Pettis: Australia should be pessimistic

Exclusively from Michael Pettis’ newsletter.

When I first started to go to Australia four years ago I think few analysts there recognized the vulnerabilities of the Chinese growth model, and so there was a general expectation that the implications of rapid Chinese growth for Australia – mainly very high prices for various commodities – would remain in place for many more years. Australia could count on very high iron ore prices, for example, into the indefinite future.

The mood has changed dramatically in Australia in recent years, as it has in the rest of the world, but not completely. In October the Australian government came out with a White Paper, Australia in the Asian Century, that projects a 7% average GDP growth rate for China between 2012 and 2025. This is pretty surprising. Although there are still a few GDP growth rate projections of around 7% to 8%, few of them are from Chinese economists (excluding official projections, of course) and even among optimistic foreigners none that I know expects growth to remain so high for so long.

This seems to put the Australian government among the most optimistic in the market when it comes to long-term growth expectations for China. I have always assumed that government projections should generally be on the pessimistic side to prepare for unexpected negative shocks (positive shocks can take care of themselves), but apparently not. I am glad to say that my own conversations with Australian government officials lead me to believe that this White Paper may represent the official view of the government, but it does not represent the private views of all Australian government officials.

And it is not just the government that is optimistic. October also saw a very long and thoughtful piece by James White, of Sydney-based Colonial First State, in which he argues that China’s capital allocation process is not only a good thing but, more importantly, it is the key to its success. I think he is wrong, but wrong for interesting reasons. White however starts out his analysis with a few paragraphs that frankly raise my hackles somewhat:

The Chinese don’t play chess. They play wei qi. Wei qi is a game of strategy played on a larger board with black and white pieces each of equal value. The Chinese government views the economy as though it’s wei qi. Each piece has its own role in the economy, but each is no more important than another.

This is an important observation. In the developed world, the economy is generally seen through the prism of capital; the stronger the outcome for capital, traditionally, the stronger the perception of the entire economy. Falling or negative returns on capital are a sure sign of economic weakness reflecting the end of a period of over-investment, which is naturally followed by a period of under-investment. This is the business cycle.

In China, capital is just one piece on the board where the aim is to raise living standards of all households. As a result, capital is used and treated remarkably differently, often to the consternation of external observers and investors. It is not a matter of aggregating up the investment decisions of individual firms and households to predict macro-economic outcomes, as was done by some economists prior to the sub-prime crisis in the US. The government’s role is paramount. Despite claims of dramatic imbalances (investment spending has made up to 45% of GDP in recent years, compared to below 15% in some developed economies), investment is driving sustainably higher economic growth.

Perhaps it is because I was born in Spain of a Greek-American father and a French mother, grew up in Pakistan, Peru, Spain and Morocco, and now live in China (with Brazilian and Iranian sisters-in law, to boot), but I find this kind of cultural stereotyping pretty funny and generally useless. Wei qi does not explain the inscrutable Oriental mind any more than does ping pong or mahjong (both of which, by the way, are more popular), or any more than chess explains the Western mind (and isn’t chess Arabic anyway?).

After all it was not 100 years ago that wei qi was also used to illustrate the essentially “feminine” nature of the Oriental mind (yes, yes, back then it was widely believed that Western culture is essentially masculine and Eastern culture is essentially feminine, whatever that means). Wei qi, it seems, can be used to illustrate all sorts of explanations of why they are different from us, in the same way that knowing references to Confucian culture are used today to explain the high savings rate in Asia, even as they were also used before the 1960s and 1970s to explain then-prevalent low Asian savings rates.

Perhaps this confusion over culture is why White believes that there is something profoundly Chinese about China’s growth model when clearly there isn’t. That some of us believe so reflects the very weak general knowledge we tend to have of economic history. The development model described in White’s paper as fundamentally Chinese is not unique to China, or even to other wei-qi-playing Asian countries, and in fact traces its roots at least as far back as the “American System” of the early 19th century, one of whose leading proponents, Columbia University’s Pechine Smith, became an advisor to the Japanese government in 1870 as it began its modernization process.

