Friday, March 18, 2011

Michael Pettis on Why China Will Not Rebalance Now

In his most recent March 16th private newsletter, Michael Pettis discussed "Forget about rebalancing now".  He noted that indications are showing China slowing quickly.  Food inflation remains high, but there was nothing in the numbers to indicate the government will not be able to bring inflation down in the second or third quarters.  He finds the PPI increase of 7.2% more worrying than consumer inflation, because it is rising quickly and likely to feed int other prices.  Consumption is not keeping up with GDP growth as evidenced by the decline of retail sales to 15.8% growth in the first two months compared to approximately 19% for the prior several months.

What will Beijing do?  "Most analysts expect more action on interest rates and at least another hike in the minimum reserve requirement ..." and he agreed with that analysis. (Note that on the 18th, China raised the reserve requirement 50 bps to 20.0% for the third time this year and the sixth time since November.)  However, he does not expect interest rates to have a major impact on inflation, because there is no consumer financing in China and most Chinese savings are in savings accounts (bank deposits) raising rates actually make Chinese households feel wealthier.  Counter intuitively, raising rates might actually increase inflationary pressure in China.

Pettis believes it might take two years of declining consumption before there is a recognition that an investment growth driven model does not itself allow for rising consumption.  The longer they wait the worse it will get, because consumption will not grow anywhere near fast enough to achieve any real rebalancing of the economy.  The longer they wait the worse debt will get and the more urgent the banking system will require transfers from households to bail it out.  China's banking regulatory authority last week warned about extending loans to local government financing vehicles, which have been sources of debt growth in efforts to push GDP up.

The chairman of the Bank of China recently denied risks in the banking sector and resorted to the historical excuse of "outsiders" claiming troubles in the banks.  This is the excuse that was used by Japan in the 1980's, by Brazil in the 1970's, and by America in the 1920's.

Pettis is observing a drop in new lending which will be closely followed with a rapid slowdown in growth that will then have Beijing stomping on the accelerator.  As the People' Bank of China tried to regulate loan growth, more loan growth took place outside regulated activities with local government and banks creating "...alternative forms of financing to get around the rules."  Pettis finds banker's acceptances to be the most worrisome, because these are unpaid corporate paper (often because the client has not access to liquidity) which are accepted by banks and used as cash.  This has been a result of the current credit tightening and the favorable treatment of state owned enterprises.

Pettis notes the strange disconnect between Shanghai copper trading at a huge discount to LME copper, as have other market analysts.  He finds this very weird and believes one plausible explanation is that, while segments of the Chinese economy are swimming in liquidity, other segments are having real difficulty in getting loans.  "Could it be that Chinese importers are buying foreign copper (which is more expensive than domestic) simply because they can get trade financing for foreign imports, and are either using the imported copper as collateral against domestic loans or are selling it to raise cash."

While Pettis sees economic growth slowly sharply, he does not expect it to last long, because, however worried Beijing is about inflation, the growth constituencies will be roaring for release within a month.  Still, he is optimistic that Beijing could bring inflation down in the second or third quarter.

Pettis then engages in a discussion of exchange rates and which currency is under or over valued and by what percent, because he finds most public discussions to be using the wrong data and not using the math correctly when calculating how much the renminbi is undervalued and the U.S. dollar is overvalued.  He finds it distressing that people can complain of how undervalued the renminbi is when it has appreciated 25.9% since 2003 while the U.S. dollar has depreciated 20.6%.  He believes the most obvious factor in this perception can be found in impact of the inflation differential in the tradable goods sector of each country on the change in the relative valuation of the nominal exchange rate.  "What matters is not CPI but rather the inflation in the cost of inputs in the tradable good sector."  Secondly, the US/China differential in the domestic differential between wage and productivity growth, because the real value of the exchange rate is lowered if one country becomes more productive at a faster rate than another country and the difference is not neutralized in the form of higher wages. Third, if the cost of capital is subsidized in one country and not the other, the heavily subsidized country will experience effective depreciation.  Since the cost of capital is an important input into the production of tradable goods, the real exchange rate is reduced" and " undervalued exchange rate is nothing more than a consumption tax on imports..." which "...reduces household consumption by reducing real household income, and it increases production by subsidizing manufacturing."  In Pettis' opinion, "The correct way to look at the causes of trade imbalances ... is to look at policies that force up or down the savings rate, or the consumption rate ..."  Undervalued currencies are like a tax on households and reduce consumption while providing a subsidy for manufacturing which increases production.  Consequently, if China were to rise the value of the renminbi and simultaneously lower real interest rates, yu would have the paradox of a rising renminbi and greater renminbi undervaluation.

Interestingly, Andy Xie on March 11th published an article on Caixin entitled "Rebalancing Cannot Wait".  Xie argues debt from China's investment growth resource extraction export model could result in stagflation and social instability unless restructuring reforms are meaningfully implemented by limiting government's expenditures and ability to collect revenue.  He wants the personal tax rate reduced to 25% from 45% and the capital gains tax increased to over 50% on residential property transactions.  He also wants the government to pursue positive real interest rates to support consumer purchasing power.  He also wants the high costs of education and healthcare reduced to dispel consumer fears.

Xie notes the growth of income inequality and property bubble, but he then makes the mistake of equating government investment with the need of government to raise more revenue.  China has its own fiat currency and, as such, is not revenue constrained.  He then continues the mistake with confusing inflation with monetary growth rather than economic growth.  Xie continues his mistakes with confusing government debt with private sector debt, including the private debt of state owned enterprises and local government financing vehicles.  He actually thinks a fiat currency national government with revenue collection abilities can go bankrupt.  Xie believes China will experience high inflation in the next decade with rising commodities prices and China should focus less on export volume and more on increasing export prices.  Like Pettis, he does correctly observe that the extent and efficiency of government investment is a problem, but if government spending is reduced, then private consumption and/or exports need to increase.  Every economy has an economic balance sheet and that balance sheet is composed of three sectoral balances which must sum to zero at any given time. According to Bill Mitchell, "The sectoral balances derived are:
  • The private domestic balance (I – S) – positive if in deficit, negative if in surplus.
  • The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.
  • The Current Account balance (X – M) – positive if in surplus, negative if in deficit."  Or private consumption/investment minus savings, government spending minus revenue, and exports minus imports.
Xie also wants China to decrease its VAT from 17% to 12%  to encourage consumption and to increase deposit rates immediately by 2 percentage points.  Xie favors the economic monetary theory that the interest rate equals the per capita income growth rate.  This is not stock-flow consistent with sectoral balances.  Obviously, property prices need to be reduced to control private debt.

Xie notes the problems of private debt and inefficient government investment/spending which discourages private consumption, while Pettis is more focused on the different sectors of the Chinese economy and, in my opinion, how it is like driving an automobile with two accelerators and two brakes.

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