The End of Efficiency

by Michael Pettis, China Financial Markets

The big news in the past two weeks has been the slew of economic data suggesting that China has firmly turned the corner on its economic close-down. Growth is up, investment is up, and inflation is down. Here, for example, is the New York Times, a newspaper whose website is no longer available in China without a VPN:

The Chinese economy grew faster than expected last month even as inflation slowed, official statistics showed on Friday, as the government continued heavy lending through its state-owned banks to rekindle growth. The latest data, including industrial production, retail sales, fixed-asset investment and electricity generation, were stronger than most economists had anticipated. They presented a consistent picture of an economy that is starting to show real growth again after a very weak spring and summer.

“It has become increasingly clear that the Chinese economy is now moving in a better direction,” Zhou Xiaochuan, the governor of the People’s Bank of China, the central bank, said at a news conference Thursday, before the October figures were publicly released. Bank economists increasingly agree. “October’s growth data delivered pleasant upside surprises across the board, providing fresh evidence that the economy has indeed bottomed out thanks to the filtering through of Beijing’s policy easing,” Sun Junwei, a China economist at HSBC, wrote in a research report Friday afternoon.

…Australia & New Zealand Banking said in a research note that the latest figures were consistent with 8 percent economic growth in the last quarter of this year and even faster expansion in the first quarter of next year.

…The Chinese National Bureau of Statistics said Friday that industrial production had risen 9.6 percent in October from the same month a year earlier, compared with 9.2 percent in September and 8.9 percent in August. Retail sales were up 14.5 percent in October from a year earlier, compared with 14.2 percent in September, even though slower inflation at the consumer level was acting as a brake on the increase in retail sales.

Fixed-asset investment was up 20.7 percent for the first 10 months of this year, after having been up 20.5 percent for the first nine months of this year. China releases only year-to-date figures for fixed-asset investment, partly because of the difficulty in tracking when money is actually spent on big construction projects.

Consumer prices were up only 1.7 percent in October from a year ago, compared with an increase of 1.9 percent in September. Western economists had expected inflation in China to stay steady in October instead of slowing. Producer prices were down 2.8 percent in October from a year ago, a slightly faster pace than the 2.7 percent decrease that economists had expected but not as fast a decline as in September, when they were down 3.6 percent.

A lot of analysts are hailing the news as evidence that the Chinese economy has “truly bottomed out”, in the words of Ting Lu at Merrill Lynch. Credit Agricole is even more bullish – astonishingly so, in my opinion:

“It’s pretty clear that there is no hard landing risk, that the economy will improve in the fourth quarter and we’re going to see 9 per cent year-on-year growth in the first half of next year,” Dariusz Kowalczyk, senior economist and strategist for non-Japan Asia, Credit Agricole CIB, told Reuters.

I think we need to be very cautious and refrain from allowing ourselves to get too caught up in the huge sigh of relief that the sell side is heaving. Growth rates in China will continue to slow dramatically in the next few years, and if there are temporary lulls, as there must be, these do not represent any sort of “bottoming out” at all. They simply represent the fact that Beijing cannot afford politically to allow the adjustment to taker place too quickly, and from time to time Beijing is are going to step on the investment accelerator to speed things up temporarily.

More credit

Doing so of course will only make the adjustment longer and more painful, but given how difficult politically the transition to a balanced economy is likely to be, we would be crazy to expect otherwise. One reason for worry was listed in the New York Times article cited above:

But the renewed growth has been fueled by rapidly mounting debt, as state-owned banks and the central bank have funneled hundreds of billions of dollars in additional lending to state-owned enterprises and government agencies to finance further investment projects.

You can get as much growth as you like if you expand credit, but once expanding credit has become the problem, it cannot also be a permanent solution to slower growth. The country’s balance sheet continues to deteriorate – and the most recent growth spurt implies faster deterioration – and this, ultimately, is the main constraint of the Chinese growth model.

Within the banking sector we are seeing all kinds of strains as companies and banks stretch for liquidity. Large-company receivables are growing quickly, as are payables (no one, it seems, wants to part with cash), loans simply are not getting repaid, and deposits are no longer growing, perhaps because flight capital is more than enough to offset China’s very high trade surplus. Here is an article in the Financial Times:

China notched up its biggest trade surplus in nearly four years in October, giving the country’s economic recovery an extra boost but potentially adding fuel to foreign criticism of Beijing’s support for its exporters.

Chinese exports increased 11.6 per cent last month, topping market expectations and pushing the trade surplus to $32bn, China’s largest since January 2009.

