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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

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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More public worrying about the Chinese stimulus

July 24, 2009 in Fiscal stimulus, Labor and unemployment, Money growth, NPLs, Real estate by Michael Pettis | 44 comments

Although I am often surprised by how eagerly foreign commentators have embraced the Chinese fiscal stimulus story and see it as a great, shining success, I am happy to say, mercifully, that in China there is a lot more skepticism.\’a0 There seems to be a serious debate among Chinese policymakers over the stimulus package.\’a0\’a0\’a0

The debate lists, on one side, people centered on the PBoC, the CBRC and the National Bureau of Statistics, who are worried that the stimulus may be exacerbating Chinese imbalances.\’a0 On the other side are people in the State Council, the Ministry of Commerce and in the provincial and municipal leadership who are more worried that any half-heartedness will lead to a significant rise in unemployment.\’a0\’a0\’a0

In the past week or so the former, with whom I am of course in complete sympathy, seem to have become increasingly worried and have been making a lot of noise.\’a0 The formidable Hu Shilu, editor of Caijing, (and by the way Evan Osmos wrote a very interesting article about her in the current New Yorker) recently made a strong case against continuation of the current fiscal program when she wrote in an editorial this week that \’93a policy that encourages loose lending and investment is driving China’s economic engine down an old, unsustainable path.\’94\’a0

Various signals suggested China’s economy had returned to a stable track by the end of the second quarter, giving us an opportunity to reassess macroeconomic policy.\’a0 Data released by the National Bureau of Statistics showed that China’s GDP rose 7.1 percent in the first half of the year, and 7.9 percent in the second quarter alone. Apparently, China’s economy has bottomed out.\’a0

Arduous efforts contributed to this upward trend. External developments have had a much more serious impact on China’s economy recently than during the Asian Financial Crisis a decade ago. However, first half growth was only a bit below the level recorded in 1998. And although heavily dependant on exports, China may yet achieve its 2009 growth target of 8 percent, even while other major export countries report contractions.\’a0

These achievements could intoxicate Chinese policymakers. But we see no miracles here. In fact, economic growth recovery in China is being driven by investment. Some 6.2 percent of the country’s first half GDP growth rate can be credited to investment, while consumption accounted for 3.8 percent. The net export business contributed a minus 2.9 percent to the growth rate figure.\’a0

Hu makes the point that the \’93surprisingly high\’94 Chinese growth is neither surprising nor cause for celebration.\’a0 It is the automatic outcome of a huge stimulus, and the real question, as I have argued many times, is not whether high current growth indicates that China has turned the corner on the crisis (it most certainly has not, in my opinion), but whether the cost of achieving this growth is excessive and will lead to more difficult conditions in the future.\’a0

It’s long been acknowledged that China’s traditional methods of achieving economic growth cannot be sustained. However, we are now racing down this traditional path of economic development.\’a0\’a0

Dramatic increases in the currency supply and lending have been backing this investment, the single most important engine of economic growth. M2 increased 28.5 percent and yuan-based lending rose 34.4 percent in the first half, setting new records for each. But nominal GDP growth was only 3.8 percent during the first six months of 2009. And these astronomical increases in currency and lending are a double-edged sword that can support GDP growth as well as endanger the economy.\’a0

\’85It’s high time we re-emphasize the actual policy of moderation. A moderately loose monetary policy is necessary for an unpredictable, downward-sloping economy. However, monetary policy that’s too loose will have more drawbacks than merits once an economy levels out. It’s only a matter of time before loose monetary policy leads to inflation and asset bubbles.\’a0

She concludes, very diplomatically I think:\’a0

In the current economic environment, the more quickly China’s economy grows, the greater the effort needed to adjust future methods of economic development. Now is the right time to consider the timing of exit from stimulus. The third quarter can be a crucial juncture.\’a0

She is not alone in criticizing the stimulus.\’a0 Another formidable lady, Wu Xiaoling, former People\’92s Bank of China vice governor, was interviewed by National Business Daily on Wednesday, and warned that the combination of excess capacity and excessively loose monetary policy was leading to asset bubbles.\’a0 According to an article in yesterday\’92s South China Morning Post,\’a0

“Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles,” she said at a forum in comments reported by the Chinese-language National Business Daily.\’a0\’a0″The money has really gone out and if it is a time when there is no investment in the real economy and no one will put the money in banks to earn interest, then the funds will flow into the property market and stock market,” she said.\’a0\’a0

China’s central bank may have to raise banks’ reserve requirements to mop up excess liquidity, she said, adding that this was simply a tool for managing the money supply and should not be misunderstood as monetary tightening.\’a0

\’85Ms Wu said that China faced a dilemma in easing the rate of loan growth. Inflationary pressures would arise if lending continued at the same pace, but without sustained lending, many big projects may wind up unfinished because they are contingent on longer-term financing.\’94\’a0

Although an increasingly large number of Chinese academics and think tank researchers have been raising warning cries, I think she is the first official or ex-official to go so public with her worries. \’a0That doesn\’92t mean other public officials don\’92t act as if they are worried.\’a0 The CBRC for example announced this week the good news that the NPL ratio declined from 2.42% at the end of 2008 to 1.77% at the end of June.\’a0\’a0\’a0

Part of this reflected an actual decline in NPLs, and most of it of course reflects the surge in new loans, but the CBRC is not acting complacent.\’a0 They have reinforced credit control policies on second-home purchases and their spokesman insisted earlier this week that there would be \’93strict enforcement\’94 of the CBRC’s mortgage lending policy.\’a0\’a0

According to another article in Caijing, \’93the authorities have consistently been encouraging banks to raise their loan-loss coverage, reflecting fears that the massive surge in new credit extended in the first half may lead to a rise in bad loans.\’94\’a0 The South China Morning Post had this to say on that subject:\’a0

Beijing has required banks to raise their bad-loan reserve ratio to 150 per cent at the end of the year, forcing the lenders to set aside an additional 70billion yuan ($79HK.4 billion) as provision amid deteriorating asset quality, a fresh sign of China’s mounting worries about a backlash from its stimulus package.\’a0\’a0

Liu Mingkang, the chairman of the China Banking Regulatory Commission, told a government working conference over the weekend that all mainland-based banks including local units of foreign giants such as Citigroup \’a0and HSBC Holdings must boost their reserve ratio to 150 per cent, as risks were increasing amid a torrent of imprudent loans in this year’s first half.\’a0\’a0

“Rapid growth in banking loans has led to accumulated risks,” Mr Liu was quoted in a CBRC statement as saying. “Reckless operations of banks were seen as some banks rushed to extend loans without due diligence.”\’a0

The article goes on to quote She Minhua, a banking analyst at China Jianyin Investment Securities as saying “The requirement is basically a message that asset quality deterioration is deepening.\’a0 A serious problem will probably surface in 2010.”\’a0

And Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said earlier this week that China, the world\’92s largest steel producing nation, should curtail \’93reckless investments\’94 in the industry by withholding project approvals. \’a0According to an article in Bloomberg:\’a0

China’s demand for steel is about 500 million metric tons, less than the annual output capacity of 660 million tons, Zhu Hongren, spokesman for the Ministry of Industry & Information Technology, said at a conference in Beijing today. Zhu is reiterating figures given by the China Iron & Steel Association in February for last year.\’a0\’a0

Crude steel output in China rose to a record 266.6 million tons in the first half as the nation\’92s $586 billion stimulus package spurred demand from builders and carmakers. Annualized, this would beat the 460 million tons output forecast by the steel association for this year.\’a0\’a0

“The industry must produce according to market needs, and avoid adding to the excess capacity,” Zhu said. “They should avoid reckless investments. The government must also take action to curtail additional investments by companies that are already in excess.”\’a0\’a0

Even Justin Lin, the World Bank’s chief economist, and someone who has been more of a cheerleader for China\’92s economic model than a critic, made a statement that suggests to me an indirect criticism of the fiscal stimulus package, although he (and others) may disagree with my interpretation.\’a0 According to a July 15 article in the Telegraph:\’a0\’a0

Justin Lin, the bank\’92s chief economist, said factories running idle around world threaten to trap economies in a vicious cycle, risking further spasms of financial stress, requiring yet more rescue packages.\’a0 “Significant excess capacity has been built up and unless this issue is addressed, we will face a deflationary spiral and the crisis will become protracted,” he told an audience in Cape Town.

\’a0

Mr Lin said capacity use had fallen to 72pc in Germany, 69pc in the US, 65pc in Japan, and as low as 50pc in some developing countries, mostly touching lows not seen in modern times.\’a0 The traditional cure for countries caught in slumps is to claw their way back to health through devaluation, but this cannot be done today because the crisis is global. “No country can count on currency depreciation and exports as a way out of recession. Unless we deal with excess capacity, it will wreak havoc on all countries. There is urgent need for global, co-ordinated fiscal stimulus,” he said.\’a0\’a0

But for all the warnings I don’t want to exaggerate my account of rising skepticism among Chinese economists and regulators.\’a0 In spite of possible back-door attempts by the PBoC and the CBRC to manage the excesses associated with the fiscal stimulus, it is pretty clear I think that policy is still being managed largely by policymakers who are far more worried about rising unemployment in the short term than about asset bubbles and an exacerbation of the unbalanced development model.\’a0

The front page of today’s People’s Daily, for example, makes this clear.\’a0 They cite Finance Minister Xie Xuren’s insistence that “China will stick to proactive fiscal policy in the second half.”\’a0 According to the article, which is also carried in Xinhua:\’a0

China will continue its proactive policy and reform its economic structure in the second half of this year to boost economic growth, Finance Minister Xie Xuren said Thursday.\’a0 Xie told local financial bureaus at a conference in Beijing on Thursday that the proactive policies, which included increased investment from government, tax cuts and subsidies to low income families, had taken effect in stimulating a recovery of the national economy.\’a0

Xinhua today also prominently cites Peking University professor Li Yining as saying that “China should stick to its proactive fiscal policy and moderately easy monetary policy to fuel the economic growth as the foundation for recovery is not solid yet.”\’a0 I was not at the conference, so I wonder if professor Li\’92s comments were spun a little, because according to the Xinhua article he also said that “the current economic advance was pushed by investment, which was not the final demand \’96 stable economic recovery should be sustained by increased consumption,” and warned that Chinese banks should “improve credit quality and structure.”\’a0

So for all the rising skepticism among policymakers and scholars I think there is little doubt that we are going to see still more fiscal stimulus along the lines we have already seen.\’a0 If there is indeed global excess capacity, as Justin Lin says there is, I cannot see how an investment-driven program to increase capacity, and one which is almost certain to involve a huge additional misallocation of capital (after all, 8% growth given the sheer size of the fiscal and banking stimulus is actually a disappointingly low level of growth), can be much more than a short-term stop gap.\’a0 On the contrary, I think it will make the medium term adjustment even more difficult.\’a0

