Find below an excerpt from a Michael Pettis post that pretty much captures everything that MB has been arguing since it was created (in part thanks to Michael Pettis!)
After last week’s tumultuous markets one of my clients sent me an email saying “I am so relieved your constant talk about worsening imbalances kept us from getting too complacent. Things really are as bad as you keep saying.”
I am not sure that what happened last week is proof of anything I’ve been saying, but I do think that the framework I have used over the past decade has been useful, at least to me, in understanding both the rebalancing process in China and the events that led up to the global crisis of 2007-08. And I think it continues to be useful in judging the adjustment process – or, more likely, the lack of adjustment – that explains why we still have a rough ride ahead of us. This framework has made it relatively easy to make predictions, sometimes “surprising” ones, because by working through the imbalances and assuming – safely, I think – that deep imbalances always eventually reverse one way or the other, we can work out logically the various ways in which this rebalancing must take place.
I have argued that since the 2007-08 crisis we have seen some adjustment in the US, very limited adjustment in China or Japan (except to the extent that Beijing under Xi Jinping has stopped imbalances from getting worse), and worsening imbalances in Europe, and it is for this reason that I have never been impressed by the strong market recoveries we saw around the world. If I had to summarize the key points about the framework I use, I would make four main points:
The adjustment process. All growth creates imbalances, and in every case these imbalances will eventually reverse. What really determines a developing country’s long-term success, I believe, is not how well it does during the growth years, but rather how well it manages the subsequent adjustment. Growth miracles are very common, but real success stories are rare. The reason, I would argue, is that developing countries too easily reversed the great gains they made during the good years because the adjustment turned out to be far more costly than anyone had anticipated. It is far more important, consequently, for economists and policymakers to understand how to manage adjustment and minimize adjustment costs than to figure out how to generate rapid growth.
Debt and balance sheets. Probably the single biggest sources of adjustment costs are the amount and structure of debt, or, more generally, the structure of balance sheets. Economists must understand (but almost never do) national balance sheets and sovereign financial distress as well as corporate finance specialists understand business balance sheets and corporate financial distress.
Savings imbalances. The purpose of savings is to fund productive investment, and while the amount of productive investment opportunities is probably infinite, institutional constraints in every country significantly can reduce the ability of productive investment fully to absorb the total amount of savings created within an economy. These constraints vary from country to country, and until we understand how to remove these constraints, rising income inequality and mechanisms that repress the growth of median household income (relative to GDP growth) often result in what I would call excess savings. The consequences of excess savings include speculative asset booms, trade imbalances, unemployment, and unsustainable increases in debt.
Globalization. In a “globalized” world, no country, not even the US, can protect itself from the consequences of imbalances elsewhere. The global economy is a system in which certain types of imbalances are impossible. I especially focus on the requirement that global savings and global investment always balance, but there are others. Because an imbalance at the global level is impossible. if there are imbalances in one country or region, there necessarily must be the opposite imbalances in another, and the more open an economy, the more likely it is to respond to imbalances elsewhere. It is impossible, in other words, to understand any non-autarchic economy in the world except in the context of global imbalances.
It is on the fourth point that I want to focus in this blog entry. I have never been even remotely an expert either on iron and steel production or on the Australian economy, but recent action in the iron ore markets and a vibrant debate within Australia has, in the past three weeks, set me up for several planned and unplanned meetings with Australians – some old friends, some fund managers and bankers, some government officials – who remembered some of the comments I made a few years ago about Australia and iron ore and who wanted to discuss future prospects.
Three-and-a-half years ago, I gave a dinner speech in Sydney to a group of Australian mining industry investors. In the speech I argued, as I always have, that the historical precedents, the extent of China’s imbalances, and the growth in Chinese debt made it very clear that China urgently needed to adjust its growth model in a way that would inevitably cause a sharp fall in demand for hard commodities. I stressed that the adjustment was going to be far more difficult than what they were hearing from sell-side analysts, most of who had only just woken up to the realization that there been a great deal of investment misallocation in China.
Australian iron ore and Chinese interest rates
But because these analysts still did not understand that over-investment was a structural problem embedded deeply into the growth model – and not simply the accidental byproduct of occasional outbursts of enthusiasm – they had failed to explain to their clients that an unsustainable growth in debt and a seemingly insatiable demand for iron were simply expressions of the same system. As soon as an analyst understood that debt was growing at an unsustainable pace, I told the conference guests, he should know that Chinese demand for iron ore was also unsustainable.
Once China began the rebalancing process, I added, demand for iron ore had to collapse, and I could say this with full confidence not because I had disc drives filled with data and sophisticated correlation models that proved my case, but simply because this was the logic of the investment-driven growth model, and we had seen this same logic work its way many times before. The powerful opposition rebalancing would necessarily unleash – from groups the Chinese press had dubbed “vested interests” as early as 2007 – always made it unlikely that Beijing would implement significant reforms before 2012. It was only then that the various factions and groups would have agreed among themselves the distribution of responsibilities and privileges of China’s new leadership, including the president and premier, Xi Jinping and Li Keqiang, respectively.
