Dr. Frank Shostak - Director fshostak@aaseconomics.

com Applied Austrian School Economics Limited

ECONOMIC INSIGHTS

Sunday, 15 April, 2012

Strengthening in money supply rate of growth bodes well for Chinas economic activity ahead
CONTENTS

Pg.2| News flash. Pg.3-4| Chinas money supply growth momentum strengthened in March. Pg 5| US money supply up strongly in early April. Pg 6| Focus on US economic indicators. Pg 7-8| Growth momentum of US CPI eased in March. Pg.9| Focus on non-US economic indicators. Pg.10| Prospects for price of gold. Pg.11| US Treasuries up on European debt crisis, Chinas GDP. Pg.12 | S&P500 fell sharply on Friday. Pg.13-16| Why not every credit expansion is good for economic growth. Glossary.

The growth momentum of Chinas money supply strengthened last month. We forecast that due to likely strengthening in Chinas banks lending the money supply rate of growth will strengthen further in the months ahead. Based on the likely strengthening in the growth momentum of Chinas money supply we suggest that this should lead to a visible strengthening in Chinas economic activity ahead. This in turn should be positive for commodity prices. We also expect the growth momentum of Chinas consumer price index to ease visibly in the months to come. In the meantime, the growth momentum of US money supply (AMS) has increased strongly in early April. A key factor behind this increase is a strengthening in the pace of inflationary lending by commercial banks. Price inflation has eased further in the US last month. The yields on the 10-year T-note have fallen below the 2% on Friday. For the week the S&P500 lost 2%. According to our model the S&P500 is likely to be under pressure for several more months before a visible rebound ensues.
KEY GRAPH

%CHNG US AMS (YOY) 20

Eco-flash
According to our model the price of gold is forecast to ease to $1,650/oz by June before climbing to $1,960/oz by November. (p 10).

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12 % 8 4 0 2008:01

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News flash
Since 2009 the amount of cash held by US non-financial companies has increased by 56% to a record $2.232 trillion, according to Bloomberg News.

Russias central bank refrained from cutting interest rates after signaling that medium term inflation risks are increasing. The central bank left the refinancing rate at 8%.

Prime Minister Mariano Rajoy said Spains future is at stake in its battle to tame surging bond yields. The 10-year government bond yield stood at 5.98%.

The Bank of Japan left its key interest rate unchanged. The central bank kept its key rates between zero and 0.1%.

China reported a trade surplus for last month as import growth trailed forecast, underscoring risks of a deeper slowdown. The trade account was in surplus of $5.35 billion compared with a median projection for a $3.15 billion trade deficit.

Earnings at S&P500 Index companies, excluding financials, are seen gaining 0.6% in Q1 and Q2 from a year earlier, according to analysts estimates.

Indian industrial production rose less than predicted in February. Production advanced 4.1% from a year earlier. The median estimate in a Bloomberg News survey was for a 6.7% gain.

New claims for unemployment benefits in the US rose last week by 13,000 to a seasonally adjusted 380,000 the highest since January.

Federal Reserve Chairman Ben Bernanke said the central bank must increase it focus on maintaining financial stability in order to prevent a repeat of the crisis that triggered the worst recession since the 1930s.

China doubled its limit on the yuans daily moves against the US dollar to 1%. Also in China the yearly rate of growth of GDP fell to 8.1% in Q1 from 8.9% in Q4.

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Chinas money supply growth momentum strengthened in March The growth momentum of money supply M1 strengthened last month. The yearly rate of growth rose to 4.4% from 4.3% in February. An important driving force in the expansion of money M1 is bank lending. The Central Bank of China has already eased its monetary stance by lowering the required reserves that banks have to keep. The authorities have also eased the restrictions on bank lending. These steps are likely to boost the growth momentum of bank loans - year-on-year the rate of growth of bank loans increased by 15.7% in March from 15.2% in the month before.
%CHNG CHINA MONEY SUPPLY (M1) YOY 40 35 30 25 % % 20 15 10 5 0 2000:01 30 28 26 24 22 20 18 16 14 2010.01 %CHNG CHINA BANK LENDING (YOY)

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2010.07

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We forecast the yearly rate of growth of bank lending to rise to 15.9% by August before settling at 17.8% in December. Consequently the yearly rate of growth of money M1 is forecast to rise from 4.4% in March to 6.1% in August and 11.1% in December. In short, it is quite likely that the growth momentum of Chinese M1 has bottomed in January.
%CHNG CHINA BANK LENDING (YOY) 30 28 26 24 % % 22 20 18 16 14 2010:01 Forecast 40 35 30 25 Forecast 20 15 10 5 0 2010:01 %CHNG CHINA MONEY SUPPLY (M1) YOY

