Random thoughts of an economist

There is a big downside risk in the property market, you know?

Posted in Economics, Forecasting, Hong Kong, Uncategorized by kafuwong on January 25, 2013

There is a big downside risk in the property market, you know?

Everyone seems to see buying properties a good investment.  Yes.  At the current interest rate.

The problem is that interest rate will unlikely stay at this low level for very long.  The US Federal Reserve will likely keep its stimulative policies until the unemployment rate falls to 6.5%. Looking at the trend of unemployment rate, it looks likely that the unemployment rate will reach 6.5%  around 2015.  See http://research.stlouisfed.org/fred2/series/UNRATE.  So, we would expect the Fed to start to raise interest rate in 2015.  Looking at historical data of the Fed Funds rate (http://research.stlouisfed.org/fred2/series/FEDFUNDS), I would not be surprised to see the rate to rise above 2.5 percent in 2016.  How would an increase in interest rate affect our investment in property?

A simple present value formula should give us a ballpark estimate.  The present value formula says, the value of an asset (say, P) is a discounted sum of the future income stream.  Suppose we have the annual rental income R and the annual interest rate r. Assume that we can collect the same rental income indefinitely.  Using a geometric sum formula, we can verify that P=R/r.  For example, when annual rental income R is 100,000 (or 0.1 million) and annual interest rate r is 0.01 (i.e., 1%), the property value should be around 10,000,000 (or 10 million).  We can explore with different R and r.

The important point is that the property price is inversely related to r.  When r drops by 50%, P will rise by 100%.  When r rises by 100%, P will fall by 50%.

Do you still want to buy?

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A consistent bias in the Hong Kong’s budget surplus forecast

Posted in Economic growth, Economics, Forecasting by kafuwong on March 11, 2012

A plot is worth a thousand words. Why has there been a consistent bias in the government forecast of budget surplus? Why has the government been consistently pessimistic about the economy?

A forecast of labor shortage in Hong Kong

Posted in Economic growth, Economics, Forecasting, Population by kafuwong on March 11, 2012

Recently, the Hong Kong government released a forecast of manpower supply and demand to 2018. February 09, 2012 (http://www.legco.gov.hk/yr11-12/english/panels/mp/papers/mp0216cb2-1010-1-e.pdf). Some key findings were summarized below.

• The overall manpower supply is projected to be 14,000 people short of the overall manpower requirement in 2018 due to the ageing population.

• Releasing its preliminary key findings today on the manpower projection to 2018, the Labour & Welfare Bureau forecast manpower supply in 2018 to be 3,582,400, while the manpower requirement will be 3,596,400. The manpower requirement is forecast to grow at an average annual rate of 1.1%.

• It said the shortfall is due to slower growth in supply, mainly attributable to the ageing population.

• The manpower requirements of the four pillar industries are projected to increase, with tourism being the highest industry at 2.9% and financial services at 2.5%.

• The three economic sectors expected to grow fastest are financial services, at an average annual rate of 2.5%; and, construction, information and communications, which will grow at 1.9%.

• The Government will continue to upgrade the competitiveness and employability of low-skilled workers through training and retraining, the bureau said.

How do we understand such projection?

First, we have to understand that from economic perspective, without regulations, markets tend to clear by adjusting prices and quantities. Shortage cannot happen if prices are allowed to adjust freely. If one predicts a shortage of manpower, one must have assumed that the prices are not allowed to change. In fact, in economics, a shortage results whenever the price is regulated at a level below the equilibrium wage. That is, a more correct statement is “If wage is now regulated or kept at the current level, the change in supply and demand condition will result in a shortage of manpower of x  number of workers.” The corollary is that “If wage is allowed to adjust to clear the market, the change in supply and demand condition will result in an increase in wage by y  percent.”

We need to read similar reports with a grain of salt. Have we seen any manpower report that forecast a surplus of manpower? Of course not. Why not? Such report is meant to accomplish something. Let’s think about it. If you tell me you forecast a labor shortage, I will probably follow you logic that the labor shortage will hinder economic growth and thus a relaxation of immigration policy is justified. My problem is: Why don’t you describe your forecast as that the wage is going to increase. Is an increase in wage bad news? It is bad news to capitalist who would like to enjoy low-cost labor. However, it is in fact good news for workers! In short, we should understand the conclusion of a labor shortage (instead of an increase in wage) helps the capitalists. Why should we help the capitalists?

If we were start from scratch to produce a similar forecast report, we would have to think about how we can forecast labor shortage using different approaches. Can we produce forecast of labor shortage using historical shortage? In a free-market economy like Hong Kong, manpower shortage is theoretically zero at any given point in time. Thus, if we want to use the historical shortage to forecast future shortage, the best forecast is zero shortage. That is, we will not get anything that is nonzero.

