China Research

A discussion forum on emerging markets, mainly China – from a macro, micro, institutional and corporate angle.

The BRICS Turmoil: Reality or Overshooting?

September 4, 2013

During summer, we have seen – and still see – quite some nervousness about the so-called BRIC countries in the emerging world – and some contagion to a couple of emerging market countries that also try to catch up, like Indonesia and Turkey. Three questions seem to be particularly interesting:

¤ Is the current nervousness about BRIC countries really motivated?

¤ Why do we have these contagion effects to several countries – to some extent similar to developments during the Asian crisis of 1997-98?

¤ Do we currently see the beginning of a real BRIC crisis which may turn much worse and which will also mean a notable downsizing of BRICS countries’ potential (trend) growth?

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BRIC is a term that has been coined in the beginning of the past decade by an economist from Goldman Sachs, a major American investment bank. BRIC –nowadays BRICS since South Africa joined the “club” a few years ago – are the initial letters of Brazil, Russia, India and China. I always considered the BRIC(S) thing mainly as a marketing instrument for asset allocation. In reality, these countries did not have enough in common to put all four eggs in one basket. Relatively good economic growth during a couple of years and a large population were simply not enough to “harmonize” analysis and investment strategies for these countries.

By the way, similar simplifications could be recognized already in the latter part of the 1990s when Eastern Europe Equity Funds and Asia Equity Funds were launched as attractive alternatives for investors. At that time, countries with different structural and institutional conditions were put in the same investment baskets, too. This proved to be wrong after some time. BRIC supporters from all over the world could have learnt from these examples.

Many experts see the main reason for the current “BRICS problems” in the expectations of – right or wrong – forthcoming cautiously rising interest rates in the traditional industrial world, especially in the U.S. Such a development could (probably) lead to (further) substantial capital outflows from BRIC countries to North America (the U.S.) and (parts of) Europe, according to the BRICS pessimists.

This explanation, however, is too fluffy. A deeper analysis of the BRICS problems is urgently needed. Are there fundamental reasons for the contagion? Or have we got a new example of overreacting financial markets?    

Let’s first look at possible common characteristics of the four BRIC countries – South Africa is excluded in this context – that may have caused negative feelings about the BRICs as a group.

¤  Portfolio shifts?  More financial inflows to the traditional OECD countries – at the expense of portfolio investments in emerging markets because of expected gradual, cautious monetary tightening by mainly the Fed  (with the assumption that the four above-mentioned, leading emerging markets are running the highest outflow risks)
–> could partly serve as an explanation because the four above-mentioned BRIC countries represent the economically four most important emerging economies.

¤  Substantial slowdown in GDP growth?   A rapid weakening of GDP could actually been noted in only two BRIC countries during the past year – in Russia and in India. Brazil even stands for growth improvements four quarters in a row after a couple of growth stimuli.

The last GDP-growth numbers for the BRIC countries look as follows:

Brazil:    2013, q2: 3.3%;    2012, q2: 0.5%         –> coming down from around 9% in early 2010

Russia:  2013, q2: 1.2%;     2012, q2: 4.3%        –> coming down from roughly 5% in early 2010

India:    2013, q2:  4.4%;    2012, q2: 5.3%         –> compared with about
9% in early 2010

China:   2013, q2:  7.5%;    2012, q2: 7.6           –> compared with about 10% in early 2010

Obviously, GDP growth has not developed simultaneously in all BRIC countries in the past few quarters – but more visibly on trend during the past 3-4 years. This is indeed true for all BRIC countries.  This development strengthens the view that more positive growth signals that currently come from the U.S., Japan and some European countries to a high extent more strongly triggered the worsening cyclical view of financial investors on BRIC countries than any other single factor. But looking at GDP-growth developments since 2010 gives also certain reasons to find structural components in the now more dampened growth outlook for BRIC. Thus, we have
–>  an obvious  cyclical BRIC phenomenon combined with certain negative structural components (like, for example, demand from Southern Europe) – and not a pure structural problem.

¤  Current account problems?   Current account deficits are frequently used explanations for the problems of the BRICs – and the need for foreign capital inflows for financing these deficits. But only India has a (somewhat) too high deficit ratio in relation to GDP (around -4.5-5% in 2013).  Brazil’s predicted deficit in the range of 3 ¼ – 3 ¾ % for 2013 is a little bit high but should not be as scaring as markets consider the entire BRIC situation. China and – probably – Russia should even continuously manage current account surpluses which takes us to the conclusion
–-> that current account problems should not really be considered as a major common problem for all the four major BRICS countries. From this point of view, the contagion effects that have been created by global financial markets, seem to be overdone. But they exist!

