Macro Roundup

Scale of the Chinese risk adverse savings is amazing. Wolf worries about the potential for additional outflows

"...The macroeconomic issue is simple: China saves more than it can profitably invest at home. In 2015, gross national savings were 48 per cent of GDP. World Bank data show that households contributed only a half of this. The rest came from corporate profits and government savings. International comparisons suggest that economic growth of 6 per cent warrants investment of little more than a third of GDP. This indicates that China’s surplus savings — surplus, that is, to domestic requirements — may be as much as 15 per cent of GDP...."

These are huge challenges that need to be discussed in full between the US and China (and others). They have profound implications for trade, but they are not about trade policy at all. They require joint consideration of macroeconomic and financial policy. They also demand attention to the management of China’s external account: above all, exchange controls, the exchange rate and foreign currency reserves. Mr Xi has people in his government who at least understand these issues. Is the same also true for Mr Trump? The stability of the world economy depends on the answer. Alas, I suspect it is no.

Suppose the Chinese authorities adopted, instead, the alternative policy of rapid liberalisation of both inflows and outflows, while relying on credit expansion to sustain domestic demand. It is possible, but unlikely, that the flow of money into China from abroad would match the outflow, as foreigners and Chinese both diversified their portfolios. Yet that would also cause three headaches. First, the domestic macroeconomic imbalances would persist. Second, the financial sector would become still more fragile. Finally, this vast, complex and fragile financial system would become fully integrated with the rest of the world’s, itself still far from fully stable. Instead of the Chinese financial crisis that many now think imminent, this would enormously increase the likelihood of another global crisis with China, not the US, at its heart.

Why is the latter essential? With such large and growing stocks of liquid, risky or low-yielding financial assets, plus a huge flow of savings, not to mention the anxieties caused by the anti- corruption campaign, Chinese corporations and individuals have been desperate to take money out. This explains why, despite a persistent trade surplus, the country’s foreign exchange reserves fell from $4tn in June 2014 to $3tn in January 2017. The reserves can certainly fall further. But the Chinese authorities will not wish them to fall indefinitely. Since they also recognise the dangers of allowing the renminbi to fall too far, they have duly tightened controls on capital outflows.

Today’s credit growth and consequent financial fragility are a direct consequence of the desire to prevent this from happening. It has been the way to keep investment up at uneconomic levels. The Chinese authorities are in a trap: either halt credit growth, let investment shrink and generate a recession at home, a huge trade surplus (or both); or keep credit and investment growing, but tighten controls on capital outflows.

Where might such surpluses go? The answer is abroad, in the form of current account surpluses. That is what happened before the financial crisis. It is likely that this is what would also happen now if the government relaxed exchange controls and brought credit and debt growth to a halt. Capital would pour out, the renminbi would tumble and, in time, a globally unmanageable current account surplus would emerge.

The macroeconomic issue is simple: China saves more than it can profitably invest at home. In 2015, gross national savings were 48 per cent of GDP. World Bank data show that households contributed only a half of this. The rest came from corporate profits and government savings. International comparisons suggest that economic growth of 6 per cent warrants investment of little more than a third of GDP. This indicates that China’s surplus savings — surplus, that is, to domestic requirements — may be as much as 15 per cent of GDP.

I have argued elsewhere that it is essential to understand the interaction of macroeconomics with finance. China’s external accounts already played a significant role in the run-up to the financial crisis of 2007-08. Now the dangers it creates are still greater.

Financially, China is the wild east. Remember what the wild west did over the last century: the Great Depression and Great Recession originated in the interaction between US-led finance and the global economy. In view of its macroeconomic imbalances and financial excesses, China could deliver at least as much global financial mayhem.

Consider a few facts. Annual gross savings in the Chinese economy amount to 75 per cent of the sum of US and EU savings, at over $5tn last year. China’s gross investment, at 43 per cent of gross domestic product in 2015, was still above its share in 2008, even though the economy’s rate of growth had fallen by at least a third. To sustain such high investment, the ratio of credit to GDP soared from 141 per cent of GDP at the end of 2008 to 260 per cent at the end of last year. The “shadow banking system”, in the form of “wealth management products” and other instruments, has exploded. Interbank lending has also soared. Last, but not least, the banking system is now the world’s largest.