The Japanese version of this development model is essentially the one followed by many Asian countries, including China, and I strongly recommend Michael Hudson’s fascinating bookAmerica’s Protectionist Takeoff: 1815-1914, to anyone who wants to know more about the history of this development model. Among other things it recognized the failure of the private sector to fund socially and economically useful investments, and so advocated an interventionist role for the state.

What has never been clear is how to address the impact of an institutional structure designed to reward state-sector players for increasing investment once state-directed investment becomes excessive, or even how to recognize the point at which they become excessive. White goes on to argue:

By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards. Effectively, China takes a broader perspective to the value of capital in an economy. Such an approach seems fraught with danger but there’s more protection than global markets seem to understand.

First, and most obviously, the government has the ability to fund losses on individual capital projects through the accumulated financial reserves, totalling at least $3.2 trillion. Second, and most importantly, the Chinese government, as ultimate capital allocator, can recoup returns from projects by capturing the positive externalities from projects in the form of higher tax revenues created by higher levels of activity.

Third, the failure of individual projects does not discourage investment elsewhere if other projects can still add value to the economy as a whole. The Chinese government can continue to invest through the business cycle. This has been a crucial driver of stable economic growth despite a number of asset price cycles.

This is completely wrong. First, as I have explained many, many times before, the $3.2 trillion in reserves does not grant the Chinese government any additional ability to fund losses. This very wide-spread misperception is based on a misunderstanding of the function and accumulation of foreign currency reserves. Foreign currency reserves are simply borrowed money – dollar assets, in the PBoC’s case, backed by RMB liabilities – and the PBoC itself is almost certainly sitting on large net losses as a result of the over 30% appreciation in the value of its liabilities relative to its assets (as the RMB was revalued against the dollar).

The reserves, consequently, cannot be used to cover losses since there aren’t even enough to cover the liabilities of the PBoC, and this doesn’t take into consideration the fact that reserves cannot be spent domestically anyway. At any rate if high levels of foreign exchange reserves allow a country to misallocate capital with impunity, Japan would not have had two lost decades after 1990 and the US would not have had a Great Depression.

Second, while in principle the Chinese government can certainly recoup losses on projects by capturing positive externalities, there is nothing Chinese about this and there is certainly nothing that says that all investment must have positive externalities that exceed the losses. There is nothing Chinese about this because all public spending, whether by Beijing or by the New York Metropolitan Authority, is aimed at generating positive externalities that exceed the investment losses, or else there would be no public spending – it would all be privately financed. This isn’t a special Chinese trick. It is just the traditional argument, dating back at least to the debate about the establishment of the Credit Mobilier in France in 1852.

As for whether positive externalities must exceed investment losses, this is the whole point of the over-investment argument of the last decade. There are very strong reasons for saying that the externalities have not been enough to cover the investment losses and only massive, and wholly uneconomic, transfers from the household sector have done so (some Chinese economists, who focus on environment costs, actually argue that especially in recent years net externalities have been negative). At any rate this seems to have been confirmed by the IMF study.

The point is that Chinese over investment, as was the case of every country that followed this investment driven model, wei qi playing or not, is almost certainly resulting in losses that exceed positive externalities. If it didn’t, we would not expect to see debt rise faster than debt servicing capacity, which we seem to be, and we would expect to see temporary imbalances in household consumption reverse themselves after a few years, which they have not. In fact these imbalances have accelerated to become the greatest such imbalances in history. Clearly while assuming sufficient positive externalities has been the default assumption of all the China bulls in the last few years, it is getting harder and harder to maintain that position.

White’s third point is true, of course, but irrelevant if the second point is wrong. Given the track record of the Chinese banking system, the incentive structure for entities initiating investment decisions, the lack of transparency and accountability, and the deep pessimism that exists among Chinese business leaders and academics (and certainly high and rising flight capital is a pretty strong indication of what business leaders think), it is hard to understand why anyone would simply assume that Beijing has discovered a magic formula for investing, but this is what White’s assumptions require.

