Three weeks ago the Wall Street Journal published my OpEd piece about concern that China may try to make the rebalancing process less painful by allowing the RMB to depreciate. In the piece I argue that this isn’t as obvious as you might think.
From July 2005 to February this year the RMB rose by just over 30% in nominal US dollars. Although on a trade-weighted basis, adjusted for changes in relative productivity growth, the revaluation has been much less than 30%, the increase in the value of the RMB has nonetheless been seen, correctly, as a part of China’s rebalancing process.
But after rising for nearly seven years the RMB has dropped 1% against the dollar since February, setting off intense speculation about Beijing’s trade intentions. Not surprisingly, the threat of a weaker RMB making Chinese exports more competitive abroad and foreign imports more expensive in China is raising worries in a world already struggling with weak demand growth.
But these worries may be unfounded. If China is serious about rebalancing its economy, devaluing the RMB will not result in a net improvement in export competitiveness. China’s export competitiveness will deteriorate no matter what Beijing does to the currency.
To understand why, it is important to see that as part of its rebalancing, China must sharply reduce investment, or at least reduce the growth rate of investment. In principle the adverse impact of slower growth in investment should be offset by faster growth in consumption, but it has proven very difficult for China to raise the GDP share of consumption, largely because, as I noted above, consumption-constraining policies are at the heart of China’s growth model, and indeed at the heart of investment growth models more generally. It will take many years of adjustment before consumption is large enough and can grow into its proper role.
This means that during the adjustment process it is a virtual certainty that growth in China will slow significantly for many years. Why? Because if Beijing brings investment growth down more quickly than can be counterbalanced by an increase in consumption growth, its overall growth rate must slow sharply.
There is however a third source of demand that affects domestic growth – the trade surplus, and this is why there is now so much focus on the value of the RMB. If China’s trade balance improves during the adjustment process, overall economic growth rates should be better than expected. If it deteriorates, growth will be worse. Clearly a healthy trade account will make it easier for Beijing to manage the adjustment process. For this reason many analysts, both foreign and Chinese, argue that by boosting China’s competitiveness abroad, a weaker RMB will provide some relief from the sharp expected slowdown associated with rebalancing.
But they are wrong. If China’s trade balance improves because of a surge in foreign demand (which is pretty unlikely), this will almost certainly be good for the economy and will allow the rebalancing process to be less painful. But if Beijing takes steps to increase China’s competiveness abroad by artificially lowering costs domestically, including by depreciating the RMB, it will have no effect on overall growth for any given level of economic rebalancing.
Why not? Because there is a lot more to Chinese competitiveness than the undervalued exchange rate. There are in fact three main mechanisms that explain the relatively low price of Chinese exports abroad, all of which transfer income from Chinese households to subsidize Chinese producers, albeit in very different ways.
The sources of China’s export competitiveness
The currency regime is certainly one of them, and the mechanism is fairly easy to understand. An undervalued currency spurs export competitiveness by subsidizing the local cost component for manufacturers. These implicit subsidies are effectively paid for by Chinese households in the form of artificially high prices for imported goods. Since all households, except perhaps subsistence farmers, are effectively net importers, an undervalued currency is a kind of consumption tax that effectively reduces the real value of their income.
The second mechanism, the difference between wage and productivity growth, does the same thing, but with a different set of winners and losers. Chinese workers’ wages have grown more slowly than productivity for all but the last two years of the past three decades, which means that until two years ago workers have received a steadily declining share of what they produce. Manufacturers benefit from this process because their wage payments are effectively subsidized, and of course the more labor-intensive production is, the greater the subsidy they implicitly receive.
The third mechanism, the most important, is artificially low interest rates, which in China have been set extremely low. These reduce household income by reducing the return households receive on bank deposits, and in China, because of legal constraints on investment alternatives, the bulk of savings is in the form of bank deposits. Artificially lowered interest rates, however, increase manufacturing competitiveness by lowering the cost of capital. Of course the more capital-intensive a manufacturer is the more it benefits.
All these subsidies goose economic growth by subsidizing producers, but they distribute the benefits in different ways. The greater the local production component, the higher the subsidy created by an undervalued currency. The more labor intensive the manufacturer, the greater the subsidy created by low wages. And finally the more capital intensive the producer, the more it benefits from artificially low interest rates.
The mechanisms also distribute the costs in different ways. An undervalued currency hurts households in proportion to the value of imports in their total consumption basket. Low wages hurt workers. Low interest rates hurt households in proportion to the amount of their savings as a share of income.
Because they boost economic growth at the expense of households, these three mechanisms cause the economy to grow much faster than household income. This is the root of China’s unbalanced economy – household income has grown so much more slowly than the economy that household consumption over the past three decades has collapsed as a share of GDP. Rebalancing in China means by definition, however, that the household consumption share of GDP must rise, and the only effective way to do this is by raising the household income share of GDP. Revaluing the currency is one way of doing so. It increases the real income of households by reducing the cost of imports, and it raises local production costs for manufacturers.
But it is not the only way. Raising Chinese wages increases household income too, while increasing labor costs for manufacturers. Finally, allowing interest rates to rise benefits households by increasing the return on savings, and it raises costs for capital-intensive manufacturers.
Domestic priorities
As China rebalances, by definition Chinese household income must rise as a share of total GDP. This is the important point that is often forgotten in the debate about Chinese competitiveness. In the aggregate, as China rebalances, the net impact of changes in all three mechanisms must result in reduced subsidies to Chinese manufacturers and so, at least initially, in reduced Chinese competiveness abroad.
If Beijing wants to rebalance, and it decides anyway to devalue the RMB, it just means that Beijing must raise wages or interest rates all the more in order to force a real increase in the growth rate of household income. Any improvement in Chinese export competitiveness achieved by devaluing the RMB, in other words, will be fully made up for by a deterioration in Chinese export competitiveness caused by rising wages or rising interest rates.
This is ultimately what rebalancing means. One way or another as China rebalances it will lose competiveness abroad because it must raise the cost of production in favor of household income. In exchange, however, China’s domestic market will become a bigger source of demand as Chinese households benefit from rebalancing. Over the long term Chinese growth will be much healthier and the risk of a Chinese debt crisis much reduced, but over the short term, unless there is an unlikely surge in global demand, China cannot both rebalance and improve its trade performance.
How China rebalances, then, will mainly reflect domestic priorities and political maneuvering. If China revalues the currency, it will disproportionately help middle- and working-class urban households – for whom import costs tend to be important – and will disproportionately hurt manufacturers whose production costs are primarily local, e.g. most manufacturers who are not in the processing trade.
If China however chooses to raise wages, it will disproportionately help urban workers and farmers and will disproportionately hurt labor-intensive manufacturers, who tend mainly to be small and medium enterprises. And finally if China raises interest rates it will disproportionately help middle-class savers and disproportionately hurt large, capital-intensive manufacturers.
These three strategies, in other words, have broadly the same impact on trade competitiveness, although in each case the winners and losers within China will be different. This is why we should not be overly concerned with what happens just to the exchange value of RMB. As long as China genuinely rebalances its economy, which will be a painful process no matter how Beijing chooses to manage it, Chinese export costs will rise and in the short term Chinese goods will be less competitive in the global markets (although as rising domestic costs force China to increase productivity and innovation, over the longer term they will actually boost Chinese competitiveness).
Which path China chooses to follow should be seen by the world primarily as something that affects the way the costs and benefits of rebalancing are distributed domestically. For the sake of more sustainable and equitable long-term growth, and in the interests of economic efficiency, it is almost certainly much better for China and the world if Beijing raises interest rates than if it revalues the RMB, but since raising interest rates is likely to be opposed by the very powerful groups that benefit from excessively cheap capital, Beijing may instead put more focus on raising wages, which comes mainly at the detriment of economically efficient but politically weak small and medium enterprises and service industries.
China urgently needs to rebalance its economy, both to avoid the risk of a domestic banking crisis and to reduce its excessive claim on global demand. How it chooses to do so, however, should not be constrained by too much focus on the value of the RMB. The exchange rate is only one of the mechanisms, and not even the most important, that will determine the price of Chinese goods abroad. It is domestic politics that will determine the form in which the rebalancing takes place, but as long as rebalancing occurs, the world should not overly emphasize the role of the currency.
