China's balancing economic acrobatics

Is China's economic stimulus too much of a good thing?

Reuters

CHINESE growth was already the envy of the world. Now recession-stricken countries will be turning an even brighter green. On Thursday July 16th new figures showed China’s GDP growth quickened to 7.9% in the year to the second quarter. That is healthy enough by anyone’s standards but the headline number conceals a more astonishing rebound. Goldman Sachs estimates that GDP grew at an annualised rate of 16.5% in the second quarter compared with the previous three months. Over the same period, America’s economy probably contracted again. China’s economic stimulus has clearly been hugely effective. So effective, indeed, that some economists are now worrying it may be working rather too well.

In the year to June fixed investment surged by 35%, car sales rose by 48%, and purchases of homes by more than 80%. After falling last year, home prices are now rising briskly in some big cities, and share prices have soared by 80% from their November low. Domestic spending has been spurred partly by the government’s stimulus package, but probably even more important was the scrapping of restrictions on bank lending late last year. In June new lending was more than four times larger than a year earlier.

One reason why the economy has rebounded so quickly is that much of the slowdown was self-inflicted, rather than the result of America’s economic collapse. In 2007 concerns about overheating prompted the government to curb the flow of credit for construction and home buying. This caused China’s economy to slow sharply even before the global financial crisis. Then, last November, the government turned the credit tap back on full.

That has given a big boost to domestic spending but raised concerns that the flood of liquidity will push up inflation, fuel bubbles in shares and housing, and store up bad loans. The M2 measure of money surged by 29% in the year to June. In fact the risk of high inflation in the near future appears low: Chinese consumer prices fell by 1.7% in the year to June, and spare capacity at home and abroad is holding down prices. But asset prices could be a bigger danger. According to one estimate, 20% of new lending went into the stockmarket in the first five months of this year.

It is probably too soon to use the word “bubble”. The stockmarket is still at only half its 2007 peak and, although house prices have risen sharply this year in Shanghai and Shenzhen, the nationwide average is barely higher than it was a year ago. But the pace of bank lending is unsustainable, and America’s recent experience suggests that it is better to prevent bubbles forming than to mop up the mess afterwards. Several officials at the central bank People’s Bank of China (PBOC) have said lending should be curbed.

At the moment, the prime minister, Wen Jiabao, is signalling that he wants monetary policy kept fairly loose. Exports remain weak and the government fears premature tightening could derail the recovery. It is also keen to create jobs and maintain social stability in the months before the 60th anniversary of Communist Party rule in October.

Still, the central bank has begun to tug gently at the reins. It has nudged up money-market interest rates and warned banks that it intends to increase its scrutiny of new bank loans. The China Banking Regulatory Commission has warned banks to stick to rules on mortgages for second homes, which require a down-payment of at least 40% of a property’s value.

The recent rebound in house sales is, in fact, exactly what the government is aiming for, since it is using property as a way to spur private consumption. Higher house sales encourage more spending on furniture and consumer appliances. Construction also creates lots of jobs; indeed, it employs almost as many workers as the export sector. Since October the government has encouraged people to buy houses by cutting the minimum mortgage down-payment on their main home from  30% to 20% and by reducing stamp duty and other taxes on property transactions. Stronger sales are now feeding through into new house building: housing starts rose by 12% in the year to June, the first growth in 12 months.

Given the importance of property to domestic demand, the government is highly unlikely to want to clamp down hard on the housing market. Despite the recent lending boom, Chinese banks’ mortgage lending is still very conservative compared with that in America—at the peak of America’s housing bubble it was easy to get a mortgage for 100% or more of the value of a home. Nevertheless, the lesson of America’s financial crisis for China’s government is plain: overly loose lending should never be ignored.

CHINA: REPLACE DOLLAR AS INTERNATIONAL FINANCIAL STANDARD

China argues to replace US dollar

The dollar has been the world's reserve currency for decades

China's central bank has reiterated its call for a new reserve currency to replace the US dollar.

The report from the People's Bank of China (PBOC) said a "super-sovereign" currency should take its place.

Central bank chief Zhou Xiaochuan has loudly led calls for the dollar to be replaced during the financial crisis.

The bank report called for more regulation of the countries that issue currencies that underpin the global financial system.

"An international monetary system dominated by a single sovereign currency has intensified the concentration of risk and the spread of the crisis," the Chinese central bank said.

