by Michael Pettis, China Financial Markets
After last week’s tumultuous markets one of my clients sent me an email saying
“I am so relieved your constant talk about worsening imbalances kept us from getting too complacent. Things really are as bad as you keep saying.”
I am not sure that what happened last week is proof of anything I’ve been saying, but I do think that the framework I have used over the past decade has been useful, at least to me, in understanding both the rebalancing process in China and the events that led up to the global crisis of 2007-08. And I think it continues to be useful in judging the adjustment process – or, more likely, the lack of adjustment – that explains why we still have a rough ride ahead of us.
This framework has made it relatively easy to make predictions, sometimes “surprising” ones, because by working through the imbalances and assuming – safely, I think – that deep imbalances always eventually reverse one way or the other, we can work out logically the various ways in which this rebalancing must take place.
I have argued that since the 2007-08 crisis we have seen some adjustment in the US, very limited adjustment in China or Japan (except to the extent that Beijing under Xi Jinping has stopped imbalances from getting worse), and worsening imbalances in Europe, and it is for this reason that I have never been impressed by the strong market recoveries we saw around the world. If I had to summarize the key points about the framework I use, I would make four main points:
- The adjustment process. All growth creates imbalances, and in every case these imbalances will eventually reverse. What really determines a developing country’s long-term success, I believe, is not how well it does during the growth years, but rather how well it manages the subsequent adjustment. Growth miracles are very common, but real success stories are rare. The reason, I would argue, is that developing countries too easily reversed the great gains they made during the good years because the adjustment turned out to be far more costly than anyone had anticipated. It is far more important, consequently, for economists and policymakers to understand how to manage adjustment and minimize adjustment costs than to figure out how to generate rapid growth.
- Debt and balance sheets. Probably the single biggest sources of adjustment costs are the amount and structure of debt, or, more generally, the structure of balance sheets. Economists must understand (but almost never do) national balance sheets and sovereign financial distress as well as corporate finance specialists understand business balance sheets and corporate financial distress.
- Savings imbalances. The purpose of savings is to fund productive investment, and while the amount of productive investment opportunities is probably infinite, institutional constraints in every country significantly can reduce the ability of productive investment fully to absorb the total amount of savings created within an economy. These constraints vary from country to country, and until we understand how to remove these constraints, rising income inequality and mechanisms that repress the growth of median household income (relative to GDP growth) often result in what I would call excess savings. The consequences of excess savings include speculative asset booms, trade imbalances, unemployment, and unsustainable increases in debt.
- Globalization. In a “globalized” world, no country, not even the US, can protect itself from the consequences of imbalances elsewhere. The global economy is a system in which certain types of imbalances are impossible. I especially focus on the requirement that global savings and global investment always balance, but there are others. Because an imbalance at the global level is impossible. If there are imbalances in one country or region, there necessarily must be the opposite imbalances in another, and the more open an economy, the more likely it is to respond to imbalances elsewhere. It is impossible, in other words, to understand any non-autarchic economy in the world except in the context of global imbalances.
It is on the fourth point that I want to focus in this article. I have never been even remotely an expert either on iron and steel production or on the Australian economy, but recent action in the iron ore markets and a vibrant debate within Australia has, in the past three weeks, set me up for several planned and unplanned meetings with Australians – some old friends, some fund managers and bankers, some government officials – who remembered some of the comments I made a few years ago about Australia and iron ore and who wanted to discuss future prospects.
Three-and-a-half years ago, I gave a dinner speech in Sydney to a group of Australian mining industry investors. In the speech I argued, as I always have, that the historical precedents, the extent of China’s imbalances, and the growth in Chinese debt made it very clear that China urgently needed to adjust its growth model in a way that would inevitably cause a sharp fall in demand for hard commodities. I stressed that the adjustment was going to be far more difficult than what they were hearing from sell-side analysts, most of who had only just woken up to the realization that there been a great deal of investment misallocation in China.
