Easing in the US. We came to the conclusion that its better to wait and see how the Eurozone economy reacts to the policies we came up with that day, but letting the markets now that just like back in 2012, we would do whatever it takes to spur inflation in the Eurozone will help increase inflation expectations. Those are the unorthodox policies that Draghi touched on towards the end of his speech. Bond yields are already very low and QE in the United States has shown that bond purchases don’t necessarily spur inflation. However, the idea of bond purchases being a possibility will definitely play a role in protecting the Euro from appreciating.

After working for hours to come up with these policies, we finally called it a night and decided to go to Angela Merkel’s mansion in Berlin for a wild party. It was strictly BYOB. Apparently Merkel is tired of buying everyone drinks. All those bailouts in Southern Europe may be to blame. I can’t tell you what went down in that party. Lets just say that many world leaders wouldn’t want the pictures to leak to the press.

Popping champagne.
This is only the pregame.

Following Draghi’s press conference in June, Eurozone inflation remained stable at 0.5%. Draghi gave me a phone call last week and thanked me for his help. I told him that he owes me one and I gave him one final piece of advice.  I told him to publish the minutes from the ECB meetings, just like the way the FED does them. This would not only give the ECB some much needed transparency but would also increase the effect that his decisions have on market expectations.

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As you can see, my friend Draghi looks awfully cute when he is happy. I hope his happiness continues and that the Eurozone can get out of this deflationary trend soon. In the globalized world that we live in, our economies are extremely interconnected. Thus, the fate of one large economy can have an effect on all of our countries and all of our lives.

“If we do not resolve the euro crisis, we will all pay the price. And if we do resolve it, we will all benefit”
-Mario Draghi

 

 

 

Nigeria’s Economic Magic Trick

On April 6th, something fascinating happened. As if by a work of magic, Nigeria grew its GDP by 89% and suddenly became the largest economy in Africa. With this clever sleight of hand, Nigeria’s economy increased its worth from $263 to  $510 billion. South Africa, with a GDP of $370 billion has lost the top economic standing in Africa. How did Nigeria pull this off? Did they really construct over $200 billion of goods over night? Or did they rely on the types of magic tricks as displayed below? The actual reason for the phenomenon lies somewhere between reality and illusion. Let me go further into detail and explain what happened.

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Nigeria’s Finance Minister right now

With a large population of 170 million people, Nigeria has been growing at a rapid pace of almost 7% over the past decade. Previously, the nation’s abundance in oil and other natural resources had been the main drivers of Nigerian growth. However, in recent years, Nigeria has drawn significant foreign investments and has witnessed thee emergence of new consumer-oriented sectors such as telecommunications, entertainment and banking. 20 years ago, Nigeria had only one phone operator and 300,000 telephone lines. Today, Nigeria has an entire telecommunication industry with over 120 million subscribers. Similarly, Nollywood, the Nigerian film industry, now produces the most movies in the world and makes up 1.4% of the country’s GDP. Finally, Nigeria’s services sector has grown by over 240% since 1990.

nigeria gdp chart

The reason for Nigeria’s overnight economic expansion is due to the way the Nigerian GDP was previously measured. For the past 24 years, Nigeria’s GDP calculation did not give much weight to these newly developed sectors. The new system of GDP calculation now incorporates the revenues from Nigeria’s new business sectors which had been overlooked before. This process of revising GDP calculation is referred to as rebasing. The IMF advises countries to go through this process every five years. However, many African countries such as Nigeria do not rebase on a consistent basis. International aid donors urge African nations to rebase regularly so that they can make more precise decisions regarding foreign aid.

nigeria GDP
Source: The Economist

The stastical illusion has not changed anything in reality . The important problems in the Nigerian economy still remain. Even though Nigeria’s economy is large, its people are still poor. Nigeria ranks 153rd out of 187 countries in the United Nation’s Human Development Index, unemployment is over 20% and GDP per capita is only $2700.Given that GDP per capita figure, South Africans are still twice as rich as Nigerians. Additionally, despite the emergence of new industries, the country still draws a majority of its revenues from oil and gas exports. Once again in contrast to South Africa, Nigeria has an underdeveloped infrastructure and has outbreaks of violence in certain parts of the country.

