- While the chances of a disruptive adjustment - including a financial crisis - are clearly rising, for now I will assume, as I have since 2009-10, that China is able to pull off a non-disruptive rebalancing.
- In that case, I expect GDP growth rates will continue to decline by about 100-150 basis points a year until some level at which during the 2012-22 period growth will average 3-4% at best. Growth in household income and consumption, of course, must be higher as China rebalances and should average around 5-6% during this period.
- For all the seeming predicting embedded in this issue of the newsletter, the key point I would make is that rebalancing can only occur in a limited number of ways, and each of these has a fairly predictable impact on various economic sectors.
- What is more, many of the alternative paths Beijing can choose to follow, especially in the way in which it implements wealth transfers to the household sector, are likely to be determined as the outcomes of political decisions.
This blog entry is largely something I wrote a year ago about the impact of a Chinese rebalancing on the global economy, and except for this first paragraph nothing has been changed. The entry on my blog that had been posted a couple of weeks earlier was an attempt to explain why it is important to consider both sides of a country's balance sheet in forecasting growth. At one point in that essay, I discuss the difficulty most economists seem to have in incorporating persistent imbalances into their economic models. There seemed to be among them, I wrote:
… a failure to understand the economy as a dynamic system in which a) imbalances could persist and grow for many years before eventually rebalancing, b) the more rigid the institutional structure of the economy, the deeper imbalances were likely to get, c) the longer they persisted, the more disruptive the rebalancing was likely to be, and the less significant the "trigger" that set it off, and d) there are many ways rebalancing can occur, and the way it actually occurs depends on institutional constraints and rigidities. These economists seem to find it difficult to understand that an economy can have a very unbalanced debt structure, with debt growing at an unsustainable rate, so that there will be a significant reduction in future growth, but a crisis is only one of the ways, and not the only way and certainly not imminent, that this reduction in future growth can happen. It is only when debt is subject to a "sudden stop" that a crisis can be inevitable, but in many if not most cases there is no crisis.
A friend of mine sent me an article a few weeks later from the Financial Observer about the views of someone by the name of Brian Singer, head of the dynamic allocation strategies team at William Blair, in which Singer discusses his outlook for China and makes a passing reference to my views:
"Everyone is aware of China's horrid debt levels and [Chinese financial markets analyst] Michael Pettis has done some great work, but he is China's 'Chicken Little'," Singer said, referring to his panic-style predictions. "He discovered through his research that China has built up a lot of debt and he is right. China's debt to gross domestic product (GDP), however, is pretty close to the United States' and Germany's.
"If we're all so terribly concerned about China's debt to GDP levels, why aren't we equally as concerned about the US?" In reality, the US would like to have the debt to GDP levels and growth dynamic China had, he said. "The US is growing at 1.5 per cent and would take an eternity to absorb that debt," he said.
I don't think Singer is referring to my having long argued that once China began rebalancing, its growth would drop by roughly 100-150 bps a year. I have been very consistent about the timing and this is exactly what has happened, and presumably a Chicken Little would have made the same prediction over and over again and was wrong each time. I assume that Singer is making the same mistake that a number of other analysts who were blindsided by China. He is probably assuming that because I have been warning since 2006-07 that Chinese growth had become structural dependent on an unsustainable increase in debt, in spite of my nearly always adding that I did not expect a financial crisis (which I began to do precisely because Singer's confusion about imbalances and misunderstanding of China's growth model was so widely shared), I must have also been predicting an imminent financial crisis.
Singer, like most analysts, doesn't understand how deep imbalances and unsustainable debt increases can be consistent with institutional constraints that keep the process going on for many years. When he read my work about Chinese debt, at a time when like most analysts he was probably bedazzled by China's growth model, I suspect he immediately assumed that I could only be predicting an imminent collapse, and so the fact that I very explicitly rejected the idea of an imminent collapse was not something he was able to process.
His confusion about debt is more general. His idea that a debt level which might be problematic for China must also logically be considered problematic for the US suggests, of course, both a poor understanding of why debt matters and very little familiarity with the history of debt across developing and developed countries. I have explained the former many times before, but almost any graph that shows current debt levels for countries ranked according to GDP per capita, or shows debt levels for countries that have defaulted, restructured their debts, or otherwise indicated financial distress, again ranked according to GDP per capita, makes it very clear that wealthier countries can sustain much higher debt levels.
Singer goes on to make growth forecasts for China that are, in my opinion, very unrealistic and which, if they turn out to be correct, would be almost wholly unprecedented in history, and it is not clear to me why something so unprecedented is not considered extraordinary enough to warrant an explanation:
"At the margin, things have slowed down and when you add all these things together, in our view double-digit growth is not viable for China, but does not mean it will grow at 1 per cent like the developed world either," Singer said. "[We think China's growth] will be something around 5 per cent, which is a reasonable assumption over the coming 10 to 20 years… Yes [the combined issues creating uncertainty for China] are a concern, but it is not the end of China as we know it."
