Never let reality get in the way of a good theory. That’s been the policy of western central banks since the end of the BabyBoomer-led SuperCycle in 2000, when the oldest Boomer moved out of the Wealth Creator 25-54 age group and into the Perennial 55+ cohort.
Inevitably this led to a slowdown in growth, as the Perennials already own most of what they need, and their incomes decline as they enter retirement. 40% of Americans aged 65+ would have incomes below the poverty line, if Social Security didn’t exist.
The well-meaning folk at the US Federal Reserve chose to ignore this development, and instead launched their subprime experiment But demographics are destiny, and their first attempt to effectively “print babies” ended in 2008’s near-disaster for the global economy.
Their problem, as John Maynard Keynes noted in his conclusion to his 1936 General Theory, was that:
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”
And in the case of today’s central bankers, they are enslaved to the theories of 2 defunct economists:
- One is Franco Modigliani, who won the 1955 Nobel Prize with his “life-cycle hypothesis”, which suggested individuals plan out their lifetime income and spending in advance, so as to even out their consumption over their entire lifetime
- The other is Milton Friedman, who won the 1975 Prize for his argument that “inflation is always and everywhere a monetary phenomenon”, ignoring the importance of supply and demand balances
Modigliani and Friedman were working before anyone realised a BabyBoom had taken place. When John Richardson and I were researching our book ‘Boom, Gloom and the New Normal: How the Western BabyBoomers are Changing Demand Patterns, Again’ in 2010, the authoritative Oxford English Dictionary gave the earliest use of the word as being in 1979.
So they might have some excuse for not being aware of the demand pressures caused by the fact that the number of US babies rose by 52% in 1946-64, compared to the previous 18 years. But today’s central bankers have no such excuse. Common sense, or a quick glance at the charts above would immediately confirm:
- Increasing life expectancy and falling fertility rates mean that an entirely new generation, the Perennials 55+, is alive today for the first time in history
- And the data shows very clearly that their spending falls off away once they turn 55, and is down 43% by the time they reach the age of 75
Similarly, common sense suggests that inflation is not a monetary phenomenon, but a function of supply and demand balances. The post-War BabyBoom was inevitably going to create a lot of demand and hence inflation, particularly as factories had first to be converted back from military production.
Similarly, when all these babies moved into the workforce, it was almost inevitable that:
- We would see more or less constant demand, as the Boomers reached their Wealth Creator years
- This demand would be turbo-charged as women went back into the workforce after starting a family, creating the two-income family for the first time in history
Fertility rates fell below replacement levels of 2.1 babies/woman as long ago as 1970. Inevitably, therefore, the number of Wealth Creators has plateaued – just as increasing life expectancy means that the number of Perennials is growing rapidly.
Since 2008, the Fed has completely failed to recognise this critical development for supply/demand balances.
Instead it has “doubled down” on the subprime policy, via record levels of stimulus. If you ask them why, they will tell you their core economic model – the Dynamic Stochastic General Equilibrium model – doesn’t need to include demographic detail, as it is based on Modigliani and Friedman’s theories.
We are therefore now almost certainly approaching a new crisis. As the chart on the left from Charlie Bilello confirms :
- The total of government bonds with negative interest rates has now reached $13tn
- The stock market is ignoring this evidence of slowing demand, and is still powering ahead
One or the other is soon going to be proved wrong.
THE END-GAME FOR THE STIMULUS POLICIES WILL LIKELY BE MAJOR DEFLATION
The central banks have spent the past 10 years following Friedman’s theory, believing they could create inflation via stimulus policies. Instead, their low interest rates encouraged companies to boost supply, at a time when the rise of the Perennials meant demand growth was already slowing.
Unsurprisingly, therefore, interest rates are going negative, as the Fed’s policies have effectively proved deflationary. Very worryingly, around 14% of US companies are already unable to service their debt, because their earnings are not enough to pay their interest bills.
