A lot of people have asked me to write about the recently “leaked” CBRC report on dodgy local government debt. Here is what the article in Monday’s Bloomberg had to say about it (and note especially that delicious second paragraph):
Mainland banks may struggle to recoup about 23 per cent of the 7.7 trillion yuan (HK$8.81 trillion) they have loaned to finance local government infrastructure projects, according to a person with knowledge of data collected by the nation’s regulator.
About half of all loans need to be serviced by secondary sources including guarantors because the ventures cannot generate sufficient revenue, said the person, who declined to be identified as the information is confidential. The China Banking Regulatory Commission has told banks to write off non-performing project loans by the end of this year, the person said.
Commission chairman Liu Mingkang said last week that borrowing by the local government financing vehicles may threaten the banking industry. The mainland’s five largest banks, including Agricultural Bank of China, plan to raise as much as US$53.5 billion to replenish capital after the sector extended a record US$1.4 trillion in credit last year.
Many analysts seemed to have been surprised by the report, and over the past few days we’ve seen a veritable flurry of “half-full’ interpretations of the numbers, but I would suggest, based on my pretty extensive experience in emerging markets, that we should assume the real problem is worse than the initial evaluation. It almost always is.
Not everyone agrees. In an article in today’s People’s Daily, the CBRC was at pains to play down the risks:
The China Banking Regulatory Commission (CBRC) said on Tuesday that nearly one-fifth of the bank loans disbursed to local governments are questionable, but will not cause any systemic risks to the banking sector.
….”These questionable loans won’t necessarily turn sour, as most of them have eligible collateral or a secondary source of repayment,” a CBRC spokeswoman told China Daily on Tuesday.
Maybe. I agree that these loans won’t pose a risk to the banking system, but that doesn’t mean that there won’t be huge losses. It just means that the losses will be covered by the household sector. For years I have been arguing that without liberalizing interest rates and pushing through governance reform, there won’t be meaningful reform in the domestic financial system. It isn’t even conceivable to me that a combination of rapid credit growth, socialized credit risk, severely repressed interest rates, and serious lack of transparency could ever have led to anything other than large-scale capital misallocation and rising debts.
So of course there are problems in the banking system, and of course there is a lot of debt piling up in all sorts of unexpected places, and of course bit-by-bit we will get more information, like this leaked CBRC report. Victor Shih’s report earlier this year on hidden local government financing was another supposed “shocker”, and at first widely dismissed, until little by little his very ugly numbers were confirmed (and he thinks his numbers are probably understated).
There’ll be more
I am sure this will not be the last scary report to come out in the coming years. Yesterday, for example, Reuters had this to say:
Shanghai banks are facing rising default risks on loans to real estate developers after the central government took steps to cool the sector, a senior banking official said in remarks published on Tuesday. Yan Qingmin, head of the China Banking Regulatory Commission’s (CBRC) Shanghai bureau, said more property loans were categorised as “special mention” in the second quarter, indicating developers’ weakening capacity to repay the loans.
And there’ll be still more, but rather than dive into what the latest releases might mean to bank capital and bank risk, I wanted to discuss a related topic that is especially relevant in the context of burgeoning of government and bank debt: local interest rates. Is China going to raise interest rates this year?
The ADB seems to think so. According to an article last week in Bloomberg:
Chinese policy makers may raise interest rates this year to cool price pressures, an economist at the Asian Development Bank said, even as slower growth compels analysts to dismiss higher borrowing costs in 2010.
“I don’t rule out the possibility that China may raise rates this year,” Srinivasa Madhur, senior director of the ADB’s Office of Regional Economic Integration, which compiles the lenders’ economic forecasts, said in an interview in Tokyo today. “China needs to speed up monetary normalization, preferably by a combination of currency appreciation and interest-rate adjustment.”
The very smart Andy Xie has been calling almost desperately for China to raise rates to head off deeper trouble. He argues that loose monetary and credit policy is driving wasteful investment, especially in the real estate sector.
But if he believes rates are indeed going to rise this year, I think he is in the minority. Most other economists seem to think China will not raise rates. Their reasoning has to do, for the most part, with inflation expectations. Those who think inflation is heading up – the minority – believe Beijing will be forced to raise interest rates in order to rein in price rises, whereas those who think inflation has peaked – probably the majority – believe that Beijing will not raise interest rates.
I used to be more of an inflation hawk, but as I explain in a June 15 entry, I now suspect that there is a mechanism in place that automatically limits the inflationary impact of rapid monetary expansion. But whether or not I am right, I wonder anyway if the relationship in China between inflation and interest rates is not a lot more complex than the arguments about the interest-rate response to inflation imply.
In the US, raising interest rates may be a reasonably effective way to head off inflation because it is likely to reduce aggregate demand faster than it reduces supply. I would argue that there are three main ways it would do this.
Will higher rates stop inflation?
First, interest rates hikes are associated with declining real estate and stock markets, and through the wealth effect a rate hike would reduce US consumption by making Americans feel poorer. Second, a rate hike makes consumer financing more expensive and so reduces the desire to borrow for consumption. Finally, a rate hike reduces corporate borrowing for investment purposes, and so also reduces aggregate demand in the short term, even if it reduces aggregate supply over a longer term.
None of these mechanisms work to nearly the same extent in China, and in fact one of them is likely to have the opposite effect. Starting from the last, the aggregate amount of corporate borrowing from banks in China has little to do with interest rates and nearly everything to do with the loan quota. Since credit for most borrowers is largely socialized, interest rates have little bearing on the decision to borrow and invest.