Goodluck Jonathan is the President of Nigeria. Despite having one of the funniest names I have ever heard, still has a lot of work to do. Yes, Nigeria has greatly grown over the past decade and has been the posterchild of rapidly growing African nations.  But in order to lift Nigeria to the upper echelons of nations, President Jonathan should seek to reduce corruption, incrase the efficiency of tax collection and reduce the bureacratic barriers to doing business in the country. As the cradle of mankind, Africa needs more nations such as Nigeria to rise above and help their people live in prosperity and security, something that they have been desperately seeking for many years.

“The work of Nigeria is not complete for as long as there is any one Nigerian who goes to bed on an empty stomach”
– Ibrahim Babangida

Hard Landing?

Over the past month, the Chinese economy depressed global markets with several negative figures. In a global economic climate where slow and sluggish growth is starting to be accepted as the new normal, China has always been the safe haven of dependable robust economic expansion. However, the pace of China’s growth has slowed over the past several years and the data received over the past month has spooked investors that China’s transition from a developing to a developed economy may end in a massive failure. To put it into simpler terms for you movie fanatics out there, China’s economy is like the bus driven by Keanu Reeves in the hit thriller Speed. If it slows down below a certain speed, it will explode and end horribly wrong for everyone on board. For those of you who haven’t seen it, here is a summary of the movie in 5 seconds. The following video may contain some explicit content.

China may not have one of the most untalented actors in Hollywood to keep its economy in the right pace, but it does have the Chinese Communist Party in sole charge of the Chinese economy. Will they keep China on course? We’ll have to wait and see. I will discuss my own analysis and opinion on the state of the Chinese economy soon, but first let’s discuss the data that filled the tickers with red arrows over the last month.

The first data point is retail sales, which displayed a year-over-year increase by 11.8% in January and February and combined. 11.8% growth may seem to be a tremendous figure, but take a closer look at the graph below and you will notice that it is quite low compared to historical data. In fact, I failed to find a graph that goes back that far, but 11.8% is the slowest pace of increase in Chinese retail sales since 2004. Some experts have speculated that Chinese Premier Li Keqiang’s recent movement to crack down on corruption and extravagant spending is the reason for declining consumption. I will soon explain why I don’t think that is the main reason.

china-retail-sales-annual

The second data point which also added to the panic regarding China is industrial production. Chinese industrial production witnessed a 8.6% year-over-year increase in January and February combined. Once again, 8.6% is a dream figure for most developed nations but as the graph below proves, China has been accustomed to rapid industrial growth over the past several years. The latest figure of 8.6% is the slowest figure that China has seen since 2009. Another disappointing figure from the Chinese.

china-industrial-production

Continuing the negative trend, on March 8th, it was announced that the consumer price index (CPI), which is a general indicator of inflation, expanded by a meager annual rate of 2% in February. Like many nations, following the financial crisis of 2008, the Chinese government opened the floodgates and unveiled a large monetary stimulus package to revitalize their economy. Even though they succeeded in keeping the economy on the path of rapid growth, inflation rose significantly throughout this period. As the graph below shows, inflation peaked at around 6% in 2011. However, it has consistently fallen since that year and has reached an alarming rate of 2%. Why is deflation alarming? If consumers are aware that prices are rapidly dropping, they will save and prefer to consume in the future. This is because they are aware of the fact that in a deflationary climate, their money will be worth more tomorrow than it is worth today. Why buy a BMW today when you know the price will drop tomorrow; right? A decrease in consumption due to deflation can lead to a slowdown in economic growth, which is what investors fear might happen to Chinese economy. (On a side note, this is also becoming a serious problem in the Eurozone as well)

china-inflation-cpi

Finally, on March 7th, Shangai Chaori Solar Energy Science & Technology, a solar-cell maker, became the first Chinese company to default on its corporate bond, adding to the scare about the Chinese economy. After being bombarded with a heap of bad news from China, pessimistic investors responded as emotionally as Keanu Reeves, and rushed to sell their Chinese stocks.

