Exclusively from Michael Pettis’ newsletter:
[W]hat does it mean to be a China bear or pessimist?Sometimes a lot less than meets the eye, I think. For many years, China bulls have made ecstatic and at times outlandish claims about the success and sustainability of the Chinese growth model, publishing excited books proclaiming and describing the new China Century. It seemed to me however that these claims often defied both historical precedent and common sense.
This isn’t the first time, of course, that we have seen this. In the past 100 years we have had our sense of excitement stimulated by the unstoppable rise to global economic dominance of the United States in the 1920s, Germany in the 1930s, the USSR in the 1960s, the OPEC Arabs in the 1970s, Japan in the 1980s, and China ad perhaps even Europe until very recently, and I have little doubt that at some point within my lifetime the Indian Century too will be proclaimed.
We know two things about these processes. First, it is always a lot more complicated than we ever expect it to be. Even the one prediction on my list that turned out to be correct – that of the rise to global dominance of the US – occurred over a much longer period than was recognized (by most measures the US was already the leading economic power by the 1870s), and turned out not to be nearly as smooth as expected. It took a horrible decade of steep economic decline in the 1930s and a devastating war that pretty much wiped out its competitors to create the US Century.
Second, in the midst of the hype it seems like an act of willful stupidity simply not to get caught up in the hype. But hype it almost always is, as my list above suggests. In that sense my analysis, at least during much of the last decade, has largely consisted of just pointing out how historically suspect and illogical some of the more feverish claims about China seemed to be. Unfortunately, as was also the case during previous periods of hype, even just two or three years ago any skepticism about Chinese growth branded one as outrageously pessimistic and perhaps even just obtuse.
This no longer seems to be the case – it is now quite fashionable to be skeptical or even bearish about China. But we shouldn’t now go too far in the other direction. China is not poised to collapse.
Unfortunately any skepticism is regularly interpreted as a prediction of disaster. As part of the feverish China hype it seemed that anyone unwilling to agree with some of the more hyperventilated nonsense about China was accused of predicting a collapse, and a collapse within months at that. But to say that a development model has reached the point at which it no longer generates healthy growth, along with which debt is building up at an unsustainable pace, and which will require a very difficult adjustment, is not the same as to say that the country will collapse, and especially not the same as saying that it will collapse with in six months or a year. It just means that an adjustment is needed, debt levels must one way or another be addressed, and the longer it takes to begin the adjustment, the more painful it will ultimately be.
Rebalancing is good for the world
I will come back to this shortly, but in his piece Grenville says that if my 3-4% growth forecasts for the next decade are correct “the world economy will indeed be a dismal place for the medium term.” As I have written many times, I don’t agree with this at all. It really depends on how successfully Beijing manages the transition. Although my long-term growth expectations for China may be lower than that of most other economists, they don’t however imply a gloomy outcome for China.
It is important to remember that much slower economic growth is a necessary consequence of China’s rebalancing, but since rebalancing requires that household income growth exceed GDP growth by a substantial margin, as China rebalances, the wealth of ordinary Chinese households can continue growing at enviable rates. In fact I argue that a rebalancing China is consistent with household income growth rates of 5-6% annually, which is an extremely high growth rate and only a little less than the reported 7-8% annual growth rate of recent years.
This, and not reported GDP, is what really matters. Chinese households, like those in the rest of the world, are not so much concerned with per capita GDP as with changes in their disposable household income and in their wealth. If China rebalances successfully there is no reason household income growth should collapse, even as GDP growth rates slow significantly. This is a big “if”, of course, and requires that Beijing understand the risks, and forces through what will be politically difficult measures, but so far it seems that they do.
Nor is rebalancing bad for the rest of the world (although as I wrote in the last issue of this newsletter copper, iron, and other hard commodity producers will suffer tremendously). The idea that China is the global engine of growth is based on confused arithmetic – it is simply the largest arithmetical component of global growth. What the world needs from China is not more growth. It needs more net demand, and a rebalancing China, even with much slower growth, will provide just that.
But even as conditions have changed it is still not clear that the China bulls understand how difficult rebalancing will be. Grenville has argued many times, for example, that it will be much easier for Beijing to bring down the national savings rates than it will be for the US to raise its savings rate.
Of course, at some time in the not-too-distant future, China needs to shift consumption up from its current 35% of GDP to a more conventional number, at least half of GDP. Compared with the task faced by most of Europe and by America (cutting consumption and raising taxes to fix the budget, while maintaining growth), China’s task is the easier one, but it does require a major change in thinking. So far China is fumbling the job.
Others have made a similar point. But China isn’t, in my opinion, “fumbling” the job. This view seems to assume that high Chinese savings rates are a cultural or personal choice that can be reversed with the right exhortations or administrative policies, which Beijing simply hasn’t come around to implementing.
They aren’t. I argue, as Grenville notes, that consumption-constraining policies are at the heart of the Chinese growth model, and reducing the savings rate can only happen with an elimination of those polices, which also means eliminating the policies that generated rapid Chinese growth (and even more rapid growth in Chinese debt). This cannot occur except at much lower growth rates. Beijing’s “fumbling” is not so much fumbling, as it is a need at first to manage the process slowly, and inefficiently, for political and social reasons.
