Global Rebalancing for Sustainable Growth: Michael Pettis

February 19, 2013Marketsby Michael Pettis

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Global Rebalancing for Sustainable Growth: Michael Pettis

In 2012, we saw the end of what some call the first stage of the global financial crisis. Most of the deepest problems have been identified and market reforms are underway to ensure that economic imbalances reverse themselves. But whether the imbalances reverse in an orderly or disorderly manner will depend on political decisions, decisions that will set the stages for future growth or future stagnation. 

I’ll be watching a number of things in 2013 in order to get a better sense of what the future will bring. On January 22 Princeton University Press will be publishing my bookThe Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead, and in the last chapter of the book I argue that the great trade, capital flow and debt imbalances the were built up over the preceding two decades must reverse themselves. Imbalances can continue for many years, I argue, but at some point they become unsustainable and the world must adjust by reversing those imbalances.

One way or the other, in other words, the world will rebalance. But there are worse ways and better ways it can do so. Large trade surpluses can decline, for example, because exports fall, or they can decline because imports rise. Large trade deficits can contract under conditions of high unemployment, but they can also contract under conditions of low unemployment. Low savings rates can rise with declining household income or with rising household income. Repressed consumption rates can reverse through collapsing growth or through surging consumption. Excessive debt can be resolved by default or by growth.

Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain. 

For this reason I have no doubt that over the next few years we will see the imbalances I have identified over the years reverse themselves, but whether they reverse in more orderly or less orderly ways will depend on policy decisions. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation.

My guess is that we have ended the first stage of the global crisis, and most of the deepest problems have been identified. In 2013 we will begin to see how policymakers respond and what the future outlook is likely to be. Here is what I will be watching this year in order to figure out where we are likely to end up.

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1. Watch how quickly growth adjusts.

The speed with which China’s GDP growth slows in 2013 will tell us a lot about how determined Beijing is to rebalance the economy in such a way that growth is driven more by higher household income and consumption and less by investment funded by rising government and government-related debt. It will also tell us how successful Beijing’s new leadership will be in consolidating power and forcing the kinds of economic and financial reforms on which most economists now agree, but which are likely to be politically difficult.

China ended the year on what many are interpreting as a strong note. Manufacturing seems to be growing at its fastest pace in a while. Here is the relevant article in an article from the People’s Daily:

December’s HSBC China final manufacturing PMI rose to a 19-month high of 51.5, thanks to stronger new business in-take and expansion of production, according to figures released by HSBC Monday. The statistics suggest that China’s economy remains on track for recovery as it enters 2013, said the HSBC report. Despite persistent external headwinds, as indicated by still contracting new export orders, the financial organization expects China’s GDP to rebound to 8.6  percent in 2013, underpinned by China’s continued policy support.

An article in last Monday’s Financial Times puts a little more meat on the bones:

China’s economy has ended the year on a strong note after a gauge of its manufacturing sector rose to a 19-month high. The HSBC purchasing managers’ index for December climbed to 51.5 from 50.5 a month earlier, according to figures published on Monday. In rising further above the midpoint of 50, the reading signalled an accelerated pace of expansion.

Although China is still set for sub-8 per cent growth in 2012, its weakest in more than a decade, momentum picked up noticeably in the fourth quarter after the government increased its spending on infrastructure. “Such momentum is likely to be sustained in the coming months when infrastructure construction runs [at] full speed and property market conditions stabilise,” said Qu Hongbin, HSBC chief economist for China.

As most of us expected, the end of the year saw a reversal of the attempts earlier in 2012 to slow investment growth, and as a result GDP growth and manufacturing activity have picked up, but so has debt. Beijing probably needed to do this for good political reasons – I suspect that there are many who would have strongly opposed a very weak ending for the Hu-Wen period of government – but the longer they keep this up, the worse the overall adjustment will be, and it will be politics that determines how quickly they can return to a real rebalancing of the economy.

I expect GDP growth in the first half to be fairly high, probably close to 8 percent, continuing the investment boom that was recently unleashed. I am not fully confident of this number because there seem to be significant strains in the banking system, and without easy credit growth there cannot be much investment growth. Of course part of any credit tightness will be “resolved” by the tried-and-true method of vendor financing, which is already becoming a problem for SOE balance sheets (see for example this article on Zoomlion, the construction equipment manufacturer, which has seen its sales rise in 2012 largely in line with their increased financing of customer purchases), but the idea that Chinese SOEs are rushing in where Chinese bankers fear to tread is not much of a comfort for me.

