In the last issue of my newsletter much of the first half was dedicated to a discussion of recent events in Spain and Italy and why they reinforce the argument that several countries will be forced to leave the euro and restructure their debt. The most worrying, but expected, fact was the amount of capital fleeing the afflicted countries. I cited an article in Spiegel that claims that in the past year an amount equal to nearly 30% of Spain’s GDP had left the country. Flight capital is both a major result of declining credibility and a major cause of further declining credibility, and because it is so intensively reinforcing it is a major warning signal.
This matters for China for at least two reasons. First, a worsening Europe will make it harder than ever for China to rebalance growth away from investment, and second, China itself is experiencing capital flight.
To address the first, any sustained increase in the growth rate of Chinese consumption – if indeed this occurs, which in my opinion is very doubtful – will not only have to compensate for a reduction in the growth rate of Chinese investment, but might also have to compensate for a reduction in China’s current account surplus. What is more, the crisis in Europe will only make the global trade environment tenser and nastier.
Notice already what is happening in commodity-exporting countries like Indonesia. According to an article in Thursday’s Wall Street Journal:
Indonesia’s trade deficit hit an all-time high in June as exports from Southeast Asia’s largest economy fell sharply, a sign that weaker demand from China and the West is affecting some of the few countries still growing at a considerable clip.
A third straight month of trade deficits in one of the world’s biggest commodity producers bodes ill for Indonesia, which had become a darling of foreign investors looking for fresh opportunities, but has struggled to contain the damage from a sharp fall in its currency in recent months that has rattled investors.
Countries whose growth depends either on growth in Chinese investment or growth in European demand are going to see significant deterioration in their trade accounts. This will almost certainly lead to even more trade intervention, currency wars, and all the other beggar-thy-neighbor polices typical of a global demand contraction. I think we should expect to see a lot more articles like this.
In addition China itself is seeing noticeable capital outflows as business owners and other wealthy people begin disinvesting and withdrawing deposits. Capital flight from China began surging in early 2010, and it seems to be getting worse, with some monthly withdrawal estimates as high as $40-50 billion, and this can’t help but put increasing pressure on China’s ability to finance the infrastructure, manufacturing and real estate bubbles that have driven the economy.
Over the long term, and in the name of rebalancing, this is probably a good thing for China. The sooner liquidity-driven overinvestment stops, the less debt will pile up and the less painful the deleveraging process will be. But in the short term it will aggravate the slowing down of the economy.
Again not everyone agrees. I have found it interesting that two of my favorite financial periodicals, both British, have such opposing views on China. While the Financial Times has been mostly in the skeptic’s camp for many years, the Economist has been noticeably bullish – although generally the most reasonable and intelligent of the bulls. For example the current issue of the Economist sees the recent retreat from the difficult rebalancing process as a good thing:
China’s unruly property market was once dubbed, with excusable hyperbole, the “most important sector in the entire global economy” by Jonathan Anderson, then at UBS, another Swiss bank. It remains the biggest fear hanging over the world’s second-biggest economy. Home prices began falling about a year ago. The declines have depressed investment and curtailed economic growth, which slowed to 7.6% in the second quarter, its slowest rate since 2009.
The only economic anxiety to rival property is local-government debt. Estimated at 10.7 trillion yuan at the end of 2010 by official auditors (and a lot higher by unofficial ones), much of it was held at one remove by so-called local-government financing vehicles. When one such, Yunnan Highway Development and Investment, told creditors in 2011 that it would not repay the principal on their loans, it was described (with equal hyperbole) as the “default heard around the world” by Business Insider, a news website.
Both worries have roots in the stimulus spree on which China embarked in November 2008. State-owned enterprises began bidding enthusiastically in land auctions, and local governments let their pet projects run wild. Ever since, the two problems have preoccupied China’s central government. In April 2010 it put curbs on speculative homebuying and spent much of last year tidying up local finances. This spring, Wen Jiabao, the prime minister, boasted that local-government debt had grown by a mere 300m yuan in 2011.
Although at the time the Economist was less worried than many of us about the 2008-9 “stimulus spree”, and still usually downplays concerns about China’s debt, they go on to say that things have gotten better:
Signs, however, are growing that both property prices and local-government borrowing are rising again. China’s National Bureau of Statistics (NBS) reports that new home prices rose in June in 25 of 70 cities it tracks. They fell in only 21. Sales volumes also strengthened. Prices are still lower, on average, than a year ago. But according to our weighted average of the (new and existing) home prices reported by the NBS, the pace of decline appears to be bottoming out (see chart). By next month (thanks to a lower base), prices may be rising again, year-on-year.
