Outlook of the global economy in 2013 by Raymond CS Lee

Australian Treasurer Wayne Swan said in the IMF Financial Committee meeting in Tokyo on Saturday, 13 October 2012 that

"The global economy is relying too heavily on Asia to make up for stagnant growth in the US and Europe"

He also urged international policymakers to do more to bolster expansion. He added

"Putting fiscal positions on a sustainable footing needs to be done hand in hand with supporting growth - this does not need to be one or the other."

Please note that this point resonates with my previous paper on the solution for the EU Crisis. However, I would like to add a paper called "From World Banker to World Venture Capitalist: US External Adjustment and The Exorbitant Privilege" by Pierce-Olivier Gourinchas [UC Berkeley, NBER and CEPR] and Helene Rey [Princeton, NBER and CEPR] to help understand what causes, dare I say all, major nations to put their fiscal positions on a more sustainable footing. Reversing the trend since the Bretton-Woods agreement where nations embarked on major deficit funding.

Against this backdrop, IMF said that failure to remedy the region's [Europe] debt problems was contributing to an "alarmingly high risk" of a steeper slowdown in the world economy.

Hence for this paper, I would like to examine 4 regions in order to assess their individual growth potential for 2013 and their possible contribution to global growth rate in 2013.

The regions identified are

Ø      United States of America (US)

Ø      European Union including UK

Ø      China

Ø      Southeast Asia

Note that this paper rely more heavily on quoting other economists on similar issues in order to contrast and highlight the diverse views and the fluidity of the situation.

• The fiscal cliff is a very "volatile" issue that comprises the end of tax cuts, tax increases, spending cuts and unemployment benefits drop. It becomes more complicated because of the ongoing bargaining between Republicans and Democrats. The outcome  may not be sufficient to reduce the deficits. Another variable is the timeline. However, one thing is sure, this added volatility will have tremendous impact on worldwide equity markets.
• The EU ongoing search for a path that satisfies the political sensitivity of the contributing nations while also meeting the needs of the indebted nations may cause more "deleveraging" and ratings downgrade of all the EU nations. This creates more uncertainty. I have included "From World Banker to World Venture Capitalist: US External Adjustment and The Exorbitant Privilege" to help you understand this phenomena.
• China's drive to find cheaper labour elsewhere and among her neighbours may no longer be so straight forward as the "territorial dispute" with its neighbours escalates.
• Southeast Asia's current economic euphoria may be short-lived. The current worldwide financial crisis may drag on. I see US averaging with about 2% growth in the next 2 years and EU is unlikely to average more than 1% growth. Corporations worldwide will likely report lower profit next year and the following year. Given no positive news in the next 2 years due to expected fiscal position tightening worldwide, the equity market will likely adjust downwards in the next 2 to 3 years. This will lead to a domino effect that will spiral downwards in the next 2 years. The picture is not good.

By quoting other economists views, I hope to present a more diverse [and hopefully more complete] picture for the reader of this paper to understand the world in 2013.

What is happening in US?

The Federal Reserve Bank (Feds in short) has just initiated the QE3 where they will pump US$40billion monthly into buying bonds to ensure the term structure of interest rates stays consistently close to 0% for the entire duration.

Does US need a QE3 or a fiscal expansionary policy?

Let's examine quantitative easing and fiscal expansionary policy separately in order to answer this question.

Please find the quotes from an article written by Nouriel Roubini that appeared in the TODAY paper on Monday, 15 October 2012 below to better understand quantitative easing.

The first quantitative easing (or QE) came in March 2009 when the S&P500 index was down to 660, EPS of the US companies and banks had sunk to financial crisis level. There is a clear need to pump liquidity into the system.

QE2 came in the summer of 2010, when S&P500 PE ratios and EPS were much lower than they are today. There is still a case that additional liquidity will help the system function better.

But the current QE3, came at a time where banks have hoarded most of the extra liquidity and creating excess reserves rather than increase lending. Furthermore, major corporations from Apple to Microsoft are seen hoarding an unprecedented amount of cash in their balance sheets.

Mr Roubini argues that it is clearly the main transmission channels of monetary stimulus to the real economy that remains weak, if not broken. The US economy is not in need of additional liquidity. Those who can borrow have ample cash and are cautious about spending, while those who want to borrow - such as indebted households, firms and smaller regional banks that are caught in the housing market bust maelstrom - face a credit crunch.

Lets consider another perspective provided by Steven Ricchiuto, chief economist of Mizuho Securities USA is his interview with Assif Shameen of The Edge Singapore in July 23, 2012 edition has this to say [I quote]

"Citigroup is not the US banking industry. More than half of their business is outside the US. JPMorgan is not the typical US bank. There are a lot of regional and smaller local banks in America, and most Americans borrow from them. Unfortunately, Wall Street focuses on the larger banks such as JPMorgan, Bank of America, Wells Fargo and Citigroup - but most small and medium-sized companies and ordinary Americans do business with regional and community banks. What I was trying to say was that banks need to improve their balance sheets first. That will help to start growing their lending and only then we will see some growth in the economy. And as I said, we also need more clarity on policies, and right now things are unclear because of the Presidential Elections on November 8 2012 and the fiscal cliff."

