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A few weeks ago, most people outside of China had never heard of Evergrande, the massive property developer. Now it is the talk of global financial markets. The yield on a four-year bond issued by Evergrande has risen from about 12% early this summer to almost 60% now. This increase reflects the massive risk premium associated with the company’s debts. Meanwhile, fear of what happens next drove a very sharp decline in Hong Kong equities last week. Here is a bit of context.
In the past two decades, there has been massive investment in residential property in China. Many of the properties that have been built remain unoccupied, held by relatively wealthy investors as speculative investments. By one estimate, there are enough empty properties to house about 90 million people, more than the population of Germany.
For some time, China’s leaders have expressed reservations about several facts—that property investment represents an unusually large share of GDP; that a large number of properties are unoccupied and were purchased as speculative investments; that a vast amount of debt was accumulated in order to fund this investment; and that a lot of debt is no longer serviceable but has been rolled over by state-run banks to avoid financial calamity. China’s president said that “housing is for living in, and not for speculation.” Thus, there is a governmental aversion to the disproportionate size of the property sector, which is why the government chose to act last year. The big uncertainty now is how the government will manage the transition to a less property-intensive economy, or if it will protect property companies from destruction, thereby kicking the can down the road.
In August 2020, to address these concerns, the government imposed new restrictions on debt accumulation by property developers. These restrictions, known as the “three red lines,” were as follows: the ratio of debt to assets cannot exceed 70%; the ratio of debt to equity cannot exceed 100%; and the developer must hold cash at least equal to their short-term borrowing. If a developer fails to meet all three requirements, it is restricted from borrowing from banks. These rules lit a fire under the feet of property developers.
In the case of Evergrande, it sold properties at a significant discount to generate cash. This enabled it to reduce debt. Still, the company failed to meet two of the three red lines. The result has been a cash crunch and a significant risk of default—although Evergrande pleased investors last Wednesday by announcing that it would make a modest debt repayment on time this week. However, on September 13, Evergrande had issued a statement saying that the company faced “unprecedented difficulties.” It has more than US$7.6 billion in debt maturing next year. No wonder Evergrande’s share price has plummeted and bond yields have soared. While the same is not entirely true of other major property developers, there is no reason to be sanguine. After all, the net cash flow of China’s publicly listed property developers has been negative in the two most recent quarters. Moreover, Asian bond yields have been rising in recent days. Thus, it appears that trouble is brewing.
There is a growing debate among economists and analysts as to what happens next. Many do not expect the government to bail out Evergrande, but they do expect a restructuring of the company and an effort to keep credit lines open. In other words, the government will avoid its own “Lehman moment.” Indeed, there is a debate about whether this situation will turn out to be a Lehman moment in which a major default cascades through the financial system (as happened in 2008), causing a near meltdown, or not. My view is that this situation will not cause a Lehman moment, but it could lead to serious outcomes. Yet while the risk of financial contagion could turn out to be modest, the risk to the real economy is considered sizable. That is, the government is likely keen to manage a transition to an economy less focused on property development, in part to boost the efficiency of investment and in part to avert a worse financial crisis down the road due to excessive debt accumulation. The transition could be messy. It will likely entail a slowdown in economic growth next year and in the years beyond. These expectations are the principal explanation for the negative impact on asset prices outside of China. The rest of the world depends on China’s vast demand for commodities, inputs, goods, and services. A weaker Chinese economy will mean weaker exports to China from the rest of the world. Thus, it is no wonder that the price of iron ore has fallen by more than 50% since July.
Another potential problem is that the ability of China to massively invest in infrastructure has been tied to the health of the property market. That is because local governments, which fund a lot of infrastructure investment, generate about a third of their revenue from the sale of property. Local government financing vehicles (LGFVs) borrow money to fund infrastructure and, in part, pay off their debts through the land sale revenue of the local governments. Any sharp fall in property prices amidst a decline in demand for property by developers will have a serious negative impact on local governments and, consequently, on infrastructure investment. In fact, in the first two weeks of this month, land sales fell 90% from a year earlier. This suggests that some debt issued by LGFVs could be in trouble.
Finally, there is risk to many households. Many have invested in wealth management products (WMPs) issued by Evergrande, which are often purchased by Evergrande employees. Many people have paid for homes that have not yet been completed. Evergrande has 800 projects in progress—half have been suspended and almost all are fully paid for. It is likely that the government will seek ways to help disrupted households while not bailing out failed debtors. Perhaps the larger issue is what the authorities will do for banks that are heavily exposed to troubled debtors. After all, it has been estimated that more than 40% of Chinese bank assets are related to property. At the least, we might see a further easing of monetary policy.
In the days and weeks to come, we will learn more about the extent of the problem and how China’s authorities intend to address the issue. This, in turn, will influence the path of China’s asset prices as well as prices of globally traded assets.
Meanwhile, as of this writing, investors in Evergrande bonds are waiting to find out if they will be paid interest that is currently due. The deadline passed with no news. If Evergrande fails to make the payment within 30 days of the due date, it will be considered a default. There are other payments due in the days to come, and more than US$7.6 billion in debts that mature in the next year.
At the same time, Evergrande relieved many investors when it made an interest payment of US$36 million last Wednesday. Moreover, the central bank injected a large amount of liquidity into the financial system, leading to a sharp increase in the price of Evergrande shares one day last week. Evidently, investors saw this news and the central bank action as increasing the likelihood that the company will survive.
Investors eagerly awaited last week’s statement by the Federal Reserve’s policy committee following two days of deliberation. Those hoping for major news that would drive markets were likely disappointed. The Fed basically had nothing surprising to say. Rather, it left interest rates unchanged (as expected) and indicated it will continue the US$120 billion per month pace of asset purchases until there is “substantial further progress” toward the Fed’s goal of 2.0% inflation as well as progress toward full employment. With inflation now well above that level, the Fed “acknowledged” progress toward the inflation goal and said that, if progress continues, “a moderation of the pace of asset purchases may be warranted.” This was typical boilerplate, not meant to move markets. That is not meant as a criticism. Rather, the Fed is doing its job well when investors collectively yawn in response to its statements and actions. It means that the Fed has been successful in anchoring expectations.
