Development Bank Research Bulletin

What US stocks China may want to buy with its foreign reserve?

China has decided to diversify away from US treasury bonds, and invest up to $200 billion of its huge foreign reserve in equities in order to boost the return on its foreign reserve holdings.

Making financial profits is certainly one of the major objectives of the foreign reserve managers, but it is also expected that Chinese government may want to create benefits for its own economy (and Chinese employment) as much as possible. In short, they don’t want too much net capital outflow. In any case, a poor country is certainly in greater need of capital. But how can Chinese achieve these goals?

One possible way is to link the portfolio allocation decision to US corporations investment decision in China. Chinese government may want to invest more in US multinationals that promise to invest more in China-based projects.

According to the Commerce Department’s “2007 Investment Climate Statement”, these large US corporations active in China include (ranking by their Chinese asset size):

Motorola, General Motors, Wal-Mart, General Electric, Kodak, DaimlerChrysler, Coca-Cola, Exxon Mobil, Ford, Intel, Anheuser-Busch, DuPont, Alcoa, United Technologies, IBM, Cummins,  and Microsoft.

In any case, these are large and liquid US stocks and are thus perfect candidates for foreign reserve investments.

Moreover, strategically speaking, some of them can be very valuable for Chinese if the Chinese can acquire significant block of shares and have a say in the management.

Wal-Mart for example can give Chinese a perfect retail distribution channel in the US for Chinese products. General Motors, which has run into financial troubles, may help Chinese build up its domestic car industry, in exchange for financial injection from the Chinese. Motorola, IBM, and Microsoft can help Chinese upgrade their information technology.

It is predictable that there will be a huge political backlash in the US when the Chinese acquire significant share block in any one of these corporations.  But who are you going to blame? If Americans save less than invest, and America has to let foreigners in to bring in the money.

The happy variety of Capitalism

The Deutsche Bank Research has just published a report titled “The Happy Variety of Capitalism.” (download PDF file)

Capitalism has many varieties; Even within Europe, the mode of capitalism differs across countries.

According to the report, Germany, Spain, France, Belgium and Austria has the less happy variety of capitalism, while Portugal, Italy and Greece, even worse, has the UNHAPPY variety of capitalism (well, Italian may be a little bit loud, but I am sure they are very happy everyday; it is just a different way of having fun)

Some funny facts:

Napping is an activity just a little bit happier than cooking. So when your feel drowsy, do some cooking instead; at least you will have something to eat as a result, and yes, lunch and dinner are happiness-improving activities.

Morning commute makes people very unhappy, even much unhappy than working; and evening commute is just a little bit happier than working.

Australia has the very happy variety of capitalism. Thousands of German still migrate to Australia every year.

India’s demographics may bring a bumpy ride for the economy

Having a large and young labor force is believed to be good for GDP growth. It has been well-received that current demographic structure of Indian population is working toward India’s favour in the next two decades when young Indian children grow up and enter the labor force. Chinese economy, which benefited and is still benefiting (but for not too long) from the 1970s babyboomers, however, will start to slow down because of the aging population .

However, young labor force can take its toll too. A study by Nir Jaimovich and Henry Siu shows that it is the “restless” workers that makes an economy volatile. Based on historical data from major industrial countries, they find that volatility of an economy is positively correlated with the share of young workers (15-29 years old) in the labor force.

To show you the result also graphically, below several charts from the paper are shown. The charts (please click for enlarged imanges) plot the business cycle volatility (the pink line) alongside with the “restless” worker ratio (the blue line) for the seven major industrial countries. The two statistics seem to track each other very well. History may not be a perfect guide, but the evidence collected by economists seems to suggest that demographics is a good predictor of economic volatility. So, Reserve Bank of India, watch out! Your inflation rate is too high!

