spex issue 27

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INCOLLABORATION

WITH

PROUDLYSUPPORTED BY

ISSUE 27

29 OCTOBER 2012

- China's Economy Heads for Soft or Hard Landing?

-Why is Singapore discouraging long term loans?

-More is Less: Dangers of Quantitative Easing in the US

The Fortnight In Brief (16th October to 29th October)US: Mixed Signals

The US economy grew at an annual rate of 2.0% in Q3 in contrast with a growthrate of 1.3% in the prior quarter. The consumer sentiment index has increased to82.6 this month, a level unprecedented since September 2007. Consumer

purchases have led the economys growth by helping to add 1.4% out of the 2.0%GDP growth. The economic situation of US is in stark contrast with its stockmarket. The S&P 500 index observes a decline of 1.5% for the past week asinvestors watched earnings reports. The mix of data comes a week before theelection, further reducing the clarity of USs future trajectory.

Asia Pacific ex-Japan: Unknown Impact of the QE3

It is still too early to tell whether QE3 has had any impact on capital flows toAsia Pacific. Stock markets performed well in Southeast Asia in the first half ofOctober, and government bond yields came down. However, it is too early togauge QE3s impact until Octobers reserve data is released, in order to

determine how extensively central banks have intervened to prevent anycapital inflows, which would lead to currency appreciation. Thus far, aggregatecapital flow data for the region have yet to reveal sustained inflows similar tothat seen after QE2 and the ECBs Long Term Refinancing Operations. Theflipside is that modest capital inflows will help control exchange rateappreciation and inflation pressure, giving central banks more scope anddiscretion to loosen monetary policy.

EU: Eurozone Recession Here to Stay

The Eurozone flash Purchasing Managers Indices (PMIs) in October indicatedthe region remains in recession, with the PMIs pointing towards a faster pace of

GDP contraction at the start of Q4 than in Q3, when GDP fell by an estimated0.2% quarter on quarter. The temporary moderation of the Eurozone crisis andstabilization of sovereign borrowing costs in the periphery following the ECBsunveiling of the Outright Monetary Transactions (OMT) bond-buying programin September has failed to register any improvement in the regions realeconomy. In fact, the Eurozone flash composite PMI fell to a new 40-monthtrough in October, down to 45.8 from 46.1 in September, mainly due to the

worsening conditions within the manufacturing sector, despite slightimprovement in the services sector. More importantly, the recession hasshown clear signs of contagion to the core, with the French PMIsindicating contracting economic activity and deterioration in Germany

following their rebound last month.

SMU Political-Economic

Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

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Copyright 2012 SMU Economics Intelligence Club

2

China's Economy Heads for Soft or Hard Landing?By Lin Fangjun, Singapore Management University

Background

Once again, China is at a crossroads. The official Purchasing Managers Index (PMI)1 dropped sharplyto 50.4 in May. The economy slowed to 7.6% in 2012Q2. This has raised concerns over whether the

cooling measures have been overdone.

In the meantime, the global economy remains weak despite repeated attempts by major central banksto revive the world economy. EU continues to struggle with its debt crisis while the US economyexpanded only 1.9% compared to 3% in 2011Q4. With the sluggish performances of Chinas two mostimportant trading partners and slowing down of its domestic economy, it begs the question of whetherChina is headed for a hard landing.

We believe that the Chinese government still has ample policy space to manage the economy. Thisreduces the risks of a hard landing happening in 2012. Structural reform is already under way and thiswill safeguard Chinas economy beyond 2012.

What is a Hard Landing for China?

In the late 1980s, China suffered a hard landing. The overheated economy led to runaway inflation ashigh as 18.0% in 1989. The subsequent heavy government intervention caused the economy to plungefrom a growth rate of 11.3% in 1988 to a growth rate of 4.1% in 1989. High economic growth did notresume until Dengs Southern Tour in 1992. This could well have been the most destructiveoverheating of Chinas economy, costing hundreds if not thousands of precious lives and delaying thedemocratisation of China by at least 30 years.

As many debate the meaning of a hard landing for China, we take it as a situation in which massiveunemployment takes place and nationwide social unrest arises, similar to what happened in 1989.

