I want to start this newsletter with a story that may be fairly illustrative of one of the problems within the Chinese economy that I worry about. There was an article in last Sunday’s edition of the South China Morning Post about a real estate project in Guangdong. (WC Fields’ was supposed to have once called Mae West “a plumber’s idea of Cleopatra”, and for some reason that story popped into my mind when I read the article.)
It says that a real estate developer is attempting to build a replica of a beautiful Austrian village in Guangdong province not too far from Shenzhen:
It is a scenic jewel, a hamlet of hill-hugging chalets, elegant church spires and ancient inns all reflected in the deep still waters of an alpine lake. Hallstatt’s beauty has earned it a listing as a Unesco World Heritage site but some villagers are less happy about a more recent distinction: plans to copy their hamlet in China.
After taking photos and collecting other data on the village while mingling with the tourists, a Chinese firm has started to rebuild much of Hallstatt in Guangdong province, just 60 kilometres away from the Hong Kong border, hoping to attract wealthy mainlanders, “homesick” expatriates in Hong Kong and tourists. The project had drawn a mixed response from residents in the original village.
The article goes on to discuss the anger many of the residents of Hallstatt feel about having their town copied and replicated without permission.
That this sort of building project seems a tad over the top is not why I bring up the article. Those of us who live here are quite used to the many sometimes-bizarre projects aimed at attracting new wealth and signaling status. Of course if it makes the residents of Hallstatt feel any better, I am absolutely certain that the Guangdong replica will not be a perfect copy of Hallstatt. I have no doubt that there will be hundreds of architectural and cultural “improvements” that will ensure that no one confuses the shiny replica with its dowdy original. Excessive restraint typically isn’t one of the sins afflicting real estate developers that cater to the local rich.
What interested me about the article was something else altogether. According to the article, the project is being developed by “Minmetals Land, the real estate development arm of China Minmetals, China’s largest metals trader.”
I’m sure MinMetals is no slouch when it comes to trading metals, but it wouldn’t have occurred to me that a metals trading background would have made anyone particularly good at real estate development, and especially at developing such an undoubtedly classy project. This kind of thing, however, is actually not an anomaly in China. A surprisingly large number of SOEs and other large companies in China have real estate development subsidiaries.
In fact a lot of Chinese SOEs are involved in a very wide variety of business activities, and are especially fond of activities in which cheap capital is the comparative advantage, or in which there is political advantage to be gained. That makes real estate development and “high tech” two of the most popular ancillary businesses.
Does it matter? Perhaps. This type of business diversification is not new and it doesn’t have a very encouraging history. For example the 1960s in the US was a period which saw an explosion in the growth of what were then called “conglomerates”, and as is always the case, there seemed to be a plausible reason for their growth: good managers are good managers, and can generate growth from many types of companies, and their ability to generate growth is magnified by the lower cost of capital associated with substantial diversification.
But after the initial enthusiasm, conglomerates performed awfully, and in the 1970s in the US a consensus developed that large conglomerates involved in very different lines of business tended to be value destroying. The reason often given was that managers who might be successful in one line of business – say coal extraction – might not necessarily be especially good in another line of business – say children’s retailing, or movie production. By forcing senior management to disperse their expertise across a wide range of very different businesses, conglomerates were very good at mismanaging many if not all of the businesses they controlled.
Incentives affect behavior
I am not sure if I am totally satisfied with that explanation, although I am sure there is some truth to it. To me the main reason why conglomerates tend to be weak at creating value has to do with the distorted incentive structures involved in their creation.
In many cases – especially when skeptical investors aren’t monitoring their every move and threatening to punish them when they fail – senior managers had no great incentive to manage shareholder money very carefully. They do, however, have strong incentives to build their assets and to diversify – the former because the larger the company the more important and more highly remunerated the managers, and the latter because highly diversified businesses are more likely to be involved in whatever business is hot today and, because they are diversified and large, are less likely to fail.
In that case, as long as there were no constraints to managers’ ability to raise money and invest in other businesses, managers naturally did just that. The problem is that what is in the best interests of the shareholder – creating economic value to be captured by shareholders – is not necessarily in the interest of managers, who might find it totally rational to overpay for assets and to pile into “hot” markets.
