Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Thursday, January 22, 2009

China Nears Recession Point As GDP Slumps

China’s National Bureau of Statistics released fourth quarter GDP growth statistics for 2008 today, and it turns out that (according to their initial estimates) the Chinese economy expanded by 6.8 per cent in the last quarter of the year when compared with the same period in 2007. This was the weakest quarterly year on year growth rate in seven years. For the year as a whole, the economy grew 9 per cent, down from the revised 13 per cent growth rate in 2007.

Strikingly, Japanese exports to the US were down some 37% yoy, losing some 26pp since the 11% yoy contraction in July. But we cannot highlight strongly enough how truly mindboggling Japan’s collapse in exports to China are. Last July they were expanding at a 16% yoy pace. Now they are contracting at a 35% yoy rate! This is a phenomenon throughout the region. Hence despite the notoriously manipulated Chinese GDP data showing a shocking slowdown in GDP growth to 6.8% yoy, I would eat my hat if the Chinese economy was doing anything other than contracting right now. Albert Edwards Societe Generale

The steepness of this slowdown is likely to have a significant impact on much of the rest of Asia, which relies heavily on demand from China. Only this week a Singapore based economist friend of mine sent me this in an e-mail:

At S'pore's port container terminal (the busiest in the world), a third of the cranes are idle. There are some companies saying they have inventories stretching 6 months out. December's plunge in Asian exports was due to the shutdown of electronic companies during the Christmas period because of the pile up in inventories.

Basically there is still far to much we don't know about what is happening in China, like, for example, the seasonally adjusted quarter on quarter rate. Barclays Capital economist Peng Wensheng estimates that after taking into account seasonal adjustments, the Chinese economy barely grew at all in the fourth quarter compared with the third quarter. My feeling is that he is most probably right. Most of the consenus analysts are therefore very probably well behind the curve. Like Daiwa Institute of Research, JPMorgan Chase & Co. and Citigroup Inc. who while they all today reduced their estimates for China’s growth in 2009 remained at remarkably high levels. Daiwa cut to 6.3 percent from 7.5 percent; JPMorgan to 7.2 percent from 7.8 percent; and Citigroup to 7.6 percent from 8.2 percent. This seems to me to be the next best thing to living in "cloud cuckoo land".

Basically it seems to me that few people other than professional macro economists and bank analysts (and far from all of these if the truth be told) really realise what the implications of such a dramatic decline in year on year GDP actually means. If the quarter on quarter rate of expansion was very low indeed, possibly verging on the negative then - guessing a bit, you know what they call back of the envelope stuff - this means output must have been moving in the October-December period somewhere in an annualised 0 to 2% range. This means we may well see quarter on quarter negative growth in 2009 in China, and that the possibility of a technical recession of two consecutive quarters of negative growth must be over 50% at this point. It wasn't so long ago that the consensus was saying that annual GDP growth which was as high as 6% would be tantamount to a recession!

It is really very frustrating to find that with all the trillions of dollars at issue, and a whole army of China watchers, virtually no one seems to be trying to derive monthly and quarterly rates of movement from the official statistics.

The OECD do at least seem to be aware of this problem and they do have a lead indicator for China (which includes items like cargo handled at ports, Enterprise deposits, Chemical fertilizer production, Non ferrous metal production, a Monetary aggregate M2, and Imports from Asia. Below I have a chart which compares this indicator for both Spain and China. Since Spain, as we know, is having a very strong contraction at this moment in time, it gives some sort of reference point. What is so striking is that it appears China is now slowing much more rapidly than even Spain, and GDP may, looking at the steepness of the recent month on month drops,have even started contracting in November. This is obviously all shell shock stuff.

Societe Generale economist Albert Edwards is one of those who has been drawing our attention to the rapid decline in China's GDP (although I myself had a go here) and he uses one very interesting "proxy" (an indicator which can serve as a rough and ready substitute for something else, in this case movement in GDP) - electricity output. If you look at the 3 month year-on-year moving average for electricity output in China (see chart below) you will see it is already falling, which means that (in all probability) China's GDP is falling, which is just wow!

The history of using electrical output as a convenient proxy where we simply don't have very adequate data has a long and reputable history - going back to the pioneering work of US growth theorist Edward Dennison in the 1960s - but in case you feel that the correlation may not be a good one, here (see below) is a chart from Edwards which shows China GDP and electricity output compared. The fit is obviously not a perfect one, but that isn't the name of the game here, what should be evident is that a drop in electrical output as large as the one we are seeing in China at this point will be reflected in a very sharp reduction in GDP output.