Had the Fed focused on demographics, it would have been obvious that the best way to create demand was to increase the spending power of the Perennials, who typically rely on savings for extra income. But instead of allowing markets to set higher interest rates, the Fed chose to lower them, making deflation almost inevitable.
History suggests their next round of stimulus policy, if/when the S&P 500 weakens again, will be to introduce Friedman’s idea of “helicopter money” – and electronically transfer perhaps $500 to every American’s bank account. This will be the ultimate test for Friedman’s theory, as if it doesn’t magically create inflation, the Fed will have nothing more to do.
Maybe, this final burst of stimulus will work. But probably most Perennials, and many Wealth Creators, will instead save the money – alarmed by the Fed’s sense of desperation. In turn, this will turbocharge the deflationary cycle – forcing interest rates even lower and risking major economic turmoil.
Last year it was Bitcoin, in 2016 it was the near-doubling in US 10-year interest rates, and in 2015 was the oil price fall. This year, once again, there is really only one candidate for ‘Chart of the Year’ – it has to be the collapse of China’s shadow banking bubble:
- It averaged around $20bn/month in 2008, a minor addition to official lending
- But then it took off as China’s leaders panicked after the 2008 Crisis
- By 2010, it had shot up to average $80bn/month, and nearly doubled to $140bn in 2013
- President Xi then took office and the bubble stopped expanding
- But with Premier Li still running a Populist economic policy, it was at $80bn again in 2017
At that point, Xi took charge of economic policy, and slammed on the brakes. November’s data shows it averaging just $20bn again.
The impact on the global economy has already been immense, and will likely be even greater in 2019 due to cumulative effects. As we noted in this month’s pH Report:
“Xi no longer wants China to be the manufacturing Capital of the world. Instead his China Dream is based on the country becoming a more service-led economy based on the mobile internet. He clearly has his sights on the longer-term and therefore needs to take the pain of restructuring today.
“Financial deleveraging has been a key policy, with shadow bank lending seeing a $609bn reduction YTD November, and Total Social Financing down by $257bn. The size of these reductions has reverberated around Emerging Markets and more recently the West:
- The housing sector has nose-dived, with China Daily reporting that more than 60% of transactions in Tier 1 and 2 cities saw price drops in the normally peak buying month of October, with Beijing prices for existing homes down 20% in 2018
- It also reported last week under the heading ’Property firms face funding crunch’ that “housing developers are under great capital pressure at the moment”
- China’s auto sales, the key to global market growth since 2009, fell 14% in November and are on course for their first annual fall since 1990
- The deleveraging not only reduced import demand for commodities, but also Chinese citizens’ ability to move money offshore into previous property hotspots
- Real estate agents in prime London, New York and other areas have seen a collapse in offshore buying from Hong Kong and China, with one telling the South China Morning Post that “basically all Chinese investors have disappeared “
GLOBAL STOCK MARKETS ARE NOW FEELING THE PAIN
As I warned here in June (Financial markets party as global trade wars begin), the global stock market bubble is also now deflating – as the chart shows of the US S&P 500. It has been powered by central bank’s stimulus policies, as they came to believe their role was no longer just to manage inflation.
Instead, they have followed the path set out by then Federal Reserve Chairman, Ben Bernanke, in November 2010, believing that:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Now, however, we are coming close to the to the point when it becomes obvious that the Fed cannot possibly control the economic fortunes of 325m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted by central banks in this failed experiment.
The path back to fiscal sanity will be very hard, due to the debt that has been built up by the stimulus policies. The impartial Congressional Budget Office expects US government debt to rise to $1tn.