Second, unlike in the US there is very little consumer financing in China – so raising its cost will have a negligible effect on total consumption. Finally and most importantly, as I have argued in my April 20 blog entry, the wealth effect of an increase in interest rates in China is the opposite of what it is in the US. Raising interest rates will actually increase household wealth, and so increase consumption, not reduce it, although this growth in consumption is likely to happen slowly.
So although I agree with most observers that if inflation should surge, the PBoC is more likely to raise the lending and deposit rates, I wonder if this is likely to be an effective instrument for heading off inflation. As I understand the Chinese growth model, slow wage growth (relative to productivity growth), an undervalued currency, and low interest raters have been mechanisms for repressing consumption growth by slowing the growth in household income relative to GDP. Reversing any of these, which is necessary to achieve rebalancing, will allow both household income and household consumption to grow more quickly.
But while it is one thing to wonder whether the PBoC should raise lending and deposit rates, it is another thing altogether to wonder whether the PBoC actually can raise them, at least enough to matter. I am not sure they have much room to raise rates even if they wanted to.
One of the problems with a severely repressed financial system, especially one with rapid credit expansion, is that there tends to be a huge amount of capital misallocation supported by borrowing, and in an increasing number of cases it is only the artificially-reduced borrowing costs that allow these investments to remain viable. I worry that even if the PBoC wanted to raise rates, it would not be able to do so without exposing how dependent borrowers are on artificially cheap capital.
Take the most obvious example, the PBoC itself. The central bank officially has about $2.5 trillion in reserves. This by the way almost certainly understates its true position but let’s ignore that for a moment. The PBoC has funded this position with an equivalent amount of RMB liabilities, which makes it very vulnerable to changes in the value of the currency.
Rate addiction
In fact there were strong rumors last year that the PBoC was technically insolvent as a consequence of the 20% increase in the value of the RMB against the dollar during the 2005-08 period of currency appreciation. Weirdly enough, although the numbers are huge, it has proven difficult to convince anyone that the PBoC is not the richest institution in the world, and that it is actually very vulnerable to big losses (although I notice that Sovereign Trends’ Terrence Keeley, in an OpEd in the Financial Times Tuesday, seems also to have done the numbers).
The problem for the PBoC occurs not just because of the currency mismatch but also because it needs repressed funding costs to keep it profitable. How much do the PBoC foreign currency assets earn? I would guess probably between 3% and 4%, maybe less. The RMB funding cost, on the other hand, is roughly between 1.5% and 2.5%. This leaves the PBoC with a net positive carry of between 1% and 2%.
If the RMB appreciates by as little as 2% a year, in other words, the PBoC runs a negative carry on its assets. Every further 1% increase in interest rates, or additional 1% rise in the value of the RMB, then, erodes its capital by at least $25 billion (annually, if it happens through an increase in interest rates).
Let’s assume, for example, that over the next two years we see a combined appreciation and interest rate increase of 10% (let’s say a 2% increase in interest rates and a 4% annual appreciation), which is, in my opinion, the absolute minimum that China must do to slow down the worsening domestic imbalances. Assuming no change in the rate earned on reserve assets, which in fact may decline, this means that the PBoC’s net indebtedness would rise by over $250 billion, or roughly 5% of the country’s GDP.
These kinds of number quickly add up. And of course it is not just the PBoC that has this addiction to repressed interest rates. Many years of very low cost borrowing has created a huge dependency on low interest rates among SOEs, local governments, and other creditors of the bond markets and the banks (not to mention the banks themselves), all of whom are directly or indirectly funded by long-suffering households.
As I discussed in an entry several weeks ago, repressing the interest rate is the equivalent of granting hidden debt forgiveness. It is probably a safe assumption that an awful lot of borrowers depend heavily on this hidden debt forgiveness to remain solvent, and would be unable to repay if rates rose to anywhere near a reasonable level (at least 400-500 basis points, I would guess, if we wanted to eliminate the overinvestment and repressed consumption consequences of financial repression).
In that case any attempt to raise interest rates to levels high enough to reduce China’s investment misallocation and to allow households to raise their consumption levels would come, in the short term, with a massive rise in bankruptcies and in government debt levels. If nothing else the PBoC is probably under huge pressure from local governments not to raise rates.
The cocaine of cheap money
All this might sound like I am effectively recommending that the PBoC continue to repress interest rates, but of course repressed interest rates are what caused the problem in the first place. To continue to do so simply makes the underlying problem worse, by piling on even more non-viable debt. Rather than suggest that the PBoC must keep rates low, what I am really arguing, I guess, is that this is a very difficult trap from which to escape.
What can the authorities do? If Beijing raises interest rates quickly, debt and bankruptcy will surge and growth will collapse – although the eventual rebalancing of the economy might happen much more quickly.
If they don’t raise interest rates, they can keep growth high for a while longer, but the amount of reserves and misallocated capital will continue rising, making the eventual cost of raising interest rates even higher. The risk is a Japanese-style stalemate in which for many years the authorities are forced to keep rates too low because they simply cannot countenance the alternative, and during this time consumption growth continues to struggle.
Finally, if they raise interest rates slowly, they will slow growth while still suffering many more years of worsening imbalances, until rates are finally high enough to begin reversing the imbalances. But for this strategy to work, they would need a very, very accommodative external sector – China’s domestic imbalances require high trade surpluses until they are finally reversed.
So there’s the dilemma: they’re damned if they do and damned if they don’t. So far the authorities do not seem to be seriously considering raising interest rates, and my guess is that if the US successfully pressures them to revalue the currency, they will be even less likely to do so.
In fact they may do what they did the last time the currency revalued – engineer a reduction of real interest rates and a rapid expansion of credit. This will counteract the contractionary effect of revaluing the currency – competitiveness lost because of a higher currency will be counterbalanced by competitiveness gained by lower costs of capital.