Local governments meanwhile have been given leave from their debtors’ prison. Reports suggest that China’s banking regulator has told banks to increase lending to “better qualified” financing vehicles. These vehicles have also increased their bond sales, issuing over 420 billion yuan-worth of paper already this year.
Is debt a problem?
The rest of the article argues in part that China can easily manage its debt problems because debt levels are actually relatively low and China has room to increase its net indebtedness:
China’s economy does need help, and its government has ample scope to provide it. Some local governments took on more debt than they could handle. But their liabilities never endangered the fiscal position of the country as a whole. The combined debts of China’s central and local governments add up to about 50% of the country’s GDP (including bonds issued by the Ministry of Railways and China’s policy banks, intended for state-directed lending). Even if local debts are understated, China has fiscal room for error.
I am not sure I agree. First, to make a minor point, I don’t think real estate has necessarily been the “biggest fear hanging over” China. I have always argued that the biggest worry is the unsustainable increase in debt, which historical precedents suggest is an almost automatic consequence of an aging investment-driven growth miracle. While the real estate bubble gets most of press, I would argue that several of the analysts who have been in the skeptic’s camp for many years, like Logan Wright of Medley Advisors or Victor Shih, now with Carlyle, usually agree that debt is the most worrying problem.
Of course borrowing money to fund a real estate bubble is an important source of bad debt, but I have argued for many years, and continue to believe, that economically non-viable infrastructure investment has been a much greater source of bad debt, by which I mean debt whose servicing cost (excluding of course interest rate repression) exceeds the debt servicing capacity created by the investment (excluding subsidies and including externalities). Empty buildings may be much easier to visualize, and much more photogenic, and many people still have an impossibly tough time understanding why it is possible to overinvest infrastructure (isn’t all infrastructure spending good?), but I would argue that sharply reducing infrastructure investment, or at least diverting it into more useful – if less glamorous – projects, is more important than reducing excess real estate development, although this too is clearly a problem.
But that aside, my disagreement with the article is really about whether or not China has a low enough debt level that we can relax about the “fiscal room for error.” Is the relevant debt really just 50% of GDP?
I doubt it. There are three important corrections that need to be made. In the first place total direct obligations of the government must include any net indebtedness within other sovereign or quasi-sovereign institutions, most notably the PBoC. We don’t really know what the PBoC’s balance sheet looks like, but remember that they run – by definition – a hugely mismatched balance sheet in which, since July 2005, the value of liabilities has risen relative to the value of assets by roughly 30% (the amount of nominal appreciation of the RMB against the dollar).
With total reserves equal to roughly half of GDP, it isn’t outlandish to suggest that the PBoC’s net indebtedness might add at least several percentage points of GDP’s worth of debt to the direct liabilities of the government, and perhaps a lot more. A thorough analysis of other relevant entities, such as the national development banks, is likely to add more debt.
Some analysts argue, very bizarrely, that since entities like the PBoC are guaranteed by the central government, and since no one knows the extent of the net indebtedness, it doesn’t really matter at all if they are or are not insolvent. This, however, is an idiotic argument. There are only three things you can do with your debt. If you are solvent you can service it out of operating income. If you are not, you can either default, or you can transfer income from some other source to cover the difference. The cost of the debt, in other words, one way or another must be borne by someone. Invisible debt is still part of the debt burden.
The second important correction has to do with contingent liabilities. It is not just the direct obligations of sovereign and sovereign-guaranteed entities that matter. More importantly, and as we saw very clearly in the last two years in Europe (and in dozens of other cases in recent history), it doesn’t make sense to talk about government debt levels without including contingent liabilities that emerge through the banking system. Here the numbers are potentially significant.
Total loans in the banking system, including the various off-balance sheet transactions engineered in large part to get around lending restrictions, are at least 180% of GDP, and we have no idea of how much potential bad debt there is on the balance sheet of the SOEs or in the informal banking system (estimates are that total loans in the informal banking system are equal to 15-25% of total loans in the formal banking system). Whatever the number, we don’t need to see anywhere near the 40% of total loans that were estimated to be non-performing in the last banking crisis a decade ago for total government debt, including contingent liabilities, to be very high.