On that note I want to recommend Victor Shih’s excellent OpEd piece in the Wall Street Journal \’96 Asia yesterday.\’a0 He argues that:\’a0

Should this pace of credit expansion continue for the remainder of the year, China may well face a difficult trade-off down the road. The economy is unlikely to face a financial crisis because most of the debt is owed to domestic investors and depositors and China can still prevent large-scale capital flight. However, if inflation spikes next year, the central government will have to choose between shutting off credit, which will reveal a massive nonperforming loan problem currently obscured by a torrent of new loans, or an unprecedented level of inflation. High inflation is destabilizing, as it has caused major runs on the banks before. If additional credit expansion in the face of rising inflation is not an option, the greater the extent to which lending is uncontrolled at the moment, the bigger a nonperforming loan problem the central government will face in the future.\’a0

An often overlooked ingredient to China’s success story is that generations of top-level central technocrats like Chen Yun, Yao Yilin and Zhu Rongji time and again used their political influence to constrain local investment bubbles, thus forestalling high inflation and major financial crises. Past retrenchment campaigns were unpopular and controversial, but senior technocrats nonetheless maneuvered to stop uncontrolled local investment. As credit continues to rocket toward the stratosphere, China is in increasing need of such leadership again.\’a0

Before closing this long post I want to add three additional comments.\’a0 The first involves a conversation I had with one of my Tsinghua students who graduated in 2003 and now works as a currency trader.\’a0 Last year he bought a few apartments in Chengdu, the capital of Sichuan, his home province, for speculative purposes, and in spite of surging land prices he seemed to think it was a terrible trade.\’a0\’a0\’a0

I asked him why, and he said that although real estate prices had gone up dramatically since he bought the apartments, and he needed the money back, he nonetheless found himself unable to sell the apartments.\’a0 That\’92s a little weird, I thought.\’a0 Rising prices should mean eager buyers, but he can\’92t get anyone to take the apartments off him?\’a0\’a0\’a0

Has any other of my blog readers experienced anything similar?\’a0 Of course the historian in me remembers that during the final two years of the Japanese bubble, when land prices soared to levels never before seen in history, there were complaints by sellers that transaction volume was so thin that they couldn\’92t actually sell their land.\’a0

My second comment concerns university unemployment.\’a0 I have been writing for three years that unemployment among college graduates in China was soaring, and that authorities were understandably nervous.\’a0 So nervous, it seems, that they have been putting pressure on university to do more to get jobs for their graduates by limiting their next-year enrollment to the number of graduates this year with jobs.\’a0

There are, of course, two ways to improve statistics.\’a0 One way is to improve the underlying reality.\’a0 The second way is just to fake the numbers.\’a0 According to a Tuesday article in the People’s Daily:\’a0\’a0

A Shaanxi graduate said his university gave him a bogus work contract to inflate its post-study employment figures.\’a0 The former student said the contract was for a job at a local company which did not exist and carried the signature of his tutor.

I had no idea that I already had a job,” the student, who had been hunting for work, wrote anonymously on a website.\’a0 In order to ensure a high employment rate and deliver a satisfactory work report during the global financial crisis, some Chinese universities have been faking work contracts or employment agreement for graduates, Southern Metropolis Daily reported yesterday.\’a0\’a0

“Faking employment rates is not an isolated case and it has existed for years in China,” an education expert, who wanted to remain anonymous, told China Daily.\’a0 Due to fierce competition among universities, especially secondary-tier ones, the performance and reputation of a school largely depends on its employment rate after graduation, he said.

\’a0

According to unwritten rules at many universities, students cannot graduate if they do not find a job, the report said.\’a0 This means many unemployed students have to buy a fake job contract or employment agreement from small companies so that they can get their certificates.\’a0\’a0

This kind of thing will mean that the college employment numbers, a very useful figure for understanding the effect of economic growth in China, are now much less useful.\’a0 Already the People’s Daily article cites differences between the Ministry of Education numbers and a private firm\’92s numbers.\’a0

The Ministry of Education said that nearly two thirds of them [2009 college graduates] had already secured jobs before graduation in early July.\’a0 But this figure differs widely with an employment report from an independent consulting firm on higher education.\’a0 A report from MyCOS HR Digital Information Co said 58 percent of prospective graduates had not signed job contracts by the end of June and that 2 percent had contracts cancelled.\’a0

By the way the article has an interesting graph on the number of college graduates over the past eight years, for those who are interested.\’a0 The total number of university graduates has surged from 1.45 million in 2002 to 5.59 million in 2008 and 6.10 million this year.\’a0 The intervening years saw 2.12, 2.80, 3.38, 4.13, and 4.95 million graduates.\’a0

My third comment is about the great article in today’s Wall Street Journal on the explosive development of the Beijing music scene, a subject that all my friends know is one dear to my heart.\’a0 Anyone who is interested in knowing more about this scene should read it.\’a0

Tags: Steundent employment, Victor Shih

RMB 1.5 trillion in new Chinese lending — can we turn this thing off?

July 8, 2009 in Banks, NPLs by Michael Pettis | 59 comments

I don\’92t have time to do a long entry today, but in my June 30 entry I marveled at the huge explosion in new lending, and claimed that credible rumors suggested that total new loans for June would be an astonishing RMB 1.2 trillion.\’a0 That would bring total new lending for 2009 to RMB 7.06 trillion, nearly three times last year\’92s first-half total of RMB 2.45 trillion.

Well, I was wrong.\’a0 Here is what an article that just came out on Bloomberg says:

China\’92s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom.

New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation\’92s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

\’93Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,\’94 said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. \’93Expect credit to slow dramatically in the second half.\’94

I was more than 20% too conservative in my prediction. \’a0This is the third biggest month in history, and of course all three of them occurred this year.

Today bank stocks were down, on rumors that the very high and clearly unsustainable loan growth rates would soon come to an end. \’a0If you need any evidence of how topsy-turvy things have become that fact should be enough.

Under \’93normal\’94 circumstances the possibility that banks would continue to force new loan growth at anywhere near the current rates should raise terrible concerns about an explosion in future loan losses and cause bank stocks to collapse.\’a0 Instead, it is concern that this lending spree might come to an end that causes bank stocks to fall.

Of course this might not be totally irrational. \’a0If you believe, as most of us do, that there is an implicit guarantee by the government on future loan losses, then this is clearly a heads-we-win, tails-the-government-loses proposition.\’a0 Let them pile on the loans at the guaranteed spread between lending and deposit rates.

I guess it is time to introduce something that I might call the Pettis Rule of Banking (although I am way, way down on the list of people who first thought of this):\’a0 \’93It is not even theoretically possible in a banking system in which bankers are given unlimited liquidity, tremendous pressure to make loans, and an implicit guarantee against losses, that enormous amounts of bad loans will not be made.\’94

Distortions in the Chinese lending environment

May 3, 2009 in Asian development model, Banks, Fiscal stimulus, Money growth, NPLs by Michael Pettis | 38 comments

Things have been so busy this past week with various writing commitments and with the celebration of the third anniversary of my music club (four amazing shows with some of Beijing\’92s greatest artists and a lot of support and coverage from local music scene participants an the press) that I have been neglecting my blog. For today\’92s entry I don\’92t have any major points to make but I did want to take a look at some of the anecdotal information we are getting about the bank-part of the fiscal stimulus package.

The context is last week\’92s post in which I argued that the almost certain reversal over the next few years of American ability to grow consumption at a faster rate than GDP will put huge pressure on the Asian development model, and will require Asian consumption to grow much faster than Asian GDP. However if the current loan explosion is mismanaged, this may itself sharply constrain Chinese consumption growth, thus locking China into a long transition period of turgid growth.

In that light two weeks ago The Economic Observer, one of the better local newspapers, had an interesting article titled \’93Millions of Small Businesses Still Starved of Credit\’94. The growth of smaller businesses, many of which are in the service industry, is one important way for Chinese net consumption to grow, but it seems that their ability to obtain financing is being sharply limited by formal or informal policies that are driving capital into the investment sector. The article suggested that even with the explosive loan growth in the banking system, smaller companies are finding it extremely difficult to get loans.

New loans in China for the first quarter of this year would amount to nearly 4.6 trillion yuan, but behind the staggering figure, millions of small and medium-sized businesses nationwide were still struggling to raise funds.

\
Data from the National Association of Industry and Commerce (NAIC) showed that in January of this year, private firms had 421 billion yuan in short-term loans, a 700 million yuan decrease from December 2008. That was despite 400 billion yuan in new short-term loans released that month.
\

The article goes on to mention a survey of businesses in Chongqing that indicated that 82% of small and medium-sized businesses there considered the lack of funds the main hindrance to their development. Quoting Chen Yongjie, an official with the National Association of Industry and Commerce, the article goes on:

The Chinese government has recently pushed measures to solve financing problems for small and medium-sized businesses – for example, China’s Banking Regulatory Commission has required banks to open loan departments exclusively for small companies. But Chen said it was hard to tell how effective these measures would be: “What we can see clearly now from the statistics is that loans for small and medium-sized businesses are still dropping.”

It would be normally be surprising that loans are expanding so rapidly (we have already increased net new lending in the first quarter of 2009 by more than all of last year\’92s loan increase) while whole sectors of the economy are struggling to find financing, but my friend Dan Rosen sent me a Bloomberg article from Friday with a line which he found very funny and a tad startling. According to the article:

The largest borrower in the quarter was government-owned China Aviation Industry Corp., or AVIC, the nation\’92s biggest aerospace company. The Beijing-based company received 236 billion yuan from 11 Chinese banks, including ICBC, China Construction and Bank of China. It won another 100 billion yuan of credit from Export-Import Bank of China on April 16, without specifying how the money will be used.

AVIC General Manager Lin Zuoming said in an April 16 interview with Beijing-based newspaper Economic Observer that his biggest worry is how to allocate the borrowings to increase returns.

It\’92s the last line, of course, which Dan marked out. The largest single borrower, it turns out, has taken out around $35 billion in loans but doesn\’92t seem terribly certain about why he borrowed the money. I don\’92t want to read too much into a single throwaway line, but it is certainly consistent with all the stories and rumors we hear about banks lending not because borrowers need money for specific (hopefully profitable) projects but rather because they want to show loan growth, and the safest way to do that is to convince large companies and projects with explicit or implicit government guarantees to borrow massive amounts of money. Of course it helps that managers aren\’92t terribly concerned about creating value for their shareholders, but this is almost certainly a recipe for future growth in NPLs.

Obviously I (along with most of the readers of my blog) am not the only ones to realize this. Friday\’92s South China Morning Post had this to say:

Citic Bank Corp, the country\’92s seventh-largest lender, is optimistic about this year\’92s earnings outlook and is reining in loan growth to safeguard against a rise in bad loans. Chief executive Chen Xiaoxian said the bank would adopt stricter loan checks and had sent inspectors to those branches that had recorded a surge in discounted bill financing in the first quarter. \’93Banks need to take more forceful actions to increase risk controls,\’94 he told reporters.

