by Michael Pettis
I spent the end of last week in Washington DC during the IMF/World Bank meetings. Needless to say this has been a pretty gloomy trip and most of the people I spoke to or heard speak had only bad things to say about the global economy.
What’s more, given how bad the markets were last week (week ending Sept. 30), it’s tempting to write excitedly about what the sharp drop in the prices of stocks, commodities and currencies is now telling us. I am not sure however what to say because I don’t believe that there was ever any chance of global growth returning for several years, and of course, to put it as politely as I can, I never believed in the emerging-markets decoupling theory. I have been arguing for the past three years that the 2007-08 crisis is not even close to being over because all the major capital and trade imbalances that have helped cause the crises afflicting much of the world remain in place.
In the US, there has been some rebalancing as private debt levels have come down sharply, but we still have a long ways to go. I expect that consumption growth will remain weak and unemployment high for several years, and it is probably only with a hardening of trade sentiments that growth will return to the US. If the US pushes hard to close the trade deficit by enacting measures that are either directly protectionist – raising tariffs or restricting foreign purchases of US government bond purchases, for example – or indirectly interventionist – more monetary expansion or a consumption tax, for example – like the UK after 1930-31, when it too went protectionist, we might see the economy revive a little more quickly.
Of course while closing the US trade deficit creates growth for the US, it does so by allowing the US to grab a greater share of its domestic demand, and in the short run this doesn’t help the rest of the world at all. On the contrary, it would be devastating for the surplus countries. None of this is being made easier by the sharp contraction in the growth rate of international trade reported by the WTO on Friday. Here is the Financial Times on the subject:
The WTO on Friday revised down its estimate for growth in global goods trade in 2011 to 5.8 per cent from an already cautious forecast of 6.5 per cent and warned that the risks were “firmly rooted on the downside”.
Meanwhile, an estimate of commerce compiled by the Netherlands Bureau for Economic Policy Analysis, a Dutch think-tank, showed growth in goods trade grinding to a halt over the summer, threatening to start contracting for the first time since it went into freefall during the global financial crisis in 2008-09.
As limited as the US adjustment has been so far, for the rest of the world it has been worse. In China the huge investment–consumption imbalance has only gotten worse since the crisis, and there is little chance that we will see much action until 2013 at the earliest. Unfortunately the longer we wait the higher debt levels will be, especially non-performing loans(NPLs), and the more difficult the adjustment will be.
Where is the demand?
In Europe the only consequences of the debt crisis have been rising debt ratios in peripheral Europe as the afflicted countries refinance at high interest rates while GDP growth goes negative, a hardening of German attitudes towards acknowledging their own role in creating the crisis, and an increasingly destabilizing political environment. In November, for example, the right should sweep out the ruling Socialists in Spain, but after a year or two the electorate is going the realize that the right can’t do anything about the crisis either, so we will be left with both major parties seriously discredited.
Here is the global problem as I see it. For much of the past decade before the crisis high global growth rates were driven by three things. Most importantly US and peripheral Europe experienced very rapid consumption growth driven by rising debt. Second, rising debt also created a boom in real estate investment in those regions. Third, developing counties, especially China, had very high rates of investment.
Since the crisis we have seen consumption growth in the US and peripheral Europe drop sharply as households deleveraged. Of course we have also seen real estate investment in both regions drop sharply. The only mitigating trend was the surge in developing-country investment, with China driving that surge to astonishing levels, which created some additional global demand to counterbalance the decline in all the other major sources.
But even leaving aside the fact that much of the increased investment will almost certainly turn out to be value destroying, the purpose of investment today is to serve consumption tomorrow. I do not believe that US and European consumption growth will return for many years, and the fact that the investment surge in places like China, because they are generating debt-servicing costs much faster than they are generating additional economic wealth, will themselves prevent domestic consumption from rising quickly enough, we still have to wait for the second shoe to drop. And that shoe will drop when investment growth in China and the rest of the developing world drops sharply in the next three years, and remains low for many years.
So where will increased global demand come from? It won’t. For individual countries of course there is one source of increased demand, but this additional demand comes automatically at the expense of their neighbors, and we call that trade war.
