“CANUTE-LIKE EFFORTS” TO DEFY ECONOMIC LOGIC HAVE LED TO A CURRENCY COLLAPSE
Turkey is heading for “a vicious cycle of inflation and depreciation”, Timothy Ash of BlueBay Asset Management tells Tommy Stubbington in the Financial Times. With inflation running at 19.89% and the Turkish lira plummeting, there is talk of a new currency crisis.
The lira has lost 40% of its value so far this year. As of Tuesday it had recorded 11 successive record lows against the dollar in as many days, say Daren Butler and Nevzat Devranoglu on Reuters.
BACK TO 2018
The latest sell-off came after the central bank cut interest rates to 15%, the third cut since September. Interest-rate cuts reduce the attractiveness of lira-denominated assets, causing investors to sell them in favour of other currencies. At the new interest rate, savings in a Turkish bank account would earn a real return of -4.89%.
President Recep Tayyip Erdogan continues to believe that high interest rates cause inflation, despite ample evidence – not only in his own country – that the opposite is true. He has fired central bankers who didn’t toe the line on easy money.
“THE MSCI EMERGING MARKETS INDEX HAS FLATLINED THIS YEAR DESPITE GLOBAL REFLATION”
Things are starting to look a lot like 2018 again, when the lira “dropped precipitously amid a crisis in relations with the US”, say Jared Malsin and Patricia Kowsmann in The Wall Street Journal.
A plunging currency is “driving up the cost of [imported] food, medicine and other essentials for average Turks”. Some commentators fear a bank run. Yet despite growing signs of discontent, Erdogan appears determined to stay the course; indeed “he has intensified his calls for low interest rates”.
Things got so bad in 2018 that policymakers were eventually forced to reverse course with emergency interest-rate hikes, says Craig Mellow in Barron’s. That sent local stocks up by “a third in four months”. Yet few are betting on a repeat this time.
Since 2018, “Erdogan has replaced professionals at the central bank with yes men”. Global inflationary pressures are amplifying domestic problems, while Covid-19 continues to weigh on the important tourist sector.
EMERGING MARKETS DISAPPOINT
Trouble in one emerging market can quickly spread to others, says Shilan Shah of Capital Economics. Investors in the asset class may panic and sell indiscriminately. Yet any such “financial contagion” is likely to be “much more limited” this time than in 2018.
Turkey aside, most big emerging countries appear to have the foreign-exchange reserves they need to ride out any turmoil. What’s more, non-residents’ holdings of Turkish stocks and government bonds are down by two-thirds since 2018. Foreign investors won’t be panicking and pulling funds from Turkey – most of them have already left.
“Did you ever think you’d be paying this much for a gallon of gas?” declared Joe Biden last Wednesday. “In some parts of California, it’s $4.50 a gallon!”
The average price of a gallon of petrol in California was $3.76 as recently as May. Last week, according to the American Automobile Association, that average hit $4.64 across the Sunshine State – even more than Biden’s estimate.
California has seen a 24pc rise in fuel costs in just six months. Despite that increase, the price of litre of petrol in Britain – which just topped a record £1.46p per litre – is still half as much again as in the States.
Biden was speaking in the aftermath of some pretty shocking US inflation data. In October, the US Consumer Price Index was 6.2pc up on the same month last year – far higher than financial markets expected.
Inflation in the world’s biggest economy is now at a 30-year high. And even if you take the “core” measure, which excludes volatile items like food and energy, US inflation was still 4.6pc last month – again, much higher than expected.
It’s not just the US, of course. Eurozone inflation surged to 4.1pc in October – significantly above market expectations. And the latest UK data shows CPI inflation of 3.1pc in September, well above the Bank of England’s 2pc target.
Just weeks ago, the Bank maintained price pressures were “transitory”. The Office for Budget Responsibility has since forecast inflation looks set to average 4.5pc next year. Even the Bank of England now accepts we could see CPI price growth peak above 5pc – with many private forecasts much higher than that.
US consumer price inflation has jumped to a 30-year high of 6.2pc
Line chart with 129 data points.
Prices were up 0.9pc on a month-on-month basis
The chart has 1 X axis displaying Time. Range: 1989-09-03 17:02:24 to 2022-02-24 06:57:36.
The chart has 1 Y axis displaying CPI (%). Range: -2 to 8.
1990199520002005201020152020-202468SOURCE: US Bureau of Labor Statistics
US consumer price inflation has jumped to a 30-year high of 6.2pc
Prices were up 0.9pc on a month-on-month basis
CPI (%)
End of interactive chart.