The article goes on to say:

Total lending by mainland banks in the first quarter reached a record 4.58 trillion yuan, close to the government\’92s minimum target for the whole year of 5 trillion yuan. Asked about his top concern, Mr Chen said: \’93Of course, it is asset quality given such fast loan growth.\’94

Mr Chen called the surge unsustainable. He did not disclose how much Citic Bank had lent in the first three months, but he said the pace would slow. \’93No matter how complicated your businesses are, you must clearly know the default rate,\’94 he said of lessons learned from the global financial crisis.

Of course Mr. Chen is right. The current rate of loan growth is unsustainable and the biggest concern must be the risk of a sharp rise in NPLs. One would expect that all of this would quickly cause the PBoC to put the brakes on lending. The always intelligent Jim Walker of Asianomics thinks this will happen, but is nonetheless so worried about continued loan expansion he asks in an April 14 report:

Exactly why is this process dangerous?

First of all, China has an extremely high M2 to GDP ratio to begin with. As Figure 2 shows, M2 in 2008 already represented 158% of GDP. Compare this with money conditions in the US where M2 accounts for just 54% of GDP (the US ratio is read off the left-hand scale). If the US\’92 monetary easing efforts are such that investors are convinced that the dollar is no longer available reserve currency then the conclusion must be the same as regards the renminbi \’96 only much more so. The only reason that the renminbi is not nose-diving in world currency markets is because domestic economic actors are not allowed to sell it.

For Walker, the explosive growth in lending is exacerbating what was already a very big problem, China\’92s huge bank-funded overinvestment. He goes on:

The second word of warning is that this breakneck monetary expansion will have to cease soon. The PBoC says that it will support economic growth through easy monetary conditions. It has certainly been true to its word so far but the problem will quickly become one of having a \’91tiger by the tail\’92. In Hayek\’92s analysis of economic growth he concluded that the only way an economic system hooked on credit could maintain its growth rate was for it to add ever increasing amounts of credit to that already existing. Adding the same amount of credit would result in recession-like conditions.

This, in his view, was the road to hyperinflation. The alternative, putting the brakes on monetary expansion, would lead to economic depression. On the assumption that Beijing will not wish to risk a hyperinflationary outcome we suspect that it will slam the brakes on the banks (which are clearly out of control already) within the next few months, regardless of the comments being made by the PBoC today. The next move in monetary policymaking in China will be to tighten, a move that will be badly received by markets that are already starved off profits.

Perhaps, but most analysts are betting against Walker. Xinxin Li of the Observatory Group points out that Wednesday\’92s decision by the State Council (effectively the equivalent of the executive cabinet) to reduce the capital ratio requirement for financing capital spending for infrastructure \’93is a further effort by the central government to implement its massive fiscal stimulus plan, in order to boost investment demand and support economic growth.\’94 In his opinion the current policy environment \’93makes any hawkish statement from the PBoC politically incorrect. Just a couple of days ago, Vice Premier Li Keqiang said that the global financial crisis is having a deeper impact on the Chinese economy, showing that the top leaders are unlikely to drop their guard on the economic difficulties until Chinese economy firmly is on a recovery track..\’94 In his April 28 report he concludes:

While the PBoC is concerned about the current pace of money expansion, it is unlikely to impose tightening measures to slow lending growth in the near term, due to an unclear economic outlook and the political priority on economic growth. China\’92s loose monetary conditions will likely persist in Q2.

The problem here is that Jim Walker\’92s analysis may be right but Xinxin Li\’92s prediction may also turn out to be right (and I suspect that Li doesn\’92t necessarily disagree with Walker\’92s analysis). Just because there is an urgent need for a policy doesn\’92t mean that it will happen. I remember that in early 2007 I argued aggressively that the PBoC would have to engineer a maxi-revaluation of the RMB because a slow revaluation would create huge hot money problems for the country. Of course the maxi-revaluation didn\’92t happen, and many of my friends seem to find my very wrong prediction a never-boring topic of conversation, but I defend myself by saying the analysis was correct, the prediction of huge hot money inflows was also correct, and soon enough the warnings about how destabilizing these inflows will be will also turn out to be correct. The global crisis intervened, and we will now see that China\’92s failure to have adjusted the currency much earlier, as a way of accelerating the transition from export growth to domestic-consumption growth when conditions were so good, will have a very painful cost.

So even if Jim Walker is right in that Beijing has no choice but to slow loan growth, he can still be wrong about assuming that they will. That of course would be the worst possible outcome.

Before ending, I wanted to cite a line from my friend Justin Winkle, who was responding to the comment discussed above that Dan Rosen found funny and startling. I am sure this has absolutely nothing to do with the topic under consideration, but here it is anyway.

My quote of the year is a line from Lewis Carroll appropriated by my stockbroker to describe the global economy: \’93If you don’t know where you are going, any road will get you there.\’94

As long as I am doing literary allusions I was just rereading PG Wodehouse\’92s classic Joy in the Morning, in which Lord Worplesdon explains to Bertie Wooster, in one of their very rare moments of camaraderie, why an American businessman they know seems so easily startled:

\’93Odd, this neurotic tendency in the American businessman. Can you account for it? I can. Too much coffee.\’94

\’93Coffee?\’94

\’94That and the New Deal. Over in America, it appears, life for the businessman is one long series of large cups of coffee punctuated with shocks from the New Deal.

I guess you can find economic history in the oddest places.

Tags: Lewis Carroll, PG Wodehouse, SMEs

The death of the Asian development model

April 25, 2009 in Asian development model, Banks, Consumption and production, Fiscal stimulus, NPLs by Michael Pettis | 77 comments

One of the few areas in which the Chinese fiscal stimulus package is unquestionably having a positive effect is on growth forecasts \’96 although mainly because forecasts seem to be coincident indicators more than leading indicators. In the past couple of week Morgan Stanley raised its 2009 forecast for Chinese GDP growth from 5.5% to 7.0%, while Goldman Sachs upgraded growth forecasts from 6.0% to 8.3%. UBS has raised its forecast from 6.5% to between 7% and 7.5%. RBS has jumped from 5% to 7% and Barclays is up from 6.7% to 7.2%. On the other hand Standard Chartered, worried about the sustainability of the \’93rebound,\’94 has kept its 2009 GDP growth forecast at 6.8%, and the IMF is still at 6.5%

At any rate I\’92ve never provided my own forecast of Chinese growth partly because I am not smart enough to come up with an economic forecast and partly because it always seemed to me that in the short-term Chinese growth was going to depend very heavily not on economic conditions but rather on the hard-to-predict outcome of the fierce policy debate taking place in China. As I see it, one side of the debate \’96 which seems to include people around the PBoC and the National Bureau of Statistics, along with many of the more prominent of the think-tank policy critics \’96 is arguing that as difficult as it is, the crisis is a good occasion to force China to change its development model and financial system in a direction that will provide China with a healthier basis for stable, long-term growth. They are eager to see policies aimed at switching resources from production to consumption, even at the expense of a short-term increase in unemployment, and they tend to see the recent surge in credit and investment not as solutions to the crisis but rather as policies that will make things worse for China in the medium term.

On the other hand a different group of policymakers and power brokers \’96 who include, I think, the Ministry of Commerce, the important exporter constituencies, and above all the powerful provincial and municipal leaders \’96 are much more concerned with enacting measures that immediately address the expected rise of unemployment in the short term. These measures include pouring money into investment \’96 mainly into infrastructure and the SOEs \’96 and of course the huge increase in bank lending. They often point out that these policies saved China after the 1997-98 crisis, and so can save China again.

As an aside, and without wanting to take the 1930s analogy too far, this debate in China is a little like the split in the 1930s between the internationalists in the US who favored hard money (incorrectly, I think) and a rapid liquidation of overcapacity (painful but probably correct), and who vehemently opposed measures, including tariffs and competitive devaluations, to boost employment via boosting the export of overcapacity, versus the large and powerful constituencies, dominated by local congressmen, miners, farmers and many industrialists, who stressed immediate moves to weaken the currency, boost production, and resolve US unemployment even at the expense of the global system. In part because the 1929 stock market collapse thoroughly discredited bankers and economists, and in part because politicians are always more likely to be influenced by large domestic constituencies than by internationalists, the latter group pretty resoundingly won the debate, at least in the early part of the crisis, and clearly not to the US\’92s obvious benefit.

Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group \’96 the domestic constituency and provincial leaders \’96 is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn\’92t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)

The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.

The period during and after the 1987 crash more or less marked the end of that stage of the Japanese miracle, although by then Japan was so caught up in the monetary expansion that had begun with the automatic monetizing of its massive trade surplus with the US in the early 1980s, that an internal bubble kept the local party going for another 2-3 years before it, too, finally ended, and ended disastrously \’96 although many people, especially here in China believe, mistakenly in my opinion, that the bubble was set off by the Plaza Accord.

But the Asian development model didn\’92t really die then (although the temporary shift in US consumption may have created the serious dislocations that helped lead to the 1997 crisis). At the time the US was itself caught up in great productivity and liquidity growth cycles that kept the model alive by causing a surge in US growth and, later, an even more rapid surge in US consumption.

The rise of US savings

What does the structure of US growth have to do with the Asian development model? As I see it the Asian development model involves polices that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources (usually subsidized by savers, and so constraining consumption) into investment and manufacturing capacity. Some people call this mercantilism, and in many ways it does correspond to certain classic mercantilist policies, but I am wary of defining it this way because \’93mercantilism\’94 is such a loaded word.

At any rate because the combination of consumer constraint and producer subsidy meant that growth in production was likely seriously to outstrip growth in consumption, the Asian development model necessarily involved generating large and consistent trade surpluses \’96 either Asian countries exported the difference between consumption and production or they would have been forced to run up ever increasing inventory. Of course for small countries, running trade surpluses didn\’92t matter too much \’96 and it made sense to have a strong external outlook because domestic markets weren\’92t big enough to create the necessary efficiencies and economies of scale to justify the huge investment, and their individual trade surpluses were easily buried within overall global trade.

In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint \’96 that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.

This is the main vulnerability of the Asian development model \’96 its dependence on an importer of last resort. We don\’92t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn\’92t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.

There are at least two reasons for the change. The first has to do with specific policy initiatives, and the second with changes in underlying economic conditions, especially household balance sheets. To address the first, I will refer to President Obama\’92s economic speech last week when he said: \’93We must lay a new foundation for growth and prosperity \’97 a foundation that will move us from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad.\’94

A New York Times editorial draws from Obama\’92s speech at least one important implication for the future growth of China and Asia:

In a series of comments in recent weeks, Mr. Obama has begun to sketch a vision of where he would like to drive the economy once this crisis is past. His goals include diminishing the consumerism that has long been the main source of growth in the United States, and encouraging more savings and investment. He would redistribute wealth toward the middle class and make the rest of the world less dependent on the American market for its prosperity. And he would seek a consensus recognizing that an activist government is an acceptable and necessary partner for a stable, market-based economy.