So what is the current condition of the Chinese economy? The economy is the foundation of the Chinese Communist Party’s (CCP) authoritarian rule over China. Their largest way of affirming their rule has been that they have been able to engineer rapid economic growth and transform China from a poor rural nation to an urban developed nation. Given the importance that the CCP has placed on the economy, if it falters, then the government is bound to lose its legitimacy to a certain point. Before we determine if the CCP will be able to keep the bus that is the Chinese economy at the right speed, we have to take a closer look at the key characteristics that define it.

So what is the current condition of the Chinese economy? The economy is the foundation of the Chinese Communist Party’s (CCP) authoritarian rule over China. Their largest way of affirming their rule has been that they have been able to engineer rapid economic growth and transform China from a poor rural nation to an urban developed nation. Given the importance that the CCP has placed on the economy, if it falters, then the government is bound to lose its legitimacy to a certain point. In order to determine if the CCP will be able to keep the bus that is the Chinese economy at the right speed, looking at a few data points isn’t enough. We have to take a closer look at several important trends on a larger scale.

Urbanization

The Chinese economy has been in the process of maturing for over two decades now. Throughout this period, it boomed in two ways; by developing the country’s underdeveloped infrastucture (ie. roads, bridges, telecommunicaiton), and by putting underemployed peasants to work in better jobs at urban factories. Just like in England during the Industrial Revolution, a rural and isolated low income nation has been on the path to become an urban and middle class nation that is connected to the rest of the world. Initially, this process yields incredible economic growth as the rural population, especially in a country with such a large population as China, urbanizes and occupies jobs in more productive sectors such as services, technology and industry. To stay consistent with the Speed references, China’s rural population is the gasoline that keeps Keanu’s bus running. However, China is approaching what is know as “the Lewis turning point”, which is the point when underemployed farmers have already left the farms and new immigrants to the cities do not add to productivity. The slowdown in China’s population growth has had a big effect on the gradual decline in urbanization. Mao Zedong, renowned Chinese historic leader, encouraged Chinese woman to have six children, which boosted the Chinese workforce in the 1980s and 90s. After Mao’s death in 1976, party leaders turned against his ideals and institute the One Child Policy in 1979. The result of this policy is that only 5 million people between the ages of 35-54 will join the Chinese labor force this decade, versus 90 million in the previous decade. Many factors about the Chinese economy remain a mystery, but one thing is certain, China’s fountain of youth is about to run dry.

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Cheap Labor

Mass urbanization of rural Chinese workers to the cities also allowed the Chinese economy to take advantage of cheap labor costs. Because these workers used to barely make a living in rural towns, they were willing to work for very low wages in the early stages of China’s transformation. However, the transformation process is reaching its latter stages. Cheap labor costs used to be the main reason why China attracted so many foreign companies and was able to maintain its status as a net exporter. “Losing jobs to China” was a phrase used by many Western politicans. But now, the cost of labor in China has risen compared to other developing east Asian countries such as Bangladesh and Indonesia, and skeptics believe it is a matter of time before China loses its advantage on labor. The graph below displays the steady rise in Chinese manufacturing wages since 1998.

china-wages-in-manufacturing

Consumption

Many economists agree that as China’s economy matures, it will be rely less on exports and will instead be driven by domestic consumption. This belief draws its roots from the idea that until now, personal savings have been intentionally raised by the govnerment in order to fund the spending on large scale investment over the past decade. Once the savings rate drops, China will export less but the Chinese people will spend more. I approach this idea with suspicion. Over the last 30 years, Chinese consumer spending has increased at almost an average rate of 9%. This rate faster than the rate generated by Taiwan and Japan dring their peak growth years. China may also be known for being home to many cheap knock-off brands but global luxury brands are now operating in China as well. In 2010, Rolls Royce sold more cars in China than it did in Britain for the first time. In my opinion, the data just doesn’t prove the notion that the Chinese government has been intentionally keeping consumption down. If the consumption is forecasted to make up for the recent drop in Chinese investment and industry output, then recent indicator pointing to a slowdown in retail sales could be a major issue for future Chinese economic growth.

