by Michael Pettis
I have been arguing for a while that as long as the Chinese government retains its capacity to raise debt we are not going to see a sharp slowdown in economic growth – at least until 2013. Any indication that the economy is slowing too quickly will be met with a relaxation of credit controls, and the concomitant rise in investment will spur growth.
On July 13, under the heading “National Economy Maintained Steady and Fast Growth”, the National Bureau of Statistics released more data on China’s economy:
According to the preliminary estimation, the gross domestic product (GDP) of China was 20,445.9 billion yuan for the first half of this year, a year-on-year increase of 9.6 percent at comparable prices. Specifically, the growth of the first quarter was 9.7 percent, and 9.5 percent for the second quarter…The gross domestic product of the second quarter of 2011 went up by 2.2 percent on a quarterly basis.
Quarter-on-quarter growth of 2.2% means that on an annualized basis the Chinese economy grew 9.1% in the second quarter. The market was expecting slightly lower growth, but I think few people expected the reported numbers to come in below 9%. We are well on track to completing the year with GDP growth rates of around or above 9%.
Why was growth so high? I think the obvious answer is that the main drivers of growth – increases in investment – stayed high:
In the first half of this year, the investment in fixed assets (excluding rural households) was 12,456.7 billion yuan, a year-on-year growth of 25.6 percent.In the first half of 2011, the investment in real estate development was 2,625.0 billion yuan, a year-on-year growth of 32.9 percent.
I think the main takeaway for the market was that we are not going to have a hard landing, as many expected. To tell the truth, I am not sure what people mean by a hard landing, but I am pretty sure that unless inflation continues to rise strongly for the next several months – which I doubt will happen, especially since June inflation seems largely to have been limited to pork prices – we are not likely to see any dramatic slowdown in growth this year or next.
Not everyone agrees, and perhaps many are still expecting a sharper slowdown. Here is what the Financial Times had to say when the GDP numbers were released:
With Beijing trying since last year to limit bank lending, cool the scorching real estate market and slow rapid price increases, most economists had expected significantly lower GDP growth in the second quarter than the 9.7 per cent year-on-year increase in the first three months.
The stronger-than-expected second quarter growth of 9.5 per cent was boosted by growth in industrial production of 15.1 per cent from a year earlier in June, up from 13.3 per cent growth in May and the fastest pace in almost a year.
June inflation came in at a higher-than-expected 6.4%, year on year. According to the July 11 release:
In June, the consumer price index went up by 6.4 percent year-on-year. The prices grew by 6.2 percent in cities and 7.0 percent in rural areas. The food prices went up by 14.4 percent while the non-food prices increased by 3.0 percent. The prices of consumer goods went up by 7.4 percent and the prices of services grew by 4.0 percent. In June, the month-on-month change of consumer prices was up by 0.3 percent. Of which, prices in cities went up by 0.2 percent and that in rural areas rose by 0.4 percent. The food prices grew by 0.9 percent while the non-food prices maintained the same as last month. The prices of consumer goods rose by 0.4 percent, and the prices of services showed no change of growth.
This suggests that once we can get food prices – especially pork, which was up 57.1% year on year – to stabilize, the period of rising inflation may be behind us. Since I wrote this blog entry for my newsletter, ten days ago, I see that in the last week pork prices have actually declined.
In that case there will be tremendous pressure to loosen monetary and credit conditions, especially for the ailing SMEs, who are facing the double whammy of rising wages and rising borrowing costs (only for marginal borrowers – SOEs, local governments and big borrowers are seeing rapidly declining borrowing costs in real terms). They are the most efficient part of the economy, but unfortunately they are getting squeezed to the point where the rise in bankruptcies has created real alarm.
Not everyone sees pressure on the SMEs as a problem. On Thursday the Financial Times had this article:
As China seeks to rein in stubbornly high inflation, measures to tighten borrowing have prompted fears that the country’s small and medium-sized enterprises (SMEs) will be hit hard, as credit is channelled instead to large state-backed companies.