Inverted balance sheets
The third important correction is usually the hardest for people to grasp. This has to do with “inverted” balance sheet structures, which I discuss extensively in my 2002 book, The Volatility Machine (Oxford University Press). When you are concerned about a borrower’s credibility, you should not just look at outstanding obligations under current conditions. You should also worry about outstanding obligations in case of a likely adverse shock.
When we think of Spanish government debt, for example, we don’t just think of the current debt load of 69% of GDP (or wherever it has climbed to since the end of last year), or even of the contingent liabilities from provincial debt and non-performing loans. We must also be concerned about the self-reinforcing relationship between the debt and the currency.
If Spain were to leave the euro, in other words, because much of its debt is external debt denominated in euros, any devaluation of the new currency (let’s call it the peseta) would cause a corresponding increase in the debt burden. The peseta could easily lose 50% of its value, for example, in which case the external debt burden would double its share of GDP.
There is a self-reinforcing relationship between the two. Since investors are aware of the risk, the worse the debt-enhancing impact of a devaluation, the more likely the devaluation is to occur, and the higher the external debt, the greater the actual devaluation will turn out to be. We saw this most spectacularly in Argentina, whose debt-to-GDP ratio, if I remember correctly, was “only” around 53% in the period just before the December 2001 corralito and debt default, which was itself followed immediately by the January 2002 devaluation. An earlier, equally spectacular case was that of South Korea in 1997. Its relatively small external debt burden before November 1997 became unbearable just one month later after the forced devaluation of the Korean won.
What does this have to do with China? Perhaps quite a lot, given the many pro-cyclical structures embedded in the country’s economy and balance sheet. If we assume that China will have no problem sailing through its economic rebalancing, the European crisis, and everything else, then clearly we don’t need to worry about anything. But if China’s rebalancing is accompanied by a sharp slowdown in economic growth, or if it occurs during a worsening of the European crisis – both very likely scenarios – then we need to think about what the debt burden will be under those conditions.
So, for example, will commodity prices drop? I think they will, perhaps by as much as 50% over the next three years, and to the extent that there is still a lot of outstanding debt in China collateralized by copper and other metals (and there is), our debt count should include estimates for uncollateralized debt in the event of a sharp fall in metal prices . Will slower growth increase bankruptcies, or put further pressure on the loan guarantee companies? They almost certainly will, so we will need again to increase our estimates for non-performing loans.
Will capital outflows increase if growth slows sharply? Probably, and of course this puts additional pressure on liquidity and the banking system, and with refinancing becoming harder, otherwise-solvent borrowers will become insolvent. Will rebalancing require higher real interest rates, a currency revaluation, or higher wages? Since rebalancing cannot occur without an increase in the household income share of GDP, and since these are the biggest implicit “taxes” on household income, there must be a net increase in the combination of these three variables, in which case the impact on net indebtedness can be quite significant depending on which of these variables move most. Since I think rising real interest rates are a key component of rebalancing, clearly I would want to estimate the debt impact of a rise in real rates.
In another issue of this newsletter I will try to list more systematically areas where I think we should be concerned about inverted balance sheet structures in China, but my main point here is that very often – in fact in the majority of cases – debt crises catch us by surprise because there is a sudden and unexpected surge in debt caused by factors we hadn’t thought about. It is the sudden and unexpected explosion of contingent liabilities that generally precedes debt crises, and not the actual debt burden a year or two before the crisis, that ends up triggering the crisis.
Just remember the finger wagging and the self-satisfied lectures on banking and debt given by senior Spanish government officials and bankers to US and European bankers as late as 2009. No one thought Spain had a problem until debt suddenly emerged from every nook and cranny as a response to the adverse shock Spain was undergoing. Some analysts will complain that it is very difficult to figure out all the contingencies in any country, so acknowledging the possibility adds nothing to the quality of our analysis. But they are dead wrong. An experienced balance sheet analysts can easily tell when overall a country’s balance sheet is more inverted or less inverted, and in the former case he must always assume that the potential for a debt crisis is much greater than the raw debt numbers suggest.
By the way I am not suggesting by any means that Beijing’s current debt level is unsustainable, but I do think it is hard to argue that it has not been rising at an unsustainable pace in recent years. What is more, in every single case in history that I can remember, during a great liquidity-driven bubble, debt structures became increasingly inverted and risky, especially in poor, developing countries, and more especially in countries whose rapid growth is driven by rapid investment growth funded by a financially repressed banking system. The reason should be obvious – when the cost of capital is artificially repressed, economic entities tend to overuse capital as an input. Perhaps that has not happened in China in the past decade, but if it hasn’t, China would represent a truly unique case in history.
