The size of the reversal of the supercycle is bigger than you think: And too big to be dealt with by monetary policy in advanced economies

2016-BFO-cover-350Adrian Blundell-Wignall, Director, OECD Directorate for Financial and Enterprise Affairs, Special Advisor to the Secretary-General on Financial Markets

The real economy will always seem to be disconnected from the financial economy during periods when the need for structural change is so overwhelming that it can hardly be otherwise. We have had the easiest monetary policy of any historical era outside of hyperinflations, and productivity fails to grow, economic activity is weak (particularly in Europe and China) and there is no sign of inflation. The 2016 edition of the OECD Business and Finance Outlook addresses the three main causes of this:

  1. The size and impact of the reversal of the supercycle centred on emerging economies.
  2. The problems with company productivity and growth in a global excess capacity situation.
  3. Forcing a zero time value for money onto investors distorts financial investment and works against long-term investment.

We focus on the first of these in this first taste of the 2016 Outlook to be released on 9 June 2016.

Many commentators simply do not seem to understand the sheer size of the supercycle now in reversal.

Two different economic systems butting are up against each other. The group of emerging economies, now comprising around half of the world economy, is not open and (via financial repression) has built up massive savings over a short period of time. These savings have been forced into investment with a heavy role of state industrial policy. Indeed, some very large economies are behaving as though they too can develop just like the small Asian Tigers in the post–1945 period. The other group of more open market based economies is responding to the reversal of the supercycle and other structural factors (such as the failure in some regions to deal with huge bank non-performing loan problems up front) mainly with monetary policy. But little is happening.

This is not so surprising. How big was this saving and investment rise? The sum of the world’s national saving (and investment) since the early 2000s has risen a startling 225%. Most of this occurred in a single country, China.

This investment in emerging market economies (EMEs) has created massive overcapacity in the supercyle sectors, like steel, aluminium, cement, energy (particularly fossil fuels), transport (especially shipping), utilities and similar.

How do we know this other than by industry anecdotes and anti-dumping duties being imposed on emerging country’s exports, such as steel and aluminium?

Well, let’s have a look at the return on equity (ROE) based on 11,000 non-financial companies versus their cost of equity (COE) and their cost of capital (COK):

Excess capacity: ROE-COE and ROE-COK in advanced and emerging economies.
Declining in advanced economies; out of control in emerging economies.

ABW-blog-Fig1Note: See Chapter 2 of the OECD Business and Finance Outlook 2016 for lists of advanced and emerging economies.
Source: OECD calculations, Bloomberg.

The ROE-COK is negative in EME companies, and spectacularly so versus the COE (which means managers can’t add value for shareholders). This is pulling down ROEs in advanced countries too.

Just how big is this supercycle investment? If only one point is to be taken from this year’s Outlook, let it be this: the size of investment related to the supercycle is much bigger than you think and its reversal is having an impact that monetary policy in advanced countries cannot hope to cope with.

Let’s look at the facts from the world’s largest companies. The figure below shows global capital expenditure by sector. The energy and materials sectors alone account for 40% of the total. This is now in decline with links to many other sectors.

ABW-blog-Fig2

Source: OECD calculations, Bloomberg.

The energy and materials sectors alone rose to 40% of capital spending of the 11,000 biggest global companies (shown in blue and grey). These are huge sectors. Energy consists of oil, gas, drilling, oil and gas equipment and services, exploration, refining, storage, transportation, coal and consumable fuels. Materials consists of chemicals, fertilisers, industrial gases, construction materials, metal and glass containers, paper packaging, aluminium, diversified materials and mining, gold, precious metals and minerals, forest products and paper products.

If industrials and utilities (for the energy to drive all this) are added, the numbers rise to 60%. The supercycle sectors have a huge derived demand for inputs and services from other sectors, so that the linkages go even further than this.

Now, capital spending in all of these sectors and their demand for goods and services from other sectors is in decline. Chinese growth collapsed in 2014-2015, and, from late 2015, it is repeating the mistakes of 2009; it is embarking on a new real estate shantytown rebuild funded by state-owned enterprise bank credit.

What does this do? Once more it raises demand in the supercycle sectors and delays the much needed creative destruction phase. Local government steel, cement, aluminium and other factories in each province (all too big to fail) have no incentive to exit.

The reversal of the supercycle and the sheer size of what is happening is such a massive headwind that it is overpowering easy monetary policy.

