by Michael Pettis
Perceptions have certainly changed a lot in the last few months. As recently as three years ago there were so few analysts who were skeptical about the sustainability of Chinese growth that we rarely disagreed among ourselves. Now, however, the group of skeptics has become large enough that there are serious disagreements among us as to what will happen next. Click on graphic for historical perspective.
One source of disagreement is about whether Beijing can turn around the current growth slowdown. Some argue that business confidence is so low that it will be all but impossible to get growth up during the rest of this year. They point to the falling demand for loans as proof that Beijing cannot simply force up credit by relaxing loan constraints in the banking system. My friend Patrick Chovanec, at Tsinghua University, seems to be in this camp, as his recent blog postings suggest.
Weak loan demand certainly does seem to be a problem. Friday’s Bloomberg has the following story:
China’s biggest banks may fall short of loan targets for the first time in at least seven years as an economic slowdown crimps demand for credit, three bank officials with knowledge of the matter said.
A decline in lending in April and May means it’s likely the banks’ total new loans for 2012 will be about 7 trillion yuan ($1.1 trillion), less than an estimated government goal of 8 trillion yuan to 8.5 trillion yuan, said one of the officials, declining to be identified because the person isn’t authorized to speak publicly. Banks are relying on small and mid-sized companies for loan growth after demand from the biggest state- owned borrowers dropped, the people said.
The drying up of loan demand attests to the severity of China’s slowdown and may add pressure on Premier Wen Jiabao to cut interest rates and expand stimulus measures.
Times have certainly changed. It used to be that the incredibly low interest rates set by the central bank all but guaranteed infinite demand for credit. After all if you are paying almost nothing for capital (perhaps even a negative real rate), and your risks are guaranteed, it almost always makes sense to borrow and invest in anything that offers even the most meager or evanescent of returns.
In those days Beijing could pretty much set the pace of growth simply by capping the maximum level of loan growth permitted to the banks (actually not so simple because for the past decade Chinese banks have expended all their ingenuity in figuring out how to cheat the loan caps). Borrowers had infinite demand and banks would lend right up to (and sometimes even over) the cap because their profits were guaranteed and their risks socialized.
Where will demand come from?
Now, it seems, the expected returns to investment are so low that even cheap capital and socialized credit risk is not enough to tempt privileged borrowers into borrowing and investing. This fact alone should worry those of us who are still not yet convinced that China has a serious investment problem. Over at The Economist there is a long section on the Chinese economy in the current issue, which is well worth reading because it puts the bull case very intelligently, but it does so in part by making a distinction between “over-investment” and “mal-investment” which I think is irrelevant.
The problem is the sustainability of debt and the cost of servicing it relative to the economic wealth generated by investment, and this occurs whether China overinvests or mal-invests. At any rate those who are very skeptical about China’s ability to regain growth this year certainly have a strong case.
Nonetheless I am not so sure I agree with them. I suspect that Beijing has a few arrows left in its quiver. I think that current loan demand may indeed be low, but if Beijing were simply to force local governments (or allow them, since they anyway love to invest bank money wantonly) to engage in another round of infrastructure investment, bad as that may be for China’s eventual rebalancing, I think it would cause another spurt of growth in the short term. On that subject here is an article from Monday’s South China Morning Post:
Premier Wen Jiabao said yesterday the country would step up efforts to maintain stable economic growth, in a statement that many read as a signal for imminent monetary easing. During a fact-finding trip to Wuhan, in Hubei province, over the weekend, Wen said macroeconomic controls should be “improved and fine-tuned” in line with the latest economic situation and problems, if any, Xinhua reported.
The central government should “properly handle” the relationship between maintaining growth, reforming economic structures and managing consumer price inflation, he said. ”We should continue to implement a proactive fiscal policy and a prudent monetary policy,” Wen said. “More priority should be given to maintaining stable economic growth.”
Many economists said Wen’s remarks showed policymakers were worried about the economic slowdown, which has already spilled into the second quarter from the first.
Certainly this, and lots of other similar signaling by Beijing, suggests, that the slowdown in growth has become so serious that it may break through the political gridlock typical of the period before a leadership transition. In my opinion, then, the rather alarming slowdown in Chinese growth is likely to be reversed in the next quarter and we will get GP growth close to either side of 8%. I hope it is lower rather than higher, because the more debt China creates to generate growth, the more difficult the ultimate adjustment, but this is politically a very important year and I don’t think anyone wants it to end with a whimper.
