Tcw Global Snapshot 060209

TCW Global Snapshots July 2, 2009

Global Snapshots no 2009-13 * July 2, 2009

TCW Global Snapshots July 2, 2009

Debunking Three Chinese Legends........................................................................................................ p.3

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We disagree with some conventional views on China. We think that (i) the fiscal stimulus will have a much greater impact on the fiscal outlook than anticipated by most analysts; (ii) high Chinese savings are not driven by households, but by corporates – reforming the pension and healthcare sectors might help but will be insufficient; and (iii) there is no sign that we are at the beginning of a domestic, and global, rebalancing of the growth pattern.

Enter the Multiplier ................................................................................................................................... p.8

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Most leading indicators point to a recovery in economic activity. The Fed’s monetary policy has succeeded in easing financial conditions. And although the financial conditions are still too restrictive, the debate is now focused on the nature of the rebound (V-shaped, U-shaped, W-shaped or L-shaped). Hence, eyes are now riveted on the impact expected from the fiscal stimulus plan adopted at the beginning of the year. There is a wealth of material examining the economic impact of expansionary fiscal policy. Theoretical and empirical studies all conclude that fiscal policy is effective in the short term, with multipliers greater than 1. However, economists clash on the scale of the medium-term impact. We believe that although a rebound in growth by mid2010 appears to be inevitable, that does not mean the upturn will be lasting.

Global Snapshots no 2009-13 * July 2, 2009

Debunking Three Chinese Legends In our last edition of Global Snapshots, we reiterated our confidence that the Chinese fiscal stimulus would work – at least to boost short-term economic growth – and that we expected domestic consumption to gain momentum in coming months. Still, we disagree with the conventional view on China which could be summarized – and, to some extent, caricatured – by a threefold misleading statement: (i) Chinese fiscal accounts are so strong that fiscal costs of the stimulus are negligible; (ii) the key problem in China is household savings which are too high, but are likely to be gradually rebalanced towards more consumption; and finally, (iii) lower Chinese household saving rates should help rebalance the Chinese economy and, more generally, the global economy. On the contrary, we think that (i) the fiscal stimulus will have a much greater impact on the fiscal outlook than anticipated by most analysts; (ii) high Chinese savings are not driven by households, but by corporates – reforming the pension and healthcare sectors might help, but will be insufficient; and (iii) there are still no signs that we are at the beginning of a domestic – and global – rebalancing of the growth pattern.

direct access to the debt market. Since the start of this year the central government has been operating a pilot program whereby the MOF will issue bonds on behalf of local governments, but we are still very far from an independent and efficient framework for sub-sovereign debt in China. Savings and Consumption: Getting the Debate Right Yes, Chinese saving rates are high and consumption is not the key driver of the economy. Nevertheless, retail sales continue to be fairly resilient and appear likely to accelerate. We reiterate that the most interesting stories coming out of China will come from consumption, not from investment. Still, we are quite skeptical that reforming pension and healthcare hold the magic key to unlocking the consumption potential of China. ƒ

Contrary to common perception, households were not the key contributor to the rise in saving rates. It was corporate and government savings that drove savings rates higher. The well-known Chinese savings glut is primarily a corporate phenomenon, not a household one. While pension reforms and healthcare reforms may help to boost domestic consumption in the future, the key issue to monitor at present is clearly on the corporate side.

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Moreover, on the household front, consumption didn’t stagnate but investment soared. While retail sales and real consumption saw robust growth over the last couple of years (on average by 9% on a real basis), investment growth outpaced them both. Consumption lived in the shadow of investment and consumption’s share of GDP had to decline.

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Overall, saving rates seem to be only partially driven by precautionary savings in the absence of poor pension and healthcare systems. Income distribution and rising income disparities may have played a much bigger role in explaining why Chinese savings rates are high.