We need to be worried about debt, in Europe and the US of course, but we need also to be worried about debt in China. The deleveraging process in any country always results in much slower growth than during the period in which debt was rising quickly, and what matters is overall deleveraging, not just government debt. At some point we will see deleveraging in China, and this must affect growth. Misallocated investment funded by debt means that losses have occurred and one way or another they will eventually be recognized. The recognition of the losses can be postponed for a time, by the simple expedient of not recognizing non-performing loans, but at some point, and usually at the worst possible time, they will be recognized.
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.
Mr Pettis,
This is the article i have been waiting for you to post. i would like to ask that since you have called for the US to devalue the dollar do you feel that the US debt has become dangerously high? In addition could the US improve their trade balance unilaterally without devaluation and simply with trade tariffs against China/Surplus countries?
RS:
Don’t remember Michael calling for the US to revalue but it could use policies that tax financial instruments to cause an effective devaluation; I believe, at least insofar as the attraction of foreign capital to US Debt.
Otherwise, it could use monetary policy to affect a devaluation. They have said that QE was devaluation, but that hasn’t seemed to work if that was the case. I assume in an emergency they could make more formal structures if that we required; Chavez in Venezuela with two-tiered system.
They could simply print at rates that China prints at, and that would make the currency weaker, with little that global capital could do to stem that tide.
As to Tariffs, much of that was handled in GATT prior to WTO which has been geared toward non-tariff barriers to trade, as WTO members would negotiate treaties that included a steady lessening of tariffs over a period of time and a lessening on NTB’s to trade.
You can look at this page:
http://www.wto.org/english/thewto_e/whatis_e/tif_e/agrm8_e.htm
Of course, laws could be enacted that impacted trade in other ways.
This might be interesting:
http://www.uscc.gov/annual_report/2011/annual_report_full_11.pdf
RS,
I am not picking on you, but since Prof Pettis does not mind comment discussions about US here goes the analyses.
Trade tariffs would be the worse idea ever especially at this time. If US puts up tariffs, China will respond with tariffs . Both China and US would loose. Even US investments in China might in danger. When China’s investment model is reaching constraints from a rise in debts and evaporating export demand (This I learned from Prof Pettis) why infuriate trading partner. This is like asking for a barn door to close when all the horses have left. Even other countries might follow .
The US model has a big hill to climb because as Prof Pettis stated private debt started to improve but public debt is still rising. The climate for US exports is limited because of Europe and slowing demand world wide. So the most promising accelerator is US internal
demand. Housing construction will probably improve in 2014.
US suffered about 40% of average family wealth, plus retiring baby boomers are not spending. So we must inject some capital to people. These monies would multiply three times through circulation which would drive the economy but is easier said than done.
My opinion is that at some point US economy will take off ,just needs some rocket fuel.
Other ideas might be like mining coal and processing into benzene which would lower our oil imports and put monies into circulation.
As prof Pettis student ,I do not have all the ideas but I think I am going in right direction.
The US needs more deficit spending by the government, that is the ‘rocket fuel’. It won’t get it though. There is a big difference between private debt (too much) and government debt. There is never a question of solvency with government debt denominated in the government’s own currency.
I do believe that is the poison and not the cure for the U.S. economy. All that does is cause further distortions in the markets.
http://economiccollapsenews.com/
Would changes in the RMB exchange rate not effect the total value of all of China’s USD reserve assests, not just the PBoC’s? If so would that not have tremendous implications? A twenty percent change in more than two trllion in USD assets would be a very large deterent.
P.S. As you have stated before the real loss occured when underpriced goods were exchanged for an overvalued currency, but who wants to around when the bookeeping has to reflect that?
Michael,
You mention the debt problems in China, the U.S. and Europe, but there’s also Japan, Australian households, etc., etc.
Has there ever been anything like the current situation with such a world-wide pervasiveness of indebtedness?
People make analogies to the 1920s and 30s, or say US sovereign debt at the end of WWII. But what we have now seems way beyond anything previously.
For instance, while government debt here in the US is approaching levels to GDP of the late 1940s, household debt at the time was miniscule.
I guess my question is, aren’t we in uncharted territory?
