June 25th, 2011
As we mentioned in our article on the European outlook a couple of days ago, the global economy is, in some respects, more precariously positioned than it was in early 2009.
Two years ago, governments around the world were still capable of unleashing trillions of dollars in fiscal stimulus. Central banks were able to slash interest rates, and in the case of the European Central Bank and Federal Reserve, force feed additional trillions of dollars of liquidity into their respective banking systems. The initial goal was to stabilize the global financial system, and subsequently engineer a self-sustaining economic recovery in each country.
As we pointed out, Europe, Japan and the U.S. face moribund growth of the sort that has plagued the Japanese economy for two decades. On the flip side are China, Brazil, and India, where the combination of fiscal and monetary stimulus succeeded too well, and has led to a bout of real inflation. Follow up:
Follow up:China, Brazil, and India comprise 15% of world GDP. While each of these countries will continue to enjoy above average growth relative to the developed economies, they are now confronting rising inflation with tighter monetary policy. This will surely lead to a slowdown in their economies in the second half of 2011. Since monetary policy is conducted by looking in the rear view mirror of economic statistics, there is the risk that each central bank may tighten a bit too much, resulting in a deeper slowdown than desired.
Balance is a state in which an object or opposing forces remain steady, while resting on a base that is narrow relative to its other dimensions. Visualize an upside down pyramid, whose tip is balanced on a narrow beam. The object is debt, and the narrow beam is global GDP growth.
Given the uncertainty and challenges facing the global economy, the narrow beam may be suspended over an abyss. The pyramid will tip, if global growth isn’t strong enough to support the debt burdens of the developed counties, or if tighter monetary policy slows China, Brazil, and/or India’s economy too much. If another tipping point is reached, it could prove more devastating than the financial crisis of 2008, since the fiscal and monetary wells are dry. The odds are not comforting, since policy makers in the U.S. and Europe are still operating with the same playbook that got us into this mess in the first place. The banks which were too big to fail in 2008 are even larger today, and the opacity of derivatives remains impenetrable. The business cycle will never be repealed by spendthrift politicians or accommodating central bankers.
Two weeks ago, the Reserve Bank of Brazil increased it’s Selicrate to 12.25%, the highest rate in the world. Inflation continues to edge higher, 6.5% in May, and up more than 1% from last year. More importantly, food staples such as beans and rice have almost doubled in the last three years, far out pacing the increase in the average worker’s pay. The unemployment rate is 6.5%, about half the level it averaged between 2000 and 2004, so the unemployment plague affecting many developed countries is not as issue. GDP growth is expected to slow to 3.5%, about half of last year’s growth.
The Brazilian National Development Bank was established in 1952 to support the large infrastructure projects needed to lift Brazil into the developed world. Up until recent years, annual lending was less than $10 billion. Since 2005, lending has exploded, rising from $20 billion to $98 billion last year, which amounts to 5% of Brazil’s annual GDP.
This surge in lending certainly works against the tightening of monetary policy by Brazil’s central bank. To say that lending by the Development Bank is politically driven would be an understatement. It is comforting to know that politicians are pretty much the same anywhere.
On June 13, China reported that its consumer price index rose 5.5% in May from a year ago. It’s the largest increase in inflation since July 2008, just before the financial crisis broke in September which caused a collapse in oil and commodities in general. On June 15, the Peoples Bank of China increased the bank reserve rate to 21.5%, the sixth increase this year, and eleventh since January 2010.
The Chinese government has also attempted to curb real estate speculation by boosting down payment requirements from 40% to 60% for second homes. In 2006, the average apartment in Beijing sold for $100,000, the equivalent of 32 years of the average workers’ disposable income. Average annual wages have increased since 2006 to about $4,000, but the average apartment now sells for $250,000, or 57 years of income.
Government policies and high prices have caused property prices in nine major Chinese cities to fall -4.36% since last year. It’s the first decline since the height of the crisis in late 2008 and early 2009, after a large run up in prices.
At the behest of the Chinese government, the state run banks in China lent $3 trillion to stimulate growth and create jobs. This is an extraordinary amount of lending and represents almost 60% of China’s annual GDP. With so money being thrown around, it’s no surprise that real estate speculation was rampant, and investment in new cities, mass transit, and export production capacity soared.
We believe excess capacity problems will emerge, as global growth slows, particularly in developed nations. With average annual income of just $4,000, China does not have a broad middle class to absorb the excess capacity that could develop, if exports to Europe, Japan, and the U.S. slow. Over the next couple of years, as much as 25% of the lending done in 2009 and 2010 could prove problematic and non-recoverable.
Much like their U.S. counterparts, the Chinese government will allow the state run banks to ignore the problem. As we are learning almost daily, big financial problems only become bigger when they are ignored.
In India, the producer price index climbed to 9.06% in May from a year ago. On June 16, the Reserve Bank of India increased its repo rate to 7.5%, the tenth increase since March 2010. Tighter monetary policy is beginning to have an impact on India’s economy.
In May, car sales slowed to the lowest rate in two years, according to the Society of Automobile Manufacturers. As in other developing countries, food inflation is particularly painful, since food often consumes 40% to 60% of the average workers income. India’s food distribution is also a problem, as almost 40% of India’s farm output rots before it reaches a local market.
As we have forecast, Brazil, China, and India are all showing signs of slowing in response to tighter monetary policy and higher interest rates. The slowdown in each of these countries will become more obvious and pronounced in the second half of 2011. Investors beware.
Are Cracks Developing in the BRICs? by Clive Corcoran
India: Deciphering and Solving the Inflation Crisis by Ajay Shah
RBI is Holding a Tiger by the Tail by Sunil Chandra
Will India GDP grow by more than 10% in this Financial Year? by Sanjeev Kulkarni
Europe in Trouble by MacroTides
Comparing World Markets by Doug Short
Stock market Cycle Analysis by Erik McCurdy
Overview of the Markets by MacroTides
China: Will Increasing Wages Lead to Rebalancing? by Michael Pettis
Chinese Inflation and the Impact on the U.S. Economy by Menzie Chinn
Economic Effects of Large Exchange Rate Appreciations by Menzie Chinn
About the Author
Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at firstname.lastname@example.org.