Wednesday, June 8, 2016

9, 8, 7, 6.7,... Speculating on China growth

The deceleration of China's GDP growth rate has been seen both as a natural transition towards more sustainable growth rates and a sign that the Chinese model of growth is coming to an end. How does this deceleration of growth rates compared to similar historical episodes for other countries? Is 6-7% a sustainable growth rate for China?

Let's frame these questions in the traditional model economists use to look at growth rates of emerging and low-income economies: the convergence model (based on the work of Robert Solow). The main prediction: countries that are lagging have more opportunities for investment and they are likely to grow faster than countries at the technology frontier. Because of faster growth rates we expect to see convergence in GDP per capita. As convergence happens, growth rates will naturally slowdown to reach those of the countries at the frontier. [The theory also states that not all countries might converge to the same level of GDP per capita but let's ignore that for a second and focus on the predictions of relative growth rates.]

Start with an example that nicely validates the theory: South Korea. Let's plot the level of GDP per capita of South Korea relative to the US at the beginning of each of the last three decades and then compare it to the growth rate of GDP per capita during the years that followed [I will treat the 2000-2014 period as the "decade of the 2000s"].



The plot above (click on it for a larger picture) shows that South Korea starts in 1980 with a level of GDP per capita below 20% of the US leading to annual growth during the 1980-90 period of about 7%). This allows the country to reach a level of 30% relative to the US by 1990. At that point growth is decelerating and during the next 10 years it goes below 5.5%. The transition continues with decelerating growth during the next decade (around 4%). Today South Korea has a GDP per capita of about 65% of the US level and it is likely that over the coming years we will see a further slowing down of its growth rate as it continues its convergence towards the US.

So far so good for our theory. How about China?



In 1980 China starts at a much lower level of GDP per capita and, consistently with our logic, a very fast growth rate of about 7%. But as the country converges towards the US growth rates accelerate to above 8% during the 90s. One potential explanation for this acceleration is that China was moving towards a more natural growth rate given how low its GDP per capita was relative to, say, South Korea. But the next decade  (2000-2014) will bring yet one more increase in growth rates towards 9%. At that point the growth rate looks spectacular compared to the case of South Korea. To put it in perspective, by 2015 China has reached a level of 25% of US GDP per capita (the vertical red line) and when South Korea had reached that level it was already growing at less than 6%. The comparison to South Korea makes clear that growth rates of 8-9% in China given its current development would have looked like a true miracle.

What if South Korea is used to benchmark future Chinese growth rates? Given the current GDP per capita of China, we are looking at a growth rate of slightly below 6% over the next decade. And a growth rate that will decelerate further as time passes. This number is slightly lower than the current target of the Chinese government, but not far given that we are talking about 10 years in a path that is likely to be one of decelerating growth rates. [Note that the growth rates above are in per capita terms. Working age population is currently not growing much in China so the GDP figures should not be too different].

Final question: is South Korea a good benchmark for China? Let's look at other potential fast-growing economies during the same years.




South Korea is clearly the best performer in the range of countries that are below 50% of the US GDP per capita (and, yes, there are plenty of failures!). So using South Korea as a benchmark is providing a very optimistic case on Chinese growth. There are a few other countries that look like outliers (from above) in this relationship but it is unclear that they are relevant examples for China. Hong Kong and Singapore are small city states. Ireland in the 90s is a very unique decade for a European country, and oil producing countries (such as Norway) have dynamics that cannot be replicated without that level of natural resources.

In summary, the deceleration of GDP growth rate in China seems like a natural evolution of the economy as it follows its convergence path. Growth rates around 6% still put China as the best performer among all countries in the world, conditional on its level of GDP per capita. There are plenty of other countries in the world that show China what low growth rates of GDP really look like. And they might be an example of what could happen to the country if it cannot keep its policies and institutions among the best in class for its current level of development.

Antonio Fatás

Thursday, June 2, 2016

The asymmetry of inflation or the ECB?

From this Financial Times article: In yesterday's press conference Mario Draghi was asked about the possibility of changing the ECB's inflation target. His answer is very revealing about the extreme asymmetric nature of monetary policy these days (or at least that's how the ECB sees it).