Across the world, global demand is rebooting but “the supply side” has yet to catch up. Spiralling oil prices and labour shortages are combining with pandemic-related logistical snarl-ups, sending business costs soaring.
Producer prices in China are now rising at their fastest pace in more than a quarter of a century. Chinese “factory gate” inflation – reflecting prices at which wholesalers buy materials from producers – hit 13.5pc in October, up from 10.5pc the month before.
Businesses of all kinds – from manufacturers to service providers, from West to East – are enduring much higher bills for labour, energy, raw materials and logistics. Slowly but surely, such rising input costs are being passed on, developing into political-explosive headline cost-of-living rises.
Earlier this month, the Bank of England held interest rates at the ultra-low emergency level of 0.1pc. With inflation well above target, this was widely viewed as a surprise. The money markets were betting the Monetary Policy Committee would bear down on price pressures, by raising rates to 0.25 per cent.
Yet, despite weeks in which market expectations of a rise were stoked by comments and speeches from MPC policymakers, the committee voted by 7-2 to keep rates on hold. Members also voted 6-3 to continue the Bank’s bond purchases under its quantitative easing programme. So, despite upward inflationary pressures, the virtual money-printing goes on.
Reflecting this surprise, the pound plunged against the dollar – a trend which extended into last week. Traders had expected higher rates, and therefore higher returns on money held in sterling. When that didn’t happen, they sold billions and billions of pounds.
When a central bank signals a rate rise, a rising currency tends to make imports cheaper, helping keep a lid on inflation. This is particularly true in the UK, given the public’s voracious import demand. But signalling a rate rise, without then delivering one, is a dangerous business.
Whether you think rates should go up or not – and I’ve been arguing for higher rates literally for years – leading central banks stand or fall on their credibility. Lose that and markets rebel, ignoring future signals, lurching through peaks and troughs, causing financial chaos.
Just weeks ago, Governor Andrew Bailey was arguing the Bank of England “had to act to tackle inflation” – words building on speeches and remarks from other MPC members. The money markets clearly moved to prepare. As such, Bailey spread confusion and dented the confidence of financial markets.
Given the extent of the UK Government’s borrowing, and the broader fragility of our stock and bond markets, bloated after years of QE, this is by no means an insignificant issue.
The UK economy is still expanding, but the pace of recovery is slowing. Our GDP between June and September was just 1.3 per cent higher than during the same period in 2020, we learnt last week. The same figure between April and June was 5.5 per cent – so growth has fallen considerably.
Ministers insist we are doing better than other advanced nations – and UK growth remains quicker than most. Yet while the US has now fully recovered, with GDP 1.4pc bigger than at the end of 2019, prior to the pandemic, the UK economy remains 2.1pc smaller.
In Germany, there’s a 1.5pc GDP shortfall, falling to 1.4pc in Italy and just 0.1pc in France. In his budget statement last month, Rishi Sunak based all his sums on full-year growth projections of 6.5pc this year and 6pc in 2022. I can’t see that happening.
The UK now faces spiralling inflation and a looming growth slowdown – which will further weaken our public finances. This is not a good time for the Bank of England’s credibility to be in play.
On Monday, though, the House of Lords will debate a hard-hitting report published in July by the Economic Affairs Select Committee.
“Quantitative Easing: A Dangerous Addiction” clearly got on the nerves of the Bank of England and the Treasury. Both institutions published somewhat dismissive responses, despite the committee being stacked with some of the UK’s most influential economists, including former Bank Governor Mervyn King.
Peers argued that the UK’s QE programme – which has ballooned during this pandemic, the Bank now on course to own no less than £875bn of government debt, bought using newly-created money – poses “inflationary dangers” and risks “a loss of credibility”.
Ahead of tomorrow’s debate, I’ve spoken to several peers, united only by their economic expertise. They are alarmed – rightly – about confused Bank of England messaging.
When it comes to inflation, the vast majority of policymakers, from the US President downward, are badly behind the curve.
So why does government make it so complicated? It’s not important to know the figures, but it is important to know enough to make a judgement if you plan to use this sort of thing. If it is a good idea why isn’t it clear and simple? I had to read this several times to get it clear - you don’t have to, but you can use this to build a stock comment for an essay.
