Squeezing out the exporters

1. edward lashinski July 29, 2009 at 07:10

   

   “He shows that for the past five years net exports accounted for about 10% to 15% of Chinese GDP growth, before collapsing n to minus 41% in 2009 YTD. ”

   For the non-economist, can you please explain how despite the investment making up 88% of fh 2009 growth, and exports down 21%+ ytd, yet trade tensions escalating and exports crushing row markets how the above statement makes sense?

   Thanks very much.
   Ed

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2. Houhui July 29, 2009 at 07:15

   

   Even more rumours of tightening today, and even rumours of the dreaded stock market transaction tax being raised again. Shanghai and Shenzhen both got a bit hammered – and copper was significantly hit.

   On the subject of BOC – Prof Pettis, what do you think of the recent “forced bill sale” from the PBOC to BOC and a couple of other banks – Pudong i think and one other?

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3. Houhui July 29, 2009 at 07:16

   

   As a separate question, do you think there is any significance to the EU, and not the US, taking the lead in this protectionist reaction?

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4. Dan July 29, 2009 at 11:49

   

   Great post. Just…great post…

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5. mannfm11 July 29, 2009 at 15:18

   

   Michael, I eagerly await your volume you are going to publish this weekend. Modern governments might have ironed out the panics, but they have created the collapses. This mess was made in China and in the USA. I find it difficult to believe that only 15% of China’s GDP growth was from exports when it is clear that most of it was derived directly or indirectly from GDP. The US made this mess by allowing everything under the sun to be collateralized into some kind of credit by Wall Street or the banking system and the resulting excess being sent to China.

   Thus, as you have repeatedly written and I have repeatedly agreed, there is not much of any way out of this mess than time. Politicians in countries that have real elections don’t have time. The French burn down the country when something is just intimated. And, Germany is going to have its own export problem.

   It is clear that all involved are making a mistake and if we aren’t careful, this will sow the seeds of the next big war. In any case, new bubbles and more debt seems to be the only solution to a problem that was created by bubbles and evermore debt. There is no greater paradox than the hair of the dog that bit you being the solution to the bite.

   China cannot continue to artificially steal the trade capacity of the rest of the world and not expect retribution. We are looking at a lower demand going forward for a lot of things and eventually there aren’t any customers to sell to if your policy is to destroy their jobs and money earning capacity. Money is earned in international trade either by putting countries into perpetual debt or by selling goods. If the Chinese are intent on monopolizing all the goods production in the world, along with the resources of the world, their trade partners have no capacity to earn return income to continue the process. Nothing can be done other than war and destruction or the continued hocking of property, aka the housing bubble.

   Martin Hutchinson of greatconservatives.com wrote a piece posted on prudentbear.com this week. In it, he says China is pursuing the policies of the British East India Company, what is known as merchantilism. Is the rest of the world to stand by and be made colonies of China? With a billion people to throw on the pile and sufficient infrastructure, they possess the capacity already to monopolize much of the world manufacturing capacity. They don’t have the customers to continue the game in China though.

   It appears to me that what is considered economic growth is going to have to change and the financial system is going to have to take the haircuts through debt reduction and bankruptcy. This cannot be solved by continued spilling of debt to China. Neither can the rest of the world get rich investing in Chinese capacity in a world that is over capacity. We are progressing right toward the second great depression.

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6. William July 29, 2009 at 18:48

   

   Carsick Cars were here just a few months ago; having trouble getting a visa again? I am glad to hear that both bands will make it. I am looking forward to seeing them perform at Underworld on Friday night.

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7. In Debt We Trust July 29, 2009 at 18:50

   

   If you think about it, the SDR scheme sounds like a complicated off balance sheet transfer of assets from China back to the West.
   It was never intended to be a global currency – just a way for them to shift the risk of loss to others.

   Looks like Beijing is learning from the best at Wall Street.

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8. Jeff July 29, 2009 at 22:10

   

   I’m not sure if anyone caught the announcement that China’s top 6 banks took 8-10 billion RMB each in the 60 billion financing for Lize, a 5.25 sq Kilometer commercial office building development in the Fengtai district of Southwest Beijing. The project is intended (according to Beijing officials) to become the Financial Center of China, housing headquarters, hedge funds, financial services firms, venture capital and media firms.

   Wait, I thought that was going to be Shanghai!

   Lize has the “support of the government” (Beijing City) The financing is mainly for infrastructure improvements. Perhaps the loans will be ok if Beijing puts its full faith and credit behind the project. But someday the piper will need to be paid, which is Mr. Pettis’ point.

   There is a big loss that is coming and it is hard to tell who will absorb it. Of course, it will ultimately end up being paid for by the citizens one way or another. Higher taxes, higher fees, sale of government property, continued low deposit rates, social spending foregone. All to satisfy some bureaucrat’s desire to best Shanghai. I think the project analysis was probably “if we build it they will come!”

   Articles today in the China South Morning Post and Bloomberg.

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9. chan-lee james July 30, 2009 at 00:09

   

   Professor Pettis: An excellent post, but your citation of the Economic Policy Institute’s estimates of China-US BILATERAL trade surplus lends credence to a POLITICAL NOT economic argument.
   There is no dispute that China’s current account surplus is extremely large and secular (despite Prof. Ross’ earlier claims). But, bilateral trade balances are a RED HERRING! Over the past 10-20 years, Japanese, Korean, Taiwanese, US and EU firms have shifted plant locations to the PRC to tap its “unlimited” supplies of cheap unskilled and semi-skilled labour, typically for the assembly aspects of the supply chain. This is why China’s exports of computers and other products exceed those of the USA — while domestic value added is relatively small, albeit growing.
   As exports are recorded by country of origin — China runs a big bilateral trade surplus with the US and EU — but a significant counter part of this is its massive imports of parts from the rest of Asia (i.e. Asia’s former trade surpluses now show up in China).
   To be sure, China needs to redress its overtly mercantilist policies, but citations of bilateral trade balances are MISLEADING. In a multilateral world, the relevant metric is the OVERALL trade and current account balance.
   Indeed, the US Trade Rep routinely trots out this RED HERRING with us. One day, a Canadian graduate said to his former US (Chicago) Prof; — “but Prof.X you taught us that bilateral trade balances are nonsense in a multilateral world in your trade class!”. He replied — yes that’s true, but this is POLITICS not Economics. In short, the situation is bad — lets stick to economics. regards James

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10. Michael Pettis July 30, 2009 at 06:12

    

    Ed, I guess I am not sure what you mean by your question. It seems to me that declining trade and escalating trade tensions can easily go hand in hand. In fact I would say that is the “normal” pattern – it certainly was the pattern in the 1930s..

    Houhui, I wonder if the PBoC is trying quietly to discipline banks. It doesn’t surprise me that the EU would take the lead since for structural and political reasons it is much less able to absorb trade deficits, and I think Germany is really reeling from the global demand contraction.

    William, please write back after the show and tell me what you think.

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11. Michael Pettis July 30, 2009 at 06:12

    

    I would agree with you, Chan-Lee, if you said that the absolute level of bilateral trade is a red herring. I think it is clear that the international division of trade can cause “normal” trade patterns to show up as very abnormal on a bilateral basis. What the Economic Policy Institute numbers show is different. There has been a huge increase in China’s share of the US deficit. Unless you assume that there has been a huge and radical shift in the organization of trade in the last three years, it seems this increase must indicate very strongly that, for policy or other reasons, Chinese net exports are contracting much more slowly than we would normally expect.