Mr Ricchiuto paints a picture of a multi-speed US economy. That even though the large financial institutions and well capitalized corporations have recovered from the worst ravages of the financial crisis. The smaller regional and community banks, indebted households and small and medium-sized households still need the additional liquidity to help them out. This point resonates with Mr Roubini's points earlier on.

The question is "how do we tweak the financial system so that this extra liquidity can reach the hands of those who need them"? Is the transmission channel really broken? If yes, how do you fix a broken transmission channel? I suppose the only way to get the system working again is to improve confidence in the economy so the people who need the money can borrow again.

Perhaps that is the reason the Fed chairman Ben Bernanke offered that the reason for QE3 is the confidence factor. That is through the Fed's commitment to maintaining generous monetary conditions for longer could possibly improve private spending - for example, if someone can buy a house at a still depressed price with a loan that he/she hardly needs to pay any interest. He/She only needs to repay the principal. Would he/she buy it? All the economy need is the confidence factor. The confidence that the price will go up. In another word, the Fed Chairman wants to kick start inflation.

BBC News reported on 20 November 2012 that house purchases and house prices are picking up. Has the confidence factor kicked in? It is too early to tell. We are only witnessing the buying of the people who can afford it. The price of houses need to appreciate to a level where existing owners negative equity on their property diminish substantially and the unemployment rate drops further.

Why doesn't the US government takeover the responsibility of investment from the private sector and start building more infrastructures such as roads and railways? It can send people back to work and with a steady income, they will start investing and consume again.

To answer this question lets consider the warning from the US Treasury Secretary, Timothy Geithner, as reported in BBC News on 14 November 2012.

"On Tuesday the US Treasury Secretary, Timothy Geithner, warned against extending all of the tax breaks that are due to expire in January 2013 as a way of giving Washington more time to broker a deal on the deficit."

Why is Timothy Geithner who is the chief person to approach for a fiscal expansionary policy warning against it?

That is because US is already in a fiscal expansionary policy for the last 4 years since Obama assumed his presidency and it caused the US a budget deficit of US$5 trillion.

The following news from BBC News on 14 November 2012 will shed more light.

"... The US government accumulated a total budget deficit of $1.1 trillion in the last fiscal year, that ended in September, or 7% of GDP."

Why don't they continue on this fiscal expansionary policy?

According to the non-partisan Congressional Budget Office, if the White House and Congress can reach a budget deal that extends the tax cuts and avoids reductions in spending, the deficit will be about $1 trillion for the budget year.

Their hands are tight.

What is the impact of this fiscal cliff?

According to Steven Ricchiuto, in his interview with The Edge Singapore for the July 23 2012 edition, has this to say

"Do I see the US economy turning around in the next few months and unemployment going back to more normal levels in the foreseeable future? The answer is no. I actually think the economy is ready to turn into a technical recession. The problem is that the growth estimates in the US have been too high. People have been reading far too much into some of the positive data, which is just a temporary bump. I believe the US economy is going to be stuck in the 1% to 1.5% growth range in the next 2 years, probably longer.

As I said, companies are not hiring because of the tax situation, uncertainty over the fiscal cliff and the whole Obamacare, or healthcare, situation. If you are a CEO of an American corporation, there are a lot of reasons why you would be extremely careful about going out and hiring more people even if your business is actually growing right now. In a free-market economy, jobs are created mainly by the private sector and if the companies aren't so sure about things, they are not going to go out on a limb and hire a whole lot of workers. So unemployment is going to remain high - at around the current 8.2% - and that means we are going to see a weak consumer and weak spending."

Steve doesn't think the US can avoid the fiscal cliff. He doesn't believe that US will get to the brink and somehow agree to sort things out just before Christmas. He believes the politicians will just keep bickering beyond December straight into the fiscal cliff.

He doesn't believe the European recession will hurt the US economy as much as people think. US economy is not as dependent on exports to Europe and American banks are no longer as interconnected because of all the liquidity that has been poured into the system both in the US and overseas.

What is this fiscal cliff?

This fiscal cliff is

• Bush-era tax cuts that reduces employees payroll tax from 6.2% to 4.2%
• The unemployment benefits drops due to the expiry of the 99-week maximum, to be reverted back to a 26-week maximum
• US$1.2 trillion in mandatory federal spending cuts
• Tax increases over 10 years to begin to kick in.

This is Obama's effort to rein in his 5-trillion budget deficit during his 4 years as president of the United States. His lack of promises during the election circuit might be a pre-cursor to the expected cut in budget deficit that he promised 4 years ago.

