Asia Sentry Economics

Discussing the possibility of a Hard Landing in China given the reluctance of Beijing to ease policy as excess capacity is now such a problem.

(Source: vimeo.com)

Washington Post

This was the article by Bloomberg that China blocked. Once again highlighting the vast wealth accumulated by the Princelings and their families.

Economists who mean something.

Oops I did it again. China has once again overtightened policy. Growth retrenching sharply.

China repeats the habitual mistake of policy over-tightening after investment booms.

The Chinese economy is indeed slowing more quickly than the punditry thought.  This should be no surprise, China has never been able to exit an investment led growth wave in its modern economic history without over-tightening.  In addition to the crimping of external demand provided by Europe, policy makers appear unaware of the dangerous creep higher in lending rates above the benchmark rate they set, nor in the constraints to lending falling deposit growth now provide.  Policy levers look constrained and the economy will do well to grow 6.5% this year.

The April suite of data for China revealed an economy that is closer to collapsing rather than merely slowing.  Whilst many in the punditry continue to insist that this is just a bit of seasonality or that growth is merely troughing,  a senior Chinese cabinet adviser, quoted on the official government Web site last Thursday, was absolutely right on the money in characterising the current period as a “sharp slowdown in the economy.”  This is not the stuff of seasonality or an economy that is troughing.  It is the stuff of an economy that through a combination of internal and external shocks is in the process of a major growth retrenchement.

Why this slowdown appears to be different.

The two clearest signs that China’ s economy is slowing more than expected are the unusual, and clearly unseasonal, swelling of metal and commodity stocks in China that has continued into the second quarter and the broad based weakness in imports, itself a reflection of a significant cooling in processing trade and commodity intensive activity.

Europe remains China’s largest bilateral trade partner and external demand has been severely crimped.  Clear evidence of over-tightening is now evident in the Chinese economy with domestic demand, particularly property and fixed asset investment now plummeting.  Ominously, we are not convinced that the traditional easing mechanism favored by Chinese, cutting the Reserve Requirement Ratio (RRR) will work as effectively in this cycle as it did during the great easing of 2008 09 given Banks have run into the wall of the loan-to-deposit constraint.

Copper stocks in Shanghai’s bonded storage, the biggest in China, are now double the 300,000 metric tons (330,693 tons) average of the past four years and iron ore stocks are about a third more than their 74 million metric tons average.

And finally, rather than absorbing funds, in 15 of the 20 full weeks so far this year, the PBOC injected cash into the market. In total, it has injected a net 383 billion yuan ($65 billion) so far this year in an attempt to bolster liquidity in the Chinese economy.

No region has been spared:  The most salient feature of this slowdown, however, is that it extends well into the interior, it is not just a function of the rich coastal provences that are so closely intertwined with and dependent on global trade.  This is truly a pan-China slowdown, that is spread geographically evenly, and reflects the twin-drags of crimped external demand and suffocated domestic demand. 

External demand has waned on European caution.

Export growth to Europe, from China, has now turned negative in terms of year-to growth.    Though demand from Europe has not weakened as sharply as it did in the immediate aftermath of the global financial crisis, and though the trough could well be shallower, we would expect it to be more extended with a prolonged period of weakness in European demand likely.

Assessment of China’s trade state of play.  Whereas China first, and then subsequently the rest of the world followed a V-shaped trade profile over the course of 2008-2009, as China dramatically increased its call on the rest of the world, particularly commodity and capital goods exporters, the trade profile for China and the rest of the world in 2012-13 is likely to be either U-shaped, though most probably L-shaped, albeit, with a lower trough than was seen in 2008-09.  China has huge existing stockpiles of commodities and it will be difficult to find new infrastructure projects where a meaningful return on capital can be expected.  China will be both slower, and less generous, in its call on the world’s capital goods and commodity exporters under any new stimulus package.

Domestic demand slowing sharply on over-tightening.

The slowdown in the domestic activity data has been consistent and broad based.  There is nothing you can sugar-coat in a suite of crappy figures.  Industrial production posted the largest downward surprise, growing just 9.3% over the year to April after nearly 12% growth in the year to March.  Fixed asset investment treaded water, in weak territory, though residential construction is now clearly sinking.  Retail sales have fallen to 14% growth, from 15% growth, a consistent deterioration from post stimulus highs and broadly tracking the weakness in residential construction

Over-tightening is unfortunately a well-worn track. The events of 2009-10 and how China was able to arrest the profound negative growth shock of the great recession is now the stuff of legend.  It is not, however, without domestic precedent.  The great imbalance between savings and investment in the Chinese economy is simply the outcome of China having used investment as its principal macro-economic control variable for the modern economic period

Essentially there have been four episodes where China has mandated state investment to either boost or support economic activity. 

