In the long term, will “easy money” come from China as well?

chinaVivek Kaul

The Chinese economic growth for 2014 was at 7.4%, a tad lower than the official target of 7.5%. This is the slowest rate that the country has grown at in 24 years.
In the aftermath of the financial crisis that started in September 2009, the Chinese government pushed the banks to ramp up lending. In a recent piece
for the Wall Street Journal, Ruchir Sharma of Morgan Stanley estimates that “since 2008 the money supply has nearly tripled to $20 trillion” in China. Sharma further writes that China ordered up “new spending” which totalled to “12% of GDP, by far the biggest stimulus of this period.”
This helped the Chinese economy to keep growing at a fast rate in the aftermath of the financial crisis, even though growth in most of the other parts of the world collapsed. The trouble was that a lot of this money went towards creating infrastructure which was not required in the first place. It also led to a huge property bubble.
As Sharma puts it: “This decay is symbolized by the bridges, apartment complexes and half-empty shopping malls rising across China—many of them wasteful projects that were hurriedly seeded in 2009 and will sap growth in the future. The message: When the state spends in haste, it will repent at leisure.”
At the same time the productivity of Chinese capital has been coming down. It now takes more capital and more loans to get the same amount of economic growth going than it did in the past. In a recent study carried out by two economists
working with the Chinese National Development and Reform Commission (NDRC), a top economic planning and regulatory agency in China, came up with some interesting results.
The study found that China’s incremental capital output ratio has risen dramatically over the years. It averaged at 2.6 for the period between 1979 and 1996. It has since jumped to 4 between 1997 and 2013. What this means is that before 1997 it took an average investment of $2.6 to get $1 of GDP growth going. Since 1997, it has taken an average investment of $4 to get $1 of GDP growth going.
The economists also found that the delivery rate of completed capital projects has come down dramatically over the years. The number stood at 74-79% in the late 1990s and has since fallen to around 60%, implying that 40% of the Chinese investment projects have either not been completed or did not finish on time.
The negative effects of the spending binge are now starting to be felt. As Wei Yao of Societe Generale wrote in a recent research note titled
China: deceleration as usual, easing as routine and dated January 20, 2015: “More strikingly, property investment growth collapsed to -1.9% year on year from +7.6% year on year, the first contraction in 18 years! Construction data further confirmed that developers are struggling. New starts remained in deep contraction, falling 26.1% year on year; growth of floor space under construction fell below 10% year on year for the first time since mid-2000; and completion growth plummeted to 1.2% year on year from 11.4% year on year in the previous month.”
The non performing loans of banks are also rising at a rapid rate. As Yao wrote in another note dated November 20, 2014, and titled
China: easing by not easing: “The non performing loan stock has been growing at a 35% clip this year. Smaller banks have seen faster deterioration, with non performing loans rising 50% year on year. The worse is still to come and banks know it.”
All this does not augur well for the Chinese economy and the government is trying to initiate what economists call a “soft landing”. This may also include ensuring that the Chinese economy does not grow as fast as it was in the past.
As Li Baodong, a Vice Foreign Minister, told reporters after the latest economic growth numbers came out: “China has entered a new normal of economic growth…That is to say we are going through structural adjustment and the structural adjustment is progressing steadily.”
This is a clear hint of the fact that the Chinese government is neither looking at spending more nor pushing banks to lend more, in order to push up the falling economic growth. “The chance of aggressive policy easing remains small,” writes Yao.
The trouble is that the Chinese investment forms a major part of the investment happening all over the world. As Sanjiv Sanyal of Deutsche Bank Market Research writes in a recent research note titled
The Capital of China is Moving: “China’s domestic investment currently accounts for a disproportionate 26 per cent of world investment, up from a mere 4 per cent in 1995. In contrast, the United States saw its share peak at 35 per cent in 1985 but now accounts for less than a fifth.”
Why is Chinese investment such a dominant part of total global investment? “China’s dominance is driven by the fact that it saves and invests nearly half of its $10.5trillion economy,” writes Sanyal.
But it is becoming more and more difficult to fruitfully deploy $5 trillion (around half of $10.5 trillion). This is primarily because the “country…already has brand new infrastructure, suffers excess manufacturing capacity in many segments and is trying to shift to services, a sector that requires less heavy investment.”
This means that Chinese investment will go down in the coming years. Hence, if the Chinese savings rate continues to remain the same or does not fall at the same rate, it will lead to surpluses.
Chances are that the Chinese savings rate will not decline primarily because China is ageing at a very rapid rate. “The experience of other ageing societies such as Germany and Japan is that investment rates fall faster than savings rates,” writes Sanyal.
In another research note
Bretton Woods III and the Global Savings Glut published in October 2013, Sanyal explains this theory in detail. Sanyal basically says that when people are young, their spending needs are greater. Hence, they need to borrow money in order to consume and/or build assets (like homes). But, as they age, their savings rise and they build up a stock of wealth, which they spend in their old age. Countries work along similar lines. Basically, what this means is that as a country ages (with the average age of its population rising), it tends to save more.
By 2030, China would go from being significantly younger to the United States to becoming significantly older to it, with a median age above 40. The excess savings that will be generated need to be absorbed somewhere.
A lot of this money is likely to find its way into the United States, feels Sanyal. And this might help the US government to continue borrowing from foreign countries. It would also keep interest rates low and help Americans keep their excess consumption going by borrowing. “The next round of global economic expansion may require the United States to revert to its role as the ultimate sink of global demand,” wrote Sanyal in the October 2013 note.
In his latest note Sanyal also states that the United States “has the necessary scale to absorb China’s surplus and the poor state of its infrastructure provides many avenues for fruitful deployment of capital.” Nevertheless, he goes on to write that “history suggests that some of this cheap money would inevitably find its way into trophy assets and bubbles.”
As far as theories go, this one sounds pretty logical. Let’s see how it goes. That only time will tell.