The dollar fell after the report was released. The US currency dropped 1% against the euro to $1.4088, and declined 0.8% versus the British pound to $1.6848.

SDRs

Mr Zhou caused a stir earlier this year when he said the dollar could eventually be replaced as the world's main reserve currency by the Special Drawing Right (SDR), which was created as a unit of account by the IMF in 1969.

CURRENCY RESERVES Foreign currency held by a government or a central bank Used to pay foreign debt obligations or influence exchange rates The dollar is viewed as the world's reserve currency as the vast majority of reserves are held in the US currency Smaller amounts are held in euros, pounds and yen Dollar poses dilemma for China

The PBOC said in the report that not only should the world adopt the SDR, but that the IMF should be entrusted with managing a portion of its member countries' foreign currency reserves.

"To avoid intrinsic shortcomings in using a sovereign currency as a reserve currency, we need to create an international reserve currency that is divorced from sovereign states and can maintain a stable value over the long term," the PBOC report said.

It also issued some veiled criticism of the US policies, saying that one of the major issues was that it was difficult to balance the needs of domestic politics with the requirements of being the world's reserve currency.

"The economic development model of debt-based consumption is most difficult to sustain," the PBOC said.

Russian President Dmitry Medvedev recently joined Mr Zhou in saying it was time to consider an alternative benchmark currency for international debt.

But Russian finance minister Alexei Kudrin then said "it's too early to speak of an alternative".

Latin America's economies That fragile thing: a good reputation

A reformed region cannot escape recession but it can mitigate its impact

FOR much of the past two centuries Latin America has been a byword for the profligate squandering of economic promise and for financial crisis. So ingrained is this reputation that when Chile’s president recently met Britain’s prime minister and boasted of her government’s foresight in saving some of its windfall revenues during the boom years, George Osborne, the shadow chancellor of the exchequer, sneered: “Gordon Brown is getting lessons from the Latin Americans about sound public finances. You couldn’t make it up.”

Happily, Mr Osborne’s view of Latin America is outdated, or at least it now applies in only a few places. Over the past decade, most of the bigger countries in the region have greatly improved their economic policies and the government institutions that implement them. That is the main reason why Latin America was until recently a spectator in the world financial crisis. Its banks are generally conservative and well-regulated. Many countries eschewed their past habit of abusing a boom to borrow. Public finances were mostly in balance, public debt fell and the region ran a current-account surplus. Indeed Chile is one of the world’s best-managed economies by almost any yardstick, but Mexico, Brazil, Colombia, Peru and Uruguay are not all that far behind.

Sadly none of this has shielded the region from the world recession (see article). Most forecasters predict that Latin America’s output will contract this year and recover only modestly next year, so income per head will shrink. Some countries are doing worse than others. Even before the flu outbreak, Mexico had been especially hard hit, because its economy is so closely tied to that of the United States. Brazil is better placed. Argentina, Venezuela and Ecuador have spurned the prudence of their neighbours and antagonised investors. Only the uncertain prospect of Chinese aid stands between these three countries and possible financial crisis next year.

Yet overall, in contrast to its past recessions, Latin America is doing no worse than the world as a whole. In other words, it is not adding to its troubles with internal weaknesses. What’s more, its governments have been able to cushion the blow with counter-cyclical policies of the kind that the rich world has taken for granted since Keynes but which Latin America’s habitual profligacy and lack of credibility denied it in the past. So instead of having to cut spending as tax revenues fall, this time many governments have been able to increase it. Their central banks have earned sufficient credentials as inflation fighters, and many have enough reserves, to cut interest rates without prompting a dangerous weakening of the currency.

Know your limits

Still, there are limits to what governments can do to mitigate the pain. While there’s scope, by and large, for easing monetary policy, fiscal policy is more constrained. The IMF, the World Bank and the Inter-American Development Bank will plug much of the gap this year, but next year looks harder. Tax revenues will have fallen further and Latin American governments’ dodgy past records may hamper their ability to raise money in debt markets that will be heavily oversubscribed.

The priority for those governments should be to maintain their hard-won reputation for financial stability. That will mean keeping a tight rein on budgets. Some of the social gains of recent years will inevitably be lost. But governments can help the poor by focusing spending on, for instance, preventing child malnutrition, discouraging pupils from dropping out of school and beefing up health services.

