Maybe Mars

The IMF warns about surplus countries and global imbalances

October 3, 2009 in Asian development model, Consumption and production, NPLs by Michael Pettis | No comments

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As Beijing slowly unlocks from its 60^th anniversary celebrations \’96 the streets are still relatively empty but more and more people are going out, although my local Starbucks still hasn\’92t reopened, forcing me to go elsewhere for my hardcore caffeine fix \’96 a lot is still going on in the rest of the world. Both the US and the IMF have come out with releases that help us to pick through the problems that China and the world are facing.

Before discussing these releases, let me make a quick digression to an event that a lot of people have been asking me about. Two weeks ago China Construction Bank announced that it would rollover 24.7 billion yuan in bonds that it had \’93purchased\’94 from its AMC, Cinda, for another 10 years. Bank of China and ICBC, which sit on 473 billion yuan worth of AMC bonds, will probably do the same when their AMC bonds come due.

What does this all mean? Remember that as part of the recapitalization of the banks after the NPL fiasco of 10-15 years ago, the AMCs (asset management companies) were created to purchase and liquidate the bad debt. There is a big argument as to whether or not they took out all the garbage loans, but at any rate they bought a lot of bad debt and, since they had no assets of their own, paid for them with issues of medium term bonds, which they exchanged in two tranches. One tranche was for 100% of the face value of one portion of the bad loans they took on, and the other was for 50% of face of the rest of the bad loans they acquired.

The problem of course is that these bad loans were worth a lot less than either 100% of face or even 50% of face. In fact they have been liquidated at a rate of about 20% of face. This leaves the AMCs bankrupt and unable to repay the bonds, so when they came due the bonds were simply rolled over. There is a sort of comfort letter from the Ministry of Finance (its exact value is in dispute), so the banks have been able to get away with treating the bonds as money good. The point of all this is to remind us that all the .losses for the earlier spate of bad loans, even assuming that all the bad loans were identified and cleaned up (which I doubt) have not been resolved.

Someone (the banks? The Ministry of Finance?) will eventually have to pay up. If the process is allowed to drag on for many years, I suspect that the banks will pay out of retained earnings, but since retained earnings at the banks consist primarily of the very wide spread between the lending rates and the interest rates that banks are allowed to pay depositors, ultimately this means that households will be forced to recapitalize the banks. If there is a short term problem, however, perhaps leading to a crisis of confidence in the banks, I suspect that the MoF (unless debt at the sovereign level in the mean time becomes a problem) will explicitly guarantee the bonds or take them directly on the government balance sheet.

US unemployment picture is ugly

To return to the rest of the world, unemployment in the US is not getting better. Yesterday the Labor Department released figures that showed the US unemployment rate climbing to a fresh 26-year high of 9.8% in September. According to an article in the Financial Times:

Official figures on Friday showed that non-farm payrolls dropped by 263,000, making it the 21st consecutive month that the US economy has shed jobs. The data were worse than even the most grim expectations, as economists predicted a 175,000 drop in payrolls, and followed a decline of a revised 201,000 jobs in August when the unemployment rate was 9.7 per cent.

Although I think most economists are expecting that US economic growth in the third quarter was a fairly healthy 3%, as far as China is concerned it is not the future growth in the US economy that matters so much as future growth in US consumption. A jobless recovery in the US, if that is what we get, probably means that dragging household consumption will not be the engine of US growth, and even less will it be the engine of Asian growth, which it was for so many years. Any Asian and Chinese recovery predicated on a revival of out-of-control US consumption is likely to be disappointed.

On Thursday the IMF released its World Economic Outlook, which was mildly positive on the global economy, arguing that \’93the recovery has started, financial markets are healing, and in most countries growth will be positive for the rest of the year as well as in 2010,\’94 although in line with the US employment report it worried that \’93the pace of recovery is expected to be slow and, for quite some time, insufficient to decrease unemployment\’94 (later in the report they say \’93the current rebound will be sluggish, credit constrained, and, for quite some time, jobless\’94). The report also argued that because most of the \’93recovery\’94 has been based on public spending and, I guess especially in Asia, gearing up capacity without much regard for demand, an economic recovery was likely to be slow and risky.

The IMF seems increasingly to be agreeing with the \’93global imbalances\’94 analysis of the economy, probably to the dismay of China and other surplus countries. Early in the report it says:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand and imports.

Surplus countries must consume more

The interesting thing for me was this focus on surplus countries. Although there does seem to be an economic rebound, the report says, the recovery will be weak unless countries with large trade surpluses step up domestic demand. To keep growth up, surplus countries like China must boost domestic spending, and appreciate their currencies. This pretty tough claim will probably not make Beijing, Berlin or Tokyo very happy, although it does chime with US views on global trade imbalances. In their own words:

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. In these economies, private consumption and investment are unlikely to pick up the slack that will be left by diminishing fiscal stimulus, given that household incomes and corporate profits will be subdued and balance sheet repair will be under way for some time, implying higher saving rates.

The authors of the report do not seem terribly optimistic about the prospects for a sustainable spurt in surplus-country domestic demand in the near term (\’93This process of rebalancing global demand will be drawn out.\’94) but I am not sure, perhaps because the IMF is after all a very politicized institution, that they specify the trade consequences. They acknowledge that there will be a problem with expected increases in savings in one part of the world conflicting with high savings elsewhere, and they don\’92t seem very optimistic about prospects for a surge in investment, but it seems to me that they shy away from working out how this will happen and how the pain will be distributed (through the trade account, I would argue).

What about overinvestment?

In a section in Chapter 4 of the report entitled \’93Do Precrisis Conditions Help to Predict Medium-term Output Losses?\’94 there was an interesting discussion about the relationship between output losses associated with a crisis and pre-crisis investment levels. On especially commented on section had this:

The prominent role of investment and capital losses suggests that the level and evolution of precrisis investment would be good predictors of eventual output losses. Indeed, regression results provide strong evidence that economies with high precrisis investment-to-GDP ratios, measured as the average investment-to-GDP ratio during the three years before the crisis, tend to have large output losses.

In contrast, the investment gap, defined as the deviation from its historical average of the investment-to-GDP ratio during the three years before a crisis, is not statisti\’adcally significant. We return to potential interpretations of these results later in this section, but it is worth mentioning that the precrisis investment share is particularly robust as a leading indica\’adtor, even after controlling for the level of the current account balance. This suggests that countries that have high investment rates tend to experience larger output declines follow\’ading banking crises, irrespective of whether the investment is financed by foreign or domestic savings.

For those of us who worry about China\’92s having recently increased its already-excessively-high investment rate, this passage was an uncomfortable read. In addition for people like me, who believe strongly that the very process of misallocated investment will act as a damper on future consumption growth (and I think this is becoming much more widely accepted, or at least discussed, in policy circles), the combination of warnings over overinvestment and pleas for more consumption from trade surplus countries is deeply worrying. By the way, for a short and quick view of why I think consumption won\’92t grow, you can check a recent debate held by the New York Times on the subject of Chinese consumption growth.

So what about all this excess investment? The State Council recently made a lot of noise about its determination to curb excess capacity. Here is the Financial Times version of the story:

China has issued a stark warning about the risk from rising overcapacity in the economy, saying it could hamper recovery and lead to a surge in non-performing bank loans. The State Council, the country\’92s cabinet, issued a new plan to combat overcapacity in seven industries, barring new aluminium smelters for three years and criticising \’93blind expansion\’94 in parts of the steel and cement industries.

The cabinet statement, which came late on Tuesday evening in Beijing, follows a crescendo of warnings from senior officials. It also outlined measures to restrict manufacturing of equipment for \’93green\’94 industries of wind and solar power. China\’92s economy has rebounded sharply in recent months due to an investment boom \’96 much into infrastructure \’96 fuelled by increased public spending and a surge in lending by the state-owned banks.

But over the past three months many government officials have begun to publicly warn that the credit binge could create overcapacity in heavy industry, which could produce a new round of bad bank loans.

The article in the South China Morning Post adds some color, and a partial explanation of why all these angry statements about preventing excess capacity over the past few years have had so little effect:

In unusually blunt wording, the cabinet also pointed its finger at local authorities. \’93Some regions have acted illegally. We are once again seeing cases of illegitimate approvals, of construction starting before it has been approved, and of construction starting even as the approval process is underway,\’94 it said.

The cabinet\’92s strident warning about overcapacity underscored why officials have been circumspect about the economy, repeatedly saying that it has shown signs of recovering from the global financial crisis but is still not on solid ground.

It is hard to give up investing

The truth is everyone in the world is against the creation of \’93excess\’94 capacity, but as long as Beijing has in place policies that explicitly subsidize investment and production, it will take an awful low more than fulminating against wasteful investment to eliminate it. I would argue that wasteful investment is the automatic consequence of policies that lower the cost of capital to \’93unreasonable\’94 levels, implicitly socialize risk, and otherwise subsidize producers in the name of boosting employment.

Since Beijing has very explicitly chosen to attack rising unemployment in the short term \’96 probably wisely, although also probably more ferociously than was optimal \’96 there is little they can do to prevent a massive rise in wasteful investment. You cannot take an economy with the highest investment rate in history, and already massive waste, and very quickly force investment rates up even higher, without also increasing waste. The problem with all this wasted investment, of course, is that someone must pay for it, and that \’93someone\’94 will undoubtedly be Chinese households, who will then almost certainly go on to disappoint us by failing to splurge on consumption.

And are they really serious about tackling excess capacity? Here is what Bloomberg said in an article earlier this week about the shipping industry:

China and South Korea\’92s support for shipbuilders may add to a glut of capacity, slowing a recovery in freight rates and vessel prices. The world\’92s two largest shipbuilding nations have taken steps this year to aid shipyards and safeguard jobs as customers delay or scrap orders amid tumbling world trade. That support will likely ensure more vessels enter service, even as lines mothball and scrap existing ships because of a lack of cargo.

\’93The Chinese and Koreans, in particular, will make sure that these ships come,\’94 Philip Clausius, chief executive officer of lessor First Ship Lease Trust, told a conference in Singapore yesterday. The \’93daunting number\’94 of ships that \’93will hit the market over the next three, four, five years will make the recovery a rather slow and painful one.\’94

China\’92s bid to become the largest shipbuilding nation by 2015 may also worsen the glut as it competes for market share, said Matthias Umlauf, senior economist at HSH Nordbank AG. The world\’92s shipyards have dry-bulk ship orders with a combined capacity of 64 percent of the existing fleet, according to data compiled by Bloomberg.

China has \’93the chance to become the world\’92s largest shipbuilding nation and they will not let this chance go,\’94 said Umlauf. \’93They will support their national champions and that will definitely add to the overcapacity situation.\’94

As I have said many times before, I don\’92t see how pressures to increase savings in the US and other trade-deficit countries will not conflict with pressures in China, Germany, and other trade-surplus countries to maintain policies that force up savings rates, especially if sustainable global investment rates decline. The only outcome, I think, is increasing trade tensions. In that light, today Bloomberg reported a very worrying escalation of the conflict:

The two largest groups representing U.S. companies in China said the Asian nation has enacted a series of policies discriminating against foreign investors and imports. The U.S. Chamber of Commerce and the U.S.-China Business Council said in testimony today that Chinese contracting rules, technical standards and licensing requirements were protectionist. Chinese officials have made the same charge against the U.S. following President Barack Obama\’92s imposition of tariffs on Chinese tire imports.

Both organizations have previously defended China, calling it a large and growing market for U.S. exports and lobbying to fend off legislation aimed at punishing China for currency policies and government subsidies. The criticisms of the two U.S. groups reflect mounting tensions that economists said could spark a spiral of retaliatory measures between the countries.

\’93There are growing indications that China\’92s movement toward a market economy has stalled,\’94 Jeremie Waterman, senior director for China at the U.S. Chamber of Commerce, testified to a hearing at the U.S. Trade Representative\’92s office today. \’93The voices of protectionism in both countries are on the rise.\’94

More trade tensions, and the very limited advantage of relative poverty

September 25, 2009 in Consumption and production, Exports and imports, Trade protection by Michael Pettis | No comments

While the G20 leaders make reassuring noises about international trade, I think the risk of rising trade tensions have not abated at all. As I see it, everything depends on whether or not domestic Chinese polices had any role in creating the global imbalances, and if they did, then we are still in the early stages of a difficult process of assigning the costs of the global adjustment through trade.

Beijing hates when anyone suggests that Chinese policies were partly at fault for the current global imbalances, and doesn\’92t even like people to use the phrase \’93global imbalances,\’94 but like it or not, we have to figure out whether in fact Chinese policies mattered. As I see it, China\’92s consumption rate, the lowest ever recorded, and it\’92s trade surplus, the largest as a share of global GDP ever recorded, could not help but have been caused by policies \’96 such as an undervalued currency regime, excessively low interest rates, sluggish wage growth, unraveling social safety nets, and manufacturing subsidies \’96 that were almost wholly under domestic control.

According to my understanding of Chinese growth, it was policies that systematically forced households implicitly and explicitly to subsidize often-otherwise-unprofitable investment and manufacturing that led to wide and divergent growth rates between production and consumption, and of course the gap between the two is the savings rate. If that is true, the stimulus package is only likely to exacerbate the domestic imbalance.

This matters because as the US begins the too-slow but irresistible process of raising its savings rate, something else must change too. At the global level savings must of course balance with investment, and with general expectations that investment will at best remain steady and probably actually decline over the next few, a rising US savings rate must result in one or more of three outcomes:

1. Total US savings do not rise \’96 which means US GDP must contract as the savings rate rises

2. The savings rate in the rest of the world declines, or at least grows much more slowly than in the past. Since China is the country with the highest savings rate and the largest trade surplus, this means China\’92s savings rate will decline, and this is just another way of saying that consumption growth will surge.

3. China\’92s GDP grows much more slowly.

So we are left with the almost inescapable fact that if the US savings rate increases, either China (and the rest of the world, technically, but in practice mainly China) must see much faster consumption growth or the world must experience a slowdown in GDP growth.

