by Michael Pettis, China Financial Markets
I’ll be watching a number of things in 2013 in order to get a better sense of what the future will bring. On January 22 Princeton University Press published my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead, and in the last chapter of the book I argue that the great trade, capital flow and debt imbalances the were built up over the preceding two decades must reverse themselves. Imbalances can continue for many years, I argue, but at some point they become unsustainable and the world must adjust by reversing those imbalances.
One way or the other, in other words, the world will rebalance. But there are worse ways and better ways it can do so. Large trade surpluses can decline, for example, because exports fall, or they can decline because imports rise. Large trade deficits can contract under conditions of high unemployment, but they can also contract under conditions of low unemployment. Low savings rates can rise with declining household income or with rising household income. Repressed consumption rates can reverse through collapsing growth or through surging consumption. Excessive debt can be resolved by default or by growth.
Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain.
For this reason I have no doubt that over the next few years we will see the imbalances I have identified over the years in this newsletter reverse themselves, but whether they reverse in more orderly or less orderly ways will depend on policy decisions. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation.
My guess is that we have ended the first stage of the global crisis, and most of the deepest problems have been identified. In 2013 we will begin to see how policymakers respond and what the future outlook is likely to be. Here is what I will be watching this year in order to figure out where we are likely to end up (and I have a related article, for those who might care, in last month’s Financial Times).
1. Watch how quickly growth adjusts. The speed with which China’s GDP growth slows in 2013 will tell us a lot about how determined Beijing is to rebalance the economy in such a way that growth is driven more by higher household income and consumption and less by investment funded by rising government and government-related debt. It will also tell us how successful Beijing’s new leadership will be in consolidating power and forcing the kinds of economic and financial reforms on which most economists now agree, but which are likely to be politically difficult.
China is ending the year on what many are interpreting as a strong note. Manufacturing seems to be growing at its fastest pace in a while. Here is an exerpt from the relevant article from the People’s Daily:
December’s HSBC China final manufacturing PMI rose to a 19-month high of 51.5, thanks to stronger new business in-take and expansion of production, according to figures released by HSBC Monday. The statistics suggest that China’s economy remains on track for recovery as it enters 2013, said the HSBC report. Despite persistent external headwinds, as indicated by still contracting new export orders, the financial organization expects China’s GDP to rebound to 8.6 percent in 2013, underpinned by China’s continued policy support.
An article in the Financial Times puts a little more meat on the bones:
China’s economy has ended the year on a strong note after a gauge of its manufacturing sector rose to a 19-month high. The HSBC purchasing managers’ index for December climbed to 51.5 from 50.5 a month earlier, according to figures published on Monday. In rising further above the midpoint of 50, the reading signalled an accelerated pace of expansion.
Although China is still set for sub-8 per cent growth in 2012, its weakest in more than a decade,momentum picked up noticeably in the fourth quarter after the government increased its spending on infrastructure. “Such momentum is likely to be sustained in the coming months when infrastructure construction runs [at] full speed and property market conditions stabilise,” said Qu Hongbin, HSBC chief economist for China.
As most of us expected, the end of the year saw a reversal of the attempts earlier in 2012 to slow investment growth, and as a result GDP growth and manufacturing activity have picked up, but so has debt. Beijing probably needed to do this for good political reasons – I suspect that there are many who would have strongly opposed a very weak ending for the Hu-Wen period of government – but the longer they keep this up, the worse the overall adjustment will be, and it will be politics that determines how quickly they can return to a real rebalancing of the economy.
I expect GDP growth in the first half to be fairly high, probably close to 8%, continuing the investment boom that was recently unleashed. I am not fully confident of this number because there seem to be significant strains in the banking system, and without easy credit growth there cannot be much investment growth. Of course part of any credit tightness will be “resolved” by the tried-and-true method of vendor financing, which is already becoming a problem for SOE balance sheets (see for example this article on Zoomlion, the construction equipment manufacturer, which has seen its sales rise in 2012 largely in line with their increased financing of customer purchases), but the idea that Chinese SOEs are rushing in where Chinese bankers fear to tread is not much of a comfort for me.
As an aside, one of my former students, now an investment banker working on the domestic IPO market, came to visit me today and warned me that there is a huge backlog of companies trying to get approval to sell shares. One of the requirements is that they must have two consecutive years of rising net earnings. Many of these firms expected to come to market in 2012 and were able to manage the needed two years of rising net earnings to 2011, but now that they have been pushed back, at least to 2013, they are struggling to show that net earnings in 2012 also went up. For that reason his firm is especially wary of sneaky attempts to boost reported earnings. There are hundreds of companies waiting for approval.
At any rate it is second half GDP growth that interests me more. If Beijing has really gotten its arms around the rebalancing problem and is serious about adjusting quickly, I expect reported growth to drop sharply, perhaps to close to 6%. If not, I expect reported growth to remain well above 7% in the second half of 2013. This would worry me.