Draghi admits that the ECB is having a very difficult time reaching its target and he is now hoping this will happen by 2018. He rules out the idea of lowering the inflation target (to make reaching the target easier) because this would lead to lower inflation expectations and higher real interest rates. So what about raising the inflation target to avoid falling into the zero lower bound again (and possibly to show a stronger commitment to higher inflation)? According to Draghi it would make no sense because if they cannot reach a 2% target why would you set a higher target that you cannot reach by an even larger margin.

This might be a realistic view on how asymmetric the effects of monetary policy are these days but it also reflects on the difficulties that central banks have at communicating their targets and policies. And possibly how this confusing communication is making their actions less effective. Here are some thoughts:
  • Mario Draghi forgets that the ECB target is asymmetric in nature. The target is below (but close) to 2%. That's a signal that falling below the target is ok while being above is unacceptable. Maybe this asymmetry is partly to blame for the difficulty of reaching 2%. 
  • In his speech he clearly states that lowering inflation is always easy but that raising inflation because of the zero lower bound is much harder. But this sounds to me like a very strong argument in favor of higher targets. The fact that he does not see it that way tells us that the ECB is really averse to higher inflation.
  • The idea that the same asymmetry is present when it comes to inflation expectations might be realistic but, in my view, it sounds too pessimistic. It might be true that raising inflation is hard but not impossible. Setting a higher target should move inflation expectations in the right direction and help reach that target. The fact that he does not see it that way is, once again, a reflection of the asymmetric view of the ECB about inflation.
So maybe the asymmetry that he sees is not completely independent of the asymmetric view that the ECB and its officials clearly express every time they talk about the subject.

Interesting times for monetary policy and a reminder that we need to change the way we teach monetary policy to our students. Olivier Blanchard has some interesting suggestions for how to modify the next edition of his textbook after what we have witnessed in the crisis but I think that he might be falling short on the changes we need to explain central bank policies and their outcomes.

Antonio Fatás

Tuesday, May 31, 2016

How informative is the slope of the Yield Curve?

The yield curve is becoming flatter. The difference between the 10-year and 2-year government bond is now approaching 1%. The yield curve tends to get flatter when the economy reaches the end of an expansion phase and it is many times seen as a predictor of future recessions.




But interest rates are not what they used to be. If short-term interest rates are stuck at zero, all the movements in the yield have to come from long-term interest rates. This is the opposite than what we have seen in previous cycles where all the action has come from short term rates.

The 2-year rate is not quite zero and has been moving recently, so an interesting question is whether the yield curve is once again driven by movements in short-term rates. Not quite. Let's calculate the correlation between changes in the slope  of the yield curve (measured as 10 year minus 2 year rates) and the changes in the 2 year rate. The correlation [calculated over a 3 year window] is plotted below.

 

If the 10 year rate did not move and all the action was coming from the 2 year rate this correlation would be -1. Prior to 2011 this correlation was always negative and in some cases as high as -0.6 signaling the importance of changes in short-term rates as drivers of changes in the slope of the yield curve.

But as of the summer of 2011 this correlation has turned positive indicating the importance of movements in the long-term rates and the way they are correlated with the 2-year rate. As an illustration: an event that causes both short-term and long-term rates to move down but where the 10 year rate falls by more would lead to a positive correlation between changes in short-term rates and changes in the slope of the yield curve.

So we are living in a new world where change in the slope of the yield curve are driven by a combination of changes in both short-term and long-term rates that are not easily mapped into previous cycles. Where the yield curve goes from here is an open question. A strong recovery and an increase in inflation expectations could result in an increase in its slope and possibly the return towards more normal times. A negative event could potentially lead to a further flattening of the yield curve and one more step towards Japanification of the US economy.

Antonio Fatás

Wednesday, May 4, 2016

World growth: mediocre or pathetic?

The recent disappointing performance of the world economy has been labelled as the "new mediocre" by Christine Lagarde, the "new reality" by Olivier Blanchard and the "new normal" by many others.

