The Asian Hedgehog and the Fox – Page 2 – Views on Asian Economics and Markets

Contemplating Investment Regimes (Part 1)

Posted on August 2, 2020 by theasianhedgehogandthefox@gmail.com / 0 Comment

Introduction – Investment Regimes

With regards to the current investment regime (a period we define as one which spans from post-GFC till now), market narratives, we reckon, were dominated by expectations of a prolonged period of subpar growth and inflation – secular stagnation and the Japanification/zombification of major economies, highly accommodative monetary policies, coupled with rising domestic socio-political polarization and geopolitical tensions. Asset markets have largely mirrored such views (low but positive growth/inflation, stimulative monetary policy – high opportunity cost of holding cash with no carry, low “default” risks, reach for yield/growth), with risk premiums low and anchored, and volatility suppressed across most markets. Most expect a continuation.

In contrast, the release of this note reflects our belief that we are much nearer to the critical juncture than most expect; investment regimes can only sustain insofar as underlying conditions and fragilities are not pushed to the extremes. Indeed, we believe that the current regime is nearing its end as it approaches its breaking point, as prior deep fragilities and fault-lines of the current regime have been further amplified by the Covid-19 pandemic. This calls for a re-evaluation of key prior assumptions, and correspondingly the need to adjust one’s portfolio to reflect such realities.

Much of the note uses data from post-GFC to pre-Covid-19 to illustrate prior underlying conditions of the global economic/financial system. The article(s) will be divided into parts, focusing on i) a brief description of the current regime, ii) why the regime is nearing its end, iii) expected scenarios, iv) conditions and paradigms underlying the scenarios, and v) asset allocation most fitting for the scenarios.

Defining the Current Investment Regime – Low Growth/Inflation was the most plausible outcome

The lack of sustainable global aggregate demand underpins the current predicament of subdued global growth and inflation – with deep-lying trends driving the 3Ds of the global economy (elevated Debt levels, aging Demographics in major economies, & the lop-sided Distribution of income – both domestic and global). The over-reliance on monetary policy over the span of the current regime has also exacerbated leverage levels globally, impeding economic adjustments, and has played a role in widening income inequality (see box 1) – via high concentration in financial asset ownership, lack of efficacy on growth, outperformance of financial assets vs. economic growth etc). This further worsens the forces at play, essentially leading to a negative feed-back loop. The lop-sided income distribution (skewed extremely heavily towards economic/financial capital owners) in turn led to domestic political instability via rising polarization, subsequently, inevitably, leads to geopolitical tensions.

Box 1: Declining Labor Share of Global Income

Since the 1980s, the labour share of income has declined around the world, reflecting a mix of factors[1], coupled with rising inequality. This shifted income away from the consuming classes (labour, median and lower income households, debtors) with higher propensity-to-consume towards capital owners, especially rentiers, and wealthier households who save a high proportion of their incomes, working to dampen overall potential aggregate demand.

The global economic/financial system also operated under a dysfunctional global financial architecture[1], one which has failed to allow flexible/automatic adjustments of global imbalances, nor allows for global excess savings to be balanced in a growth-conducive manner. The existing global financial architecture is far from a deliberate and well-designed system, rather, it is more a concomitant of a confluence of major historical events – including Bretton Woods I & II – USD based global reserves system, the Cold War, Asian Financial Crisis, dominance of neo-liberal policies/Washington consensus, the ascension of China and its entry into the WTO, and the creation of the Euro, amongst others. The result is a combination of elements which, considering feedback loops and dynamic interactions within the system, produced a high degree of stasis with regards to global re-balancing (i.e. the presence of persistent deficits/surpluses in the same economies with no automatic adjustment mechanisms in place). These elements include i) USD as the global reserve currency, ii) the dominance of capital flows over trade flows in the modern financial system, iii) the development of “efficiency” maximization global supply chains/hubs and tax regimes, and iv) divergent and distorted political/financial/economic structures of major players in the global trading system.

These elements allowed the weakening share of labour income and rising inequality to be enabled and reinforced by a corresponding global dimension (two sides of a balance sheet), as reflected by the “secular” group of current account surplus/deficit (creditors/debtors) economies. Certain economies have doggedly pursued an export-driven, neo-mercantilist growth model to safeguard domestic stability, growth and employment. These surplus economies employed a mix of policies which directly/indirectly suppressed the labour (consumption) share of income, including financial repression, undervalued FX, fiscal conservatism, negative labour welfare reforms[2], and mandatory saving schemes, in turn forcing up their savings rate and maintaining them persistently. This came at the expense of economies with institutional setups that are “compelled” to absorb such surpluses – these usually involve free and open capital account markets (US/UK/AU/NZ/CAD, the pre-euro-zone sovereign crisis peripheral EU; these economies were recipients of capital inflows and the corresponding current account deficits). This too led to a decline in potential aggregate demand as income shifts to surplus economies, and away from the consuming classes.

The post-GFC rebalancing of excess savings did not address the root cause under-lying the weakness of aggregate demand. The US remained the most important ‘consumer of last resort’, running the largest current account deficit in absolute terms by some extent. Amongst surplus economies, a key part of EU’s post-crisis strategy was to double down on Germany’s existing growth model (which generates large surpluses), forcing a mixture of unit labor cost compression (largely via unemployment), collective FX devaluation, exploitation of regional tax regimes by specific economies (NTL/IR), and fiscal austerity across the entire Eurozone. China, on the other hand, shrank its external surpluses largely via a rapid build-up of leverage (but without a corresponding improvement in its credit-allocating institutions/processes), thereby significantly aggravating its domestic imbalances. This, together with the structural oil price decline in 2014 (inherently a massive one-off wealth transfer from oil exporters to the global consumer; giving respite in particular to major oil-importing economies such as CN/EU/IN/ID), were key drivers which helped maintain the global expansion post-GFC.