Do not expect, in other words, that China will steal export share from the rest of the world while rebalancing its economy by depreciating the RMB. Increasing competiveness in export markets is not compatible with rebalancing. As China rebalances it has no choice but to reduce its export competitiveness. Even if Beijing devalues the RMB, this will not improve Chinese competitiveness abroad because Beijing will have to raise wages or interest rates all the more.
This is an abbreviated version of the newsletter that went out just over two weeks ago. 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.
Michael,
Another fantastic piece. It’s so rare to read something on the subject written with an actual understanding of the forces involved.
As you’ve pointed out, in many ways, China is in a similar position to Japan ca. 20 years ago. Many people say Japan bungled rebalancing, hence the two decades of flat GDP. You have pointed out that it’s not as bad as that because households’ share of GDP has increased.
But surely something is very off in Japan, with the level of government debt well above 2% of GDP and still rising at a good clip.
What mistakes did Japan make that China can avoid?
Also, is there a way for Japan to avoid the scenario Peter Boone and Simon Johnson outline in the Atlantic?
The Next Panic
http://www.theatlantic.com/magazine/archive/2012/10/the-next-panic/309081/?single_page=true
Bob, thanks for the kind words. In my April 9 posting I try to figure out how the rebalancing can take place and in it i suggest that Japanese wealth transfers from the government occurred primarily in the form of government assumption of private sector debt. China might do the same thing, in which case it will end up with very low growth and a tremendous government debt burden, just like Japan. However it could also transfer wealth directly in the form of privatization, etc. which would allow it to escape Japan’s mistakes. This, however, will be politically very difficult.
Perhaps I don’t understand well what you mean by China centralizing the private debt? It seems to me that this would be very inflationary (on the majority and only the minority would get the capital) and thus would not re-balance consumption and fixed investment.
I continue to find that the only way China can re-balance is for the central planning and control to decrease.
By “2%” did you actually mean “200%”?
Well stated. One thing that we must get away from, and I’m sorry to be so picky on individual words, is the concept that a trade surplus is good. I refer to “China cannot both rebalance and improve its trade performance”. I’m assuming you are giving the adjective “performance” to imply trade surplus.
Doesn’t the whole issue that China has, and is a characteristic of the Asian growth model, teach that a trade surplus is not good in the long run. Even for a developing country, imports of machinery, fuel, etc, should balance off thriving exports. And healthy developed countries, Canada, have basically a balance in trade. Sure Canada loves to export, but we also love the beaches in Mexico in February.
And with balanced trade, the value of your currency should generally remain the same.. no issue, and you get to visit those beaches!
Actually in economics we use the words “improvement” and “deterioration” in the trade account very specifically to mean increases or decreases, respectively, in exports relative to imports. You are right that surpluses in themselves are neither good nor bad, it depends on the circumstances that create the surplus, but here I am merely following conventional usage.
cjared’s point was very interesting. I think that’s a very unfortunate choice of conventional terms. The trade-surplus advocates appear to have better marketing skills.
How many politicians are going to want to be responsible for headlines reporting a “deterioration” in the trade account, even if in fact that’s precisely what the country needs and they can prove it? It will take too long to explain.
The choice of terms is frequently used to guide the decisions of those too busy or weak-minded to think carefully, when ideally language should be made neutral. Is a loan a debt or an asset? Does one make “deposits in” a bank (sounds safe), or make “loans to” a bank? Within an economy, is it better to have “higher employment” … or “greater leisure”? Is it an improvement if the “unemployment rate” drops, even though fewer people are working, as a fraction of the general population? At what point do banks stop being lenders and start being credit-pushers? One could rewrite the entire language of finance from a consumer-protection perspective and it wouldn’t sound at all like what the marketers write.
I agree with the conclusion.
Subsidizing low-knowledge, high-labor manufacturing, and thus also causing a surplus of such capacity, both result in lower macro competitiveness and real profit margins.
Agreed that the economy will grow faster (or shrink slower than) than (real) household income, but this doesn’t mean the economy is certainly growing in real terms. Grossly lying about inflation and padding the nominals can hide negative real growth.
China can’t lower the value of the RMB, as this will drive inflation crazy, and they are already limited in policy decisions by high inflation. But rising RMB squeezes the profit margins (demand falls at the margins) due to the surplus of manufacturing capacity.
China is checkmated. The only way to rebalance, is to collapse its (non-liar) real GDP and start over. I suspect this is already underway. Diesel hints real GDP may be near 0%.
But is China actually rebalancing? Are the authorities merely paying lip service to rebalancing?
Exactly! The title of the post would seem to be, “If China rebalances, can China increase export competitiveness?” Everything in the post is predicated on the axiom that China will, should, or wants to rebalance. The conclusion is fine granted the axiom, but I would dispute the axiom; so I don’t see any reason why China may not try to increase its export competitiveness.
As I have argued many times before, unless you assume unlimited debt capacity as well as global capacity for infinite increases in the current account surplus, neither of which, obviously, can be true, China has no choice but to rebalance. The only interesting questions is “how?”
While “how?” is an interesting question, “when?”, is another. Perhaps “when” is just around the corner, but an argument that it is needs to put a hard limit on debt capacity and the current account surplus and not just note it’s finite. Finite, at least theoretically, can be awfully big, which means that “when” could be far in the future
My guess is that rebalancing will come even though the Chinese do improve their export competitiveness – it’s just the rest of the world’s economies will have slowed enough, that the increased competitiveness won’t increase exports more than what they’re losing from the recessions elsewhere.
I’m pretty sure they can’t. With the government’s rising minimum wage limit, costs for Chinese exporters and manufacturers are bound to go up.
Do you not think that in the very short term China is likely to revert to a substantial trade surplus as the effect of the infrastructure and property construction splurge wears off, with the result that China’s vast imports of hard commodities (which have been masking China’s structural trade surplus since 2009) tail off?
Probably. Remember that the current account surplus is simply the excess of savings over investment, and that in the short term it might prove easier to bring investment down than to bring savings down (although the latter might occur very rapidly in the form of a collapse in corporate profits). The key is the ability of the rest of the world to absorb a rising Chinese current account surplus.
2 Questions
What if Beijing Doesn’t Rebalance or Doesn’t fully commit to Rebalancing? What the expected consequences for China
Do you think China will rebalance and where is the evidence?
I don’t see how this work. The SOE might have influence at the heights, but local officials and their alliances have influence, too. Do you think they seriously would allow disposable income to rise? I mean, one of the big changes that’s also happening is the increased focus on rebalancing local revenues to income/social security taxation/stopping evasion/better utility collection. They don’t really have a choice, given the local debt portfolio and dealing with various local payment crisis. Reduce the debt via central bailout using various means would lead to bad outcomes that generally would either stop the rebalancing or creates major issues for the central bank in handling the export side.
See my response to AKP
But maybe China doesn’t want to rebalance. Keeping the RMB undervalued may be a last-gasp attempt to keep the investment-and-export party going.
Michael
In your opinion/experience do large US companies realize this? Production jobs still seem to be moving toward China if not other Asian countries with the same export model.
RS I think corporations, and especially commodity producers, have been even slower than sell-side analysts and investors to understand the unsustainability of China’s growth model, but it does seem as if the relevant FDI has declined.
Also, how much do you think the CCP really controls wage inflation? My sense is that recent min wage rises are more a recognition of reality – ie urban labour demand is now growing faster than the incremental supply of migrant workers. Isn’t this the point in western 19th century industrialisation that labour began to earn real bargaining power, and therefore median wages (not to mention health and safety, voting rights and the welfare state) all began to improve radically?
I’m a bigger fan of wage hikes than interest rates or revaluation, since it’s the method that keeps the most people honest, I think. Nominally the PBOC could raise interest rates and charge SOEs a market interest rate on loans, but it’s naive to think these SOEs will be allowed to go bankrupt. So then the whole science of loan valuation should be thrown out the window. I’m just thinking back to Shandong Helon, and how the local governments vowed to keep it open no matter what. The first time a Chinese company could have defaulted on its bonds, and what happened? Lots of government intervention.