2. Watch how quickly new debt emerges. Debt problems are going to continue to emerge in 2013, but as long as each new manifestation of excessively rising debt is treated as a specific and localized problem that can be resolved with specific polices, overall balance sheets will continue to get worse. We need to watch what Beijing does to rein in the growth in debt, and of course this is closely related to overall GDP growth. As long as GDP is growing at levels above 6% or 7%, it is almost a certainty that debt is rising too fast. If GDP growth levels come in much below 6 or 7%, there is a chance that debt growth is not excessive.
How do we keep track of debt levels? Obviously this is no easy task in China, where both the banks and the informal banking system have done a great job in recent years of hiding loan growth and keeping formal debt levels from looking to risky.
But follow the cash. Large increases in infrastructure investment and in real estate development are almost always funded, directly or indirectly, by increases in debt. Many of the banks seem to be facing tight liquidity conditions, so we should also be watching payables and receivables on the SOE balance sheets. We should also be watching off-balance-sheet activity by the banks.
3. Watch for financial scandals. We should also be keeping track of stories about defaults and bank runs. Remember that the Chinese financial system does not really “do” defaults. When borrowers are unable to repay debt out of operating cashflow, the problem is usually “managed” away by forcing losses onto some other entity.
South China Morning Post columnist Shirley Yam, who, I am glad to say, recently returned from a one-year leave of absence, wrote one of her typically intelligent articles in January explaining how a RMB 3.5 billion default by Metallurgical Corporation of China was resolved. It is worth reading to get a sense of how low non-performing loan numbers in the Chinese banking system are nonetheless compatible with a surge in bad investments funded by debt.
This is why those economists who understand the structure of Chinese growth and who worry about the consequences of rising debt notice even relatively small defaults. When a default actually takes place, it usually means that the relevant principals have exhausted all other means of hiding the debt and were forced into recognizing the losses. For example, a month ago the South China Morning Post published this article:
A former employee of Shanghai Pudong Development Bank is alleged to have acted as a loan shark and run illegal businesses to the tune of 6.4 billion yuan (HK$7.9 billion). It is the latest scandal to reflect the severity of the mainland’s shadow banking problem and banks’ lax management of their branches. Ma Yijiang, formerly deputy head of a branch in Zhengzhou, Henan province, allegedly used the money from cash-rich depositors for loan sharking schemes. The bank said in a statement it was assisting the authorities in their investigations.
Last month, the failure of a wealth management product (WMP) issued by Huaxia Bank’s Jiading branch in Shanghai, which resulted in depositors losing several hundred million yuan, set off alarms in the country’s banking sector, and analysts warned similar scandals would surface in the coming months.
A Zhengzhou court heard Ma’s case earlier this week. The Shanghai bank said he resigned in October 2011. The 21st Century Business Herald, an influential business newspaper, said Ma enticed depositors to hand their money to him by offering lofty interest rates between 2009 and 2011.
He lent the money, reported to to amount to 6.4 billion yuan, to other businesses, such as property developers, charging super-high interest, the newspaper said. “It again proved a lack of proper supervision of banking outlets around the country,” said an official with the Shanghai branch of the China Banking Regulatory Commission. “There are increasing risks that the defaults in the shadow banking system would lead to a credit crisis.”
Old news, you might say, and no big deal, but remember that these kinds of problems when they arise tend immediately to be suppressed, and only become public when there is no way to prevent information from leaking out. The fact that we are being regaled almost weekly with stories of banking fraud and scandals suggests just how unsteady credit in China has been. Remember what Irving Fisher told us in The Debt-Deflation Theory of Great Depressions:
The public psychology of going into debt for gain passes through several more or less distinct phases: (a) the lure of big prospective dividends or gains in income in the remote future; (b) the hope of selling at a profit, and realizing a capital gain in the immediate future; (c) the vogue of reckless promotions, taking advantage of the habituation of the public to great expectations; (d) the development of downright fraud, imposing on a public which had grown credulous and gullible.
When it is too late the dupes discover scandals like the Hatry, Krueger, and Insull scandals. At least one book has been written to prove that crises are due to frauds of clever promoters. But probably these frauds could never have become so great without the original starters of real opportunities to invest lucratively. There is probably always a very real basis for the “new era” psychology before it runs away with its victims. This was certainly the case before 1929.
The late stages of a debt bubble are almost always characterized by the sudden emergence of financial fraud, and the huge extent of the frauds lead many to assume that fraud was the source of the credit problems, when in fact widespread financial fraud is more typically a symptom of a financial system that has already gone to excess. This is why I am going to be following financial scandals closely, no matter how arcane or small. The occurrence and pattern of financial scandal will tell us a lot about the likely problem areas in the financial system.