Back in 2015, we envisaged a prolonged period whereby global competition for demand will further intensify (hence the increasing reliance on monetary policies) and increasing risks of direct/indirect retaliatory measures by the US to reject its status as the global consumer of last resort. We believed global cooperation enabling structural reforms (the onus lying more on surplus economies) and the re-calibration of the global financial architecture were extremely unlikely.

Underlying Fragilities and Fault-lines

We did not see the current regime as stable even before the global pandemic, instead we argue that the above-mentioned support structures were reaching its limits, inevitably necessitating a change in the regime soon. We discuss the key factors (mostly mutually reinforcing) below.

A. Politics

US President D.Trump’s policies have essentially led to a unilateral dismantling of the current global order. Prior cooperative games among countries have shifted to one based on short term, transactional-based relationships. President Trump have made access to US demand, markets, defense and geo-political support, dependent on explicit gains that the US can recognize in the short term. Correspondingly, the fallout of such policies forces the Rest of the World to recognize the explicit costs. As such, the coming Nov 2020 presidential election is, we believe, an important event in determining the future trajectory of the global economic and political regime. The relationship between capital and labour, the role of the state, and the US’s place in the world – economic, finance and trade, geopolitics, global order – will undergo a seismic change contingent on who occupy the White House come 2021.

In addition, the world is shifting towards greater polarization, both domestic and international, reflecting a prolonged period of slow progression, if any. This is happening in many parts of the world, most evident in the US, UK and parts of Europe and Asia. Violence has also erupted in countries with weaker institutions and social stability in parts of Central/South America and the Middle East. A prolonged/deeper slowdown will inevitably lead to a further flare up of domestic/international tensions.

B. The impotency and rising side-effects of accommodative global monetary policies

We also see signs of ill effects brought about by an over-reliance on monetary policy easing globally; going forward, we are likely to enter a period in which the omnipotence of central banks will get increasingly questioned by markets. Such signs include:

i. The level of global leverage limits the scope for future debt expansion to support growth as debt servicing costs starts to bind. Furthermore, both portfolio re-balancing and signaling channels of monetary policy transmission are blunted by low interest rates and financial asset risk premiums, limiting monetary stimulus via the asset inflation channel. At current asset valuations, further non-earnings-based asset inflation would intensify existing imbalances (see box 2)

ii. Competitive devaluation, driven by divergent global monetary policies, works earlier in the cycle as economies (China, EM, US, Japan, Europe during stages across 2010-2018) with stronger demand were able to provide a lift to other economies as demand is shifted around globally via the REER channel. However, the global economy is now in a synchronized slowdown and monetary policies are moving in the same direction (growth and policy convergence) which limits the extent of potential stimulus that the FX channel can provide, going forward. In addition, protectionism is on the rise globally, partially in response to such devaluations. This is especially evident in current account surplus economies as despite falling FX (less so for their REER), trade activities continued to slow.

iii. Further, in economies where internal imbalances reflect low household share of income (vis-à-vis corporate, financial, government sector), low returns on monetary assets (risk-free rates and REER) transfer wealth away from the consumption class, leading to wider imbalances (exactly the wrong antidote).

iv. Evidence thus far suggest that JP/EU are nearing ‘reversal rates’ given the substantial negative trade-offs when rates are in negative territory. These trade-offs (based on Scandi/EU experience thus far) include lower banking system profitability, reduced rather than increased credit growth, higher rather than lower savings rates, reduced liquidity in bond markets, increasing pension liability mis-matches, and widening income inequality

Box 2: Weakening Economic Dynamism

Distortion of capital markets and ossification of the economy structure: An extended period of accommodative monetary policies have led to a preference of economic entities to inflate prices of existing assets (low costs financing, acquire existing share of demand) – financial engineering, share buybacks, M&As – over economic capital/asset creation (uncertain growth outlook), leading to depressed asset yields (income generated to asset capital values). Such behavior has also reinforced the rising monopolistic/oligopolistic nature of markets as companies with preferential capital market access are able to acquire other companies. The survival of loss-making companies and lack of aggregate supply rationalization (consolidation and corporate exits) due to low interest rates have also worked to weaken economic dynamism. The rise of loss-making “unicorn” companies with questionable business models which are supported by accommodative capital markets (typically NBFIs) are increasingly challenged by shifting investor behavior due to the fear of capital losses. All these factors weigh on the economy and have led to a further expansion in Minsky’s speculative and Ponzi finance.

C. Pain Distribution Have Extended to Surplus Economies

Political changes in the two largest current account deficit economies, the US and UK, will add further headwinds to the global economy. US President D.Trump has made trade a key policy focus, threatening and imposing tariffs and other administrative measures on economies that ran sizeable bilateral trade deficit (Asia, Europe, Canada, Mexico) with the US. US demand to the rest of the World, as such, will become increasingly volatile and uncertain, and arguably, at a lower magnitude[3]. In the UK, massive income inequality (education, employment, health opportunities), coupled with the rise in political charlatans, have led to Brexit. The weakening of the UK economy will impose costs on the rest of the world with the UK economy being the 2^nd largest current account deficit economy[4].

