Weekly global economic update has been saved
Limited functionality available
China’s economy decelerated in the third quarter. Real GDP grew 4.9% from a year earlier, the slowest growth since the third quarter of 2020. In addition, real GDP was up only 0.2% from the second to the third quarter, which translates into an annual growth rate of less than 1.0%. This was the second-lowest quarterly growth since the government began tracking this in 2010. As such, one can argue that the Chinese economy effectively stalled in the third quarter. Why? Among possible explanations are the damaging effect on production from the shortage of electricity; disruption of supply chains due, in part, to COVID-19; weakening of the massive property market; and the negative impact of periodic regional outbreaks of the virus on consumer mobility. China’s zero-tolerance policy toward the virus has meant that even modest outbreaks have been met by strict restrictions on activity.
For the first three quarters of 2021, China’s economy grew 9.8% from a year earlier, fueled by very rapid growth in the first quarter. For the first three quarters, consumer spending accounted for 64.8% of growth. Investment contributed 15.6% while exports accounted for 19.5% of growth. China’s government acknowledged that the country faces significant headwinds, both domestic and foreign. A spokesman for the government said, “The overall national economy maintained the recovery momentum in the first three quarters. However, we must note that the current uncertainties in the international environment are mounting, and the domestic economic recovery is still unstable and uneven.”
Nonetheless, a spokesman for China’s central bank suggested that the recent headwinds will be temporary. With respect to the electricity shortage, he said, “The energy supply shortage is temporary, and its impact on the economy is controllable.” Meanwhile, regarding the property situation, he note, “The risk exposure of individual financial institutions to Evergrande is not big and the spillover effect for the financial sector is controllable.” This is a relatively optimistic point of view. Moreover, it can be argued that strong exports masked weaknesses in the domestic economy. If exports weaken in the coming quarters as global demand wanes, then China’s economy could face even slower growth.
Meanwhile, the government released monthly statistics that provide insights into the direction of the economy. For example, retail sales were up 4.4% in September versus a year earlier, better than the 2.5% growth in August. The easing of restrictions related to the virus likely contributed to the improvement. Still, this was the second-slowest rate of retail spending growth since mid-2020 and one of the slowest rates of growth on record. Some areas of spending were up rapidly in September versus a year earlier, such as jewelry (up 20.1%), telecoms (up 22.1%), and building materials (up 13.3%). Other categories were weak, such as apparel (down 4.8%) and automobiles (down 11.8%).
In addition, industrial production in China recorded the slowest growth since March 2020—it was up only 3.1% in September versus a year earlier. The slowdown has been attributed to periodic shutdowns of factories due to electricity rationing. Electricity rationing reflects a shortage of coal, partly induced by environmental restrictions meant to meet climate targets. This is part of a larger global problem of limiting the burning of carbon-based fuels before the development of alternative sources of power of fully realized. Going forward, China will boost coal usage temporarily in order to avert further disruption.
Finally, in the first nine months of 2021, fixed asset investment was up a relatively modest 7.3% from the previous year. Investment by the state sector was up 5.0% while that by the private sector was up 9.8%. Property investment was up 8.8%, a deceleration from the previous month. Property sales by floor area were up 11.8%, again a deceleration from the previous month. Meanwhile, new construction by floor area was down 4.5%. Thus, the long-awaited deceleration of the property sector has begun. How far it goes will help determine the health of China’s economy in 2022.
The latest data provides evidence of the accelerating disruption and potential shrinkage of China’s vast property market. Following the recent report on the slowing growth of real GDP in the third quarter, the government provided more detail. Specifically, it reported that the real estate sector contracted by 1.6% in the third quarter while the construction sector contracted by 1.8%. This was the first contraction for both sectors since the first quarter of 2020 when economic activity nearly collapsed at the start of the pandemic. The government also reported that, in the first nine months of 2021, housing starts were down 4.5% from the previous year.
The latest contraction likely reflects the impact of government efforts to reign in excessive debt and excessive investment in the property sector. This effort was manifested by the financial troubles of Evergrande and other major property developers. Interestingly, sales of construction excavators fell 38.3% in September versus a year earlier. This suggests that builders are downwardly revising their construction plans for the months to come.
Meanwhile, the average price of new homes in 70 major Chinese cities was up only 3.8% in September versus a year earlier. This was the slowest growth since December 2020 and one of the slowest rates of growth on record. In addition, prices were unchanged from the previous month after having risen 0.2% in August. In other words, house prices have stalled. Notably, although prices were unchanged on average from a month earlier, prices in more than half of the 70 cities analyzed actually declined.
The government appears sanguine about financial risk to the property sector. A central bank spokesman said that “Evergrande’s creditors are scattered and individual banks’ exposure is small. The risk of spillover to the financial industry is controllable.” Still, while the government might choose to not directly protect property companies, it evidently intends to protect the banking system. It will boost required capital buffers for the country’s 19 banks that are considered too big to fail. In addition, many smaller banks will be required to improve their capital buffers. It has been estimated that Chinese bank lending to property companies is equal to more than half of bank capital. Although greater capital requirements for banks means less lending, more capital will be welcome if a significant share of the property sector has difficulty in servicing its debts.
In the past decade, China’s authorities periodically attempted to pop property price bubbles by imposing restrictions on credit activity. Then, when prices decelerated, the authorities would ease credit market conditions to avert a downturn, thereby allowing for yet another boost to prices. Homeowners and investors became accustomed to this pattern, which meant that the authorities were never successful in shifting investment away from property. This time may be different. The government does not yet appear to be turning away from its current policy of restricting the property sector. Prices are declining in numerous cities. Many investors might shift their expectations and become more averse to the property sector. That, of course, is the government’s goal. In fact, home purchases, measured by value, fell 17% in September versus a year ago. Still, to facilitate a permanent shift away from property, the government will need to accept a possibly prolonged period of disruption that will suppress overall economic growth.