It may have taken a surprisingly long time for analysts to understand why the credit process made rebalancing both urgent and inevitable, but it was clear to many economists, especially among Chinese academics, that severe distortions had been building at least since the beginning of the last decade. As early as 2007 Premier Wen openly acknowledged the distortions and imbalances that Chinese growth generated (it is probably not a coincidence that this is around the time we began hearing of “vested interests” in the Chinese press).
As an aside, it seems generally to be the case that the longer an adjustment is constrained, the more likely that the adjustment takes place in the form of what traders call “gapping” – which is a big, discontinuous change instead of a smooth adjustment – so when the change finally took place, the fall in demand (and iron ore prices) would almost certainly occur very quickly, in a matter of two or three years, perhaps. As Rudiger Dornbush said of financial crises, they often take much longer to come than you expected, but then things fall apart much more quickly than you thought they would. This means, to return to iron, if you understood China as a growth “system”, with its own logic, its liquidity channels, its institutional distortions, its balance sheets that embedded pro-cyclical or counter-cyclical tendencies, etc. you would have known that once the process started, rebalancing was going to cause iron ore prices (and prices of other hard commodities) to collapse, and I stressed, as I often do, that I did not think the word “collapse” was overly dramatic.
This is because any shift in Chinese demand for iron ore will necessarily be a big shift in total demand. China consumes about 60% of global iron ore production, an extraordinarily high share probably unmatched in history except perhaps (I am not sure) by England in the mid 18th century, when it was pretty much the only country in the world building machines, railroads, and iron bridges. This would be an astonishing consumption share even for the United States at its peak share of global GDP (around 33% in the late 1940s?), and so was all the more so for a country that represented only 12% of global GDP.
China’s disproportionate demand for iron was clearly the result of its intensely investment-driven growth model. This would change dramatically, I told the guests. I expected that the shift in demand for iron ore generated by rebalancing would cause iron ore prices within 3-4 years to drop by over 50% from their then-current levels of around $180-90 a ton.
The audience was clearly shocked by this forecast. The question and answer session at the end of the speech was brisk and suggested quite a lot of resistance to my predictions. But I really was convinced of my math, which connected iron ore prices inexorably with the extraordinarily large gap between China’s Nominal GDP growth and interest rates set by the PBoC, and it was clearly impossible to maintain this gap. In fact as I started writing more about the outlook for hard commodity prices over the next year, I adjusted my outlook downwards and proposed that iron ore prices would fall below $50 a ton before the end of the decade. A few months after this particular conference I was back in Sydney to speak at another conference, and after I spoke, Gerard Minack, former chief strategist at Morgan Stanley Australia, gave his own presentation on the world economy and, more specifically, on the slow-turning battleship of expansion in the production of hard commodities.
He is obviously an extremely smart guy and his presentation was an eye-opener for me. For anyone interested, I summarized some of his arguments in a September 16, 2012, blog entry, in which among other things I quoted the CEO of Fortescue as saying:
Iron ore prices have slumped to $US104 a tonne in recent days, yet Mr Power said it could soon rebound as high as $US150. ”As soon as restocking and production returns to normal we expect to see prices back in the $US120 to $US150 per tonne range,” he said.
In my blog entry I followed his quote with “He will almost certainly be wrong”. Even though I know nothing about the iron ore market, and certainly not as much as the CEO of Fortescue, I know arithmetic, and even before I heard Minack’s discussion of the global increase in production, I simply could not get the arithmetic that connected Chinese interest rates with Australian iron ore exports to work otherwise. Minack’s in-depth analysis of the supply side just made the arithmetic all the more convincing.
Rebalancing demand for metal
Needless to say my metal price projections, especially for iron ore, were not popular in countries like Australia, Brazil, and Peru, where I have many friends and clients and visit often. I think however that most of my clients understood my reasons for expecting Chinese demand to drop. It simply wasn’t possible that any growth rate could keep China consuming 60% of total iron ore. That even a small adjustment in Chinese demand, let alone the large one I expected, would cause a big drop in global demand seemed brutally logical to me and, I hope, to the clients to whom I tried to explain it.
Early this week I was with an Australian government representative in Beijing whom I have known for many years and he told me that iron ore prices were currently around $83 (I think they dropped another $2 last week), and that while some people in Canberra were reluctant to say it too loudly, he and others were increasingly in agreement with my lower forecast of less than $50 well before the end of the decade, in part because supply has come off much more slowly than predicted, but mainly because they now recognize that China’s rebalancing was indeed going to be a far bigger deal for Chinese demand than sell-side research had predicted.
The fact that China’s demand remained so high for so long had created complacency among iron ore producers about China’s ability to continue buying so much iron, but we have to remember that when an adjustment takes longer than expected, the correct interpretation, I would argue, is not that it is less likely to happen, but rather than when it happens, it will take the form of larger-than-expected gapping. China has only completed the first part of the rebalancing – interest rates, wages and the currency have all moved sharply closer to healthy levels, levels at which the imbalances are no longer getting worse, in other words, but Beijing has still not got its arms around credit growth because to do so would cause GDP growth to drop much more sharply than Beijing is willing to tolerate.
