Mega Themes

Following the debacle of the failed attempt to repeal and replace Obamacare, the Trump Administration is focusing on another important part of its policy platform: reforming taxes and reshaping government spending. In theory, the legislative obstacles should be easier to overcome than with the controversial health care bill, but many challenges still lie ahead. Meanwhile, the assumptions underpinning many of the key measures are questionable. The Administration's fiscal proposals are based on the following assertions: The level of U.S. taxes puts the U.S. at a competitive disadvantage and is a hindrance to faster economic growth. Military and infrastructure spending needs to rise sharply after having been cut back too severely in recent years. The federal government, outside of defense, has become bloated and needs to be drastically pruned. Entitlement spending remains politically untouchable. Proposed tax changes will be broadly deficit neutral after allowing for the revenue boost from faster economic growth. The above assertions supporting the administration's policy platform are a mix of facts, fallacies and fantasies. A frustrating aspect of economic debates is that it often is relatively easy to cherry pick data to support any particular argument one wants to make. In other words, there are plenty of alternative facts to choose from. In this report, I will endeavor to illuminate the debate about fiscal policy with unvarnished official statistics, untainted by partisan biases. Are U.S. Taxes Too High? Taxes are a necessary evil if a country's residents want their government to provide some services such as defense, policing, schooling, and old-age benefits etc. In a democracy, the exact level of services provided by a government is a choice that can be voted on at election time. Sometimes, politicians campaign on a platform of increased government spending (and implicitly higher taxes) and at other times, the opposite is true. As a presidential candidate, Donald Trump campaigned on a promise to reduce the government's involvement in the economy and society in general, with a corresponding reduction in tax burdens. The government's revenue grab takes many forms beyond just taxing incomes and can occur at the federal, state or local level. There are taxes on spending, assets, imports and employment, and a multitude of fees ranging from park entrance charges to speeding tickets. Chart 1 shows total U.S. tax and fee revenues from all levels of government, expressed as a share of GDP since 1980.1 The most striking thing about the chart is how little the ratio has changed over the past quarter century. Government revenues have averaged around 27% of GDP over the period and the only years with a marked divergence from that level were the late 1990s when the tech-driven stock market boom triggered unusually strong capital gains tax receipts and in 2009/10 when the economic collapse and temporary tax cuts led to a plunge in revenues. The other interesting point to note is that, according to OECD data, the U.S. is the lowest taxed industrial country, except for Ireland. Taxes and social security contributions as a share of GDP are more than ten percentage points below the unweighted average of 21 other industrial countries. And this gap has been relatively constant over the years (Chart 2). The unweighted average for European countries is almost 39% of GDP. Chart 1U.S. Total Tax Burdens U.S. Total Tax Burdens U.S. Total Tax Burdens Chart 2U.S. Tax Burdens: An International Perspective U.S. Tax Burdens: An International Perspective U.S. Tax Burdens: An International Perspective As noted earlier, whether a country's overall tax burdens are high or low is largely a reflection of voter preference. In the majority of countries outside the U.S., the government is the main or even sole provider of health care and that often is used to explain the lower level of U.S. taxes. Yet, it is not widely realized that U.S. government spending on health care as a percent of GDP is higher than the industrial country average (Chart 3).2 The point is that the U.S.'s low ranking in terms of global tax burdens does not simply reflect the lack of a universal government-funded health care system. Low taxes are a very good thing if they are sufficient to finance the required level of government services and provide positive incentives for economic growth. However, there is a loose but positive correlation between the level of tax burdens and structural budget deficits. In other words, the countries with low tax burdens have tended to have higher average cyclically-adjusted budget deficits (Chart 4). Again, that is choice that voters can make: choosing lower taxes today at the expense of rising debt burdens that will have costs in the future. The U.S. has been at the extreme end of the spectrum so far this century with the combination of low taxes and large deficits. Chart 3Government Spending on Health Care Government Spending on Health Care Government Spending on Health Care Chart 4Lower Tax Burdens Generally Mean Larger Fiscal Deficits U.S. Fiscal Policy: Facts, Fallacies And Fantasies U.S. Fiscal Policy: Facts, Fallacies And Fantasies The data I have shown highlight that the U.S. is a low-tax country from an international perspective and that overall tax burdens have not changed dramatically over time. Nonetheless, there is plenty of scope for reforming taxes in order to improve economic incentives and efficiency. The Case For Tax Reform There is a disconnect between low overall U.S. tax burdens and the facts that the country has the highest marginal corporate tax rate in the industrial world and that so many people feel over-taxed. The principal explanation is the skewed nature of the U.S. tax system with its heavy dependence on taxes on income rather than consumption. The U.S. is the only industrial country in the world without a national value added tax (VAT), and state and local sales taxes are low by international standards. This means that taxes on goods and services account for less than 18% of general government tax revenues in the U.S. compared with an unweighted average of almost 33% for all OECD countries (Table 1). As a result, the U.S. is forced to rely more on taxes on income and profits. These account for almost 48% of tax revenues in the U.S., 14 percentage points higher than the OECD average. General perceptions about tax burdens probably are more affected by income tax rates than by taxes on goods and services, many of which are hidden from view. Table 1The Structure of Government Tax Receipts U.S. Fiscal Policy: Facts, Fallacies And Fantasies U.S. Fiscal Policy: Facts, Fallacies And Fantasies Problems are compounded by the skewed distribution of income tax payments. For example, although the marginal U.S. corporate tax rate is around 39%,3 many large companies with overseas subsidiaries pay a significantly lower rate. According to Internal Revenue Service (IRS) corporate tax return data, the largest businesses (annual receipts above $100 million) paid an average federal rate of 22.8% on their taxable income in 2013 (the latest year for which detailed corporate returns are available), compared with 32.2% for companies with sales between $10 million and $100 million and 27.5% for those with sales of less than $10 million. It is no wonder that many multinationals are keen to shelter income overseas. There is a case for reforming the corporate tax code to equalize the playing field between multinationals and those with domestic operations. When it comes to personal taxes, there also are distortions. As is well known, there are many hard-to-justify allowances including those on carried interest and on mortgages up to the value of $1 million. Even if the government wanted to use the tax system to subsidize home ownership (which many countries have stopped doing), it would make sense to cap the benefit at the mortgage required to finance a median-priced home. The national median price for a single-family home currently is $230,000. A key problem is the fact that many people do not earn enough to pay much income tax, so the burden falls heavily on a relatively narrow group. The average personal federal tax rate has not changed very much over the past 35 years (Chart 5), but Table 2 shows the remarkably skewed nature of personal tax payments by income level. In 2014 (the latest year for detailed IRS personal data), 148 million tax returns were filed, but more than one-third had no taxable income. Almost 45% of filers reported gross adjusted income of less than $30,000 and, overall, this group received net tax refunds. At the other end of the scale, those with incomes above $200,000 represented only 4.2% of filed returns yet accounted for almost 63% of total federal taxes paid. It is no surprise that many high-income earners feel over-taxed. It is harder to justify the fact that 55% of respondents to a recent Fox News poll said that taxes were too high. The message is that taxes can never be low enough! Chart 5The Average Federal Personal Tax Rate The Average Federal Personal Tax Rate The Average Federal Personal Tax Rate Table 2The Skewed Nature of Personal Income Taxes U.S. Fiscal Policy: Facts, Fallacies And Fantasies U.S. Fiscal Policy: Facts, Fallacies And Fantasies An obvious way to improve the tax structure would be to eliminate some deductions and use the savings to reduce marginal rates. An even more significant change would be to broaden the tax base by introducing a VAT, using the revenue to dramatically lower income tax rates. The regressive nature of a VAT can be countered by exempting certain items such as food, energy, and children's clothing. The main argument against a VAT is that, once introduced, it becomes an easy way to raise revenue and an initial rate of say 5% eventually could end up at European levels (20%). The proposal for a new Border Adjustment Tax would be a step toward rebalancing tax burdens toward consumption and away from incomes. However, there is considerable opposition to such a move and its future is in doubt. To conclude, the data do not support the notion that the U.S. is overly taxed - either compared to its own history or relative to other countries. But the system has many distortions and there is a strong case for increased taxes on consumption, using the revenues to reduce marginal income tax rates in both the corporate and personal sector. The Case For More Spending On Infrastructure And Defense Unlike tax reform, increased infrastructure spending is not a contentious issue. As Larry Summers likes to quip, anyone flying to New York and driving into Manhattan can see infrastructure spending needs all around, from dreary airports to dodgy bridges and pothole-filled roads. Real government spending on non-defense structures (a proxy for infrastructure) has risen by only 20% over the past 50 years, a drop of almost 30% in per capita terms (Chart 6). As a share of GDP, infrastructure spending has almost halved in the past half century. The administration has talked about boosting infrastructure spending by $1 trillion over the next ten years. If we assume a constant baseline of spending averaging 1.6% of GDP (the 2016 level), an additional $1 trillion would equate to an additional 30% rise in overall infrastructure expenditure over the decade. But even with this increase, spending would still only be 2% of GDP, a relatively modest level by historical standards. The administration's infrastructure proposal is quite reasonable in terms of its scale and desirability. Of course, there is no guarantee that it will materialize. The administration's plan to significantly increase defense spending is a more debatable issue. The number of military personnel has been in a sharp downtrend since the end of the Vietnam War. In the past 35 years or so, a key driver has been the impact of technology with machines replacing people, but defense spending as a share of GDP also has been in a structural downtrend (Chart 7). At the same time, real spending per military employee has been in a strong uptrend, reflecting the switch in strategy away from boots on the ground towards sophisticated equipment. From an international perspective, U.S. defense spending remains very high compared to other countries. According to the SIPRI Military Expenditure Database, in 2015, the U.S. spent as much as the next eight largest military spenders combined.4 Yet, the combined GDP of those eight countries was 55% above that of the U.S. Chart 6Government Infrastructure Spending Government Infrastructure Spending Government Infrastructure Spending Chart 7Trends In Defense Spending Trends In Defense Spending Trends In Defense Spending The Budget Control Act of 2011 put tough spending caps on discretionary spending and these have not been repealed. According to the Congressional Budget Office (CBO), under current law, defense outlays as a share of GDP would fall from 3.2% of GDP to 2.6% by fiscal 2027. The Trump Administration has proposed a $54 billion increase in defense spending authority for fiscal 2018, implying an increase of around 9% from the 2017 level. And while we do not have details, we can assume that the longer-term plan is to reverse the downtrend in spending as a share of GDP. What is the right level of defense spending? The world remains a dangerous place, but the U.S. already outspends other countries by a huge margin. At the end of the day, financial constraints mean it boils down to a choice between defense and other spending programs. Voters may state a preference for increased defense spending, but that likely would change if other programs were crowded out. Is The Federal Government Bloated? Chart 8Federal Non-Defense Discretionary Spending Federal Non-Defense Discretionary Spending Federal Non-Defense Discretionary Spending Spending on entitlements is widely regarded as untouchable from a political perspective and it is no surprise that Trump has promised to defend these programs. Given the administration's platform of tax cuts and increased military and infrastructure spending, containing budget deficits implies tough constraints on non-defense discretionary spending. This includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veterans Affairs. Such spending has already declined sharply during the past several decades, both as a share of total government outlays and as a share of GDP (Chart 8). The administration seeks further drastic cuts in the years ahead. There is a general perception that much of government spending is wasteful, implying huge savings can be made. At the same time, surveys show that people do not want cuts in areas such as security, veterans affairs, education and health. The problem is that spending by the Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. Thus, pressures for spending cuts fall heavily on other areas. But this often is not practical given that many of these other programs are so small. For example, spending on foreign aid represents less than 0.2% of GDP and less than 5% of non-defense discretionary spending. As for federal employment being bloated, it should be noted that civilian federal employment has shown no net change over the past 50 years, despite the marked growth in the population and economy over the period. Federal employment currently accounts for less than 2% of total employment, down from 4% in 1970 (bottom panel of Chart 8). There inevitably are areas of wasteful government spending and it is appropriate to look for savings. However, it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlements programs and preventing a massive rise in the budget deficit. And that is even without adding in the cost of the proposed border wall with Mexico. Entitlement Spending Is The Major Problem Social Security has been called the third rail of American politics - touch it and you are dead. No politician seeking election would dare campaign on a platform of major cuts to the program in the form of reduced benefits, higher contributions, means testing, or an increase in the age eligibility limit. And the same is broadly true for Medicare. Voter dislike of government involvement in the provision of health care does not seem to extend to those over the age of 65! The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 and older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart 9). Spending on entitlements (Social Security, Medicare, Medicaid, income security, and government pensions) is on an unsustainable trajectory. In fiscal 2016, these programs equaled 74% of federal revenues and the CBO estimates that this will rise to 84% by 2027, absent any change to current law (Chart 10). If we also allow for net interest costs, total mandatory spending is projected to exceed revenues within the next 12 years or so, meaning that deficit financing will be required for all discretionary spending. Chart 9The Demographic Fiscal Headwind The Demographic Fiscal Headwind The Demographic Fiscal Headwind Chart 10The Entitlement Problem The Entitlement Problem The Entitlement Problem Politicians operating in a world of two-year election cycles have no incentive to support short-term pain for long-term gain. At some point, markets will force change, but it is hard to know exactly when that will happen. According to the CBO's latest estimates, current policies imply that the federal deficit will average 4% of GDP over the next decade, rising to 6.2% and 8.4% over the subsequent two 10-year periods. As a result, the debt-to-GDP ratio rises from 77% currently to 113% by 2037 and 150% by 2047.5 Of course, that is a long way in the future and much can happen to undermine these projections - for the better or for the worse. Long-run fiscal projections are subject to a wide margin of error because, in addition to legislative changes, they are very sensitive to assumptions about economic growth, inflation and interest rates. The CBO's baseline estimates published in mid-2009 had Medicare spending rising from 3.1% to 7.2% of GDP between 2010 and 2037. The latest CBO report has 2037 Medicare spending at a much lower 5.3% of GDP, representing massive savings from the 2009 estimate. Unfortunately, total federal revenues as a share of GDP were revised down by an even greater amount, with the result that expected deficits and debt levels have been revised up sharply since the 2009 report, despite the slower path of Medicare spending (Chart 11). Chart 11Long-Term Fiscal Projections: Prone to Revisions Long-Term Fiscal Projections: Prone to Revisions Long-Term Fiscal Projections: Prone to Revisions One can point to Japan as an example of how a high government debt-to-GDP ratio need not imply economic disaster. Japan's gross debt currently stands at 250% of GDP and there has not been any difficulty in financing its ongoing deficits. However, two qualifications are necessary. First, it is too soon for Japan to claim victory: its horrible demographic profile points to an ever-worsening fiscal position and there likely will be a crisis at some point. Secondly, Japan finances its deficits internally which protects it from the whims of foreign investors. Although the dollar's status as reserve currency also gives the U.S. protection, the country's ongoing large current account deficit creates vulnerability to financing problems if overseas investors lose confidence in the U.S. fiscal outlook. Concluding Thoughts Public discussions of fiscal policy invariably morph into partisan arguments about the appropriate size and role of the government in the economy. It quickly becomes frustrating when the warring factions then use misleading or outright wrong data to support their positions. In the spirit of the adage that "everyone is entitled to their own opinions, but there is only one set of facts," I have focused this paper on published and reputable data about government revenues and spending. Several points emerge: One may want taxes to come down, but it is a FACT that the U.S. is a low-tax country by international standards, and tax burdens have not noticeably risen over time. It is a FACT that the U.S. tax system has serious distortions and is crying out for some reform. But what these reforms should be is open to debate, and are a matter of opinion. There is a strong case for increased infrastructure because it is a FACT that spending has fallen sharply over the years. It is less obvious that a major rise in defense spending is warranted. It would be a matter of preference rather than incontrovertible need. It is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control. Of course, there are many places where the government can make cuts and improve efficiency, but squeezing this category of spending will provide only limited savings. It is FANTASY to think that entitlement programs can be maintained over the long run in their current form. The longer that reforms are delayed, the bigger the cutbacks will have to be. Government deficits and debt do matter, but it is virtually impossible to predict when financing problems might occur. There is no particular level of the debt-to-GDP ratio that will trigger a crisis because much depends on the domestic and global economic and financial environment. But, to quote the late Herb Stein, "if something cannot go on forever, it will stop." The Trump administration's fiscal desires are a mix of sensible policies, wishful thinking and impracticalities. Hopefully, there will be progress with boosting infrastructure, and making some positive reforms to the tax code. However, there will be serious challenges to tax changes once special interests get involved. The end point may very well be outright tax cuts without reform, and that would be much less desirable. On the spending side, increased defense spending is a perfectly legitimate choice, but the planned severe cuts to non-defense discretionary spending are impractical. The good news is that the odds of such severe cuts being implemented are very low. It seems almost certain that federal deficits will head higher over the coming few years. Using dynamic scoring to suggest that the economy will improve by enough to make tax cuts and spending increases virtually self-financing will have little credibility outside of the administration and will be challenged by the calculations of the CBO and Joint Committee on Taxation. If the government is successful in implementing major fiscal stimulus then the biggest problem might be overheating the economy. As I discussed in a recent report, the U.S. economy already is operating close to full capacity and it will not take much to create a classic late-cycle build-up of inflationary pressures.6 That would set the scene for enough Fed tightening in 2018 to give high odds of a recession in 2019. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 The totals exclude government interest receipts and transfers from the Federal Reserve to the Treasury as those largely represent transactions related to intra-government holdings of Treasury securities. 2 Overall the U.S. devotes a much larger share of its GDP to health care than other countries. According to OECD data, total health care spending represented 16.9% of U.S. GDP in 2015, compared to an unweighted average of 10% for other industrial countries. Within these totals, the government share was 8.4% in the U.S and 7.6% elsewhere, with the private sector making up the difference. 3 This comprises a top federal rate of 35% and state and local taxes of 6%, fully deductible against federal taxes. 4 SIPRI stands for the Stockholm International Peace Research Institute. Details available at https://www.sipri.org/databases/milex 5 For more information, please see The 2017 Long-Term Budget Outlook, Congressional Budget Office, March 2017. Available at www.cbo.gov 6 Please see BCA Special Report, "Beware the 2019 Trump Recession," dated March 7, 2017 available at bcaresearch.com

The aim of this Special Report is to elaborate on and explain the different views on China that have coexisted at BCA in recent years. Although BCA strives to achieve consensus among its strategists, this is not always possible, as has been the case with China. Peter Berezin of the Global Investment Strategy service and Yan Wang of China Investment Strategy have been positive, while Arthur Budaghyan of Emerging Markets Strategy has been negative on both China's business cycle and China-related plays. The focal points of divergence are centered on how Peter, Yan, and Arthur view and explain the relationship between savings, debt, and the misallocation of capital, as well as how they see China's potential roadmap going forward. The debate is moderated by BCA Global Strategist Caroline Miller. Caroline: Peter and Yan, the world - including the Chinese government - is climbing a wall of worry about China's debt load. Why are you guys still smiling? How many Maotai did you have last night? Peter: I don't know what a Maotai is, but I am sure that if I had more than one I wouldn't be smiling this morning. But yes, I am not as worried as Arthur that China is in the midst of an unsustainable credit bubble. Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors in the global equity market (Chart 1). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 2). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 3). Chart 1Chinese Banks: Unloved And Unwanted Chinese Banks: Unloved And Unwanted Chinese Banks: Unloved And Unwanted Chart 2Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Recent Credit Bubbles Developed Amid Widening Current Account Deficits Recent Credit Bubbles Developed Amid Widening Current Account Deficits Chart 3Hong Kong Is The Correct Analogy Hong Kong Is The Correct Analogy Hong Kong Is The Correct Analogy Yes, there is a lot of debt in China. But there is a lot of savings too. In fact, to a large extent, China's high debt levels are just a function of its high saving rate. The evidence suggests that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies (Chart 4). China sits close to the trend line, implying that its debt stock is roughly what you would expect it to be. Chart 4Positive Correlation Between National Savings And Indebtedness The Great Debate: Does China Have Too Much Debt Or Too Much Savings? The Great Debate: Does China Have Too Much Debt Or Too Much Savings? Arthur: Allow me to both agree and disagree with Peter. No, there is no bubble in Chinese equities, but yes, there is a bubble and euphoria in China's property market. Property prices have risen exponentially and are extremely high by any metric. Chinese bank equity valuations have already adjusted, but bank stocks could still sell off if their profits shrink considerably, as I expect. Bank shares are not expensive, but not cheap either, if one adjusts for non-performing loans. I concur that China's property market adjustment will likely resemble that of Hong Kong as opposed to that of the U.S. As Peter noted, in Hong Kong in the late 1990s, property prices plunged by 70%, but few homeowners defaulted on their mortgages. Yet property starts/construction also collapsed by 80% (Chart 5). Chart 5Hong Kong's Property: ##br##Few Mortgage Defaults ##br##But Collapse In Construction Hong Kong's Property: Few Mortgage Defaults But Collapse In Construction Hong Kong's Property: Few Mortgage Defaults But Collapse In Construction Presently in China, the risk is not mortgage defaults but a renewed drop in property construction as well as other types of capital spending. Less construction/capital spending entails less demand for commodities, materials/chemicals and industrial goods. China's residential and non-residential construction activity will contract anew as speculative/investment demand for property weakens. Yan: I agree with Peter that China's rising debt is fundamentally a function of the country's abundant savings. Moreover, the fact that the country's massive savings pool is primarily intermediated via the banking sector and other debt instruments exacerbates the debt buildup. If a country's savings are primarily intermediated by the stock market through equity financing, then high savings do not necessarily lead to high debt, as "savers" become "shareholders" rather than "creditors." In China's case, the country's still relatively undeveloped and volatile equity market has not yet been able to play a meaningful role in financial intermediation. Instead, banks still play a dominant role channeling financial resources. In other words, China's high savings and a banking-centric financial intermediation system are key drivers of the ever-rising debt level. In fact, as long as these two features persist, the country's debt will inevitably continue to rise, as it simply reflects the accumulated savings. Caroline: Arthur, does this line up with how you think about the relationship between savings and debt? Arthur: My thesis has been that China's abnormal credit growth has been the result of speculative, euphoric behavior among Chinese banks and the shadow banking system - and not the natural result of the country's "excess savings," as Peter and Yan have argued. What economists call "savings" or "excess savings," non-economists refer to as "overproduction" or "excess capacity." This is about concepts, not about China. In economic science, the term "savings" is used to denote the number of goods and services that a nation has produced but not consumed - i.e., they can be used for investment or exports. Peter and Yan are using this textbook definition of "savings." Hence, by "savings" or "excess savings" they mean "excess production." Logically, the glut of goods and services does not flow to banks and create deposits. In brief, "savings" or "excess savings" are real economic variables and have nothing to do with bank deposits - i.e., "monetary savings." Peter, Yan and many other commentators make this mistake by mixing up national savings - which is literally output of goods and services that were not consumed by households and government - with "monetary savings," i.e., deposits in the banking system. I have no doubt China has had a high savings rate, i.e., it has had overcapacity and over-production in a number of sectors. The textbook concept of national savings is calculated as a residual from the national accounts and balance of payments. In particular: Savings - Investments = Current Account Balance and Savings = Investments + Current Account Balance A few remarks on the economic interpretation of this equation are in order. First, in any country, "excess" national savings over investment, i.e., current account surpluses, lead to an accumulation of net foreign assets, but has no implication on domestic loan creation.1 Second, a country that invests a lot and does not run a large current account deficit will have a high savings rate as per the economic textbook's definition of national savings. The opposite also holds true. Critically, national or household savings are in no way linked to the amount of deposits at banks. When households decide to save a part of their income, they do not create new deposits or "monetary savings." They save deposits that already exist in the banking system. To sum up, the amount of deposits in the banking system does not change as a result of households' decision to save a part of their income. When a person gets paid in cash and deposits that cash in a bank as a savings deposit, there is no new money created either. That cash was a deposit and was withdrawn from a bank a few days before, and now this cash returns to the banking system as a deposit again. In this case, the amount of total outstanding money supply in the economy (cash plus deposits) has not changed. In general, when a bank receives a deposit, it does not create new money, or "monetary savings." The deposit simply moves from one bank to another or from cash to deposit. The amount of money supply does not change. When a country enjoys a lot of overcapacity, strong bank loans or money growth will not cause inflation and interest rates will stay low, encouraging more borrowing. This is why in Peter's Chart 4 there is a positive correlation between the national savings rate and debt-to-GDP ratio across countries. Overcapacity entails low inflation; the latter keeps nominal interest rates low, which in turn entices more borrowing and debt build-up. In brief, the linkage between national savings/excess capacity and the credit-to-GDP ratio is indirect via subdued inflation and low interest rates that encourage debt build-up. Caroline: Arthur, you have made the case that savings are not a constraint to loan origination. Can you elaborate? Arthur: The banking system does not intermediate "savings" or "excess savings" from the real economy into loans. The commercial banking system as a whole creates deposits at the time it originates loans. This is true of all countries. Indeed, whenever commercial banks make a loan, they simultaneously create a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart 6). In other words, bank loan origination creates deposits and money.2 Chart 6Commercial Banks: Credit Origination Creates Deposits The Great Debate: Does China Have Too Much Debt Or Too Much Savings? The Great Debate: Does China Have Too Much Debt Or Too Much Savings? China's banking system has a lot of deposits because banks have created too many loans. In addition, a bank does not need liquidity (reserves at the central bank) for each loan it originates. It still requires some liquidity to settle its net balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it may not require liquidity to "back up" the loan. There are many variables that constrain bank loan origination, but they do not include national savings or "excess savings." We discussed these constraints in detail in our EMS report titled Misconceptions About China's Credit Excesses.3 Finally, when central banks opt to keep short-term interest rates steady, they must provide commercial banks with as much liquidity as the latter demands. This point is greatly relevant to China. For the past few years, China's central bank has silently moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money) (Chart 7). As a result, nowadays the People's Bank of China (PBoC) has very little quantitative control over money/credit creation by commercial banks. Chart 7The PBoC Has Begun Targeting Rates In Recent Years The PBoC Has Begun Targeting Rates In Recent Years The PBoC Has Begun Targeting Rates In Recent Years It is Chinese commercial banks that effectively drive money/credit/deposit creation. The PBoC decides whether or not to accommodate banks' liquidity needs by allowing interest rates to rise or fall, or by keeping them steady.4 To conclude, what habitually drives credit booms in any country are the "animal spirits" of banks and borrowers - not national savings. This has been the case in China too. Caroline: Peter, do you agree with Arthur's assessment? Peter: I don't want to get bogged down in the weeds of monetary theory, but let me briefly address two distinct points that I think Arthur is making. The first is the claim that the ability of banks to create money "out of thin air" is somehow not constrained by the volume of bank reserves and cash in circulation (the so - called "monetary base"). The second is the claim that there is no meaningful link between savings and deposits. I think Arthur is wrong on both counts. On the first claim, it is true that when a bank issues a loan, it also creates a deposit. To the extent that bank deposits are treated as "money," this expands the money supply. This is simply the "money multiplier" taught in introductory economics classes. Where Arthur's logic falls short is in his implicit assumption that all lending translates into additional bank deposits. It doesn't have to. Some of the deposits will be withdrawn and kept as cash. Governments have complete control over how much cash there is in circulation by virtue of their monopoly over the printing press. As long as cash exists, central banks can influence the broad money supply via open market operations. By the way, this is true even in banking systems where there are no reserve requirements. Regarding Arthur's claim that lending can occur without savings, this is often true when someone is borrowing money to buy an asset. However, it is generally not true if they are borrowing money to finance new spending. Let me offer a concrete, albeit somewhat whimsical, example to illustrate this point. Suppose I am living in a closed economy where no one saves anything. Now, let's imagine that I decide to throw a party for myself and need to borrow $1000 to do this. Who is going to provide me with the resources? Well, we just said that no one wants to save, so "something" has to adjust for me to have my party. That "something" is the interest rate. In order to entice