Reform, not liquidity, is the way out

Andy Xie
March 15, 2009

The global economy is sinking into the abyss. Big trading economies like Japan, Korea, and Taiwan see their exports halved. The US’s unemployment hit 8.1%. Stock markets around the world have dived below their lows last November and are into the valuation levels last seen in the 1970s-the horrifying decade of stagflation. The share price of Citigroup, the erstwhile financial supermarket, has sunk to one dollar. It was $55 in 2007. The share price of HSBC is diving like Royal Bank of Scotland, Citigroup or Bank of America’s before. Toyota, the most vaunted carmaker in the world, is seeking government assistance. It feels like Armageddon.

Amidst the carnage, analysts are singing a hopeful song over rising liquidity, in particular, China’s surging lending in the past two months. China’s stock market has outperformed other markets by over 40% since November last year. The surging lending and rising stock market have caught the eyes of investors around the world. On several occasions markets around the world rose or fell on their perceptions of what were happening in China. It shows how important China has become. Investors know that the next economic upturn, regardless of when and how, will have a lot to do with China. As the US may need years to repair its balance sheet and Europe and Japan are weighed down by aging populations, China seems the only hope to power the next upturn. This is why what occurs in China is affecting global markets.

The faith in liquidity, however, is misplaced. Liquidity took on mythical power during the Greenspan Era. Financial professionals spend numerous hours talking about it. Few, however, know what it really is. When a central bank says it is injecting liquidity. It buys some financial securities, e.g., government bonds, in exchange for cash. When it is done with the operation, its balance expands: on the liability side, it owes the financial system more money, on the asset side, it owns more securities. The changes in the balance sheet of the financial system are exactly the opposite: it has more money and fewer securities. With additional money, the financial system may be inclined to lend more or buy more securities. The former increases the borrowers’ ability to spend. The later lifts asset prices. Economists usually focus on the former, while financial professionals the later.

Liquidity became respectful through Keynes’s writings. It was synonymous with speculation before. He was primarily concerned about how to stimulate demand during frequent recessions in early 20th century. Liquidity was associated with fiscal stimulus, i.e., providing support for fiscal bonds to fund fiscal deficit. The main idea is that, when someone is unemployed, giving him something to do would be positive. Even if his work is totally useless, he would spend the income, which would lead to a chain reaction in creating useful economic activities. When an economy is unemployed, fiscal deficit will improve it.

In contrast, Joseph Schumpeter advocated recession as creative destruction-a cleansing process to weed out the weak and create room for new businesses. In this theory, boom-burst cycles are a sign of progress. Government interventions to ‘smooth’ the cycle may be counterproductive, e.g., suppressing innovations. The rising prosperity in the 19th century despite violent economic cycles seems to support this theory.

The world is not black and white like what the Keynesian or Schumpeterian theory suggests. When an economic downturn is severe, it could trigger social revolutions. The revolutions in the 1930s and 40s had a lot to do with the Great Depression. Keynes is right that governments have a responsibility to stimulate in a severe recession. But, stimulus doesn’t work in the long run. Governments must bear in mind that innovation is ultimately the source of economic growth. Dependency on stimulus may lead to stagnation. A recession could serve a useful purpose in shaking out the underperforming businesses.

During the stagnation of 1970s, liquidity as an ominous tool for economic management was discredited. Workers anticipated correctly the inflationary impact of monetary growth and demanded wage increase to offset inflation. The wage inflation immediately led to CPI inflation. There was a direct path between monetary expansion and inflation. Hence, central banks were just causing inflation without stimulating demand. The era ended when Paul Volker became the Fed Chairman and increased interest rate massively to tame inflation. His action laid the foundation for the low inflation era afterwards.

When Alan Greenspan became the Fed Chairman, the inflation expectation was low. When he increased money supply, it flowed into asset markets first. The resulting asset inflation boosted demand. It made his liquidity pumping highly effective in stimulating demand. The low inflation era was prolonged by globalization, as over one billion workers from the developing world entered the global economy. As Greenspan kept up his effectiveness, financial markets became used to the effectiveness of his liquidity policy. Most financial professionals came to worship liquidity as the silver bullet for reviving economies.

When the current crisis began in August 2007, central banks again created liquidity to deal with it. The faith in liquidity boosted confidence and stabilized financial markets for a few months. But, through 2008, it began to lose traction. The liquidity didn’t lead to rising asset prices or improving demand. Global economy and financial markets dived in a vicious spiral. Why hasn’t it worked this time?

Even though financial professionals often talk about liquidity like free money, it is actually short-term debt. It works when there are enough households or businesses that are willing to borrow to spend. When a debt bubble bursts, there are few entities that could borrow more regardless of how low interest rate is. Hence, liquidity doesn’t work in the aftermath of a debt bubble bursting. All that liquidity does is to build up in the financial system. In the jargon of monetary economics the money multiplier decreases with liquidity rising.

China’s situation is different from the western economies. It doesn’t have high leverage in general. In particular, the household sector doesn’t have much debt at all. This is why there is so much attention paid to China’s liquidity surge. It has the potential to turn into demand. However, China’s structural imbalance between the household sector and the government/business prevents it from turning into demand.