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12. chan-lee james July 30, 2009 at 08:30

    

    Professor Pettis: Yes, you are correct about trade patterns — but commodity compositions can shift sharply in periods of violent shocks.
    My comment is akin to a warning on cigarette packages. The problem is that the journalists constantly confuse bilateral and multilateral trade concepts. This is then unfortunately picked up by politicians which fan protectionists rhetoric and “China bashing” unnecessarily.
    It will be interesting to see the breakdown of the recent decline in China’s net exports — there may be big surprises as their price deflators are to say the least, weird. best regards James

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13. CNM Zhige July 30, 2009 at 20:48

    

    We tend to look at net trade in terms of its impact on GDP a measured by output. If we look at this more broadly in terms of national balance of payments, with the assumption that most of China’s trade surplus is actually foreign earnings by foreign comapanies, then deficits take on a new dimension. If a foreign company reports that its earnings in China jumped in any given period, this is taken as a strength. For many of them these earnings are probably trade related. I am not sure whether it balances out, but for as much as the US loses in terms of GDP in the form of a net trade deficit, it makes back a bunch of it from net foreign income, much of it earned by flows attributable to corporates. Would be interested in further comments on this.

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14. steve from virginia July 30, 2009 at 21:05

    

    For some reason your article depresses me. The unfolding of this Global Financial Crisis is similar to a Greek tragedy. I have beeb hoping that some country or group would take a slightly – or radically – different policy approach and give some depth to the experiment. To seize a policy initiative, to provide leadership.

    So far, it has been New Zealand forgoing a zero interest rate policy.

    I think the biggest problem from the US side is the old, cold- war habit of looking at China as an adversary first, as an expedient, second. I doubt there is anyone in Washington, DC who can approach the Chinese outside of the conventional/formal Neo- classic economic humbuggery. The political background is painted over rehash of Anna Chennault’s John Birch- isms. Like Elvis, Chiang Kai-Shek is still alive, working at a 7-11 somewhere. Look @ US Treasury and Fed policy and listen to the Chinese complain about it … then watch the Chinese do the same things; follow the same tired, exhausted prescriptions.

    How many more empty concrete office buildings are needed in China? How many more rotting strip malls in the US? Can’t anyone learn anything new?

    What I’m getting at is this:

    Why do I insist on teaching “new political economy” as a graduate course? Because I believe that sooner or later, the public themselves need to choose which path of development path to take, what kind of lifestyle to lead, what sort of political process is necessary. This is what is meant by public choice.

    This is from Professor Wang Ding Ding, of China Center for Economic Research Peking University. I don’t know how much ‘throw weight’ this fellow can deliver in his mileu, but certainly more ‘soul searching’ than can be found among the talking- heads of the US economy.

    I get the idea the Chinese are feeling isolated … and prehaps a bit used. They are a punching bag; a dump for US industrial pollution, a sump for terrible US ideas and lazy thinking; they are importing Helicopter Boy’s inflation … and being scapegoated into the bargain!

    They have a lot of US paper; it’s a force in being and no more1 It is insufficient ot lever US polity. In the currency markets, how much is $2 trillion? It’s speed bump … the Chinese know this. They know their reserve is California IOU’s.

    Unfortunately, the only places they can spend their dollars is in Saudi Arabia or here in the USA. They are deathly afraid of getting ripped off.

    Where would they ever get that idea?

    Why not ‘dollarize’ the Chinese economy? Why not allow yuan to circulate in the US? Why not currency integration? Radical, no? The Chinese could save excess dollars and quell dollar inflation fears and the US could spend the flood of new yuan on Chinese ‘stuff’ again … at least for a little while. We would instantly import China’s savings and increase consumption @ the same time.

    If something went wrong, one conntry could blame the other just like they do now!

    Or … the Chinese could create debt and currency for the US and we could do the same for China. Both would instinctively abd be expected to follow self- interest, to be construed most narrowly. The Chinese would want to cut debt issuance in dollars and revalue dollars upward … the Treasury would want to cut the yuan float to beggar the dollar … eventually both sides would realize that one absolutely depended on the other.

    We could export our discredited public officials and sleazy banker to Chine would would execute them in the public square. It’s hard ot argue against such progressive policy …

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15. chan-lee james July 31, 2009 at 01:52

    

    CNM ZHIGE: How Multinationals affect National Accounts and Balance of Payments statistics is a Pandora’s box. I am no expert, but there are big inconsistencies in BOP data that are hard to reconcile, especially on a US-China bilateral basis.
    In theory, a MNE should have neutral effects on the BOP statistics, because its activities should either show up as exports and imports above the line or as profits and retained earnings below the line (i.e. as direct capital inflows).
    This is not the case because MNEs can often decide where to declare (or hide, shelter) their profits to minimise tax (via transfer pricing). As stated, retained earnings should show up in the data as capital inflows — but many (most) countries do not follow this procedure.
    Other sources of inconsistencies are that exports (fob) are recorded differently from imports (cif) and there are transport lags between exports and imports. These factors make a big difference when trade flows are huge. And to add to the confusion gold producing countries (Canada, Australia, S.A.) treat gold differently (exports) than gold importing countries (reserve accumulation).
    To give you some idea of how shaky the data are: The US is by far the world’s biggest debtor. Hence, it should be running a big deficit on its net foreign interest, profits and dividends account. The last time I looked 10 years ago the US was still running big surpluses — and I think still is. Similarly, if you accumulate the US current account deficits you should have a good idea of its stock of NET foreign assets. Try doing it and compare them to the published numbers, good luck!
    Another metric is to compare the implicit rates of return on foreign assets of the USA, the UK, Japan, etc. In theory, globalisation should harmonise rates of return among MNEs? In practise, there are big persistent differences. Again why?
    In short, lies, damn lies and statistics. regards James

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16. purple July 31, 2009 at 03:39

    

    The New York Times – more or less a mouthpiece for the U.S. political establishment – just recently endorsed the concept of carbon tariffs… so trade wars are brewing everywhere.

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17. Richard July 31, 2009 at 06:04

    

    Michael – this post was referred to in an FT Alphaville article that drew the following response – i wonder whether you would like to answer it?

    “John Ross Jul 31 11:45

    Michael Pettis unfortunately arrives at a wrong prognosis on China, predicting a slowdown of its growth to at best 5-7% a year and quite possibly lower, because his article is in wrong factually and makes errors in terms of economics.
    Professor Pettis writes that ‘Although Chinese exports have dropped, imports have declined even faster.’
    This is factually inaccurate. China’s imports have fallen significantly less rapidly than its exports. Since the peak month of August 2008 China’s exports have fallen by 28.0% but its imports have only declined by 18.5%.
    Consequently China’s trade surplus reached its peak reached in January 2009, with a monthly surplus of $42.1 billion, and since then China’s surplus has fallen steadily and rapidly – the surplus for June was $8.25 billion.
    Expressed in terms of 3 monthly moving averages China’s monthly trade surplus was $22.5 in August 2008, immediately before the onset of the financial crisis and the collapse of Lehman brothers, rose to $38.1 billion January 2009, and has since dropped to $12.5 billion.
    This shrinking of China’s trade surplus is despite trade price shifts which have tended to exaggerate it. Research published by Goldman Sachs estimates that in real terms, that is if an adjustment is made for changes in export and import prices, China’s surplus has shrunk to one-third of its level twelve months ago.
    However, even in nominal terms the factual trend is the opposite of that stated by Professor Pettis. I have dealt with this issue at greater length elsewhere (http://ablog.typepad.com/keytrendsinglobalisation/).
    Economically Michael Pettis writes: ‘the decline in the US trade deficit must result in a decline in China’s ability to export the difference between its growth in production and consumption. When this happens, China’s economy will grow more slowly than Chinese consumption… rather than act as the lower constraint for GDP growth, as it has for the past two decades growth in Chinese consumption will become the upper constraint.’
    This is erroneous economics as it confuses China’s domestic demand with China’s domestic consumption. Investment is equally a source of domestic demand and therefore increased growth of both investment and consumption is entirely capable of allowing China’s economy to grow more rapidly than its rate of growth of consumption – as indeed it is doing at present.
    Given these errors in both fact and analysis therefore Professor Pettis’s conclusions of a sustained growth slow down does not follow. On the contrary, numerous international studies show that investment is the main source of economic growth both in economically advanced countries and in China – see for example Dale Jorgenson and Khuong Vu. Therefore a high level of investment by China permits it to maintain rapid growth of the type seen in the last thirty years.
    China’s economic stimulus package has therefore been successful because it is based on sound economic fundamentals and does not make the errors in Professor Pettis’s article noted above.
    John Ross, Visiting Professor Jiao Tong University Shanghai”