The Young, the Old, and the Restless: Demographics and Business Cycle Volatility (PDF file)

We investigate the consequences of demographic change for business cycle analysis. We find that changes in the age composition of the labor force account for a significant fraction of the variation in business cycle volatility observed in the U.S. and other G7 economies. During the postwar period, these countries experienced dramatic demographic change, although details regarding extent and timing differ from place to place. Using paneldata methods, we exploit this variation to show that the age composition of the workforce has a large and statistically significant effect on cyclical volatility. We conclude by relating these findings to the recent decline in U.S. business cycle volatility. Using both simple accounting exercises and a quantitative general equilibrium model, we find that demographic change accounts for a significant part of this moderation.

Can minimum wage law say anything about Larry Page’s 1 dollar annual salary?

Google's founders Larry Page and Sergey Brin earned salaries of just $1 a year.

I am curious whether this contract violates the minimum wage law? :-)

The $1 wage of Google's $14bn founding fathers (From the Guardian newspaper)

Google's founders Larry Page and Sergey Brin earned salaries of just $1 (50p) last year, documents have revealed.
The pair, who built up the internet giant from their dorm room at Stanford University in the late 1990s, drew only nominal wages from the company in 2006. Statements filed with the US securities and exchange commission show that Google's chief executive, Eric Schmidt, also took a salary of just $1.
It is the third year in a row that the trio have taken basic salaries. Their bank managers will be consoled, however, with the news that their shares are now worth five times more than when Google floated on the stock market two and a half years ago.

Monetary policy simulation game

Do you want to test your skill as a central banker? The Swiss National Bank -- the central bank of Switzerland -- has created a monetary policy simulation game called MoPoS, and you can try your skills without doing too much damage to our economy.

The game program can be downloaded from here

And an instruction guidebook is also available in a pdf file.

MoPoS (short for: Monetary Policy Simulation Game) is a computer game which lets the player act out the role of a fictitious central bank by implementing monetary policy in a simple virtual economy. The purpose of the game is to give the player a feel for the options and limitations of monetary policy.

There is, however, no connection whatsoever between MoPoS and the monetary policy conducted by the Swiss National Bank.

On the one hand, no special background knowledge is necessary to play the game, which has been designed for interested lay persons as well as pupils and students. Since, on the other hand, it allows the model specifications (monetary policy regulation, parameter values, shock characteristics) to be altered at will, informed users will also find numerous forms of application. MoPoS was developed by former National Bank economist Yvan Lengwiler.

Return to Capital is not low in China

There are two famous myths about China.

The first one is that the savings rate is high because ordinary Chinese worry about the lack of safety net. This myth has been busted because evidence has shown that Chinese household savings rate is actually lower than the Indian one. The overall saving rate is high because businesses heavily save their self-generated profit for re-investment. For private business, the reason is the lack of access to other forms of external finance. For state-owned enterprises, managers always prefer re-investing the profits to paying dividends to the government. Therefore, the right solution is: (a) to reform the financial sector and improve the access to finance for private sector businesses; (b) force state-owned enterprises to pay dividends! Building a safety certainly will help, but only at the margin.

The second famous myth is that return to capital is very low in China, and that the current high investment rate is a sign of money being wasted. A NBER working paper "The return to capital in China", written by three prominent Chinese economists, however shows that the return to capital in China has been remained flat at roughly 20% since 1998, which is not low compared to the rest of the world. Olivier Blanchard also provides a nice discussion (PDF file) of of the results.

As a matter of fact, the myth about the high investment rate per se has also been overturned. Goldman Sachs economist Hong Liang show that the investment rate is between 36%-40%, and the incremental capital-output ratio (ICOR) is about 3.1 in recent years. These are two very reasonable numbers for a rapidly growing economy. In at least the export-oriented sectors in China, improvement in productivity still remains that greatest driver of growth.

I have long been the subscriber of the view that China is still a very poor country; the gap to the productivity frontier is still so wide that the main decision to make is still how much to invest rather than where to invest. Chinese are starting to worry about investment efficiency, but at this moment it is still of second order importance. The nation’s production is still so inefficient that there are numerous easy opportunities waiting for entrepreneurs to capitalize on. In order for this to happen, the government should remove the planning-economy-era regulations that create the inefficiency, and protect the property rights of entrepreneurs. These reforms will create prosperity much more than will any scientific breakthrough.