Ample Tools at Hand

China is in an enviable position compared with other major economies. In June, inflation receded to2.2%, the lowest in two years. With low inflation, the central government need not worry aboutoverheating as banks extend more credit and inject more liquidity into the system. This allows thegovernment more scope for expansionary monetary and fiscal policies. As with the experience in 2011,when inflation was stubbornly high, the authorities would be wary in loosening monetary policy. Theresultant cautious approach will ensure that the economy is on a sustainable growth path and reducesthe risk of a hard landing in the foreseeable future.

In terms of monetary policy, the central bank has a number of tools at hand. Today, after two recent

cuts, the benchmark interest rate is still well above its historical low of 5.31% in 2010 and the reserveratio lies well above its 2009 level of 15.5% at the depth of global financial crisis. Even though there isa limit to how low these rates can go, at least for now, the central bank has a plethora of options,sufficient to engineer a soft landing for the economy.

Adequate Fiscal Strength

China has no lack of fiscal firepower to support the economy. China not only sits on the worlds largestforeign exchange reserves, but is also in a favourable fiscal position. In 2011, Chinas fiscal revenue(include both central and local government) increased by 24.8% to 10.37 trillion yuan and thenationwide fiscal deficit stood at 1.1% of GDP. China has enjoyed many years of high fiscal revenue

growth owing to remarkable economic growth and handsome corporate profits. Hence, the

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government is able to jumpstart the economy with fiscal stimulus2 should the economic situationworsen to unacceptable levels.

However, many have argued that Chinas actual public debt level is at an unsustainable level. Estimatesrange from 90% to 160%, near that of Greece. No doubt, this is a cause for concern. But the centralgovernment has allowed the rollover of local debts while policy experiments have been launched toallow local government to issue bonds. These policy moves have won China precious time to reform itspublic financing system. Thus, at least in the near future, government debt is not a big problem.

These favourable conditions give Beijing ample elbow space to conduct expansionary monetary andfiscal policies. Besides that, China can lift its control over the property market to spur growth whenneeded, though not advisable. Thus, China is likely to avoid a hard landing in 2012 and continue itsrapid growth.

Structural reform

As the Hu-Wen administration comes near to the end, some long awaited reforms have been launched.These reforms will see China through this turbulent period.

China is building its social security and healthcare systems. These reforms will reduce the need for

saving and spur domestic consumption. According to World Bank, real wages continue to grow intandem with GDP growth. While the overall real wage growth has shown signs of slowing, real wagegrowth at the low end of the job market has not ceased accelerating since 2009. In 2011, Chinas realwage increased by more than 10%, faster than GDP growth (Fig. 1). This is the result of labour policychange initiated in 2008. All these have built a solid foundation for a consumption based economy.

Figure 1: Real Wage Growth

Source: World Bank

Financial reform

Lately, China took a significant step towards interest rate liberalisation. Alongside with the unexpectedinterest rate cuts, banks are now allowed more flexibility in setting deposit and lending rates.Meanwhile, the China Securities Regulatory Commission (CSRC) has also introduced a series ofreforms in the security market. The curent low inflation environment is conducive to such financialreforms. Severe inflation tends to cause social unrest. During periods of high inflation, Beijing wouldbe reluctant to kick start any reform, lest the reforms run out of control and topple the whole system.Now with a subsided level of inflation, the government will take bolder steps towards building amodern financial system that can support future development.

Financial reform is essential in moving towards a consumption driven economy. Chinas saving rate

comes close to 50% of GDP, but the majority of the savings yield mediocre returns. With financial

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reforms, savers can diversify their investments and reap higher returns. This will increase disposableincome3 for the savers and boost domestic consumption, putting the economy on a more stablefooting.

Political risks

However, there remains a significant risk factor - the political system. Modern economy cannotoperate and function fully without the rule of law. Without effective checks on power, corruption will

worsen and the income gap will widen. This will lead to an unstable society and increase theprobability of a hard landing. In a few months time, China will start the transition from Hu to Xi.Political infighting may potentially destabilise the economy in the short run as government at all levelprefer to keep to the status quo and the much needed measures are delayed. In the medium term,without significant change to the political structure, it will remain as a considerable liability to theoverall economy.