someone to spend a bit less, the bank (on my behalf) will offer depositors a higher interest rate. If rates rise by enough, someone will decide to forego a bit of consumption today in order to have more consumption tomorrow. In other words, my decision to borrow must result in someone else's decision to save. So do savings create debt or does debt create savings? The answer is both: interest rates adjust to ensure that the two end up being different sides of the same coin. Caroline: Yan, what's your perspective on China's high debt profile? What could you be missing? Yan: As you can see Arthur and I view China's debt profile through different theoretical lenses. I don't think we can fully reconcile our different frameworks on the matter, but we hope our debate can deepen clients' own understanding of this issue, so they can make up their own minds. What I do want to stress is that those analysts who fear that China's corporate debt problem constitutes an alarming systemic financial risk focus exclusively on the rapid increase in the country's debt-to-GDP ratio. While undoubtedly there is merit to this ratio, I think it is also important to validate this judgement by looking at other indicators. In our previous research, we looked beyond this widely cited conventional indicator for corroborating evidence of a "debt bubble." Our findings suggest that the level of Chinese corporate sector leverage is not as precarious as widely perceived. For example, in the Chinese corporate sector, the area of China's economy where investors worry most about leverage, the debt-to-asset ratio of China's industrial sector has been falling since the late 1990s, down to 56% from 62%, contrary to popular belief (Chart 8). State-owned enterprises have witnessed an increase in their debt-to-asset ratio since the global financial crisis, but it has barely reached late 1990s levels, and has actually rolled over in recent years. Meanwhile, SOEs are a shrinking part of the overall economy and therefore, when looked at in conjunction with the private sector, have not moved the needle on the broader trend of corporate balance sheet "deleveraging." This stands in stark contrast to Japan's corporate sector at the peak of its debt bubble. In the early 1990s, Japan's corporate sector debt-to-asset ratio topped out at 78% when the country's "balance sheet recession" began (Chart 9). Even after two decades of deleveraging, Japan's current corporate debt-to-asset ratio is comparable to China's. To validate this conclusion, we also calculated several other key ratios to compare the leverage situation of Chinese listed companies relative to their global peers. Ratios such as liability-to-assets, net debt-to-EBITDA and interest coverage assess both leverage levels and debt servicing capacity. As Chart 10 shows, our extensive survey, both from the top down and the bottom up, suggests that China's leverage situation is comparable if not superior to its global peers. Chart 8The Leverage Picture From A Balance Sheet Perspective The Leverage Picture From A Balance Sheet Perspective The Leverage Picture From A Balance Sheet Perspective Chart 9Japan's Debt Bubble And Deleveraging Japan's Debt Bubble And Deleveraging Japan's Debt Bubble And Deleveraging Chart 10Leverage Ratios: How China Compares The Great Debate: Does China Have Too Much Debt Or Too Much Savings? The Great Debate: Does China Have Too Much Debt Or Too Much Savings? Therefore, I think we should be skeptical about the widely held view that China's corporate sector leverage is precariously high. It is at a minimum inaccurate, if not misleading, to rely solely on the debt-to-GDP ratio to reach such an ominous conclusion. Caroline: Arthur, I take it you don't agree? Arthur: Since January 2009, China's corporate and household debt has risen by RMB 130 trillion (about US$ 19 trillion) or by 100% of GDP (Chart 11). I do not believe even the most sophisticated financial/credit systems can allocate such amounts of credit in such a short time and not misallocate capital. By capital misallocation, I am implying investments in projects that do not generate sufficient cash flow to service debt. The accounting value (valuation) of assets is irrelevant in these cases; the cash flow generation is critical. The debt-to-GDP ratio is a much more superior measure to debt-to-asset-ratio. The basis is that the GDP is a proxy for cash flow, while accounting value of assets could be extremely inflated during a credit bubble. To be sure, I am not suggesting that all investments in China have gone sour. Nobody knows the extent of capital misallocation in China. But I suspect it is large enough to make a difference for the macro outlook/business cycle. Caroline: Peter, you have made the comparison between China today and Japan in the 1990s. Could you expand on that? Peter: Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 12). In order to keep unemployment from rising, the Japanese government was forced to run large budget deficits. In effect, the government ended up having to absorb the private sector's excess savings through its own dissaving. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 13). Chart 11China: The Credit Boom China: The Credit Boom China: The Credit Boom Chart 12Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Fiscal Largesse And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 13China: Debt Increased When ##br##The Current Account Surplus Began Its Descent China: Debt Increased When The Current Account Surplus Began Its Descent China: Debt Increased When The Current Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (please see Chart 8). In effect, China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere": They are a necessary evil. Caroline: Arthur, your thoughts? Arthur: What Peter and Yan in effect propose is that Chinese banks should continue creating credit/money "out of thin air" in order to create demand for these "excess" goods, i.e., overcapacity sectors. In a nutshell, a number of Chinese companies made bad decisions by over expanding capacity, and now banks have to continue lending/creating demand to justify these bad investments. As a result, persisting explosive credit growth has allowed these unviable or zombie enterprises to survive, and they are not compelled to restructure. This is not how capitalism and markets work. This is de facto socialism. Socialism usually does not lead to prosperity. One of the key reasons behind the failure of socialist economic models is that productivity growth in socialist systems is very low, often close to zero. The basis is that productivity growth is generated not by government officials but by the private sector and entrepreneurs. China's economic success over the past 35 years or so has been due to allowing private enterprises to function and flourish - not because government officials necessarily made correct business and investment decisions. I am for countercyclical fiscal and monetary policies. However, the credit boom in China has gone well beyond the countercyclical policy framework. The concept of countercyclical policies does not suggest that the government or public banks should continue to spend in perpetuity to support fundamentally unviable businesses that invested too much and created excess capacity. Besides, "countercyclical" means for a couple of years. China has been expanding bank/credit/money for about nine years - since January 2009. Peter and Yan argue that they should keep doing it further. If the authorities do what Peter and Yan propose, investors should be structurally - not cyclically - bearish on Chinese stocks. Chart 14There Has Been No Shortage ##br##Of Demand Since 2010 There Has Been No Shortage Of Demand Since 2010 There Has Been No Shortage Of Demand Since 2010 The basis is that a socialist growth model is not friendly for shareholders. Shareholders often lose money when companies operate for maximizing employment rather than profits. This is why Chinese SOEs and bank stocks trade at low multiples - because they destroy capital and value for their shareholders. Notably, "overproduction" and "excess capacity" could be an outcome of either a demand downturn or oversupply/overproduction. Keynes recommended countercyclical policies to fill the gaps when demand shrinks. Chart 15Fiscal Outlays & Credit Origination ##br##Are Close To 50% Of GDP Fiscal Outlays & Credit Origination Are Close To 50% Of GDP Fiscal Outlays & Credit Origination Are Close To 50% Of GDP In China's case, there has been no domestic demand downturn to warrant multi-year countercyclical policies. China did the right thing in early 2009 to offset its export plunge amid the Global Financial Crisis, and it helped the global economy recover. However, since 2010 global demand and mainland exports have been stable (Chart 14), making the extended and ongoing credit boom in China unwarranted and excessive. As to the argument that most credit should be counted as a form of fiscal spending, I do not think Chinese policymakers themselves would agree with this statement. In fact, if this is correct, it would mean that government officials are allocating about 50% of GDP each year. Chart 15 illustrates general (central plus local) government spending and annual credit origination as a share of GDP. How fast would productivity grow in an economy where government bureaucrats allocate 50% of GDP annually? It is true that China's central government has a low debt load so it can afford to take over a large chunk of corporate debt. If and when they do so, I will change my view. So far, they have not done this, and will likely only contemplate such a policy move when things get really messy. Investors do not want to be long China plays going into such a scenario. That said, a tactical buying opportunity could emerge when the government takes over a large chuck of corporate debt. Caroline: Yan, how worried should we be about the misallocation of capital in China? Yan: Every economy experiences some level of capital misallocation. The real question is whether China's level of capital misallocation is more serious than that of its global peers. Theoretically, if a country has a bigger capital misallocation problem than others, the economy should have systemically lower capacity utilization, weaker pricing power, and lower profitability. These metrics are easily cross-referenced: Chart 16 contextualizes China's industrial sector capacity utilization ratio relative to global peers. By and large, most countries' capacity utilization ratios hover around 80%, not much different from China's, especially since the 2000s. In fact, barring some obvious outliers, capacity utilization ratios across countries have been largely synchronized, reflecting the ebb and flow of the global business cycle. Chart 16Capacity Utilization: A Global Perspective Capacity Utilization: A Global Perspective Capacity Utilization: A Global Perspective Industrial sector output prices have shown similar swings (Chart 17). Almost all countries suffered producer price deflation in recent years, and are now experiencing a synchronized upturn in wholesale pricing power. China's falling PPI was widely regarded as a tell-tale sign of misallocation of capital. Conversely, this was in fact more a reflection of stagnating global aggregate demand and weak resource prices worldwide than structurally weak pricing power among Chinese manufacturers. Chart 17Producer Prices: A Global Perspective Producer Prices: A Global Perspective Producer Prices: A Global Perspective Similarly, Chinese listed companies' deteriorating Return on Equity (ROE) was again singled out as a sign of capital misallocation. This view is easily debunked by Chart 18, as ROEs have fallen in all major markets. In fact, Chinese companies' ROEs have been structurally higher than the global averages. Even some Chinese sectors that have been derided as being plagued by massive overcapacity and inefficiency such as materials and energy exhibit ROEs almost identical to their global peers. The important point is that we should put China in a global context, rather than analyzing it in isolation. Some Chinese firms' efficiency and profitability have weakened notably over the past several years, but to me, this is more of a reflection of the sluggish global macro backdrop, rather than an indictment of China's discrete growth model. Caroline: Turning to the investment implications, Yan, how does the debt bubble concern impact your view on Chinese equities? Yan: Global investors' widespread concerns over Chinese debt levels and other macro issues have contaminated Chinese stocks with a broad-brushed bearish undertone. Chinese equities have been unduly punished, underweighted and under-owned for many years. As shown in Chart 19, Chinese investable stocks' ROEs have been structurally higher than the global benchmark, and have followed similar cyclical fluctuations. However, their stock prices are trading at massive discounts to the global benchmarks, based on conventional yardsticks (Chart 19). This in my view represents the "China risk premium," which is unjustified and unsustainable. I expect the misperception will eventually unwind, and Chinese shares will be re-rated. This is the fundamental factor supporting my positive view on Chinese equities. Strategically it makes sense to overweight Chinese stocks against their global peers. Chart 18Chinese ROEs Are Not Inferior To Global Peers Chinese ROEs Are Not Inferior To Global Peers Chinese ROEs Are Not Inferior To Global Peers Chart 19Chinese Equities' Large Valuation Gap Chinese Equities' Large Valuation Gap Chinese Equities' Large Valuation Gap Caroline: Arthur, how does your view impact your outlook for investment prospects in China and the rest of the emerging markets space? Arthur: There has not been any adjustment in China's corporate leverage. Deleveraging in China has not yet started. On the contrary, the credit bubble is getting larger. I mean the credit-to-GDP ratio continues rising exponentially and credit and bank loan growth remain in double digits (Chart 20). It is very risky to be bullish on financial assets linked to a bubble when the adjustment has not yet begun. It is like running in front of a steamroller trying to collect pennies. Besides, when there is a major imbalance in the system like the credit bubble happening in China now, I tend to overplay the importance of marginal policy tightening and underplay the significance of easing. Recent marginal policy tightening in China - in particular the clampdown on shadow banking, including banks' off-balance-sheet asset expansion - will cause credit growth to decelerate. This is a major risk to Chinese and EM growth in the second half of this year (Chart 21). Chart 20China: Money/Credit Is Still Booming China: Money/Credit Is Still Booming China: Money/Credit Is Still Booming Chart 21Is China's Recovery At Risk? Is China's Recovery At Risk? Is China's Recovery At Risk? Even if China does not have a full-blown crisis, we are likely to experience another down leg in China plays, commodities and EM risk assets similar to the second half of 2015, when Chinese import volumes contracted and global markets tanked. A few words about the potential adjustment trajectory are in order. I have been negative on China's growth and China-related plays in global financial markets since 2010, but I have never used the word "crisis." China may or may not have a crisis, but investors holding risk assets exposed to China's growth will suffer considerable losses again similar to the 2011-16 period. It is essential to differentiate cyclical from structural growth drivers. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, China will move toward a socialist model and structural growth will tumble. That said, the growth deceleration would be gradual, as depicted in Chart 22. Chart 22Toward Socialism = Secular Stagnation And Inflation The Great Debate: Does China Have Too Much Debt Or Too Much Savings? The Great Debate: Does China Have Too Much Debt Or Too Much Savings? If we assume China's productivity is currently growing at a rate of about 5.5-6% (which is already very high and hard to sustain), and if the country embarks on a socialist path, odds are that productivity growth will drop by 50-100 basis points in each of the following years. In five years or so, productivity growth would be only around 1-3%. This path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-cycles around a falling primary growth trend. The latest acceleration in China's growth is probably one of these mini-cycles. How can investors invest in this scenario? The stylized mini-cycles depicted in Chart 22 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. In short, investing around economic mini-cycles is difficult because it assumes near-perfect timing. Caroline: Peter, is it all that bad? Peter: I think Arthur is too pessimistic. Investors have been predicting a Japanese debt crisis for years. It hasn't materialized and probably won't. They are making the same mistake about China. If China averts a debt crisis, as I think is likely, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions in local-currency terms. For global bonds, the implications are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Caroline: Yan, do domestic politics play into your outlook for the RMB versus the dollar and on a trade-weighted basis? What is your outlook for monetary policy given recent signs of improving economic momentum? Yan: How President Donald Trump will deal with China on the RMB issue is a wildcard. Recent rhetoric suggests that the new U.S. administration intends to follow normal legal protocol to decide if China is manipulating its currency. This is a significant departure from Candidate Trump's repeated campaign trail promises. If the U.S. Treasury follows the formal process laid out in the statute, it is unlikely to label China a currency manipulator in the next semi-annual assessment to be published in April, simply because the country does not meet all the criteria for that label at the moment. The odds of an immediate clash between the U.S. and China on the RMB have ebbed. From China's domestic perspective, how the People's Bank of China intends to manage the exchange rate is also a thorny issue. From a long term point of view, the PBoC clearly wants to achieve a free-floating exchange rate, but the recent downward pressure