Newspapers like to repeat the same punch line “the money is wasted in building roads that lead to nowhere” when describing the government investment in infrastructure in China. But people familiar with the geography of China would find it difficult to find any such “roads that lead to nowhere.” Even if an idiot randomly draw a line on the map in the eastern seaboard and build a toll road; in five years the road capacity will be full. That’s exactly why there are so many corruptions in such infrastructure projects: high returns are guaranteed so long as you can get the license to build the toll roads that almost always lead to somewhere. The new Chinese saying: money follows the roads.

The Return to Capital in China (download pdf file)
Chong-En Bai, Chang-Tai Hsieh, and Yingyi Qian
NBER Working Paper No. 12755
December 2006
ABSTRACT: China's investment rate is one of the highest in the world, which naturally leads one to suspect that the return to capital in China must be quite low. Using the data from China's national accounts, we estimate the rate of return to capital in China. We find that the aggregate rate of return to capital averaged 25% during 1978-1993, fell during 1993-1998, and has become flat at roughly 20% since 1998. This evidence suggests that the  aggregate return to capital in China does not appear to be significantly lower than the return to capital in the rest of the world. We also find that the standard deviation of the rate of return to capital across Chinese provinces has fallen since 1978.

Rafael Correa: another Latin American president with an econ Ph.D.

Rafael Correa has been favored to become the next president of Ecuador, in the upcoming election, probably after a second-round run-off (See the Latin Americanist Blog for a brief). He is very likely to become another Latin American president with a Ph.D. degree in economics (e.g. Ernesto Zedillo, Mexican president 1994-2000, Ph.D. Yale '81)

He has been rumored to be a leftist and a close friend of Hugo Chavez. Nevertheless, as a U.S.-trained economist with a Ph.D degree in economics from the University of Illinois ('01), and a previous degree from Belgium, it is a neccesory strategy for him to campaign under an ultra-leftist and anti-West platform, otherwise other candidates from the far-left can easy attack him and alienate him based on his U.S. education background.

His former professor, Werner Baer, who is a Latin American expert, knows the trick very well: "My guess is that some of the posture he's taking now is because that's the way he hopes to get elected and win votes. Once in power, I doubt that he would be virulently anti-American like Chavez." He said Correa would more likely follow the lead of President Luiz Inacio Lula da Silva of Brazil, who spooked investors with radical discourse as candidate, but once in office "became extremely orthodox in his economic policy."

In April 2005, Correa was appointed economy minister, but he was forced to resign after four months when he failed to consult the president before publicly lambasting the World Bank for denying Ecuador a $100 million loan. He now portrays himself as a “Christian leftist”, and concurs with Chavez’s attack of Bush by adding that "to call Mr. Bush the devil is an insult to the devil" and that “The devil is evil, but intelligent.”

This cheap talk is all understandable and predictable. Do you know of any other easier strategy that can help you accumulate political capital so fast in Latin America?

His professor Baer described Correa as a top-notch economist, which I would not agree.
At least his doctoral dissertation did not appear to confirm it. According to a self-description Correa made when he was still a Ph.D. student in University of Illinois (UIUC), his research was mediocre:

“My dissertation and research interests are Economic Development and International Economics. Specifically, the first part of my dissertation evaluates the effects of liberalization and globalization on the Latin-American economic growth, investment, and productivity. I am using state of the art techniques in instrumental variables and dynamic panel data models. The panel includes 19 Latin-American countries. The second part of the dissertation studies the economic desirability of a monetary union for the Andean countries. In this study, the basic techniques are vector auto-regressive models and disturbances orthogonalization. The third part of the dissertation is an evaluation of the impact of structural reforms on growth, human development and poverty in Latin America.”

However, he is certainly not a leftist! He is simply a political opportunist. We will see.