The alternative is to forecast the labor supply and labor demand separately. Labor supply can broadly be estimated as the population between 15 to 65. In a close economy, we can produce a pretty accurate forecast based on population pyramid, taking into account the mortality rate and birth rate. The forecast can become slightly more complicated when immigration and emigration are taken into account. Immigration and emigration depends on the economic opportunities of Hong Kong relative to the rest of the world. When Hong Kong offers better opportunities than the United States, then some Americans will come to Hong Kong. Similarly for the flow between Hong Kong and mainland China. Of course, mainland China will be the major inflow. The flow from mainland has been driven by differences in economic opportunities, welfare, freedom, and re-union (cross-border marriages). To forecast this flow, we need to forecast the difference in economic performance of Hong Kong relative to many other countries. This task is daunting but we can always focus on a handful of countries from which we have more flow of people (both in and out). If we can produce a labor supply forecast, we definitely want to have a forecast by age group and education background. To do this kind of forecast, one will need to do extensive research. The easier alternative is to sit in an armchair and guess some reasonable numbers.

Labor demand is complicated. If we want to forecast labor demand using historical demand, we only have one data point at each given month. That data point is in fact the equilibrium quantity of labor, the result of an interaction of labor supply and demand. Thus, unlikely this quantity will be useful to forecast labor demand. One possibility is to do a survey and ask firms how many more workers they will hire in the coming 10 years — at the current wage rate. How many firms will be able to tell us such number? Unlikely any. Thus, one boils down to sitting in an armchair and trying to make some “reasonable” assumption of labor demand growth by sectors. How do we get those numbers? Likely by gut feelings. Sometimes, we will make an assumption of 2% growth in a sector, and let the computer to simulate what happen after many years.

In fact, what we are doing here is called scenario analysis. There is a popular way to do similar scenario analysis — computable general equilibrium (CGE) models. Here is an excerpt from wikipedia, http://en.wikipedia.org/wiki/Computable_general_equilibrium

Computable general equilibrium (CGE) models are a class of economic models that use actual economic data to estimate how an economy might react to changes in policy, technology or other external factors.

Given all this armchair forecast, how accurate will this forecast be? Highly inaccurate. It could be the case that when we adjust an assumption slightly, we can get a forecast of labor surplus. Will we report the labor surplus when we forecast one? Of course not! We are given the task to write a report that serves the hidden agenda. Only a forecast of a big labor shortage will cut it!

If I were going to do similar work (very time-consuming) with adequate freedom, I would want to report the set of parameters and models from which a given forecasted labor shortage will result. At least, it gives the readers a sense how reasonable (or unreasonable) my underlying assumptions are. I would also put my codes on the web so that other researchers could replicate my work, change the assumptions and produce new set of forecast.

Finally, we must note that an increase in wage in Hong Kong (i.e., better opportunities) will attract inflows of people from other countries. Even if there is an increase in demand for labor, it is likely filled by inflow from the other countries. That is, nothing to worry about. Let the market guide us. Do not use the highly inaccurate forecast that is led by a hidden agenda to help the capitalists.

Containing the monster of inflation!

Posted in China, Economics, Exchange rate, Forecasting, Nguyen Phuong Thuy, Trade balance by kafuwong on February 17, 2011

[Written jointly with Nguyen Phuong Thuy]

Experiencing a global quick recovery, Chinese economy is beginning to over-heating (relatively high economic growth and inflation). It is reported that the country attempts to control inflation by increasing the interest rates and let their currencies appreciate. (http://www.bloomberg.com/news/2011-02-08/china-raises-benchmark-one-year-deposit-lending-rates-by-25-basis-points.html)

How do these tools help contain inflation?

To simplify the discussion, let’s imagine that China produces only widgets.  Then, inflation will simply be the percentage change in the price of widgets.  A rapid increase in the price (a high inflation, in other words) is driven by an increase in demand or decrease in supply.  To contain inflation, one must reduce the speed of increase in demand or the speed of decrease in supply.  Interest rate is a cost of consuming and investing today instead of tomorrow.  Thus, raising the benchmark interest rate encourages people to reduce their demand for consumption and investment today.  Thus, a higher interest rate will lower the demand or reduce the speed of increase in demand.  (Of course, since interest cost is a cost of production, a higher interest rate will also raise the cost of production and therefore reduce supply.  However, the impact of interest on supply curve is usually relatively negligible relative to its impact on demand.)