For the past decade, China’s economic growth has, in part, stemmed from massive property market speculation. The recent restrictions on the issuance of debt by property companies, which are roiling the property sector as well as property finance, were meant to stifle further speculation and start a transition to a less property-intensive economy. To compel that transition, the government wants to implement a nationwide property tax. The idea is that people and businesses will be less likely to speculate in the property market if they must pay a tax on unused property. It has been estimated that as much as 28% of all residences in China are unoccupied, having been acquired by individuals as a speculative investment. Such an investment would be less profitable under a property tax regime. Moreover, a property tax might help to reduce the frothy prices of urban residences, thereby making housing more affordable to a larger number of households. In addition, less speculation in housing would mean that investors would put their money in more productive investments. Property market activity would decline as a share of GDP, allowing for a transition to a more balanced economy.
China has already experimented with property taxes in some cities, but considerable resistance has been reported to the government’s plans for a nationwide property tax. Many critics worry that a property tax would suppress housing prices that have already fallen, thereby hurting investors for whom the lion’s share of their wealth is in housing. Indeed, about 90% of urban dwellers own their homes, and housing accounts for about 80% of their wealth. Reducing house prices could have a negative impact on consumer spending. In addition, lower property prices could hurt local and provincial governments that rely on land sales for a significant share of their revenues. Given the considerable resistance, the government intends to roll out the tax in a small number of cities and wait until 2025 to roll it out nationally. There remains debate about the rate of taxation.
Around the world, central bankers and other economic policy makers are apprehensive about the potential implications of a shift in US monetary policy. The US Federal Reserve has signaled that it will soon taper, or gradually reduce, asset purchases. There is an expectation that, when this happens, US bond yields will rise, thereby stimulating flows of capital from other countries into the United States. That, in turn, would likely put upward pressure on the value of the US dollar, or downward pressure on other currencies, especially those in emerging markets. Indeed, bond yields and the US dollar have already risen recently, partly in anticipation of the shift in policy.
In China, policy makers have lately publicly addressed this issue. China is in a favorable position compared to many other emerging countries, given its vast supply of foreign currency reserves. Moreover, it has regulatory limits on outflows of capital, although investors in China are often able to find ways to move money in and out of the country. This includes using false valuations for invoices of either imports or exports.
Still, once the US Federal Reserve starts to act, China will face a choice. It can either continue to stabilize its exchange rate, which would likely entail selling foreign currency reserves—doing so would mean a tightening of Chinese monetary policy as it would entail a reduction in the central bank’s volume of assets—or it could let the currency float, in which case it might depreciate sharply. This would boost the competitiveness of exports, but it would also add to inflationary pressure. Moreover, depreciation might cause further tension with the United States that often complains that China intentionally undervalues its currency. In addition, depreciation would not be helpful to Chinese companies with foreign currency debts. Thus, there is no easy solution.
The administrator of China’s State Administration of Foreign Exchange, Pan Gongsheng, who also serves as deputy governor of China’s central bank, says that China is well prepared for a US tapering. He said, “We have accumulated a lot of experience and policy tools and have taken many pre-emptive actions this year.” Perhaps the experience to which he alludes was related to the so-called “taper tantrum” a decade ago. At that time, markets reacted badly when then Fed Chair Bernanke said that tapering was coming. This time around, there was no tantrum when Fed Chair Powell signaled a change in policy. Still, investors and central bankers are likely experiencing heightened anxiety, nonetheless.
Meanwhile, Pan provided an indication as to how China will handle US tapering. He said that “the yuan exchange rate will be basically stable at a level of equilibrium. As its flexibility improves, it can play a better role in self-adjustment.” In other words, it appears that China intends to let the renminbi float rather than intervene to stabilize the currency. Thus, China would opt to avoid a tightening of monetary policy. The authorities are likely not worried about the inflationary effect of depreciation given that, so far, inflation has remained relatively muted.
Moreover, Pan said, “In the current round of policy tightening, the gap between the US and other economies is apparently smaller in terms of growth and monetary policy. This will affect the room of US dollar appreciation.” In other words, he anticipates that the downward pressure on the renminbi will not be substantial. Moreover, given that the renminbi appreciated considerably in the first year of the pandemic, there is likely room for depreciation without too much disruption to the economy. Finally, keep in mind that predicting currency movements is a fool’s errand. Even after tapering, it is possible that the US dollar may not appreciate, especially if there are other factors that put downward pressure on the dollar, such as higher-than-expected inflation or a delay in normalizing interest rates. Thus, China seems to be prepared for any eventuality.
In the debate about the future of inflation in the United States, analysts examine each new bit of data for evidence to support their point of view. Supporters of the view that inflation is going to be a long-term problem were pleased, therefore, that the consumer price index accelerated slightly in September. It appeared to suggest that the deceleration seen in the previous two months was not a trend. At the same time, supporters of the view that inflation will turn out to be transitory were likely pleased that core inflation, which excludes the impact of volatile food and energy prices, was relatively low. They were also likely pleased that the prices of some categories, which had previously contributed to the surge in inflation, actually fell in September. This included airline fares, apparel, used cars, and car rental services.
In any event, here are some details—the consumer price index increased 0.4% from August to September, after having increased 0.3% in the previous month. Prices were up 5.4% from a year earlier, up slightly from the 5.3% increase in the previous month. When volatile food and energy prices are excluded, core prices were up 0.2% from August to September, up from an increase of 0.1% in the previous month. Core prices were up 4.0% from a year earlier, the same as in the previous month.
The price of energy increased substantially, with the price of gasoline up 1.2% from August to September and up 42.1% from a year earlier. The price of natural gas was up 2.7% from August to September and up 20.6% from a year earlier. It is this sudden and massive shift in energy prices that has contributed to rising expectations of future inflation, with investors recalling what happened in the 1970s. Of course, most of today’s investors are not old enough to remember what happened in the 1970s. Sadly, I am old enough.