1.            The first was immediately after modern economic reforms were enacted by Deng Xiaopeng in 1978 and saw the first wave of state sanctioned infrastructure growth occurring in the early 1980s.  Investment as a share of GDP rose from around 30% at the beginning of the decade to around 35% by the middle of the decade. 

2.            The second, and till recently the most significant investment wave, following Deng’s “great southern tour” saw the creation of the Special Economic Zones and accelerated the emergence of modern China.  This investment wave saw investment as a share of GDP rise from around 35% to nearly 45% in the pace of just ttwo years.  That is, nearly 10% of GDP was spent on investment. 

3.            The third was in the lead up to, and immediately after World Economic Ascension.  Over the decade from 1995 to 2005 investment share of GDP rose by around 7ppt of GDP from 35% to 42.5%. 

4.            The fourth wave, was the massive infrastructure package announced by Beijing in November 2008 in response to the global economic crisis.  Though many still refer to it as the CNY4trn package, the reality of the stimulus measures is that bank lending was injecting that much money into the economy on average every 3 months.  The total injection of liquidity into the Chinese economy over 2009-10 via official channels (bank lending) was probably four-to-five times this amount. 

As the chart below shows, investment as a share of GDP, has consistently ratcheted higher after each of these four investment waves.  That is, the economy has not been given ample time to rebalance, or for consumption to emerge, after each investment wave.  The only real investment cycle occurred over the 1980s and 1990’s when investment surged on the back of Deng’s great southern tour, and then subsequently collapsed in the 1990s when China had effectively bankrupted its banking system financing the previous decades investment binge.

Now, news that China is about to embark on its fifth wave.  With the actual extent of the damage to the banking system done by the last investment binge unclear, we have news coming through that China has already significantly relaxed lending restrictions for infrastructure and residential construction.  In short, China now appears to be about to embark on its fifth investment wave.  There is good news and bad news in this.  First of all, the good news.  We know that this policy prescription has worked before.  As China is a command economy, the lags between announcing an actual policy and the implementation of that policy are incredibly short.  If China is serious about stabilizing growth, investment is the only way it can do it in the short term.  Adjusting consumer behaviours so that consumers save less and spend more is nigh on impossible in the short term.  If China wants to stimulate the economy quickly, it must use investment.

Second, China appears to understand the urgency of boosting economic activity.  The Australian Trade Minister met with China’s policy troika on Wednesday of this week and certainly came away with the impression that China was winding up the State apparatchiks for another tilt at stabilizing growth. Trade Minister Emerson met commerce minister Chen Deming, economic vice premier Wang Qishan and Zhang Ping from the National Development and Reform Commission.  Emerson’s paraphrasing of their discussion was that more would be done to stabilize growth, which would not be allowed to soften much further.

The real issue then, is just how soft is Chinese growth right now?

The mid 1980s investment wave and subsequent impairment of the banking system is the most similar to the current situation.  The first two investment waves of the early 1980s and the mid-1990s were the two that was one China should have learnt many policy lessons from.  By the late 1980s and just one decade later, the Chinese economy was significantly overheating.  With real growth peaking at around 14-15%, it is likely that nominal growth in the Chinese economy was probably tracking around 20-25%y/y at the peak of these first two investment waves. 

The profound degree of overheating was so great that in both episodes Beijing called an imminent end to all investment and infrastructure projects.  The effect was to be disastrous for the Banking system, which via state directives to lend, had financed these two great booms.  With railways only half built, or airports only half complete, the sudden cessation of lending resulted in inoperable projects.  You can’t run an inter-city railway line if you have only built half the track, or if you have built the entire track but not yet purchased rolling stock.  The non-performing loan ratio for the large banks rose to 50% of all loans extended, whilst the smaller and regional banks were straddled with NPLs as high as 75%.  It would take China the best part of a decade to repair the damage done to is banking sector by simply trying to stop the investment boom cold in its tracks.

China learnt the policy lesson in the third investment wave.  Rather than once again using its banks as fiscal agents, it privatized the State-Owned Enterprises, destroying the social contract with workers and plunging millions into unemployment for the first time.  Joint ventures were struck, primarily with Hong Kong and Macau companies, and some State Owned Enteprises were opened up to Foreign Direct Investment from the west.  This has perhaps been the only investment cycle which China has managed that has not inflicted significant systemic damage on its Banks and Financial Institutions.

