Category: Asia (Emerging)

The key chart

Visual summary of the CMMP Analysis framework linking all economic sectors together (Source: CMMP)

The key message

The key message from CMMP Analysis is that the true value in analysing developments in global finance lies less in considering investments in banks’ equity and more in understanding the implications of the relationship between the money sector and the wider economy for macro policy, corporate strategy, investment decisions and asset allocation.

The 2023 “messages from the money sector” included the importance of post-GFC debt dynamics, the risks of policy errors, the failure of banks to support productive economic activities, and the increasing abuse of macro statistics.

The seven key lessons were:

1. The risk of a Chinese balance sheet recession dominated 2023 and will DOMINATE 2024 too
2. “US bears” ignored structural shifts in US debt dynamics post-GFC and underestimated the RESILIENCE OF THE CONSUMER as a result
3. Aggregate demand in credit-driven economies is equal to income (GDP) PLUS THE CHANGE IN DEBT. Policy makers continue to ignore this truism at OUR peril
4. The ECB’s policy celebrations may prove PREMATURE
5. UK policy making is still based on UNBELIEVABLE forecasts and FLAWED macro thinking
6. Banks are failing to support PRODUCTIVE ACTIVITY and the SME sector in particular
7. The ABUSE of macro statistics is rife – beware of “panic charts” and their accompanying narratives

Seven lessons from the money sector in 2023

The importance of post-GFC debt dynamics

Lesson #1: the risk of a Chinese balance sheet recession dominated 2023 and will dominate 2024 too

January 2023: Trends in Japanese, Spanish and Chinese private sector debt ratios (% GDP) (Source: BIS; CMMP)

CMMP Analysis began 2023 by questioning the popular, “China-opening story“. We highlighted three structural risks to this narrative – (1) the level of private sector debt, (2) the rate of growth of household debt, and (3) the affordability of private sector debt. We asked two questions.

First, what happens if rather than seeking to maximise profit/utility as traditional economics assumes, the Chinese private sector turns to minimising debt or maximising savings instead?

Second, and following on from this, what if China experiences a balance sheet recession instead?

December 2023: Trends in “excess credit growth” in China since June 2013 (Source: BIS; CMMP)

The balance sheet narrative remained on hold during 2023, but risks remain as we enter 2024. All sectors of the Chinese economy are increasing leverage still. The Chinese government is the main driver here, rather than the private sector, however. Crucially, the dynamics of Chinese money creation and potential growth are shifting. Credit agencies may (mistakenly) wish for lower levels of government debt in China, but given current debt dynamics it will be fiscal policy/government spending that will have to do the heavy lifting in 2024 if China’s growth is to recover.

Lesson #2: “US bears” ignored structural shifts in US debt dynamics post-GFC and underestimated the resilience of the consumer as a result

January 2023: Trends in the stock of US consumer credit ($tr) and the consumer credit to DPI ratio (%) (Source: FRED; CMMP)

CMMP Analysis also began 2023 by questioning the equally popular, “US consumer slowdown narrative”. We argued that “US bears” were ignoring the key structural shifts in US debt dynamics that saw the US leading the advanced world in the structural shift away from high-risk HH debt towards relatively low risk public debt in the post-GFC period. In September 2023, we noted greater affordability risks in other developed economies such as Canada, Switzerland, Sweden, France and Finland and in emerging markets such as Brazil, China and Korea instead.

December 2023: Trends in monthly flows of US consumer credit (Source: FRED; CMMP)

That said, we also noted signs that the US consumer was starting to crack as the year progressed. Quarterly consumer credit flows in the 3Q23 ($4bn) were the weakest since 2Q20, and only a very small fraction of the pre-pandemic average quarterly flow of $45bn. Monthly flow data for October 2023, also suggested that momentum weakened further at the start of 4Q23.

Note the key differences between China and the US here – China’s challenges are more structural in nature, while the US’s challenges are more cyclical.