The increasing ‘unwillingness’ or ‘incapacity’ of large deficit nations to absorb excess savings by a much larger extent are now worsening conditions for surplus economies to make the necessary adjustments. Without sufficient external demand, maintaining balance sheet resilience via current account surpluses at the current juncture (as opposed to before when conditions were favorable) will surely entail much slower growth (S-I can only widen in a limited number of ways). Furthermore, prior tailwinds to global growth – drop in global commodity prices and CN’s build up in leverage (as mentioned earlier) – will remain limited. Without prior growth tailwinds, surplus economies are now at a critical point whereby they need to choose between economic reform/restructuring (likely at the expense of political capital and/or erosion of well-entrenched interests), or face possibly a far larger and more prolonged period of pain absorption. We briefly focus on the most important/major surplus economies:

China. China’s debt-driven economic model is increasingly reaching its limits, with the build-up of debt and financial stability risks leading to a fall in China’s debt servicing capacity[5]. Since 2008, in order to support economic growth, efforts have been made to “re-balance” the economy towards domestic demand (with massive demand spillover globally as the current account fell by close to 6%pts). First via investment by SOEs, then the local governments and LGFVs, followed by the central government through higher spending supported by the PBoC and the policy banks and more recently via higher consumption by households (through household credit – mortgage and consumer credit and proceeds from the shantytown redevelopments). As a result, the economy cyclically rise/fall depending on the policy easing (both monetary and fiscal) cycle, all the while leverage (both public and private) builds, debt servicing capacity worsens and, inevitably, growth slows further.

US President D.Trump’s trade agenda against China poses an additional risk, considering that external demand is one of the few sources of demand (outside of income-driven domestic demand) that does not require a further build-up of debt in China.

The government, under Xi, has (seemingly) changed its approach (from a signaling standpoint thus far), focusing more on increasing the income share of households and the private sector (eg. tax cuts, fee rebates, hukou reforms), while tightening its grip on credit expansion across 2018-2019. In addition, a more assertive China (in its longer-term objective to fulfill its great power ambitions) will likely seek to augment its economy structure, strategizing to acquire technology, shorten its supply chain, support onshore demand and attain economic dominance (China 2025).

The path(s) chosen, going forward, to resolve its domestic imbalances will have significant impact on both China and the rest of the world.

Europe. The recent EU recovery fund – importantly led by GE & FR – is undoubtedly a step in the right direction. At the minimum, this serves as a precedent for regional burden sharing in times of crises while potentially improving the political legitimacy/support for the EU in the South – helping reduce fragmentation risks. Taken in isolation, however, the scale of the fund is unlikely to meaningfully lift the EU out of its growth stagnation (address tail-risk but does not improve the medium-term economic circumstances). We have also noted meaningful positive shifts in debate with regards to fiscal policy/banking union domestically in GE since 2019; although this seems to be at least partially motivated by a relatively sharper domestic growth slowdown pre-Covid-19 and more importantly, a gradual erosion of its labor cost competitiveness vis-à-vis the rest of the EU in recent years. It remains to be seen if the temporary departure from its constitutional debt break induced by Covid-19 will eventually lead to a more permanent, and flexible counter-cyclical approach to fiscal policy for both itself and the EU.

Beyond that, we still see Euro-zone growth dynamics as being structurally constrained by its internal architecture (lack of fiscal union/burden-sharing, poorly-designed fiscal rules/sovereign fiscal flexibility, lack of banking union, inseparable linkages between sovereign bonds and domestic banking systems, monetary hegemony from core/creditor EU, lack of uniform regulatory capital, tax regimes, divergences in competitiveness across countries etc.) As the de-facto monetary hegemon, more structural reforms, we believe, will have to be led by Germany to be politically enforceable/sustainable.

Since the GFC, adjustments via internal and external devaluation, coupled with deleveraging, have taken a huge toll on the populace of the current account deficit economies (peripherals) as income were squeezed via a mix of unemployment, falling wages, cuts in public benefits, and weakening external purchasing power. Regional re-balancing did not occur as the Euro-zone current account surpluses were generated almost exclusively via external demand with key current account surplus economies (Germany, Netherlands) continuing to run wide current account surpluses while deficit economies gained via demand suppression/import compression, coupled with adjustments elsewhere. This acts to dampen global aggregate demand.

This led to increased domestic and intra-EU socio-political/economic tensions, and the rise in “alternative”, both extreme left/right, political parties seeking another path. A sustained period of weak growth, going forward, is unlikely to be politically stable (domestically and regionally) as the European populace – through the democratic process – will force changes, one way or another; risks of revolts against regional “rivals” and the distant, centralized, bureaucratic European institutions remain high.

Covid-19 Accelerates Cost Recognition; an Amplifier of Underlying Fragilities

The above factors, together, suggest to us an inevitable shift in the global economic/investment regime, regardless of the Covid-19 pandemic. As prior imbalances, implicit costs and tradeoffs are forced to the surface and explicitly recognized, adjustments, one way or another, will occur. Covid-19 has accelerated the timing of cost recognition, in our view, having intensified the prior tendencies contributing to the regime’s fragilities. The pandemic has brought about severe demand destruction (relative to supply), of which part of it will likely be permanent. The additional debt buildup thus far serves primarily to partially offset lost income (expensed not spent) and are unlikely to be self-liquidating – higher indebtedness to output (adding to the zombification of major economies). Income inequality will also likely worsen, with monetary policies mainly supporting capital owners while the consuming classes continue to bear most of the costs. Global cooperation – much-needed to address issues surrounding the global financial architecture – continues to be severely lacking.