Japan – the world’s 3rd largest economy – is the Case Study for the problems likely ahead:
- Consumer spending is 55% of Japan’s GDP. It falls by around a third at age 70+ versus peak spend at 55, as older people already own most of what they need, and are living on a pension
- Its gross government debt is now 2.5x the size of its economy, and with its ageing population (median age will be 48 in 2020), there is no possibility that this debt can ever be repaid
- As the Nikkei Asian Review reported in July, the Bank of Japan’s stimulus programme means it is now a Top 10 shareholder in 40% of Nikkei companies: it is currently spending ¥4.2tn/year ($37bn) buying more shares
- Warning signs are already appearing, with the Nikkei 225 down 12% since its October peak. If global stock markets do now head into a bear market, the Bank’s losses will mount very quickly
CHINA MOVE INTO DEFLATION WILL MAKE DEBT IMPOSSIBLE TO REPAY
Since publishing ‘Boom, Gloom and the New Normal: how the Ageing Boomers are Changing Demand Patterns, Again“, in 2011 with John Richardson, I have argued that the stimulus policies cannot work, as they are effectively trying to print babies. 2019 seems likely to put this view to the test:
- China’s removal of stimulus is being matched by other central banks, who have finally reached the limits of what is possible
- As the chart shows, the end of stimulus has caused China’s Producer Price Inflation to collapse from 7.8% in February 2017
- Analysts Haitong Securities forecast that it will “drop to zero in December and fall further into negative territory in 2019“
China’s stimulus programme was the key driver for the global economy after 2008. Its decision to withdraw stimulus – confirmed by the collapse now underway in housing and auto sales – is already putting pressure on global asset and financial markets:
- China’s lending bubble helped destroy market’s role of price discovery based on supply/demand
- Now the bubble has ended, price discovery – and hence deflation – may now be about to return
- Yet combating deflation was supposed to be the prime purpose of Western central bank stimulus
This is why the collapse in China’s shadow lending is my Chart of the Year.
Oil and commodity markets long ago lost contact with the real world of supply and demand. Instead, they have been dominated by financial speculation, fuelled by the vast amounts of liquidity pumped out by the central banks. The chart above from John Kemp at Reuters gives the speculative positioning in the oil complex as published last Monday:
- It shows hedge fund positioning in terms of the ratio of long to short positions across the complex
- The ratio had been at a near-record low of 1.55x back in June last year, before the rally took off
- On 30 January it had risen to a record 11.9x – far above even the 2014 and 2017 peaks
The size of the rally has also been extraordinary, as I noted 2 weeks ago. At its peak, the funds owned 1.5bn barrels of oil and products – equivalent to an astonishing 16 days of global oil demand. They had bought 1.2bn barrels since June, creating the illusion of very strong demand. But, of course, hedge funds don’t actually use oil, they only trade it.
The funds also don’t normally hang around when the selling starts. And so last week, as the second chart shows, they began to sell their positions and take profits. The rally peaked at $71/bbl at the end of January, and then topped out on 2 February at $70/bbl. By last Friday, only a week later, Brent was at $63/bbl, having fallen 11% in just one week.
Of course, nothing had changed in the outlook for supply/demand, or for the global economy, during the week. And this simple fact confirms how the speculative cash has come to dominate real-world markets. The selling was due to nervous traders, who could see prices were challenging a critical “technical” point on the chart:
- Most commodity trading is done in relation to charts, as it is momentum-based
- The 200 day exponential moving average (EMA) is used to chart the trend’s strength
- When the oil price reached the 200-day EMA (red line), many traders got nervous
- And as they began to sell, so others began to follow them as momentum switched
The main sellers were the legal highwaymen, otherwise known as the high-frequency traders. Their algorithm-based machines do more than half of all daily trading, and simply want a trend to follow, milli-second by milli-second. As the Financial Times warned in June:
“The stock market has become a battlefield of algorithms, ranging from the simple – ETFs bought by retirees that may invest in the entire market, an industry, a specific factor or even themes like obesity – to the complex, commanded by multi-billion dollar “quantitative” hedge funds staffed by mathematicians, coders and data scientists.”
JP Morgan even estimates that only 10% of all trading is done by “real investors”:
“Passive and quantitative investors now account for about 60% of the US equity asset management industry, up from under 30% a decade ago, and reckons that only roughly 10% of trading is done by traditional, “discretionary” traders, as opposed to systematic rules-based ones.”