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18. Roger J July 31, 2009 at 11:37

    

    This is a very interesting article posted on ZeroHedge Blog:
    http://www.zerohedge.com/article/galbraith-chinas-drastically-overstated-trade-surplus

    In the article, there is a link to James Galbraith’s slides (warning: full of numerical data — for interpretation, refer to the above article):
    http://www.zerohedge.com/sites/default/files/Galbraith%20China%20Hot%20Money%20Slides.pdf

    Key point:
    “Galbraith argues the “fake profits” are so large that China may have actually ran a trade deficit in some years, and these figures casts serious doubt on the reported P&L of Chinese companies.”

    Prof. Pettis, if you could give some takes on this, it will really help. Thanks in advance.

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19. PMJ July 31, 2009 at 22:32

    

    ha ha i see ross is still trying to achieve credibility by haunting professor pettis, but as his facts are still weirdly wrong, although stated with the uusual self importance. his trade numbers are carefully selected by date to show the opposite of what has happened. he argues that the trade suplus is down even though the trade surplus for the first half of the year is almost identical to last year’s first half, a record year.

    but in spite of the fact that he can’t even get the numbers right, his nitpicking misses the point. pettis’ argument is not that the trade surplus hasn’t declined. he says that it hasn’t declined by anywhere near the decline in the US trade deficit, and that fact forces bigger adjustments on other countries. nitpicking dates to show whether there has been a small arithmentic decline or a small artihmetic increase totally misses the point, and a quick glance at the trade numbers of palces like germany, japan, korea, taiwan, etc. shows why this matters.

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20. JackZhang July 31, 2009 at 23:39

    

    Richard,

    This is what I posted on the FT Alphaville article you cite:

    John Ross seems to have decided that he might build a career based on his resentment of Pettis and Martin Wolf and spends a remarkable amount of time and effort misunderstanding and “refuting” Pettis with some pretty questionable facts. The argument that Chinas’ trade surplus has declined is not just wrong in absolute terms — the second quarter trade surplus is one of the highest I think in Chinese history — but even weird in the context of Pettis’ main claim that it has not declined at nearly the rate at which the US trade deficit has declined. Ross never stops making the same criticisms, but on Pettis’ blog I think Ross’ arguments have been pretty quickly dealt with, and more usually by readers of the blog who seem to have a much easier understanding of the points Pettis makes. I also wonder about Ross claim that invesment will continue to surge as a share of Chinese GDP without, aside from the improbability of the highest investment share ever recorded continuing to go up for many years, considering questions about sheer debt sustainability. It is true that Pettis was at first the only one to worry about Chinese debt levels and sustainability, but by now most analysts, especially in China, are making the same point.

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21. Michael Pettis August 1, 2009 at 00:34

    

    Richard, although I guess I am flattered that Ross expects to achieve fame mainly by stalking me (all bloggers on Chinese topics seem to attract stalkers), dealing with his arguments every time is getting to be tedious. If the point were to debate and increase our understanding of China’s complexity, that would be one thing, but if the point of the debate is to decide whether or not I am an evil doctor, I think my our discussion would quickly become even more tedious for my readers than for me. As a rule I never take ad hominem arguments very seriously.

    I think PMJ’s and Jack Zhang’s response are correct, even though PMJ forgets to point out that this year’s trade surplus was almost certainly sharply reduced by the government’s decision to stockpile strategic commodities, probably as a way of reducing the PBoC’s exposure to dollars. Although I am not sure I agree with their reasons for doing so (see my upcoming South China Morning Post column on Monday, August 3), the fact is that replenishing stockpiles is not current demand in any meaningful sense. It represents an anticipation of future demand and will be reversed in the coming months or years.

    If we could subtract that commodity stockpiling, I suspect that the trade surplus for the first half of 2009 would exceed that of any half in Chinese history barring the second half of 2008, which was a record. Since the crisis began in 2007, and since then the US trade deficit has contracted by roughly a half (I think), it is hard for me to understand how China’s having run in the past twelve months, even when understated by anticipated demand, the largest trade surplus it has ever run indicates that Chinese negative net demand is contracting at anywhere the rate of US net demand.

    But look, this can be put far more politely and in an easily testable way. I have argued strongly (not in the FT piece, of course, because OpEd pieces always require brevity over rigor), that I do not believe that China’s investment rate is sustainable, and I expect it to decline over the nest 3-5 years. Ross simply asserts that I am wrong. I would guess that since Chinese investment rates are at historically high (and unprecedented, I think) levels, the burden would fall on him to explain why it will so obviously continue rising. Bu no matter. I predict that in the next 3-5 years investment will decline as a share of Chinese GDP. Ross says it must rise. Perhaps he doesn’t understand why that must follow from his arguments, but if investment doesn’t rise, savings don’t drop, and the trade deficit nonetheless declines, then GDP must grow more slowly than consumption, which he says will not happen.

    That is the second test. I say consumption will grow faster than GDP. He insists I am wrong. Fair enough. If I am right, then by definition consumption will grow as a share of GDP and savings will decline. He argues that consumption will decline as a share of GDP and savings grow. Let us see what happens. These are fairly straightforward and testable propositions.

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22. Armando August 1, 2009 at 00:46

    

    Well, Ross vs Pettis. Who is wrong or who is right? Only time will tell. In the past, it was fashionable and chic to keep mentioning about China NPL and that Chinese banking system is bankrupted and now we know which banking system is bankrupt and it taking the whole world down!
    They criticize China as not having transparency and full of corruption when compared with the West and now this economic crisis is showing that the Western system lack transparency and is right with corruption. Toxic triple A+ asset anyone?!

    John Ross is more of the Austrian school of finance that favor saving and investment while Pettis is just another Kennesyan economist. What Pettis want is that China keep lending money to the USA to finance USA deficit.

    Most of the Chinese investment have been on the China infrastructure and not much in the real state. Pettis keep saying that China is investing in the wrong part of the economy and here is a link that clarify what is China is investing now

    http://www.morganstanley.com/views/gef/archive/2009/20090729-Wed.html#anchor94a2f39f-7c3d-11de-b5d1-6d6288639586

    Global Economic Forum E-mail Article
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    China
    Railways versus US Government Bonds: Putting China’s ‘Over-Investment’ in Context
    July 29, 2009

    By Qing Wang | Hong Kong

    ‘Over-Investment’ or ‘Over-Savings’?

    In This Issue
    China
    Railways versus US Government Bonds: Putting China’s ‘Over-Investment’ in Context
    United States
    Challenges to Rebalancing the US Economy
    View GEF Archive

    The Global Economics Team

    Richard Berner
    Dick Berner is a Managing Director and Co-Head of Global Economics.

    Qing Wang
    Qing Wang is an Executive Director and Chief Economist for Greater China.