There is another, harder lesson. Latin America’s recent growth owed much to the outside world, cheap money and high commodity prices. With the world economy facing (at best) several sluggish years, the region will have to look closer to home for growth, by raising its productivity. That needs a huge effort not just to improve education, but also to implement long-postponed reforms of, for instance, labour markets. Such things are never easy in Latin America, where democratic politicians face voters who have to bear the world’s widest inequalities of income. But if the region is to consolidate its still novel reputation for prudent progress and good management, they will have to be done.

(From The Economist print edition)

The Economies of latin America

A reformed region cannot escape recession but it can mitigate its impact

FOR much of the past two centuries Latin America has been a byword for the profligate squandering of economic promise and for financial crisis. So ingrained is this reputation that when Chile’s president recently met Britain’s prime minister and boasted of her government’s foresight in saving some of its windfall revenues during the boom years, George Osborne, the shadow chancellor of the exchequer, sneered: “Gordon Brown is getting lessons from the Latin Americans about sound public finances. You couldn’t make it up.”

Happily, Mr Osborne’s view of Latin America is outdated, or at least it now applies in only a few places. Over the past decade, most of the bigger countries in the region have greatly improved their economic policies and the government institutions that implement them. That is the main reason why Latin America was until recently a spectator in the world financial crisis. Its banks are generally conservative and well-regulated. Many countries eschewed their past habit of abusing a boom to borrow. Public finances were mostly in balance, public debt fell and the region ran a current-account surplus. Indeed Chile is one of the world’s best-managed economies by almost any yardstick, but Mexico, Brazil, Colombia, Peru and Uruguay are not all that far behind.

Sadly none of this has shielded the region from the world recession (see article). Most forecasters predict that Latin America’s output will contract this year and recover only modestly next year, so income per head will shrink. Some countries are doing worse than others. Even before the flu outbreak, Mexico had been especially hard hit, because its economy is so closely tied to that of the United States. Brazil is better placed. Argentina, Venezuela and Ecuador have spurned the prudence of their neighbours and antagonised investors. Only the uncertain prospect of Chinese aid stands between these three countries and possible financial crisis next year.

Yet overall, in contrast to its past recessions, Latin America is doing no worse than the world as a whole. In other words, it is not adding to its troubles with internal weaknesses. What’s more, its governments have been able to cushion the blow with counter-cyclical policies of the kind that the rich world has taken for granted since Keynes but which Latin America’s habitual profligacy and lack of credibility denied it in the past. So instead of having to cut spending as tax revenues fall, this time many governments have been able to increase it. Their central banks have earned sufficient credentials as inflation fighters, and many have enough reserves, to cut interest rates without prompting a dangerous weakening of the currency.

Know your limits

Still, there are limits to what governments can do to mitigate the pain. While there’s scope, by and large, for easing monetary policy, fiscal policy is more constrained. The IMF, the World Bank and the Inter-American Development Bank will plug much of the gap this year, but next year looks harder. Tax revenues will have fallen further and Latin American governments’ dodgy past records may hamper their ability to raise money in debt markets that will be heavily oversubscribed.

The priority for those governments should be to maintain their hard-won reputation for financial stability. That will mean keeping a tight rein on budgets. Some of the social gains of recent years will inevitably be lost. But governments can help the poor by focusing spending on, for instance, preventing child malnutrition, discouraging pupils from dropping out of school and beefing up health services.

There is another, harder lesson. Latin America’s recent growth owed much to the outside world, cheap money and high commodity prices. With the world economy facing (at best) several sluggish years, the region will have to look closer to home for growth, by raising its productivity. That needs a huge effort not just to improve education, but also to implement long-postponed reforms of, for instance, labour markets. Such things are never easy in Latin America, where democratic politicians face voters who have to bear the world’s widest inequalities of income. But if the region is to consolidate its still novel reputation for prudent progress and good management, they will have to be done.

Global downturn: In graphics

This is one of the most tumultuous times on record in the global financial markets.

TRILLION-DOLLAR BAIL-OUTS

Huge amounts of money have been committed in financial support for banks.

BILLION-DOLLAR STIMULUS PACKAGES

Governments are spending billions of dollars to kick-start economic growth. Measures include tax cuts and building projects.

VICTIMS

The financial landscape has changed dramatically, with several giants of the business world disappearing.

UK BANK BAIL-OUT PACKAGE

The UK has spent £94bn to prop up Royal Bank of Scotland, HBOS and Lloyds TSB as well as nationalised Northern Rock and parts of Bradford & Bingley.

