Wen passes, Ben twists, Angela sticks

In a new paper from the HKUST academic team of Li, Liu & Wang, the authors lay out a clear exposition of the way that the Chinese institutional framework conspires to leach out profits from the predominantly private, cut-throatedly competitive, highly efficient, export sector and delivers an undue share to the state-owned or –controlled giants who occupy quasi-monopolistic positions ‘upstream’ in the largely non-traded, but also almost unavoidable sectors such as energy, metals, telecoms, logistics, finance, health, and education.

The paper lays out in some detail — in narrative, empirical and, inevitably, mathematically-modelled form — how this vertical separation helps perpetuate the ’imbalances’ in China’s top-heavy economy, by concentrating the bulk of the nation’s impressive gains from trade in the hands of those whose activities are both investment-heavy and sensitive to the imperatives of the state, rather than to the needs of the ordinary consumer. Moreover, Li et al also demonstrate a mechanism by which this ’commanding heights’ strategy, one consciously adopted by the CCP so as not to lose control over the system as it became partially ‘opened up’ to the outside world, helps suppress the share of wages — and hence of domestic consumption — in the aggregate mix.

What the authors do not dwell upon is the further implication that the political aspect of this confronts the Party with an almost insoluble problem now that it is beginning to realise that the SOEs may represent not so much a bulwark of their rule, but a potential barrier to that progressive betterment of their subjects upon which their legitimacy as rulers depends.

It would be bad enough trying to steer resources away and strip privileges from these over-mighty entities were the problem just one of economics, but, given that the upper echelons of these giants are packed with senior party members, their boardrooms populated by red ’princelings’ and politburo spouses, the knot assumes one of truly Gordian proportions.

In light of this engrained favouritism, it is also salutary to note just how badly even these vampire enterprises are doing in the current slowdown.

According to the official data, SOE profits fell 11.8% YOY in May, leaving the YTD total 10.4% below the comparable period in 2011. With revenues for the first five months up 11.3% from the previous year, this means operating margins must have fallen nearly 20%. In the export powerhouse of Guangdong, things were even worse (this time over the period Jan-April) as the SOEs there suffered an eye-watering 30.5% drop in income.

At the national level, return on sales is running at 5.1%, the lowest since the Asian Contagion, 28% below the WTO era median, and even 15% below the worst recorded in the LEH Crash itself. For reference, US manufacturers, absent much – if not all – trace of state support,  just posted an 8.9% after-tax return on sales in QI, while miners recorded a figure of 16.6% and InfoTech one of 11.2%.

Note, too, that in such credit constrained conditions as persist in China at present, one must even doubt what exactly is meant by ‘sales’ – i.e., how much are accounts receivable piling up as vendor finance is extended and channels are stuffed in an attempt to  massage the figures. One thing that is for sure is that the proportion of such ’sales’ as was paid in hard cash is likely to be scant, indeed.

Not that we will ever know, now that the Party  has officially banned all negative reporting ahead of the leadership handover (sic) and in light of (should that be ‘in the obscurity of’?) its prohibition on local audit firms co-operating with the SEC and the PCAOB in the US in the latters’ (belated) attempt to clear up a few trifling ‘confusions’ contained in the financials filed—and all too frequently not filed—by US-listed, Chinese corporates.

If any confirmation were needed of the dire state of play here, just look at the export figures from China’s more developed satellites in the Pacific cluster, or consider the HSBC/Markit flash PMI which dipped again to a 7-month low, with China’s own export orders sub-index hitting its lowest level since the dark days of early 2009.

Recent reports also suggest that the Big 4 banks have only managed to lend CNY25 billion in the first half of June (a system-wide monthly run-rate of less than CNY150 bln!) with deposits off by Y400 bln (which could require loan contraction of anything up to CNY300 bln) and this when many banks are already fully utilising the new leeway granted them of paying 35bps over the official deposit rate.

No doubt the actual total will miraculously surge as month end (quarter end, in fact) approaches, but such window-dressing should not blind us to the fact that generic credit demand remains weak, or at least the rationally-fulfillable kind does. No wonder there are reports that the banks are being told to encourage another round of local government profligacy and hang the structural re-adjustments which policy has insisted the country needs.

The China slowdown has not yet run its course.

Over in the US, Blackhawk Ben has done what he knows best: perpetuated his violence upon the capital structure and pricing mechanism of the world’s largest economy by extending the somewhat pointless Operation Twist until — well, basically, until he runs out of short-date paper to sell (though we would not put it past the man to issue Fed bills at that point in order to turn the whole of the US debt stock into nearer-money instruments and drain the system of every last drop of duration).