In 1973, the global price of crude oil quadrupled when Saudi Arabia turned off the spigot to punish US support for Israel, and then doubled again in 1979 after the Iranian Revolution. During the 1970s, oil consumption as a share of GDP was more than double what it is today as energy usage was far less efficient. Thus, the impact of higher prices was massive, in terms of both inflation and economic growth. Today’s situation is not comparable. Oil prices remain relatively low by historical standards. In addition, natural gas prices are starting to fall substantially. The current relatively high prices are likely to spur increased investment in producing carbon-based fuels. In the 1970s, limited supply was driven mostly by political factors, which is not the case today.
Meanwhile, many important prices fell in September. The price of used cars was down 0.7% from August to September, airline fares were down 6.4%, apparel was down 1.1%, televisions were down 0.6%, sporting goods were down 0.4%, toys were down 1.3%, hotel stays were down 0.1%, car rentals were down 2.9%, and tickets for movie theaters were down 0.1%. Notably, all these categories were up substantially from the same month in 2020. What appears to be happening is that, following a sudden surge in prices due to a sharp increase in demand, prices are starting to decline as supply chain disruption abates and businesses take steps to boost capacity. Moreover, demand is starting to abate in some categories. And shipping costs are starting to come down.
That being said, a measure of underlying inflation from the Federal Reserve Bank of Cleveland, that excludes the impact of the 16% of categories that are most volatile, increased in September versus August. This suggests that, although the most volatile categories are starting to ease, inflation is becoming more broadly based. This fact will likely be cited by those arguing that inflation is here to stay. Moreover, a survey by the National Federation of Independent Businesses found that the share of small companies planning to raise prices in the next three months is now the highest since 1979. And, although bond market data indicates that investor expectations of inflation remain relatively muted despite having risen modestly, a survey by the Federal Reserve Bank of New York found a sizable increase in consumer expectations of inflation.
Meanwhile, the great inflation debate continues. The name Arthur Burns keeps popping up in this debate. He was the chairman of the US Federal Reserve from 1970 to 1978 and presided over one of the worst increases in US inflation in history. How did a conservative Republican let this happen? And what lessons does it offer today? Burns was expected to maintain a very tight monetary policy. In fact, in the 1976 presidential campaign, candidates for the Democratic nomination railed against Burns’ allegedly tight policy and vowed to replace him.
The reality, however, was that, when oil prices quadrupled in 1973, Burns said that the increase would turn out to be transitory and that it was not a monetary event. Therefore, there was no need to worry about inflation or to shift monetary policy. Another possible factor in Burns’ failure to act was that he was personally close to then-President Nixon and was under pressure not to suppress economic growth by tightening monetary policy. In any event, inflation rose sharply and remained high. Monetary policy remained accommodative. An inflationary psychology set in. Consumers, workers, and businesses came to expect high inflation and acted accordingly, thereby exacerbating the problem. It was only when Fed Chairman Volker dramatically raised interest rates and engineered two back-to-back recessions in 1980 and 1982 that inflation expectations were dramatically reduced and inflation decelerated sharply.
Why is this bit of history of interest today? The answer is that we are, again, experiencing an increase in oil prices alongside an increase in inflation that has been fueled by a combination of supply chain disruption, a stimulus-induced surge in demand, and an unusually easy monetary policy. Inflation hawks now worry that the Fed will ignore factors that they deem to be transitory and, in the process, will allow inflation to get out of hand as happened in the 1970s. Former Treasury Secretary Lawrence Summers has said as much. Specifically, he said, “I’m struck by the fact that we’re going through a kind of cycle that’s familiar to people who studied the history of the 1960s and 1970s. First, we deny that inflation is rising, and predict that inflation will remain low. Then, we ascribe inflation to a variety of specific factors that [vary] from month to month. Then, we take encouragement when specific factors reduce it for a month or two. And then, we argue what is so harmful about somewhat higher inflation, anyway, relative to the catastrophic costs of recessions, particularly for the disadvantaged.”
What is the counterargument to Summers? Inflation sceptics could argue that today’s situation is nothing like 1973, that oil prices have increased only modestly and that the supply chain disruption that has led to shortages is likely to abate within a year or two. Moreover, while Summers argues that fiscal stimulus was far too much, critics will argue that much of the stimulus money was saved rather than spent. In addition, there are already signs that the surge in spending on durable goods is abating. Finally, although monetary policy has resulted in a surge in the money supply, the speed at which money changes hands (velocity) has dropped dramatically, thereby reducing the impact of monetary policy.
Meanwhile, the bond market continues to confound those who worry about inflation. The ten-year breakeven rate (which is an excellent proxy for investor expectations of average annual inflation in the next 10 years) increased from 2.28% on September 22nd to 2.52% on October 15th – not a huge increase and not an indication of serious concern about ruinous inflation. The increase likely reflected a view that higher oil prices will boost inflation slightly in the coming decade. Yet given that the five-year breakeven rate is higher than the ten-year (which itself is unusual), investors evidently expect higher inflation to take place in the short term, not the long term. This is consistent with the Federal Reserve’s view that the current high inflation will be transitory.
Michael Wolf, a global economist with Deloitte Touché Tohmatsu Limited, discusses the global shortage of truck (lorry) drivers and its impact.
Reports of a trucker shortage have been seemingly ubiquitous in the United States and Europe this year. The increased demand for goods, low pay, challenging work conditions, and immigration barriers have all contributed to the trucker shortage. Efforts to attract significantly more applicants to the profession have yet to yield positive results. Higher pay may be necessary to overcome the current shortfall.
Perhaps the largest disruption to the trucking industry has been the change in consumer preferences during the pandemic. Spending on goods has surged, boosting demand for the truckers needed to transport those goods. For example, US real personal consumption expenditures on goods grew by nearly 18% in the six quarters to 2021 Q2. It took more than 18 quarters for goods spending to grow that much prior to the pandemic.1 This means goods consumption growth since the pandemic hit has been roughly three times the rate seen before the pandemic.