This of course will also put more upward pressure on the trade surplus, allowing China to continue to use the external sector to absorb excess capacity. Of course it will also sharply increase the asset misallocation problem – as Japan demonstrated after 1985 when, in response to the appreciating yen, they reduced interest rates and expanded credit.
So interest rate policy has to choose between rising bankruptcies or rising misallocation of capital. Even ignoring political pressures, this isn’t an easy choice. And it will require a great deal of sympathy and cooperation from abroad.
I have been reading your commentary for many months now and the puzzle is finally coming together for me. Thank you. It has been my unsubstantiated guess for many years, that in the interest of creating a more understanding world developed nations want China’s free markets to succeed and are prepared to gracefully accept declining manufacturing prowess to pursue a more even global distribution of wealth. It is so hard, however, to see a good ending when the imbalances which have supported China’s incredible efforts are left to tip further from their fulcrum. It does not appear that policy makers grasp how important it is that our Chinese friends make this work. Serious, compassionate talks need to be conducted between serious national representatives and long term plans need to be forged to level the playing field – I just can’t see this happening.
Also, if Chinese rates go far above US rates, doesnt this put a negative carry on PBOC’s sterilized FX reserves? In a related piece of yours, you cited Japanese FX reserves as 4-5% of GDP at the peak of their 1980′s bubble. The best stat I can find is Japanese FX reserves plus gold of $26bn in 1985 vs. Japanese GDP of $1.3trn and global GDP of 12.9trn, so 3.6% and 40bps respectively. Do you have the numbers you used handy? Intuitively, it would seem like your assertion would be right, but the data I’m looking at shows Japan’s huge reserve accumulation didn’t really pick up until the 2000′s.
E. Devine, the piece in which I said that about Japanese reserves was in my hastily-typed-out response to Thomas Friedman during a trip to the US, and I really should have been more careful about specifying what I meant because I have seen that claim quoted many times since then. As China is probably doing, but to a much greater extent, a lot of Japan’s reserves were actually accumulated in accounts controlled by the MoF but not technically speaking within the BoJ, so you have to add those back to BoJ reserves to get a full accounting of what Japan really had.
There is one institution, for example, and I don’t have my notes in front of me so I can’t tell you the name, that is to all intents and purposes the twin of the BoJ, except that it funds with longer term obligations. Its purpose is ostensibly to sterilize reserves more efficiently but there was also a lot of speculation in the 1980s that it existed in part to reduce the politically sensitive headline amount of reserves. For perhaps similar reasons lots of dollars were also held by banks and official institutions and were in that sense controllable by the MoF and accumulated as a consequence of the current account surplus.
Japan’s reservers were not nearly as high as I said in that piece, but that is because most of the reserves had been “outsourced”. Since they had almost exactly the same impact as reserves, however, and since they were accumulated in exactly the same way and were fully available to “protect” Japan’s external accounts, like reserves are, I bundled them all together.
Michael,
Apart from your very valid point about the implications of entrenched repression of finance for policy, what about possible tensions between the PBoC (in its persona of enlightened desinterested technocratic institution with the country’s interest at heart which may be a stretch) and more pedestrian cliques (provinces, SOEs, maybe the MOF) about what the banking system should be doing, how it should be regulated and to what extent Zhu’s reforms need to be maintained (see also the apparent struggle about Central Huijin). If the PBoC does not have the united backing of the CPC top echelons and does not want to lose face, it and CBRC do not have a lot of choice. Everyone knows that though listed and partially privatized, the banks are part of the state and have a lot of decentralized friends. Hard budget constraints may be aout of fashion again.
And why these western sounding comments from a senior PBoC official on the long-awaited but unsurprising IMF consultation? Interesting times..
“So there’s the dilemma: they’re damned if they do and damned if they don’t.”
Don’t remember starting from when, the only two choices China has are “bad” and “worse”. What a pity that even though with the crystal-clear explanation of the financial repression mechanism in China given by Professor Pettis, something I’m pretty sure those top policy makers are well aware of, it is mostly the extremely uneven political advantages of SOEs and local government that has blocked the tiny necessary adjustment in Chinese economy, to an extent that will dwarf the so-called “shameless” partisanship of Republicans in US Congress. Yet no matter which way China chooses, the household will inevitably be forced to pay most of the cost for adjustment, or put it more clearly, a lower level of life quality than they deserve.
It seems to me that the most efficient/effective way for China to deal with this is to shift their stimulus towards direct spending by the central government rather. The monetary/forced lending approach has resulted in the money going into a lot of low value projects coupled with hidden contingent liabilities. With direct spending the government still has the liabilites but they can control where the money goes and direct it to areas that better benefit the country. It also seems that the PBOC should prefer to have China government bonds as assets on their balance sheet versys US government bonds because of the currency risk issue. Perhaps they will eventually figure this out as the negative aspects of forced lending become more apparent.
Reduced interest rates also reduce consumption for a significant fraction of the US public. For example, many retired folks depend on interest from bank CDs and bond coupons for a substantial fraction of their income. The low rates of the past couple of years have definitely affected many of these people. For people entering or near retirement the low rates also depress yields from certain investment vehicles such as immediate annuities. While these effects may be relatively smaller in the US than in China they are clearly not insignificant.
Thank you, Michael. Interesting as always.
One quick question: If in order to drive higher consumption levels the Chinese gov’t were to raise interest rates, couldn’t that result in a short/medium term INCREASE in savings rates? My logic, drawing on your insights into targeted levels of savings from your prior interest rates/savings post, goes something like this: higher rates lead to bankruptcies across many areas of Chinese industry, especially those tied in to China’s fixed asset investment boom (bubble); Chinese savers lose out, either through bank failures or inflation following a printing-press-driven bailout of the banking system; needing to replenish their lost safety nets, Chinese citizens continue to save at a very high rate until returning to comfortable levels of personal savings.