Consumption growth determines trade tensions

How quickly can China raise its consumption growth rate? Optimists, and those who think that Beijing\’92s policies did not contribute to the global imbalances, believe that the fiscal and credit expansion of the past several months can cause both investment-led growth and a sustainable rise in consumption growth. Pessimists point out that it was exactly these sorts of highly inefficient investment-driven policies that left China with its savings and trade imbalances, so that intensifying them can only exacerbate the imbalances over the medium term.

If the optimists are right, and China sees a long-term and sustainable surge in consumption, most of the brunt of the global adjustment will take place in the US, and China and the rest of the world will return relatively quickly to growth. If the pessimists are right, and of course I am a pessimist, the global economy is likely to suffer a period of struggling growth as tendencies to force up global savings conflict with the tendency of global investment to decline.

In that case the main mechanism for distributing slower growth among the world\’92s major economies will be through international trade. Differences in the savings and investment rates in each country show up as surpluses and deficits in the trade and capital accounts. With consumption being the most valuable commodity, both trade surplus countries, with their consumption deficits, and trade deficit countries, with their consumption surpluses, will be maneuvering ferociously to access as much global consumption as they can. In that case expect a sharp and continuing rise in trade tensions. The G20\’92s best intentions won\’92t matter.

This, by the way, seems to be a repeat of the Japanese story in the 1980s and the 1990s. As regular readers of my blog know, I believe there are lessons for China from what happened to Japan after the US stock market crash in 1987 signaled the need to end Japan\’92s dependence on a burgeoning US trade deficit to absorb its excess capacity. Japan then, as China now, responded to the collapse in its biggest export market with a credit and fiscal expansion that at first protected Japan from the employment consequences of the contraction in US net consumption, but which ultimately may have exacerbated Japan\’92s imbalances and made its adjustment all the more difficult.

The Japanese parallel

I\’92ve been speaking to a lot of investor groups in the past month, and when I discuss the parallels between China today and Japan after the 1987 US stock market crash I am often told that the comparison isn\’92t useful because of one (or both) of two major differences. The first is that since China\’92s current consumption level is so much lower than Japan\’92s in 1987, it is far more reasonable to expect a surge in Chinese consumption to replace the declining US demand for Chinese excess capacity than for a surge in Japanese consumption to have done the same after 1987. Japan might not have been able to pull it off, but, they say, it is much easier for China to do so because it is so much poorer and starting from a much lower base.

The second objection \’96 perhaps not so different from the first \’96 is that since China is so much less developed than Japan was in 1987, an infrastructure investment surge is a lot more sustainable. After all, Japan already had great infrastructure in place at the time, so that much of its new investment after 1987 was inevitably in the form of highly wasteful \’93bridges to nowhere\’94. Since China has much lower quality infrastructure stock, they argue, there is much more it can do in the way of sustainable investment.

I am always a bit puzzled by how widely-held these views seem to be, especially in China but also abroad. The idea that being poorer makes policy easier can\’92t have emerged from looking at the experience of developing countries. I suspect that it arises from assuming that poverty does not represent differences in real factors \’96 worker productivity, education, the institutional and legal framework, etc. \’96 so much as in policy mixes.

It is true that poorer countries are able generally to achieve faster growth rates than richer countries, perhaps because they have only to play catch-up, but there is little evidence from other countries that poverty leads systematically to more profitable investment or to more sustainable consumption growth. I think both objections stem from implicit assumptions that there is some highly attractive upward limit to either consumption or infrastructure investment, and that the further away we are from that limit the stronger the attraction towards it. But if that assumption weren\’92t mistaken poverty should have ended long ago.

Take consumption. At the very least if consumption growth were an inverse function of wealth, or of existing consumption levels, the US would have the slowest consumption growth rate in the world and certain African or Caribbean nations would have the fastest. This clearly isn\’92t the case.

Household income growth determines consumption growth

I would argue instead that the growth rate in consumption is partly a function of demographics and income distribution, partly a function of the willingness of banks to increase or reduce consumer credit, and more generally a function of the growth rate of household income. Other things matter too \’96 for example I agree with many of my colleagues in and out of China that a good health insurance system may reduce the need for Chinese households to save since it smoothes out expected health costs \’96 but it seems to me that absolute level of wealth is almost irrelevant in determining potential consumption growth rates. Rich people, after all, seem as determined to increase their consumption as poor people (you can easily see that in the behavior of the hordes of the new wealthy in Beijing and Shanghai), although of course the goods and services they will want to buy will be very different.

In that case what really matters to Chinese consumption growth is the rate at which wages and other forms of household income grow, and the extent of implicit taxes or subsidies that penalize or favor consumption. I exclude possible growth in consumer credit because Chinese banks have never figured out how to do this without a rapid increase in non-performing loans.

Of course it is very important to remember that household income in China is not just wages. Interest on bank saving deposits is also an important source of income, as are various social transfers. There are also a variety of hidden taxes on household income \’96 some obvious and very significant, like the low deposit rates the PBoC demands to subsidize bad lending practices and otherwise non-viable investments, others less so, like an undervalued exchange rate, which effectively creates a consumption \’93tax\’94 on imported goods.

These are the things that matter. While other factors may affect consumption rates at the margin, I think it is pretty clear that the growth in total household income \’96 wages, interest income, and other social transfers including the various \’93safety nets\’94 \’96 largely determine the growth rate in consumption in China, Japan, and in almost any country. If this is true, the relative wealth or poverty of a county says little about future consumption growth, and the fact that China is much poorer today than Japan in 1987 in no way should convince us that it will be that much easier to boost Chinese consumption.

Two asides

It is worth making two asides which may seem obvious, but are often lost in discussion. First, in discussing the resolution of global imbalances we need to take gross amounts into consideration. In other words because both the Japanese and the US economies are so much larger than China\’92s, and their consumption rates higher (more than twice as high, in the case of the US), a 1% slowdown in US consumption is not dissipated by a 1% growth in Chinese consumption, and a 1% increase in Japanese consumption does not have the same effect as a 1% increase in Chinese consumption. In both cases the change in Chinese consumption would have to be much greater.

Second, there is a big difference between consumption growth and growth in the consumption share of GDP, and this difference matters very much to the whole rebalancing debate. If Chinese consumption is growing at the 8-9% rate characteristic of the past several years, it still might not resolve the problem of a decline in US consumption even though by any standard that would represent a rapid rate of growth. If Chinese GDP is growing faster than this, as it has done for the same period, the imbalance is not only not being resolved, it is getting worse.

Chinese consumption, in other words, has to grow faster than Chinese production over the medium term in order replace a decline in net US consumption. High growth rates in China do not resolve the imbalance if production grows faster than consumption.

This is a very long way of saying that in comparing of policy responses the lower level of consumption in China is not at all an important difference between China today and Japan in 1987. Even if it creates more \’93room\’94 for a rise in Chinese consumption than in Japanese consumption \’96 a claim about which I am very skeptical \’96 it does not make it any easier for Chinese consumption to rise to the challenge in a way that Japan could not. It still means very broadly that over the medium term Chinese household income will have to rise faster than Chinese GDP \’96 something it has not been able to do at all in the last decade \’96 in order for China to absorb the declining net demand from the US for Chinese goods once its government-fueled investment boom peters out.

But what about investment \’96 must the government-fueled investment boom peter out? China has a much weaker and lower quality infrastructure than Japan did in 1987, so it seems a safe bet that China can sustain its investment boom for a lot longer than Japan could, right? This is the second objection to the comparison between China today and Japan in 1987.

Again, I think this is a fallacy. Let\’92s leave aside the obvious problem that much of China\’92s infrastructure investment may be wasted on spending that has no social benefit or simply is stolen, not because this is a small problem but rather because most of us would easily understand that a government debt-fueled investment boom to finance the purchase of private homes in Paris or Los Angeles or even large swimming pools and luxurious dining facilities for local municipal officials must still be repaid, and that it will be repaid out of future household income that would be better and more fairly spent on future household consumption.

The problem is that even \’93good\’94 infrastructure projects, like airports, railroads and highways, also have limits. These projects have to repay their cost, including the appropriate cost of capital, because if they don\’92t, the payment must anyway be made out of future household income, acting as a drain on future consumption. Some projects can pay for themselves, and some might not pay for themselves directly but can increase economic value so that ultimately, by creating wealth, they effectively pay for themselves out of higher future income. In either case households are left wealthier even after paying for those projects, and so able to consume more.

Productivity matters

But does relative poverty really improve the value of these investments? It might seem obvious that taking a good railroad system in Japan and turning it into a state-of-the-art railroad system increases the value of the railroad less than taking a bad or non-existent railroad system in China and turning it into the same state-of-the-art railroad system. In that case China seems to have more scope for additional investment than Japan does.

But does it? Maybe not. Japanese labor costs a lot more than Chinese labor, and is far more productive, so it is not clear that the improvement in labor efficiency caused by the railroad investment is necessarily more valuable in China than in Japan, even though the absolute change in quality of the railroad service in China is certainly higher than in Japan in my example.

That is I think core of the problem. The scope for nominal improvement in infrastructure is certainly higher in China than in Japan, but nominal improvement doesn\’92t matter. It is the economic value of that improvement that matters, and the economic value of improving the railroad in China is not necessarily higher than in Japan since, for example, every hour of transportation time saved in Japan may be substantially more valuable than an hour saved in China.

In fact I would argue \’96 as have many economists, by the way \’96 that China\’92s obsession with high-technology or state-of-the art infrastructure is extremely wasteful because the benefits of the most advanced technology only justify the costs if labor productivity and labor costs are very high. This is perhaps another way of saying that China\’92s highly capital-intensive growth is far from optimal for China, and probably only reflects the fact that capital is so cheap in China, at least for the capital-intensive SOEs that get the bulk of bank financing. This means that achieving Japan-style levels of infrastructure are not necessarily the best way to invest in infrastructure. The optimal infrastructure level in China is lower than the optimal in Japan, so the fact that China starts from a lower base does not automatically mean that it has more scope for profitable investments.

Airports are perhaps a good way of thinking about this. China doesn\’92t have as many airports as Japan does (adjusting for size and population), so clearly that means that China can engage in an airport-building spree that would be folly in Japan, right? Maybe not. Chinese are far less likely to be able to afford air travel than Japanese, and are less likely to need to ship goods by air than are the Japanese, so China needs efficient air travel much less than does Japan. Simply pointing to the fact that China has fewer airports does not imply that it has more room to build airports. In fact in my opinion it is very likely that we are going see so much money spent on Chinese airports in the next few years that it is almost impossible that we will ever recoup their cost.

As an aside I am often told about, as another example of the kind of investment spending that can pull China out of the crisis, the building of \’93shadow\’94 cities next to older ones, with much better facilities. Eventually everyone is expected to move out of the old city, with its less than optimal facilities, to the new state-of-the-art version. If enough cities do this, the argument goes, China can achieve huge growth rates.

Of course it can, in the short term. And if the US government were to raze Chicago and immediately rebuild it, I suppose that they could build a far more efficient city and would certainly create a huge short-term boost to the local economy (for one thing they would probably wipe out local unemployment).

Spending must be justified

But is this a good idea? If the US government were to propose doing it I am sure President Obama would meet with a storm of criticism. It would be pointed out that the increase in productivity created by this new, improved Chicago would almost certainly be only a fraction of the cost of rebuilding the city, and the difference would represent a straight increase in net indebtedness.

They would almost certainly be right. But I think this kind of activity is actually even more wasteful in China than in Chicago because much higher productivity levels in the US mean that the resulting \’96 expensively acquired \’96 improvements in efficiency would be more valuable in Chicago than in China. So building ultra-modern facilities may appease the pride of local officials, but it may do so at a cost far greater than its true economic benefit.

What about cases in which there is very rudimentary infrastructure that is being upgraded as part of the 2009 stimulus package? Here too I am not sure that we should be overly sanguine about the surge in infrastructure investment. China already has excellent infrastructure for such a poor country, and well before the stimulus package it was widely accepted that there had already been overbuilding, misallocated capital, and wasted investment in infrastructure. The recent surge in investment might all be for very productive purposes whose resulting increase in production will easily pay off the true, unsubsidized cost, but this is an argument that would need an awful lot of proof before I would believe it.

It is hard to imagine that a system that was already misallocating capital on a huge scale (for example by almost any reasonable standard most SOEs are value destroyers, whose viability is only assured because of input subsidies and highly subsidized borrowing costs) would suddenly, under tremendous pressure to expand investments massively and quickly \’96 and with the understanding that all risks would be socialized \’96 could do so without increasing the number of unprofitable investments. Maybe I will prove to be wrong, but I do think a lot of skepticism is warranted.

By the way my argument is not that \’93Keynesian\’94 spending is a waste. I think its usefulness depends on existing capacity use, including employment, and can generate more value for the economy than it costs. My argument \’96 a much more limited one \’96 is only that infrastructure spending is not automatically more economically viable in poor countries than in rich countries. The larger possible \’93nominal\’94 improvement in the quality of infrastructure will only lead to greater economic value if the poorer country is able to capture as much economic benefit from the investment as the richer country.

If labor productivity is much lower, as it is in China, it might not be able to do so. In fact I would go further. State-of-the-art infrastructure in China is almost always harder to justify economically than in Japan.

The coming clash in savings

September 21, 2009 in Consumption and production by Michael Pettis | No comments

Perhaps it has been because I have been so busy in meetings and school in the past week but it seems to me that not a whole lot has happened to give us much more sense of what is happening in China since the big release of economic data by the National Bureau of Statistics on Friday 11.\’a0 As I wrote then, the data was able to confirm both those who see the stimulus package has having been a big success in protecting China from the ravages of the global economic crisis as well as those who worry that it is actually making the Chinese imbalances worse.\’a0 Both are right, in my opinion.

In that light there was an interesting article in the Financial Times suggesting that the CBRC, as it has been all year, almost alone among the official institutions, is still worrying out loud and publicly about the impact of the stimulus package on the banking system:

China\’92s top banking regulator on Friday warned of growing risks to the country\’92s financial system as a result of an unprecedented expansion in new loans and urged the country\’92s lenders to improve their internal management.

The statement by Liu Mingkang, chairman of the China Banking Regulatory Commission, may signal a more assertive stance from the body in the build-up to a top-level Communist party meeting scheduled for November that will set the country\’92s economic agenda for the coming year.