Even before the surge in goods spending, the trucking industry was grappling with a labor shortage. Germany has struggled with trucker shortages since at least 2016 while the United States has had a trucker shortage for decades. In the United Kingdom, 24% of trucker positions are sitting vacant. The United Kingdom’s departure from the European Union forced thousands of foreign workers out of the country, adding to the trucking industry’s woes. All three countries are exploring ways of getting more foreign workers to supplement the supply of truckers, though efforts, such as the United Kingdom’s 5,000 temporary visas, have been too small to overcome the staggering numbers of “missing” truckers.
The shortage in the United Kingdom is particularly acute, with the country reportedly in need of 100,000 more truckers. The number of job ads for transport, logistics, and warehousing was up 246% year-over-year in September, considerably higher than the 147% year-ago gain for all industries.2 Germany is short 45,000 to 60,000 truckers. The net share of German road freighters reporting a shortage of qualified workers was more than twice the share for the service sector as a whole.3 The trucker shortage in the United States is expected to reach 100,000 in 2023, though this is considerably smaller than the shortages seen in the United Kingdom and Germany as a share of employment. The trucker shortage also appears comparable to labor shortages experienced in other US industries. For example, the US job openings rate for the broad category of transportation, warehousing, and utilities has tracked the openings rate for all private industries.4
In many ways, long-haul trucking, can be an undesirable and difficult occupation. It can be a dangerous job that requires long stints away from home and periods of unpaid work. Adding to the undesirability of the profession is the lingering threat that autonomous vehicles will make long haul truckers obsolete. However, trucking is certainly not the only dangerous and undesirable job in the world. Such jobs often require higher pay to compensate for the unattractiveness of the occupation.
Unfortunately, pay growth for the trucking industry appears to be sluggish. In Germany, negotiated wages for transportation and storage workers were up just 2.8% in the two years to September 2021. The growth rate was 3.6% for all services over the same period.5 After including bonuses, average weekly earnings for the United Kingdom’s transportation and storage sector were slightly lower in August compared to two years prior. Average weekly earnings for the whole economy were up 7.8% over the same period.6 The situation in the United States is slightly different as wage growth for truckers there has finally picked up. The average year-ago wage gain since 2020 was 5.4%, besting the private sector’s 4.6% growth. For decades prior to the pandemic, the US trucking industry complained of trucker shortages but wage growth remained slow. For example, between 1993 and 2019 wage growth for truckers averaged just 1.8% year-over-year, more than one percentage point slower than the average for the private sector.7 It seems the trucker shortage in the country has become severe enough that wages are beginning to pick up.
The trucking industry has been hesitant to increase wages. After all, it is difficult to reverse wage hikes. Instead, efforts to expand the pool of available labor have been prioritized. One of the challenges for the industry is that its workforce skews older, and more people retire from the profession than take it up as a new career. The United States is piloting an effort to lower the age requirement for interstate trucking. Some are advocating Europe do the same. Trucking is also a predominantly male profession, so efforts to increase female participation could widen the pool of applicants. The United Kingdom is attempting to undo some of the Brexit effects by offering temporary visas to foreign workers. Other countries are also looking outside their borders to ameliorate the trucking issue. So far, such efforts have not been sufficient.
Higher wages are likely to be necessary, especially the longer the shortage persists. After decades of shortages, the United States is only now beginning to raise wages for truckers at a stronger than average clip. European trucking companies will likely need to do the same. Other efforts to expand the available supply of labor for trucking can help, but it is likely to be marginal.
With an electricity shortage threatening to derail China’s economic recovery, the government will raise the cap on electricity prices in order to bring supply and demand into balance. It will increase the upward range of prices permitted from 10% above the base to 20% above the base. In addition, there will be no ceiling for high energy-using industries. Until now, the weak supply of coal boosted the cost to power-generation companies, which were limited in their ability to pass on the higher cost to their customers. Unable to make a profit, they failed to boost output. Thus, electricity output was limited and had to be rationed, leading to significant disruption of China’s industrial sector. The hope now is that the new pricing flexibility will help to alleviate shortages by enabling power companies to be profitable and, consequently, boost output. In addition, pricing flexibility is meant to suppress demand.
In addition, the government says it will prioritize boosting the supply of coal and natural gas. Premier Li Keqiang said, “Electricity and coal supply is crucial to people's lives and a stable economic performance. It must be guaranteed. Ensuring energy security and keeping industrial and supply chains stable are among the six priority areas where protections are needed." As such, many Chinese coal mines were instructed by the government to boost production. They had previously held back due to government efforts to reduce carbon emissions. Power companies will now be offered tax breaks to offset the impact of high coal prices.
Finally, the government said that, going forward, investments in industrial projects that involve heavy consumption of carbon-based fuels will be discouraged. Premier Li said, “We must strengthen and improve the regulatory policies for coal and electricity. The mechanism for coordinated supply of coal, electricity, oil, gas, and transportation services will be better leveraged, and market-based methods and reform measures effectively employed, to ensure electricity and coal supply."
Japan’s new Prime Minister Fumio Kishida has called for a new election to take place on October 31. In anticipation, he is offering a new approach to economic and social policy. In an interview with the Financial Times, he said that Abenomics, the economic policy mix of former Prime Minister Shinzo Abe, had failed to provide a broad-based improvement in living standards. He said, “Abenomics clearly delivered results in terms of gross domestic product, corporate earnings and employment. But it failed to reach the point of creating a ‘virtuous cycle.’ I want to achieve a virtuous economic cycle by raising the incomes of not just a certain segment, but a broader range of people to trigger consumption. I believe that’s the key to how the new form of capitalism is going to be different from the past.” Recall that Abenomics entailed three so-called arrows. These were monetary stimulus, fiscal stimulus, and deregulation of the domestic economy.
Kishida wants to focus on raising purchasing power of a broad segment of society. This will entail financial incentives for companies to boost wages and other measures meant to address rising income inequality. He has also called for greater collaboration between the government and the private sector to assure Japan’s competitiveness in key industries. He said, “It is important to ensure a self-sufficient economy when we are considering future growth. We need to make sure that Japan has technologies that are critical to complete global supply chains so we can achieve indispensability.” This is similar to messages offered by leaders in the United States and the European Union. It is likely meant to reduce dependence on China. The danger is that such efforts could entail protectionist restrictions on trade that would boost costs and prices, inhibit symbiotic relations with companies in other countries, suppress innovation, and retard growth.
