Monday, 19 December 2005

Awash with liquidity, drowned by overcapacity?

As 2006 comes to a close, the world's central banks are still mainly on inflation watch. However, it is also quite clear that many central bankers are keeping one eye on growth -- or more specifically, its potential shortfall.

December saw the world's two leading central banks raise interest rates. The European Central Bank (ECB) raised the interest rate on the main refinancing operations by 25 basis points to 2.25 percent on 1 December, while the Federal Reserve raised the target federal funds rate by the same amount to 4.25 percent on 13 December.

Ironically, the prior month, November, was the month that saw consumer prices fall in both Europe and the United States. The harmonised indices of consumer prices in the European Union rose 2.3 percent from the previous year in November but fell 0.3 percent from October. The US consumer price index rose 3.5 percent rose from the previous year in November but fell 0.6 percent from October, its largest monthly drop since July 1949.

However, the fall in energy prices was a big factor behind the fall in consumer prices in November. For example, the US core consumer price index -- excluding food and energy -- rose 0.2 percent in the month and 2.1 percent over the year, around the same rate as previous months.

Nevertheless, both the Federal Reserve and the ECB have given markets reason not to price in too many more rate hikes in the near future. In its statement accompanying the rate hike, the Federal Reserve dropped its previous description of monetary policy as accommodative, implying a move into a tightening stance and hence, the possibility of an imminent end to rate hikes, while the ECB has also made clear that its interest rate increase was not part of a series of hikes.

Having said that, not too many central bankers are actually declaring that the battle against inflation has already been won. There are indicators that suggest that underlying inflationary pressures remain.

For example, on 15 December -- the same day that the November US CPI was announced -- the Federal Reserve reported that capacity utilisation for total industry in November was at 80.2 percent. This is well up from the trough of 73.9 percent at the end of 2001.

And just one week prior to that release, the Federal Reserve had released its flow of funds data that show that US debt levels continued to rise in the third quarter. Total debt outstanding in non-financial sectors hit US$25.7 trillion in the quarter, a record high.

With the rate at which US consumer spending has increased over the past few years, it is no surprise that the increase in household debt has been the main reason for the overall rise in debt levels. Household debt grew in the third quarter at a 11.6 percent annual rate -- the highest since 1987 -- to hit US$11 trillion. This is 45 percent higher than the debt level at the end of 2001 and is 87 percent of GDP, a record high.

Debt in the US has grown despite the Federal Reserve's interest rate hikes of the past one and a half years. The rate hikes have helped to reduce US M2 growth to only 3.9 percent in November over the previous year, down from 5.2 percent growth over the preceding year. On the other hand, M3 growth rate hit 7.4 percent in November, up from the preceding year's 5.6 percent.

Liquidity indicators are similarly strong elsewhere in the world. In the euro-zone, M3 grew at an annual rate of 8.0 percent in October while credit grew at a 7.7 percent rate. China, where much of the world's liquidity is flowing to, saw M2 surge 18.3 percent in November from the previous year.

And even in deflation-ridden Japan, prices are stabilising, with prospects for further reflation as, on Friday, the Bank of Japan elected to keep pumping liquidity into the economy by maintaining the reserve target at between 30 trillion yen and 35 trillion yen. This in a country saddled with a national debt that is projected to reach 774 trillion yen -- 151 percent of gross domestic product -- by March.

However, outside the consumption binge in the US, the most obvious manifestation of the expansion in global liquidity in the real economy has been the rise in investment spending in China.

In an article in the Global Economic Forum on 12 December, Morgan Stanley's chief economist Stephen Roach claimed that while some economists studying developed economies have noted an accumulation of corporate savings and are waiting for an upsurge in capital spending, investment spending has in fact been alive and well. Roach pointed out in his article that once one takes into account investment spending in China, it can be seen that the surge has already happened.

According to him, if one takes investments in the G-5 countries (the US, Europe, Japan, Canada, and the UK) plus China as a proxy for global capital expenditure, then, by his reckoning, that expenditure "surged to an estimated 15.4% of world GDP in 2005 -- a sharp increase from the cycle low of 13.7% established in 2002 and a ratio that now surpasses the prior peak of 14.9% hit at the end of the bubble in 2000". Accounting for China's fast-rising share of global capital expenditure is critical, according to Roach.

Indeed, so fast is investment rising in China that many economists in the country are concerned about overcapacity. At a conference over the weekend, Cao Yushu, deputy secretary-general with the State Development and Reform Commission, said that eleven sectors including cement, steel and auto making are facing, or will face, surplus in production capacity.

Morgan Stanley's chief Asian economist Andy Xie concurs. "China faces massive overcapacity and an overextended property market", Xie wrote on 15 December in the Global Economic Forum. "China has over-invested substantially in steel, auto, electronics, cement, chemicals, and many other industries. The excess capacity sometimes exceeds 100% of current sales."

Speaking of overcapacity, it is probably worthwhile noting that even in the US, although industrial capacity utilisation has been rising strongly in the past few years, the Federal Reserve's data show that it is still 0.8 percentage point below its 1972-2004 average.

And despite the global economic expansion of the past few years, labour market slack remains considerable. The unemployment rate in the European Union in October was at 8.5 percent. While the unemployment rate in the US, at 5.0 percent in November, is much better, a considerable proportion of the employment gains in recent years have been built on housing foundations -- Marisa DiNatale of estimates that housing and related industries have produced nearly one out of four new jobs in the US since 2003 -- a precarious situation to be in if central bank tightening deflates the housing boom at the same time it slows the overall economy.

Therein lies the risk facing central banks. While optimists point to the low inflation numbers as a good sign -- that economies are able to expand credit without overheating -- the reality may be that they are actually signs of overcapacity.

In other words, central banks tightening monetary policy today to prevent an excess of credit and capacity growth face the risk that they may already be too late.

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