Which takes me on to my next point, how reliable is Chinese data? Well, perhaps I am going to surprise some of you here, but I would day that for my purposes it doesn't really matter, since what I think we need to know is the rate of contraction (or expansion) in Chinese GDP, and not its absolute level. What matters to the rest of the world is not expecially how rich - or poor - China actually is (from a macro economic analysis point of view that is), but how rapidly it is expanding - or contracting - and what the rate of export and reserves growth is. The rest is interesting, but from a nuts and bolts point of view, it constitutes what Boris Vian used to call froth on the daydream. If the official data is rather inaccurate, then it is not unreasonable to assume that the inbuilt biases are the same from one time period to the next (the same point applies to the existence of the so called "informal economy"), and so my message here is - arrived at on the basis of looking at one economy after another in rapid succession - how much we can learn from how little, if only we know what we are looking for that is. This electrical output picture is also to some extent confirmed by China's manufacturing purchasing managers index, which has been contracting for some months now, and to an extent which begins to be compatible with GDP contraction, given the dependence of China on manufacturing activity.

Well China isn't quite in Great Depression mode yet, but manufacturing activity - which forms the core of the Chinese economy and accounts for 43% of all activity - is already very close to a technical recession, and phew, it wasn't very long ago that the Chinese economy was registering double digit growth. So the turn around is gigantic. The "close to technical recession in manufacturing industry" call comes from the people over at CLSA Asia-Pacific Markets, who compile the China purchasing managers index, and they base their judgement on the fact that their Chinese manufacturing index has now been registering contraction for five consecutive months.

Export Slump

China is an export driven economy, and you can't simply switch from external to internal demand as a driver at the click of a finger (or mouse, if you make your financial transactions online). Another economist who mailed me this morning said this:

"I don't cover China so unfortunately, my views on that country are not very informed, but I do agree with your point about the China internal consumption argument. In my opinion, the belief that domestic consumption will take over from exports as a growth engine is nothing more than myth. Perhaps I'm misunderstanding the argument, but when factories and the export sector, in general, are bleeding jobs, it would be rather odd for internal consumption to take off at this point in time."

So what is happening to exports? Well, China’s exports fell the most in nearly a decade in December, with shipments down by 2.8 percent over December 2007. That compares with a 21.7 percent increase a year earlier. Over the whole of 2008 exports were up by 17.2 percent, a reduction on the 25.7 percent gain registered in 2007, and suggesting that the drop in the last two months of the year may have been very sharp indeed. Exports to the European Union, China’s biggest export market, fell 3.5 percent in December from a year earlier. Shipments to the U.S. dropped 4.1 percent. Imports dropped even more sharply - by 21.3 percent, meaning the trade surplus failed to fall, and at $39 billion it remained the second-biggest on record.

And China's declining imports are also being felt elsewhere, since in Japan's December trade report (which was out this morning, and was a complete horror story) we find that exports to China were down 35.5 percent year on year.

So to some up, while it may well be true that China is not (yet) entering the Second Great Depression, I am arguing that China is really going to be one of the worst case scenarios in the current global recession, and that consensus thinking still has a very very long way to go in catching up with events in the China case.

Friday, January 02, 2009

The Second Great Depression Wends Its Way Forward in December

And lands in China.

Well China isn't quite in Great Depression mode yet, but manufacturing activity - which forms the core of the Chinese economy and accounts for 43% of all activity - is already very close to a technical recession, and phew, it wasn't very long ago that the Chinese economy was registering double digit growth. So the turn around is gigantic. The "close to technical recession in manufacturing industry" call comes from the people over at CLSA Asia-Pacific Markets, who compile the China purchasing managers index, and they base their judgement on the fact that their Chinese manufacturing index has now been registering contraction for five consecutive months.

Now for those of you who are new to the world of Purchasing Manager's Indexes (PMIs), welcome. Basically these indexes are very useful, since they give you a "just in time" point of reference to tell you what is actually happening. These are composite indexes - measuring things like current output, new orders (both domestic and export), employment and input prices. They are not perfect, but they are reasonably accurate - the fit which you can get between composite PMIs (manufacturing and services combined) and GDP is often attractively good - and in a country like China where the main data we get is year-on-year (which in a critical moment of rapid change like this one is virtually useless) it is very hard to see what is happening. The Shanghai-based Industrial Bank estimate, for example, that GDP growth in China will be 5.6% in Q4 2008. But what does that data point - if accurate - tell us? That the economy is slowing fast, well we already knew that. But just how fast? Well GDP was 9% in Q3 - down from 10.1% in Q2. So the deceleration is very rapid, but did the Chinese economy actually manage to contract in Q4? I doubt it, but it may do in Q1 2009, although the only way we would really know would be if the National Statistics Office published quarter-on-quarter seasonally adjusted numbers, which as far as I can see they don't. Indeed only a small group of highly developed economies actually take the trouble to do this, and you don't even find all EU member countries doing it yet, although Eurostat (thank god for Eurostat) do require such data from members (but those of you who ever get round to checking will see there are still blanks for some countries in the Eurostat quarterly releases).

Hence you can see why, in the case of somewhere like China, the PMIs are very, very useful, for those of us who would like to try and follow what is happening as it actually happens.

As for the PMI itself, China’s composite manufacturing index contracted for the fifth consecutive month in December as recessions in the U.S., Europe and Japan bit deep into demand for exports - indeed China's exports fell year on year for the first time in seven years in November. The CLSA China Purchasing Managers’ Index registered a seasonally adjusted 41.2, compared with a record low of 40.9 in November. On such indexes any reading below 50 reflects a contraction.