Higher interest rates would clearly help household savers, but I’m not convinced that it would hurt borrowers. There would be implicit government guarantees to push down loan interest rates, and a nice bailout package waiting at the end of the tunnel if an SOE is in danger. Of course this would be disastrous for the debt situation, but I can’t see local governments allowing huge enterprises that employ thousands of people from going bankrupt. They’ll throw the kitchen sink at it if they have to, like they did with Shandong Helon.
Professor, how would the banks be able to raise interest rates on savings while enforcing high interest loans on government corporations? Part 1 seems easy, but I think there are too many competing interests for part 2 to work.
Wage hikes are politically the easiest thing to do, but the problem with wage hikes is that it penalizes the labor-intensive (and very efficient) SMEs rather than the capital intensive (and very inefficient) SOEs. If China ever wants to be have an innovative and value-added economy it must do the opposite.
Disagree. The first and most fundamental problem is that there should be no centralized control over wages (free market should set them, i.e. no Yuan peg), in order to have maximum efficiency in the economy. China suffers historically from habitually ignoring degrees-of-freedom.
Although the labor-intensive SMEs may be “more efficient” in terms of the level of subsidies they don’t extract from the household sector (Pettis has insightfully explained that SOEs are operating at up to -800% subsidized profit), they are only efficient relative to SOEs, within the confines of the systemic growth model of the Yuan peg. In the external free market, there is an overcapacity of cheap labor in the world, and no country is going to see sustained growth by pursuing a low-knowledge economy. We are leaving the industrial age and entering the knowledge age:
http://www.coolpage.com/commentary/economic/shelby/Understand%20Everything%20Fundamentally.html
To increase the efficiency of rebalancing, China’s central authority needs to be weakened. This can happen in several ways. As far as I know, history says that vested regimes don’t usually give up power willingly and transitions tend to be abrupt and chaotic.
Efficiency is fitness. Period. I could go into an extensive proof, but let me give an anecdote for now. Imagine a car with no reverse gear (one less “degree-of-freedom”), it has to go around the block, just to go backwards a short distance. Degrees-of-freedom is a very precise scientific term that wikipedia explains is the equivalent of potential energy. Further explanation:
http://copute.com/index.html.orig (see Skeptical -> Higher-Level -> Degrees-of-Freedom -> Physics of Work)
This is an example of how thinking about economies in terms of macro-levers as Professor Pettis apparently likes to do, is antithetical to economic fitness, because a macro lever can never do just one thing. Thinking in terms of macro-levers can be useful, but we must not lose sight of fitness and external entropy (Coase’s theorem). I think in many cases Pettis is correctly looking at external impacts on those macro-levers (e.g. he correctly states the current account trend and growth model can continue forver if the export markets can’t grow forever), but the free market fitness is not considered (or at least I haven’t yet read his comments in this regard). Only the free market can decide the winners and losers in various strategies, because a centralized planner is analogous to not having a reverse gear (not in the sense of not being able to go backwards in time, but in the sense of generally having less degrees-of-freedom). The centralized planner can’t see all the factors at the diverse local scenarios (sort of analogous to how the police are always 15 minutes late to the crime scene).
China’s fundamental problem now and for 1000s of years, is that it has always wanted to be big and economics run by conquest and centralization. It was the first to create a paper fiat currency. The big gains in China have come from infrastructure efficiencies, i.e. using the waterways to connect markets was one of China’s big wins in history. But in my limited study of China’s history, they seem to always mess themselves up with their lack of appreciation of degrees-of-freedom and fitness. Even I read that their current education system is very rigid based on testing performance, together with their one-child policy (can’t just do one thing, multiple side-effects), they are negatively impacting their ability to adjust to the future outcomes.
This time will not be different.
Typo: “growth model can continue forver”
Correction: “growth model can’t continue forever”
Professor, to further prove my point, please note how your (current choices for) macro-levers don’t have enough degrees-of-freedom. You state that China must do the opposite of rising wages in order to become more efficient. But in other cases, you argue that real wages must rise in order for China to rebalance towards normal levels of consumption and household wealth. Your other option of rising interest rates on savings requires rising real wages (the savings have to be invested profitably and not in fixed capital investment, so again real wages must rise to support more consumption).
This lack of viable options is why I made the conclusion that China is checkmated. All the options going forward that I see, are extremely bad– collapse/disintegration or doubling down on centralization with an external war (to later follow with collapse/disintegration).
I do understand that not all SOEs are necessarily low-knowledge labor-intensive, but I think it is correct to assume that the significance of China’s labor-intensive economy is relatively low-knowledge compared to the west. One of your points has been that China’s real wages (i.e. the relative knowledge-level of their labor) is too low to make the real return on the lavish infrastructure positive.
Mankind prospers via knowledge and technology, not by distributing 1000 spoons to 1000 men to dig ditches. The discovery of the combustion engine enabled 1 gallon of petrol to do the work of 500 men. Steve Jobs explained how the computer is the “Bicycle of the Mind” (available on YouTube), etc..
The wage trap (systemic growth model and centralized control levers) has disincentivized (insulated and isolated) China from the global knowledge economy. They’ve apparently been centrally directed towards rote learners, followers, and copiers. Of course there are exceptions in China (and I don’t intend to disparage all Chinese), but we are talking here about the aggregate macro levels of significance. I am hoping that China could recognize this historical weakness, but I am not optimistic because they have historically oscillated with exponential moves between utterly big and utterly failed. It is a trap of extremes that is very hard to escape from, because the extremes reinforce the cultural tendencies. Sort of analogous to the “circle of poverty” on an individual level, where being poor causes one to not get a good education, etc..
Professor Pettis wrote an insightful and detailed article on the ways China can rebalance, and explained why it is impossible to avoid rebalancing forever:
http://www.mpettis.com/2012/04/09/the-ways-china-can-rebalance/
The key non-timing point is that the necessary raising of the relative value of household sector, necessarily requires bankrupting some of the larger fixed investment sector.
The politically connected gain their wealth from the fixed investment sector. So I expect chaos as this sector stops growing (or slows), because the unity of the political sector would be subject to competition (fighting) over a shrinking pie. I have anecdotal evidence to speculate this is happening right now.
This is why I don’t believe that any of the gradual scenarios for rebalancing are realistic.
Once China enters political paralysis, then it will be unable to maintain orderly brakes on the free market forces.
As for timing, China needs another massive stimulus program now in order to maintain growth in fixed investment, because the globe is rolling over into falling imports:
http://www.zerohedge.com/news/2012-09-23/global-trade-cycle-turns-lower
Thus I expect consumption share to rise via a shrinking GDP, consumption, and employment, with consumption falling less than GDP as the state sector is bankrupted.
Or I expect China to double-down on repression and perhaps the only way to maintain that would be to go to war and conscript the population. So this would mean killing all the political dissenters (re-unifying). China has done this in the past. And note how the wealthy are getting their money and families out of China at an accelerating rate.
@Shelby wrote:
———————————————————
Eric S. Raymond wrote:
http://esr.ibiblio.org/?p=4773&cpage=1#comment-394364
Ah as I had suspected.
“And finally if China raises interest rates it will disproportionately help middle-class savers and disproportionately hurt large, capital-intensive manufacturers.”
middle-class might have their bulk of their saving in deposits, yet their bulk of net worth (investment) is in housing. Rise in interest rates will increase the mortgage burden at a time when housing prices most likely will fall (and continue to fall for a long time).
Anyhow, this is just a small issue in the grand scheme of it all. What the prof. writes might be necessary yet it is for sure not sufficient. For an economy to turn consumer based it has to be a part of a structure which support it, such as decent rule of law. Otherwise we’re looking at a second Russia, at best.
Hoping for the best, of course.
Hi Michael,
Thank you for another great piece.
As I am trying to think through the probability of success in the Chinese rebalancing effort, I am drawn to thinking about how much of a margin of safety their economy has in making the handoff from the current economic structure to a more consumer driven model. During the period of adjustment, it would seem critical that the current structure not be pushed too hard too fast since its collapse before a successful hand-off would negate any possibility of the consumer economy emerging (if the restructuring causes – early in the process – a massive rise in bankruptcies and layoffs, it would be hard to imagine material growth in consumption under such circumstances). Given the trade-off here, it seems to me that a critical factor in the success or failure of the restructuring will be the existing margins of those companies that will inevitably see a reduction in competitiveness through the adjustment period. If it is the case – and I do not know if it is or not – that such companies are already operating on razor thin margins at the start of the rebalancing process, then the problem is much larger than if they start the process with thick margins that would give them a much larger buffer with which to absorb the coming squeeze on those margins.