We think prior fragilities are now being brought to extremes which render the current investment regime unsustainable; we are now likely to transition into a world which pushes the need to generate sustainable domestic demand to the forefront as key to safeguarding one’s place (sovereignty and domestic stability, both politically and economically). The alternative path is stagnation, but unlike before, one which is likely far more volatile and violent, economically and politically.

This will, either by choice or circumstance, force a fundamental re-think from policymakers on their respective major economic/political constructs; thereby accelerating the shift away from what is already a fragile regime near its breaking point. The transition should also entice a re-think (at the very least) over prior assumptions hardened over the past decade.

Key assumptions include:

– Global growth and inflation will remain low but positive while recession risks ebb and flow

– Central banks will be forced to keep policies highly accommodative indefinitely

– Subdued commodity prices for an extended period

– Current account deficits/surpluses (regardless of funding/growth dynamics) are inherently negative/positive

– Lenders/capital/savers will continue to dominate vis-à-vis borrowers/labour/consumers with regards to dictating future adjustments/policies

– Outperformance of asset markets vis-à-vis underlying economic performance (financial cycles > economic cycles)

Part 1: The End

[1] See http://www.theasianhedgehogandthefox.com/?p=11

[2] Labour is forced, sorely in most instances, to adjust to negative shocks vis-à-vis other sectors. Adjustments can be through uncompensated firings/unemployment, reduced hours/compensation, reduced welfare payments and state support, stringent means-testing leading to fear and exploitation, loss of insurance/medical coverage/pensions, etc.

[3] Impact of the protectionist measures on the US current account is uncertain and depends on how income is shifted among US households and corporates (consumer/produces prices), and the government (tariff redistribution among sectors), and external parties (terms-of-trade, FX, prices, margins). Others factors include the elasticity of demand and supply, degree of openness of US’s capital account, and degree of global balance of payment distortions. We believe, on the whole, that cyclically adjusted, protectionist measures will have positive implications on US’s current account dynamics – considering elasticity of demand/supply (importance of US demand) and global supply-side shifts (as surplus shifts from highly distorted economies to economies with less external distortions).

[4] Analysis based on exports to/from UK/EU is highly flawed without determining net flow of demand.

[5] PV of the future increase in production generated by the investment must be =/> than the cost of the investment. Debt has grown quicker than income.

Macro/Secular Views/Uncategorized

Our Secular View

Posted on May 5, 2015 by theasianhedgehogandthefox@gmail.com / 0 Comment

This is an Asia-centric blog that focuses on macroeconomics and markets. The inspiration behind the name of the blog is derived from Isaac Berlin’s philosophical essay which divides human cognition into two distinct categories – the hedgehog and the fox. The hedgehog views the world through a single defining idea while the fox relies on various sources of experiences/inputs, believing that the world cannot be explained by one defining concept. To put it simply by quoting the ancient Greek poet Archilochus on which Berlin’s essay was based, “The fox knows many things, but the hedgehog knows one big thing.”

While hesitant to make such a distinct and simplified categorization of the human mind, we believe that the qualities of both the hedgehog and the fox, used in the proper context, are essential in helping us comprehend the global economy and uncover investment opportunities. We are a duo – Siamese twins in investment philosophy seeking to learn from each other and hopefully from readers as well through this conduit. Hence, the name of our blog – The Asian Hedgehog and the Fox (TAHTF).

The Fox vs. the Hedgehog

The fox, in us, understands that Asia is diverse; each country with its own ethnicity and culture, as well as structural economic strengths/weaknesses, politics and demographics. It is imperative to understand the idiosyncrasies of each to navigate Asia’s diverse and fast-developing capital markets. The hedgehog in us, on the other hand, believes in the need to understand the ebb and flows of global capital flows. We find the process of achieving a concise understanding of global capital flows provides us with a proper framework to evaluate the global economy and, subsequently, establish an accurate global context for Asian financial markets. This is important as economic history has taught us repeatedly that Asia has ‘gained’/’suffered’ as a consequence of global developments, especially those which significantly alter the landscape of capital flows.

Our investment approach is conceptually simple, but yet difficult to apply studiously and consistently without proper analysis (the constant need to maintain this discipline, we feel, is where we derive our satisfaction). First, we attempt to form an accurate context of the global economy through the capital flows framework (the hedgehog), and determine what we think is the path of least resistance for the global economy. The fox – by understanding key idiosyncrasies – enables us to identify key beneficiaries/losers in our hypothesized future global economic environment. In order for such an approach to work, the hedgehog and the fox must always work in tandem, each providing verification and context for the other.

Our investment process then seeks to interpret Asian markets accurately (i.e. what is priced in) to the maximum of our technical abilities, and combine this with a good grasp of the widely-accepted narratives. The latter will aid us in anticipating future changes in expectations based on our fundamental view of the world, with the belief that future expectations are essentially what drive markets. Subsequently, we identify opportunities with the highest potential for market ‘surprises’ (i.e. where market prices are an attractive distance from where we perceive future developments). TAHTF’s cross-asset portfolio is constructed with the aim of exploiting investment opportunities in Asian financial markets via the most cost-efficient manner.

