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2009-05-12
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Stimulating away our problems?

Andy Xie/May 10, 2009

Momentous news continue to dominate the global economy: (1) the outbreak of the swine flu threatens tourism industry-one tenth of the global economy, (2) the Chapter 11 bankruptcy filing by Chrysler casts uncertainty on the global auto industry-4% of the global economy, and (3) the delay in releasing the results of the US’s ‘banks stress test’ is raising suspicions that many banks are insolvent. These three industries in the news are about one fifth of the global economy.

On the other hand, policymakers continue to speak of ‘signs of stabilization’ and ‘green shoots’, Japan have announced another stimulus package, and China’s bank lending is zooming. The positive rhetoric by policymakers and the anticipation of effects to come from past stimulus and the possibilities for further stimulus have boosted financial markets substantially. Global equity market (MSCI World Index) was up by 26% by May 1 from its March low, though still halved from the peak in November 2007

The flow data suggest that the global economy is bottoming. The retail sales in the US are probably stabilizing, after declining nearly 10%. Japan and the UK’s are probably picking up sequentially from the first quarter. The trade data are suggesting the precipitous drop in the last quarter of 2008 and first quarter of 2009 is coming to an end. The global trade is probably stabilizing at a level one fifth less than the peak in the first half of 2008.

As I have written in this page several times, the last quarter of 2008 and the first quarter of 2009 would see a global hard landing, stability would return in the second quarter of 2009, and the global economy would see a stimulus-inspired bounce in the second half of 2009. However, I continue to believe that the economic difficulties will last for years and the global economy may dip again in 2010.

The stability that we are seeing is mostly due to liquidity support for the corporate and household balance sheet. The bursting of the property-cum-credit bubble severely damaged the credit worthiness of businesses and households. As market refuses to roll over their debts, they have to sell assets to repay their debts. Of course, when everyone wants to sell, the price would be extremely low, potentially bankrupting everyone. Central banks and governments have replaced market to roll over their debts. Without the immediate pressure to pay back debts, businesses and households are not under pressure to change their habits. What this implies is that the current stability is based on the government support. When this support is removed, problems will return.

Many would argue that, once the economy grows, the problems that businesses and households face will vanish under a rising tide. For example, improving earnings will make businesses more credit worthy. Market will become willing to roll over their debts. Household income improves in a rising economy, which boosts property demand and property price. Rising property price will improve home loan quality and decrease borrowing. Essentially, we could grow out of the existing problems.

The ‘stimulate and grow out of our problems’ strategy that everyone seems to be pursuing will not work. It may lead to rampant inflation, currency collapse and political instability. The current economic difficulties are structural in nature. The global bubble caused severe distortions to supply, demand, and income distributions. The bursting of the bubble has exposed that all the pieces in the global economy don’t fit together. The liquidity is like the glue that holds the pieces together for now. Unfortunately, the glue will wear off overtime. It merely postpones the inevitable adjustment.

Take the auto industry as an example. At first sight it seems far away from the property-cum-credit bubble. It is actually part of the bubble. On the supply side, the auto industry has suffered overcapacity for years. Why hasn’t it adjusted? Cheap credit allowed everyone to keep excess capacity. Further, financial businesses like GMAC were being used to subsidize automakers’ operating businesses. Of course, the financial arms of the automakers were part of the credit bubble. On the demand side, cheap credit enticed buyers to change cars frequently. The zero down payment-and-zero interest rate financing vastly exaggerated auto demand. Global vehicle sales may fall below 55 million in 2009 from the peak of 62 in 2007. Even when the global economy stabilizes, the sales won’t go back to 62 millions.

The current global sales are below the 2004 level. On the other hand, the auto industry has added nearly 20 million in production capacity since. Just think the industry had massive overcapacity before. The global auto industry needs to shrink one fourth at least. But, if you listen to the industry, they are talking about growth opportunities like electric cars and are demanding government subsidies. Mark my words: electric car is a concept that will waste massive amount of taxpayer money. Every time the auto industry is in trouble, it talks about new products. That’s how it sucks in money to stay alive.

Hybrid car is a mature technology that saves one third or more of fuel and survives in market without government subsidy. This technology is good for the next five years. Why is the push for government subsidy to produce electric cars that cannot travel far without recharging and the charging infrastructure isn’t there? Electric car may become commercially viable in a decade. Market will find the right technology and the right balance. If government wants to help, it should pump R&D money into research centers, not subsidizing the production and purchase of unviable product.

Chrysler’s bankruptcy won’t solve the industry’s problem. The US government intends to use the process to force its creditors to accept 80% write-down on their debt holdings. After wiping out shareholders 100% and debt holders 80% the company seems to be able to survive. However, it survives because of the capital subsidies, which puts pressure on other producers that have the same financial burden. It starts a vicious cycle that forces other automakers down the same path.