Monetary policy has nothing to say about the sectoral misallocation of resources and excess capacity in the global industrial sectors; and certainly not in countries largely cut off from the discipline of openness and market forces.

The Outlook analyses this in some detail and then delves into the problems with company productivity in the excess capacity world since the crisis. It looks at what the companies that adjusted to the shock of the crisis did in terms of key corporate finance decisions, which helped them to negotiate this difficult post-crisis world. These companies are compared to those that didn’t adjust and are now part of the problem. It then looks at the portfolio consequences of setting a zero time value for money.

Watch out for the next blogs on these topics, but above all come and discuss the full publication being launched on the 9th of June.

Useful links

Business-Finance-Outlook-20126-callout-350The launch of the 2016 OECD Business and Finance Outlook takes place at 9.30am CET on 9 June 2016. Register to participate or watch the live webcast www.oecd.org/daf/oecd-business-finance-outlook.htm

The 2016 OECD Forum on 31 May – 1 June, is entitled “Productive economies, Inclusive societies”. The Forum is organised around the three cross-cutting themes of OECD Week: inclusive growth and productivity, innovation and the digital economy, and international collaboration for implementing international agreements and standards.

OECD Economic Outlook: “Disconnected from real needs”?

Last week, we reported on the latest OECD Economic Outlook. Writing in the New York Times, Paul Krugman was highly critical of the Organisation’s analyses and policy recommendations. Here we summarise Krugman’s argument and the reply by OECD Deputy Secretary-General and Chief Economist Pier-Carlo Padoan.

Krugman argues that the most ominous threat to the still-fragile economic recovery is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.

He contrasts this with actions taken when the financial crisis first struck, and most of the world’s policy makers responded by cutting interest rates and allowing deficits to rise.

He goes on to say that “The extent to which inflicting economic pain has become the accepted thing was driven home to me by the latest report on the economic outlook from the Organization for Economic Cooperation and Development… what [the OECD] says at any given time virtually defines that moment’s conventional wisdom. And what the OECD is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.

What’s particularly remarkable about this recommendation is that it seems disconnected not only from the real needs of the world economy, but from the organization’s own economic projections.”

His demonstration is as follows. The OECD declares that interest rates should rise sharply over the next year and a half to head off inflation, but inflation is low and declining, and OECD forecasts show no hint of an inflationary threat.

The reason the OECD wants to raise rates is in case markets start expecting inflation, even though they shouldn’t and currently don’t.

Likewise, although the OECD predicts that high unemployment will persist for years, it asks that governments cancel any further plans for economic stimulus and that they begin fiscal consolidation next year.

Krugman insists that both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because a weaker economy depresses tax receipts, wiping out any gains from governments spending less.

Moreover, the reasons for doing this don’t hold. Investors aren’t worried about the solvency of the US government and interest rates on federal bonds are near historic lows. And “even if markets were worried about U.S. fiscal prospects, spending cuts in the face of a depressed economy would do little to improve those prospects”.

This contrasts with the OECD’s calls for cuts because inadequate consolidation efforts “would risk adverse reactions in financial markets.”

Krugman is worried that this view is spreading, citing the case of “conservative members of the House, invoking the new deficit fears, [who] scaled back a bill extending aid to the long-term unemployed… many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.

He concludes by stating that “more and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.”

In reply, Padoan starts by saying that they differ on the strength of the recovery, with the OECD more optimistic than critics of the Outlook. Unemployment will take time to fall to acceptable levels, but this will be underway by 2011. A double-dip recession cannot be ruled out, but is not very likely. The risks of running big fiscal deficits and a zero interest rate monetary policy are rising.

Recent events in Europe are a warning sign and even though the US has the world’s biggest capital market, the risks are shifting. In this unsettled financial environment, governments need to get out ahead of markets, because otherwise they will be hostage to them.

On inflation, he argues that it is not a risk today, but could be in two-years’ time. Monetary policy needs to be forward looking and this means easing up on monetary stimulus in anticipation.

“To be clear, we are not arguing for contractionary policy, but for progressively less stimulus. In fact, stimulus should not be withdrawn completely until the economy returns to full employment. But the process should be started fairly soon, to take into account the well known long and variable monetary policy lags.”

How quickly interest rates should rise depends on many things, especially inflation, inflation expectations and the pace of growth. It also depends on fiscal policy, which influences growth.

“All else equal, if fiscal policy turns out to be tighter than in our projection, then monetary policy should be looser to compensate.”

Useful links

OECD Economic Outlook