A Chinese central planner could be forgiven for thinking that his job (life?) might be on the line in the above circumstance. A mess of bankruptcies and unemployment, and all without achieving the desired effect – at least in the short term – of an economic rebalancing.
Am I wrong for thinking that the policy makers in China will find it much more tempting to just let things run as they are until the wheels fall off, even if it means a continuation of China’s capital misallocation problems?
What will be the worst impact for a central bank to be insolvent due to rapidly appreciating home currency against its foreign reserve? Other than an ugly spot on the balance sheet, I can’t really see any adverse impact…
Michael, you say ” Raising interest rates will actually increase household wealth”, I am not so sure. While it would certainly increase the value of capital already accumulated, if the effect of higher interest rates triggers massive unemployment then the effects become even more heterogeneous. I am sure that those employees that loose there jobs would much rather have had the lower capital returns. That is not to say that a rebalancing is not coming anyway, but I can’t think of anyone willing to pull the trigger.
Thanks again for a great piece. I want to focus in on one aspect. If the yuan appreciates and causes losses for the PBOC, is that not more than offset by the higher asset valuation of all other yuan denominated assets in the economy as I believe you have previously suggested? If so, is there something at the micro level or political level that makes a PBOC hit so unacceptable that it must be prevented?
Professor,
It’s Yucho Bank, a postal savings bank which has the largest amount of deposit in Japan. It was slated for privatization, but the process has been postponed for now.
So there is no happy ending for this?
All of this sounds more alarming than US or European problems.
This is going to affect all markets, not just China, the numbers are too big…
Rein Huizer and Cuca, one of the things I never want to suggest is that there is not a serious debate within Chinese policymaking circles. But like all political debates, it is as much about adjusting demands according to relative power as it is about figuring out the underlying needs. The PBoC, while probably very aware of the problems creating the domestic imbalances, is not nearly as powerful as other entities, and there are very strong and persistent rumors about their concern that insolvency would require a capital injection from, and a ceding of power to, the MoF. I have no idea if this is true, but it sounds plausible. Many of the more powerful domestic constituencies, on the other hand, like SOE heads and local municipal and provincial authorities, don’t seem to understand the accounting constraints of the balance of payments and the savings/consumption relationships. As I have said before, the US had pretty much the same split in the early 1930s, and the wrong side, in retrospect, won.
G Stephen, yes I agree. Changes in interest rates affect many different segments of the population very differently, but what is important here is the aggregate effect. The PBoC however cannot choose to hold MoF bonds rather than USG bonds without dismantling the currency regime and destroying the export sector, as I explained in last week’s entry.
Dan and Glenn, there’s the rub. All of the mechanisms that could reverse the flow of income from the household sector to the SOE and state sector – higher interest rates, higher currency value, higher wages – can only happen slowly because if they happen too quickly they would cause a rise in unemployment and a short term drop in consumption. The problem with heavy subsidies, as we know from thousands of previous examples, is that they create dependency, and cannot be removed without creating distress. Damned if you do, damned if you don’t.
Henry, the result would be rising net indebtedness at the sovereign level. If total debt levels were very low, it wouldn’t matter any more than any other sovereign debt, but if you believe that there is a lot of government debt out there in the form of contingent liabilities, then the last thing we would need is more debt.
Dean, yes, there would be no net loss for China as a whole, but there would be a sharp deterioration in some major balance sheets and a small improvement in many smaller balance sheets, with the net effect probably being positive. The problem is that financial distress occurs as a consequence of specific balance sheets, not average balance sheet.
KD, the postal savings bank certainly may be one of the institutions that hoards dollars on behalf of the BoJ, but I am thinking of another institution. I wish I could remember its name.
SMS, Europe, China, Japan and the US all have big problems, especially banking problems. I don’t know who is in the best and who is in the worst shape, but all major economies will need to clean up their banking systems, to the cost of poor households everywhere.
Professor,
You may be referring to Shikin-un’yobu or Trust Fund Bureau under Ministry of Finance, which managed government-related fund such as postal savings and employee contribution. It was abolished in 2001.
Well,Professor,reading yr articles remind me about the great depression which actually happened when USA was riding high and well on its way to be the number (1),and to replace UK as the imperial global power.
But talking to many knowledgeable people,it seems that many of them have come to the conclusion that nothing can or should happen to PRC,people who talks about PRC problems must be people with ulterior politicasl agendas.,etc
The fact of the matter is that truly truly they know not but truly truly they do believe that they have the great wisdom
What to do?I see/talk to lots of them in Singapore.
with its currency pegged to USD, China will NOT have an autonomous monetary policy as simple as that. thru the peg, China will automatically acquire US’s deflation-fighting, aka reflation, monetary policies. In the end, they will have even bigger wasteful investment in real estate and infrastructure. History has shown us again and again every credit binge eventually ends up in tears. IMHO we will witness their road to ruin and tears one more time in China.
Hi Michael thanks for the piece, very good as always.
One question. If in your view the issue is overinvestment, why not ration credit quotas much more to stop the credit expansion while at the same time leaving rates low to allow existing projects to be repaid?
Also, on the asset/liability structure of the PBoC, isnt that true of every net exporter emergint market country? Brazil probably has the same issue but with a much higher negative carry given BRL rates, right?