The main news is that, collectively, the members of the policy committee—the Federal Open Market Committee (FOMC)—expect to accelerate the timing of interest rate normalization versus past expectations. That is, the members expect three interest rate increases by end of 2023 when previously they expected two increases. In addition, half the FOMC members expect the normalization of interest rates to start in 2022.
However, the Fed also acknowledged risk. It said that the main factor driving the economy is the virus. It said that it will be “prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals. The Committee's assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.” In other words, the Fed might delay normalization of monetary policy if the virus-led situation worsens or if financial market conditions worsen. At the same time, it might accelerate the pace of normalization if inflation turns out to be a bigger problem than currently expected.
Meanwhile, the yield on the US Treasury 10-year bond increased to the highest level since early July. This likely reflected an expectation that the Federal Reserve will soon start to taper bond purchases, in part based on the relatively elliptical statements from the Fed. The Fed signaled an intention to ease up on bond purchase sometime soon, especially if, as expected, the Fed’s targets for inflation and employment remain on track. Another explanation for rising bond yields is that many investors are starting to worry about the ability of the Congress to increase or suspend the debt ceiling before the Treasury runs out of money sometime in mid-October. Finally, investors might be concerned about the potential spillover effect of a default by China’s Evergrande. However, if investors become averse to Chinese securities, it is more likely that they will move money into US Treasury securities, thereby suppressing US bond yields. Meanwhile, equity prices were up sharply in the United States and globally.
Let’s further consider the US debt ceiling. The last suspension of the debt ceiling recently expired, and the government is currently taking extraordinary measures to remain solvent. However, if the Congress fails to raise the debt ceiling by mid-October, the government will likely default on some of its debts for the first time ever. There are sufficient votes in both houses of Congress to pass a debt ceiling bill by a simple majority. The problem is that, in the Senate, a simple majority is not sufficient for passage as a vote of 60 out of 100 Senators is needed to stop debate. In the Senate, there are 50 Democrats and 50 Republicans. Passage, therefore, will require all 50 Democrats plus 10 Republicans—which is not likely.
Still, Republican Senate leader Mitch McConnell has said that the debt ceiling must be increased and that default is not an option. However, he said that it is the responsibility of the party in power to pass the bill, In other words, he expects the Democrats to include a debt-ceiling measure in the massive spending/tax bill it intends to pass through the reconciliation process, which can be done by a simple majority. The Democrats have not, so far, included a debt-ceiling measure in the reconciliation bill because they want Republicans to share the pain in the a politically unpopular but necessary bill. One problem is that the reconciliation bill might not be ready for passage in time to avert default. This, evidently, concerns investors. Where will this go? It could be argued that the debt ceiling will be raised or suspended at the eleventh hour and that financial markets will not enjoy this game of chicken. That is exactly what happened several times during the Obama administration.
The latest purchasing managers’ indices (PMIs) for major economies indicate some deceleration of economic activity in September. PMIs, which are published by IHS Markit, are forward-looking indicators meant to signal the direction of economic activity. They are based on sub-indices, such as output, new orders, export orders, employment, input and output pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity. The higher the number, the faster the growth. Markit publishes PMIs for manufacturing and services. It released flash (preliminary) PMIs for the United States, United Kingdom, and Eurozone. Here are the details.
In the United States, the manufacturing PMI fell from 61.1 in August to 60.5 in September, the lowest in five months but still a number indicating very rapid growth. The services PMI fell from 55.1 in August to 54.4 in September, a 14-month low. Markit commented that the deceleration of growth in both sectors indicates a weakening of economic growth in the third quarter after breakneck speed in the second quarter. They attribute the slowdown to “a combination of peaking demand, supply chain delays, and labor shortages.” The weakening of demand was mainly for services and likely reflected a change in consumer behavior in response to the latest outbreak of the virus. On the manufacturing side, demand was strong, but businesses faced challenges in meeting that demand because of supply chain and labor force issues. The result, according to Markit, was a further increase in backlogs and “another month of sharply rising prices charged for goods and services as demand outpaces supply, and higher costs are passed on to customers.”
In the Eurozone, the manufacturing PMI fell from 61.4 in August to 58.7 in September, a seven-month low. Still, the rate of growth remained strong. The services PMI fell from 59.0 in August to 56.3 in September, a four-month low but a very respectable rate of growth. In part, the deceleration in growth comes after breakneck growth during the summer. It was inevitable that the fast pace following the end of restrictions would not be sustained. Still, Markit says that the slowdown partly reflects supply chain delays and shortages. This has constrained the ability of both manufacturers and service providers to satisfy rising demand. One consequence of this situation has been a decline in business confidence.
Finally, the United Kingdom saw a similar pattern to that of the United States and Eurozone. The manufacturing PMI fell from 60.3 in August to 56.3 in September, a seven-month low. The services PMI fell from 55.0 in August to 54.6 in September, also a seven-month low. Markit suggested that the country could be heading toward stagflation, in which growth slows but inflation accelerates. As elsewhere, there appears to be a cooling of demand, combined with supply chain disruption, that is leading to accelerating prices and shortages of goods. In addition, Markit noted that “Brexit was often cited as having exacerbated global pandemic-related supply and labor market constraints, as well as often being blamed on lost export sales.”
Last week the United States and United Kingdom agreed to provide Australia with the technology needed to develop a fleet of nuclear-powered submarines (although the submarines will not carry nuclear weapons). The advantage of nuclear power is that nuclear-powered submarines are far quieter than traditional submarines, and thereby more difficult for enemies to follow. They can also stay under water longer and can travel farther. This deal will mean that Australia can play a key role in challenging the growing military footprint of China in the South China Sea. It also comes shortly before an in-person meeting of the leaders of the “quad,” four countries (United States, Japan, Australia, and India) with a common goal of constraining Chinese geopolitical power. Taiwan and Japan hailed the agreement, while France complained because a previous French deal to sell non-nuclear submarines to Australia will be abandoned.
Notably, just hours after the announcement of the submarine deal, China formally applied to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), a regional trade deal from which the United States withdrew in 2017. A little history is in order.