The Capital Flows Framework

The rest of our first post provides a brief explanation of the capital flows framework, as well as our secular outlook for the global economy.

The hedgehog’s framework focuses on analyzing the i) direction; ii) distribution; iii) magnitude; and iv) absorption quality of global capital flows. Before we go on, we first highlight a few key points which we think readers should keep in mind (important for readers without basic understanding of balance of payments accounting):

Global capital balances are the inverse of current account balances by definition.
Current account balances is also equivalent to the savings-investment gap. Any policies which affect the savings rate or the investment rate of the economy will also affect its current account balance and, by definition, the capital balance.
Current account balances are mostly determined by trade balances, and as such, policies which influence exchange rates, competitiveness, trade protectionism etc will affect the current account balances and, by definition, capital balances.
On an aggregate level, gross current account surpluses equate gross current account deficits. By definition, gross capital exports will equate gross capital imports, on aggregate.
As net current account balances sum to zero, on aggregate, it is thus easy to comprehend the idea that actions by major economies which affect global capital flows significantly, will have a major impact on the rest of the world. The ability to understanding how macroeconomic policies enacted by major economies affect their own current account balances (i.e. savings-investment gap) and subsequently external balances for the rest of the world is critical. This illustrates our point that the qualities of the fox – by recognizing the idiosyncrasies of major economies – can not only help enhance the robustness of the capital flows framework (the hedgehog) but also serves as a reality/feasibility check by taking into account varying economic/political contexts.
The framework is based on the assumption that the global economy will be on a more sustainable footing if (1) gross current account balances are on a smaller magnitude; (2) gross current account balances are distributed more evenly; and (3) the absorption quality of capital is high (i.e. channeled towards productive investment which boost potential growth in the long run).

Our capital flows framework looks back at modern economic history (we’d like to go further back but it’d be too much for the first post) focusing on the period from the Asian Financial Crisis leading to the Global Financial Crisis and the Euro-zone Crisis. We think this period is most appropriate, given that the inherent linkages between the crises are more conspicuous through the lens of the capital flows framework. Hopefully this provides a clear concept of our approach and how through this framework we derive our rather pessimistic secular view of the global economy.

The Capital Flows Framework

Recipients vs. Suppliers

Our framework encompasses both the recipients (current account deficit countries) and suppliers (current account surplus countries) of global capital flows – with the understanding that a country’s current or capital account is never merely a function of its own macroeconomic policies but also equally dependent on external developments. In aggregate, global net current account balances sum to zero; if a region of the global economy enacts policies through which the primary objective is to aggressively generate a widening current account surplus (this can be in the form of indirect/direct export subsidies, artificial depression of the domestic exchange rate, domestic wage suppression etc.), it is inevitable that the rest of the world will experience a widening current account deficit, to the extent that there is insufficient counter-balancing measures from the rest of the world. In reality, there are always multiple forces in play affecting global capital flows – the purpose of the framework is thus to consider the major elements and provide a coherent secular/cyclical outlook of the global economy.

From the AFC to the GFC – Asia the Major Suppliers of Capital

An understanding of both the recipients and suppliers of capital flows, we believe, helps illuminate the inextricable linkages between the AFC and GFC (and subsequently the Euro-zone crisis). Much of mainstream research have placed the emphasis on the rise in leverage as well as excessive financial asset inflation/innovation in the US and peripheral Europe (the major capital recipients or current account deficit countries. We shall use the example of Spain to depict peripheral Europe’s external balances from here on) in the lead-up to the GFC. This has not, however, been proportionately accompanied by an understanding of the suppliers of capital which funded these excesses.

In Asia’s context, the region played an important role in driving global gross current account surpluses in the post-AFC period leading up to the GFC. The AFC and the subsequent temporary loss of economic sovereignty led to an aggressive repair of external balance sheets by policymakers – largely via an economic model which focused on generating substantial trade surpluses.

The rationale was obvious – it was painfully evident that excessive and unproductive investment/consumption, funded by short-term foreign liabilities (EM Asia as a region ran significant current account deficits driven by high investment rates pre-AFC) significantly increased Asia’s balance sheet volatility. Building up international reserves thus became the priority for the region post-AFC, with international reserves seen as synonymous with ensuring its financial sovereignty.

Methods to generate trade surpluses varied amongst Asian economies (within the context of diverse policy considerations of Asian policymakers, as well as the differing political systems in Asia where varying powers of ruling parties influenced the extent to which policies could be effectively implemented), but the intention of Asian economic policy post-AFC was broadly similar – it was largely a combination of indirect export subsidy and financial repression to boost excess domestic savings (via an undervalued exchange rate, fiscal conservatism, depressed wages, immigration policy, mandatory saving schemes etc). Post-AFC, Asia adjusted largely via a significant decline in its investment rate, coupled with a pick up in the savings rate; the resulting excess savings meant that Asia began exporting capital to the rest of the world in meaningful magnitude.

In contrast, the US and peripheral Europe – given the lack of intervention by policymakers to influence exchange rates, credit allocation, financial innovation, labour policies or ‘forced savings’ (at least relative to surplus countries) – had the institutional ‘willingness’/capacity to absorb such flows, thus driving up significant current account deficits.