Australian Iron Ore and Chinese Interest Rates: A Story of Gaps
But because these analysts still did not understand that over-investment was a structural problem embedded deeply into the growth model – and not simply the accidental byproduct of occasional outbursts of enthusiasm – they had failed to explain to their clients that an unsustainable growth in debt and a seemingly insatiable demand for iron were simply expressions of the same system. As soon as an analyst understood that debt was growing at an unsustainable pace, I told the conference guests, he should know that Chinese demand for iron ore was also unsustainable.
Once China began the rebalancing process, I added, demand for iron ore had to collapse, and I could say this with full confidence not because I had disc drives filled with data and sophisticated correlation models that proved my case, but simply because this was the logic of the investment-driven growth model, and we had seen this same logic work its way many times before. The powerful opposition rebalancing would necessarily unleash – from groups the Chinese press had dubbed “vested interests” as early as 2007 – always made it unlikely that Beijing would implement significant reforms before 2012. It was only then that the various factions and groups would have agreed among themselves the distribution of responsibilities and privileges of China’s new leadership, including the president and premier, Xi Jinping and Li Keqiang, respectively.
It may have taken a surprisingly long time for analysts to understand why the credit process made rebalancing both urgent and inevitable, but it was clear to many economists, especially among Chinese academics, that severe distortions had been building at least since the beginning of the last decade. As early as 2007 Premier Wen openly acknowledged the distortions and imbalances that Chinese growth generated (it is probably not a coincidence that this is around the time we began hearing of “vested interests” in the Chinese press).
As an aside, it seems generally to be the case that the longer an adjustment is constrained, the more likely that the adjustment takes place in the form of what traders call “gapping” – which is a big, discontinuous change instead of a smooth adjustment – so when the change finally took place, the fall in demand (and iron ore prices) would almost certainly occur very quickly, in a matter of two or three years, perhaps. As Rudiger Dornbush said of financial crises, they often take much longer to come than you expected, but then things fall apart much more quickly than you thought they would. This means, to return to iron, if you understood China as a growth “system”, with its own logic, its liquidity channels, its institutional distortions, its balance sheets that embedded pro-cyclical or counter-cyclical tendencies, etc. you would have known that once the process started, rebalancing was going to cause iron ore prices (and prices of other hard commodities) to collapse, and I stressed, as I often do, that I did not think the word “collapse” was overly dramatic.
This is because any shift in Chinese demand for iron ore will necessarily be a big shift in total demand. China consumes about 60% of global iron ore production, an extraordinarily high share probably unmatched in history except perhaps (I am not sure) by England in the mid 18th century, when it was pretty much the only country in the world building machines, railroads, and iron bridges. This would be an astonishing consumption share even for the United States at its peak share of global GDP (around 33% in the late 1940s?), and so was all the more so for a country that represented only 12% of global GDP.
China’s disproportionate demand for iron was clearly the result of its intensely investment-driven growth model. This would change dramatically, I told the guests. I expected that the shift in demand for iron ore generated by rebalancing would cause iron ore prices within 3-4 years to drop by over 50% from their then-current levels of around $180-90 a ton.
The audience was clearly shocked by this forecast. The question and answer session at the end of the speech was brisk and suggested quite a lot of resistance to my predictions. But I really was convinced of my math, which connected iron ore prices inexorably with the extraordinarily large gap between China’s Nominal GDP growth and interest rates set by the PBoC, and it was clearly impossible to maintain this gap. In fact as I started writing more about the outlook for hard commodity prices over the next year, I adjusted my outlook downwards and proposed that iron ore prices would fall below $50 a ton before the end of the decade. A few months after this particular conference I was back in Sydney to speak at another conference, and after I spoke, Gerard Minack, former chief strategist at Morgan Stanley Australia, gave his own presentation on the world economy and, more specifically, on the slow-turning battleship of expansion in the production of hard commodities.