And my third and last question, pls correct me if im wrong: PBoC accumulates reserves bc the country is a net exporter and exporters are not allowed to keep foreign currency and are obliged to sell USD, EUR… and buy CNY. So the increase in reserves is financed by an increase in the money in circulation/monetary base, right?
then why do you say that “China’s domestic imbalances require high trade surpluses until they are finally reversed”? that only worsens the situation of the PBoC right?
Professor Pettis:
You said “The PBoC however cannot choose to hold MoF bonds rather than USG bonds without dismantling the currency regime and destroying the export sector, as I explained in last week’s entry.”
The banking system can loan to SOEs, local governments, real estate speculators, etc. without upsetting the currency peg. Your comment above suggests that they cannot loan to (buy bonds of) the central government without “dismantling the currency regime.” I am having difficulty understanding why there is any difference.
A large increase in central goverment spending should over time result in a reduction of the trade deficit and hence the number of dollars the PBOC needs to buy to maintain the currency peg, so that gradually over time the new US bonds the PBOC needs to buy to maintain the peg is reduced.
Thanks for another excellent article (and also for your thoughtful and polite followup comments).
After following your writings for some time, my conclusion is that expectations (fears?) of China dominating the world economy are somewhat exaggerated (as were similar expectations of Japan doing the same 30 years ago). Certainly, China is (and should be) a major, and increasingly important, economic power. However, the same system that has generated amazing economic growth for China over the last 30 years has also embedded major economic issues that will challenge the Chinese economy for years to come.
The issues that China faces are, no doubt, no more challenging than (and somewhat similar to) those facing the major western economies (excessive government appropriation and mis-allocation of resources, perverse incentives that encourage mal-investment, and demographic issues that complicate matters).
Hopefully, these issues will be resolved peacefully (both domestically and internationally) by all nations. However, I fear, that by seeking to continue policies that have successfully propelled our (China and Western societies) ruling elites to wealth and power past the point where they are beneficial to society (and indeed, become destructive) these elites are sowing the seeds of their own destruction by both our long-suffering masses. While it may seem silly to compare the situation of the average Chinese to the average Westerner, our greater properity is counterbalanced by greater expectations.
Frankly, I wonder if the imbalances of the Chinese economy are not matched by the imbalances of Western economies and the strains placed on social and political cohesion by long overdue adjustments to more realistic goals and lifestyles may not be just as dangerous here as in China. It would be interesting, assuming either ruling elite would answer honestly, to determine which group feels more “damned if you do, damned if you don’t.”
Should China Dump Dollars for Commodities? What about the “Nuclear Option” of Dumping Treasuries? Can Global Trade Collapse?
http://globaleconomicanalysis.blogspot.com/2010/07/should-china-dump-dollars-for.html
Pettis: I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.
Mish: While I agree that the math MUST balance, to say that attitudes play no part in the formation of that math is simply wrong.
If consumers decide to stop buying goods from China there is almost nothing China can do about it? Why? Wages! ….
If US consumers decide to hold out for lower prices, China will be in an enormous squeeze, unable to cut prices much.
I agree 100% with Pettis that Europe will not pick up the slack. However it is not a mathematical certainty the US will pick up the slack. Perhaps no one picks up the slack. Given the math must balance, pray tell what is stopping a collapse in global trade?
Nothing as far as I can see. It all depends on consumer attitudes. Certainly Bernanke and Congress will do their best efforts to get banks to lend and consumers to spend, it is by no means a certainty the Fed will succeed. ….
Can Global Trade Collapse?
Given that Bernanke has already failed once, and in a big way, why can’t he fail again? I suggest he will. Regardless of the outcome (even if Pettis is correct), consumer attitudes towards spending and debt will determine the global trade imbalance math NOT preordained math deciding the role of the US.
The result may be a collapse in global trade, not an inflationary event to say the least.
Mish
Michael,
Firstly, thanks, as always, for your efforts.
There’s a point of some importance in this post on which I’m not at all clear. You talk about the “carry trade” and are suggesting that RMB appreciation will turn positive carry into negative carry. I don’t see how that’s possible. Certainly, it would appear as a loss in the notional mark-to-market but that’s not the same as the accruals. I can’t see how a changing exchange rate would affect the accruals from the currency mismatch one way or the other. The logic of this section of the post appears to contradict your previous writings (from which I’d thought it was clear to me that the exchange-rate mark-to-market is not relevant). It’s important in this particular instance as it leads in your post to a conclusion that China could be up for a 5% hit on its GDP under the scenario you describe and therefore I’d like to get a better handle on this (a 5% reduction in GDP could, I’m sure you would agree, have dire consequences for this country). Thanks in advance. Geoff Gibson, Nanjing University.
Apologies: you didn’t say 5% of GDP, you said PBoC indebtedness would be 5% of GDP – which is not quite the same thing.
KD, not its not that either. I recently moved so a lot of my notes and books are in a mess, but I will trawl through and find it. But the main point, of course, is not the name of any specific institutions but rather that reserve holdings were “outsourced” to several institutions.
Alvaro, rationing via quotas may resolve one of the problems, that of too much lending, but there quotas can be highly politicized transactions and, more importantly, I think the only thing driving Chinese growth is expanded investment, which is driven by loan expansion, so serious credit quotas could kill growth. As for your second question, yes, every central bank runs the currency mismatch. This is a good thing if the rest of the country has the opposite mismatch (i.e. a lot of external debt) but of course much less useful when it doesn’t. Finally, the fact that there are limits on the ability of Chinese residents to hold foreign currency assets means that the recycling of the current account surplus, which must occur anyway by definition, occurs largely through the PBoC.
G, Stephen, the point is that if the PBoC exchanges its foreign currency for domestic assets, including Chinese government bonds, it must dismantle the currency peg. Of course if they simply purchase Chinese government bonds and fund the purchases domestically, as you point out, it will have no impact on the currency regime.