Why does the capital account matter more? The answer is that this is where two interrelated aspects of an economy interact with the world economy: macroeconomic balances between savings and investment; and the financial system. In both respects, the Chinese economy is, to cite the celebrated words of former premier Wen Jiabao, “unstable, unbalanced, uncoordinated and unsustainable”. That was true in 2007, when he said it. It is truer today. As the Chinese authorities realise, but their western counterparts may not, the integration of China’s financial system into the global economy is fraught with peril.

Donald Trump, US president, is to meet Xi Jinping, his Chinese counterpart, at Mar-a-Lago in Florida this week. Discussions of economics seem likely to focus on China’s trade and exchange rate policies. This would be a mistake even if the US president’s views of trade were not mistakenly fixated on bilateral imbalances. Far more challenging and important is integrating China into the financial system. US policymakers should worry about China’s capital account, not its current account. That is where danger now lies.

Given its macroeconomic imbalances, China could unleash global mayhem

Chinese finance is storing up trouble for the rest of the world

Martin Wolf, "Chinese finance is storing up trouble for the rest of the world,"Financial Times, April 4, 2017, https://www.ft.com/content/da94e4e2-1787-11e7-9c35-0dd2cb31823a

"...China, for example, severely repressed interest rates in order to boost growth. This simultaneously reduced the household share of Chinese GDP to among the lowest ever recorded and raised Chinese savings to among the highest -- so high that, even with the fastest-rising investment in the world, China still needed large trade surpluses to make up for weak domestic demand. What happens next is the most confusing part for economists who don’t understand how trade has changed. When new capital pours into advanced economies that have always had easy access to investment -- such as the U.S. and southern Europe -- it doesn't boost investment further. Instead it automatically causes savings to contract...As counterintuitive as it may seem, if Trump wants to address the U.S. trade deficit with China, he must focus on the capital account, not the trade account. Instead of imposing tariffs, he should either implement policies that absorb foreign savings more productively into the U.S., say by exploiting historically low interest rates and investing in much-needed infrastructure whose economic benefits are too diffuse to be captured by the private sector.Or his administration should change the way savings imbalances are transmitted into the U.S., for example by taxing capital flows, which the U.S. was doing as recently as the 1960s....."

What Trump shouldn't do is get involved in a tit-for-tat tariff war with China that sidesteps the real sources of the imbalances. In a world in which capital flows overwhelm trade flows, trade imbalances are driven by imbalances in global savings, and the U.S. cannot resolve the former without addressing the latter. Nothing he and Xi discuss this week will change that fact.

As counterintuitive as it may seem, if Trump wants to address the U.S. trade deficit with China, he must focus on the capital account, not the trade account. Instead of imposing tariffs, he should either implement policies that absorb foreign savings more productively into the U.S., say by exploiting historically low interest rates and investing in much-needed infrastructure whose economic benefits are too diffuse to be captured by the private sector. Or his administration should change the way savings imbalances are transmitted into the U.S., for example by taxing capital flows, which the U.S. was doing as recently as the 1960s.

These automatic adjustments, and many others, force down savings rates in the capital-receiving countries. With its deep and flexible capital markets and dominant reserve currency status, the U.S. is especially vulnerable. It is the only country able to absorb large amounts of foreign capital, currently taking in nearly half of the world’s excess savings.

There are many ways this can happen. Capital inflows might raise the real exchange rate, which reduces savings by increasing household purchasing power. Inflows can also lower interest rates and weaken credit standards, both of which encourage high-flying households to fund consumption binges. They can set off wealth effects, as foreign money pours into real estate and leaves households suddenly feeling richer. They can raise unemployment, forcing workers to dig into savings.

What happens next is the most confusing part for economists who don’t understand how trade has changed. When new capital pours into advanced economies that have always had easy access to investment -- such as the U.S. and southern Europe -- it doesn't boost investment further. Instead it automatically causes savings to contract.

While the experiences of China and Japan may seem different on the surface, they were broadly similar in impact. China, for example, severely repressed interest rates in order to boost growth. This simultaneously reduced the household share of Chinese GDP to among the lowest ever recorded and raised Chinese savings to among the highest -- so high that, even with the fastest-rising investment in the world, China still needed large trade surpluses to make up for weak domestic demand.

German businesses, blessed with higher profits, responded unhelpfully. They paid down debt instead of investing the profits, increasing the share of national income devoted to savings. As the growing gap between German savings and investment soon became among the largest in history, so did the German trade surplus. German banks exported the excess savings into other European countries, no longer protected by the interest-rate and currency adjustments proscribed under the rules of the euro. By 2009, after insolvency prevented one European country after another from absorbing any more of the German tsunami of capital outflows, these shifted to countries outside Europe.