One of the remnants of the pre-reform Communist era in China is the system of residency permits, known as the hukou system. It provides that people have a residency permit based on where they come from. Thus, if a person from a small rural village migrates to a big city, they retain their rural permit. The result is that they generally lack full access to local services in the big city, such as education, health care, and good-quality housing. In recent decades, China experienced one of the biggest migrations in human history, with hundreds of millions leaving rural areas to find higher-paying work in big cities. This migration contributed to a surge in productivity, given that manufacturing workers tend to produce more per hour than farm workers. These migrant workers currently account for roughly one fifth of China’s population of 1.4 billion people. Moreover, this system has exacerbated income inequality, creating two classes of people living in China’s largest urban areas. In some ways, it is similar to the situation for Central American migrants in US cities or African migrants in European cities.
Recently, a senior figure at China’s central bank, the People’s Bank of China (PBOC), said that reforming the system by providing migrants with local residency permits would have the effect of substantially boosting their spending power. Doing so would accomplish two things: first, it would boost overall consumer spending in an economy in which consumer spending is an abnormally low share of GDP. Indeed, the government is keen to reduce the economy’s dependence on investment and increase consumer spending as a share of GDP—part of a transition that would make China’s growth and prosperity more sustainable. Second, reform of the hukou system would address the problem of income inequality. The government has lately called attention to the problem, especially the existence of a class of super rich entrepreneurs. The government has urged a focus on “common prosperity.”
Meanwhile, Beijing has started to gradually ease the hukou system, saying that residency permits would be eliminated in cities with modest populations and would be eased in cities with moderate populations. Still, it has not yet addressed the issue of China’s largest cities. Chinese city governments have resisted reform because it will mean that they must pay for services for a larger number of people. Many urban governments are already financially strapped. They are reliant on the sale of property to fund investments in infrastructure at a time when it is likely that demand for land is likely to diminish as the government discourages debt-fueled property investment.
According to recent reports, the cost of shipping containers from China to the United States fell sharply in the past two weeks. Specifically, the cost of shipping a 40-foot container from China to the US West Coast fell from US$15,000 a week ago to US$8,000 this week. The cost of shipping from China to the US East Coast fell by a quarter. Although the cost has fallen sharply, keep in mind that, prior to the pandemic, the cost of shipping across the Pacific was about US$1,500. Thus, costs remain relatively high. This reflects strong US demand for durable goods combined with disruption to the supply of containers and container ships. Why, then, did the cost fall so sharply in just a short period? The answer likely has to do, in part, with the current and severe shortage of electricity that is disrupting the Chinese economy. The shortage of electricity has caused a decline in manufacturing production as factories are forced to operate limited hours. Thus, the supply of goods available to be shipped has likely declined, reducing the demand for shipping capacity. As long as the shortage lasts, it is likely to have a negative impact on shipping costs. Lower shipping costs will reduce inflationary pressure in the United States. Even then, limited supplies of durable goods will boost inflationary pressures as long as demand remains strong, especially during the upcoming holiday season.
The outbreak of the Delta variant of the virus continued to disrupt the US job market in September. The data for the latest employment reports was collected mid-month, before the rate of infection started to decline. Job growth was surprisingly weak, in part because of a sharp decline in employment at local public schools, but also because of continued weakness in the hospitality sector as many consumers continued to avoid social interaction. The weak report will raise questions as to when and by how much the Federal Reserve will begin to taper its asset purchase program. Meanwhile, despite the news of weak job growth, US Treasury bond yields increased after initially dropping, as investors evidently remain concerned about the inflationary effect of frothy oil prices. In fact, West Texas Intermediate prices are now at the highest level since 2014.
In any event, let’s examine some of the details of the jobs report. The US government releases two reports on the job market: one based on a survey of establishments, the other based on a survey of households. The establishment survey found that 194,000 new jobs were created in September, down from the upwardly revised 366,000 new jobs created in August. The September number was the weakest since December 2020. However, it is notable that there were 317,000 new private sector jobs in September, almost the same as in August; it was the slowest growth since April. Overall, September employment was 4.97 million or 3.3% below the pre-pandemic level from February 2020. Thus, there is room for significant improvement.
By sector, employment growth was strong in manufacturing (up 26,000), retailing (up 56,100), transportation (up 47,300), information (up 32,000), and professional and business services (up 60,000). However, employment at hotels was up only 2,100 while employment at restaurants was up only 29,000. Prior to the Delta outbreak, these two categories had seen rapid growth as they recovered from the doldrums of the pandemic. The Delta variant has, evidently, delayed the full recovery of these sectors that involve a high degree of consumer interaction with workers. Meanwhile, employment in health care declined 17,500 and employment at local public schools fell 144,200. Keep in mind that this data is seasonally adjusted. That is, it is adjusted for the fact that, in some industries, employment rises or falls on a seasonal pattern. Thus, the data presented shows the movement of employment that is outside of the normal seasonal pattern. With local education, employment grew strongly in September as schools resumed activity. A decline in the seasonally adjusted number indicates that employment at schools did not grow as much as normal. The main reason was likely the continuation of the pandemic.
Given that the weakest areas of employment growth were principally related to the pandemic while those sectors less affected by the pandemic had strong job growth, one can argue that the underlying economic situation remains good. One can also argue that, once the Delta variant fades, and assuming a new outbreak does not emerge, job growth should rebound. This might explain why investors were not especially alarmed by this report.
Regarding wages, the report indicated that average hourly earnings of workers were up 4.6% from a year earlier. Given that inflation is running slightly above that level, this means that real (inflation-adjusted) wages have declined—which is not what one would expect in the midst of a labor shortage. Interestingly, wages in the leisure and hospitality sector were up 10.8% from a year earlier, indicating that companies in this industry are boosting compensation in order to lure reluctant workers. However, wages in the massive retail sector were up only 3.9% from a year earlier. In our own professional and business services sector, wages were up 4.7%. So far, at least, it does not appear that conditions exist for the kind of wage-price spiral that would fuel persistent high inflation.