Gary P. I too am very skeptical about the global hyperventilating about the rise of China. I would be more nervous about my contrarian stance if we hadn’t seen the same story so many times before. As for your last point about whether Chinese imbalance are matched by opposite imbalance abroad, you are absolutely correct. This must be true by definition. The global balance of payments, which are affected by the domestic savings and consumption ratios of every country, must always balance.
Mish, I think it is a lot more automatic in the aggregate than you suggest. There isn’t really an American consumer. There are millions of consumers with every possible sort of preference the exercise of which is limited by institutional constraints. Changing the underlying conditions changes the constraints that prevent the population as a whole from exercising its preferences. At the simplest level, if the US imposed a 20% consumption tax, you would see that Americans in the aggregate would reduce their consumption and increase their savings regardless of whether or not there was a change in cultural or individual preferences. If the RMB were revalued by 20% and interest rates by 4%, almost immediately Chinese households would “prefer” massively to reduce their savings rate.
Geoff, yes. It would be a balance sheet change.
Professor Pettis,
Since you are in a mood to answer questions- let me take the opportunity to ask some!!!
In an earlier post, you had argued that China faced a situation of collapsing international demand for its goods. The post I am refering to is- “There are monetary echoes from the 1930s tooJan 21st, 2009″.
Now, you are putting forward a situation that the US deficits and mirroring those- Chinese surpluses will get higher before they somehow re-adjust.
In the interim, I guess, what changed everything is the effect the US expansionary policies have had. They have suceeded in what they set out to do.
My question is- can’t this really go on for a decade- till the China economy grows bigger and Chinese consumer spending increases, Chinese surpluses slowly become smaller and smaller? Meanwhile, the US dollar and Euro depreciates slowly- regaining competitiveness for the respective economies.
Chinese households will subsidise the losses within the Chinese system. China overall will help US fund its deficit at a cheap- low interest rate. Meanwhile, inflation stays low- because overall demand is growing very slowly indeed- so there may not be a risk for hyperinflation or debased currencies. Demand for everthing goods, assets will be low while the deleveraging process is on for a decade.
Is this a viable scenario? What can unravell this scenario? What can make it more real?
Ronnie
So interest rate policy has to choose between rising bankruptcies or rising misallocation of capital. Even ignoring political pressures, this isn’t an easy choice. And it will require a great deal of sympathy and cooperation from abroad.
Don’t expect much sympathy in the U.S. with an unemployment rate of 9%. Rightly or wrongly, the average person in the US, including the educated (Friedman for example), ‘knows’ that China ‘owns’ us through its large holdings of bonds, etc.
Also, China-bashing is the one thing – maybe the only thing – both political parties in Congress agree upon. It’s the White House and Treasury that have pushed back hard against yuan legislation , but they will not be able to stop it much longer
“…the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.”
This point bothered me when I first read this article a few days ago. Yes, the math has to balance, but that implies nothing about which way causality runs, or what is a “consequence” of what. US consumers could decide to buy less from China, and then, for the math to balance, China would have to adjust.
I tire of hearing of the US cultural penchant for profligacy. Although the US consumer has never been a significant saver, US savings rates in the 80′s and 90′s were certainly far better than what was exhibited in the first decade of the new century. I fail to think that in a period of 7 years or so, US consumers decided there is no need to save. Instead, it’s clear to me that the bubbles in the asset markets gave consumers a false sense of wealth. Of course, some idiots abused this by over leveraging their homes (a personal ATM) and the lending community, in perhaps the greatest of failure of risk recognition in history, failed to rein in this leveraging. Now as the US consumer and corporate community deleverages, the US government is stepping in to provide the Keynesian demand in a desperate attempt to keep employment. Unfortunately, China, Germany, and Japan, all with excess capacity, are skimming off that demand and therefore, US employment improvement remains sluggish.
The debt levels that the US is incurring are unsustainable and there would be substantial debate about this even if US employment were improving. It is political suicide if no improvement occurs, and this may play out as early as November. As part of the political bloodletting, there will be tremendous pressure to erect trade barriers. US tax payers will see their taxes and government deficit to increase to support an undervalued RMB and unpopular military actions in Iraq, Afghanistan and Pakistan, which in part protect investments and workers from the trade surplus countries in those areas.
Michael, on the 23% of potential bad loans anticipated by the CBRC, this is just the worst of the worst, those deals that have bad documentation, unauthorized borrowings, essentially sham transactions. Only about 1 fourth of the loans reviewed by the CBRC were supported by sufficient project cash flow. That means the other 3/4s are not supported. These non-supported deals would be a minimum Special Mention in the US banking system and probably rated as substandard. I think there is a lot more than 23% of these loans that will get into trouble. Furthermore, the analysts that reviewed these loans for the study, frankly, are not the sharpest tools in the shed when it comes to determining cash flow.
And this is just the loans to the Government Investment platforms. There are lots of other loans that also have issues. I wonder about the contractors who are doing work on the infrastructure projects. If the contract owner strings them out for payment, they may have no choice to “finance” the receivables for much longer than they thought. Chinese banks ought be looking at the second order derivative effects of the problem.
You are very right about the issue of raising interest rates and its impact on commercial companies. Many companies, especially provincial SASAC owned companies, could not withstand a 150 bp increase in rates and remain profitable because they are highly levered and have such tight margins. Doesn’t mean they will go bankrupt, but again, there will be need for restructuring of debt and perhaps some forced marriages of ailing companies.
Michael
What do you think about the following:
China, the world’s largest energy consumer, may reduce monthly coal imports to the lowest level in more than a year in the second half as the economy cools.
