The year of the doddering dragon

Will the slowdown in China’s economy endanger Kazakhstan’s?


China buys one-eighth of the oil and gas exported from Kazakhstan (11 million tons per year; Kazakhstan produced roughly 80 million tons per year in 2010 and 2011), according to Robin Paxton of Reuters. Since oil and gas exports account for roughly a fourth of Kazakhstan’s GDP, a slowdown of the world’s second largest economy could affect us substantially.

The Chinese economy is growing less rapidly. GDP in the second quarter of 2012 grew by the annual rate of 7.6%; the corresponding rate in the second quarter of 2011 was 9.5%. Similarly, GDP in the first quarter of 2012 grew at an annual rate of 8.1%, sharply below the rate of that quarter in 2011. In the world financial crisis of 2008-2009, the growth rate of Chinese GDP fell as far as to 6.6% (which is still twice the current rate of global economic growth). Apparently, GDP in Q1 of 2012 was less than 2% higher than in Q4 of 2011, but much of that change might have been seasonal. Finally, China’s economy may be reacting to the globe’s: The International Monetary Fund (IMF) estimates that recession in Europe may reduce Chinese GDP by as much as 4%, reports Rob Minto of The Financial Times.

Indirect indicators of GDP are also murky. On one hand, industrial production is rising at a healthy annual pace, well over 9%. On the other hand, production of electricity, steel and concrete (an indicator of China’s construction market, the world’s largest) is slowing or falling, noted Keith Bradsher of The New York Times. Fixed-asset investment is down sharply this year, and urban housing prices have been falling since late 2009. These trends suggest that the government recognizes that the economy already has excess capacity. In that event, the GDP slowdown may be temporary.


Easy does it


The Chinese slowdown does not seem likely to affect global oil prices as much as the Eurozone crisis will. The Chinese handled well the global crash of 2008 as well as the Asian currency crisis of 1998, and they have improved their management of inflation over the past 20 years.

A soft landing of their economy seems likely. After resisting interest-rate cuts for three years, the central bank -- The People’s Bank of China -- has cut them twice in a month, amid cooling inflation, reported The Financial Times. This year the Bank also reduced the share of deposits that banks are not permitted to lend out.

Half of the GDP growth of 2012 was in capital spending, which Beijing can stimulate by permitting local governments to invest, according to Nick Edwards and Kevin Yao of The New York Times. Private consumption is only just over a third of GDP, so fiscal policy can be relatively powerful. China’s small debt could enable a fiscal stimulus that packs a wallop: The national government’s debt share of GDP is 25%, as compared to 102% in the United States, wrote Bob Davis and Tom Orlik of The Wall Street Journal. (In China, the GDP share of local government debt is another 22%.)

On the other hand, the fiscal stimulus of 2009-10, which focused on infrastructure, increased the debts of local governments and stimulated inflation. The IMF recommends a stimulus to private spending – tax cuts and subsidies for consumption of durable goods, reported Minto. The private sector’s share of the economy may already be growing: 2011 wages were up by 18%, a bit faster than GDP (with no adjustment for inflation), noted Orlik. Disturbingly, an increase in private or public consumption would likely increase the credit-to-GDP ratio, which was 171% in 2010, up from 122% in 2008, said The Economist.


The IMF forecasts that China’s economy will grow by 8% per year for the next five years, noted Ian Johnson of The New York Times. That had been Beijing’s target rate since 2005 until it lowered it to 7.5% this March. Before the financial crisis of 2008-09, Chinese growth rates averaged over 10% per year.

Financial investors may overstate the Chinese slowdown, to judge from circumstantial evidence. Although emerging market economies are growing more rapidly than developed economies, a stock market index for the former performs worse than is average, reported The Financial Times. The MSCI stock market index for emerging market economies has lost 21.7% of its value in the past year. The global version of that index lost 10.7%. Conceivably, stock markets in emerging economies perform poorly because investors over-estimate the Chinese slowdown and its subsequent impact.


