Article
12 October 2021

Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

12 October 2021
Ira Kalish

Ira Kalish

United States

Week of October 12, 2021

A proposal to address imbalances in the Chinese economy

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.

The cost of shipping from China to the US suddenly declines

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.

Delta variant inhibited US job growth in September

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.

The US offers greater clarity on trade policy

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.

The latest on the troubled energy market

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.

Week of October 4, 2021

Will the experience of Spain and Ireland be repeated by China?

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. 

China adds electricity shortage to its list of headwinds

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. 

Understanding the sharp rise in natural gas prices in Europe

Ian Stewart, Chief Economist, Deloitte UK, and  Max Lambertson, Economist, Deloitte UK, offer a perspective on the sharp rise in energy prices in Europe.

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.

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Ira Kalish

Ira Kalish

Chief Global Economist, Deloitte Touche Tohmatsu

Subscribe

to receive more business insights, analysis, and perspectives from Deloitte Insights