Despite the apparent small improvement in December the current output index actually fell sharply, and was down to a record low of 38.6 from 39.2 in November, so production was falling, and the index was basically nudged up slightly by other factors, such as the measure of new orders which rebounded to 37 from 36.1, driven by a rise in export orders to 33.6 from a horrific 28.2 in November. However, according to the report, Chinese manufacturers reduced the size of their workforces at a series record in December, and the employment index has now contracted for five consecutive months, to hit 45.2 in December.

So where exactly are we? Well we aren't (quite) in the Second Great Depression yet, but the situation is deteriorating, and rapidly. Manufacturing output is now contracting at quite a sharp pace, while it was rising in the first half of the year at something like a 15% year on year rate. In a useful summary of the Chinese situation back in November, Nouriel Roubini defined a hard landing in China - which he felt was coming - as follows:

There is thus now a growing risk of a hard landing in China. Let us be clear what we mean by hard landing. In a country with the potential growth of China, a hard landing would occur if the growth rate of the economy were to slow down to 5-6% as China needs a growth rate of 9-10% to absorb about 24 million folks joining the labor force every year; it needs a growth rate of 9-10% to move every year about 12-14 million poor rural farmers to the modern industrial/manufacturing urban sector.

This is more or less the consensus view of what we used to think a hard landing would mean in China, but I think the latest data already take us beyond that. I think there is now a real risk of a technical recession in the more or less classic sense of two consecutive quarters of negative growth (let's say that the risk is 50-50 at this point), and of serious economic and financial dislocation following in the train of this (btw, just how quickly can you burn your way through $1.7 trillion in reserves, it will be an interesting experiment I think).

Brad Setser (further down the same link) has long been more cautious on China, being sceptical about the impact of a dramatic slowdown in exports (and even more importantly in export oriented investment) on an export driven economy, but those of us who have been closely watching other export dependent economies like Germany and Japan over the last decade and a half were surely not quite so sceptical. However even Brad himself is clear that the possibility of an export downturn feeding its way back into the domestic economy - via some sort of negative feedback process - is real enough:

But the real key to forecasting China’s future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly. And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

The $1.7 trillion question is, then, just why China is so export dependent? Doubtless there are many factors at work, but one of these is, I am almost sure, China's very special demographics (30 years of one child per familiy policy), and the special problems that these present in the context of building a sustainable national pensions system at the same time as the population pyramid inverts. Obviously the absence of a credible pension system has to be one of the factors influencing the strong desire to save which we are seeing in China. Economics Nobel Franco Modigliani also thought this, and specifically addressed the Chinese saving puzzle in his last published paper:

China's per capita income ranks below 100th in the world. Its saving rate, however, has been one of the highest worldwide in recent decades. In this paper, we attempt to explain the seeming paradox within the framework of the Life-Cycle Hypothesis developed by Franco Modigliani. The key LCH variables are income and population growth. Our results based on data we put together from official sources show that income growth has been the dominant factor behind the dramatic increase in China's saving rate, as predicted by the LCH. Demographic structure and inflation also had significant impact on the fluctuations of the saving rate.
The Chinese Saving Puzzle and the Life-Cycle Hypothesis - Franco Modigliani and Shi Larry Cao

By Way Of Brief Conclusion

Well basically, the conclusion here is that there is no conclusion, at this point at least. But I would draw attention to two potential points of interest for all you "economy watchers".

Firstly, a couple of months back my fellow blogger Doug Muir drew our attention to a very interesting point being made by US economic historian Scott Reynolds Nelson:

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

At the time of reading this I thought to myself hmmmm! This isn't that simple, but he is on to something. Basically I think no two (or does that make it now three) Great Depressions are ever really exactly alike. I certainly think the resemblence between what is going on now and what happened between 1929 and 1933 is more than passing (especially for the sequencing, of which more in another post), but evidently there are elements of the 1873 one too, and Scott Reynolds puts his finger on some of them, especially in the context of surplus to requirement investment and large capacity overhangs. So my best guess is that what we have is a hybrid, and that what is now happening in China is the best example of the underlying dynamics behind that other great depression that hit our grand- (or great grand) parents and that may well be now about to come back to hit us, boomerang style.

Which brings me to my second point, the Smoot-Hawley Tariff Act, which, as wikipedia explain, was signed into law on June 17, 1930, and raised U.S. tariffs on over 20,000 imported goods to record levels. After the act was passed, many other countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. Many economists now regard the Smoot-Hawley Act as having been the principal feedback catalyst for the severe reduction in U.S.-European trade, and which took it from the 1929 high down to the depressed levels of 1932 and which thus accompanied the start of the Great Depression. And here, in the spectre of a repeat performance comes just the danger we face in the wake of the dramatic contraction which is now underway in China.

It is my personal guess that the first major issue to face Barack Obama as President of the United States may well be what to do about China, and especially what to do about a China which lets - as I now suspect they may well do - the yuan float, in order to see it float DOWN as the economy unwinds. If this does indeed happen then Obama will really have to struggle to hold back the protectionist pressure I think.