If you want the real outlook, read forecasts back to front

PUBLISHED : Thursday, 26 July, 2012, 12:00am
UPDATED : Thursday, 26 July, 2012, 12:00am


The International Monetary Fund gets a terrible press. It's not always deserved.

Over the last few days the IMF has taken a hammering following the publication of a resignation letter sent to the fund's board by one senior official.

'After 20 years' service, I am ashamed to have any association with the fund at all,' wrote Peter Doyle, a division chief in the IMF's European department.

Doyle was disillusioned because the IMF had 'suppressed' discussion of mounting risks ahead of the global financial crisis and the European debt crisis.

'Timely sustained warnings were of the essence. So the failure of the fund to issue them is a failing of the first order, even if such warnings may not have been heeded,' he wrote.

His criticism isn't entirely fair. The IMF does issue warnings. You just have to know where to look for them.

The fund seldom splashes warnings on the front page of its economic health checks. That's partly because it doesn't have the political independence to slam the governments that fund it, and partly because its officials are afraid that by sounding the alarm they might precipitate the very crisis they are trying to avoid.

So the IMF's warnings tend to be buried deep inside its reports. For example, in April 2007, the executive summary of its main economic outlook was still forecasting sunny weather.

But anyone who delved further in got a very different view. Inside, the report's capital markets section warned that credit was absurdly easy, leverage ludicrously high, and that financial institutions were running outrageous risks in the credit derivatives market.

Any shock to the system could lead to a 'disorderly unwinding of positions' that would be 'amplified by the rise in leveraged investment positions, the increased use of complex derivative instruments that remain untested in more volatile market conditions, rising portfolio exposure to illiquid instruments, and the prevalence of crowded trades'.

In other words, almost 18 months before Lehman Brothers imploded, the IMF was predicting a full-on financial crash.

So the message is clear; if you want to know what the IMF's analysts really think, ignore the front-page bullet points and head straight for the small print inside.

In that light, let's take a closer look at its annual health check for China published yesterday, skipping over the key message that Beijing is successfully piloting the economy to a soft landing, and turning directly to the internal nitty-gritty of the report.

Here the prognosis is less encouraging. As well as warning of all the usual risks like 'China's inherent tendency for property bubbles' and 'a clear risk of deterioration in bank asset quality' following Beijing's 2009 stimulus, the analysts concentrate on the effects of China's continued dependency on high levels of investment to generate growth.

'Time is running out on the current growth model,' they conclude.

With the cost of capital and other key inputs such as energy too low, government and industry both have powerful incentives to over-invest.

As a result, the economy has amassed enormous excess capacity, with capacity utilisation rates falling from 80 per cent before the 2008 financial crisis to just 60 per cent today (see the chart). In other words, China has 67 per cent more capacity than it can now use.

Beijing's recent efforts to step up investment to counter slowing growth will only exacerbate the problem. According to the IMF, the danger is clear: 'Persistent overcapacity could lead to deflationary pressure, a rise in bankruptcies and large financial losses.'

If China tries to export its way out of trouble, it is likely to trigger a trade war. Either way, the endgame is similar. 'A sharp correction in investment would become inevitable, with significant negative implications for growth and employment.'

So there: we have been warned, even if we do choose not to listen.

No doubt there will be great excitement in Hong Kong's financial circles over the news that non-residents will be allowed to open yuan bank accounts in the city.

But don't overdo it. With the interest rate on a one-year yuan time deposit at just 0.6 per cent, and the Chinese currency falling so far this year at an annualised rate of 2.4 per cent against the US dollar, investors have little incentive to hold yuan.

Of course, non-residents might want yuan to settle trade transactions. But even here we have to temper our enthusiasm. According to the IMF, settlements for both goods and services trade in the first quarter of the year came to 585 billion yuan (HK$717.57 million).

That might sound a lot. But transaction service provider Swift says that last month, the yuan ranked only 16th as a currency of global payments, 'ready to overtake the South African rand, currently at number 15'.

Given that the IMF figures show yuan settlements declining slightly over recent months, it may take a while to get even that far.