Taoyuan Nights

In this article, I looked at how simple indicators and a smattering of economic knowledge can give you some useful ability to guess the state of an economy. Specifically, the current ‘value of money’ as measured by its availability and the cost of borrowing, can often indicate whether an economy is likely to be suffering from unsustainable and dangerous asset bubbles.

I’ve received some feedback since I wrote the original article, so I thought I’d follow the article up with a few more thoughts on cheap money & how it affects an economy…

Cheap money

First of all, a question: What do I mean by ‘cheap money’? Historically, interest rates around the world have averaged a little higher than inflation. In other words, if I know that prices of beans, cars, monkeys and so on will be higher in 3 years time, then if I lend you money for 3 years, I will want to get enough money back so that I can still buy at least the same amount of beans, cars, and monkeys in 3 years time. Further, I will want a bit of extra money as a thankyou for accepting the risk you might not pay me back, and for the fact that I have allowed you to make use of my money for 3 years, and for the risk that inflation might have been higher than I expected. So if I say ‘cheap money’, I mean money that is being lent rather freely without too much consideration for:

• Likely or possible levels of inflation over the period of lending.
• Achieving good returns over and above the rate of inflation.
• Risk of default, i.e., when the money doesn’t get paid back.

Does Taiwan have ‘cheap money’?

The long term average for inflation (over most of this century) in most developed economies is around 5%, with short-term interest rates averaging around 7% and long-term mortgage rates around 8-9%*. So typically, people throughout history in stable countries are looking for 2% ‘real’ return over inflation, in exchange for lending their money, and another 1-2% of real return for a riskier longer term loan that is backed up by a house (which can be sold if the borrower stops repaying the loan).

It depends, of course on what you mean by inflation: increases in wages? increases in the average shopping basket cost? increases in the average cost of living?

These measurements bring immediate headaches. Whose wage rises do you consider? Do you take the median or the mean? What is the ‘average shopping basket’ spend each week by someone in Taiwan - how do you measure the average, when the items people buy change so much every year (TVs, computers…)?

So, the first thing we can see is that there is a lot of difficulty in measuring the true rate of inflation. In fact, the situation is even worse because most governments play cunning tricks to confuse consumers, so they don’t ask for such big wage rises.

Take Britain, America and Europe. They don’t include the cost of housing in their inflation figures, because it is ‘too volatile’. That’s right - it makes the inflation graph look all wobbly and difficult to read, so they just leave it out - after all, who owns a house? Instead, nice ‘non-volatile’ items are used, such as hamsters, TVs and so on. Because if there’s one thing the human body needs to survive, it’s hamsters, not a roof over your head. This example is not made up. Around the time the UK dropped housing costs from it’s standard measurement of inflation (when it adopted CPI), it added hamsters. Nice.

Taiwan’s official inflation figure, should we choose to believe it, is currently 2.3% (2005), or 1% (2006)**. With the exchange rate at record lows relative to other currencies (making imports super-expensive), energy prices having gone through the roof, and with house prices having soared relative to a few years ago, frankly this seems not just hard to believe, but literally impossible.

Fortunately, we can choose to be ignorant of such statistics here without damaging the argument. Taiwan’s interest rates are somewhere around 1.5% (best consumer savings rate) and 2.3% (base rate for adjustable rate loans)***. We can immediately ask, is this savings return figure going to be much higher than inflation?

Frankly, there is not much room below 2.5%. Therefore, without knowing anything else besides the savings rate, it is immediately obvious that ‘real’ gains from lending money, that is, the return after inflation, are not likely to be very high.

In fact, unless prices on most goods and assets (property, company shares) are quite obviously either standing still or dropping like a stone from the viewpoint of the average person in the street, real returns on lending are likely to be very close to zero. Money is therefore effectively ‘free to borrow’ from the point of view of the consumer.

Worse, if my beliefs (above) about the current level of inflation in Taiwan are correct, then money is not just free to borrow, the borrower is effectively being ‘paid’ in real terms to take it off the bank’s hands!

We can see that the first checkbox, a very low short-term cost of borrowing is ticked. It is cheap to get your hands on cash here in absolute terms (2.3% is a low number, compared with the historical average rates even in the US or Europe!) and real terms (money is effectively ‘free’ to borrow in real terms, because by the time you repay your loan, the money you repay will buy ‘the same amount of stuff’ as the original loan would have bought).

Is money ‘easy to borrow’ in Taiwan?

From the number of adverts encouraging people to borrow money to finance cars/houses/whatever that can be seen on the TV, on posters, and on the Internet - and from the number of banks that have gone bust in the last few months due to ‘lending to people who don’t bother to pay it back’, I think the answer to this one has to be YES. Borrowing money is not difficult. In fact, I get the impression from my Taiwanese friends, that some savers are so desperate to beat the appauling returns from the bank that they will lend to anyone in their family or circle of friends who says they can turn any kind of profit with it.

I’ll leave this one to the reader to decide for themselves.

So what?

Knowing from our everyday experiences and from the interest rate figure that we have cheap and easy money available, what kind of things can we predict seeing in the economy around us?

• When the ’savings return’ is so low, and the ‘cost of borrowing’ is also low, people will be more inclined to take big risks to try and get better return, by borrowing money and putting it into adventurous financial endeavours. Buying up rental housing is just one example of this behaviour, and it is probably the most obvious form in most countries. But you will see the same effect on the stockmarket (it will be pushed artificially high, as people borrow cheap money to buy shares).

  I haven’t checked this before, so let’s take a look at the Taiwanese stock market.