The risks of policy errors

Lesson #3: Aggregate demand in credit-driven economies is equal to income (GDP) PLUS THE CHANGE IN DEBT. Policy makers continue to ignore this truism at OUR peril.

In September 2023, CMMP Analysis argued that central bank decision making that appears largely “data independent” in relation to private sector credit dynamics is unlikely to produce positive economic outcomes. Instead, it increases the likelihood of policy errors, especially in credit-driven economies.

September 2023: Trends in the UK PS debt ratio (RHS) and PSC relative growth factor (LHS) (Source: BIS; CMMP)

The fundamental error is to ignore that aggregate demand in a credit-driven economy is equal to income (GDP) PLUS THE CHANGE IN DEBT. The addition of the change in debt means that, in reality, aggregate demand is far more volatile than it would be if income alone was its source (as typically assumed). This is especially true for highly indebted economies.

If Schumpeter could understand this in 1934, why can’t policy makers understand it in 2024?

Lesson #4: The ECB’s celebrations may prove to be premature

ECB officials spent much of 2023 arguing that the transmission of monetary policy was working. The tone became almost celebratory by the end of the year, with Board members arguing that not only was the transmission working but also that it was delivering results that were EXACTLY what the ECB wanted to see.

December 2023: Trends in PS financing flows (EUR bn, 12m cum flows) and nominal NFC and HH borrowing costs (%, RHS) (Source: ECB; CMMP)

The risks that these celebrations may prove to be premature are obvious, however, or at least they should be. While monetary policy transmission in the euro area is working as textbooks suggest, both the pace and scale of current tightening is unprecedented. The ECB lacks a playbook for such a scenario and EA economies now find themselves in uncharted territory. Policy tightening continued even as the EA money sector was indicating increases stresses for banks, households and corporates. The end result – a combination of NEGATIVE financing flows to the private sector, historically high policy rates and elevated costs of borrowing – is unlikely to be sustainable in 2024.

Lesson #5: UK policy making is based on unbelievable forecasts and flawed macro thinking

November 2023: Historic and forecast trends in sectoral balances for the UK private and public sectors and the RoW expressed as % GDP (Source: OBR; CMMP)

Official OBR forecasts for the UK economy remain unbelievable when viewed through CMMP Analysis’ preferred sector balances perspective. The March 2023 version suggested a return to the pre-pandemic world of economic imbalances and an economy forecast to remain heavily dependent on net borrowing from abroad – the irony of post-Brexit Britain. The November 2023 version presented a more balanced outlook and a more realistic forecast for private sector dynamics but was simply too dull to be true.

December 2023: Trends in UK PS debt ratio (% GDP, RHS) and relative growth versus nominal GDP (3Y CAGR %, LHS) (Source: BIS; CMMP)

The UK private sector debt ratio fell back to its March 2022 level at the end of 2Q23. This matters because neither Jeremy Hunt (the current UK Chancellor) nor Rachel Reeves (his likely successor) appear to recognise the folly of combining austerity with private sector deleveraging (“pre-COVID Britain”). The next general election will be fought on the wrong macro battleground as a result. Both parties will repeat the flawed narrative that governments (that enjoy monetary sovereignty) face the same financial constraints as households and that public debt is a problem while largely ignoring private debt. A depressing thought for the year ahead.

The failure of banks

Lesson #6: Banks are failing to support productive activity and the SME sector in particular

February 2023: Trends and breakdown of UK FIRE-based (red and pink) and COCO-bases (blue) lending (£bn) (Source: BoE; CMMP)

A more appropriate macro policy debate in the run-up to the next election would focus on the role of banks. UK banking, for example, is heavily geared towards less-productive FIRE-based lending that supports capital gains rather than productive COCO-based lending that supports investment, production and income formation.

October 2023: Trend in the outstanding stock of SME loans since 2013 (£bn) (Source: BoE; CMMP)

UK banking also fails SMEs, the lifeblood of the UK economy. Only 22 pence in every pound lent in the UK is for productive purposes and only c.7pence is lent to SMEs. This is despite the fact that SMEs account for 50% of private sector turnover and 60% of employment. SMEs cannot invest fully in growth, job creation, innovation and equality if and when: (1) their access to external capital is constrained by LT structural factors; (2) flows of financing (both loans and overdrafts) are negative; and (3) their cost of borrowing is rising so rapidly.