He is obviously an extremely smart guy and his presentation was an eye-opener for me. For anyone interested, I summarized some of his arguments in a September 16, 2012, blog entry, in which among other things I quoted the CEO of Fortescue as saying:
Iron ore prices have slumped to $US104 a tonne in recent days, yet Mr Power said it could soon rebound as high as $US150. ”As soon as restocking and production returns to normal we expect to see prices back in the $US120 to $US150 per tonne range,” he said.
In my blog entry I followed his quote with “He will almost certainly be wrong”. Even though I know nothing about the iron ore market, and certainly not as much as the CEO of Fortescue, I know arithmetic, and even before I heard Minack’s discussion of the global increase in production, I simply could not get the arithmetic that connected Chinese interest rates with Australian iron ore exports to work otherwise. Minack’s in-depth analysis of the supply side just made the arithmetic all the more convincing.
Rebalancing Demand for Metal
Needless to say my metal price projections, especially for iron ore, were not popular in countries like Australia, Brazil, and Peru, where I have many friends and clients and visit often. I think however that most of my clients understood my reasons for expecting Chinese demand to drop. It simply wasn’t possible that any growth rate could keep China consuming 60% of total iron ore. That even a small adjustment in Chinese demand, let alone the large one I expected, would cause a big drop in global demand seemed brutally logical to me and, I hope, to the clients to whom I tried to explain it.
Early this week I was with an Australian government representative in Beijing whom I have known for many years and he told me that iron ore prices were currently around $83 (I think they dropped another $2 last week), and that while some people in Canberra were reluctant to say it too loudly, he and others were increasingly in agreement with my lower forecast of less than $50 well before the end of the decade, in part because supply has come off much more slowly than predicted, but mainly because they now recognize that China’s rebalancing was indeed going to be a far bigger deal for Chinese demand than sell-side research had predicted.
The fact that China’s demand remained so high for so long had created complacency among iron ore producers about China’s ability to continue buying so much iron, but we have to remember that when an adjustment takes longer than expected, the correct interpretation, I would argue, is not that it is less likely to happen, but rather than when it happens, it will take the form of larger-than-expected gapping. China has only completed the first part of the rebalancing – interest rates, wages and the currency have all moved sharply closer to healthy levels, levels at which the imbalances are no longer getting worse, in other words, but Beijing has still not got its arms around credit growth because to do so would cause GDP growth to drop much more sharply than Beijing is willing to tolerate.
This is the next great challenge for Beijing, and when the regulators finally do start to repair overextended balance sheet, with a much higher debt-to-GDP ratio than any other country at China’s stage of economic development, according to a presentation Monday night by my very smart former student, Chen Long, I expect annual GDP growth rates will continue dropping steadily, by 1-2 percentage points a year through the rest of this decade (and there has been increasing talk in the past month or two that GDP growth rates are already 1-2 points below the printed rates). As I have argued before, except under implausible scenarios (at least 2-4% of GDP transferred every year from the state to households) I cannot work out arithmetically any meaningful rebalancing process that is consistent with average GDP growth much above 3-4% during President Xi’s 2013-23 term in office. This used to be considered a shocking prediction not so long ago, but not anymore. In fact I notice that in a recent paper, Larry Summers and Lant Pritchett have suggested that the arithmetic of previous growth miracles implies that China will grow by 3.9% on average over the next two decades.
History Has Proven Unkind Even to Pessimistic Rebalancing Estimates
Like with my prediction, a number of people have responded to the 3.9% projection with incredulity, but Summers and Pritchett point out, like I have many times, that the same historical precedents that form the basis for expecting much slower growth during the adjustment period also predict that it will be nearly impossible for anyone to believe these lower projections. I have studied most of the major growth miracles of the past 100 years (and directly experienced some), and in every case there have been pessimists that predicted a difficult adjustment process with much slower growth. In every such case, however, these pessimistic predictions were met with general incredulity (and for some odd reason almost always written off as “wishful thinking”) but while I have indeed found that the pessimists have always been wrong, it always turned out that they were wrong because actual growth turned out to be much worse than they predicted.