As regular readers will be aware, the momentum of money growth in the US has receded significantly from the rip-roaring pace which helped fuel the rebound at the back end of 2011, taking with it a good deal of the impulse behind the real economic upswing — regardless of the fact that corporate bond yields are again where they last were when the Fed first unleashed the demons of inflation, back in 1965.

In one thing has our esteemed Chairman succeeded, viz., he has made equities as cheap as they have ever been compared to bonds. Witness the gap between the earnings yield on the S&P500 and the BAA corporate bond of almost 2% points in bonds’ favour! Equity risk premium, please phone home.

Jigging the arithmetic slightly, this gives us a long-term, real earnings growth factor (rEGF) of minus 1.8% per annum, fully 2.7 standards below the 1980-2012 mean. More telling, however, is the fact that this datum also lies 1.4 standards lower than it normally does in relation to the current growth in private sector GDP — a benchmark which, you may not be surprised to learn, has displayed almost exactly the same median value of 3.2% over the past three decades as has the rEGF.

The fact that a disparity of 4.6% between the two has opened up could imply that market participants have seen through the fraud of ludicrously suppressed bond rates (and, arguably, are also somewhat sceptical of long term growth in what is still an overly stimulus-dependent economy).

Thus, the Fed is keeping the stock market supported, but only at the expense of just about every other rational means by which to allocate capital. We should be thankful that the political environment is not conducive to its undertaking anything more far-reaching in its effects than tinkering with a yield curve which — given the intense desire to park flight capital in something deemed to be relatively safe — would probably have remained flatter than normal in any case.

Charting these waters in investment terms is therefore none too easy. The US is decelerating, right on schedule, but is not yet actually declining. So, while we may be in for a steady diet of mild disappointment, it is hard to identify a specific trigger which could tip the real world into the abyss — at least not before most of the alternative destinations for one’s capital have been sent plunging into its Stygian gloom first.

That said, while there are one or two more heartening signs — e.g., that household deleveraging (and default) has already stretched to 20% of household income; that dips in the gas price are seemingly filtering through into abstention from consumer credit; that the ratio between non-residential fixed investment to housing has gone from a four-decade low to an all-time high, though the proportion of net private investment in potentially productive equipment and structures is still a very paltry fraction of the sums consumed annually, either privately or by the ever-open maw of the state.

Until a genuine end to what has been a generation-long decline in provision for the future (interrupted only briefly by the euphoric waste of the Tech Bubble), we cannot wax too lyrical about America’s longer term prospects, cheap energy or no.

All of which brings us wearily back to Europe where the only question remains when and if the Germans will blink and start writing cheques to all their neighbours and, if so, what conditions will they apply to their long-delayed largesse.

So far, Frau Merkel is sticking to the only strategy that she can — of insisting that future aid is tied to the construction of budgetary oversight, reduced national sovereignty, and the implementation of labour market reforms which, at one and the same time, calls the bluff of the likes of M. Hollande while paying lip-service to her own countrymen’s obvious unwillingness to pay for what they view as their counterparts’ indolence or improvidence.

How long this can last is an open guess. Certainly, the markets — suffering a paroxysm of fear on Monday, when Bonos hit 7.29%, 588bps over Bunds and BTPs touched 6.17%, 476bps over — have since recovered what is either a measure of poise, or a slug of undiluted wishful thinking (according to taste) with Spain back at 6.55%, 500bps over, and Italy at 5.68%, 412bps over.

A gauge of how much this relies on the assumption of a ‘Ja, endlich, wir bezahlen!’ emanating from Bonn can perhaps be had by noting that German 10-year CDS still stand at a lofty 132bps, juxtaposed to the Aa3 pairing of Japan and Chile and that Bunds have seen their 50bps yield discount to Treasuries dwindle to a single figure difference in the past several weeks of bail-out speculation.

Perhaps the real lesson is to be had from the Baltics where drastic ‘internal devaluation’ has accompanied genuine ‘austerity’ in the form of government cut backs stretching from 10% in Estonia, to almost 20% in Lithuania, and near 40% peak-to-trough in Latvia. As a result, of the bitter medicine swallowed there, private GDP is now on the rise, with growth rates of 0.9%, 4.9%, and 3.9%  annualized over the past six months in Estonia, Latvia, and Lithuania, respectively.