on the RMB due to elevated capital outflows has forced the PBoC to heavily intervene to prevent a vicious, disorderly cycle, in which currency depreciation and capital flight reinforce each other. In terms of monetary policy, China's improving economic momentum has allowed the PBoC to follow the Fed in raising short-term interest rates. However, tighter capital account control measures will remain in place until the downward pressure on the RMB from capital outflow dissipates. Moreover, investors have been overwhelmingly focused on the negative economic effects of a weaker RMB, somehow ignoring the reality that as the world's largest manufacturer and exporter, China also stands to benefit from a weaker currency. In my view, the depreciation of the trade-weighted RMB since 2015 has played a critical role in reflating the Chinese economy (Chart 23). A weaker RMB has helped producer prices to reflate, and lowered the real cost of funding for manufacturers, which in turn has eased China's monetary conditions and supported cyclical growth improvement. In this vein, the downside of the RMB should be self-limiting, as the reflationary impact of a weaker exchange rate will help boost Chinese growth, which in turn will reduce downward pressure on the currency. Caroline: Peter and Arthur, is rampant capital flight still a risk? Where do you see the RMB heading over the coming 12-18 months? Peter: I think the RMB will weaken somewhat over the coming year, but that is more a reflection of my bullish view on the dollar than a bearish view on the yuan. Much of the capital flight that China has experienced recently has just been an unwinding of the hot money flows that entered the country over the preceding four years. Despite all the talk about a credit bubble, Chinese corporate external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 24). At this point, most of the hot money has exited the country and hence, I expect the pace of capital outflows to subside. Chart 23A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery A Weaker RMB Leads Cyclical Recovery Chart 24The Rise And Fall Of Corporate Foreign Credit The Rise And Fall Of Corporate Foreign Credit The Rise And Fall Of Corporate Foreign Credit Nevertheless, the chronic shortfall of domestic demand that I described earlier will keep pressure on the Chinese government to try to export excess production abroad by running a larger current account surplus. This requires a weak currency. Thus, while I don't expect the yuan to plummet, I don't expect it to soar either. Arthur: I believe the RMB is set to depreciate by 10% or more against the U.S. dollar in the next 12 months or so. The Chinese yuan is not expensive, but it will stay under downward pressure because the mainland banking system has created too many yuan. When the supply of money goes vertical, its price drops. It seems the Chinese people are sensing there is too much RMB floating around, and they are trying to get rid of local currency. They have been overpaying for properties and have been shifting their wealth into foreign currencies. Finally, in China, the real deposit rate has turned negative (Chart 25, top panel). In the past, when the real deposit rate turned negative, the central bank hiked interest rates (Chart 25, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Chart 25Real Deposit Rate Is Negative Real Deposit Rate Is Negative Real Deposit Rate Is Negative In brief, I expect capital outflows to persist and policymakers to allow the currency to depreciate further. Caroline: Peter/Yan/Arthur: Final thoughts: What are each of you watching for signs that China's macro landscape is evolving as you expect? Conversely, what would signal that your assessment has missed the mark? Peter: I am watching for signs of a policy mistake. Until China can reorient its economy towards one that is more consumer-centric, it will have to rely on high levels of investment to sustain aggregate demand. Any attempt to aggressively curb debt growth will only backfire. Arthur talks about resource misallocation from subpar investment projects, but there is no worse resource misallocation than a person who wants a job but can't find one. I am also watching trade policy. I don't think a trade war between China and the U.S. is in the cards for the time being, but if the U.S. economy turns down in 2019, as I expect, Trump will be backed into a corner. And with another election looming, he will strike out at China. That could trigger a global trade war. Yan: I agree with Peter that we should watch for policy mistakes and some sort of "Trump shock," both of which constitute downside risks. A less talked-about risk is potential growth overheating, which could require much tighter policy, leading to greater economic volatility. In fact, some cyclical indicators that are tightly linked to industrial activity have rebounded sharply, which is also reflected in the rebound in some raw materials prices. If exports get a further boost from continued improvement in the U.S. economy, the possibility of China's economy overheating cannot be completely dismissed. Another potential trouble spot is the housing market. The Chinese authorities have begun to tighten housing policy, but developers appear to be gearing up for another construction cycle. Sales of construction equipment such as heavy trucks and excavators have soared. Historically, construction machine sales have been tightly correlated with real estate development (Chart 26). If history is any guide, the renewed strength in construction equipment sales could be a harbinger of an impending boom in new home construction. This is good news for business activity and GDP growth, but probably antithetical to policymakers' broad agenda. We will follow up on these issues closely in our future reports. Arthur: The key variables to watch are various interest rates, credit/loan growth and inflation - in addition to keeping an eye on lending standards and credit demand. Recent increases in borrowing costs amid the enormous credit overhang give me confidence to argue that China's credit origination and economic growth are bound to decelerate later this year. A billion-dollar question is whether the recent rise in China's consumer inflation is transitory or the beginning of a notable uptrend (Chart 27). If consumer price inflation rises to 3% and higher, the game will be over - interest rates will need to go up and credit growth will tumble. If interest rates do not rise amid intensifying inflationary pressures, capital outflows will escalate and the currency will depreciate a lot. Chart 26An Upturn In Housing Construction? An Upturn In Housing Construction? An Upturn In Housing Construction? Chart 27China: Inflation Is Picking Up China: Inflation Is Picking Up China: Inflation Is Picking Up I will be wrong if policymakers manage to slow down credit growth from 11-12% toward 7-8% or so without generating notable economic weakness. This can occur only if productivity growth in China accelerates meaningfully. It is difficult to observe productivity growth in real time - it is a black box. 1 Please see Emerging Markets Strategy Special Report, titled "Do Credit Bubbles Originate From High National Savings?" dated January 18, 2017, available at ems.bcaresearch.com. 2 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 3 Please see Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 4 Please see Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com.

Highlights In any country, excess national savings, i.e., current account surpluses, lead to an accumulation of net foreign assets, but have no implications on domestic loan creation. Savings are not necessary for the banking system to originate loans. Quite the opposite, new loans boost purchasing power and spending and, thereby, create new income and additional savings. Unlimited loan/money creation will ultimately lead to currency depreciation and/or inflation. The RMB is at major risk because Chinese banks continue creating enormous amount of credit/money "out of thin air." Feature This week we publish the third report in our trilogy series on money, credit, savings and investment, where we address several misconceptions that dominate mainstream macroeconomic thought as well as the investment industry. Our previous Special Reports were: Misconceptions About China's Credit Excesses, and China's Money Creation Redux And The RMB.1 This third report focuses on: (1) Elaborating on the link - or lack thereof - between the investment-savings identity and domestic credit creation in any country; (2) Demonstrating how new loans lead to new income and ultimately new savings creation, and not, vice versa; (3) Discussing the macro limits to money/credit creation among banks. Macroeconomics has many areas that are not well understood or developed. We do not pretend to have all the answers related to savings and loan origination and their links to other factors. Even though all points of this report are applicable to any economy, the practical relevance and goal of our analysis is to demonstrate that China's credit excesses are not the natural outcome of its unique macro features such as a high savings rate. In fact, the leverage expansion that has been underway since early 2009 (Chart I-1) is nothing more than a credit bubble driven by banks willingness to create credit exponentially and policymakers' tolerance of it. Chart I-1Chinese Companies Are Extremely Leveraged Favor Indian Banks Versus Chinese Ones Favor Indian Banks Versus Chinese Ones That said, this does not mean that the Chinese credit bubble is about to burst. BCA's Emerging Markets Strategy service has been negative on China's credit cycle and growth since 2010, yet has never used the word "crisis". China may well experience one at some point, but it is impossible to time it. A more distinct possibility is that the country's growth could stagnate/slump further, and financial markets leveraged to its growth sell off materially - particularly in the wake of last year's rally. The investment implications are that there is more downside to Chinese financial markets and China-related plays globally. National Savings And Domestic Credit Creation One of the prevailing notions that justifies China's large credit excesses, as elaborated by some of my colleagues at BCA and others in the investment industry as well as academia is as follows: A current account surplus implies that national savings exceed investment. If a country generates a lot of national savings, as China does, it must either absorb those savings through domestic investment or, where possible, export the savings to the rest of the world by running a large current account surplus. As a reminder to readers, the investment-savings identity is as follows: Investment = Savings is an identity for a closed economy; and Savings (S) - Investment (I) = Current Account Balance (CA) holds true for an open economy. While on the surface this proposition might appear very intuitive, a deeper examination reveals there is no link at all between the national savings-investment identity (S - I = CA) and domestic credit creation in any country: S - I = CA is an identity of the real economy. It means an economy produces more goods and services than it consumes, and that the difference between production and consumption (excess supply) is being exported. Hence, "excess savings" here are "real excess savings" in the form of goods and services that were produced but not consumed in the economy, but rather sold abroad. These "real excess savings," or the CA surplus, have nothing to do with aggregate deposits in the country's banking system, or money/credit origination by its banks. As we elaborated in the first report of our three-part series, banks do create loans and deposits "out of thin air". Banks do not intermediate deposits into loans. They create deposits when they originate loans. For a more detailed discussion on this, readers should refer to our report titled, Misconceptions About China's Credit Excesses.2 Consequently, banks can create as much in the way of loans as they like (subject to the regulatory capital constraints), regardless of the country's current account balance. Chart I-2 and Chart I-3 depict that, historically, in various countries there has been no correlation between the national and household savings rates and bank credit origination. Chart I-2China: Credit And Savings ##br##Are Not Correlated China: Credit And Savings Are Not Correlated China: Credit And Savings Are Not Correlated Chart I-3The U.S., Korea And Taiwan: ##br##Credit And Savings Are Not Correlated NPL Ratios In Perspective: India & China NPL Ratios In Perspective: India & China When a country runs a current account surplus, it does not mean it brings in "excess savings" and invests those funds domestically. A current account surplus (or an excess of national savings over investment) only means that the country's net foreign assets will rise - i.e., the nation's "excess savings" have to be exported in the form of capital outflows (more on this below). On the whole, the S - I = CA identity is derived from the national accounts and balance of payments, and it has no relationship to how loans and deposits are created within the domestic banking system. Empirical evidence supports neither positive nor negative correlation between the current account balance and loan origination. For example, Germany has had massive current account surpluses, but its non-financial debt-to-GDP ratio has been stable (Chart I-4). On the contrary, the U.S. and Turkey have been running large current account deficits, while their domestic credit and leverage has boomed (Chart I-5 and Chart I-6). Chart I-4Germany: National Savings And Debt India: Public Bank Loan Growth Has Slumped India: Public Bank Loan Growth Has Slumped Chart I-5U.S.: National Savings And Debt India's Capital Spending Is Sluggish India's Capital Spending Is Sluggish Chart I-6Turkey: National Savings And Debt Indian Consumer Health Is Strong Indian Consumer Health Is Strong As the popular argument goes, more national savings lead to more deposits within the domestic banking system and ultimately more domestic loans stem from the application of the intermediation of loanable funds (ILF) model of banking. The ILF model states that banks intermediate deposits (savings) into loans. Yet, as we argued in the first report of this series, the ILF model is simply wrong. Commercial banks create both loans and deposits, simultaneously, "out of thin air". Consequently, any macro thesis that uses or relies on the ILF model is misguided. Bottom Line: National savings is a real economy concept, and has no relevance to loan creation and leverage in the country in question. Below we show that current account (CA) surpluses ("excess savings") lead to an accumulation of net foreign assets, but have no implication for domestic leverage. CA Surplus = Accumulation Of Net Foreign Assets CA surpluses are consistent with a nation expanding its net foreign assets, while CA deficits are congruent with a reduction in a country's net foreign assets. They do not suggest anything about domestic credit origination and leverage. Chart I-7U.S. Net International Investment Position India's Employment Is Turning The Corner India's Employment Is Turning The Corner The mechanism of converting CA surpluses into net foreign assets (external assets minus external liabilities) is somewhat different between fully floating and managed exchange rate regimes, so we consider both cases: A fully flexible exchange rate (the central bank does not interfere in the currency market): Let's assume Country A had a current account surplus over a given period. Exporters can keep the proceeds abroad and buy foreign assets, or bring them back and sell these dollars to other domestic players who want to buy foreign assets. Alternatively, exporters can sell these dollars to foreigners who sold assets in Country A and want to repatriate capital out of Country A. In this case, the nation's net foreign assets still rise because foreigners' claims on its assets shrink. Provided the central bank does not intervene in the currency market and the balance of payments, by definition, equals zero, the current account surplus is offset by a deficit on capital/financial accounts. In brief, the sole result of an excess of national savings relative to domestic investment is net capital/financial outflows and an ensuing increase in a country’s net foreign assets. This does not lead to any change in the banking system’s local currency loans.3 Chart I-7 demonstrates that the U.S.'s net foreign assets have dropped from - US$ 0.4 trillion in 1995 to - US$ 6 trillion currently, because the U.S. has been running current account deficits - i.e., on a net basis, foreigners have accumulated enormous amounts of claims on America. In spite of these persistent CA deficits and a low national savings rate, the U.S. bank loan-to-GDP ratio has risen substantially over the same period, proving the lack of relationship between national savings and loan origination. In the case of a managed or fixed exchange rate system (i.e., when the central bank intervenes in the currency market, by buying/selling foreign exchange), the dynamics are somewhat different, yet the end result is the same. If Country B has a current account surplus and its central bank is involved in managing the exchange rate, the central bank could buy foreign currency and thereby accumulate net foreign assets. Hence, the dynamics are the same, but the nation's central bank, rather than other economic agents, amasses more net foreign assets. If foreign exchange interventions are not completely sterilized, the central bank’s accumulation of foreign assets will be accompanied by issuance of high-power money (banks' reserves at the central bank) and new money (bank deposit) creation, but not a loan creation.4 Some observers might argue that the increase of bank reserves at the central bank would lead commercial banks to originate more loans. However, in the first and second reports of our trilogy series, we documented that commercial banks in the majority of countries, including all advanced economies and China, do not require central bank liquidity to originate loans. On the contrary, banks originate loans first and then, if needed, ask the central bank for liquidity. Chart I-8The PBoC Has Begun ##br##Targeting Rates In Recent Years India: PMIs Are Positive India: PMIs Are Positive In the case of China, there is evidence that from early 2014 until very recently, the People's Bank of China (PBoC) was targeting short-term interest rates (Chart I-8). When any central bank targets the price of money (interest rates), it cannot steer/manage the quantity of money - i.e., it has to provide/withdraw as much liquidity as commercial banks desire at a given interest rate level. Therefore, since early 2014, the PBoC has met commercial banks' demand for liquidity by keeping interest rates at its preferred target. In such a case, commercial banks - not the PBoC - decide on the amount of loan origination at a given interest rate level. Even in this case, the CA balance has no bearing on loan origination by commercial banks. Central banks nowadays steer loan growth and economic growth primarily via interest rates. Unless the current account dynamics lead the monetary authorities to alter interest rates, balance of payments dynamics will not have direct impact on credit growth. Bottom Line: A CA surplus raises a nation's net foreign assets, while a CA deficit reduces its net foreign assets. CA balances do not affect or determine commercial banks' capacity for domestic credit creation. Savings Are Not A Constraint On Loan Origination Mainstream economic literature typically relies on treating deposits as savings - i.e., refraining from spending by households or enterprises. Then, it uses the Intermediation of Loanable Funds (ILF) model to argue those savings flow to the banking system to become deposits. In turn, banks intermediate these savings (deposits) into loans. We have to again emphasize that the ILF model is simply wrong - in reality, this is not how the banking system works in any country in the world. This was the focal point of the first report of our trilogy. In particular, Fabian Lindner states that "...saving does not finance investment. No saving and abstention of consumption is needed for any lending to take place since lending and borrowing money are pure financial transactions that only affect gross financial assets and liabilities."5 Similarly, Zoltan Jakab and Michael Kumhof utter: "In the ILF model, bank loans represent the intermediation of real savings, or loanable funds, between non-bank savers and non-bank borrowers. But in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor". 