Is China and Europe trying the wrong type of stimulus?

William Gamble 29 September 2014

QE has not necessarily shown major benefits other than inflating stock markets. Injecting more money into economies that certainly do not need it is easy, but eventually those economies, like other addicts, will collapse as well

The word stimulus is magic for markets. Just the word or the hint of more stimulus will send markets to new highs. The highs are so dizzying that stimulus has often been compared to heroin. However, as any addict will tell you, to get the new highs you need a stronger dose. A slight mistake will lead to an overdose. Too much of a good thing and the addict drops dead. Central bankers and governments might take heed of the analogy.

A fortnight ago, the markets celebrated the news that the People’s Bank of China (PBoC) had injected a rather large amount into their banking system. They gave the five largest state banks Rmb500 billion ($81 billion). But will this do anything? Probably not. Presently during the first half of 2014, each new $1 of credit adds only twenty cents to GDP growth. This has been consistently coming down. In 2012, it was 29 cents for each dollar of credit and in 2007; it was 83 cents for each dollar. Therefore, the real amount of the stimulus was only about $16 billion.

Worse, the money went to the five largest state owned banks. Most of these lend only to large local state owned industries. These companies are very inefficient and many of these are either losing money or are on the verge of bankruptcy. For example, as I wrote in an earlier piece, 20 out of the 36 largest coal companies are losing money. Many of these are state owned. The same is true for other large state owned companies. About a third of steel, aluminium, and cement companies lost money. The new stimulus money will only be used to roll over unpaid loans. It will not stimulate new growth.

The sector of the economy that really needs the money is the shadow banking system where half the lending takes place. The real problem is the asymmetry of maturity dates. The trust companies make up the largest part of the shadow banking system. They took in money for a term of a few months promising to pay high interest rates. They used the money for loans of several years, often to real estate developers. As the real estate market slows, developers often cannot pay. Without new injections of money from the PBoC, there will be more defaults. How many of these will be bailed out is the next question.

China has stuffed itself with credit. Its economy is about half the size of the US and its money supply is 61% bigger and growing. The Chinese simply cannot use more money. The loan demand fell to 66% from 71%. Without demand, creating more stimulus might delay defaults but it would not prevent them.

Mario Draghi, the president of the European Central Bank (ECB), has a similar problem. He has been telling anyone who would listen for months that he could use “unconventional policy measures” to stimulate the Euro zone economy and avoid deflation. So far, this has meant a program known by its acronym, TLTRO. Under this program, the ECB offered three-year ultra-cheap loans to banks. The program offered €400 billion to the banks. Most economists did not believe that the banks would want that much. They forecast that banks would take only €150 billion. In the end, the demand was not even for that much. The auction of the loans resulted in banks borrowing only €82 billion. Worse, some banks paid off earlier ECB loans for €19.8 billion. In short, this unconventional policy measure failed.

The next “unconventional policy measure” will involve the ECB purchasing bundles of securitized assets. The ECB would love to purchase hundreds of billions of these things. But loan demand has been contracting since 2012. Securitized assets got a bad reputation in the crash, so there are simply not enough of them out there for the ECB to buy. This is especially true since the ECB is trying to reduce its credit risk by only buying the best. However, why should anyone want to sell anything that is paying a decent return?

Because of the problems with the other “unconventional measures”, markets expect the ECB to try quantitative easing. But this will involve the purchase of peripheral Eurozone bonds, specifically Italy’s.

Italy has a major problem. It has a very high debt to GDP ratio (over 130%). Its credit rating by Moody’s is Baa2 and by S&P BBB low medium investment grade a notch above junk. Its growth rate is very low even negative. Its working age population is falling and those Italians who are educated and still work are leaving. This combination of high debt, falling inflation or even deflation and a shrinking population is a recipe for default.

If Draghi wants to invoke QE for Europe, he has to convince the Germans that they should buy debt that may require a 50% write off. For me that sounds a bit far-fetched. No sane politician would agree to spend taxpayer money to buy anything with a high probability of losing money no matter what the benefits. QE has not necessarily shown major benefits other than inflating stock markets.

The real problem is that both the Europeans and the Chinese are trying the wrong type of stimulus. The right type of stimulus is the one proposed by Indian Prime Minister Narendra Modi. He wants to bring India’s ranking in the World Bank’s Doing Business Index up from its present rank of 134 to 50. This is a monumental undertaking but it is the only one that will work. Injecting more money into economies that certainly do not need it is far easier, but eventually those economies, like other addicts, will collapse as well.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)

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