Month: September 2023

Financial Repression Has Won For Now

 

The world’s most prominent central banks operating in the largest and most liquid financial markets have successfully implemented financial repression policies over the past three years which have significantly reduced debt burdens.

The prize for the most agressive financial repression goes to the Bank of England. Negative interest rates over the past three years averaging -3% have reduced the U.K.’s total debt to GDP ratio by a whopping 71%, from 315% to 243%; and government debt to GDP was reduced by 47% , from 141% to 94%. As the chart below shows (data from the Bank for International Settlements, BIS) this pattern of financial repression has been the norm, and led by the world’s leading financial powers, the Euro Group and the United States in particular. The United States has has negative interest rates in 14 of the past twenty years, and since 2020, these policies teamed with “fiscal dominance” have caused a sharp fall in debt ratios.

In the case of emerging markets, Turkey, Poland, Malaysia, Argentina, Chile and Saudi Arabia stand out for their reductions in debt loads. Korea, China and Thailand are among the few countries that saw their debt burdens increase over this period. China, which faces strong deflationary forces caused by excess capacity, malinvestment, a real estate bust and a sharp decline in consumer confidence, has seen its debt ratios continue to rise from already extremely high levels. China’s total debt to GDP ratio rose over the past three years from 294% to 306%. Moreover, if China’s GDP is overstated by as much as 25% as many economists argue, China’s ratio may be approaching Japan’s stratospheric 407% ratio.

The case of Brazil is somewhat unique and points to the future for other countries. Brazil’s central bank has pursued ultra-orthodox policies, meaning that it has managed only a brief honeymoon with negative interest rates and now faces a long period with high real rates. Central bankers in Brazil don’t have room for financial repression, being as they are reined in by unstable “hot money” capital flows from both domestic and foreign investors.

The U.S. Fed, though in a much better shape than Brazil’s central bankers, is also facing challenges from new inflationary forces and fiscal deficits that are expected to rise consistently to fund the retirement of Baby Boomers.

The losers of financial repression (e.g., holders of government bonds and mortgage securitizations) have surely learned their lessons and, at any sign of a new crisis addressed with more quantitative easing, will flee to real assets that have a better chance of preserving value.

 

 

Chinese Auto Exports Threaten the Auto Industry Worldwide

Benefiting from technology transfers from multinationals and massive government subsidies, China has made itself the dominant force in the automotive industry over the past two decades. It has achieved this supremacy at a time when the industry is undergoing the most significant technological shift in 70 years: the transition from the internal combustion engine (ICE) to the electric motor. China had the foresight to anticipate this transition and leapfrog to the forefront of EV (Electric Vehicle) technology by harnessing subsidies and private capital. However, given the current reality of global geopolitical conflict and economic stagnation, China’s dominance of this critical industry may increasingly be seen by many countries as an unacceptable strategic and security threat.

Since the launch of Ford’s Model T in 1908, the automobile industry has been at the forefront of mass production manufacturing. By the 1950s, when the industry reached its peak impact on the American economy, the industry’s core technologies had been developed, and it entered its maturity stage. Since 1960, auto manufacturing has barely grown in the U.S., and the leading firms in the industry focused on disseminating their mass production skills around the world, a process that culminated with major multinational auto companies setting up plants in China between 1984 and 2004.

The chart below shows the auto industry’s annual growth rate since the 1950s. Global growth peaked in the 1960s, driven by Europe, Japan, and Latin America, and then has fallen every decade, except during the 2000s because of the precipitous rise in Chinese domestic demand. Growth for the twelve-year period ending in 2022 has been at a record-low 0.8% annually, despite a 50% increase in China’s output. U.S. production growth stalled much earlier, already in the 1950s, and only recovered in the 1980s and 1990s because protectionist policies were introduced to force foreign firms to make their cars in the U.S. There has been no increase in U.S. output since 1990.