This distorted incentive structure ended up encouraging capital misallocation, and after a few exciting years, the profitability of conglomerates plummeted. Incentive structures, in other words, determine behavior in the aggregate, and if the incentive is to ignore value creation in favor of some other objective, value creation tends not to occur. In fact the opposite occurs. Value tends to be destroyed if those other objectives can be met by deploying capital.
It is hard to imagine that in China today the incentive structure for top managers of SOEs is aligned with that of creating economic value. Like anywhere else, the bigger your company, the more important you tend to be as CEO, the more preciously your bankers and investment bankers will treat you, the more time you will spend with senior political leaders, and the more highly remunerated you, your family and friends tend to be. What’s more, as Beijing tries to consolidate smaller companies into larger ones, the bigger you are the most likely you are to be the head of the surviving company. In that case companies will want to grow.
There is an additional and very important distortion. The most important comparative advantage that large Chinese companies have is access to cheap credit, and so from a P&L point of view the best policy is always to borrow as much as you can and buy or build assets. Even if you overpay or if your projects are actually value destroying, it doesn’t matter too much because artificially low interest rates are the equivalent of debt forgiveness, and after several years of hidden debt forgiveness, even the worst investments start to seem profitable.
Under those circumstances, I would not be confident that every large SOE investment or every move to diversify is likely to create economic value. The fact that nearly every important SOE, and many not-so-important ones too, have real estate development subsidiaries probably has a lot more to do with access to cheap capital and the opportunity to share in the real estate bonanza than with any real ability to add to the underlying wealth of China.
Everything is debt financed
And of course if it is true that SOEs are investing unnecessarily for reasons that have nothing to do with value creation, one consequence is likely to be an increase in debt, as SOEs borrow and invest. I have written a lot about unsustainable increases in debt in China, and on that note let me append below something that I wrote this week for the New York Times.
I was asked by the newspaper to identify some of the difficulties facing China with an especial emphasis on the worries that have surged in the past year over the large debt levels run up by local government financing vehicles. My response was that the focus on this kind of debt might be at least partially misplaced.
For the past decade China-focused analysts have been able to describe static economic conditions with some accuracy but have failed generally to understand the underlying growth dynamics. We’ve done a great job, in other words, of describing the landscape through which the train is passing, but because we don’t understand where the train is headed we are constantly shocked when the landscape changes.
It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt. As recently as two years ago most analysts were ecstatically – and mistakenly – praising the country’s incredibly strong balance sheet, but when Victor Shih shocked the market last year with his analysis of local government borrowing, the mood began to change. Now the market has become obsessed with municipal debt levels.
But dangerously high levels of municipal debt are only a manifestation of the underlying problem, not the problem itself. Even if the financial authorities intervene, unless they change the economy’s underlying dependence on accelerating investment, it won’t matter. They will simply force the debt problem elsewhere. In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.
China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.
I want to stress this point. Right now everyone is worried about municipal debt levels and wondering if Beijing’s plans to resolve the problem will work or not to clean up the municipalities. But this is the wrong focus. The problem is not whether or not the municipalities will be able to repay. Repayment simply means shifting the debt servicing to another entity, and we should be worrying not about the debt-servicing ability of specific borrowers but rather about the whole system. The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.
When is an increase in debt unsustainable?
As I see it there are three things that make increases in debt unsustainable. The first, obviously, is borrowing for consumption. This is what happened in the US and in the peripheral countries of Europe until the 2007-08 crisis, and it is pretty clear that this kind of borrowing cannot go on forever. Why not? Simply because with consumer financing the value of liabilities rises more quickly than the value of assets, and this cannot go on forever unless the borrower has an infinite amount of excess assets.
But it is a testament to how US-centric the whole world is that we cannot seem to separate underlying problems from the US manifestation of that problem. Since the US spent much of the past decade experiencing an unsustainable increase in debt to finance consumption, most of the market assumes that this is the only way it can happen. Since we aren’t seeing consumer financing in China, then there cannot be an unsustainable debt rise in China.
But consumer financing isn’t the only way it can happen. The second way we can experience an unsustainable increase in debt is when borrowing is used to fund investment that is misallocated or wasted. Whenever the value of liabilities rises more quickly than the value of assets, the increase in debt is by definition unsustainable unless, of course, the borrower has an unlimited amount of excess assets. This is a little more complicated to explain, but the process is just as definitive.