Before returning to the topic of trade and currency wars I wanted to discuss a related topic. As one European country after another finds its access to bond markets blocked, hopes are rising that the developing world might step in and relieve the crisis by buying the bonds that European investors and official entities are unwilling or unable to buy. And why not? After all, the BRICs alone have between them over $4 trillion in reserves. This can fund a lot of deficits.
Send in the BRICs
The latest frenzy over a developing-country rescue was set off when the Financial Times reported last Monday that the Italian government had announced that China might buy a boatload of Italian bonds:
According to Italian officials, Lou Jiwei, chairman of China Investment Corp, one of the world’s largest sovereign wealth funds, led a delegation to Rome last week for talks with Giulio Tremonti, finance minister, and Italy’s Cassa Depositi e Prestiti, a state-controlled Italian officials were in Beijing two weeks ago to meet CIC and China’s State Administration of Foreign Exchange (Safe), which manages the bulk of China’s $3,200bn foreign exchange reserves. Vittorio Grilli, head of treasury, met Chinese investors in Beijing in August. Italian officials said further negotiations were expected to take place soon.
The possibility of Chinese investment comes at a critical moment for Italy, as markets demand increasingly high yields to buy Italian public sector debt, projected to reach 120 per cent of GDP this year, a ratio second only to Greece in the eurozone.
The next day Brazilian finance minister Guido Mantega pumped up the frenzy even further when he said senior officials of the BRICs nations would meet in Washington this week to figure out a rescue plan for Europe. Some people suggested he may have gone further than he should have, but Dilma Rousseff didn’t completely back down from his comments. According to an article in Wednesday’s Financial Times:
Brazil’s president Dilma Rousseff has thrown her weight behind proposals for an “international effort” to help rescue Europe from its debt crisis.
Although she stopped short of proposing a solution involving only the “Bric” emerging nations, which aside from Brazil include Russia, India and China, she said if Europe could present a viable framework for a rescue package, her government would support it. “Brazil will always be willing to participate in any international effort,” Ms Rousseff told reporters in Brasília.
Any effort by Brazil to co-ordinate a Brics response to the European debt crisis would mark a significant step in the country’s efforts to increase its influence in world affairs. Brazil’s finance minister Guido Mantega first floated the idea on Tuesday when he said senior officials of the Brics nations would meet next Thursday in Washington to hammer out a possible rescue plan for Europe. While he did not elaborate, Brazilian newspaper Valor Econômico reported the plan could involve buying European sovereign bonds, probably those of Germany.
Brazil is clearly trying to make grand statement. After all it would be the first time in history that developing countries had put together a financial rescue package for Europe, and that has to be pretty exciting.
Not what it seems
But right away there were rumblings that suggested that, once again, the market was not thinking through its position. There is little chance that any BRIC rescue is likely to happen, and if it does, it would be bad news for Europe, not good.
First off to spoil the party was India, whose response to the announcement that it was going to help rescue Europe was a bit like that of a man being congratulated for having been chosen to “volunteer” to charge into a burning building to rescue the portrait of Chairman Kim. “Uh, not so fast” they said, “We gotta talk.” According to the Financial Times:
Brazil had sprung the suggestion of the leading developing nations coming to the rescue of the eurozone on its fellow Bric countries, India’s finance ministry said on Wednesday. R. Gopalan, secretary in the department of economic affairs at the Indian finance ministry, told the Financial Times that Brazil had “thrown” its proposal at the grouping only days before it is to meet in Washington on September 22.
On Tuesday, Guido Mantega, Brazil’s finance minister told reporters that officials from the leading emerging market economies would meet next week to discuss potential joint action to help the crisis-hit eurozone.
“The idea has been thrown at us by the Brazilian finance minister,” said Mr Gopalan. He declined to say what measures India might consider to assist the eurozone but said his country would wait to see what was discussed at the talks in Washington, which are to include ministers from Brazil, Russia, India, China and South Africa.