The CPTPP, which is the successor to the Trans-Pacific Partnership (TPP), was first negotiated as an initiative of the Obama administration with the goal of liberalizing regional trade and enabling the United States to play a key role in leading economic integration in the Asia Pacific region. Notably, the TPP did not include China. Yet the day after Donald Trump was inaugurated as US president, he withdrew the country from the TPP. China was reported to be pleased. Meanwhile, China continued to pursue a separate regional agreement, the Regional Comprehensive Economic Partnership (RCEP), which is a more modest free trade agreement than the TPP. Later, the non-US members of the TPP reconstituted the agreement, renaming it CPTPP. They have expressed the hope that the United States would rejoin under the Biden administration, although the administration has not yet signaled its position on this. However, China, eager to avert an increase in the United States’ power in the region, suggested it might like to join. Then, with the submarine announcement, China quickly submitted a formal application to join.
What happens next? Japan said that China’s application will be judged on its merits. However, Japan’s Minister of Economy noted that “[they] need to carefully assess whether China is prepared to meet the very high standards” of the CPTPP. Those standards include strict protections of intellectual property, limits on state subsidies, and limits on the role of state-owned enterprises. Yet China’s application comes at a time when China appears to be boosting the role of the state. In addition, the CPTPP forbids governments from forcing technology companies to disclose source codes. Yet China has required companies to disclose such information to obtain permission to engage in commerce. Also, the CPTPP forbids discrimination between domestic and foreign companies in government procurement. Yet China has promoted a “buy China” policy for government agencies.
Thus, there appears to be a large gap between Chinese practices and what would be required to join the CPTPP. Meanwhile, to join the CPTPP, China it will have to obtain unanimous agreement from all existing members. These are Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, and Vietnam. Of these, China currently has troubled relations with Canada and Australia. Moreover, Vietnam is seen as a competitor in attracting export-oriented investment.
For China, CPTPP membership would go a long way toward challenging the United States in the region. That alone is likely a desirable goal from China’s perspective. In order to join, China would have to commit to significant structural changes to its economy, changes that the United States and others have urged. The question now is whether such changes, which would undermine the role of the state in China’s economy, are worth the geopolitical benefits that might accrue to China. At the same time, if China’s accession to the CPTPP is considered likely, the United States may be compelled to reconsider joining the CPTPP. Currently, the reluctance of the administration to join is likely driven, in part, by strong Congressional aversion—on both the right and the left. Such aversion might end if joining the CPTPP is seen as a challenge to China.
For the past half year, it has been difficult to discern the direction of trade policy on the part of the United States. The latest news is that the Biden administration is considering raising tariffs on Chinese producers that receive government subsidies. Yet, at the same time, the administration is considering reducing some existing tariffs, with a focus on those tariffs that have been most deleterious to the US economy. Where the United States chooses not to lower tariffs, it may agree to a higher volume of exclusions from such tariffs. Meanwhile, imposition of new tariffs on the basis of alleged subsidies would require a lengthy review process, beginning with an investigation of Chinese practices. This would be done through Section 301 of the 1974 Trade Act. It is possible that the administration actually has no intention of imposing such tariffs. Rather, it is using a well-publicized threat to put pressure on China.
This spurt of activity comes following the recent telephone conversation between US President Biden and Chinese President Xi. It was only the second such conversation since Biden became president. It possibly signals an intention to ease tensions that have roiled relations in recent months. It also comes at a time when US business leaders have been pressuring the US administration to provide a roadmap with respect to trade policy. After Biden became president, it was announced that there would be a policy review and that action on trade would take a back seat to domestic policy action. The uncertainty surrounding this review process has not been welcomed by the business community. It could be that, now, the administration is moving toward providing more clarity on policy intentions.
That being said, while the administration wants to support business interests in trade to boost employment and investment, it must also navigate a tough political environment. If the administration were to give the appearance of not being tough on China, it would likely pay a political price. Given that the administration is being pulled in two different directions, it is not surprising that the latest news on policy suggests a lack of direction and clarity. Still, the outlines of a trade policy that is more nuanced than that of the previous administration is starting to emerge. It appears that the administration wants to ease tariffs and other trade barriers where they are hurting the US industry, but also restrict trade in cases where it believes that China is using subsidies to boost key industries of strategic importance. This outline could be helpful to global businesses, but greater clarity will surely be welcomed.
Separately, there are other trader-related issues that the US Congress is currently addressing. The House of Representatives voted to renew Trade Adjustment Assistance, which provides subsidies for workers displaced by trade liberalization. But the House voted against a Republican proposal to reauthorize the Trade Promotion Authority (TPA) that would give the president the power to negotiate new trade agreements. The Congress could only vote yes or no, rather than make amendments, to any such agreement. Without the TPA, no new trade agreements are likely. This could be problematic in that many business leaders have been urging the administration to negotiate an Asia Pacific digital trade agreement. Such a measure had been included in the TPP, from which the United States withdrew in 2017. Business leaders say that, if the United States does not involve itself in developing digital trade rules in Asia, China will take the lead in setting them. An official from a US-based technology industry group said that “the increasing frequency of data-restrictive practices and digital protectionist measures around the world requires that the United States play a more active role in the establishment of global norms governing digital trade.”
The huge surge in inflation seen in the United States in recent months has begun to subside. It is possible that this reduction in inflation was driven by the recent outbreak of the Delta variant, which has had a negative impact on consumer mobility and spending. It could also be the case that some of the supply chain disruption and shortages that drove inflation have begun to abate. Regardless of the reason, the numbers favor the Federal Reserve’s view that the rise in inflation would turn out to be transitory. Let’s look at the numbers.
The consumer price index increased 0.3% from July to August, the smallest monthly increase since January. Prices were up 5.3% from a year earlier, down from the recent peak of 5.4% seen in both June and July. When volatile food and energy prices are excluded, core prices were up only 0.1% from July to August, the smallest monthly increase since February. Core prices were up 4.0% from a year earlier, much lower than the 4.5% peak reached in June. The month-to-month increases now suggest an inflation rate that is quite modest.