“Purchases may drop to 59.5 million metric tons, or 9.9 million tons a month, from 81 million tons in the first six months of the year, a decline of 27 percent, ….The monthly forecast would be the smallest level of imports since May last year.” and;
“Demand growth from industries, including power, steel, construction material and fertilizer, has seen a noticeable decrease since April,”
http://noir.bloomberg.com/apps/news?pid=20601072&sid=a47jBzOZ7TiQ
Does this signal a shift away from FAI, a retrenchment of growth that has occurred during the stimulus phase where FAI might have comprised an even larger percentage of GDP than expected, if a substantial reduction where do you think growth (and.or) sustenenace of GDP at present levels will come from. There do seem to be some encouraging signs of stabilization elsewhere globally if this is a jobless recovery.
Thank you again, Professor Pettis. I learn something important every time I read your blog.
Summing up what others have suggested here, how about this middle course toward ‘normalization’ in China:
1. Keep interest rates on existing loans constant.
2. Reduce the amount of capital for new loans.
3. Take the amount that would have been used for new loans, and use it to subsidize bank deposit interest rates. Declare an interest bonus.
4. Allow a modest amount of foreign assets to be held by individuals. These stocks or deposits would have a higher return, and also allow households to feel more secure.
5. Allow corporations to hold a certain amount of foreign currency assets.
Each of these changes are small, and can be adjusted up or down as time passes. With this kind of rudder to adjust, households can get a better return, while not triggering too much unemployment.
The assumption seems to be that an accounting identity somehow causes things to happen. That is a category mistake. An accounting identity is not that kind of thing. It does not cause events, it just describes them. A statement that is true by definition does not require anything to happen; it remains true no matter what happens. People in China and America make decisions for whatever reason, as a result of which interest rates change, prices change, trade increases or decreases, investment increases or decreases – and no matter what they do, when you add everything up, the math balances. The accounting identity exerts no causal force at all on the events as they happen. The accounting identity does not require anybody to do anything that they would not do anyway. Nobody ever does anything *because* the math has to balance. It’s a different kind of “has to.”
Mr Pettis
Just wondering if the interest rate addiction you referred to is not merely the macro version of the interest rate addiction equity markets have been experiencing for some time.
Hope to get your input on a different topic: Asian investor mentality, will send a request by email, hope you will provide an opinion on that.
@Lyle Burkhead
Agree with what you are saying re causality. Just playing devil’s advocate: as accounting identities describe events, when events show a change in some components of the equation, would it not then prove troublesome for the idea that the statement/equation must be true by definition? Personally leaning towards empiricism however irrational that may sound :p
@Judy Yeo
A quarter has a heads side and a tails side. It’s the same quarter, looked at in different ways. If you have a thousand quarters, the number of heads is equal to the number of tails, because each one has a heads side and a tails side. This is not an empirical statement. It is not the kind of thing that can turn out to be false. It must be true because we are counting the same coins.
Accounting identities are like that. Dollars that show up in the current account (“heads”) also show up in the capital account (“tails”). The current account has to be equal to the capital account because they are the same dollars, looked at from different points of view.
When I wrote my first comment on this thread, #38, I had not thought this through. I wrote “US consumers could decide to buy less from China, and then, for the math to balance, China would have to adjust.” After posting that comment, it kept nagging at me. First of all I should have said buy more, not buy less, to fit the hypothetical scenario, but the main problem was in the phrase “for the math to balance.” As if they have to try to make it balance? I seem to be suggesting that there is a room somewhere in Beijing, with a bunch of guys sitting around trying to decide on the interest rate, and one of them says “We had better get this right, because if we set the wrong interest rate, the math won’t balance! We will destroy the whole system!” No, obviously that’s not how it works. They can set the interest rate however they want, and the accounting identity will take care of itself.
There is nothing anybody can do to make the accounts balance, and nothing anybody can do to prevent them from balancing. No matter what anybody does, the same dollars appear on both sides of the equation.
When I wrote my second comment, #42, I still didn’t get it right. I should not have said that accounting identities describe events. That is almost right but subtly wrong. Accounting identities describe how we describe events. They are the structure we project onto the situation.
Judy: “as accounting identities describe events, when events show a change in some components of the equation, would it not then prove troublesome for the idea that the statement/equation must be true by definition?”
When events show a change in some components of the equation, other components automatically cancel those changes, and the balance remains undisturbed. For every heads there is a tails, continuously. The balance, or identity, is the framework within which things happen and cannot be affected by the events within it. The framework and the events are different kinds of things on different levels.
@Lyle Burkhead
Your last comment on accounting identities and components of the equation is perfectly reasonable if you assume that all components are captured in the equation and equilibrium is the implied result of these equations, but is that realistic in the real world? Equilibrium (which is what double entry accounting is really based on) may not exist for all practical purposes, it is a theoretical state(as accountants should realise) where deficits=surpluses which is double-entry accounting summarised. The assumption of equilibrium in formulating the equation determines the result of the equation, which unsurprisingly is equilibrium,or balance as you put it. Would empirical observation of real world transactions and events undermine the assumption of balance/equilibrium – maybe that’s the real question.
Judy,
The accounting thing is like that but accounting is not economics, it is just a tool. The accounts balance because someone has exported more than he imported and exported capital to finance the surplus sale. Without the sale the capital export would not have taken place and vice versa, that is, in the aggregate.It does not matter whether the lender, the buyer and the seller are two, three or 7 billion persons, the accounts show that that happened.