Given this, I am wondering both if you agree and also if you have written anything specifically addressing this issue of the extent of this margin “buffer” across the current Chinese economic structure and how it will effect the potential for success in the rebalancing effort?
Ray
You point out a very hard-to-solve problem, which exists in large part because Beijing waited far too long to manage the adjustment. Somehow the state sector is going to have to subsidize the cost of the adjustment or else we will see spreading financial distress. This brings us right back to the issue of some sort of privatization as a necessary part of the rebalancing.
Thank you for your response.
Is it not the case that, even with a large privatization program, if those sectors being privatized are no longer economically viable it doesn’t solve the problem? Afterall, if those sectors currently operate on very thin margins, many will be pushed into bankruptcy as their labor and/or capital costs rise as a result of the adjustment process (in the way you describe). Transfering the ownership of even a large portion of these companies to the public will have limited effect if they are fundamentally uneconomic in the new circumstance; and if they are uneconomic they will have little or no value. It just seems like they’ve driven down a dead-end having missed turns that might have led them to a better long-term destination; if they have now passed all such preferable detours and are approaching the dead-end, how does now giving the steering wheel to someone else help matters?
Indeed, you raise many of the points that cross my mind too.
See the other comments I added above today.
I see collapse and distress and perhaps even greater repression as the only option forwarded. The question of timing is a bit more difficult (could they double-down on another massive stimulus first?), but I agree with Prof. Pettis that is not likely more than 2 – 3 years from now.
There is a lot of debt but there are even more assets, including unencumbered assets like land, toll roads, air[orts, mining rights, air space, etc. Many companies are in relatively good shape even if others are insolvent. Finally, even insolvent companies have positive equity value.
Assets are a liability if not productive, and takes time.
More developed assets, have less opportunities to be redeployed profitably, i.e. the best time to privatize was decades ago.
Marginally solvent companies can become insolvent in a declining (re-balancing) economy.
Some people (Chanos) think most (nearly all) companies in China have overstated accounting.
I would be concerned not only by balance sheet issues, but also profit/cash flow margin issues. There may be many companies that are operating on very thin profit/cash flow margins even though they are not highly debt leveraged; a company with no debt but very thin margins and a large labor cost component will get into trouble quickly if those labor costs rise even a small amount (of course they can lay off workers in this situation, but if that happens to a material degree across the economy it will be very negative for unemployment and job security generally – and therefore for consumption growth).
The two issues that seem to me the critical ones in terms of judging whether or not privatization is a practical solution are,
(1) Is it realistic to believe that a material enough amount of privatization is politically possible? It would, after all, require many vested interests to loose their wealth. For those in power it could also involve taking a significant political risk given the uncertainty of the outcome at the start of the process (call this the Pandora’s Box problem).
(2) Given that the adjustment process itself will cause an increase in labor and/or capital costs for those very entities being privatised, how much value would those assets have once in the hands of the public (and would those values cause enough of a positive wealth effect to counter what would likely be a period of bankruptcies, layoffs and increased job insecurity among those workers being relied upon to increase their consumption to create a successful adjustment)?
The two questions are also inter-related since the harder the values of the to-be-privatised companies are likely to be hit by the adjustment process, the more political resistance there is likely to be against the proposed privatisation program. The idea seems to me to require some kind of sensitivity analysis to see whether the likely level of positive wealth effect would overcome the likely negative effects on consumption patterns caused by the economic distress of the adjustment process itself. The size of the privatisation program and the level of damage done to the current existing economic structure by the adjustment process (and thereby the values of the privatised assets once privatised) seem to me to be the two most important factors in judging likely success or failure.
FDI would solve both cash flow issues and the downward spiral of asset prices. Of course it would have gone much better two years ago.
Michael,
I’m curious about the effects of the destination of income and the distribution of income on rebalancing. I understand the relationship between household disposable income and consumer spending, but I’m interested in the impacts of corporate income given the large share of SOEs. Since GDP equals national income, in a capitalist system where households ultimately own the majority of physical capital through ownership of companies, households have a claim on corporate income even if it is retained. This wealth/potential future capital income influences consumption in addition to current household income. And the distribution of the claim on corporate income is skewed toward the wealthy.
In China, with a large share of SOEs, the claim on that corporate income is held by the state. While some of this claim may be siphoned off by the elite, how does this different structure affect household spending, investment, and government spending? In general, how does the wage share of income and the capital share of income influence household consumption and rebalancing?
Thanks,
Peter
I have written about this elsewhere and it will be an important part of my upcoming (February) book “The Great Rebalancing “, but I think the best guides for thinking about this are tow 19th Century economists, the British John Hobson and the American Charles Arthur Conant. They both discuss the impact of inequality on forcing excessive savings relative to consumption that can only be resolved by speculative investments domestically and capital exports.
Very well argued. One comment i have that might add to your argument is that increasing Equity returns is consistent with raising interest rates. Few SOEs pay dividends and overall the cost of equity capital is quite low to the point where i think the cost of equity capital is cheaper than debt capital. This goes to your suggestion to privatize the SOEs.
Yes, you are right. In China equity is simply debt without a coupon.
Prof Pettis,
Is it true that China has a fiat currency? And with a fiat currency one can do anything one wants. I saw even fiat cars riding on water.
All countries either have fiat currencies or are pegged to fiat currencies.
Michael,
What about the government do a tax cut, while increase wage or interest?
As you said, increase wages or interest rate will cause a cost increase for labor-intensive or capital-intensive firms respectively. So the gov could in the same time make a tax cut for firms. Your three mechanics consider the share of consumers and producers, forgetting the share of gov. The gov could maintain producers’ share of GDP, increase consumers’ and decrease gov’s in the same time, I think.
– Gabriel
China’s real taxes are hidden taxes (currency, wage and financial repression taxes, for the most part) so it is the aggregate that matters, and actual taxes in China are, in my opinion, largely irrelevant. It also depends how they fund the tax cut. If they are funded by borrowing, the household sector still pays the tax, except in the form of the financial repression tax. if it is funded by selling government assets, then it works. Notice that takes us right back to privatization. We cannot escape it as the best solution to Chinese imbalances.
Yes but privatization is “stealing” from the party. Limited privatization only worked politically to the extent that the entire pie was expanded, including the corrupt portions in this corrupt growth model.
Dear Michael, please give some comments on this response to your OpEd piece on WSJ by Larry Long.
http://online.wsj.com/article/SB10000872396390444914904577616573150975052.html#articleTabs%3Dcomments
I forwarded it here to make it easier for you to respond:
”
Larry Long Wrote:
Very interesting article. Mr. Pettis – AND the WSJ – might do us a favor by presenting the other sides of this disingenuous argument.
“Yuan appreciation will disproportionately help urban households—for whom import costs tend to be important. And it will disproportionately hurt manufacturers to the extent that their production inputs—mainly labor, land, logistics and raw materials—are priced domestically.”
Let’s get rid of the idea that lowering the cost of imports by a few percentage points is a significant factor for domestic households in China. What percentage of China’s domestic spending goes on imports? Mr. Pettis doesn’t bother to tell us, but it isn’t high, and the effect will be minor. Yuan appreciation helps nobody except the currency speculators – and the US government which wants China’s rise to end so as to stop the threat to its own quest for global hegemony.
On the other hand, raising the RMB exchange rate will help to kill China’s export production, as the US has been trying to do for decades now. In any case, there is no evidence that China’s currency value is out of line, no matter how much Charles Schumer screams and obfuscates.
“Raising Chinese wages will help household income too.” TOO? Raising wages will help household income “TOO”? Now, that’s cute. Raising the RMB and reducing import prices by minuscule amounts will help Chinese households the most, but actually raising the wages and salaries will add just a little positive effect.