The FT quotes Mr. Liu as writing that \’93This year, all kinds of risks have arisen in the banking sector along with the rapid credit expansion. Banking institutions should always stick to the bottom line of compliance management, to lay a solid foundation for risk management.\’94

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Xinhua also carried the story in an article Friday although, perhaps not surprisingly, they seemed to play it a little softer and give it a more postive spin:
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China’s banking regulator has reiterated that domestic lenders should seek to enhance their risk management and stick to regulatory requirements to reduce worries over financial risks caused by rapid credit growth this year.\’a0 “With bank loans growing rapidly, all kinds of risks are rising in the banking industry”, Liu Mingkang, chairman of the China Banking Regulatory Commission, was quoted as saying by Saturday’s China Daily.

Although Mr. Liu’s statements will not come as a surprise to senior policymakers, i suspect that everyone’s attention was focused on last week’s annual plenum of the Communist Party Central Committee.\’a0 Something many people were expecting to happen did not happen, leading to a whole lot of speculation about whether or not this has significant implications for a factional disagreement within the top leadership.\’a0\’a0 The always insightful Australian journalist John Garnaut had this to say:

Palace intrigue has swept Beijing following the failure of President Hu Jintao’s assumed successor to receive a crucial promotion. Vice-President Xi Jinping was expected to be promoted to Central Military Commission deputy chairman at last week’s annual plenum of the Communist Party Central Committee.

Mr Hu was given the position at the equivalent stage of his career. Mr Xi is still considered the most likely candidate to succeed Mr Hu, but his path now appears to be contingent on a period of bruising deal-making.

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I am not smart enough to say whether Xi’s failure to get the promotion was indeed as significant as many of my Chinese and foreign friends seem to think (many also disagree), but it adds to constant rumors about factional differences, disagreements among policymakers, and other noise that is clouding our ability to understand what policymakers may do next.
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I have been working on a few pieces about what i am increasingly thinking as a possible global savings clash.\’a0 To summarize briefly, we know that savings and investments must balance.\’a0 If it does not balance domestically, it balances globally through adjustments in trade and capital accounts, so that countries with excess savings (over investment) export capital to countries with excess investment.\’a0 of course to do so they must also run current account surpluses.
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This, in a nutshell, is the relationship between China and the US.\’a0 In China savings had reached the highest rate, probably ever recorded, while in the US savings declined to extremely low rates.\’a0 Both were possible because China ran a large and growing trade surplus with the US.
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I have always argued that high Chinese savings were a result of specific industry and trade policies that favored investment and manufacturing and that subsidized them through sluggish wage growth, low deposit rates, and other “taxes” on household income.\’a0 Obviously if production grows significantly faster than consumption, the result is a rising savings rate.
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That means that for global savings and investment to balance, any change in one of the major net savers or dis-savers will have an effect on others.\’a0 As i have written many times before, I expect that one consequence of the crisis will be a deleveraging of US households and an increase in the savings rate.\’a0 This can be forestalled for a while by government dis-savings, but i don’t think government borrowing can forever hold back the necessary rise in the US savings rate.
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Unless global investment rises significantly, an increase in US savings must come with a decrease in non-US savings, and in practice this means Chinese savings.\’a0 If global investment declines, of course, this is even more true.\’a0 But I do not believe that it will be easy for the Chinese savings rate to decline, for all the reasons i have mentioned many times before, especially once the impact of the stimulus package wears off.
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So how does this clash over global savings get resolved?\’a0 Obviously there are lots of ways it can get fixed.\’a0 One way, of course, is a completely benign surge in Chinese consumption.\’a0 Another way is a slowdown in global growth.\’a0 The first is unlikely.\’a0 The second almost by definition means a huge increase in trade tensions since it is through the trade account that the global slowdown will be distributed.\’a0 Needless to say every country will be eager to pass on the adjustment to other countries, and in this kind of fight I am afraid trade surplus countries are more vulnerable than trade deficit countries.
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On a related note, several investors i have met in the past two weeks have been very worried about some seemingly bizarre reports that apparently argue that the dollar is in for a very difficult period over the next few years because of the Chinese adjustment.\’a0 As far as I understand it, the claim is being made that the Chinese trade surplus is destined to fall rapidly over the next few years.\’a0 So far so good.\’a0 I agree.
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The report then argues that because of the fall in the Chinese trade surplus, the PBoC and other Chinese institutions will be buying fewer dollar assets.\’a0 Again, I agree.\’a0 This is simply the statement of an accounting identity.\’a0 But here is the bizarre part.\’a0 The report then claims that such a massive decline in dollar purchases by Chinese investors is very bearish for the dollar.\’a0 If one of the world’s biggest buyers of dollars stops buying, in other words, the dollar must decline.
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On the face of it this might seem true, and even obvious, but a very quick glance at the balance of payments suggests that this view seriously confuses the nature of dollar flows.\’a0 For many years a lot of commentators argued that the dollar was destined to collapse because of the large US trade deficit, which had the effect of forcing a huge flow of dollars onto foreign investors.\’a0 Since the flow of dollars was likely to exceed the appetite for dollars, this would unquestionably put downward pressure on the dollar.
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In the standard trade model this would almost certainly be true, but Jim Walker, of Asianomics, manged to undermine the argument with his “51st state” thesis.\’a0 He argued that this would only be true if the US ran a current account surplus with non-dollar bloc countries who weren’t forced to recycle their surpluses because of the nature of their currency regimes.\’a0 If they didn’t recycle, in other words, the dollar would weaken and the current account surpluses and deficits would disappear.\’a0 As long as they were forced to recycle, however, this wouldn’t occur.\’a0 If you combine all the dollar bloc countries (China, much of Latin America, etc.) into a “51st state”, Walker concluded, the US in fact ran no current account deficit and so there was no balance of payments pressure on the dollar.
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I think Jim walker is right, but I also agree that when a country is running large current account deficits it is natural to worry about a depreciation in its currency as the resulting outflow through the current account leaves investors less willing to continue holding more.\’a0 That is why the new argument for dollar appreciation is, in my opinion, a little weird.\’a0 It is true that China will soon be buying a lot fewer dollars, but this will happen presumably because a rapidly declining US trade deficit is forcing the decline in the Chinese trade surplus.\’a0 That means that although the demand for dollars by foreigners will decline, it will decline at the same time and for the same reason that the supply of dollars also declines.\’a0 there isn’t likely to be any imbalance between supply and demand.
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I have no idea which way the dollar is going to go over the next few years, but I am pretty sure that if it declines it will not be because the Chinese are buying fewer dollars as they recycle their smaller trade surplus.\’a0 That doesn’t make sense to me.

China\’92s August data confirms both optimists and pessimists

September 11, 2009 in Consumption and production, Fiscal stimulus by Michael Pettis | No comments

Regular readers of my blog will have noted all sorts of unfortunate goings on here in recent days. \’a0It has become impossible to get into the comments section, or indeed into any other section of my blog except the front page, and so to my great dismay the excellent discussions that have been so useful for me have been temporarily halted. \’a0I am not sure why this is the case, and now that school has started again I hope to get one of my terribly smart Peking University students to find out and fix it. \’a0

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Actually in recent months a large number of China scholars who I know \’96 and me too \’96 seem to have been targeted by very specific viruses, with emails and attachments cleverly disguised to look like something we would want to read from someone we would trust.\’a0 I am not smart enough to know what those viruses do, but I have been warned that they probably allow someone access into my computers. \’a0

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Perhaps for the same reason my own blog has been hacked in some way, but it seems to me that if anyone really wanted to close me down they would have closed down the blog altogether and not just the comments section, so unless there is a commenter that regularly raises the ire of some censor out there, I suspect the problem has more to do with my blog site than with any malicious intent.\’a0 Of course if my blog suddenly begins posting pornographic pictures, spewing venom, or otherwise does some unexpected and obnoxious things, please know that it was probably not me who came up with the idea.

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I have also had a lot of trouble getting my regular proxies that allow me to jump the great firewall and post onto my blog. \’a0That is why my posting has slowed a bit, but it seems that yesterday and today the anti-proxy regiments have been at least temporarily defeated.

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That\’92s good, because of course today the National Bureau of Statistics has released a whole lot of data.\’a0 A European TV station asked me to comment on the import of the data, and while I hate to make too much of a few data points, I was able to say rather glibly that the data pretty much confirmed the hopes of the optimists as well as the fears of the pessimists. \’a0

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I will explain why I think this below, but I should note that most analysts were pleased with the results, and the stock market surged on the news.\’a0 The SSE Composite was up 2.2% today.\’a0 Surprisingly it was down 0.7% yesterday, suggesting that there was probably no information leakage.\’a0 Things seem to be improving on that front.

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To summarize the data released today, manufacturing output was up by 12.3% year on year, better than last month\’92s 10.8% and higher than consensus, although I think last August, during the Olympics, a lot of factories were closed so that this number may not be as impressive as it seems.\’a0 Steel output was up 29% and auto production was up 90%, which as my friend Mark Williams at Capital Economics points out is not likely to soothe worries about overcapacity creation.

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Urban fixed-asset investment was up 33.0% for the first eight months of the year, which slightly exceeded already-high estimates of 32.5%.\’a0 This suggests that it is still investment that is in the driver\’92s seat, as far as growth is concerned.\’a0

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This might not be as obvious as all that.\’a0 A lot of people were excited that retail sales climbed 15.4%, slightly higher than consensus and the highest growth rate all year after seasonal factors are stripped out, but remember that retail sales are not a very good proxy for consumption growth. \’a0Also remember that this surge in liquidity can easily cause consumption to rise in a temporary way without indicating anything structural about changing consumption and saving patterns in China. \’a0In 1988-89 consumption in Japan also surged, probably as a consequence of the investment boom, but it was unable to survive, if I remember correctly, the contraction in that boom in the 1990s.

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The most interesting piece of information is that net new lending for the month was RMB 410 billion, less than half the monthly average this year (RMB 1,105 billion).\’a0 This seems small given the huge numbers we\’92ve seen but, as I pointed out two weeks ago, last August new lending was around RMB 272 billion, and if you strip out the bills coming due the real increase in medium- and long-term lending is closer to RMB 550-600 billion. \’a0More importantly, RMB 410 billion is a lot more than the rumors of RMB 300 billion that had panicked the market last week.\’a0

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The one piece of news that everyone read as negative was the trade data. \’a0Exports were down 23.4% and imports down 17.0%, both substantially worse than expected, although leaving the trade surplus at a still-hefty $15.7 billion, which is roughly average for the year.\’a0

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For the optimists, the economic numbers, with the exception of the trade data, were all positive and suggest that China is on track to recovery.\’a0 For them, the great risk to China was that the global contraction in demand would result in terrible damage to China\’92s export industry and, with it, would cause factory closings and soaring unemployment.\’a0 Rising unemployment would lead to a collapse in consumption, and of course would not make China\’92s transition easier

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The main purpose of the stimulus package, in this view, was to forestall an economic contraction and with it the possibility that the economy would fall into an ugly process in which rising unemployment would cause a contraction in Chinese consumption which, when added to the contraction in foreign demand for Chinese exports, would push the economy into a tailspin.\’a0 In that sense the stimulus has proven to be a great success.\’a0 Chinese growth has slowed, but by a lot less than expected, and unemployment seems to be manageable.\’a0 The August data points pretty solidly to continued growth.

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And yet, and yet\’85.

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For pessimists like me the global contraction underscored Chinese vulnerability to out-of-control US consumption, and the need to develop a more balanced approach in which Chinese consumers take a larger share of China\’92s production.\’a0 This vulnerability existed in large part because China was overly reliant on investment for its growth.\’a0 China has had probably the highest investment rate ever recorded for a large economy, and for years there has been widespread concern that much of this investment was misallocated.\’a0

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It is only because the cost of capital is artificially so low (thanks to Chinese households, who are forced to earn a miniscule return on their savings) that many companies are able to show profits at all. \’a0A few months ago I wrote about an HKMA paper that suggested that the implicit interest-rate subsidy to SOEs \’96 not relative to the \’93right\’94 interest rate in China (whatever that may be but which is certainly many percentage points higher than the official lending rates) but relative to the borrowing cost of large Chinese private corporations \’96 accounted for 100% of SOE profitability. \’a0If China had reasonable interest rates, in other words, (and in fact there were negative real rates for much of the recent past), SOEs would on average be value destroyers.

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This, by the way, is why China\’92s supposedly puzzling addiction to capital-intensive growth rather than labor-intensive growth \’96 more befitting to an economy with lots of unskilled labor and very poor technology \’96 is not so puzzling. \’a0If you artificially lower the price of a particular input, it is not surprising that producers will use more of that input than might otherwise be considered optimal.\’a0 With capital practically free, capital is everyone\’92s favorite input in spite of incredibly low labor costs.

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With the recent surge in government financed investment (and I include most bank lending in this category), it would be surprising to me if much of this year\’92s new investment were not of even lower quality than the older investment, with very low or even negative expected returns.\’a0 If this turns out to be true, it means that the only way these investments could be viable is by effectively continuing to \’93tax\’94 Chinese households to subsidize state-owned enterprises and large manufacturers.\’a0 This tax of course will come mainly in the form of low wage growth and extremely low deposit rates on the savings of Chinese households.

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This is why we all hope Chinese growth will become more reliant on rising consumption rather than on rising investment, much of which is certain to be unprofitable.\’a0 The current path requires a large trade surplus to absorb the difference between what China consumes and what it produces, but it is not clear that foreign consumers will absorb the balance.\’a0 China is trying to plug the gap by a surge in government-financed investment, but this is likely only to widen the gap in the future.\’a0

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So the August data suggests that while China is growing, it is actually more reliant, not less reliant, on investment.\’a0 What is worse the very poor import numbers suggest that in spite of high retail growth figures, consumption growth in China is still sluggish.

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For the pessimists, then, the August numbers confirm that the stimulus package may be boosting production solely because of government-financed investment, and that a serious misallocation problem will result in more future pressure on Chinese households to foot the bill.\’a0 The export numbers show that China\’92s external accounts continue to deteriorate, and it will take more than simply an end to the global crisis to return to the good old days.