David Prosser
Business columnist
How to tackle the yo-yo tax
YOU CAN REDUCE YOUR TAXABLE INCOME BY THE SUM YOU SPEND ON MACHINERY
Approach the government’s fast-changing schemes to encourage business investment with caution
Accountants have nicknamed the annual investment allowance (AIA) the “yo-yo tax” because it has moved up and down so often. Last month’s budget was no exception. Chancellor Rishi Sunak announced that rather than falling to £200,000 a year from January as previously expected, the AIA will now be maintained at £1m until 31 March 2023.
The higher AIA now comes to an end on the same day as the “super-deduction”, which the chancellor introduced earlier this year. The two schemes, both designed to encourage businesses to invest more, will now operate in tandem for the next 15 months or so. The schemes work in a similar way, but with subtle differences, so it is important for businesses to work out how to make the best of them. The basic idea with both is that when you invest in something for your business – new plant or machinery, say – you are entitled to subtract the cost of this investment from the pre-tax profits that you declare to HM Revenue & Customs. It will then charge you corporation tax on the lower figure, with the tax saving lowering the total cost of your investment.
HOW MUCH CAN YOU SAVE?
With the AIA, assuming that you spend £1m on new machinery, your pre-tax profit will be adjusted down by the same amount. With corporation tax at the current rate of 19%, that reduces your tax bill by £190,000. So you’re effectively investing £1m at a cost of £810,000. The super-deduction is more generous because it offers 130% relief. Invest £1m and you can take £1.3m off your pre-tax profits. That brings your tax bill down by £247,000, so your £1m investment costs only £753,000.
This makes it a good idea for businesses to make use of the super-deduction before turning to the AIA. Unlike with the latter, there is no limit on how much investment you claim the super-deduction for. But the rules on qualifying assets are less generous. For example, you can’t normally claim the relief if you’re investing in second-hand assets rather than brand-new items. And if you’re leasing equipment, rather than buying it outright, you may not be able to use the super-deduction. In both cases, you may still have access to the AIA.
The other wrinkle is that the super-deduction is due to disappear just as the main rate of corporation tax in the UK increases from 19% to 25%. More cynical analysts say the only reason the Treasury introduced the super-deduction was to deter companies from putting off investment until after the tax increase, when the AIA effectively becomes more valuable. It is probably no coincidence that in cash terms, the value of the super-deduction is almost identical to the value of the AIA once the new corporation tax comes into play.
Note, however, that small businesses with profits below £50,000 a year will continue to pay corporation tax at only 19%, and those with profits between this level and £250,000 won’t pay the full 25%. For these firms, the super-deduction is a real bonus, since their lower tax rates mean the AIA won’t become more generous.
Getting the best out of the system will therefore depend on the size of your firm, the timing of the investments you are planning, and the nature of those investments. A broad range of assets can qualify, from computing equipment to heavy machinery, but if unsure, take advice from an accountant.
Finally, don’t forget about research and development (R&D) credits, which your business may also be entitled to if it invests in innovative projects in science and technology. For small and medium-sized businesses, these credits are even more valuable than the super-deduction: you can set 230% of the cost of this investment against your tax bill.
Too few businesses take advantage of the R&D tax-credit scheme, because they think it is only available to specialist companies conducting breakthrough research. In fact, it is open to any company developing some sort of scientific or technological advance, including work on how the business produces a product or service, as well as the product or service itself. The innovation does not even have to prove successful. Again, if you’re in any doubt about your firm’s eligibility, take advice so you don’t miss out. There are specialist firms that offer advice on claiming R&D credits, but they often want a cut of the proceeds. Speak to your accountant in the first instance.
For macro purposes you could skim most and read the last paragraph; to get a good idea of how to analyse something and provide evidence for the statement in the last paragraph take a deeper look at some of the charts and consider what they reveal:
The Case of Evergrande: Is There a Housing Bubble in China?
China has made the world’s capital markets nervous. Evergrande, the largest real estate developer in China and one of the largest in the world, is on the ropes. It is very likely to go bankrupt (it has already defaulted on some interest payments on its bonds). Some people are debating whether this is the “Chinese Lehman Brothers.” Are we on the verge of a new global financial collapse?
Let’s begin by analyzing the health of the sector in which Evergrande finds itself. What is the state of the housing sector in China? Are there signs of a housing bubble?
The Chinese Housing Bubble and Empty Cities
The Chinese housing bubble has been reported for over a decade. The primary evidence is the existence of ghost cities, cities that are practically empty. For over ten years, ghost cities have not appeared to be causing a systemic problem, although they undoubtedly pose a local problem. However, the vacancy rate has continued to grow in China’s secondary cities. Even in Beijing, the vacancy rate has reached 20 percent.