Probably prices will now attempt to stabilise again before resuming their downward movement. But clearly the upward trend, which took prices up by 60% since June, has been broken. Similar collapses have occurred across the commodity complex, with the CRB Index showing a 6% price fall across major commodities:
- Typically, inventory build ahead of price rises can add an extra month of “apparent demand” to real demand
- This inventory will now have to be run down as buyers destock to more normal levels again
- This means we can expect demand to slow along all the major value chains
- Western companies will now see slow demand through Easter: Asia will see slow demand after Lunar New Year
This disappointment will end the myth that the world is in the middle of a synchronised global recovery. In turn, it will cause estimates of oil demand growth to be reduced, further weakening prices. It will also cause markets to re-examine current myths about the costs of US shale oil production:
- As the charts from Pioneer Natural Resources confirm, most shale oil breakeven costs are below $30/bbl
- Pioneer’s own operating costs, typical of most of the major players, are below $10/bbl
- So the belief that shale oil needs a price of $50/bbl to support future production is simply wrong
PREPARE FOR PROFIT WARNINGS AND POTENTIAL BANKRUPTCIES BY THE SUMMER
Over the summer, therefore, many industrial companies will likely need to start issuing profit warnings, as it becomes clear that demand has failed meet expectations. This will put stock markets under major pressure, especially if interest rates keep rising as I discussed last month.
Smart CEOs will now start to prepare contingency plans, in case this should happen. We can all hope the recent downturn in global financial markets is just a blip. But hope is not a strategy. And the risk of profit warnings turning into major bankruptcies is extremely high, given that global debt now totals $233tn, more than 3x global GDP.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
Since January, I have also been monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. Today’s forecast for oil prices to fall initially to $50/bbl is therefore now added to those on ethylene/polyethylene and the US 10-year interest rate. I am also increasing the confidence level for the interest rate forecast to 70%, and will continue to update these levels when circumstances change.
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Every New Year starts with optimism about the global economy. But as Stanley Fischer, then vice chair of the US Federal Reserve, noted back in August 2014:
“Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”
Will 2018 be any different? Once again, the IMF and other forecasters have been lining up to tell us the long-awaited “synchronised global recovery” is now underway. But at the same, they say they are puzzled that the US$ is so weak. As the Financial Times headline asked:
“Has the US dollar stopped making sense?”
If the global economy was really getting stronger, then the US$ would normally be rising, not falling. So could it be that the economy is not, actually, seeing the promised recovery?
OIL/COMMODITY PRICE INVENTORY BUILD HAS FOOLED THE EXPERTS, AGAIN
It isn’t hard to discover why the experts have been fooled. Since June, we have been seeing the usual rise in “apparent demand” that always accompanies major commodity price rises. Oil, after all, has already risen by 60%.
Contrary to economic theory, companies down the value chains always build inventory in advance of potential price rises. Typically, this adds about 10% to real demand, equal to an extra month in the year. Then, when the rally ends, companies destock again and “apparent demand” weakens again.
The two charts above confirm that the rally had nothing to do with a rise in “real demand”:
Their buying has powered the rise in oil prices, based on the free cash being handed out by the central banks, particularly in Europe and Japan, as part of their stimulus programmes.
They weren’t only buying oil, of course. Most major commodities have also rallied. Oil was particularly dramatic, however, as the funds had held record short positions till June. Once they began to bet on a rally instead, prices had nowhere to go but up. 1.4bn barrels represents as astonishing 15 days of global oil demand, after all.
What has this to do with the US$, you might ask? The answer is simply that hedge funds, as the name implies, like to go long in one market whilst going short on another. And one of their favourite trades is going long (or short) on oil and commodities, whilst doing the opposite on the US$:
- Since June, they have been happily going long on commodities
- And as Reuters reports, they have also been opening major short positions on the dollar
The chart highlights the result, showing how the US$’s fall began just as oil/commodity prices began to rise.