Dragon on a cigarette break


To some degree, the Chinese slowdown may be intentional. The overall saving rate in China is 51%, and Michael Pettis, a finance professor at Peking University, argues that China must increase consumption’s share of its economy in order to provide balanced growth. To do this, China must “get household income to rise from its unprecedentedly low share of GDP,” he wrote in The Financial Times. “This requires China to increase wages, revalue the renminbi and, most importantly, reduce the enormous tax that households implicitly pay to borrowers in the form of artificially low interest rates.” If The People’s Bank does not cut market interest rates as rapidly as the expected rate of inflation has fallen, then real interest rates will rise. China could also boost consumption by providing comprehensive health care, for which households today must save, remarked The Economist.

Chinese demand for crude oil remains at a peak despite the fall in the rate of GDP growth, said UniCredit. If Chinese growth slows to 8% per year, then this could directly reduce Kazakhstan’s GDP by .06 of one percent. Conceivably, the indirect impact on Kazakhstan may be more severe: Each change in Chinese GDP of 1% relates to a change in global oil prices of 10% to 30%, claims Ruchir Sharma of Morgan Stanley. Obviously the estimate could hold only for small changes in the size of the Chinese economy; a fall of just over three percentage points in GDP is not going to cut oil prices to zero.  The dragon is not that powerful. – Leon Taylor tayloralmaty@gmail.com



Notes

Chinese purchases of oil and gas directly generate about 3% of Kazakhstan’s GDP ((1/4)*(1/8) = 1/32). A Chinese slowdown of 2% could decrease our GDP by roughly (1/50)*(1/32) = 1/1600.


References

Jamil Anderlini. China cuts rates amid growth fears. Financial Times. July 5, 2012.

Keith Bradsher. Affirming slowdown, China reports second month of scant economic growth. New York Times. June 9, 2012.

Keith Bradsher. After barreling ahead in recession, China finally slows. New York Times. May 24, 2012.

Bob Davis and Tom Orlik. Beijing's growth tools are limited. Wall Street Journal. May 13, 2012.

Economist. How strong is China’s economy? May 26, 2012.

Economist. Not with a bang. July 28, 2012.

Nick Edwards and Kevin Yao. Hand forced, Beijing opts for old fix. Reuters. Published in New York Times. July 16, 2012.

Leslie Hook and Peter Marsh. Sany job cuts signal Chinese slowdown. Financial Times. July 4, 2012.

Ian Johnson. China’s growth rate slowed in the 2nd quarter. New York Times. July 12, 2012.

Rob Minto. IMF: Europe could hit China, hard. Financial Times. February 6, 2012.

Tom Orlik. Numbers show China’s still working. Wall Street Journal. May 29, 2012.

Robin Paxton. Update 3 -- Kazakhstan sees 50 pct oil export growth by 2020. Reuters. October 4, 2011.

Michael Pettis. A slowdown is good for China and the world. Financial Times. July 23, 2012.

Ruchir Sharma. China slows down, and grows up. New York Times. April 25, 2012.

Jochen Hitzfeld and Kathrin Goretzki. Weekly commodity outlook. UniCredit. July 3, 2012.

Wall Street Journal. Economists React: China GDP Growth Hits Three-Year Low. July 13, 2012.

Bettina Wassener. Slow first quarter in China, but recent signs of growth. New York Times. April 12, 2012.

Robin Wigglesworth. China slowdown fears overstated, says Mobius. Financial Times. July 27, 2012.

Beware of chimps bearing darts

Is KASE as chaotic as it seems?


Kazakhstan’s stock market is as changeable as Almaty’s weather. In May, a sudden drop of two-thirds in the price of Kazakhtelecom stock precipitated a swoon in the KASE index of 12%, reported Bloomberg News. The problem may be general. In the first half of this year, the volume of KASE trading had fallen nearly 13% since early 2011, reported the business weekly Kursiv’.

One can interpret such mercurial price movements in one of two ways. First: The stock market here is not efficient. Trades are few and far between, so the price adjustments that would occur daily, and on a small scale, in a more active market tend to pile up in ours. Second: The market here is efficient, in the sense that it responds right away to new information. The price changes are large not because the market tarries in digesting news but because we know so little about Kazakhstan’s emerging economy that recent events can change radically our perception of it.