I sometimes wonder if the only way out will be some fundamentally new system, like Chartalism.
According to the Urban Institute and Brookings Institution “Tax Policy Center” tax receipts since 1945 have averaged 18.1% of US GDP. Tax receipts in 2000 were at 20.6 % of GDP and in 2011 they were at 15.4% of GDP. The last time the tax receipts were lower was in the year 1950 at 14.4%. Since year 2000 US lost 5.2% of GDP mainly due to tax cuts and economic slowdown. Tax expenditures since 2000 increased to 5.9% of GDP. This increase included Medicare drug benefit, wars, bank bailout and stimulus.
From the numbers, we can see if we restore tax cuts and economic growth the budget will in the balance. Maybe some taxes to pay for accumulated deficits over 60 years say 30 years pay period . Then the other future debt is to control the rising cost of Medicare to some reasonable %. Control future debt in Medicare is possible if we adapt say Swiss model or any other health model expenditure by the developed countries.
But the debt at present prevents us from stimulating economy or adding jet fuel to launch a
economic growth.
No it doesn’t. And ‘balancing the budget’ now would be a catastrophe.
My second paragraph should read – From the numbers, we can see if we rescind latest “Bush’s” tax cuts and restore economic growth the budget will be in balance.
Stan,
Rescinding “Bush’s” tax cuts to the tune of 5.2% of GDP and restoring economic growth cannot be achieved in concert. The fiscal tightening that the tax increase would entail would be sure to tip the US back into a recession: see Spain, Greece, etc.
Alex I totally agree.
csteven you are correct ,I apologize. The only excuse I have is that English is my third language which I learned in US High School & college
In addition , I am to blunt with my critical statements but I want to present the total economic picture but I should learn more tactful approach from Prof Pettis.
Stan:
Your English is written well, but when speaking of we, you are not a native speaker nor an American, so it is better to say, “It” or the US, and speak as an observer, as we do when speaking on China. You often leave out the “be” form when writing, multiple times, and a hard concept to master for non-native speakers.
Anyway, much of your perspective is spot on, as to areas that caused, contributed to the current mess and longer term problems.
Bob in MA; a rarely heard but very insightful set of points.
My thesis generally, is that the pace in development and the way in which some recent large players, skew the global economic development model and system not allowing breathing room for the advanced counties, or space for other developing countries to grow, has caused, in the present great dislocations (and we know it is not because of adherence to market principles) and will cause in the future (great alterations in acceptance) where it does not change.
Over an extended period of time although it seems to have altered, Libertarians, the 50 Centers, and others who deny the utility of the global economic development system that has benefited the globe for more than a half-century, had decried that the US makes nothing and consumes everything on debt financed byu other people. But some start to realize that that deficit function debt function led to vast and advanced growth at least rationalization for such.
In response to your notion, I am largely of the perspective, that for other developing countries to grow, that largely across the world the world needs to move toward the dynamics that were decried of the US (70%, 30%). That by and large, most of an economy, each economy around the world, need be produced and consumed, in the country.
That means Suntek making Solar panels in the US for America as GM produces car in China for China, and Siemens makes electronics in X for X. That, as Michael has described, not because of debt dynamics in the developed world, but because of the massive size of China in the game, the Asian Development Model is dead.
Countries that had domestic consumption of 55% during their rapid industrialization phase, where China is in the 30′s currently.
And then maturity in these matters and perhaps a return to some Ricardian notions of comparative advantage.
As I have argued repeatedly, China is less a threat to the status of the developed world although it has had great debilitating impact, it is a constraint creator on the advancement of other developing nations. This of course, must alter. It is unfortunate that the post-2004 period, only exacerbated previous excesses.
My perspectives are gained by experience in each developing country that I live in, and I am purposely living in another developing area of the world right now, and in a year or two will live elsewhere in the developing world.
Another area to watch in righting this listing ship is the need to change the short-termism perspectives that are existent around the globe. Americans, and perhaps Asians in misjudging theirs as well, often are guilty of falsely understanding their values, in misjudging theirselves and others, I suspect,….but essentially, many think that the West suffers from short-term perspectives. On the financial news media, they do. But, of course this is far more advanced, and experienced perspective, in the developing world where people expect returns over 100% in a year.