2010:07

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Based on the likely strengthening in the growth momentum of money supply we suggest that this should lead to a visible bounce in the yearly rate of growth in cement and steel production and economic activity in general. This in turn should provide support to commodity prices. Note that the yearly rate of growth of cement production jumped to 7.3% in March from 4.8% in February while the yearly rate of growth of steel production increased to 6.5% last month from 4.6% in February. (Now, the yearly rate of growth of real GDP eased to 8.1% in Q1 from 8.9% in the previous quarter).
YOY%CHNG:CHINA CEMENT PROD. VS M1 LAG 1 3 (NORMALISED SCALE)

YOY%CHNG:CHINA STEEL PROD. VS M1 LAG 4 2.0 1.5 1.0 (NORMALISED SCALE)

0.5 0.0 -0.5 -1.0

-1

-2 CEMENT M1 -3 2010:01 2010:07 2011:01 2011:07 MONTHLY 2012:01 2012:07

-1.5 -2.0 2010:01

STEEL M1 2010:07 2011:01 2011:07 MONTHLY 2012:01 2012:07

Meanwhile the yearly rate of growth of overall industrial production edged up to 11.6% in March from 11.4% in the month before. We hold that the growth momentum of industrial production might have already bottomed. Although the yearly rate of growth of the CPI jumped to 3.6% last month from 3.2% in February we suggest that based on the lagged money supply rate of growth the growth momentum of the CPI is likely to ease in the months ahead.
YOY%CHNG:CHINA IND.PROD. VS M1 LAG 2 (NORMALISED SCALE)
YOY%CHNG:CHINA CPI VS M1 LAG 8 (NORMALISED SCALE)

4 3

2
2

1 0 -1

-1 IND.PROD. M1 -2 2010:07 2011:01 2011:07 MONTHLY 2012:01 2012:07

-2 -3 2000:01 CPI M1 2005:01 MONTHLY 2010:01

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US money supply up strongly in early April The growth momentum of our measure of US money supply AMS has visibly strengthened in early April. Year-on-year the rate of growth jumped to 16.2% from 12.6% in March. In dollar terms AMS increased by $133.1 billion against March after rising by $31.4 billion in March versus February. A major contributor to this increase was demand deposits, which have risen by 56.7% in early April versus the year before.
%CHNG US AMS (YOY) 20
60 50 %CHNG US DEMAND DEPOSITS (YOY)

16
40

12 %
%

30 20 10

0 -10 2008:01

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We suggest that a key factor behind the strong increase in demand deposits is a strengthening in the pace of inflationary lending by commercial bank. (Banks are currently sitting on $1.488 trillion cash). Year-on-year the rate of growth of banks inflationary lending stood at 23.2% in early April versus 20.8% March and minus 1.4% in May 2011. Observe that currently the pace of pumping by the US central bank has actually weakened sharply. The yearly rate of growth of Feds balance sheet fell to 7.2% in April from 11.6% in March.
%CHNG US COMM BANK INFLATIONARY CREDIT (YOY) 25 20 15 10 %

%CHNG FED BALANCE SHEET (YOY) 25.0 22.5 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2010:01 %

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Focus on US economic indicators The trade deficit narrowed more than forecast in February. The gap shrank 12% to $46 billion, the smallest since October, from $52.5 billion in January. The February trade deficit with China narrowed to $19.4 billion from $26 billion, as imports plunged 18%. In the meantime, the government budget deficit widened to $198.2 billion in March against $188.2 billion in March last year. The 12-month moving average of the budget stood at a deficit of $104 billion in March versus $103 billion in February.
US TRADE ACCOUNT -20
40 20 US FEDERAL GOVERNMENT BUDGET (12MMA)

-30

0 -20

BILL $

BILL $

-40

-40 -60 -80 -100

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-120 -140

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The growth momentum of wholesale sales has strengthened in February. Year-on-year the rate of growth climbed to 9.3% from 7.4% in the previous month. Using the lagged yearly rate of growth of AMS we can suggest that the growth momentum of wholesale sales is likely to come under pressure for several months before a turning point emerges. Confidence among US consumers cooled in April from March. The Thomson Reuters/University of Michigans preliminary index of consumer sentiment fell to 75.7 from 76.2 in March. The expectations component of the index jumped however to 72.5 this month from 69.8 in March.
YOY%CHNG:US WHOLESALE SALES VS AMS LAG 25 (NORMALISED SCALE)
US CONSUMER SENTIMENT INDEX 80

