Weekly global economic update

Week of December 4, 2023

• Capital flows out of China 
• China encourages private sector investment
• China encourages retention of global supply chains
• Eurozone inflation continues to recede
• In the United States, consumers continue to spend while inflation recedes
• Bond yields signal view that central banks are done raising rates

Capital flows out of China

• China has strict capital controls, which makes it challenging for people to transfer wealth outside the country. Such controls are meant to enable the central bank to stabilize the value of the currency without having to resort to massive currency market intervention. Yet, controls inhibit China’s ability to make its currency a global vehicle for trade and asset holding. Still, capital controls haven’t stopped people from moving large amounts of money out of China. It is reported that wealthy Chinese have moved hundreds of billions of dollars out of China. They have purchased foreign apartments, equities, and insurance properties. They have become the principal buyers of expensive apartments in Tokyo. London and New York are also popular destinations.

Why is this happening? And what is the economic impact? There are several possible reasons for this. First, US interest rates have risen sharply, boosting the attractiveness of dollar-denominated bonds and other instruments. Second, the principal form of wealth in China is residential property, and property prices have declined. Moreover, there is uncertainty about the future direction of property prices given the troubled nature of the market. Thus, foreign property has become more popular. Third, there is likely concern about the future direction of economic policy, especially given the government’s shift toward support for the state sector at the expense of the private sector. Finally, people might be worried about the troubled relationship China has with the West and its impact on China’s future prosperity.

The movement of money, estimated at roughly US$50 billion per month recently, likely puts downward pressure on the value of the renminbi, thereby requiring the central bank to purchase renminbi to stabilize the exchange rate. In so doing, the central bank is withdrawing liquidity from the financial system. It is essentially a tightening of monetary policy. This is not welcome at a time of low inflation and slow economic growth. While most experts say that the current flow of money is manageable, the risk is that an acceleration in outflows could destabilize the currency and the financial system, similar to what has happened in the past in unstable emerging markets. 

Meanwhile, it is not only affluent Chinese who are causing an outflow. Global companies are also contributing to the flow. Specifically, there has been a sharp slowdown in inbound foreign direct investment (FDI) into China. In addition, outflows of FDI have increased, especially as foreign companies repatriate their local earnings. The result is that, for the first time in decades, there is a net outflow of FDI. This, too, puts downward pressure on the value of the currency. In addition, it deprives China of investments that bring new technologies and expertise into the country. In the longer term, less inbound FDI will mean less sophisticated investment and less trade between China and the rest of the world. Foreign investment often provides the basis for trade. 

The slowdown in FDI inflows and the accelerated outflows are likely due to several factors. First, troubled relations between China and some of the Western governments have caused some global companies to be more cautious about investing in China. Second, as Nicholas Lardy of the Peterson Institute has written, “Beijing’s closure of foreign consultancy and due diligence firms that are critical to foreign firms’ evaluation of potential new investments and its increasingly stringent regulatory environment, including a new national security law and restrictions on cross-border data flows, have led foreign firms to reduce their direct investment or even to disinvest from their existing direct investments.” Meanwhile, the government has indicated a desire to encourage more inbound investment.

China encourages private sector investment

• Given that private sector investment in China has slowed down, the People’s Bank of China (PBOC), which is the country’s central bank, is encouraging commercial banks to boost lending to the private sector. Specifically, the PBOC and other regulators asked banks to set annual lending targets. In addition, the regulators established 25 measures meant to boost lending to the private sector. 

The biggest source of trouble in private sector investment is the property sector. Investment into technology continues to grow. Thus, the PBOC said that banks should “reasonably meet the financial needs of private real estate enterprises.” It is reported that the Chinese government is establishing a list of property developers that will be eligible for government support. 

Still, there is a larger problem beyond property. It is the perception that the government favors state enterprises at the expense of private sector players. It is not clear if more willingness to lend to private sector companies will offset the worries that private sector companies have about the potential return on investments, especially at a time of relatively weak economic growth and troubled global relations.

China encourages retention of global supply chains

• There has been plenty written about changing global supply chains, with some global companies reducing exposure to China, inbound investment into China decelerating, and Southeast Asia becoming an increasing focal point for supply chain investment. Premier Li Qiang said that China wants to attract global companies and wants them to invest in supply chains in China. 

Specifically, Li said that “we are willing to build closer production and industrial supply chain partnerships with all countries.” In addition, he warned against protectionism and said that China wants an international business environment characterized by adherence to the rule of law. Li’s comments were made at the opening of the China International Supply Chain Expo in Beijing. It is meant to highlight the opportunity available to global companies. In fact, of 550 exhibitors, 130 are foreign-based companies.

It is evident that several conflicting trends are taking place. On the one hand, China wants foreign investors and growing trade. On the other hand, the government wants greater control over data and wants to influence the direction of the market economy. On the one hand, global companies want to benefit from China’s huge market as well as its manufacturing prowess and strong technology base. On the other hand, some Western governments want to restrict China’s access to technology and capital. How these divergent trends will evolve is hard to say. In the interim, the uncertainty is making many investors nervous and could explain the exodus of some foreign capital from China.

Eurozone inflation continues to recede

• The European Union (EU) published inflation data for the entire 20-member Eurozone recently. It brought especially good news and raises questions about the future policy direction of the European Central Bank (ECB).

Here are the details: Consumer prices in the Eurozone were up 2.4% in November versus a year earlier, the lowest rate of inflation since July 2021. Recall that inflation had peaked in 2022 at 10.6%. Prices fell 0.5% from the previous month. Inflation was substantially suppressed by a sharp decline in energy prices, which fell 11.5% from a year earlier and fell 2.2% from the previous month. When volatile food and energy prices are excluded, core prices were up 3.6% from a year earlier but down 0.6% from the previous month. The annual rate of core inflation was the lowest since April 2022. 

Prices of nonenergy industrial goods were up 2.9% while prices of services were up 4%. As such, although inflation has fallen sharply, underlying inflation remains significantly higher than the ECB’s 2% target. 

By country, there were disparities. Annual inflation was 2.3% in Germany, 3.8% in France, 0.7% in Italy, 3.2% in Spain, 1.4% in the Netherlands, –0.7% in Belgium, 2.3% in Ireland, 3% in Greece, 2.3% in Portugal, and 0.8% in Finland. Notably, in 16 of the 20 Eurozone countries, consumer prices fell from October to November, mainly due to the sharp decline in energy prices. 

Regarding Germany, the largest economy in the Eurozone, consumer prices were up only 2.3% in November versus a year earlier. This was the lowest rate since June 2021 and down sharply from 6.4% as recently as August. German inflation had peaked at 11.6% in October 2022. Consumer prices were down 0.7% from the previous month. 

German inflation was down in all major categories, suggesting that underlying inflation is becoming less onerous. Core inflation (excluding the impact of volatile food and energy prices) was 3.8% in November, down from 4.3% in October. Energy prices were down 4.5% while food prices were up 5.5%. Service prices were up only 3.4% in November from a year earlier, down from 3.9% in the previous month.  

German bond yields fell sharply on the inflation news, with the yield on the 10-year bond hitting 2.43%, the lowest since July 2023. Many investors interpreted the inflation data as signaling a greater likelihood that the ECB will hold rates steady and cut them sooner rather than later. 

The favorable inflation data led investors to push down the value of the euro on expectations that the ECB could cut rates sooner than previously expected and sooner than the US Federal Reserve. On the other hand, ECB President Christine Lagarde said earlier this week that now is “not the time to start declaring victory.” She expressed concern about rapid increases in wages that are not yet being offset by accelerating productivity. This suggests that getting underlying inflation from 4% to 2% could be challenging and may require a weaker labor market. Indeed, the OECD recently predicted that the ECB will not start cutting interest rates until 2025.  

In the United States, consumers continue to spend while inflation recedes

• In October, consumer spending in the United States decelerated but continued to grow. After having grown rapidly in the third quarter, a moderate deceleration is welcome. From the perspective of the US Federal Reserve, the optimal situation is for the US economy to grow more slowly while inflation comes down. That appears to be happening. Indeed, the Fed’s favorite measure of inflation also decelerated in October, including core inflation. Let’s look at the details.

Last week, the US government reported that, in October, real (inflation-adjusted) disposable personal income (which excludes taxes) increased 0.3% from September. In addition, real personal consumption expenditures increased 0.2% during the same period. The personal savings rate increased slightly from 3.7% in September to 3.8% in October.

Real spending on durable goods fell 0.3%, nondurables increased 0.3%, and spending on services increased 0.2%. These numbers suggest moderate growth of consumer spending.

Also, the government reported on the Fed’s favorite measure of inflation: the personal consumption expenditures deflator, or PCE-deflator. It was up 3% in October from a year earlier and unchanged from the previous month. When volatile food and energy prices are excluded, core prices were up 3.5% from a year earlier, the lowest since April 2021. Prices of durable goods were down 2.2% while prices of nondurables were up 1.6%. Prices of services were up 4.4%.

Overall, today’s report offered welcome news. The consumer sector slowed but continued to grow, underlying inflation declined, and real income continued to rise—albeit more slowly. This data probably increases the likelihood that the Federal Reserve will continue to hold rates rather than raise them. If inflation continues to fall and the economy softens, then the Fed will likely be in a position to ease monetary policy sometime in 2024.

Bond yields signal view that central banks are done raising rates

• In the United States, bond yields continue to decline. The yield on the Treasury’s 10-year bond fell below 4.3% recently, the lowest level since mid-September and down sharply from the peak of 5% reached in mid-October. The decline since then reflects increasing confidence on the part of many investors that the Federal Reserve is finished raising interest rates and may cut them sooner than previously anticipated. Indeed, one of the most hawkish governors of the Federal Reserve, Christopher Waller, said that “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to [the Fed’s target of] 2 per cent. If we see disinflation continuing for several more months—I don’t know how long that might be, three months, four months, five months—you could then start lowering the policy rate just because inflation’s lower.”

Waller’s confidence that the economy will slow down came on the same day that the government upwardly revised its estimate of third-quarter GDP growth. Previously, the government reported that real GDP grew at an annualized rate of 4.9% in the third quarter. Now it reports that growth was 5.2%. Yet many investors evidently believe that this will not be repeated and that the economy will slow down. October data on retail sales and job growth confirms a likely slowdown. 

Meanwhile, the drop in bond yields has caused a drop in the value of the US dollar (a rise in the value of other major currencies). Specifically, as of this writing, the euro is just under US$1.10, the highest level since mid-August. The euro had bottomed at US$1.046 in early October and has been rising ever since. For the United States, a rising currency is disinflationary. For Europe and Japan, a declining currency will ultimately boost export competitiveness, although it could also boost inflation. For US companies doing business globally, a declining dollar will boost dollar-denominated earnings. 

Also, the OECD recently released its latest economic prognostications. It expects global economic growth, including that of the United States, to decelerate in 2024 and that inflation will continue to decline. It expects the US Federal Reserve to cut interest rates in the second half of 2024, although it expects the ECB and the Bank of England to hold rates until 2025. It expects the Bank of Canada to start cutting rates at the same time as the United States. It urged central banks not to loosen policy too soon. 

Finally, given that many investors are increasingly confident that the US Federal Reserve, the ECB, and other major central banks will not raise interest rates any further, they are starting to pile into riskier assets as evidenced by rising equity prices. In fact, in November, global equities rose faster than in any month since November 2020 when prices rose on news of a breakthrough in developing a COVID-19 vaccine. 

Equity prices tend to be anticipatory. That is, they are based on expectations about future profits and future borrowing costs. The rise in equities reflects a view that interest rates will come down soon. It also reflects a view that, although the global economy might weaken further in 2024, that will be the turning point before the ultimate recovery. As such, investors likely see profit growth coming soon.