In The Headlines

Is China Headed for Japanese Style Economic Stagnation?

China and Japan may seem to inhabit alternative economic universes. After more than two decades of stagnation, Japan is a fading global power that cannot seem to revive its fortunes no matter what unorthodox gimmicks it tries. By contrast, China’s ascent to superpower status appears relentless as it gains wealth, technology, and ambition. Yet these Asian neighbors have a lot in common, and that does not bode well for China’s economic future. The sad case of Japan should serve as a cautionary tale for China’s policymakers. Beijing pursued almost identical economic policies to Tokyo’s to generate its rapid development. Now China’s leaders are repeating the missteps the Japanese made that tanked Japan’s economy and thwarted its revival.

“Just like Japan, we believe China will eventually face a period of much slower growth,” Goldman Sachs investment strategists said in a report earlier this year. Analysts at ratings agency Moody’s, writing in May, warned that China could suffer “a prolonged period of sub-optimal economic growth and persistent deflationary pressures, or possibly even economic stagnation.” James Chanos, founder of fund manager Kynikos Associates, has compared China’s trajectory to Japan’s “on steroids.” Some may disregard these warnings as the same predictions of doom that China has shrugged off time and again. But recall that 30 years ago, few foresaw the decline of Japan, either. Japan was the East Asian giant poised to overtake the U.S. as the world’s top economy. Driving that ascent was an economic system that many considered superior to laissez-faire American capitalism. By fostering close, cooperative ties among the state, big corporations, and banks, Japan’s policymakers encouraged investment and guided a national industrial strategy. Bureaucrats in Tokyo interfered with markets to a degree unthinkable in the U.S. by protecting nascent industries and directing financing to favored sectors and companies. Backed by such support, Japanese companies burst onto the world stage and pushed their American competitors to the wall.

But even as Japan appeared destined for greatness, its economy was, in reality, starting to rot. Those clubby ties among finance, business, and government misallocated capital and led to wasteful investments. Growth was given a boost by cheap credit in the second half of the 1980s, but that also helped inflate debt levels and stock and property prices. When this “bubble economy” burst in the early 1990s, the financial industry was flattened. Japan has yet to fully recover. China could be hurtling down a similar path. The methods Beijing employed to generate rapid growth—directing finance, nurturing targeted industries, and promoting exports—are replicas of Japan’s. And since the state in China’s “state capitalism” plays an even larger economic role than Japan’s officious bureaucracy does, the Chinese government interferes with markets to a greater degree. In China, the chummy government-business-banking triumvirate has led to excess steel mills, cement plants, and apartment blocks on a staggering scale. And Beijing’s policymakers have responded to overbuilding with a massive influx of easy cash to keep the old, sputtering growth engines spinning. The flood of Chinese yuan has fueled unstable spikes in asset prices, as the flood of Japanese yen did in Japan. Last year stock markets in China escalated to nosebleed levels, only to deflate in a panicked crash. Now property prices in Shanghai, Shenzhen, and other major cities are rising so quickly that officials have stepped in to control them.

Perhaps more dangerously, China’s loose money has also pumped up a mammoth increase in debt—like Japan’s in the 1980s. Ratings company Fitch shows that total debt relative to national output in Japan jumped almost 80% to 275% from 1980 to 1989, on the eve of the country’s financial meltdown. The same ratio in China has risen steeply—more than 100 percentage points from 2007 to 2015, reaching 255% of its gross domestic product, according to the Bank for International Settlements. There are economists who argue that China’s mountain of debt is not as risky as it appears. Since the debt consists (to a great degree) of loans made by state banks to state enterprises, the government is likely to step in and support the financial system. And because Chinese debt is almost entirely domestic and backed by massive savings, the financial sector is unlikely to fall prey to outside shocks. The experience of Japan suggests otherwise. It, too, was a creditor nation with large trade surpluses and ample savings in the early 1990s, but that did not prevent a financial crisis. If anything, Japan is proof that a bubble-prone, debt-obsessed economy is susceptible to failure, no matter the circumstances.

Japan can provide China with a model of exactly how not to handle such problems. Rather than allowing indebted, struggling companies to fail, the Japanese kept many afloat with continued credit, debt-for-equity swaps, and other tricks. Such “zombie” companies drag down the economy to this day. To sustain growth, the government turned to artificial stimulus—deficit-financed spending on infrastructure and unprecedented printing of yen by the central bank. That managed to swell Japan’s total debt to almost four times its national output at the end of 2015 while failing to revive the economy. The meddlesome bureaucracy has never reduced regulation nor opened markets enough to spur competition, efficiency, and entrepreneurship.

