Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Oil, China and Prospects for the US Economy

Thursday, May 12, 2016


April 15, 2016

Global stock markets were off to a rocky start in 2016. Was the sharp decline in U.S. stock prices early in the year a signal that the economic expansion that began in 2009 is about to end, or is the canard “The stock market has predicted five of the last three recessions” again relevant? The dramatic decline in petroleum prices has contributed to the malaise of the residents of the ten U.S.states that produce 80 percent of domestic crude oil. The prices of oil company stocks are down sharply.  Real GDP and household incomes have declined in Russia, Nigeria, Venezuela, Saudi Arabia, Kuwait, the Emirates, and in the other countries that depend on petroleum sales for 80 percent of their exports and 90 percent of their fiscal revenues.

The bad news for the energy producers is good news for American consumers and those in Japan, China, and Europe who have benefited from a massive reduction in the cartel tax.  The puzzle is that when oil prices have declined, stock prices have dropped, and confounded the logic.

Stock prices in China have fallen by nearly 15 percent over a three month period The government has claimed that the growth rate in 2015 was a nickel shy of 7.0 percent.  Wang Baoan, director of the National Bureau of Statistics of China, was arrested in late January.  The micro data–commodity imports, electricity consumption, freight car loadings-suggest that the growth rate in 2015 was much lower, and probably below five percent. There has been a massive “run” on the Chinese yuan as more and more residents of Beijing and Shanghai and Shenzen recognize that beanstalks do not grow to the sky.   Chinese firms are repaying their U.S. dollar loans and their Japanese yen loans because they anticipate that there is a non-trivial likelihood that the price of the yuan will be reduced.

The continuing economic slowdown in China will be the most important game changer in 2016 as its economy continues to adjust to the massive imbalances in its credit market, its housing market, and the market for plant and equipment. This slowdown already has had dramatic impacts on export volumes and prices from Brazil, South Africa, Canada, and Australia; the prices of their currencies have declined sharply. Some Chinese firms have increased exports to compensate for the fall in domestic sales, the increase in steel exports to Britain has led several mills there to close.  (Can you imagine that a steel mill in China would reduce production because of an increase in imports from South Korea or India?)

The adjustments in China are similar to those in Japan in the 1990s when its massive asset price bubble popped. Its economy then was the second largest in the world but there are several differences–the imbalances in China are much larger, the Chinese economy is much larger relative to the global economy, and the ratios of its imports and its exports to its GDP are more than twice as high as those in Japan.

The U.S. economy is at full employment and developing momentum; the month-to-month increases in the number of individuals at work have been impressive for more than a year.  The labor force participation rate has been increasing after a marked decline. Real wages are increasing. The growth rate has averaged between two and two and one half percent. Auto

sales have set records.  Home prices are climbing, which has meant a massive increase in household net worth. The U.S. government’s debt in the hands of the public has been growing less rapidly than GDP.

The next section reviews the petroleum market developments and the prospects for significant increases in the price of oil in the next two years.   The second section focuses on the outlook for the Chinese economy as investment spending falls sharply. The last section looks at the impacts of oil market development and the slowdown in the Chinese growth rate on the prospects for the U.S. economy in 2016.


One of the unique features of the petroleum market is that both demand and supply are very price inelastic in the short run; as a result, any shock that leads to a modest percentage decline in  supply leads to a percentage increase in price that might be forty or fifty times larger. Then adjustments occur on both the demand and the supply sides and eventually the price reverts toward its pre-shock level.

Whenever there has been a sharp increase in the price of petroleum the fans of “peak oil” come out of the woodwork. M. King Hubbert developed this concept in the mid-1950s; he observed that even though oil production was increasing from one year to the next, production was declining in about half of the twenty largest oil fields in world. Changes in annual production were a “race” between increases in output from new fields and the declines in older fields. Hubbert forecast that global oil production would peak in the early 1970s at twenty million barrels a day. Production is now above 85 million barrels a day.

The first of the three major oil price spikes in the last fifty years was in the Autumn of 1973 after the Yom Kippur war; the Saudis embargoed oil shipments to the United States and the Netherlands. Individuals became convinced that gasoline would be in short supply, they rushed to fill their gas tanks–and there were temporary shortages because of the spike in demand even though supply did not decline.  The sourcing pattern changed; the United States and the Netherlands increased imports from other countries and Saudi Arabia increased its exports to those countries who formerly had relied on supplies from the countries that had increased their sales to the United States and the Netherlands.  The price increased by a factor of five.