(The column appeared on as a part of The Daily Reckoning as on Jan 23, 2015)

Debt ceiling: Why the Great American Ponzi scheme might just keep running

3D chrome Dollar symbolVivek Kaul 
Governments typically spend more than they earn. This difference is referred to as the fiscal deficit. The government of the United States (US) is no different on this front. It has been running fiscal deficits greater than a trillion dollars every year since 2009. It makes up for this deficit by borrowing. It borrows money by selling bonds on which it pays interest.
Currently, the US government has sold bonds close to $16.69 trillion. Of this, around $4.8 trillion worth of bonds have been bought by agencies of the US government which primarily run pension funds and retirement funds. The American households own around $1.2 trillion or around 7.2% of the total outstanding bonds of $16.69 trillion.
This is not surprising given that the savings rate in America has averaged at around 4.6% of the disposable income over the last 10 years. In July 2005, it had fallen to as low as 2% of disposable income. It has since recovered and since the beginning of 2013, it has averaged at 4.4% of the disposable income. The moral of the story is that the average American doesn’t save enough to be able to lend to his government.
So who are the other lenders to the US government? 
As I explained in detail yesterday the Federal Reserve of United States, the American central bank, is a major lender to the government. Currently it holds bonds worth $2.086 trillion or around 12.5% of the total outstanding bonds of $16.69 trillion.
This lending has gone up by 434% over the last five years. On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion.
The Federal Reserve doesn’t have any money of its own. It basically prints money and uses that money to buy government bonds. This money printing adds to the money supply. This excess money can ultimately lead to high inflation with excess money chasing the same amount of goods and services.
Hence, the Federal Reserve printing money to buy US government bonds is something that cannot continue forever. In fact, Ben Bernanke, had indicated in May-June 2013, that the Federal Reserve will go slow on money printing in the months to come. Since then, he has gone back on what he had said and indicated that the money printing will continue for the time being.
But even with that change in position, the US government cannot continue to rely on the Federal Reserve to finance a significant part of its fiscal deficit by buying its bonds. As I mentioned yesterday, between 2009 and 2012, the US government ran a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
So the question is who will the US government have to ultimately borrow from? The answer is other countries.
As of the end of July 2013, foreign countries held 
a total of $5.59 trillion of US government bonds. Of this China was at the top, having invested $1.28 trillion. Japan came in a close second, with $1.14 trillion. How has this holding changed over the years? As of September 2008, the month in which the current financial crisis started with the investment bank Lehman Brothers going bust, the foreign countries held US government bonds of $2.8 trillion. Hence, between September 2008 and July 2013, their holdings have doubled (from $2.8 trillion to $5.59 trillion).
Given this, what it clearly tells us is that the foreign countries have helped by the US government run its trillion dollar fiscal deficits by buying its bonds.
Let us look at this data a little more closely. As of the end of December 2008, the foreign countries held US government bonds of $3.07 trillion. By December 2012, this had gone up to $5.57 trillion. This meant that during the period foreign government bought bonds worth $2.5 trillion. During the period the US government ran up a fiscal deficit of $5.09 trillion. The foreign governments financed around 49% of this, by buying bonds worth $2.5 trillion($2.5 trillion expressed as a % of $5.09 trillion).
During this period, some of the bonds that foreign countries had bought would have matured. The US government spends more than what it earns. Hence, it does not have the money to repay the maturing bonds from what it earns. Given this, it needs to sell new bonds in order to repay maturing bonds. A part of these new bonds being sold over the last five years have been bought by the Federal Reserve. The Federal Reserve has done this by printing money.
Hence, the US government has paid for a part of its maturing bonds by simply printing dollars. This is similar to running a Ponzi scheme, where the government is paying off old bonds by issuing new bonds. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