Officially, China’s president, Xi Jinping, has embarked on a different course. He has pledged to undertake a sweeping program of pro-market reforms that could shift the economy toward new sources of growth, scrub out excess and waste, and promote private enterprise. In practice, however, China is following in Japan’s footsteps. Despite promises to eliminate zombie companies, Beijing has kept them alive by flooding the economy with credit and state stimulus. In October government planners announced the details of a debt-for-equity swap plan ostensibly aimed at rescuing “good” companies, but more likely perpetuating excess capacity. Meanwhile, China’s debt burden continues to get heavier, as the expansion of credit outpaces GDP growth. But that credit is not stirring the economy. As in Japan, a kind of paralysis is setting in that renders all that cash less effective. There are indications that more and more new credit is being used just to pay off old debts. That means less and less money is going toward investment that could boost the economy.

China and Japan also share one long-term trend that hampers their economies—aging. Japan’s working-age population decreased 0.4% per year from 1990 to 2015. That hurts growth because fewer productive, income-earning workers are supporting a larger army of retirees. As a result of China’s decades-long policy of limiting many couples to only one child—a restriction Beijing eased only over the past three years—the Chinese population is set to age even more quickly, with the workforce expected to shrink nearly 0.5% annually over the next 25 years, according to Goldman Sachs. Fortunately for China, nothing in economics is inevitable. Xi and his policy team can still swerve off Japan’s course if they more forcefully implement the reforms they’ve promised. Until then, the risks that China will become like Japan will only mount. Beijing and Tokyo have suffered from the same fatal flaw: a deep-seated unwillingness to alter a growth model that no longer delivers results.

Citations

1. http://bloom.bg/2eESRBp – Bloomberg
2. http://cbsn.ws/2eSRH85 – CBS News

How Wind Power Blows New Profits Into MidAmerican Energy

The easiest way to understand the utility model is to think of a utility like a bank. The utility loans money to the public to pay for the power plants and other components of the electric grid, and in return for building and operating the grid, the utility gets to earn a rate of return on the capital expenditures it makes. So, in general, utilities have an incentive to build infrastructure; it is how they make money, which is where state regulators come in. Given this structure, when a utility says it wants to build an expensive power plant or transmission line, it almost always means the utility’s electric rates will go up (and usually substantially). MidAmerican Energy, however, plans to spend $3.6B on new wind farms—and claiming that doing so would actually lower its customers’ electric rates.

The reason the company can build so much new infrastructure while lowering electric rates is that building the new wind power lowers the utility’s overall operating costs for the entire grid by more than it costs the utility to build the new wind farms, even when including the utility’s approximately 11% rate of return. There are a few reasons for this, but one of the primary drivers is federal subsidies. If the utilities can start construction this year (or spend enough money procuring turbines this year), the wind farms will be eligible to receive about 2.3 cents in federal tax credits for every kWh (kilowatt-hour) they generate for the first ten years of the plant’s life. To put that figure in perspective, MidAmerican’s 2,000 MW (megawatt) wind project should easily generate over $180 million per year in tax credits for each of the project’s first ten years. Of course, tax credits alone are not enough to generate a windfall for ratepayers. The rest comes in two forms: (1) the profits the utility earns from selling the new wind power into the regional electric market; and (2) the utility’s savings when buying power from that regional market due to the lower market prices caused by adding all of that new wind.

Wind has a very low marginal cost to operate, meaning MidAmerican can bid into the regional electric market at a very low price (sometimes at even less than zero). But all power plants that sell into the regional electric market get paid at the market clearing price (i.e., at the highest priced power plant chosen by the grid operator to operate), not at the price they bid into the market. Because wind turbines do not cost much to operate, the utilities that own wind farms earn a hefty profit every time their wind turbines generate electricity in the market.

Similarly, when MidAmerican goes to buy power on the market for its customers, it will be able to buy that power at a much lower overall cost because it has loaded the market with all of its new, lower cost wind. In other words, by adding 2,000 MW of new wind to the market that does not cost much to run, MidAmerican will be lowering the regional electric prices for everyone, including itself.
Overall, MidAmerican’s modeling show that its new wind project will save its customers hundreds of millions (if not billions) of dollars over the next forty years. This is because all of these market profits and savings get passed on directly to ratepayers. All of the ratepayer groups in Iowa have analyzed the modeling results on their own and agreed to allow the project to go forward. In other words, the groups with the largest vested interest in keeping electric rates low have blessed the projects. And in the last few months, so has the Iowa Utilities Board.

Wind is not just in the money right now, it is printing money. And even though the federal tax credits for wind are scheduled to phase out over the next few years, expect the Midwestern wind boom to continue for many years to come.

Citations

1. http://bit.ly/2fNyIL3 – Forbes
2. http://dmreg.co/1TTGi66 – Des Moines Register

The Good News Is . . .