¤  Insufficient fiscal stability?  Public debt – annual and total – is, of course, an economic indicator that all country analysts watch very carefully. In this respect, Russia and – probably – Brazil seem to have their structural fiscal conditions roughly under control. China seems to be on the safe side for the time being – at least when official numbers are analyzed (about which, unfortunately, one may have serious doubts). India finally has been affected by negative fiscal developments since a long time ago. Thus, the question is
–> why well-known fiscal conditions – which are not really bad in all four BRIC countries – suddenly should lead to general worries on global financial markets. We probably can find psychological explanations in this respect. This urges for deeper analysis.

¤  Lagging structural reforms?  Sure, all emerging countries have more or less burdening structural or fundamental shortcomings. What concerns Brazil, one may mention, for example, insufficient productivity gains and declining international competitiveness, lagging education and pension systems, etc. Furthermore, Brazil is nowadays increasingly competing with – currently – a more reform-minded and economically improving Mexico. Russia suffers from a significant number of institutional deficits – the financial system and support of entrepreneurship included – a too large role for the government/state in the economy and a too high dependence on the energy sector.

India, on the other hand, has more obvious fiscal problems than Brazil, Russia and China and more growth-impeding infrastructural shortcomings which are – also according to my own micro experience from these countries – much more serious than in the three other large emerging countries. The same conclusion can be made about the Indian current account deficit. Last but not least China. Nobody questions that China’s economy has proceeded substantially in the past two decades or so. But we know also that China despite all economic progress still suffers from lots of structural shortcomings particularly when it comes to microeconomic and institutional conditions – unfortunately combined with worrying transparency shortcomings.

Putting together the reflections of the above-mentioned structural thoughts means that structural shortcomings exist in all four  BRIC countries  
–> but without strong logical correlation for motivating sudden distortions and disappointment for the BRIC region as a whole as we have seen in the past months.    

Conclusions                                                                 

In my opinion, the recent negative pressure from global financial markets on the artificial BRIC group – South Africa is excluded in this analysis – should not be considered as the result of a completely consistent and logical approach. Several factors point also at psychological overshooting. Common issues for all four BRIC countries are the insufficient demand for their exports, mainly caused by weak global demand – an issue that probably is characterized by both cyclical and structural dimensions – and the expected future monetary tightening in the U.S.

I have also found that several negative macroeconomic indicators do not point at the same degree of imbalance in all four BRIC countries (if at all).Consequently, it can be singled out that certain psychological overreactions are/were in place.

For this reason, I would argue that current developments have re-set the previously overdone BRIC enthusiasm – to some extent the result of artificial financial marketing – to a more justified stance of growth expectations (without considering the issue of the middle-income trap). This should induce some reduction of previously exaggerated expectations of BRIC countries’ potential GDP growth – but probably less dramatically than described in many recent analytical pieces. Again: Almost all countries have their own characteristics. This makes it most doubtful to put several “(emerging) country eggs” in one single analytical basket.

However, occasional negative contagion effects from one country to another will most probably be inevitable in the future as well. Here we have another example that clarifies the need for more research in behavioral finance.

Hubert Fromlet
Visiting Professor of International Economics, Linnaeus University
Editorial board

 

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China’s Options for its Future Exchange Rate Regime from a European Perspective

August 20, 2013

Abstract

China abandoned its formal currency peg to the U.S. dollar in the summer of 2005. Complaints about what – according to many foreign voices – is an undervalued currency have never stopped since the start of this revised exchange rate system, which appears to be similar to what is more commonly known as a “dirty or managed floating” system or a kind of dollar-peg system – a system that is still determined by China’s political leadership rather than by market forces. Currently China is making considerable efforts to internationalize its currency. This strategy should not be equated with a transition to a fully convertible currency any time soon. The latter development assumes much deeper reforms in the domestic financial sector and cross-border financial movements, including the (almost) complete opening of the capital balance. Coming to such a final point should lie a decade or further ahead.  

In the meantime, a lot of small and major financial reform steps have to be taken. One of the great challenges is the design of China’s future exchange rate regime(s). Some interesting questions emerge in this context. Which currency regime options are realistic, both in the shorter term and in the longer run? What is needed for these – theoretically possible – changes of exchange rate regimes to occur? How will these possible changes of exchange rate policy affect China itself as well as the rest of the world? A group of China experts give their views on this in a special survey.

There is no doubt that future changes in China’s exchange rate regime will have an increasing impact on the global economy – and on many companies in China as well as the rest of the world.  Many different factors – including non-economic factors – may influence China’s future choice(s) of the exchange rate regime. China’s road to modifications and real reforms of the exchange rate policy will be part of the changing economic landscape – with effects on Europe, the U.S., and all other continents and countries. In this paper, particular interest is dedicated to the European perspective.