Just in case there was any doubt, former Prime Minister Lee Kuan Yew chimed in, saying on Thursday that Singapore had no plans to participate in a bailout. “We’re in no position to rescue the Europeans by buying their bonds. Nor do I think buying their bonds will necessarily rescue them,”
And China? Aside from the chance to get in some finger wagging, they didn’t seem too eager either. Premier Wen, at the World Economic Forum meeting in Dalian, explained what helping out meant. According to an article in the People’s Daily:
Premier Wen Jiabao said on Wednesday that China is ready to increase its investment in debt-ridden Europe, and urged the European Union (EU) to recognize China as a full market economy. “European countries are facing sovereign debt problems and we’ve expressed our willingness to give a helping hand many times. We will continue to expand our investment there,” Wen said while addressing 1,500 business leaders and government officials at the opening of the World Economic Forum, known as the “Summer Davos”.
Wen said that he reiterated China’s support to European Commission President Jose Manuel Barroso in a recent phone call. However, he added that “EU leaders and the leaders of (Europe’s) major countries must look at Sino-EU relations from a strategic viewpoint. “Based on WTO rules, China’s full market economy status will be recognized by 2016. If EU nations can demonstrate their sincerity several years earlier, it would be the way a friend treats a friend,” he said.
Perhaps not surprisingly, the article in the South China Morning Post was a little more forthright and suggests not that China is softening its position but perhaps hardening it:
Premier Wen Jiabao yesterday spelled out China’s demands for helping the US and Europe overcome their financial and economic difficulties in remarks seen as a shift in China’s attitude towards the developed economies.
Speaking to 1,500 delegates at the opening of the annual World Economic Forum event in Dalian , Wen delivered a message that was both polite and clear. While the US and Europe could count on China’s continued financial support, China also had “hopes” from them, he said.
“Countries must first put their own houses in order,” Wen said. “Developed countries must take responsible fiscal and monetary policies. What is most important now is to prevent the further spread of the sovereign debt crisis in Europe.” Wen’s biggest hope for Europe, which is struggling with a growing debt crisis, was recognition of China at the World Trade Organization as a full market economy.
…“For quite a few times, China has offered its help by increasing our investment in Europe,” Wen said without giving examples. “Up to now, we still believe Europe can pull through its current difficulty and we are still ready to expand our investment there,” he said. “But China also hopes that European leaders will muster the courage to appreciate the strategic importance of the Sino-European relationship, such as recognising China’s status as a fully fledged market economy,” he said.
Later during the forum Zhang Xiaoqiang, vice-chairman of the National Development and Reform Commission, the country’s top economic planning agency, said that Beijing is willing to buy euro bonds from countries involved in Europe’s sovereign debt crisis “within its capacity”. How much capacity does it have? That wasn’t made clear.
Does Europe need the BRICs?
So there you have it. Something substantial might happen, or it might not.
My guess is that nothing will happen except a few token gestures aimed mostly at generating positive headlines and boosting confidence. Why? Because if Germany, with its superior understanding of the politics of the EU and greater dependence on European demand, while enjoying the benefits of information asymmetry, is not willing to buy Spanish and Italian bonds, it would be pretty foolish for the BRICs to step into the breach, and the BRICs pretty much know this. Their idea of “helping” Europe, I suspect, consists of buying German bonds, not those of Italy and Spain.
In which case how does it help? Not a lot, and in fact it will make things worse for Europe. This is because more foreign investment will not help Europe. Local governments, it turns out, are suffering from a classic case of skewed incentives, in which actions that benefit individual players like the governments of Spain, Portugal or Italy in the short term may hurt Europe as a whole.
Why won’t BRIC purchases help those countries overall? In the short term it would seem that a country having trouble funding itself at manageable interest rates should welcome any major new investor no matter his provenance. Every large buyer is a valuable resource, especially if it is large enough to restore confidence to the markets and spur other investors.
But we have to remember that foreign investors are not the same as domestic investors. Any net increase in foreign purchases of euro-denominated local government bonds has an impact far beyond the short term funding impact. It also affects the trade environment.
This impact is an automatic consequence of the way the balance of payments works. Today Europe runs a current account surplus. By definition this means that far from being starved of capital, European savings exceed European investment, and it exports the excess to the rest of the world.