COMPANIES HAVE NO CHOICE BUT TO BUILD INVENTORY WHEN COMMODITY PRICES RISE
This pattern has been going on for a long time. But I have met very few economists or central bankers who recognise it. They instead argue that markets are always efficient, as one professor told me recently:
“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”
But if you were a purchasing manager in the real world, you wouldn’t be sceptical at all. You would see prices rising for your key raw materials, and you would ask your CFO for some extra cash to build more inventory. You would know that a rising oil, or iron, or other commodity price will soon push up the prices for your products.
And your CFO would agree, as would the CFOs of all the companies that you supply down the value chain.
So for the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.
Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.
THE RISE IN COMMODITY PRICES, AND “APPARENT DEMAND”, IS LIKELY COMING TO AN END
What happens next is, of course, the critical issue. As we suggested in this month’s pH Report:
“This phenomenon of customers buying forward in advance of oil-price rises goes back to the first Arab Oil Crisis in 1973 – 1974. And yet every time it happens, the industry persuades itself “this time is different”, and that consumers are indeed simply buying to fill real demand. With Brent prices having nearly reached our $75/bbl target, we fear reality will dawn once again when prices stop rising.”
Forecasting, as the humorist Mark Twain noted, “is difficult, particularly about the future”. But hedge funds aren’t known for being long-term players. And with refinery maintenance season coming up in March, when oil demand takes a seasonal dip, it would be no surprise if they start to sell off some of their 1.4bn barrels.
No doubt many will also go short again, whilst going long the US$, as they did up to June.
In turn, “apparent demand” will then go into a decline as companies destock all down the value chain, and the US$ will rally again. By Q3, current optimism over the “synchronised global recovery” will have disappeared. And Stanley Fischer’s insight will have been proved right, once again.
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The US 10-year Treasury bond is the benchmark for global interest rates and stock markets. And for the past 30 years it has been heading steadily downwards as the chart shows:
- US inflation rates finally peaked at 13.6% in 1980 (having been just 1.3% in 1960) as the BabyBoomers began to move en masse into the Wealth Creator 25 – 54 age group
- Instead of simply boosting demand, as during the 1960s-1970s, they began to work and create new supply
- This meant supply/demand began to rebalance and interest rates then peaked at 16% in 1981
By 1983, the average Western Boomer (born between 1946-1970) had arrived in the Wealth Creator cohort, which dominates consumer spending, and the economy really began to hum. There was a final inflation scare in 1984, when US inflation suddenly jumped from 3% to 5%, but after that the trend was downwards all the way.
The Boomers were the largest and wealthiest generation that the world had ever seen. Their move to become Wealth Creators completely transformed the inflation outlook, as more and more Boomers joined the workforce. And they transformed the economy by moving it into the NICE era of Non-Inflationary Constant Expansion.
Central bankers took credit for this move, claiming it was due to monetary policy. But in reality, people are the key element in an economy, not monetary policy. You can’t have an economy without people. And sadly, the idea that the US Fed Chairman Alan Greenspan had somehow become a Maestro, blinded everyone to 2 key issues for the future:
- Life expectancy was rising rapidly, meaning that the Boomers would not normally die just after retirement. Instead, they would likely live for another 15 – 20 years after reaching age 65
- From 1970, fertility rates had fallen below replacement level (2.1 babies/woman) across the Western world
This combination of a rise in life expectancy and a collapse in fertility rates was creating a timebomb for the economy.
THE RISE IN LIFE EXPECTANCY AND COLLAPSE OF FERTILITY RATES CREATED AN ECONOMIC TIMEBOMB
Western economies are based on consumer spending. And spending declines once people reach the age of 55 – they already own most of what they need, and their incomes decline as they approach retirement, as the second chart shows:
- There were 65m US Wealth Creator households in 2000, who spent an average of $62k ($2017)
- There were only 36m in the 55+ cohort, who spent just $45k each
- In 2017, there were 66m Wealth Creators (almost the same as in 2000) who spent $64k each
- But there were now 56m in the 55+ cohort, who spent just $51k each
The rise in 55+ spending was also only temporary, as large numbers of Boomers have just reached 55+ and have not yet retired. Spending by those aged 74+ was down by nearly 50% versus the peak spending 45-54 age group.