    Read about other GEF team members

    The Chinese economy is staging a strong recovery, driven by rapid fixed asset investment (see China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009). As the tail risk of a severe recession diminishes, an increasing number of market observers have begun to voice concerns about China’s ‘over-investment’, which, in their view, would only exacerbate the imbalances in China and the global economy.

    A popular evidence of ‘over-investment’ in China is its high investment/GDP ratio, which reached over 50% in 2008, higher than the peak levels of not only major economies such as the US, Japan and Germany, but also other major emerging market economies in the region. Although there is no theoretical benchmark for an optimal investment/GDP ratio, the fact that China has the highest level among countries is considered by many as a strong indication of over-investment in China.

    With ‘over-investment’ being the buzz word in the policy debate at the current juncture, much attention has been paid to the high investment/GDP ratio. However, we believe that a more important phenomenon in this regard is the high national savings ratio in China. To the extent that the high investment ratio is a function of the high national savings ratio in China, discussing over-investment without discussing the high saving ratio loses sight of the big picture, in our view. Put differently, to argue that there is over-investment, one needs to make a case that there is ‘over-savings’ in the first place.

    We are convinced that the high savings ratio in China can be attributed to several deep-rooted factors (e.g., demographic profile, underdevelopment of financial and capital markets, weak social safety net, high return from investment) that evolve very slowly. In this context, we think that any discussion of over-investment in China in the short-to-medium run (i.e., one to three years) should be based on the premise that the savings ratio in China will remain broadly stable at a high level.

    Rapid Investment Growth = Over-Investment?

    Another popular argument of over-investment in China is the high growth rate of fixed asset investment. Indeed, despite the global recession, fixed asset investment growth in China accelerated from 23%Y in 4Q08 to 36%Y in 2Q09. The concerns about over-investment are based on the argument that since the sharp contraction in external demand amid a severe global recession has already laid bare the over-capacity of production in China, additional investment will only exacerbate the problem.

    While in general such concerns make sense, we believe that the devil is in the details. First, rapid fixed asset investment is the key component of the economic stimulus package implemented by the authorities to combat what is widely believed to be the most serious economic recession since the Great Depression. The case for a classical Keynesian-style policy response has never been stronger, especially when boosting private consumption in China in the short run proves to be very difficult. Any discussion of over-investment without taking this context into account is not particularly helpful, in our view.

    Second, the rapid investment growth is driven primarily by infrastructure investment rather than investment in manufacturing sectors that suffer from over-capacity. Infrastructure investment actually lagged other types of investment by a large margin in the past few years. Moreover, the investment projects mainly involve railways, intra-city subways, rural infrastructure, low-income housing and post-earthquake reconstruction, which are quite different from the infrastructure projects that were carried out in the context of the Asian Financial Crisis a decade ago. Both rounds of infrastructure investment boom helped to boost domestic demand in the face of negative external shocks in the short run. However, their medium-term implications are quite different: while investment in the immediate aftermath of the Asian Financial Crisis laid the foundation for a subsequent take-off in China’s manufacturing sector and hence exports, the current investment boom should facilitate urbanization and help to lay the groundwork for a potential consumption boom in the years to come, in our view.

    Third, much of the concern about over-investment is based on the notion that investment is derived demand (e.g., investment to build a factory that produces widgets) instead of final demand (e.g., consumer demand for the widgets). When final demand like private consumption or exports is weak, it will eventually translate into weak investment demand. However, the line between derived demand and final demand is blurred when it comes to such urbanization-related infrastructure investment as intra-city subways, rural infrastructure and low-income housing. For a rapidly growing, low-income country like China, these investments are of final demand nature, as faster and more convenient travel is as desirable now as more food and clothing, in our view.

    Bridges to Nowhere?

    But isn’t there over-capacity even in infrastructure in China? Is China not building ‘bridges to nowhere’, as it was argued that Japan did in the 1990s? Indeed, many overseas visitors who have been to China in recent years have been amazed by the high quality of infrastructure in the country, especially in comparison to that in other developing countries at similar levels of development. Some market observers compare the current capacity utilization of infrastructure projects in China (e.g., highways) with that of industrialized countries and come to the conclusion that there is massive infrastructure over-capacity in China.

    These concerns are not unwarranted, in our view. However, we see several reasons that caution against jumping to the conclusion that there is massive over-capacity in China’s infrastructure:

    • First, infrastructure is public or semi-public goods, whose value to the economy cannot be assessed simply on commercial criteria. Since the contribution of infrastructure projects to the economy is reflected in improved productivity and profitability in other parts of the economy, a more appropriate measurement in this regard should be the gains in aggregate productivity of the economy, i.e., the total factor productivity (TFP). In this regard, the consensus among academic studies on this subject is that the TFP growth in China was relatively high and a key contributing factor to strong GDP growth over the last decade.

    • Second, making a static comparison of the current capacity utilization of infrastructure projects in a low-income but rapidly growing economy like China with rich and slow-growing industrialized economies like the G3 is rather misleading, in our view. In particular, many years of under-investment in infrastructure has been widely recognized as a key challenge facing some of these economies.

    • In a similar vein, comparing the current investment boom in China to Japan’s experiences in the 1990s seems far-fetched, in our view. Japan’s GDP per capita reached US$35,000 and its urbanization ratio was nearly 80% in the 1990s, while China’s GDP per capita barely reached one-tenth of that in the 1990s and its urbanization ratio was only 45% in 2008. To wit, while some of the bridges to nowhere built in Japan in the 1990s may be unused or under-utilized today, any potential bridges to nowhere in China will most likely become bridges to somewhere in a few years, in our opinion.

    • Fourth, we argue that a more meaningful cross-country comparison in this regard should be about the capital-labor ratio in the economy. On this score, China’s capital-labor ratio is, not surprisingly, way below that in industrialized economies, suggesting much upside for investment expansion. A key question in this context is: if it were to take China much less time to reach the same capital-labor ratio as in industrialized economies because of China’s consistently higher investment growth, would this suggest over-investment? The answer is far from conclusive, in our view.

    The Bottom Line: Railways versus US Government Bonds

    A perhaps more relevant question at the current juncture is where the money would be spent were it not being used to finance the massive infrastructure investment program, or what is the opportunity cost of China’s fixed asset investment program?

    Given China’s high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Since China maintains tight controls over outbound capital flows, about 70% of China’s total offshore assets are in the form of official FX reserve assets as a result of investment made by a single-largest investor – the central bank. Moreover, we estimate that about 65-70% of China’s official FX reserves are invested in US dollar assets, the bulk of which are US government bonds.

    We therefore think that from the perspective of the economy as a whole, the opportunity cost of domestic fixed asset investment, or formation of physical assets onshore, should be the total returns on US government bonds. Put in simple terms, in the debate about over-investment at the current juncture, it actually boils down to an investment decision on building railways in China versus buying US government bonds, given China’s high national savings.

    In view of the negative consensus outlook for US government bonds, the opportunity cost of China’s massive infrastructure investment program could be quite low and may even be negative, if the potential renminbi appreciation against the US dollar is taken into account. Considering the opportunity cost, we think that infrastructure investment is a better method of deploying China’s savings, especially when the cyclical conditions also warrant a strong boost of domestic demand in a relatively short period.