The Treasury and the Bank of England have pledged hundreds of billions of pounds of further support for the fragile banking system.

A £250bn credit guarantee scheme announced in October is being expanded to encourage banks to lend more, with a commitment of up to £50bn.

US BANK BAIL-OUT PACKAGE

There has been an array of measures to provide support to the battered US financial system.

A $700bn scheme approved last year, known as the Troubled Asset Relief Programme, was used to help lenders like Citigroup and Bank of America as well as the automobile industry.

Major changes to the programme have been announced by the new administration, including a partnership with the private sector to buy toxic assets from banks.

ECONOMIES HIT

World economic growth is expected to slow sharply, with the UK among the hardest hit. Developing countries such as China and India should fare better.

LEGACY OF DEBT

As countries try to spend their way out of recession, debt levels are forecast to rise.

Losses from Meltdown to reach 4 Thrillion USD

The International Monetary Fund (IMF) has warned that potential losses from the credit crunch could reach $4 trillion (£2.75tn) and damage the financial system for years to come.

It says that even if urgent action is taken to clean up the banking system, the process will be "slow and painful", delaying economic recovery.

It says that banks may need $1.7 trillion in additional capital.

But it warns that political support for further bank bail-outs is waning.

WHY $4TN LOSS MATTERS The banks' huge losses have made them reluctant to lend The lack of lending has pushed the world economy into a deep recession Government budgets are strained by the cost of the bail-outs, hitting taxpayers

One year ago, the IMF estimated that total losses from the credit crunch would be $1 trillion, which has been exceeded, showing how rapidly the financial meltdown has escalated.

The IMF now says that banks are likely to lose $2.7 trillion, but other financial institutions such as insurance companies and pension funds are also now coming under strain.

And it says that emerging market economies, which will need $1.8 trillion in refinancing next year, will be hard-hit by the collapse of cross-border lending, and it predicts that there will be no net private lending at all to developing countries this year.

The report comes as the IMF and World Bank are beginning their spring meeting in Washington, after receiving a promise of $750bn in fresh funds agreed at the G20 summit.

Policy response

The IMF's latest Global Stability Report says that the banking system has not yet been stabilised, despite the billions of dollars spent by governments.

Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested IMF

But it warns that they may be "a real risk that governments will be reluctant to allocate enough resources to solve the problem" because the public has become "disillusioned by what it perceives as abuse of taxpayer funds".

This is the situation especially in the US, where Congress appears reluctant to allocate additional bail-out funds above the $700bn approved last autumn despite the inclusion of another $750bn in President Obama's latest budget proposal.

The US Treasury has instead proposed a private-public partnership to buy up troubled assets underwritten by loans from the Federal Reserve.

But the IMF comments that "uncertainty about political reactions may undermine the likelihood that the the private sector will constructively engage in finding orderly solution to financial stress."

Deeper recession

The IMF says that restoring the banking system so that it functions normally is likely to take several years, and this will make the recession longer and deeper than usual.

COST OF REBUILDING BANKS US banks: $275bn Eurozone banks: $725bn UK banks: $250bn Other European banks: $225bn Source: IMF, based on 6% capital/assets ratio

But it warns that if policies are unclear or not implemented forcefully and promptly, "the recovery process is even more delayed and the costs, in terms of taxpayer money and economic activity, are even greater."

It says that the worldwide recession has deepened the financial crisis.

"Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning.

"Further effective government action - particularly geared toward cleansing balance sheets and strengthening institutions - will be required to stabilise the global financial system and to provide the foundation for a sustainable economic recovery."

On Wednesday, the IMF will present its world economic forecast.

It is expected to be the gloomiest for 60 years, with the world falling into a global recession, and an even sharper decline in output in the rich countries.

The rise and fall of the Filthy rich

The rich under attack

Apr 2nd 2009
From The Economist print edition

Going for the bankers is tempting for politicians—and dangerous for everybody else

The Bridgeman Art Library

STONES thrown through a banker’s windows in Edinburgh, workers “bossnapping” executives in France, retrospective 90% tax rates proposed in Washington, and now a riot in London as G20 leaders arrived for their summit (see article). A sea change in social attitudes that could have profound effects on politics and the world economy is under way.