The second spike in the petroleum price occurred in the last several months of 1980 after the Iraqi invasion of Iran led to a reduction of the global oil supply of six million barrels a day.  The price tripled.

The third oil price shock began in 2004 and involved an increase in price that continued for ten years in response to growth in the Chinese demand; the price increased by a factor of four.

The oil price has declined after each spike as both demand and supply have responded to the much higher price. Demand side responses reflect conservation–more fuel efficient homes, higher mileage for autos, replacement of incandescent light bulbs with fluorescent tubes and then the tubes by diodes. The Boeing 787 Dreamliner is 20 percent more fuel efficient per passenger seat mile than the 777.

The supply side responses include the development of new technologies including wind power and solar and horizontal drilling and fracking.  U.S. petroleum production about doubled in the last eight years.

Currently global oil production exceeds consumption by 1.5 million barrels a day;  some firms are adding to their inventories and storing physical oil in railroad cars and ocean tankers because they believe that the price will increase, and by more than enough to cover the physical costs of storage and the opportunity costs of the investment.  Demand is likely to fall as the limits to storage are reached, and the implication is that price will fall.

Iran plans to increase its petroleum exports by 500 thousand to 1 million barrels a day now that its export sales are no longer limited.   Russia and several other countries are increasing production to offset some of the sharp decline in their revenues from the much lower prices. The Venezuelan government has increased the domestic price of gasoline so that more of the current production will be exported.   A new conservative parliament in Caracas would be likely to undertake policy changes to induce the multinational oil companies to return to increase production if the current president leaves office.

In the more distant future price will increase because of adjustments on both the demand and supply sides. Sales of pick up trucks have soared. Supply will diminish in response to the decline in production from older wells and smaller investment in new production.

Whether there will be a significant increase in the price of petroleum in the next several years depends primarily on whether Saudi Arabia will reverse its relatively recent policy of seeking to maintain its market share. Its previous policy had been to maximize current oil export revenues, which meant that it reduced production as demand declined and as production from shale fields increased. The trade-off was between maximizing current revenues and maximizing the present value of future revenues. In the short run, the increase in Saudi revenues from the increase in the price of the oil would be much larger than the reduction in revenues from the decline in export volume. The Saudis know that if they reduced output, the Iranians would benefit from the higher price.  (Each of the large oil exporters—Russia, Iran, Iraq–could have the same impact on the price of oil by reducing its production.)

The rift between the Sunnis and Shiites now seems more intense than ever. The implication is that oil is much more likely to remain in the range of $30 to $40 as long as this rift remains huge.


One of the fascinating recent cross border investments is that ChinaChem has offered to buy Syngenta, large Swiss biochemical firm. ChinaChem is government-owned and has never shown a significant profit. ChinaChem paid almost a thirty percent premium to the market price. Some months earlier Anbang Insurance, a Chinese company paid nearly $2 billion to buy the Waldorf Astoria Hotel in New York. Anbang is twelve years old, and appears to be owned by twenty or thirty state owned enterprises; it has no previous experience in managing a high end hospitality property in a extremely competitive industry. Anbang made several passes at buying Starwood Hotels.

Whenever a Chinese firm buys a foreign firm, it pays an above market price. The Chinese buyers are not worried that their shareholders will complain that they are overpaying. One motive for these purchases is the demand for trophies, like Van Goghs “Portrait of Dr. Gauchet” which was purchased by a race track entrepreneur in Osaka at the peak of Japan’s asset price bubble. In the 1980s and especially in the second half, Japanese entrepreneurs and firms purchased 10,000 items of French art; in the 1990s the Japanese banks sold most of these items after the buyers defaulted on their loans.

The Chinese purchases of foreign firms require cash payments; there is a lot of “free cash” in China, in part because the government has eased credit to stimulate bank lending. A Chinese version of quantitative easing.

An earlier commentary interpreted the slowdown in China in terms of the Andy Warhol Theory of Economic Growth, which is that every country grows rapidly for thirty or forty years and then its growth rate declines sharply. During its growth sprint, its exports surge, often at a pace that is two or three times faster than world exports; low wage rates provide a competitive advantage that enables the country to capture market share. The sprint ends as the excess supply of labor on the farms is exhausted; wages increase sharply and the country loses its competitive advantage.

