Martin Wolf’s FT Economist’s Forum, 18th October 2006
China World Profits and World Inflation.
The impact of China on world inflation and profits are so important that it calls for a response to Martin’s views set out in his website comment of 18th October “Andrew Smithers makes three comments.”
Martin claims or hopes that China is sterilising its foreign exchange purchases by the classic route, called “sales of long dated bonds to the non-bank private sector.” He then claims that the growth of such bonds relative to GDP can be sustained so long as the interest on the reserve assets at least equals those on the bonds.
There are three objections to this: (i) No such market appears to exist, or, if it does, his FT colleagues are remarkably coy about discussing it. (ii) That if it did exist, the growth of the market relative to GDP would be unsustainable because it would lead to rapidly rising costs both through a steepening yield curve and because it would grow exponentially as the debt interest would add to the domestic borrowing. Martin implies that foreign currency interest could be used to offset this, but this is only true for fiscal accounting purposes, unless the interest receipts are converted from dollars to renminbi, which would be incompatible with stabilising the nominal exchange rate.
Long-term sterilisation of the domestic financing of China’s reserves is thus extremely improbable through bond issuance and, in the absence of an alternative and convincing explanation, remains improbable by any route.
In today’s FT (20th October, 2006 “How Beijing hit back against hot money”) Richard McGregor writes that the Bank of China is “…buying dollars coming into the country and draining the extra renminbi out of the system by selling bank bills.” This is neither the sale of long dated bonds nor are the bills being sold to the non-bank private sector. In a command economy this process might amount to sterilisation, but only if bank lending can be restrained by fiat. It this is occurring in China today, it seems unlikely to be more than a temporary stop gap.
Martin also claims that a labour shock through tripling of the world’s labour supply has caused a rise in the US and rest of the world profit margins. In theory a labour supply shock should increase profit margins with a jump, after which they would fall back to trend. This is also the actual experience of past labour shocks. For example, the destruction of capital in World War II constituted such a shock, particularly in Europe and Japan. Japanese profit margins which are available for non-financial companies from 1954 show a high starting level followed by a long-term trend fall. It seems likely that the pattern in Europe would have been similar, though I cannot find European data for this period.
US profit margins have behaved in the past as if the US is a mature economy with mean reverting profit margins that are little if at all affected by external labour shocks.
Furthermore the assumption that, nonetheless, this time things are different and a China labour supply shock has affected US margins does not seem to fit the data. There has, for example, been no sharp jump in US margins at any time, let alone one that fits with the likely timing of a China shock. If it is thought necessary to try to explain why US margins are currently high, for other than the normal cyclical reasons, the most crying need is to explain why this should have been due mainly to rising margins in finance.
Charts are available showing from the early 1950s to today (1) Comparing Japanese and US non-financial profit margins. (ii) US total profit margins. (iii) Comparing US financial and non-financial margins. (I am happy to let anyone have the excel file of these charts and their spread sheets on request.)
If the China labour shock profit theory is accepted, then we have experienced a slow burning shock which has not caused a sharp rise in margins, but a trend rise, which appears to have started in the early 1970s. We cannot compare this with past shocks which have had a different pattern, but we can appeal to theory. This would suggest that as the shock dissipates we will have a long-term narrowing of profit margins in addition to the likely cyclical fall.
I expect the latter, but I find it difficult to be as pessimistic about the longer term profit outlook that advocates of the China syndrome would appear, by implication at least, to support.