Global Imbalances – when the Quality of Absorption is Poor

A trade surplus-driven growth strategy in one region of the global economy naturally leads to an increased burden on the rest of the world to create demand for their goods – whether this leads to sustainable global economic growth largely depends on how such demand is created. The trade surplus-driven growth model employed by most emerging economies, including Asia, ultimately proved unsustainable in the lead-up to the GFC. Excess savings from surplus countries was absorbed by developed economies via an increase in discretionary consumption/unproductive investment. Demand in DM was fuelled by a rise in leverage and inflated financial asset valuations (the former supported the latter, which reinforced the former in a classic credit-asset cycle boom), both a by-product of capital re-cycling flows. The resulting consumption/investment binge, a reflection of illusionary temporary wealth gains amid loose credit conditions in both the US and peripheral Europe, were not fundamentally supported – as it came to an abrupt end when leverage constraints were breached.

This is not an attempt to attribute blame to surplus economies for the GFC, rather to emphasize that there will always be multiple sides to the global capital flows equation (Germany is another major capital exporter – largely through wage suppression – but the common currency in the Euro-zone meant that this was largely absorbed within the Euro-zone by ‘peripherals’ without currency flexibility to counter-balance inflows. The quality of the absorption was again poor as illustrated by the lead-up to the Euro-zone sovereign debt crisis. Latin America and the Middle-East also ran large trade surpluses which largely reflect the commodity price boom). The above casts light on an important reason for the “success” (at least till the GFC) of the trade-surplus focused strategy of Asia post-AFC: the institutional ‘willingness’/capacity of the US and European ‘peripherals’ to absorb rising magnitude of gross surpluses. From another perspective, the ‘ability’ for consumers in the developed economies to go on a consumption binge of such magnitude were aided in part by the ‘cheapening’ of exports from abroad. By extension of the above, we believe a healthy re-balancing of global capital flows entails shared responsibility from both surplus and deficit countries, in “coordinating” both the magnitude and distribution of flows.

An equally, if not more, important analysis pertains to the quality of capital flow absorption – in addition to the magnitude and direction of gross surpluses/deficits. It is not as important which region/country is running a surplus/deficit (classical economics suggest that capital should flow to economies with higher rates of return adjusted for risk), insofar as capital flows are absorbed by recipients in a sustainable and growth-accretive manner for both the local and global economy. Whether this can be achieved is more dependent, we believe, on the context and environment (such as the political/economic/governance/technological structure of the recipient economies at that point in time) rather than the state of economic development of recipient economies (e.g. the quality of capital absorption is not synonymous with the level of GDP per capita or demographics dependency ratio; conventional yardsticks which relates more closely to the capacity for rather than the quality of capital flows absorption). Finally, we believe that the efficiency and sustainability of capital flows absorption is inversely proportionate to the pace of the build-up and absolute magnitude of gross imbalances – taking into account the psychology of greed and complacency, coupled with leverage.

What Constitutes a Healthy Re-balancing?

Our main worry, with regards to the secular outlook, is the ‘unhealthy’ manner in which global external balances have adjusted post-GFC. We will cover this in greater detail, but first, we explain how, we believe, a healthy, sustainable global re-balancing should occur. The more obvious being that gross capital flows of smaller magnitude enhances the likelihood that flows may be absorbed in a more efficient, growth conducive manner. Equally important is how flows are being absorbed. A healthy re-balancing will require 1) surplus countries taking responsibility to generate aggregate demand by reducing gross excess savings in both a sustainable and growth-conducive manner (this is important as excess savings can be reduced in ways which are neither sustainable nor global growth-conducive); and 2) deficit countries to absorb capital inflows in a productive and sustainable fashion.

The policies/strategies which the global economy should employ, we believe, are reasonably well understood by mainstream economists (albeit not always within the context of global economic growth sustainability but, rather, the prospects of individual economies/region based on standalone analyses). For major surplus countries, like China, this includes a successful re-balancing towards domestic consumption as the driver of the economy, as well as a more efficient market-based capital allocation process. An example of unsuccessful re-balancing will be a messy deleveraging process in which the investment rate collapses far more rapidly than consumption. The end result may be an arithmetically higher contribution to GDP by domestic consumption, but the resulting hard landing will hardly be conducive for global growth, while the collapse of the investment rate relative to the savings rate will add to gross surpluses globally (this will likely be partially counter-balanced by a fall in the savings rate for commodity exporters, obviously in a counter growth-conducive manner). In the Euro-zone, Germany can help to achieve internal balance by moving towards a fiscal union and taking up responsibility in creating aggregate demand. For Japan, what is paramount is the successful implementation of the third arrow of Abenomics. Meanwhile, the sharp fall in global oil prices have made the necessary adjustments for Middle-Eastern oil producers in the short run. For a major importer of capital – the US – corporate and public sectors can take advantage of historically low interest rates by allocating a greater share of capital towards much-needed productive infrastructure investment/capex. Other major capital importing countries in EM Asia, such as India and Indonesia, which are facing a short-fall of domestic savings, have room to absorb flows to help boost potential growth by unlocking supply-side constraints. We will address these in greater detail in future posts.