Capital has gotten way too ahead of itself. The cost of real estate is at levels far too advanced relative to domestic conditions in most parts of the world; regardless as to whether we are speaking of East Asia, South Asia, Central Asia, or Eastern Europe as to my experience. Unfortunately it seems to me, that most future gains, are already built in in present prices, and will be a serious constraint to rebalancing. Perhaps, Michael, can use his extraordinary insight and body of knowledge to review that at some time.
But for me Bob you are right.
Again lest we forget due to angst, where we are at now, is due to the success of the system and not its failure. Where we forget that, and even though hard choices, perhaps even hardened positions need to avail where we forget this, we deprive lasrge swathes of the developing world opportunity to advance in my positions especially where extra-system institution evolutions occur. What my be in the interest, perhaps need of some large recent additions to that system, may be highly destructive more globally, in pursuit of forward development. The story has been played otherwise of late, but must of reality alter as impacts become to be felt.
As I understand, when debt cannot be serviced, deleveraging is a must, and the sooner the better. The problem is that nobody wants to take loses and deleveraging never starts until there is nobody left supporting the debt. In this sense, eurozone rescue plans are designed just to avoid deleveraging, and to force punishment until the day of reckoning finaly arrives. When that day arrives, periphery countries are descapitalized, saddled with mass unemployment and less competitive. As spanish, I see a sad future of my country unless there is an unlikely shift in debt policy. My children, will soon be teenagers and I expect that when they join the labor force (by 2020) unemployment will still be very high or even higher than today is. Wages will be lower in real terms and job openings will not offer exciting opportunities.
I’d rather prepare them to be ready to emigrate. That is the success of the euro experiment.
Alternatively, I should not postpone the moment and take my family with me to another country before the day of reckoning arrives. At least I personally don’t owe any money to anybody and I have lived in other countries before… Biotech is still booming elsewhere.
Michael
Another very interesting article. I think your framwork for analyzing China to be the most convincing one that I’ve seen
I wonder if Chinese manufacturing overcapacity isn’t almost as big a problem as infrastructure malinvestment (I assume that manufacturing plant isn’t normally included as infrastructure). Nomura did a report a few months ago which indicated that China’s current steel production capacity is already far in excess of what would be needed even under a very optimistic scenario for urbanization, and yet China is still adding steel production capacity. Any rebalancing strategy would surely require a dramatic restructuring/downsizing of China’s steel industry, which would surely lead to substantial unemployment . And given that the expansion was funded by loans, restructuring/downsizing the industry would mean more bad loans would have to acknowledged /written off. I doubt that steel is the only industry which suffers from this level of overcapacity.
This is a good point. The manufacturing overcapacity also has a foreign policy element, in that these steel companies are currently NOT slowing down production, so at some point they are going to have to dump all this excess steel on the international market. Everyone from Germany to US to Korea will have a fit about this, but the Chinese leadership either does this or risks massive unemployment and capital loss after investing so much into steel-making capacity.
At least if they continue building bridges to nowhere, they won’t enrage all their trading partners. But dumping steel, chemicals, etc. could spark a trade war. With all the excess capacity and employment concerns though, what other choice do they have?
I read an interesting article by Professor Shu Jie Yao about the shoddy quality of China’s GDP.
姚树洁的博客
http://blog.sina.com.cn/shujieyao
Shoddy investment props up GDP – Global times.cn
http://www.globaltimes.cn/content/729397.shtml
An eight-lane bridge collapsed Friday in Harbin, Heilongjiang Province. The bridge, which had been in operation only nine months, has added a total of 1.9 billion yuan ($298.89 million) to China’s gross domestic product (GDP) tally – and despite its collapse, this figure is likely to stay on the books as an achievement in the country’s economic development. What’s more, if the bridge is rebuilt, an additional 1 billion yuan will probably be added to the GDP figure.
in 1990,consumption at, 63% of GDP,it decreased to 47% in 2011, during the same time period,US’s consumption rose from 88% of GDP to 90% of its GDP.
So US spent 10% of its GDP on investment,resulting in a GDP growth of 3.5%,if their investment can be increaased to 30% of its GDP,it would result in an annual growth of 10%,the same as China,
On the other hand,with 53% of its GDP in investment,China had a annual growth rate of 10%,if all the other conditions ar identical,23% of China’s GDP in investment had been an investment wastage.He went on to discuss in details of shoddy investment,most of it are well known.
Michael,
I have just finished reading some work by Andy Lees out of London, who points out that receivables in a number of industries seem to be jumping and while only the machinery industry was published, there were five industry groups represented including steel.