6 They also provide a further distinction between savings and financing: "...if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does." 6 Let's consider an example: Company A - which intends to build a production facility - requests a loan from Bank Z. After approving the loan request, Bank Z opens an account for Company A and grants a loan of $100 million by crediting Company A's bank account and in turn creating purchasing power for the company. Hence, Bank Z originated a loan and deposit of $100 million "out of thin air". As Company A uses this amount to pay for construction of production facility, it pays the builder, architects, engineers and various suppliers. These entities, in turn, pay their own suppliers as well as their employees, while the profits (dividends) are remitted to shareholders. All entities, and ultimately their employees and shareholders involved in the project, derived income from the original loan. Thus, their income was contingent on the loan that was originated by Bank Z and spent by Company A. Without it, these households, other companies and their shareholders would not have earned that income. In turn, these households and companies would spend/consume part of their income and save the other part. A few observations: Loan creation by Bank Z generated household income and enterprise profits that otherwise would not have occurred. This extra income would produce extra saving. In other words, without the loan origination by Bank Z, these extra savings would not have arisen. The fact that all companies and their employees involved in this project decided to save a part of their income does not mean they deposited new funds at their banks. Their "savings" already existed in the banking system. In fact, these deposits were created by Bank Z when the latter originated the loan. Ultimately, with banks willing to originate new loans, spending can exceed current income. Claudio Borio of the Bank for International Settlements corroborates this point: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated".7 Bottom Line: Savings are not necessary for the banking system to originate loans and finance investment and consumption. Quite the opposite, new loans boost spending and create new income and additional savings (even though they may not impact the savings rate). Applying this to China, this means that the absolute amount of household savings is high because before 2008 booming exports, and since 2008 mushrooming loan growth, produced robust income growth. In sum, households decide on their savings rate, yet the credit boom since 2008 has tremendously boosted their income and has thereby expanded the absolute amount of their savings. Limits On Country Loan Origination Does this mean any country (specifically, its commercial banks) can originate unlimited amounts of loans/money, and thereby print their way to prosperity? To date, no country we are aware of has accomplished this. Indeed, if this were the case, there would be no poor countries. In the first report of our trilogy, we elaborated on the constraints banks face in originating loans, such as tighter monetary policy, lack of credit demand, government regulations and capital requirements, bank shareholders appetite to lend and liquidity constraints for banks. Chart I-9China: Signs Of Budding Inflation India's Share In Global Trade India's Share In Global Trade Herein we elaborate on limits at a macro level for banks to originate loans and finance investment and consumption. The supply side of an economy and its capacity to produce goods and services that are in demand is ultimately a macro constraint on credit/money issuance. China's ability to sustain such rapid money creation has been due to its strong supply side - i.e., its productive capacity. This makes China different from other emerging markets such as Turkey. China has low inflation and a CA surplus, while Turkey has had high inflation and a large CA deficit. Ultimately, a country's growth trajectory depends on its potential growth, which is the sum of labor force growth and productivity growth. China's "economic miracle" of the past 30 years has been due to its productivity, not credit/money creation. Money/credit origination greases the wheels of the supply side "machine" but does not replace it. Indeed, China's productivity boom over the past three-plus decades has been due to reforms that have allowed for the emergence and development of private enterprises, and attracting foreign technology/know-how. It has not been due to government control over the economy and credit creation. By and large, China is facing two potential growth trajectories, as depicted in Chart I-12 and Chart I-13 and explained in Box 1 on pages 13-15. A credit-driven economic downtrend entails deflation, while the path towards socialism warrants inflation. Barring a deflationary credit-driven growth slump, inflation in China will pick up sooner than later. The reason is that growing state control of the economy and resource allocation means poor capital allocation and much slower productivity - and in turn potential GDP growth. The latter, along with double-digit credit, creates fertile ground for an inflation outbreak (Chart I-9). If banks create too much money/credit, the price of money will go down- i.e., the currency will ultimately depreciate both versus foreign currencies as well as relative to goods/services and real assets like property. Chinese banks have created too much money (RMBs), and it is not surprising property prices have gone exponential and that the RMB is under downward pressure. In fact, Chinese households may be sensing there are too many RMBs floating around, and want to get rid of them by converting them into foreign currencies and buying real assets (real estate). On the whole, the exchange rate is a key to China's macro dynamics. If unrelenting credit creation persists, the yuan will continue to fall because Chinese households and companies will be reluctant to hold local currency. In such a case, credit origination will have to be curtailed to stabilize the exchange rate. Bottom Line: Unlimited credit/money creation will ultimately produce a major currency depreciation and/or inflation. These, in turn, will short-circuit the credit boom. Conclusions When investors and commentators justify exponential moves in credit or asset prices by the unique features of a particular economy - implying this time is really different - critical consideration is warranted. For example, Japan's 1980s bubble was justified by exclusive particularities of the Japanese economy; Hong Kong's real estate bubble of the 1990s was justified by limited land on the island; and the U.S. tech bubble of the late 1990s was explained by a "new era of productivity brought on by technology." Needless to say, in retrospect we know that these were bubbles, and they all deflated. Explaining away China's exponential surge in domestic leverage as a bi-product of its high savings rate makes us wary. The report explains why high national savings rates do not warrant high credit creation. China is facing two potential growth roadmaps, as depicted in Chart I-11 and Chart I-12 and elaborated in Box 1 (see page 13-15). Regardless of which way China's economy evolves, the medium-term outlook for mainland growth is downbeat. BCA's Emerging Markets Strategy team expects double-digit RMB depreciation in the next 12 months. We continue to recommend short positions in the RMB via 12-month NDFs. This is the rationale behind our negative stance on Asian currencies. We believe EM equities, credit markets and currencies will underperform their DM counterparts, regardless of the trajectory of share prices in the U.S./DM. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com BOX 1 Two Growth Path Forward For China1 1. Short-Term Pain / Long-Term Gain If the authorities were to allow market forces to prevail, the state should withdraw meaningfully from the credit allocation process. In that case, credit markets will bring discipline to both debtors and creditors - in effect, an emerging perception of potential losses rather than government-led bailouts will make creditors less willing to lend, and debtors less willing to borrow and expand. The result will be a considerable dampening in credit origination. In this scenario, it is very likely that credit growth slows from 12% currently to the level of potential nominal GDP growth of 7-8% or lower (Chart I-10), leading to a classic credit-driven economic downtrend (Chart I-11). In that case, cyclical growth will undershoot. Chart I-10China: Credit Is Outpacing ##br##GDP Growth By Wide Margin India Has Been Losing Export Market Share India Has Been Losing Export Market Share Chart I-11Capitalist-Style Credit-Driven Downtrend India's Education Improvement Has Stalled India's Education Improvement Has Stalled However, potential GDP growth (the red line in Chart I-11) - which has been falling in recent years - will stabilize and probably improve. The reason being that by allowing market forces to prevail in credit allocation and corporate restructuring/reorganization, China will ultimately improve its capital allocation and productivity. In brief, potential GDP growth - which equals productivity growth plus labor force growth - will stop falling and, in fact, could improve as productivity growth ameliorates. 2. No Short-Term Pain But Long-Term Stagnation It is essential to differentiate cyclical growth drivers from structural ones. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, structural growth will tumble and China will embark on a path of economic stagnation. That said, the growth deceleration would be gradual, as depicted in Chart I-12. Chart I-12Toward Socialism = Secular Stagnation And Inflation Upgrade Indian Bourse Within EM Universe Upgrade Indian Bourse Within EM Universe A rising role of state and government officials in capital allocation and business decision-making guarantees suboptimal capital allocation, resulting in poor efficiency and declining productivity growth. Since China's labor force growth is projected to be flat-to-negative, the sole source of potential GDP growth going forward will be productivity growth. Besides, it is much easier to achieve high productivity growth in manufacturing than in the service sector. Finally, high productivity growth is possible when the productivity level was low. From the current levels, it is hard to grow productivity more than 5-6% annually. Chart I-13Socialist Put Will Depress ##br##Productivity Growth Socialist Put Will Depress Productivity Growth Socialist Put Will Depress Productivity Growth If we assume China's productivity is now about 6% (which is already very high) (Chart I-13), and if the country embarks down this path, odds are that productivity growth might drop by 100 basis points in each of the following years. In five years or so, productivity growth would be only around 1%. Given that labor force growth will be zero, if not contracting, in five years' time, potential GDP will drop to 1% or so, as shown in Chart I-12 on page 14. Hence, this path is the ultimate recipe for economic stagnation in China. The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-recovery cycles around a falling primary growth trend. The latest acceleration in China's growth is probably the first mini-cycle. How can investors invest in this scenario? The mini-cycles depicted in Chart I-12 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. Besides, financial market swings for China-related plays will differ from the economy's growth mini-cycles because markets can be driven by factors other than growth like politics, geopolitics, credit events, and other global variables such as the U.S. dollar and bond yields. In short, this analysis explains why we have been and remain bearish on China-related financial markets despite the stimulus that has been injected about a year ago. Investing around economic mini-cycles is difficult because it assumes near-perfect timing. Without that, investors cannot make money. 1 Originally published in January 11, 2017 EMS Weekly Report. 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, the links are available on page 18. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, the link is available on page 18. 3 This example assumes that neither the central bank nor local commercial banks are buying foreign currency. In the case when a commercial bank buys foreign currency, that transaction creates new money/deposit in the banking system although it does not create a new loan. The opposite is also true: when a commercial bank sells foreign currency, existing money/deposits are destroyed. 4 This example assumes that the local commercial banks are not buying foreign currency and only the central bank buys foreign currency from non-banks. 5 Lindner, F. (2015), "Does Saving Increase the Supply of Credit? A Critique of the Loanable Funds Theory", World Economic Review 4: 1-26, 2015 6 Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 7 Borio, C. and Disyatat, P. (2015), "Capital Flows and the Current Account: Taking Financing (more) Seriously", BIS Working Papers, No. 525, October 2015 Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Mind The (Output) Gap Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3a bca.gis_wr_2016_12_23_c3a Chart 3BJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3b bca.gis_wr_2016_12_23_c3b Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4a bca.gis_wr_2016_12_23_c4a Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4b bca.gis_wr_2016_12_23_c4b Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Global Debt Levels Are Still High Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate bca.gis_wr_2016_12_23_c9 bca.gis_wr_2016_12_23_c9 Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights A central bank cannot control/target the quantity and price of money simultaneously. For the past few years, China's central bank has silently moved away from controlling money growth toward targeting interest rates. As such, the reserve requirements imposed on banks have not and will not be a constraint on Chinese commercial banks' ability to lend and create money if the PBoC continues to supply banks with reserves "on demand." China's banks have created too many RMBs (broad money/deposits) and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Continue shorting the RMB and Asian currencies versus the U.S. dollar. Re-instate a short Colombian peso trade; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble. Feature Following our October 26 Special Report titled, "Misconceptions About China's Credit Excesses",1 some clients have asked us how our analysis squares with fact that the People's Bank of China (PBoC) conducts its monetary policy using a reserve requirement ratio. The relevant question being, why would the PBoC's reserve requirements not limit commercial banks' ability to create money/credit? In that Special Report, we wrote: "A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks "on demand." Given PBoC lending to banks has surged 5.5-fold over last three years (Chart I-1), we concluded that the reserve requirement ratio had, for all intents and purposes, lost its meaning in China. In this week's report we elaborate on this issue in detail. The main implication of our analysis today reinforces our conclusion from the previous report: namely, China's commercial banks have expanded credit enormously, and the PBoC has accommodated it. With respect to financial market implications, there are simply too many RMBs (broad money/deposits) in the system (Chart I-2). Chinese households and companies can instinctively sense this, and are opting to move their wealth into real assets, such as real estate, or foreign currencies. Hence, the oversupply of RMBs will continue to weigh on China's exchange rate, which will depreciate much further. We expect the US$/CNY to reach 7.8-8 over the next 12 months. Chart I-1The PBoC Has Provided Banks With