Even among the greatest “Japan skeptics”, for example, I cannot find anyone who came anywhere close to predicting in the late 1980s or early 1990s that Japanese growth over the two decades after 1990 would average well below 1%. For all the economists, especially Brazilian economists, who began in the late 1970s and early 1980s seriously to doubt the Brazilian miracle, to take a second example, I am unable to find anyone who expected growth in the 1980s to be negative. For a third example, not everyone in the early 1960s believed that the USSR would inevitably overtake the US economically before the end of the century, but excluding fierce anti-Communists predicting fire and brimstone, I don’t know anyone who expected that by the 1980s the USSR would essentially be insolvent (technically it wasn’t, but LDC debt traders nonetheless included the country in their universe of defaulted or restructuring sovereign borrowers). The 1997 Asian crisis, in yet another example, exceeded in virulence any prediction that I can find. This history proves nothing about China’s future, of course, but it does suggest how little informational content there is in the incredulity with which such pessimistic forecasts are treated. This is exactly what is supposed to happen.
Adjustments are always the most difficult part, and have nearly always been harder than anyone expected, but it is important to remember that they represent the rebalancing process, so that the adjustment in growth is not symmetrical. In the case of China, for example, whatever GDP growth turns out to be, and again this is just arithmetic, Chinese household income growth will be higher and investment growth lower – after nearly thirty years of the reverse relationship – so that the impact of slower growth will be disproportionately smaller on consumption growth and larger on investment growth. This means both that lower Chinese growth will not be nearly as painful for Chinese households as we might expect, and that demand for metals will get especially hard hit.
What matters to the Chinese adjustment process, and therefore to iron ore prices, will be how Beijing resolves balance sheets distortions. But when we think about how the Chinese adjustment will affect Australia, we must also consider the impact of savings imbalances globally. The most difficult question to answer for a country like Australia, I think, is whether slower Chinese growth leads to greater Chinese flight-capital outflows, especially when Australia is a favored destination for worried Chinese business owners.
Will the US Ride to the Rescue?
Normally the contraction impact of much weaker iron ore export prices should be partially mitigated by the expansion impact of a weaker Australian dollar, as iron-related inflows drop sharply. If these inflows however are counterbalanced by rising private inflows from Chinese businesses and wealthy individuals taking money out of China, either because of weaker domestic growth prospects of because of rising nervousness and uncertainty, asset prices might not fall as much as we would have expected, but Australia will be caught in a vice a little like that of, for example, Spain, in which export weakness cannot be partially counterbalanced by a weaker currency. (Editor’s note: But, of course, the difference would be that Australia’s sovereign currency adjustment would be mitigated by the capital inflows from China rather than Spain’s problem of not having its own sovereign currency.)
How China, Australia, Brazil, Europe and all the rest will adjust will be determined in part by their debt structures. Thanks to Hyman Minsky’s growing group of followers, we are beginning to remember some of the things we knew about the nasty interplay between debt, overvalued currencies, and unemployment back when John Maynard Keynes, Mariner Eccles and most of all Irving Fischer explained these things to us. I am not completely sure about what Australian balance sheets look like, but I am often told that debt levels in certain sectors (the household sector, for example) are quite high. Higher debt implies a tougher adjustment because as worries about default rise, the debt itself changes the behavior of economic agents in ways that nearly always reduce growth and increase balance sheet fragility. The good news, however, is that Australia tends to have the kinds of institutions (legal, financial, etc.) that reduce the frictional costs of adjustment, so if it is any consolation, they would be worse off if they were a member of the EU. (Editor’s note: And of course we have the sovereign currency situation again in play, a primary tool for rebalancing.)