• A measure of consumers’ attitudes rose to its highest level since June this month. The Index of Consumer Sentiment hit 91.6 in November, according to University of Michigan. The index is up from 87.2 in October’s final reading. Economists had expected the index to rise to 89.5. The most striking finding in early November was that both near and long-term inflation expectations jumped to 2.7% from last month’s record matching lows of 2.4%. The monthly survey of 500 consumers measures attitudes toward topics like personal finances, inflation, unemployment, government policies and interest rates.

• Kohl’s Corp., a leading department store chain, reported earnings of $0.80 per share, an increase of 6.7% over year-earlier earnings of $0.75 per share. The firm’s earnings topped the consensus estimate of analysts by $0.10. The company reported revenues of $4.33 billion. Management attributed the results to a strong back-to-school season and improvements in its inventory management.

• CenturyLink, a network provider, announced it would acquire rival Level 3 Communications. Both companies provide communications and services like data, voice and video transmission for large enterprises and each is trying to take market share from rivals AT&T and Verizon. The $25 billion deal would make the combined company the second-largest provider of communications to business in the United States, after AT&T. It brings CenturyLink an additional 200,000 route miles of fiber and potentially big commercial customers. Under the terms of the deal, CenturyLink will acquire Level 3 for $26.50 in cash and 1.4286 shares of CenturyLink stock for each Level 3 share.

Citations

1. http://bit.ly/1gDEQwe – University of Michigan
2. http://cnb.cx/1gct3xa – CNBC
3. http://bit.ly/2fmJM3j – Kohl’s Corp.
4. http://nyti.ms/2esgfGe – NY Times Dealbook

Planning Tips

Tips for Yearend Tax Savings

It is easy to get caught up in the holiday hoopla, but do not forget about Uncle Sam. As the end of the year approaches, now is the time to make some tax moves that could lower your tax bill or increase the refund on your return come next April. Below are some simple tips for doing this. Be sure to consult with your tax advisor to determine the tax strategy most appropriate for your circumstances.

Go back to school – It pays to get an education, at least according to the government. Families with children starting college, graduate school, or even enrolling in a single class can prepay their tuition before the New Year to get the tax benefit in 2016. There is the American Opportunity Tax Credit of up to $2,500, the Lifetime Learning Credit of up to $2,000 and the tuition and fees education tax deduction of up to $4,000 (as long as your income is below a certain threshold).

Use the money in your flex spending and health savings accounts – Check what is left in your flex spending account and health savings accounts so you can spend that money before the end of the year. Those are tax-free dollars that you can put toward new glasses, filling prescriptions or dental care that is not covered by insurance, like a replacing a filling. And while you are looking at your medical expenses, add them up. You may have incurred enough to hit the medical expense threshold (which is 10% of your adjusted gross income if you are under 65), and in that case, you can deduct everything you spent over that figure—but you cannot double dip. In other words, you cannot claim a tax deduction for medical and dental expenses you paid with funds from your flex spending account and health savings accounts.

Contribute to your retirement nest egg – If you contribute to your 401(k), you lower your taxable income. If you are 18 or older, you can contribute up to $18,000, and if you are over 50 you can contribute an additional $6,000 for a total of $24,000. With IRAs you can contribute $5,500, and if you are over 50 there is an additional $1,000. Those who are self-employed can make tax-deductible contributions to a Simplified Employee Pension account, or SEP IRA. Those savers can contribute up to 25% of their net earnings for a maximum contribution of $53,000 this year. Then there is the Saver’s Credit, which can also be taken for contributions to a 401(k), traditional, Roth IRA or SEP, of up to $2,000 (or $4,000 if married and filing jointly), depending on your income.

Make an early mortgage payment – You may not be thinking of January expenses before Thanksgiving, but consider paying your mortgage payment early and get the deduction now, and incur the present value of the tax savings. For example, if you have a mortgage on your house or condo and there is a payment due on January 1, pay it a few days earlier—say, December 28 instead—and you can take the interest expense as a deduction in 2016 (the year in which it is paid). Depending on your tax bracket, that could mean a 25% to 40% tax savings come April.

Donate appreciated assets to charity – If you plan to make a significant gift to charity, consider giving appreciated stocks or mutual fund shares that you have owned for more than one year, instead of cash. Doing so supercharges the saving power of your generosity. Your charitable contribution deduction is the fair market value of the securities on the date of the gift, not the amount you paid for the asset, and you never have to pay tax on the profit. However, do not donate stocks or fund shares that lost money. You would be better off selling the asset, claiming the loss on your taxes, and donating cash to the charity.

Citations

1. http://bit.ly/1aTsVYH – Kiplinger
2. http://bit.ly/1vkUALW – Bankrate.com
3. http://cnb.cx/2eskmlt – CNBC
4. http://bit.ly/2esne23 – Forbes
5. http://bit.ly/1gbpUL8 – Business News Day