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So who is right, the optimists or the pessimists?\’a0

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In fact both are right.\’a0 If the purpose of the stimulus package was solely to protect China from the immediate employment impact of the global contraction in demand, it has been an almost unqualified success.

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But if at least part of the goal was to help China shift its unbalanced growth model to one less reliant on foreign, and especially American, consumers, it is not clear that any progress has been made.\’a0 In fact to the extent that a significant share of new investment has been wasted, it may actually make future imbalances worse.

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China\’92s response to the global crisis needs to be seen as a two-part process.\’a0 The first part is to goose economic growth in response to the rapid deterioration in the external environment.\’a0 The second part is to rebalance the economy away from its excess reliance on investment and foreign demand.\’a0 The August data seem to confirm that China is very successfully managing the first part.\’a0 Whether it has made any progress on the second part is still very much open to question.

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The Shanghai market calls the tune

September 3, 2009 in Fiscal stimulus, Stock market by Michael Pettis | 23 comments

The Shanghai and Shenzhen stock markets are still hogging the spotlight.\’a0 Although down 18.0% from its recent peak exactly one month ago, the past three days have been good for Chinese stock market investors.\’a0 After rising 0.60% on Tuesday and 1.17% on Wednesday, the SSE composite was up a very smart 4.79% today.\’a0

So what happened?\’a0 Better-than-expected earnings from Chinese corporations?\’a0 A surge in US household income and a decline in US unemployment boosting the prospects for China\’92s tradable goods sector?\’a0 A huge new loan number for the month of August?

Actually, none of the above.\’a0 In fact the US numbers look especially bleak for China.\’a0 In spite of some seemingly good news on the macroeconomic side, unemployment in the US is still rising, and even that masks the depth of the problem.\’a0 Many Americans who have lost jobs have since then found new jobs, but at lower pay, so that although they don\’92t show up adversely in the unemployment data, they nonetheless represent lower income to workers as certainly as rising unemployment does, and this will have an impact on future private consumption.

Societe Generale\’92s ever bearish Albert Edwards had an excellent piece on the subject on August 6, in which he argues that:\’a0

US nominal household incomes are now contracting at an unprecedented rate. The largest component of household income is wages and salaries which had been declining some 1% yoy. But after revisions the statisticians now admit to an unprecedented 4.8% decline! Total pre-tax household income is now recorded as falling 3.4% yoy in June.\’a0

If US household income is declining so sharply, we can\’92t really expect a sharp pick-up in imports, even ignoring the fact that households are also in the process of deleveraging, and so cutting back even more sharply on consumption that their incomes might indicate.\’a0 But in spite of still-bad news in both the external or internal environments, the markets are nonetheless in a much better mood than they were just a few days ago.\’a0 Why?\’a0 The People\’92s Daily explains:\’a0

Chinese equities climbed Wednesday after the country’s securities regulator said it would take measures to promote the steady and healthy development of the market.

Or, if you prefer Bloomberg\’92s slightly more forthright explanation:

China\’92s stocks rose the most in two weeks on speculation regulators will adopt measures to boost the nation\’92s equities following declines in the past month.

The main cause of the surge seems to be a statement made Liu Xinhua, vice chairman of the China Securities Regulatory Commission, at a forum in Beijing yesterday which was proclaimed on the front pages today of China\’92s two biggest financial newspapers, the China Securities Journal and the Shanghai Securities News.\’a0 Mr. Liu promised that regulators will promote a \’93stable and healthy\’94 market.\’a0 This has been interpreted to mean that the authorities will not let the market continue falling, and will introduce measures to force it up.

Bloomberg continues, with something that is widely acknowledged but wasn\’92t covered in the People\’92s Daily article:
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The government may take measures to stabilize the market before the 60th anniversary of the founding of the People\’92s Republic of China on Oct. 1, the start of a weeklong holiday. \’93They want everything to be stable and in harmony,\’94 said Francis Lun, general manager of Fulbright Securities Ltd., in an interview with Bloomberg Television today. \’93They will approve more stock market funds and allow them to buy into the market.\’94

There is a general sense that no one wants the markets to misbehave before the all-important October 1 celebration of the sixtieth anniversary of the birth of the People\’92s Republic.\’a0 Needless to say this begs the question about when exactly should you, as an investor, get out of the market?\’a0 The day before?\’a0 But if everyone knows that, then shouldn\’92t you get out two days before, or maybe three, since everyone has presumably figured that one out too?
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In 2006, 2007 and 2008 I wrote often about the dangers of this sort of market signaling.\’a0 There may be perfectly good reasons to want to manipulate the markets with non-fundamental information, but every time this happens it further undermines the development of a healthy capital market that allocates capital based on economic prospects by undermining the value of fundamental information and reinforcing the value of speculation on government intentions.\’a0 Still, on such an important anniversary I suppose it was totally unrealistic to think that the authorities would let angry investors spoil the party.
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The stock markets may have also taken some heart from a good, although sobering, speech from Premier Wen when he met with World Bank President Robert Zoellick earlier this week.\’a0 According to an article in Xinhua, Premier Wen said that
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China’s government would continue to pursue proactive fiscal and moderately easy monetary policies. \’a0″We will not change the orientation of our policy,” Wen said.
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Wen said China would fully implement and continue to enhance and perfect policy in response to the international financial crisis to achieve the goals of economic and social development.

This was taken by everyone as a pretty clear conformation of what I discussed in last week\’92s entry \’96 that although there were increasing worries about the cost of the fiscal stimulus package and the lack of an \’93exit strategy,\’94 in the end the State Council and the policy leadership were still more worried about a sharp slowdown in growth than about the risks of excessive investment:

I wonder, and I know I am not the only one wondering, what Zhongnanhai is thinking as it sees the impact of these rumors of a contraction in the furious rate of credit expansion. For one thing it seems that there are only two positions on the switch \’96 \’93surge\’94 and \’93swoon\’94 \’96 and I suspect that very quickly we will see the switch turned back to \’93surge\’94. Although there seems to have been a little upward blip in US import numbers, I think this represents more of a temporary bounce from a steep earlier decline, and that the external environment continues to be very poor.
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My guess is that if the local stock markets do not soon recover their bounce (and they won\’92t without government help) and, even worse, if we start to see the awful sentiment seep into the real estate sector, Beijing will once again push forcefully for credit and fiscal expansion. In my opinion there is simply no way that domestic consumption \’96 unless it is primed with government giveaways \’96 can make up the slack quickly enough.

A recent report by CLSA also says that the PBOC apparently believes that one of the causes of the lost decades of Japanese growth was premature tightening in the late 1990s which \’93killed the momentum of economic recovery when it was only in the budding state,\’94 and so the PBoC has cautioned against doing the same in China.\’a0 It is better to be too loose than too tight.\’a0
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Although I think perhaps the right comparison is not with Japan in the later 1990s but rather with Japan in the late 1980s, this \’93lesson\’94 was reinforced by another, according to the same report:
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Beijing seems to agree with Ben Bernanke that \’93The correct interpretation of the 1920s, then, is not the popular one–that the stock market got overvalued, crashed, and caused a Great Depression. \’a0The true story is that monetary policy tried overzealously to stop the rise in stock prices. \’a0But the main effect of the tight monetary policy, as Benjamin Strong had predicted, was to slow the economy \’96 both domestically and, through the workings of the gold standard, abroad. \’a0The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash.\’94

Although I think I agree with Bernanke, again, I am not sure this is the right lesson for China.\’a0 The problem is that loose monetary policy is exacerbating the imbalance that China needs to work though, since most of the expansion is being directed at investment in expanding current and future capacity, but this comes at the cost \’96 which was not the case in the US \’96 of constraining the future growth in domestic consumption. \’a0Without rapid future consumption growth, as I have argued many times, I just don\’92t see how China can support rapid GDP growth once the huge fiscal push becomes unsustainable and runs out of steam.
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Clearly this concern is still part of the internal debate.\’a0 Chi Fulin, president of the China (Hainan) Reform and Development Research Institute and a member of the Chinese People’s Political Consultative Conference had an interview which was reported in an article in today\’92s People\’92s Daily.\’a0 In his comments he makes many of the same points I have been worrying about, albeit perhaps in a more politically acceptable way:
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Chinese leaders should rethink the country’s reform package amid changing global and domestic situations and take “quicker and radical” steps to move toward a market-oriented economy by 2020, said a senior political advisor.\’a0 The reform measures should speed up urbanization, break down industry monopolies by the State, deregulate energy, offer equal social welfare for both rural residents and urbanities, and improve the government’s efficiency.

“Our top leaders should take quicker and radical measures in these endeavors within the coming two or three years. By doing so, China can do a better job in post-crisis management as well,” Chi Fulin, president of the China (Hainan) Reform and Development Research Institute told China Daily in an exclusive interview.\’a0 “Looking at the goal of realizing a market economy by 2020, we cannot afford to lose the time window of the next two or three years in the reform.”

\’a0Several times in the interview Chi mentions the \’93urgency\’94 of the need for reform, which included removing many of the production subsidies, price deregulation of resource products, and reducing the State’s industry monopoly.\’a0 My interpretation of his comments is that he is, as politely as possible, warning that the government still hasn\’92t taken the necessary steps to restructure the economy. \’a0He concludes “Whether consumption can become a leading engine of China’s economy depends on how successful the reform is.”

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On a very, very different subject, I hear that there were more demonstrations and unrest in Urumqi today.\’a0 My understanding is that the large group involved met in a square over claims that people in Urumqi have been attacking innocent people with syringes.\’a0 There have already been demands for retribution.\’a0 Here is what China Daily says:
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URUMQI: Police have seized 15 people for stabbing members of the public with hypodermic syringe needles in northwest China’s Xinjiang Uygur Autonomous Region, a senior local official said Wednesday.\’a0 Of the 15, four were officially arrested and prosecuted, said Zhu Hailun, head of the political and legal affairs commission of the Communist Party of China (CPC) committee in Xinjiang.

This is way outside my area of expertise, but ever since the early days of AIDS there have been persistent reports around the world of AIDS victims randomly attacking people with syringes and injecting them with infected blood.\’a0 I have no idea of what has happened in Urumqi, but I wonder if this talk about syringe-wielders isn\’92t underpinned by these kinds of rumors. \’a0I am not a weapons expert, but it seems to me that attacking someone with a syringe would otherwise be pretty inefficient. \’a0Even an ordinary beer bottle has to be a better weapon than a syringe.

For what it\’92s worth, it seems that as widespread as these AIDS-infected-syringe claims have been in the past, and as certain as many people are that they have occurred, there has apparently never been any credible confirmation of such an attack — no eyewitnesses, no police records, no medical records. \’a0This is apparently one of those urban myths that we seize upon for reasons that may have more to do with our own fears than with any reality.\’a0 I\’92d be curious to see whether or not these attacks in Urumqi are confirmed and, if so, to get a better sense of why anyone would use such a weird weapon.

It\’92s not yet the end of China\’92s massive stimulus

August 31, 2009 in Consumption and production, Fiscal stimulus by Michael Pettis | 31 comments

\’a0According to a recent article on Reuters, on Saturday Lou Jiwei, the chairman of the CIC, China\’92s sovereign wealth fund, said at a conference on Saturday in response to a question about his expected performance: \’93It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.\’94
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In my last entry I noted that after the recent \’93green shoots\’94 period, during time which it seemed hard to find anyone who was skeptical of our seeming ability to turn the corner on the crisis without actually having addressed any of the underlying imbalances, it was good to see that more and more analysts, and especially policymakers, had begun to worry again.\’a0 President Hoover went down in a blaze with his \’93light at the end of the tunnel\’94, and of course one of my favorite stories of that time is his response in June 1930 to a delegation requesting a public works program to help speed the recovery: \’93Gentleman, you have come sixty days too late. The depression is over.\’94
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As I see it the more policymakers worry, the better. This crisis is far from over. Until we know how the continued adjustment in US household consumption and debt will evolve, and how this adjustment will play out in China\’92s own changing consumption rate \’96 most importantly whether it will complement the fiscal and credit expansion embarked upon by Beijing or, as I believe, conflict enormously with it \’96 the crisis won\’92t be over. We need policymakers to resist the green-shoots nonsense and to worry about what happens when fiscal, monetary and credit tools stop working.

Although I thoroughly disagree with the \’93So we can\’92t lose\’94 part of Mr. Lou\’92s statement \’96 I have been a trader for too long to hear those words with anything but the deepest dread, and I am sure he didn’t intend\’a0the way it read\’a0\’96 it is nonetheless interesting to me that by now skepticism is so widespread that a major investor can even propose our inability to work through the imbalances as a reasonable investment strategy.

We need skepticism. For one thing it has caused Beijing increasing worry about the risks of continuing to extend the stimulus package, to the point where they are now making serious noises about cutting back. My biweekly column in today\’92s South China Morning Post argues that in spite of the damage this has done to the stock market, it is undoubtedly a good thing that they are thinking about cutting back.

So Chinese policymakers have had to choose between policies that boost employment in the short term while making the overcapacity problem in the long term worse and, on the other hand, force a more efficient adjustment in the domestic imbalance while increasing job losses.

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Until now, Beijing had come down resolutely on the side of boosting employment. It had shifted a massive amount of resources, mainly through the banking system, into new investment in infrastructure and new production facilities. This created jobs and boosted consumption, but it did so by expanding current and future production even faster, only worsening the domestic imbalances and making China even more reliant on US consumption.

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It probably had no choice. As in nearly every major economy, the first instinct of policymakers since the crisis began has been to enact measures to slow unemployment growth. If unemployment grew too quickly and caused consumption to fall, it could easily tip the economy into a long-term and irreversible contraction.

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But there was always a limit to how far Beijing should push. It could continue spending like crazy on good and bad projects to keep workers employed, but if all this spending simply increases capacity faster than it raised consumption, the net result would be an unsustainable debt burden and a more difficult reckoning.

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That is why we should welcome the signs that Beijing may be reaching the limits of its investment push. The government believes that it has created enough momentum to avoid the worst consequences of the global crisis and the contraction in the export markets, but it is also stepping back from creating a worse crisis.