China compounded its forgotten lessons in exiting the fourth wave by not only drastically curtailing bank lending to infrastructure projects, but also simultaneously choking off the residential construction sector.  Not only were a number of major infrastructure projects brought to a complete halt, China was also faced with a residential construction bubble as a large amount of lending were leaked towards property development.  The property sector has felt the brunt of both a rationing of liquidity and outright regulation of the property sector with multiple purchasers now blocked.

The residential construction figures, to my mind, are perturbing.  They clearly speak of an economy where tightening has been too brusque. Despite some stabilisation in the property sales contraction (-12.8%yoy in April vs. -13.3%yoy in March), property investment and new starts remained on a sharp downward trend. Total property investment growth more than halved to 9.2%yoy from 19.6%yoy in March, and residential investment slowed to only 4%yoy. Moreover, floor space newly started contracted 14.6%yoy in April. These growth rates were very close to the previous bottom hit in early 2009. The April retail sales figures represent the clearest evidence to date of over-tightening in residential construction with property sluggishness now infecting consumption as well.  Household appliance sales recorded the lowest growth rate of 7.7% among the major retail sales categories.

Despite some stabilisation in the property sales contraction (-12.8%yoy in April vs. -13.3%yoy in March), property investment and new starts remained on a sharp downward trend. Total property investment growth more than halved to 9.2%yoy from 19.6%yoy in March, and residential investment slowed to only 4%yoy. Moreover, floor space newly started contracted 14.6%yoy in April. These growth rates were very close to the previous bottom hit in early 2009. In today’s report, we see clearer evidence that the impact of the property sluggishness is spreading to consumption as well. Household appliance sales recorded the lowest growth rate of 7.7% among the major retail sales categories

And then there are the safety issues.  The much vaunted efficiencies that were going to be delivered to the Chinese economy have failed to materialize from the labyrinth of high speed railways and freeways that now criss-cross the country.  The skimming of quality building materials means that high speed rail lines are dangerously subsiding and most lines now have significant speed restrictions in place whilst other lines are closed.  Highways and freeways are jammed and rapidly eroding on unregulated traffic.

Two robust supply-side proxies I like to use, now confirm that Chinese growth has ground to a halt. 

It would not surprise me if the economy was indeed contracting in real quarter-on-quarter terms. It is not surprising then, that excellent supply side proxies of the Chinese economy such as electricity production have now fallen to levels that suggest the Chinese economy is in fact not growing at all.   The sharp fall in electricity production that occurred in the first quarter of 2012 brings production back to levels that have not been seen since the depths of the Lehman crisis in the second half of 2008.  A range of indicators confirm that the Chinese economy is indeed that weak.  Recall, that most analysts believed the Chinese economy actually contracted in sequential quarter-on-quarter terms in the first quarter of 2009.

The second proxy I like to use is M1 growth as it is a short-hand for both liquidity and the velocity of money in the Chinese economy.  It has NEVER grown as slowly as it is now.  Coincident economic activity held up for approximately 2 quarters as M1 growth collapsed in 2008.  The disparity between coincident economic activity and M1 growth now has never been greater, except for the period of 1994-95.  The historic experience is that the relationship recouples by coincident economic activity collapsing, not by money growth or velocity rescuing the situation. 

Assessment of the current state of play.  The Chinese economy has experienced a dramatic loss of growth momentum similar to that which occurred from Q4-2008 to Q1-2009 and prior to that, similar to the dramatic slowdown in growth that occurred in 1985 as China exited its first exit wave and in the mid-1990s as China mis-managed it’s banking system after using it as a fiscal agent to finance investment. 

The key questions at this time, is whether:

1.            policy is once again likely to be as stimulatory?  N0, the quantum of stimulus in Yuan terms will be significantly lower.

2.            Will Policy be as effective?  No, the policy multipliers appear to be constrained, and financial liberalization has neutered the abilities of banks to lend without a significant increase in deposits growth.

China’s RRR cut reeks of a panic move. 

In immediate response to the woeful activity data for April, the PBoC cut the RRR for all commercial banks by 50bps with the move to be effective from the 18th of May.  In a clear sign of the over-tightening that has occurred over the course of 2011-12, the RRR for big banks still stands at 20%, at 18% for other banks at at 16.5% for rural credit cooperatives. 

Of more concern than the over-tightening that has occurred is the growing concerns that Chinese monetary policy no longer works.  China’s move to liberalise domestic markets has seen deposits growth slow significantly.  The RRR is a quantum method of adjusting policy, by releasing the amounts of deposits that the banks have available for lending.  As financial liberalization in the domestic markets has advanced at a robust pace, deposits growth has slowed significantly, indeed, there is an outflow from the banking system to non-bank assets.

