I gave the following lecture to students on the International Finance course at the London Business School on 3 June.
(Biggest movie of 2016)
Let me start with a question. Which movie has made the most money this year in any one country? No, it’s not Captain America: Civil War, it is actually Mei ren yu (The Mermaid). It has so far made $530m in China. This compares to Captain America’s $380m in the US. The reason for highlighting this is to show how big the Chinese economy has become. At over $11trn it is the second-largest economy in the world after the US ($17.8trn) and more than the double next-placed Japan ($4.7trn). Back in 2007 before the financial crisis, China was only a quarter the size of the US, rather than two-thirds the size and it was smaller than Japan.
This may help explain why what happens in China reverberates around the world in big, as well as smaller, economies. Last year’s devaluation in the Chinese yuan in August was testament to that. Not only did Chinese and regional markets suffer from the shock, but the US equity market fell by 10% around the event. The Federal Reserve’s focus on China in formulating its monetary policy should therefore not come as a surprise.
It is also important to contextualise China in the recent history of crises we’ve experienced. The way I like to think about these things is that we’ve been unwinding credit bubbles one after the other in each region. We started in the US in the 2000s, where inappropriately priced mortgages fuelled a borrowing binge that started to unravel in 2007 and culminated in the 2008 financial crisis.
Then from 2010 to 2012, we saw the Euro area crisis, which undid the assumption that all sovereign risk was the same with the creation of the Euro area in 1999. That assumption had led to previously higher-risk countries like Spain and Greece being able to borrow on Germany’s lower risk standing. I should add that this was not a simple story of profligate borrowers from the South, but also misguided lenders from Germany and the North who also bought into the credit convergence. In 2010, the sustainability of Greece was questioned, which escalated to Spain and Italy by 2012. It required various fiscal backstops and ECB assurances for the crisis to be contained.
Now it’s China’s turn. The backstory is well known. China started to liberalise under Deng Xiaoping in the late 1970s and benefited from an export-led development model, especially in the 1990s as it worked towards entry to WTO in 2001. The 2000s, though, saw a new domestic engine of growth emerge, a dramatic increase in domestic infrastructure and property spending partly to accommodate greater movement of workers from rural areas to urban areas and partly to improve the structure of the economy. A fixed exchange rate helped reduce perceived currency risk and ample credit helped fuel the growth.
The 2008 global financial crisis provided a blow, which was met with a very large stimulus programme, much of which went to investments that haven’t returned what was expected. Moreover, even as authorities were trying to rein in excessive lending in property and related sectors, new forms of shadow financing emerged to fill the gap. These included wealth management products which allowed individuals to lend at attractive interest rates to property developers and US dollar financing, which was attractive as US interest rates were so low. Various schemes were also employed to get around capital controls – the restriction of bringing dollars into China – such as over-invoicing exports, which in essence would disguise a capital flow as a trade flow.
All this changed as the Fed started to taper its quantitative easing programme in late 2013, which drove US borrowing costs higher, impacting both China and emerging markets in general. The Chinese economy was also struggling to turn credit into economic growth. Together, this turned the trend in the Chinese yuan to weakness, which in itself introduced currency risk to Chinese corporates in a way not experienced for years. Capital outflows ensued, which ended up forcing the authorities to take action last summer.
China still has overcapacity in many sectors of its economy and rising debt problems, so we cannot say China’s troubles have ended. This means that the negative growth shock to the world that China has released will stay us. It also needs to be recognised as one source of weakness in developed world economies from Europe to the US to Japan.
Indeed, in recent years it has been fashionable to frame weak growth and ultra-easy monetary policy in the developed world in a “secular stagnation” context. This framework argues that people are incentivised to save, rather than spend, due to fears over their pensions, less ability to borrow on their houses, and income inequality. On the side, investment is lacklustre due to a declining labour force, cheaper capital goods and tighter credit conditions. This results in too much savings and too little investment. In theory Interest rates should fall to transform these excess savings into investments, but in reality with interest rates at the zero bound, we have hit the limits of how low interest rates can go (even in real terms).
(Who can borrow at zero?)
Missing from this, is the China slowdown as mentioned, but also an obvious point of what interest rates are we talking about. While it is true that government bond yields and interbank bank rates are very low and in many cases negative in both nominal and real terms – only governments, banks and highly-rated companies can borrow at those rates. The rest of us cannot.
Take the US, this decade the 2yr government yield has averaged -1% in real terms (adjusted for core inflation). In the noughties, it averaged 1.4%, in the 1990s it averaged 3.4% and in the 1980s it averaged 4.8%. So it has successively been falling. But what about the real interest rate on personal loans? This decade it has averaged 8.9%, which is lower than the noughties’ 10.4%, but higher than what we saw in the 1970s, 6.8%. Similarly, BAA-rated corporate loans have averaged 3.7% this decade, which is higher than in the 1970s and 1960s. In all cases, there are considerably far away from zero.
(No-one likes negative rates)
Rather than pushing the rate that banks or highly-rated companies can borrow ever lower, it therefore make more sense to drive down interest rates for other segments of the economy (i.e. credit easing). Indeed, even cutting rates into negative territory appears to be having unexpected consequences. All the countries that have cut their policy rates to negative (the Euro area, Sweden, Switzerland and Japan) have seen their financial sectors suffer relative to others in the months after the cuts (and in most cases longer). The Bank of Japan’s cut in January is a case in point, as not only did Japanese banks faltered after the announcement, but the currency strengthened as domestic investors repatriated on heightened risk aversion.
So where does that leave us? Well, the first thing to note is that we are in an interconnected world, therefore we need to keep a close eye on developments in the US, Euro area, China and Japan. Second, the efficacy of monetary policy depends on the transmission of lower interest rates to the broader economy – real rates below zero are not available to everyone. Finally, I didn’t mention demographics and the politics of fiscal policy, which are worthy of another lecture alone. Thank you.