The separate survey of households indicated that the size of the labor force declined in September as some potential workers stopped seeking employment. This resulted in a modest decline in the overall participation rate. With employment growing and participation falling, the result was a sharp decline in the reported unemployment rate, dropping from 5.2% in August to 4.8% in September.
Katherine Tai, US trade negotiator, offered the first significant explanation of the trade policy of the Biden administration. This alone is newsworthy. That is because, when the new administration came into office in January, there was considerable anticipation as to whether it would quickly reverse the Trump trade policy. Recall that, President Trump initiated a trade policy significantly different from what had largely been a bipartisan consensus for most of the post-war period. While most presidents in the post-war era sought trade liberalization (despite instances of implementing trade restrictions), Trump’s policy was focused on using tariffs to compel trading partners to boost imports of US goods. He called himself a “tariff man.” He imposed major tariffs on China and others, with China retaliating in kind. By the end of Trump’s term, the effective average US tariff level was the highest since the 1930s.
Joe Biden had spent most of his career favoring trade liberalization. As vice president under President Obama, he had been a champion of efforts to liberalize trade in Asia and to boost relations with China. When he entered office, however, he indicated that there would be no immediate change in trade policy and that domestic affairs would take precedence for the first several months. His administration said that there would be a relatively long policy review on trade. He continued his predecessor’s policy of being tough on China on issues involving human rights, intellectual property protection, and national security. The policy review is now over, and Tai last week offered a view as to where things go from here.
She said that the United States will launch new trade talks with China but, in the interim, tariffs will remain in place. However, she indicated that importers will be better able to pursue exemptions from tariffs. Thus, while the headline tariff level will not change, it seems likely that the effective tariff (tariff after exemptions) will decline. This is a way to move in the direction of trade liberalization, which will please many business leaders, without displeasing some members of the president’s party as well as the opposition party. In addition, and to the surprise of some, Tai said that the United States will seek China’s full compliance with the so-called phase one trade agreement that Trump signed with China in early 2020. She added that the administration will not seek a phase two agreement that would likely have meant more tension with China. Republican leaders, who in the past were strongly pro-trade, took umbrage at the administration’s allegedly relaxed position with respect to China. Trump clearly changed the political dynamics of trade. Today, neither party has a strong wing that favors trade liberalization.
Although Tai offered few details as to how she will approach negotiations with China, one could interpret her general remarks as signaling a future that could involve a reduction of existing tariffs on both sides. My view is that the Biden administration is attempting to gradually ease trade restrictions in order to boost trade, reduce prices, and improve US competitiveness. Meanwhile, the administration seems likely to remain stringent in its efforts to restrict trade and/or cross-border investment in areas that are deemed critical to national security or to the competitiveness of the country’s most pioneering industries. Whereas Trump cast a wide net regarding trade, Biden’s policy has sometimes been described as focusing on a small yard with a big fence.
Russia’s economy has benefitted lately from the surge in natural gas prices in Europe. However, high prices could inhibit economic growth and fuel higher inflation in Europe, leading to tighter monetary policy by the European Central Bank and the Bank of England. In the longer term, that would not be good news for Russia. Rather, Russia would gain from a middle ground. That is, the price should be high enough to generate strong revenue in Russia, but sufficiently low not to hurt economic growth in Russia’s key export market. Thus, it is not entirely surprising that Russian President Putin last week hinted at an increase in output. He said, “Let’s think through possibly increasing supply in the market, only we need to do it carefully. Settle with Gazprom and talk it over. This speculative craze doesn’t do us any good.” In response to these comments, the price of natural gas fell sharply.
Meanwhile, it is reported that the surge in gas prices might reflect Russia limiting output to the level reflected in long-term contracts. As demand has suddenly accelerated, Russia has not allowed for an increase in output based on conditions in the spot market. Now, it appears, this might change. Although Russia has been criticized for the current situation, outgoing German Chancellor Merkel defended Russia’s position, saying that Russia is simply supplying what the market demands. US Energy Secretary Jennifer Granholm suggested that the United States might be able to help the European situation and warned against Russian manipulation of gas prices.
Separately Granholm said that the United States will consider releasing oil from the government’s Strategic Petroleum Reserves in order to suppress the recent surge in US gasoline prices. The government has a stockpile of more than 600 million barrels that, in the past, have been used to counter wide swings in prices. The last release took place in 2011.
Although much has been written about the shortage of electricity in China, less attention has been paid to the growing shortage in India. There, as in China, a shortage of coal has led to a significant decline in domestic coal reserves, thereby threatening to undermine the stability of electricity generation, about 66% of which depends on coal. Moreover, the global shortage of coal has led to a surge in coal prices. Yet Indian power companies are locked in long-term contracts and cannot easily pass their costs onto customers. Thus, there is little incentive to boost output when facing weak or negative profit margins. Still, power companies are urgently attempting to boost imports of coal. Yet without an increase in retail prices, demand will remain strong.
The coal shortage in India comes about at a time when the economy is rapidly rebounding after a period of weak growth during the worst of the pandemic. Demand for electricity is rising faster than the ability of the market to supply coal. Plus, alternative sources of power, such as hydroelectric, have been disrupted by inadequate rain during the monsoon season. The danger now is that India could face the same disruption to industrial activity that has already happened in China. If that happens, growth forecasts will need to be revised downward.
The electricity shortage in China is having a disruptive impact on the global technology industry. It is reported that suppliers to several major Western technology companies have either stopped or reduced production at certain facilities due to the electricity shortage. In addition, production of semiconductors, which are in short supply globally, has been further disrupted by the electricity crisis. In Jiangsu Province, some cities told companies to stop using electricity during the last week of September. This comes following guidelines from Beijing regarding use of coal.