The assumption that Chinese growth will average around 5% for the next ten to twenty years is not "reasonable" at all. Given the relationship between GDP growth and credit growth that has been obvious for at least a decade, GDP growth above some sustainable level, a level almost certainly below 3-4%, requires that debt grow faster than debt-servicing capacity, and as the debt burden grows, that sustainable level will itself decline further. Even a decade of 5% growth would require that Chinese debt levels rise from the current 250% of GDP to something north of 400%, which for a developing country would be almost unprecedented (I say "almost" because there may have been cases of developing countries in which debt was higher, but only after a currency crisis forced up external debt).
More importantly, as Singer and most analysts have failed to understand, the only way credit can rise to those levels is if it is purchased and effectively monetized by the central bank, in which case the consequence would be downward pressure on household consumption growth. Simple arithmetic suggests in that case that the only way to keep GDP growth at 5% would require wealth transfers from local governments at probably 5% of GDP or more, and given the political difficulty of even generating wealth transfers of 1-2% of GDP, which I hope to see begin in next year, I doubt this is one of Singer's assumptions.
I don't mean to beat up on Singer. The friend who sent me the article included it among several others because he thought it showed the strategies used by analysts who were late to see the Chinese adjustment coming, even though it should have been obvious years ago. But as I explained later in the same blog entry, I am less cynical about the motives of these analysts because I think they genuinely fail to understand how imbalances are created, how they can persist, and how they affect and are affected by the structure of balance sheets. That is why they cannot distinguish between deep imbalances and unsustainable credit growth on one hand and imminent crisis on the other.
What does a rebalancing China mean for the world?
While the chances of a disruptive adjustment - including a financial crisis - are clearly rising, for now I will assume, as I have since 2009-10, that China is able to pull off a non-disruptive rebalancing. In that case, I expect GDP growth rates will continue to decline by about 100-150 basis points a year until some level at which during the 2012-22 period growth will average 3-4% at best. Growth in household income and consumption, of course, must be higher as China rebalances and should average around 5-6% during this period. This can only occur as wealth is systematically transferred, either implicitly or explicitly, from the state sector to the household sector.
Because I have explained many times before how this process might work and where it is vulnerable to disruption, the rest of the newsletter will focus on trying to work out the impact of a non-disruptive Chinese rebalancing on various parts of the Chinese and global economy. Before addressing each of the sectors I think relevant, I thought it might be useful to present a table I stole from John Mauldin's blog, which he takes from Barry Ritholtz, that shows the sheer extent of China's presence in commodity markets. The table leaves out China's consumption share of global iron ore production, which I believe was 63% in 2012, but it includes most other major commodities.
1. Effect on metals
The table above suggests why it turned out to be quite easy to make what I think was my only China-related "Chicken little" prediction. In late 2011 and early 2012, I argued that because China's rebalancing had become difficult to postpone much longer (indeed it began, I would argue, in 2012), the prices of most industrial metals would fall by over 50% within three years and iron ore would test $50 by 2017. This would happen whether or not China's adjustment happened non-disruptively.
Metal prices did indeed fall as expected, and there is now a pretty substantial debate over whether, as a recent Financial Times headline put it, "mining is at rock bottom". I am not as confident today as I was in 2011-12 about overriding my basic ignorance of the metals industry and predicting metal prices largely on the basis of my China expectations, but I continue to believe that metals prices will fall - probably to levels not very far from those typical at the turn of the century (adjusting for inflation and the strength of the dollar).
I say this because China has only begun its adjustment process, and investment growth still has a long ways to fall. Global demand is structurally weak, probably because of high levels of income inequality which tend to reduce both consumption growth and growth in private investment. Unless we were suddenly to see roaring growth in India over the next few years, which is not out of the question given how its poor infrastructure guarantees an obvious productive destination for investment flows, I don't expect any counterpart to China's continued declining demand for metals.
2. Effect on energy
I am often asked how I expect China's rebalancing to affect demand for energy, but I find my framework not especially useful in answering this question. As China's growth slows and demand switches from investment to consumption, I assume there will be slower growth in China's demand for energy because except for automobile purchases, which have probably peaked even in the best of cases, consumption tends to be less energy intensive than the kinds of investment that has dominated Chinese activity in the past.
I have to confess, however, that I am much less certain about this, and given how politics can interrupt the supply side, I am largely mystified by energy price swings. Perhaps the only thing I can say with some confidence is that if China attempts to maintain current growth in economic activity, and with it even faster growth in debt, there is a rising probability of a disruptive adjustment in which economic growth suddenly collapses, in which case I expect energy prices would fall sharply.
