by Andrew Hunt
One of the key features of the global economy – and particularly of the “Pacific Rim economies” – that has most concerned us over recent months has been the immensely weak investment spending trends that are starting to appear across Asia. We firmly believe that this weakness in capital spending, which has stretched from China to Indonesia, has been brought about by a pressing need for companies in many of the emerging markets to raise cash to fund what have become, in the matter of only a few quarters, an almost chronically high level of debt repayments.
Apparently still unbeknown to many, beginning in 2004 there was an intense and probably entirely unprecedented increase in global credit flows that ran for almost ten years and which paused only momentarily during the GFC. With the US central bank now promising to raise interest rates, though, and relative yields collapsing within the debtor countries, many of these often short-term credit flows are beginning to reverse and this has created a massive drain on the available cashflow of many corporates within the emerging markets, with the result that companies in these countries have been forced to curtail many of their former investment activities and adopt austerity measures of their own.
Crucially, one of the most obvious results of the ensuing drop in Asia’s capital spending has been a reduction in Asian import demand and a consequent “ballooning” in the region’s combined trade surpluses. We must admit that when we first drew this chart, even we were shocked by the rise in the surpluses but having checked and re-checked the numbers, it does seem that to all intents and purposes Asia’s trade surpluses are exploding upwards – although equally shockingly we find that even these trade surpluses have not been sufficient to halt the loss of foreign currency reserves within the region. Even these mammoth trade surpluses have not been enough to fully finance all of the required level of debt repayments and hence Asia’s central banks have had to step in and provide additional funding by running down their foreign exchange reserves.
Over recent weeks and days the world has been almost exclusively focussed on events in Greece and the prospects for GREXIT and this is quite understandable – we do believe that once again the Euro is facing one of its existential crises (in fact, the Euro project may well fail if Greece defaults on the “wrong parts” of its existing debts – that is, those to the ECB) – but at the same time we should note that the increase in the Asian trade surpluses over the last 9-12 months has been the equivalent of Greece’s annual GDP while Asia’s net capital outflows (that have been caused by its enforced need to retire previously incurred debts) have been larger over the last two quarters alone than Greece’s entire existing debt burden.
It therefore seems to us that the world may in some senses have been guilty of overlooking the events that are occurring in Asia currently and the problems that this situation may create for other countries. Specifically, given the closed nature of the global economy, any country or region that undergoes an improvement within its trade accounts must be matched by some other country or region that suffers a deterioration.
The most obvious group of countries that have suffered the matching deterioration in their trade accounts have been the oil and other commodity producers, although some of the world’s capital goods producers have also experienced considerable fallout. Clearly, the trade accounts of the Middle Eastern oil states have suffered significantly, although actual data on the extent of the deterioration in their positions has been surprisingly hard to come by.
We can see all too clearly, though, the adverse trends that have developed in the trade accounts of Brazil, South Africa, Peru, Australia and even New Zealand; Asia’s apparently enforced economic slowdown has reduced both the volume of their exports and the prices that they have received for many of their primary goods exports. Only Chile seems to have been immune from this trend but this seems to be only because the country’s domestic economy has remained in such a deep slump that its imports have fallen along with its export receipts. We would also note that Australia’s trade balance trends would in all probability have been somewhat worse had their domestic economies not weakened.
Unfortunately, we are also aware that during the most buoyant moments of the commodity price bonanza in the mid-2000s and again in 2011-12, many of the commodity producer countries “decided” that the boom would be long-lasting (if not, in fact, infinite) and they adjusted their “permanent income expectations” accordingly. Consequently, rather than waiting for the expected higher incomes to actually occur – and more importantly for them to be received – they increased their levels of domestic expenditure (both consumption and investment) in anticipation. In effect, many of the commodity producing economies chose to advance their spending plans by mortgaging their expected higher income streams by embarking on quite intense domestic credit booms that have left many of these countries notably more indebted relative to their incomes than they were even before the boom in commodity prices.
Having taken on notably higher debt levels on the basis of what seemed to be an almost “unwavering” belief that economic growth in China and the other emerging markets would prove exponential, many miners, commercial companies, farmers, property investors and even some governments have since been caught out by the latest slowdown in the emerging markets, with the result that many are now facing financial difficulties of their own. For example, it is reported that almost half of New Zealand farms are now notionally loss-making as a result of the decline in milk powder prices, while in Australia the once-hot property markets in the resource-dependent areas are now facing crisis-like conditions that perhaps their central banks may have been slow to recognise.
We find rather unfortunately that many policymakers in the producer countries had also become so overtly besotted with the China and emerging market eternal growth/commodity price theme that they failed to properly control their domestic credit cycles during the boom years. In some cases they have compounded their mistakes by then not easing fast enough when growth in the emerging markets began to fall away and commodity price trends slackened, presumably because they believed that China et al would soon come “roaring back” and thereby rescue their now-significantly-more-indebted economies.
In fact, it seems to us that under the almost unfaltering optimism over the outlook for the emerging markets and, in particular, China’s long term that had possessed the financial markets, many real-world companies and even the world’s policymakers have been the cause of a number of important lending, market price and even official policy misjudgements over recent years, including the commodity producers’ seemingly tardy reaction to China’s current slowdown.
Looking ahead, the majority of the world’s commodity producers now urgently need higher export incomes to not only grow their economies but, perhaps more importantly, so that they can afford to service and justify their now-more-elevated debt burdens. If commodity prices do not revive, though (and we see little reason why they should do so, given events in Asia), then we can only assume that these overly-indebted economies will continue to struggle and that they too will ultimately be obliged to enter their own forms of deleveraging processes, something that will lead to more economic weakness in these economies. At this point, we would expect their central banks to find themselves moving towards the types of very low/near-zero interest rates that others have adopted, most likely with a predictable impact on their still “over-owned”, once-high-yielding currencies.
Faced with their higher debt burdens, we suspect that it will ultimately become imperative that the commodity countries defend their rates of nominal GDP growth and weaker currencies seem likely to become the mechanism by which this aim might be achieved, despite their impact that weaker exchange rates might have on any of their residents or institutions that have tapped foreign credit markets. Consequently, we can see no reason why the currencies of many of the more highly indebted economies – including that of New Zealand – will not find themselves “round-tripping” back to their pre-commodity-price-boom levels of the early 2000s if Asian economic trends remain as soft as they are currently.
Andrew Hunt International Economist London
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