ConclusionIt is unlikely that the Chinese economy will suffer a hard landing in 2012 or in the coming few years.Beijing has ample policy space to manage a sharp economic downturn with both monetary and fiscalpolicies. Some may worry that the further the economy slides, the less effective these tools willbecome. However, I would argue that a longer downturn in China is more beneficial because it willforce more inefficient firms out of business. If this is followed by just-in-time expansion of credit andfiscal spending, the rebound will be more robust and the growth will be of better quality. Not to forget,China has embarked on a number of structural and financial reforms that will keep the economy on asustainable growth path. Overall, one should remain cautiously optimistic about the state of theChinese economy in the near future though more is to be seen after the power transition.

Sources: World Bank, Financial Times, Federal Reserve, Boston.com, Reuters, The Asset, Bank for

International Settlements

Why is Singapore discouraging long term loans ?: a

Behavioural Economics ExplanationBy Leung Weiwen, Singapore Management University

1 A key indicator of industrial activities reflecting purchasing managers acquisitions of goods and

services

2 A standard Keynesian prescription of increasing government spending to pull the economy out of

recession

3 Disposable income is the amount of money households have available for spending is calculated by

subtracting personal current taxes from total personal income.

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In the first week of October, the Monetary Authority of Singapore (MAS) introduced newrequirements for long-term loans. Homebuyers who wish to finance their purchases withloans of over 30 years will have to fork out 40 percent of the purchase price as down payment.Additionally, 10 percent of the down payment must be in cash.MAS revealed statistics showing that the average loan tenure for new residential propertieshad risen from 25 years to 29 years over the past three years. With MAS new ruling, over 45percent of all loans will be affected.

Assuming that the typical homebuyer is 30 years old, a 35 year loan would mean that onewould have to pay off loans until age 65. If temporarily stopping payment for one or two yearsis allowed (e.g. due to unemployment), and one takes advantage of this provision, the buyerwould be even older.

Why might people seek such long tenure loans, and what is the rationale for governmentintervention? MAS move was interpreted by some analysts as a measure to preventspeculation; however, it is unlikely that preventing speculation is the sole or major motivebehind this particular government intervention. Some of the long term loans were clearlydesigned with those buying their first home in mind. On 6 August, a major local bank

announced that its 50 year loan was developed to "to help younger executives afford theirfirst home"1. At the same time, when the National Development Minister Khaw Boon Wanspoke against the 50 year loans, he did not speak against speculators, but for future graduatesto be more prudent in decision making: "There is now some gimmick, a bank offering 50-yearloans. Buy a three room flat first if your salary allows, then subsequently upgrade. If you wantget a five-room flat immediately after graduating, and think that a 50-year loan will help youachieve that, I don't think that is very wise."

In this article, I propose an explanation of government intervention based on market failure:people do not always recognize what is best for them. Therefore, the government implementsrules to make people better off.

It is well known in behavioural economics that humans engage in hyperbolic discounting.That is, discount rates are very high at first, but decline over time.

What is discounting?

For the unfamiliar, discounting simply means that people value future payoffs less.Suppose I am offered a reward of $1000 in a world where the real interest rate is zero,and there are no investment opportunities. Theoretically, I should be indifferent toreceiving the $1000 today, tomorrow, or next year. However, most people would prefer

to receive the $1000 today, because they value future rewards less, hence the termdiscount. If I am indifferent to receiving $1000 today or $950 next year, my discountrate is around 5%.

What is hyperbolic discounting?

The standard experiment used to demonstrate hyperbolic discounting is as follows:Suppose you were given a choice between receiving $2 today and $2.10 tomorrow. Mostwould prefer $2 today. Now, how about receiving $2 in 30 days and $2.10 in 31 days?Most would prefer $2.10 in 31 days (the second option). However, after 29 days have

1 http://www.todayonline.com/Hotnews/EDC120806-0000032/50-year-loan-a-gimmick--Khaw

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passed, people may again prefer receiving $2 now compared to $2.10 the next day. Onecan logically explain that one prefers receiving $2 today when faced with the first set ofdecisions, and also prefers to receive $2 in 30 days when faced with the second set ofdecisions. Alternatively, another consistent set of preferences is receiving $2.10tomorrow and $2.10 in 31 days with the respective set of decisions. However, it seemsillogical and inconsistent for someone to prefer receiving $2 today and $2.10 in 31 days.Indeed, humans make very inconsistent decisions! An explanation for the seeminglyinconsistent decision is hyperbolic discounting: discount rates are too high initiallyand/or too low in the later stages. If humans acted in a way to maximize theirsatisfaction, they should have a lower discount rate in the initial stages and/or a higherdiscount rate in the later stages.