3. Effect on agricultural commodities
Unlike with the demand for metals, Chinese demand for agricultural commodities is likely to be highly sensitive to whether or not China is able to adjust non-disruptively according to the assumptions I list above. If it does, household income growth in China will remain strong - rising by 5-6% a year - while income inequality stabilizes or even declines. Chinese demand for food would continue to rise sharply, and so would probably support the prices of agricultural commodities, and this is even more likely to be the case if India performs as well as some expect.
In the case of a disruptive adjustment, however, demand for agricultural commodities would not hold up. In that case, I would expect growth in demand for food to fall sharply, at least for a few years, because China's rebalancing would then take the form of a sharp drop in investment combined with a drop in household income - one that is less brutal than the drop in investment, but a drop nonetheless. In that case, along with lower consumption, we would probably see a reversal of the shift in recent years towards more grain-intensive forms of food (i.e. less meat consumption).
4. Effect on labor-intensive manufacturing abroad
A rebalancing China must be accommodated, for mainly arithmetical reasons, by a relative shift of wealth from the state sector to the household sector. If Beijing does not take steps to promote this shift, it will occur more painfully, at lower and even negative levels of GDP growth and household income growth levels perhaps two or three percentage points higher. If Beijing implements policies that accelerate this transfer, both GDP growth and household income growth will be that much higher.
There are many ways, however, that wealth can be transferred, and it is important to remember that the way in which it is transferred is ultimately a political decision more than an economic one. After many years in which it lagged productivity growth, wage growth began to pick up around 2010, and while I expect it will continue, most of the forms of wealth transfers that are implicit in the reforms proposed in the Third Plenum are likely to increase household income indirectly rather than in the form of higher wages. What is more, slower growth, especially in the real estate sector, will reduce upward pressure on wage growth.
For this reason, I suspect that we may have already seen much of the relative adjustment that was likely to take place in the form of rising wages. As China continues to rebalance, then, although I think the manufacturing sectors in other developing countries will continue to benefit, especially in countries, like Mexico, that were hardest hit by Chinese competition in the last decade, I believe that rising Chinese wages will no longer provide as much support for low wage economies that compete with China as they had in the past.
I say this without great certainty because, as I want to stress, although we can be reasonably confident about relative wealth transfers from the state to Chinese households, we have to think about the forms in which these transfers take place largely as the outcome of political decision-making, based, of course, on political conditions that hold at the time. A Beijing that is more concerned for example about workers, including migrant workers, than about the urban middle class is more likely to favor wage growth than an appreciating RMB, higher deposit rates, or other forms of transfer that benefit the urban middle class.
The key for any analyst should be to pay attention to political signals emanating from Beijing. For now, however, I expect that labor-intensive manufacturing abroad will benefit less than it has in the past 3-4 years from China's rebalancing.
5. Effect of capital-intensive manufacturing abroad
The same logic holds for capital-intensive manufacturing abroad, but with different consequences. Nominal GDP growth in China, along with the GDP deflator, began falling very rapidly in 2012, one of the most important and beneficial consequences of which was effectively a collapse in the financial repression tax. This tax heavily penalized households for whom savings in the form of bank deposits and, to a somewhat lesser extent, interest-bearing wealth management products, is an important source of income, and is probably the single most important cause of China's deteriorating imbalances before 2011-12.
There was a second important and beneficial consequence, and this of course was the elimination of the massive borrowing subsidy made available to borrowers with preferred access to bank lending. It was this subsidized lending rate, negative in real terms for much of this century, that more than anything else explains the wanton misallocation of capital during the last decade.
Not surprisingly, however, as interest rates have risen sharply in relative terms since 2011-12, borrowers who had taken out the most debt and invested in the lowest yielding projects, including most of the country's provinces and municipalities, are suffering from painful debt-servicing costs, and there is enormous pressure on the authorities to reduce borrowing costs. SOEs that once seemed to be well-managed money-making machines are among the worst hit as we learn, which we always seem to do when the economy shifts into its liquidity contraction phase (the case of Enron, for example), that unexpectedly high profitability was often driven not by brilliant management so much as by highly speculative balance sheets.
For all the bellowing by desperate borrowers, China has managed to refrain so far from the easy expedient of slashing interest rates, and rumors are that the PBoC has been especially opposed to doing so. By so refraining, Beijing reduces the overall cost of China's adjustment and improves the economic outlook for the country over the longer term, but of course this means absorbing the pain today.
I expect that Beijing will continue to use interest rates to force borrowers into better investment decision-making, and while unless there is a jump in inflation, which isn't likely, we may start to see interest rates drop, I don't think they will drop sharply in real terms.