In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.
Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.
How would this happen? There are many ways, but the most obvious is that as foreign central banks sell large amounts of dollars to buy euros, the euro strengthens against the dollar. As this happens, European manufacturers become less competitive globally and their exports drop.
Foreign investment creates its own adjustment
This would cause a rise in European unemployment as those manufacturers are forced to fire workers. It would also cause total European savings to decline as total production drops more quickly than consumption. Remember that savings is simply the difference between production and consumption. In other words as more foreign savings enter Europe, one consequence might simply be less European savings, which is hardly likely to resolve the solvency problem.
Of course there are other ways Europe could adjust. Europe could prevent a rise in unemployment if all of the new foreign funding was used to fund direct investment. Every dollar given to Spain by the BRICs, in other words, would have to be matched by a one-dollar increase in Spanish infrastructure spending. Might this happen? Of course not. Given the need for transfer and welfare payments, it is very unlikely that Spain in this example would transfer the additional money to a new investment project, and anyway if it did it would not solve the original problem of selling bonds to finance its day-to-day needs.
There is a third way. As workers are fired because the European manufacturing sector becomes less competitive, European governments could borrow even more money to cover the transfer payments or otherwise give them jobs. This is really just a variation on the above, but the conclusion is a little different. It suggests that any net increase in foreign purchases of European bonds will be met by a more-or-less equivalent increase in the amount of government bonds issued. This, of course, does not help Europe in the aggregate, although it may temporarily help the governments issuing those bonds.
As the above cases show, the increase in foreign investment would simply be matched either by an equivalent reduction in domestic savings or an equivalent increase in domestic debt to counteract the rise in unemployment. Rather than ease the burden, in other words, foreign investment simply replaces domestic savings, undermines the manufacturing sector, and raises unemployment or debt. The BRICs, in other words, won’t help Europe by buying Italian bonds. They will simply help the Italian government at the expense of Europe generally.
So is there any way the BRICs can help? Yes, there are two ways, one cynical and the other not so cynical. If it is certain that Spain, Italy, Portugal and so on will default, BRIC purchases can be matched by European purchases of US government bonds. This will eliminate the currency impact and leave unchanged the various capital and current account imbalances – although at the expense of a large negative carry. But, when the issuing government defaults, a portion of the cost of default will be borne by the BRICs. Clever, right? Unfortunately the BRICs are probably fully aware of this risk.
The second way that the BRICs can help is by funding direct investment in infrastructure and manufacturing capacity throughout Europe. If the infrastructure is economically viable, European wealth will grow faster than European obligations to the BRICs and everyone can be better off. Of course this solution eliminates the possibility that the BRICs will simply buy government bonds.
One way or the other I am unable to see any way in which Italy’s great hope of Chinese bond purchases can leave Europe better off. It is easy nonetheless to see why desperate governments welcome official money from the developing world with their trillions in reserves. European savers are increasingly refusing to provide financing, and so any alternative source of funding is seen as a godsend.
But we must remember that although the afflicted European governments will benefit in the very short term from the help of foreign investors, the adverse impact on European manufacturers and on European savings overall more than makes up for it. An increase in foreign funding creates slower growth and, with it, the need to increase fiscal deficits in order to prevent a rise in unemployment.
Turning to foreign sources of capital will only aggravate the problem from which Europe already suffers. Even assuming that developing countries are willing to take on risks that Europeans find prohibitive, their help will not improve prospects for Europe. On the contrary, it will hurt growth prospects and make the ultimate resolution of the debt crisis more difficult than ever. BRICs should be exporting more demand, not more capital.
It is important that the desperate short-term funding needs of certain governments do not lead to an overall worse outcome for Europe. If Europeans do not want to fund credit-impaired European governments, they should not ask foreigners to do so. Slower growth and foreign debt will not help resolve the problem of insolvency.
About the Author
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Shenyin Wanguo Securities (HK). Pettis has an impressive work history on Wall Street, Latin America, Europe and Asia (see his blog China Financial Markets for a complete bio).