You needn’t be an economist to understand that rising wages has by far the greatest, and the most immediate effect on household income, and therefore on consumption. And this is a path the Chinese government is following; in many areas, minimum wage levels have risen sharply, and wages all across China are rising. In Guangdong, many industries such as auto and electronics have seen wage increases of 40% or more in just the past year.
“But the best way to rebalance is raising interest rates. Of all the three mechanisms, this is the most important one, since it strikes at the heart . . .” Yes, Mr. Pettis, raising interest rates strikes at the heart of the agenda of the Carnegie Institute for Sedition, Anarchy and Revolution, since it is the best way by far to kill China’s economy completely.
The reason is that this will accomplish everything the US wants, in its quest to shut China down. Higher interest rates will cause the RMB to rise, thereby rendering China’s exports less competitive, damaging an already suffering sector and possibly causing substantial unemployment – which “professor” Pettis neglects to mention.
Since the higher RMB will make imports cheaper, it will damage China’s trade balance as well as helping to kill the investment in infrastructure, plant and R&D which are so vital for China’s continued development.
“The winners will be every saver, whose higher income will then allow him to consume more. The losers are the large capital-intensive companies.”
My God, I hope nobody believes this ideological drivel. Interest rates would have to rise by heavy margins before that translates into “higher incomes” for China’s general population and that would convert into increased consumption. The small increase in domestic savings would be overwhelmed by the severe damage to China’s companies that so badly need increased capital for both operations and investment.
Given the fragility of the world’s economy, caused entirely by the US and its greed-driven “free market” and worldwide banking frauds, a sharp increase in China’s domestic interest rates would serve only to add China to the long list of basket-case economies, and of course that is what Mr. Pettis, the Carnegie Institute, and all Americans, want for China.
Congratulations to the WSJ for publishing this piece of idelogical rubbish.
China is doing i…”
If Larry Long had a serious and well thought-out argument he would probably put it in a serious and intelligent way. That his response is so rabid and bitter should suggest how absurd his arguments are likely to be.
In fact they are. To say that raising interest rates is part of the Carnegie Institute for Sedition, Anarchy and Revolution program to undermine the Chinese economy suggests that I have a lot more colleagues than I know, including the PBoC, most economists at Tsinghua and PKU, and probably even the future premier of China. Even the most bullish analysts now recognize that low interest rates are at the heart of both Chinese capital misallocation and low household income. They are the single most important variable to change but, as Long notes, it is extremely difficult to do so because after so many years too much of the Chinese economy is addicted to free capital, and to raise the cost would create enormous financial distress. This is part of the problem with the whole adjustment process.
As for raising wages, many people find it hard to understand how other factors can be just as important as wages in determining household income, so it is perhaps not surprising that Long doesn’t understand the point, but clearly he doesn’t follow economic events in China very closely or he would have noted that two years of rising wages have badly hurt the SME sector, which tends to be labor intensive — just as my PKU students predicted nearly two years ago. To raise wages while keeping the cost of capital low means essentially transferring resources and wealth from SMEs — who are widely recognized, although apparently not by Long, to be the most efficient part of the Chinese economy — to SOEs, who have been value destroyers for years. This isn’t a terribly good idea, although it is certainly politically easier than raising interest rates or the currency, as I noted in my piece, because SMEs have little political power.
My suspicion is that Long is one of the insecure nationalists who see any skepticism about the Chinese growth model as a threat to his personal sense of self, but hasn’t realized that in the last few years it was the excitable cheerleaders who were wrong, and who hurt China by their lack of basic economic understanding, while the skeptics now dominate the discussion. Had the skeptics been listened to in 2005 or 2006 China would be in much better shape today.
Of course the worse the Chinese economy gets, the more likely the Longs of the world are likely to rage with anger, so I expect many more comments like his in the next few years, but is it really so crazy to have a serious debate about one of the world’s major economies without one side or the other being characterized as devils? Most other major economies are the subject of debate — why not China? This seems on the face of it to suggest that Long is not interested in China’s economy. He is interested in boosting his sense of self-worth. Unfortunately as an economist there isn’t much I can do about that problem.
Yes, Larry Longs is a cultural revolution Chinese who is very angry to allow anyone to debate on China, and so he makes many mistakes but can not correct them. Chinese must change this way of thinking or Chinese people will not advance. Thank you for your understanding of China.
Well put, you are more magnanimous than I would have been. I like Mr. Long’s point about rising imports “damaging” China’s trade position. Once again, trade surplus is seen as “virtuous”.
The level of sensitivity when talking about the Chinese economy has reached new levels of absurdity, at least among the Chinese people I speak with.
Thank you so much, Michael. I have learned a lot from your response. Appreciated.
Mr. Pettis has touched upon a raw nerve within some of the local psyche. In my recent travels in China, there has been some fervor that China will eventually dominate the world economy. Until recently, I remarkably saw this in Hong Kong as well. How China could dominate world economy by producing more and more goods and selling them to the U.S. and Europe doesn’t make sense to any of us who study economics? One should see the fallacy in that logic out of hand. We had these same discussions about Japan 20+ years ago. The discussion here is not nationalistic propaganda on behalf of the West but rather market economics in which no nation controls the outcomes. Many Chinese seem to realize the Chinese government cannot control economic outcomes and others do not believe this. My fear is that the rebalancing will trigger local frustration with the Chinese government and the government will attempt to redirect popular dissent towards the U.S. This would not be the first time a country that hit a big bump in the development cycle blames the U.S. Recently, a prominent European leader was blaming the U.S. for Europe’s problems.
Shelby and others are correct in pointing out the challenges and difficulties that will come with rebalancing, but I would not extrapolate views from Mr. Pettis’ writings that are not explicitly presented. Mr Pettis is just pointing out what adjustments need to occur and that they are inevitable. The analogy is one of a man walking towards a wall. He only has three options. Turn left, turn right or go backwards. Mr. Pettis is just pointing out that we have hit the wall and here are the necessary turns. I think anyone who reads this column fears China going backwards. Yes, the Chinese government can re-tighten its control on the economy, but lets hope for adjustments that continue China’s development towards a stronger and balanced market economy. In my opinion (notice the qualifier), Mr. Pettis’ writings have generally spoke on economic options and less about the politics and political risks. Although, I am sure he is profoundly aware of the political challenges.
The proverbial “wall” mentioned above is the very real limit on further expansion of the trade surplus as a source of growth. The U.S. simply cannot afford to borrow more and more money to pay for more imported goods. In my final note of verbosity, I will paint a picture where in a few years the U.S. succeeds in inflating the global economy by monetary expansion and the Chinese can expand their trade surplus in nominal dollars, but not in real terms. This could trigger more inflation in the Chinese economy resulting in wage and profit increases. The next step would be to then allow the currency to appreciate which would allow the market to do its work and contribute towards rebalancing. Call me an eternal optimist.
Thanks, Phil. It shouldn’t be necessary to say all of this but apparently it is. To argue that China’s growth model is unsustainable and will lead to a difficult adjustment is simply an exercise of economic logic, and while it may be correct or incorrect (and by now it is pretty clear that it was correct), it is not the same as wishing or hoping that China’s economy will fail. On the contrary, to the extent that the argument is correct, and is acted upon, the Chinese economy benefits.
How does inflation re-balance? I thought inflation is a regressive tax (transfers wealth from those who spend most of their income, to those wealthy who hold assets).
The key is currency revaluation. In the case of China, currency revaluation during the days of high inflation would have assisted rebalancing. Wages go higher and purchasing power goes higher. However, China and other countries before it find it tempting to continue pushing the investment and export growth model by holding down the currency. There is a big difference between inflation driven by monetary expansion and inflation driven by export demand. It appears the U.S. Fed is pursuing the latter in an effort to support domestic asset values. The Fed is also attempting to stimulate domestic and global demand. The jury is still out on their actions.
Inflation is a sort of tax but is not necessesarily regressive. It transfers wealth from those with currecy based savings (cash, bank deposits, bonds etc.) to debtors and the issuer of the currency, i.e. the government.
Inflation could contribute to rebalancing essentially the same way as an increase in the exchange rate would. If workers wages are increasing faster than the rate of increase of import prices then the workers see a reduction in the real cost of imports, etc.