But it won\’92t be easy, and I suspect that already the effect of rumors about slowing the fiscal expansion is strengthening the hands of those who want to stomp again on the gas pedal. For example the stock market was down 6.7% today, bringing its total decline since August 4 to 23.3%. Even my superstar PKU student Gao Ming, who has so far ridden this chaos pretty well, admitted to me today that it was not a good day for him.

Why did the market collapse? Forget about fundamentals. As I have argued many times before, China lacks the necessary tools that fundamental investors use (e.g. good macro data, good financial statements, a clear corporate governance framework, a stable regulatory environment, a market discount rate) and so no matter what people say, there are no fundamental investing here. There is only speculation, and the two things above all that drive the markets are those old speculator favorites, changes in underlying liquidity and government signaling.

The whole market is worried about both, and the most important is concern that the days of explosive bank credit growth are behind us. On Friday, for example, Bloomberg reported that:

Bank of China Ltd., the nation\’92s third-largest by assets, plans to slow credit growth in the second half of the year and improve loan quality after posting an unexpected profit gain in the second quarter.

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\’85Lending in the second half will be \’93much smaller,\’94 with new credit in July and August dropping from the monthly averages of the first half, President Li Lihui told reporters yesterday.

Today the mainland newspapers were even more worrying. Several reported that new loans in August would be just RMB 300 billion, after last months\’92 new loan total of RMB 356 billion, and RMB 1,231 billion on average during the previous six months.

RMB 300 billion is nothing to sneeze at, especially since that probably nets out a lot of bills coming due \’96 so that new medium-and long-term investment is likely to be substantially higher. It is also worth remembering that August is normally a bad month for new lending \’96 last year net new loans were only RMB 272 billion.

Still, after the deluge of new lending for the first half of the year, it clearly represents a significant contraction in the rate of credit expansion, and if you believe, as I do, that China\’92s \’93impressive\’94 growth rate this year is actually a very disappointing consequence of a huge fiscal and credit stimulus, any indication that the stimulus will slow down cannot be good for sentiment.

Speaking of which I saw an interesting article in today\’92s People\’92s Daily. On the one hand it seems positive for an eventual generational-inspired rise in consumption, and on the other hand it seems negative about structural impediments:

College students, once a major demographic for banks issuing credit cards in China, are now finding that many lenders such as China Merchants Bank and Bank of Communications have recently steepened their application requirements or stopped issuing credit cards to students altogether.

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The changes in policy originate with a notice issued by the China Banking Regulatory Commission at the end of July. According to the notice, other than parents authorizing access their account, banks are not allowed to issue credit cards to those under 18. For students over 18 unemployed or without income, a cosigner is required.\’a0\’a0 Paying with plastic is really common on campuses, and is not unusual for a student in China to have up to 3 to 4 credit cards.\’a0\’a0“Whenever I go back home, I use a credit card to buy plane tickets, because at the end of the semester I’m usually short on cash,” said Sun Chenghao, a senior student at the China Foreign Affairs University.\’a0\’a0

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But such convenience also has its drawbacks. Of all recent credit card debt cases heard at the People’s Court in Beijing’s Xuanwu District this July, about 25 percent involved college students.

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The credibility of farmers, priests and prostitutes \’96 and bankers?

August 26, 2009 in Banks, Financial crisis, NPLs by Michael Pettis | 51 comments

Three weeks ago China Daily published a pretty funny article about a recent survey on credibility that had taken place in China. According to the article,
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At a time when shamelessness is pervasive, we are often at loss as to who can be trusted. The five most trustworthy groups, according to a survey by the Research Center of the Xiaokang Magazine, are farmers, religious workers, sex workers, soldiers and students.\’a0
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A list like this is at the same time surprising and embarrassing. The sex business is illegal and thus underground in this country. The sex workers’ unexpected prominence on this list of honor, based on an online poll of more than 3,000 people, is indeed unusual.\’a0
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It took the pollsters aback that people like scientists and teachers were ranked way below, and government functionaries, too, scored hardly better.\’a0 Yet given the constant feed of scandals involving the country’s elite, this is not bad at all. At least they have not slid into the least credible category, which consists of real estate developers, secretaries, agents, entertainers and directors.

I am not sure what secretaries have done to get themselves such poor rankings (could they mean party secretaries?), and I am not sure what kind of directors they mean (movie directors? managing directors?) but not everyone found this survey funny.\’a0 Last week a columnist in the People\’92s Daily had this to say about the same survey:

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In recent years, China has already paid a high price for the prevailing credibility crisis. The annual losses caused by bad debts have reportedly amounted to about 180 billion yuan, and the direct economic losses induced by contract fraud each year is also up to 5.5 billion yuan. Besides, shoddy and fake products contribute to another great loss involving at least 200 billion yuan. Generally, credibility crisis would cost China as much as 600 billion yuan every year.
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The shortage of credibility is not only seen in the market transactions, but in the officialdom as well. Corruption in any form is about to erode the faith of the general populace in authorities and officials at different levels.
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Perhaps, the survey result can just give a restricted description on China’s credibility status, or people can take it with a grain of salt. But it did portray a picture of the spiritual outlook of today’s Chinese society, with money as the overriding motive. It is this that especially deserves attention.

Although I fully accept that sex workers are more credible than government officials, I am outraged that teachers are so much lower on the list than prostitutes.\’a0 Since bankers have become so out-of-fashion recently, I have been vociferously denying my banker roots and assuring everyone that I am and always have been a professor, but now it seems that in order to get any respect I am going to have to buy tight jeans and a leather jacket and try to convince friends that I actually make my living turning tricks.\’a0 At my age it won\’92t be easy, but probably a lot easier than convincing people that I am a farmer (unless it\’92s on a plate I can\’92t tell a potato from a chicken) or a priest.
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Speaking of low credibility, last week the South China Morning Post reprinted a New York Times article on continued losses in the US banking system:
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Banks in the United States are now losing money and going broke the old-fashioned way: They made loans that will never be repaid. \’a0As the number of banks closed by the US Federal Deposit Insurance Corp has grown rapidly this year, it has become clear the vast majority of them had nothing to do with strange financial products that seemed to dominate the news when the big banks were nearing collapse and being rescued by the government.
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\’85Staying away from strange securities has not made things better. Jim Wigand, FDIC’s deputy director of resolutions and receiverships, says lenders that are failing now are in worse shape – in terms of the amount of losses relative to the size of the banks – than the ones that collapsed during the last big wave of failures from the savings and loan crisis.
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The severity of the current string of bank failures shows many of the proposed remedies batted about since the crisis began would have done nothing to stem the closures. \’a0These banks did not go beyond their depth with derivatives or hide their bad assets in off-balance sheet vehicles. Nor did their traders make bad bets; they generally had no traders. They did not make loans they expected to sell quickly, so they had plenty of reason to care that the loans would be repaid.
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What they did do is see loans go bad, in some cases with stunning rapidity, in volumes that they never thought possible. \’a0That so many loans are souring is a testament to how bad the recession – and the collapse in property prices – has been. But looking at some of the banks in detail shows they were also victims of their own apparent success. Year after year, these banks grew and took more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities.
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Besides the fact that this suggests that it is not just in China that prostitutes may be more respected than bankers, I found this article very interesting for two reasons.\’a0 The first is because it suggests pretty clearly that green shoots notwithstanding, we are far from an end to the banking crisis in the US (and, I assume, elsewhere), and it is going to take a while longer before bank balance sheets are robust enough to expand.\’a0 All of this will adversely impact both consumer spending and business investment for the foreseeable future.
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The second reason I found this article interesting is that I think it supports an argument I have been making for a while, that the current financial crisis was not \’93caused\’94 by derivatives or complex securitizations.\’a0 It was caused, as nearly all financial crises in history have been caused, by banks being forced to accommodate excess liquidity and taking on too much risk \’96 something they must do when monetary conditions are too loose for too long.\’a0 Making opaque investments in derivatives and complex securitizations is, of course, one way to take on too much risk, but it in no way caused the excessive risk-taking.
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When observers insist that it was the deregulation and fragmentation of the \’93Anglo-Saxon\’94 financial model, and the ease with which Wall Street was able to innovate financially that caused the big losses, I can sympathize only with the observation that we paid an awful lot of money to some very smart people whose great contribution to society \’96 a newer kind of exotic swap, let\’92s say \’96 was not terribly valuable.\’a0 But it wasn\’92t the system itself that caused the crisis. \’a0After all one of the main reasons for the prestige of the \’93Anglo-Saxon\’94 model was that its greatest competitor, the very highly regulated, rigid, highly integrated and almost innovation-devoid counterpart, the Japanese banking system, collapsed so frightfully \’96 if less spectacularly \’96 after 1990, and now the article cited above suggests that a lot of banks even in the US also managed to collapse in very old-fashioned ways \’96 something Hyman Minsky would have predicted would happen even without the help of dastardly derivatives.

This is one of the reasons why I take it almost as an article of faith that the massive expansion in Chinese credit will lead inevitably to a massive expansion in bad lending, and that the \’93great\’94 economic data is actually worryingly weak given the amount of resources, especially banking resources, expended to produce those numbers.\’a0 Too many regulators here who should know better (and too many foreign observers, too) are convinced that Chinese banks are safe from losses because Chinese banks were too slow to understand complex financial instruments and so took on very limited (and often ill-advised) exposure to these instruments, and because they continue to be sharply constrained in their abilities to do so.\’a0 In fact the biggest losses are always caused by exposure to real estate or lending against insufficient future cashflows, whether these comesin the form of old-fashioned loans or in the form of total-return swaps on sub-prime mortgage tranches.
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Interestingly enough, it seems that recently there has been an increasing chorus of warnings within China about mounting risks in the banking system, and more generally about problems in the fiscal stimulus package.\’a0 For much of the year the Chinese fiscal stimulus has been described \’96 as I heard repeatedly during my testimony last February in Washington, to my surprise \’96 as the \’93gold standard\’94 of stimulus packages, but over the past two months the number of worriers seems to have expanded dramatically.\’a0 The Financial Times in an article earlier this week put it this way:
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Official readings of industrial production, fixed investment, power consumption and gross domestic product all show a strong revival, while equity and property prices have soared in recent months. There have even been signs of a recovery in exports, although these are still about one-quarter below the levels of a year ago.
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But a growing number of economists and officials say the positive growth data hide worrying structural imbalances and the government\’92s response to the crisis may only have postponed an inevitable reckoning. With the world looking to China as a beacon to lead the way out of economic gloom, a second downturn would have a big impact on global confidence, not to mention commodity prices.\’a0 \’93There is such a thing as good 5 per cent growth and bad 8 per cent growth,\’94 according to one senior adviser to the government. \’93We worry that what we\’92re seeing falls more into the latter category.\’94
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The concerns are the ones I have been discussing here for the past year \’96 the fiscal stimulus is exacerbating the domestic imbalances, non-performing loans are certain to rise dramatically, and there is little evidence that consumption is going to grow organically quickly enough to absorb Chinese capacity.\’a0 The article goes on to say:
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\’93The main concern we have now is that a tremendous volume of loans was extended very rapidly to the corporate sector at a time when corporate profitability was declining,\’94 says Charlene Chu at Fitch Ratings. \’93That would suggest there will be some significant asset quality problems down the road.\’94
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While state-owned enterprises have been inundated with loans from the state banks, economists worry too that China\’92s vibrant private sector has been largely left to fend for itself.\’a0 \’93The fiscal and monetary policy response to the crisis has mostly benefited the largest enterprises and biggest projects,\’94 says Wang Yijiang, professor of economics and human resources management at the Cheung Kong Graduate School of Business in Beijing. \’93The small and medium-sized enterprise sector provides 75 per cent of the jobs to China\’92s urban workforce but now it is shrinking for the first time in 30 years of economic reforms.\’94
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Not surprisingly, it was Chinese economists who were quicker to sense the problems than most foreign economists and observers, whose optimism has generally been more robust.\’a0 For example the highly respected Yu Yonding, an economist with the Chinese Academy of Social Sciences and a former member of the PBoC\’92s monetary policy committee (who told me three months ago at a conference at Tsinghua University, during which I presented my now-standard argument that China\’92s development model was about to fail, that the problem with my analysis was that I am much too optimistic about China), had an OpEd piece in today\’92s Financial Times that repeats the familiar litany:
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China has rebounded from the global slump with vigour. In the second quarter, its official figures showed year-on-year gross domestic product growth of 7.9 per cent. Those who doubt the quality of China\’92s macroeconomic statistics can check its physical statistics: in June, electricity production increased 5.2 per cent, reversing the falls of the previous eight months. It is almost certain that China\’92s GDP will grow more than 8 per cent this year.
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But there are problems looming. More investment thanks to China\’92s rescue package threatens to worsen the already severe overcapacity, while the cash injection is already creating asset bubbles.
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Dr. Yu warily suggests specific policy recommendations when he says that \’93China\’92s rebalancing is more the result of the global economic crisis than of policy initiative. China could do more to eliminate both internal and external price distortions to reduce its dependency on external markets.\’94\’a0 Eliminating these price distortions involves, I suspect, revaluing the currency, liberalizing interest rates, and doing the other things that I and others have suggested would address the root imbalances between consumption and production, albeit at the expense of accelerating unemployment in the short term.\’a0
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Premier Wen himself has been actively warning about trouble ahead.\’a0 Earlier this week the South China Morning Post had this to say (although I wasn\’92t able to find any reference in the local press):
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Premier Wen Jiabao warned the mainland faces new economic problems and said Beijing would stick to its stimulus plan because the recovery lacks a solid foundation, according to comments reported yesterday. Mr Wen cautioned against being “blindly optimistic” despite improvements in the economy, according to a statement on the State Council’s website.