The decline of the U.S. as a manufacturer of motor vehicles and the rise of China can be seen in the following chart (source: OICA, International Organization of Motor Vehicle Manufacturers). The U.S. emerged from World War II with nearly 80% of world output, was overtaken by Japan in the 1980s and 1990s, bottomed at a 10% share in 2010, and in 2022 had a 12% share. Since 1990, when the first joint-ventures with foreign firms began operating, China has grown its share of world output from 1% to 32%. The dominance of China in EV manufacturing is even more pronounced, reaching 59% of world output in 2022, compared to 19% for the United States. Germany, Japan, and South Korea followed, with shares of around 10%, 8%, and 6%, respectively (Canalys).

The following two charts show emerging market producers: first, mature players (Mexico, Brazil, Korea); and second, newcomers still enjoying growth (India, Indonesia, Thailand, Turkey, and Eastern Europe). Brazil’s share of global output peaked in 2010 but is now below 1980 levels. Mexico, despite NAFTA, is back to the level of 1990. Korea is also losing global share. In the case of countries growing their share of the global automotive pie, India and Eastern Europe stand out. Indian manufacturers benefit from trade protectionism (70% tariffs) and rapid economic growth. Eastern Europe has taken advantage of favorable EEU (Eurasian Economic Union) policies allowing firms to move production to places with lower wages.

The Market’s Reaction to the Inception of Chinese Vehicle Exports

The slowdown of China’s economy and low consumer confidence, combined with sustained investment in new production capacity, has caused excess manufacturing capacity and a surge in Chinese motor vehicle exports over the past two years. According to the China Association of Automobile Manufacturers, domestic sales of ICE (Internal Combustion Engine) vehicles peaked at 2.4 million monthly in 2018 and are now running at a monthly rate of 1.6 million, 36% lower. Exports of ICE cars have surged and are expected to reach 3.2 million units in 2023, an increase of 45% over 2022 levels. EV exports may reach 1 million units this year, a 60% increase. Remarkably, in three years, China has gone from almost no participation in auto exports to the leading position. China surpassed Korea in 2021, Germany in 2022, and long-time export leader Japan in 2023.

In the case of ICE cars, most of these exports are going to Russia, Eastern Europe, and developing countries in Asia and Latin America, undermining the competitiveness of manufacturers in those regions. EVs are mainly exported to more developed regions, such as Europe, which have high “climate change” incentives for EV sales, but this is also changing fast. For example, BYD has had enormous success exporting electrical buses to major emerging market metropolitan areas suffering from high pollution levels.

China’s increasing EV exports are creating a huge dilemma for traditional auto manufacturing countries around the world. In Europe, politicians are committed to promoting EVs but are also determined to support an important domestic industry that needs time to navigate the transition to EV technologies. This week the European Commission launched an anti-subsidy probe into EVs coming from China, aiming to protect European firms from “competitors benefiting from huge state subsidies.”

The situation today is different than in the 1980s when Japanese firms were required to build their cars in the U.S. At that time, the Japanese, a key strategic ally which had outcompeted U.S. firms with marginal improvements in manufacturing efficiency (just-in-time process) and better quality, were pressured into accepting a political concession. Today, Xi’s China is a strategic geopolitical adversary competing with “unfair” advantages and seeking dominion in a frontier technology of critical economic, social, and ecological importance.

Developing countries face, perhaps, even bigger challenges. Countries with long-established automotive industries cannot sustain competition from China’s ultra-competitive, modern, and highly subsidized auto sector, and, even in a best-case scenario, would lose regional customers in markets without the industrial base. For example, in Chile, a country that imports all of its cars, China has captured 40% of the market over the past few years. Half of the car models available for sale in Ecuador are Chinese, and these brands have captured nearly half the market since 2020. Also, China’s BYD has captured half of the bus markets of Santiago and Bogota with its electric buses over the past five years.

Moreover, any shift to EVs implies the importation of batteries and motors, which leaves only minimal value-added in final assembly. EVs also pose a mortal threat to local part suppliers that are an intrinsic part of the ICE value chain. The shift to EVs implies a transition from a mature industry with processes and technologies fully assimilated by countries like Brazil and Mexico to an industry on the technological frontier, which these countries have little hope of dominating.

