Exclusively from Michael Pettis’ newsletter:
The world seems to be rapidly moving away from the China-is-the-most-successful-economy-in-the-history-of-the-world rant to the China-is-weeks-away-from-collapse rant.
But repeating a story often doesn’t make it more true. My guess, and it is only a guess, is that China can continue with the current growth model for at least another four or five years before it runs out of debt capacity – although when it does, it runs the risk of falling into the debt crisis that has stopped every previous example in history of an investment-driven growth miracle. Of course I am hoping that the leadership radically changes the model long before we hit the debt capacity limit.
But the point is that I don’t think we are there yet. Debt levels are very worrying, and the structure of the debt – when you can actually figure it out – is even more worrying, but I believe we are not yet on the verge of a debt crisis, and we need to make sure that we don’t scare ourselves into overreacting.
What do I mean by limits to debt capacity? Because of government guarantees of the banking system, in a practical sense China can continue to force banks to serve its fiscal needs for a very long time. But I would consider that it has reached the end of its debt capacity when at least one of three things has happened.
- Depositors flee the banking system because of uncertainty about repayment prospects. I think this is unlikely to happen unless inflation rises sharply and, because of the highly adverse cash flow impact of high nominal rates, the PBoC is unable to raise deposit rates sufficiently.
- Household transfers are too high. Debt servicing costs should be met out of the increased economic activity generated by the debt. If they aren’t, the balance one way or another must result in a transfer of wealth from one sector of the economy – usually the household sector. As these transfers rise, the ability of that sector to generate growth becomes smaller and smaller. At some point the transfers are too large to be managed, and investment growth must stop. Of course if the government begins to privatize assets and uses the proceeds to clean up the banks and repay loans, this problem need not happen.
- The private sector becomes so worried about the possibility of financial instability and rising of financial distress costs that they disinvest faster than the government can invest.
One of the things that did occur to me when I was in Brazil two weeks ago is that there is an additional way of extending debt capacity limits, and so extending the period of high growth and overinvestment, although in the long run this would be much worse for China. Switching from domestic debt to external debt can do this.
After all this is exactly what Brazil did in the mid-1970s. As it reached limits in its ability to fund higher investment levels out of domestic resources, around 1974-75, it was “saved” by the massive petro-dollar recycling and the subsequent LDC lending boom of the 1970s. This allowed Brazil to keep on investing and growing – and to raise debt to even more dangerous levels – for a few more years before the 1982 crisis and the Lost Decade.
Can China do this? In principle yes, but my instinct is that it almost certainly won’t. Why? Because if it become a net borrower from abroad it must also allow its huge current account surplus to reverse into an equally huge current account deficit. I want to think about this a little more, but I think there would be significant institutional impediments preventing this from happening.
…And so on to the last topic. Several people have asked my to comment on an in the Wall Street Journal by my friend and colleague at the Carnegie Endowment, Yukon Huang. In the article he says:
Those who see doom and gloom in China’s growth prospects these days typically point to its low consumption-to-GDP ratio at 35% and a high investment-to-GDP ratio that exceeds 45%. Both indicators raise concerns that the economy will eventually implode. Yet few pause to notice that these numbers, especially in consumption, are inconsistent with market perceptions.
He argues that consumption levels are in fact much higher than the official numbers and that there is no serious imbalance within the Chinese economy.He concludes:
Predictions of any imminent economic collapse, because of the supposed imbalance between consumption and investment, are on shaky grounds. There are other reasons for China’s growth model being vulnerable. But this isn’t one of them.
Although I agree that we are not likely to see an imminent economic collapse, I disagree with his dismissal of the consumption imbalance as the fundamental problem, and have discussed why many times. To summarize briefly:
- Huang notes that there are studies that suggest that both income and consumption are much higher than the official numbers. Yes, and there are also studies that suggest consumption is even more imbalanced than the numbers suggest. Although he doesn’t cite the relevant studies, the most credible I have seen was sponsored by Credit Suisse earlier this year and suggested that because of understated income, China’s GDP may actually be 10% higher than reported.
However the same study also noted that this hidden income accrued heavily to the rich – around two-thirds went to the top 10% and almost all of it went to the top 50% of earners. Since the rich consume a much smaller share of income than the poor, if anything the study suggests that consumption may be even more imbalanced than the official numbers suggest. Credit Suisse suggested that it represented 32% of revised GDP in 2009, down from the official 35%.
- The sheer size of the reported imbalance is simply astonishing, and although there is no doubt some fudge in the numbers, even an extraordinary amount of correcting (and only allowing corrections in the direction that support Huang’s claims) would still leave us with terrible ratios.
Assume for the sake of argument, for example, that consumption is actually 50% higher than the NBS data and that it was the only “hidden” part of uncounted GDP (this last being a very unrealistic assumption). This would bring the “real” household consumption share of GDP from 34% to 42%, still making China the most unbalanced economy probably in modern history.
By the way if it is true that the NBS data are so awfully wrong, as Huang suggests, this would not increase my confidence at all in China’s invulnerability from economic crisis. It would simply mean that the second largest economy in the world, in which economic decision-making is highly centralized and prices are heavily distorted by policy – thus making the quality of statistical data even more important to economic decision-making than in other economies – is being managed completely blind. This is hardly a reason to stop worrying about domestic imbalances.
- One would imagine that if the data so grossly overestimated the problems of domestic consumption imbalances, Beijing policymakers and economic advisors would have had some inkling and would not be so obviously worried about the need to raise consumption. Certainly it would not have been proposed in Premier Wen’s speech in March as the second target, after maintaining price stability, in the new Five-Year Plan.
- In the end none of the above argument need to be made. We know consumption is extraordinarily low because the balance of payments tells us it is extraordinarily low.
How so? By simple balance of payment accounting identities. Globally investment and savings are equal to each other, by definition. For individual countries, however, they differ, and the difference is equal to the amount of capital they export or import. Of course the net amount of capital they export or import is the obverse, and equal to, their current account surplus of deficit.
Assume for a moment that Chinese investment and savings levels are exactly equal to the global average. Since there is no excess or deficient savings, in this case its current account surplus would be zero. Now assume (correctly) that China has by far the highest investment rate of any country. If China’s savings rate is equal to the global average, it will have by definition a huge current account deficit. If China’s savings rate however is extremely high, equal to its extremely high investment rate, then by definition China would have a current account balance of zero.
But China doesn’t have either a current account deficit or a balance of zero. It has instead one of the highest current account surpluses ever recorded. This can only happen if the savings rate exceeds by a huge margin the investment rate – which, remember, was itself by 2008 the highest we had ever seen, and which has soared even further in the past few years.
By definition, then, China’s savings rate must be extraordinarily high to allow it both a huge investment rate and a huge current account surplus. Since savings is simply the difference between total production and total consumption, China must also have an extraordinarily low level of consumption in order for the balance of payments to balance. I would argue that it almost certainly does.
Today is Mid-Autumn Festival day in China and I have several boxes of mooncakes that my students have given me. Happy mooncake day. Next time I write I will be several pounds heavier.