Financial market liberalization has led to over-tightening

The degree of tightening of policy was most likely underestimated by Beijing.  As a result of financial market deregulation, the degree of tightening that occurred over 2010 to 2011 was much greater than what has occurred in previous cycles simply because lending rates became less anchored to the cash rate

As the chart above shows, the proportion of loans where lenders were charging interest rates higher than the benchmark rate rose from 35% in early 2010 to around 70% now.  This has no doubt placed significant stress on lenders and made a number of projects no longer viable with state-owned enterprises now unable to afford interest repayments after the 2009-10 borrowing binge.  Recall that industrial profits in China contracted in April

Further, China has pursued a monetary policy regime where it controls the VOLUME of money in the economy, in particular the banks, not the PRICE of money, that is the interest rate. Banks are currently constrained in their lending practices by the loan to deposit ratio.  As deposits growth has slowed dramatically, again to an unprecedented low, the ability of the Banks to significantly grow their loan books is now questionable.

In short, China will have to fast track financial liberalization, removing important constraints on the Banking sector such as the loan to deposit ratio, if it is to have any hope of significantly using bank lending to fund growth in this stimulus package.  

In the absence of more significant regulatory reform, this easing cycle may not be as potent as previous easing cycles given falling deposits growth is already lowering the lending base of the commercial banks.  In this environment of regulatory restraints, but also the past knowledge of lending largesse, it is not surprising that Banks are becoming more risk adverse. 

A rapidly cooling growth environment would certainly be doing nothing to dissuade risk aversion.  Based on the April figures, growth in the second quarter is shaping up to be particularly weak.  We think the figures could print as low as 7.0%YoY growth for Q2, though the actual growth pulse of the Chinese economy should be considerable weaker.  The Chinese Statistician is notorious for smoothing troughs and peaks.  

State of Play on Monetary Policy.  The sum of these problems, the loan-to-deposit ratio and growing risk aversion was borne out by M1 growth which dropped to an unprecedented low of just 3.1%yoy in April.  As the Chinese economy is now clearly trending at its weakest pace since the global financial crisis, the institutional mechanisms of monetary easing appear to be failing.  At its most basic level, the collapse in M1 growth points to a rapid slowing in the velocity of money most likely entirely attributable to constrained or dysfunctional credit multipliers

Cutting lending and deposit rates symmetrically will do nothing to ease this problem.  Indeed, further cuts to interest rates are likely to worsen the banking sectors loan-to-deposit ratio by making it more difficult for commercial banks to attract or retain depositors.  As such, in the absence of regulatory reform to significantly modify the loan-to-deposit ratio, it will be extremely difficult for lenders to do just that, lend more money into the economy. 

This suggest that the quantum of cuts required to generate X amount of lending is probably much greater in this cycle than in previous cycles.  Or to use the boxing analogy, the PBoC is punching well below its weight with each RRR move in this cycle.

China’s only has a choice of sub-optimal policy prescriptions this time.

So what can China do?  All policy options at this stage are far from optimal. 

An even larger Investment Overhang

In short, a repeat of 2009, though a much more controlled and tightly managed reprise of infrastructure lending appears likely.  The key initial target will likely be to push infrastructure investment back into positive yearly growth rates.  China’s planning agencies have already fast tracked a number of key infrastructure projects and Bank lending could rebound to the CNY1trn level for the next three months.

The quality of this lending, and the likely return on capital, can only be considered as highly dubious given the gargantuan lending program of 2009-10.  Seriously, are there any quality infrastructure investments left to be made in China at this time.

Bubble Trouble 2

The second policy option, once again allowing residential construction to support the economy, seriously risks re-inflating the housing bubble.  The housing market is the clearest example of where policy has potentially been overtightened with a dramatic downturn in housing activity.

Acceleration of pro-consumption reforms

Subsidies for households to purchase consumption goods.  This will inevitably favour domestic manufacturers who are much more closely aligned with the domestic housing cycle.  China still largely tends to import most of its capital goods, to the benefit of South Korea, Taiwan, Japan and German.  The move to more strongly support consumption, at the expense of capital investment, will benefit chinese manufacturers at the expense of the above countries.  This means that whereas China’s previous stimulus efforts have been of broad assistance to the rest of the world, particularly trade-partners in Asia, the move to accelerate consumption-share growth would actually penalize the rest of the world, and overwhelmingly favor mainland Chinese companies. 