\’85Embedded in that approach is a far-reaching implication: that the rest of the world should no longer count on the United States to snap up imported goods or run up large trade deficits. It is by no means clear that Mr. Obama has the policy tools needed to bring about that kind of change; we are, after all, fundamentally a consumer society. His advisers point to his support for innovative ways of increasing personal savings.

We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic \’96 and seemingly improbable \’96 US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn\’92t be a good idea to bet heavily against success..

Negative US consumption growth?

More importantly, during the past decade while the US was growing rapidly, the US trade deficit surged from just over 1% of GDP to over 7% of GDP. When consumption growth exceeds GDP growth, which must happen when the trade deficit is growing, it necessarily implies a build-up of debt, and sure enough, debt levels in the US surged while savings collapsed to zero and the trade deficit grew rapidly.

Those days are almost certainly over. Even without Obama\’92s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don\’92t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.

If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan \’96 and China for that matter \’96 may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth \’96 high savings development models, in other words \’96 will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.

This is what I mean about the \’93death\’94 of the Asian development model. The not-so-hidden but also not-always-explicit assumption behind Chinese growth \’96 with China, as I wrote earlier, representing the Asian development model on steroids \’96 is that large and growing US trade deficits were vital to its success. But if the US is now entering a period of contracting deficits, the model is dead.

This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand \’96 domestic Chinese demand \’96 will itself be sharply constrained by current policies, especially credit policies.

Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.

This is because if China\’92s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again. There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won\’92t be nearly enough to resolve the NPLs \’96 the World Bank estimates that the last banking crisis cost China 55% of GDP.

Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).

Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China\’92s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.

By the way in their next meeting the Guanghua Students Monetary Policy Committee will debate whether or not the PBoC should cap loan growth. I will report the arguments and conclusions of these remarkably sophisticated students.

Banker? Or Grocer?

March 16, 2009 in Banks, Currency regime, NPLs by Michael Pettis | 12 comments

Replenishing bank capital

One of the students in Peking University’s Guanghua Students Monetary Policy Committee, a group for which I am an advisor, put together last week a summary of plans to raise capital adequacy ratios for Chinese banks.\’a0 I thought it would be useful to reproduce his numbers.\’a0 According to him, Shenzhen Development Bank, Everbright, China Merchant Bank and CCB have recently issued RMB 83.2 billion ($12.2 billion) in subordinated debt.\’a0 Minsheng Bank, ICBC, Industrial Bank and BoC plan to issue an additional RMB 243 billion ($35.5 billion) of subordinated debt. \’a0Minsheng is also planning to issue RMB 1 billion in shares.\’a0

At the same time in December the CBRC required that the big five banks raise their loan loss provisions from 100% to 130% of the loans in the bottom three of the five credit categories.\’a0 Off the top of my head I think the second category \’96 \’93special mention\’94 loans \’96 comprises roughly three times as many loans as the bottom three categories combined, and many analysts assume that anywhere from one-half to all should properly be classified as doubtful or impaired. \’a0Given the huge growth in lending and lax lending standards during the past few years (during what had to be a great time to be a banker), I think skepticism about the quality of bank portfolios is very much in order.

Policymakers are assuring everyone that the banking system is healthy, as policymakers everywhere always do.\’a0 I, of course, have my doubts, so I think it is very prudent that while they praise the banking system on one hand the authorities are making banks take on more capital and larger loan loss provisions. \’a0I think it is extremely unlikely that we don\’92t see a surge in NPLs over the next two years.\’a0 This is particularly likely since credit expansion for February turned out to be RMB1.1 trillion, three to four times the amount of new lending last February which, when combined with last month’s RMB1.6 trillion, means than net new loans for the first two months of this year are significantly more than half of net new lending in 2008.\’a0 Of course it might be pointed out that most of this new lending is to state-sponsored projects and was strongly “encouraged” by policymakers, so it is likely to come with explicit or implicit guarantees, but in the case of a surge inNPLs I suspect that banks will nonetheless be forced to take losses before the government itself steps in.

Aside from loan and capital-raising figures other numbers are not looking too positive.\’a0 The wholesale price index came out today, with wholesale prices falling 6.0% year on year.\’a0 Part of this was caused by falling crude and commodity prices, but there is enough left over to make me continue wondering about underlying liquidity conditions.\’a0 Logan Wright told me Saturday that he expects to see very low, or even negative, reserve accumulation over the quarter, and regular readers of my blog know that\’a0I consider reserve accumulation to be the strongest indicator of underlying monetary conditions in China.
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Manufacturing output for the first two months of the year was up 3.8% from the same period last year, which was well below already low projections (because of the moving Spring Festival holidays it doesn’t make much sense to compare individual months in the first quarter).\’a0 Much of what little growth occurred was powered by a surge in concrete production and, to a lesser extent, by a sharp increase in vehicle sales.\’a0 The optimists would say that this shows that the government stimulus is working.\’a0 Pessimists would argue that the increase in auto sales may well be short-lived because it surged largely after a cut in taxes, and there are persistent rumors of a significant increase in car purchases by government-related entities.\’a0\’a0 In both cases the\’a0 growth in sales might then be seen as anticipated purchases that take will have trouble persisting.

Likewise pessimists would also argue that the surge in concrete production is not evidence that the stimulus is having an effect but rather evidence\’a0 that people believe that it will have an effect, and so are building inventory in anticipation (the same is probably true of the recent surge in steel production and inventory levels).\’a0 This is good news if the stimulus actually does have a big impact on demand, since rising inventory prevents bottlenecks, but of course bad news if the stimulus turns out to be weaker than expected, in which case the need to work off inventory will slow future production to below actual usage.\’a0

Aside from high loan growth numbers and low growth in manufacturing output, retail sales figures also came out last week. \’a0 According to an article in Thursday’s South China Morning Post:\’a0

Growth in retail sales slowed to 15.9 per cent over January and February from December\’92s 17.4 per cent growth and 22 per cent in October, the statistics bureau said.\’a0 \’93It seems clear the domestic demand is slowing in China, and this could be happening at a faster pace than the sales data suggest,\’94 said Moody\’92s Economy.com analyst Sherman Chan in a report. \’93Having households pull back on spending is exactly what China does not need.\’94

Beijing is trying to prod consumers to spend more with measures that include subsidizing appliance purchases for rural families. But families save heavily for education, health care and other expenses, and analysts say they are unlikely to spend more on consumer goods until Beijing creates a social safety net to ease such burdens.\’a0 A market research company, DDMA, said a February survey found 45 per cent of those polled had cut back on spending, down from 7 per cent in January.\’a0

Xinhua put a different spin on the numbers in an article the next day:\’a0

China’s retail sales grew 15.2 percent in the first two months to 2 trillion yuan (293.8 billion U.S. dollars), the National Bureau of Statistics (NBS) said Thursday.\’a0 The figure, although lower than the 20-percent-plus increase a year earlier, was encouraging, analysts said.

Retail sales growth in January and February was equal to or even higher than last year adjusted for inflation, said Zhuang Jian, senior economist with Asian Development Bank.\’a0 The consumer price index (CPI), a major gauge of inflation, hit a 12-year high of 8.7 percent in February 2008 but fell 1.6 percent in the same month this year.\’a0 “Domestic consumption has remained stable so far, despite the economic slowdown,” he added.\’a0\’a0

I think Xinhua’s interpretation is probably closer to the mark but in either case it seems, not surprisingly, that household consumption is almost certainly declining.\’a0 Remember that retail sales are not a great indicator of household consumption in China because they include lots of other things, including government consumption.\’a0 In addition I should add thatCICC , one of China’s three leading investment banks, came out with a report on March 11 which I cannot excerpt but which basically advised caution about the retail sales figures and the outlook for household consumption.

A difficult transition

On a very different subject, two days ago I received a very interesting and intelligent email from one of my readers, a student who I believe is from the South\’a0of China (I am guessing this because he mentioned his plan to set up a business in Guangxi) although I am not sure if he is currently at Peking University or at another school.\’a0 He has allowed me to reprint his email, although I am not sure whether he is comfortable with my using his name, so I will reprint part of his letter while leaving out his name and any private references.\’a0 I have edited the letter slightly to make it follow the format that I use in this blog:

Being a student and a loyal reader of your blog, you have all but convinced me that China should continue to allow its currency to appreciate, for China and the world’s sake. This is in spite of the fact that my family runs an export business and appreciation of the currency will most definitely affect our business in a negative way.\’a0 In light of the global financial crisis, the big theme in China is how to increase domestic spending and gradually make the export oriented businesses more domestic-dependent. And I always tell myself that the appreciation of the RMB will help because imports will be cheaper and that will directly increase the purchasing power of Chinese consumers.\’a0

Today, I went shopping with my girlfriend at Carrefour and I was trying to find some evidences to support my theory. Today we bought about RMB100 of food, typical of the things that we would need for the next 2-3 days.\’a0 Roughly, I would say we bought RMB30 worth of meat (chicken and pork), RMB40 worth of fish, RMB20 of milk/dairy and RMB10 of shampoo.\’a0 Then I try to determine how much the Chinese consumers would save if the exchange rate was changed.\’a0 Here is what I realize:\’a0

All RMB 100 of food are made right here in China. Even the RMB10 foreign brand shampoo is made by a factory in Shanghai. So, I thought, what would happen if the dollar to RMB exchange rate becomes 1:4? Well, the cost of making these items wouldn’t decrease that much because most of the components that go into producing these items are not imported and would stay pretty much the same. (Please correct me if I am wrong in this assumption.)

However, if the exchange rate suddenly becomes 1:4, a lot of Chinese exporters, including my family’s juice business, which actually has a good margin compared to other labor intensive industries, will go out of business.\’a0\’a0

In addition, perhaps now it would make economic sense for western companies to import their products (beef, fish, milk, shampoo) into China (of course assuming that the tariffs stay the same) and domestic consumers would buy imported goods because they are better quality and may now be cheaper. \’a0

So this also adds additional pressure to the manufacturers. furthermore, perhaps now P&G would in this new exchange rate environment consider producing its shampoo in the U.S., because relatively speaking, P&G’s cost of production in the U.S. would have gone down.So China gets hurt in a multiple of ways as a result of China revaluing its currency:\’a0

1. Export companies go out of business.

2. Domestic companies get more competition from foreign companies and are forced to cut prices and maybe wages.

3. Foreign companies will have less incentive to invest and do production in China.

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The benefit is that Chinese consumers will buy more imported goods, but I am not even sure if the consumers will get more purchasing power as a whole because as in our shopping experience, almost all of the things that I buy are made locally, so the prices wouldn’t really drop. (I can see in the case of luxury goods, i.e. LV, or Gucci, where they would be come sufficiently cheaper if the exchange rate re-values.)\’a0

\’a0So in conclusion, on the one hand, based on PPP or Big Mac index, I get the impression that the RMB is greatly undervalued (i.e. 1 Big Mac in US is $4, and 1 Big Mac in China is RMB 12-15). Yet, if the RMB were to really go up in value, the economy would definitely be hurt in many ways.