In recent months, the very high inflation seen in the United States was concentrated among a relatively small number of merchandise and service categories, which experienced very large price increases. For many of these, the trend has now reversed. For example, consider used cars. As recently as June, used car prices were up 10.5% from the previous month, accounting for one third of overall inflation. Yet in August, used car prices fell 1.5% from the previous month. Or consider air fares. Prices for airline tickets had risen sharply in recent months, although they remained below prepandemic levels. Yet in August, prices were down 9.1% from the previous month, likely driven by the impact of the Delta variant on travel. In addition, prices of hotel accommodations fell 3.3% from July to August after having risen sharply in both June and July. Likewise, the price of renting a car fell 8.5% from July to August. These volatile situations were not driven by the kinds of factors that would lead to sustained inflation such as monetary and fiscal policy. Rather, they were influenced by industry-specific circumstances.
Thus, it appears the worst is over, at least for now. Still, one concern is that the recent experience with sharply rising prices will convince consumers, workers, and businesses to anticipate persistent inflation. Such expectations could affect behavior in ways that reinforce inflation. Moreover, if and when the Delta outbreak subsides, there could be renewed pressure on supply chains if demand suddenly soars. This, too, could cause inflation to spike, bringing expectations along for the ride. Finally, if residential rents accelerate after eviction protections are removed, this could boost the reported rate of inflation.
Going forward, the job of the Federal Reserve will be to properly anchor expectations of inflation, in part by adjusting monetary policy as it now intends to do. For the Fed, which has signaled that it will soon taper asset purchases, the question is whether the Delta outbreak will soon abate or will linger. This will determine the timing and speed of an easing of asset purchases.
Meanwhile, investors reacted well to the latest inflation news. The yield on the US Treasury’s 10-year bond fell sharply, as did the yields on government bonds issued by several other developed countries. Investors evidently downwardly revised their expectations for future inflation.
Inflation increased in the Eurozone to the highest level in a decade, spurring a sharp rise in Eurozone bond yields as investors upwardly revised their expectations for future inflation. This data also will likely increase the probability of a shift in European Central Bank (ECB) monetary policy.
Specifically, consumer prices in the Eurozone were up 3.0% in August versus a year earlier, the highest annual inflation since November 2011 and significantly above the ECB’s target of 2.0% inflation. Prices were up 0.4% from the previous month, the highest monthly inflation since March 2021. When volatile food and energy prices are excluded, core prices were up 1.6% from a year earlier, the highest rate since July 2012 but still below the ECB target of 2.0%.
The big gap between headline and core inflation was due to a 15.4% annual increase in the price of energy. Meanwhile, inflation varied by country. Annual inflation was 3.4% in Germany, 2.4% in France, 2.5% in Italy, 3.3% in Spain, 2.7% in the Netherlands, and 4.7% in Belgium.
Going forward, there will likely be vigorous debate among ECB leaders about the direction of monetary policy. The ECB has already signaled that it intends to ease the pace of asset purchases. Late last week, German and Italian bond yields increased sharply on expectations that a more rapid tapering of asset purchases will result in a larger supply of bonds to the market. Moreover, futures markets are now pricing in a rise in short-term interest rates before the end of 2022. What the ECB ultimately does will depend on to what degree it views the current surge in inflation as transitory.
British consumer price inflation accelerated in August, hitting a level well above what the Bank of England had previously anticipated as the peak level of inflation. Yet the recent weakening of demand due to the delta outbreak could help to restrain inflation going forward. Moreover, there remains a widely held view that the current surge in inflation will turn out to be transitory because it is driven by one-off factors. For example, the surge in the price of used cars is mainly related to the shortage of semiconductors, which has affected the ability to produce new cars. On the other hand, future inflation could be driven by persistent shortages of labor, exacerbated by the impact of Brexit on the supply of non-British workers. Still, if productivity rises in line with wages, then there would be no need to boost prices.
In any event, here are the details: British consumer prices were up 0.7% in August versus a year earlier, the highest rate of monthly inflation since August 2018. Prices were up 3.2% from a year earlier, the highest annual inflation since March 2012. When volatile food and energy prices are excluded, core prices were up 0.7% for the month and were up 3.1% from a year earlier, the highest rate of underlying annual inflation since November 2011. Some core prices were up strongly. For example, the price of restaurant and hotel services was up 8.6% from a year earlier, possibly reflecting a rapid rebound in demand for which businesses were unprepared.
Given the surprisingly high level of inflation in August, the question arises as to what this will mean for the Bank of England’s (BOE) monetary policy. With inflation now more than one percentage point above the BOE’s target rate of 2.0%, the BOE governor will be required to write a letter to the chancellor of the Exchequer explaining what he intends to do about this. It is likely that his letter will suggest that nothing needs to be done as this will most likely be a transitory increase that will rectify itself. Indeed, most of the increase in the CPI took place in the last six months, during which demand rebounded sharply. Still, the latest data puts pressure on the BOE. An important part of its jobs is to appropriately anchor market expectations about inflation. That means engendering investor trust that it will do the right thing, whatever that may be. Meanwhile, the latest data led to a moderate increase in British bond yields, suggesting investors have become a bit more worried about inflation.
Although the weak August employment report in the United States will possibly cause the Federal Reserve to delay the tapering of asset purchases, many investors and officials around the world remain worried about what will happen when tapering ultimately begins. Authorities in China have expressed concern, with a top official saying, “It is normal for some foreign investors to relocate their assets considering the changes to international monetary policies. This won’t lead to big inflows or outflows. However, we must prevent some foreign-funded institutions from facilitating market changes with their investment decisions. This is where we must pay particular attention.” Unlike some other emerging countries, China restricts capital outflows and, theoretically, is not vulnerable to capital flight should yields in the United States rise sharply. However, the official alluded to the fact that foreign investors, having brought capital into China, can pull it out. That kind of outflow could be disruptive to Chinese financial markets. Moreover, despite restrictions on capital outflows, many investors often find ways to facilitate outflows, such as by inflating invoices for imported goods. Notably, the official talked about preventing foreign-funded institutions from causing a change in markets due to their investment decisions. Does this imply Chinese government action to limit repatriation by foreign companies? This was left unclear.