Please note that the fiscal cliff is not a complete package - it actually has many components. Depending on the presidential election, you may see, for example, the Bush tax cuts continuing but there might be additional taxes for the rich and the federal spending cuts may be staggered over a few years rather than the full impact on Jan 1 2013,

To fully appreciate how complicated the negotiations between the White House democrats and the congress controlled republicans, read the following article in the Wall Street Journal Asia Edition on 14 November 2012 entitled "Threat of Tax Hike Spurs Selloff" that try to speculate the options available on negotiation table for the US Tax rate.

"US tax rate could be heading higher

Capital Gains Tax: The rate for those earning more than $69,000 is set to rise to 23.8% on January 1 2013, from 15% now.

Dividend Tax: The rate on dividend could almost triple to 43.4% from the current 15%."

Unrealized Gains: The market's rally since the financial crisis has left many investors sitting on paper profits. The impending increase in capital gains tax may lead to huge sell off in Wall Street before 1 January next year.

Peter Eadon-Clarke, Macquarie Securities head of pan-Asian economics and thematic strategy based in Tokyo, through an interview with Assif Shameen in the September 3 2012 edition of The Edge Singapore has a more positive view. Below are excerpts of the interview

"We are forecasting 1.9% growth in the US next year and I believe the consensus is around 2.3%, so we see the US economy continuing to stumble on. In a long grinding cycle, the US continues to grow around 2% for the next few years. What the US has always had, fortunately, are innovation and wealth creation. Right now, there is shale gas, which is providing help not just to the energy sector but also new opportunities to downstream users."

So there may yet be a surprise on the upside, according to Eadon, even though we have to consider discounting growth rate due to the fiscal cliff in the 1H of 2013.

What is happening in Southeast Asia?

According to an article written by Nishant Kumar and Stuart Grudgings, Southeast Asia appears to be a safe haven as China and India stumble, The Edge Singapore July 16 2012. According to them,

"Short term investors in Southeast Asia stocks and bonds are being overtaken by those with a longer-term horizon, signalling growing confidence in a region of 600 million people that boasts a rapidly growing middle class.

[Of course, this claim is difficult to verify.]

Foreign investment in regional funds is at a record high. Assets managed by offshore mutual or exchange-traded fund dedicated to Southeast Asia rose to more than US$26 billion in March 2012, according to an analysis by Lipper data.

Indonesia is set to grow by 6.5% this year. The Philippines economy raced ahead at a 6.4% annual pace in Q1, its fastest in a year and a half, fuelled by strong consumption and state spending."

Is this a sign of the things to come?

Consider this insight,

"Some economists see the upswing as a temporary wave of exuberance that risks losing momentum without deeper reforms. The rise in consumer spending has been partly fuelled by easy personal credit in countries such as Indonesia and the Philippines and by strong fiscal spending on others, such as Malaysia and Thailand", says HSBC's Neumann.

"Increasingly, we have to ask ourselves really hard questions as to how sustainable is this process and how we can put growth in Asean on a much more sustainable trajectory," he adds.

One problem facing investors is that markets in Southeast Asia already seem to have priced in much of the good news, and the region is vulnerable to short-term wobbles.

[My comments] I think this region needs to sustain this strong fiscal spending and easy personal credit for at least another 2 years, if they hope to ride through this global slowdown. The crunch will come next year when revenues of their private enterprises begin to few the pinch of the global slowdown and when tax revenue will also slow. Foreign Direct Investment will also expect to slow in line with the global slowdown in demand.

Peter Eadon-Clarke, Macquarie Securities' head of pan-Asian economics and thematic strategy based in Tokyo, in a Sep 3 2012 interview with Assif Shameen offered this phenomena a broader view point.

"It does appear that companies have been investing for rapid global growth. We can see at the industry level, where there is broadening excess capacity, which will only lead to more market share wars, price erosions and weaker profits, probably for the next 18 months or so across Asia [also slowing inflation in China]. You can see excess capacity in industries as diverse as steel, coking coal, cement and, indeed, in the broader manufacturing sector. The other things I would mention is that as the US undertakes more growth-oriented policies, the US dollar has begun an appreciating trend and implications of that are generally negative for Asia. When the US dollar, in real effective exchange rate terms, goes up, it tends to suck capital out of the region and tightens credit and so the credit-supported growth, which has been fairly robust for the last few years, begins to abate.

The big theme in Asia is that capital is leaving. Foreign-exchange reserves will begin to grow negative year-on-year as more foreign capital leaves Asia over the next year or so and the US dollar appreciates further."

[My comments] Please note that the ongoing actions coming out of the US is basically

• Deleveraging, where the US is selling their foreign assets that generally attracts higher yield [hence trading at a profit] to cover their outstanding foreign liabilities. Note that even though US net foreign asset is negative but income derived from these net foreign asset position has always been positive. I believe this exercise of deleveraging is just to reduce risk so that they will be less vulnerable to the sudden change in their assets' yield. This has the effect of strengthening the US dollar.
• Enhancing the liquidity in US. This is the quantitative easing that has the effect of easing the US dollar.

