LIBOR Rising, Trade Wars, and the Economy
True, political crises on the order of magnitude that match pre-1914 imperialist rivalries, or the purely economic 1929 Great Depression for that matter, could hardly be construed as equilibrium phenomena and the accompanying growth paths, in no stretch of imagination, as proportionate growth trajectories. Similar considerations could easily apply to the 2007-2009 Global Financial Crisis. However, this phase of the business cycle, a cycle that bordered disequilibrium, is now over. The global economy is reset to forge ahead. This is the general picture. A widespread wave of new technology is coming up next.
However, in the shorter runs, there are sometimes periods when ‘lamentations of a Bear’ may matter. Today also we are passing through one such episode. These are not only times of financial distress; also, there is a global uneasiness going on. So, people tend to think, ‘the lira might stabilize indeed, but at the cost of high interest rates, lower than anticipated growth and lower current account deficit, lower than consensus earnings’ and so on. This, indeed, would make the PE outlook rather dim, given that adjusted to lower expected earnings Turkish stocks would not look so cheap. Recommending high dividend payers, low be- ta defensive stocks and companies with large cash positions stands out as a rational choice. I am not that “bearish” though. Whether the tariff on goods imported from China will have a significant bearing on the Chinese economy remains to be seen, but it is unlikely that the impact will be anything more than a 0.2-0.5 percent reduction of GDP. It is probably true that the U.S. economy will be hit more, and so will be global trade due to spill-over effects. After all, we are no longer in the early 2000s. The anecdotal phrase ‘China produces, the US consumes’ is no longer true. Not only is China’s foreign trade surplus lower, but also the surplus of the bilateral trade with the U.S. is much smaller. It is only 20 percent of China’s overall current account surplus. Furthermore, foreign investments account for something like one-third of the Chinese manufacturing industry. In a world of supply chains, FDIs of large magnitude, technological transfers and all sorts of linkages, it isn’t easy to foresee the impact of such moves. Still, it isn’t a joke, and the trade war is set to produce some results.
China has always run a trade surplus against the U.S. and other industrial countries, but a deficit against Japan, Taiwan and other Asian countries, whereas the U.S. has been in deficit against almost every bloc. What China has had in the past was a large inflow of foreign financial capital linked to foreign direct investment. The problem with China is that this was a financial capital inflow she didn’t probably need and couldn’t safely absorb given her already high rate of saving and her underdeveloped and incomplete financial markets. That was back in 2005-2007. Therefore, the common prescription against running huge current account surpluses didn’t seem applicable because there was no sign of the allegedly legendary trade and current account surpluses anywhere in the available figures even 10-12 years back. So, the fuss about devastatingly huge Chinese trade surpluses is largely a myth because it always was so, as an ordinary fact of life. It happens today because the repeated attempts of 2003-2007 at forcing China to appreciate the Renminbi at that time didn’t work, and because after the 2007-2009 Crisis, attitudes have changed. The approach today is more targeted and designed to protect some sectors in the U.S., but it may as well prove to be counter-productive.
There is also the following argument: The intertemporal approach to the current account suggests that the U.S. would need to run trade surpluses to reduce this imbalance. But obviously part of the adjustment could take place through a change in the returns on U.S. assets held by foreigners relative to the return on foreign assets held by the U.S. Importantly, this wealth transfer might have already occurred via a depreciation of the dollar. Almost all U.S. foreign liabilities were (are) in dollars and approximately 70 percent of U.S. foreign assets were in foreign currencies. A back of the envelope calculation indicates that a 10 percent depreciation of the dollar represents, caeteris paribus, a transfer of 5 percent of U.S. GDP from the rest of the world to the U.S. For comparison, the U.S. trade deficit on goods and services was only 4.4 percent of GDP in 2003 – the current account deficit was higher than the trade deficit because of transfers.
