Friday, July 19, 2013

China getting close to hit the Great Wall

In a New York Times column Paul Krugman makes the point that the Chinese economy is going to have difficulties continuing growing with its current model. He uses the expression that China is about to hit its Great Wall (from an economic point of view). A few years ago, Ilian Mihov and I wrote a paper that we labelled "The Great Wall" to talk about the challenge that many countries face going beyond a certain level of development. Others have referred to this as the "middle-income trap". Let me repost a blog post from last year (March 2012) where we updated our analysis, for those interested in the topic.

Reposted from March 26, 2012

Last week China's Vice Premier Li Kequiang mentioned that reforms in China have now entered "a crucial stage and cannot be delayed." And a few days earlier Prime Minister Wen Jiabao explicitly referred to the need of a second phase of growth and talked about how "political structural reform" needed to follow economic reform. In its absence "such a historic tragedy as the Cultural Revolution may happen again." These two quotes fit nicely with an article we published three years ago about how China needed to increase the pace of reforms to eventually join the club of rich economies.

The argument that institutional quality is important for growth is not new and many have written about it, but our emphasis is on the changing relationship between institutions and growth at different stages of development. In the early phases of growth the relationship between institutions and income per capita is very weak (no need for radical reform) while it becomes very strong for higher levels of development.

We just updated our original chart with more recent data (2010) and the result is shown below (institutional quality is measured as the average of the six governance indicators produced by the World Bank; GDP per capita is adjusted for PPP).

The conclusions of our previous work remain. The chart suggests that there are two phases of growth. A first one where institutional reform is less relevant. When we look at the chart we see almost no correlation between quality of institutions and income per capita for low levels of development. To be clear, not everyone is growing in that section of the chart so it must be that there is something happening in those countries that are growing (moving to the right). Success in this region is the result of good "policies" in contrast with the deep changes in institutions that are required later (you can also call them economic reforms as opposed to institutional reforms).

The second phase of growth takes countries beyond the level of $10,000-$12,000 of income per capita. It is in this second phase when the correlation between institutions and income per capita becomes strong and positive. No rich country has weak institutions so reform becomes a requirement to continue growing.

In our original article we called this region "The Great Wall". Economies either climb the wall to become rich or they hit it and get stuck. Economies that illustrate the notion of hitting the Wall are the former Soviet Union that collapsed after not being able to "go through" the Wall with its institutional setting; or Latin American economies such as Venezuela or Argentina which have incomes around that level and do not seem to be able to take their economies to the next step.

We named that threshold "The Great Wall" as a reference to China: a country that over the last decades has displayed the highest growth of income per capita in the world with a set of institutions that are seen as weak (at least relative to advanced economies). China is once again highlighted in our updated chart above and what we can see is that, while it is still in the first phase of growth, it is getting closer and closer to the Wall. It is therefore not a surprise that in the last weeks we have heard senior officials in China talking about the challenge of the next phase of growth.

Characterizing the two phases of growth and making explicit the necessary reforms that are needed to go from one to the other is not an easy task and it is likely to lead to different policy recommendations for different countries. For a very detailed analysis of institutional reform, I strongly recommend the recent book by Daron Acemoglu and James Robinson Why Nations Fail. Their work highlights the need to develop inclusive institutions to allow for the second phase of growth (you can read their thoughts at their blog and find there a link to their book). Others have presented alternative views of how to think about the different phases of growth, as it is the case of Dani Rodrik, who emphasizes the role that different sectors play in this transition.

Antonio Fatás

Friday, July 12, 2013

Show me the model

Most of the commentary one reads these days about the negative consequences of the policies set by central banks (low-interest rate and quantitative easing) are not backed by any economic model that I know. The criticisms make constant reference to "distorted" interest rates, "artificially low" cost of capital, mispricing of bonds and other assets as channels through which the misguided policies of central banks are causing low growth, uncertainty and volatility. But what is the economic model that can provide a theoretical justification to an environment where the central bank can significantly affect equilibrium asset prices and interest rates for a prolonged period of time and without causing inflation? I have not seen it yet.

When we teach the effects of monetary policy we tend to use economic models that have a Keynesian flavor to it, with some form of price rigidity and where changes in the nominal interest rate by central banks have a short-run impact on real interest rates (as inflation moves slowly). But this only works in the short run, while prices are rigid. Once price flexibility kicks in there is no way for the central bank to have an influence on relative prices (of assets or goods and services). 

But what I find most puzzling is that those who talk about distorted and manipulated interest rates are the ones who tend to criticize the predictions of Keynesian models in the first place! They are the ones who tend to use as a justification for their arguments models where central banks have no impact on the economy even in the short run. How is it that now suddenly central banks have become so powerful that they can determine "real" (relative) prices for an extended period of time? I need to see the model.

Antonio Fatás

Wednesday, July 10, 2013

The New Normal is to forget economic history

Mohamed El-Erian in the Financial Times today puts forward again the argument that quantitative easing has generated little benefits and is now creating unnecessary volatility in financial markets. He presents the current monetary policy stance and the potential exit strategy as a unique experience that is generating distortions and volatility in financial markets that we have never seen before.

He uses two very simple examples of how bond returns are becoming volatile as interest rates start moving up. The logic is simple and well understood by anyone who understands bond markets: a fixed-rate bond that was issued yesterday will see its price change if interest rates move (in an unexpected manner) over the horizon over which the bond is outstanding. Here is a quote from his article:

"As a simple illustration, consider the 5-year US Treasury note issued at the end of March. A low coupon and relatively modest yield curve roll-down meant the most investors could reasonably expect at issuance was a total return of 2.7 per cent over the subsequent two-year period. If, however, five-year rates were to go up by 70 basis points, which in fact they did over the next three months, the bond was already 3.25 per cent under water (as of the June 25 close), altering the risk/return outlook."

Correct. Bonds that were issued in March under the assumption that interest rates will remain low over the next five years now look like a poor investment because the market today is looking at a scenario of higher interest rates. Without debating on whether the market is right or wrong, this is something that is standard in bond markets. News on future interest rates will cause volatility on bond prices. By reading the article one gets the impression that the current volatility is unusual and that it is the fault of the zero interest rate policy of central banks and quantitative easing. Quoting from the article:

"This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy."

I can see the market is indeed getting worried about the exit strategy and that we are potentially heading for some volatile period in terms of interest rates. But what is nor correct is to argue that what we are seeing is that unusual. Any time monetary policy gets tighter (regardless of the level of interest rate), we see volatility in interest rates. And in previous episodes we have seen volatility that is possibly as high or higher than what we have witnessed so far. 

Below are the plots of the interest rate on the 5-year US Treasury note around the current episode and during the 1994 episode of monetary tightening by the Fed.

The two episodes are not directly comparable but as we can see that during the 1994 episode, 5-year rates increased from 5% to 7% in a matter of 2 to 3 months (in the current episode we have seen rates increasing by about 0.8% in the last two months). This time it is very likely that 5-year rates will continue to go up and possibly increase by more than in previous periods of monetary tightening (if we measure it in percentage points). And this might be a surprise to some who thought that growth will never return and it might not be a surprise to those who are indeed betting that interest rates will go up and are trying to make money on that bet (as Pimco has done in the past). Putting the blame on this volatility on the central bank and the current monetary policy stance is not correct. Markets trade on differences of opinion about the future. Some will be right and some will be wrong and these will generate volatility in ex-post returns. While central banks can be proactive and provide forward guidance on their policies, they cannot control everyone's expectations about future interest rates. If we want to judge central bank policies and their communications we need to wait and see if the forward guidance they provided was a good indication of what they did later.

Antonio Fatás