Hence, it may be true that profitable assets may be liquidated but at the same time we are witnessing re-investment especially when the currency of the host country falls. For this reason, I believe the Singapore government is holding their currency steady because this is the only way to reduce the volatility in the equity market.

He [Peter Eadon] further adds

"The good news is that Southeast Asia is somewhat insulated from the excess capacity across manufacturing industries which seems to be a North East Asia phenomenon - China, Japan, South Korea and Taiwan. But ultimately, it is all interconnected now - Southeast Asia is part of a global supply chain. If there is excess capacity in China or South Korea, the suppliers in Southeast Asia will inevitably get hit. Just look at the worrying developments in export trends in July, China's exports were up 1%, Japan -8%, South Korea -9% and Taiwan - 12%.

What is happening is supply chains are being emptied in anticipation of Europe's slipping into a double-dip recession. As the US dollar goes up, you need to worry about the competitiveness of Eastern Europe for components. At Macquarie, our Asian export growth forecasts for next year are no more than 5% to 6%. The anaemic global growth story is clearly having an impact on the supply chain. Clearly, Southeast Asia is not immune to the global slowdown. While the region is slightly less vulnerable, it is certainly not a driver of growth. There are some economies that are continuing to grow - like Indonesia, which has a strong investment cycle - and fiscal balances in the region aren't particularly troublesome at this point, but while the region may do relatively better, no country or region is in isolation. As global growth continues to stumble, everyone is impacted to a degree."

Consider also the comments of Chua Hak Bin, Head of Emerging Asia Economics at Bank of America Merill Lynch to Joan Ng of The Edge Singapore, for the July 16 2012 edition.

Chua figures the convergence of factors in North East Asia and the world at large paints a promising economic picture for Southeast Asia. Although he expects slower growth in the region this year because of the turmoil in the developed countries, he sees Asean enjoying healthy investment flows and economic growth in the years ahead. Below are some excerpts of the interview:

"15 years ago, wages in China were comparable to those of Indonesia and Vietnam. Now they are almost double. In fact, companies operating in China are complaining about labour shortages and that the workers are demanding wage hikes of as much as 20% a year. It also hasn't helped that the RMB has appreciated significantly over the last few years. That's pushing some manufacturers to move further inland to access cheaper labour. "I just attended a textile garment conference in Shanghai and it's interesting that China's now losing market share to countries like Bangladesh.""

I believe China is not losing market share to Bangladesh or the countries in Southeast Asia but it is a conscious effort to position themselves for higher value added work. This is part of the broader scheme of the Chinese government to move up the value chain where the Eastern counties of China will focus more on knowledge [or service based] industries and the Western and North East China on key manufacturing industries and they will slowly relinquish their hold on polluting labour intensive industries to South and Southeast Asia through their trans Asian railway and the Asean FTA, as well as, to Africa and South America. I believe the picture will slowly emerge through the years to 2025 or 2030. The Southeast Asian economies will emerge and merge with North East Asia economies as the supply and consumption chain strengthens. I expect the trade in this region to quadruple within the next 15 years from the current already substantial base.

One of the reason China is projecting lower GDP growth is because China intends to divest their investments out of China.

What is happening in China?

The outlook for China varies greatly depending on the economist. Below are some of their comments:

The Edge Singapore, July 16 2012, "China braces for marked slowdown" by Jonathan Laing. Excerpts:

"Infrastructure, the other major area of China's investment boom, may similarly be running into the wall of diminishing returns, GMO's chancellor talks of a highway system with sparse traffic, local airports running at half-capacity and the rapidly expanding national high-speed railroad system, a technical marvel that can't charge ticket prices sufficient to pay for itself. He terms China a "Field of Dreams" economy built on the shaky premise of build and they will eventually come.

Despite lip-service given in the latest 5-year plan to rebalance the economy by making the transition to consumption-led growth, powerful special-interest groups stand in the way of such a change. The state-owned enterprises and other state-denominated joint-stock companies, which have enormous sway in the communist party, account for more than half of employment and fixed-asset investment in the non-farm economy.

As a result, the giant state-owned enterprises - outfits like energy colossus Sinopec, telecoms giant China Mobile, conglomerate Norinco and integrated steel maker Baosteel - have become overly dominant in the economy, thanks to their oligopoly positions, implicit government guarantees, cheap credit, tax breaks and subsidised access to cheap raw materials.

The Wall Street Journal Asia Edition also reported that "Compared to state-owned companies, it's usually harder for us [private enterprises] to get loans, and the interest rates we pay are relatively higher"

Personally, I felt it is an acceptable world wide practice that businesses or corporations that have more established track and profit records with known business connections often get loans with better conditions. The problem with China is not to change such practices but to provide alternatives for private enterprises to get loan from alternative sources such as private lenders in the form of trust companies or even foreign lenders. This entails more liberal banking regulations, better quality audit and central bank regulatory requirements in China. I believe the Chinese authority is already working on both fronts. But this need to be urgent before such practices -or unlevel playing field - become firmly entrenched as the norm in China.