 

If China’s Boom is Over, Where Will Demand for Commodities Come From?

China’s economy has experienced a multi-decade period of high growth, similar to “miracle” surges previously witnessed by other countries. Today’s wealthy nations once went through these surges as well: the U.K., the U.S., and Germany in the late 19th century; and Japan in the early 20th century and again in the 1960s. Various developing countries have also seen periods of so-called “miracle” growth, such as Brazil and Mexico in the 1960s, and Korea, Taiwan, and Malaysia since the 1970s, with China starting its own in the 1990s. A significant contributor to these periods of accelerated growth is a broad and powerful one-time build-out of physical infrastructure. This will be especially true in China, which has witnessed one of the greatest construction booms in history.

The amount of infrastructure investment undertaken by China is breathtaking. For example, Shanghai had four crossings of the Huangpu River in 1980 and now boasts 17. Shanghai did not possess a subway system in 1980, and now it encompasses over 800 kilometers of lines, making it the world’s longest. China claims eight of the top ten longest subway systems globally, with a total extension of 9,700 kilometers across 45 cities. In comparison, the U.S. has 1,400 km of subway lines in 16 cities. Since 2000, China has constructed 38,000 km of high-speed train lines, more than tripling the amount built by Europe since 1980. China’s National Trunk Highway System, primarily built over the past 20 years, now totals 160,000 km, compared to the 70,000 km of the U.S. Interstate Highway System.

China’s construction boom over the past decades can be measured by its share of the world’s production of basic building materials. For example, China consistently produced more than half of the total world cement output over the past decade, securing 56% in 2019. China also commands a similar share of the world’s steel output, reaching 57% in 2020, according to the American Iron and Steel Institute (AISI). The chart below illustrates China’s increasing share of world steel output, surpassing the level the U.S. had at the end of World War II.

The following chart displays steel output since 1950, with China’s ramp-up beginning in 2000.

Major infrastructure expansions do not need to be repeated. For instance, New York City’s infrastructure (bridges, tunnels, highways, subway system) was largely completed by the 1920s, and the bulk of the U.S. highway system was constructed between 1959 and 1972. The London Underground and the Paris Metro were built before the First World War, and France established most of Europe’s best high-speed train network between 1980 and 2000. The chart below illustrates this historical process and how it has impacted the production of steel in countries undergoing these surges in investment. Steel production surged in Europe in the late 19th century (railroads, steamboats, bridges, etc.) and again in the 1920s and 1930s (automobile infrastructure) and finally in the post-World War II “Golden Years.” The U.S. followed a similar path but also had a massive expansion of automobile infrastructure in the 1950-1970 period due to suburbanization and interstate highways. Brazil experienced an infrastructure boom in the 1960-1980 period, as did Korea in the 1970s. Invariably, these booms come to an end, and steel output plateaus, tapers, and eventually decreases.

The following table presents this data in percentage terms, with the total increase in steel output for the previous ten years. The data shows that multi-decade expansions in steel output are not uncommon: Europe and Japan (1970-1900); U.S. (1970-1940); Japan (1930-1970); Germany (1950-1980); Brazil (1950-1990); and Korea (1950-2010). China has been expanding steel output since the 1950s, which provided a high base for the mammoth expansion since 1980. India has been growing output at a swift rate even before reforms were launched in the 1980s, and it is already, with over 100 million in annual steel output, at a much higher level than China was when it started its “miracle” phase of economic growth.

Eighty-seven percent of the increase in world steel production over the past 22 years occurred in China, raising the question of which countries can pick up the slack if China’s construction boom is over. The hope is that India and emerging Southeast Asia can step up. Assuming China’s steel output remains flat, to maintain the 3.5% annual increase in global steel demand of the past twenty years, it will be necessary for India, Vietnam, Indonesia, and a few more high-growth economies to more than double their steel output every decade.