White goes on to make some interesting points about the effect of competition (although he seriously overestimates the extent of competition in much of the Chinese economy) and how the need for profits can lower the socially optimal investment level in any economy. Although I think his overall argument was easier to make a few years ago, following the extraordinary explosion in credit of the past few years it is hard to see why anyone would still make the same argument today.

On a related subject, William Overholt has an article in Asia Times on the widespread recognition among the policy making elite that the economy is in trouble and urgently requires economic (and political) reform. He argues that although many analysts have decried the new political lineup as having excluded all the obvious “reform” names, in fact the new leadership is nonetheless committed to reform:

Of course, getting China moving again will be difficult. The interest groups – big state enterprises, the provinces, and the army – have far greater clout than they did before the Hu Jintao era. Even though the “extreme” views have been quieted, the leaders’ opinions remain quite diverse. The old factions remain vigorous just below the top.Against this, it is crucial to understand the sense of urgency, not just among the leaders but throughout society. A decade ago, it was the opposite. Western pundits expected that Hu Jintao, whose term at the Central Party School saw innovative thinking about political reform, would initiate new reforms. They did not understand how weary Chinese society was after a decade of Zhu Rongji’s reforms that cost 50 million state enterprise jobs and 25 million manufacturing jobs. The top of government was cut in half and everyone felt insecure. Hu’s promise of a “harmonious society” provided just what people wanted.Now the mood is the opposite, and the numbers say that the old economic drivers – cheap exports and infrastructure investment – have permanently weakened. Beijing’s atmosphere on this exactly parallels Washington’s fear of the fiscal cliff. Western pundits disappointed by the absence of their favorites from the top seven are missing what is truly important: the sense of urgency, the streamlining, and the universal acknowledgment among the top leaders that bad economic numbers and political discontent demand decisions. Economic reform is coming.

I agree with Overholt and I think it is a point worth repeating. Within China’s economic policy making elite there are few, I think, who do not realize how serious Chinese over investment has become, how rigid the imbalances, how dangerously debt levels have risen and how urgent, consequently, is the need to reform the growth model radically. The only question, as the debate in China during the last two years makes clear, is whether powerful vested interests will permit the reforms.

If the Australian government is still excessively optimistic about Chinese growth prospects, I think the Brazilians – once also overly optimistic – are in a much more somber mood. For the past few years I have been arguing that China’s rebalancing has important implications for the developing world, and that countries that had benefited disproportionately in the past from Chinese growth would, in the future, do very poorly, whereas countries that had suffered disproportionately would do well in the future.

The former group consists of countries like Brazil that are important exporters of hard commodities. China’s massive investment boom was great for hard commodity prices because it created huge Chinese demand – although only 11-12% of the world China now comprises around 40% of global demand for such things as copper and zinc and 60% of global demand for such things as iron and cement. Since rebalancing means, among other things, a sharp drop in investment growth, and perhaps even contraction, while commodity producers have been ramping up production, the result is likely to be a collapse in the prices of hard commodities. This is bad news for Brazil (and Australia).

The latter group consists of countries like Mexico whose manufacturing base was destroyed by Chinese expansion in the tradable goods sector. I have already written about why rebalancing also means almost by definition an erosion of Chinese export competitiveness, and why I think the next few years will be very good for countries like Mexico, who will see their manufacturing base revive, as already seems to be happening.

The next few years, however, will be bad for the commodity exporters, and this seems already to have started. According to an article in the Financial Times:

Brazil’s hopes of returning to the club of high-growth emerging markets were dealt a blow on Friday following the release of figures that showed the economy is on track for one of its slowest years in a decade. Gross domestic product grew only 0.6 per cent in the third quarter over with the second – in spite of a prediction this week from Guido Mantega, finance minister, that it had expanded at twice this rate – setting Brazil on course for growth of just 1 per cent in 2012.

“It’s a very weak economy,” said Alberto Ramos, economist with Goldman Sachs. “It should prompt the government to think structurally about what’s going on with investment, with confidence, to think about the structural impediments to growth.”

Instead the government seems to be thinking about a completely different, and in some cases irrelevant, set of problems:

The government has been taking measures to stimulate investment, announcing R$133bn of road and rail concessions, auctioning off important airport projects to private sector consortiums and lowering social welfare taxes on payrolls.