By the way everything I have said about Australia is likely to be even truer about Brazil, although I don’t think Brazilians need to be much worried about a sharp pickup in Chinese flight capital into Brazil. On the contrary, they are likely to see their own flight capital outflows, especially as depreciation pressures increase. Either way all of this creates ugly and self-reinforcing disinflationary dynamics in Australia and ugly and self-reinforcing depreciation dynamics in Brazil (depending on the extent and structure of external debt, about which I no longer remember much) both of which cases may be hard to shake off without a major US recovery.
The “Euroglut” Ogre
But will there be a US recovery? I have always been optimistic about the creativity of the US economy and the speed of its adjustment processes historically – socially painful, let us not forget, but economically efficient – but recent reports about what some are calling the “euroglut” will make a US recovery all the more difficult, perhaps even derailing it, not to mention having a potentially awful impact on China’s adjustment. The “euroglut”, for those who have not followed, is a process described and named by Deutsche Bank strategist George Saravelos, whose note last week caused a frisson of well-justified fear throughout the markets.
This euroglut is not new in the making. A year ago I wrote about a graph prepared by EU economists and presented by them at my Peking University central bank seminar. This graph showed how Europe planned to resolve its domestic imbalances. By running large and growing current account surpluses, or, to put it differently, by forcing their excess savings onto an unwilling world, Europe hoped that it would reduce unemployment at home by taking a bigger share of demand from abroad.
Because we have spent a lot of time working through the global implications of changes in trade and capital flows in any one part of the world, my students were quick to get the implications, and they pounced on the visiting economists (always politely, of course). They quickly pointed out that Europe is too large simply to assume that the world can absorb large changes in its capital and trade accounts, and as they debated about the ways global constraints would affect the assumptions about European surpluses most of them quickly decided that either the markets would not permit surpluses of this size, perhaps by bidding up the euro, or the impact of these surpluses would be very negative for the world.
It would probably be so negative that I referred to this graph as “the scariest graph in the world” in one of my subsequent newsletters. In the newsletter I said I hoped that European attempts to export its demand deficiency would be undermined by a rising euro (Martin Wolf had made this same argument in one of his columns) that would reverse the contractionary impact on the global economy of European attempts to absorb a larger share of foreign demand. The world simply would not be able to accommodate this kind of surplus. It is surprising how many policymakers in so many places simply assume that the world will absorb whatever surplus they need to assume in order to make their policies work.
But it turns out that I may have been wrong to think that an appreciating currency would make the scariest graph in the world nothing more than an opportunity for my students to debate global imbalances. Last week’s report by Deutsche Bank may have changed our views. Speaking of what he called a $400 billion “euroglut” of excess European savings over already-paltry European investment, Saravelos argued that the European export of savings was structural, driven by a (rational) refusal by European investors to invest in a stagnant Europe with rising debt and rising unemployment, and so the euroglut could not be undermined by a rising euro. He further wrote:
The clearest evidence of Euroglut is Europe’s high unemployment rate combined with a record current account surplus. Both are a reflection of the same problem: an excess of savings over investment opportunities. Euroglut is special for one and only reason: it is very, very big. At around $400 billion each year, Europe’s current account surplus is bigger than China’s in the 2000s. If sustained, it would be the largest surplus ever generated in the history of global financial markets. This matters.
I need to think a little more before I believe that a euroglut really can be sustained, but its size certainly does matter, and the fact that some Europeans think this is a legitimate policy to allow Europe, and especially Germany, to avoid repairing its weak domestic demand and to continue ignoring workers incomes suggests that Europe is willing to in a way that only recently they found unacceptable and irresponsible in China. We will see how serious Germany is about recent suggestions that it plans policies aimed at increasing domestic demand.