The problem now is that the impending holiday season in the West is normally a time of massive production of consumer electronics, much of which could be seriously disrupted in the weeks to come. This could have a cascading effect on several global industries including shipping, distribution, retailing, and overseas manufacturing which depends on components from China. A furtherance of inflation in the West could be one outcome of this situation.
More than a decade ago, the bursting of a housing bubble in several European countries led to a ruinous recession. In Spain and Ireland, for example, housing-market activity reached an unsustainable level after several years of excessive debt-fueled investment. The reversal of that situation caused a sharp decline in economic activity. Now, with China facing a similar situation, there is concern that the consequences for economic activity could be significant, even if the government takes steps to avoid financial contagion.
A recent analysis by Kenneth Rogoff of Harvard University suggests that, China’s efforts to shrink the property sector will lead to significantly negative consequences for economic growth. China’s leaders have long expressed concern about the size of the sector, the amount of debt that fueled the sector’s growth, the inefficiencies in the economy that excessive property investment creates, and the need to reform the sector. Now, a change appears to be in the works. A year ago, the government established limits on the ability of property developers to take on new debt. The current crisis involving the property developer Evergrande is likely a direct result of that regulatory shift.
It is worth noting the degree to which things have gotten out of hand. Rogoff offers some interesting data demonstrating the nature of the problem. For example, he estimates that combined real estate and construction activity accounted for 28.4% of China’s GDP in 2015 (It is likely even higher now.). In the same year, this figure was 16.5% for the United States, 20.0% for the United Kingdom, 18.7% for Spain, and 10.1% for Ireland. The latter two are important because their property markets experienced a major crisis a decade ago. Spain’s real estate and construction industries peaked at 28.7% of GDP in 2006 while Ireland’s peaked at 21.6% in 2007. After that, both fell sharply, bringing down economic activity in the process. As for China, the share of real estate and construction industries increased from about 10% of GDP in 2000 to 20% in 2010 to 28% in 2015.
The surge in property investment and activity in China in the past two decades caused employment in real estate and construction to rise from roughly 15 million in 2010 to 30 million by 2017. The average price of a home in China roughly doubled from 2009 to 2018, with the ratio of home prices to income in Beijing, Shanghai, and Shenzhen more than double the ratios in such cities as Singapore, London, Tokyo, and New York. Yet the share of residences that are unoccupied is estimated to be around 28%, far higher than in any other major country. By 2017, the massive increase in property investment in China led to residential space per capita of 41 square meters. That is an unusually high number for an economy that is considered middle income at best. Another country with a similar per capital income, Brazil, has 32.3 square meters of residential space per capita. In rich countries, the numbers are similar to that of China. In both France and the United Kingdom, per capita space is 42.2 square meters, nearly the same as in China. In Spain, the figure is 35.9 square meters. Only in the United States, Canada, and Australia, with their abundant land and massive suburban homes, are the figures much higher (60.9 square meters per capita in the United States, with Canada and Australia close behind).
Given these figures and the evident excess capacity, it is hard to see how China continues to invest in property at this rate, especially because of the need to accumulate more debt to do so. In fact, the government has slammed the door on further debt accumulation. Thus, it seems likely that the sector will retrench. Although the Chinese government is likely to attempt to engineer a smooth transition to a new normal, attempting to avoid financial contagion, a slowdown in growth is likely. Rogoff points out that “with an impact of real estate production and property services on GDP of 29%—rivaling Ireland and Spain at their pre-financial crisis peaks—it is hard to see how a significant slowdown in the Chinese economy can be avoided even if banking problems were contained.”
Meanwhile, the Evergrande crisis is not taking place in a vacuum. China now faces several other headwinds that will likely cause a deceleration in economic growth. These include a severe shortage of electricity that is causing blackouts, and a zero-tolerance policy regarding the virus that has already suppressed factory and port activity.
If China slows down substantially in 2022, there are several things that are likely to happen. First, China’s imports from the rest of the world could decelerate, leading to slower export growth in major trading countries, such as Japan, Korea, Taiwan, ASEAN, the United States, and the European Union (EU). Second, slower imports of commodities could put downward pressure on global commodity prices, including energy prices. Finally, a weakening of China’s property sector could lead to a further decline in home prices and asset-backed property prices. This will likely hurt household wealth and bank balance sheets, and weaken credit growth unless the government takes countervailing action.
Amidst other significant concerns (the Evergrande crisis, COVID-19, high debt, troubling demographics, etc.), China is now facing a shortage of electricity that is threatening economic recovery. In the past month, 16 of 31 provinces in industrial regions have implemented electricity rationing. Administration said that this was done in order “to avoid the collapse of the entire grid.” In some cities, the shortage of electricity has led to the failure of traffic lights, causing significant traffic congestion. In Jilin Province, authorities say that electricity and water shortages could last at least until March 2022. In Guangdong Province, authorities have urged people not to use elevators for the first three stories of office buildings. Some companies have had to switch factory operations to overnight due to daytime shortages. In many provinces, factories have temporarily shut down or are operating below capacity. In some cities, streetlights are not turned on at night. Power to homes and small businesses is cut during the day and resumed at night. For those living in tall buildings, the lack of elevator service means staying inside. This situation stems from the requirement that electricity be rationed in order to avoid a complete shutdown of the electric grid.
This crisis stems from a shortage of coal that fuels the vast majority power plants, weaker hydroelectric output due to drought, and the impact of government targets for emissions reduction. Plus, government controls on electricity prices mean that there is little incentive for electricity consumers to curtail demand. The short supply of coal has caused a surge in coal prices, which has affected the willingness to keep factories open. One problem is that demand for electricity has risen much faster than economic output this year. Specifically, while real GDP was up 12.7% in the first half of the year versus the previous year, electricity demand was up 16.2%. This pattern is due, in part, to the sharp rebound in global demand. Especially notable has been the sharp increase in domestic and overseas demand for aluminum and steel, both of which have very energy-intensive production. Industry uses about 70% of electric power in China.