How mediocre is global growth? The answer to this question heavily depends on the way we measure world GDP. Aggregating national GDPs can be done in two ways: using market exchange rates or using PPP (purchasing power parity). Because PPP puts larger weights on emerging markets and because these countries have shown faster growth rates in recent decades, the two measures have been diverging over time and now they offer a very different picture of the state of the world economy.

Below I plot world real GDP growth rates (smoothed by taking a 7-year centered average) measured at market exchange rates and PPP (both data are produced by the IMF).



During the early 80s both measures were identical because emerging markets did not grow faster than advanced economies (plus their relative size was smaller). Since the 90s the gap opens and reaches a maximum of about 1.5% a year during the mid 2000s, the time when emerging markets were growing at their fastest rate.

What do we make of the last decade? Using the PPP yardstick it simply looks like a return to the rates of early decades. The exceptional years where the 2003-2008 period where the world grew above 4%. Rates of 3-3.5% look normal.

But using market exchange rates recent data paints a picture of mediocrity (or worse). Rates in the range 2-2.5% are very low by historical standards. The last years feel like the worst years we have since in terms of growth.

Which of the two numbers is the right one? The use of PPP is justified when measuring improvements in living standards. The larger weight given to emerging markets makes sense given that the volume of goods and services they produce is larger than what a market exchange rate conversion suggests.

But from many other perspectives market exchange rates make more sense: financial flows are aggregated using market exchange rates so from the perspective of financial markets the market exchange rate GDP measure might be more precise. Also from the perspective of a multinational company looking at the world economy as a source of demand market exchange rates are likely to provide a better picture of the state of the world.

It is therefore not surprising that when we look at the state of the world economy what looks like returning to earlier growth rates for some might look like mediocre (or even pathetic) growth for others. Make sure you read the footnote before you check the next chart on the state of the world economy.

Antonio Fatás

[And talking about footnotes here are two: First, the data above includes forecasts for the years 2016-2018 to calculate the last years in the chart. Second, an interesting question is what happens to world growth rates as PPP rates change -- one day prices in emerging markets might be as high as those in advanced economies. This is not captured in the chart above. The IMF and others use the latest PPP estimates (2011) as a base for international prices when calculating PPP adjusted data for all years in the sample.]

Tuesday, March 29, 2016

Central Banks need to get real (not nominal)

While the ECB and Bank of Japan are exploring negative interest rates, the US Federal Reserve is preparing us for a slow and cautious increase in short-term interest rates. Long-term rates remain at very low levels and inflation expectations have come under pressure and also remain below what they were a few months or years ago. And as this is going on markets are trying to figure out if they like low or high interest rates. And even if they decide that they like low rates, are negative rates too low?

In all these debates there seems to be an unusual amount of what economists call money illusion or lack of understanding of the difference between nominal and real interest rates. This confusion, in my view, is partly motivated by the communication strategy of central banks that seem to obsess with the asymmetric nature of their inflation targets (for both the ECB and US Fed, inflation targets are defined as close but below 2%) and are not clear enough on their final goal and its timing.

How do we want interest rates to react to aggressive monetary policy? The common answer is that we want interest rates to go down. This is correct if we think in real terms: given inflation expectations (or actual inflation), we want interest rates to move down relative to those inflation levels. But in some cases, in particular when inflation expectations are lower than what central banks would like them to be, the central bank by being aggressive is targeting higher inflation expectations and this can possibly lead to higher nominal (long-term) interest rates.

This is what happened in the three rounds of quantitative easing by the US Federal Reserve. 10-Year interest rates went up which was a signal of increasing inflation expectations (and even higher expectations of future real interest rates). This was seen as a success.



But the behavior of long-term interest rates or inflation expectations in response to recent communications by central banks has gone in the opposite direction. Long-term rates have come down (in particular in the Euro area). But don't we want lower interest rates? Isn't this the objective of massive purchases of long-term assets by central banks? Yes if we talk about real interest rates but not obvious if we talk about nominal ones. What we really want is inflation expectations (and inflation) to increase and this is likely to keep long-term interest rates from falling so much. 