Assume, for example, that a local mayor borrows $100 dollars to build a subway system. The subway creates economic value, directly because businesses can grow more quickly thanks to lower transportation costs, and indirectly because consumers can spend more of the time and they have money left over,
If the economic value of the subway exceeds $100 dollars, the mayor can service the loan by taxing (directly or indirectly) the increased economic value. In that case net assets rise because there is more than enough to repay the cost of the investment.
If the economic value created is less than $100, however, the loan cannot be fully serviced without forcing someone – usually the taxpayer – to step in a make up the difference. This is what we mean by an unsustainable increase in debt – it will result either in a default or in a rescue.
We need to be careful about how we define the loan servicing cost. What matters is not the interest rate actually paid, but rather the theoretically “correct” interest rate. Why? Because that is the true servicing cost to the economy as a whole. Imagine if the US government passed a law saying that the interest rate on all of its debt is now set at 0%. Would it have any trouble servicing its debt? Of course not. So why not do it if it solves the debt servicing problem? Because artificially lowering the interest rate is simply a way of transferring the borrowing cost to the lenders. It does not reduce the true cost, it simply turns it into something else.
So if we want to know what the debt-servicing cost in China really is, it doesn’t help to look at the financial statements of the borrowers to determine whether revenues exceed the interest expense, even if you trust the financial statements. You would have conceptually to raise the interest rate for local and municipal governments, SOEs, real estate developers, etc. substantially – probably by at least 5 or 6 full percentage points or more – to eliminate the impact of artificially suppressing the rates. It is only then that you can calculate the true debt-servicing cost
Forget about consumer financing
The third kind of unsustainable debt increase is caused by a sudden explosion in contingent liabilities. When balance sheets are structured in risky or mismatched ways, an unexpected change in circumstances can cause a sharp change in the relationship between the values of assets and liabilities, and so result in a net surge in indebtedness.
There are many examples of this kind of mismatch. Financing companies that lend against assets, including copper or land, run the risk of a surge in net indebtedness when asset prices fall. Banks that borrow short and lend long are mismatched, and can see assets fall relative to liabilities when interest rates surge. The PBoC has a huge currency mismatch on its balance sheet. Because it borrows in RMB and lends in foreign currency, mostly dollars, as the value of the RMB rises against the dollar, its net indebtedness automatically rises too.
Mismatched balance sheets are not always a problem. When the surge in contingent liabilities occurs under “good” conditions, it can actually be stabilizing for the economy because there will usually be a corresponding reduction in net liabilities when things are going badly. For example central banks usually like their currency mismatches because they only lose money when their economies are doing very well and there is pressure for their currency to appreciate. When their economies are doing badly, of course, the pressure is for depreciation and they actually make a profit on their mismatch just when they need it.
They are hedged in that case. To be hedged means to make money when things are otherwise going badly for you and to lose money when things are otherwise going well. It is only when the balance sheet is what I called “inverted” in my book that you have a problem.
Take copper financing by lenders in China. This is an example of an inverted balance sheet. As the biggest consumer of copper, China largely sets global copper prices. If China is growing quickly, this tends to push up the price of copper, and lenders who are secured by copper see the value of their loans increase – they become more secure. The lenders of course are delighted. They are probably making good money because China is growing, and on top of it their loans are becoming more secure than ever.
Of course this changes if the Chinese economy were suddenly to slow, especially if it slows sharply. In that case the lenders would probably see their revenues decline at the same time as the value of the collateral supporting their loans declines. If their borrowers are then forced to liquidate the collateral in order to repay the loans (which is likely to happen if the economy slows sharply), the liquidation value could easily be less than the value of the loans. In that case China would see an unsustainable rise in its debt – and notice this always happens at exactly the wrong time.
It is important to remember this when thinking about financing risks in China. We often hear analysts argue that because China has little consumer financing and because mortgage margins are high, they don’t have a debt problem. This argument is about as useless as the claim that because China has large reserves it is unlikely to have a financial problem. The limited consumer and mortgage financing in China means that china will not have a US-style financing problem, and the large amount of reserves means that China won’t have a Korean-style financing problem, but no one has ever seriously argued that those are the kinds of risks China faces. What matters is the level of debt, whether or not its growth is sustainable, and the kinds of contingent structures that are embedded. I would argue that all three measures are worrying.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Good piece Michael. You would be surprised by the tonnage of copper held by Chinese financial institutions as a punt on the copper price, but against Chinese warehouse receipts they raise funds from the banks to punt in other Chinese markets. Top government economists in Beijing I have spoken to are aware fully of what is going on and are nervous of taking a sledgehammer to the issue because of the risk of a systemic failure!