Liquidity 'On Demand' bca.ems_sr_2016_11_23_s1_c1 bca.ems_sr_2016_11_23_s1_c1 Chart I-2There Are Too Many RMBs Floating Around bca.ems_sr_2016_11_23_s1_c2 bca.ems_sr_2016_11_23_s1_c2 Targeting Either The Quantity Or The Price Of Money Any central bank can target and control either the quantity of money or the price of money, but not both simultaneously. This holds true for any monopolist supplier of any good/service that does not have control over the demand curve. A demand curve for money is the function that ties the quantity demanded at various price points (the price being interest rates). Central banks - being monopolist suppliers of money, but unable to control money demand - must choose between controlling either the quantity of money or the price of money. The system of required reserves (RR) is a tool to control money supply (the quantity of money). When central banks reinforce the RR ratio, interbank interest rates typically swing enormously and often deviate considerably from the target policy rate (Chart 1). For example, when commercial banks expand loans too much and lack sufficient reserves at the central bank, they must borrow from the interbank market and thereby bid up interbank rates- i.e., short-term interest rates rise. This in turn restrains credit demand or the willingness to lend, and eventually reduces money growth. The opposite also holds true. When a central bank wants to target interest rates (the price of money), it cannot control money supply. To ensure that interbank/money market rates stay close to the policy rate - i.e., to reinforce its interest rate target - a central bank should provide the banking system with reserves "on demand." In other words, when interbank rates rise above the target policy rate, a central bank should inject sufficient liquidity into the system to bring interest rates down. Similarly, when interbank rates fall below the target policy rate, a central bank should withdraw enough liquidity from the banking system to assure interbank rates rise converging to its target policy rate. By supplying commercial banks with reserves (high powered money) "on demand" - i.e., providing as much reserves as they need - a central bank is de facto failing to enforce reserve requirements. As such, the central bank is giving up control over money creation. By and large, RRs lose their effectiveness if a central bank provides commercial banks with as much reserves as they request. In short, when a central bank opts for targeting interest rates, it cannot steer monetary aggregates - i.e., RRs and RR ratios lose their meaning. In the 1970s and 1980s, most central banks in advanced countries targeted money supply to achieve their policy goals such as inflation and sustainable economic growth. However, starting in the early 1990s, developed nations' central banks (the Federal Reserve, the Bank of England, the Bank of Canada, the Swiss National Bank and others) began to move away from controlling money supply (monetary aggregates) and toward targeting interest rates. Individual banks' limitations to borrow from the central bank often rests with the availability of collateral. So long as a commercial bank has eligible collateral (often government bonds), it can access central bank funding. This is true for Chinese commercial banks too. Bottom Line: Monetary authorities cannot control/target the quantity and price of money simultaneously. The Money Multiplier In An Interest Rate Targeting System When a central bank opts for targeting interest rates, commercial banks can originate an unlimited amount of loans and demand the central bank provide additional reserves, as long as they have eligible collateral. This corroborates our point from our previous report that a commercial bank's loan origination is not constrained by its reserves at the central bank if the latter supplies liquidity (reserves) "on demand." In a fractional reserve system, the ability of commercial banks to create loans/money is defined by a money multiplier. A potential ceiling for a money multiplier (MM) is calculated as: MM = (1 / RR ratio) For example, when the RR ratio is 10%: The money multiplier MM = (1 / 0.1) = 10 In effect, the banking system can create up to 10 times more money/loans/deposits per one dollar of reserves. Under the current system of interest rate targeting – which has prevailed among most developed countries since the early 1990s and more recently in China (more on China below) – we can think of the RR ratio as heading towards zero because central banks provide banks with almost unlimited liquidity (reserves). The RR ratio is not zero because there are still limitations on banks' ability to borrow from central banks due the availability (or lack thereof) of eligible collateral or compliance with Basel III requirements. Yet as the RR ratio gets smaller in size, its reciprocal (1 / RR ratio) becomes very large (not infinite, but a plausibly very large number). Overall, when a central bank targets interest rates, the ceiling of the money multiplier is not set by the central bank. Rather, the money multiplier is de facto determined by commercial banks' willingness to originate loans. Thus, the money multiplier can potentially be very high when animal spirits among bankers and borrowers run wild. Consequently, the points discussed in our Special Report titled, "Misconceptions About China's Credit Excesses"2 - namely that commercial banks create loans/money/deposits out of thin air - holds, and is relevant in a system where central banks target/control interest rates. Bottom Line: When central banks opt to control short-term interest rates, they must provide commercial banks with as much liquidity as the latter demands. In such a case, RRs and the RR ratio become almost irrelevant. Therefore, in an interest rate targeting system, banks' ability to originate loans/create money and deposits is not contingent on their reserves at the central bank. This point is greatly relevant to China. The PBoC: Shifting From Money To Interest Rate Targeting For the past few years, China’s central bank has silently moved away from controlling money growth to targeting interest rates. As a result, nowadays the PBoC has very little quantitative control over money/credit creation by commercial banks or the money multiplier. It is Chinese commercial banks that effectively drive money/credit/deposit creation. Chart I-3SHIBOR Crises In 2013 Forced PBoC ##br##To Start Targeting Interest Rates bca.ems_sr_2016_11_23_s1_c3 bca.ems_sr_2016_11_23_s1_c3 We suspect this shift in China's monetary policy management has been occurring since early 2014 on the heels of the so-called SHIBOR crisis, which erupted in June 2013 when interbank rates surged and was followed by another spike in interbank rates in December 2013 (Chart I-3). During these episodes, the PBoC enforced reserve requirements and thus did not provide liquidity to banks that were running short on it. In essence, it did whatever a central bank targeting money growth via control over RR would do. However, as interbank rates surged and banks complained, policymakers backed off, and provided banks with as much liquidity as they demanded. This stabilized interbank rates and, importantly, appears to have marked the PBoC's shift toward interest rate targeting. Thus, by de facto moving to a monetary system of targeting interest rates, the PBoC cannot effectively reinforce reserve requirements because it must supply any amount of reserves that commercial banks require to preclude a major spike in interbank rates. A few points illustrate that in fact the PBoC has been targeting short-term money market rates, and banks have expanded loans enormously despite their excess reserves being flat: Volatility in interbank rates has dropped substantially (Chart I-4), as the PBoC's claims on commercial banks has exploded 5.5-fold since the early 2014. Even though commercial banks' excess reserves have been flat, their lending has been booming - i.e., the money/credit multiplier has been rising (Chart I-5). This is only possible when the PBoC has been supplying reserves "on demand" or when it cuts the RR ratio. Since the RR ratio has not been cut over the past two years, it means that the former is true. Chart I-4Interbank Rate Volatility Has Fallen As ##br##PBoC Injected A Lot Of Liquidity bca.ems_sr_2016_11_23_s1_c4 bca.ems_sr_2016_11_23_s1_c4 Chart I-5China's Money/Credit Multiplier##br## Has Been Rising bca.ems_sr_2016_11_23_s1_c5 bca.ems_sr_2016_11_23_s1_c5 Just like central banks in advanced economies, the only way the PBoC can alter money/credit growth is if it lifts or cuts its interest rate target. Barring any changes to its policy rate, commercial banks, not the PBoC, determine money/loan/deposit creation in China. As to other factors that determine the amount of credit/money creation by commercial banks in China, we elaborated on these in the above-mentioned report. Bottom Line: It appears the PBoC has shifted toward targeting interest rates. Consequently, the PBoC cannot pretend to control money/credit origination unless it changes its interest rate target. Moreover, we reiterate that China's abnormal credit growth has been the result of speculative behavior among Chinese banks and borrowers, and not the natural result of the country's high savings rate. Oversupply Of RMBs = A Lower Currency As China's central bank has been printing RMBs and commercial banks have been "multiplying" them at a high rate (by originating loans), the supply of RMBs has continued to explode. Such an oversupply of local currency will continue to depress the value of the nation's exchange rate. The PBoC's liquidity injections have exploded in recent years (Chart I-6). The central bank has not only been offsetting the liquidity withdrawal due to its currency foreign exchange market interventions, but it has also been providing banks with as much liquidity as they require. The objective seems to have been to avoid a rise in interbank rates when corporate leverage is extremely high and banks are overextended. Since February 2015, the PBoC's international reserves have dropped by US$0.9 trillion, or 4.2 trillion RMB (Chart I-7). This means that the PBoC has withdrawn 4.2 trillion RMBs from the system. If the central bank did not re-inject these RMBs into the financial system, interbank rates would have skyrocketed. As the PBoC has injected RMBs into the system, it has effectively undone its RMB defense. The whole point of defending the exchange rate from falling or depreciating too fast is to shrink local currency liquidity. Yet, naturally, that would also lead to higher interbank rates. If the central bank chooses not to tolerate higher interest rates and continues to inject local currency into circulation, the RMB's depreciation will likely continue and accelerate. By injecting RMBs into the system, the monetary authorities have allowed banks to continue to lend, thereby creating enormous amounts of money and deposits. Banks create deposits when they lend. The Chinese banking system has a lot of deposits partially because commercial banks have lent too much. In short, the supply or quantity of money (RMBs) has continued to explode, despite massive capital outflows. Notably, if the PBoC did not lend RMBs to commercial banks, the latter's excess reserves would have plunged by 4 trillion RMB (Chart I-8) and banks would have been forced to pull-back their lending. Chart I-6PBoC's Liquidity Injections Have ##br##Exploded Since Early 2014 bca.ems_sr_2016_11_23_s1_c6 bca.ems_sr_2016_11_23_s1_c6 Chart I-7China: Foreign Exchange##br## Reserve Depletion bca.ems_sr_2016_11_23_s1_c7 bca.ems_sr_2016_11_23_s1_c7 Chart I-8China: What Would Have Banks' Excess Reserves##br## Been Without Borrowing From PBoC? bca.ems_sr_2016_11_23_s1_c8 bca.ems_sr_2016_11_23_s1_c8 Overall, in the current fiat money system, when a central bank targets interest rates, the monetary authorities can print unlimited high-powered money (bank reserves) and commercial banks can multiply it by creating enormous amounts of loans/deposits.3 However, there is no free lunch - no country can print its way to prosperity (otherwise all countries would have been very rich already). The negative ramifications of unlimited money creation are numerous, but this report focuses on the exchange rate implications. The growing supply of RMBs will lead to a much further drop in China's exchange rate. It seems Chinese retail investors and companies intuitively sense this, and are eager to get rid of their RMBs. This also explains Chinese investors' desire to overpay for any real or financial asset, domestically or abroad. We expect growing downward pressure on the RMB as capital outflows accelerate anew. Although China’s foreign exchange reserves are enormous in absolute U.S. dollar terms, they are low relative to money supply (Chart 9). The ratio of the central bank’s international reserves-to-broad money is 15% in China and it is relatively low compared with other countries (Chart 10). Chart I-9China: International Reserves Are Not##br## High Relative To Broad Money bca.ems_sr_2016_11_23_s1_c9 bca.ems_sr_2016_11_23_s1_c9 Chart I-10International Reserves-To-Broad##br## Money Ratio China's Money Creation Redux And The RMB China's Money Creation Redux And The RMB As a final note, the oversupply of local currency has not created inflation in the real economy because of massive overcapacity following years of booming capital spending. However, continued money creation will eventually lead to higher inflation. This does not seem imminent but we will be monitoring these dynamics carefully going forward. Bottom Line: China's banks have created too much RMBs and the PBoC has accommodated them. Such enormous supply of RMBs and mainland households' and companies' desire to get rid of their RMBs will lead to further yuan depreciation. Investment Implications: A Free-Fall For RMB And Asian Currencies The RMB's value versus the U.S. dollar will drop much further. Our new target range for US$/CNY is 7.8-8 over the next 12 months, or 11-14% below today's level. The forward market is discounting only 2.8% depreciation in the next 12 months (Chart I-11). We maintain our short RMB / long U.S. dollar trade (via 12-month NDF). A persistent relapse in the RMB's value will drag down other Asian currencies. In particular, the Korean won and the Taiwanese dollar have failed to break above important technical levels (their long-term moving averages), and have lately relapsed (Chart I-12). Chart I-11RMB Will Depreciate Much More##br## Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards RMB Will Depreciate Much More Than Priced In By Forwards Chart I-12Asian Currencies:##br##More Downside Ahead bca.ems_sr_2016_11_23_s1_c12 bca.ems_sr_2016_11_23_s1_c12 For the Korean won, we believe there is considerable downside from current levels. Consistently, we recommended shorting the KRW versus the THB trade on October 19.4 Chart I-13EM ex-China Currencies Total Return##br## (Including Carry): Is The Rally Over? bca.ems_sr_2016_11_23_s1_c13 bca.ems_sr_2016_11_23_s1_c13 Traders who believe in continued U.S. dollar strength, like we do, should consider shorting the KRW versus the U.S. dollar outright. For DM currencies, this means that the drop in the JPY has further to go. In emerging Asia, we are also shorting the MYR and the IDR versus the U.S. dollar and also versus Eastern European currencies such as the ruble and the HUF, respectively. As emerging Asian currencies depreciate versus the U.S. dollar, other EM currencies will likely follow. It is hard to see the RMB and other Asian currencies plunging and the rest of EM doing well. The total return (including the carry) of the aggregate EM ex-China exchange rate versus the U.S. dollar (equity market-cap weighted index) has failed to break above a critical long-term technical resistance, and has rolled over (Chart I-13). This is a bearish technical signal, implying considerable downside from these levels. As such, we maintain our core short positions in the following EM currencies outside Asia: TRY, ZAR, BRL and CLP and add COP to this list today. This is based on an assumption of diminished foreign inflows to EM and lower commodities prices. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Colombia: Headed Toward Recession In our May 4 Special Report on Colombia,5 we argued that despite a bright structural backdrop this Andean economy was headed for a growth recession (i.e. very weak but still positive growth). Domestic demand has buckled and now we believe the nation could be on the verge of its first genuine recession in two decades (Chart II-1). Colombia's Achilles heel is its low domestic savings rate, reflected by a still large current account deficit financed by FDI and portfolio capital inflows (Chart II-2). As a result, low oil prices and rising global interest rates have exposed the nation's main cyclical vulnerability. Given the trade deficit is still large (Chart II-3) and our bias is that oil prices will be flat-to-down, a further retrenchment in domestic demand is unavoidable. Chart II-1Colombia's First Recession##br## In 20 Years? bca.ems_sr_2016_11_23_s2_c1 bca.ems_sr_2016_11_23_s2_c1 Chart II-2Colombia's Lingering Balance Of ##br##Payments Vulnerability bca.ems_sr_2016_11_23_s2_c2 bca.ems_sr_2016_11_23_s2_c2 Chart II-3A Weaker COP Will Force The ##br##Necessary Adjustment bca.ems_sr_2016_11_23_s2_c3 bca.ems_sr_2016_11_23_s2_c3 Going forward, the external funding constraint will continue to bite. Moreover, policymakers are trapped and will be unable to prevent growth from contracting. The central bank is stuck between the proverbial rock and hard place. Cutting interest rates will undermine the appeal of the peso to foreign investors. Raising rates to prop up the currency, however, will exacerbate the economy's downward momentum. In the end, downward pressure on the exchange rate and still high inflation mean the central bank will not cut rates soon (Chart II-4). Tight monetary policy in turn means that private sector credit will decelerate much more (Chart II-5). Chart II-4High (Well Above Target) Inflation Limits##br## Central Bank's Ability To Ease bca.ems_sr_2016_11_23_s2_c4 bca.ems_sr_2016_11_23_s2_c4 Chart II-5Colombia: Credit Growth Is ##br##Headed Much Lower bca.ems_sr_2016_11_23_s2_c5 bca.ems_sr_2016_11_23_s2_c5 Our marginal propensity to consume proxy, an excellent leading indicator for household spending, signals consumption is set to weaken even further (Chart II-6). Facing weakening demand, investment is set to continue contracting (Chart II-7) and, ultimately, unemployment will be much higher, reinforcing the downtrend in consumer expenditures. Chart II-6Colombian Domestic Demand##br## To Retrench Further bca.ems_sr_2016_11_23_s2_c6 bca.ems_sr_2016_11_23_s2_c6 Chart II-7Contracting Investment Bodes ##br##Poorly For Employment bca.ems_sr_2016_11_23_s2_c7 bca.ems_sr_2016_11_23_s2_c7 Meanwhile, fiscal policy will remain tight as Colombia's orthodox policymakers struggle to adjust the fiscal accounts to the structurally negative terms-of-trade shock in this oil-dependent economy. The current fiscal reform effort is very positive for sustainable long-run dynamics, as influential central bank board members have highlighted.6 Yet particular parts of the reform, such as raising VAT taxes from 16% to 19%, will almost inevitably lead to a drop in consumer demand. Furthermore, nominal government revenues are already contracting and a slumping economy means that the total fiscal effort will need to be greater than currently envisioned. Overall, with monetary and fiscal policy stimulus hamstrung by the nation's low domestic savings rate (i.e. large current account deficit), a mild recession seems very likely. And while a lot of weakness has already been priced into the nation's financial markets, we think there is still more downside ahead. For instance, the Colombian peso may be cheap in real (inflation-adjusted) terms, but it is highly vulnerable due to the nation's still wide current account deficit. This week we recommend re-instating a short position in the peso; this time against an equal-weighted basket of the U.S. dollar and the Russian ruble.7 Turning to equities, Colombian stocks have fallen sharply since 2014, mostly a reflection of the collapse of the nation's energy plays. At present bank stocks account for 60% this nation's MSCI market cap, and though we believe they will fare better than many other EM banking systems,8 they will not go unscathed by a recession. Still, orthodox policymaking should limit the downside in the performance of this bourse and sovereign credit (U.S. dollar bonds) relative to their respective EM benchmarks. Meanwhile, fixed-income investors should continue to bet on yield curve flattening by paying 1-year/ receiving 10-year interest rate swaps, a trade we have recommended since September 16, 2015.9 The recent steepening in the yield curve will prove unsustainable as the economy tanks. Bottom Line: Colombia is probably headed toward recession and policymakers are straightjacketed and cannot ease monetary and fiscal policies to prevent it. As such, the currency will be the main release valve and it will depreciate further. Go short the COP versus an equal-weighted basket the U.S. dollar and the Russian ruble. Dedicated EM equity and credit investors should maintain a neutral allocation to Colombia within their respective EM benchmarks. Continue to bet on flattening in the yield curve by paying 1-year/ receiving 10-year interest rate swaps. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016. 3 As we argued in Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses", dated October 26, 2016, it is new loans that create new deposits and vice versa. 4 Please refer to the section on Thailand in our Emerging Markets Strategy Weekly Report, titled " The EM Rally: Running Out Of Steam?" dated October 19, 2016. 5 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength," dated May 4, 2016, available at ems.bcaresearch.com 6 Please see Cano, Carlos Gustavo "Monetary Policy in Colombia: Main Challenges 2016 -2017" Bank of America Merrill Lynch, Small Talks Symposium, October 7, 2016, Washington DC http://www.banrep.gov.co/sites/default/files/publicaciones/archivos/cgc_oct_2016.pdf 7 For more on the ruble please refer to the section on Russia in our Emerging Markets Weekly Report, dated November 16, 2016, titled, "Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade". 8 Please refer to the Emerging Markets Special Report titled, "Colombia: A Cyclical Downturn Amid Structural Strength" dated May 4, 2016, available at ems.bcaresearch.com 9 Please refer to the section on Colombia in our Emerging Markets Weekly Report, dated September 15, 2015, titled "Colombia: An Incomplete Adjustment", available at ems.bcareseach.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." -- Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.1 Election Post-Mortem Chart II-1Election Polls Usually ##br##Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."2 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!3 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.4 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.5 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are Not ##br##Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.6 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.7 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.8 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.9 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.10 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.11 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.12 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.13 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality And Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.14 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."15 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.16 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering ##br##Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.17 Another contested election in a contested era. Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.18 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.19 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.20 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.21 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Except that it is better armed. 2 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 3 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 4 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 9 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 10 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 11 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 12 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 13 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 14 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 15 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 16 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 17 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 18 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 20 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 21 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Highlights China's abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks - and not the natural result of the country's high savings rate. Banks do not intermediate savings into credit, and they do not need deposits to lend. Banks create deposits and money by originating loans. A commercial bank is not constrained in loan origination by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. What habitually drives credit booms are the "animal spirits" of banks and borrowers. We are initiating a relative China bank equity trade: short listed medium-size banks / long large five banks. Continue shorting the RMB versus the U.S. dollar. Feature For some time, the consensus view has been that rampant credit growth in China and the resulting excesses have been the natural result of the country's high savings rate, particularly among Chinese households. We have long argued differently: abnormal credit growth has been the result of speculative, high-risk behavior among Chinese banks and other creditors and borrowers. In this vein, China's credit bubble is no different than any other credit bubble in history. Although an adjustment in China might play out differently than it has in other countries where credit excesses became prevalent, China's corporate credit bubble is an imbalance that poses a non-trivial risk to both mainland and global growth (Chart I-1). Chart I-1China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP China's Outstanding Credit Is Large Relative To Global GDP In a nutshell, Chinese banks have not channelled large amounts of household deposits into credit. Without mincing words, it is our view that banks have originated loans literally from "thin air" as banks do in any other country. In turn, credit has boosted spending, income and, consequently, savings. Do Deposits Create Loans, Or Do Loans Create Deposits? It is a widely held view among academics, investors and market commentators - including some of our colleagues here at BCA - that China's enormous credit expansion over the past several years has been a natural outcome of the nation's high savings rate. The argument goes like this: China has a very high savings rate, and it is inherent that household savings flow to banks as deposits. In turn, banks have little choice but to lend out on these deposits. The upshot of this reasoning is as follows: China's abnormally strong credit growth is a consequence of the country's abundant savings rather than an unsustainable excess. This argument hails from the Intermediate Loan Funds (ILF) model, otherwise known as the Loanable Fund Theory. This model suggests that deposits create loans - i.e., banks intermediate deposits into credit. Even though the ILF model is the most widespread theory of banking within academia and in textbooks, it unfortunately has little relevance to real-life banking - i.e., banking systems around the world do not function as the model posits. An alternative but much less recognized theory, the Financing Money Creation (FMC) model, asserts that banks create deposits from "thin air" when they originate a new loan. This is the model that banking systems in almost all countries in the world subscribe to. Indeed, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, therefore creating new money in the process (Chart I-2). In other words, bank loans create deposits and money. Chart I-2Commercial Banks: Credit Origination Creates Deposits Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Herein we cite various papers that discuss this matter and delineate the key points: "Banks do not, as many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo - extending a loan to the borrower and simultaneously crediting the borrower's money account" (Turner, 2013). "When banks extend loans, to their customers, they create money by crediting their customer's accounts" (King, 2012). "Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don't need a pile of "dry tinder" in the form of excess reserves to do so" (Dudley, 2009). "In a closed economy (or the world as a whole), fundamentally, deposits come from only two places: new bank lending and government deficits. Banks create deposits when they create loans." (Sheard, 2013). "Just as taking out a new loan creates money, the repayment of bank loans destroys money" (McLeay, 2014). The papers cited in the bibliography on page 18 elaborate on this topic in depth and readers are encouraged to review this literature. Bottom Line: Banks do not need deposits to lend. They create deposits and money by originating loans. Do Banks Lend Their Reserves At Central Banks? Another misconception about modern banking in general and China's banking system in particular is that banks lend out their excess reserves held at the central bank. Provided that Chinese banks have plenty of required reserves at the People's Bank of China (PBoC), some economists and analysts argue it is a matter of cutting the reserve requirement ratio to free up reserves (liquidity), which will allow banks to boost their loan origination. Again, we cite several papers as well as specific views from central bankers who reject the notion that banks lend out their reserves at the central bank: This comment by William C. Dudley (President of the New York Federal Reserve Bank) states "the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not" (Dudley, 2009). "In fact, the level of reserves hardly figures in banks' lending decisions. The amount of credit outstanding is determined by banks' willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly" (Borio et al., 2009). "While the institutional facts alone provide compelling support for our view, we also demonstrate empirically that the relationships implied by the money multiplier do not exist in the data ... Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected..." (Carpenter et al., 2010). "...reserves are, in normal times, supplied 'on demand' by Bank of England to commercial banks in exchange for other assets on their balance sheets. In no way does the aggregate quantity of reserves directly constrains the amount of bank lending or deposit creation" (McLeay 2014). "Most importantly, banks cannot cause the amount of reserves at the central bank to fall by "lending them out" to customers. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain "parked" at the central bank" (Sheard, 2013). More detailed analysis on this topic is available in the papers cited in the bibliography on page 18. Bottom Line: Banks do not lend out their reserves at the central bank. A commercial bank is not constrained in loan origination/money creation by its reserves at the central bank if the latter supplies liquidity (reserves) to commercial banks 'on demand'. Empirical Evidence: Savings Versus Credit This section presents empirical evidence that there is no correlation between national and household savings rates and loan origination. This is true for any country, including China. Credit growth and credit penetration (the credit-to-GDP ratio) have little to do with a country's or with households' savings rates. Chart I-3 illustrates that there has been no correlation between China's national or household savings rates and the credit-to-GDP ratio. China's savings rate was high and rising before 2009, yet the credit bubble formation only commenced in January 2009 when the savings rate topped out. Looking at other countries such as Korea, Taiwan and the U.S., historically we find no correlation between their savings and credit cycles1 (Chart I-4). Chart I-3China: Credit And Savings ##br##Are Not Correlated China: Credit And Savings Are Not Correlated China: Credit And Savings Are Not Correlated Chart I-4The U.S., Korea And Taiwan:##br## Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated The U.S., Korea And Taiwan: Credit And Savings Are Not Correlated Importantly, a high or rising savings rate does not preclude deleveraging. There were many two- to four-year spans of deleveraging in China when the credit-to-GDP ratio was flat or falling (Chart I-5) - i.e., the growth rate of credit was at or below nominal GDP growth. This occurred despite the country's high and rising savings rate. So, not only is deleveraging not unusual for China but it has also occurred amid a high savings rate. This contradicts the commonly held view that Chinese credit has always expanded faster than nominal GDP because the nation saves a lot. Deleveraging at the current juncture will likely be very painful, because the size of credit flows is enormous and even a moderate and gradual deceleration in credit will produce a major drag on growth. Specifically, the credit impulse - the second derivative of outstanding credit that measures the impact of credit growth on GDP - will be equal to -2.2% of GDP if credit growth moderates from 11.3% now to 7.8% in the next 24 months (Chart I-6). Chart I-5There Were Periods Of ##br##Deleveraging In China Too There Were Periods Of Deleveraging In China Too There Were Periods Of Deleveraging In China Too Chart I-6China's Credit Impulse Will ##br##Likely Be Negative China's Credit Impulse Will Likely Be Negative China's Credit Impulse Will Likely Be Negative As Chart I-6 also demonstrates, China's credit impulse drives Chinese imports, the most critical variable for the rest of the world. Chart I-7China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 China: A Growth Engine Shift Since 2009 Further, it is possible to argue that vigorous credit growth generates robust income growth. The latter, in turn, allows a nation as a whole and households in particular to save more. If Chinese banks had not originated as many loans since early 2009 as they have, many goods and services in China would not have been produced and sold, and income growth for all companies, households and even government would be much lower. Even if the savings rate were held constant, less income would entail lower absolute amounts of both national and household savings. In short, China's exponential credit growth since 2009 has helped boost both national and household income levels, and in turn the absolute level of their savings. Chart I-7 illustrates that before 2009, mainland economic and income growth were driven by exports, but since early 2009, credit has been instrumental in generating income growth and prosperity. Finally, many analysts rationalize strong loan growth among Chinese banks by their robust deposit growth. This logic is flawed: Chinese banks have substantial deposits on hand because they originate a lot of loans. Bottom Line: China's and any other country's national or household savings rate does not explain swings in credit creation. Banks do not intermediate savings into credit. Rather, banks create deposits and money. What Drives Bank Lending? If a credit boom is not driven by abundant savings, what is the foundation for a credit boom in general, and the one currently underway in China in particular? Loan origination by a bank depends on that bank's willingness to lend, as well as general demand for loans. Also, depending on policy priorities, regulators often try to encourage or limit banks' ability to lend by imposing and adjusting various regulatory ratios. Barring any regulatory constraints, so long as there is demand for loans and a bank is willing to lend, a loan will be originated. Hence, in theory, banks can lend to eternity unless shareholders and regulators constrain them. In the immediate wake of the Lehman crisis, the Chinese authorities encouraged banks to open the credit floodgates. Thus, there