Take Germany, for example. After a decade of trade deficits and high unemployment, worried leaders in Berlin implemented labor reforms in 2003-05 whose main effect was to weaken wage growth. As unemployment dropped and business profits surged, the reforms also shrunk the share of national income allocated to ordinary households, driving down the consumption share as well.

This has profound implications for trade. Large, persistent trade surpluses such as the one China runs with the U.S. are no longer the consequence of explicitly mercantilist measures. Instead, they're driven by policies that distort domestic savings rates by subsidizing production at the expense of households.

During this time trade imbalances were mostly determined by direct differences in the cost of traded goods, while capital flowed from one country to another mainly to balance trade flows. Today, however, conditions have changed dramatically. Capital flows dwarf trade flows, and investment decisions by fund managers determine their direction and size.

Unlike in the past, most deficits today have little to do with currency manipulation or unfair tariffs. In the 19th century, import tariffs were the main instrument of trade intervention, increasingly supplemented during the 1920s and 1930s by currency machinations. This continued well into the 20th century. Even as international agreements -- usually championed by the U.S. -- began to restrict the use of tariffs in the post-Bretton-Woods era, Europe and Japan, taking advantage of Cold War exigencies, protected domestic industries for decades by keeping their currencies undervalued relative to the dollar.

U.S. President Donald Trump has warned that discussions with his Chinese counterpart Xi Jinping in Florida this week will be "very difficult," in large part because of disagreements over trade. But before Trump can shrink America's lopsided trade deficits -- with China or anyone else -- he first must recognize what's driving them.

What's Really Driving the Trade Deficit With China

Michael Pettis, "What's Really Driving the Trade Deficit With China,"Bloomberg, April 3, 2017, https://www.bloomberg.com/view/articles/2017-04-04/what-s-really-driving-u-s-trade-deficit-with-china

"...A little less than40 per centof the mortgage debt owed by American households was held directly on the balance sheet of “US-chartered depository institutions” in the years before the crisis. That share has since dropped to just over 30 per cent:..."

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The more useful takeaway is that the trend highlighted by the Boston Fed economists, combined with anecdotes about changes in underwriting standards and the growth of compliance staff, suggests banks may have learned something useful from the crisis. They are willing to spend more today to ensure they avoid legal liabilities for negligence and “misrepresentation” in the future. That would be welcome news, even if it means consumers are “paying” more for credit up front than they did in the past.
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The Boston Fed authors think it might help to have morefloating-rate mortgages, which would obviate the need to create an entire new loan whenever a borrower wants to take advantage of a drop in interest rates. From their point of view, more floating-rate debt would improve the transmission of monetary stimulus in a downturn by putting more money in the hands of mortgage borrowers rather than the banks. It doesn’t seem particularly helpful to suggest such a thing now, however, when the Fed seems determined to push interest ratesup.

This relationship between mortgage rates and refinancing createsnegative convexitythat investors tend to hedge by selling Treasury bonds. Of course, most of the post-crisis agency MBShas been bought by the Fed, which doesn’t have to worry about marking its holdings to market, which might help dampen some of the traditional volatility caused by these hedges.

These two factors are partly related, since the rate of mortgage applications is affected by announcements of Fed stimulus. After all, falling mortgage rates makes refinancing a lot more attractive. In the post-crisis period, the rate of mortgage applications has been strongly related to changes in the spread between what existing borrowers pay on their mortgages and the 10-year Treasury yield:

Their charts below show how the “price of intermediation” has tended to move in line with these constraints. On the left, you can see how banks tend to respond to an uptick of mortgage applications with slower processing times. The typical processing time (red line) seems closely related to the “price of intermediation” (gray line). On the right, you can see how wages in the sector rose rapidly during the period that borrowers were getting charged more:

Second, banks have limited capacity to properly underwrite new mortgages. Sudden increases in loan applications can’t easily be accommodated without hiring more people or paying existing staff more. Borrowers end up being the ones who cover these costs.

When the third round of large-scale asset purchases was announced inSeptember 2012, only about half of the large drop in MBS yields got passed along to borrowers. By contrast, the full brunt of the “taper tantrum” was felt by prospective mortgagers. (Some might argue this was helpful insofar as it helped recapitalise banks still wounded from the crisis.)