Meanwhile, provincial suppliers of power are normally permitted to raise or cut electricity prices by no more than 10% from the base. Larger changes require negotiation with Beijing. In Guangdong Province, home to a disproportionate share of China’s manufacturing and technology industries, electricity prices for industrial users will go up 25% during peak hours. This means that Beijing is becoming more amenable to using a price mechanism to address supply-demand imbalances. The action in Guangdong Province is meant to encourage industry to boost output during non-peak hours (meaning nighttime).
The hope is that a change in pricing will compel major electricity consumers to shift usage in a way that helps to avoid blackouts. Moreover, power suppliers face much higher prices of coal, but are limited in their ability to raise prices for consumers. This hurts their profitability and discourages them from boosting power generation. The sharp rise in prices in Guangdong could become a model for what happens elsewhere in the country. For now, the key will be to use pricing to suppress demand as it is unlikely that supply will rise sharply in the short term.
The shortage of electricity is already taking a toll on the economy as evidenced by no growth in the manufacturing purchasing managers’ index in September. Meanwhile, China’s National Day holiday season started this past weekend and there are expectations that holiday travel will be muted due to virus considerations and electricity shortage.
It is likely that there will be weaker economic growth in the fourth quarter versus previous expectations. The crisis could hurt the availability of holiday gifts that are exported to the rest of the world. This could exacerbate the problem of consumer price inflation in North America and Europe. In addition, the crisis could exacerbate the global shortage of semiconductors, thereby having a spillover effect on the global technology and automotive industries. In addition, the weakening of factory output could lessen China’s own demand for inputs and commodities, thereby easing shortages and suppressing commodity prices.
Natural gas prices in Europe and the United Kingdom have quadrupled over the past six months to record highs. Gas accounts for 40% of UK electricity generation, almost a quarter in the EU and is also a key fuel for heating (80% of UK homes) and industrial production. The surge in gas prices has fed through to wholesale electricity prices, which have almost tripled since March.
Last year, as economic activity collapsed, gas demand plummeted, and Europe found itself with a record storage surplus. Then a cold winter and hot summer pushed up gas demand, drawing down storage levels. Add to that maintenance work in the North Sea and Russia, gas stock building in Asia, low wind speeds hitting wind power, and droughts limiting hydropower, and European and UK gas availability/reserves look uncomfortably low heading into winter.
Britain, with a heavy dependence on imported gas and electricity, and domestic renewables, has a particular problem. For most of the last 50 years the country enjoyed abundant, instantaneous supplies of North Sea gas. However, it failed to invest in gas storage capacity, creating new vulnerability as supplies from the North Sea dwindled and spot prices soared. (The Financial Times estimates UK gas storage capacity at 2% of annual gas demand compared to 20–30% for its European peers). An obvious alternative is liquefied natural gas, which is shipped from the United States, Qatar, or Russia. But demand from state-backed utilities in Asia has bid up prices and redirected supply away from Europe. Meanwhile, a fire at one of the two interconnectors that provide the United Kingdom with electricity from France has disrupted energy imports.
Fixed-rate tariffs and the energy price cap—that limits the unit cost of gas and electricity for those on the standard variable rate tariff—constrain the immediate pass-through of higher spot prices to consumers. But the price cap is reviewed twice a year and is already set to rise by 12% in October, affecting 12 million households. The cost of the cap and fixed-rate deals are putting smaller energy providers, seven of which have already failed, under heavy pressure.
High gas prices make gas-intensive industrial activity unprofitable. UK fertilizer plants have shut down as gas prices spiked. This has hit the supply of CO2, a by-product of fertilizer production, and a major input to many processes, including food and beverage production and nuclear power plant cooling.
Governments have scrambled to respond. France and Italy have announced direct subsidies to consumer energy bills, while Spain imposed a windfall tax on energy companies that have benefitted from the price surge. The UK government is considering support for surviving energy suppliers to take on customers of failed suppliers, given that existing fixed tariffs do not cover the cost of supplying new customers. Last week the UK government agreed a deal with CF Fertilisers to restart CO2 production at its plant on Teesside.
The resolution of the gas crunch will depend heavily on the weather. A mild winter would alleviate heating demand and faster wind speeds would increase wind power and ease demand for gas. Additional gas supplies from Norway and Russia would also help. If neither weather nor the gas supply picture improves, Goldman Sachs has warned of a “non-negligible risk” of power outages.
The rise in energy costs will push up inflation, which has already surprised to the upside in recent months. In August, consumer energy inflation hit 15.4% in the euro area and 9.5% in the United Kingdom. The 12% rise in the energy price cap in October means that consumers who are on tariffs below the current cap may see their bills rise by up to 50%, according to the Financial Times.
Last week, the Bank of England raised its inflation forecast to above 4% by the end of the year and said that a further increase of the energy price cap in April could push inflation above 4% in the second quarter of 2022. This would mean several quarters of inflation well above its 2% target.
Central banks continue to argue that the surge in inflation is transitory and will dissipate without requiring aggressive monetary tightening. So far, energy futures markets support this narrative, indicating that gas prices will return to closer to normal levels after the winter.
Surging energy prices fuel inflation, but in the medium term they are likely to be deflationary. When the United Kingdom last faced surging energy prices, in 2008 and 2011, headline inflation hit 5.2% on each occasion. Disposable income nosedived and, with it, consumer spending. Other forces are also weighing on incomes. More than 5 million people will be affected by the ending of the temporary £20 per week uplift to Universal Credit in early October. And employees’ National Insurance contributions will rise by 1.25% in April 2022.
The gas crunch is another example of extreme events—this time soaring gas prices—exposing vulnerabilities in complex systems. The Financial Times columnist Izabella Kaminska compares the effects of rising gas prices to the 2008 financial crisis. When faced with an extraordinary shock the financial system, which was thought to be highly efficient, proved frail. Like the financial crisis and the pandemic, the gas crunch highlights the primacy of resilience over efficiency in a crisis. It also demonstrates that when things go seriously wrong, governments have to step in.