There is No Free Lunch: Fiscal Accounts Do Matter Implementation of fiscal stimulus can be very efficient; but is not free. From a relative perspective, China may have more fiscal firepower than both developed and emerging markets countries. Still, the total cost of these gigantic fiscal measures seems to be underestimated by most analysts. China’s official fiscal deficit projection is around 3% of GDP for 2009 (excluding social security and extra-budgetary funds). Even after assuming that expenditures could moderate in the second half of the year, a budget deficit of 4 to 5 percent of GDP looks like a more realistic scenario. Although Chinese authorities can handle a higher than expected deficit in 2009, there is no fiscal free lunch; and a higher deficit in 2009 means there will be lower fiscal ammunition for 2010. Thus, even though we understand the reasons behind greater optimism among most market participants for 2009 GDP growth, which we long argued were excessively pessimistic, we find it difficult to understand the rationale behind a significant upward revision for 2010 based on expectations for continued acceleration of public investment. A breakdown of the fiscal stimulus spending should reveal some skeletons in the public debt closet; and could force Chinese authorities to acknowledge that public debt ratios, including various levels of government, are actually much higher than official data currently show – i.e., potentially far above 45% of GDP, rather than below 20%. Sub-national governments in China are responsible for a much larger share of spending than in most other countries. Local governments have not been legally allowed to borrow, although this constraint has long been bypassed and only sporadically acknowledged. Not only will local governments have to concede how much debt they have on their balance sheets, but the central government will also have to come up with a more consistent legal framework for local governments to have

No End in Sight for Imbalances There is no obvious quick fix. Certainly, education, pension and healthcare system reforms might help, but this will be far from sufficient. It would also require a significant change in income distribution and investment structure. With such a recent aggressive fiscal stimulus and still rising current account surpluses, China does not seem to be heading in this direction. In the short term, surpluses and rising supply capacity will continue to dominate. We are, therefore, both constructive on Chinese consumption and skeptical that Chinese growth model will evolve in the near term. Jean-Charles Sambor

Global Snapshots no 2009-13 * July 2, 2009 3

Enter the Multiplier Most leading indicators point to a recovery in US economic activity. The Fed’s monetary policy has succeeded in easing financial conditions. And although financial conditions remain excessively tight, in our view, the debate is now focused on the nature of the rebound (V-shaped, U-shaped, W-shaped or Lshaped). Hence, eyes are now riveted on the impact expected from the fiscal stimulus plan adopted at the beginning of the year. There is a wealth of material examining the economic impact of expansionary fiscal policy. Theoretical and empirical studies all conclude that fiscal policy is effective in the short term (less than one year), with multipliers greater than 1. However, economists clash on the scale of the medium-term impact (1-3 years). Does The Multiplier Exist? The theoretical studies on the multiplier debate are based on model simulations, and all conclude with a public spending multiplier effect greater than 1 in the short term. In fact, in addition to the direct impact of an increase in public spending on the level of GDP (i.e. an additional $1 in public spending equates to $1 of economic activity), there is the increase generated in household income, which boosts household spending and ultimately yields an impact on economic activity grater than $1. As a general rule, tax multipliers (related to tax cuts) tend to be lower than public spending multipliers, insofar as households save part of their income. Over the longer term, the models’ conclusions diverge. More sophisticated models simulate the impact of stimulus plans on interest rates and household behavior. First, additional demand generates inflationary pressures which lead to expectations of monetary tightening and a general rise in interest rates. The latter is particularly significant, since it is accompanied by an increase in the bond risk premium demanded by investors. The general rise in interest rates adversely affects private investment. Second, foreseeing higher taxes in the future, households are prompted to save more here and now. Ultimately, the increase in public spending crowds out private demand, rendering the stimulus plan ineffective, and the multiplier falls below 1. In other words, growth moderates again. What Do Empirical Studies Teach Us? The stimulus plan passed by Congress amounts to USD 787 bn (5.5% of GDP). Three-quarters of this plan will be put in place in 2009-10. Nearly half the measures announced come in the form of tax cuts. For the moment, less than 20% of the funds have been allocated. The substantial portion earmarked for tax relief can primarily be attributed to the need to find a bipartisan agreement between Democrats and Republicans in Congress. However, it is striking to observe that empirical studies carried out on the US economy in recent years validate this decision by finding a tax multiplier that is much higher than the public spending multiplier (the latter being considerably weakened by the crowding out effect).

