De-sensationalizing China's reserve losses

Here's how the NY Times today described what is going on with China's currency and foreign exchange reserves (emphasis mine):

HONG KONG — China is burning through its huge stockpile of foreign exchange reserves at the fastest pace yet as it seeks to prop up its currency and stem a rising tide of money flowing out of the country. 

Even after a record monthly decrease of nearly $100 billion, China still has the world’s biggest cache of foreign reserves, standing at $3.56 trillion at the end of last month, government data showed on Monday. 

The total has declined steadily from a peak of nearly $4 trillion in June of last year, as slowing economic growth caused investors to move money out of the country in search of better returns elsewhere. As a result, the Chinese central bank has had to sell huge amounts from its foreign reserves to maintain the strength of the nation’s currency, the renminbi.

In reality, the news out of China is not nearly as breathless.

In August, China sold about $100 billion of its foreign exchange reserves, for a decline of 2.6%. China's reserves have now fallen by 11% from their all-time high just over a year ago. Since its all-time high early last year, the yuan has declined by about 5% vis a vis the dollar. The Chinese central bank is not seeking to "prop up" its currency; it is responding to what to date have been modest outflows of capital by lowering the yuan's peg to the dollar. 

This marks a reversal of the yuan's trend over the previous 20 years, to be sure, but it does not represent a radical policy departure. China has managed the yuan's currency peg on a consistent basis over the years, allowing the currency to appreciate as capital flowed into the country, and now, allowing the currency to depreciate as capital leaves the country. What this means is that China is no longer the powerhouse that it used to be and therefore its currency is not as attractive as it once was. The new reality in China is one of adjustment to slower growth. If capital continues to leave the country—as seems likely—the central bank will continue to shrink the Chinese monetary base and continue to adjust the yuan's peg downward until a new equilibrium is reached. This is all straight out of monetary policy textbooks. 

Even after its recent declines, the yuan's value is still almost double, in real terms, what it was against a large basket of currencies 20 years ago (the chart above reflects data through July '15). Remember how China's critics for many years have charged that China was artificially depressing the value of its currency in order to boost its exports? Now those same critics say the sky is falling because China is trying to keep its currency from weakening. In reality, the yuan has been and continues to be one of the world's strongest currencies, and China's foreign exchange reserves still tower over those of the world's developed economies.

The problem is the lack of productivity

August job gains were weaker than expected (+173K vs. +217K), but that shortfall was exactly offset by upward revisions to prior months. (That's a reminder that this series is volatile and can be significantly revised after the fact, so you can't read too much into any one month's report.) It did nothing to change the big picture, which is one of an economy that for the past six years has been growing at a moderate, but disappointingly-slow pace. That it has not grown faster despite extremely low interest rates and very accommodative Fed policy is not evidence of the failure of monetary policy or the need for yet more Quantitative Easing. No, the failure to grow faster is rooted in weak productivity, which in turn is the result of weak investment, a general aversion to risk-taking, and a general unwillingness to work. Those problems are not the sort that respond to the Fed's ministrations, nor can they be fixed by more money; instead, they respond to changes in the after-tax incentives to work, invest and embrace risk.

The chart above should be a real eye-opener. What it shows is the annualized growth rate of labor productivity over rolling 5-yr periods. For the past 5 years, productivity has increased by a miserably slow 0.54% per year on average. In the past 70 years, productivity growth was weaker only in the 1976-82 period—a period notorious for its high and rising inflation and a general malaise among the population.

The chart above highlights the degree of month-to-month volatility in the jobs numbers. For the past 4 years, the private sector has averaged jobs gains of 212K per month, with a standard deviation of 70K. The August report was within this range.

For the past four years, the year over year growth rate of private sector jobs has been in a range of 1.9-2.7%. It's currently 2.4%. Steady as she goes—nothing at all remarkable here.

One enduring problem of the current business cycle expansion is the very slow growth of the civilian labor force. Lots of people—about 10 million—have simply "dropped out" and are no longer looking to work, for a variety of reasons. Hint: transfer payments now make up almost 20% of disposable personal income, up 20% from 2007 levels and up 300% from the 5% that prevailed in 1951.

Still, despite the disappointments, there has been a non-trivial expansion in the number of private sector jobs: a little over 4 million net new jobs have been created since 2007, the peak of the last expansion. In contrast, the public sector has shed a net 500K jobs since 2009, for which taxpayers should be grateful.