\’93[The economy] still faces many new difficulties and problems,” Mr Wen was quoted as saying during a visit to southeastern China that ended yesterday. “There are still a lot of unstable and uncertain factors ahead and the economic situation ahead is still very grave, although both the world economy and the national economy are making positive changes now.” \’a0He cautioned that the effects of some government measures might fade while others would take time to show results, the cabinet statement said, without elaborating.
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Meanwhile there is more and more talk about attempts by the PBoC and the CBRC to limit and control the banking expansion.\’a0 The CBRC has apparently been tightening capital adequacy requirements and is reportedly going to disqualify subordinated debt from being counted as bank capital. \’a0Chinese banks have been encouraged to raise their capital ratios, and one of the ways they have done so is by selling subordinated debt \’96 there was about $30 billion issued in the first half of 2009, versus about $10 billion in 2008. \’a0But much, if not all, of this subordinated debt was purchased by other banks, so it always made a lot of sense to eliminate bank subordinated debt from any notion of a capital cushion.\’a0 In a banking crisis, just when banks need capital, this asset immediately becomes worthless.
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Yesterday\’92s Financial Times had an interesting little piece on all this:
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The banking regulator last month told lenders to raise reserves to 150 per cent of their non-performing loans by the end of this year, up from 134.8 per cent at the end of June. A communiqu\’e9 last Friday canvassed views on deducting holdings of other lenders\’92 subordinated or hybrid debt from supplementary (non-core) capital. Then there are softer measures, such as reminding banks to ensure that loans for investment in fixed assets actually end up there. The central bank also has raised money-market rates to drain liquidity. The effects of all this can be seen in the M2 measure of money supply, which was up 28 per cent at the end of July, year on year, but which fell 3 basis points from the end of June.
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This is how China tightens: imperceptibly, by degrees. As Goldman Sachs points out, China\’92s last tightening cycle began not when it raised rates in November 2004 but 18 months earlier when the central bank began to issue short-term bills to mop up excess cash. Listen to the rhetoric now, and you can almost hear the fluttering of doves. But look at the evidence, and it is obvious that hawks are gathering.

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Yet another discussion on the Asian savings glut hypothesis, and why it matters

August 20, 2009 in Asian development model, Consumption and production, Exports and imports, Policy, Savings glut, Stock market by Michael Pettis | 84 comments

The Shanghai stock market was up 4.5% in very nervous trading today but down 16.3% since its recent peak at 3478 on August 4, and still trading at more than 30 times earnings.\’a0 All this turmoil is triggering all sorts of worried comments about the sustainability of the fiscal stimulus package and whether it has already reached the end of its effectiveness (it hasn\’92t \’96 the government still has credit and fiscal firepower, and will use it if growth slows down significantly in the next few quarters).\’a0 It also makes it harder, but probably more useful than ever, to focus on the bigger picture, and this entry is definitely big picture.\’a0 It also turned out to be a very long piece, as these big-picture pieces tend to.\’a0

The topic is whether or not the global imbalances that have led to the current crisis were in any way \’93caused\’94 by the Asian savings glut, and besides arguing why I think this may be the case, I want also to argue that getting this argument right is far more important than many seem to realize. \’a0Mohamed Ariff, executive director of the Malaysian Institute of Economic Research, indirectly suggests why in a good OpEd article in today\’92s New Strait Times:\’a0

China\’a0is seen as the beacon of hope in these days of gloom and doom. This has led some observers to think China will lead East Asian economic recovery and thereby spearhead a global economic turn-around. But this faith in China as saviour may be misplaced.China’s imports from the rest of East Asia consist mostly of raw materials, intermediate products and components and parts, the bulk of it turned into manufactures for exports. China’s imports of consumer products from the region account for no more than a small proportion.

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China’s imports from its neighbours have plummeted in the wake of the slump in China’s own exports, although the Chinese economy is growing at seven to eight per cent, because China depends largely on domestic production for its own consumption, which does not spill over to the rest of the region through trade.

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Therefore, China will import more only if it can export more. For this to happen, the demand for China’s exports in the US and European markets must first recover.

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But our definition of a \’93recovery\’94 in the US, and whether it will indeed happen in the way that Ariff requires for Asian growth to return, depends in an important way on whether or not the current imbalances were caused primarily by an original distortion in US consumption or in Asian savings.\’a0

I started writing this because while googling around looking for something else, I stumbled early this week upon a blog by LSE\’92s Danny Quah with the intriguing title \’93Where in the world is Asian Thrift and the Global Savings Glut?\’94\’a0 I later found that like mine, his blog is carried by Nouriel Roubini\’92s RGE Monitor.\’a0 I also subsequently discovered by a weird coincidence that on Saturday I am sharing a panel with him in a conference at the Guanghua School at Peking University, where we will be discussing the \’93Reconstruction of Global Finance\’94.\’a0\’a0\’a0

The whole \’93savings glut\’94 debate is a controversial one because almost from the start it has degenerated into a fairly silly argument about who to blame for the global imbalances and the subsequent crisis \’96 or more specifically and more excitingly, whether the predator was wholly the foolish American consumer or the beetling Chinese saver.\’a0 Three months ago Brad Setser discussed all this in one of his blog entries that (inevitably) drew more comments than most, and as usual he provides a concise and enlightening discussion on the subject which you might want to read.\’a0 He is a proponent of the hypothesis, but nonetheless pretty fair-minded.\’a0

Professor Quah weighs in on the other side of the savings glut debate although, unlike most others in the debate, he seems not terribly concerned about assigning full blame to any of the major parties.\’a0 It is neither excess US consumption nor excess US savings that solely \’93caused\’94 the imbalance, in other words, because necessarily both sides are required for it to exist.\’a0

Except for the possibility of trade with outer space, the US deficit has to be matched dollar-for-dollar by trade surpluses in the rest of the world. Correspondingly, therefore, the rest of the world has been saving\’97consuming less than it has been producing\’97and accumulating dollar claims against the US as a result.\’a0

In this description, however large the global imbalance, a savings glut\’97wherever or however it might arise on Earth\’97has no independent existence. It makes as much sense to say the world\’92s excess savings caused enthusiastic US consumers to flood into Walmart to buy $12 DVD players, as to say US consumer profligacy made hungry Chinese peasants abstain even more and instead plow their incomes into holdings of US Treasury bills.\’a0\’a0

When two variables have always-identical magnitudes, obviously neither can usefully be said to cause the other.\’a0\’a0

Who are the predators?

This is correct, but as an aside, the discussion about enthusiastic American consumers forcing the Chinese to save, or hungry Chinese savers forcing Americans to consume, typically uses colorful but totally inappropriate images to describe the dynamics of the this process.\’a0 For example, I often hear opponents of the Asian savings glut hypothesis say, voices dripping with disbelief, that the savings glut hypothesis insists that the poor American consumer rushed out to buy another DVD player because terrible China forced him to borrow the money and buy the DVD player.\’a0 How could that possibly happen?\’a0

Well, that\’92s not how it would have happened.\’a0 In any large country, there are millions of households able and interested in increasing savings or in increasing borrowing.\’a0 Specific policies or financial conditions will determine at any given time changes in the behavior of some of these individual households, so that at the macro level, and only at the macro level, the country will have seen an increase in savings or an increase in consumption.\’a0\’a0\’a0

It is not every household that rushes out to consume when consumption rises, and this never happen because predatory savers force an otherwise unwilling consumer to buy. \’a0So if it had indeed been rising Asian savings that drove the US consumption binge, policies aimed at constraining Asian consumption and boosting Asian production (which cause savings to rise) will have initially led to a rising Asian trade surplus and US trade deficit, as the tradable goods sector in Asia expands and the tradable goods sector in the US contracts.\’a0

This surplus would be recycled into the US via purchases of highly liquid securities.\’a0 If the Fed failed to respond to this increase in liquidity by raising interest rates and contracting money (and contracting the tradable good sector), the financial system would have to accommodate the rising liquidity as it has always done throughout history \’96 by growing financial balance sheets and taking on more risk.\’a0 In that case the conditions for consumer borrowing will have been made increasingly easy, and those households who needed or were predisposed to borrow under easier lending conditions, and pressure on the parts of banks to extend credit, will do so.\’a0\’a0\’a0

As long as there are some households willing, however appropriately or foolishly, to increase consumption, the easier availability of consumer credit will cause them to increase consumption \’96 this has happened many times and in many countries, and has nothing to do with a predisposition to excess consumption.\’a0 Furthermore as recycled liquidity boosts household wealth by boosting the value of homes and investment portfolios, the rising wealth of each individual household will have an impact similar to rising income \’96 and with it consumption will rise.\’a0\’a0\’a0

So the point is the not very controversial suggestion that a surge in domestic liquidity in the US can easily cause US consumption to rise.\’a0 If that liquidity surge was \’93caused\’94 by the recycling of a large and growing trade deficit, then it is easy to see how at the macro level US consumption would rise in response to a surge in Asian savings.\’a0

Similarly, the proponents of the Asian savings glut hypothesis wonder in disbelief how an American consumer deciding to buy a DVD player could have possibly \’93forced\’94 poor Chinese peasants to cut their already minimal consumption and increase their savings. \’a0But there was no force.\’a0 A sudden explosion in binge consumption in the US would divert production from China, and as China increased the share of its output dedicated to exports, total production would not immediately be matched by total domestic consumption (Americans bought some of it) and the Chinese savings rate would necessarily increase \’96 whether at the household level or at the corporate or government level.\’a0

The interest rate argument\’a0

The point is that sarcastic comments about predatory American consumers forcing dim-witted Chinese households to save more and consume less, or predatory Chinese savers forcing helpless American households to borrow and consume, may be good debating tactics but they are misleading and explain nothing.\’a0 At the macro level either event \’96 higher Asian savings leading to higher American consumption, or higher American consumption leading to higher Asian savings, or even a combination of the two \’96 is perfectly possible.\’a0

So why should we accept the Asian savings glut hypothesis?\’a0 One argument that I first saw proposed by Brad Setser was that if the imbalances had been driven by US consumption, and therefore US borrowing needs, the consequence should have been an increase in US interest rates.\’a0 Had they been driven by excess savings, US borrowing rates would have probably declined.\’a0\’a0

In fact during most of the relevant period US interest rates did decline, even leading to the US Fed several times complaining about its inability to control domestic long-term rates.\’a0 So that pretty much settles it, right?\’a0 But Professor Quah dismisses this argument:\’a0

Many other factors could, of course, have driven down short rates: US monetary policy responded to national economic downturns in 1991 and 2001. Through the 1990s inflation rates worldwide converged and fell, together with short-term interest rates set by central banks everywhere. The burst of the dot-com bubble in March 2000 saw the NASDAQ index decline 77% in the following 18 months, prompting action by the US Federal Reserve. Japan\’92s monetary policy during its decade-long recession drove nominal interest rates there to zero.\’a0

Although he is right, this is not a completely satisfying dismissal.\’a0 The same savings glut that pushed down US interest rates could easily have pushed down global interest rates, especially in a world that was seeing rapidly rising capital flows that in many cases were aimed at \’93arbitraging\’94 (absolutely the wrong word, of course, but one widely used in the markets at the time) interest rate differentials.\’a0 After all it is often the case that, especially during periods of large international movements of capital, increases or reductions in US interest rates (or in British rates during the globalization period at the end of the 19th Century) are matched by changes in foreign interest rates.\’a0

Still, the fact is that his response does show that the interest rate argument is not final.\’a0 There might be other perfectly good reasons that explain the decline in US interest rates.\’a0

The bilateral trade argument\’a0

Quah\’92s main argument against the savings glut hypothesis, at least as far as his blog entry, seems to be that it could not have been a rise in Asian savings that drove the global imbalances because had it done so, much of the imbalance would have rested between Asia (or China, more specifically) and the US.\’a0 The strongest piece of evidence he presents is a chart that shows the US bilateral trade balances between the US on one side and China, developing Asia, the EU, and oil exporters on the other.\’a0 I have reproduced the graph below, but if you can\’92t see it well, just click on Quah\’92s blog (blocked in China, so China-based readers will need to use a proxy), and click on the graph itself for an enlargement (I wish I was clever enough to do things like that).

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As the chart shows, the US trade deficit rose nearly as quickly, or even more so, with those other regions as it did with China and/or developing Asia.\’a0 It wasn\’92t just a US-China phenomenon or a US-Asia phenomenon, it was a US-everybody phenomenon.\’a0

Quah\’92s argument seemed to be a powerful one at first, and I had to think about it for a while or else I would have to find myself deserting from the \’93savings glut\’94 camp.\’a0 In the end, however, I think his argument it turns out not to be very satisfying and I still think it runs against a timing story that better explains the imbalances.\’a0 I\’92ll say more on that later, but it seems to me that in a \’93globalized\’94 world, if the Asian savings glut hypothesis is true, not only would rising bilateral trade deficit between the US and other countries outside of developing Asia be possible, but they would even be almost necessary.\’a0

Why?\’a0 Because we have to be careful about misreading bilateral trade numbers.\’a0 It is the aggregates that usually matter.\’a0 I don\’92t have the data in front of me, but I believe that Europe did not run significant and rapidly growing aggregate trade surpluses during this period.\’a0 If that\’92s the case, then a growing bilateral surplus with the US is perfectly consistent with the savings glut hypothesis as long as you assume that trade is international and that any specific product can be produced and assembled in many countries \’96 which is of course a pretty unremarkable assumption.\’a0

So, for example, if rising Asian net savings \’93caused\’94 rising American net consumption (in the way described above \’96 no sarcasm, please), it would mean that money recycled from Asia into the US caused the US trade deficit to rise as it was intermediated by the financial system into consumer financing, even as it caused Asian trade surpluses to rise.\’a0

It\’92s the aggregate balance that matters\’a0

But, and this is the important point, the trade did not need to occur only at the bilateral level.\’a0 If rising Chinese savings was intermediated into rising US consumption and this bilateral relationship was resolved, to take a concrete example, by Chinese exporters producing shoes and American consumers buying shoes, the trade would not have had to occur directly between the two.\’a0 When Americans shop for shoes, they don\’92t care which country saw net savings rise, and when Chinese sell shoes they don\’92t care whose economy saw an increase in net consumption.\’a0 China could have produced shoes, sold them to a designer in Italy, where they would be packaged and branded, and then sold to American consumers.\’a0

In this simple case, Chinese excess savings would have \’93caused\’94 Americans to borrow money and buy the shoes, and so China would run a trade surplus, the US would run a trade deficit, and Italy would be balanced.\’a0 But Italy would nonetheless show a bilateral surplus with the US and a bilateral deficit with China.\’a0\’a0\’a0