BELIEF IN MONETARISM LED TO THE DOTCOM AND SUBPRIME DISASTERS
The dot-com crash in 2000 should have been a wake-up call for the failure of monetarism. It also, after all, marked the moment when the oldest Boomers began to join the 55+ cohort. But instead, policymakers thought monetarism could solve “the problem” and cut interest rates to boost the housing market – causing the subprime crash in 2008.
One might have thought – as we wrote in Boom, Gloom and the New Normal in 2011 – that this disaster would have destroyed the monetarism myth. But no. Abandoning monetarism would have led to a difficult conversation with voters about the need for everyone to retrain in their 50s, and prepare to take on new, and less physically demanding, roles.
Instead, policymakers tried to replace lost BabyBoomer demand by printing vast amounts of free money via the Quantitative Easing and Zero Interest Rate Policies. Their aim was to avoid deflation, as inflation had fallen to just 0.6% in 2010 – although why this was a “bad thing” was never explained. But in reality, they were running uphill, and the pace of the climb was becoming more vertical, as the average Western Boomer joined the 55+ cohort in 2013.
Of course, flooding the market with cheap money boosted asset prices, as they intended. Stock markets and house prices soared for a second time. But it also created a major new risk. More and more investors began to panic as they hunted through the markets, trying to obtain a decent “return on capital”. They assumed central banks would never let markets fall, and so gave up worrying about the risk of making a dud investment.
INTEREST RATES ARE NOW HEADED HIGHER AS PEOPLE WORRY ABOUT RETURN OF CAPITAL
The end of the Bitcoin bubble has highlighted the fact that that risk and reward are normally related. Most investments that offer potentially high rewards are also high risk – a lot has to go right, for them to make the possible return. This process of price discovery – the balance of risk and reward – is the key role of markets.
Left to themselves, markets will price risk properly. But they have been swamped for the past decade by central bank liquidity and their crucial role has been temporarily destroyed. Now, the fact that the US 10-year bond has broken out of its 30-year downtrend tells us that markets they are finally starting to regain their role.
How high will interest rates now go? We cannot yet know, and we can also be sure they will not move in a straight line as central banks will continue to intervene. But as more and more investments, like Bitcoin, prove to be duds, so more and more investors will start to worry about return of capital when they invest.
4% therefore looks like the next level for rates, as we are now trading within the blue bars on the chart. It may not take very long for this level to be reached, given the fact that the world now has a record $233tn of debt – 3x the size of the global economy. After that, we shall have to wait and see.
I strongly believe that forecasts should be monitored, which is why I always review the previous Annual Budget forecast before issuing the next Outlook, and always publish the complete list of Annual Budget Outlooks.
I now plan to begin monitoring my blog forecasts, using the percentage mechanism highlighted in Philip Tetlock’s masterly “Superforecasting” book. The first forecasts relate to last week’s post on US polyethylene exports and today’s forecast for the US 10-year Treasury bond. I will change confidence levels as and when circumstances change.
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China is no longer seeking ‘growth at any cost’, with global implications, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
A pedestrian covers up against pollution in Beijing © Bloomberg
China’s President Xi Jinping faced two existential threats to Communist party rule when he took office 5 years ago.
He focused on the first threat, from corruption, by appointing an anti-corruption tsar, Wang Qishan, who toured the country gathering evidence for trials as part of a high-profile national campaign.
More recently, Mr Xi has adopted the same tactic on an even broader scale to tackle the second threat, pollution. Joint inspection teams from the Ministry of Environmental Protection, the party’s anti-graft watchdog and its personnel arm have already punished 18,000 polluting companies with fines of $132m, and disciplined 12,000 officials.