In economics one wonders whether that process will continue, because the lender in the previous chapter may not want to go on lending and prefers to satisfy someone who can pay (say, a domestic customer) in that case, at the end of the chapter, there is no incremental capital export. There is also the stock/flow issue: the lender may want his money back because he does not like the stock of debt because he believes the borrower is borrowing more than he can afford. In the case of US/ China, the accounts will always balance (some E&O) etc) but not always to the ex ante satisfaction of both.
Because China controls a variety of prices (the CNY, but also many others) and because her international sector is a de facto USD one (like HK and Taiwan) in order to arrive at a competitive price level in USD (this is of course an extreme oversimplification) it is under the influence of US monetary policy (and the Chinese feedback is as yet too small to influence US policy) more or less like Spain is under the influence of (Greater) German policy in the EUR zone without too much feedback, despite the fact that the domestic conditions in Spain might favor a different one (not everyone agrees with that though). Now, the big point here is that there are two dimensions to monetary policy: price (interest rates paid/received by the non-financials) and availability. In economies with a lot of spare capacity or underdevelopment (like parts of Spain) an output gap approach (loosely speaking) would be entirely warranted, even for a conservative like myself, but given the uncertainty about how the underdevelopment portion of the output deficit (say in relation to Germany) would be handled (or the productivity of investment undertaken to close the gap), a high risk premium (i.e. cost) and strong capital provider scrutiny must be applied, in order to have efficient budget constraints (i.e, budget constraints that result in useful allocation) and a sustainable financial system. In markets like the US that should not be a problem (that it nevertheless was makes one wonder about the relevance of the theory: if not in the US where else?) but in markets where the (local) banking system refuses to price for risk (for a variety of reasons) and where the financial system itself faces very soft budget constraints, you are likely to get a host of pathologies, as did the late USSR. And so may China, as is very well known in leadership circles, but managing this issue is apparently too hard politically. Although, they make a clever use of market psychology, look at the latest regulatory move re stress tests…The tests are probably meaningless, but their announcement has an effect. Maybe the centre that grasps at every straw to stay in control and international regulation, and a growing “finance” constituency within the elite (maybe that is an exaggeration) have found some common ground. Still, my money is on the (destructive) forces outside Beijing and in the big national SOEs -as it would be (after some relabelling) in the US. The consent of the public is easier to manage than the support of your mates, especially in China.
Judy and Lyle,
Thanks for the comments. I think the point is that accounting identities (and other identities) create a way to see the world. The important thing is to know what are the components of the identities and understand the policy implications of fiddling with the levels of those components. Just like what we learned in Macroeconomics 101, the Keynesian world defines Y= C+I+G+(X-Im). But included in I, Investment, is inventories. On the surface, Investment seems like a good thing, a conscious forward thinking decision to invest. But by including inventories in the identity of Investment, you can have the potential for inventory buildup in a downturn, a kind of “involuntary” investment.
Knowing the identity components can help see through obfuscation of politician’s statements. Unfortunately, we ascribe emotional values to many of these terms, such as “saving” (good), and “consumption” (bad). Unfortunately, unavoidably, we use these emotive terms to describe technical concepts which then can then influence the policy debate. The Chinese are masters at playing this card, grabbing the moral high ground in what should be a technical discussion. Michael helps put that debate back where it should be, a reasoned, unemotional discussion.
I recall an economics professor I had, who was an eminent authority in antitrust law. He often testified as an expert in court and he told me that in one case an opposing counsel made a huge point out of the fact that some of the statistical evidence presented was based on a “biased” sample. Anyone who has studied statistics knows that every sample has some form of bias. But the emotional word “bias” was important to the attorney’s rebuttal.
I love for economics because of its analytical rigor, a critical thinking that it seems like less and less people in the world have. It’s important to see what assumptions are implicit in the argument put forward. That’s why I like Michael’s blog so much.
Huizer:
The accounting thing is like that but accounting is not economics, it is just a tool. The accounts balance because someone has exported more than he imported and exported capital to finance the surplus sale. Without the sale the capital export would not have taken place and vice versa, that is, in the aggregate.It does not matter whether the lender, the buyer and the seller are two, three or 7 billion persons, the accounts show that that happened.
Agree with the stats and numbers but not with the implied causality. Am saying that the accounting identities are (perhaps even the whole system of double-entry accounting) based on the concept of equilibrium (that is, everything gets balanced out, summarised in the deficits=surpluses equation). That is what I have real doubts about, don’t believe there is equilibrium, it’s fine as a theoretical concept or political argument (and in the long run ;p) but maybe not as a description of present economic reality. For example, when has the world really reached a state of “balance” in recent memory or any of the periods of economic history.
nice hearing your thoughts. haven’t seen your posts in some time, hope all is well with you.
was actually prepared for some nasty verbal slams online, especially of the “dumb broad” variety, so far so good.
Suppose you have a school of goldfish. Each one has a left side and a right side. If they are swimming quietly, with everything in equilibrium, there are as many left sides as right sides. Now suppose a predator appears, a bigger fish that eats goldfish. They all scatter and swim about trying to escape. The situation is no longer in equilibrium, but the number of left sides is still the same as the number of right sides. The left = right identity remains true no matter what the fish are doing.
Accounting identities imply nothing about equilibrium. “Balance” and “equilibrium” are similar concepts but they apply in different domains.
@Lyle:
accounting identities imply that for every transaction, there’s a corresponding debit and credit entry – that’s double-entry accounting, the figures are the same just the signs (positive or negative) are different – that means they balance off (or for accountant, they cancel/net out), this in turn implies there is equilibrium. What I am asking is, could there ever be a real world transaction or event where there is no neat balance or where there is imbalance(whether due to time lags or other factors which may not be economic) , therefore upsetting the assumption of equilibrium and balance which pervade the double entry accounting system?