Agreed that inflation transfers capital to debtors (who waste it, i.e. capital is misallocated), but this is precisely the opposite of rebalancing in China. The household sector are not the debtors. They are getting screwed by depositing their money in banks at negative real interest rates. So they chase the shadow banking market, condos, or stock market for real yields, but then end up in a fixed investment bubble any way, so they are still going to be screwed when it pops.
And it is always regressive, because debtors are not gaining net worth. Sustaining indebtness delays the debtors from becoming efficient in the market place, stop wasting capital, and grow net worth. And they are not getting any younger. I know as I approach 48 and my eyesight and other aspects are declining, that I can’t be as productive as I used to be, in spite of still having an adequate mental facilities.
To summarize those long comments I made the prior day, the problem with the wages and the interest rate, is that they were not set by the free market for so long, that now there are massive imbalances in the economy that can not be fixed by changes to any of these macro levers (without incurring some negative effects).
The more centrally planned an economy, the greater the extremes of the cycle of exponential growth and crash. Blaming some outside force (as Larry Long does) denies the true cause of the failure (i.e. the existence of central planners).
I had commented in Pettis’s prior article that during the 1800s in the USA on a gold money system (with multiple private banks doing independent fractional reserve lending), there were growth and bust cycles (with runs on the banks), yet as far as I know, these were more frequent, shorter duration, and more shallow. I assume this was because the market had more actors making independent decisions (degrees-of-freedom) and thus economic fitness deviated less and re-adjusted faster.
Although many people may by now admit that China needs to re-balance consumption and fixed investment, my stance is that the only thing that will re-balance China is for the central planning to decrease. Someone might argue that a significant decline in GDP could re-balance China (because consumption would decline less), but I would argue that the centrally planned (one party) political system can not survive such a decline in its current largess form.
Professor Pettis is far too polite to even bother answering to this Mr. Long who obviously did not make even a minimal effort to think through and make reasonable arguments and instead opted to bashing for some provocative effect.
Beware demand destruction
China’s leaders want to increase the level of personal discretionary spending to boost the consumption ratio in China’s GDP, a worthy goal. In the US, personal spending once reached 70 percent of GDP, a shockingly high percentage and a trend that will surely never return due to the ongoing destruction of the US dollar.
Meanwhile, Taiwan’s leaders, politicians and judges — many of whom only claim to be Taiwanese — make a celebratory ritual out of stealing from the poor and laughing all the way to the bank while pretending to have competent ideas about improving Taiwan’s economy or returning the “ill gotten assets” to Taiwan’s treasury where they belong.
It is simple math, really. With the Post Office savings rate a little over 1 percent, and the inflation index, or CPI, at around 3 percent, Taiwanese who have been saving for decades are now finding that their wealth is dwindling during their retirement years while they watch their household expenses rise as they get older and require more personal care.
At the same time, certain Taiwanese special interest groups benefit from a government-guaranteed 18 percent interest rate on their savings, higher than any other investment return in the world. I was delighted when former candidate Democratic Progressive Party chairperson Tsai Ing-wen (蔡英文) said she would abandon this unjust practice during her presidential campaign.
This special interest rate is absorbed into Taiwan’s national debt — which of course relies on our children’s as yet unearned wages to repay. It is quite an unfair system, even if you are one of the lucky few. In an environment where a workers’ savings are diminishing over time relative to inflation, it is hard to imagine that consumers will go running out on shopping sprees.
To ensure that a country’s citizens spend freely, it is necessary for the central bank to guarantee that savers’ long-accumulated wealth is not diminished over time. I would mandate that the interest rate on Post Office savings accounts be brought up to the level of the CPI. I would reduce this 18 percent preferential rate over three years, so that investors can carefully move their savings elsewhere.
Most of Taiwan’s TAIEX-traded companies pay dividends of around 5 percent annually, widely above the rate of inflation and the best bet is obviously Taiwan Semiconductor Manufacturing Corp (TSMC), the global leader in shrinking microchip geometry with the highest production volume — a “safe haven.”
Downside risks include all of TSMC’s facilities getting bombed into dust by some of the 1,600 missiles China has aimed at Taiwan, but if the People’s Liberation Army decides to launch all of them, there will not be much incentive for Taiwanese to hold savings at all, as most Taiwanese would likely die in the ensuing conflagration anyway.
All investors around the world want a safe haven for their paper-based, “fiat” currency because prices everywhere are going up all the time. I reiterate my recommendation on Commonwealth coins that are available at your corner jewelry shop, as I expect a doubling of the gold price within the next six months.
I repeat that this Year of the Dragon will involve an intense reversion to the mean.
Oops – clicked “Submit” before explaining my post. Professor Pettis, I can’t decide if I like you or Professor Chovanek better, but you’re both really great. I’m in Taiwan, and this is a (admittedly snarky, as is my style) piece about our situation here vis-a-vis personal savings and the interest rate. I have a lot of respect for your answer to Mr. Long, and I’d appreciate any comments you have about my piece, especially since you’re such a big inspiration to me. Torch
Torch,
The U.S is not immune to these kind of interest rate manipulations by the government to help one group over another. The Fed’s low interest rate policy first assists banks over savers/retirees. Most borrowers are not seeing the extent of the Fed’s generosity factoring into lower borrowing rates stifling its stimulative aspects. Another aspect of the manipulation is large U.S. banks are borrowing from the Fed at almost zero rates and earning a spread by buying U.S. treasuries that are issued to finance the enormous fiscal deficit. As perverse as these left pocket/right pocket antics are, it is one of the Fed’s ways of supporting weak (and strong) banks after this major recession. This maneuver is just opaque enough to not rile the electorate. These policies have continued to bail-out bank management teams and their investors from years of risky behavior and bad investments. Obviously you need a healthy banking industry, but critics have argued that the Fed’s monetary expansion is not assisting the general economy only manipulating bank profits and bank balance sheets.
Did I forget to tell you that many Bank CEOs sit on the Fed’s Regional Boards including the New York Fed?
Thnaks, Torch, but I don’t understand the Taiwanese financial system well enough to comment.
Prof. Pettis, I find myself wondering how privatization would work in practice. A simple way to privatize a SOE would be to sell a majority position in the company on an equity exchange. This would improve the balance sheet of the company, but if the company is in the position of (assets < liabilities), doesn't this simply shift the debt onto the new shareholders? If the newly capitalized company is indeed run more efficiently than the original SOE, then in principle it could dig its way out of debt and gradually improve its balance sheet further; but it would be starting at a pretty significant disadvantage in the form of rolled-up debt, in the case of many of the SOEs.
Is it possible for the gov't to assume the debt of an SME while privatizing (e.g., selling) the assets? I'm thinking of an example like, say, the high-speed rail system. It has a lot of debt and its balance sheet might well be under water, in the sense of assets < liabilities. But if the liabilities disappeared (haha!) the assets would probably be a lot more attractive to a buyer. I realize that leaving the debt in the hands of the gov't doesn't truly make it go away, but on the other hand leaving it in the company might make it very difficult to find buyers. No? I guess what I'm asking is what different forms can privatization take?
There are a lot of different ways to manage a privatization process, Luddy, including transferring out the debt, but I want to make sure that we distinguish the word “privatization” between the way I use it and as the investment banks use it. When I talk about privatization I simply mean the direct or indirect transfer of state assets to the household sector. Even just transferring the equity of an SOE to the pension fund system, in this sense, constitutes privatization, as long as, of course, there is real corporate governance reform so that the SOE is run to maximize the wealth of the pension fund and not to accomplish state obejectives or enrich senior officials.
Interesting article as always. I have learned a tremendous amount about economics (especially trade issues) reading your articles.
I wonder if you have given thought to the possibility that US politics may intervene and force China’s hand (to some degree) on re-balancing.
Romney has already discussed labeling China as a “currency manipulator” (if my memory serves) and since the Democrats are far more dependent on Unions and are more populist, might they also (as the US economy worsens, as I believe it certainly will) become more protectionist (i.e. blaming China for the US’s problems).
If a large export market (the US) begins to aggressively discourage Chinese imports, might that force China to focus on internal customers as opposed to export customers?
Along the same lines, might the worldwide depression we are currently in, as it deepens (as I expect) also force China to look inward for customers?
Regardless of what the CCP wants, might they be forced to change.