Part-time employment during the current expansion has behaved pretty much the way it always has. Coming out of the recession, part-time employment surged, as businesses began to hire but were reluctant to make long-term commitments. As the economy became more resilient and confidence in the future picked up, part-timers were replaced by full-timers. 

In the 55 years since 1960, there have only been 15 years or so when the unemployment rate was lower than it is today. Today's 5.1% unemployment rate says the economy is doing a good deal better than average. One naturally wonders, therefore, why the world is so concerned that the Fed might raise rates above zero. This is a fragile recovery desperately in need of monetary TLC?

No. This is a sluggish recovery desperately in need of better incentives to work, invest, and take risk. Cutting marginal tax rates would help tremendously, as would a reduction in regulatory burdens.

Volatility still high, but service sector still fine; plus a note on the role of hedge funds

Markets are still on edge, worried that a China slowdown will prove contagious to the rest of the world—a new twist on the old catchphrase "When the US sneezes, the rest of the world catches a cold." But the mainstay of the U.S. economy—the service sector—is still quite healthy. The U.S. economy has been underperforming for years, but that has everything to do with our own bad policy choices. Even a substantial slowdown of the Chinese economy would have little impact on the U.S., since China's purchases of goods and services from us represent a mere 0.7% of our annual GDP. 

As the chart above shows, the service sectors of both the U.S. and the Eurozone have been gradually improving over the past year or two (and the U.S. survey beat expectations, 59 vs. 58.2). This arguably trumps any slowdown in the growth of the Chinese economy.

The Business Activity subindex of the ISM service sector survey is still at historically high levels, and doing much better than at anytime during the current expansion. This represents about 80% of our GDP. This is great news.

The Employment portion of the ISM service sector survey is still at relatively healthy levels. This suggests that businesses are reasonably confident about their future prospects.

Despite all this good news, the market remains very nervous. The Vix/10-yr ratio today was about as high as anytime in the past two and half years (excluding last week).

The chart above compares the daily closes of the S&P 500 and the Vix index. Note that the two lines are virtually mirror images of each other. Rising fears accompany lower stock prices, and vice versa.

The chart above uses the same indices as the previous charts, only it flips the Vix index to show how the two move in inverse lockstep. The correlation between these two series is an impressive 0.87.

Background: the Vix index is the implied volatility of equity options. As such, the Vix index is a proxy for how cheap or how inexpensive options are, because the more volatile prices are, the more likely an option is to hit its strike price.  A higher Vix thus implies more expensive options. Buying options is a classic way for investors to lower their risk profile, since the worst that can happen to an option you purchase is that it expires worthless. In contrast, the worst that can happen if you own stocks is that you can lose everything. But if things go well, buying call options gives you the opportunity of participating in most of the upside of stock prices, and buying put options gives you the opportunity to profit from most of the downside of stock prices. When people are nervous about the future, one natural strategy is to replace outright ownership of stocks with call options, and to replace outright selling of stocks with the ownership of put options. But either way, the more nervous people get, the more expensive options become.

What many investors arguably fail to appreciate is that the people selling options to the public are not likely taking on unlimited downside risk by being "naked" short sellers. They are hedging their positions by selling stock as stock prices fall, and buying stock as prices rise (aka "delta hedging"). If there is a surge of interest in buying stock options, the sellers of those options must immediately establish a hedge by selling stocks. So there is a hedging connection between implied volatility and stock prices: the higher the implied volatility the more selling of stocks there is, and vice versa. Bloomberg has a story today which helps to explain this.

What all this suggests to me is that the volatility of stock prices is almost exclusively a function of the market's intolerance for risk. Fears, not reality, are the driving force behind volatile stock prices, and the mechanism which links fears and stock prices is hedging (e.g., mechanical) activity, not necessarily a deterioration of the economic fundamentals. This type of hedging activity has the potential to destabilize markets if mechanical selling overwhelms the ability of natural buyers of stock to respond. But at the same time, the higher cost of options provides a huge incentive for speculators to effectively become sellers of options and (via their hedges) buyers of stock. These episodes can be terribly nerve-wracking, but eventually they sort themselves out and the fundamentals reassert themselves. I suspect that's what will happen this time too.