Despite this, foreign countries have been more than happy to buy US government bonds. As we saw a little earlier in this piece, they have doubled their holding of US government bonds between September 2008 and July 2013. In short, foreign countries along with the Federal Reserve have helped the US government to keep running its Ponzi scheme.
Why is that the case? The United States with nearly 25% of the world GDP is the biggest economy in the world. By virtue of that it is also the world’s biggest market where China, Japan and countries from South East Asia and South America, sell their goods and earn dollars in the process.
The way things have been evolved, the US imports and countries like China, Japan, Saudi Arabia etc earn dollars in the process. These dollars can either be kept in the vaults of central banks of these countries or be invested somewhere.
Hence, over the years, these dollars have made their way to be invested in US government bonds, deemed to be the safest financial security in the world. With so much money chasing them, the US government, has been able to offer low rates of interest on them.
This has helped keep overall interest rates low as well. It has allowed American citizens to borrow money at low interest rates and spend it on consuming imported goods. So the Americans could buy cars from Japan, apparel and electronics from China and countries in South East Asia and oil from Saudi Arabia. And so the cycle worked. The US shopped, China and other countries earned, they invested back in the US, the US borrowed, the US spent, China and the other countries earned again and lent money again.
The way this entire arrangement evolved had the structure of a Ponzi scheme. China and other countries invested money in various kinds of American financial securities including government bonds. This has helped keep interest rates low in the US. This helped Americans consume more. The money found its way back into China (like a return on a Ponzi scheme), and was invested again in various kinds of American financial securities, helping keep interest rates low and the consumption going. Like in a Ponzi scheme, the dollars earned by China and other countries has kept coming back to the US.
Hence, foreign countries have an incentive in keeping this Ponzi scheme going. Earlier, it was important for them to keep buying US government bonds to keep interest rates low and help American consume more. It was also important to keep buying these bonds to ensure that the US government had enough money to repay them. Now it has reached a stage, where the US government is repaying them by simply printing dollars.
But even with this foreign countries are likely to continue lending money to the US government by buying its bonds. Sanjiv Sanyal, global strategist, Deutsche Bank Market Research makes this point in a recent report titled 
Bretton Woods III and the Global Savings Glut.
As he writes “The basic idea is that, when people are young, they have little savings and may even need to borrow in order to spend on consumption and/or build assets. However, as they grow older, their net savings rise as they build up a stock of wealth that is later run down in very old age. The same dynamic can be said to broadly hold for countries as they experience demographic transitions although there are nuances that vary according to cultural context and fiscal incentives of individual countries.”
Basically what this means is that as a country ages (with the average age of its population rising) it tends to save more. Sanyal expects many developing countries to age at a very fast pace over the next two decades. As he writes “The link is even clearer if one considers the pace of aging by comparing the current median age with the expected median age in 2030. For instance, Japan will then have a median age of 51.6 years while China will go from being significantly younger than the US in 2010 to becoming significantly older after two decades. The aging of South Korea is even faster.” He expects these countries to have a median age of 40 by 2030.
Given this, it is likely that as countries age, they will keep generating excess savings. A lot of this money is likely to find its way into the United States, feels Sanyal. As he writes “we know that lenders do not just care about high returns but about policy risk, property rights, corporate governance and the overall ability/willingness to the borrower to return the money. Thus, aging current-account surplus countries may prefer to park their funds in safer countries even though returns are higher in certain emerging markets.”
And this will help the American government to continue borrowing. It will also keep interest rates low and help Americans keep their excess consumption going. “The next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand,” writes Sanyal.
And so the Great American Ponzi scheme might just continue for a while.
The article originally appeared on on October 18, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)