China's lobbying industry spends $2.5 billion annually

According to an article "The harder they fall" in the Economist (Sep 30, 2006):

"More than 5,000 localities from provincial down to county level have opened offices in Beijing in recnet years, spending some $2.5 billion annually on lobbying, according to China's media..."

A huge industry!

Chinese private sector firms are twice more productive than state-owned firms

An OECD report “Fast-falling barriers and growing concentration” (pdf file) shows that Chinese private firms are twice more productive than state-owned firms.

This seems to be a very clear and common sense fact that shouldn’t need to be studied in the first place, but there are actually many people who still believe that state-owned firms, with proper restructuring and introduction of modern management expertise, can turn around, and do much better than private sector firms.

The favorite example they always cite is the higher profitability of giant state-owned firms listed in Hong Kong, particularly those in the energy and telecommunication sector, compared to low profit margin private sector firms in the consumer electronic industry. They are comparing apples with organs though. Even an idiot can run a very profitable state-owned firm in the energy sector: a monopoly can charge whatever price it wants and realizes any level of profitability it wants . Consumers are losing out and paying the bill though.

This OECD report sends a hard blow to people who still believe in the viability of state-owned firms. The report uses data from the government statistics bureau: if anything, it should have underestimated the productivity of private sector firms, for they always understate their revenue for tax purpose.

State-owned firms, go kill yourself, you are wasting everyone’s resources.

Indian households save more than Chinese!

According to a new report by McKinsey “Putting China's capital to work”, Chinese households save 23.8% of their disposable income, not particularly high compared to the saving rates of Asian tigers in their high growth period.

Indian households save 31.9% of their income, a ratio that is much higher than Chinese. The current saving rate of French is 16.6%

Chinese = high saving rate? Myth busted!

The report points out that the high total saving rate of China is mostly the result of higher corporate saving rate, which stands at twice world average. The report however also cautions readers that the higher household saving rate of Indians could be the result of small and micro businesses reporting themselves as households.

Nevertheless, the Chinese saving rate could be overestimated too, as Chinese disposable income, the denominator of the ratio,  is severely under-reported because of the huge underground economy.

Note that saving rate of an average Chinese household could be much lower than the headline number. In 2003, 1.86% of the wealthiest Chinese households control 60% of the total stock of liquid financial assets in China, and they certainly have much higher saving rate than poor people. A McKinsey survey indeed shows that the lowest income quintile of Chinese households save only 20% of their income.

A new political economy: China grew at 10.9% in 1H06

China grew at 10.9% in the first half of 2006, and 11.3% in the 2Q, surprising almost all major investment banks.

"Maybe this is a new economy" said Stephen Green, China economist for Standard Chartered Bank, "Maybe China can grow fast without inflation"

I am not sure whether China can grow fast without inflation, but I am expecting the fast growth this year and I am not surprised at all.

As I wrote in the Bulletin back in April, things are changing in China. It may not be a "new economy", but it is certainly a "new political economy!"

The Communist Party's 17th national convention is upcoming in the second half of 2007, and thus major personnel promotion decisions will be made in the first half of 2007. Every provinical boss is working hard to secure political capital before the event, and GDP is the key political capital. In today's new political landscape where strongman politics is phasing out, GDP becomes more and more important a bargaining stake for provincial bosses.

So don't expect a slowdown in the second half. The economy is going to operate at full speed.

As I wrote in that article:

"Year 2006, however, is the last year of the 2002-2006 political cycle, and based on past experience, should grow at the lowest speed. The economy however grew at the highest speed in ten years. Something must have changed. One speculation is that the incentive structure has changed. In the past, provincial heads worked hard in the first and second year of the cycle to impress their national boss. Now they work hard in the last year to pro-actively build up political capital for their future career which will be decided in the 2007 national meeting of the Communist Party, and the best political capital in China is GDP, GDP, GDP!  At national level, central government wants to slow down the investment boom, but provincial bosses have made up their own minds. "

Czech Republic to overtake East Germany in seven years

What could explain why East Germany, with all the rule of law and administrative integrity in place, plus 1 trillion euro of subsidy, is soon going to be overtaken by Czech Repbulic (in gdp per captia) which is plagued by rampant "looting" and "no law and no finance"? Labor market inflexiblity is the key.

