Thursday, May 5, 2011

Michael Pettis on Rebalancing Through Wage Increases in China

In Michael Pettis' most recent private newsletter, from which I am only allowed to make excerpts, which arrived by email yesterday, he brings up in the beginning the question of what is going on in copper in China and comes to the same conclusions I did in my April 29 article, "China: Copper In, Copper Out".  He observes, "What is happening here in China is not that credit growth is too slow, but rather that infrastructure and real estate investment is so high that it has overwhelmed the available sources of credit ... Borrowers are resorting to some fairly convoluted and expensive ways of obtaining short-term credit largely because they cannot obtain financing from the local banks ... That doesn't mean there isn't liquidity in China.  There is tons of it, but much of the credit is being disintermediated because of constraints on bank lending ... So Chin's problem isn't that liquidity is tight --- how could it be with so much credit expansion and hot money inflow?  The problem is that much of the real investment growth seems to be funded outside the normal lending channels ... The weird distortions in the banking system, where credit isn't rationed by price but by quantity and hierarchy, has turned China, at least temporarily, into a revolving door for copper imports and exports."

In response to Jeremy Grantham's newsletter, on which I commented as part of my article, "Where Is the Global Economy Going?", he provides a revised set of tables comparing Chin's contribution to world GDP as opposed to its consumption of food and non-food commodities:

Share of global GDP
China’s GDP
China’s GDP (PPP basis)

Non-food commodities
Share of global demand
Iron Ore      

Food commodities
Share of global demand

He observes that these tables show "... the disproportion between China's share of global GDP and China's commodity consumption"  and "The tables give a very good sense of what might happen to global demand for various commodities as China rebalances."  If Chinese demand declines 10%, world global demand will decline nearly 5%.  However, he is stressing non-food commodities, because "... food consumption will continue rising as Chinese households move up the income scale."

He then asks is China currently rebalancing?  Rebalancing would have to consist of three segments: rising wages, appreciating currency, and interest rate hikes.  "... rebalancing means eliminating and reversing the wealth transfers from the household sector to the state and corporate sector.  The most important of these transfers has been the undervalued exchange rate, the lagging wage growth, and artificially low interest rates."  In the last year this has begun to reverse with the currency appreciating, interest rate hikes, and wages surging.  To the question of have we "... seen an improvement in the underlying economy caused by a rising consumption share", his answer is no.  He cites the most recent (April 2011) World Bank quarterly report on China from which he quotes a summary citing resilience in moving towards macroeconomic normalization with fiscal and monetary contribution, with which Pettis does not agree.  He does, however, think the rest of the quote about the slow down in consumption growth in 2011 is key.  The World Bank said, "Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4%, largely on higher food prices."  For Pettis, "Growth has been propped up by what I think are very unhealthy increases in investment, and you can always increase growth in the short term by increasing investment, but its sustainability is really questionable."  It should be understood that "increasing investment" is referring to state owned enterprise (SOE) investment as opposed to private small companies.  This imbalance is creating an unsustainable situation which is causing a slow down in consumption growth that one would not expect (as shown by this World Bank graph) if rebalancing growth was taking place with GDP growth.

If China is doing all of the right things --- raising wages, the exchange rate, and interest rates, Pettis asks, why isn't the economy rebalancing?  For Pettis, the key is the difference between real and nominal changes, because the nominal changes are not what matters.  Since last June the currency has appreciated approximately 5% since last June.  "On an annualized basis that's around 6% in currency appreciation since June.  But changes in a currency's real value reflect more than just changes in its nominal value.  They also depend crucially on inflation growth differentials and productivity growth differentials."  If Chinese inflation is higher than US inflation, then "... the RMB is appreciating in real terms even if its nominal exchange value hasn't changed.  Conversely, if US inflation is higher than Chinese inflation, then the RMB is depreciating in real terms."  Pettis then engages in an analysis of inflation in China and dismisses the argument that the higher inflation in China means is being appreciated by 8-9% annually by a combination of nominal appreciation and inflation and the 25% undervaluation of the renminbi could be eliminated in three years, because it would "... only be true if there were no differences in the productivity growth rates between the two countries."  But the Chinese worker productivity is growing faster than the American worker productivity and Chinese CPI inflation has not been in the tradable good sector but almost all in the food sector.  Pettis believes there has been relatively low inflation in the price inputs to both the US and Chinese tradable goods sector making the relevant price differential relatively small.  "In other words we can probably ignore the impact of inflation on the real changes in the currency." Pettis obviously disagrees with those who believe China's relatively high CPI means China's appreciation is not as low as it seems and is two or three percentage points higher. 