Related News: Economic Growth in China May Reach 8.2% in 2013

Related Infographic: Chinese Foreign Direct Investment Patterns In 2012

As an aside, one of my former students, now an investment banker working on the domestic IPO market, came to visit me today and warned me that there is a huge backlog of companies trying to get approval to sell shares. One of the requirements is that they must have two consecutive years of rising net earnings. Many of these firms expected to come to market in 2012 and were able to manage the needed two years of rising net earnings to 2011, but now that they have been pushed back, at least to 2013, they are struggling to show that net earnings in 2012 also went up. For that reason his firm is especially wary of sneaky attempts to boost reported earnings. There are hundreds of companies waiting for approval.

At any rate it is second half GDP growth that interests me more. If Beijing has really gotten its arms around the rebalancing problem and is serious about adjusting quickly, I expect reported growth to drop sharply, perhaps to close to 6 percent. If not, I expect reported growth to remain well above 7 percent in the second half of 2013. This would worry me.

2.  Watch how quickly new debt emerges. 

Debt problems are going to continue to emerge in 2013, but as long as each new manifestation of excessively rising debt is treated as a specific and localised problem that can be resolved with specific polices, overall balance sheets will continue to get worse. We need to watch what Beijing does to rein in the growth in debt, and of course this is closely related to overall GDP growth. As long as GDP is growing at levels above 6 percent or 7 percent, it is almost a certainty that debt is rising too fast. If GDP growth levels come in much below 6 or 7 percent, there is a chance that debt growth is not excessive.

How do we keep track of debt levels? Obviously this is no easy task in China, where both the banks and the informal banking system have done a great job in recent years of hiding loan growth and keeping formal debt levels from looking to risky.

But follow the cash. Large increases in infrastructure investment and in real estate development are almost always funded, directly or indirectly, by increases in debt. Many of the banks seem to be facing tight liquidity conditions, so we should also be watching payables and receivables on the SOE balance sheets. We should also be watching off-balance-sheet activity by the banks.

3.  Watch for financial scandals. 

We should also be keeping track of stories about defaults and bank runs. Remember that the Chinese financial system does not really “do” defaults. When borrowers are unable to repay debt out of operating cashflow, the problem is usually “managed” away by forcing losses onto some other entity.

Related News: Chinese Banks Rollover $482bn in Loans to Stave Off Massive Government Defaults

South China Morning Post columnist Shirley Yam, who, I am glad to say, recently returned from a one-year leave of absence, wrote one of her typically intelligent articles earlier this month explaining how a RMB 3.5 billion default by Metallurgical Corporation of China was resolved. It is worth reading to get a sense of how low non-performing loan numbers in the Chinese banking system are nonetheless compatible with a surge in bad investments funded by debt.

This is why those economists who understand the structure of Chinese growth and who worry about the consequences of rising debt notice even relatively small defaults. When a default actually takes place, it usually means that the relevant principals have exhausted all other means of hiding the debt and were forced into recognising the losses. For example, on Saturday the South China Morning Post published this article:

A former employee of Shanghai Pudong Development Bank is alleged to have acted as a loan shark and run illegal businesses to the tune of 6.4 billion yuan (HK$7.9 billion). It is the latest scandal to reflect the severity of the mainland’s shadow banking problem and banks’ lax management of their branches. Ma Yijiang, formerly deputy head of a branch in Zhengzhou, Henan province, allegedly used the money from cash-rich depositors for loan sharking schemes. The bank said in a statement it was assisting the authorities in their investigations.

Last month, the failure of a wealth management product (WMP) issued by Huaxia Bank’s Jiading branch in Shanghai, which resulted in depositors losing several hundred million yuan, set off alarms in the country’s banking sector, and analysts warned similar scandals would surface in the coming months.

A Zhengzhou court heard Ma’s case earlier this week. The Shanghai bank said he resigned in October 2011. The 21st Century Business Herald, an influential business newspaper, said Ma enticed depositors to hand their money to him by offering lofty interest rates between 2009 and 2011.