And here is where I feel the central banks are not helping themselves. There are two mistakes they are doing: in their messages about interest rates they do not distinguish clearly between nominal and real interest rates. What I want to do is to send a message that real interest rates will remain low for an extended period of time to ensure higher inflation ahead and to ensure that nominal interest rates increase in the future so that we can escape the zero lower bound. By talking only about nominal interest rates central banks are sending a signal that we will be stuck at the zero lower bound for a long time, a message that seems to be an admission of defeat. They cannot get out of this trap.

And this leads me to the second mistake of central banks: their asymmetric view of their inflation target. In the US, inflation and core inflation is slowly moving towards the 2% target. This is seen by some as a proof that the zero lower bound or the deflation trap has been defeated. But this is the wrong reading. The fact that the federal funds rate remains so close to 0% means that we are still at the zero lower bound or close enough to it and we should not be complacent with what we achieved. The US Federal Reserve should only call it a success when the federal funds rate is back to 3% or higher, safe away from 0%. But to get there we need to shoot for higher inflation, at least temporarily. The same message or even stronger applies to the ECB. 

In summary, success in escaping the zero lower bound should be judged by how central bank interest rates manage to move away from 0% not by how long they stay at 0%. Central banks are not communicating this clearly because of the fear that this would be interpreted as a message of future tightening of monetary policy. But by doing so they are hurting their ability to escape the deflation/lowflation trap.

Antonio Fatás




Thursday, March 10, 2016

ECB: I cannot do whatever it takes

The ECB just announced a further reduction in interest rates, extended its QE program by increasing the rate at which buys assets, beefed up the TLTRO program and extended its horizon. It all sounds like good news and many of these actions had been expected in the last meeting of 2015 and they did not happen. Markets reacted very positively on announcement but later, after the press conference, they went down to levels that were significantly below where they were before the announcement.

It is always hard to comment on why markets react in a certain way to monetary policy announcements but I must say that watching the press conference I learned about the state of desperation and possibly confusion of the ECB, which was not very reassuring. It might not be their fault, this is life when central banks hit the zero lower bound on interest rates and there is very little they can do. And the available tools are not easy to communicate to markets and the general public. An extra 20 billion for QE, including corporate bonds, loans to banks that have an interest rate contingent on the amount of net lending are all policies that are much harder to understand and calibrate (even for economists) than a reduction in interest rates.

So what did we learn yesterday? That the ECB wants to do more but that there is no magical tool that will get the Euro area out of where it is. That the ECB is willing to do more, despite some of the internal resistance, is good news. But the message (explicit and implicit) that they have clearly reached their limit is bad news. From the press conference it was clear that interest rates cannot go down any further. And when it comes to QE there is always room for enlarging the set of assets that are included in the program but the Bank of Japan has tried that for a while without great success.

In summary, the zero lower bound trap is a real one. In the absence of aggressive fiscal policy or a sudden and large improvement in the world economy, the ECB is going to have a hard time reaching its inflation target or helping the Euro zone economy return to normal growth rates.

Whatever it takes to fix this does not seem part of the tools that the ECB has at its disposal. And I do not want to think about what future ECB press conferences are going to look like.

Antonio Fatás

Thursday, February 4, 2016

A 2016 recession would be different

If the US or the Eurozone entered a recession this year, a few macroeconomic variables would look very different relative to previous recessions.

1. The Yield curve would be very steep. Unlike in any previous recession when the yield curve was flat or inverted.

















2. The real federal funds rate (or the ECB real repo rate) would be extremely low and would be at a level similar to that of the beginning of the expansion. Unlike in previous recessions where the real central bank interest rates was high relative to the beginning of the expansion.

3. And nominal central bank interest rates would be stuck at zero so there will be no room to lower them in response to the recession. Unlike in previous recessions where nominal interest rates came down by about 4-7 percentage point (this is also true for real interest rates, see previous chart).

So maybe this tells us that a recession is not about to happen. But if it is, the lack of space to implement traditional monetary policy tools should be a big concern for policy makers. If a recession ends up happening, helicopter money will likely become a policy option.

Antonio Fatás