KASE is not the only stock market to defy characterization. Three or four decades ago, financial economists thought that markets for stocks and bonds absorbed information quickly (the “efficient markets hypothesis”). If, in 2009, you heard that General Motors was about to go bankrupt – and who didn’t – then you need not have bothered to sell its stock short; other investors had already acted on the information, selling the stock and forcing down its price right away. Only unanticipated events – “news” – can affect current stock prices. Since news, by definition, occurs at random, so do changes in current stock prices. These changes will be independent of previous prices.

In that case, technical analysis, which seeks visual patterns in past stock prices, can’t predict the price. One financial economist, Burton Malkiel, called technical analysis “alchemy.” In a 2000 study, Andrew Lo, Harry Mamaysky and Jiang Wang conceded that “the presence of geometric shapes in historical price charts is often in the eyes of the beholder.” To detect patterns more objectively, they permitted random price movements in either direction to cancel out. Working with a 31-year sample, they concluded that “several technical indicators do provide incremental information and may have some practical value,” especially for a U.S. stock exchange favored by computer firms, Nasdaq.


The chimp paradigm


In lieu of technical analysis, one could comb financial information in search of stocks that are under- or over-valued, given the firm’s apparent strength. But such “fundamental analysis” won’t work if stock prices already reflect enduring information about the firm. You might as well buy shares in a good index fund as to speculate. Malkiel writes: “A blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts.”

Malkiel concludes that stock investors cannot earn unusually high returns without accepting unusually high risks. One thinks of the student who espies a $100 bill on the ground and is about to pick it up. “Don’t bother,” says his economics professor. “If it were really a $100 bill, it wouldn’t be there.” Malkiel argues that there are no $100 bills on the trading floor. Market bubbles may sometimes occur; but in the long run, “true value will win out.”

Recently other economists have questioned the efficient markets hypothesis. Robert Shiller, who popularized the phrase “irrational exuberance,” may be the best-known of these critics. They maintain that patterns in past stock prices can enable investors to earn unusually high rates of return, even when adjusted for risk.

Early work on the efficient markets hypothesis looked for correlation across time in stock prices. Such a connection can enable us to predict tomorrow’s price. Many studies of the 1960s and 1970s failed to find correlation.

But some new studies do. They argue that stock prices move in the same direction often enough not to qualify as “random walks,” in which a price is as likely to rise as to fall. In Irrational exuberance, Shiller offered an explanation: “Investors under-react to new information.” If the full impact of news unfolds only over time, then we may observe positive correlation in stock prices: The higher prices of yesterday link to the higher ones of today.


Fiascos, fads and finance


Malkiel doubts these arguments. The correlations observed in stock prices are too small to yield an unusually good return to the investor. Lo and coauthors say that technical analysis provides “incremental information.” As for the behavioral economists, while fads may pop up from time to time, little evidence suggests that they occur systematically. Malkiel cites a 1998 survey of studies, in which Eugene Fama concluded that investors under-reacted to news about as often as they over-reacted. Also, the returns observed depended on how the model was specified: A study that equally weighted the returns of various stocks after some announcement led to different results than did a study that weighted the returns by value.

In his 2003 article, Malkiel asserts that stock-price correlations appearing in the late 1990s had disappeared by 2000. Some patterns may disappear shortly after publications disclose them because investors take advantage of the information. For example, the “January effect,” in which stock prices rose in early January, no longer seemed to exist.

In the long run, high stock returns fall, and low returns rise. Why? In a widely-cited 1985 study, Werner DeBondt and Richard Thaler looked at whether stock investors over-reacted to “unexpected and dramatic news events,” as people seemed to do in experiments by psychologists. The two authors concluded that investors may over-react to recent events. Stock prices rise or fall, then return to the average. “Portfolios of prior ‘losers’ are found to outperform prior ‘winners’.” Maybe you should buy dogs and avoid beach beauties.