With large gross asset and liability positions, a change in the dollar exchange rate could transfer large amounts of wealth across countries. And it did! The U.S. has already benefited from prolonged episodes of dollar weakness. So, things aren’t necessarily what they appear to be. any approach that fails to take into account capital gains and losses on the net foreign asset position, i.e. valuation effects, would necessarily be misleading in a world of instantaneous financial capital flows. The currently huge gross cross-holdings of foreign assets and liabilities make sure that asset price movements largely affect highly leveraged country portfolios. What this implies should be obvious. There is room for large wealth transfers across countries that alter asset price dynamics. Balance of payments reports the current account at historical cost, and the same consideration applies to national income accounts. For countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies – China and Japan are now good cases in point - it is imperative to take into account valuation effects.
Nevertheless, the trade war story comes at a time when LIBOR has been climbing the ladder similar to the 2012 European sovereign debt crisis peak. Credit is more expensive, but also it is riskier because the LIBOR-OIS spread is widening. It is clear now that funding costs have already risen. What matters is the future path of funding costs. If it continues to rise, then we will see a new equilibrium on a global scale because corporate debt and non-core bank liabilities will soar. Consumer credit lines that are considered to be riskier than others will perform poorly. Even if there is collateral, one wouldn’t like to extend a 10-year loan at a fixed local currency rate if the cost of funding is truly uncertain. As deposit and loan growth rates move largely hand in hand, it will be all the more problematic to get a long duration risk on the basis of less than three months deposit cost repricing. 120 months (loan) against 3 months (deposit) isn’t exactly a good match. It is obviously correct that funding costs for banks’ overseas borrowings are a lot more important than the trade war zone. Because China will not jump into an economic war of attrition head-on and because it is hard to imagine that such measures will suffice to contain China, it is more of a long-term and now fully acknowledged, even anticipated, event.
I reiterate that public banks still lead credit expansion locally as the graphic illustrates. Furthermore, because mortgage loan rates are high, i.e. 14.87 percent on average now, and because they admit long duration relatively speaking, private commercial banks are unlikely to be active in that particular branch of lending. The counterpart is the unwillingness of the buyers on account of the fact that they still anticipate a negative wealth effect, i.e. home prices head down in inflation-adjusted terms. As short-term LIBORs continue to rise, it is unimaginable that, if left to the market alone, mortgage rates will fall naturally and first home sales will redress within the year. The FX-adjusted, 13-weeks annualized loan growth rate stands at 9.5 percent for private banks, but 17.6 percent for public banks. In other words, public banks already give all the support they can to the loan market. They can’t run ad infinitum at loan growth rates that almost double up that of private banks. On the asset side, which people look at most, bond rates also climb. The CBRT would perhaps tighten a bit more in the short-run should the currency continue to depreciate. It is within our forecast, and we believe all banks and corporates have already discounted a basket depreciation that exceeds inflation by 2-3 percentage points, but when it happens in a short span of time it feeds into expectations, costs of production and inflation fast. It actually happens faster than before because the exchange rate pass-through has been plugged in the pricing behaviour.
Retail sales is another important item that pinpoints the allure – or lack of it - of domestic demand. They look good if we compare data with last year’s same period data. From January 2017 to January 2018 the rate of increase at calendar-adjusted constant prices retail sales jumped by 10.7 percent. Food & tobacco rose by 9.5 percent, and non-food by 12.6 percent. So, what is the problem? There is none, not anything in the data because the seasonally and calendar-adjusted monthon-month changes are also good. The respective growth rates are 1.2 percent, 0.8 percent and one percent. Annualize from this and you get a glamourous start-up for 2018. However, this is the first month only. As we eat into 2018, the consumer will need the support of general purpose loans, and subsidies and incentives of all sorts. The first month’s paycheques always look good! That can be done, however, because for lending over short durations, the banking sector is ready with a 1.6 percentage points higher capital adequacy compared to 2013. The problem doesn’t lie in the power and willingness to lend overall, but rather with some sub-segments that don’t look attractive.
The whole story of the last decade is bound to be drastically transformed, and a new growth story tellingly foretold this year, both politically and from the macro and microeconomic stratagems that the country clearly needs. We will probably see clearer signs of such an incoming drive shortly.