    The debate on railways versus US government bonds is also relevant from another perspective. Despite the attention paid to the return of China’s official FX reserve assets, to be fair, the primary purpose of these assets is not for investment returns but to play the role of an insurance facility against potential domestic and external shocks to the macro economy. To date, China’s outsized FX reserves serve this purpose very well. However, since the current size of China’s FX reserves is arguably more than adequate for insurance purposes, we believe that more attention should be paid to the aspect of investment returns from FX reserves assets. While the short-term investment return from infrastructure projects like railways may be low, there is a large positive externality from these infrastructure projects. We liken this positive externality to the enormous benefits in terms of financial stability in general and low vulnerability to external shocks in particular, which are afforded by China’s holding of sizeable official FX reserves. In this context, infrastructure projects like the railways will likely not only deliver better investment returns, but also bring about a positive externality as the outsized official FX reserves do.

    When Over-Investment Warrants Real Concern…

    Rapid investment growth will become a real concern if investments are not made in infrastructure or related areas that lay the foundation for a potential future consumption boom. If investment is instead made to further expand the production capacity of China’s export industries, it will not help to boost China’s domestic final demand and will only contribute to perpetuating China’s external current account surplus, which, in turn, will result in more accumulation of China’s official FX reserves. While this type of investment helps counter-cyclical downturns in the short run as infrastructure investment does, it does not result in meaningful and better allocation of national savings. Moreover, the returns from this type of investment will likely be low due to over-capacity of production that is likely to be perpetuated by prolonged weak external demand. Furthermore, the social returns from such investment will likely be very limited.

    Another important concern relates to the financing of infrastructure fixed asset investment. Given its nature as a public good, the investment should be financed as much as possible by fiscal spending instead of private sources, including bank loans, in our view. This concern is more about transparency and accountability of financing rather than bank lending quality per se. Specifically, we are not particularly concerned about the quality of the loan that is used to finance these infrastructure projects, because the loans carry explicit or implicit guarantees by the central or local governments. Further, we are not concerned about the central or local governments’ ability to guarantee, because the governments’ balance sheets are strong – especially when the assets owned or controlled by the government (e.g., SoEs, land) are taken into account.

    Market Implications

    Besides the obvious benefits of boosting growth amid a serious economic downturn, quality infrastructure as a strong investment will benefit the rest of the economy. While the infrastructure projects themselves may or may not be very profitable businesses, especially in the short run, the positive externality they bring to the rest of the economy will be internalized by the private sectors in the form of improved productivity and profitability. For instance, a new subway system in a city may elevate the intrinsic value and thus the prices of real estate nearby, even if the subway system itself may not be profitable in the short run.

    Looking beyond the near term and to when cyclical conditions normalize, the need to maintain strong investment to counter the cyclical downturns should diminish. However, the persistence of high national savings would suggest that more aggressive promotion of outbound investment by Chinese savers through further capital account liberalization should be the next logical step. In this regard, we take note that the Chinese authorities recently announced a number of measures to facilitate outbound foreign direct investment by Chinese enterprises. Besides direct investment, further liberalization of outbound portfolio outflows through Qualified Domestic Institutional Investor (QDII) and Qualified Domestic Retail Investor (QDRI) programs may also be considered, in our view.

    Additional Thoughts: Two Pots, Three Lids

    Many market observers are uncomfortable with the aggressive fashion of boosting growth in China. Some argue that China should carry out profound structural reforms to boost domestic consumption to help rebalance the economy. However, the rebalancing in China will likely be a very slow process, in our view.

    China’s large current account surplus is symptomatic of its high national saving ratio. If one characterizes the over-borrowing situation in the US as ‘three pots, but only two lids’, an adjustment will be forced upon by the market and thus become inevitable. The over-saving situation in China can be characterized as ‘two pots and three lids’, which allows room for muddling through. In this sense, while the rebalancing in the US is market-driven, that in China will more likely be policy-driven, in our view.

    A policy-driven rebalancing will reflect policymakers’ preference. Gradualism, which has proven to be a successful reform approach, is the hallmark of Chinese policymaking. This time is no exception. Structural reforms that help to boost domestic consumption take time, while crises entail prompt and decisive policy response. Massive investment in infrastructure that can potentially help to boost domestic consumption in the years to come is the strategy chosen by the Chinese authorities. Whether this strategy is a first-best solution from the perspective of a rigorous economics framework is debatable. However, we think that this strategy is not a bad one on the margin and therefore caution against undue concerns. First, it helps to deliver quick results in terms of boosting growth amid a serious crisis. Second, it is a better way of deploying China’s large savings than the status quo (e.g., the railways versus US government bonds).

    More generally, since there is much structural rigidity, or distortion, in the Chinese economy, macroeconomic management does not necessarily require the same type of surgical precision as in mature industrialized economies. China’s economic success since the early 1980s suggests that as long as the Chinese economy keeps showing marginal improvement by gradually removing distortions, the resultant efficiency gains will help to sustain reasonably strong growth. The current rapid investment growth, led by infrastructure projects that could help to boost future domestic consumption, is yet another example of this. While Chinese economic policy strategy has never satisfied every pundit, investors around the globe are generally happy with what the Chinese economy has delivered. Looking ahead, we expect this trend to continue.

    A key question remains: when will ‘two pots, three lids’ turn into ‘three pots, two lids’? We plan to devote a report to discussing China’s high national savings in the near future. Stay tuned.

    Reply →
23. PMJ August 1, 2009 at 00:55

    

    ha ha armando, your morgan stanley article would have carried a lot more weight if steve roach, their boss at morgan stanley, hadn’t said almost the opposite in the financial times earlier this week. and is it really true that “What Pettis want is that China keep lending money to the USA to finance USA deficit.” i though he was actually arguing almost the opposite. he does say that nothing seems to confuse people more than the workings of the balance of payments, so maybe he has just been proved right.

    Reply →
24. Michael Pettis August 1, 2009 at 06:30

    

    One of my former Beida students now in banking just sent me the following message:

    Just read an very interesting piece of news on People’s Daily. The article stated with a very optimistic tone that although China’s export keeps shrinking, but in the first 5 months of 2009, China’s shares of imports of US, Japan and Europe have increased by 4.1%, 3.6%, 3%. I think this set of figures confirmed with your previous expects and obviously also reinforced your concerns over trade war. Can’t wait to see your new blog posts on global imbalance.

    Reply →
25. Houhui August 1, 2009 at 06:54

    

    “What Pettis want is that China keep lending money to the USA to finance USA deficit.”

    Haha. Brilliant. Even better than Ross himself. Is there a school of debate which actually teaches this stuff?

    Reply →
26. Houhui August 2, 2009 at 05:57

    

    Jeff

    I saw this Lize thing and was a bit shocked too. Everyone has just finished moving into “Financial Street” in west Beijing, and now they want ANOTHER CBD financial area.

    I think Beijing does have some political linked advantages over shanghai – all major banks have to HQ here to be closer to the govt. (members of which normally run the banks).

    On the other hand, I really don’t see the need for another such district in Beijing…

    Reply →
27. Armando August 2, 2009 at 08:57

    

    Which banking system is bankrupt and which one is not, is not that obvious to most of your people?
    For some people China has not done any thing right but I let result speak for itself.
    Wait a year or two and we will see if China economy is in problem or not and we can compare China economy with the American one!
    The way I see, the USA will need to raise interest rate in the near future to fight inflation and that would worsen more the residential and commercial real state situation in the USA!

    Reply →
28. Armando August 2, 2009 at 09:06

    

    Houhui | 1/08/09

    “What Pettis want is that China keep lending money to the USA to finance USA deficit.”

    Haha. Brilliant. Even better than Ross himself. Is there a school of debate which actually teaches this stuff?

    Here is the answer to your question that Pettis want China to keep lending to the USA so the USA can keep borrowing!

    http://mpettis.com/2009/07/more-public-worrying-about-the-chinese-stimulus/#comments

    Michael Pettis | 25/07/09

    Biil J, as I have said many, many, many times, the idea that China must choose between a policy that leads to trouble and a policy that leads to happiness is a myth. China must choose between bad and worse, and the trade off, I suspect, is between a short term rise in unemployment or a long term slowdown in growth.