[...] – Michael Pettis’ latest newsletter. [...]
So the SOEs are really great feudal estates. The larger the estate, the greater the prestige of the feudal nobel. The difference is that the estate and the patent of nobility are awarded by the Communist Party for service to the State instead of being awarded by the King for service to the Kingdom.
Simon, as the great footballer and wordsmith Kevin Keegan once said: “Well, if that’s true then it would be a big surprise, but then nothing surprises me in football these days.”
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Daalders Dagelijkse Links (week 27)…
Lukas Daalder, strateeg van het Financial Markets Research-team van Robeco, publiceert regelmatig een selectie links die elk een eigen visie op de macro-economische situatie van dat moment geven.Onderstaande links komen van publieke websites, waarbij…
[...] Incentives and debt Michael Pettis. I may post about this over the weekend; it’s very consistent with my experience of Japan in its bubble era. [...]
Michael: you wrote in your NYT piece that investment-driven growth in China can go on for at least two more years. During those years, delayed losses should be piling up as malivestment grows. Do you think that those losses will necessarily grow bigger after adjusting them by the size of the economy? Would it be wise or not to try reining in investment-growth, thus provoking a slowdown sooner rather than later?
Yes, Ignacio, sooner is always better, in fact this process should have started seven or eight years ago, but it seems to me that given the factional disputes, especially during the leadership transition period, it will be very risky from a political point of view to initiate the adjustment, and it almost certainly won’t happen before the leadership change. My guess is that it will take at least a year or two before there is a sufficiently widespread consensus to abandon the current growth model.
Excellent analysis. I just came from a tour through China and I was really surprised at the size of the bubble. I came up with a slightly different view of looking at things.
Economists usually talk about debt, imbalances, etc. in a kind of very static way. That’s why your piece is so enlightening for many: debt, etc. depends on expectations.
While in China, I thought along these lines: here everything is built around expectations of huge growth. Everything seems to be overbuilt for 8 times actual demand (highways, airports, etc.). This could be profitable if expected growth really happened, but it *might* just not happen.
So I came up with a new metric: %GDP based on growth expectations. In my view, my country (Spain) had a 20% GDP which more or less directly depended on growth expectations (including higher-price expectations for several asset types) at the peak of the bubble. This meant as soon as expectations fade, 20% GDP disappeared overnight.
I made a couple of back-of-the-envelope calculations while in China, and it looked as if 40% China’s GDP depended on growth and higher-price expectations. This may only mean as soon as expectations fade, 40% GDP will disappear overnight.
«The most important comparative advantage that large Chinese companies have is access to cheap credit, and so from a P&L point of view the best policy is always to borrow as much as you can and buy or build assets. Even if you overpay or if your projects are actually value destroying, it doesn’t matter too much because artificially low interest rates are the equivalent of debt forgiveness, and after several years of hidden debt forgiveness, even the worst investments start to seem profitable.»
This applies also to the entire financial sector in the USA and the UK, which have been lent apocalyptic amounts of money at near zero interest rates against dubious collateral to allow them to rebuild their balance sheets with the resulting carry trade (basically a large capital donation).
Prof Pettis
A question. Is it possible that even after accounting for trade imbalances there is just too much debt in the world economy. If “surplus” countries have hidden debt and Countries like the UK and US have explicit structural debt in the form of social security and medicare/medicaid payments is it not possible that the world economy needs a debt readjustment?
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Michael,
Question. Let’s assume ALL the debt in China is bad, and will eventually default. What would be the downside effects of the Chinese central bank, or govt., essentially forgiving all the debt? Creating enough money to pay back the debt would probably be inflationary, but what about forgiving it, since it is essentially money owed to the government in the first place?
Are there limits to debt forgiveness in a centrally controlled economy like China?
Vinz
Seems like SOE are being transformed into the chinese equivalent of korean chaebol and japanese zaibatsu. (companies that diverge into core competent areas ) . but I’m not sure that this model would work in china.
