An exclusive excerpt from Michael Pettis’ most recent newsletter:
[Recently] the PBoC cut minimum bank reserve requirements for the second time. According to a February 18 article in Xinhua:
China’s central bank on Saturday announced to lower banks’ reserve requirement ratio (RRR), underling its efforts to ease short-term credit crunch and secure growth in the wake of a lacklustre external market. The cut, the second of its kind in three months, will drop the RRR by 50 basis points to 20.5 percent for large commercial banks and 17 percent for mid- and small-sized banks, the People’s Bank of China (PBOC) said in a statement on its website.
The move will become effective on Feb. 24 and release an estimated 400 billion yuan (63.54 billion U.S. dollars) in capital into the market. The PBOC in December cut the RRR by 50 basis points for the first time since December 2008, after hiking the RRR six times last year in an effort to check inflation.
I, along with I think most other analysts, had been expecting reserve cuts to come earlier given how weak the economy has been and the relatively slow pace of credit expansion so far this year, so this wasn’t really a surprise. There have been some suggestions that the lateness of the two cuts suggests that Beijing is more optimistic about growth than the rest of us, and this has been seen as a positive sign.
I am not so sure. Certainly given the level and nature of the debate in China I don’t see any evidence that people aren’t concerned about domestic imbalances, the impact of further European deterioration, and the political atmosphere during the upcoming US election. Last week, for example, I was invited, along with five prominent Chinese economists, to a lunch to discuss China’s economic prospects with senior EU representatives (who were all in town) and I was in the unaccustomed spot of not being the most worried person at the table. Some of my Chinese colleagues were far more pessimistic than I was about Chinese growth prospects and the difficulty of engineering a rebalancing. Clearly we worriers are no longer outliers.
So why has the PBoC been so slow in loosening? One reason may be inflation. At 4.5% January’s year-on-year CPI inflation was much higher than the 3.8-4.1% most analysts were expecting. Commentators immediately explained away the problem by citing the earlier-than-usual Spring Festival, but the earliness of the festival was hardly an unknown and unexpected event.
So why was inflation high? Last summer, when inflation was a much bigger problem, I was in the (majority) camp that argued that inflation was going to come down quickly over the year in spite of rising wages. My reasons for saying so had to do with real interest rates, which had declined sharply over the year and so put significant downward pressure on household income and with it household consumption.
Now that inflation seems to have declined, however, this implies that real interest rates have risen, in which case one of the causes of inflation restraint has disappeared. The combination of higher deposit rates and higher wages, I suspect, may over the next few months create some partial rebalancing towards consumption, and could also keep inflation stubbornly higher than many expect. We’ll see how the numbers evolve over the next few months.
The politics of real estate
The other reason the PBoC has been relatively late in lowering the reserve requirements may have something to do with politics. A very perceptive Chinese friend explained this to me last week. His argument was that on the rare occasions in which the Standing Committee is completely unanimous about a policy position, it becomes very hard for anyone to deviate from that position, and so it tends to be held pretty rigidly.
According to my friend there had been unanimity within the Standing Committee on the need to keep up pressure on the credit markets until the real estate bubble was truly broken. This, he said, was why even though there has been evidence of slowing for many months, the PBoC has not relaxed as quickly as most analysts expect.
His argument sounds plausible. Let’s see what happens next. For me the key is the level of interest rates. If the PBoC does not give in to pressure to lower interest rates, we will see a speedier rebalancing (or rather, less worsening of the imbalances) but precisely for that reason it will come at the expense of inflation stubbornness.
By the way contrary to some recent research reports cited in the press I do not think we have seen any substantial rebalancing of the economy towards consumption in 2011. This is largely an argument being made by economists who did not see why Chinese consumption repression was all along at the heart of the growth model. These economists are now too quick, I think, to hail evidence of a surge in consumption, but I find the evidence very weak and more importantly I am convinced that there cannot be a sustainable surge in consumption as long as the investment-driven growth model is maintained and as long as debt continues to rise unsustainably.
And as for debt, it is still rising quickly. As regular readers know I have always argued that the rise in Chinese debt, as bad as it is, was not going to lead to a banking collapse or any other sort of financial collapse because of the way local and specific debt problems would be “resolved”. Debt would simply be rolled onto the government balance sheet.
Last Monday I was in Hong Kong visiting few clients, and during my visit to Hong Kong the Financial Times gave me a nice gift – an opportunity to center my discussions – with this article:
China has instructed its banks to embark on a mammoth roll-over of loans to local governments, delaying the country’s reckoning with debts that have clouded its economic prospects. China’s stimulus response to the global financial crisis saddled its provinces and cities with Rmb10.7tn ($1.7tn) in debts – about a quarter of the country’s output – and more than half those loans are scheduled to come due over the next three years.
Since the principal on many of the loans is not repayable, banks have started extending maturities for local governments to avoid a wave of defaults, bankers and analysts familiar with the matter told the Financial Times. One person briefed on the plan said in some cases the maturities would be extended by as much as four years.
We are going to see a lot of stories like this. There is a growing amount of unrepayable debt in China and ultimately most if not all of it will end up on the government’s balance sheet.
Restructuring state involvement
The World Bank report will apparently warn that China is facing a very difficult economic transition:
An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation’s leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.
“China 2030,” a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China’s most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.
It is unquestionably a good thing, in my opinion, that Beijing is made aware of how difficult, and urgent, the transition is likely to be, but it is also a little disheartening that it has taken so long to warn about what should have been deeply worrying us five or six years ago. China’s growth model was clearly unsustainable even back then, and was just as clearly heading to a debt crisis, and the longer it took to address the problems the more severe they were likely to get.
According to the WSJ:
The report warns that China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the “middle-income trap.” A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.
It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.
…The World Bank and DRC argue that asset-management firms should oversee the state-owned companies, say those involved in the report. The asset managers would try to ensure that the firms are run along commercial lines, not for political purposes. They would sell off businesses that are judged extraneous, making it easier for privately owned firms to compete in areas that are spun off.
“China needs to restrict the roles of the state-owned enterprises, break up monopolies, diversify ownership and lower entry barriers to private firms,” said Mr. Zoellick in a talk to economists in Chicago last month.
Currently, many state-owned firms have real-estate subsidiaries, which tend to bid up prices for land, and have helped to create a housing bubble that the Chinese government is trying to deflate.
The report also recommends a sharp increase in the dividends that state companies pay to their owner—the government. That would boost government revenue and pay for new social programs, said those involved with the report.
This is good as far as it goes, but it doesn’t go far enough. Of course increasing SOE dividends to the government for use in social programs will transfer wealth from the state sector to the household sector, but if the total profitability of the SOE sector is less than one-fifth to one-eighth of the direct and indirect subsidies transferred from the household sector, as I have argued many times, then even 100% dividends is not enough to slow the transfer significantly, and remember the transfers have to be reversed, not merely slowed. This proposal falls in the better-than-nothing category, but just.
What we really need are much more dramatic transfers, for example wholesale selling of assets, with the money used either to clean up bad loans or delivered directly to households. According to the article, however, “neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.”
This is the problem. The best solution for China, economically, seems to be off limits because it will be politically difficult. In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.
And how much will growth slow? The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years. That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.
And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall. With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today. Chinese investment demand simply cannot hold up much longer.