Gove rnm e nt Spe nding vs . Tax Cut M ultiplie rs : Re ce nt Em pirical Studie s 3.5 G o v e rnm e nt s pe nding

T a x c ut s

3.0

1 year 2 year

2.5 2.0 1.5 1.0 0.5 0.0 Tax cuts (1)

Tax cuts (2)

Tax cuts (3)

Gov. spending (1)

Gov. spending (2)

However, we can question these findings in the current economic environment, because the sharp rise in unemployment and the major asset shock that households have experienced with plummeting stock markets and property prices have prompted them to rebuild precautionary savings. This could ultimately limit the expansionary impact of tax cuts. In other words, once the short-term stimulus effect faes (expected in 6-12 months), the stimulus plan is likely to prove ineffective, either because households will have saved too much or because interest rates will have risen too quickly, adversely affecting corporate investment and preventing the stabilization of the housing market. Towards a Relapse in Activity? The risk of a “false rebound” is undoubtedly in the minds of the authorities. In its June 25 communiqué, the FOMC reiterated that despite signs of recovery and rising commodity prices, inflation will remain contained due to excess production capacity. The Fed is thus looking to anchor fed funds rate expectations close to zero for a significant period of time. Moreover, Christina Romer – head of the White House Council of Economic Advisors – recently defended this policy by recounting economic policy errors committed in 1936-37. As early as 1936, against the backdrop of a rebound in activity and declining unemployment, the Fed was concerned about the “exit strategy”. Fearing the formation of a new bubble caused by excess liquidity from very accommodative policy, the Fed decided to increase required reserves. Then in 1937, fiscal stimulus disappeared and taxes were raised. The pain was felt quickly and the economy lapsed into recession again in 1937-38. At a time when there are growing signs of economic recovery, it is useful to reflect upon the experience of the 1930s. The helps remind us that if normalization of economic policy occurs too rapidly, it can prove counterproductive. On this point, the lessons learned from economic history reinforce the conclusions that we can draw from the weakness of mediumterm multipliers. Although a rebound in growth by mid-2010 appears to be inevitable, that by no means ensures that the upturn will be sustainable. Didier Borowski

Global Snapshots no 2009-13 * July 2, 2009 4

Market Data Emerging Markets Equity (MSCI) vs. Fixed Income (EMBIG) Indices

Developed Markets Equity (MSCI) vs. Fixed Income (Citi WGBI) Indices

1500

500

1200

400

900

300

600

200 MSCI EMF (lhs)

300

100

900

200

700

175

500

150

300

0

Citi World Govt Bond Index (rhs)

100

0 02

03

04

05

06

07

08

125

MSCI World (lhs)

JPM EMBIG Diversified (rhs)

100 02

09

03

Commodity Prices CRB Index

04

05

06

07

08

09

Crude Oil (WTI Spot Price, $/b) 160

600

140

500

120 100

400

80

300

60 40

200

20 0

100 91

93

95

97

99

01

03

05

07

91

09

93

95

97

99

01

03

05

07

09

Select Global Exchange Rates As of July 1, 2009 F/X Rate

% Ch. WoW

% Ch. YTD

USD/EUR USD/GBP GBP/EUR JPY/USD JPY/EUR CHF/USD CHF/EUR Asia Pacific CNY/USD IDR/USD KRW/USD PHP/USD TWD/USD THB/USD INR/USD Latin America ARP/USD BRL/USD CLP/USD COP/USD MXN/USD VEB/USD EMEA CZK/EUR HUF/EUR PLN/EUR RUB/USD ZAR/USD TRY/USD