China has had thirty five years of brilliant economic growth.   200 million to 300 million people have moved from huts with dirt floors in the farms and villages to the cities, with clean water in and dirty water out.

During this rapid expansion, several major imbalances developed–one was in the market for credit, another in the market for housing, and a third in the market for plant and equipment. As growth slows, there will be dramatic adjustments in each of these markets. The imbalances in the credit market began more than thirty years ago after Deng Xiao Peng traveled to Tokyo, he was amazed at its modernity and returned to Beijing with the Japanese model of financial regulation. Ceilings limited the interest rates that the banks could pay household savers, which meant that the real rate of return that they could earn on their deposits often was negative after adjustment for the increases in the consumer price level. The household saving rate increased and together with business saving and government saving, the national saving rate approached fifty percent.

Ceilings also limited the interest rates that the banks could charge borrowers. The demand for credit at these interest rates was much greater than the supply. The lenders rationed credit; political factors–and connections–determined which borrowers were the first to get credit.   Provincial government leaders leaned on the local offices of the national banks to increase loans to local firms.

The combination of low interest rates charged by the banks and the rapid growth in the supply of credit meant that many borrowers were involved in “evergreen finance”–they did not have the cash to pay the interest on their indebtedness, instead the scheduled interest payments were added to their outstanding indebtedness.

The imbalance that developed in the housing market was a response to the massive increase in the demand for accommodation as seven to ten million people a year moved from the countryside to the cities.  There was a shortage of apartments and prices increased by twenty percent a year. (This extraordinary increase in prices contributed to the high savings rate; households increased the amounts they saved to get enough money to buy their first home.) Individuals acquired apartments as a store of value because of the high anticipated rate of return. Individuals bought apartments because prices were increasing, and prices increased because they were buying apartments. Individuals now own ten million unoccupied apartments.

China now has eleven “ghost cities” that were developed by local governments and their affiliates, in part because the revenues from the sale of apartments would enable them to finance part of their operating expenses. Construction costs were financed with money borrowed from the banks.

The property developers—both private firms and the affiliates of local governments—own 25 million unoccupied apartments. Moreover another ten to fifteen million units are in the construction pipeline.

The ballpark estimate is that there are between 35 million and 40 million unoccupied apartments compared with 200 million occupied apartments.

The imbalance in the market for industrial plant and equipment reflects that investment has been extraordinarily large relative to value of the sales of the firms, in part because credit was readily available and most firms wanted to increase their market shares. (In more technical terms, the capital-output ratio of these firms as a group may be twice that of U.S. firms.)  A lot of investment in the steel industry was used to increase the steel-making capacity so that more steel could be produced. China has massive excess productive capacity in steel and many other industries.

The migration to the cities is over. Adjustments will occur to absorb the unoccupied apartments. Prices will fall dramatically, household net worth will decline sharply, investment spending on apartments will tumble, and the banks will incur massive losses on their loans to real estate developers. In the 1990s Japanese real estate prices declined from 100 to 20 as market developments sought to ensure that the rental rate of return on property was competitive with rates of return on other investments. The price adjustment in China could be even larger in percentage terms because of the abundance of unoccupied apartments.

The prices of the stocks of the property developers and of the banks will become virtually worthless. Household net worth will decline by more than fifty percent.

Investment in residential real estate construction will fall sharply. China had been building ten million apartments a year, and investment in residential real estate had accounted for ten percent of GDP.   As prices fall, the incentive to invest in the construction of a new apartments will diminish. One back-of-the-envelope metric–if construction of new apartments declines from ten million to five million units a year, the rate of economic growth becomes negative. Since the incentive to invest in apartments will be trivial as long as prices fall by fifteen or twenty percent a year, the decline in starts will be even larger.

One metric–if the average price of an apartment is the yuan equivalent of US$600,000 and the banks have lent the developers fifty percent of the sales price, then bank loans to developers total the yuan counterpart of $7,500 billion–modestly less than China’s GDP.  If bank loan losses are fifty percent of loans, the losses could reach $4,000 billion.

The sharper the decline in the growth rate, the larger the losses that banks must recognize. These losses on loans to state owned enterprises and local governments will be immense because the banks “have kicked the can down the road” and postponed the recognition of losses.