First, the Fed’s aggressive purchases of agency MBScrushed credit spreads so muchthat banks could lower interest rates to prospective borrowers while also pocketing some of the collapse in their funding costs for themselves.

The Boston Fed economists attribute this asymmetry to two main factors.

A one dollar decrease in the MBS price translates into a one dollar reduction in the rebate, but a one dollar increase only leads to an 80 cent rebate increase.

In general, changes in MBS prices flow through quickly to changes in what banks lend, although this is more obvious on the way down than on the way up:

The difference between the interest rates on mortgages and the yield on the MBS, adjusted for the g-fees, is therefore a pretty good proxy for the cost of what banks actually do. More precisely, the banks get paid the difference between what they raise when they sell their mortgages to the GSEs and what they actually lend to borrowers (the rebate). This is what the Boston Fed researchers are studying.

(Fannie and Freddie got into trouble during the crisis because they had charged insufficient g-fees during the bubble and were insufficiently capitalised to compensate for that mistake. Making matters worse, the banks had sold dubious loans to the GSEs, which led the Federal Housing Finance Agency to repeatedly sue the banks for “misrepresentations” after the bubble had burst.)

Investors in typical agency MBS of “conforming” mortgages don’t have to deal with the risk that borrowers will default. That risk is instead borne by taxpayers and ostensibly covered by the guarantee fees paid by borrowers to the banks and then to the GSEs.

The pre-bubble and the post-crisis norm is for most securitised mortgages to be issued by the government-sponsored enterprises of Fannie Mae and Freddie Mac. The yield on these agency MBS is more or less the cost the banks pay to fund their mortgage lending. Unsurprisingly, this is lower than the interest rates paid by borrowers on the mortgages bundled into a given bond.

That worked out poorly for those investors and the market has essentially disappeared since the crisis. Almost the entire net decline in the stock of mortgage debt since the peak in 2008 has come from defaults on mortgages packaged into private-label MBS:

During the go-go years, abouthalf the growth in mortgage borrowingwas funded by the growth of “private-label” securitisation, which was when banks packaged loans and sold them directly to investors:

A little less than40 per centof the mortgage debt owed by American households was held directly on the balance sheet of “US-chartered depository institutions” in the years before the crisis. That share has since dropped to just over 30 per cent:

The Boston Fed research focuses on the fact that most American mortgages are sold to investors after being bundled into securities, rather than held by banks on their balance sheets.

These were choices. In the go-go years, there didn’t seem to be much point risking market share to competitors who didn’t spend as much on their back office. After all, if investors didn’t care about underwriting, why should the banks? And it wouldn’t matter if a borrower’s income were insufficient to meet his mortgage payments, since rising house prices would “guarantee” profits for mortgage lenders even if they had to foreclose and sell the collateral at a discount. These were bad assumptions, but they were the consensus.

Banks failed to do these jobs properly both before and during the crisis. Their underwriting was poor, which is one reason household debt ballooned, particularly among people who weren’t able to repay it. And when the bubble began to deflate, banks lacked the staff to ensure they followed the rule of law, modify mortgages, and do what was best for creditors. (The government’s apparent lack of interest also didn’t create much incentive for the banks to change their approach.)

That sounds bad, but these extra costs may be there for good reason. Banks play an important role in American housing finance even though most of the credit is provided by others. Banks are supposed to vet potential borrowers, set appropriate terms for loans, collect payments, and foreclose in the event of default. (Unfortunately they also have a track record offoreclosing on people who didn’t default, and sometimes even on people who owned their homes outright…)

Researchfrom economists at the Federal Reserve Bank of Boston finds this spread has steadily increased since the crisis, with American borrowers effectively paying banks an extra $140 billion in 2009-2014 above what you might have expected given historical patterns. As they put it, “over extended intervals during our sample period, mortgage rates would have been 30-40 basis points lower under the counterfactual”.

It’s a quaint misconception that banks fund mortgages. They do, however, affect thepriceof mortgages by charging a spread over their cost of funding.

Matthew Klein, "Post-crisis mortgages cost more but maybe that’s a good thing,"FT Alphaville, April 7, 2017, https://ftalphaville.ft.com/2017/04/07/2187034/post-crisis-mortgages-cost-more-but-maybe-thats-a-good-thing/ Post-crisis mortgages cost more but maybe that’s a good thing