The bottom line is that the global overcapacity is equal to the US sales time two. The demand and supply are roughly in balance if two of the three US automakers shut down for good, not restructured or revitalized. However, it doesn’t look that way. The political process seems to be wiping out shareholders and bondholders first and use taxpayers’ money next to keep an over bloated industry alive. The industry will destroy capital for years. When governments subsidize electric cars, it would waste more money. If you invest in the auto industry, you will likely lose.

In a desperate effort to boost automobile demand, Europe and the US are offering car owners incentives to junk old cars for new ones. This is just advancing future demand. It lessens the pressure on the auto industry to restructure and stretches out the problem. Auto industry is an example that the current economic difficulties couldn’t be overcome by stimulus and governments are not yet on the right path.

Transactions in secondary property market have picked up recently in China, the US, and many other economies. Many pundits interpret the data as signs of the market recovering. Property is at the center of the current crisis. If it is recovering, the global economy is surely to follow. I think this interpretation is wrong. The pickup in transaction volume is a response to price decline, which is adjustment, not recovery. When a property bubble bursts, it tends to be a protracted affair. After a significant price decline some buyers who couldn’t afford the property before but can now come in. After such buyers are exhausted, the market declines again to attract potential buyers further down the price curve. The process ends until the market drops at or below historical average ratio of price to income. I believe property market would bottom earliest in late 2010 and could do so in 2012.

Retail sales seem to be stabilizing in all major economies. This may be temporary and certainly doesn’t presage a significant recovery. After a bubble bursts people cut back and adjust downward their expenditure level. But defending lifestyle is a powerful force; the cutback may not be sufficient. When people realize how much poorer they have become, they may have to cut again. Unemployment rate is still rising around the world, which is a headwind to consumption. The wealth and income developments remain negative for consumption through 2009 and probably 2010.

My interpretation of the current situation is the same as I forecast at the beginning of the year. The global economy is stabilizing in the second quarter at about 3% below the average level in 2008 and probably 6% below the peak level in the second quarter of 2008. The economic collapse in the past three quarters is certainly the biggest since the 1930s. The second half of 2009 could see a stimulus-inspired bounce that may see the global economy up 2% or so. Neither the current stability nor the bounce in the second half would signal the return of good growth. The global economy may see a second dip in 2010 and sluggish growth for several years afterwards. The reasons are that the supply and demand of the real economy are not matched and European and the US governments are dragging their feet on recapitalizing their banks.

I discussed the sorry state of the automobile industry above. Far more serious is what’s going on in the financial system. The odds are that the losses undisclosed or to occur within European and the US’s banks are more than their equity capital. These banks are technically bankrupt but survive on government guarantee of their debts. If a bank can borrow, it doesn’t have to fold shop even if it doesn’t have any capital. However, they couldn’t function normally like lending to all credit worthy borrowers. They are likely to maximize interest spread to recapitalize themselves instead. This ‘earn your way back’ scenario is exactly what European and the US policymakers are hoping for.

However, even if this strategy works, it will take a long time. If banks earn 15% annual return on their capital, a very optimistic scenario in a poor economic environment, it would take over five years for the banks to recapitalize. If the losses are twice as much, a conceivable scenario, it would take ten years. Before then the banks won’t lend normally. And the global economy would stagnate that long.

Economic stagnation could have nasty social and political consequences. Europe, for example, seems unstable. Its unemployment rate is heading back to double-digit rate like a decade ago. Its unemployed youth are in a rebellious mood. Its aging problem is far worse now. The baby boomers who are retiring are desperate to hang onto their expected benefits. They will react violently to any cutback of their pension and other benefits. But, European governments all suffer from unsustainable fiscal deficits. They have to raise taxes or cut benefits. If they do the former, their economies will deteriorate further, and unemployment may surge to endanger social stability. If they do the later, the baby boomers may rebel. Europe is a mess for the foreseeable future.

The ratio of US household debt to income needs to drop by one third or more. Saving more is the right thing to do. But it keeps consumption down. It will take at least five years for the US household sector to bring debt level down to its historical mean, which means a sluggish US economy for five years.

Many, if not most investors, refuse to accept that scenario that the global economy will take a long time to heal. They hang their hope on government stimulus and its potential to bring on another asset bubble. The theory-‘get the stock market up and everything else will follow’-is very popular among institutional and retail investors. Such sentiment can make the stock market go up for a period of time. But, ultimately, it will fail. The hoped-for improvement in fundamentals won’t materialize.

As governments and central banks around the world try to solve structural problems with stimulus, the global economy is probably heading towards stagflation. Despite exceptional demand weakness oil price has been rising. The current price of over $50/barell cannot be justified by demand and supply balance. Rather, financial demand and supply withholding are the drivers. Money has been flooding into exchange traded funds that buy oil futures. Oil exporting countries are cutting production. They think that it is better to keep oil underground than to exchange it for paper currencies that could drop precipitously in value. Rising prices of oil and other commodities, driven by inflation expectation, could trigger inflation in 2010 despite a sluggish global economy. We could be witnessing a replay of the 1970s.

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