In addition he said that another problem in the banking industry is a web of borrowers who are borrowing for others as well as themselves and then getting guarantees. This would suggest a potential domino effect on the banking industry and suggests that debt levels are dramatically higher than admitted (I know you have spoken about this before).
My question to you is two-fold: 1) Is this information correct or exaggerated in some form; and 2) would you agree this suggests that China’s growth could slow at least down to your levels (as per your bet with the folks at the Economist) or could your own estimate be high?
Thank you for your insight.
Alan Rosenfield
Thank you again Prof. Pettis.
I have a question which is unfortunately slightly off topic. I remember you mentioning Richard Koo (maybe more than a year ago) and I have finally got around to reading his book and also watchign some of his videos on the post 2008 situation. I was wondering whether you agree or disagree (i suspect the latter) with his prognosis on how China played the GFC perfectly etc with a fiscal boost? I always saw it as more of a monetary / credit boost…and if I have been reading your posts correctly I think so do you?
How about default on debt for Spain along with pesetas re-introduction, and reform of its economy, its welfare state and rigidities? You restore competitiveness through currency and reforms and you repudiate the debt and lower debt burden, fresh start like in Iceland.
There is a sick obsession with competitivity but nobody offers any true solution except “cutting expenses (?)” or increasing flexibility (with 5 million unemployed). What about private sector investment?
If someone can explain reasonably well how cutting wages increases productivity (and then competitivity) feel free…
The key to private investment is: expected after-tax risk-adjusted return-on-investment. Reduced wages lower cost which increases expected return on investment. Greater labor market flexibility reduces risk and may also reduce costs. These increase the likelyhood of private investment which usually increases employment and/or productivity.
That is the confidence fairy. What drives investment (your after tax returns) is the expectation of incomes wich in turn depends on consumption. While salaries are reduced in numbers and wages in real terms the expectation of incomes remains weak and investment does not increase.
Michael,
I am big fan of your work and I have read your book. You are right to be wary of inverted structures and also to carefully count all of China’s liabilities, eg. PBoC. However, your two arguments do net each other out to some extent, as the PBoC is long dollar short RMB and thus have a regular rather than inverted balance sheet. Am I missing something?
Regards,
Jordan L.
Hi Michael,
This is a great post. To me the best part of the post is when you highlight the importance of considering contingent liability and the reinforcing relationship between debt and currency.
Most of the analysis done ignores the contingent liabilities or or what I consider generally as broader but hidden trends. It is part economics and part human psychology to ignore such trends.
Anyways, on your point on devaluation, I think the documentation of the issuance could be of some relevance.
Most of the emerging market debt that is sold to the US investors is documented under New York Law. What it means is that the issuing government agrees to be bound by the law outside of their country. So if they devalue their currency their debt obligations goes up accordingly like you mentioned. So a normal default for such country would be they devalue (debt is in US$, so effectively debt goes up) and they default on payment and then negotiate with the investors. The process would obviously involve international law where a foreign government will be taken to to US court by the investors.
The European government issuance is a special case. In this case the sovereign borrowed in Euro but it was documented under their own legal system. The difference is that they can just change their law as after all it is the Greek parliament that decides the Greek Law. The difference I see if that they could have in theory, separated by Euro Zone, devalued the currency and still not have defaulted as the debt would change to new currency.
In reality as Greece would again need to go back to the sme investor to borrow in future, it make make little differece but they had an option. The option not available anymore as the documentation law was changed from Greek Law to UK Law during last restructuring. Some may say its an small point, but then if it was negotiated during the restructing then it must of of some value.
The point is that Spain may still have this option.
RS (and CSeven), the Fed doesn’t really control the value of the dollar so I am not sure the US can “:devalue” the dollar. At any rate I don’t think I have ever called for the US to devalue. When my new book comes out (in February) I hope to explain that any policy that directly or indirectly forces up the savings rate is, in trade effect, the equivalent of depreciating the currency.
Stan, thanks for crediting me with all this. Much of what you say is right, but I think that in a trade dispute there is a very asymmetric balance of power. Very often deficit countries do benefit. Surplus countries almost never do.