Ireland and Portugal, to give them credit, have seen something similar occur, with the state’s slice of the pie shrinking 13% in the first and 15% in the second, but Spain has barely managed a 5% cumulative cut and Italy is already well on its way back to unchanged from the peak, despite all Mario Monti’s protestation about his performance in trimming the excesses of the past.

‘Austerity’ which not only forces those who have become dependent upon the state to go out and seek other ways of making a living, but confiscates more of their and their private sector neighbour’s earnings when they do so, by imposing swingeing increases in taxes (and so pushing down marginal returns to labour and capital at just the wrong moment), is, as we have said before, a very luxurious form of achieving budget balance, indeed. Aimed, as it is, not so much at reinvigorating individual endeavour as at minimising the reduction in the reach and importance of the state, this is truly a policy prescription to satisfy neither those who would apply Keynes’ soothing nostrums, nor Austria’s much tougher love.

THAT is what is ’self-defeating’ about such measures, not the simple fact of trying at last to live within one’s means and to re-orient one’s activities more to wealth creation than wealth destruction – as we fear the unfortunate citoyens de L’Hexagon—the French—are about to discover under their newly installed, traditional left-wing, tax-and-spend, New Dealer leadership.

A Catalogue of Errors 

A man who is both tireless and tiresome in his efforts to promote the cargo cult of Keynes  is Robert Skidelsky. Our noble lord is actually a historian who, it is said, ‘learned economics’ in order to be able to write a better biography of the Bloomsbury Beelzebub, but that has not impeded his proselytising just one bit, despite the fact that if anyone should be aware of his idol’s personal depravity, political guile, and professional slipperiness, it is he. A blog review of a recent book written by Skidelsky, pere et fils, in which the pair rehash Keynes’ ludicrous vision of a world beyond scarcity ignited a long debate which turned out to be replete with bad economics and even worse politics to the point I felt obliged to chip in with a few words of austro-libertarian wisdom, in which the reader might hopefully find some wider merit.

CJC – June 20 7:09pm

@ Tom: Hang on. First you say: “The suggestion that profits derive from artificial scarcity is nonsense.” Then you say: “Artificial scarcity is just another term for monopolistic behaviour.”

Are you saying that monopolistic behaviour does not give rise to profit? Surely the extraction of profit or ‘economic rent’ is the whole point of monopoly (aka artificial scarcity)?

Economic rent derives from privileged property rights like ownership of commons (land, natural resources, knowledge) or from limited liability, or from the privatisation of sovereign credit (the ‘credit commons’) since 1694.

If unearned income from economic rent were equitably taxed (and taxes upon earned income from labour cut dramatically) the resulting pool of value could be shared as a national dividend.

There would then be plenty to go around so that people enjoyed as of right a decent standard of living, accommodation and so on.

Then beyond that it’s up to them. High status jobs would then be paid the least, because of the demand for them, while the worst jobs which no-one wants to do could be highly paid.

My Reply:-

Profit, as Prof. George Reisman correctly argues, is the antecedent form of income. When Crusoe spent time standing over a stream, poised with his sharpened stick, the ‘profit’ from his labour was the fish he speared.

Later, when Friday turned up, absent any skills, tools, homesteaded property rights, or other means of sustenance, Crusoe offered him a deal: a pre-emptive share of the fish as that secondary return to labour we call a ‘wage’ – in effect a contractual call upon the income out of which Crusoe’s profit would emerge –  in exchange for assistance in the process of catching them. Crusoe’s entrepreneurial gamble was naturally that the two of them acting co-operatively together could each harvest more of the bounty of the river than either could on his own.

‘Rent’ in strict economic terms is nothing to do with this benign process of voluntary association, but is an undue benefit inequitably extracted by enlisting the intrusive, coercive power of the state – such as the granting of some monopoly or restrictive charter, ensuring the enforced take-up of an otherwise sub-optimal product (eg, biofuel boondoggles), or the enforcement of a protective tariff or broader competitive exclusion (here many libertarians would add patent rights).

‘Rent’ may indeed be ‘unearned’  – but its removal is a matter of abrogating privilege, not of imposing taxes. Profit is not only earned, but is earned in the service of the greater good, being only obtainable by recognising that some resources (including human ones) are being undervalued in their current employment and transforming them in some way to meet a greater expressed need than they currently do. This is an essential arbitrage for which profit is the due reward, one which has the merit of exerting a beneficial ‘selective pressure’ on the entrepreneurial ‘gene pool’: the better operators thrive and can compound up the capital they so accumulate to extend the scale of their endeavours; the poorer ones eventually go broke and return to selling their labour, not hiring that of others in sub-marginal – and hence wasteful – projects.