The rich are certainly not the only targets in the current populist backlash. Frightened by the downturn, people are furious with politicians, central bankers and immigrants. But a rising wave of anger is directed against the new “malefactors of great wealth”. Today’s villains are a larger and more global bunch than the handful of American robber barons Teddy Roosevelt denounced a century ago; and most of them are bankers and fund managers, rather than owners of trusts and railroads. Yet the themes are similar to those at the end of that previous gilded age: rising inequality—the top 0.1% of Americans earned 20 times the income of the bottom 90% in 1979 and 77 times in 2006—and a sense that the greedy rich have cheated decent working people of their rightful share of the pie.

Some of this cheating has been of an old familiar sort: building Ponzi schemes and bribing politicians to secure favourable deals. There are greyer areas, in which the rich hide their cash in tax havens and get tax law written to their advantage—witness the indefensible treatment of private-equity profits. But what makes the rich’s behaviour so galling for many critics is that their two greatest crimes were committed in broad daylight, as they were part of the system itself.

The two great cheats

The first charge is that the rich created a new form of heads-I-win-tails-you-lose capitalism. Traders and fund managers got huge rewards for speculating with other people’s money, but when they failed the parent company, the client and ultimately the taxpayer had to pay the bill. Monetary policy contributed to this asymmetry of risk: when markets faltered central banks usually rescued them by cutting interest rates.

The second charge is that the bankers and fund managers were not doing anything useful. Unlike the “deserving” rich entrepreneurs who set up Microsoft and Google, the “undeserving” traders and brokers just shuffled money around the system to nobody’s profit but their own. The faster the money went round, the larger the financial sector loomed in the rich countries’ economies. At its peak it contributed 41% of domestic American corporate profits, more than double the rate two decades ago. As finance grew, the banks got ever bigger—too big to fail, eventually, so when they tottered taxpayers had to prop them up. Far from epitomising capitalism, the undeserving rich undermined it: it was socialism for the wealthy.

These two charges run together, but the second has much less justification. Enormous though the cost of bailing out the banks has been, there is nothing inherently undeserving about finance; even in their flawed state, more liquid markets have brought huge benefits to the rest of the economy. The lower cost of capital has made it easier for industry to invest, innovate and protect itself against interest and exchange-rate risk. Trying to single out financiers from entrepreneurs is a fool’s errand: you will end up hurting both.

The heads-I-win charge is not entirely proven, either: some of the people who ran banks did lose when they went bust. Yet even a newspaper as inherently pro-business as this one has to admit that there was something rotten in finance: the basic capitalist bargain, under which genuine risktakers are allowed to garner huge rewards, seems a poor one if taxpayers are landed with a huge bill for it all. Hence the anger.

A time for correction and brown paper bags

Periods of excess, when inequality has grown, tend to be followed by eras of reform: Roosevelt bust the trusts and shortly afterwards Congress moved towards introducing a federal income tax. Part of the genius of capitalism is its ability to adjust to disruption from within and attacks from without.

Indeed, the system is already beginning to correct itself. As our special report this week points out, the rich are not as rich as they were: some $10 trillion, around a quarter of the wealthy’s assets, has been lost. Inequality will decline. Investment banks and hedge funds are shrinking; private-equity groups are struggling to finance takeovers. Having discovered how volatile markets can be, banks will be less keen on trading in the future. There is even a correction going on in conspicuous consumption: Net-a-porter, a pricey website, offers to deliver designer outfits to its customers in brown paper bags.

The market’s self-correction will not be enough, however. Higher taxes will eventually be inevitable, since so many governments have lurched heavily into deficit. But politicians must tread carefully. Tax rises right away would be a rotten idea, since for the moment fiscal stimulus is needed. And even when governments raise the money, they should first get rid of deductions and reverse unmeritocratic measures (such as George Bush’s repeal of America’s death tax) rather than jacking up income-tax rates to punitive levels. Squeeze the rich until the pips squeak, and the juice goes out of the economy.

As for heads-I-win capitalism, the problem of asymmetric risk should shrink, because the rule changes needed to make the financial system safer will also remove unwarranted profits. Contra-cyclical capital requirements, forcing banks to build more reserves during good times, will leave them less cash to splurge on bonuses. Many of the sweetest sources of profit sprang up in the cracks between regulatory systems; governments are now filling in these gaps. If central banks focus on asset markets when they rise as well as when they fall, they will remove much of the froth. Treat a bank that becomes too big to fail like a utility, and it will make less money.

Curbing the excesses of wealth, then, will be a side effect of regulations designed to make capitalism work better. Such measures will not provide the lyrics to revolutionary anthems, but they are going to be better than going after the wealthy. The rich are an easy target. But when you try to bash them, you usually end up punching yourself in the nose.