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The Future

China is much diferent than the country it was just severaly years ago. A significant Chinese middle class has emerged risen and now demands better social services, cleaner air and less political corruption. Due to the slowing economy, the CCP consistently has set a lower target for the annual GDP growth rate, with the latest being at all time low of 7.5%. In the latest annual session of the National People’s Congress, premier Li Keqiang placed economıc growth as a secondary objective and vowed to crack down on corruption and pollution. In fact, looking at China reminds me of Japan in the 60s and 70s. Following WW2, the Japanese economy also grew at a rapid pace and was also driven mainly by exports. Many Americans feared of Japan ovepowering the United Stats on the global economic stage. However, Japan was forced by the United States to appreciate its currency against the US dollar, which contributed to Japan’s gradual slowdown and eventual economic crisis.

In all honestly, I do not understand the mystery behind the future of the Chinese economy. The pessimists are as wrong as the optimists. China is obviously in the middle of transforming from a developing market to a developed and matured economy. Thus, China still has a lot of room to grow, albeit at a slower rate.  Low inflation also means that the Chinese Central Bank has more room to expand the economy with monetary easing. The recent data are symptoms of this transformation and the fact that the state is gradually releasing its hold on the economy and allowing more free market functions to operate. The default of Shanghai Chaori Solar Energy is a sign that free market principles are gaining a foothold in the Chinese economy. This is a very small company, and in an economy dominated by companies propped up and supported by the government, a bond default is a good sign. The days of +10% Chinese growth are past us.  If China moves to a 6-7% growth rate in the coming years, it might appear that China is entering a recession. However, this will hardly be a cataclysmic event. The Chinese economy is now so big (over $9 trillion) that even at a 6% growth rate, China will still be the largest contributor to global growth in the upcoming years.

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On a final side note, I gathered much of the information and developed my personal opinion on the Chinese economy after reading Ruchir Sharma’s book, Breakout Nations. I advise you to read through it if you want to get a better understanding of the countries that are seen as the next big players on the global economic stage.

“The biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”
– 6th Chinese Premier Wen Jiabao (2008)

Emerging Markets in Emergency Mode

Despite how much we prayed for a peaceful and prosperous year, 2014 has started off with a crisis; this time in the Emerging Markets. In a previous Economy in Digits post, I had discussed how India and Turkey had responded to large losses in the value of their currencies by raising interest rates. In the following days, the sell-off in stocks and currencies extended to other Emerging Markets. If you’d like to get a better understanding of Emerging Markets, feel free to check out one of my earlier posts regarding upcoming Emerging Market elections, which I will touch on shortly. As you can see from the following graph provided by Bloomberg, the MSCI has been performing very poorly. Lets take a look at what is causing all this mess in the countries that not so long ago were deemed to lead the world out of the global economic crisis.

emerging markets index

The first reason for the rapid sell off of Emerging Market stocks is a topic that my regular readers might be getting sick of hearing, but its tapering. The main reason why most Emerging Markets fared so well after the economic crisis of 2008 was that central banks in developed nations pushed interest rates to almost 0%. Seeing as how they would make almost no money on investing in developed countries, investors sent their money to do its magic in Emerging Markets where interest rates are higher. Combined with an increase in price of global commodities, which is an important source of income for many Emerging Markets, the inflow of foreign funds caused Emerging Market economies to skyrocket. However, in the last week of January, the FED decided to continue tapering by reducing its bond purchase program by another $10 billion. This is causing interest rates to rise in developed markets, especially in the United States. Thus, investors are now doing the opposite of what they did in 2008 and are now pulling their money away from Emerging Markets and are putting their cash back in developed markets such as the US and the UK.