He lent the money, reported to to amount to 6.4 billion yuan, to other businesses, such as property developers, charging super-high interest, the newspaper said. “It again proved a lack of proper supervision of banking outlets around the country,” said an official with the Shanghai branch of the China Banking Regulatory Commission. “There are increasing risks that the defaults in the shadow banking system would lead to a credit crisis.”

Old news, you might say, and no big deal, but remember that these kinds of problems when they arise tend immediately to be suppressed, and only become public when there is no way to prevent information from leaking out. The fact that we are being regaled almost weekly with stories of banking fraud and scandals suggests just how unsteady credit in China has been. Remember what Irving Fisher told us in The Debt-Deflation Theory of Great Depressions:

The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.

When it is too late the dupes discover scandals like the Hatry, Krueger, and Insull scandals. At least one book has been written to prove that crises are due to frauds of clever promoters. But probably these frauds could never have become so great without the original starters of real opportunities to invest lucratively. There is probably always a very real basis for the “new era” psychology before it runs away with its victims. This was certainly the case before 1929.

The late stages of a debt bubble are almost always characterised by the sudden emergence of financial fraud, and the huge extent of the frauds lead many to assume that fraud was the source of the credit problems, when in fact widespread financial fraud is more typically a symptom of a financial system that has already gone to excess. This is why I am going to be following financial scandals closely, no matter how arcane or small. The occurrence and pattern of financial scandal will tell us a lot about the likely problem areas in the financial system.

Related News: Chinese Businesses Turning To Shadow Banks For Loans

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4.  Watch bank activities. 

More generally I am going to watch the relationship between total credit growth and the growth in RMB loans. Much of the off-balance sheet financing in China is designed specifically to skirt regulations, and the relative size of these transactions will tell us about transparency (or lack thereof). A typical example of this might be this Bloomberg article from last Wednesday:

China’s bank loans as a share of funding in the economy may have fallen to a record low, highlighting the growth of alternative financing channels that have prompted warnings of rising credit risks. New yuan loans probably dropped 14 percent last month from a year earlier, according to the median projection in a Bloomberg News survey of 37 analysts ahead of data due by Jan. 15. That would give bank lending a 55 percent share of aggregate financing for 2012, based on UBS AG estimates, the least in figures dating to 2002.

The decline underscores the waning ability of official loan data to capture the scale of debt in the world’s second-largest economy as borrowers and investors turn to less-regulated, higher-return shadow-banking products. The People’s Bank of China is putting greater emphasis on aggregate financing and the International Monetary Fund says the growth of nonbank credit poses “new challenges to financial stability.”

In 2002, if I remember correctly, bank lending represented 93 percent of aggregate financing as defined by the PBoC as total social financing.

5.  Watch inflation.

Inflation is actually a positive indicator for China’s rebalancing, and also worth watching because I expect (hope) it to rise in 2013, although not by too much. This may sound like a strange thing to say – everyone else thinks of rising inflation as a bad thing – but remember that the more you repress household income growth, the more you divert resources, especially through cheap financing, from consumption into production, and so this tends to be disinflationary.

If China is truly rebalancing, at least part of this is going to show up in upward inflationary pressure, although it is likely to be the “right” kind of inflation – i.e. it will hurt the rich more than the poor because it will be based on non-food rather than food items. Perhaps this inflation is already starting to happen, although not in the way I would like it to happen. There has been an uptick in inflation but it seems to have been caused by the impact of cold weather on food prices, rather than because consumption of manufactured goods is rising faster than production. According to an article in last Friday’s South China Morning Post:

China’s inflation spiked to a six-month high in December after a freezing winter pushed up vegetable prices, possibly complicating efforts to sustain a shaky economic recovery. Consumer prices rose 2.5 per cent over a year earlier, up from November’s 2 per cent and the fastest rise since June, the National Bureau of Statistics reported.

That was driven by a 14.8 per cent jump in vegetable prices after the coldest winter in seven years led to smaller harvests. The statistics bureau said vegetable prices in some areas rose as much as 40.8 per cent. Higher inflation could hamper the government’s ability to support China’s recovery with interest rate cuts or other moves for fear of igniting a politically dangerous price spiral. Consumer prices are especially sensitive in a society where the poorest families spend up to half their monthly incomes on food.

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