But whether or not I am right about China’s ability to increase loan demand by forcing more infrastructure spending there is still a lot of reason to worry about the lack of natural demand for credit. In that light I found this article from Monday’s Financial Times very interesting:
Chinese consumers of thermal coal and iron ore are asking traders to defer cargos and – in some cases – defaulting on their contracts, in the clearest sign yet of the impact of the country’s economic slowdown on the global raw materials markets.
The deferrals and defaults have only emerged in the last few days, traders said, and have contributed to a drop in iron ore and coal prices. “We have some clients in China asking us this week to defer volumes,” said a senior executive with a global commodities trading house, who warned that consumers were cautious. “China is hand to mouth at the moment.”
A senior executive at another large trading house also confirmed there had been defaults and deferrals in both thermal coal and iron ore.
The source of imbalances
This is the kind of thing, of course, that experienced economists always worry about. Companies are having trouble raising cash, with many forced to default on obligations, debt is rising, and even the most foolhardy of investors are having second thoughts. When borrowers who never worried much about profitability are reluctant to take on free loans, they must be glum indeed about their prospects.
And to cap it off, my friend Mark Williams at Capital Economics sent me his latest piece on China where I saw the following:
In broader terms though, coming quarters are likely to highlight the growing fragility of China’s growth model. Figures released this week confirm that investment spending rose last year to 49.2% of GDP, up one percentage point from 2010. Meanwhile, the share contributed by household consumption remained rooted at 34.9%, dashing hopes that rebalancing had already started. With the government now embarking on another investment-led stimulus, prospects that the economy will soon be put on a more sustainable, more consumer-led footing still look remote.
So investment is up as a share of GDP and investment flat. If Williams is right, it suggests that even in 2011, the latest year in which the China bulls have promised that the long-awaited rebalancing towards consumption had finally begun, there has been no rebalancing.
I have argued, of course, most recently in my April 6 newsletter, that absent a massive and unlikely privatization program I cannot even conceive of how rebalancing could occur with growth rates much above 5 or 6%. That is why I have asserted, without evidence of course, that there has been no major rebalancing in 2011. Perhaps the evidence is finally emerging.
Before closing I wanted to mention a very interesting study prepared by a group of economists at HKUST (Hong Kong University of Science and Technology). The abstract of the paper is
This paper documents a hallmark feature of China’s state capitalism as the state controlling the economy in a vertical economic structure: State-owned enterprises (SOEs) monopolize key industries and markets in the upstream, whereas the downstream industries are largely open to private competition. We develop a general-equilibrium model to show that this unique vertical structure, when combined with openness and labor abundance, is critical in explaining a puzzling fact about China’s economy: SOEs outperformed non-SOEs in the past decade while the opposite was true in the 1990s.
We show how the upstream SOEs extract rents from the liberalized downstream sectors in the process of industrialization and globalization. It implies that the unusual prosperity of SOEs in China can be merely a growth-undermining symptom of the incompleteness of market-oriented reforms rather than a proof of their efficiency dominance over non-SOEs.
The paper was sent to me by one of the authors, Xi Li, who also sent me a link, which I assume works. The paper is called “A Model of China’s State Capitalism” (co-authored by Xi Li, Xuewen Liu, Yong Wang). Parts of the paper are pretty math and statistics heavy, but the point is that the structure of the Chinese economy has resulted in upstream monopoly pricing power by SOEs, and this explains why their profitability over the past decade has been increasing rather than decreasing, as one would expect. Monopoly pricing, of course, means that profitability does not arise from greater efficiency but rather from the implicit ability to tax households, and unfortunately rebalancing requires that among other things we undermine the ability of SOEs to remain profitable.
Why is this important? It may be important in part because it means that characteristics of the Chinese economy that force up the savings rate by transferring wealth from the household sector to the state sector are so deeply embedded in the economy that those of us who continue to be very pessimistic about the ease with which China can transition to a consumption-led economy may very well be right. This would certainly help explain why the economy has gone backwards, not forwards, in the seven years since Beijing has promised with increasing urgency to reverse the imbalances.