Any forced contraction of the current account surplus will, of course, make the adjustment process sin China that much more difficult. In fact I expect this to occur. Historical precedents suggest that during periods of global demand contraction when everybody is fighting to get a bigger share of global demand, deficit countries will take steps to divert more of their domestic demand to domestic production. Surplus countries will ry to do the same thing, of course, by intervening in the currency, subsidizing exports, penalizing imports, enforcing local content rules, and so on, but this is a fight which the deficit countries almost always win, for obvious reasons.
Another great post Michael! It is a true gift to successfully argue that what appears simple is not so simple. At the same time, make the point that what appears not so simple is simple indeed.
On the topic at hand, and to illustrate just how misunderstood the issue is have a look at Jin Baisong’s ( director of a policy-research unit affiliated with the Chinese Ministry of Commerce) recent rumblings. He has suggested ( unintentionally ) making Japan more competitive over the Island dispute. As Patrick Chovanec stated “Even if China decided to sell Japanese debt, the worst that could happen is that they drive down the yen, which is what Japan has been hoping to do itself,”.
Thanks Glen. Of course the claim made by many in China and abroad that China can “punish” Japan, the US, or anyone else by selling its debt is based on a complete misunderstanding of the balance of payments. Buying foreign government debt is a way to get a trade surplus vis a vis that country. Selling it means giving up the trade surplus.
If China sells Japanese debt, it simply means that Japan gets what it wants — a weaker currency and a bigger trade surplus — and China gets what it doesn’t want — a stronger currency and a smaller trade surplus. This doesn’t seem like a very powerful threat. The only way China can protect itself is by buying even more US government bonds, so that China regains its trade surplus and forces a larger deficit onto the US, which can’t help but make the US-China trade relationship a lot worse.
In the end it doesn’t matter how often we explain the sheer stupidity of those remarks. They will continue to be made until long after we are dead and gone.
Please someone explain this to me, I guess I’m one of the stupid ones. Many thanks in advance.
“The only way China can protect itself is by buying even more US government bonds, so that China regains its trade surplus and forces a larger deficit onto the US,”
My question: from the US/Japan perspective, if selling debt to China or foreign countries in general is not good, why sell it at all? Why can’t Japan just issue new debt, then print money to purchase their own debt instead of selling it to China? Isn’t selling new bonds equals to printing money? And also, if Japan issues debt (sells bonds) the currency to purchase these bonds has to be Japanese currency?
Gloria, Japan (and the US) have open capital markets, so they cannot prevent China or anyone else from buying government debt. In the 1960s the US did not allow open foreign purchases of US securities, so this was not much of a problem, but once the US eliminated all capital flow restrictions it could no longer control who purchased its debt.
Great work and well argued,
There is one thing I don´t understand. As a depositor in the Bank of China (and other Chinese banks) I can buy investment products with interest rates between 5 – 10 % (depending on the risk) for somewhere between 40 to 180 days. This means that private savers this year and last year have had access to some fairly high yielding investments.
I think the general interest rates in China are closer to a rebalancing level then what we experienced in 2009,2010 or 2011. To me it therefore seems like your argument against low interest rates is in reality a direct attack on the interest rate discount that SOEs get.
Is you main concern low interest rate in general or the interest rate discounts the SOEs get ?
Another problem is that capital intensitive sectors are used to secure a political structure. This means that what you are suggesting is not just changing an economical model but changing a political system. In that sense I think you and others might focus to much on the SOEs as those who need to change. If private or semi-private consumption is going to subtitute the reduction in investments, exports and government spending there has to be an political incentive model behind the rebalancing.
My hope or question is therefore (and I know it is a bit much to ask for) is it possible to sustain the correct political structure based on private consumption?
Clearly not, and of course I am not comfortable speculating in public on the topic. More importantly, as a writer on economic topics, my only interest is in explaining why China has no choice but to rebalance the economy and to describe the various possible rebalancing paths. I leave the political implications to people specialize in these things.
I think I asked the question in a wrong way sorry. Is there any way the economical structure can rebalance towards private consumption and still fund the lower levels of government in the same way as before? I ask this because China can choose not to rebalance and then increase debt levels while letting the inflation slowly eat it away. If you own all the assets then you just slowly let the inflation erode the debt related to them away. I think that is the real reason why Chinese like commodities, they are safeguards against inflation.
Anders, letting inflation eat away the value of the debt is just another form of financial repression, and it will still mean a transfer of resources from the net savers (i.e. the household sector) to the net borrowers. In that case it cannot be part of the rebalancing process.
If you erode the debt of net borrowers (local government and SOEs) and erode the savings of net savers (private households) you will be able to put off any rebalancing forever. Growth might slow over the years, private consumption might also slow and competitiveness will be eroded but political control will be intact. That why I asked if there are is anyway to generate economical growth based on private consumption and let this growth benefit the local governments in the same way debt accumulation based on fiscal spending. This is a pure economical question. You cannot privatize local governments so there has to be role for them in the rebalancing or else it will take decades before anything happens.
Anders, I’ve read that 30% of China’s population survives on $2 per day, so inflation is politically destabilizing (think of the 51 year old man brutally beaten for driving a Japanese Corolla).
Inflation drives wages up and/or consumption demand down (unless money is transferred directly to the household sector via government handouts), thus stressing profits and increasing either defaults or debts. So basically your argument is that debt and misallocation of capital can increase forever, but we can prove to ourselves this is not true by simplying paying everyone in the world to dig holes all day with spoons. Then of course no one eats, and we all starve to death.
I tend to agree with you that the political structure and the economic model (industrial overcapacity at the nadir of Knowledge Age and zenith of the Industrial Age) in China is probably intractable and insoluble, and privatization can only lead to more overcapacity. I don’t know this with complete certainty however.
Micheal,
Would the implementation of any one of the three methods of re-balancing (exchange rate, interest rates, or wage increases) be agnostic for China’s trading partners? That is to ask, would China’s trading partners have a preference of which method?
Yes. This is an excellent question and I leave the topic to another post, but just as there is a different set of winners and losers in China for each of the policies, there is also a different set abroad.
PBoC seems to be accepting slower growth and re-balancing:
http://finance.yahoo.com/news/china-underestimated-global-slowdown-key-101544595.html
They also seem to be saying there is limit to how far they will let the free market take the decline, where they would step in.
Amazingly (good) the PBoC now recognizes that it can’t do “one size fits all” easing:
http://www.bloomberg.com/news/2012-09-27/pboc-adviser-says-easing-restrained-by-concerns-on-homes.html
I have said that re-balancing must come in the form of increased degrees-of-freedom in China’s economy. There is no other solution that achieves re-balancing.
Appears they were hoping to be able to get more support from global demand, and they may have to ease if the global situation deteriorates (which I am nearly certain it will, QE3 won’t reach consumers soon, and Europe is increasing austerity).
I expect China to wait too long to ease and for there to be a hard landing, because they are more proactive on the structural re-balancing and waiting for the contraction to get unbearable enough to force them to back off on that goal.
China appears to be constrained as to how much it can do in terms of re-balancing at least quickly (i.e. privatization and Yuan depegging are not being done now), i.e. no massive boost in degees-of-freedom coming quickly enough to get the optimum rebound. And so the PBoC is probably looking at only two options near-term, hard landing or massive easing. They’ve been doing targeted easing, such as loan subsidies for exporters, which sustains some misallocation (thin or negative profit margins in the oversupply of manufacturing capacity), but this is apparently not enough to abate the GDP decline (I assume because fixed investment is the driver of the economy).
Thankyou Prof. for a great post and also for so many thoughtful and patient answers!
On the subject of privatisation, there are several big issues that arise from the east european experience:
1) Who has the financial capacity to buy these assets (without leveraging the purchase)?
2) How do you prevent corruption of the privatisation process, i.e. so that assets are not transferred to insiders at token realised value for the state?
3) Are there managers with sufficient expertise in running a large private sector company?
4) If a business is a quasi monopoly or a major employer or a strategic asset or a major obligor to the banks, how is the government able to enforce a hard budget constraint even after privatisation?
5) Can the government credibly commit to respecting the private property rights of the buyer of a state asset?
6) How do you ensure effective corporate governance (particularly in the case of mass voucher privatisations)?