The biggest problem (& one important factor driving our pessimistic secular outlook), in our view, is that this has yet to lead to political consensus despite broader economic consensus over the future course of action. In China, what is required is a shifting of the balance of power from the elites to the masses, notwithstanding the need to unwind its large debt stock and industrial overcapacities in an orderly fashion. Germany currently has a balanced budget constitutional obligation, and does not have a political establishment that believes fiscal stimulus is part of a wider solution for the Euro-zone. Indeed, widespread distrust within the Euro-zone has largely reduced the possibility of achieving win-win agreements, while at the same time, rising social discord threatens to break the unstable political status quo. Abenomics’ third arrow will inevitably sacrifice vested interests both in the bureaucracy and the business community. A major shift in the political consensus for any fiscal response in a meaningful manner is also required in the US. The new political regimes in India and Indonesia got off to an encouraging start in varying degree, but the hard work lies ahead when political capital diminishes, while transmission from top-down and well-intentioned policymaking may be hindered by entrenched complex political/bureaucratic systems. The list is long but the point is clear – political obstacles and implementation risks to enact what we see as necessary economic policies for the global economy are aplenty.

The Arithmetic Re-Balancing – & the Role of Monetary Policy

The burden to tackle the seeming lack of aggregate demand post-GFC has fallen largely on monetary policy around the world – as political and leverage constraints have significantly reduced the ability of governments to provide a fiscal response (most evident in the Euro-zone and the US). Yet, the ability of monetary policy to spur aggregate demand in the absence of other policy levers has proven to be largely constrained, especially in light of structural downward pressures on potential growth emanating from demographics and a lack of capital investment to support weakening productivity growth. Within the context of external balances, monetary policy has effected adjustments via two key transmission channels (and what we believe reflects the true intentions behind the QE programs of both the ECB & the BOJ) – 1) enhancing export competitiveness though a weaker currency, and 2) exporting easy monetary conditions by collapsing term premiums, in particular, to emerging economies (including Asia); indirectly subsidizing the rise in leverage in regions where leverage constraints were less binding in the immediate aftermath of the GFC. The latter, in effect, lowered excess savings in these economies. The intention of ECB and BOJ is thus not so much to generate aggregate demand internally, but rather to improve conditions to tap external aggregate demand.

We believe the over-reliance on monetary policy has affected the quality of global ‘re-balancing’ post-GFC. To illustrate the point, the charts below offer a quick summary of the ‘arithmetic adjustments’ of global external balances post-GFC:

The Euro-zone is now collectively the largest capital exporting region globally on a gross basis (led by the relentless German export engine and the massive adjustment by peripheral Euro-zone), exceeding that of China (& the whole of EM economies as a bloc). This is accompanied by the shrinkage of the US current account deficit. The major counter-balancing forces include the narrowing of Asian current account surpluses and the swing to deficits in major Latin American economies. More importantly, global gross surpluses and deficits have declined (comparing the grey bars vs. the blue bars in the 1^st chart), in what seem like healthy arithmetic adjustments on the surface (based on the argument that gross surpluses/deficits of lower magnitudes enable better absorption of capital flows globally).

Yet, we have been somewhat less encouraged by the underlying forces driving these adjustments, given the quality of ‘re-balancing’ and lopsided proforma distribution of gross deficits (which are now highly concentrated in the US). For deficit countries, the immediate aftermath of the GFC led to massive demand destruction in the form of higher unemployment in developed economies (in particular peripheral Euro-zone) which, in the absence of other policy levers to complement monetary policy, has yet to meaningfully recover. Much of the massive shift to surpluses (or the decline in deficits in some instances) in peripheral Euro-zone in particular (note Spain’s adjustment in its C/A balance from a deep deficit to surplus post-GFC) can thus be traced to the severe destruction of domestic demand, driven by weak investment which outweighed the decline in savings (in the form of higher unemployment and lower income). From the trade balance perspective, the adjustment has been made disproportionately through a decline in import demand relative to export growth. Similarly, in the US, the decline in current account deficits has been led by a decline in investment (with trade accounts helped by an improvement in the energy balance due to the shale revolution and drop in oil prices). On a gross basis however (given its still substantial trade deficit), US is now the remaining major provider of global aggregate demand, and reflects the lop-sided distribution of gross balances post-GFC. The nature of adjustment in developed economies (largely through domestic demand destruction and high unemployment) – while understandable given the ongoing need to unwind excessive leverage and the subsequent inefficacy of monetary policy to support real growth and inflation expectations – is hardly conducive for global growth in the medium term.

For surplus countries, the inability of domestic demand in the developed economies to recover meaningfully from GFC has forced economies such as Asia’s to seek domestic drivers of growth. This was partly aided by importing favorable credit conditions allowing such economies with less leverage constraints than developed counterparts to lever up at relatively cheap prices. From a savings-investment perspective, EM, ASEAN and China have made adjustments via both a decline in the savings rate and an increase in the investment rate – these in part reflects a rise in leverage in major segments of the respective economies. The main reason why we are equally pessimistic over the quality of ‘re-balancing’ is what we deem a less than efficient/productive use of leverage in EM – including Asia.

source: BIS/Bloomberg source:McKinsey

Given that this is an Asia-focused blog, we will focus on the region to illustrate our point above. Post-GFC, Asia was able to lift domestic demand growth, leading to initial tales of “de-coupling”. However, the quality of re-balancing in Asia has, in our opinion, been equally poor.