4. Watch bank activities. More generally I am going to watch the relationship between total credit growth and the growth in RMB loans. Much of the off-balance sheet financing in China is designed specifically to skirt regulations, and the relative size of these transactions will tell us about transparency (or lack thereof). A typical example of this might be this Bloomberg article from last Wednesday:
China’s bankloansas a share of funding in the economy may have fallen to a record low, highlighting the growth of alternative financing channels that have prompted warnings of rising credit risks. New yuan loans probably dropped 14 percent last month from a year earlier, according to the median projection in a Bloomberg News survey of 37 analysts ahead of data due by Jan. 15. That would give bank lending a 55 percent share of aggregate financingfor 2012, based on UBS AG estimates, the least in figures dating to 2002.
The decline underscores the waning ability of official loan data to capture the scale of debt in the world’s second-largest economy as borrowers and investors turn to less-regulated, higher-return shadow-banking products. The People’s Bank of Chinais putting greater emphasis on aggregate financing and the International Monetary Fund says the growth of nonbank credit poses “new challenges to financial stability.”
In 2002, if I remember correctly, bank lending represented 93% of aggregate financing as defined by the PBoC as total social financing.
5. Watch inflation. Inflation is actually a positive indicator for China’s rebalancing, and also worth watching because I expect (hope) it to rise in 2013, although not by too much. This may sound like a strange thing to say – everyone else thinks of rising inflation as a bad thing – but remember that the more you repress household income growth, the more you divert resources, especially through cheap financing, from consumption into production, and so this tends to be disinflationary.
If China is truly rebalancing, at least part of this is going to show up in upward inflationary pressure, although it is likely to be the “right” kind of inflation – i.e. it will hurt the rich more than the poor because it will be based on non-food rather than food items. Perhaps this inflation is already starting to happen, although not in the way I would like it to happen. There has been an uptick in inflation but it seems to have been caused by the impact of cold weather on food prices, rather than because consumption of manufactured goods is rising faster than production. According to an article in the South China Morning Post:
China’s inflation spiked to a six-month high in December after a freezing winter pushed up vegetable prices, possibly complicating efforts to sustain a shaky economic recovery. Consumer prices rose 2.5 per cent over a year earlier, up from November’s 2 per cent and the fastest rise since June, the National Bureau of Statistics reported.
That was driven by a 14.8 per cent jump in vegetable prices after the coldest winter in seven years led to smaller harvests. The statistics bureau said vegetable prices in some areas rose as much as 40.8 per cent. Higher inflation could hamper the government’s ability to support China’s recovery with interest rate cuts or other moves for fear of igniting a politically dangerous price spiral. Consumer prices are especially sensitive in a society where the poorest families spend up to half their monthly incomes on food.
6. Watch the prices of hard commodities. Of course I will be watching copper prices and prices of other hard commodities. I expect that hard commodity prices will fall sharply over the next two to three years, but to the extent that prices rise in the short term, as they have in the past three months, it is likely to reflect additional investment growth in China.
As a quick measure this means that declining copper prices can be seen as a measure of the extent of Chinese rebalancing. The longer it takes for copper prices to drop, the slower is the Chinese adjustment likely to be.
There has, I should add, been a lot of talk recently about the price impact of copper ETFs. Here is a relevant article from the Financial Times:
A group of copper users has rounded on the Securities and Exchange Commission for its “arbitrary and capricious” decision to approve the first US investment product that would hold physical copper. The move is likely to pave the way for a formal appeal, potentially further delaying the launch of the proruct by JPMorgan, which was first publicly proposed in October 2010.
The users, including fabricators who account for about half of US copper demand as well as London-based trading house Red Kite, said the SEC had insufficient evidence for its conclusion that the launch of the product would not affect supply of the metal.
In aletter sent to the SEC by their lawyer, the copper users reiterated their view that the launch of the exchange-traded fund would “obviously drive up the price of copper available for immediate delivery and create shortages of such supply”. The SEC’s conclusion to the contrary was “not based on substantial evidence and is therefore arbitrary and capricious”, they alleged.
I think I would agree with the SEC here. If there is significant stockpiling of copper to back these ETFs, clearly it can have a short term price impact, but I don’t see how the price impact can be sustained much beyond the purchasing period, and even this is likely to be muted if buyers of the ETF substitute it for other long positions in copper. Still, even if it only has a short-term impact on prices it might muddy the water and make it a little hard to interpret the impact of copper price changes, but the price of other hard commodities, including iron ore, can help clarify the role of Chinese demand.
7. Watch the trade numbers. China’s trade surplus for November came in much higher than expected, although there are so many discrepancies in the numbers that not all of us are confident about how to interpret the numbers. It seems like growth in both imports and exports may have been exaggerated, as local authorities may be round-tripping both exports and imports in order to make their numbers look good.