China’s housing vacancy rate is relatively high when compared with other countries, although in 2017 it was lower than that of Spain and Italy.
The data on the vacancy rate are not alarming, but when this indicator (and the existence of ghost cities) is combined with other indicators, the Chinese housing sector’s situation does indeed look alarming.
Housing-Price/Rental-Price Ratio
Housing is a durable capital good, and as such must be valued. How is the price of a capital good determined? The most common way is to base it on the income the good is capable of generating. In the case of housing, the income it generates is the rent (either through the market or through the rental payments the owner avoids). Accordingly, it is crucial that the value of the house be a reasonable multiple of the rental value.
The housing-price/rental-price ratio gives a sense of how inflated a housing market is. When the indicator is very high, purchasing a house cannot be justified by the income it will generate. The only reason someone will buy a house in this case is if they hope to sell it for a higher price (and if everyone operates on the same expectation, we are facing a bubble by definition).
The housing-price/rental-price ratio in the Chinese real estate market is incredibly high. It is exceeded only by the real estate market in Turkey and Taiwan. Purchasing a home in China and renting it out is a very poor business plan, as it takes a whopping forty-eight years to recoup the investment.
The Profitability of Purchasing a House
The profitability of investing in housing can be analyzed in a similar manner. The income of a house is divided by the house’s sales price. The result (once costs are deducted) is the profitability of investing in the housing sector. An analysis reveals that investment in real estate in Chinese cities is less profitable than in cities almost anywhere else.
Further, the returns from investing in China’s housing market are much lower than the country’s prevailing mortgage interest rate. So purchasing a house in China does not make economic sense. This is a clear sign of a housing bubble.
Homes’ Purchase Price versus Citizens’ Median Income
Another way of analyzing whether the housing market is in a bubble is to determine whether the average citizen can buy a home. The main purpose of a house is to be lived in (final demand). If the price of housing grows well above the purchasing power of the average citizen, the demand for housing (which drives the price growth) may well turn out to be purely speculative and collapse in the future when it becomes clear that the final demand does not exist.
China’s ratio of housing price to per capita income is the second highest in the world (behind only India’s). It would take the average Chinese citizen 146 years to pay for a home if they were to devote all of their income to housing.
The previous indicator could be problematic as a means of comparing countries since it relates national per capita income to the price of urban housing (despite this, it is worth discussing it because of the huge contrast between China and other countries). If we disaggregate the indicator by city, we reach the same conclusion: the price of housing is too high relative to the income of Chinese inhabitants.
The Housing Sector’s Contribution to GDP
Another way to assess whether the Chinese housing market is in a bubble is to look at the housing sector’s contribution to GDP. A high contribution indicates too many resources are allocated to housing. This indicator is the logical corollary of those discussed above: if house prices are high, producers react by increasing supply, in the process drawing resources from other parts of the economy.
The contribution of China’s housing sector to its GDP is greater than the corresponding contribution seen in the huge Irish and Spanish housing bubbles of the 2000s. Nearly a third of China’s economic activity is linked to bricks.
The Disproportionate Concentration of Wealth in Housing
Another sign of a bubble is the concentration of wealth and investment in a single sector. Real estate is a favorite investment among Chinese citizens. The recent increase in the income and quality of life of Chinese citizens have exponentially increased their ability to save and invest. The asset in which they invest has almost exclusively been real estate. In 2018, 76 percent of Chinese household wealth was invested in housing (in Japan this figure is 41 percent, and in the United States it is 27.7 percent).
The concentration of assets in the housing market makes Chinese households vulnerable to shocks in that market. The valuation of the Chinese housing market today is double the valuation of the US housing market, even though China’s GDP is 25 percent lower than the United States.’ In the Japanese housing bubble that burst in the 1990s, the market valuation at the peak was also double that of the US housing market.
The huge demand for housing is generating a housing supply far greater than the housing needs of Chinese citizens (a typical bubble trait). In 2008, only 30 percent of new housing was bought by people who already possessed at least one home; in 2018, this figure was 88 percent.
Chinese Authorities Want to Burst the Bubble
The problems discussed here are so evident that the Communist Party leadership has taken action. They have implemented relatively restrictive financial measures such as debt ratios and capital requirements for housing developers. These measures have meant that the most financially irresponsible developers are prohibited from increasing their debt by even a single yuan. The Chinese housing bubble is enormous; various economic indicators leave no room for doubt. Evergrande’s problem is not an isolated issue but a systemic problem with the Chinese economy.
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