The abuse of macro statistics

Lesson #7: The abuse of macro statistics is rife – beware of “panic charts” and their accompanying narratives.

CMMP Analysis suggests that US public sector debt and trends in narrow money (M1) are the most widely abused macro statistics of the year.

May 2023: 50 years of US public sector debt dynamics – plotted differently! (Source: FRED; CMMP)

The abuse of US public sector debt data involves five elements. First, ignoring the fact that public debt is both a liability for the government sector and an asset of the non-government sector. Second, making no comparison with GDP. Third, ignoring inflation. Fourth, presenting long time series data using linear scales. Fifth and finally, ignoring private sector debt dynamics completely (see also lesson #2 above).

November 2023: Growth trends (% YoY) in narrow money (M1) and other short term deposits (M2-M1) (Source: ECB; CMMP)

The abuse of monetary aggregate statistics is more understandable given that growth in narrow money is falling rapidly, and that real growth rates in M1 typically display leading indicator properties with real GDP. This means that M1 dynamics make great headlines for sure, but they only tell one part of the macro and banking stories. The rising opportunity cost of holding money, on-going portfolio rebalancing and the mechanics of money creation are important too. Policy normalisation leads to natural re-adjustments in the structure of MFI consolidated balance sheets. This can and does create dramatic movements in individual items and monetary variables such as M1 and increases the risk of misinterpretation.

In short, monetary aggregates still matter. To return to the key message from CMMP Analysis, they tell us a great deal about the interaction of the banking sector and the wider economy, but they need interpreting with due care and attention…

Thank you for reading and very best wishes for a very happy and healthy new year.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.

The key chart

The key message

The true value in analysing developments in global finance lies less in considering investments in banks’ equity and more in understanding the implications of the relationship between the money sector and the wider economy for macro policy, corporate strategy, investment decisions and asset allocation (see key chart above).

The 2022 “messages from the money sector” have taught us a great deal about macro policy (and its flaws), risks to financial stability and the transition from pandemic-economics to economic slowdown/recession in advanced economies.

Macro policy

Over the past twelve months, the money sector has reminded us that flawed macro thinking continues to drive macro policy in many advanced economies (lesson #1). The first flaw is to argue that governments (who enjoy monetary sovereignty) and households face the same spending and budgetary constraints. They do not. The second flaw is to largely ignore private sector debt. In a world that sees public debt as a problem but largely ignores private sector debt, it is common to overlook elevated private sector risks in Sweden, France, Korea, China and Canada (lesson #2). This is a mistake.

Financial stability risks

Among the sample of economies listed above, the banking sectors in China and Korea have the highest exposures to elevated private sector debt risks. Banks and investors share risks more equally in Sweden, France and Canada (lesson #3).

Rising levels of financial inequality are creating very real social, economic and political problems in many developed economies. Lower-income households have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. Does this justify sensational headlines about rising levels of consumer credit? Without playing down the genuine hardship that many are facing now, the answer is no (lesson #4).

Lower-income households hold relatively small shares of mortgage debt and consumer credit. Furthermore, a recovery in demand for consumer credit at the aggregate levels was a positive sign reflecting a normalisation of economic activity during 2022. This does not mean that complacency about rising NPLs is justified, however.

From pandemic-economics to economic slowdown/recession

Monetary cycles in the UK and EA have remained highly synchronised (despite Brexit) and pointed to a clear break from pandemic economics during 2022 (lesson #5).

Consumer credit is losing momentum, however, and sharply slowing real growth rates in money and credit point to slowdown/recession in 2023 (lesson #6).

The UK has already returned to the unsustainable world of pre-pandemic imbalances (lesson #7). The fact that this is an integral part of official forecasts returns us neatly to lesson #1 – flawed macro thinking drives current macro policy.