In a study of stocks from 1957 to 1971, Sanjoy Basu found that those with low price-earnings ratios generally earned higher returns (adjusted for risk) than did stocks with high P/E ratios. “Contrary to the growing belief that publicly available information is instantaneously impounded in security prices,” Basu wrote in 1977, “there seem to be lags and frictions in the adjustment process.” In 1983, Basu added: “While neither E/P nor [firm] size can be considered to cause expected returns, the evidence lends credence to the view that, most likely, both variables are just proxies for more fundamental determinants of expected returns for common stocks.”

In principle, the price that one would pay for a stock depends on the size of its expected dividends. (Yes, you may sell your stock before collecting dividends, but the price that you receive will depend on the dividends that the new owner expects.  Even if you do not sell the stock, an increase in its price reflects the market's expectation of higher dividends.) Via market competition, the P/E ratio should tend to be the same for all stocks bearing the same risk. A stock with a low P/E ratio is presumably under-valued, so it should attract buyers. They will push up its price. The initial under-valuation may be an over-reaction to temporarily bad news. And likewise for over-valuation: Behavioral economists think that the stock market is subject to fads. For example, initial public offerings of dot.coms skyrocketed in the U.S. stock markets of the technophilic late Nineties.

Malkiel believed that the strongest evidence for a negative correlation in stock prices over time came from the Great Depression, which might not be a typical period. The negative correlations may result from fluctuations in the interest rate, which also reverts to the mean. When the interest rate rises, you would expect stock prices to fall, since investors may sell their stocks in favor of bonds that deliver a relatively higher return than before. When the interest rate falls back to the mean, demand will shift back to stocks and push up their price. – Leon Taylor, tayloralmaty@yahoo.com




Good reading

Burton G. Malkiel. A random walk down Wall Street: The time-tested strategy for successful investing. W. W. Norton. 2003.

Burton G. Malkiel. The efficient market hypothesis and its critics. Journal of Economic Perspectives 17. Winter 2003.

Robert J. Shiller. From Efficient Markets Theory to behavioral finance. Journal of Economic Perspectives 17. Winter 2003.

Robert J. Shiller. Irrational exuberance. Crown Business. 2006.



References


Sanjoy Basu. Investment performance of common stocks in relation to their price-earnings ratios: A test of the Efficient Market Hypothesis. Journal of Finance 32. June 1977.

Sanjoy Basu. The relationship between earnings’ yield, market value and return for NYSE market stocks: Further evidence. Journal of Financial Economics 12. June 1983.

Werner F. M. de Bondt and Richard Thaler. Does the stock market overreact?  Journal of Finance 40.  July 1985.

Eugene Fama. Market efficiency, long-term returns, and behavioral finance.  Journal of Financial Economics 49. September 1998.

Nariman Gizitdinov and Ksenia Galouchko. Kazakhtelecom retreats most ever as dividend date passes. Bloomberg News. May 16, 2012. www.businessweek.com

Andrew W. Lo, Harry Mamaysky and Jiang Wang, Foundations of technical analysis: Computational algorithms, statistical inference, and empirical implementation. Journal of Finance 55. August 2000.

Yurii Valykov. “Punkt naznacheniya” KASE. Kursiv’. July 19, 2012.

Market clout

Does privatization always improve economic performance?



The government’s planned sale of large enterprises, “The People’s IPO,” allegedly would make Kazakhstan’s economy leaner, meaner and competitive. In reality, competitiveness depends not on whether individuals own a firm but on the firm’s clout in the market. Privatizing Kazakhtelecom (the government still owns 51%) wouldn’t make the market for telecommunications competitive in the sense that no seller or buyer would be large enough to affect the market price. Given its track record, Kazakhtelecom will dominate the market regardless of whether it has one owner or many. It has 90% of the fixed-line subscriptions, and it is the only holder in Kazakhstan of a license to Long Term Evolution, an advanced wireless standard, according to OpenNet Initiative and Halyk Finance, respectively.

The government can take one of two courses: Recognize that Kazakhtelecom is a virtual monopoly and regulate it accordingly; or break it up into many firms, each too small to set the market price. The justification for the latter course is that small firms must fight to survive by pleasing consumers, whereas a firm that dominates the market need not cater to anyone.