In any event, the US Fed’s program of asset purchases in the last year and a half led to a massive increase in US money supply, low bond yields, and a search for yield outside the country, thereby leading to downward pressure on the value of the dollar. When the Fed ultimately reduces or ends asset purchases, the opposite is likely to be true, with higher US bond yields, inflows of capital, and upward pressure on the dollar. For China, the challenge will be to manage this process in a way that is not hugely disruptive to the Chinese economy. US tapering and a subsequent outflow of capital from China could lead to dampened Chinese asset prices and downward pressure on the Chinese currency. That, in turn, could compel China’s central bank to change monetary policy.
Meanwhile, China ultimately wants to ease restrictions on capital outflows in order to prepare for the internationalization of the renminbi. Despite this goal, China does not appear to be in a hurry to make this transition. One is reminded of Saint Augustine, who said “Given me chastity and continence, but not yet.”
Recently, the US Federal Reserve and the European Central Bank signaled a likely adjustment to the pace of asset purchases, although they have both left policy interest rates untouched. Yet in several major emerging markets, central banks have felt compelled to take substantial action to suppress inflation, avert capital outflows, and stabilize currency values. As such, the rapid rebound of developed economies and the attendant disruption have placed an especially severe burden on lower- to middle-income countries.
Nowhere has this been truer than in Russia. Last week, Russia’s central bank increased its benchmark interest rate for the fifth time this year, boosting the rate by 25 basis points to 6.75%. As recently as March, the rate was 4.5%. This comes at a time when inflation has surged, recently hitting 6.75%, far above the central bank’s target of 4.0%. Elvira Nabiullina, head of Russia’s central bank, said, “The Bank of Russia doesn’t rule out a possibility of a further rate hike at its next meetings. In order to return to 4 per cent inflation, more than one hike could be needed. In that sense, the signal has become more hawkish.” Russia’s economic activity has returned to prepandemic levels and global disruption of supply chains is limiting the ability to meet rising demand, thereby fueling inflation. Nabiullina said, “When there’s not enough manpower or component parts, stimulating demand through fiscal policy can’t increase output or consumption. If demand for cars goes up more, that won’t mean there’ll be more of them. It will just increase the lines for them and speed up the pace of price rises.”
The central banks of developed countries, such as the United States and the Eurozone, see the current surge in inflation as transitory and are willing to wait for a return to a normal level rather than tightening monetary policy now. The fact that expectations of inflation have remained modest in these countries allows these central banks to avoid a tightening of monetary policy. The same is not necessarily true of emerging markets where investors are likely skeptical that inflation will revert to a lower level. Thus, failure to tighten now could lead to severe capital outflows and currency depreciation.
Indeed, Russia is not alone. Other emerging markets have acted as well. Brazil increased its benchmark rate from 2.0% in March to 5.25% today. In Ukraine, the benchmark rate increased from 6.0% to 8.5%, in Mexico from 4.0 to 4.5%, and in Chile from 0.5 to 1.5%. However, the central banks of India, Indonesia, Turkey, South Africa, and Thailand left their rates unchanged over the same period. Each country must analyze the risks and the rewards of leaving interest rates alone. Naturally, raising rates can be deleterious to interest-sensitive sectors of an economy, thereby hurting economic growth. The real test for emerging markets will come when the big central banks, such as the Federal Reserve and the European Central Bank, start to adjust monetary policy. The International Monetary Fund has warned that this could set off a financial crisis in some emerging markets.
The European Central Bank (ECB) said that it will slow the pace of asset purchases, but also said that it is not tapering. Perhaps tapering is now considered a dirty word. After all, when US Federal Reserve Chairman Ben Bernanke announced he was tapering in 2013, it set off a “taper tantrum” that was highly disruptive to global financial markets. In any event, ECB President Christine Lagarde announced that the Pandemic Emergency Purchase Program (PEPP) will continue, but at a slower pace. The program was initiated at the start of the pandemic with the goal of engaging in EUR1.85 trillion of asset purchases. The ECB continues to plan on this level of purchases and intends to continue to engage in purchases at least until March 2022. The PEPP is different from the asset purchase program of the US Federal Reserve in that there is a precise amount of asset purchases planned. The Fed has never said how much it will ultimately purchase. In any event, the US Federal Reserve and the Bank of England have said that they will soon start to taper purchases. The central banks of Canada, Australia, and New Zealand have already begun to taper.
Regardless of how one defines it, clearly there will be a change in policy. This is being driven by two factors: an acceleration in economic growth and a rise in inflation. The two, of course, are related. The economy is picking up speed due to a rising number of vaccinations, an easing of economic restrictions by member governments, and the continued impact of fiscal and monetary stimulus. The decision to shift policy likely reflects a view that the regional economy no longer needs the degree of central bank support that has lately been provided—assuming that another serious outbreak does not emerge. Moreover, the ECB is likely confident that the European Union’s collective borrowing to fund investment in member countries will have a positive impact on productivity and growth in the coming years. ECB President Lagarde said that “the rebound phase of the recovery of the euro area economy is increasingly advanced.” However, she also said that “there remains some way to go before the damage done to the economy by the pandemic is undone” and that “we are not out of the woods.” She noted that employment remains below the prepandemic level.
Many investors reacted to the ECB announcement by pushing down bond yields. This is interesting because, normally, a reduction in demand for bonds would lead to a rise in yields. Why did yields fall? One explanation is that investors had anticipated a more significant shift in monetary policy and were surprised by the relatively mild action by the ECB. Indeed, the ECB left the size of the asset purchase program unchanged, meaning that the statement leaves the ultimate size of the ECB balance sheet unchanged. Another explanation is that investors interpreted Lagarde’s comments as signaling less concern about inflation than expected, thereby implying lower expectations for future inflation.
Although the US Federal Reserve has signaled that it will start to taper asset purchases sometime this year, there is debate about the timing and scope of such tapering. The recent report that employment growth decelerated substantially in August suggests that the Fed might wait a bit longer before adjusting policy. However, one Fed leader thinks otherwise. James Bullard, President of the Federal Reserve Bank of St Louis, says that, regardless of what the employment report said, the Fed should start tapering soon. Specifically, he said, “There is plenty of demand for workers and there are more job openings than there are unemployed workers. If we can get the workers matched up and bring the pandemic under better control, it certainly looks like we’ll have a very strong labor market going into next year. The big picture is that the taper will get going this year and will end sometime by the first half of next year.”