Bank assets are 350 percent of GDP.  If loans to borrowers other than property developers are 200 percent of GDP, and losses are thirty percent of total loans, the losses will be sixty percent of GDP.  One insight from the Japanese experience is that a significant part of bank loans to industry were “real estate loans in drag.”

The Chinese government must recapitalize the banks. The government will seek to minimize this investment, and it will compel the banks to force borrowers to sell assets to pay down indebtedness.  Assets can be sold only if there are buyers. The banks will require indebted firms to sell many of the foreign assets that they have recently acquired, since few of their domestic assets will be saleable.

The recapitalization of the banks will lead to an increase in the ratio of government indebtedness to GDP from 60 percent to 170 percent.  As a result, the ratio of the government’s annual interest payments to GDP will increase by three percentage points.

There are a large number of institutional ways that the government could recapitalize the banks. One is to establish a Reconstruction Finance Corporation (RFC); the government would transfer newly-issued government bonds (in effect, the IOUs of the government) to the RFC, and at the same time, the RFC would provide shares in the RFC to the government. The RFC would transfer the bonds to the government-owned banks in exchange for the non-performing bank loans.

The estimates are ball park, informed guesses more than rocket science. What is inescapable is that the adjustments to the financial shock will be much larger than in the United States after the 2008 crisis.

China must adjust to a significant decline in investment spending. What are the norms for China, what would be the composition of final demand that would lead to full employment, and what would be the pattern of production that would fit the changes in the demand profile? Some insight comes from comparing production and demand characteristics with those in some nearby countries.

Figure 1

Patterns in Production and Demand

.                             Supply Side         Demand Side

China  6.1 10 45 45 35 14 49
Japan 46.7 1 26 73 61 20 21
South Korea 22.6 3 39 58 54 16 28
Taiwan 20.4 2 30 68 60 12 19
Malaysia 10.4 10 41 49 49 14 26

Source: The Economist, Pocket World in Figures, 2015 Edition

Y/H$ = per capita income in US dollars
Ag = Agriculture
Ind = Industrial
Serv = Service
PRCON = Personal Consumption
PUCON = Public Consumption
INV = Investment

The left column in Figure 1 shows the per capita income in China and these other countries in local currency converted to U.S. dollars at market exchange rates. The estimate of per capita income in China seems low, and may reflect that the low price of the yuan. The next three columns show the shares of GDP produced in each of the major sectors–agriculture, industry, and services. Japan, Taiwan, and South Korea have much smaller agricultural sectors, each imports a much larger share of its foodstuff. Because of its very large population, China wants to be nearly food self-sufficient. The industrial sector in China accounts for a much larger share of GDP than in any other country except Malaysia. The production of services accounts for a much smaller share of GDP, in part because the prices of services are low.

The striking feature on the demand side is that the ratio of investment spending to GDP in China is more than twice as high as in most of these other countries. Seven or eight percentage points of the difference is that real estate investment in China has been so much higher.

The task for Chinese leadership is to induce a massive increase in consumption spending to offset the decline in investment spending, even as households will be reluctant to spend more because of the sharp decline in their wealth and employment insecurity. The implication is that public consumption spending will increase dramatically. Government spending to improve the environment will surge; government loans to foreign governments to provide the financing for high speed railroads will increase.  The increase in public consumption spending will lead to an increase in the fiscal deficit, perhaps to ten or twelve percent of GDP. Government indebtedness will increase two or three times more rapidly than the country’s GDP.

This shift in the composition of final demand will lead to a significant decline in the growth rate, since productivity in services is much lower than in industry. (Indeed the shift of ten or fifteen percent of the labor force from industry and investment to services would lead to a decline in GDP since value added per worker in services is much lower than value added per worker in industry.)

One comment in an earlier post was that China was entering a transitional period as adjustments occurred to reduce these imbalances and that this period might last ten years, about the length of the transition in Japan after the implosion of its massive asset price bubble.  The Government of China is more interventionist than the Government in Japan; it might seek to slow the pace of the adjustments, which would lengthen the transitional period.