This course is ill-advised. A national infrastructure for telecommunications, such as fiber-optics links between the cities, costs much to build. Net fixed assets for Kazakhtelecom were 227 billion tenge (about $1.5 billion) in fiscal 2011, 54% of total assets, according to Bloomberg News. There is no point in throwing bad money after good by inducing a new firm to build a duplicate infrastructure, particularly when fiber optics networks tend toward excess capacity.

Perhaps the government could retain control of the infrastructure and carve up Kazakhtelecom into small firms that would lease this network in order to sell services. (Roughly 100 Internet providers have been leasing in recent years, according to OpenNet.) Competition among them would hold down prices.

The first course – regulation – is deceptively simple. As a private firm, Kazakhtelecom would control the infrastructure; but the government would limit its price to consumers, subsidizing it if necessary so that it would earn a normal rate of return. Over time, however, the government may rely increasingly on Kazakhtelecom for market information vital to estimating the size of the subsidy, since its own data – obtained when the firm was a public enterprise -- may become obsolete. Kazakhtelecom may be tempted to fudge the numbers.

Going, going, begone


Here’s a hybrid approach: The government could auction off a lease of the infrastructure to the private firm that bids the lowest price at which it would sell to consumers, for a given subsidy; or the government could specify the consumer price and then grant the lease to the firm that bids for the smallest subsidy. The beauty of the auction is that it induces the firm to provide accurate information about its costs, in the form of a bid. However, the experience of United States governments with auctions in a similar market -- cable television -- has not been ecstatic. A firm might enter an artificially low bid and then, after winning the auction, force government officials to provide a larger subsidy than it had originally requested. In Milwaukee, the winning bid promised to provide 108 channels for a monthly fee of $4.95. What Milwaukee actually got was 54 channels for $11.95, according to regulatory economists Kip Viscusi, Joseph Harrington and John Vernon.

An American drama may shed light on problems that Kazakhstani regulators might face in loosening constraints on the telecommunications market. For decades, American Telephone & Telegraph (AT&T) enjoyed a protected position as a regulated monopoly. It was known as the safest financial investment in the country. But by the 1960s, demand increases as well as cost-cutting innovations were expanding the telecommunications market beyond the point where one firm could serve it efficiently. Gradually the federal government deregulated the submarkets such as the one for a firm providing internal phone services. By the early 1980s, AT&T’s monopoly was confined to the market providing phone services between cities – and it was coming under attack there, too.

The question was whether to let AT&T compete in submarkets that had already been deregulated. On one hand, the company might be able to cut costs for the deregulated good because of synergies with production of the regulated good. For example, experience with local phone service might reduce the cost of long-distance service. On the other hand, AT&T might cunningly use guaranteed profits in the regulated market to pay for price-cutting in the deregulated one; after driving rivals out of the latter market, it could charge the highest price that buyers could bear.

In 1982, a pact with regulators, supervised by the courts, shut out AT&T from deregulated markets. It slipped into a coma. In 2005, it was acquired by one of its own spinoffs, Southwestern Bell.

One problem may be that regulators balk at experimenting, note Viscusi, Harrington and Vernon. Change is politically risky since it may raise prices or cripple an industry. Also, deregulation curtails the agency’s duties, reducing “power, prestige, and income for the regulators.” So we may get too much change too late. – Leon Taylor, tayloralmaty@gmail.com



Good reading

W. Kip Viscusi, Joseph E. Harrington, Jr., and John M. Vernon. Economics of regulation and antitrust. Fourth edition. Cambridge, Mass.: The MIT Press. Chapter 15 discusses the AT&T case.



References

Bloomberg News. Kazakhtelecom JSC. 2012. bloomberg.com

Kazakhtelecom. General information. April 12, 2012. telecom.kz

Timur Omoev. Key takeaways from meeting with managers. May 15, 2012. halykfinance.kz

OpenNet Initiative. Kazakhstan. 2010. opennet.net .