  Surprise surprise! It has doubled in ‘real terms’, if you believe there has been no inflation, in just 3 years. World stockmarkets usually double in real terms every 14 years. This suggests the stockmarket is rather likely to crash back to where it should be, and perhaps even overshoot, when the ‘cheap money’ is removed from the market and people must repay their loans at higher rates, often by selling back their shares.
  

• Taiwan’s exchange rate should become terrible, as people borrow TWD to buy other currencies with better ‘real interest rate returns’ (and sell their borrowed TWD in the process). This ‘borrow and sell’ process makes TWD ‘worth less’ internationally - since supply for TWD then exceeds demand. It’s known as the ‘carry trade’. This has also happened, though most people involved in the carry trade would pick Japan before Taiwan as a source of borrowings. Only the other day on CNN Asia, I saw one of the heads of HSBC’s subsidiaries saying they were trying to get out of the carry trade, because it is becoming so dominated by crazy retail (i.e. you and me) investors who had no idea what risks they are really taking.
  

• Risk becomes ‘mispriced’ in every sense. People stop worrying about risk as the chase for higher returns on savings becomes their overriding aim. For example: People should try to start up small businesses more often with low interest rates, and they will take less care to make sure the business is a good idea, because the loan seems ‘cheap’ to them at the time.

  I see this all the time here! Businesses start up and go out of business within 1-6 months here constantly. I know Taiwan is an ‘entrepreneurial country’, but what I see is just crazy! Shops with no customers at all, from day 3 onwards.

  When money is at ‘a sensible price’ in terms of the cost and ease of borrowing, you will see a slower rate of new businesses, but they should be more successful because people only take the risk when the idea is very good! Now, all the good ideas are driven out of business by millions of ‘copycats’ who just want to try and beat their savings account… but there aren’t enough customers to go around…
  

• People buy big expensive items because the payments seem cheap. Houses are one example, cars are another. Everyone in Taiwan seems to be driving a luxury car, even in the poorest areas I visit, where there are no jobs. It’s incredible and completely unsustainable. No one has the ‘right’ to a luxury car, including me - it is something you should work hard for a long time to earn. Here, the japanese cars most people drive would cost them around 5-10 years of their savings (or 2-3 years of their full salary before tax)!

  Interestingly, no one seems to be able to pay for the expensive repair the first time a scooter crashes into their car (probably, because that is not available on cheap credit).

However, if the cost of borrowing rises, or it becomes more difficult to borrow money due to bank or government restrictions on lending, then the foundation of these asset bubbles and crazy behaviours erodes quickly.

Are rates likely to rise in Taiwan?

“Governor Perng Fai-nan (彭淮南) said last month that the benchmark rate had yet to reach the “neutral level” where it neither fuels nor curbs inflation and growth, suggesting more rate rises.” ****

And keeping up with the neighbours? 2007: Japanese rates rise, British rates rise, Australian rates rise,New Zealand rates rise, European rates rise, Indian rates rise, PRC to raise rates, and they’re also restricting lending.

In fairness:
Amid a collapsing house market, (22 lenders have gone bust in the last 2 months!) the US is holding rates steady but big banks are restricting lending. After a year of raising rates, Korea is holding rates still, as recession looms over their economy. Indonesia is in a similar situation, with rates up around 10% already. Canada stands still.

However, very few parts of the world are cutting rates, and those that are, have rates around 10% currently; every single country that is holding rates steady has far higher interest rates than Taiwan currently (usually around 5-10%); and most of the ‘biggies’ (Europe, Japan, UK, PRC) are pushing rates upwards.

So what happens?

What I expect to happen is the following, over the next 3 years - not just in Taiwan, but in most countries that have had their rates too low, for too long.

1. Credit cards and car loans can’t be paid back by consumers. Cars and items being taken back by the lender.
   

2. Car dealerships going out of business.
   

3. 10000’s-100000’s small businesses abandoned, as the costs of running them rise quickly and profits fall at the same time (because of reduced spending by consumers struggling to repay loans).
   

4. People really struggling to pay their mortgage. People starting to lose their homes, move back to their parent’s houses, share with friends, or rent instead. Household density increases (slightly more people start living in each house on average) leaving lots of property empty.
   

5. Banks stop lending mortgages to most people, since it has become too high risk.
   

6. The ’surviving’ small businesses starting to do much better from reduced competition after the initial difficulties.
   

7. Collapse of the housing market: house prices halve, or more, relative to the price of other goods.
   

8. Possible collapse of the stockmarket? (maybe - Taiwan’s stock market is export driven and so is being sustained by the weak exchange rate. It really depends on whether the same scenario plays out in the US and Europe).

Item 7 is the most interesting, because a drop in house prices in ‘real’ terms can happen two ways. Either:

(7a) house prices stay the same, and everything else becomes expensive (with very high interest rates), making houses relatively cheap.

(7b) house prices drop, and the price of everything else stays the same (with low interest rates), making houses relatively cheap.

Historically, it is usually (7a) that happens, because governments panic whenever people stop spending money, and governments start spending extra money like crazy or lending it out cheaply via the central bank, to try to get people to spend, spend, spend. Consequently, too many dollars floating around in the economy makes the price of things (measured in dollars) go up, i.e. inflation goes up.

The high interest rates that then appear (as rates rise to keep ahead of inflation) leads to many people struggling to survive.

(7b) would however be extremely interesting to watch. Japan and Germany have both experienced (7b), and it pushed their economies into disaster for 10 years. So, I’m very curious to see how this all turns out in the end…

Mu

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Some sources….

* i.e. here, here…

** i.e. CIA factbook,Taipei Times/Bloomberg 2 weeks ago…

*** Bank of Taiwan, 25th Feb 2007.

**** Comments from the governer of Taiwan’s central bank.