The economic transition in the East Bloc is always said to be a failure. Rapid convergence didn’t happen, income level stagnates, reforms and polices are wrong... Nevertheless, to give a fair judgment, we need to find a proper benchmark, because otherwise we don’t know how things otherwise would have evoled.

For Czech Republic, the perfect benchmark is East Germany. Before taken over by the communists, The Czech lands (Bohemia and Moravia) were at similar level of economic development as what later became Democratic Republic of Germany. Four decades later, at the time of communism’s collapse, Czech was poorer than East Germany. East Germany is bigger than Czech (population: 16 million vs. 10 million at the time of transition), but not much bigger. They are not only neighbors, share a lot of historic background, but also similar in industrial structure (as a result of Soviet planning) at the time of transition.

What did East Germany get afterward?  East Germany got pretty good institutions (legal system, political system, business environment) in place in short period of time, , rapid transfer of knowledge and know-how from fellow Germans from the West through training and transfer programs, efficient banking sector as a result of the direct takeover of East German Bank by more efficient Frankfurt banks, and on top of all these, one trillion Euro of fiscal transfer to finance massive public investment in equipment and infrastructure.

With all of these perfect advantage, East Germany was supposed to be converge to living standard in the West pretty soon and further widened the gap with its Easter neighbor the Czech Republic.

In the Czech Republic, in contrast, legal system is not functioning, “looting” was rampant among corporate managers in the midst of mass privatizations, business environment is plagued by corruption and bureaucracy red-tape, inflation was high and fiscal policy was not working for most of the 1990s, financial system was in bankruptcy until foreigners start to take over some of them......and not to forget, there is no "West Czech Republic" that can inject one trillion Euros.

All of these contracts will forecast East Germany’s rapid and certain dominance of Czech Republic in terms of economic growth and rising GDP per capita.

The results in hindsight however contract such predictions made back then. Yes, Now East Germany is still some 15% richer than Czech Republic (note that East Germany started richer), but the trend in the past seven years or so will project that with another seven years, the Czech Republic is going to take over East Germany in terms of GDP per capita, if Czech Republic continues to growth at 3.3% /year while East Germany at 1.0%/year.

The reason, as Professor Jennifer Hunt (McGill University) suspects is rooted in the labor market in East Germany.  East Germans are half as productive as their Western counterparts, but with the slogan “The same pay for the same work” they are demanding the same level of salary.  In 2003, although Eastern GDP per capita was only 67% of the western level, disposable income per capita was already 82% of the western level.  Western firms thus would rather expand their facilities in the West to serve the new consumer market in the East, instead of employ workers in the East.

It is certainly a good and attractive slogan that everyone gets the same pay, but when you are not as good as others (at least at this moment before you go through some skill training), demanding the same level of wage as the smarter people are getting can only give you two results: (1) unemployment; why would employers (except the public sector) want to pay more to get less. (2)  lower paid and dirty jobs that people in the West don’t want to do; so you are segregating yourself by your own decision. As an old communist-era axiom in the Czech Repubic goes: "We pretend to work, and they pretend to pay us". True in East Germany now.

The whole plot was conspired by the labor unions in the West, which got higher wage pact for their comrades in the East. The true intention was to price out East German workers from the market, not to show solidarity!

Reference:

Jennifer Hunt: Is the transition in East  Germany as success?  (pdf file)

Technology industry and the over-educated Russia

In a Goldman Sachs research note (pdf file), the human capital of four BRIC countries are analyzed.

It is found that, China has only marginally more tertiary graduates than Russia despite having 10 times the population of Russia.

Russia, despite much lower income than the U.S., already reaches 60% the U.S. level, in terms of tertiary graduates per capita.  Among population over age 25, in the U.S. there are 192 tertiary graduates in every 1,000 people, while in the Russia, it is already 115. The correspond number for China and India are merely 16 and 14, respectively.