China’s current liquidity results from the huge trade surplus due to faster decline of imports than exports. As the central bank has not been issuing sterilization papers like before to mop up the surplus, the liquidity has built up in the banking system. The banks have lent some of the surplus liquidity to state-owned enterprises in the form of discounted bills. As the interest rate on such loans is very low, the state-owned enterprises could deposit the borrowed money without incurring significant cost and, sometimes, even pocket a small profit. The practice has rapidly expanded the balance sheet of the banking system from accounting perspective.

The lending, however, won’t turn into demand soon. Most industries, especially the capital intensive ones, face overcapacity. Steel industry, for example, may have 30% overcapacity. The ship-building industry is seeing massive defaults in orders. Many, if not most, shipbuilders are facing bankruptcy. Most property developers are not selling and, if given money to build more, would dig a deeper hole for themselves. China’s supply side has too much capacity. It is unlikely that more loans to businesses would spark an economic recovery.

Lending to government projects can support demand. It serves as a multiplier on the fiscal stimulus program. Bank lending may double its impact. The government has budgeted Rmb 1 trillion of fiscal deficit or 3% of GDP for 2009. The stimulus could stabilize the economy but not restart high growth. Exports and property were contributing 6-8 percentage points to GDP growth rate per annum in the last cycle and are now contributing a negative amount of similar magnitude. No amount of stimulus could completely offset the impact of their contraction. Further, China is already investing too much and shouldn’t push it excessively to pump up the economy temporarily and face a worse downturn later.

Export recession and the bursting of the property bubble are the sources of demand shortfall. The former is a consequence of the bursting of the global credit bubble. Globalization shifted production from developed to developing countries. The asset bubbles that western central banks tolerated during globalization allowed western consumers to defend their lifestyle with income extracted from asset bubbles despite the wage problem. As the bubbles bursts, their demand for exports from developing countries like China declines to what their wage could support.

China’s property market has been a bubble. In many cities the average price per square meter is three times average monthly salary or higher, while the amount of building is equivalent to one third of the existing housing stock. Such combination of high price and high volume is not sustainable. The strong demand before 2008 was a bubble phenomenon as buyers were betting on prices going higher or trying to lock in before the prices became out of reach.

To solve the demand weakness, China must boost household demand to offset export weakness and decrease property purchase cost to clear the existing inventory. China’s economy could not resume high growth without both issues addressed. Confidence is not the main reason for the relative weakness of China’s household demand. Low household income and wealth are. The quickest solution is to distribute the shares of listed state-owned enterprises that government holds to Chinese population. It will have a powerful short-term effect on consumption. As business profits improve in a booming economy, the shares appreciate, which further supports household demand and make the boom last.

In 1998, the government sold public housing flats to their tenants at notional prices, which laid the foundation for the housing boom afterwards. If China distributes the SoE shares to the household sector, it could ensure another decade of economic boom.

In terms of how to distribute the shares, the government can set up an account automatically for each Chinese citizen with his or her ID card number at one of China’s state banks. He or she could claim the asset at any branch of the designated state bank with his or her ID card.

Some argue that poor people who get the shares may sell them cheap. This happened in Russia in the 1990s. I don’t think Chinese people will behave the same way. China’s brokerage accounts are 10% of the population vs. 0.5% in Russia. It implies that Chinese people treasure stocks much more than Russians and would be careful in disposing them. Further, Chinese state-owned enterprises should distribute dividends together with the distribution of the shares. When people see the dividends, they will treasure the shares more. I suspect that the dividends will have a bigger impact on the economy than the SoEs spending the money on capex in overcapacity industries.

Others argue that the shares should be used to capitalize the social security fund. Lack of social security is a reason for the consumption weakness. But, I doubt that people would view the money in the social security fund the same way as the money in their pockets. Some studies in developed economies suggest that people discount each dollar in a government-controlled social security fund by 60%. Hence, it is much more powerful to put money into people’s pockets than in a government-run fund.

To clear the property inventory, the purchasing cost per square meter should decline to about 1.5 months of salary. This is not low by international standard. But, as China could sustain high economic growth for another 15 years or longer, the property price could be higher than the international average. The reduction of the purchasing cost probably needs to be shared evenly between price reduction and tax incentives. As China’s property market is so big, unless its health is restored, domestic demand would not likely resume robust growth.

Some hope liquidity would improve the economy through inflating asset markets, i.e., creating another bubble. This is what Greenspan achieved after the tech burst in 2000. Of course, his glory then has become today’s nightmare. Creating another bubble to deal with the consequences of the burst of a bubble is irresponsible even if it can be done. I doubt that it can be done in China today. Some of the liquidity did flow into the stock market in December 2008 and January 2009. At its recent peak the stock market rose by 40% in three months. But, it is extremely hard to manufacture a stock market bubble in a difficult economy. I cannot recall one in modern history. The reason is that speculators are quicker to take profits in a poor economy than in a booming economy.

Further, it is virtually impossible to inflate China’s property market by encouraging speculation, i.e., making funding easier to get and interest rate low. The current inventory is unprecedented by any measure. This is probably the biggest overhang per capita of physical properties completed or under construction in modern history. It would take three years to digest under the best policy combination. Re-inflating the bubble with liquidity is just a pipedream.

China’s problem is weak household demand. The reasons are low household income and wealth. Confidence is an issue but not the most important one. Strong exports in the past decade supported China’s massive investment. Now we urgently need household demand to replace exports to make the investment profitable. The quickest solution is to redistribute government wealth to the people. Focusing on liquidity only delays the solution and prolongs the hard economic time.