Interest rate liberalization is another area that requires urgent attention.

"Critics say the interest-rate controls shield banks from pressure to compete for business, hurting smaller borrowers, and that the controls penalize the depositors that Beijing hopes will become more active consumers."

This is what Zhou Xiaochuan, governor of the People's Bank of China, the country's central bank has to say, "interest-rate liberalization is a process that will take a while but the pace has picked up".

The statement is fair. However, China will not be able to liberalize its financial system as long as this persists. China needs to liberalize if it hopes to earns any of the US extra "positive valuation effect" from their net foreign assets account.

Please note that allowing big banks in China interest controls basically take away the effectiveness of the central bank to control money supply, the speed of money and consumer sentiments. This may explain why China's central bank prefers to use reserve requirements to control money supply rather than interest rate.

According to Peter Eadon-Clarke,

"At Macquarie, our forecast potential growth rate for China for the next 5 years is closer to 7%, which is consistent with over 2% inflation. Obviously, economies go through cycles around trends. Having said that, you still have over-capacities across broad swathes of Chinese companies with severe profit margin pressures. While the world remains fixated with whether the Chinese economy will grow 7%, 7.5% or 8% it is interesting to note that in more than half of the Chinese provinces, there is an excess of over 20% in cement capacity. It doesn't matter whether growth is 7% or 7.5%, you are still going to have excess capacity in broad swathes of sectors that have high fixed costs and where the imperative is to have those plants keep producing at close to full capacity to spread those high fixed costs over as much volume as possible. This means tremendous downward pressure on profitability, but at some point, somebody has to get squeezed out. The overall GDP might look fine, growing at 7% or 7.5%, but there is frantic competition going on, which could end up with fairly brutal corporate earnings.

Well, it is easier to ask why we haven't seen a big stimulus already, although people have been talking about it for months. I believe the real explanation is because the policymakers are aware that the labour market is tight and nominal household income in urban areas has been growing 14% year on year and in rural areas, 21%. We also know about the demographics in China and yet the export slowdown has not led to high unemployment or looseness in the labour market conditions, so it is hard to imagine why the authorities need to be aggressive at this point."

[My comments] I believe all the charges about over-capacity investment into capital expenditure mentioned above about China is true and I also believe that Chinese central government is actively using state firms as vehicles for these capital investment ventures much like the US and UK have  done at the turn of the previous century. I believe the real crux of the matter is that western economists do not believe that a centrally-planned economy could efficiently allocate resources. However, China is not strictly a centrally-planned economy, it has an active private enterprises that have proved more than capable to fill in the "gap" left by central planners. It is a hybrid system.

The following article "500 million farmers to be urbanised by 2020", China Today, October 2012 edition would help to shed light on what is happening in China and why are China policymakers and entrepreneurs so bold as to continue to plough in huge sums of capital expenditures to build capacity for the future.

"The Institute for Urban and Environmental Studies (IUE) of the Chinese Academy of Social Sciences released The Annual Report on Urban Development of China (2012), also known as Blue Book of Cities in China. According to the report, at the projected annual growth of 0.8% to 1%, China's urbanization rate will reach 60% by 2020. This means that within 20 years more than 200 million farmers will migrate to cities. Taking into account new migrants who have already come to cities but are yet to enter the urban social security and public service networks, a total of 400 to 500 million farmers are estimated to be urbanised. To provide them with social security and public services will cost RMB40 to RMB50 trillion. In the opinion of Wei Houkai, deputy chief of IUE, China is still far from being an urbanized society. The old lifestyle and spending habits die hard among the multitude of migrant workers and farmers who gain urban residence status through city expansion."

Despite such massive migration, the urban unemployment rate in China was last reported at 4.1% in Q2 2012. It has not shifted much since 2008.

Even though this data is obtained from a reliable source - www.tradingeconomics.com who in turn got their information from the Ministry of Human Resources and Social Security of the PRC - I would like to caution users that most of the farmers are not part of the urban census and hence the data are at best estimates of city planners. This can be confirmed by the relative "static" of the data as compared to the more fluid population data of the US or Australia where citizens are entitled to unemployment benefits and hence are more conscientious in their effort to update relevant government agencies.

Basically, I would like the user of this report to understand the reason for the huge capital expenditure in China and that the practice of state enterprises investing in infrastructure while private enterprises filling the gaps with homes and other "software" is a common practice worldwide that should not be a major surprise to us. But do not for a moment, lower your guard on the possible risk involved. China is building many whole-towns that are bigger than Ang Mo Kio (a high density suburb in Singapore) in all parts of the country with the confidence that they will be filled. We should start to panic if China's unemployment rate inch up to 5% or if GDP growth rate slows down to 5%. These towns could continue to be empty because farmers will stop migrating. Just so you can gauge the picture, in the last 10 months alone China has built more than 8 million public housing. They will build even more because this number is insufficient to meet demand. China is a country that is developing very fast.