Remember that thanks to disguised flight capital and commodity stockpiling the surplus is almost certainly a lot larger than reported, and yet banks are still feeling the liquidity squeeze. And for all their happy noises, the authorities nonetheless are worried, at least about certain parts of the banking system.  According to an article in the South China Morning Post:

The mainland’s bond regulator has stopped approving debt sales by governments below provincial level, underscoring concerns of defaults arising from a flood of bond issues by local government financing vehicles this year.

The National Association of Financial Market Institutional Investors, appointed by the central bank to supervise the interbank bond market, had suspended applications to issue medium-term bills by local governments other than provinces, municipalities, provincial capitals and other specially designated cities, industry sources said.

The suspension, expected to last until the end of next month, was aimed at controlling risk after “shell companies” without any cash flows or assets applied to issue debts on behalf of some local governments, a source close to the association said.

Most worrying of all Charlene Chu, perhaps the only analyst who actually understand what is happening in the banking system, released a new report with Fitch Ratings that is described in a Reuters article:

Fitch Ratings says faster growth of broad credit in Q312 was one factor behind the recent improvement in Chinese economic data. In a comment published today, the agency highlights that, after slowing from Q411 to Q212, broad credit is back on track to surpass CNY17trn (USD2.7trn) in 2012.

Fitch’s measure of broad credit includes shadow and offshore sources omitted from the central bank’s official total societal financing metric.

“This marks the fourth year in a row that net new credit will exceed one-third of GDP,” said Charlene Chu, Head of Chinese banks’ ratings at Fitch. At current growth rates, by 2013 China’s banking sector assets will have expanded by nearly USD14trn since 2008. This is equivalent to replicating the entire US commercial banking sector in just five years. Such massive balance sheet expansion has limits, according to the agency.

You can accelerate investment forever

It is, to me, astonishing that China in just five years is “replicating the entire US commercial banking sector”, and yet so many analysts are expressing delight with China’s return to growth. Of course you can generate growth if you force such a tremendous expansion in credit, but this is simply unsustainable.

I know I’ve said this many times, and I apologize for boring regular readers, but while I expected that politics would require a jump in growth over the rest of this year and the beginning of the next, this “good growth” tells us nothing about the health of the underlying economy. It only tells us how difficult politically the transition is likely to be.

My guess is that the more difficult the consolidation of power, the longer the period of above 7% growth – so the happier the sell-side analysts are, the more worried long-term investors should be. At some point growth will start dropping rapidly again, and of course the same analysts who are now hailing the return to rapid growth will assure you, when growth begins to slow sharply again, that this was part of Beijing’s plan and was fully predictable. China is slowing because Beijing wants it to slow, they will say, and that’s a good thing. Meanwhile the fact that China is speeding up is also a good thing.

For those who are interested, I discuss some of this is a debate I have with the estimable Nick Lardy in last week’s Wall Street Journal. Round 1 was held on November 2 and Round 2 on November 7.

I also published for Foreign Policy last week a longer piece on the challenges facing the new leadership in China. My main argument in the Foreign Policy piece is that both historical precedents and a common sense understanding of the rebalancing process suggest that politics, not economics, will determine China’s success. So far Beijing has succeeded largely because of its ability to collect and control the total savings of the country, and unleash waves of investment whenever necessary.

Many countries have done the same things, but once credit expansion is no longer efficiently invested, few countries have made the transition to a different growth model. Powerful groups who benefited from the old growth model – in China they are referred to generically as “vested interests” – have always succeeded in diluting or preventing the necessary reforms.

The rebalancing always occurs anyway, either in the form of a debt crisis and negative growth or in the form of a long period of no growth and slow rebalancing. Some times – very rarely – the country completes the rebalancing and then moves swiftly on to becoming a developed country, but this doesn’t happen often. Of the dozens of developing economies that have experienced investment-driven growth miracles in the past 100 years, the only ones that have managed the transition to developed country status are South Korea, Taiwan, and maybe Chile. This is a pretty limited success ratio.

China’s previous success, in other words, tells us noting about how it will manage the next stage, and the precedents give us little reason to assume that the country can’t help but advance to the next stage of development. In fact the more confident Beijing is that it will manage the transition successfully, the less likely it is to succeed, which is why I am delighted that policy advisors seem so much more pessimistic than sell-side analysts. What happens to China will be determined largely by the political decisions it will make in the next few years, and it is foolish to assume we know how things will turn out.

Related Articles

Analysis and Opinion articles about China

GEI News articles about China