Where do you draw the line if they are going to successfully long term ( like becoming national champions) or becoming a failure? Can we expect the capital SOE received (despite becoming highly addicted to it) would be beneficially in the long run (eventually become value creator someday) ?
Naive question. Given the low-level of development in China as a whole, and its enormous population can’t an investment-driven model go on for quite a bit longer? I understand that the investments may not be the ones needed. But, isn’t there still a huge need for infrastructure in China — homes, roads, bridges, water, sewer, rail, power plants, and later recreation facilities? Or, does China already have enough of all that?
[...] What’s the right way to think about China’s economy? [...]
@SteveK9. Investment on infrastructure could become profitable if somehow Chinese growth keeps on its stellar path for two additional decades. But why would it keep on being so high? The only way would be for the government to forget about investment and stimulate the internal *market*, consumption.
But why would the Government do that? Why would it be so wise? Why would well-connected bureaucrats waive away their profitable grip on the economy (banks, large companies, etc.)? Despite pompose speeches, they’re doing nothing to create a real market and adress imbalances.
In other words: the Chinese have been very efficient at convincing the West that their system is superior and crisis-proof. It just isn’t, hence they’re planning for the 20th next movement in chess while they’re on checkmate in 2 moves.
Michael,
I agree with your comments about conglomerates, however, I wanted to add a theory of mine. It seems to me that, despite the misaligned incentive structures and the potential for value destruction, there are certain periods when conglomerates make economic sense. Those periods occur when financing is scarce.
The 1960′s and early 1970′s in the west were a period of relative financial repression. Loans were hard to come by, corporate bond markets were underdeveloped. Many conglomerates thrived because they were able to take cash from their profitable cash cows and invest it in their growth businesses or new ventures – areas that might have struggled to raise their own growth financing. (A good example in the UK is how Racal Electronics created a new business in cellular telephony that went on to become Vodafone.)
My theory is that during these periods the value added by the internal financing function of the conglomerate outweighs the value destroyed by the misaligned incentive structures. In the west, financial liberalisation and especially the rise of the corporate bond market brought an end to the conglomerate advantage. However, I think we will see a new age of the conglomerate because everything I see happening to the western financial system suggests a new age of financial repression is upon us.
The marginal utility of new real investment decreases, as the aggregate amount of real investment increases. If you disregard this, the marginal utility of new investment will eventually be negative. The roads you have already built erode quicker than you manage to build a new one. Either you consume what you produce, or time will do it for you.
Building national reserves (internal or external) means building expectations among the holders of that nation’s bank accounts. Inflation dashes these expectations, and signals that the real value of the reserves built, does not correspond to the real input (e.g labour) provided for the creation of these reserves. People are working for nothing.
In China, the transfer of labour resources from “producing” investements and foreign reserves into producing domestic consumption COULD have taken places through an increasing CNY. Now, it comes through inflation instead. Probably a less stable method.
Just wondering, if you can’t estimate how large is the total debt outstanding, how do you know about how much money there is in china’s coffer? If you’re not sure, how could you then be sure that the country doesn’t have the money to solve its problems and will eventually go under?
Grandiosity often accompanies very rapid successes. It finds it limitations after some destructive efforts. Eventually they all get MBA’s and begin to focus on the widgets again.
Over 80% of SOE’s have speculated on land – everything from soybean crushers to railroads.
http://www.nber.org/papers/w16189.pdf
A study by the Hong Kong Monetary Authority showed that SOEs have received below market interest rates on their loans. Without those terms, they would not be profitable. Historically, have expected forebearance on even those loans.
Interestingly, someone had the public research i uploaded to scrib pulled down, but here is a summary.
http://historysquared.com/2011/01/06/without-loans-favors-chinese-soes-would-have-no-profits-leaves-banking-system-exposed/
Underpaid executives bread corruption, as shown by the recent study points to hundreds of billions that have been pulled out of the country in the last couple decades.
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Mr Pettis
Your newsletters are always a pleasure to read and never fail to provide new insight of the Chinese economy, especially aspects which newspapers(like FT, Economist) and economics bloggers fails to pursue in-depth.