Lastly, the ability of China to diversify its export dependency from US and EU to other parts of the world and to Southeast Asia will determine whether its GDP growth will slow down to 5%.

Next, consider this paper "Shanghai Slowdown turns hard", by Daryl Guppy:

"... The rainstorm that has inexorably charged the driving conditions is the slow moving collapse of Europe. The rebalancing of the Chinese economy towards domestic consumption may have been sufficient to offset the fall in exports to the US. It is, however, not enough to offset the impact of the combined export decline in the US and Europe.

Hand in hand with the restructuring necessary to increase domestic demand comes wage pressure. Put simply, poor people cannot consume beyond a basic level. To stimulate domestic demand, you need to pay workers higher wages. Wages have increased substantially in China's tier-one and tier-two cities. The government is committed to further national mandated wage increases. In the longer term, this will feed the fires of domestic demand. In the short term, it makes China's low-cost industries less competitive - factories are moving to Laos, Cambodia, Indonesia and Vietnam."

In truth China is actively exporting jobs and factories out of China. To truly appreciate, China's actions consider Hong Kong of the early 1980s.

The book "The End of Cheap China, Economic and cultural trends that will disrupt the world", Shaun Rein - the founder and Managing Director of the China Market Research Group - may shed some like on this phenomenon [an excerpt from his book in page 151]

"Plans to further broaden Chinese involvement in Africa are constantly being proposed. Top officials, led by Premier Wen Jiabao and Robert Zoellick, the president of the World Bank, are discussing relocating factories that produce lower value goods from Southern China to Africa. While this will increase pollution in Africa, and unload jobs no longer desired by Chinese onto Africans, its countries needs the jobs and the hard currency. Chinese factory owners want to maintain a cheap source of labour, but know that they will no longer find it at home as workers there demand higher wages."

I strongly believe that the Chinese are sparing no expense to build the TransAsian Railway for exactly the same reason - to find new labour market to diversify its productions so its own factory could move up the value chain and to find new market for its finished goods. The same scene will play out not just in Africa and South America but in another 5 years, it will happen right behind our doorstep in Myanmar, Cambodia, Thailand and North Korea.

Having said that, the current territorial dispute between China, Japan and other Southeast Asian nations could derail China's effort to diversify. The Straits Times reported on November 17 2012 that Obama is actively canvassing support in Myanmar right before the Asean+3 summit. Even though, no details are disclosed I believe the TransAsian Railway is currently actively pursued by all stakeholders. On the same day, in the same newspaper, it is also reported that "Work on Laos-China railway to start in 2013" even though its economic benefit [or profitability] is still questionable. The fight for its control is fierce.

To understand how China is diversifying and strengthening its manufacturing prowess and competitiveness besides cheap labour, consider the following excerpts from "The Greater Pearl River Delta and the Rise of China", by Michael Enright, Edith Scott and Chang, Ka-Mun. Page 45 states

"In the years following China's initial opening, Guangzhou and its immediate surroundings continued to play a leadership role in traditional industries.

In 2002, Guangzhou's retail sales exceeded those of any other city related services. Guangzhou's leading manufacturing industries by gross industrial output were transport equipment (US$5.09 billion), raw chemical materials and chemical products (US$4.2 billion), electronics and telecommunications equipment (US$3.67 billion) and electrical equipment and machinery (US$2.72 billion). Guangzhou provided a strong base for light manufacturers, including garments and textiles, leather goods, and plastic products. Other leading industries included ship building, food processing and sugar refinery, iron and steel production and rubber products ... the leading center ... for a range of services, including software and domestically oriented logistics and distribution.

From 1992 to 2000, Shenzhen's output in such "high-technology" industries grew at an annual rate of 53.2% per annum, reaching almost RMB106.5 billion or 42.3% of Shenzen's total industrial output value. Since 1999, Shenzhen has hosted China's annual Hi-Tech fair, the nation's leading exhibition of electronics and related products. Shenzhen's technology-based investment initially came from Hong Kong, Taiwan, Japan, Europe and the US. Over time, these companies have moved more and more sophisticated activities to Shenzhen."

These excerpts are meant to illustrate that unlike other developing countries, China industries encompassed the full "ecosystem" of industries that allow them to evolve and improve almost naturally and rapidly over time. Now they are exporting their industries overseas. They are creating a larger footprint through the transportation advantage that they have and are creating through the construction of the TransAsian Railway connecting all the ethnic Chinese in the central of Asia - namely Myanmar, Thailand, Vietnam, Cambodia and Laos. That will be their next growth engine after the development of Western China. This place will be their "Shenzhen" as they play the new "Hong Kong" as manager and innovators.

 What is the current progress of this Trans Asian Railway?

According to The Edge Singapore, "New China "Stimulus Package" set to significantly boost railway spending, by Assif Shameen in the September 17 2012 edition.

"... by the end of 2014, the network will link Kunming from where passengers could catch a local train down to the border with Myanmar ..."

What has China done in recent months?