Thank you for reading and very best wishes for a very happy and healthy New Year

Seven lessons from the money sector in 2022

Lesson #1: flawed macro thinking drives macro policy

Over the past twelve months, the money sector has reminded us that flawed macro thinking continues to drive macro policy in many advanced economies.

The first flaw argues that currency issuers (e.g. governments who enjoy monetary sovereignty) and currency users (e.g. households) face the same spending and budgetary. The second flaw sees public sector debt as a problem but largely ignores private sector debt.

Jeremy Hunt, the latest Chancellor of the Exchequer in the UK, argued recently that, “Families up and down the country have to balance their accounts at home and we must do the same as a government.” He was following in the well-trodden footsteps of Thatcher, Cameron, Osbourne and Sunak before him. In the past, this rhetoric and mistaken belief set was used to justify austerity policies (which had well-documented, negative impacts on UK growth). Such arguments reflect a flawed understanding of how modern monetary systems work. They also ignore the fact that the correct fiscal response is the one that balances the economy not the budget.

Back in February 2022, France’s state auditor sounded the alarm about the impact of pandemic spending on France’s widening budget deficit and rising debt levels (see chart above). The auditor was factually correct to highlight the impact of pandemic spending on the government’s net borrowing but the analysis fell short in three important respects. First, the net borrowing of the French government was a necessary, timely and appropriate response to the scale of the private sector’s net lending/disinvestment. Second, while the outstanding stock of French government debt may be the fourth highest in the world, France ranks much lower in terms of government indebtedness. Third, from a risk and financial stability perspective, CMMP analysis is more concerned about France’s private sector debt dynamics, particularly in the corporate sector (see Lesson #2).

Lesson #2: its a mistake to ignore private debt

In a world that sees public debt as a problem but largely ignores private sector debt, it is common to overlook elevated private sector risks in Sweden, France, Korea, China and Canada. This is a mistake.

Why focus on Sweden, France, Korea, China and Canada?

First, their levels of private sector indebtedness exceed the “peak-bubble” level seen in Japan (214% GDP, 4Q94) and, in the cases of Sweden and France, the peak-bubble level seen in Spain (227% GDP, 2Q10) too. Potential warning sign #1.

Second, in contrast to other economies that exhibit high levels of private sector indebtedness (eg, the Netherlands, Denmark, and Norway) affordability risks are also elevated in these five highlighted economies. Their debt service ratios are not only high in absolute terms (>20% income), they are also elevated in relation to their respective 10-year, average affordability levels. Potential warning sign #2.

Note, finally, that among these five economies, Sweden, Korea and Canada have over-indebted NFC and HH sectors, while the risks in France and China relate more, but not exclusively, to their NFC sectors. When it comes to private sector debt dynamics, the world is far from a homogenous place.

Lesson #3: exposure of Chinese and Korean banks

Among the sample of economies listed above, the banking sectors in China and Korea have the highest exposures to elevated private sector debt risks. Banks and investors share risks more equally in Sweden, France and Canada.

In China, bank credit accounts for 84% of total private sector credit and the bank credit ratio of 184% GDP exceeds the peak-Spanish bank credit ratio of 168% GDP. Similarly, in Korea bank credit accounts for 73% of total private sector credit. The bank credit ratio of 161% GDP is slightly below the peak-Spain level but well above the peak-Japan level of 112%

In contrast, risks in Sweden, France and Canada are shared more equally between banks and investors (see chart above). Bank sector credit accounts for 51%, 50% and 49% of total private sector credit in Sweden, Canada and France respectively (reflecting the greater development of alternative sources of credit in advanced economies).This does not mean that banks are not exposed, however. The bank credit ratio in Sweden is 138% GDP, above the peak-Japan level. In France and Canada these ratios are the same or slightly below the peak-Japan level (112% GDP and 109% GDP respectively).