The ICIS maps below confirm the broad nature of the inspections. They will have covered all 31 of China’s provinces by year-end, as well as the so-called “2+26” big cities in the heavily polluted Beijing-Tianjin-Hebei area.
The inspections’ importance was also underlined during October’s five-yearly People’s Congress, which added the words “high quality, more effective, more equitable, more sustainable” to the Party’s Constitution to describe the new direction for the economy, replacing Deng’s focus from 1977 on achieving growth at any cost.
It is hard to underestimate the likely short and longer-term impact of Mr Xi’s new policy. The Ministry has warned that the inspections are only “the first gunshot in the battle for the blue sky”, and will be followed by more severe crackdowns.
In essence, Mr Xi’s anti-pollution drive represents the end for China’s role as the manufacturing capital of the world.
The road-map for this paradigm shift was set out in March 2013 in the landmark China 2030 joint report from the World Bank and China’s National Development and Reform Commission. This argued that China needed to transition “from policies that served it so well in the past to ones that address the very different challenges of a very different future”.
The report focused on the need for “improvement of the quality of growth”, based on development of “broader welfare and sustainability goals”.
However, little was achieved on the environmental front in Xi’s first term, as Premier Li Keqiang continued the Populist “growth at any cost” policies of his predecessors. According to the International Energy Agency’s recent report, Energy and Air Pollution, “Average life expectancy in China is reduced by almost 25 months because of poor air quality”.
But as discussed here in June, Mr Xi has now taken charge of economic policy. He is well aware that as incomes have increased, so China is following the west in becoming far more focused on ‘quality of life issues’. Land and water pollution will inevitably take longer to solve. So his immediate target is air pollution, principally the dangerously high levels of particulate matter, PM2.5, caused by China’s rapid industrialisation since joining the World Trade Organization in 2001.
As the state-owned China Daily has reported, the Beijing-Tianjin-Hebei region is the main focus of the new policy. Its high concentration of industrial and vehicle emissions is made worse in the winter by limited air circulation and the burning of coal, as heating requirements ramp up. The region has been told to reduce PM2.5 levels by at least 15% between October 2017 and March 2018. According to Reuters, companies in core sectors including steel, metal smelting, cement and coke have already been told to stagger production and reduce the use of trucks.
The chemicals industry, as always, is providing early insight into the potentially big disruption ahead for historical business and trade patterns:
- Benzene is a classic early indicator of changing economic trends, as we highlighted for FT Data back in 2012. The chart above confirms its importance once again, showing how the reduction in its coal-based production has already led to a doubling of China’s imports in the January to October period versus previous years, with Northeast and Southeast Asian exporters (NEA/SEA) the main beneficiaries
- But there is no “one size fits all” guide to the policy’s impact, as the right-hand panel for polypropylene (PP) confirms. China is now close to achieving self-sufficiency, as its own PP production has risen by a quarter over the same period, reducing imports by 9%. The crucial difference is that PP output is largely focused on modern refining/petrochemical complexes with relatively low levels of pollution
Investors and companies must therefore be prepared for further surprises over the critical winter months as China’s economy responds to the anti-pollution drive. The spring will probably bring more uncertainty, as Mr Xi accelerates China’s transition towards his concept of a more service-led “new normal” economy based on the mobile internet, and away from its historical dependence on heavy industry.This paradigm shift has two potential implications for the global economy.
One is that China will no longer need to maintain its vast stimulus programme, which has served as the engine of global recovery since 2008. Instead, we can expect to see sustainability rising up the global agenda, as Xi ramps up China’s transition away from the “policies that served it so well in the past”.
A second is that, as the chart below shows, China’s producer price index has been a good leading indicator for western inflation since 2008. Its recovery this year under the influence of the shutdowns suggests an “inflation surprise” may also await us in 2018.
Paul Hodges and Daniël de Blocq van Scheltinga publish The pH Report.
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