Bullard sees the slowdown in job growth in August as being temporary, largely driven by the impact of the Delta variant on consumer-facing industries that scaled back hiring. If Delta abates in the coming month or two, then job growth will likely resume at a faster pace. As such, the Delta variant can be seen as generating a modest pause in an otherwise strong recovery. Of course, this assumes that Delta will indeed abate and that it will not be succeeded by yet another variant that disrupts the recovery.
The biggest problem now for the US economy continues to be a failure of people to get vaccinated in big numbers. The number of daily vaccinations per capita remains at the low end of the spectrum among major nations. The share of the population that is fully vaccinated has grown only modestly in the past few months while it has grown rapidly in nearly every other major nation. Moreover, the problem in the United States is highly localized, with the current Delta outbreak disproportionately affecting states in the south, such as Florida, Alabama, Mississippi, and Louisiana. For example, the COVID-19 death rate in Florida is five times higher than in California. Unless more people in these states get vaccinated and unless more unvaccinated people wear masks and avoid social interaction, the problem is likely to persist, thereby stifling economic recovery. Meanwhile, US President Biden announced that all businesses that employ more than 100 people will have to require employees to get vaccinated or be subject to weekly testing. Separately, Biden ordered that all Federal government employees and employees of Federal contractors get vaccinated or be subject to frequent testing and be required to wear masks.
Finally, the US economy will soon face disruption from the withdrawal of government stimulus and government protections against eviction and mortgage foreclosure. The enhanced unemployment insurance that was enacted earlier this year expires this month. Roughly 7.5 million people will lose this financial benefit. In addition, the Federal moratorium on eviction of renters is ending (although some states are retaining a moratorium). The cancellation of the Federal moratorium is expected to affect 3.5 million households. Those that cannot come up with the back rent that they owe will likely face eviction, thereby exacerbating the problem of homelessness. As for homeowners, the Federal government had temporarily postponed foreclosure on those who are delinquent on their mortgages. That protection is also ending. The good news is that, if the value of a home has risen, a delinquent homeowner can sell the home and eliminate the problem. In any event, the changes taking place this month could have a dampening effect on overall consumer spending.
For eight years, Bank of Japan (BOJ) Governor Kuroda has focused on boosting Japanese inflation to 2.0% on a sustained basis. This has not happened. In fact, over the past 20 years, there have only been two very brief periods during which annual consumer price inflation has exceeded 2.0%, one of which was due to the temporary effect of boosting the national sales tax. For most of the past two decades, inflation has been close to zero and has often been negative. This is despite the fact that, under Kuroda’s leadership, the BOJ has implemented the most aggressive monetary policy in its history. Through asset purchases, the central bank’s balance sheet increased roughly 28% since the start of the pandemic, after having roughly quadrupled since the last financial crisis in 2008-09. Moreover, the bank has maintained negative policy interest rates. Normally, such a policy would lead to much higher inflation. And, although monthly inflation has lately accelerated as the economy emerges from the pandemic, no one expects inflation to rise permanently or sustainably. What went wrong?
Kuroda has attributed the problem to a deep deflationary psychology, saying that “past deflation is still affecting peoples’ mindsets” and that “spurring inflation has taken longer than hoped.” The deflationary psychology has affected Japan’s labor market. Nominal wages have barely budged during the past two decades as businesses sought to hold costs down, with workers evidently accepting their fate. Moreover, demographics have likely played a role. Japan’s population is declining and aging, thereby weakening consumer demand and generating persistent excess capacity. This, too, has a deflationary impact. Meanwhile, it could be argued that monetary policy has not gone far enough. After all, the US Federal Reserve’s balance sheet has roughly doubled since the pandemic, far more than the BOJ’s balance sheet. The result is that the United States is experiencing a sharp increase in inflation.
Kuroda has pledged to maintain an easy monetary policy, going forward. He said, “We will continue our present measures of monetary easing and help with companies' financing. If necessary, we are prepared to take additional easing measures without hesitation.” He said that asset purchases will continue, adding, “We will continue our present measures of monetary easing and help with companies' financing. If necessary, we are prepared to take additional easing measures without hesitation.” With an election coming soon in Japan, there could be a change in fiscal policy. One candidate for the leadership of the governing party has called for a temporary suspension of fiscal targets. Kuroda said that interest rates will stay low, even if fiscal policy becomes more aggressive. He said that low interest rates “may provide a positive environment to make fiscal policy more effective." Whether Kuroda’s policy will ultimately generate significantly higher inflation is difficult to know. Still, a more aggressive monetary policy will render the yen cheaper than otherwise, which is beneficial to export competitiveness. Also, when the US Federal Reserve ultimately shifts monetary policy, it will likely lead to a higher valued dollar, which means a cheaper Japanese yen.
China’s monetary authorities are of two minds. On the one hand, they are likely concerned about the substantial increase in non-governmental debt during the pandemic, fearing that this could set the stage for a surge in bad debts and financial instability. They are also concerned that excessive debt-fueled investment in property could create a bubble that will ultimately burst. As such, they are reluctant to encourage too much credit creation. On the other hand, authorities are also concerned about the evident deceleration of economic activity, in part driven by the recent rise in infections. As such, they are eager to enable bank lending to grow at a reasonable pace, especially for those parts of the economy that are especially troubled. Consequently, the People’s Bank of China (PBOC) has taken steps to boost lending to small- and medium-sized enterprises while, at the same time, discouraging too much property investment.
This ambivalence on the part of the PBOC reveals itself in the latest money supply and bank lending data. In August, the broad money supply was up 8.2% from a year earlier, the slowest pace of increase since April. The volume of outstanding bank loans was up 12.1% from a year earlier, the slowest pace of increase since the early days of the pandemic in 2020. Moreover, total social financing, which includes lending by non-bank entities, increased 10.3% in August versus a year earlier, the slowest pace of increase since 2018. Then again, the monthly volume of lending increased in August versus the prior month, although not by as much as investors anticipated. The weaker pace of borrowing could be due to business reluctance to take on new debt in the face of an uncertain economic environment.
