Money, banking & insurance

Is it a bubble and will it burst?

China may be on the verge of a sovereign default. The Royal Bank of Scotland has recommended credit default swaps, just in case. But with inflation running at an official 5% (and vegetable prices up 20% in a month), it’s not surprising China is taking a more prudent monetary stance. Money supply rose at 40% during 2009 and the first half of 2010.

When inflation runs rampant it creates dissent because only a few can protect their living standards. The Chinese economy is now experiencing inflation with much of the surplus money going into property, potentially creating a bubble comparable with America’s subprime crisis or Tokyo in the 1980s. In Bejing, house prices are 22 times disposable income (18 times in Shenzen), compared to 8 in Tokyo. In America, it was 6.4 during the crisis and is now around 4.7. Private credit is now 148% of GDP, compared to 41% for emerging markets.

Meanwhile, China may have reached a “Lewis turning point”, the moment when the supply of cheap rural labour drops and wages shoot up. There were 120 million rural migrants about 4 years ago compared to 25 million today. On top of that, China is aging and there will be fewer workers available. While China has reserves of $US2.6 trillion, of 5-6% of GDP, it cannot be used internally in the economy. If growth in China slows to 5%, more or less recession, it will create worldwide ripples. There could be a 20% fall in global commodity prices (affecting Australia in particular), a 25% fall in Asian bourses, and weakening of Asian emerging economies. Asia’s big five will feel it the most (Japan, Korea, India, Indonesia, China). These are fairly powerful signs that 2011 could be as momentous for economies as the GFC.

Cash keeps you healthy

Here’s an interesting cure for obesity: throw away your credit card! A recent study published in Journal of Consumer Research, found that when people felt the “pain” of paying cash for food, they were more likely to buy fruit and vegetables. When “protected” from the purchase by using a credit card, they bought more junk food. The study analysed 1,000 households over 6 months. Researchers said, “cash payments are psychologically more painful than card payments, and this pain of payment can curb the impulsive responses to buy unhealthy food items”.

The idea that rising obesity in America (now 33% of people) may be linked to credit card use is a radical one. But it makes sense if you think that credit cards lead to impulse purchases of all types, not just food. A credit card may encourage all kinds of “junk” purchases. The big question is, if cash is dying out, what does this mean for the “pain” of purchase and impulse purchase in general?

How will we pay for pensions?

Governments everywhere are pondering how to look after their aging citizens when they stop working. One answer is to lift retirement age. But that’s just putting off the inevitable. A recent report by Standard & Poor’s says age-related expenses would push government spending to 60% of GDP, compared to 44% today, and up to 430% of GDP by 2050. Obviously action needs to be taken to minimise the damage, whether it’s higher taxes or more credit.

Aging people tend not to invest at the same rate as younger people. Barclays Capital compared price/earnings ratios of stocks since 1950 with the ratio of 35-54 year olds. The more investors, the higher the multiples. But share values are likely to fall as people age and fewer invest and this is why pension funds are more likely to invest in bonds as people approach retirement. The developed world is aging more rapidly than emerging markets so they may help to keep the rest of us afloat. Jeremy Siegel, a professor at Wharton School, suggests our comfort in retirement almost completely depends on productivity growth in the developing world. No wonder China is such a concern.

A Japanese study of stock prices and working populations (in 85 countries from 2004-2010) claims aging nations can still sustain stock growth. In Japan, for example, the number of workers 15-64 decreased 3.76% compared to the stock price average drop of 3.54%. In the US, working population rose 4.81% while the index fell 1.18%. When all countries are plotted, the graph shows a generally rising trend. In Japan, stock indices rise 0.49% for every 5-year growth in population of 1%. This is why Japanese industry is in favour of immigration. See 'Why immigration is complementary', for more reasons to encourage immigration. Of course, immigrants age too, so sooner or later, we will have to create better ways of dealing with the later part of life. Given that medical technology is keeping us alive for longer, this should become a compelling focus.

The dark side of microfinance

The original idea of offering small loans to poor people to get them out of poverty was inventive and transformative. It enabled women to start small businesses to support their families. Muhammed Yunus, who made the first microloan, won the Nobel peace prize. And Grameen Bank was founded in Bangladesh, to much global applause. Unfortunately, quick and easy money has become a curse, quickly and easily. Many people in India and Bangladesh are unable to pay off their loans and the loan sharks are gathering round the poor as they always have.

Part of the problem is the scale of the industry. What began in a small way became a vibrant industry, for example, there are about 800 non-bank finance institutions in India, 147 of them quite large. SKS Microfinance, which claims to have 7.8 million borrowers, was recently listed on the Indian stock exchange. India’s microfinance sector has $7 billion in loans outstanding, most of which was borrowed from banks. Since it’s expensive to service millions of small loans (typically, $250), the lenders charge high rates. They were recently cut from 27% to 24%, so anyone with a loan had better pay it off quickly or become more indebted.

In Bangladesh, outstanding microfinance loans are worth $US2.2 billion, with 30 million borrowers. The prime minister claimed “microlenders make the people of this country their guinea pig. They are sucking the blood from the poor in the name of poverty alleviation”. There are doubts about whether microloans can do more than lift people above the poverty line, and whether it is better to improve lending to small and medium businesses with economies of scale that can employ more people and reach bigger markets.

Why gold looks shiny again

It has been 40 years since the US put an end to the gold standard: the dollar could no longer be converted to gold or other reserve asset. There is some evidence now that gold is making a comeback. The president of the World Bank, Robert Zoellick, suggests gold is being seen as an alternative monetary asset. The dramatic rise in the price of gold, from $US250 a troy ounce in mid-1999 to over $US1,400 today, could be a sign that investors have lost confidence in paper money.

You can’t print gold, which is one advantage over money. But if US consumers had paid for their shopping in gold coins, since 2000, the amount of gold needed to buy a loaf of bread would have fallen by three quarters. Not a pretty deflation. Moreover, the price of gold fluctuates rather rapidly. However, it could be used as a measure of sentiment about the future value of currencies.

Mine output has been fairly flat since 2001 and tending to move to riskier environments like Africa and central Asia. An increase in the amount of gold scrap has helped hold prices. Investors have found new ways to buy gold, for example, exchange traded funds (ETFs), which smooth the way to buy and sell gold. Hedge funds are choosing gold in the face of dwindling value in paper money.

There are several reasons why gold may be useful. If the consumer price index included asset prices, then gold would more easily reveal general purchasing power rather than just the cost of consumption. The fact gold does not provide an income – an original reason for eschewing it - hardly matters when interest rates are low. Last, investors may be buying gold because they want to buy the renminbi but can’t.