3 2 1

75

70 INDEX

0 -1 -2 -3 -4 2000:01 SALE AMS 2005:01 MONTHLY 2010:01

65

60

55 2009:01

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Growth momentum of US CPI eased in March The growth momentum of the US consumer price index (CPI) softened further in March. Year-onyear the rate of growth eased to 2.65% from 2.87% in February. In March 2011 the rate of growth stood at 2.68%. The yearly rate of growth of the CPI services component stood at 2.1% in March against 2% in the month before and 1.44% in March 2011.
%CHNG US CPI (YOY) 6 5 4 3 2 % 1 0 -1 -2 -3 2000:01 0 2000:01 1 % 3 4 5 %CHNG US CPI SERVICES (YOY)

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The yearly rate of growth of the CPI food and beverages component fell to 3.2% from 3.8% in February. In March 2011 it stood at 2.8%. Also observe that the yearly rate of growth of the CPI energy fell to 4.6% last month from 7% in February. According to the Bureau of Labor Statistics the growth momentum of consumer purchasing power eased slightly last month. Year-on-year the rate of growth stood at minus 2.46% in March against minus 2.88% in the month before and minus 2.6% in March 2011. In short, the erosion of peoples purchasing power has slowed down.
%CHNG US CPI FOOD & BEVERAGES (YOY) 7 6 5 4 %
% 3 2 1 0 -1 %CHNG PURCHASING POWER OF US CONSUMER (YOY)

3 2 1 0 -1 2000:01

-2 -3 -4 -5 -6 2000:01

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Using the lagged yearly rate of growth of our monetary measure AMS we can suggest that the growth momentum of the U.S. CPI is likely to weaken further the months ahead. Based on the yearly rate of growth of AMS (lagged by 29 months) we have estimated that the yearly rate of growth of the U.S. CPI could fall to 1.3% by October before settling at 1.4% by December.
YOY%CHNG:US CPI VS AMS LAG 29 3 2 1 0 -1 -2 -3 -4 2000:01 % (NORMALISED SCALE) 4 Forecast 3 2 1 0 -1 -2 -3 2009:01 %CHNG US CPI (YOY)

CPI AMS 2005:01 MONTHLY 2010:01

2010:01

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In the meantime, the yearly rate of growth of the CPI less food & energy core CPI stood at 2.3% in March versus 2.2% in the month before. Note that in March 2011 the yearly rate of growth stood at 1.2%. The lagged yearly rate of growth of industrial production indicates that the yearly rate of growth of the core CPI has likely peaked in March. By December the yearly rate of growth is forecast to settle at 2%.
%CHNG US CPI LESS FOOD & ENERGY (YOY) 3.0

YOY%CHNG:US CPI LESS F.ENERG. VS IND.PROD.(-19) (NORMALISED SCALE)

2.5

0
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-3 CPI LFE IND PROD 2005:01 MONTHLY 2010:01

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Focus on non-US economic indicators A UK house price index rose to a 21-month high in March as the first time buyers sought to take advantage of an expiring property tax exemption, the Royal Institute of Chartered Surveyors (RICS) reported. The gauge rose 3 points from February to minus 10, the highest reading since June 2010. In Germany price inflation has eased last month. The yearly rate of growth of the CPI fell to 2.3% in March from 2.5% in February.
UK RICS HOUSE PRICE GAUGE 80
4 %CHNG GERMAN CPI (YOY)

40

GAUGE

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%

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In Australia employment increased by 44,000 in March against the median estimate for a 6,500 increase in a Bloomberg News survey of 24 economists. The unemployment rate stayed at 5.2% compared with expectations for a rise to 5.3%. Meanwhile, the growth momentum of Japanese AMS has eased in March. Year-on-year the rate of growth fell to 0.3% from 0.8% in February.
AUSTRALIAN UNEMPLOYMENT RATE 6.0

%CHNG JAPANESE AMS (YOY) 6 4 2 0

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% -2 -4 -6 -8 2008:01
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4.8