Henning Aarnes, Oslo, Norway
As to the skewed incentives, my favorite story is the steel industry, an industry of severe overcapacity. The government was supposed to be taking the lead in forcing mergers that would, in theory, reduce the excess capacity and phase out the old inefficient energy consuming facilities. That did not really happen. The core issue is local employment which hampers rationalization of inefficient steel facilities. In fact the 2010 fourth quarter rush effort to meet the energy usage targets by turning the lights out on certain businesses was far more effective at taking steel capacity off line. Sadly, most of these mills have quietly restarted in 2011 with the tacit approval of local cadres who need the employment and the VAT revenue.
But my favorite part of the story is that, in the face of a stated government desire to reduce capacity through consolidation, major steel firms were paradoxically spending like crazy on new plant and equipment! The reason is that the CEOs of these firms believed that the critereon for survival in the post merger beauty contest would be size. The bigger your firm is, the more likely it is that you will run the new merged entity! How’s that for messed up incentives?
Will Chinese’s problem be a Japan-style financing problem?
Professor Pettis,
One issue you brought up was a matter of collateral by local governments (or investment vehicles) for loans. Usually this is land, but also copper and even soybeans are sometimes used. What I’m curious about is the actual availability of land, especially in dense metropolitan areas like Beijing and Shanghai. Is there a risk of local governments simply running out of land to use as collateral? Presumably this would create an even larger housing crisis, since new supply would be essentially zero, so housing costs would rise further.
Is there a chance that running out of land could cause municipalities to default?
RS, yes, I think we have gone through 10-20 years of unsustainable debt growth and so there is too much debt around the world. The process of deleveraging will mean a slowdown in demand growth. If it happens quickly the growth consequence will be minimal but the social disruption higher. I think the next several years will not be easy for the global economy.
Vinz, since the debt is owed eventually to depositors, the government cannot “forgive” the debt. It can force depositors to take the loss – and it will – but this will reduce household wealth and, with it household consumption. Debt is not simply a bunch of numbers. It represents a real transfer of resources from one entity to another.
Steve, this is a common fallacy – that because a country is poor it has unlimited potential for infrastructure increase. The optimal amount of infrastructure matches the economic cost of the infrastructure and the value of the increase in worker productivity. Poor countries have very low labor productivity, and so have low optimal levels of infrastructure.
YCH, China doesn’t really have a “coffer”. The role of the government is to transfer resources from one sector to another. If this transfer is wealth enhancing, it is economically viable. If it is not, it isn’t.
Adam, one of the popular ways of increasing the value of land held by city governments is to move the city center to a new area. This increases the value of previously worthless land, although of course at the expense of those who own land in the old center.
Dear Professor Pettis,
I think your article is quite insightful as to what is going on in China today. However, two questions:
1. What gives you confidence that China’s economy can continue to “mal-invest” for two more years before the debt bubble blows?
2. The Italian and Spanish government bond markets have seized up in the past few days. What is your opinion as to whether China’s debt markets are at risk of contagion and your two year time frame might be accelerated?
Your thoughts are greatly appreciated.
@Michael K, I am not so smart as Mr Pettis, but here is my humble opinion:
1. Unlike in the West, Chinese banks and large companies are in hands of the political caste. Apparently, this means they can keep on piling mal-investments for longer. No one can be sure for how long, but doing it for longer than 2 years with no hyperinflation and/or stagnant GDP seems unplausible. However, it is argued Chinese officials would like to extend artificial, investment-driven growth until the next government takes over in 2013.
2. The Italian and Spanish government bond markets have *not* seized up. While a number of structural problem remains in the EU, the situation is no different from a week ago. I’d say this panic was engineered by some hedge funds whose bets on Greek debt are going very badly (no default event as of now, contrary to what many expected); the ECB and EU banks have rightly defused the panic through massive debt purchases, akin to the proverbial slap in the face to counteract hysteria.
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Michael: ‘Poor countries have very low labor productivity, and so have low optimal levels of infrastructure.’
Not to be argumentative, but what determines labor productivity —infrastructure, education, and ‘systems’ of production (?). Presumably China is investing in the latter two as well. I suppose though that infrastructure investment could get ahead of the rest.
Michael – could use your take on Europe – would be a good service as of now.
Also if Europe is basically dismantled what effect on China. Very little appropriate and solid macro econ applied to the issue with some pragmatic constitutional analysis thrown in that a solid EM person would have.