$61.7bn Loss reported by AIG

AIG reports record $61.7bn loss

Ed Liddy: 'The basic operations of AIG remain rock solid'

Insurance giant AIG has reported a loss of $61.7bn (£43bn) in the final three months of 2008 - the largest quarterly loss in corporate history.

And the firm will receive an extra $30bn from the US government as part of a revamped rescue package.

AIG has already received $150bn in financial support - the biggest bail-out by far of any US company.

Stock markets slid sharply as AIG's plight underscored fears about the health of the global financial system.

The Federal Reserve and the Treasury said that AIG posed a "systemic risk" to the global financial system.

"The potential cost to the economy and the taxpayer of government inaction would be extremely high," they said.

BAIL-OUTS RECEIVED AIG - $180bn Bank of America - $45bn Citigroup - $50bn JP Morgan Chase - $25bn Wells Fargo - $25bn Goldman Sachs - $10bn Morgan Stanley - $10bn State Street - $3bn Bank of New York Mellon - $3bn

"The additional resources will help stabilise the company, and in doing so help to stabilise the financial system."

As well as insuring households, AIG plays a key role in insuring risk for financial institutions around the world.

The news of AIG's historic loss comes as HSBC, Europe's biggest bank, seeks to raise £12.5bn ($17.7bn) to strengthen its finances following a 62% fall in annual profit.

Revamp

The revamped rescue package also involves a restructuring of AIG's operations.

It calls for the Federal Reserve to take stakes in two of AIG's international units in exchange for reducing AIG's debt.

The new measures will also effectively cut the interest payments the insurer must pay to the Federal Reserve.

The AIG financial support is about three times greater than that given to Citigroup, which has received $50bn, and Bank of America, which has received $45bn.

AIG chief executive, Ed Liddy said that the loss, while hefty, could be explained.

"Asset values on a worldwide basis are going down. When we record those declines, they go through our P&L [profit and loss account] - that's about half of our loss," he said.

"Second, when you're going through a restructuring of a company, it calls into question things like good-will and deferred tax assets... We've written down the value of some of those. That's primarily what constitutes that $62bn.

"If you look past that - admittedly that's a big ask - the basic insurance operations of AIG remain rock solid."

Fear of failure

AIG: QUICK FACTS 30 million US policy holders Operates in 130 countries Provides insurance to 100,000 companies and other entities

US officials fear that a failure of AIG would be disastrous for both the US and the global economy.

Credit rating agencies, such as Moody's, Fitch and Standard & Poor's, had been poised to cut AIG's credit ratings as a result of the record loss.

That could have forced AIG to default on its debt, which would have had a knock-on effect on all of AIG's businesses.

AIG provides insurance protection to individuals, small firms, municipalities, personal pension plans and major US listed companies.

It also insures major financial institutions against complex deals going wrong through derivative contracts such as credit default swaps - the main cause of its problems.

The company first received financial assistance from the state in September in the wake of Lehman Brother's collapse.

In the UK, AIG is best known as a sponsor of Manchester United, but the deal is due to come to an end.

It also underwrites insurance sold by a number of High Street names including Boots and Argos.

Nosediving US Economy?

US economy suffers sharp nosedive

Falling exports have hurt US economic growth

The US economy shrank at an annual rate of 6.2% in the last three months of 2008 official figures show, a far sharper fall than previously reported.

Plunging exports and the biggest fall in consumer spending in 28 years dragged the annualised figure down from an earlier estimate of 3.8%.

The decline was much worse than analysts had expected, sending US stocks spiralling lower.

In 2008 as a whole, the economy grew by 1.1%, the slowest pace since 2001.

The blue-chip Dow Jones industrial average dropped 119.15 points, or 1.66%, to 7,062.93. The broader Standard & Poor's 500 Index fell 2.36% to 735.09 - a 12-year low.

Recession warning

Consumer spending, which accounts for about two-thirds of domestic economic activity, fell by a rate of 4.3% in the final quarter - the biggest fall since the second quarter of 1980. This was a revision of the earlier figure of 3.5%.

It shows the weak state of the world's largest economy Matt Esteve Tempus Consulting

With rising unemployment, sliding home values, increasing numbers of repossessions and the slumping value of investments, observers say many US consumers are hanging on to whatever disposable cash they have.

