I recently returned from a week in Asia where I was looking to get a better sense of China's reform agenda and a one year update on Abenomics in Japan. You may recall a piece I wrote a year ago (Japan: Die Another Day) where I expressed skepticism regarding Japan's ability to deliver on their structural reform agenda. I would like to share a few of the observations and insights I gained on my recent trip.
I was attending another Global Macro Conference organized by Goldman Sachs, the same I had attended a year ago. I immediately noticed that the mood in early 2014 was dramatically more relaxed than it was a year ago, a fact echoed by some of the speakers such as Kofi Annan. He stated that it was the first time in six years that with no obvious crisis in sight, it is time to return focus to many of the big picture issues affecting global sustainability. Some issues include climate change, income inequality, and resource sustainability. These issues matter over the longer term but do not tend to move markets in the shorter term. Jan Hatzius, Chief Economist at Goldman Sachs, said the risks in the U.S. seem to be the lowest they have been in his 17 years at the company. While many longer-term challenges remain, there are no obvious and imminent risks facing the U.S. economy and markets today.
These two comments serve to support our view that 2014 is a year in which the healing of the global economy is expected to continue. Things continue to get better! Yet for many investors our views remain biased by our more recent history of lurching from crisis to crisis since 2008. We have become conditioned to expect another crisis to lurch into view or a hiccup to become a systemic global concern. For now this seems unlikely. While many of the structural challenges, particularly in Europe and Japan have not been solved, the extraordinary monetary policy response from central bankers has curtailed the risks, calmed financial markets and essentially bought time for the structural adjustments and rebalancing to occur. Many of these adjustments will take years and cannot be done quickly, but progress is being made. Time will judge whether enough has been done and we expect there to be further crisis in parts of Europe and especially in Japan. With stronger global economy and financial systems, the timing is less imminent and the risks of true global contagion are diminished.
Against the broader view of an improving global outlook here are a few key country specific takeaways:
China - Recurring sentiment from well-connected individuals was the degree of commitment to embrace broad based structural reforms focused on the supply-side. This is expected to improve the allocation of resources and factors of production, improve the sustainable growth of the economy, facilitate a rebalancing of growth toward consumption from investment and to limit the degree of control over the economy by the government and hence the degree of corruption. A surprise has been how quickly the new leadership under Xi Jinping appears to have consolidated power. Rebalancing requires growth but while the government will be more reluctant to embrace fiscal stimulus in the face of a slowdown, they do not want growth to slow below 7%. Most believe that growth of 7-8% is sustainable. I continue to believe it will trend lower toward 6% over the next few years.
Here are a few points regarding the issues on shadow banking. First it is a bit of a misnomer as shadow banking is regulated. China is trying to build a diversified financial system akin to that in the U.S. and do not want a bank dependent system. They have no desire to move shadow lending back onto bank balance sheets, rather they are happy that they have been able to develop a shadow banking channel and now want to improve the oversight, and in particular, develop proper risk pricing in the channel. According to Fan Gang, a leading economic advisor to the government, "...shadow banking is in the early stages of development and the issues we are facing are more cyclical/teething pains...the real issue is 'we finally got shadow banking!' Now let's improve the risk pricing process." China has the resources and the determination to tackle this issue and will do so. It may be rocky in the near term as credit gets squeezed and there is definitely execution risk but they appear headed in the right direction.
Overall, the most significant takeaway I observed about China is that they are well aware of the challenges and are drawing up the roadmap to address them. They see it as a multi-year process that will take time and are very focused on the 2020 timeframe. China is one of the few governments that fundamentally believe they need radical reforms to drive long term growth. In contrast to most that only pay lip service to structural reform and only act reluctantly when forced to the brink (think of peripheral Europe). As usual, most commentators in the West continue to misinterpret China, or to focus only on the challenges they face and not the potential solutions.
Japan - The polar opposite of China. All talk and no action on true reform. Abenomics remains a money printing story that aims to drive asset prices higher and the currency lower. The so called third arrow or reform agenda continues to underwhelm and avoid tackling the difficult, but important, aspects such as labour market reform, agricultural reform, medical reform and immigration. Even many of the bulls over the past year on Japan, when pushed, admit that the likelihood of achieving the targets are slim. As one of the biggest boosters of Abenomics told me "the only real goal of Abenomics is to change the psyche of Japan to believe that things will get better! It is about optimism and confidence because without a healthy economy Japan becomes irrelevant on the global stage. Abe is very aware that QE is monetary hokus pokus and he only wants to buy time." Yikes! This was from one of the more optimistic Japan boosters over the past year.
Japan remains a very fragile experiment in the use of aggressive monetary policy. One of the first big tests will come in April after the consumption tax rises from 5% to 8% and the economy slows back down into recession. The government will launch further fiscal spending and further money printing to try and offset this, but the risk comes if and when markets eventually lose confidence. Timing is tough to call and some believe this can last for five or more years as long as Japan remains a net saving nation, but with an aging and shrinking population, the private sector savings rate is in structural decline. When it falls below the government deficit level, Japan will be forced to attract capital from abroad and rates will begin to rise. Higher interest rates are not helpful when your debt to GDP is near 250%. As Bob Zoellick, ex-president of the World Bank mentioned, "Japan is rolling the dice...and there is no plan B."