Russia seems to have huge potential in moving to higher value-added technology industries than India does!

The research also finds that Russia has almost as many science and engineering PhDs as Germany, which is much richer than Russia.

But when it comes to the number of R&D workers, i.e., those who went through the education and are actually applying what they learn in the college to what they are supposed to do,  Russia starts to fall behind China and Japan. India is nowhere in the sight.

For Russia, the gap between number of people with science and technology degrees and the number of R&D professionals  seems to corroborate the worry by  cops around the world: mafia organizations are entering a new level of sophistication after Russians enter the trade, because most Russian mafia members have Ph.D. degree in physics or mathematics.

Goldman Sachs: China makes largest progress in energy efficiency than other developing countries

Goldman Sachs publishes a note "Improving energy intensity across the BRICs"  (pdf file). There are several interesting take-away points:

(1) China’s energy use per unit of output in industry fell by 56% between 1994 and 2003, which is the largest energy-efficiency improvement progress in developing world. In the same period, India only achieves reduction of 30%, and Brazil almost makes no progress.

Why is everyone blaming China for using too much energy?! China uses more energy simply the population is larger and the economy is still in the early stage of industrialization, and as such a large economy, China is already making much better progress than others.

(2) Russia remains the most energy-intensive countries in the world, The country’s energy intensity is close to three times that of US.

Not surprising, considering that the government is subsidizing energy (for Russian residents) to such an extend that electricity is almost free. By the way, Venezuela always consumes a lot of gasoline, because the price is heavily subsidized. I always say that letting market to determine the price is the best weapon against energy waste.

(3) In China, non-industrial sector is twice more energy-intensive than industry.

I have no idea why!

(4) Projection results show that BRICs (except Russia) will consume much less energy per capita than the current level in more developed economies (U.S., Japan, etc) when  they reach the same income level of developed economies.

I.e., both now and in the future, Americans will remain the heaviest user of energy, even on per capita term.  Why do Americans still point fingers at developing countries and keep on blaming China for exhausting the energy resources of the planet?

Implication for the relationship between growth and environment : as a country gets richer, it will use less energy (because industry becomes more productive and structural shift to service sector will also save energy). The best weapon against pollution is economic growth, not to turn Africa into a zoo.

Year-half assessment of investment banks’ forecast accuracy on China’s GDP growth

In a previous Bulletin article written back in February, I summarized several major investment banks’ forecast of China’s 2006GDP growth rate.

Now it is time to assess the accuracy of these forecasts after six months have passed.

In the first half of 2006, China was growing at unprecedented and unexpected pace, at 10.9% on year-to-year basis. Only Credit Suisse’s forecast of 10.1% can be said to be in line with the actual outcome. CSFB’s China economist Dong Tao is doing well

Thus most investment banks are revising their forecast up ward:  Deutsche from 9% to 9.9%, Citigroup from 8.7% to 9.3%, and Morgan Stanley from 7.8% to 9.5%. The consensus now is 9.7% (based on data from Consensus Economics).  (Deutsche Bank again is following the herd in setting their forecast! Can they be a little bit braver?)

Morgan Stanley, after two years of very poor performance in forecasting China’s GDP growth finally makes a large upward revision of the number. They have been voicing their worry about China slowdown for a long time, and have been the most pessimistic about growth rate of India and China back in 2004, and 2005.

Stephen Roach in his commentary (10/21/2005) in MS’s Global Economic Forum supplied some explanations on why they were wrong on the "China slowdown", and why they still believed that slowdown in American consumption (as a result of oil shock and low saving rate) may “ultimately” causes a China slowdown. Well, he is wrong again.... I am expecting a follow-up execuse from him

I think China's potential slowdown in the future is more likley to be caused by domestic problem instead of external factors. China is not exporting many durable goods to the U.S., and I think Americans even in recessions have to buy clothes and have to give Christmas gifts to children. I don’t deny that China is dependent on U.S. market, but not in the same way as Japanese do (they export cars, the demand of which is more cyclical)