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Prospects for the price of gold At the end of March the price of gold closed at $1,694.7/oz a fall of 1.6% from February. The growth momentum of the price of the yellow metal has also weakened. Year-on-year the rate of growth fell to 16.7% from 20.1% in February. The ratio of the price of gold to its 12-month moving average fell to 1.011 in March from 1.04 in the month before.
PRICE OF GOLD 2,000 1,600 1,400 1,200 US$ PER OUNCE 1,000 800 600

PRICE OF GOLD TO 12MMA RATIO 1.4

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To assess the future direction of the price of gold we have employed our gold model. The price of gold in our model is driven by the state of US economic activity, US monetary liquidity the production of gold and the state of Chinas economic activity. The simulation of the model against the actual data is presented in the chart on the left below (see chart). According to our model the price of gold is forecast to ease to $1,650/oz by June before climbing to $1,960/oz by November. In December the price is forecast to ease to $1,800/oz.
GOLD PRICE VS MODEL SIMULATION 2,000 1,600 1,400 1,200 US$ PER OUNCE

GOLD PRICE 2,000 1,800

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ACTUAL MODEL 2000:01 2005:01 MONTHLY 2010:01

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US Treasuries up on European debt crisis, Chinas GDP Treasuries rose on Friday, pushing 10-year yields below 2% on speculation Europes sovereign debt crisis is worsening. Treasuries were also supported after a report showed Chinas GDP rose less than economists forecast, raising expectations for a deepening world economic slowdown. Yields on 10-year note fell 7 basis points to 1.98%. Yields have declined 30 basis points since the week ending March 16. According to a survey by Citigroup Global Markets almost 45% of investors said they didnt expect the Fed to carry out a third round of quantitative easing, known as QE3. That was down from almost 60% who said no QE3 in a March survey. The yield spread between 10-year and 2-year Note stood at 1.719% versus 1.878% in March.
YIELD US 10-YR T-NOTE 4.0 3.0 2.8 2.6 3.2 2.4 % 2.2 2.0 1.8 2.0 1.6 1.4 2009:01 YIELD SPREAD US TREASURIES:10YR VS 2YR

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1.6 2009:01

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The TED spread stood at 0.380% against 0.397% in March. The spread is the difference between the 3-month rate to borrow in the London inter-bank market and the rate on the 3-month US T-Bill. Our model, which is driven by liquidity, price inflation, economic activity and outstanding federal debt, indicates that the yield on the US 10-year T-Note could settle at 2.15% by August. By December the yield is forecast to climb to 2.26%.
"TED" SPREAD 1.2
4.0 YELD US 10YR T-NOTE

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Forecast

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S&P500 fell sharply on Friday The S&P500 index fell 1.3% on Friday to close at 1,370.26. For the week the index fell 2%. The stock price index fell on the back of a fall in consumer sentiment, a fall in the Chinese GDP rate of growth and on the growing risk of a Spanish sovereign debt default. Against the end of March the S&P500 fell 2.7%. The growth momentum of the stock price index has also fallen visibly. The yearly rate of growth fell to 0.49% from 6.2% in March. The S&P500 to its 12-month moving average fell to 1.059 from 1.089 in March. Note though that the stock price index was still up 9% this year. The S&P500 per share profit growth slowed to 1.7% during Q1 of this year from 4.9% in Q4. For 2012 the profit growth is forecast to stand at 8.6%, according to analysts estimates compiled by Bloomberg.
S&P 500 1,600 1,400 1,200 INDEX
RATIO 1.2 S&P500 TO 12-MMA RATIO

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We have employed our model to assess the future course of the S&P500. The model is driven by monetary liquidity and the overall state of US economic activity. The model simulation against the actual data is shown in the chart below left (see chart). According to our model the S&P500 stock price index is forecast to close at 1,368 by May. Afterwards the S&P500 index is forecast to bounce visibly closing at 1,580 into December.
S&P500: ACTUAL VS MODEL 2,000 1,500 1,000