Read the full article here

Hubert Fromlet
Professor of International Economics
Editorial board

 

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The Mystique of the (Chinese) Purchasing Manager Index

June 7, 2013

PMIs (Purchasing Manager Indices) use to be interesting readings. PMIs have three advantages.

First, they are the fastest of the published short-term business-climate indicators. They are published for manufacturing – which is the most important one – and services just a few days after the surveys have been concluded and only around two weeks after the questionnaires have been sent to the purchasing managers. Second, purchasing managers operate quite early in the planning and production cycle of a company which gives them a “competitive analytical advantage”. Third, purchasing managers are usually very skilled also what concerns the business climate in different sectors and countries – both in an aggregated and an individual corporate perspective. This broad analytical approach is necessary to manage successful price negotiations. This assumes knowledge about price and wage trends, currencies, etc., too.

I feel safe in these conclusions since I introduced the PMI via SILF/Swedbank in Sweden myself almost twenty years ago – roughly at the same time as the UK did (which meant that the UK and Sweden were the first countries outside the U.S. to produce the PMI numbers for manufacturing). Now the PMI can be found in almost 40 countries, China included.

China even has even two PMIs. One – the official one – is produced by the China Federation of Logistics & Purchasing (CFLP), the other one by the large financial institution HSBC in co-operation with the research house Markit in the UK. Usually, these two indices do not have exactly the same numbers for the same month. Sometimes, directions may be even (somewhat) different. During the roughly eight years of their common existence, the HSCB PMI tended to give somewhat lower numbers than the index prepared by the CFLP (however less obviously in the past few years).

These statistical differences may have several reasons. For example, the number of participating companies in the CFLP survey nowadays is almost four times larger than the one of the HSCB PMI (which is not necessarily related to quality). It can also be added that the HSCP index seems to be more sensitive to changes in the exporting manufacturing sector. Other comments I have heart from Chinese and other economists point at weaker seasonal adjustment systems in the PMI system of CFLP. In my opinion, it could even be a mix of all these – and other – explanations. Transparency is simply too low in this respect.

Altogether: it is hard to really judge the quality of the two PMI indices. Despite certain shortcomings, they probably still deserve the reputation of being the best short-term industrial climate indicators in China (and many other countries). Unfortunately, financial markets so far have not always understood what PMIs really are all about. This includes the understanding of China’s PMI.

Five types of misunderstandings happen very frequently in this index system where a composite index below 50 is defined as a location in the declining area of industrial activity and above 50 as a result that indicates production growth in manufacturing.

–  Smaller deviations between result and expectations/predictions – for example, 49.4 compared to 50.1 – can be often practically very irrelevant even when financial markets at the same time express strong initial disappointment. The “50-points limit” should not be treated as an exact borderline between positive and negative industrial growth (yes: economists use the term “negative growth”).  Not in China either. In some countries, it is even discussed whether the borderline of index 50 still is valid or if another index number defines the growth and recession areas in industry more precisely.

–  The PMI is a diffusion index. This means that a relative limited number of purchasing managers who changed their current opinion on the PMI’s sub-indicators just a little bit compared to the previous questionnaire may affect the PMI number with 0.6 or 0.7 points. Deviations of this limited size may be (occasionally) given too much attention by financial analysts and the press.

–  The PMI does not say anything about the strength of the changes. A (slightly) falling PMI number may in reality be much less alarming if the negatively answering companies only have been affected by very small downturns in, for example, new orders, production or employment (the same can be concluded when index numbers move in the other direction). Again: the PMI does not register the magnitudes of changes during the past month.

–  PMI numbers should not only be examined on a monthly basis. When I prepared the monthly PMI index and reports on behalf of SILF and Swedbank until 2008, I always made graphs for three/six months moving averages as well. This kind of exercise made the PMI graphs (somewhat) less volatile and my own reactions many times more relaxed.

–  Thus, too little emphasis is usually given to somewhat more historical studies. Comparisons with the same month one year ago may be quite useful. Such an easy approach makes the analysis of current index levels somewhat easier to interpret.

To summarize: China’s PMIs may have weaknesses – also when it comes to parts of methodology and transparency (but one can observe these kinds of shortcomings in other countries as well). Monthly PMI numbers should get somewhat less focus than it is nowadays often is the case. The use of moving averages could be preferred in certain applications. But the PMI still tells us quite a bit about the temperature in the industrial (and service) sector. That’s why it is important. This is true of China, too.

Hubert Fromlet
Professor of International Economics
Editorial board

 

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