The historical evidence supports the argument that lowering the savings rate is going to be very difficult. Since 2005, when household consumption dropped to then-shocking level of 40% of GDP, Beijing has made reducing the savings rate an urgent priority. But in seven years the national savings rate has continued increasing, with household consumption now an astonishing 35% of GDP. The US, on the other hand, and in spite of plenty of ham-fisted policies, has managed to raise its savings rate. This should at least suggest just how hard it is for Beijing to rebalance its economy away from excess savings.
Did I tweak the numbers?
Clearly I have a number of disagreements with the China bulls on the outlook for China’s economy, but there is one part of Grenville’s piece which I think is unfair. I don’t think it is intentional but rather reflects the difficulty the bulls have had in understanding why rebalancing matters and what are the implications.
Grenville mentions that my current growth forecast for China is 3-4% annual growth on average for the next decade, but he suggest that I have “tweaked” my long-term growth forecasts in response to a changing reality. As growth rates stayed high, in other words, I kept postponing the beginning date of the period of lower growth.
This is simply not true and is based, I think, on a misunderstanding of what rebalancing in China means. I have always argued that it was very unlikely that any real adjustment would have started before 2013. The adjustment would be extremely difficult economically and, even more so, politically, and so was unlikely to happen before the new leadership took power. From time to time in my blog I have sloppily used the phrase “this decade” to describe the period of slower growth (I write a great deal and often too quickly), but for Grenville to imply that my first projection was based on the calendar decade and only later, as I was proven wrong, did I push the date back, is wrong and, I think, unfair.
On the contrary, it has been the China bulls that have constantly revised their forecasts downwards, and this isn’t about to stop. They revised downwards as the Chinese economy progressively ran into the series of problems – rising debt, a declining consumption share, misallocated investment – that the skeptics warned about and that the bulls didn’t foresee. In 2009, for example, it was hard to find many economists who did not expect medium to long-term GDP growth for China in the 8-10% range.
By now most analysts have sharply lowered their forecasts to 5-7%, with the bulls at the high end, without however explaining what they know today that they didn’t know in 2009. Debt has surged, it is true, the banking system is insolvent and increasingly illiquid, policy measures are losing traction, and wealthy Chinese are pulling money out of the country, but these have been happening all along and their continuation was long predicted by the skeptics as automatic consequences of the investment-heavy growth model China had pursued for too long. None should have been unexpected.
Here by the way is last week’s Financial Times on bad debt. China’s banks are reporting low and declining NPLs even as the world refuses to believe it:
Chinese banks have reported only the smallest of increases in loan defaults, but signs of trouble are starting to bubble up from beneath the placid surface of their public disclosures – prompting a warning from a top rating agency. At first glance, Chinese banks appear to be in excellent health. With new loans growing much faster than defaults, the non-performing loan ratio for the sector as a whole edged down to 0.9 per cent in the second quarter – the lowest in more than a decade, according to the banking regulator.
But investors and analysts have taken a much dimmer view of their first-half results in recent weeks. Bank of China was the first of the big banks to report, and it set the tone. It said its non-performing loan ratio had fallen 6 basis points in the first half. This might have been seen as a remarkable achievement in credit management, given the deceleration in Chinese growth this year, which has caused pain across business sectors from property developers to sportswear makers.
Instead, investors have reacted with concern, pushing Bank of China’s share price down 5 per cent since its results. Rather than focus on Bank of China’s headline bad loan figure, analysts have pointed to the fact that its overdue loans increased 17 per cent in the first half. What’s more, its impairment charge was only half the size it was this time last year.
Denying bad debt is not going to make the transition easier. Of course I think the current consensus of 5-7% average growth for the next ten years is still too high, and the historical precedents make it clear that we tend to underestimate sharply the cost of an adjustment of this nature (think for example of the USA in the 1920s, the USSR in the early 1960s, Brazil in the late 1970s or Japan in the late 1980s, all of whom suffered much more difficult subsequent adjustments than even the skeptics had expected). Already this year Beijing has announced growth rates for China of 7-8%, but a large number of economists in China, based on alternative measures of economic activity, doubt the accuracy of the official numbers, with some arguing that real growth this year may be as low as half the posted rates.
I am not smart enough to say if they are right or wrong, but one way or the other I expect growth forecasts among China bulls to continue declining over the next few years. If Beijing seriously begins to rebalance its economy in 2013, as I expect, I believe, as I always have, that the average annual growth rate over the following ten years will not exceed 3-4%.
This, by the way, has implications especially for stocks whose value is sensitive to growth expectations, the most obvious being, in my opinion, bank stock. As I see it, the stock of a large, insolvent bank is the closest thing there it to a pure call option on underlying economic growth, and its value will change as growth expectations change. When large Chinese banks were trading at 3-4 times book, I argued that they would fall sharply, and of course they have — to around book value or slightly below. Many might think making the same call today is a lot more risky, and it may be, but I am convinced that growth expectations will continue to decline in the next year or two and with them, so will the value of the banks. The larger state banks could be trading at half of book by 2013-14.