According to The Economist, China's Economy , Slow Boat, September 1 2012.

"Some of the global headwinds buffeting China were foreseeable. Nonetheless, most economists assumed the country's policymakers could quickly revive growth if necessary. In China, in contrast to Japan or America, interest rates (and bank reserve requirements) have plenty of room to fall. China has an enviable amount of fiscal leeway. And its property slowdown largely reflects government curbs on speculative home buying that officials could leave if they so choose.

The government has done some of what was expected of it. It has cut rates and reserve requirements a bit. Infrastructure spending has picked up. In replacing business taxes with a value-added tax, the government has eased the fiscal burden on small firms."

Hence China is using this time to correct some structural issues such as replacing business taxes with VAT to give it private enterprises some flexibility and reprieve. Besides taxes, it is also correcting other issues within its economy. Read the following.

According to The Economist, China's Stock markets like it's 1999, October 13 2012.

"... In the past year they have also fallen under the wing of one of China's more vigorous policymakers: Guo Shuqing, who was appointed head of the China Securities Regulatory Commission (CSRC) in October last year.

During his first year in charge, Mr Guo has set about cracking down on insider trading, cajoling firms to pay dividends, opening the door to foreign investors, uprooting rotten companies from the exchange, and encouraging better firms to list on it, at better prices."

Carl Weinberg has this interesting view point to share.

"In July last year, food prices were rising 15% year-on-year because of bad crops in 2010. That eroded the real purchasing power of Chinese households. For people who spend 35% of their incomes in urban households and 45% of incomes in rural households, food went from a decline of 5% year-on-year to a rise of 16%. That meant there was less leftover to spend on other things. ... Since then, food price rises have slowed to 4% year-on-year increases and are now going even lower. Inflation is down from 6.5% to 3.5% and slowing. To my mind, that's as big a fiscal stimulus as you can imagine. It's only a matter of time before the slowdown in food prices turns into a resurgence of demand in China and a return to the 9% growth that we have been used to."

There is another aspect of China that should be factored in when studying China.

"According to a report published on July 31 2012, more than 16% of China's rich have already emigrated, or handed in immigration papers to another country, while 44% intend to do so soon. Over 85% are planning to send their children abroad for their education, and one-third own assets overseas."

I believe this is a result of slowing reform in China in the last few years but Mr Xi Jinping has already provided glimpses of his administration direction in the next few years. It is to direct China to follow in the direction of Singapore. Furthermore, it is an accepted norm in behaviour and aspiration among Chinese in China and overseas Chinese to provide their children with a "western" education and themselves with a retirement home in a country in the "west".

What is happening in Europe?

According to Carl Weinberg, founder and chief economist of New York-based global economic research consultancy High Frequency Economics, in an interview with Assif Shameen for The Edge Singapore October 8 2012 edition.

The crux of the problem is

"The problem is easily solvable, but politicians are making it impossible to reach resolution. We all know how to fix the banking system, which is the real issue, but the politicians cannot raise their eyes above the horizon and see anything beyond their national political objectives."

Simply because if you ceded too much you will not see yourself re-elected. Actually, the European problems can be solved using the American's way but the key difference between them are - America is a single nation whereas EU is not. Hence the central European bank cannot impose on the banks in Greece or Italy and because of such limitations are unwilling to offer help freely.

So what will happen next, Carl foresees

"I don't think the eurozone will break up. I believe that every country has a big incentive to stay in the eurozone. Next time you watch the European protests on TV, don't look at the pretty women in the front or the rioters. Look back at the parking lots at those Mercedes, BMWs, Audis. That is what Europe is all about. That's why Spain will never leave the eurozone and Germany will never throw them out. Europeans have been making too much money from what they have going. All of the iterations that we have had - EU, EC, the common market, all the way back to the 1950s - each has yielded more benefits and better trade for the people who have stayed on. But just because they stick together and nobody has the economic incentive to leave doesn't mean that they can afford a very, very sharp economic downturn, which will be triggered by a cascading series of bank failures will generate a sharp contraction of credit, which, going by the latest data, may have already begun. Eventually, it will create an economic event more akin to the Great Depression than to any business cycle we have seen in our lifetime."

On 20 November 2012, France loses its triple A rating. EU crunch time will come next year when their corporations declare their results. It will not be pretty, we will see more retrenchments, more cutback on investments and further hit to the equity market. It has actually done well in October 2012 when it established a common bank but the devil is in the details. Someone has to force them to form a single nation like the US, with a common treasury and bank. If they do, they can easily rise back like the US.

Why small country like Estonia can recover so quickly from its country capital restructuring while financial powerhouses like US and France fear to tread?

To answer this question, I would like to introduce a very interesting paper entitled "From World Banker to World Venture Capitalist: US External Adjustment and The Exorbitant Privilege" by Pierce-Olivier Gourinchas [UC Berkeley, NBER and CEPR] and Helene Rey [Princeton, NBER and CEPR].