If I am right, the implications are clear. One of China's great competitive advantages for much of the century has been extraordinarily cheap capital, and while SOE managers in capital-intensive industries liked to claim that their success in international trade was explained by superior management techniques, like their Japanese counterparts in the 1980s, in fact in both cases it was more likely that access to artificially cheap capital was far more relevant.
As China continues to rebalance in the ways set out above, in other words, capital-intensive manufacturing abroad will continue to benefit disproportionately as Chinese exporters no longer benefit from heavily subsidized capital. But as in the case of labor-intensive manufacturing abroad, whether or not this continues to be the case is ultimately subject to political decisions about how wealth is to be transferred, and so it is important to note again that we must pay attention to political signals emanating from Beijing.
6. Effect on consumption of luxury and super-luxury goods in China
It is almost part of the definition of rebalancing that after three decades in which they received a disproportionate share of growth, the elite and the rich must pay a disproportionate share of the adjustment costs, in favor of the middle and working classes. In the case of a non-disruptive rebalancing income inequality in China must decline. This means the halcyon days of luxury consumption in China are over and will not return under almost any plausible scenario for many more years. Those who think luxury consumption is down only because of President Xi's anti-corruption campaign, and that once the latter ends we will return to the days of spectacular growth, will be very disappointed.
The exception might be in in the market for super-luxury goods - so that anyone selling $50 million yachts, super conspicuous art, European football teams, etc., might do well. This is because ultimately if China is to rebalance non-disruptively, it is hard for me to work out any scenario that does not involve at least partial privatization of SOEs, most likely those owned and managed by local governments. There are many ways in which this privatization can occur, including ways designed to overcome the inevitable opposition from vested interests. In that case, some of these may be especially beneficial to the highest levels among the elite, whose opposition must be bought out one way or another.
7. Effect on middle class consumption in China
Again, because it is almost part of the definition of rebalancing that after three decades in which they received a disproportionate share of growth, the elite and the rich must pay a disproportionate share of the adjustment costs, in favor of the middle and working classes, in the scenario of a non-disruptive Chinese rebalancing, the growth rate of median Chinese household income is unlikely to slow very sharply. This means that middle class consumption growth in China, in other words, probably will not slow by much unless the rebalancing is postponed long enough for it to disrupt the economy.
8. Effect on real estate prices abroad
Unless the PBoC were to impose much sharper restrictions on capital outflows, and this may not be easy to do either politically or technically, it is hard to imagine many scenarios in which capital outflows do not remain high for several more years. Because much of this will be driven by wealthy Chinese looking to acquire secure assets abroad, the demand for premium real estate in places popular with wealthy Chinese will probably remain strong.
9. Effect on investment abroad
In the previous issue of this newsletter, I explained why declining reserves, and declining purchases by the PBoC of US government bonds, was unlikely to force up US interest rates.
10. Effect on EM
I have long argued that the emerging-market decoupling thesis was always patently absurd. EM growth was maintained after the 2008-09 crises undermined US and European demand not because demand had become self-sustaining in the developing world but because China had responded to the crises with massive increase in already excessively high levels of investment and mu8ch of the resulting demand, especially for hard commodities, benefitted EM.
But because the global crisis exacerbated already-high excess capacity, the Chinese stimulus, which only increased capacity further, was always unsustainable and would inevitably result in a more difficult ultimate adjustment for EM. In my opinion, we are clearly at the end of another convergence period for developing countries, and historical precedents suggest we should be prepared for a decade or more of both sovereign debt defaults and economic divergence. Developing countries that most urgently recognize the change in underlying circumstances and focus most heavily on institutional reforms that unlock productivity growth, and who pay especial attention to efficient capital allocation, are the least likely fall behind in relative terms and the most likely to be in a position to benefit when global demand finally recovers.
For all the seeming predicting embedded in this issue of the newsletter, the key point I would make is that rebalancing can only occur in a limited number of ways, and each of these has a fairly predictable impact on the various economic sectors described above. What is more, many of the alternative paths Beijing can choose to follow, especially in the way in which it implements wealth transfers to the household sector, are likely to be determined as the outcomes of political decisions.
That is why rather than pay attention to the standard kinds of predictions economists often make, it is far more useful to work through the various rebalancing paths and to try to understand the changing plausibility of each of these paths. Above all, we must recognize the ways in which imbalances can deepen or recede according to institutional constraints, and this means at a minimum rejecting the false dichotomies in which imbalances necessarily adjust quickly and disruptively in the form of financial crises. A financial crisis, while always a real possibility in a deeply unbalanced economy in which debt levels are high enough to create uncertainty about the allocation of debt servicing costs, is simply one of the many ways in which debt and imbalances can be resolved.