Much of the government’s rhetoric has also focused on the exchange rate, with Mr Mantega accusing the US of inflating the value of Brazil`s currency, the real, against the dollar through the monetary easing policies of the Federal Reserve. On Friday the real fell to 2.12 against the US dollar, its lowest level since 2009, as investors speculated the government would step up efforts to weaken the currency to aid manufacturers.

But economists argue much more needs to be done as growth in Brazil lags behind not only the other Brics economies, but also other Latin American countries. Mexico, for instance, with an economy much more open to trade, is growing more rapidly than Brazil.

“Look at what Mexico did in terms of containing unit level costs, in terms of containing real wages,” said Goldman Sachs’ Mr Ramos. “Brazil priced themselves out of the global economy by not containing costs – Brazil does not have an exchange rate problem, it is a cost competitiveness problem.”

Brasilia will continue manipulating its currency while vociferously denouncing foreigners for doing the same. QE in the US has especially become Finance Minister Mantegna’s one-size-fits-all explanation for much of what is going wrong in Brazil, although I would have thought that QE would have been even worse for Mexico. Brasilia doesn’t seem to realize that much of their success in the past decade depended on extraordinarily unbalanced growth in China, and that this must end. As it does, so will Brazilian growth. Policies in Brazil would best be aimed not at slowing or preventing the necessary economic adjustment in Brazil but rather at accelerating the Brazilian shift to a post-China-investment-boom world.

Likewise, Mexico’s “success” in containing unit level costs was also, in my opinion, at least partly caused by aggressive pricing by Chinese exporters. As Chinese costs rise, Mexico will find itself increasingly competitive in the international markets and it will experience a manufacturing boom.

I think we will repeat this story around the world. Struggling developing countries with important but weakened manufacturing sectors will suddenly see their economies do much better than expected, while high-riding developing countries that sailed the commodities boom will get killed. As the great Chinese story of the past decade reverses, its outsized demand for commodities and its equally outsized supply of low-end manufacturing will also reverse. Any country that was affected by China in the past decade of investment-led growth will also be affected – but in the opposite way – by a rebalancing China. Among other things, I am sad to say, this might also mean the end of the newly optimistic Africa story.

Houses and Holes
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  1. Since rebalancing means, among other things, a sharp drop in investment growth, and perhaps even contraction, while commodity producers have been ramping up production, the result is likely to be a collapse in the prices of hard commodities.

    Not according to the MineBot’s definition of rebalancing, which somehow means continued strong investment growth, and strong prices and volumes for hard commodities.

    Lets see him tie himself in knots again trying to explain this view.

  2. All this glOom is a bit ridiculous guys, it s not all bad, I love MB but the continually ( and bit disconnected) depressing view gets annoying

          • By def shorters go against the trend hence their very low success rate, they need luck not skills

            In a way I m short gold/shares and long in property

          • Really?! So those guys in The States who analysed their property market in ’06 and shorted the guts out of it were just ‘lucky’ were they? Any market price is where it is at any given time because it factors in ALL known and assumed factors – (otherwise the price would be somewhere else?). Being short is an evaluation process, as is being long. And reading articles, like this one, that support one’s view, whilst it may be confirmation bias, is not being Gloomy, as your original point suggested.

          • Oh, and to make your day…that’s why Australasian property is going to take such a hiding! It has so much assumed price growth in it that it’s improbable that it can be achieved. 40 years of ‘prices always go up’ are built into today’s prices. You speak of luck…well for those in property today…Good Luck!

  3. Maybe we could join in mass wish thinking otherwise known as prayer to fix our problems.

    I know MB can be a bit neg but I think we are old enough not to need too much sugar to sweeten the facts.

    “Just give it to me straight Doc!”

  4. HnH, do you play wei qi yourself? If you have not, I would recommend you to learn. You would not be disappointed for the time you invest into it.

    It is a very elegant game that helps develop one’s strategic thinking (and wisdom). The game also contains many important concepts that are very useful and yet difficult to explain (to those without the knowledge of the game).