Cheers
@SteveK9. Imagine you are in a developed country. You can invest massively in the development of a supersonic plane that will cut long-range flight time by half, hence improving labour productivity. The cost of providing subsidized supersonic flights to every businessman is equivalent to 1,000 euros per hour saved. Suppose the labour productivity of the average businessman is 200 euros per hour. Even if labour productivity increases because of subsidized supersonic flights, it is a very bad investment, a distorsion of market forces and a drag on future growth.
Oversized airports and Administration buildings in China are equivalent to supersonic flights in Europe and the US.
Diego, I am not sure I would agree that panic was “engineered” by anyone, hedge funds or otherwise. The problem in the European deficit countries is that their debt burdens are unsustainable and their costs, especially labor costs, are too uncompetitive to allow them to grow their way out of the debt burden. These are real serious constraints and will, in my opinion, lead almost inevitably to debt forgiveness and de-linking from the euro. The experience of Europe in the 1930s and Latin America in the 1980s makes it pretty clear that the sooner this happens, the better, but as long as governments slow down the adjustment process in order to protect French and German banks, we are going to get these very volatile fluctuations on the way down. We will see many more of these occasions over the next few years.
Steve K9, of course investment in infrastructure improves productivity, but it doesn’t then follow that there is no such thing as too much infrastructure investment. Diego’s analysis is exactly right. This is a little like arguing that if one pill makes you better, ten pills make you ten times better.
George, I will write more about Europe, although whenever I do I get hate mail accusing me of being an “Anglo-Saxon” (my father is American of Greek descent, my mother is French, and I was born in Spain, weirdly enough). Basically for ten years I have been arguing that the historical precedents made it very clear that without fiscal union, or a reasonable facsimile, the euro could not survive the first global debt crisis, and I have seen nothing to make me change my view.
On the contrary, it seems to me that we are falling into the same trap that Keynes railed about in the 1930s, in which the surplus countries are foolishly insisting that the deficit countries must bear the full brunt of the adjustment, even though trade and debt imbalances are more the fault of the surplus countries than the deficit. As happened then, first the deficit countries will have debt crises, after which they will move to protect their domestic economies (among other things by devaluing), and then the surplus countries will follow with even worse crises. I hate to use the expression “slow-motion train wreck”, but it really does seem apposite here.
Well done! Love the site.
Michael, Diego. I understood both your points. The question I am trying to ask (poorly) is this. There is presumably a path for China to reach the stage of being a fully ‘developed’ country. That will involve an enormous amount of infrastructure from the present condition (or is that not true?). Of course if you need one airport and you build 10 that is wasteful. My question about education, etc. was directed at the idea that although China may not be in a position yet to make use of some infrastructure, they will in the future. It is a question about first things first. I can see that too much construction now can be wasteful. But, I wanted to understand if the overall need for infrastructure to raise the standard of living in China to the level of the most advanced countries was still large, or whether that in fact is not true. I do appreciate the concept of timing, but wondered if there is still plenty of growth remaining in the building of infrastructure?
Prof Pettis
Your predictions seem to grow increasingly dire. how should one prepare for the coming adjustments?
@SteveK9, it’a a question of first things first. E.g. you cannot take all sub-saharan African savings and get Africa deep in debt in order to build high-speed lines to nowhere. That would be catastrophic even if Africa will sometime in the future need all kind of infrastructure.
But right now, consumption markets, the rule of the law, the end to corruption and cronyism (which are heavily related to that high investment figure) and balancing the economy away from exports are far more important than even more infrastructure. The level of overinvestment in China is really absurd, you cannot imagine it unless you get there. They are building $300m parks around museums to increase tourism, it’s really crazy.
[...] Incentives and debt - Michael Pettis – “For the past decade China-focused analysts have been able to describe static economic conditions with some accuracy but have failed generally to understand the underlying growth dynamics. We’ve done a great job, in other words, of describing the landscape through which the train is passing, but because we don’t understand where the train is headed we are constantly shocked when the landscape changes.“ [...]
With regard to debt, bubbles, and an over heating economy, China is a fairly new at this crooked game. I fear that when all hell breaks loose China will NOT be ready to handle a dire situation.
[...] China Financial Markets » Incentives and debt. « HORAN Capital Advisors: Michael Mauboussin Interview: Challenging Investors’ Behaviors [...]