Then in 2025 or 2027 the ratio of the indebtedness of the Chinese government to the country’s GDP will increase to 250 percent. “China will be Greece” with the difference that Greece defaulted on its indebtedness to foreigners.  Since the ratio of government indebtedness to GDP cannot increase without limit, then some form of default is inevitable. Bank depositors will receive a “haircut” of some form. The value of their deposits and especially of large deposits might be reduced. There might be inflation to reduce the purchasing power of their deposits. Interest rates on deposits could be very low.

As the ratio of government indebtedness to GDP increases, the smart money guys will shift to foreign securities.  That may be partly the motivation for the surge in foreign acquisitions; the buyers acquire Swiss franc assets and U.S. dollar assets with the funds obtained by increasing yuan indebtedness.

One of the major external impacts of this scenario is that the Chinese demand for imports of iron ore, copper, and other commodities that are important inputs in residential real estate investment will decline further. Moreover, China’s imports of machine tools and other capital investments will fall.

As domestic demand growth slows, firms with excess capacity will seek to grow their sales in foreign markets, much like the Chinese steel firms. Because there are few recognized Chinese brand names, the effort to increase exports means price reductions will be significant. The prices that these firms will charge in these foreign markets will be significantly below their prices in the Chinese market. Their foreign competitors will charge that the Chinese firms are dumping. Trade frictions will escalate.

In August 2015 the Chinese government botched the management of the price of the yuan in terms of various foreign currencies. Chinese holdings of international reserve assets have declined in the last year, in part because Chinese firms with indebtedness denominated in the U.S. dollar or the Japanese yen are down paying their indebtedness. The Chinese government would rationalize the decline in the price of the yen with the comments that the prices of nearly every other currency have declined by twenty percent of more. A devaluation of the currency would lead to many fewer charges that Chinese firms are selling in foreign markets below cost.

China’s current account surplus will surge, even if exports increase at a modest pace. China’s current account surplus is now about three percent of its GDP, this ratio could quickly increase by five or six percentage points. The current account deficits of some countries will increase; some of these countries will be the emerging market countries whose exports have declined. The U.S current account deficit might increase to provide global consistency.


Changes in the global environment have major impacts on the U.S. macro economy; changes in the foreign demand for U.S. dollar securities have had a major impact on their price and on the U.S. rate of economic growth.  When the foreign demand for U.S.  dollar securities has increased, the price of the U.S. dollar and the price of U.S. securities have both increased. The prices of both U.S. bonds and U.S. stocks surged in the first half of the 1980s as the foreign demand for U.S. dollar securities increased sharply and the price of the U.S. dollar increased by fifty percent. The price of the U.S. dollar and the price of U.S. stocks both increased sharply in the last several years of the 1990s.  U.S. real estate prices soared after 2002 as foreign demand for U.S. dollar securities increased.

The current U.S. dollar cycle began about 2012 when Prime Minister Abe talked down the price of the yen. Then the price of the Euro fell by twenty percent.  The declines in the prices of the currencies of the petroleum and other commodity exporters have been noted. The price of the British pound has declined by ten percent in over four months. The price of the Chinese yuan is more likely to decline than increase.

A cycle is a cycle is a cycle; eventually the phase of a stronger dollar will be followed by a weaker dollar. The decline in the price of the dollar might be a response to the increase in interest rates in other countries.  Monetary policy is in flux in the United States, the European Monetary Union, Britain, and Japan.  Central banks have been extraordinarily ambitious; their efforts to increase the prices of securities have led to negative interest rates.

Because the U.S. economy is at full employment, the Fed is likely to be in the lead in allowing market forces to lead to higher levels of interest rates.  The Fed eventually will come to realization that its inflation target of two percent is unwarranted as a way to prevent the debt-deflation cycle of the 1930s. The implication is that the next phase of the dollar cycle is not likely to begin in 2016.

Although the U.S. trade deficit is likely to increase and impact profits in the tradable goods sector, the increase in the trade deficit is likely to be modest because of the reversal in the payments positions of the oil exporting countries.

In 2014, when the oil price was $100 a barrel, the oil exporting countries put $500 billion in the bank–these were the excess profits from the cartel tax, that diversion of spending slowed the growth of the industrial countries.   Now that the oil price is $40, these countries will spend more on imports than they are earning from exports.  Oil importing countries as a group will have trade surpluses; the implication is that the surge in China’s trade surplus will have a smaller impact in leading to a larger U.S. trade deficit.