Excess US consumption, in other words, would still have been \’93caused\’94 by excess Chinese savings in this case, but global trading and processing networks would have the bilateral trade imbalances, and their countervailing obverses, spread out though the world.\’a0 Many countries would run surpluses with the US and deficits with Asia, but at the aggregate level they would balance out at close to zero, and the US would be left with the sum of its bilateral deficits and Asia with the sum of its bilateral surpluses.\’a0

The point is that there is nothing in the Asian savings glut hypothesis that requires that all trade imbalances occur at a bilateral level and only between the participating countries \’96 that the deficit/surplus imbalances occur between the US and Asia.\’a0 It only requires that the US, as the equilibrator to rising Asian savings, have a large and growing trade deficit and Asia have a large and growing trade surplus.\’a0 If other regions also have large and growing aggregate trade surpluses that fed into the US deficit at the same time, that would perhaps be the problem Quah says it is, and either would need to be explained or would create problems for the hypothesis.\’a0 But they didn’t.\’a0

With one big exception, of course.\’a0 Oil exporters did see not only rising bilateral trade surpluses with the US, but they also saw rising aggregate surpluses.\’a0 Does this somehow weaken the savings glut hypothesis?\’a0 Again no, because those surpluses reflect one thing only, rising oil prices, and in an environment of rapid US and Asian growth, we would expect oil (and other commodity) prices to rise.\’a0 In fact the savings glut hypothesis would predict that as long as the recycling was occurring efficiently, both countries would grow quickly and high commodity prices would be not only possible, but in fact highly likely.\’a0

So as I see it, this is how the arguments and counterarguments stand:\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The argument that declining US interest rates proves the correctness of the savings glut hypothesis is wrong.\’a0 Declining US interest rates are suggestive but not final.\’a0 Other things could have explained declining US interest rates during this period, and of course there is easily a possibility of feedback loops in which any initial decline in US interest rates could, by increasing household wealth (via rising asset values) increase consumption and the US trade deficit, leading to Asian recycling, and so on to more lower interest rates.\’a0

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The argument that rising US bilateral deficits with many regions around the world disprove that the savings glut hypothesis is also wrong, and much less suggestive.\’a0 On the contrary, if the hypothesis is correct and if trading is truly globalized, we would expect US bilateral deficits to be high with nearly everybody.\’a0 At the aggregate level, however, we would not expect anyone except the high-saving Asian saving countries to run large trade surpluses.\’a0

3.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 There was also an argument that I associate with Morgan Stanley\’92s Stephen Roach \’96 a very smart man who by the way disagrees strongly with the hypothesis \’96 since he was the one who first made this argument to me, over a lunch at Peking University two years ago.\’a0 According to Roach there has been no significant increase in global savings during the savings-glut-hypothesis period, which pretty much demolishes the idea of a saving glut.\’a0\’a0\’a0

I disagree because the hypothesis doesn\’92t imply in any way that global savings have increased.\’a0 In a closed economic system, unless investment has increased commensurately, an increase in savings in one part of the system must necessarily come with a reduction in savings elsewhere, and this was exactly the point of ascribing the current trade imbalances to a forced rise in Asian savings.\’a0 Rising Asian savings \’93forced\’94 declining US savings by causing the US financial system to accommodate growing domestic liquidity by taking on risk (again, no sarcasm please \’96 you might disagree but in itself this is not implausible).\’a0

Timing the flows\’a0

So where does that leave us?\’a0 Before answering, I think there is another thing to think about here, as I wrote earlier in this entry, and that is the timing issue.\’a0

In a June 4, 2008 entry, much of which is reproduced here, I mentioned a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the \’93Global Capital Flows Paradox\’94).\’a0 In it the author considers the \’93paradox\’94 of high and rising capital flows from developing to developed countries during the past decade.\’a0 This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.\’a0

Bibow rejects the Asian savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds \’96 he claims that the saving glut hypothesis is based on the \’93fatally flawed\’94 (his words) loanable funds theory.\’a0 However his narrative (to be horribly post-modern for a moment) of events seems very close to my own.\’a0

What interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).\’a0 First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.\’a0\’a0

Basically, according to the data quoted in Bibow\’92s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.\’a0 The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.\’a0 The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward to peak at around 7% of GDP in 2007.\’a0\’a0

As an aside I should add that there was an acceleration of the growth rate of the deficit around 2004, if I remember, and I have a pretty strong suspicion that this had something to do with the financing of the Iraq war.\’a0 As I have pointed out before, US asset markets and consumption often boom during unpopular wars, like the Vietnam War, which tend to be financed not with taxes but with money creation and debt, and often these two things lead to great markets \’96 for a while.\’a0

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges \’96 a small one from 1984-88 and a very large one after 1997.\’a0 If it was driven by Asian savings, this pattern becomes a little easier to understand \’96 or at least, what amounts to the same thing, we can posit a more plausible story to explain it.\’a0\’a0\’a0

The narrative\’a0\’a0

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.\’a0 The post-1997 surge is much larger and more interesting.\’a0 1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day.\’a0\’a0

Since the main cause of the crisis seemed to be the sudden reversal in the early 1990s of current account surpluses into substantial deficits, along with highly unstable balance sheets in which large external obligations were mismatched with domestic assets and \’93hedged\’94 with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.\’a0

These countries, consequently, but into place \’93mercantilist\’94 policies in order to achieve both goals \’96 persistent trade surpluses and large amounts of foreign currency reserves. \’a0This (I think plausible) story is reinforced by another graph Bibow reproduces.\’a0 The global capital flow \’93paradox\’94 to which he refers in his title is the fact that developing countries are exporting capital to rich countries.\’a0 According to his data, developing countries have almost always been net recipients of private capital flows \’96 which is what one would have expected from most economic theory and history.\’a0\’a0\’a0

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.\’a0 (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)\’a0

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.\’a0 This is when the \’93paradox\’94 of net capital flows from developing to developed countries begins.\’a0 Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).\’a0

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit, although exacerbated by the second surge around 2004.\’a0 Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.\’a0\’a0\’a0

The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.\’a0 Of course that doesn\’92t mean that nothing relevant happened in the US.\’a0 US monetary policy was clearly too accommodative, and especially in reaction to the Iraq war, so that it exacerbated the conditions created by the Asian savings glut.\’a0 If anyone is still looking for which country to blame, my understanding of the creation of the imbalances suggests that you can blame almost anyone you like and there is a good chance that you\’92ll be at least partly right.\’a0

Why does this matter?\’a0

The issue of what drove what is not simply of academic interest.\’a0 The consequences for the world of a system in which imbalances were driven by a sudden and self-perpetuating explosion in US consumption, which then forced higher savings onto Asian countries, are very different from a system in which imbalances were driven by a sudden and self-perpetuating increase in Asian savings, which then forced higher consumption onto non-Asian countries.\’a0\’a0\’a0

Deciding whether or not the savings glut hypothesis is correct is important not just because it allows us finally to decide which country really is the evil predator, the US or China.\’a0 It matters for a very different reason.\’a0

If it was an explosion in US consumption which drove the global imbalances, then we are likely to see a fairly benign resolution to the crisis for everyone, except maybe the US.\’a0 After all in that case the imbalances were driven by US consumption excesses, and since those excesses are, like it or not, going to be resolved by the need for US households to repair their badly-damaged balance sheets, the imbalances too will be resolved, and in a way that is mostly benign for everyone except recovering US households.\’a0 This process may be postponed by current US fiscal policy, and especially by recent policies that subsidize consumption, but it will only be postponed, not derailed.\’a0

And just as Americans can no longer binge consume, their binge consumption will no longer force Asians to save such a high and rising portion of their income.\’a0 Asian growth, and especially Chinese growth, will be much more balanced.\’a0

But if the global imbalances were driven by a surge in Asian savings, Asian and Chinese growth will still rebalance, but the rebalancing will be much more difficult.\’a0 Why?\’a0 Because too-high Asian savings, caused in large part by post 1997 policies that encouraged differential growth between consumption and production (as I discuss here, for example), have until now been matched by too-low US savings rates.\’a0 As long as the two imbalances balanced, the world economy could continue functioning without too much distortion.\’a0

But now if we can expect net savings in the US (and perhaps in many other parts off the world) to rise, we need to see a rapid change in those policies that encouraged too-high Asian, and especially Chinese savings. \’a0In that light there was an interesting and worrying OpEd article in today\’92s Financial Times by the Peterson Institute\’92s Fred Bergsten and Arvind Subramanian:\’a0

The Obama administration is increasingly signalling that the US will not continue to be the world\’92s consumer and importer of last resort. The clearest statements came last month from Larry Summers , White House economics director, in a speech at the Peterson Institute for International Economics and in an interview with the Financial Times. The US, he said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth.\’a0

If the US really is serious about this shift towards higher savings, and if the primary source of the imbalance was the Asian savings glut, and not an original US consumption \’93glut\’94, this means that in the future US policies will be in direct conflict with still-current Asian policies, and unless the US is unable to accomplish these goals, Asian countries will need to force through an adjustment in their development policies as quickly as possibly.\’a0 Asian and especially Chinese officials have acknowledged the need to increase consumption more quickly.\’a0

But for now this adjustment in policies that encouraged too-high Asian, and especially Chinese, savings does not seem to be happening.\’a0 “The optimal choice is to expand household consumption,” PBoC governor Zhou Xiaochuan said in a speech last month. \’a0″That is, however, easier said than done. While the current income structure cannot be dramatically changed in the short term, the second-best choice is to maintain and expand investments.”\’a0 He is almost certainly right, at least except for his last statement.\’a0

In fact as I have argued many times (for example here, and here), I suspect that most of the Chinese fiscal stimulus is exacerbating the imbalances \’96 both by boosting current and future production and by creating conditions that will constrain future consumption growth.\’a0\’a0\’a0

In that case there has been no significant rebalancing yet towards more rapid consumption growth taking a greater share of Chinese production \’96 just a frenzied attempt to keep current growth rates high by boosting investment, which will almost certainly lead to capital misallocation and rising non-performing loans, and clearly unsustainable attempts by the Chinese government artificially (and unsustainably) to boost short-term consumption by subsidizing it heavily with government debt (something the US seems to have been doing too) which has the effective consequence of reclassifying fiscal expenditures as household consumption.\’a0

The end result?\’a0 Planned increases in investment in China eventually become forced increases in investment \’96 rising inventory \’96 that ultimately must lead either to writing inventory off or closing down production facilities in the future.\’a0 This is, by the way, just another way of stating the excess capacity problem.\’a0\’a0

Perhaps what we need is a real return to Confucian roots. \’a0I recently read this quote from Lao-Tzu: \’93The sage does not hoard. Having bestowed all he has on others, he has yet more. Having given all he has to others, he is richer still.\’94\’a0

Tags: Bibow

The USG doesn\’92t need foreigners to finance the US fiscal deficit? Who knew?

August 17, 2009 in Fiscal debt and deficits, Global liquidity by Michael Pettis | 53 comments

I usually don\’92t post a new entry so soon after the last post, but there was an interesting article in today\’92s Wall Street Journal by Andrew Batson.\’a0

China is center stage when it comes to fears that buyers will one day spurn U.S. Treasurys. The bond market has been the source of much political theater between the U.S. and China in recent months, with Chinese officials passing up few chances to lecture the U.S. on its profligacy.\’a0

But that has obscured an important change: The market for Treasury bonds is now more reliant on U.S. buyers — including the Federal Reserve after its recent buying spree — than the Chinese.\’a0

China held $801.5 billion in Treasury debt at the end of May. The Fed at that time held about $598 billion, although that has now risen to $704 billion. The latest figures for U.S. households, from the first quarter, showed holdings of $643.9 billion — more than double the $266.6 billion in the fourth quarter of 2008.\’a0\’a0

The rising budget deficit, which has led to record issuance in recent months, doesn’t necessarily mean the government is becoming more indebted to foreigners. While the U.S. government is borrowing furiously, the current account deficit has actually halved from an annualized $829 billion in mid-2005 to an annualized $409.5 billion in the first quarter of 2009. That shows the U.S. is now less dependent on external financing, because it is saving more domestically. The U.S. government may be in hock, but it is increasingly to its own citizens.\’a0

This shouldn\’92t be a surprise.\’a0 The reason for the growing US fiscal deficit is to slow the economic impact of a rise in US household and corporate savings.\’a0 This means that the period in which very high Asian savings were matched by very low US household savings is changing to one in which the pressures to save in Asia remain while US households are increasing their savings (or reducing their borrowing, which amounts to almost the same thing).\’a0 The pool from which the US Treasury can borrow is increasing, not decreasing.\’a0\’a0

In addition, as the US current account deficit drops, foreign net purchases of dollar assets must also drop.\’a0 The rising US fiscal deficit will increasingly be financed by Americans and less and less by foreigners, and the much-decried impact on US interest rates of the massive US borrowing turns out to be very small.\’a0

Brad DeLong, who also expected this to happen, has a very similar take from a different angle, which he discusses in a recent blog entry:\’a0

And the interesting thing is that I knew that this [that the market would easily absorb a huge increase in government debt] was going to be what would happen–or, rather, I strongly believed that this was going to be what would happen–and all because I had read John Hicks (1937).\’a0

Let me give you the Hicksian argument about what happens in a financial crisis–a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms’ desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.\’a0

In Hicks’s model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely–in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.\’a0

Batson goes on to say in his article:\’a0

History suggests there is plenty of room for households to increase their holdings.\’a0

The Chinese government may be politically uncomfortable with lending money to the U.S., but it remains locked into purchasing Treasury bonds because of its currency’s tight peg to the dollar. The challenge for the U.S. government isn’t just reassuring China.\’a0

It also is to maintain the confidence of the domestic investors who are an increasingly important source of financing for the wave of government debt supply hitting the market.\’a0