But the real picture is more complex. Rather than facing a widespread credit squeeze, the SME sector is undergoing a painful process of restructuring. Capital is being funnelled towards high-tech and green energy-related companies at the expense of traditional low-end manufacturers.
The article goes on to argue that problems in the SME sector are part of an overall push to increase productivity, and focuses on the town of Wenzhou, widely considered the heart of the SME sector:
Mr Zhou says at least 20 per cent of Wenzhou’s SMEs – there are 360,000 in the city – have already cut back operations or closed their doors this year. State media have carried reports of cash-strapped SMEs borrowing from underground lenders at annualised rates of 60 per cent.
But for all the alarmist talk, Wenzhou is hardly on the brink of collapse or, for that matter, about to run out of cash. Instead, interviews with local factory managers, investors and bankers reveal a city in the midst of fundamental change in what it produces, with the government prodding companies to make more sophisticated products as rising wages undermine the low-cost model of manufacturing. A lack of financing, they say, is a symptom and not a cause of the troubles facing traditional industries.
I am not sure I would be so optimistic. As Chinese growth slows down, as it inevitably must and as even the government has warned will happen, the Chinese economy needs to become more labor intensive, and not more capital intensive. It is already too capital intensive, mainly because the cost of capital has been pushed down to extraordinarily low levels. Channeling more money from the household sector to subsidize more capital intensive industries – in sectors where China’s only comparative advantage seems to be its willingness to shovel losses onto the household sector – is not going to increase national wealth, nor increase overall productivity, and it certainly is not going to help absorb labor as the economy slows.
I would argue that we urgently need to see a shift in the economy away from infrastructure, SOEs and real estate towards service industries and SMEs, especially those that are labor intensive. Until we do it is pretty meaningless to talk about a real adjustment in the engines of economic growth.
China has no choice but to adjust, but as long as it is easy to borrow – and I think we have at least four or five more years during which time debt levels can continue rising before we hit crisis levels – the adjustment problem can always be put off a little longer. That is why we are unlikely to get a real sharp slowdown in growth for at least another year or two.
But what to do about rising debt levels? This is the real problem China is facing now, and my biggest concern is that policymakers are buying into the argument that China can “grow out” of the current debt burden, just as it did after the banking crisis of a decade ago. In other words, if we keep investment levels high, we can keep growth high, in which case we can safely ignore the huge pile of debt, just as we were able to ignore the huge pile of NPLs that the banks had accumulated in the 1990s.
But no, no, no! This is the worst thing policymakers can do. Contrary to popular opinion, China did not grow its way out of the previous debt crisis. What happened was very different. By keeping interests rate incredibly low, China was able to do two things.
First, very low interest rates presented a huge subsidy for borrowers, so it allowed them to borrow and invest in every conceivable project, whether of not it made economic sense. Of course all this investment created growth in the present, but because investment was misallocated, it simply meant that in future years growth would be much lower. To that extent, we didn’t have real growth – we simply overstated current growth rates in exchange for being forced to write the growth off in the future. Over the next few years we are going to pay for that misallocated investment in the form of slower growth. That means that much of the growth that allowed us to “grow” out of the debt problem simply involved pushing the real cost of the debt crisis forward.
Second, very low interest rates effectively created substantial debt forgiveness for the borrowers, so again even with the artificially high growth, China did not “grow out” of its debt. It just wrote most of the debt off, at the expense of course of depositors. This is why consumption collapsed during this period as a share of GDP.
For this reason the idea that we can “grow” out of the debt problem once again by keeping investment high is wrong. First, it would only increase capital misallocation and debt levels, and would require even lower growth in the future. We can’t keep pushing the cost off into the future, as attractive an option as that always seems. Second it would put unbearable pressure on household income and consumption, and so ensure that the one thing China needs above all – a rapid rise in household consumption – is all but impossible.
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