James Bevan: All eyes on Central Banks

There is no doubt that now that they have started, China’s authorities have a significant chance of creating some form of cyclical recovery within their economy over the coming months. With the level of reserve requirements in the economy running at the equivalent of 30% of GDP, they clearly have huge room for manoeuvre when it comes to boosting the potential supply of base money in the system. Therefore, unless China really has entered some form of endogenous de-leveraging cycle as a result of the existing high debt ratios and weakness in its property markets, the authorities can probably create another credit cycle of some as yet unknown magnitude over the course of the next year. It is therefore our base scenario that China’s economy will experience some form of cyclical ‘bottom’ over the next few weeks and that growth in the early part of next year will look a little better. As to how much better growth will be will depend on whether the private sector really has embarked on a policy-neutering de-leveraging cycle and how much of the expanded supply of base money is ‘swallowed up’ by the banks as they seek to restructure their liabilities but nevertheless we should expect sentiment towards Chinese growth to continue to improve over the next few weeks, even if sentiment towards the RMB sours as a result.

In Europe, the EU commission is promising some form of centrally orchestrated stimulus but so far the plans seem sketchy and Herr Juncker’s recently announced €300bn stimulus plan looks like it’s really about €20bn. The ECB will however presumably soon solve its operational difficulties to produce some form of QE and we may suspect that a number of European governments will follow Spain’s lead with some form of domestic fiscal stimulus. Therefore, the odds favour there being at least a stabilization or perhaps even some modest improvement in European growth rates later in 2015. Again, this may come at the expense of the currency if the ECB does find a way to ease effectively next year.

And whilst how much growth there will be is uncertain, we can expect markets to be optimistic in the near term. Meanwhile, it seems to take a lot of stimulus to achieve any form of positive result. For example, over the last 12-18 months the UK household sector experienced an almost 3% of GDP net stimulus from the ‘PPI-pay-outs’ and other one-off receipts while at the same time households borrowed the equivalent of more than 5% of GDP but their level of real spending on goods and services only rose by less than 3%. Thus It took a lot of pushing to achieve even this growth after a long period of weakness and this as a sign as to just how weak underlying household incomes, balance sheets and even sentiment are at present. It seems that just as in the mid-2000s when the ‘marginal productivity’ of private debt began to fall away, there now needs a massive stimulus simply to achieve any form of economic growth headway. Nevertheless, central banks and their political masters seem committed to providing near term support for markets if currency markets do not become too volatile of deflationary. In particular, competitive easing cycles in North Asia can become highly deflationary competitive devaluation cycles.

Unfortunately, what central banks cannot do on their own is to alter the medium term economic outlook and more particular alter the shifts occurring within global trade patterns at present. Western economies are now running their first aggregate current account surplus for generations but much of this surplus has arisen simply because the West has been reducing imports and thereby providing less stimulus to the rest of the world.

Some modest part of the weakness in imports to the West over recent years can be traced to the US’s exploitation of its newly discovered hydrocarbon reserves. Some of the weakness can also be attributable to Western economies’ own private sector de-leveraging cycles, although the impact of these may be quite small given that not only has progress in deleveraging been quite modest outside the US household sector but also because private sector de-leveraging (where it has occurred) has tended to be offset by heavy public sector leveraging. Some of the weakness in Western import demand is also due to the implicit costs of the Euro project which have hammered domestic demand within Europe and by extension, global growth.

Optimists may argue that fiscal easing in Europe, resumption of growth in the US and more QE will now lead the West into importing more and indeed this may be the case in the short term. However, the West will still need to de-leverage and therefore savings rates in the West will ultimately still have to rise, with the West’s aging demographics making this all the more likely. Specifically, if we look at an individual’s spending versus income ‘timeline’, as children, we notionally spend but don’t earn. As young adults, people tend to mortgage their future incomes so that they can enjoy life but as they reach middle age people should start to save, so as to clear debts and to build a nest egg for retirement. Unusually for economics, this model can be scaled up for whole societies – countries with young or old populations should have low savings rates (and probably current account deficits) but middle-aged populations should save more and tend to have current account surpluses. But as a result of weak underlying income trends since the late 1990s and overtly expansionary monetary policies in the 1990s and 2000s, many Western ‘middle-aged’ societies did not – or were not able to – begin saving ‘early enough’ and now they need both to clear their existing debt burdens and to accumulate hard savings quite urgently. For this reason, Western savings rates will likely rise quite significantly over the next decade or so, and in consequence these countries will have to continue to run current account surpluses. Saving more implies spending less relative to incomes, and so unless Western real income growth accelerates significantly, spending growth will have to be weak or simply negligible. Similarly a current account surplus can either be achieved by exporting more (i.e. earning more) or by importing less by spending less – and one route is expansionary, the other contractionary.

The savings adjustment/current account adjustment model may well represent the overriding theme of the next decade, with de-leveraging forming part of this process. In the near term, the West’s central banks may try, and on occasion succeed, in delaying or even reversing this adjustment process by using monetary policies to suppress savings rates. But ultimately this life cycle will likely dominate the economic landscape if only because we are all getting older.

As to whether the underlying longer term process of adjustment (away from the central banks’ tactical operations) will take the expansionary or contractionary route will likely depend on two factors: whether the West will be able to produce more goods that the rest of the world wants to or can buy, and whether the rest of the world will provide a market for Western exports. If these conditions are not met, then the world will likely default to the contractionary route with deflation, protectionism and currency wars, and it’s interesting to note how quickly these started to emerge as global growth stumbled over the summer.

Meanwhile many policymakers seemingly believe that the way to get the rest of the world to consume more from the West involves these countries experiencing credit booms of their own so that they consume more of everything including imports. This is just what the world attempted between 2009 and 2012. For a while it did seem to work, but it is also why EMs and increasingly Frontier Markets now have debt ratios that resemble those of DMs in 2007.

The problem with using a credit boom or even an expansion of budget deficits, to achieve a trade adjustment is that these credit cycles can’t be sustained indefinitely. Ultimately, borrowers become weighed down by debt, economies too distorted and overheated, and the credit boom must end. Japan followed this route in the late 1980s and while it worked for a while, and Japan produced a current account deficit in early 1990, once the credit boom ended, the economy slumped and the current account returned rapidly to a surplus position. Quite simply, raising the level of total nominal domestic demand through either monetary policy or fiscal deficit means does not change its composition over the longer term. To achieve the latter, there must be genuine structural reform.

Asia is of course being encouraged to change with markets forcing change by appreciating real exchange rates, as with the SGD, the RMB and until Mr Abe’s arrival the JPY. However, vested interests, policy inertia and political structures of these economies have thus far prevented change: there has been no third arrow in Abe-nomics and Xi seems to be harking back to Deng-era strategies rather than Modi style reforms. To make matters worse, China and Japan also face demographic challenges that make reforms less likely but if these economies do not alter their economic structures to produce more non-traded goods more efficiently, while producing relatively fewer traded goods, then the West will find it harder to earn more by exporting more, and the world will find itself defaulting to the deflationary/contractionary type of trade adjustment.

In summary, while global policymakers can engineer a market-friendly if limited growth revival in early-mid 2015, with the US not raising rates and Europe/China taking growth friendly steps, we can suspect that without genuine structural reform in Europe and North Asia, we will revert to disappointment in late 2015, with markets less forgiving of another ‘failure’ to generate lasting economic recovery.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla