Key Trends in the World Economy

China has overtaken the US to become the world's largest industrial producer

The period since the international financial crisis began has for the first time in over a century seen the US displaced as the world’s largest industrial producer – this position has now been taken by China. It has also witnessed the greatest shift in the balance of global industrial production in such a short period in world economic history. In 2010 China’s industrial output exceeded the US marginally but this has now been consolidated into a more than 20% lead with the gap still widening further.

In 2007, on UN data, China’s total industrial production was only 62% of the US level. By 2011, the latest available comparable statistics, China’s industrial output had risen to 120% of the US level. China’s industrial production in 2011 was $2.9 trillion compared to $2.4 trillion in the US – this data is shown in Figure 1.

Figure 1

 

When the comparable data is released for 2012, China’s lead will have increased substantially– between December 2011 and December 2012 China’s industrial output increased by 10.3% whereas US industrial production increased by only 2.7%. Calculations based on estimates in the CIA's World Factbook indicate in 2012 the value of China's industrial production was $3.7 trillion compared to $2.9 trillion for the US – which would mean China's industrial production was 126% of the US level.

Taking only manufacturing - that is excluding mining, electricity, gas and water production - in 2007 China’s output was 62% of the US level, by 2011 it was 123%. Again the gap has widened in 2012 and 2013.

No other country’s industrial production now even approaches China - in 2011 China’s industrial output was 235% of Japan’s and 346% of Germany’s.

World Bank data, using a slightly different calculation of value added in industry, confirms the shift. On World Bank data China’s industrial production in 2007 was only 60% of the US level, whereas by 2011 it was 121%.

Therefore in only a six year period China has moved from its industrial production being less than two thirds of the US to overtaking the US by a substantial margin. If China was the ‘workshop of the world’ before the international financial crisis it is far more so now

The trends producing such dramatic shifts in such a short period are shown in Figure 2. In six years China’s industrial output almost doubled while industrial production in the US, Europe and Japan has not even regained pre-crisis levels. To give precise statistics, between July 2007 and July 2013 China’s industrial production increased by 97% while US industrial output declined by 1%. Industrial production data for July is not yet available for the EU and Japan, but between June 2007 and June 2013 EU industrial output fell by 9% and Japan’s by 17%.

Figure 2

 

It is this enormous rise in China’s output which also drove the much discussed global shift in industrial production in favor of developing countries - in the six year period to June 2013, the latest date for which combined data is available, industrial production in advanced economies fell by 7% while output in developing economies rose by 65%.

As is clear from Figure 3, China accounted for the overwhelming bulk of the increase in the developing economies. Industrial production in Latin America rose by 5%, in Africa and the Middle East by 6%, and in Eastern Europe by 10%. But China’s industrial production in this period rose by 100% - industrial output in developing Asia as a whole rose by 65%, but the majority of this was accounted for by China.

Figure 3

The quite literally historic scale of these shifts makes clear that by far the most important development in world industrial production in the last period is this extraordinary rise of China. Between 2007 and 2011 China’s industrial production rose by $1,465 billion, in current prices, while US industrial output rose by only $88 billion in current prices and declined slightly in inflation adjusted terms. China’s industrial production rose by 17 times as much as the US.

Such a rise in China’s industrial production has consequences spreading far beyond industry itself. Industry has easily the most rapid increase in productivity of any economic sector – notably compared to services. The decline of industrial production in the EU and Japan, and relative stagnation in the US, means China is cutting the productivity gap between itself and the advanced economies. This is crucial for progress in raising China’s relative GDP per capita and living standards.

This rising productivity also explains why China’s exports have been able to maintain their competitiveness despite substantial increases in the exchange rate of China’s currency the RMB. On Bank for International Settlements data, the RMB’s nominal exchange rate rose by 25% between July 2007 and July 2013. But China’s real effective exchange rate, that is taking into account the combined effect of the nominal exchange rate and inflation, rose by 31% But despite this major currency revaluation China’s exports continued to exceed its imports.

The ability of China to successfully absorb such high increases in its exchange rate, due to high levels of industrial productivity increases, directly translates into relatively lower prices for imports and improved relative living standards for China’s population.

This data also settles the dispute between who believed there was a major industrial revival in the US, such as the Boston Consulting Group, and Goldman Sachs and other analysts who correctly concluded no such major revival has occurred. Those in China, such as Lang Xianping, who wrote that a great US industrial revival was taking place and China’s industry was in crisis look foolish in the light of data showing China’s industrial output doubled in a period when US industrial production did not grow at all. The only reason US industrial performance does not appear very weak, with negative net growth over a six year period, is because of the even worse performance of a major decline in industrial output in the other advanced economic centers – the EU and Japan.

It is naturally important not to exaggerate this scale of advance by China in industrial production. China’s industrial output is now considerably larger in value terms than the US, but the United States retains a substantial technological lead which it will take China a considerable period to catch up with. Due to a long period of globalization and consolidation by US companies, both processes which are only at early stages in China, US manufacturing firms are still four times the size of China’s in terms of overall global revenue– although between 2007 and 2013 Chinese manufacturing firms overtook Germany to become the third largest manufacturing companies of any country.

The scale of these changes in world industrial production also make clear that in comparison to developments in China gas and oil ‘fracking’ in the US, which have attracted widespread media attention, is merely a statistical sideshow – as already noted overall US industrial production has not even recovered to pre-crisis levels.

For the first time for over a century the US has been definitively replaced as the world’s largest industrial producer. Such a once in a century shift can literally only be described as historic.

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An earlier version of this article appeared at China.org.cn 

The US economic slowdown is much greater than China's

Publication of US 2nd quarter GDP data, following that for China, makes it possible to accurately compare the recent performance of the world's two largest economies. The results are extremely striking as they show that in the last year the slowdown in the U.S. economy has been far more serious than in China. Consequently the data shows that while both economies are being adversely affected by current negative trends in the world economy, China is dealing with these more successfully than the U.S. Intense media discussion in China about its ‘slowdown’  is therefore misplaced unless equivalent attention is paid to understanding why the US  economic slowdown is much worse than China’s.

To accurately establish the facts, it should be noted China and the U.S. publish their economic data in slightly different forms. It is therefore necessary to ensure that like is compared with like. The U.S. emphasizes annualized change in GDP in the latest quarter compared to the previous one; for the newest data this means it takes the growth between the 1st and 2nd quarters of 2013 and basically multiplies it by four. China emphasizes the growth between the 2nd quarter of 2013 and the same quarter in 2012.

Both methods have advantages and disadvantages. Quarter by quarter comparisons depend on seasonal adjustments being accurate, which is not always the case, while year by year comparisons are less sensitive in registering short term shifts.

But in the present case the conclusion is not fundamentally changed whichever method is used. If the method emphasized by China is used, then, as shown in Figure 1, in the 2nd quarter of 2013 China's GDP grew by 7.5% compared to a year earlier, while U.S. GDP grew by 1.4%. This means that China's economy grew at over 500% of the rate of the U.S. economy. Using the method preferred by the U.S. China's annualized GDP growth in the 2nd quarter was 6.8% and the U.S.'s was 1.7%, which means that China's economy grew at 400% of the rate of the U.S. economy.

Due to the difficulties of making accurate seasonable adjustments in both China and the U.S., the author would emphasize the year on year comparison; but whichever method is preferred China's economy was growing at 4-5 times the speed of the U.S. economy.

Figure 1

 

If the whole period since the international financial crisis began is taken then the disparity in growth between China and the U.S. is even more striking. In the five years up to the 2nd quarter of 2013 China's GDP grew by 50.7% and U.S. GDP by 4.5% (Figure 2). China's GDP grew more than ten times as rapidly as the U.S.

Figure 2

 

Turning to the most recent period, it is widely understood that since the beginning of the international financial crisis, China's economy has far outperformed the U.S., even if the dimensions of this are not clearly grasped. What is not so often understood is what has happened during the last year. During that period the economies of both China and the U.S. slowed, indicating the negative trends in the international economic situation. But the U.S. slowed far more than China.

China's year on year GDP growth fell from 7.6% in the 2nd quarter of 2012 to 7.5% in the same quarter of 2013 - a decline of 0.1%, or a 1.3% deceleration from the initial growth rate. However the year on year growth rate of the U.S. in the same period fell from 2.8% to 1.4% - that is by 1.4% or by 50% of the initial growth rate (Figure 3). Consequently China's growth fell marginally but the U.S.'s growth rate halved.

Figure 3

 

Furthermore, as the Financial Times correctly pointed out in its editorial on the latest U.S. data, U.S. economic growth has been particularly depressed in the last nine months. In that total period the U.S. economy grew by only 0.7%, or an annualized rate of under 1%. In the same period China's economy grew by 5.3%, or an annualized rate of slightly over 7%. Therefore if over the entire course of last year China's economy has been growing at 4-5 times the speed of the U.S. economy, in the last nine months China's economy has been growing at 7 times the speed of the U.S.

This does not mean that the US cannot partially recover from its extremely depressed 1.4% annual growth rate in the last year – the 10 year moving average of US annual growth is 1.8% and its 20 year annual moving average is 2.5%. But even recovery to these rates would leave the US growing at only one third of the rate of China. 

The latest data therefore shows that the global economic discussion about the present world economic situation is not about China's "slowdown" and U.S. "recovery". It is "why is China coming so much more successfully through an adverse global economic situation than the U.S.?" And "why has the U.S. economy slowed so much more dramatically than China's in the last year?

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An earlier version of this article appeared at China.org.cn.

Claims of big success by 'Abenomics' are a fake

The claims 'Abenomics' is a big success are so far fake.

Headlines have appeared such as 'Japan revises up Q1 growth to annual 4.1%' with commentary this, 'was much higher than the preliminary estimate of 3.5 per cent, which was already the fastest rate recorded by any Group of Seven economy.' This ignores that this annualized 4.1% growth in the 1st quarter of 2013 was only recovery from a 3.6% fall in the second quarter of 2012.

Year on year GDP growth in Japan in the 1st quarter of 2013 was only 0.2%, the lowest since the 4th quarter of 2011 - see Figure 1, Table 1, and Figure 2

Figure 1

Table 1

Figure 2

 

Japan’s GDP remains 1.2% below its peak in the 1st quarter of 2008 and its recovery remains slow – Figure 3.

Figure 3

 

At best all ‘Abenomics’ has done so far is stop the renewed decline which commenced in Japan’s economy in 2011. But the ‘Abe recovery’ is simply in line with the trend since 2009. Only if the growth seen in the 1st quarter of 2013 continued for a significant period could ‘Abenomics’ really claim any significant success.

In short the claims to date of a big success by ‘Abenomics’ are a fake.

China’s investment stimulus ensures it will retain its international growth lead in 2013

In the 4^th quarter of 2012 China’s economy speeded up, with GDP growth rising to 7.9%. For 2012 as a whole China’s GDP rose by 7.8%. Internationally this contrasted sharply with the EU and Japan, both of which have passed into new downturns, and the US where economic growth in 2012 was 2.2% - anaemic compared to previous recoveries. China’s industrial production in the year to December rose by 10.3% - compared to 2.9% in the US. China’s annual economic expansion now exceeds the US in dollar as well as percentage terms – China’s GDP in 2012 rose by $982 billion compared to $600 billion for the US.

 

 

The scale of changes in the world economy involved can be seen even more clearly if the period since the international financial crisis began is taken. Peak US GDP prior to the financial crisis was in the fourth quarter of 2007. Since then China’s GDP has grown by 52.5%. But in the 4th quarter of 2012 US GDP was only 2.4% above its pre-crisis level.

In the last five years China’s economy has therefore grown more than twenty times as fast as the US while the economies of the EU and Japan have shrunk. In current dollar prices China’s GDP has risen by $4.7 trillion and the US by $1.65 trillion.

In industrial production, the most internationally traded sector, and the one with the fastest productivity growth, the change in the last five years is even more dramatic. On the latest available data EU industrial production is 12% below its pre-crisis peak and Japan’s 22% below. In the US, despite unsubstantiated talk of ‘industrial revival’, in December US industrial output was still over 2% below its peak of more than five years previously. In the five years up to December 2012 US industrial production had fallen by 3%, but China’s industrial production had risen by 80%.

These huge economic shifts pose two questions entering 2013. This year can China maintain the pickup in economic momentum that was clear in the fourth quarter of 2012? Can China maintain this over the medium/longer term with the consequences for further changes in the structure of the world economy flowing from this? Examining the economic processes unfolding at the beginning of 2013 gives the answer ‘yes’ to both questions – and for the same reason.

Turning back to short terms trends, undoubtedly at the beginning of 2012 China's economic policy makers had underestimated the difficulties in the developed economies. China's official prediction of a 10% export increase in 2012 could not be achieved without significant growth in developed markets. This did not materialize and exports rose only 7.9%.

As external demand was overestimated there was a delay in launching a program to stimulate domestic demand. Therefore China’s economy slowed. By May 2012 annual fixed asset investment growth had fallen to 20.1%, the lowest for a decade. In August the yearly increase in industrial production declined to 8.9%. In the same month the annual increase in industrial company profit fell to 6.2%.

However, by mid-2012 policy was adjusted appropriately. In late May Premier Wen Jiabao announced an infrastructure centred investment program that grew to $157 billion. Theoretical support to this new stimulus was given by former World Bank Chief Economist and Vice President Lin Yifu - who has now returned to Beijing to be a major influence in China’s economic policy making.

The correctness of these policies was rapidly shown. By December the investment decline reversed, with the annual increase in fixed asset investment rising to 20.6%, and industrial output growth accelerating to 10.3%. Industrial company profits grew – rising to a 22.8% annual increase in November. These trends underlay the GDP growth increase from 7.4% in the third quarter to the fourth quarter’s 7.9%.

In a perfect world doubtless China would have launched its domestic stimulus a few months earlier. But in economics it is impossible, due to the enormous number of variables involved, to make precisely accurate projections, only orders of magnitude can be accurately predicted. In particular policy makers had to take into account that China’s population is extremely inflation adverse. If export demand had been at the level expected, launching a domestic stimulus would have threatened economic overheating with inflationary dangers. In the grand economic scheme of things, with China’s GDP rising at 7.8%, the US at 2.2%, and the EU and Japan not at all, a few months delay is virtually neither here nor there.

Nevertheless there exists a small industry of those claiming China is ‘soon’ to suffer deep economic crisis – the ‘soon’ merely progressively moving forward in time when it doesn’t materialize. A few examples will give the flavor of the genre:

• Gordon Chang in The Coming Collapse of China in 2002 declared ‘A half-decade ago the leaders of the People's Republic of China had real choices. Today they do not. They have no exit. They have run out of time.' Actually rather than collapse China was entering a decade of the most rapid growth ever experienced by a major economy in human history.
• Michael Pettis of Beijing University, a frequent predictor of ‘sharp slowdown’ or ‘crisis’ in China, in 2009 reiterated: ‘I continue to stand by my comment [made] last year... that the US would be the first major economy out of the crisis and China one of the last.’ In fact since the peak of the last US business cycle, in the fourth quarter of 2007, China’s GDP has grown by 53% and US GDP by 3%.
• The Economist magazine, in a special supplement in 2002, ‘A Dragon Out of Puff’, predicted: 'In the coming decade, therefore, China seems set to become more unstable. It will face growing unrest as unemployment mounts.' And 'the economy still relies primarily on domestic engines of growth, which are sputtering. Growth over the last five years has relied heavily on massive government spending. As a result, the government's debt is rising fast. Coupled with the banks' bad loans and the state's huge pension liabilities, this is a financial crisis in the making.' In fact in the next 10 years China underwent the most rapid growth of any major economy in history.

The fact that such predictions are regularly refuted by events does not stop them being put forward. A slight delay in China launching a domestic stimulus in 2012 therefore created a frenzy of speculation in such circles regarding a ‘hard landing’ or ‘crash’ in China’s economy – which as always failed to materialize and instead, as already noted, China’s economy accelerated.

A new ‘theory’ therefore had to be put invented of why China’s economy will substantially slow – that China’s government is allegedly sacrificing the long term interest of its economy for a short term ‘fix’. According to one formulation of this, by Jamil Anderlini and Simon Rabinovitch in the Financial Times: ‘China went into reverse in the second half of 2012 in its efforts to rebalance its economy… Though steady, consumption took a back seat to capital spending as a driver of growth.’

Unfortunately this line of argument makes as little sense as, and will be therefore be just as refuted by events as, the numerous others.

First, taking the long run, modern econometrics shows clearly that as an economy develops it becomes more dependent on investment for growth, not less. As China moves from a developing to a developed economy investment would be expected to play a greater role in its growth.

Second Lin Yifu has rightly stressed that the industrial upgrading of an economy consists of it moving from labor intensive to increasingly investment intensive industries. This is precisely the path China is following with its exports increasingly switching from labour intensive products such as textiles and toys into more capital intensive ones such as ships, construction equipment, smartphones and cars.

Finally, in the purely short term, the present global economy conforms to economic theory showing that investment fluctuates more than consumption, and it is investment downturns which therefore create economic recessions. The latest data shows in developed economies fixed investment is nearly 10% below its peak and has been declining since the first quarter of 2012. China’s ability to counter such threats by an investment stimulus program is therefore a sign of the strength of its economy, not a weakness. It is this ability to control and raise investment which determined that China’s economy continued to grow rapidly, while the sharp decline of investment in the developed economies led to their stagnation or renewed recession.

Consequently, rather than China’s government’s policies sacrificing the long term strength of the economy to short term expedients, the stimulus launched from summer 2012 integrates both short and long term considerations in economic development. This is why the majority of predictions for growth in China’s economy in 2013, from both Chinese and the majority of international experts, are for a further speed up in GDP growth to more than 8% - the World Bank’s 8.4% being fairly typical.

The main dangers to China’s growth in 2013 are therefore not domestic but those from external weakness in developed economies. The latest prediction by the World Bank for growth in 2013 is 1.9% in the US, 0.8% in Japan and -0.1% in the Euro Area. For this reason the World Bank’s overall projection for global growth is a low 2.4% in 2013.

Naturally China, as the world’s second largest economy, and the world’s largest goods exporter, cannot isolate itself from world economic trends. If the world economy slows in 2013 China is likely to slow, and if the world economy accelerates China’s economy is likely to speed up. But whatever the short term ups and downs China will continue to enjoy its 6-7% growth lead over the developed economies.

In regard to the medium term a major turning point in world history is being approached. The IMF projects that, in comparable price levels, that is parity purchasing powers, China will overtake the US to become the world’s largest economy in 2017. At market prices China will overtake the US to become the world’s largest economy a few years later. Exactly when the latter transition will take place depends on the assumption on exchange rates, with 2019-20 being the most central date. To be safe it may be said China will become the world’s largest economy ‘within 10 years’. Given the short time scale, unless China’s economy slows very drastically and very quickly this transition is inevitable.

No one alive has ever lived in a world in which the US was not the largest economy – it gained that position in approximately 1870. It is, among other reasons, because it is mentally difficult for humans to adjust to the new and never experienced that constant theories are put forward that China’s economy must be about the slow substantially. But, for the reasons already outlined, China will maintain its rapid economic growth. That is 2013’s realistic economic perspective.

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An earlier shorter version of this article appeared in China Daily.

Investment will boost China’s economy

The underlying weakness in the US, European and Japanese economies was underestimated in China’s forecasts for 2012. The US is currently consuming more capital than it creates, while its percentage of investment in GDP is near post-World War II lows. Japan’s investment levels have declined for two decades while its savings rate has fallen. EU investment is the lowest percentage of GDP since World War II and declining. These economies cannot achieve rapid recovery under such conditions.

These structural features dictated the poor short term performance of Western economies during 2012. The EU entered a new recession with GDP still 2.1% below 2008’s peak levels. Japan’s latest GDP data shows tortoise like 0.8% annualized growth with output still 1.9% below its peak. US GDP growth decelerated from 4.1% at the end of 2011 to 1.7% in the last quarter. The US PMI fell for three months to 49.6 in August. US industrial production in the same month only rose 2.8% compared to a year previously – less than a third of China’s growth.

The problems in developed economies directly affected China. China’s 10% projected export increase in 2012 will not be achieved, helping explain why China's economy significantly decelerated in the first part of the year. GDP growth fell to 7.8 percent in the first half of the year, while August’s industrial growth declined to 8.9 percent and the official manufacturing Purchasing Managers Index fell to 49.2.

Weakness in Western economies can to a certain degree be compensated for by China’s export growth to developing countries as the latter now constitute 53% of China’s exports. But as Western economies still account for almost half China’s current global market the growth prospects for China’s exports are structurally limited. Consequently, as the great majority of analysts conclude, China’s economic expansion in the next few years must be based primarily on domestic demand. It is therefore good news for China’s economy later this year that lessons drawn by China’s economic policy makers have begun to overcome some confusions which existed earlier regarding the dynamics of China’s domestic demand. This process has been aided by policy recommendations by Lin Yifu - China’s former World Bank Senior Vice President and Chief Economist.

Problems had earlier been created in discussion of China’s economic policy by confusing ‘domestic demand’ with ‘domestic consumption’. The two are not the same. Domestic demand consists not only of domestic consumption but also domestic investment. Formulas such as the following, which were regularly used, were therefore erroneous: ‘China will not be able to rely on exports for its economic growth. Therefore, China will have to adopt a consumption-driven growth strategy.’

From the viewpoint of increasing domestic demand, China’s exports can just as much be replaced by raising China’s domestic investment as by increasing consumption. Indeed whether, and in what proportion, to expand China’s domestic demand by expanding investment or consumption is a crucial economic policy choice.

The clarity necessary on this has been highlighted by Lin Yifu and confirmed by trends in China’s economy in the first part of 2012. Lin argued that, compared with boosting consumption, encouraging investment is a more sustainable and successful path. This analysis, which is justified by factors set out in Lin’s writings on long term economic growth, was also clearly confirmed by trends in China’s economy during 2012.

Some deceleration in China’s economy was inevitable in 2012 due to negative international trends. Nevertheless this was magnified earlier in the year by errors in China’s normally surefooted economic policy which are now being overcome.

China’s economic policy during the last period took as a key aim raising consumption – i.e. living standards. This indeed should be economic policy’s aim – the target should be maximizing the sustainable rate of increase of consumption. But unfortunately this became confused with a different idea of sharply increasing the percentage of consumption in China's GDP. These two goals are actually contradictory as GDP growth, which is largely fueled by investment, underpins sustainable consumption. Sharply increasing consumption’s percentage in GDP cuts investment levels, thereby inadvertently leading to lower GDP and consequently lower consumption growth.

The practical consequences of this confusion were clear in 2012. To attempt to raise the share of consumption in China's GDP, wage increases far above the economy's growth rate were pushed through. In the most striking examples, Sichuan raised the 2012 minimum wage by 23 percent, and Shenzhen announced a 16 percent increase to the 2012 minimum wage following a 20 percent increase in 2011.

Such measures increased inflationary pressures in China’s economy and squeezed private and state company profits, helping create in the first half of 2012 a trend accurately termed ‘profitless growth’. Falling profits in turn led to investment reductions, with fixed asset growth declining from 25.0% in August 2011 to 20.2% in August 2012. Falling economic growth also reduced government tax receipts, pressuring the state budget.

This process illustrates why the phrase ‘consumer-led growth’, sometimes used in China, is fatally confused. In a market economy production does not take place because there is a demand for consumption. It only occurs if production is profitable. As profits declined in 2012 investment fell, the economy slowed, and consumption's growth rate therefore declined. The growth rate of retail sales, before adjusting for inflation, fell by 4.9 percent between December 2011 and August 2012 while the CPI fell by 2.2 percent. Real retail sales growth, the main factor in consumption, therefore fell. Predictably, attempting to sharply increase consumption's percentage in GDP led to the population’s consumption rising more slowly!

But while consumption was boosted the government initially did not use available policy tools to halt the decline in fixed investment – as shown by the fall in fixed asset formation. These policies are now being corrected. Instead of the confused formula of ‘consumer-led growth,’ Premier Wen Jiabao has rightly emphasized ‘a pattern in which economic growth is jointly driven by consumption, investment and exports.‘ A $154 billion state-stimulated investment program has been announced. These practical steps by the government are clearly broadly in line with the economic policy arguments advanced by Lin Yifu.

If China's government continues these corrections, China’s growth will stabilize and then accelerate towards the end of 2012.

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This article originally appeared in China Daily.

Quantitative easing - US and non-US markets

An important article by Gavyn Davies on his Financial Times blog analyses the effects of US quantitative easing (QE) on bond, share and commodity markets and the relation of these to trends in the productive economy.

Gavyn Davies charts the graph in Figure 1.

Figure 1

 

His commentary is self-explanatory:

‘A quick glance at the graph suggests that equities, bonds and commodities have all been in bull market trends ever since the successive rounds of quantitative easing started. However, a closer inspection reveals that this is not in fact the case. Only bonds have been in a continuous uptrend. The behaviour of global equities and commodities can more meaningfully be split into two separate phases.

‘From the start of the recovery to the end of April 2011, both equities and commodities recorded extremely strong bull markets, with both asset classes rising by some 90 per cent.

‘Since then, however, the bull market in risk assets has fizzled out. In the second phase (shaded blue), equities have been volatile around a broadly flat trend, and commodities have actually fallen by 16 per cent from the peak, despite their recent rally. Quantitative easing has not been powerful enough, at least up to now, to restore the 2009-11 bull market.’

As regards bond markets the essentially continuous upward trend of prices noted by Gavyn Davies naturally indicates that the intended goal of QE of depressing interest rates has been achieved. As regards commodity prices he is accurate that these have not yet regained their post-financial crisis peaks reached in April 2011 – as is clear from Figure 2.

Figure 2

 

World share prices have also not significantly risen above their April 2011 post-international financial crisis highs – see Figure 3. However this graph also illustrates the sharp difference between US and non-US share price performance.

US shares have continued to advance since April 2011, more than overcoming their decline in the second half of 2011. Non-US shares have, however, fallen back from April 2011 levels.

Whereas up to April 2011 US and non-US share markets moved in the same direction, both showing recovery, since April 2011 US and non-US share markets have moved in opposite directions with the former having risen and the latter fallen.

Figure 3

 

In order to illustrate this more clearly Figure 4 shows the changes in world, US and non-US share prices since 31 March 2011. By 21 September US share prices were 9.9% above their 31 March 2011 levels whereas non-US share prices were 9.2% below them.

Figure 4

 

These contrary trends in US and non-US share prices naturally don't contradict Gavyn Davies’s fundamental argument. But they highlight an important trend within its overall framework.

US QE policies have been accompanied by, almost certainly caused, a significant and continuing rise in US share prices which continued after April 2011. But US QE policies have been accompanied since April 2011 by a fall in non-US share prices. Any analysis of trends in world markets must take into account and explain these divergent trends.

It is also unlikely that the explanation can simply be more rapid economic growth in the US compared to other economies . Despite some recent slowdowns emerging economies have grown significantly more rapidly than the US, but emerging economy share prices have performed significantly worse than the US – Figure 5. Whereas emerging economy share prices have fallen by 14.2% since 31 March 2011 US shares have risen by 9.9%.

Figure 5

 

The Federal Reserve could, therefore, argue that it has created a ‘wealth effect’ within the US through QE – US house prices have also stabilised and then risen slightly this year. However the data from commodity markets and non-US share markets indicates no such effect has been created by QE outside the US.

Whether US QE has contributed to the negative trends in non-US economies, as countries such as Brazil have argued, would of course requires a separate article. The distinction between US and non-US markets is however relatively clear.

Quantitative easing - US and non-US markets

An important article by Gavyn Davies on his Financial Times blog analyses the effects of US quantitative easing (QE) on bond, share and commodity markets and the relation of these to trends in the productive economy.

Gavyn Davies charts the graph in Figure 1.

Figure 1

 

His commentary is self-explanatory:

‘A quick glance at the graph suggests that equities, bonds and commodities have all been in bull market trends ever since the successive rounds of quantitative easing started. However, a closer inspection reveals that this is not in fact the case. Only bonds have been in a continuous uptrend. The behaviour of global equities and commodities can more meaningfully be split into two separate phases.

‘From the start of the recovery to the end of April 2011, both equities and commodities recorded extremely strong bull markets, with both asset classes rising by some 90 per cent.

‘Since then, however, the bull market in risk assets has fizzled out. In the second phase (shaded blue), equities have been volatile around a broadly flat trend, and commodities have actually fallen by 16 per cent from the peak, despite their recent rally. Quantitative easing has not been powerful enough, at least up to now, to restore the 2009-11 bull market.’

As regards bond markets the essentially continuous upward trend of prices noted by Gavyn Davies naturally indicates that the intended goal of QE of depressing interest rates has been achieved. As regards commodity prices he is accurate that these have not yet regained their post-financial crisis peaks reached in April 2011 – as is clear from Figure 2.

Figure 2

 

World share prices have also not significantly risen above their April 2011 post-international financial crisis highs – see Figure 3. However this graph also illustrates the sharp difference between US and non-US share price performance.

US shares have continued to advance since April 2011, more than overcoming their decline in the second half of 2011. Non-US shares have, however, fallen back from April 2011 levels.

Whereas up to April 2011 US and non-US share markets moved in the same direction, both showing recovery, since April 2011 US and non-US share markets have moved in opposite directions with the former having risen and the latter fallen.

Figure 3

 

In order to illustrate this more clearly Figure 4 shows the changes in world, US and non-US share prices since 31 March 2011. By 21 September US share prices were 9.9% above their 31 March 2011 levels whereas non-US share prices were 9.2% below them.

Figure 4

 

These contrary trends in US and non-US share prices naturally don't contradict Gavyn Davies’s fundamental argument. But they highlight an important trend within its overall framework.

US QE policies have been accompanied by, almost certainly caused, a significant and continuing rise in US share prices which continued after April 2011. But US QE policies have been accompanied since April 2011 by a fall in non-US share prices. Any analysis of trends in world markets must take into account and explain these divergent trends.

It is also unlikely that the explanation can simply be more rapid economic growth in the US compared to other economies . Despite some recent slowdowns emerging economies have grown significantly more rapidly than the US, but emerging economy share prices have performed significantly worse than the US – Figure 5. Whereas emerging economy share prices have fallen by 14.2% since 31 March 2011 US shares have risen by 9.9%.

Figure 5

 

The Federal Reserve could, therefore, argue that it has created a ‘wealth effect’ within the US through QE – US house prices have also stabilised and then risen slightly this year. However the data from commodity markets and non-US share markets indicates no such effect has been created by QE outside the US.

Whether US QE has contributed to the negative trends in non-US economies, as countries such as Brazil have argued, would of course requires a separate article. The distinction between US and non-US markets is however relatively clear.

The shape of the new EU downturn

The data released by the OECD for 2nd quarter GDP for the EU shows clearly the shape of Europe's new economic downturn. The situation is dominated by the decline in fixed investment – see charts below.

In the US$ Parity Purchasing Power (PPP) terms in which the OECD now releases such data EU GDP, in inflation adjusted terms, is still $307 billion below its peak in the 1st quarter of 2008. However EU fixed investment is down by $485 billion – that is the decline in fixed investment more than accounts for the entire fall in EU GDP. EU consumer expenditure is also down, by $122 billion, but this is only one quarter of the decline in fixed investment. Net trade and government consumption are positives.

In short the EU’s economic situation, as in the developed economies as a whole, is dominated by the fixed investment decline.

Figure 1

Figure 2

Misanalysis in China of Europe’s economic crisis

The following article originally appeared in Beijing Times.

* * *

This week Greece’s Prime Minister Samaras met, and publicly argued, with German Chancellor Merkel over the EU’s latest attempt to solve the Greek economic crisis. Given that earlier misunderstandings in China of the dynamics of Europe’s crisis have damaged its own economy it is therefore important that a correct assessment is made of this new stage in Europe.

The reason China was previously damaged by a wrong analysis was that the seriousness of Europe’s economic crisis was considerably underestimated. By July 2012 China’s exports to the EU had declined by 16% in a year – easily the most serious blow to China’s exporters. Yet a year previously few analysts in China were predicting such negative European trends.

The reason for this widespread underestimation of the seriousness of the situation was that many analysts in China supported austerity policies being pursued in Europe and rejected the alternative proposal for European governments to launch economic stimulus programs. As most European governments were following austerity, and austerity was considered the correct policy, such Chinese analysts concluded Europe’s crisis would be overcome.

However the results clearly show that Europe’s austerity policies have worsened the situation and analysts who supported Europe’s austerity policies were dangerously mistaken.

To assess accurately Europe’s real economic dynamics, and their consequences for China, first the overall results of the different policies pursued internationally to deal with the financial crisis can be summarized and then the situation in individual European countries analyzed.

Internationally three types of policies were adopted in response to the financial crisis:

· The EU combined loose monetary policy with no stimulus to the productive economy – the ‘austerity’ approach. The outcome is that EU GDP is 2.1% below its peak of four years ago and Europe is in ‘double dip’ recession.

· The US combined loose monetary policy with a stimulus to consumer spending via a large budget deficit. The outcome is that average annual US GDP growth in the last four and a half years is only 0.4%

· China combined loose monetary policy with an investment focused stimulus to the productive economy. China’s GDP grew by more than 40% in four years.

The EU’s ‘austerity’ policy was therefore easily the least successful approach to dealing with the financial crisis. This is further confirmed by analyzing the individual EU countries committed to austerity. In the UK, where Cameron’s government voluntarily implemented the policy, GDP is 4.5% below its peak output and the UK is in a new recession. Considering countries which adopted austerity as a condition for bailouts, Ireland’s economy is 8.8% below its peak, Portugal’s GDP is 5.2% below its peak and has been declining for two years; Spain’s economy is 4.7% below its peak and is in a new recession, while in Greece the economy has contracted by 13.0%.

Given these dreadful economic results analysts in China should realize support for Europe’s austerity policies was mistaken. Instead they should hope European leaders will initiate an EU wide economic stimulus. As Greece is clearly too small to launch this, a stimulus must be started by the main European economies. International experience confirms such a stimulus will be more effective if concentrated on investment, as in China, rather than on consumption as in the US. If neither stimulus is launched then China must prepare for a long drawn out European crisis with negative consequences for China’s economy.

The incredible shrinking UK economy - an update

Earlier this year this blog published an article entitled ‘The Incredible Shrinking UK Economy’. It noted: ‘The magnitude of the blow suffered by the UK economy since the beginning of the financial crisis is very considerably minimized by not presenting it in terms of a common international yardstick. Gauged by decline in GDP, using a common international purchasing measure, dollars, no other economy in the world has shrunk even remotely as much as the UK.’ .

Data at that time was only available up until the end of 2010. Since then the World Bank has updated its data to cover 2011 and the pattern remains the same.

Taking first the situation of the world’s major economies, the G7 and BRICS, this is summarised in Table 1. The comparison made is between the last year before the financial crisis started, 2007, and the last available comprehensive international data – for 2011. As may be seen the $381 billion decline, in current dollar terms, of UK GDP is, without comparison, the worst of any major economy – indeed it is easily the worst in the world. As a percentage of world GDP the UK lost 1.6 percentage points – easily the worst performance of any European economy. The advance of all BRICS economies is also clear from this data. 

Table 1

 

Taking the situation within Europe this is shown in Table 2. As the UK, Ireland, and Iceland are the three economies which have suffered the biggest losses in GDP in dollars during the financial crisis this table may also be taken to show the ‘sin bin’ of world economic performance. The way in which the UK economy has declined in absolute terms far more than any other European economy is again evident.

Table 2

Where does this leave the UK in the world rankings of economies? In terms of current dollar exchange rates. as shown in Table 3, the UK has slid from 5th to 7th position under the impact of the international financial crisis – being overtaken by France and Brazil

Table 3

 

However, as is well known, current exchange rates substantially understate the size of developing economies compared to calculations in internationally equivalent prices (Parity Purchasing Powers - PPPs). This is particularly strikingly the case for India which at current exchange rates is only ranked 10th but in terms of PPPs in 2011 overtook Japan to rank as the world's 3rd largest economy . In PPPs the UK has declined from 7th to 9th position – also being overtaken by France and Brazil on this measure.

Table 4

 

The data is therefore clear. In terms of its real international position the decline in the position of the UK is by far the worst of any major economy. There is no reason to change the analysis. In terms of international comparisons the UK’s is truly ‘the incredible shrinking economy’