Another reason why Emerging Markets are in trouble is because of China. China had been the poster child of Emerging Market success in the past several years. However, as the country reaches a limit on urbanization and its population transitions from rural to middle class, the government has had to enact reforms that inevitably slow down the Chinese economy. Combined with the fact that the Chinese government has also tried to reduce credit in the Chinese economy due to fears of a credit bubble, some investors now fear of a “hard landing” for the Chinese economy. These fears were strengthened in the final week of January as Chinese officials announced that the country’s Purchasing Mangers Index (PMI), a monthly manufacturing report that surveys private manufacturers, contracted for the first time since 2008.The reason why China is so crucial to other Emerging Market nations is that China is one of the world’s largest importer of commodities. On the other hand, most Emerging Markets are net exporters of commodities. Thus a slowdown in China would mean less demand for commodities from other Emerging Markets, causing a chained slow down across all Emerging Market nations. Here is a video that further breaks down whats going on in China.

Finally, we have the isolated incidents across individual Emerging Markets. In an earlier post, I discussed the political crisis created from a corruption probe in Turkey and rampant inflation in India. However, other Emerging Markets have also had their own troubles. Thailand has been in social and political turmoil since November of last year. Protesters have taken to the streets across Thailand to force Prime Minister Yingluck Shinawatra to resign and postpone the elections that was supposed to occur in the beginning of this month. Protesters see Mrs. Yingluck’s regime as corrupt and wishes her to reform the Thai political structure before elections are held again. In fact protesters managed to postpone the elections which were planned on February 2nd. To learn more about the events in Thailand, feel free to read more about it on the BBC.

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To make matters a tad bit worse, as if it wasn’t bad enough already, the Argentinian economy is rapidly deteriorating. On February 13, Argentinian inflation was announced to be at 44%. That is at levels where one would call it hyperinflation. Argentina had once been a prosperous nation. But a crisis in 2001 has left it with naively populist governments that have slowly shut itself out of global capital markets. The gradual downfall of the Argentinian economy is an issue I will cover in another post but for now check out this post by the Economist to get a better understanding.

So what happens now? Are Emerging Markets doomed for eternal decline? First of all, even though most people like to lump all Emerging Markets together, not all countries are the same and not all have suffered greatly over the past couple of months. In fact, in January, shares in the MSCI Indonesia rose by 4.6% while the market in the Philippines gained 2.4%. These countries have done well to turn the money that was invested in their economies into long term growth opportunities that improve their trade balances over the long run and increase the education and productivity of their population. However, many of the Emerging Markets  that experienced rapid economic growth in 2010 and 2010 were fueled by short term foreign investments and increasing consumer demand which required constant to satisfy. As foreign investors pull out and domestic demand cools, these economies will start looking back to 2010 and 2011 as the glory years of the past. Countries such as Turkey, India and Brazil, which were on the verge of double digit growth back in those years will now find it difficult to reach 4% let alone 5% growth. Even though Emerging Markets may not collapse and fall out of favor with all investors, I think the markets in these nations will revert to a new normal which is slower growth.

“So much of what happened to India late last year and early into 2011 is the same story we’ve seen with other big emerging markets, and that is that investors started to realize that the growth trajectory in India would have to get moderated by tightening policy.”
-Jerrry A. Webman

Video of the Week – Taper Continues

This video does a great job to explain what I wanted to talk about from the previous week. However, I know you’d be devastated if you didn’t get a taste of my elegant writing. Have no fear.

As he passed the torch to Janet Yellen, Ben Bernanke announced in his last FOMC meeting that the FED would continue tapering QE by decreasing the bond buying program by another $10 billion. This brings the total of the program down to $65 billion of treasury bonds and mortgage-backed securities. FED officials decided that the American economy is strong enough for a second round of tapering, despite recent mediocre data including a weak jobs report.