    I supect they will choose the latter, and there may be good reasons concerning social stability for doing so, but it is not necessarily the least costly choice in economic terms. In fact if Chinese fiscal and monetary policies are not coordinated with those of the US, with an explicit commitment by the US to keep borrowing to slow down its demand contraction, or if there is a collapse in trade, the latter might not only be more constly in the long term, but it might also be more socially disruptive.

    I plan to discuss this more fully in my next entry, on what I hope (but doubt) will come out of the SED.

    Reply →
29. John Ross August 2, 2009 at 13:19

    

    Michael Pettis is exactly right on one key point. We are discussing testable propositions on China’s economy. That is, the factual development of the situation will show who is right – which is precisely as it should be. The Wolf/Pettis thesis of China’s oversaving/overinvestment’ is simply wrong, not ‘evil’. However while Martin Wolf and Professor Pettis both put forward the same overall ‘overinvestment/oversaving’ thesis on China their mistakes are somewhat different. As the issue of China’s stimulus package is of great importance to the world economy it is worth dealing with these issues in detail. Richard above has quoted in full by a post of mine which was on the Financial Times site but readers should obviously find Michael Pettis’ articleto which it refers in full to get both sides.
    Professor Pettis, first, continues to make an error in economic accounting. Second, related to this, he is factually wrong as regards what is occurring in both the US and Chinese economies. The issues will be considered in that order.
    As regards economic accounting Michael Pettis continues to confuse (implicitly and sometimes explicitly) ‘demand’ with ‘consumption’ – which leads to wrong analysis and therefore prediction. Demand is necessarily equal to the sum of consumption and investment: it is not equal to consumption alone. Michael Pettis’ errors resulting from failing to maintain clarity on this distinction will be considered first for his arguments concerning the US and then for those regarding China. Precisely in order to move the discussion along detailed use will be made of the second quarter GDP figures published on 31 July which further clarify the real trends in the US economy.
    Michael Pettis argues that US debt levels will decline and: ‘as a result American consumption will grow substantially slower than the US economy, and so the trade deficit will decline.’
    The two halves of this sentence do not follow from each other from the point of view of economics (therefore the word ‘so’ is not valid). Nor, as will be seen, are they correct as a factual description of the situation.
    The US balance of payments is identical, by the fundamental balance of payments accounting identity, to the difference between US investment and US savings. If US consumption grows more slowly than the US economy then this may mean US savings are rising, but it does not at all follow from this that the US balance of payments deficit therefore declines. If US investment were to rise more than savings then consumption could fall as a percentage of GDP while simultaneously the US balance of payments deficit would increase – it would mean that investment was increasing as a proportion of US GDP more rapidly than consumption was falling as a percentage of US GDP.
    It might (contingently) turn out to be the case that US consumption grows more slowly than US GDP and the US balance of payments deficit shrinks, which is the case Michael Pettis argues – which would mean that US investment was not falling as a percentage of GDP as rapidly as consumption was declining as a percentage of GDP (i.e. saving was rising compared to investment). But there is no necessity from the fact that consumption shrinks as a proportion of GDP, and savings rise, that the balance of payments deficit will fall – it depends on what happens to investment.
    Equally, to take the exact opposite trend to the case Michael Pettis argues, the US balance of payments deficit could fall without US consumption declining as a percentage of GDP – it would mean that investment was falling more rapidly than savings. The latter is in fact what has been occurring in the US – as will be seen.
    But in any case there is no necessity in Michael Pettis’s argument. He confuses US domestic demand (the sum of investment and consumption) with domestic consumption. It does follow that if US demand grows more slowly than US GDP then the balance of payments deficit declines, but it does not follow that if US consumption grows less rapidly than GDP therefore the US balance of payments deficit must decline.
    Before going on to discuss what is actually factually happening let us first consider the parallel error Michael Pettis makes in the case of China. Here the mistake made between consumption and demand is still clearer. Michael Pettis argues ‘the decline in the US trade deficit must result in a decline in China’s ability to export the difference between its growth in production and consumption.’ But China does not export the difference between production and consumption – unless a weird, and self-evidently false, claim were to be made that China does not produce anything for investment. China (net) exports the difference between China’s domestic demand (that is consumption plus investment) and its domestic production.
    As China’s balance of payments surplus is equal to its excess of savings over domestic investment it follows that for China’s balance of payments surplus to shrink it is not necessary for its domestic consumption to rise as a percentage of GDP. Making, for the moment, the simplifying assumption that China’s savings rate stays the same then, if China’s investment rose as a percentage of GDP its balance of payments surplus would fall while consumption remained exactly the same as a percentage of GDP – it simply would mean that Chinese savings were being redistributed so that they were used inside China rather than abroad. A fall in China’s balance of payments surplus is therefore compatible with its consumption rising, falling or staying the same as a percentage of GDP – all that it depends on is the balance between savings and investment.
    Now turn to what is actually factually happening. The US statistics below are derived from the second quarter GDP figures published on 31 July.
    As is by now well known the US balance of payments is shrinking fast – one of the famous ‘global imbalances’ is declining. While full US balance of payments statistics for the second quarter of 2009 are not yet available the figures for trade, which dominate the balance of payments trends, are available and leave no doubt as to the rapid fall in the US deficit. The US balance on trade in goods fell between the second quarter of 2008, the last quarter before the open financial crisis commenced with the collapse of Lehman’s, and the second quarter of 2009 from 6.2% of GDP to 3.5% of GDP. The total trade balance for goods and services fell from 5.2% of GDP to 2.5% of GDP – in annualised terms the deficit on goods and services fell from $739 billion to $348 billion.
    But this decline in the US trade deficit is not because, as in Professor Pettis’s analysis, US consumption is growing less rapidly than US GDP. On the contrary US consumption has been growing more rapidly than GDP – i.e. the proportion of the US economy devoted to consumption has been rising.
    Over the period since the onset of financial crisis after the second quarter of 2008 US consumption (the sum of personal consumption and government consumption) rose from 90.2% of GDP to 91.3% of GDP. (Household consumption rose by 0.3% of GDP – from 70.3% of GDP to 70.6% of GDP, and government consumption rose by 0.9% of GDP – from 19.8% of GDP to 20.7%).
    Although US consumption has risen, not fallen, as a percentage of GDP the trade deficit has been declining because US investment has been falling even more rapidly than US GDP. Taking the same periods as above total US investment fell from 14.9% of GDP to 11.2% of GDP with fixed investment falling from 15.5% of GDP to 12.3% of GDP and inventories falling from minus 0.3% of GDP to minus 1.1% of GDP. Total investment therefore fell by 3.7% of GDP, and fixed investment by 3.2% of GDP. It is therefore the fall in investment as a percentage of US GDP, not a fall in the proportion of the economy devoted to consumption, that explains the shrinking of the US balance of payments deficit.
    These changes are sufficiently large that they clearly indicate what has been happening to US saving – even although the new GDP data do not yet give official figures for total saving. US saving has clearly been falling. If investment has fallen by 3.7% of US GDP, but the balance of trade has only improved by 2.7% of GDP, then (unless some wholly improbable shift has taken place in other components of the US balance of payments) this necessarily means that total US savings have declined – if US savings had remained even static, and other components of the US balance of payments had remained constant, then a 3.7% of GDP fall in investment would have translated into a 3.7% improvement in the trade balance.
    The reason some media commentators claim US saving is rising when it is actually falling is because they confuse household saving (which has indeed risen from 2.6% of GDP to 4.0% of GDP) with total saving (the sum of household, company and government saving). The rise in US personal saving is being more than offset by the decline in company and government saving and therefore total US saving has fallen – hardly surprising given the scale of the budget deficit.
    The US balance of payments deficit has therefore shrunk because US investment has fallen even more rapidly than US saving – not because US consumption has fallen as a percentage of US GDP. Far from it being the case that US consumption is shrinking as a percentage of GDP and therefore the trade deficit is declining, the case argued by Michael Pettis, consumption has been rising as a percentage of US GDP while simultaneously the trade deficit has been shrinking.
    If we now turn to China while slightly less precise detail can be given, as Chinese statistics are not as comprehensive as those for the US, nevertheless the shifts are so large it is perfectly possible to work out what is occurring.
    First China’s investment is rising as a percentage of GDP. The components of the 7.1% rise in GDP in the first half of 2009 were 6.2% rise in investment, 3.8% rise in consumption, and a minus 2.9% fall in net exports. Unless China’s savings were rising equivalently this rise in investment necessarily means that China’s balance of payments surplus must fall.
    While savings figures are not available for China at present there is good reason to believe they have certainly not risen to match China’s rise in investment and may well have declined. The reasons for this are that China’s budget is projected to move into a 3% of GDP deficit, profitability of export and other industries is under pressure from the international financial crisis, and given a 15% rise in retail sales there is no reason to believe household saving has risen significantly (if at all).
    As China’s savings are almost certainly not rising as rapidly as its investment, and may well be static or slightly falling, if follows that the balance of payments surplus must shrink. But it is not shrinking because consumption is rising as a proportion of GDP, as on the Michael Pettis analysis, but because investment is rising as a proportion of GDP.
    So far, therefore, the imbalances in the world economy – decline in the US balance of payment surplus and a drop in China’s balance of payments surplus – are indeed occurring. But they are not at all developing for the reasons that Martin Wolf and Michael Pettis suggest – that is rising saving in the US and rising consumption in China. They are falling as both savings and investment are falling in the US, but investment is falling even more rapidly than savings, and because investment, not consumption, is rising in China. Their model, in short, is wrong theoretically and factually.
    Now let us turn to the two direct challenges/arguments Michael Pettis’ makes to myself.
    The first is: ‘if investment doesn’t rise, savings don’t drop, and the trade deficit nevertheless declines then GDP must grow more slowly than consumption, which he says will not happen.’
    I am sorry but such a development is an economic non-sequiter, as it is internally inconsistent – i.e. it is arithmetically impossible for all three things to happen simultaneously. As China’s balance of payments is equal to the difference between its investment and its savings then if, ‘investment doesn’t rise, savings don’t drop’ the balance of payments must necessarily stay exactly as it is. Unless some extremely extraordinary claim is being made regarding the movement of non-trade parts of GDP (which are not being made and in any case would be too small to affect the situation) then stating that savings stay the same, and investment stays the same, but the trade deficit should fall is the equivalent of demanding that 2 plus 2 equal 3. The fact that something is being proposed as a scenario which is literally impossible shows that the mix up of demand and consumption has landed the Martin Wolf/Michael Pettis argument in a confused place.
    Michael Pettis second challenge is that he says China’s consumption will rise as a percentage of GDP. The answer to that is ‘yes, of course this is possible theoretically’ – although at present the opposite is happening. But if China’s investment were to rise as a percentage of GDP it could not be for the reasons outlined by Professor Pettis because, as noted, these are: (i) wrong at present factually as regards what is taking placed both in the US and China; (ii) wrong from the point of view of economics.
    As stated at the beginning, while Martin Wolf and Michael Pettis have the same overall ‘oversaving/oversaving’ analysis of China the errors of their analyses are not the same. Martin Wolf, strangely, does not refer to the numerous studies of the relation between China’s investment and growth made by the top international experts in econometrics – such as Dale Jorgenson, Alwyn Young, Khuong Vu etc. In his entire book length study Fixing Global Finance, a large part of which is devoted to China, these do not appear in the references, the index or the text. Martin Wolf may later clarify if this is because he hasn’t read them (which would be strange when such an important topic is being written about), because he has consciously decided to ignore their findings (in which case, as these are some of the world’s top experts in the field of economic statistics it would seem he should be explaining his justifications for doing so) or some other reason. But what is clear is that, when there is a huge literature on the subject, and when Martin Wolf doesn’t confront it at all, his assertions views cannot be treated as valid. These issues, however, would require a further discussion and are not those which Michael Pettis deals with.
    But although they make different errors the outcome of the mistakes by Martin Wolf and Michael Pettis have the same consequences. Because their analysis is wrong they are led to the wrong practical conclusion that China’s stimulus package will fail. The correct analysis of China’s economic fundamentals, some of which are dealt with above, on the contrary shows why this stimulus package is being successful.
    Given the great importance of the issue both for China and for the world economy it is well worth spending time on. And, yes, the factual unfolding of the situation will make it clear which analysis is correct.