Summary of market implications

The trajectory at which the Chinese economy is descending suggests the landing won’t be soft.  Indeed, it is very difficult to believe that Q1 was the trough for growth, with Q2 and Q3 likely to represent the trough.  With Japan likely to experience a clear curtailment to growth over these two quarters, then the delta of Asian growth will be particularly modest and could potentially flat-line or be negative. 

If this view is borne out by the regional data then cyclical currencies such as the AUD are likely to come under significant pressure.

Equities and commodity prices will need to adjust lower.  Bonds will remain well supported by a new bearish trend in global growth.

Make sure you are following me on Twitter.  @AsiaSentry.

Asia. Global trade appears to be retrenching sharply.

The Chinese trade dynamic appears to be slowing with both exports and imports weakening more than expected.  Korean figures foretold a regional slowing.

The Chinese trade data for April is a real source of concern with the import side of the equation suggesting Chinese domestic demand may be slowing at a quicker pace than previously expected. 

China’s call on the rest of the world is through imports.

These rose by just 0.3% over the year to April, a stunning downward surprise on the 10% rise forecast by the punditry and even the weak 5.3% increase posted over the year to March.  Imports have definitely moved into a much lower trend range compared to the 20% plus import growth figures China was posting in 2009 and 2010 when it made an extraordinary call on the world’s commodity and capital goods producers.

To be sure, there are probably some valuation effects occurring with the recent fall in commodity prices depressing import values.  Still, a range of coincident indicators suggest that we shouldn’t be surprised by the abrupt slowing in China’s imports and exports.  South Korean trade data was already suggesting that global trade appeared to be retrenching sharply.  The Chinese figures not only conform to that view, they reinforce it.

South Korea is the canary in the global trade coalmine.

Jim O’Niel and Ed Yardeni have recently cottoned on to something most analysts in Asia have known for a long time.  One of the best leading indicators of the region is the South Korean trade figures.  One, they are accurate.  Two, they are released in an extraordinarily timely manner.  Indeed, Mr O’Niel has done some fancy statistical analysis to show that the South Korean export figures have a strong contemporaneous co-movement with all the major Asian economies and only trail the US, Europe and Japan in rank order in terms of their correlation with global trade.

The South Korean Canary fell off its perch in April.

Exports shrank 4.7 percent in April from a year earlier, a bigger drop than the 1.5 percent fall forecast in a Reuters survey and following a revised 1.4 percent decline in March.

The government’s projection for about 7 percent growth in exports for the whole of this year, already a weak forecast, now looks like pie in the sky.

Canton Fair export deals shrink for first time since global crisis

A more anecdotal indicator, nonetheless a relatively accurate one, is the number of export deals signed at the Canton Fair, widely considered a good barometer of China’s export growth.  The value of signed exports deals shrunk by 2.3% from a year ago, the first annual drop since the global crisis.

China’s policy response likely to be lower import duties.

The immediate response to the softer import data is likely to be a fast-tracking of plans to cut import duties rather than an ease in interest rates or reduction in the Reserve Requirement Ratio.

Summary of market implications

Taken in concert, the Chinese and Korean trade figures are ominous, suggesting that global trade is retrenching at its sharpest pace since the global financial crisis itself. 

If this view is borne out by the regional data then cyclical currencies such as the AUD are likely to come under significant pressure.

Equities and commodity prices will need to adjust lower.  Bonds will remain well supported by a new bearish trend in global growth.

The Australian Government’s 5000 Page Suicide Note

Tim Colebatch, economics editor of The Age, has a fine turn of phrase, amusingly describing the volumes of budget papers that outline the government’s sheer doggedness on returning the budget to surplus as its 5000 page suicide note.  Fairfax gets a highly commended for that.  Murdoch ‘s News Limited, however, takes out first prize for their “Mine Shaft” online headline which is perhaps the only two words you need to read to understand the gist of the budget.  About $5bn of increased taxation on the mining and resources sector will be routed to families, those with school age children receiving the most largesse, as direct transfer payments.  In short, the miners got shafted to subsidise the ALP’s cash handouts to their rapidly deserting core constituency.  News Limited must also be commended for cutting right to the chase with their “The Cold Facts:  How the Budget affects your beer?” article, the ninth most read article of the day.  Only in Australia!

So, what do I think of the Budget?

As outlined last week, I think the decision to return to the Budget to surplus was a dangerous misalignment of the political and economic cycles.  For some reason, the ALP seems to be convinced that a surplus budget will be some kind of electoral salvation.  Rather than pander to their inferiority complex that the Liberal Coalition are perceived as much better economic managers, they should have taken greater comfort from their stewardship of Australia through the Global Financial Crisis.  The irony of Greece and France both outright rejecting politically sanctioned austerity the weekend before Australia announced too much austerity was never enough should be lost on no one in Canberra.  This was not the time for fiscal heroics. 