Once again, this second step of tapering will end up lowering US stock markets, raising interest rates in the United States and appreciating the US Dollar in value against other currencies. This is having a profound on effect on Emerging Markets such as Turkey and South Africa where a devaluing currency and a rise in American interest rates is causing investors to flee those markets. In response, Emerging Markets have resorted to raising interest rates but so far they have not been able to regain the losses to the value of their currencies. In response to the effects that tapering is having on foreign countries, FED officials have stated that their priority is to maintain the strength of the American economy and tthat if they succeed, then Emerging Markets would fare better off as well.

“Most projects start out slowly – and then sort of taper off.”
-Norman Ralph Augustine

Economy in Digits – 02/01/2014

In the past couple of weeks I didn’t see any significant economic indicators in the news. However, we got a lot of data over last week.

United States

Driven by the fastest consumer spending in the last three years and a rise in exports, US GDP increased by 3.2% year-over-year in the 4th quarter.The calculations also showed a 1.9% increase in GDP across all of 2013, compared to 2.8% the previous year. The 2013 figures showed that a significant decrease in government spending due to the shutdown in October had dragged GDP figures down when compared to last year. That was of course accompanied by the extreme cold temperatures in the winter which also hampered the economy. However, the numbers are still positive and despite the continuation of tapering by the FED, the US still remains the safest economic harbor right now. As we’ll discuss soon, Emerging Markets are not doing too well right now.

united-states-gdp-growthTurkey and India

Both the Turkish Central Bank and the Indian Central Bank resorted to drastic interest rate hikes. In Turkey, a corruption probe against government officials had led to the resignation of various cabinet ministers. The following levels saw the Turkish Lira lose significant value and brought the Turkish Lira/US Dollar spot rate to unprecedented levels. To stop the devaluation, the Turkish Central Bank sold parts of its foreign reserves but it was to no avail. Finally, the Central Bank had enough and they raised interest rates sharply. The benchmark interest rate was raised from 4.5% to 10% and the over night lending rate was hiked from 7.5% to 12%. Following the rate hike, the Turkish Lira gained 4% against the US dollar. However, the crisis is yet to be averted. Even though the Lira gained in value after the Central Bank’s decision, the sell off creeped in again. This decision is surely to slow Turkish economic growth and that could prove crucial to determining the outcome of the upcoming local elections in March.

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On to India, another country that required a rate hike this past week. As I stated in an earlier post, India is struggling with high inflation and lackluster growth and just like Turkey, they will be having elections this year. However, the Indian Central Bank let everyone know that they are serious about battling inflation when they increased the repo rate by a quarter point to 8% and announced that they plan to reduce the inflation rate to 6% by 2016. As you can see from the graph below, the latest inflation figure in India is over 11%.

indiainflationGreat Britain

Another GDP figure came from Great Britain as GDP growth was announced to be 0.7% in the 4th quarter of 2013 and by 1.9% in 2013 overall.That figure might seem as slow as Shaq running down a basketball court however that is the fastest growing quarter that Great Britain has had since the 2008 economic crisis. The main force behind the growth was the services and the manufacturing sectors and evidences that slowly, eventually and oh so gradually, the British economy is picking itself up.

Historical Data Chart

EU

The Eurozone had been battling a rather unfamiliar problem, deflation, which is the opposite of inflation. To battle the deflation, the European Central Bank had decided to lower interest rates last month. However, we got new inflation figures from the Eurozone which don’t look so bright. Consumer price inflation across the Eurozone fell from 0.8% in December to 0.7% in January.. Even though the worst of the European debt crisis is behind us, deflation means that firms and individuals are more likely to hold off on spending money until the future, which could take a toll on growth. Even though I see it to be unlikely, European Central Bank officials stated that if matters get worse, they could resort to negative deposit rates for banks’ deposits at the European Central Bank.

Historical Data Chart

That was what made economic headlines this week. Stay tuned for more economic news in Economy in Digits in the following weeks.

“Economics is extremely useful as a form of employment for economists.”
-John Kenneth Galbraith