This is the next great challenge for Beijing, and when the regulators finally do start to repair overextended balance sheet, with a much higher debt-to-GDP ratio than any other country at China’s stage of economic development, according to a presentation Monday night by my very smart former student, Chen Long, I expect annual GDP growth rates will continue dropping steadily, by 1-2 percentage points a year through the rest of this decade (and there has been increasing talk in the past month or two that GDP growth rates are already 1-2 points below the printed rates). As I have argued before, except under implausible scenarios (at least 2-4% of GDP transferred every year from the state to households) I cannot work out arithmetically any meaningful rebalancing process that is consistent with average GDP growth much above 3-4% during President Xi’s 2013-23 term in office. This used to be considered a shocking prediction not so long ago, but not anymore. In fact I notice that in a recent paper, Larry Summers and Lant Pritchett have suggested that the arithmetic of previous growth miracles implies that China will grow by 3.9% on average over the next two decades.
Like with my prediction, a number of people have responded to the 3.9% projection with incredulity, but Summers and Pritchett point out, like I have many times, that the same historical precedents that form the basis for expecting much slower growth during the adjustment period also predict that it will be nearly impossible for anyone to believe these lower projections. I have studied most of the major growth miracles of the past 100 years (and directly experienced some), and in every case there have been pessimists that predicted a difficult adjustment process with much slower growth. In every such case, however, these pessimistic predictions were met with general incredulity (and for some odd reason almost always written off as “wishful thinking”) but while I have indeed found that the pessimists have always been wrong, it always turned out that they were wrong because actual growth turned out to be much worse than they predicted.
Even among the greatest “Japan skeptics”, for example, I cannot find anyone who came anywhere close to predicting in the late 1980s or early 1990s that Japanese growth over the two decades after 1990 would average well below 1%. For all the economists, especially Brazilian economists, who began in the late 1970s and early 1980s seriously to doubt the Brazilian miracle, to take a second example, I am unable to find anyone who expected growth in the 1980s to be negative. For a third example, not everyone in the early 1960s believed that the USSR would inevitably overtake the US economically before the end of the century, but excluding fierce anti-Communists predicting fire and brimstone, I don’t know anyone who expected that by the 1980s the USSR would essentially be insolvent (technically it wasn’t, but LDC debt traders nonetheless included the country in their universe of defaulted or restructuring sovereign borrowers). The 1997 Asian crisis, in yet another example, exceeded in virulence any prediction that I can find. This history proves nothing about China’s future, of course, but it does suggest how little informational content there is in the incredulity with which such pessimistic forecasts are treated. This is exactly what is supposed to happen.
Adjustments are always the most difficult part, and have nearly always been harder than anyone expected, but it is important to remember that they represent the rebalancing process, so that the adjustment in growth is not symmetrical. In the case of China, for example, whatever GDP growth turns out to be, and again this is just arithmetic, Chinese household income growth will be higher and investment growth lower – after nearly thirty years of the reverse relationship – so that the impact of slower growth will be disproportionately smaller on consumption growth and larger on investment growth. This means both that lower Chinese growth will not be nearly as painful for Chinese households as we might expect, and that demand for metals will get especially hard hit.
What matters to the Chinese adjustment process, and therefore to iron ore prices, will be how Beijing resolves balance sheets distortions. But when we think about how the Chinese adjustment will affect Australia, we must also consider the impact of savings imbalances globally. The most difficult question to answer for a country like Australia, I think, is whether slower Chinese growth leads to greater Chinese flight-capital outflows, especially when Australia is a favored destination for worried Chinese business owners.
Will the US ride to the rescue?
Normally the contraction impact of much weaker iron ore export prices should be partially mitigated by the expansion impact of a weaker Australian dollar, as iron-related inflows drop sharply. If these inflows however are counterbalanced by rising private inflows from Chinese businesses and wealthy individuals taking money out of China, either because of weaker domestic growth prospects of because of rising nervousness and uncertainty, asset prices might not fall as much as we would have expected, but Australia will be caught in a vice a little like that of, for example, Spain, in which export weakness cannot be partially counterbalanced by a weaker currency.
How China, Australia, Brazil, Europe and all the rest will adjust will be determined in part by their debt structures. Thanks to Hyman Minsky’s growing group of followers, we are beginning to remember some of the things we knew about the nasty interplay between debt, overvalued currencies, and unemployment back when John Maynard Keynes, Mariner Eccles and most of all Irving Fischer explained these things to us. I am not completely sure about what Australian balance sheets look like, but I am often told that debt levels in certain sectors (the household sector, for example) are quite high. Higher debt implies a tougher adjustment because as worries about default rise, the debt itself changes the behavior of economic agents in ways that nearly always reduce growth and increase balance sheet fragility. The good news, however, is that Australia tends to have the kinds of institutions (legal, financial, etc.) that reduce the frictional costs of adjustment, so if it is any consolation, they would be worse off if they were a member of the EU.
There is much more here. You should read it all.