The higher interest rate or yield will also make domestic assets more attractive to foreign investors. IF China’s currency is perfectly convertible, we would expect a higher demand for RMB by foreigners, resulting in an appreciation of the RMB.  Consequently, Chinese exports become more expensive to foreigners and imports from foreign countries become cheaper to Chinese firms.  This reduction in foreign and domestic demand for Chinese products will further reduce the demand for widgets. 

Of course, China’s currency is not freely convertible.  Consequently, to reduce the demand for widgets from the foreign trade sector, the government has to revalue (or appreicate) its currency.  

          China is not alone in dealing with its overheating economy.  Other economies in the region also raise their rates in order to keep inflation as targeted. The deposit rates first announced in Feb 2011 of the top bank deposit accounts in Asia can be found at http://asia.deposits.org/ .

          How long it takes for these effects to work, on the other hand, depends on how the quick economic agents in the economy respond to the change in the interest rates, for example, how consumers change their decisions over spending and savings. Therefore, we should expect the size of timing to be different in different economies.  Nevertheless, full effect of monetary policy like this is expected to take about one to two years.  

History tells us that rate hikes are usually higher serially correlated (a rate hike tomorrow is more likely if there is a rate hike today).  So, one would expect more rate hike to come. 

Let’s wait and see.

When will you publish your book?

Posted in Econometrics, Forecasting, teaching by kafuwong on April 24, 2010

Today is the last teaching day of a postgraduate level course of Economic Forecasting. After the lecture, a student quietly waited for me.  Usually, right after lecture, I would be busy saving my video lecture, packing up my laptop and the external sound card connected to the AV system. etc.    It turned out that he was waiting for my signature on the printed copy of my textbook draft for the course.  I no longer use any published text for the course.  I have written one.  It still needs polishing but it is a readable draft. 

I signed on the cover of his copy.  I feel so honored.  He also pointed out some mistakes in the book.  I am glad.  At least one student has been reading my book seriously. 

“When will you publish the book?”  He is not the first one to ask this question.  Some of my colleagues did before him.  Honestly, I have no plan to do so.  You know what: A typical printed copy of a textbook will be priced at two hundred Hong Kong dollars, out of which the author will get less than 40 dollars as royalty.  Counting the trouble of publishing I have to go through, the 40 dollars of royalty is not worth the effort.  Why do I write the book then?  I started writing the book because I was not satisfied with the books available.  I wanted to use a customised book to improve teaching and learning of the course materials.  My effort of writing the book will be worthwhile if my students learn better with it. 

When I feel the draft is ready, I intend to make the book available to all soon — free of charge.  I am not the only one with such intention.  If you search the internet, you will easily find a lot of free textbooks.  The extreme is http://pareto.uab.es/mcreel/Econometrics/.  Michael Creel has made his graduate econometrics text an “open source”, specifically, licensed as GNU GPL. In his words, “anyone can access the document in editable form, and can modify it, as long as they make their modifications available. This allows for personalization, as well as a simple way to make contributions and error corrections. The hope is that people preparing to teach econometrics for the first time might find it useful, and eventually be motivated to contribute back to the project.”  If more authors contribute in similar manner, we will likely have a faster progress in knowledge advancement.

Impact of an revaluation of Reminbi on the Chinese economy

Posted in China, Econometrics, Economics, Exchange rate, Forecasting, Research, Trade balance by kafuwong on April 17, 2010

Recently (early 2010), the United States has been pushing China to revalue its currency (Reminbi).   Central to the debate of revaluation of Reminbi (RMB) is the impact of such revaluation on the Chinese economy.  I have seen people giving a qualitative analysis (for instance, http://mpettis.com/2010/03/how-will-an-rmb-revaluation-affect-china-the-us-and-the-world/).  How do we obtain a quantitative estimate of the impact? 

Building a structural model?  Building a structural model of the Chinese economy can take enormous time and resources — not something you and I can afford.  An alternative but cheaper approach is to assume that a small set of macroeconomic variables (employment, real exchange rate, trade balance, consumer price index, etc.) approximately evolves over time as a close system.  This set of macroeconomic variables is known as a vector of variables.  This vector is assumed to evolve over time as an autoregressive process (i.e., y_t=a_0+a_1 y_{t-1} +... +a_p y_{t-p}+e_t, or in other words, current values of the vector depends on the past values of the vector and a shock).   We can then apply Ordinary Least Squares (OLS) to estimate the parameters equation by equation.  An impulse response function can be calculated.  The impulse can be a change in the real exchange rate (which is a ratio of domestic and foreign prices adjusted for exchange rate).  The response can be the trade balance, or the unemployment rate.

This modelling technique is called the Vector AutoRegressions, or VAR in short.  It is often taught in courses like Economic Forecasting.