    Reply →
30. alan August 2, 2009 at 21:08

    

    Here is an exchnage that appeared in Brad Setzer’s blog:

    Twofish:
    I need to put this on a sign, since this is the fiftieth time I’ve said this:
    Yd = C + I + G + (X-M)

    CONSUMPTION IS NOT DEMAND.

    China can deal with a drop in exports by increasing investment or government spending.

    Pettis: But rapidly rising bank lending, especially if misallocated to nearly the same extent as in previous loan surges, cannot be a long-term solution for slowing Chinese growth.

    First of all, economists seem to be so concerned about “long term solutions” that they ignore the short term. If you are following from the sky into a wilderness, then pulling on the parachute is not a “long term solution” to your problems, but you got to do it because if you don’t get past the short term then the long term does not matter.

    Second, I don’t think that previous loan surges were grossly misallocated. The banks did end up with huge non-performing loans in the early 1990’s, but these were because they were ordered by the government to provide social welfare spending to state owned enterprises, and given that was a crucial part of winding down the SOE’s, I hardly think that it was a misallocation or a mistake.

    Similarly the burst of infrastructure spending around 2001-2002 led to things that for the most part increased economic growth. Again, it’s going to take a lot of convincing to argue that Chinese bank lending in that period was misallocated. The notion of Chinese banks as grossly misallocating capital is a common one, but it’s something that people have just got to defend now, because it doesn’t seem to be to be true at all.

    Also, the infrastructure spending this time for the most part seems to directed at useful things. Railways. A lot of the stimulus was also directed to increase consumer spending. The government fired up the helicopters and dropped appliances purchase certificates that let consumers buy refrigerators.

    Part of the issue here is that personally I think that the Chinese economy basically works. Sure there are a dozen things that can be done to improve it, but it’s basically a functional economy.

    AK:
    2fish, I read the full article and one of his posts and I think you may be getting too caught up in a static economic model.

    Yd = C + I + G + (X-M) is simply an accounting expression of economic components at a point in time, but changes in any of these things will cause the model to evolve, and the point of I is to generate production which must be consumed in the future.

    In the medium term whether an increase in “I” can cause Yd growth sustainably to exceed consumption growth is very doubtful. If “I” is to have any meaning (for example unwilling increases in “I”, also called inventory build-up, can in theory go on for a long time, as they did in Japan, but this is not a meaningful measure of wealth creation) it must lead to increases in production that are matched by increases in consumption, or else we are right back to rising inventory.

    There is also the problem of sustainability that Pettis keeps referring to. You may be confident that the fiscal and credit boom will not lead to misallocated capital, but this suggests that Chinese banks have radically changed their approach to lending and Chinese authorities have forsworn the types of “investment” to which they were so prone until recently. In China there is almost no one in the banking industry that would agree with you, except maybe in front of a reporter.