Glen, an appreciation of the RMB would certainly cause great losses to the PBoC and other net dollar holders, but it would not cause a loss to China because the dollars held by the PBoC can just as much “stuff’ before the revaluation as after. In fact revaluing the RMB effectively transfers wealth from the PBoC , exporters and long dollar holders to those in China who are implicitly short dollar, e.g. importers, which of course include most of the household sector. This is why revaluing the RMB is part of China’s rebalancing. It transfers wealth from the government to households.
BobinMA, I think global debt levels are much higher today than they have ever been, but at the same time global debt capacity (which in my opinion is a function of wealth, underlying volatility, liquidity and risk management) is probably also higher than it has ever been.
Ignacio, unfortunately I agree with your concern. My understanding is that in fact we will soon be seeing a serious increase in Spanish emigration. And it is the most entrepreneurial who tend to leave.
Mark (and Andao), manufacturing overcapacity is a huge problem, and of course the global crisis jut made it a lot worse, but most studies I know suggest that SOEs in general, were it not for the direct and indirect subsidies they receive, would lose $5-8 dollars for every dollar they state as profit.
Jack2, we have known for many years about the problem of construction quality, but those of us who didn’t get caught up in the enormous China hype of a few years ago had already argued that it was easy to predict. If you consider the incentive structure it is not hard to guess that expanding access to credit, in part by taking on as many projects as possible and completing them as cheaply and quickly as possible, is a winning strategy and ensuring quality control is not.
Alan, surging receivables are a big problem. My growth projecting can always end up being optimistic. That often happens. It depends on the politics of the adjustment process.
Jacques, I strongly disagree and have written about this many times. I am not sure Koo understands how this works and I was less impressed by his book than some others.
Jordan, the inversion in China is very different from that of Mexico and Korea as I described in my book, but remember that China does not face a catastrophic devaluation so it doesn’t matter. I have written about this bfore and will do so again, soon.
Rahul, you might be right. I hope you are. The debt dynamics would otherwise make the devaluation very, very painful.
@alan r.
Absolutely there is a build up in receivables on balance sheets for a number of reasons, none of which are comforting. In a normal market economy, as the business cycle enters a slow down, sales fall and typically, receivables balance reduce as they are collected. Those balances are not replaced by new receivables since sales have declined. Inventories will typically build as well as firms overshoot sales expectations. In a normal economy, management adjusts its expectations down and restricts investment in new inventory. Balance sheets deflate as receivables and inventory levels fall to the new sales outlook. Cap ex budgets are reduced. Therefore, demand for credit falls and prices adjust to clear out old inventory. Some firms go out of business, removing excess capacity. But China has not adjusted that way, heretofore. Firms continued to invest in new equipment throughout 2010 and 2011. Already under margin pressure and yet compelled by local officials to maintain employment, firms sought to avoid reporting losses by capitalizing everything they could. Interest expense on the construction of new factories, building inventory, carrying receivables instead of writing them off all were ways to fudge income statements. Now new factories can no longer be carried as construction in progress, inventories are frighteningly high and even fee hungry auditors cannot pass some receivables as valid assets. Demand for credit continues and the income statement management techniques are morphing more and more to shear fraud as companies become more desperate.
The situation is not so imminently desperate in my mind as to suggest a true banking crisis as Patrick Chovanec suggests for example. But i suspect there will be a significant coordinated effort by local governments with public and private equity funds and banks to address the problems. The small firms, with little employment impact if they go dark, will go dark. Moderate sized firms with a material work force will be either recapped or merged into larger SOEs.
But this only defers the real problem, which is absolute incompetence by large scale firms and public officials to recognize market forces and adjust to them. Bigger is not always better but try to tell that to a CCP member business man who has visions of greatness. There is no momentum at ZhongNanHai to give up economic power and loosen control of market forces.
I agree with Michael, the real crisis fireworks will come in late 2013. If foreign demand has not returned the Chinese economy will be at a real cross roads. I think longterm there will be a retooling of the tax regime and far more centrailzation of revenues and power from the ragtag tax regime now. This will be important as the central government must 1) control spending decisions to force more consumer like spending such as in health care and education, 2) rein in corruption which comes about with unchecked local officials and 3) show its commitment to the laobaixing to avoid social unrest. Sadly, i suspect that the result will be higher taxes rather than lower taxes (as Andy Xie has called for).
One of the few blogs that I enjoy reading, http://www.alsosprachanalyst.com, has a pettisian (my trademarked synonym for logical) look at China’s over-investment…
http://www.alsosprachanalyst.com/economy/chinas-overinvestment-the-problem-of-having-too-much.html