What is wrong and what can we do?\’a0\’a0

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This is a great letter because (aside from the fact that it shows why I enjoy teaching here so much, given the intelligence and thoughtfulness of so many of the students I meet) it indicates in a very concrete way how complex the policy decisions are and how difficult the transition process is likely to be.
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The first thing I would bring up is the issue of the effect of revaluation on the food purchased at Carrefour.\’a0 Of course it is true that the cost to make those Chinese-made goods would not decline in RMB terms except to the extent that they included foreign components (which may be more than many realize, since much of the fertilizer used by Chinese farmers comes from abroad, as does the oil they use to transport their products to Carrefour), but that does not necessarily mean that their cost to the consumer would not decline.\’a0 All of these things can be manufactured abroad, and it may be that Malaysian chickens, Australian milk or the same shampoo manufactured in Vietnam would become so much cheaper that either Chinese consumers would begin to buy more foreign food, or Chinese producers would have to lower their costs or improve their quality to compete.\’a0 This directly benefits Chinese consumers.\’a0

Of course it might hurt Chinese farmers and producers, and this is why the transition becomes difficult.\’a0 In a very abstract way we can argue that whatever pain the farmers feel is less than the gains other Chinese enjoy.\’a0 Cheaper food for Chinese consumers means that they have more money leftover to go to restaurants, buy books, or get haircuts, and so Chinese businesses that supply these services will benefit.\’a0\’a0

In an even more abstract sense we can argue that China does some things relatively better than other countries, and some things relatively worse \’96 that is, the specific conditions in China, including its infrastructure, labor markets, educational systems, and so on mean that Chinese can do some things more productively and efficiently and other things less so.\’a0 By allowing the RMB to appreciate (or by otherwise relaxing constraints that affect the relationship between production and consumption), Chinese businesses and producers will be forced to concentrate on the things they can do more productively and efficiently than others, while leaving others to do the things they don\’92t do so well.\’a0\’a0

This increases the total economic well-being of China and the countries with which it trades, and so at least in principle every country can become a little better off.\’a0 Remember that if China buys more from abroad, that doesn\’92t mean that Chinese producers must sell less.\’a0 Whatever money China exports to pay for those imports represents a net increase in either 1)foreign buying of things that Chinese producers are good at making or 2)foreign investment in China, which increases the productivity of Chinese workers.\’a0 Both of these are good for China\’92s economic prospects and both result in rising employment.\’a0

But there is no getting around the fact that the process will be painful in the short term, as the student writing the letter has pointed out.\’a0 Although in the long run China and Chinese workers and consumers will almost certainly be better off as China makes the transition to a more balanced and domestic-driven economy, there are nonetheless short term costs.\’a0 Resources and labor will not be smoothly reallocated from exporters to domestic service producers and manufacturers who serve the local markets.\’a0 What usually happens is that, to use the very dry jargon of economists, these resources and labor will be \’93freed up\’94 as exporters go bankrupt or downsize.\’a0\’a0

As economic conditions change, and as exporting becomes less profitable, businesses aimed at local consumers will take advantage of newly available assets, resources and labor to begin operating, and gradually China will once again reach more or less full employment with a very different economic structure.\’a0 But of course remember that at first, domestic demand (and domestic employment) will actually decline as workers lose their jobs.\’a0 This is where the government can and should play an important role, for example by boosting domestic consumption as much as possible so that it quickly becomes profitable for Chinese companies to target the domestic market.\’a0

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Allowing and even encouraging this transition may therefore seem like a bad idea for China, but as the global crisis shows, it will be impossible for a large economy like China’s to continue depending so much on the export sector and on foreign investment.\’a0 It must make the transition, and the later it does so the more difficult it will be.\’a0
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\’a0When the US made a similar transition 200 years ago, after the panic of 1797 when the Bank of England suspended gold payments, and when the US Quasi-War with France and the Napoleonic Wars in Europe decimated the US export trade, it did so over at least two very difficult decades, and after sharp rise in unemployment in the early years.\’a0 Eventually the whole country shifted its economic structure and, needless to say, the shift turned out to be crucial for the subsequent success of the US economy.\’a0\’a0
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Japan was forced to confront the failure of its own export-led model in the late 1980s and early 1990s, and, as everyone knows, the process has not been easy. \’a0Of course it would have been better for the US and Japan if they had try to adjust earlier, when global trading conditions were optimal, but like China in the past decade, it is hard to make an adjustment when things seem to be going so well.\’a0 It almost always takes a crisis to force the change, even though this makes the process of change that much more difficult.

By the way although much of the above is a fairly standard exposition on how free trade benefits everyone, I am not necessarily a believer in unfettered free trade for China.\’a0 Remember that under conditions of free trade and no currency intervention Chinese businesses and producers will be forced to concentrate on the things they can do better than others, while leaving others to do the things they don\’92t do so well.\’a0 This of course benefits the whole world in the short term, but China may not be happy over the long term with its comparative advantages.\’a0 It might find that cheap labor and low technological skills are not the kinds of advantages it wants to enjoy.

In that case a very strong argument can be made that selective protection can alter the relative advantages China has by encouraging innovation and development in areas in which China now has a relative disadvantage.\’a0 I won\’92t say much more about this (which is anyway likely to be highly controversial) except to note that as far as I have been able to determine from the historical evidence, with exception of a few very small trading nations, every technologically and socially advanced country since the British in the 17th and 18th centuries did so behind trade and other barriers aimed explicitly at altering the country\’92s technological and commercial position.\’a0

Much of this theory is beautifully summarized and implemented in Alexander Hamilton\’92s writings, and it is worth noting that the US, unlike its largely free-trading counterparts in Latin America, had the highest import tariffs of any major country for most of the 19th Century.\’a0 The risk of this kind of protectionist policy of course is when trade protection is allied with attempts to foster national champions, which almost always results in the worst of both worlds.\’a0 Competition breeds innovation, and state-supported national champions are almost always global losers.\’a0

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Before closing I should switch the subject and mention that Canada’s Globe and Mail had an article Friday about my insistence that a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process, and that it is probably more useful to think of China as a shop that sells to the US and accumulates IOUs, rather than as its banker.\’a0 You can find the article here.\’a0 Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store.\’a0 It is an important distinction, I think.

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Tags: Subordinated debt

Will China have to choose between social stability and long-term growth?

February 9, 2009 in Financial crisis, NPLs, Policy by Michael Pettis | 25 comments

Wow! There are now rumors that Chinese net credit growth in January was substantially higher than the already-astonishing rumors of RMB 1.2 trillion I reported last week. I will get to that at the end of this entry, but I wanted first to discuss a possibly important issue related to credit intervention.

It is probably not at all controversial to suggest that the way governments in the US, China and elsewhere respond to the current crisis will determine economic growth prospects for the next decade and more, but it is probably also worth repeating this point as often as possible. In the panic to respond swiftly to some of the short-term problems facing policymakers, it would be easy for them sometimes to forget the longer-term impact of current policy responses, and so saddle us for many years with unwanted consequences.

Over the weekend I was reading a paper by Gonzalo Fern\’e1ndez de C\’f3rdoba (Universidad de Salamanca) and Timothy J. Kehoe (University of Minnesota), called \’93The Current Financial Crisis: What Should We Learn from the Great Depressions of the Twentieth Century?\’94 Basing their work on Great Depressions of the Twentieth Century, published in 2007 by the Federal Reserve Bank of Minneapolis, in which Timothy Kehoe and Edward Prescott, together with a team of 24 economists from around the world, analyze a number of \’93great depressions\’94 experienced by various countries in the 20th Century, they try to determine the impact of policy on the subsequent severity of the contraction.

Although I always worry about ideological predispositions in these kinds of analyses (one group of economists always seems to find that government intervention made things worse, while another always seems to find that in fact specific policies helped), some of the examples they use \’96 in Latin America primarily \’96 involve countries and histories with which I am pretty familiar, and at least this part of their analysis rings true to me.

Based on the data analyzed in the book, they conclude that massive public interventions in the economy to maintain employment and investment during a financial crisis will, if they distort incentives enough, make things much worse. I guess that probably wouldn\’92t come as a very controversial statement to anyone, but what interested me was that they seemed to focus especially on ways that governments have intervened in credit markets and in investment decisions. Two examples were especially illuminating, Mexico and Chile \’96 which both experienced massive crises beginning in 1982, the year which usually signals the beginning of the LDC Debt Crisis (or the \’93lost decade\’94, as Latin Americans call it). Their policy responses in the financial sector were radically different:
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In 1982 in Chile, banks that held half of the deposits were suffering severe liquidity crises. The government took control of these banks. Within three years, the Chilean government had liquidated the insolvent banks and reprivatized the solvent banks. The government set up a new regulatory scheme to avoid mismanagement. These new regulations allowed the market to determine interest rates and the allocation of credit to firms. The short-term costs of the crisis and the reform in Chile were severe, and real GDP fell sharply in 1982 and 1983. By 1984, however, the Chilean economy started to grow, and Chile has been the fastest-growing country in Latin America since then.

In 1982 in Mexico, the government nationalized the entire banking system, and banks were only reprivatized in the early 1990s. Throughout the 1980s, in an effort to maintain employment and investment, the government-controlled banks provided credit at below-market interest rates to some large firms and no credit to others. Even the privatization of banks in the early 1990s and the reforms following the 1995 crisis have not been effective in producing a banking system that provides substantial credit at market interest rates to firms in Mexico. The result has been an economic disaster for Mexico: Between 1982 and 1995, Mexico experienced no economic growth and has grown only modestly since then.

The differences in economic performance in Chile and Mexico since the early 1980s have not been in employment and investment, but in productivity. In Chile, unproductive firms have died and new firms have been born and grown. Workers and capital have been channeled from unproductive to productive firms. In Mexico, a poorly functioning financial system has impeded this process.

GDP per working age person in Mexico declined substantially in the 1980s and only began recovering by 1988, but a second banking crisis in 1995 eroded much of the recovery and as of today it has still not reached its 1982 peak. In Chile, the decline at first was much sharper. In two years GPP per worker in Chile dropped by around 20%, which it took six years to happen in Mexico. However productivity growth surged thereafter so that by 1988 it had fully recovered to 1982 levels and as of today it has doubled. Chile, as most of us know, has been for the past twenty years the fastest growing country in Latin America, even though it as among the worst hit by the debt crisis.