When borrowing money to purchase properties, hyperbolic discounting can lead to choiceswhich do not maximize an individuals satisfaction: Consider a husband and wife buying a $1million property and placing 20% downpayment. They each service 50% of the loan, and areconsidering between two options:

Option 1 Option 2

Loan Tenure 20 years 35 yearsInterest Rate 5% 6%

Monthly payment for eachperson

$2640 $2280

Table 1. Two loan options

Given hyperbolic discounting, Option 2 may seem more attractive to the couple. This isbecause discount rate is very high initially and Option 2 reduces the total payment during thefirst few years, allowing them to spend more on daily necessities. Therefore, the pain oftaking the loan appears to be less compared to Option 1. Even though the couple will pay off

the loan for a much longer time, they do not, at present, place much weight on the paymentsthey have to make from year 21 to 35.

However, discount rate in the initial periods should be lower relative to later periods asestablished earlier. Because of this, the couples situation is similar to the situation I presentedearlier: the couple may prefer Option 2 initially, but after a decade, the couple regrets takingOption 2 and felt that Option 1 would have been the better decision. It would be too late tochange the decision by then.

The couple could have a legitimate concern in that if they take Option 1, they may not haveenough money for spending on daily necessities. However, it appears that the more

appropriate solution would be to buy less expensive property in this case. I acknowledge thatthe best choice for a few people may genuinely be Option 2. For example, some may valuecommuting time highly and need to buy an expensive flat near their workplace. However, it isunlikely that Option 2 is the optimum choice for over 45% of buyers.

MAS move of requiring a higher downpayment significantly increased the amount peoplehave to fork out at the time of buying the property, thus increasing the pinch on homebuyersseeking a long term loan. Although some analysts have said that this is akin to increasinginterest rates (see for example, the Straits Times article published on 9 October 2012), thereality is that the move is likely to be more impactful than raising interest rates for long-termloans (relative to medium term loans) by a fixed amount.

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More is Less: Dangers of Quantitative Easing in the

USBy Samuel Ong, Singapore Management University

As a scholar of the Great Depression, I honestly believe that September and October of 2008was the worst financial crisis in global history, including the Great Depression. Those werethe words of Ben Bernanke, chairman of the Federal Reserve. These words emphasized the

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severity of the crisis and prompted the use of unconventional tools for an unconventionalsituation.

Quantitative Easing1 (QE), the tool of choice, allowed central banks to inject money into theeconomy even while the nominal interest rate is very near zero. Since the crisis, three bouts ofQuantitative Easing (QE1, QE2 and QE3) have been announced. In addition to these, OperationTwist2 was also announced between the period of QE2 and QE3.

With the third round of monetary bazooka set loose by Ben Bernanke, QE3 seems poised totake centre stage in the recovery of the US economy. To analyse the possible effects of QE3,one would turn to the first two bouts of QE and Operation Twist to try to extrapolate theresults. Unfortunately, no one can answer the counterfactual question of what the economycould be like without them. However, there has been general consensus that QE andOperation Twist have helped. During the periods when QE2 and Operation Twist were carriedout, the unemployment rate has trended downward as shown in Figure 1 below.

Figure 1: Unemployment Rate and 10-Year Bond Yields Over Time

Though QE has generally been beneficial to the economy, it is not without costs. It is of graveimportance that the Federal Reserve adequately weighs the costs of their actions. One of themajor costs cited by QE dissenters is inflation.

Inflation occurs when the growth in money supply outpaces the growth in the economy. There

is normally a delay between an increase in money supply and inflation as the economy adjustsslowly to new prices. Since August 2008, the monetary base 3 in the US has more than tripledfrom US$843 billion to US$2.653 trillion while the growth of the US economy has beenunimpressive (shown in Figure 2 below). Although inflation is now low, there is bound to besome inflationary pressure in the future with such a huge discrepancy between the growthand money supply and the growth in the US economy.