Meanwhile, exports - which had until recently been supporting the economy - fell at the sharpest rate since 1970 at an annual rate of 23.6%, down from 19.7%.

Earlier this week, Federal Reserve chief Ben Bernanke warned Congress that without the right policies from the government, the US recession could last into 2010.

But he said if the Obama administration and the central bank can restore some measure of financial stability, 2010 could be a year of recovery.

President Obama recently signed a $787bn (£556m) recovery package of increased government spending and tax cuts, and unveiled a $75bn scheme to stem repossessions.

No good news

The latest GDP figures were "just awful" said Matt Esteve, a currency trader at Tempus Consulting in Washington DC. "It shows the weak state of the world's largest economy."

And Boris Schlossberg, director of currency research at GFT Forex said there was "doom all over".

He predicted that the dollar would not weaken too much against the euro because "there's no good news on the other side of the Atlantic, either".

Economics focus Banks need more capital

Alan Greenspan says banks will need much thicker capital cushions than they had before the bust

Greenspan AssociatesAlan Greenspan was the chairman of the Federal Reserve Board from 1987 to 2006. He is now president of Greenspan Associates

GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis.

For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of market perceptions of potential bank insolvency and thus of extra capital needs, rose from a long-standing ten basis points in the summer of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS spread appeared range-bound for about a year up to mid-September 2008. The Lehman default, however, drove LIBOR/OIS up markedly. It reached a riveting 364 basis points on October 10th.

The passage by Congress of the $700 billion Troubled Assets Relief Programme (TARP) on October 3rd eased, but did not erase, the post-Lehman surge in LIBOR/OIS. The spread apparently stalled in mid-November and remains worryingly high.

How much extra capital, both private and sovereign, will investors require of banks and other intermediaries to conclude that they are not at significant risk in holding financial institutions’ deposits or debt, a precondition to solving the crisis?

The insertion, last month, of $250 billion of equity into American banks through TARP (a two-percentage-point addition to capital-asset ratios) halved the post-Lehman surge of the LIBOR/OIS spread. Assuming modest further write-offs, simple linear extrapolation would suggest that another $250 billion would bring the spread back to near its pre-crisis norm. This arithmetic would imply that investors now require 14% capital rather than the 10% of mid-2006. Such linear calculations, of course, can only be very rough approximations. But recent data do suggest that, while helpful, the Treasury’s $250 billion goes only partway towards the levels required to support renewed lending.

Government credit has in effect acted as counterparty to a large segment of the financial intermediary system. But for reasons that go beyond the scope of this note, I strongly believe that the use of government credit must be temporary. What, then, will be the source of the new private capital that allows sovereign lending to be withdrawn? Eventually, the most credible source is a partial restoration of the $30 trillion of global stockmarket value wiped out this year, which would enable banks to raise the needed equity. Markets are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind). Human nature being what it is, we can count on a market reversal, hopefully, within six months to a year.

Though capital gains cannot finance physical investment, they can replenish balance-sheets. This can best be seen in the context of the consolidated balance-sheet of the world economy. All debt and derivative claims are offset in global accounting consolidation, but capital is not. This leaves the market value of the world’s real physical and intellectual assets reflected as capital. Obviously, higher global stock prices will enlarge the pool of equity that can facilitate the recapitalisation of financial institutions. Lower stock prices can impede the process. A higher level of equity, of course, makes it easier to issue debt.

Another critical price for the return of global financial stability is that of American homes. Those prices are likely to stabilise next year and with them the levels of home equity—the ultimate collateral for global holdings of American mortgage-backed securities, some toxic. Home-price stabilisation will help clarify the market value of financial institutions’ assets and therefore more closely equate the size of their book capital with the realities of market pricing. That should help stabilise their stock prices. The eventual partial recovery of global equities, as fear inevitably dissipates, should do the rest. Temporary public capital injections into banks would facilitate this process and arguably provide far more benefit per dollar than conventional fiscal stimulus.

Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter.

Why China is not to blame for the surge in global inflation

Inflated claims

Aug 14th 2008
From The Economist print edition

Why China is not to blame for the surge in global inflation

MANY people in America and Europe think that the recent surge in inflation, like almost everything else these days, is “made in China”. For a number of years, cheap Chinese goods helped to reduce prices in rich economies, but more recently wages and prices have surged in China. On top of this, the hungry dragon’s insatiable appetite for food, energy and other raw materials has given cartoonists an emotive image for the surge in global commodity prices. As a result, it is claimed, China is no longer exporting deflation to the rich world, but inflation.