The main point the paper seems to want to make is that intervention in the allocation of credit had a huge impact on the way the country was able (or not) to recover from the crisis and regain productivity growth:

Japan suffered a financial crisis in the early 1990s and followed similar sorts of policies as Mexico, keeping otherwise insolvent banks running, providing credit to some firms and not others, and using massive fiscal stimulus programs to maintain employment and investment. Japan has stagnated since then. Finland also suffered a financial crisis in the early 1990s and followed similar sorts of policies as Chile, paying the costs of reform and letting the market dictate the allocation of credit to the private sector. The Finnish economy has grown spectacularly since then.

What implications this might have for Chinese policy-making in response to the current crisis? Again, we always need to protect ourselves from conclusions that owe more to ideology than evidence, but at the very least we should consider the possibility that massive intervention in the banking system, for all the short-term countercyclical benefits (i.e. banks are forced to expand, to satisfy policy interests, rather than contract, to satisfy commercial interests) can create serious enough distortions that Chinese growth for the next decade or so might be sharply constrained. In their words:

We need to avoid implementing policies that stifle productivity by providing bad incentives to the private sector. With banks and other financial institutions in crisis, the government needs to focus on providing liquidity so that banks can provide credit at market interest rates, and using the market mechanism, to productive firms. Unproductive firms need to die. This is as true for the automobile industry as it is for the banking system. Bailouts and other financial efforts to keep unproductive firms in operation depress productivity. These firms absorb labor and capital that are better used by productive firms. The market makes better decisions than does the government on which firms should survive and which should die.

Of course someone will inevitably argue that it actually makes commercial sense for Chinese banks to expand loans now, since there is likely to be an implicit, or even explicit, guarantee that makes most new lending essentially risk-free. Yes, of course, but that doesn\’92t change the underlying logic. Banks will be channeling capital to companies not based on their economic prospects but rather based on the guarantee, and so little commercial distinction will be made between healthy and unhealthy borrowers. My guess, and not a particularly controversial one I suppose, is that the provision of implicit or explicit government guarantees will have more to do with a company\’92s impact on employment than its economic prospects.

I don\’92t want to overstate the relevance of market versus government allocation of credit, but by the late mid-1980s, when I first started trading Latin American debt, it was pretty clear that Chilean banks were in much better shape than were Mexican banks, and were much more independent (Mexican banks were not privatized until the early 1990s). I specialized primarily in Mexican debt and bonds until I ended up running the Latin American trading desk, so losing my country focus, but it did always seem to me that the Mexican financial system was a lot less prudent than the Chilean, and government \’93guidance\’94 had a very big impact on credit allocation.

Before someone suggests that perhaps poor guidance leading to credit misallocation might be less of a problem in well-governed China than in poorly-governed Mexico, I would argue that much of China\’92s recent growth came about because of the massive expansion in credit, and while the sheer size of the expansion guaranteed that there would be many years of bubble-like growth, we will only now, over the next three to five years, discover whether or not the capital was indeed misallocated on a massive scale. I think it was.

The paper makes a point of saying that the difference in subsequent GDP growth between countries that intervened heavily in credit allocation versus countries that didn\’92t was not a function of different levels of employment, but rather different growth rates in worker productivity. There were no noticeable differences in employment levels between countries that followed one strategy versus the other.

In that case one can make the argument that if the goal of policy is to minimize social disruption, the \’93Mexican model\’94 may actually be better than the \’93Chilean model\’94 because while neither model created a noticeable difference in employment levels, in Mexico an economic contraction roughly similar in magnitude took six years, versus the two years it took in Chile. Mexico may have achieved this socially less disruptive adjustment at the expense of sharply lower levels of productivity growth over the long term, and perhaps this is the tradeoff that governments face in dealing with crises. Japan, it seems to me, also chose a socially less disruptive model, in exchange for a lost decade of growth.

In other words the best policy advice for the government to maximize China\’92s growth prospects, based on the Fernandez and Hehoe paper, is probably politically unpalatable. It would involve acknowledging that too much capital was allocated to production, and that a period of consolidation is necessary. Unfortunately this consolidation means that capital migrate in a major way from less productive users to more productive users, which is just a bloodless way of saying that a lot of companies are going to have to be allowed to fail, and banks and financial markets should be weaned away from political control and encouraged to make their own commercial decisions.

But should this happen in the midst of a global crisis? On the one hand, in China \’96 and probably most other countries \’96 real reform only seems to occur after a crisis, and so this is an important opportunity to get things right. On the other hand global conditions are too ugly for China to allow bankruptcies to take their swiftest course, and so undermining the social pact, so a strong case can be made for intervening heavily now and reforming later. Ultimately this is a political question that the Chinese must make: is there a tradeoff between long-term growth and short-term instability, and if so, which should China choose?

As I noted at the beginning of this entry, hot off the press is some related news about credit intervention. In an entry last week I mentioned the astonishing RMB1.2 trillion increase in loans that had been unofficially reported for January. This was a full 50% more than the previous monthly record, and nearly one-quarter of the total increase in 2008 (to be fair however January is traditionally always a big month for new lending).

Although this was seen widely as good news for the economy, since credit expansion will probably goose up the short-term GDP and employment numbers, I of course worried about exactly how much of this was real and, more importantly, how much of this will end up as future NPLs. It seemed to me that even the most prudent and commercial banking system in the world cannot expand at this rate without shoveling in an awful lot of garbage, and loan expansion of this base represented a gamble on the duration of the global contraction.

Well, it seems I was wrong. Reuters has just announced that net new lending may have actually been and even more surprising RMB 1.6 trillion \’96 twice the previous monthly record and an amazing one-third of credit growth in all of 2008. We will know by February 15 at the latest, when the PBoC publishes lending data, but if this is true (and the report was seen as highly credible by one of my friends at Reuters) it will probably goose the stock market up further while making people like me more worried then ever. Since for me much of the Chinese growth explosion of the past several years was caused by a badly allocated credit boom, the idea that the solution to a slowdown is to jack up the credit boom even further is very worrying. It is a little like the idea that the best way for the US to adjust to the decline in its debt-fueled household consumption binge is to replace it with a debt-fueled government consumption binge, although perhaps the US and China would choose very differently in the possible trade-off between long-term growth and short-term social stability.

At any rate if this number is true, and if these credit growth levels persist, at least it suggests China is very serious about contributing its share of global fiscal expansion. This should be part of China\’92s negotiations with the US on trade relationships.

Tags: Chile, Great depressions, Mexico

Hooray! China has bottomed out.

February 5, 2009 in Money growth, NPLs by Michael Pettis | 31 comments

Note: In response to many complaints by people who were confused by the headline — I was being sarcastic. Puerile humor, perhaps, but the point is that over the last year it seems that we hit absolute bottom roughly every fifth week.

Have we reached a bottom? A lot of analysts are pointing to the improvement in both measures of Chinese PMI to suggest that Chinese manufacturing may finally have reached a bottom, even though both PMI measures are still well below 50 and so indicate a contraction in manufacturing. More impressively the stock market has rebounded, with the SSE Composite bouncing off its January 13 close of 1863 to reach, as of yesterday 2108 (up 13.1%). Today it traded up another 2.0% in the morning before giving it all back, and more, during the afternoon to close down 0.5% for the day. Before the market turned Bloomberg today reported a very optimistic fund manager:

\’93Stocks continue to be lifted by speculation more stimulus measures are on the way,\’94 said Michiya Tomita, a Hong Kong-based fund manager of Chinese stocks at Mitsubishi UFJ Asset Management Co., which oversees $61 billion. \’93There\’92s a growing perception that China\’92s economy will recover surprisingly fast.\’94

Surprisingly fast? I\’92ll take that bet. Aside from the normal excitement we all get from the right kinds of stimuli, part of the recent optimism seems to reflect the huge upsurge in bank lending I reported last week \’96 with loans in January rising by RMB 1.3 trillion. Nearly one-quarter of that was provided just by ICBC. According to an article in today\’92s Bloomberg:

Industrial & Commercial Bank of China Ltd., the nation\’92s largest, said it offered 252.1 billion yuan ($36.9 billion) of new loans in January in response to the government\’92s stimulus plan to avert an economic slowdown. The bank lent 69.3 billion yuan to power grid, railway, roads, and hydroelectric power projects, and 135 billion yuan in discounted bills to small and medium-sized companies, the Beijing-based firm said in an e-mailed statement, without giving comparisons. New loans to individuals, including mortgages, amounted to 16 billion yuan.

China dropped lending quotas and unveiled a 4 trillion yuan stimulus package in November to maintain economic growth and counter the global financial crisis. Banks have responded by raising lending targets and focusing on railways, roads, power grids and other infrastructure projects with stable returns. Domestic banks offered a record 1.2 trillion yuan of new loans last month, representing almost a 50 percent gain from a year earlier, the China Securities Journal said yesterday.

ICBC aims to advance 530 billion yuan of new loans in 2009, about the same as last year, the 21st Century Business Herald reported today. The bank plans to complete 45 percent of the loan target in the first quarter. ICBC attracted 271.2 billion yuan of deposits in January, equivalent to a quarter of the total increase in 2008, according to today\’92s statement.

I have long argued that credit is a much better gauge of money supply in China than any of the monetary aggregates, so this explosion in bank lending should suggest at least that China is making the right moves from a monetary point of view \’96 pumping liquidity into the system to avert a contraction in money supply that would exacerbate the contraction in demand. But I have three very serious problems with the optimism associated with the latest numbers on credit expansion.

First, this credit expansion is not all that it may seem. Aside from the fact that a lot of this new credit has consisted of an increase in bill discounting, in order to understand what is really happening to total credit in the Chinese economy we need much better data. There are persistent rumors that part of the increase in bank lending consisted of putting back on balance sheet loans that were taken off balance sheets in 2007 and 2008 when the PBoC was trying to constrain bank lending. It isn\’92t really new credit. We also don\’92t have a very good feel for what is happening in the informal banking sector, and in the past there was evidence that contraction and expansion in the informal banks counteracted what occurred in the formal banking sector.

What is more, there is clearly an increase in lending games aimed at making policymakers happy by showing fat loan books. One of my students just visited me today with an example that involved his father. I don\’92t want to get into too much detail, for obvious reasons, but the net effect of the transaction involving his father was that an entity was created to borrow money from a bank, the proceeds of which were deposited in a CD, which was then assigned in ownership to the real borrowing entity, which then used the CD as collateral for the \’93real\’94 loan. Aside from the complications used probably to get around credit restrictions, one single loan was recorded as two loans plus a CD deposit. Apparently the lending bank knew about all the intermediate steps. Surprise, surprise! It turns out that if your career prospects depend on increasing the total amount of loans outstanding, with less focus on the quality or structure of the loans, in fact it isn\’92t hard to show very nice, fat loan book.

One of the readers of this blog, yesterday gave another very interesting example of what might be included in this new lending. He says:

As for the sudden surge in lending, this looks to me to be an accounting exercise, clearing or otherwise funding non-bank debts piled up by SOEs. Many large SOEs (not central ones, regional/local ones, though the central ones win no prize themselves) are behind on paying wages, suppliers etc, and the stimulus provided by this lending surge is really just to ease the log-jam of triangular debts. This implies that there will not be much \’93bang\’94 for all of this lending

Second, exploding credit may provide a fillip to growth in the short term, but if it leads to a future increase in bad loans, it will have exactly the opposite effect in the near future. As I discuss in my previous blog entry, this represents a big bet on the duration of the slowdown.