First, the run-up of private sector credit in Asia has been substantial, leading to an mature credit cycle which will hinder domestic drivers of growth. The heavy use of leverage will have been less worrying if it had been channeled towards productive investments/reforms which should, in due course, drive higher productivity and wage growth, and subsequently sustainable domestic demand growth. Instead, we see signs that leverage, in China and across parts of Asia, was used to fund unsustainable domestic consumption/investments based on unrealistic expectations of aggregate demand (both internal and external), essentially bringing forward demand from the future.

source:BIS/Bloomberg

Asia’s credit efficiency has been declining, with incremental credit growth generating less marginal product. While some of the decline reflects falling productivity from weaker global trade growth, we believe that a huge part of the decline was due to credit being channeled to unproductive spending; real estate, consumption, infrastructure and capacity expansion with low returns. The non-market based capital allocation system in China has contributed to the build-up of industrial over-capacities, given the concentration of debt in government-linked but inefficient enterprises. Asian households have also become highly geared both vis-à-vis history (HK, KR, SG, TH, MY) and in absolute terms, driven by most part rising asset prices (HK, SG) which can unravel quickly through negative feedback loops (especially if leverage is concentrated and inequitably distributed) and non-productive consumption (KR, TH, MY).

We will explore the details in more detail in future posts, but the key point remains that the quality of rebalancing, from both deficit and surplus countries, has been poor.

What Lies Ahead – the Secular Stagnation Debate

We feel encouraged that the ongoing secular stagnation debate has helped shone light on the role global capital flows play in international economics. Ben Bernanke, in his new blog, highlighted the role that international capital mobility can play in mitigating the risk of secular stagnation in the US. While seemingly theoretically possible idea, it neglects the quality of re-balancing and the absorption of flows; in effect, the idea fails to take into account idiosyncrasies of different economies. Moreover, we see more reasons for skepticism regarding free international capital flows especially considering exchange rate regimes of key economies in the modern world. China runs a broadly fixed exchange rate vis-à-vis the US, . Meanwhile, the Euro-zone runs a gold standard-like monetary regime amongst economically heterogeneous nations with the central bank, we think, seeking to achieve external surpluses for the entire bloc via a weakened currency. In order for the latter to be successful, it is, by necessity, that the devaluation of the euro has to be of a magnitude sufficient for peripheral Euro-zone to achieve superior relative price competitiveness (or else high unemployment will continue to account for the bulk of the cost adjustment) – an adjustment of that magnitude will mean that euro will remain substantially ‘too “cheap”’ for stronger countries within the Euro-zone (i.e. Germany – the subsequent impact on the country’s external balances is clear). Ben Bernanke envisions a world with minimal policy intervention on currencies, trade and capital flows. This is perhaps a more theoretically-driven idea that is largely not within the context of the current day economy.

Under the capital flows framework, we see three potential, and more, realistic outcomes for the global economy in the medium term. Determining the path of least resistance, we believe, will go a long way in resolving the secular stagnation debate:

Global cooperation with major economies enacting growth conducive and sustainable policies thereby facilitating a healthy rebalancing of global external balances. This may help support conducive and sustainable growth for the global economy and dispel secular stagnation fears
Global competition for demand through reliance on monetary policy continues – major economies are fixated on driving external surpluses and compete for weak, marginal external aggregate demand resulting in a less than favorable collective outcome. Gross balances globally remain largely status quo (though the magnitude will likely be exacerbated) – with the American consumer primarily the ‘buyer of last resort’ for the global economy. Such high level of dependence on a single country to generate global aggregate demand is likely to prove ultimately unsustainable – but may aid a cyclical recovery in the global economy
Global competition for demand through reliance on monetary policy continues – major economies are fixated on driving external surpluses and compete for weak, marginal external aggregate demand resulting in a less than favorable collective outcome. However, US policymakers acknowledge the negative impact of a strong USD on the US economy and introduce retaliatory measures to reject its status as the buyer of last resort. This will have a greater negative impact on global aggregate demand and may prove the secular stagnation hypothesis right

Our base case scenario is mostly a mixture between scenarios (2) and (3). On a global basis, we see US as the only major economy with a reasonable degree of institutional ‘willingness’/capacity to absorb greater capital flows (neo-liberal economic philosophy; limited scope for QE; reserve currency status; partial healing of the aggregate household balance sheet etc). On the other hand, we believe the magnitude will also be substantially more limited compared to the previous cycle given still significant domestic leverage constraints and income imbalances. This will also raise the possibility of direct/indirect ‘retaliatory’ measures (possibly in the form of continued easy monetary policy/macro-prudential policies to mitigate financial stability concerns). Our base case scenario will thus assume a low level of aggregate demand for a prolonged period of time, with continued reliance on central banks’ credibility to underwrite financial markets’ volatility. This is a longer-term secular outlook, and will partly be in contrast to the cyclical view, which we will present in the following post.

The implication of the secular view for Asia is obvious – the export-driven growth strategy will no longer work, considering Asia’s economic size, given the lower magnitude of capital flows that the rest of the world can absorb sustainably. As such, Asia requires a new growth model only possible via a new set of reforms. Such opportunities exist, ranging from labour market liberalisation (CN, KR, IN, ID, PH), infrastructure investments (CN, IN, TH, ID, PH), welfare enhancements (KR, CN, SG) and institutional reforms (CN, IN, MY, TH, ID, PH). Over the longer horizon, we are more optimistic on economies which have made significant progress on this front.

It is a lot to cover for the first post but we believe provides us with ample scope to expand and explore key issues in greater detail in the future. We will follow-up with our cyclical outlook and end our first series with a construction of the TAHTF portfolio.

Next-up: TAHTF’s Cyclical Outlook