With respect to productivity growth differentials, Chinese worker productivity has been growing annually at two to three percent faster than US worker productivity and maybe even more depending on how one measures it.  This would mean the renminbi should nominally appreciate 2-3% just to keep from depreciating in real terms.  "Real appreciation, in other words, is less than nominal appreciation because of China's more rapid productivity growth."  He concludes there may have been some real appreciation against the US dollar but not very much.  Given the dollar is the world reserve currency and the renminbi is pegged to the dollar and the sharp depreciation of the dollar against the euro and other major currencies, the renminbi has also probably depreciated depending on the period at which you look.  "So what does this mean?  Just this: the claim that one of the key components of rebalancing --- an appreciating currency --- has been occurring may be vastly overstated or even simply wrong.  There has been little or no real appreciation of the RMB and there may actually have been some depreciation."

Just because interest rates have gone up since October does not mean rebalancing either.  While lending rates have gone up 100 basis points, depending on maturity rate, inflation has gone up 200-300 basis points, depending on the construction of the inflation index and focus on components.  "Real interest rates, in other words, have actually declined steeply.  Borrowers can obtain financing at lower real costs than ever, and depositors are suffering a significant and growing real loss on the money they leave in the banks.  This just increases the transfer of wealth from net depositors, who are households for the main part, to net borrowers, who are the state and corporate sector."  In fact, the imbalances from interest rates have been exacerbated.

With respect to wage growth, wages have been growing very quickly in the last year, but, given inflation, real wages have been growing less quickly than nominal wages.  Pettis believes that real wages have probably risen faster than productivity, which means that household wages have comprised a growing share of GDP.  Pettis' concern is the reason for the rising wages may be "... that demand for workers is driven primarily by unsustainable and unhealthy increases in the past two years in real estate and infrastructure development ..."  However unhealthy the reason, if it continues,  the problem of lagging wage growth to productivity growth may be eliminated and reversed.

Pettis summarizes that the undervalued exchange rate has not changed much and has not contributed to rebalancing, excessively low interest rates have gotten worse and significantly exacerbated the imbalances, and wage growth has gotten better and has contributed to rebalancing.  He sees no real way to compare the impact of these variables to judge the net effect.  He believes all one can do is look at household consumption, its relationship to GDP growth, and infer the net impact.  If, as the World bank suggests, household consumption is slowing, it might infer the imbalances are getting worse or it might mean there is a lag in the positive impact of rising wages and we will just have to wait until the end of 2011 to make an assessment.

Pettis has more surety in knowing, if wages are rising and interest rates are declining, there would be more real wealth transfers within the economy from corporates to households in the form of wages and from households to corporates in the form of lower interest rates.  This "... means that labor-intensive industries are bearing more than the full cost of whatever adjustment may be happening and capital-intensive industries are bearing a negative cost."  he then anecdotally relates he is hearing from his students, many of whom are the children of the owners of SME (small and medium enterprises), which tend to be labor intensive, that they are raising wages as fast as they can and still losing workers to the SOE's, which are capital intensive.  For SME's, wages are a significant portion of the business expenses, particularly if the cost of borrowing is declining.  It is Pettis' position the small businesses have driven real and sustainable growth in China, while SOE's and government investment have promoted growth by pumping wasteful levels of unsustainable investment.  For me, this brings up the question of why the SMEs and SOE's are competing for the same workers given the unemployment problem in China and the use of infrastructure projects to put people to work.  I am just surmising, but it would appear the SOE's may be raising wages faster than the SME's, leaving the SME's the job of training new employees.  If that is so, then government infrastructure projects are not hiring the unemployed and training them as much as such projects would warrant.  All of which goes back to Pettis' problem with the SOE's privileged existence.

For Pettis, the hope is not for smaller companies to grow faster to facilitate the reduction of investment growth, but the necessity to engineer the reduction of investment growth.  "The more important the capital-intensive sector is to the economy, and the more addicted these companies become to cheap capital that can be flung into wasteful projects, the harder it will be to rebalance the economy."  It will only make rebalancing transfers more difficult.

It is clear to Pettis that China is not rebalancing.  Beijing's growth model implies to Pettis that rebalancing cannot happen in theory except with a sharp contraction of investment growth.  It is not happening.  Pettis thinks, if there is another year or two of stagnant consumption as a share of GDP, maybe policymakers will wake up.  Until then do not expect the SME sector to prosper.  You can expect more of the same.

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