Going forward, it seems likely that the PBOC will encourage more credit creation in order to offset the deceleration of the economy. That said, the recent surprisingly strong export data could convince the PBOC that things are better than previously believed and, therefore, further monetary easing is not necessary. Time will tell.
In recent weeks, many economists have wondered about the degree to which the rise of the Delta variant has adversely affected the US economy. Late last week we learned that the impact was substantial. In August, employment growth decelerated dramatically from the previous month, with employment in the leisure and hospitality sector remaining unchanged after several months of blistering growth. It was in August that the Delta variant took a significant toll, with the number of daily infections rising from 79,300 on August 1 to 165,000 on September 1. The number of deaths increased from 360 on August 1 to 1,403 on September 1. The number of people hospitalized with COVID-19 doubled during August.
This dramatic surge in the outbreak, which was disproportionately concentrated in southern states, did not lead to significant changes in regulations governing social interaction. Instead, it evidently scared enough people to have a voluntary impact on social interaction and on the willingness of consumer-facing businesses to hire. High-frequency data shows that certain types of economic activity have begun to decelerate. For example, the number of people passing through airport security checkpoints has fallen as a share of the 2019 volume. The number of people making online reservations to dine at restaurants, after having risen sharply, has been declining since mid-July relative to the 2019 numbers. Finally, since July, the volume of gasoline supplied to the market has fallen as a share of the volume in 2019. In other words, data that reflects the willingness of individuals to engage in social interaction or to travel, after having recovered strongly in recent months, is now going in a negative direction. Last week’s employment report demonstrates how public health events can influence economic activity.
The US government releases two monthly reports on employment. One is based on a survey of establishments, the other based on a survey of households. The establishment survey found that, in August, 235,000 new jobs were created. This contrasts with the revised increase in July of 1,053,000 jobs. Job growth was slower than even the lower range of forecasts from Wall Street economists. Interestingly, there was a strong 37,000 increase in employment in the manufacturing sector, which included a 24,100 increase in employment in the automotive sector. There was also a strong 74,000 increase in employment in professional and business services.
The problem in August, however, was largely in consumer-facing services. After having risen 289,600 in July, employment in restaurants declined 41,500 in August. As for employment at hotels, after rising 73,000 in July, it increased only 6,600 in August. In addition, employment in retailing continued to contract, falling 28,500 in August. Overall, employment in August remained 3.5%, or roughly 5 million, below the prepandemic level of February 2020. The establishment survey also found that average hourly wages were up 0.6% from the previous month and up 4.3% from a year earlier. While high, this is still lower than annual inflation. Thus, in real (inflation-adjusted) terms, wages are actually declining. This suggests that, despite a labor shortage, workers are not exerting much leverage.
The separate survey of households offered a more positive take on the labor market. That survey includes the impact of self-employment. It found that employment grew much faster than the labor force, thereby leading to a decline in the unemployment rate from 5.4% in July to 5.2% in August. The labor force participation rate remained unchanged. However, the size of the labor force (those employed or actively seeking employment) was down 1.8% in August from the prepandemic level. Interestingly, while the overall unemployment rate dropped, unemployment among teenagers increased substantially, likely a reflection of the loss of jobs in low-paying consumer-facing services.
The employment report could lead the Federal Reserve to alter its plans. Recall that Fed Chair Powell recently said that the Fed will likely start to taper its program of asset purchases before the end of the year. That decision was based on the assumption that the economy is moving steadily toward maximum employment. Yet the August employment report means that the transition to maximum employment is slowing. The big question is whether the Delta variant will continue to disrupt the job market in the months to come. That will depend, in part, on how quickly people get vaccinated and whether they engage in social distancing and wear masks. These factors will determine the nature of the outbreak. If the outbreak abates, it will likely have a positive impact on employment growth—and vice versa. Meanwhile, the Biden administration is likely to argue that the weak employment report justifies the need for more spending on infrastructure and other programs.
In August, the global manufacturing industry decelerated due to pandemic-related supply chain issues. In China, factories and ports were disrupted by outbreaks of the Delta variant and the resulting restrictions imposed by the government as part of its zero-tolerance policy. In Southeast Asia, many factories shut down as the Delta variant became a significant problem. Although global demand for manufactured products is mostly strong, factory and port interruptions, shortages of transport capacity, hoarding of key inputs, and resulting shortages of those inputs have all contributed to the decline of industry growth—especially in East Asia. The growing gap between supply and demand has also contributed to rising inflation in many countries.
The latest purchasing managers’ indices (PMIs), released by IHS Markit, signal the deceleration. PMIs are forward-looking indicators meant to signal the direction of activity in the manufacturing sector. They are based on sub-indices such as output, new orders, export orders, employment, pricing, inventories, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa.
The global PMI declined from 55.4 in July to 54.1 in August, a six-month low. Out of 31 countries for which Markit collects data, 24 experienced a decline in their manufacturing PMI. However, 21 continued to have a PMI above 50, indicating continued growth in activity. Ten countries had PMIs below 50, indicating contracting activity. Markit noted that global output grew, but at a slower pace. It commented that “efforts to raise production further were constrained by supply chain issues and, in some cases, shortages of labor and skills.” Not surprisingly, it said that exports of manufactured goods grew at the slowest pace in seven months. After all, transportation of goods has been disrupted.
The PMIs for the United States, Eurozone, and the United Kingdom were at a high level, reflecting rapid growth of activity. Still, the PMIs did decline somewhat. The main contributor to the decline in the global industry, however, has been East Asia. The PMI for China fell from 50.3 in July to 49.2 in August, indicating a decline in activity. The sub-index for output fell for the first time since February. The main problem in China has been the disruption from the virus. Markit commented, “The latest COVID-19 resurgence has posed a severe challenge to the economic normalization that began in the second quarter of last year. Manufacturing shrank in August as both supply and demand weakened. Meanwhile, overseas demand also dropped. The job market weakened slightly, though it managed to maintain overall stability. Manufacturers cut purchases, leading to a rise in stocks of finished goods.”