    Most estimates of the last lending boom suggested 30-40% of the loans went bad. Not only is the current lending boom far in excess of the last, but as Victor Shih said in the WSJ last week, last time around Zhu Rongji was cracking the whip and slamming bad projects – and there is no equivalent today. Maybe you are right. Perhaps Chinese bankers have found religion, but the circumstantial evidence isn’t there.

    Pettis also claims Chinese debt levels are higher than we think. I have no idea if he is right and often think that Pettis tends to get overly fussy about balance sheets, but I think he is right to argue that to have achieved nominal GDP growth of 3-4% in H1 with an expansion of loans equal to 25% of GDP and central and provincial government deficits of around 4-6% (the data is, as always, fuzzy) does not necessarily indicate money well spent. And last week the NBS said investment accounted for 88% of GDP growth, which is a number that I don’t ever recall having seen in history. This means that the ability of the government to push “I” for much more than a year or two is limited, and then we get right back to the problem of consumption growth limiting GDP growth.

    I think if you accept his argument as a medium-term argument, not a point-in-time argument, it might make more sense.

    Reply →
31. PMJ August 2, 2009 at 21:11

    

    Armando, that’s too easy. The Chinese banking system is held up because of implicit and explicit guarantees by the government. Japan’s banking sysytem was too, until after 1990, when everyone had to admit the fact of its bankruptcy.

    Reply →
32. Michael Pettis August 2, 2009 at 21:29

    

    Armando, relax. A discussion of the risks of China’s fiscal stimulus is not an attack on China. As for your saying that I just want China to keep lending to the UIS, I suspect you haven’t really read more than a few lines of my posts or the issue has thoroughly confused you. My arguments here, which are almost the opposite of what you say, have always been very specific.

    1. China has no choice but to lend to the US as long as it expects to run a trade surplus with the US. This is true of every country. China cannot “decide” whether or not to do so in any meaningful way without either causing the trade deficit to shift elsewhere (e.g. to Europe, which would not accept it), or forcing a sharp contraction in its exports.
    2. If the US wants China to lend a lot more money, all it has to do is force a significant increase in the US trade deficit. Since this would not be in the US interest, it turns out that the less China lends to the US, the better For the US (now do you see why I say my position is almost the opposite of what you claim?).

    The selection you quoted argues something very different from what you think. It says that although it may be in the best narrow interest of the US to cut down its borrowing, and so contract its trade deficit more quickly, the impact on China would be very difficult, in which case the more the US slowed down its adjustment, the better for the world.

    Reply →
33. Michael Pettis August 2, 2009 at 21:46

    

    Ross, like AK says above, you are confusing a static model with a model that evolves over time. Over the medium or long term a rise in investment that does not result in a rise in consumption becomes either wasted investment directly, or wasted investment indirectly through inventory build-up. The economic point of investment is to increase production, and although the “demand” for what is produced can feed investment at a point in time, over the longer period it must be consumed. China cannot run a successful decade on inventory build-up. Either foreigners consume the excess through the trade surplus, or Chinese do through rising domestic consumption.

    Your point about a rising savings rate in the US not necessarily leading to a declining trade deficit is technically correct, but only because OpEd pieces are required to be short. In my original draft I included a brief discussion, which I had to remove, presumably because it was too obvious to need saying, that investment in the US is declining, not rising. The US government is attempting to reverse this decline by its own fiscal spending, but very few people, including me, expect investment in the US to rise faster than savings over the next few years. It would be great if it did, but I suspect you are only insisting it must in order to score points. Weirdly enough, you then argue later that investment is falling in the US in order, once again, to score points. This is tedious at best.

    This has become a pretty pointless debate because it isn’t progressing at all. We will see what happens next. I argue that over the next five years Chinese consumption growth will outpace Chinese GDP growth, and that this can occur either through a much more rapid increase in consumption (the good way) or through a slowdown in GDP growth (the bad way). You argue that Chinese savings will rise and Chinese consumption will decline. Fair enough. Let’s see.

    Reply →
34. greg August 2, 2009 at 22:08

    

    you gotta hand it to john ross. he is really determined to get on the map one way or the other. but I still don’t know what he believes except that he really resents wolf and pettis. i think if he wants to be famous it would be better if he could analyze and explain his views concisely. attacking wolf and pettis can only take him so far, and I don’t know about the rest of you but I am already bored.

    also why do so many people assume that either you praise all chinese government policies uncritically or else you hate china? i know that this is the official government line, but aren’t the people who read this blog smarter than that?

    Reply →
35. Vinnie the P August 2, 2009 at 22:29

    

    I wouldn’t read too much into these steel dumping disputes. The global steel industry is deeply screwed up, and all the major steel producing countries have played this anti-dumping game at one time or another (not too long ago China was pursuing anti-dumpling claims against Korea and Japan–and who’s the most active claimant in anti-dumping cases? India.) If you study up on the Chinese steel industry you’ll find that Beijing has been working overtime to try to straighten it out (check the average price of steel in China vs. global average, just for instance.)

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36. Michael Pettis August 3, 2009 at 00:38

    

    By the way Ross says:

    “Michael Pettis argues that US debt levels will decline and: ‘as a result American consumption will grow substantially slower than the US economy, and so the trade deficit will decline.’ The two halves of this sentence do not follow from each other from the point of view of economics (therefore the word ‘so’ is not valid).”

    Yes they do follow. I recognize this analysis isn’t part of standard economics modeling (not that this worries me), but the idea that growth in consumption is equal to growth in GDP plus or minus the change in debt comes from Steve Keen, an Australian economist and someone who I have been reading a lot of lately. He is a ferocious critic of the traditional static-model school of economics (his most famous book is Debunking Economics), but as a hard-core Minskyite he has a balance-sheet orientation towards growth – something very poorly understood by most economists – and it is perhaps not surprising that I find myself in sympathy with much of what he says. Rather than explain the relation between growth, consumption and debt, I recommend that you read his blog, which does a much better job than I could.

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37. Paul August 3, 2009 at 00:42

    

    I agree with CNM Zhige. It seems rather imprecise to analyze an age of transnational production solely in terms of individual nations (GDP). Anybody know of a good analysis of American and/or Chinese trade from a broader perspective (eg, GNP)? Thanks!

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38. TR August 3, 2009 at 01:30

    

    I have been reading Steve Keen too. I agree with you. He is very unorthodox and very smart.

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39. Houhui August 3, 2009 at 11:17

    

    Greg,

    He would probably do a bit better if he argued in a consistent way too.

    As to your second point, I would say that the education system here often discourages open debate and criticism (at least at a pre-university level – and mostly so even after that), and so people can react quite angrily / defensively when faced with any criticism – no matter how it is presented or how constructive it is. The same problem occurs with the media, here the vast majority of the media is positive, so when people look at foreign media (normally of course only looking for stories about China) and see so much negative news ( criticism which they normally fail to realise is aimed in all directions, not just at China), they can become quite angry at “western media” (whatever that is).

    At least this blog is not attracting the “1 yuan” (or is it “5 mao”) bloggers yet, then things really get tedious.

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40. simon August 3, 2009 at 19:33

    

    Hi Michael,

    I am just wondering if there is perhaps a motive behind the excess commodities hoarding of not only speculative reasons but also to in the short term mask the trade imbalances between China and the rest of the world.

    By substantially lowering their supposed trade surplus i guess that in a way will also help to dampen the trade disputes for now? Although if this is in fact a tactic i wonder how they are going to mask future trade balances since i am assuming there is not much more room in hoarding the commodities.

    Reply →

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