The only point with which I disagree is on the need to \’93reassure\’94 China. \’a0As I have pointed out many times, although there are plenty of good reasons for China to worry about the value of its dollar holdings, and I hope many people, not just the Chinese, are looking warily at growing US fiscal deficits and making disapproving noises, the fact is that there is little China can do about its dollar holdings without either causing a damaging rise in trade tensions with Europe (or any other country whose currency is an alternative to the dollar) or causing a collapse in its export industry.\’a0 As long as China\’92s trade surplus directly or indirectly is connected to the US trade deficit, China will have to recycle the surplus into the dollar pool that ultimately funds the US fiscal deficit, and it is in the best interest of the US that the US trade deficit decline smoothly, which means that it is also in the best interest of the US that foreigners, including the Chinese, buy fewer US dollar assets.\’a0

What is confusing is the conflict between China\’92s natural position and its stated position.\’a0 Rather than demand reassurance that the US will control its fiscal spending, China should be secretly hoping that the US fiscal deficit will mushroom.\’a0 It is after all largely the size of the US fiscal deficit that will determine the speed with which US imports and the US trade deficit contract, and it is in China\’92s best interest that these contract very slowly.\’a0

On a similar subject, I was recently interviewed for a TV show about \’96 yet again \’96 the awful continuing prospects for the dollar as a the dominant reserve currency.\’a0 Besides expressing my deepest skepticism that the most recent hullabaloo about the dollar was likely to be more reasonable than during all the previous the-sky-is-falling-on-the-dollar periods, I also said that it seems to me that the argument had somehow gotten backwards as far as its proponents and opponents were lining up.\’a0

In my view it is the US who should be agitating for an end to the US dollar as the default reserve currency, because this means that any time a country needs to grow reserves or turbo-charge domestic growth with mercantilist industrial policies, thanks to the flexibility of the US financial system and the foreign desire to accumulate dollars, it is almost always the US tradable goods sector that is forced to adjust.\’a0 In a similar vein it should be foreigners, especially Asians, and most especially China, that should want to maintain the existing currency system.\’a0\’a0\’a0

I also suggested to the interviewer that in two or three years no one would be talking about this topic anymore.\’a0 She was surprised and asked me why.\’a0 The reason has to do, I think, with the expected evolution of the US current account deficit.\’a0 For several years the US has been running, as we all know, very large current account deficits.\’a0\’a0\’a0

This means that the net accumulation of dollars by foreigners (foreign purchases of dollar assets minus American purchases of foreign assets) has been extremely high \’96 just as in the 1960s when the combination of a trade deficit, foreign military spending, and large foreign aid programs created a dollar glut, along with heated arguments about the international role of the dollar.\’a0 If the US current account deficit remains high, foreigners will continue to be large net acquirers of dollars.\’a0

But if the current account deficit declines quickly, as it has and as I expect it to continue doing for a while longer, the problem of too many dollars being held abroad will disappear \’96 or, more technically, it will simply be the obverse of the change in investment flows into the US.\’a0 Once the world stops accumulating hundreds of billions of dollars every year through the US current account deficit, the argument over the dollar will fade away and, not coincidentally, a larger portion of foreign reserves, and probably international trade, will naturally be denominated in non-dollar currencies.

Predicting consumption growth in China

August 15, 2009 in Consumption and production by Michael Pettis | 31 comments

My ten-day trip \’96 partly holiday on Phuket and Phi Phi islands (even more beautiful than I had expected) and mostly meetings in Bangkok, Hong Kong and Singapore \’96 finally ended yesterday.\’a0 Besides three presentations to large investment groups, I met about twenty to thirty institutional investors in small meetings, and those meetings were very instructive.\’a0 There is a real mix out there it seems to me of tentative optimism about Chinese prospects on the part of the majority of investors and deep pessimism on the part of a minority, which included both Chinese nationals and foreigners.\’a0\’a0\’a0

Perhaps this is because of my own prejudices as a former bond-markets trader, but the pessimistic minority seemed much more experienced and literate to me.\’a0 They were also generally a lot more senior.\’a0 That might not mean much but it does suggest to me that there is a risk of bad news in the future causing a stampede of pessimism.\’a0 Of course the majority is not necessarily wrong (in spite of the claims of contrariarans, who paradoxically enough include nearly everyone, it seems), but the volatility impact of information that confounds their expectations is much greater than that of information that reinforces their expectations.\’a0

I may discuss the impressions I got from some of these meetings more later, but I wanted to talk a little about consumption growth in China.\’a0 My Financial Times OpEd piece published two weeks ago about the consumption constraint on Chinese growth seems to have generated several letters in disagreement.\’a0 I don\’92t think most of them made much sense as far as I could understand.\’a0 One seemed to have an overly optimistic assessment of the Chinese banking system.\’a0 It seemed to claim that since officially reported NPL ratios today are much lower than unofficial private estimates of ten years ago, the banks are in very strong shape, and so we don\’92t have to worry about the NPL effect of the recent surge in lending. \’a0That seems to me to be a defensible if illogical claim, but pretty implausible.\’a0\’a0

The letters also generally assumed \’96 and this confusion seems to happen an awful lot \’96 that the accounting identity GDP = C + I + G is something prescriptive, with GDP growth largely independent of consumption growth and sustainable in the medium and long term by forever-increasing amounts of government-financed investment.\’a0 Apparently the argument that foreigners won\’92t consume this rising current and future capacity, and that Chinese won\’92t consume this rising capacity either, which must lead either to forever-rising inventories, to dumping and trade tensions, or to write-offs, none of which is a happy solution, can simply be resolved by repeating GDP = C + I + G several times.\’a0

Nonetheless one of the letters in disagreement, by Professor Peter Williamson of Cambridge University made a lot more sense and identified the main weakness of my argument, as I see it.\’a0 According to Williamson:\’a0

Michael Pettis is right to remind us that correcting the fundamental imbalances in the global economy means that China’s export-orientated growth model is no longer tenable (\’93Get ready for lower Chinese growth\’94, July 31). But he is unduly pessimistic about the potential of Chinese consumers to generate sustained, double-digit growth in Chinese gross domestic product.\’a0

Between now and 2025 some 350m Chinese are set to become new city dwellers. This alone will give a boost to demand equivalent to the size of another Germany. The government\’92s stimulus package will also initiate more spending by consumers. The \’a373bn to provide universal cover for basic healthcare in China by 2011, for example, will encourage savers fearing medical bills to spend more freely. Workers made redundant from export-processing jobs, meanwhile, are adapting quickly \’96 finding new work and retraining (4m in Guangdong alone). Their consumption will rebound.\’a0

Local consumption is, indeed, the key to China sustaining high growth over the next decade. But that should be cause for optimism rather than despair.\’a0

Professor Williamson accepts the argument that China\’92s medium to long term growth rate will be constrained by the growth rate of domestic consumption, but he disagrees with me in assuming that the rate of growth in Chinese consumption (roughly 8-9% annually over the past several years) will remain the same or even decline in the next few years.\’a0 He thinks it is likely to grow much faster.\’a0

He may be right, and whether or not he is right is I think the key to the validity of my argument as a prediction of the future.\’a0 But I am not convinced.\’a0 For reasons I have discussed many times, I don\’92t think by his first argument, that China\’92s plan \’93to provide universal cover for basic healthcare in China by 2011,\’94 will cause a future explosion in consumption \’96 at least not in the time needed to address the adjustment in the global imbalances.\’a0\’a0\’a0

For one, simply because the government has announced the plan to put into place a good healthcare system by 2011 doesn\’92t mean that this is a done deal.\’a0 The government also announced several years ago that Chinese growth would become much more environmentally friendly, Chinese income would become more fairly distributed, corruption would be reduced, the banking system would be cleaned up, SMEs were to receive a growing share of loans, and the corporate bond markets would become a major source of funding, and yet anyone living in China might wonder if any progress had been made on any of those things.\’a0 Putting in a good health care system is very difficult in the best of circumstances, and with almost no accountability in local governments and local hospitals, and with rapidly rising deficits at both the central and provincial levels, I am pretty skeptical about their ability to achieve anything close to their stated ambitions.\’a0

But more importantly, even if they do pull it off, and give China Swedish levels of health care within a year or two, we shouldn\’92t assume that it will immediately affect consumption levels.\’a0 Anyone living in China knows how skeptical many Chinese are about government promises, and I would guess that it will take many years of testing the system successfully before even a significant fraction of Chinese household feel that it is no longer necessary to save enough to protect themselves from medical emergencies.\’a0 After all there are not many responsible adults who will throw caution to the winds when it comes to the possibility of an aged parent or, even worse, a son or daughter, needing serious medical treatment, and cash for that treatment.\’a0 In that case you don\’92t give up your safety net of hoarded cash until you are thoroughly and totally convinced that you will no longer need it, and that conviction only comes through experience.\’a0

I am also skeptical about his other claim for a surge in consumption based on a flexible work force quickly replacing export jobs with other jobs.\’a0 Unemployment seems to be rising (of course the official urban employment data is nearly worthless, but the anecdotal evidence isn\’92t good), and the main reason it hasn\’92t surged is probably because of the massive stimulus package, so once again we circle back to the argument about the sustainability of the stimulus package.\’a0 In that light let me just highlight a passage from the ft.com’s Dragonbeat by my friend Arthur Kroeber, a very smart China watcher with whom I used to disagree in the past a lot more than I do currently (perhaps a little to my chagrin, because given how much he knows about China, debates and disagreements with Arthur were always very educational for me):\’a0

China’s ability to maintain economic growth of around 8 per cent despite the global shock took many by surprise. But this ability has nothing to do with systemic advantages, a distinct \’93China model\’94 of growth, or skill in macroeconomic management.\’a0

Still less has it anything to do with the reasons cited by the People\’92s Daily editorial [Note: this is in reference to an especially silly editorial you can find here].\’a0 China\’92s present economic vitality results from a Great Wall all right \’96 a Great Wall of borrowed cash. There is nothing remarkable or spiritual about an economy growing at 8 per cent when credit is allowed to expand by 34 per cent.\’a0

The fact becomes even less remarkable when we recognise that nominal GDP (the appropriate comparator for nominal credit growth) grew just 3.8 per cent in the first half.\’a0 In other words, 10 dollars of new loans were required to generate just one dollar of economic growth.\’a0

In fact China\’92s first-half growth shows one thing and one thing only: the existence of a powerful state with the ability to commandeer its citizens\’92 wealth and plough it into more buildings, bridges and roads, with no regard for the return those investments will bring.\’a0

Not to be outdone, Shen Minggao, Caijing\’92s chief economist, also worries about the Chinese adjustment in an article in this week\’92s Caijing.\’a0 In particular he is concerned that Chinese consumption needs to accomplish the very difficult task of increasing at a rate commensurate with the increase in US savings:\’a0

During the S&ED the United States highlighted signs of healthy economic adjustments. For example, the savings rate for U.S. residents climbed to over 7 percent in June and will likely reach 10 percent in the future. The United States has done better than China in terms of these adjustments. China has to change its current exports-driven growth mode because a U.S. recovery does not necessarily boost consumption, given the soaring saving rates.\’a0

\’85The wealth decrease for American households did not shake the foundations of consumption.\’a0 Though the recession led to negative consumption growth, the largest year-on-year decline was only 4.4 percent, recorded in the last quarter of 2008. It was far less than the 8.9 percent drop during the late 1970s oil crisis.\’a0\’a0\’a0

However, it is uncertain whether deleverage of household balance sheets and rising savings rates are a one-time thing or a permanent change. As U.S. financial regulators tighten systemic risk supervision and easy lending becomes no longer available, American consumers have to rely on savings rather than borrowing to spend.\’a0

\’85In contrast, China’s high saving rates and constant inflows of foreign funding compel the Chinese government to make a hard choice: continue investing in infrastructure or buy Treasury bonds? China will have to suffer additional risks if the dollar depreciates but to continue investing in infrastructure will bring about low efficiency caused by overinvesting.\’a0

If China wants to avoid such a dilemma, it must boost domestic consumption. Chinese consumers must lower their savings rates. Meanwhile, the percentage of residents’ incomes in the gross national product should be increased greatly. Second, China needs to push for the appreciation of the yuan. Chinese firms have to rely more on domestic markets than overseas markets. Finally, China needs to turn potential consumption into real consumption during its industrialization and urbanization. Only in this way can China become a new engine for global economic growth and gain a bargaining advantage in future U.S.-China negotiations, which is commensurate with China’s economic size.\’a0\’a0\’a0\’a0

In another article another writer in the same magazine warns of growing overcapacity in steel:\’a0

The government will freeze approvals of new steel projects for the next three years in a bid to curb overcapacity, Ministry of Industry and Information Technology chief Li Yizhong told a news conference August 13.\’a0 Li said oversupply is a serious problem, with annual production capacity of 660 million tons far exceeding estimated demand of 470 million tons. China will produce a record 580 million tons of prime steel in 2009, far above the government’s target of 460 million tons, according to China Iron and Steel Association data.\’a0

So it\’a0mostly boils down to what policymakers can do to boost consumption growth \’96 net consumption growth \’96 in the short and medium\’a0term, and the sustainability of the fiscal stimulus to get the economy over the hump, and there is a whole lot of skepticism on my part, and on the part of many of my favorite China-based\’a0observers, that this is not going to be easy.\’a0\’a0\’a0

Of course Williamson may be right that there is a possibility of a surge in Chinese consumption, and if he is right my entire argument about a sharp slowdown in Chinese growth over the next decade will thankfully get thrown out the window. That is the main point \’96 my whole argument rests, I think, on whether or not consumption growth can be positively and, more importantly, sustainably affected by the current fiscal stimulus.\’a0 It is hard enough\’a0to present one’s full case\’a0in a letter to the editor, so I may be slighting the full extent of Williamson’s argument, but for now I think the evidence is still far more bearish than bullish on Chinese consumption growth.\’a0

« Older entries

Maybe Mars

The IMF warns about surplus countries and global imbalances

More trade tensions, and the very limited advantage of relative poverty

The coming clash in savings

China\’92s August data confirms both optimists and pessimists

The Shanghai market calls the tune

It\’92s not yet the end of China\’92s massive stimulus

The credibility of farmers, priests and prostitutes \’96 and bankers?

Yet another discussion on the Asian savings glut hypothesis, and why it matters

The USG doesn\’92t need foreigners to finance the US fiscal deficit? Who knew?

Predicting consumption growth in China

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