The disruption in China, combined with local outbreaks of the virus, have significantly hampered the industry in Southeast Asia. The PMI for ASEAN remained unchanged at 44.5, having fallen significantly from June to July as the pandemic worsened. The current PMI is at a level indicating a rapid decline in activity. Of particular concern is Vietnam, where the PMI fell from 45.1 in July to 40.2 in August, a level reflecting a dramatic decline in activity. Markit noted, “Vietnamese manufacturers are facing a near-impossible task at present as the restrictions put in place to try and contain the spread of the COVID-19 outbreak in the country constrain their ability to produce goods. Some are closed outright, with others operating at reduced capacity and with scaled down staff members.” Given Vietnam’s major presence in the textile, apparel, and footwear markets, the disruption there is likely to hurt the ability of major retailers to obtain inventory for the holiday season.
The manufacturing industries of Japan, Korea, and Taiwan continued to grow in August, unlike those of China and Southeast Asia. The PMIs were 52.7 for Japan, 51.2 in South Korea, and 58.5 in Taiwan. The strong number for Taiwan reflects the country’s considerable presence in the robust technology sector. However, in Taiwan as well as in Japan and South Korea, the PMI declined from July. This was due to the supply chain disruption that has affected much of the world. In fact, in the case of Japan, the weakening of the sector was directly linked to the troubles in Southeast Asia, which supplies components to many Japanese factories.
Inflation in the 19-member Eurozone suddenly accelerated sharply in August, raising questions about whether the current easy monetary policy of the European Central Bank (ECB) ought to be reconsidered. In August, the consumer price index was up 3.0% from a year earlier, the highest rate of annual inflation since November 2011. This was far higher than the 2.2% clocked in the previous month. Prices were up 0.4% from July to August. When volatile food and energy prices are excluded, core prices were up 1.6% from a year earlier, also the highest in about a decade. Core prices were up 0.3% from July. The difference between headline and core inflation is due to the very large increase in energy prices. The surge in inflation likely reflects the supply chain disruption that has affected the global economy.
Within the Eurozone, some countries experienced relatively high inflation. For example, from a year earlier, prices were up 4.7% in Belgium, up 3.4% in Germany, and up 3.3% in Spain. At the same time, prices were up a more modest 2.4% in France, up 2.6% in Italy, up 2.7% in the Netherlands, and up 1.2% in Greece. The inflation in Germany is especially noteworthy as it is the highest in 13 years and is at odds with Germany’s historic role as the low-inflation economy in Europe. Still, it can be argued that much of Germany’s higher inflation reflects one-off factors that are not likely to be sustained. Moreover, there are not yet significant wage pressures in Germany that would normally augur higher sustained inflation.
The latest inflation data comes at a time when the volume of infections in Europe is declining, economic restrictions are being eased, and the stage is being set for a robust further recovery of Europe’s economy. Thus, there is an increasing number of voices calling for the ECB to reduce asset purchases, especially now that the US Federal Reserve has signaled its intention to do likewise. The argument for ECB tapering is that the Eurozone economy is on a favorable path and that the economy no longer requires central bank support. Still, most analysts, including many ECB leaders, expect that the current surge in inflation will turn out to be transitory. Indeed, many bond investors appear to agree given that bond yields increased only modestly and, in the case of Germany and France, remain negative. Thus, it can be argued that a shift in monetary policy is not urgently required.
When US Fed Chair Jerome Powell spoke at the virtual Jackson Hole meeting of central bankers recently, he managed to convey a likely shift in the policy of quantitative easing (asset purchases) without unleashing a taper tantrum as previously happened in 2013. That is a significant accomplishment. Recall that, in 2013, then Fed Chair Ben Bernanke announced that the Fed would soon ease, or taper, the pace of asset purchases that the Fed had initiated during the financial crisis of 2008-09. The decision made sense, but it caught investors off guard. The resulting sharp rise in bond yields came to be known as the taper tantrum. At that time, investors feared that, without the support of the Fed through asset purchases, the market for Treasury bonds would collapse. Fortunately, investor fears turned out to be wrong. The market ultimately recovered nicely, but not before there was much damage, especially to emerging markets. They experienced substantial capital flight as investors poured money into higher-yield US Treasuries.
Fast forward to now. Powell’s speech was met with a collective yawn. Bond yields actually fell in response to his remarks. Evidently investors have learned a thing or two from the experience of 2013. Moreover, Powell has done an excellent job of communicating his intentions and helping investors to set realistic expectations.
Still, there are those that worry about what might happen next. One person who has expressed concern is Gita Gopinath, chief economist of the International Monetary Fund. She said that emerging markets “are facing much harder headwinds They are getting hit in many different ways, which is why they just cannot afford a situation where you have some sort of a tantrum of financial markets originating from the major central banks.” She noted that the economic consequences of the pandemic have been especially harsh for low- and middle-income countries. Not only have they seen damage to economic growth, they have also experienced significant inflation, compelling many emerging market central banks to raise interest rates to fight inflation, stabilize currencies, and avoid capital flight. Thus, a taper tantrum would make a bad situation even worse. Gopinath said that “a lot of the problems we’re facing, even with regard to inflation and supply bottlenecks, have to do with the fact that we have the pandemic raging in different parts of the world.” She added that, if higher inflation persists, “that can feed into inflation expectations and then have a self-fulfilling feature to it”.
Ms. Gopinath concluded, “We are concerned about a scenario where you would have inflation come up much higher than expected, and that would require a much quicker normalization of monetary policy in the US.” In other words, she worries that Powell’s relatively benign expectations of US inflation could turn out to be wrong, thereby leading the Fed to tighten faster than currently expected. In such a scenario, bond yields might jump precipitously.
Meanwhile, the head of Russia’s central bank, Elvira Nabiullina, echoed Gopinath’s sentiment, warning that the global economy could face a repeat of the 2008 crisis if the Federal Reserve is compelled to significantly tighten monetary policy. She said that the sharp rise in public and private sector debt during the pandemic creates greater risk and sets the stage for financial disruption.
Specifically, she said that, under a negative scenario, “risk premiums will increase significantly, the most indebted countries will struggle to service their debt, and a significant financial crisis will begin in the global economy in the first quarter of 2023—one comparable to the 2008-2009 crisis, with a long period of uncertainty and a protracted recovery.” Russia’s central bank, like those of several other major emerging markets, has already significantly increased its benchmark interest rate to quell inflation, avert capital outflows, and stabilize the currency.