Third, the biggest problem has to do with how much credit expansion will make a difference. Andrew Batson at the Wall Street Journal (sorry, I don\’92t have the link) makes this point when he discusses the \’93string of dire profit warnings has signaled a rapid deterioration in the financial health of Chinese companies.\’94 His relevant paragraphs:

Corporate investment is hugely important to China’s economy, where capital spending accounts for more than 40% of annual output, one of the highest ratios in the world. The profit decline will have major effects across the economy as companies have less money to buy new equipment or expand their businesses.

\’85Economists have long warned that Chinese companies’ heavy reliance on retained profits would tend to exaggerate swings in the nation’s investment cycle. Official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.

Basically Chinese corporate profitability in China is dropping sharply, and nearly everyone expects the trend to continue over the rest of 2009. If nearly two-thirds of investment in China was funded by retained earnings, a sharp drop in profitability should result in an equally sharp drop in investment funded by retained earnings. I don\’92t know the magnitude, but I would guess that a very large increase in real bank lending aimed at real investment, far more than has been reported, would be needed just to make up for the decline in investment out of retained earnings. This, by the way, is an argument that has also been made by my friend Sam Baker at TNR.

For these three reasons (and a few others), I am not as impressed as many others are by the recent expansion in credit. I acknowledge, of course, that I may be hemming myself in intellectually because of my very strong belief that China will be forced one way or the other to make a necessary but difficult adjustment from export orientation to growth based on domestic consumption, and so I am blind to the good news, but for now I am sticking with my belief.

Aside from doubting the beneficial impact of credit expansion a larger part of the reason for my continued skepticism is that I am much more impressed by the expectations of hordes of workers returning to work after the Spring Festival and not finding jobs. Today\’92s South China Morning Post starts off an article today

One of the world’s leading luxury furniture makers has folded in Shenzhen amid the economic crisis, leaving more than 2,000 unpaid workers blocking traffic in protest until the local government paid more than 10 million yuan (HK$11.3 million) in back wages. DeCoro, the Shenzhen-based Italian sofa manufacturer employing nearly 3,000 people, had gone into liquidation with all assets seized by a local court in Longgang district, the National Business Daily reported.

Less anecdotal is another article, also in today\’92s edition:

Guangdong authorities are expecting millions of unemployed migrant workers to pour into the province in search of work, despite official warnings that the prospects are slim. Provincial labour authorities say 10.25 million migrant workers left for the Lunar New Year holiday, and of the 9.7 million expected to return soon, about 20 per cent would find it extremely difficult to find work.

But the biggest problem I have is that anyone taking a global view, and not just a very local view, cannot fail to be impressed by how bad the numbers out there are. For one thing, US GDP contracted by 3.8% in the fourth quarter of 2008. Normally that would be a horrible piece of news, but most analysts were pleasantly surprised because they expected something closer to 5.5%. Does that suggest that the US, too, is bottoming out? No, because apparently what saved the US from a much larger contraction was heavy orders from factories, including foreign factories, based on a surge of optimism during the summer. According to an article in Monday\’92s Wall Street Journal (I don\’92t have the link because I read it in the plane, but for those interested the article is titled \’93US Economy Dives as Goods Pile Up\’94):

While the fall wasn\’92t as steep as expected \’96 most forecasts had GDP falling by 5% to 6% — output was boosted somewhat by a rise in inventories of goods that were produced but not sold in the fourth quarter. Excluding the inventory adjustment, GDP fell at a 5.1% rate, which economists say more accurately reflects the nation\’92s weakness.

Rising inventories, in other words, accounted for the better-than-expected US economy in the fourth quarter of 2008. But now those inventories have to be sold. That means however bad we expect US demand to be in the next few months, US companies will buy even less because they have excess inventory that needs to be run down. The unexpectedly good results for the last quarter will cause an unexpectedly bad result this quarter (not unexpected, of course, but you know what I mean).

And there is more. The US savings rate dropped to below zero in 2005 and 2006 but since then has been rising as Americans are forced to pay down debt and save more. Savings rose to nearly 3% of disposable income in the fourth quarter, from 1.2% in the previous quarter, according to the same article. But 3% is not enough. My guess is that this represents less than a third of the total adjustment that needs to be made. Remember that every dollar the US saves is a dollar that doesn\’92t go towards consumption.

Here is another way of looking at the same data. David Pilling has a very sober piece in yesterday\’92s Financial Times in which he argues that \’93China should raise wages to stimulate demand.\’94 Of course he is right and of course they should (at least this is what I have been arguing for a while), even though it seems completely counterintuitive. Most analysts both in and out of China are arguing that China should try to increase the competitiveness of its manufacturers and the profitability of its businesses, and in this light raising workers\’92 wages seems stupid, but in fact I would argue that this is the best medium-term strategy to minimize the cost of the downturn to China. I will argue this more fully another day, but I do want to extract two paragraphs from Pilling\’92s article:

To see why, look at US personal consumption, which hovered around 67 per cent of gross domestic product in the last quarter of the 20th century. That was already high by the standards of the previous 25 years. But from 2000 to 2008, it shot up again to an unprecedented 72 per cent. That trend has now gone into painful reverse. As Stephen Roach, chairman of Morgan Stanley Asia, notes wryly: \’93We are already all the way down to 71 per cent.\’94 In other words, it will be a very long time before Americans are again filling up their shopping carts.

\’85In 1980, 65 per cent of output of developing Asia was accounted for by consumption. Today it is about 47 per cent. The main reaction to the Asia crisis of 1997-98, when economies\’92 vulnerability to financial flows was exposed, was to build up exports. In doing so, Asia has swapped one kind of dependence for another.

US consumption dropped from 72% \’93all the way down\’94 to 71%. Of course Stephen Roach is joking. US consumption has to decline by a lot more than that, and it will. Any attempt to understand China\’92s economy without situating it firmly within the global context, and especially within the contraction in global demand (remember as a major trade-surplus country China needs foreign demand to absorb its huge overcapacity) will not get the picture right.

By the way, on a related note, the US \’93Buy America\’94 plan, which has been both widely criticized and widely replicated \’96 explicitly or implicitly \’96 by a lot of countries including China, is an example of how things are likely to turn when it comes to trade prospects. The good news, I think, is that those of us who worry about an explosion of protectionism are getting so alarmed that there may be a concerted fight to ward it off.

One other piece of mild good news, China yesterday increased the tax rebate for textiles. According to an article in today\’92s People\’92s Daily:

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China will increase the tax rebate rate for textile and garment exports from 14 percent to 15 percent, an executive meeting of the State Council (Cabinet) announced Wednesday. The move would reduce exporters’ costs and support the textile industry, the Council said.
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Increasing the tax rebate is actually a bad thing, in my opinion, since it seeks to improve the trade \’93competitiveness\’94 of Chinese textiles and so increase China\’92s ability to export overcapacity, but the increase was much less than the industry expected. Thank god for small favors.

P.S. The day after I posted this the South China Morning Post provided a bit more clarity on the composition of ICBC’s loan expansion. According to an article in today\’92s edition:

Routine “bill financing” accounted for more than half of the loans the mainland’s largest bank by assets granted last month, underscoring concerns that the lending upsurge Beijing recently hailed as a sign of economic recovery may be inflated. Industrial and Commercial Bank of China extended 135 billion yuan (HK$153.12 billion) in “bill discount loans” and 117.1 billion yuan of other loans last month, the lender said yesterday. In discounting a bill, the bank takes on a company’s bill to a buyer before it is due and credits the value of the bill, after a discount charge, to the customer’s account.

Analysts said that of the 1.2 trillion yuan in loans made in January, about 65 per cent or 780 billion yuan were estimated to be “real” loans. That was slightly lower than last year, meaning the loan surge was largely illusory. “Banks are snapping up quality clients and projects,” a credit officer at a large bank said. “The more an enterprise does not need money, the more willing banks are to lend to it.”

…Banks generally only lend to quality small enterprises with loan yields of 6 per cent to 7 per cent, or 10 to 30 per cent above benchmark loan rates, according to Goldman Sachs. With the share of discounted bill financing in monthly incremental loans rising sharply from 5 per cent to 33 per cent over the past five months, the proportion of medium to long-term loans has shrunk from 50 per cent to 32 per cent.

Thus, the strong lending growth’s boost to fixed-asset investment was limited, China International Capital Corp said in a report. The truth may be a blow to mainland officials who are eager to see the economy on track to a recovery, but it could offer relief to bank shareholders in the short term.

P.S.S. On Friday afternoon I had an email discussion with Standard Chartered\’92s Stephen Green, one of my favorite research analysts, in which I asked if numbers provided by the PBoC branch in Wenzhou (Wenzhou is widely known as the capital of the informal bank sector in China) suggested that the informal banking sector was contracting loans. His answer: \’93Yep, that seems to be the thrust of it. In Wenzhou informal pool around CNY 600bn in recent years but new report by Wenzhou’s PBoC reports that between Jan and Dec ‘08, total deposit in Wenzhou’s banks rose 27.9% to CNY 208.5bn, indication they say that unofficial lending has slowed down. Certainly that was what seemed to be going on when we visited in September, large number of financiers had shut down for various reasons.\’94

Tags: Inventory, wages

All but the kitchen sink?

January 31, 2009 in Balance sheets, NPLs by Michael Pettis | 27 comments

As the rhetoric around trade continues to deteriorate and the incidence of name calling rises, it is getting harder and harder to discuss global trade and monetary conditions dispassionately and objectively. This should not\’a0come as\’a0a surprise, and is something I have been \’93predicting\’94 for several years as part of the standard package of events that mark the end of a major liquidity cycle, but it is nonetheless frustrating.