Lesson #4: the risks of rising financial inequality

Rising levels of financial inequality are creating very real social, economic and political problems in many developed economies. Lower-income households have less flexibility to adjust their spending in response to rising prices and are less likely to have a cushion of savings to protect them. Does this justify sensational headlines about rising levels of consumer credit? Without playing down the genuine hardship that many are facing now, the answer is no.

Lower-income households hold relatively small shares of mortgage and consumer credit in the UK and EA, for example. In the UK, the bottom-three income deciles account for 5% and 8% of the outstanding stock of mortgages and consumer credit respectively. Similarly in the euro area, the bottom-two income quintiles account for 13% of total household debt, albeit with significant variations at the country level. Furthermore, at the aggregate level, a recovery in demand for consumer credit is a positive sign reflecting a normalisation of economic activity rather than a sign of systemic stress/economic weakness.

This does not mean that complacency about rising NPLs is justified. According to the latest OBR forecasts, for example, the household debt servicing cost in the UK is set to rise from £60bn at the end of 4Q22 (3.8% of disposable income) to £107bn at the end of 4Q23 (6.6% of disposable income) and £125bn at the end of 4Q24 (7.5% of disposable income). Beyond that, the debt service ratio is assumed to stabilise at around 7.5% of disposable income. High but (perhaps conveniently?) below the 9.7% level seen at the time of the GFC.

Lesson #5: the break for pandemic-era economics

Monetary cycles in the UK and EA have remained highly synchronised (despite Brexit) and pointed to a clear break from pandemic economics during 2022.

Pandemic-era economics was characterised by a spikes in broad money driven by the hoarding of cash by HHs and NFCs, subdued credit demand and a record desynchronization of money and credit cycles.

Broad money growth has slowed from a peak of 15.4% to 5.6% in the UK and from a peak of 12.5% to 5.1% in the EA. HHs and NFCs have stopped hoarding cash, monthly consumer credit flows have recovered and money and credit cycles have re-synched with each other. Mortgage demand, the key driver of so-called FIRE-based lending is also slowing, notably in the EA.

Lesson #6: lower consumer momentum and slower growth

Consumer credit is losing momentum, however, and sharply slowing real growth rates in money and credit point to slowdown/recession in 2023.

Recall that in the face of falling real disposable incomes, HHs can either consume less, save less and/or borrow more – or a combination of these behaviours.

In relation to pre-COVID trends, US consumers repaid less consumer credit during the pandemic and have borrowed much more in the post-pandemic period than their UK and EA peers. Monthly flows of US consumer credit peaked at $45bn in March 2022 at 3x their pre-pandemic levels. According to the latest data release, they fell to $27bn in October 2022 but remain almost double pre-pandemic levels.

The messages from the respective money sectors is that downside risks to consumption remain more elevated in the EA and the UK where monthly consumer credit flows have already fallen back below pre-pandemic levels.

Real growth rates in M1, HH credit and NFC credit typically display leading, coincident and lagging relationships with real GDP. Each indicator is falling at an increasing rate in the UK and the EA. If historic relationships between these variables continue, this suggests a sharp deceleration in economic activity over the next quarters.

Lesson #7: the UK returns to the unsustainable pre-COVID world

The UK returned to the unsustainable world of pre-COVID economics with twin domestic sector deficits counterbalanced by significant current account deficits in 2022. The OBR expects these dynamics to continue throughout its forecast period to March 2028.

The good news for Jeremy Hunt, the Chancellor of the UK, is that the net financial deficit of the UK public sector is forecast to fall sharply and to trend to c2-3% of GDP throughout their forecast period. The bad news for UK households is that their net financial position is forecast to fall from its recent (and typical) surplus to sustained deficits of between 0.1% and 0.4% GDP. In short, the UK is set to become a nation of non-savers with households also spending more of their income on servicing their debt.

To return to the first lesson of 2022, the lack of appropriate health warnings and the implied structural shift in risk away from the public sector to the private sector here reflects either flaws in macro thinking and policy making and/or the heavy hand of reverse engineering. Neither are good news.

Please note that the summary comments and charts above and below are abstracts from more detailed analysis that is available separately.