S&P500 1,600 Forecast 1,500 1,400

INDEX

300 200 150 100 ACTUAL MODEL 1990:01 2000:01 MONTHLY 2010:01

INDEX

500 400

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50 1980:01

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Why not every credit expansion is good for economic growth In their various statements central bank policy makers have said that the key to economic growth is a smooth flow of credit. For them it is credit that provides the foundation for economic growth and raises individuals living standards. So from this perspective it makes a lot of sense for the central bank to make sure that credit flows again. Following the teachings of Friedman and Keynes it is almost the unanimous view of most experts that if lenders are unwilling to lend then it is the duty of the government and the central bank to keep the flow of lending going. For instance, if in the commercial paper market lenders are not there then the Fed should step in and replace these lenders. The important thing, it is held, is that various businesses that rely on the commercial paper market to keep their daily operations going should be able to secure the necessary funding. Now it is true that credit is the key for economic growth. However, one must make a distinction in this regard between true and false credit. It is true credit that makes real economic growth possible and thus improves peoples lives and well being. False credit however, is an agent of economic destruction and leads to economic impoverishment. True credit versus false credit There are two kinds of credit: that which would be offered in a market economy with sound money and banking (true credit), and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (false credit). Banks cannot expand true credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (lenders) to borrowers. To understand why, we must first understand how true credit comes to be and the function it serves. Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight. He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week's time. Note that credit here is the transfer of 'real stuff' i.e. eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes. Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight. Note that the saved loaves of bread provide support to the shoemaker i.e. it sustains him while he is busy making shoes. This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is a path to real economic growth. Money and credit The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to shoemaker. With eight dollars the shoemaker can secure either eight loaves of bread or other goods to support him while he is engaged in the making of
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shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things also has eight loaves of bread that the baker has produced. Also note that without real savings the lending of money is an exercise in futility. Observe that money fulfils the role of a medium of exchange. Thus when the baker exchanges his eight loaves for eight dollars he retains his real savings so to speak by means of the eight dollars. The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services. There is one provision here that the flow of production of goods continues. Without the existence of goods the money in the bakers possession will be useless. The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker. The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes. Despite the apparent complexity that the banking system introduces, the essence of credit remains the transfer of saved real stuff from lender to borrower. Without an increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings. Now, when the baker lends his eight dollars we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully 'backed-up' dollars so to speak. False credit - an agent of economic destruction Trouble emerges however if instead of lending fully backed-up money, a bank engages in issuing empty money (fractional reserve banking) that are backed-up by nothing. When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoeswhat he needs instead is bread. Since the printed money masquerades as proper money it can be used to "steal " bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money out of "thin air" is all about. If the extra eight loaves of bread weren't produced and saved, it is not possible to have more shoes without hurting some other activities, which are much higher on the priority lists of consumers as far as life and well being is concerned. This in turn also means that unbacked credit cannot be an agent of economic growth. Rather than facilitating the transfer of savings across the economy to wealth generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of

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wealth formation. It has to be realised that banks cannot ongoingly pursue unbacked lending without the existence of the central bank, which by means of monetary pumping makes sure that the expansion of unbacked credit doesn't cause banks to bankrupt each other. We can thus conclude that as long as the increase in lending is fully backed-up by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of "thin air", is bad news - credit which is unbacked by real savings is an agent of economic destruction. Neither the Fed nor the US Treasury are wealth generators and hence they cannot generate real savings. This in turn means that all the pumping that the Fed has been doing recently cannot lift lending unless the pool of real savings is expanding. On the contrary, the more money the Fed and other central banks are pushing the more they dilute the pool of real savings. Yet most commentators are of the view that given the present fragile state of the financial system the central bank and the government must intervene to prevent the collapse. But how then can the government and the central bank help in this regard? How can the central bank or the government generate more real savings? The only thing that the government and the central bank can do is to redistribute real savings from other people and give it to banks. Now if the pool of real savings is still expanding this can work and lending might flow again. If, however, the pool of real savings is falling then it will not be possible to increase the flow of productive i.e. true, lending.

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GLOSSARY Money AMS - stands for the Austrian School of Economics money supply definition. The aim of this definition is to ascertain as accurately as possible the amount of money in an economy. Monetary liquidity - stands for the yearly rate of growth of money AMS adjusted for the rate of growth of nominal economic activity. The pool of funding - stands for the stock of final goods ready for human consumption. The state of the pool sets the limit for economic growth. Real savings the amount of consumer goods produced locally less the amount taken by the producers of these goods. The reshuffling process - the diversion of real savings from wealth generating activities towards activities that sprang up on the back of loose monetary policy. Productive consumption - consumption that is preceded by production of wealth i.e. consumption that is backed up by the production of wealth. Non-productive consumption - consumption that arises as a result of monetary pumping and is not supported by wealth production. This type of consumption weakens the flow of real savings. Unbacked loans - lending that is not backed up by real savings. This type of lending is created through fractional reserve banking i.e. lending out of "thin air".

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