Taxing profit unduly is therefore a business of penalizing a success which attends only those who serve their fellows’ material needs better than others do. It is also highly unfair, since the tax falls on those who achieve what they set out to achieve and leaves the failures unscathed.

‘Heads, I the Fisc, win: Tails, you lose’ is hardly the way to incentivise anyone to excellence!

As for ‘sharing out the national dividend’ – what a world of tyranny, moral turpitude, petty envy, and sheer inefficiency is contained in those honeyed syllables. ‘From each according to his means to each according to his needs’  – for the red-shirted butchers – ‘Gemeinnutz geht vor Eigennutz’  – for their brown-shirted counterparts!

Nor does anyone have a ‘right’ to anything other than one of equality before the law and of respect for their property (in which their own person also consists). No-one has a ‘right’ to demand a ‘decent standard of living’ at the expense of another. Besides, who is to decide what is ‘decent’? Is it 1500 calories a day? A blanket to wrap onself in on the workhouse bunkbed? Or is it a 2-up, 2-down semi with a Ford Fiesta in the drive? An iPhone and a subscription to Sky TV?

The horrors of an upwardly-creeping boundary of insistence upon the provision of such ‘amenities’ out of the spoils of expropriation by the Tutelary Deity of the welfare state, all showered upon the masses simply dint of its members having a pulse, is what has delivered us into the depths of the deeper crisis afflicting us today.

And, finally, ‘high status’ jobs pay well because the providers of the services to which these give rise are rare (and have often undertaken considerable investment of time and money in acquiring the necessary skills and experience to boot), while ‘low status’ ones can be filled by almost any of us dogsbodies, if so required. That, I am afraid, is basic economics and quite frankly, I am more than happy that my heart surgeon takes home a good few bob and so stays shapr and motivated even if it also means I have to bow to my fellows’ unfathomable exercise of their power of consumer sovereignty in paying Messrs Rooney and Cole a king’s ransom for kicking an air-filled spheroid about an expanse of turf for ninety minutes at a time.

Utopian collectivism such as is being expressed here is to blame for almost as many woes –  and far more suffering and death – even than the evils of fiat money and corporatist cronyism which everywhere masquerade as the free market.

We do not love in a Land of Milk and Honey – not since dear old Eve took a fancy to that first, enticing Cox’s Orange Pippin – but if you do want something to stir into your tea and spread on your bread in the morning, you had better leave it to an entrepreneur, out in search of profit and funded by a capitalist saver, to provide it, otherwise you will either have to do without them, pay more for them than you need to, or have to suck up to some insufferable little busybody sporting a coloured armband in order to jump the interminable queue for the trifling amount not commandeered by the guardians of the people!

Rational exuberance | June 21 8:49am

The better operators die and leave their valuable capital in the hands of their wasteful, drug-addicted offspring. Or even worse, investigate when and where the oldest and greatest European fortunes were won.

Spain: Duchessa de Alba – Robbing and murdering the Dutch, especially sacking Antwerpes, the foremost trading venue of its time.

Germany: Friedrich Karl Flick – Buying undervalued assets, legitimately owned by murdered Jews, directly from the highest levels of the SS.

You get the drift…

In any case, real money survives generations and please don’t tell me Paris Hilton is a superior human being somehow.

My Reply:-

Dear Rational Ex,

Indeed, many of them are the scions of banditti, warlords, mailed bullies   – AND OTHER PROTO-GOVERNMENTAL PLUNDERERS – who have precisely NOTHING to do with the market order and the republic of law.

Those latter institutions, however – the ones which, even in their current barely operative state, have generated both the most material comfort and the greatest individual freedom for the largest (and yet still increasing) number of people  – are precisely those you would shrink in favour of handing power back to a new generation of governmental plunderers!

As for inherited wealth, for which you seem to have an irrational aversion, I can only bid you wait awhile. Even Ms Hilton will have to manage her endowment wisely – or be smart enough to hire someone to do it for her – and hence will have to contribute to funding clever entrepreneurs in some form or other as they go about improving the lot of their fellow humans – or she and her seed will also be back operating the check-out at Wal-Mart where you so obviously and invidiously wish to see them.