The paper performed a detailed analysis of the historical evolution of the US external assets and liabilities at market value since 1952. They discovered sizeable excess return of gross assets over gross liabilities. This excess return increased after the collapse of the Bretton Woods Fixed Exchange Rate System. It is mainly due to a "return discount": within each class of assets, the total return (yields and capital gains) that the US has to pay to foreigners is smaller than the total return the US gets on its foreign assets. They also find evidence of a "composition effect": the US tends to borrow short and lend long. As financial globalisation accelerated its pace, the US transformed itself from a World Banker into a World Venture Capitalist, investing greater amounts in high yield assets such as equity and foreign direct investments. They use these findings to cast some light on the sustainability of the current global imbalances.

The paper also believes that, everything being equal, the depreciation of the US dollar through quantitative easing may generate a capital gain on US foreign asset holdings, which increases the return on its net foreign portfolio.

One fact: A rating downgrade of US sovereign debt rating will narrow this "return discount" and send US financial system to a free fall. This will not happen. It cannot happen. However, even the existence of another currency that allows an alternative will narrow this "return discount". This global imbalance is not sustainable. This is the reason for the deleveraging effect that we are witnessing currently.

What is the deleveraging effect?

To understand deleveraging effect we have to understand net international investment position or the net foreign asset position of a country. The net foreign asset position of a country is basically the value of asset that the country owns abroad minus the value of the domestic assets owned by foreigners. It reflects the indebtedness of the country.

A country basically funds their current account deficit through the changes in net foreign assets. Since foreign assets and liabilities are real assets. They need to be marked to market. Hence we have valuation effects. Therefore, a country's changes in net foreign assets should equal the current account plus the valuation effect.

Some countries, such as New Zealand and Australia, have very high net foreign debts due to historical reasons and their British heritage. US, UK and EU have seen their net foreign debts grown in recent years because of the positive valuation effect. They borrow to invest because their assets have higher yield than the liabilities that they owe their "foreigners".

Due to the global sovereign rating downgrades, the foreign assets yield are affected hence these nations are deleveraging. Furthermore, global equity markets are likely to trade lower over time in the next 2 years.

Note that even though most people focus on a country's external debt position. I choose a more balanced view, of net foreign asset position or net international investment position. Then we can grasp the financial muscle of the US and understand the effect of deleveraging.

Finally, why the US cannot recover as fast as Estonia is precisely because of the size of its foreign debts and net international investment position. Based on data from Wikipedia, US net international investment position is -16.9% of its GDP as at 2010 but if you look only at only the external debt perspective you will see that it is in excess of US$16 trillion as at November 2012 according to Wikipedia.

The opinions in this document are entirely the authors own and should not be construed as any professional advice.

Important note: While every care has been taken in the preparation of this document. The author makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided

References

¹ From World Banker to World Venture Capitalist: US External Adjustment and The Exorbitant Privilege by Pierce-Olivier Gourinchas [UC Berkeley, NBER and CEPR] and Helene Rey [Princeton, NBER and CEPR]

² Nouriel Roubini, TODAY's paper , 15 October 2012

³ The Edge Singapore July 23 2012 edition, Interview with Steven Ricchiuto, chief economist of Mizuho Securities USA by Assif Shameen

⁴ The Edge Singapore July 16 2012 edition, Southeast Asia appears to be safe haven as China and India stumble, by Nishant Kumar and Stuart Grudgings

⁵ The Edge Singapore September 3 2012 edition, Macquarie's Eadon-Clarke sees gloomier global and Asian Outlook, by Assif Shameen

⁶ The Edge Singapore July 23 2012 edition, Midas on a new track, by Joan Ng

⁷ Wikipedia, List of countries by external debt, http://en.wikipedia.org/wiki/List_of_countries_by_external_debt

⁸ Wikipedia, List of countries by net international investment position, http://en.wikipedia.org/wiki/Net_international_investment_position

⁹ China is Okay, Stephen Roach, http://www.theedgemalaysia.com

¹⁰ The Edge Singapore September 3 2012 edition, Shanghai Slowdown turns hard, by Daryl Guppy

 

¹¹ The Greater Pearl River Delta and the Rise of China, by Michael Enright, Edith Scott and Chang, Ka-mun

¹² BBC News , US Budget deficit rises sharply, 14 November 2012

¹³ Wall Street Journal Asia Edition , Private Lending Fills a Void in China, by Dinny McMahon, November 12 2012

¹⁴ Wall Street Journal Asia Edition , China's Banks Face Shifting Landscape, by Lingling Wei, November 12 2012

¹⁵ Wall Street Journal Asia Edition , Threat of Tax Hike Spurs Sell off, November 12 2012

¹⁶ China Today , 500 million Farmers to be urbanized by 2020, October 2012 edition

¹⁷ The Edge Singapore July 16 2012 edition, China braces for marked slowdown, by Jonathan Laing

¹⁸ The End of Cheap China, Economic and cultural trends that will disrupt the world by Shaun Rein