7) What happens if the real value of state assets is revealed by the privatisation process to be negligible (i.e. SOEs are shown to be negative value adding, generating reported profits from rent seeking and accounting fraud)? In this case there is a risk that privatisation sets in motion a mass liquidation process that can lead to a deflationary downward spiral
Bena, these are obviously all very important questions and they are going to have to be addressed. Remember however that if the goal is to transfer wealth from the state sector to the household sector, the fact that it is down in a more efficient or a less efficient way is not wholly relevant to that particular goal (although it matters for lots of other reasons, of course). I cannot say with certainty how China will manage a privatization program, but I can say with certainty that however they do it, if it results in a real transfer of wealth, it will also result in a real rebalancing towards higher household consumption.
Mathematically it is possible that if GDP implodes due to rebalancing, households could become poorer in real terms, i.e. 50% of 50% is less than 30% of 100%.
Also rebalancing may negatively impact the new middle class more than the poorest (their investments in condos).
An exacerbating factor is the extent of external contagion.
The global solution is to remove government controls over migration, capital flows, exchange rates, investment, etc., i.e. reduce the pervasive collectivism, statism, and socialism (and the resultant rising fascism). This would cause a boom, unleashing the full potential in the developing world and offsetting the misallocation of capital up to this point in this corrupt globalization we’ve been undergoing.
Instead we are likely to see increasing centralization of control, e.g. my prediction from Nov. 2011 that the EU to become more centralized is coming true (when most everyone else was predicting some countries to exit):
http://www.gold-eagle.com/editorials_08/moore112311.html
Thus my point is I don’t think it is sufficient to argue for rebalancing as a solution, without looking deeper at the nature of the global problem and its cause.
In short, we have the world’s growth potential being held hostage by the vested collectivists.
However, I think the broader persective is that this is the death of the industrial age, and the dawn of the knowledge age (covered in my link above). So from that perspective, it makes sense to me that all the vestiges of the old are clinging on as it falls into the dustbin of history. Note that in the knowledge age, government has no control over the movement of the knowledge capital, virtual migration (e.g. offshoring call centers), etc.. It is happening now, not just some theory.
Why is everything so messed up? The Industrial Age is dying.
The return on capital in high labor content industries simply doesn’t pace with the knowledge industries. Thus the only way for this sector to compete is to steal. This is essentially what is happening globally. The global capitalists were losing share (remember small things grow exponentially faster than large ones, oak trees don’t grow to the moon) and the only way to maintain their share is to ramp up government’s share, leveraging the political support of the population not skilled in the knowledge age.
This is acutely bad for China, as it was late to the game of the industrialization, and it inhibited knowledge formation in the process of maximizing the level of industrial overcapacity. Tack on the one-child policy which exacerbated its future demographics.
And this is why India (nor any other country) won’t bother significantly industrializing at this point– they (and others such as the Philippines) will move directly to the knowledge age.
Huge subsidies and some part of the reported “GDP” result from development firms taking land from peasants for compensations much below market value and selling apartments at market level. The balance is then declared as profit and saving for the developer. In fact, the peasant is subject to expropriation and negative saving at the same time.
If, for example, the land value was 20% of the value of the complete property, and the peasant could instead retain his wealth and (for example) retain or buy 20% of the apartments (e.g. build on his land for himself), nominal saving would be lower (as he only switched his property from land to building) but the macroeconomic situation would be basically the same.
Without these subsidies, some of the original owners of real estate property would rather consume more of the compensation they receive for their property.
Given the limited scope of property rights to land, much of which was redistributed by the communists anyway since the revolution, their disposessing may appear less inadeqaute, but the profits generated by developers nevertheless are based on such subsidies.
Also infrastructure projects (including city roads) would turn out even more ineffective if they would have to pay land values in line with market values for land zoned for residential or commercial construction.
In conclusion, overall savings are less than they appear to be, as negative savings of the expropriated (i.e. implicit subsidies to developers) are not accounted for.
Zero real interest rates (for saving) are common in most of the world for perceived low-risk investments like government bonds of Germany, Japan, US etc.
Subsidies to Chinese SOC or private companies with easy access to capital thus consist not on an overall low interest rate, but on waiving an adequate premium for the risk on lending to them. In the past such risks may have been quite irrelevant for lenders (i.e. banks), as it was easy to make a profit with whatever investment in a low wage growth economy like China. This has changed with higher capital intensity.
So in fact, much of the inherent subsidizing of corporate lenders is not at the expense of savers (for whom a zero interest rate is market oriented), but of banks.
In proper accounting, banks would have to make provisions for losses which would reduce GDP statistics.
The Chinese solar cell and module production industry, which is often private but has taken up huge debts for equipment that is often outdated before it had amortized, is a cute example: The default risks are high in this industry and for the whole economy, have risen quite much recently.
For solar power , the central government has reacted by multiplying goals of installations for 2015 from 5 GW to 10 GW to 20 GW and (as it seems) to 40 GW. This is to some extent a reaction to lower solar costs and thus the ability to replace polluting coal plants more easily, but also motivated by protecting the loans to said solar industry. The other aspect is that solar and any renewables are capital intensive and thus capable of absorbing more surplus savings than other industries.
In any way, forget about capital being rare and thus entitled to a positive price, i.e. risk-free interest. (I am not saying that some assets, such as land do not produce a retun, i.e. rents) With high savings and low birth rates, that concept is obsolete. Maybe that is the single communist aspect of Chinas communist party.
Somewhere in one of my comments on this blog or the prior one, I expected that China’s services (consumer share) was to some extent a multiplier from and dependent on the fixed investment sector (and manufacturing/export) sector, so now there is evidence that this might be correct:
http://finance.yahoo.com/news/china-services-pmi-falls-53-015649699.html
I am fearful that China can not rebalance without imploding back to the peasant level and starting over with move from agrarian society to towards the knowledge economy. Surely (and hopefully) the reality is some where between apocalypse and soft landing.
The recent comment pointing out how land was expropriated from the peasants at lower than market value, in another evidence that China has created a massive misallocation of moving peasants to the city into derivatives of export and fixed investment sectors.
Distorting market prices every where in the economy, e.g. even food prices are semi-regulated, has to mean that there is very little information in the economy.
Professor Pettis,
What are the implications for the US treasury market if China goes through this re-balancing?
This sounds like extremely bad news for America in the long run. With US deficits are at 10% of GDP producing only 2% growth and if the US creditors are no longer willing to fund its profligacy then we are in a lot of long term pain.
Fed reserve is planning to monetize debts no matter what which means that dollar is going to crash. If FED stops monetizing then rates will shoot up to 5-6% which will immediately make USA insolvent.
We are entering uncharted territory here and am beginning to suspect that Chinese leaders are actually aware of the predicament America is in and wanted to limit collateral damage.
US creditors do not fund anything other than their own trade surpluses.
Won’t raising interest encourage households to save more and consume less? It will reduce consumption rather than raise it.
In China, households save in the banking system in order to reach a TARGET. This has been explained in Michael’s earlier posts in this blog.
Example: Say I need to save 100,000$ in order to retire 20 years from now.
(a) If real interest rates are 7%, I will need to save (put away) 200$ per month.
(b) If interest rates on my deposits are 3.5%, I will need to save (put away) 300$ per month
So higher interest rates REDUCE the monthly amount I MUST put away in order to meet my retirement TARGET.
Therefore, higher interest rates make more of my income available for consumption.
I hope I have been of help.
http://www.bloomberg.com/personal-finance/calculators/retirement/
Insightful, but I am skeptical they are that dumb as to target a fixed amount when Chinese are very aware that inflation eats their savings. Rather I think it is a simple function that higher real interest rates paid on deposits transfers more wealth back to (or less wealth away from) the household share of the economy. More wealth means higher consumption. It very simple, the household sector is starved of international trade purchasing power by the Yuan peg. Low interest rates are the symbiotic means of keeping the low profit margin economy growing nominally, and transferring wealth from the citizens in real terms.
With 1.3 billion potential consumers China should rethink its strategies, the south east asian crisis in 97 has shown us how lethal it could end if the whole economy is just build around export. Wealth in China is growing, and at one point companies will leave China, like the left Europe and the US, to countries with cheaper production costs.
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