On face value, the Budget looks to be a dreadful fiscal policy mistake.  With a much lower starting point, a deficit of AUD44bn in 2011-12, the government will have to make a fiscal adjustment of over AUD45bn to hit the forecast 2012-13 surplus of AUD1.5bn.  That’s a 2.6% of GDP hit to the economy in just one year.  Recall, that in 2009, most developed countries stimulated their economies by 2% of GDP in the immediate aftermath of the global financial crisis.  That was a once-in-a –century fiscal policy ease.  The Australian government now appears to want to be tightening policy as quickly and by as much as it was eased.  The Australian economy is clearly not in the position to be able to weather such a fiscal withdrawal.  A 2.6% of GDP turnaround in the fiscal position in just one year will stop the Australian economy dead in its tracks.

There is simply no economic justification for a fiscal consolidation of this magnitude.  Ominously, the Mid-Year Economic and Fiscal Outlook released last November already foretold of an Australian economy that was starting to cool rapidly as a result of the early withdrawal of fiscal stimulus and trim monetary policy being offered by the Reserve Bank.  The RBA has implicitly acknowledged it’s read of the economy was incorrect and is now cutting rates aggressively to return monetary policy to a more appropriate setting.  Unfortunately, Treasury and the Government has misread the economy, but rather than reverse tack on policy, they have decided to cut even harder.  This perverse setting of fiscal policy does pose a very real risk of the Australian economy recessing in the coming fiscal year.

The clear anti-Keynesian position adopted by the Government is easily identifiable by the growth and employment forecasts.  Growth is slowing and unemployment is rising.  Again, this is not the time to be withdrawing fiscal stimulus. 

Treasurer Swan has previously said, in justifying the return to surplus, that “If we are going to be Keynesians in the downturn, we have to be Keynesians on the way up again. That means a speedy return to surplus…”

Keynes, like the bible, is often quoted or asserted but far less frequently read, or understood.  Swan has misrepresented Keynes whose basic argument was that the Government should only let the private sector grow when the economy was running up against its full employment constraint.  In this case, a contractionary fiscal policy would be essential to maintaining inflation stability. 

Australia has entered into a dangerous phase where fiscal policy has become pro-cyclical.  That is, net discretionary spending is being withdrawn from the economy at a time when it is already slowing.  In a fragile external environment, this is a high risk gambit.  The political cycle is also dangerously entwined with the opposition claiming they would have delivered, and plan on even larger surpluses. 

The days of the Australian economic miracle appear to be numbered.  The fiscal policy misjudgment of May 2012 could well prove to be its death knell.

Summary of market implications:

The relative strength of the Australian government’s balance sheet, a smaller debt issuance program (net debt is likely to peak below 10% of GDP) and the maintenance of the near extinct AAA status, coupled with what is likely to be a slowing economy, little inflation, and a back-pedalling central bank all bode well for Australian bonds.  Though ACGB’s are already at 60 year lows (in terms of yield), I would expect the benchmark 10 year AU-US spread to shift into a lower trading range with further medium-term compression likely.

Japan’s nuclear summer of discontent

The complete shutdown of nuclear capacity in Japan will trigger a “consumption switching” dynamic in energy markets and significantly worsen Japan’s trade position.

Though Japan is the world’s most efficient economy in terms of energy consumed per unit of output, the (albeit temporary) loss of nuclear capacity, which prior to the 2011 earthquake and tsunami accounted for 30% of electricity produced in Japan, is going to hurt.  Indeed, the Japanese economy could well recess on this loss of power and the costs of having to switch to coal fired of LNG powered electricity.

The market impact of Japan’s decision to suspend nuclear power will be significant.  It is likely that over the period of the shutdown Japan will replace China as the marginal demander of energy.  That is, the delta in demand for energy commodities is now likely to come from Japan rather than China where energy consumption trends appear to be stabilizing.

Nuclear accounted for 30% of Japan’s electricity.  Even an instant restart would take two working weeks to bring nuclear power back online.

Japan ceased the nuclear generation of electricity at 11.03pm on the night of the 5th of May with fission at its last operating reactor ceasing approximately 5 hours later.

Even with an instant clearance of safety checks and stress testing of nuclear facilities to withstand earthquakes and tsunamis, it takes over two working weeks to bring a nuclear reactor back online.

Japan has stood by the US decision to boycott Iranian oil.