China’s inflation rate did indeed hit almost 9% earlier this year (by July it had fallen to 6.3%). And after declining for several years, the prices of America’s imports from China jumped by 5.3% in the year to July, pushing up the prices of goods in Wal-Mart, where many Americans shop. However, import prices from China are rising more slowly than the cost of goods from elsewhere: the average price of manufactured goods imported into America from industrialised countries rose by 10.1% over the past year (see left-hand chart). Moreover, all of the increase in the price of Chinese imports reflects the fall in the dollar against the yuan, not higher costs in China. In yuan terms, average Chinese export prices are still falling.

There is something to the claim that China’s huge demand for food and energy is pushing up global commodity prices. China has accounted for a big slice of the growth in global consumption of oil and especially metals this decade, helping to drive prices higher. But its effect on global prices over the past year (when rich-world inflation took off) is easily overstated. The pace of growth in China’s oil demand slowed to 4% last year. That is still relatively high, but not nearly as much as its annual rate of 12% in 2001-04, a period when the Fed was fretting about deflation, not inflation. And China’s food production has grown faster than consumption over the past few years. As a small, but growing, net exporter of wheat, maize and rice, China has, if anything, helped to ease world grain prices.

A more nuanced argument, suggested in a recent speech by Donald Kohn, the Federal Reserve’s vice-chairman, is that lax monetary policies have recently caused emerging economies such as China to grow too fast, putting extra demand on resources. Mr Kohn concluded that central banks in emerging economies should tighten policy to restrain economic growth and so reduce global inflation. There are merits to this argument, but there is also a danger that Mr Kohn may be trying to pass the buck. After all, America’s interest rates have been historically low for most of the past decade and thus it must share much of the responsibility for higher global inflation.

Mr Kohn used to argue that globalisation had a muted impact on American inflation. In 2006 he said that emerging economies were mildly disinflationary, because by running current-account surpluses they were adding more to global supply than to demand. China still has a large external surplus, so—using the same logic—how can it now be fuelling world inflation? Other inconsistencies abound. Some economists accuse China of overheating and exporting inflation, at the same time as they criticise it for overinvesting and creating excess capacity, which would imply downward pressure on prices. Last year it was fashionable to argue that China should boost its domestic demand to reduce its excess saving; now it is being told to tighten monetary policy, which would slow the growth in demand.

Cheap at twice the price

Some of this confusion reflects a widespread misunderstanding about how China’s integration into the world economy affects prices in the rich world. A common mistake is to assume that falling export prices mean that China is exporting disinflation, whereas rising export prices imply it is exporting inflation. The truth is that the level of Chinese prices matters much more than their rate of increase. China helped to hold down inflation in developed economies not because its prices were falling, but because its goods were much cheaper.

In theory, global trade should cause prices in different countries to converge: the prices of low-cost producers should gradually increase as wages rise (ie, China’s falling prices were a temporary anomaly), while the prices of high-cost producers should fall. Thus so long as China’s wages and the prices of its goods remain well below those in rich countries (see right-hand chart, above), its increasing penetration of world markets will continue to depress prices for many years. For example, according to BCA Research, a firm of economic analysts, the prices of Chinese exports of electric motors and generators doubled over the past five years, yet because they remain much cheaper than American-produced products, their share of the American market has more than doubled, forcing local producers to cut prices. As China moves up the value chain, it will export cheaper products in new industries, such as cars. This will help to hold down global prices—although possibly by less than in the past.

Perhaps the best way to determine China’s impact on world inflation is to gauge whether its net impact is to increase aggregate global demand or supply. China is boosting both, but so far its “positive supply shock” has been the more important. The integration of China and other emerging economies into the world trading system has, in effect, more than doubled the global labour force, and by curbing workers’ bargaining power it has restrained pay demands in most developed economies in recent years. Despite higher consumer prices in America and the euro area, wage growth has remained subdued and real wages have fallen, which has prevented inflation from becoming entrenched.

Imagine if China did not trade with the rest of the world. Oil prices would be cheaper, whereas clothes, DVD players and computers would be dearer. China’s biggest global impact is on relative prices. The net result, however, is still disinflationary. China is a handy scapegoat, but the real blame for the rise in inflation in the rich world may lie with monetary policy closer to home.

taken from:http://www.economist.com/finance/displaystory.cfm?story_id=11920640