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The name calling at times gets pretty silly.\’a0 For example I have been criticized by trade nationalists as being a hopelessly naive free-trading fundamentalist for saying that\’a0over the medium term US trade deficits don’t worry me as much as they do many others.\’a0 What I had found unsustainable in the past decade was not the fact of the deficits, but rather the way they were financed — by binge borrowing for household consumption.\’a0\’a0Although I strongly support free trade I am not a fundamentalist, whatever that means.\’a0 On trade issues (and on many others)\’a0I am a staunch follower of Alexander Hamilton. \’a0I think free trade is almost always good for\’a0highly productive, technologically advanced countries like the US, but\’a0if trade policies are used wisely (which they almost never are) they can also alter unfavorable structures of comparative advantage for countries with low levels of productivity, like China.
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However, at the same time that I am attacked for being a panda-hugging free-trade fundamentalist I am also regularly accused of being anti-trade or, even worse, anti-China, when I argue that Chinese\’a0policies\’a0aimed at\’a0promoting “competitivity” will, if they exacerbate global overcapacity, almost certainly lead to trade friction,\’a0and that both theory and historical evidence suggest that in a world of collapsing demand, trade friction\’a0is especially\’a0difficult for trade-surplus countries like China.\’a0 These “anti-trade” and “anti-China” accusations I find especially idiotic:\’a0\’a0Examining and citing historical\’a0precedents to understand how trade frictions are likely to arise is certainly not the same thing as\’a0calling for\’a0trade war.\’a0 On the contrary, it is an attempt precisely to reduce the likelihood of trade friction.\’a0

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The debate over the underlying causes of the global monetary imbalance is often even more muddled. This almost always quickly degenerates into a profoundly silly argument over whether the current crisis is all China\’92s fault or all the fault of the US.\’a0 In fact it has become fiendishly difficult to make what should be a very obvious point: that every major participant in the massive and wholly unprecedented distortions in the global balance of payments that characterized the past decade are necessarily implicated in the resulting imbalances, and any policy-making aimed at minimizing the cost of the adjustments are doomed to fail if the role of each major participant and the implications of its role are not understood.\’a0

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Are both China and the US both responsible for the policies that exacerbated the monetary imbalances of the past decade?\’a0 Of course they are (and many other countries too). \’a0After all the two participants in this system have between them run up the largest trade deficits in history, the largest trade surpluses in history, the largest accumulation of reserves in history, and in so doing\’a0stumbled into\’a0the first sustained period in history of massive (truly massive) capital flows from poor countries to rich countries.\’a0 All of these things, and the numbers are huge even by global standards,\’a0must have mattered in some way, right?\’a0 To say that China was merely the victim of US machinations must be as idiotic as saying that the US was merely the victim of Chinese machinations.\’a0 Both countries locked themselves, for good or bad reasons,\’a0into monetary policies in which each reinforced the other’s imbalance and which together\’a0were at the heart\’a0of the mechanism that created the explosion in global liquidity.\’a0 It was this excess liquidity\’a0that was at the root of the subsequent global asset and credit bubbles.
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In the US there is very occasionally a real debate on monetary policies that doesn’t automatically degenerate into your-fault-my-fault.\’a0 See for example a very interesting discussion on Econobrowser, in which the moderator largely disagrees with the claim that the Asian savings glut\’a0is the prime\’a0mover, but acknowledges the role of Chinese and Japanese (and OPEC) savings in the imbalances, and hosts a real debate.\’a0 In China unfortunately except at the left- and right-wing academic fringes there is very little real debate as far as I can see on China’s role in the imbalances, although I can say that the Guanghua Students Monetary Policy Committee (a sort of PBoC shadow committee run by a dozen brilliant grad and undergrad students at Peking University) is ferociously debating the issue openly and intelligently.\’a0

\
Probably the main reason the discussion so easily takes this your-fault-my-fault turn is that most analysts and commentators seem to have only the vaguest grasp of balance of payments mechanisms and the role of central banks within that mechanism.\’a0 In trying to understand why, I saw a very helpful recent blog entry\’a0by Paul Krugman in which he worries about the widespread argument that the identity between savings and investment indicates that fiscal expansion is useless.\’a0 He says:

What\’92s so mind-boggling about this is that it commits one of the most basic fallacies in economics \’97 interpreting an accounting identity as a behavioral relationship. Yes, savings have to equal investment, but that\’92s not something that mystically takes place, it\’92s because any discrepancy between desired savings and desired investment causes something to happen that brings the two in line

I think something similar is happening in analyses of the balance of payments, in which the requirement that accounts balance is seen as implying a crude causality — the direction of which depends on your geopolitical predisposition — where none need exist.\’a0 At any rate\’a0discussions about China and the US are destined forever to get mired in crude political grandstanding.

\’a0

Anyway, enough whining.\’a0 I should be honored that people take my musings seriously enough to accuse me of evil intent.\’a0 On a very separate note I have been enjoying the amazing weather in southern Spain where I’ve spent most of the past three days sunbathing and reading Antony Beevor’s excellent (and profoundly depressing) book on the Spanish Civil War, so I haven’t been following global events too closely,\’a0and the pleasant daze in which I live when\’a0I am home in Spain\’a0should explain, I hope, the scarcity and thinness of recent blog entries.\’a0 I was nonetheless awakened from my stupor by a report from Credit Suisse that projects an increase in January bank lending\’a0in China of RMB 1.3 trillion.This is a huge number — about one-quarter of last year’s total increase.\’a0 According to Credit Suisse’s Dong Tao:

We observe that most of the expected lending is earmarked for infrastructure projects. Infrastructure lending is \’93politically correct\’94, backed by collateral, and should have steady cash flows. Lending to the industrial sector and export sector should see minor improvements, however, and banks remain cautious on the economic outlook.\’a0 Large property developers should get some lending as well, but smaller and \’93weak\’94 ones are still barred from receiving credit.\’a0 The private sector seems to be experiencing greater trouble obtaining loans than the public sector and state-owned enterprises.\’a0\’a0

Dong Tao then goes on to make the point that worries me:

We are concerned about the quality of bank lending but the move to increased lending would be positive news for China\’92s GDP and global demand. We do wonder how banks conducted their due diligence to allow them to lend one-forth of last year\’92s lending within three weeks. The potential consequence to the health of the banking sector remains to be seen. Nevertheless, with this massive credit expansion, our upbeat 2009 growth forecast of 8% is more likely to be met.

China has to make an adjustment from an economy overly dependent on exports to one more focused on domestic consumption.\’a0 This adjustment was never going to be easy and there will definitely be a significant cost.\’a0 Every other country in history that I can think of that successfully made the adjustment only did so with great difficulty, in the throes of crisis, and over decades.\’a0 My worry, which I started discussing a few months ago, is that in their desperation to reduce the\’a0combined cost of the transition and the global slowdown — instead of forcing the transition during good times they waited until they were forced into it during a crisis — policymakers are going to throw everything they have against the resulting slowdown, including out-of-control bank expansion.\’a0 While this may reduce the extent of the slowdown this year, as Dong Tao points out, it does so at the risk of creating\’a0much deeper instability in the banking system.

\’a0

If the global crisis lasts only a year, this all-but-the-kitchen-sink strategy will probably have turned out to be a good one, but if, as I suspect, the crisis is going to last two or\’a0three years or more, weakening the banking system so early in the process may create much greater risks for China in the future.\’a0 Piling up loans in such an undisciplined way and having the banks bear most of the heavy lifting in the fiscal expansion plans is good only if it does not result in a sharp rise in non-performing loans.\’a0 That, most of us would agree, and Victor Shih has been especially worried about this possibility, is unlikely.\’a0 If it does result in surging NPLs, however, in the near future policymakers will be seriously constrained in their ability to fund more expansion and may even find themselves caught up in a monetary contraction as bank portfolios go bad.\’a0 The monetary side of policy making in China continues to be, in my opinion, the most difficult and uncertain part of the process, and I think it pays to be cautious.

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I know, I know, it sounds like I am warning that China’s growth will be much lower than expected (I still think well below 7% for 2009), which is a bad thing, but if I am wrong, and growth is higher, that is an even\’a0worse thing.\’a0 That sounds a little mean spirited, doesn’t it, and possibly inconsistent?\’a0

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Maybe, but not necessarily.\’a0 I have been arguing for three years that an adjustment in China is very necessary and that this adjustment does not involve\’a0choosing policies\’a0that lead either to good or bad outcomes but rather\’a0that lead to\’a0bad or worse outcomes.\’a0 In other words Chinese overcapacity was based on excess investment and massive capital misallocation.\’a0 There will be a significant\’a0cost to reorienting capital and\’a0resolving the earlier misallocation.\’a0 This necessarily entails a slowing of the economy — reallocation of capital typically takes place disruptively and via bankruptcies.\’a0

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If adjustment policies had been put into place during periods when the global economy was booming — always easier\’a0said then done, politically — the adjustment would have been more easily absorbed, but clearly that is no longer an option.\’a0 There is however still a chance to postpone the adjustment by accelerating the misallocation process, but this only postpones the adjustment and, of course, increases its\’a0magnitude.\’a0 This strategy may be politically necessary but ultimately represents a gamble on the duration of the global slowdown.\’a0 If\’a0the duration\’a0is short and the slowdown light, it will have been a winning gamble, and once the world takes off again China can get serious about resolving the internal imbalances.\’a0

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Of course if the global slowdown is long and deep, the gamble will have failed.\’a0 That means, dear readers, that if Chinese GDP growth in 2009 is higher than I projected — say 8%\’a0– I will not whip out the party hats and favors.\’a0 Instead I will immediately begin whining about the state of the banking system.\’a0 Perhaps that indicates intellectual rigidity on my part, but I have been working with and studying developing economies long enough to know that problems that we identify may take longer to emerge than we expected, and often emerge differently from what we projected, but they almost always do emerge in the end.

\’a0

By the way recent growth numbers from Japan\’a0suggest just why we shouldn’t expect the global crisis\’a0to be a one-year problem.\’a0 Fourth quarter Japanese GDP numbers will be released later in February and will show a double-digit decline in GDP and, according to CNBC, that “Japanese industrial production fell a record 9.6 percent in December, while core annual inflation almost evaporated, reinforcing expectations of a record economic contraction as the global financial crisis worsens.”\’a0 If true, these\’a0are staggering numbers.\’a0 It is hard to imagine a contraction of this magnitude not having ugly implications for the rest of Asia and the world.\’a0 If it were only Japan, that would be bad enough, but I don’t need to tell anyone who reads newspapers that other large economies aren’t following radically different paths.

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Finally, I see that Wen Jiabao and Angel Merkel had a good meeting yesterday.\’a0 Following their meeting China and Germany have vowed to make joint efforts to stabilize the global economy amid the ongoing financial and economic crisis.\’a0 As the two leading trade surplus countries I think both of them are going to be subject to the same kinds of very sharp criticism from their trading partners concerning their failures to boost domestic demand and their undermining of fiscal expansion in trade deficit countries.\’a0\’a0\’a0According to Sina.com , “the two sides agreed to strengthen dialogue on economic and trade, currency and fiscal policies and pledged to support each other on their economic stimulus plans based on their own situations…The two sides also stressed the importance of curbing trade protectionism, saying they will oppose trade and investment protectionism in whatever forms. “

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I am sure they will.\’a0 Unfortunately nearly all the trade-protection cards are in the hands of the trade deficit countries.
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Tags: Name-calling

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NPLs

The IMF warns about surplus countries and global imbalances

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

More public worrying about the Chinese stimulus

RMB 1.5 trillion in new Chinese lending — can we turn this thing off?

Distortions in the Chinese lending environment

The death of the Asian development model

Banker? Or Grocer?

Will China have to choose between social stability and long-term growth?

Hooray! China has bottomed out.

All but the kitchen sink?

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