Asia is the largest customer of Iranian Oil, taking 65% of output.  Whereas China and India have both resisted US and EU calls to slash Iranian oil imports, Japan and South Korea have fallen in lock-step with the US and dramatically slashed imports from Iran.

Secretary of State Clinton recently announced that Japan and 10 European countries will now be exempt from US penalties on countries/institutions that deal with Iran’s central bank.

Industrials reactions to power shortages will likely involve significant costs and greater outward FDI from Japan.

As we head into the Japanese summer, unseasonably warm weather could see widespread electricity shortages with production likely to be 20% lower than peak demand.

Bloomberg reports that a number of food producers may switch to night time production in an effort to avoid warm day time temperatures and possible shortages that prevent refrigeration.  In this instance, a significant increase in costs would be the outcome with significant overtime in shifting production out of day time hours.  These costs would ultimately be passed onto consumers with a significant pick up in inflation pressures likely.

Summary of market implications

Within the energy commodity complex, a consumption switching dynamic is now underway.  Demand for LNG and coal in particular will rise and for fissionable materials will fall. 

The confluence of a falling terms of trade and deterioration in the trade deficit is likely to put downward pressure on the yen.

Japanese inflation has a very high sensitivity to energy prices and Japan’s relative inflation performance is likely to deteriorate putting some downward pressure on lon

Australia. RBA uses two key words to signal a pause

The most notable thing in today’s RBA statement was the extremely strong message the Bank was able to send using just two key words.

First, the word “somewhat”.  As for the panic the punditry had whipped themselves into over recent economic data, the RBA calmly noted that ” information received over the past few months…suggests that economic conditions have been somewhat weaker than expected”.  Hardly any sign of panic or alarm there!

Most analysts probably had to reach for the thesaurus when the Bank chose to use the word “accretion” to describe the development of economic data over the first part of this year.  Accretion is a term that economics has borrowed from the hard-sciences, it is typically used to describe an as-expected scientific outcome.  The common meaning associated with the use of accretion in the financial markets is predictable changes in the price of financial assets. 

In short, the Bank is basically telling us that their is nothing alarming about the recent developments in the Australian economic circumstance, that it has largely been predicted, and implicit in that, the RBA has not committed the grave misreading of the Australian economy some key business leaders would have us believe. 

Australia: Mayday! Mayday! RBA sinks the cash rate by 50bps.

Governor Glenn Steven’s appears to have met the market, cutting the cash rate by a larger than expected 50bps to 3.75%.  In announcing the outcome of today’s policy board meeting, the Bank noted that inflation had moderated whilst economic activity data had been “somewhat” weaker than expected.

Though a rather bullish rates market is likely to have cheered the larger than expected outturn, risk takers may well be disappointed with the overall tone of the statement.  It very much appears to have been a 50bp cut delivered and a signal that the cash rate is now, once again, viewed as at an appropriate level.  Indeed, it could well be another 3 months before the Bank considers cutting rates again, when it sees the second quarter inflation figures, released in July.

How do we know this?  Simply because the RBA has a process.  In all of its communications on monetary policy, it always uses the final sentence of each statement to guide expectations of further policy increases.  For instance, last month, the Bank kept policy on hold, but in its last sentence said that “at today’s meeting, the Board judged the pace of output growth to be somewhat lower than earlier estimated, but also thought it prudent to see forthcoming key data on prices to reassess its outlook for inflation, before considering a further step to ease monetary policy”.  With a significant downward surprise in the Q1 inflation figures, the Bank was therefore able to ease monetary policy by 50bps today.

And what of today’s statement?  Well that’s where the RBA sounds unambiguously on hold.  The final sentence is more a statement of fact, and not providing and forward clues on monetary policy.  The Bank said today that:

“In considering the appropriate size of adjustment to the cash rate at today’s meeting, the Board judged it desirable that financial conditions now be easier than those which had prevailed in December. A reduction of 50 basis points in the cash rate was, in this instance, therefore judged to be necessary in order to deliver the appropriate level of borrowing rates.”

There is absolutely no forward guidance from the Bank on the future stance of policy.  Typically when the Bank has used a backward looking tense to conclude their statement, they have moved into a period where policy is on hold.

The bulls in the market may have got the 50bp cut they were baying for, however, the cost is likely to be less further rate cuts in coming months.  To me, the risk is that the Bank will now wait to see the Q2 inflation figures to assess just how quickly inflation is decelerating.  There is certainly nothing in today’s statement from the Bank to suggest they have a further significant easing profile in their own assessment of the economy.

Australia: A problem not even the world’s highest paid central banker can solve.