Savings as an Expression of International Love
Only an increase in German demand will work. Saravelos says that Europe must export savings not because of rising domestic thrift but because of a structural fall in investment as slow growth and worries of an unsustainable debt load cause wealthy individuals and businesses to take money out of the country as fast as they can. This is important. I don’t think many of the sell-side analysts writing about China have yet understood the connection between European capital exports and China’s adjustment process. In a year or two I suspect we will all get it, but for now I would keep a very wary eye on the incompatible needs of the European and the Chinese adjustments. I need to learn more about this euroglut, but if it exists, I should make two points about its impact on global growth:
- If excess European savings flow primarily into developing countries with huge investment needs that have remained unfunded largely because of a lack of reasonably-priced domestic savings, and here India and parts of Africa immediately jump to mind, European savings exports will cause global GDP to grow and global unemployment to fall.
- If excess European savings flow primarily into developed countries – the US being the most obvious candidate – or into developing countries with excess investment and savings – China, most obviously, not so much by flowing in as by preventing outflows – it will cause European unemployment to shift abroad to those countries. The net global impact – if there is no immediate response in the form of aggressive trade intervention and a sharp increase in beggar-thy-neighbor policies, of course – will be a potential shutting down of a US recovery, a virtual guarantee that Abenomics will fail (not that there was much hope for success anyway), and a brutal increase in the difficulty of a Chinese economic adjustment.
If the prospect of a sustained euroglut, on the other hand, causes enough trade intervention and beggar-thy-neighbor retaliation that prevents Europe from running the proposed surpluses, a wave of European defaults, including sovereign defaults, is almost certain (and I am certainly not the first person to have noticed that a massive wave of defaults has historically been one of the most efficient, if brutal, ways of resolving huge savings excesses). The only alternative would be even higher unemployment, which would certainly bring the savings rate down, but at a cost that is probably politically unacceptable.
Europe must resolve its demand deficiency by increasing domestic demand. Attempts to export its excess savings can only lead to one of three outcomes:
A) Global growth rises because Europe’s savings are all directed at developing countries with significant infrastructure investment needs and insufficient capital;
B) Global growth drops sharply, global unemployment rises, and China’s adjustment becomes all but impossible; or
C) International trade and capital flows collapse in a repeat of the 1930s, so that Europe is forced to resolve its savings imbalance either by a massive increase in unemployment or a wave of sovereign defaults.
· Option A would be a wonderful outcome but is very unlikely, especially as the euroglut is being driven by private capital exports, and to the extent these are seeking safety, India and Africa are unlikely to be major destinations.
· Option B is likely to be the most likely outcome at first, but it could quickly cause global trade relationships to become bitterly acrimonious, in which case we will quickly switch to –
· Option C.
Last night, while I was taking a break from writing this article, I decided to flip through Keynes’ Economic Consequences of the Peace and I came across this ominous line: “There is no European country in which repudiation may not soon become an important political issue.” No European country indeed. I am glad I don’t believe in omens.
The Political Solution Possibility
We should hope that Saravelos is mistaken in his euroglut hypothesis. It would mean that German industrialists and their government allies, who have attempted to grow not by investing in productivity but by forcing German workers and their European partners to subsidize their unit labor costs, after having caused huge damage to peripheral Europe’s balance sheets and European workers everywhere, including in Germany, will now pass the cost onto the rest of the world. Probably the only winner out of all of this is Marine le Pen. The longer Europe refuses to debate honestly about debt and the euro, and the the longer it suffers from stagnation and unemployment, the more credible the Front National becomes in denouncing centrist parties for sacrificing workers and the middle class to protect the interest of bankers.
This article started out on iron ore and Australia, but is finishing with Marine le Pen. As I say in my book, in a globalized world anything that affects the relationship between savings and investment in one country – and nearly everything affects that relationship – must have the opposite effect on the rest of the world. There is no way of escaping the fact that imbalances generated in one country become a problem for everyone.
The possible, if implausible, silver lining in the euroglut story is that if the euroglut ends up financing an infrastructure investment boom in India and Africa, I will have turned out to be totally wrong about iron ore prices (and Marine le Pen won’t become President of France).