was a de facto deregulation in the nation's banking system in early 2009 - policymakers encouraged strong credit origination. The experience of many countries - documented by numerous academic papers on this topic - has demonstrated that banking sector deregulation typically leads to excessive risk-taking by banks, and abnormal credit growth. These episodes have not ended well, with multi-year workouts following in their wake. By and large, a credit boom often occurs when risk-taking by banks surges and shareholders and regulators do not constrain them. This has been no different in China - the credit boom since 2009 has been powered by speculative and excessive risk-taking among banks and their management teams in particular, amid complacency of regulators and shareholders. Bottom Line: What habitually drives excessive credit creation are the "animal spirits" of banks and borrowers. Banks' and borrowers' speculative behavior and reckless risk-taking typically degenerates into a credit boom that often ends in an economic and financial downturn. It has been no different in China. What Constrains Bank Lending? The following factors can limit bank credit origination: Monetary policy can limit credit growth via raising interest rates, which dampens loan demand. Also, banks can become more risk averse when interest rates rise as they downgrade creditworthiness of current and prospective borrowers. Government regulations can impose various restrictions on banks, restraining their risk-taking and ability to originate infinite amounts of credit. In China, to limit banks' ability to lend, regulators have imposed several mandatory ratios on commercial banks, and also practice 'Window Guidance'. First, the capital adequacy ratio (CAR=net capital / risk-weighted assets). This ratio limits banks' ability to originate infinite amounts of loans by imposing a minimum level CAR. In China, most banks comply comfortably with CAR. The CAR for the entire commercial banking system is currently 13.1%. While the minimum requirement is 8%. The caveat is that in China, banks' equity capital is nowadays considerably inflated because they have not provisioned for non-performing loans (NPLs). If banks were to fully provision for NPLs, their equity capital would shrink significantly, and they would probably not meet the minimum CAR. Table I-1 shows that in a scenario of 12.5% NPL ratio for banks' claims on companies and zero NPL on household loans and mortgages as well as a 20% recovery rate, a full provisioning by banks would erode 65% of their equity. In this scenario, the CAR ratio would drop a lot - probably below the required minimum of 8% and banks would be forced to raise new equity (dilute existing shareholders) or shrink their balance sheets - or a combination of both. Table I-1China: NPL Scenarios And Banks' Equity Capital Impairment Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Second, the leverage ratio - computed as net Tier-1 capital divided by on- and off-balance-sheet assets. According to government regulation, this ratio should be at least 4%. As of June 30, 2016, the leverage ratio for the entire commercial banking system was 6.4%, comfortably above its floor. Nevertheless, as with CAR, the leverage ratio is overstated at the moment because the numerator - net Tier-1 equity capital - is artificially inflated, as it is not adjusted for realistic levels of NPLs, as discussed above. If 65% of equity is eroded due to sensible loan-loss provisioning and write-offs (as per Table 1), the leverage ratio would drop to about 2.3%, below the required minimum of 4%. Hence, banks would need to raise new equity (dilute existing shareholders), shrink their balance sheets or do a combination of both. Equity dilution is bearish for bank stocks and, if and as banks moderate their assets/loan growth, the economy will suffer. Third, regulatory 'Window Guidance' is implemented through PBoC recommendations to banks on their annual and quarterly credit ceilings, and on their credit structures. There is no official disclosure of this measure, and it is done between the PBoC, the Chinese Banking Regulatory commission (CBRC) and banks' management. In recent years, the efficiency of 'Window Guidance' has declined dramatically. Banks have defied bank regulators' efforts to rein in credit growth by finding loopholes in regulations. What's more, they have de facto exceeded credit origination limits by moving credit risk off their balance sheets and classifying it differently than loans. The result has been mushrooming Non-Standard Credit Assets (NSCA). Table I-2 reveals that on- and off-balance-sheet NSCA stand at RMB 10 trillion and RMB 19 trillion, respectively. Furthermore, banks have lately expanded their lending to non-depositary financial organizations that include trust companies, financial leasing companies, auto financing companies and loan companies (Chart I-8). This has probably been done to circumvent government regulations. Hence, Chinese banks have taken on much more credit risk than regulators have wanted them to by reclassifying/renaming loans as NSCA, and parking these assets both on- and off-balance-sheet. Table I-2China: Five Largest Banks Hold ##br##Only 40% Of Credit Assets Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Chart I-8Non-Bank Financial Organizations##br## Are On A Borrowing Spree From Banks bca.ems_sr_2016_10_26_s1_c8 bca.ems_sr_2016_10_26_s1_c8 In short, regulatory measures in China have not been effective at restraining credit growth in recent years. Bank shareholders are the biggest losers when banks expand credit uncontrollably, and then their default rates rise. The reason being that banking is a business built on leverage. For example, if a bank's assets-to-equity ratio is 10 and 10% of assets go bad (default with no recovery), shareholders' equity will completely evaporate - i.e., they will lose their entire investment. Hence, it is in the best interests of bank shareholders to halt a credit expansion when they sense deteriorating credit quality ahead. Doing so will hurt the economy, but limit their losses. Why have shareholders of Chinese banks not stepped in to curb the credit boom and misallocation of capital? We believe they have either been satisfied with such a massive credit expansion, which has initially driven shareholder returns up, or weak institutional shareholder mechanisms have meant they have been unable to enforce credit discipline on their banks. All in all, if China's or any other credit system is driven by the principals of capitalism and markets, creditors are the ones who should curtail credit growth - regardless of what impact it will have on the economy. If a country's credit system in general and banks in particular do not operate on principals of capitalism and markets, banks can expand credit infinitely, thereby perpetuating capital misallocation and raising inefficiency, leading to stagnating productivity - in other words, a move to a more socialist bend. Only in a socialist system do banks expand their credit portfolios in perpetuity, since they are not run to maximize wealth for shareholders. On a related note, there is another misconception that all Chinese banks are state-owned and the government will be fast to bail them out by buying bad assets at par. Table I-3 illustrates the ownership structure of 16 Chinese banks listed the A-share market, including the large ones. The state (central and local governments) and SOEs have a large but not 100% ownership stake. In fact, foreign investors have considerable equity shares in many banks. Table I-3Chinese Banks: Shareholder Structure Is Diverse Misconceptions About China's Credit Excesses Misconceptions About China's Credit Excesses Hence, a government bail-out of these banks at no cost to shareholders would mean the Chinese government is using taxpayer money to benefit domestic private as well as foreign shareholders. Given the considerable amounts involved, this will be politically difficult to achieve unless the benefits of doing so are explicitly greater than the costs of doing nothing. Chart I-9Commercial Banks Are On ##br##Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC Commercial Banks Are On Borrowing Spree From PBoC We are not implying that a government bailout is impossible. Our point is that it will take material pain and considerable deterioration in the economy and financial markets before the central government bails out banks at no cost to other shareholders. No wonder the authorities have not recapitalized the banks so far. In the long run, if the Chinese government is serious about improving the credit/capital allocation process, it has to allow market forces to take hold so that creditors and debtors are not bailed out but instead assume financial responsibility for their decisions. This means short-term pain but long-term gain. The lack of demand for credit is an important constraint on credit origination. If there are no borrowers, banks will have a hard time making a sizable amount of loans. Liquidity constraints also limit banks' ability to expand their assets. Let's consider an example when liquidity constraints arise. Bank A originates a loan, and Borrower A wants to transfer money to its Supplier B, which has an account at Bank B. In theory, Bank A should reduce its excess reserves at the central bank by transferring money to Bank B's reserve account at the central bank. However, if too many borrowers of Bank A try to transfer their money/deposits to other banks, Bank A will run into liquidity constraints as its excess reserves dry up. In such a case, Bank A should borrow money from the central bank or the interbank market to replenish its excess reserves. Provided many G7 central banks are nowadays committed to supplying as much liquidity (reserves) as banks require, in these countries banks do not really face liquidity constraints in lending. The focus of advanced countries' central banks is to control short-term interest rates - i.e., they manage liquidity in a way to keep policy rates at the target. In the case of China, even though the PBoC has a high required reserves ratio (RRR) for banks, it apparently supplies commercial banks with whatever amounts of liquidity they require. Chart I-9 reveals that the PBoC's claims on commercial banks have surged by fivefold in the past three years. Given the Chinese monetary authorities have in the recent years been very generous in meeting banks' demands for liquidity, the high RRR has not constrained mainland banks' ability to originate loans. This contradicts some analysts' assertions that the PBoC can boost lending by cutting the RRR. As the PBoC presently fully accommodates banks' demands for liquidity, the significance and impact of required reserves has declined. On the whole, nowadays, commercial banks in China are not facing liquidity (reserves) constraints to expand credit. High debt servicing costs could constrain bank lending. Are there limits to the credit-to-GDP ratio? It is illustrative to consider a numerical example for China. Corporate and household debt presently stands at 220% of GDP and, according to Bank of Intentional Settlement (BIS) calculations, debt servicing costs (including interest payments and amortization) account for around 20% of disposable income (Chart I-10). If credit indefinitely expands at a rate well above nominal GDP growth (Chart I-11) and interest rates do not decline, debt servicing costs will rise substantially. For example, let's assume that mainland corporate and consumer leverage reaches 400% of GDP in the next several years. If and when this happens, debt servicing costs could double, approaching 40% of income assuming constant interest rates and debt maturity. Chart I-10China's Corporate And Household##br## Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? Chart I-11Will Credit Growth Slow Toward##br## Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? Will Credit Growth Slow Toward Nominal GDP Growth? No debtor can continue to function under such debt burden. Hence, debtors will have to cut their spending (for companies it will be a reduction in capex budgets) or these debtors will need to borrow to pay interest and retire old debt. In short, this becomes an unsustainable Ponzi scheme, where debtors borrow to service their debt obligations. Anecdotal evidence suggests this is not rare in China nowadays. One way the authorities could reduce debt servicing is to cut interest rates to zero and lengthen the maturity of debt. This is what many advanced economies have done. If Chinese credit penetration does not stop rising, the PBoC will be forced to cut rates to close to zero. This in turn will lead to large capital outflows, and the RMB will depreciate versus the U.S. dollar. Bottom Line: The following factors can restrain bank credit origination: monetary policy (higher interest rates), government regulations, bank shareholders, lack of credit demand, liquidity constraints and high debt servicing costs. Investment Implications Chart I-12Short Small Banks / Long Large##br## Banks In China Short Small Banks / Long Large Banks In China Short Small Banks / Long Large Banks In China If banks' shareholders and other creditors in China act in accordance with their self-interests to preserve the value of their assets, they will have to reduce credit origination/lending. As a result, China will experience an acute economic downturn. This would constitute a capitalist-type adjustment, which in turn will lead to more efficiency, solid productivity growth, and reasonably high economic growth over the long term. However, it will also mean significant short-term pain. If the government bails out everyone, underwrites all credit risks, and gets even more involved in capital/credit allocation, the economy will not experience an acute slump for a while. However, this would represent a shift toward socialism and the potential growth rate will collapse in the next several years. With the labor force stagnating and probably contracting in the years ahead, China's potential growth will be equal to its productivity growth. In socialism, productivity growth is low, often close to zero. The growth trajectory in this scenario will follow mini-cycles around a rapidly falling potential growth rate. In brief, China's growth rate is bound to slow further, regardless of what scenario plays out over the next several years. Today, we are initiating a relative China bank equity trade: short listed small- and medium-size banks / long large five banks in the A-share market (Chart I-12). There has been more speculative high-risk lending from the small- and medium-size banks than the large ones. As we documented in our June 15, 2016 Special Report titled Chinese Banks' Ominous Shadow,2 the largest five banks have fewer non-standard credit assets than medium and small banks. If 12.5% of banks' claims on companies turn sour and the recovery rate is 20%, 100% of the equity of 11 listed small- and medium-sized banks will be wiped out. The same number for the large five banks is 42%. Hence, these 11 listed small- and medium-sized banks are more exposed to bad loans than the large five. Finally, mushrooming leverage entails that the monetary authorities should reduce interest rates drastically. However, lower interest rates will spur more capital outflows from the mainland. Hence, the RMB is set to depreciate further. We have been shorting the RMB versus the U.S. dollar since December 9, 2015, and this position remains intact. 1 We discussed this at length in Emerging Markets Strategy Special Report, "China: Imbalances And Policy Options", dated June 12, 2012, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominious Shadow", June 15, 2016, link available on page 22. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Bibliography Borio, C. and Disyatat, P. (2009), "Unconventional Monetary Policy: An Appraisal", BIS Working Papers, No. 292, November 2009. Carpenter, S. and Demiralp, S. (2010),"Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series, No. 2010-41, Divisions of Research & Statistics and Monetary Affairs, Washington, DC: Federal Reserve Board Dudley, W. (2009), "The Economic Outlook and the Fed's Balance Sheet: The Issue of "How" versus "When"", Remarks at the Association for a Better New York Breakfast Meeting, available at http://www.newyorkfed.org/newsevents/speeches/2009/dud090729.html Jakad, Z. and Kumhof, M. (2015), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", Bank of England, Working Paper 529, May 2015 King, M. (2012), Speech to the South Wales Chamber of Commerce at the Millenium Centre, Cardiff, October 23. Ma, G., Xiandong, Y. and Xim L. (2011), "China's evolving reserve requirements", BIS Working Papers, No. 360, November 2011. Turner, A. (2013), "Credit, Money and Leverage", September 12. Sheard, Paul (2013), "Repeat After Me: Banks Cannot And Do Not 'Lent Out' Reserves", Standard & Poor's Rating Services, August 2013, New York Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. See King (2012), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 6, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Dudley (2009), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. See Carpenter and Demiralp (2010), "Banks Are Not Intermediaries of Loanable Funds - and why this Matters", pp. 13, cited in Zoltan Jakab and Michael Kumhof, Bank of England Working Paper 529, May 2015. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

The secular bond bull market is over. Safety is in a bubble. The shift from monetary to fiscal easing is the most likely candidate to prick the bubble in safety.
In this piece we revise our yield portfolio to increase its resilience to interest rate shocks.

The complete annihilation of all human life represents the mother of all tail risks. We estimate that there is a 50% chance that doomsday will occur by 2290, and a 95% chance that it will occur by 2710. If the risk of doomsday is elevated, what is an investor to do?

In China and the majority EMs, credit impulses will be negative over the next 12 months as and if their credit growth converges towards their current nominal GDP growth. These negative credit impulses will dampen EM/China growth and their corporate profits. In the next 12 months, the credit cycle is most vulnerable in China, Brazil, Turkey, and Malaysia and least vulnerable in central Europe, the Philippines, and Mexico.