Tomorrow we will know whether the Reserve Bank of Australia considers itself to have been wrong and delivers a 50bp rate cut as its mea culpa.  My view is that it hasn’t been wrong and is therefore unlikely to indulge the silly nonsense that it now needs to move interest rates dramatically lower at a faster pace to salvage an economy the consensus would have you believe has stopped dead in its tracks.

The real economic issue in play is being steadfastly ignored, or misunderstood, by the Australian market.  The reason why the Australian economy has slowed as we moved into 2012 has little to do with monetary policy.  More importantly, it is a problem that monetary policy can’t solve.  Even 100bps of easing by the RBA in the next four months will have little impact on a slowdown for which Canberra, not Martin Place, is responsible. 

This time last year, the punditry that is now screaming for a 50bp rate cut was obsessing about the Australian economy being near full-employment and in the middle of once-in-a-generation mining boom that would see inflation accelerate dramatically unless the RBA significantly tightened monetary policy and the government returned the budget back into surplus.

In his 2011-12 Budget Speech, Treasurer Swan said that “with the investment pipeline ramping up and unemployment falling, the boom will test our economy and our workforce, and price pressures will re-emerge”.  {chortle chortle}.  He went on to say that was the principal reason for the “strict spending limits” in which last year’s Budget was framed  so that the Government would not “compound these pressures” with the arm of economic policy, fiscal policy, that they autonomously control.  Unlike the RBA who considers monetary policy settings every month, there is only one budget per year and fiscal policy settings are very rarely revisited on an intrayear basis.

So where are the calls for a change in the stance of fiscal policy then?  Why isn’t anybody saying “look how wrong Canberra has got it…they must dramatically revise fiscal policy now”?

Unfortunately, nobody would be listening.  The RBA will cut rates but the government will not budge from its misguided and erroneous view that returning the budget to surplus is the optimal economic outcome for Australia.  It is not, and the unprecedented magnitude of the swing from deficit to surplus that Treasurer Swan is currently engineering will ensure that the Australian economy will slow even more significantly than it has thus far.  The risk of a fiscal driven recession occurring over 2012-13 is much higher than anybody publicly acknowledges.

Here is why the current policy mix in Australia is deeply troubling.

First, monetary policy is not working as effectively as it has prior to the global financial crisis.  Indeed, it may not be working at all.  Though the RBA can still cut interest rates significantly (the cash rate here is 4.25% here compared to 0% in both Japan  and the US), the problem is that the household and corporate sectors, but particularly the household sector, have become insensitive to interest rates.

Following a two decade boom in asset prices and rise in debt levels to unprecedented levels, households are now moving to strengthen their balance sheets by either deleveraging or taking on debt at a slower rate.  This dynamic is NOT being driven by money or debt being too expensive.  It is being driven by a structural break in household saving/spending behavior over the past two years with households simply no longer comfortable with the level of debt they hold relative to income.  Changing the price of money, interest rates, is not going to do anything to change that dynamic.  Even if interest rates are cut by 100bps in the next quarter, households are not going to stop deleveraging.  If anything, the rate cut may allow them to reduce leverage at a slightly faster pace, but the impact on real economic activity (that would require the rate cuts to boost household spending) are just not going to eventuate.

On the household side then, there is an important structural dynamic in play that has reduced the sensitivity of the household sector to rate cuts. 

For corporates, one of the defining features of the global recession was that it was led by the financial sector, not the non-financial sector.  Non-financial corporates have extremely large amounts of cash sitting on balance sheets, and this has reduced their sensitivity to monetary policy as well.  If they wanted to invest (lift productive capacity) or employ (lift labour capacity) they can fund this off balance sheet, rather than having to borrow.  Indeed, sentiment surveys also suggest a leverage-adverse corporate sector.  Hence, we find the sensitivity of the corporate sector to rate cuts, has probably also fallen.

So what of fiscal policy then and what Canberra can do?

This is where the real and significant error on economic policy is occurring. 

When monetary policy becomes ineffective, be it due to deleveraging, zero rates, or a liquidity trap, it is vitally important that fiscal policy is eased significantly and quickly.  When monetary policy is not working, the only way aggregate demand can be increased for any given nominal cash rate is for the government  to spend more.  That the government is still going ahead with a fiscal adjustment that is likely to be around 3% of GDP is a suicidal policy choice for the Australian economy.

Glenn Stevens is wearing the blame for an economic outcome that is not of his doing.  As the Australian economy grinds to a halt, the punditry may belatedly realize that fiscal policy has been mismanaged to a much greater extent than monetary policy.  Unfortunately, it will be May 2013 before that growth retarding mistake can be revisited.