Tuesday, March 8, 2011

Michael Pettis on Why China Doesn't Add Up

In his China Financial Markets Newsletter yesterday, Michael Pettis sees the statements China's central bank officials as implying that minimum reserves will probably be raised another 100-150 bps before the tightening cycle is over.  While the emphasis of some party leaders, such as Premier Wen, has recently changed to make keeping the price level stable and increasing household consumption and the number one and two priorities, there is no strong consensus among policy makers.  Pettis thinks growth will slow if Beijing is serious a bout tightening credit growth, but it will just result in another period of acceleration.

Pettis respectfully disagrees with Barry Eichengreen on the doom of the U.S. dollar and the rise of the renminbi as a reserve international currency.  "The RMB is unlikely to become a serious reserve currency in the foreseeable future.  There are a number of reasons for this.  First and most obviously, there are few realistic mechanisms by which the world can acquire RMB.  Either China needs to run a large current account deficits, or it needs totally open domestic financial markets in which foreigners can easily acquire domestic RMB-denominated bonds to the tune of several percentage points of China’s GDP annually...

"We are unlikely to see either for many, many decades.  Although China will struggle to bring its current account surplus down, there are only two ways it can do so ... 

"One way is for a further surge in investment.  At current levels, however, investment is already so value-destroyingly high (to coin a new adverb), and it is pretty clear that Beijing is desperate to reduce the economy’s dependence on further investment growth, so we can pretty much dismiss investment acceleration as something that is likely to be maintained over the next decade.

"The other way is to reduce savings by raising the consumption share of GDP.  As I have written before, however, this is going to be excruciatingly difficult, and will likely come about only with a sharp reduction in Chinese GDP growth (in which case one of the main reasons for predicting the rise of the RMB will be undermined)."

Household consumption was 35.1% of GDP in 2009 and the government wants a goal raising consumption 2-3%, which would only be 37-38% while it was 40% only five years ago and 46.4% in 2000.  This means China will still be reliant upon trade surplus and the investment growth it wants to limit.  Additionally, the financial sector reforms necessary to open the RMB bond market is massive and there has been no significant reform of the banks.  Pettis also believe the geopolitical conditions are bad with most nations in the region distrusting China.

In comparing China to the United States, Pettis states "Countries with current account surpluses have no choice but to acquire foreign assets.... In practice the U.S. is the only economy large enough, flexible enough, and open enough to act as the counterpart to the net current account surpluses accumulated by the rest of the world."

Pettis was impressed by a Caixin story on a Unirule Institute of Economics study on the inefficiencies and economic cost of state owned enterprises.  Pettis' conclusions are that SOEs are massive value destroyers and only able to show profits because households are forced to subsidize their borrowing costs, which are several times their profits.  He remains skeptical of infrastructure investment, because, after many years of very cheap credit and government supported credit risk, any economic system trends towards value destruction investment.  It is not just a question that the country needs a variety of infrastructure investment, but that it is being done in a way which creates over capacity within infrastructure segments, such as airports.

Coming back to the consumption problem by noting that consumption would need to be 40-50% to work and the math does not support that possibility, because it has been significantly declining.  "Household income growth sharply underperformed GDP growth in the past decade as well.  Although the 2010 data has not released yet, there is reason to believe that household consumption number is likely to clock in around 35-36% of GDP.  The National Bureau of Statistics announced on Tuesday that urban and rural household income grew by 7.8% and 10.9%, respectively, sharply lower in the aggregate than GDP growth.  Under those conditions it is reasonable to assume that consumption growth did not keep pace with GDSP growth either.

"If over the next five years consumption is going to grow from 35-36% of GDP, its current level, to 40-50% of GDP, then consumption growth will have to outpace GDP growth by anywhere from 2.9 to 7.9 percentage points.  So if China indeed grows over the next five years by the 7% predicted by Premier Wen, consumption has to grow by anywhere from 9.9% to 14.9% annually to get China to the target."

While it is theoretically possible, it is more likely to fall into the Japanese route of slower household consumption and much slower GDP growth. While Beijng could keep increasing the investment, Pettis wants to know who is going to pay for the waste.  It is the household of course.

Pettis finishes the newsletter with  a discussion of Yi Gang's (PBoC) speech last week at Peking University in which he directly tied trade imbalances and domestic monetary policy in which he correctly noted that the monetary base is relatiely loose, because surpluses are too large and if banks did not buy foreign exchange inflows, the yuan would not be so stable.  Pettis sees this as evidence of a very tough and nasty debate in China in policy making and advisory circles between a nationalist position "...that China will be able to maintain or even bring down its trade surplus, maintain or slightly reduce credit and monetary policies, raise consumption, and keep GDP growth above 8%" and a reform position which argues that the adjustment will be much more difficult than that.  "The reformists are not very popular.  A lot of people in China seem to have very low tolerance for anyone arguing that the growth model needs serious adjustment.  Even as Premier Wen was setting a 7% average growth rate target for the next five years, provincial governors were forecasting their own growth targets.  One-third of China’s provinces expect to double their GDPs in the next five years, and in the aggregate they expect to clock in 15% annual growth rates over the next decade."

Pettis concludes "I wish the optimists were right, but I still come back to that damned arithmetic problem.  Without accelerating investment – and by now I think we can be pretty sure that it is leading to alarmingly rising debt – the only way we can keep growth rates high is by jacking up household consumption.  And the only way we can jack up household consumption is by sharply reversing the transfer of wealth from the household sector to the state and corporate sector.  But on the other hand the only way we can keep GDP growth rates high is by jacking up investment and continuing the wealth transfer."

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