Figure 2: Monetary Base Growth Against GDP Growth

0

0.5

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10YearBondYield(%)

UnemploymentRate(%)

QE2 QE1 Operation Twist Unemployment Rate 10 Year Yield

Source: U.S. Bureau of Labor Statistics, Federal Reserve Data Releases

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However, it should not be assumed that the monetary base will keep expanding forever. It is

expected that the Federal Reserve will attempt to extricate itself from the situation andreduce its support. During the two periods when the Federal Reserve withdrew its support,interest rates plummeted. This phenomenon exposes the fact that the economy is stillextremely dependent on the support of the Federal Reserve. With the US economy in a fragilestate, it is simply not feasible for the Federal Reserve to withdraw their support now andexpect the economy to hold up. Furthermore, compared to at the start of the crisis,unemployment rates are still considered to be at very high levels.

With the most recent announcement on September 14, QE3 is expected to flood the economywith US$40 billion monthly without an end date in mind. With QE3 in place, the FederalReserve is expected to add US$85 billion monthly until December 2012 and US$40 billion

monthly thereafter. Since Ben Bernankes emphasis is on job creation, it helps to quantify howmuch is spent on creating each job. The first two rounds of QE, totalling US$2.3 trillion createdroughly 2 million jobs. This translates to a cost of approximately US$1.15 million per job.Assuming QE3 lasts until the end of 2013, QE3 needs to create 713,000 jobs to maintain thesame cost per job. This may be considered rather unrealistic since QE3 is smaller than QE1and QE2, possibly reducing its effectiveness.

Given the size of the previous rounds of QE, it leads us to wonder why the impacts (asillustrated in Figure 1) are not sustained. The answer lies in the mechanism of how QEstimulates the economy. By conducting QE, the Federal Reserve increases the reserves in thebanking system hoping that this would encourage lending in the wider economy. Withwidespread uncertainty surrounding the recovery of the US, the Eurozone crisis, and Asiasslowdown, businesses are taking a wait-and-see approach. Unfortunately, this is preciselywhat causes the drastic drop in the money multiplier, a metric that quantifies how muchmoney is created for every dollar injected into the economy (as shown in Figure 3). This hasvastly diminished the Federal Reserves ability to prop up the economy and indicates therising cost of QE.

Figure 3: Money Multiplier

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Jul-08

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Monetary Base Growth GDP Growth

Source: IMF Data and Statistics, Federal Reserve Data Releases

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Even though now is not the time for the Federal Reserve to withdraw QE support, they havenot yet articulated any exit strategy. The benefits of Federal Reserve support currentlyoutweigh the costs, but these costs are rapidly gaining ground. Quantitative Easing cannot be

expected to hold up the economy indefinitely.

With the Fiscal Cliff rapidly approaching, the future president has to make commitments tobudget balancing to prevent triggering steep tax increases and sharp cuts which potentiallycan cause the US economy to sink into deep recession. However, this is far easier said thandone as it requires very careful balancing between the stimulation of the US economy and theimplementation of budget cuts. With both expansionary fiscal and monetary policies facingstrong headwinds, the US government has both its hands tied in the battle against recession.

Sources: U.S. Bureau of Labor Statistics, Federal Reserve Data Releases, IMF Data andStatistics

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded inthe United States. It has been widely regarded as a gauge for the large cap US equities market

0

0.2

0.40.6

0.8

1

1.2

1.4

1.6

1.8

2006 2007 2008 2009 2010 2011 2012

Source: Federal Reserve Bank of St. Louis

1 A form of monetary policy used to increase money supply via the purchase of securities (from

the government or otherwise from the market. This is usually done to encourage lending in the

economy.

2 A form of monetary policy conducted in September 2011 where the Federal Reserve bought

long-term T-bonds and sold short-term T-bonds to bring down long-term bond yields.

3 Monetary Base measures liquid money and consists of sum of currency in circulation and the

commercial deposits held in the central banks reserves.

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The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market countryindices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand.

The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalizationcompanies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy,Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents

Ben Lim (Vice President, Publication)[email protected] Management UniversitySingapore

Herman Cheong (Vice President, Operations)[email protected] Management UniversitySingapore

Tan Jia Ming (Publications Director)[email protected] Management UniversitySingapore

Fariha Imran (Marketing Director)[email protected] Management UniversitySingapore

Vera Soh (Liaison Officer)[email protected] Management UniversitySingapore

Randy Lai (Editor)[email protected] Management UniversitySingapore

Seumas Yeo (Editor)[email protected] Management UniversitySingapore

Lin [email protected] Management UniversitySingapore

Leung [email protected] Management UniversitySingapore

Samuel [email protected] Management UniversitySingapore

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