2008

Year End 2007

2006

2005

1.41 1.65 0.86 96.86 136.53 1.08 1.52

0.5% -0.3% -0.8% -1.6% -2.0% 0.1% -0.4%

1.3% 12.7% 11.2% -6.4% -7.6% -1.3% -2.6%

1.39 1.46 0.95 90.64 126.14 1.07 1.49

1.47 2.01 0.73 112.04 164.93 1.12 1.65

1.32 1.96 0.67 119.16 156.93 1.22 1.61

1.18 1.72 0.69 117.75 139.48 1.31 1.56

6.83 10190.00 1278.30 48.10 32.95 34.04 48.00

0.0% 1.6% -0.4% 0.3% -0.3% 0.1% 0.8%

-0.2% 7.0% -1.3% -1.1% -0.6% 2.0% 1.2%

6.82 10900.00 1262.00 47.55 32.76 34.72 48.58

7.29 9392.50 935.80 41.28 32.43 29.50 39.41

7.80 8993.50 930.00 49.01 32.59 36.10 44.11

8.07 9830.00 1010.00 53.09 32.83 41.03 45.05

3.80 1.93 534.35 2120.90 13.24 2.15

-0.2% 1.8% -0.5% 1.5% 0.3% 0.0%

-9.1% 20.8% 19.3% 6.0% 4.5% 0.0%

3.45 2.33 637.25 2248.58 13.83 2.15

3.15 1.78 497.95 2017.25 10.92 2.15

3.07 2.14 532.25 2239.75 10.80 3.34

3.03 2.34 512.00 2287.00 10.63 2.15

25.77 271.11 4.39 31.08 7.90 1.52

1.5% 2.4% 3.2% 0.3% 1.5% 1.8%

4.3% -1.6% -5.4% -1.8% 17.7% 1.2%

26.88 266.70 4.15 30.54 9.30 1.54

26.63 253.73 3.59 24.54 6.86 1.17

27.49 251.77 3.83 26.33 7.04 1.42

29.09 252.65 3.85 28.74 6.33 1.35

Local Currency Appreciation/Depreciation

Global Snapshots no 2009-13 * July 2, 2009 5

Past Issues 2009-8, April 23 ƒ ƒ ƒ ƒ ƒ ƒ

Hunting for Yield and the Return of Risk Appetite Sustainable Recovery? Not Yet! Beware of the New ChinaMania! Quantitative Easing – Will the ECB be Forced to Go There? South Africa: Generation Next Eurozone – Financial Integration Under Siege

2009-9, May 7 ƒ ƒ ƒ ƒ ƒ

The Fed’s TALF to Jump-starting Securitization Mexico Update: The Bulls Trample the Pigs Taiwan: The Great Wall of Capital Commodities: Focus on Shares The Shadow of the BOJ’s Contribution

2009-10, May 21 ƒ ƒ ƒ ƒ ƒ

GDP Details Will Give the Big Picture! The ECB Takes the Plunge, but Into the Shallow End of the Pool! Eastern Europe: Punch Drunk, but Still Standing South East Asia: Selective Tail Winds External Accounts, Domestic Demand and Currency Adjustment in Latin America

2009-11, June 3 ƒ ƒ ƒ ƒ ƒ

Will the Dollar’s Fall Trigger a Euro Overshoot? India: The New Political Compass UK: Towards a Higher Risk Premium on Financial Assets Peru: Riding the Commodities Roller Coaster The Invisible Election

2009-12, June 18 ƒ ƒ ƒ ƒ ƒ

The Leverage Race Emerging Asia: Decoupling is Dead…Long Live Decoupling Eurozone: The Housing Market Will Not Escape the Downturn Mexico and Argentina: A Lot at Stake in Mid-term Elections Three Misconceptions to Avoid Following the European Elections

DISCLAIMER This publication is for information purposes only. Past performance is no guarantee of future results. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. The views expressed herein are solely those of the author and do not represent the views of TCW as a firm or of any other portfolio manager or employee of TCW. Any holdings of a particular company or security discussed herein are under periodic review by the author and are subject to change at any time, without notice. In addition, TCW manages a number of separate strategies and portfolio managers in those strategies may have differing views or analyses with respect to a particular company, security or the economy than the views expressed herein. This report may include estimates, projections and other "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. This publication is not to be used or considered as an offer to sell, or a solicitation to an offer to buy, any security. Nothing contained herein should be considered a recommendation or advice to purchase or sell any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. © Copyright 2009, The TCW Group. Global Snapshots no 2009-13 * July 2, 2009 6

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Global Snapshots no 2009-13 * July 2, 2009 7