In addition, as I have argued many times, China’s exports are likely to be misleadingly low and its imports misleadingly high (and so its real trade surplus higher than the official trade surplus) to the extent that there is significant commodity stockpiling and hidden capital flight. Of course destocking and capital inflows will have the opposite effect.
But in spite of all this confusion the direction of the trade numbers, especially the trade surplus, tells us something important about the rebalancing process. Remember that the current account surplus is simply equal to the excess of savings over investment. China must bring both its savings rate and its investment rate down sharply. If it can bring savings down faster than investment, China is probably rebalancing in the right way, and this should show up as strong growth and a declining trade surplus.
If, however, the trade surplus rises, then clearly savings are contracting more slowly than investment. This means that consumption isn’t growing fast enough to compensate for the reduction in investment growth. It is easy to bring investment rates down (ignoring the political opposition to doing so). It has proven very difficult to bring the savings rate down because this can only happen by diverting resources away from wealthy and powerful groups and families in favor of ordinary households. The evolution of the trade surplus will tell us something about how successful China has been in bringing down the savings rate.
8. Watch the Spanish bond market. Obviously I, like everyone else, will be watching the Spanish bond markets. They ended the year relatively well. Here is the relevant article in El País:
Taking advantage of improved market conditions, the Spanish Treasury comfortably exceeded its maximum issue target at its first bond auction of the year. The debt management arm of the Economy Ministry sold 5.817 billion euros in two-, five- and 13-year bonds, compared with its goal of five billion euros as the rates offered fell in line with an easing of yields in the secondary market.
It sold 3.397 billion euros of a new two-year benchmark issue carrying a coupon of 2.75 percent. The marginal yield emerged at 2.587 percent, down from 3.280 percent at an auction for paper of a similar maturity held in October of last year. Bids for the issue amounted to 7.016 billion euros.
It issued a further 1.949 billion euros in bonds maturing in 2018 as the cut-off rate declined to 4.033 percent from 4.769 percent in a tender held in November. Demand came to 5.050 billion euros. In the third leg of the auction, the Treasury sold 470 million euros in paper maturing in 2026 at a marginal rate of 5.569 percent, down from 6.218 percent in July.
Analysts said the outcome of the auction reflected a reduced aversion to risk as investors seek higher yields. “Today’s [Thursday] auction reflects there’s no imminent concern Spain might go down the same road as Portugal, Ireland and Greece,” Fadi Zaher, the head of fixed-income sales and trading for Barclays Wealth and Investment Management in London, told Bloomberg.
I do not think anything important has changed as far as the European crisis is concerned. The fact that there is a additional liquidity for bond purchases does not mean, as I see it, that Spanish competitiveness has been resolved and it does not mean that the economy can grow out of its debt burden. It simply means that there is temporarily a little less pressure to resolve the underlying problems. I would guess that by the second quarter of 2013, and likely earlier, markets will once again have gotten much worse.
More important to me is what is related in another article from the same newspaper:
Spain’s household savings rate fell to its lowest level on record in the third quarter of last year as high unemployment and wage deflation in the latest recession obliged them to devote more of their disposable income to consumption, according to figures released Wednesday by the National Statistics Institute (INE).
…The main reason for the drop in the third quarter was falling income. The INE said net disposable income in the period declined 1.6 percent from a year earlier to 164.675 billion euros. This in turn was the result of a 5.4-percent contraction in salaries and a fall in other sources of net income such as interest on bank deposits and share dividends of 4.4 percent.
If the savings rate is declining even while national income declines, then Spain is not rebalancing properly. Rising unemployment of course generally results in a declining savings rate because people with income still need to consume, and they do so by either borrowing or by dipping into their savings, but if Spain is going to repay its debt it probably will need to be a net exporter of savings, which means that savings have to exceed investment. If savings decline, the only way for this condition to be met is for investment to decline much more quickly. This, of course, isn’t good for growth.
9. Watch Target 2. On a related topic, I will continue to watch Target 2 closely as an indicator of strains within the European banking system. This too ended 2013 on a positive note. Here is an article from Spiegel:
There is cause for hope in Southern Europe. New numbers indicate that trust is returning to banks located in countries that have been hit hardest by the euro crisis. But even as discrepencies in the Continent’s Target2 payment system shrink, danger still lurks.
The turning point came almost exactly four months ago. On Sept. 6, 2012, 22 men gathered on the 36th floor of the European Central Bank building in Frankfurt to reach a momentous decision on the Continent’s common currency. The euro, said ECB President Mario Draghi at the press conference following the meeting, is “irreversible.” To save it, he added, his bank would undertake unlimited purchases of sovereign bonds should it become necessary.
Since then, an amazing thing has happened. Although the ECB has yet to embark on any such bond shopping sprees, countries such as Italy and Spain, at risk of being engulfed by the crisis, no longer have to pay the horrendous interest rates they did in the middle of 2012. Furthermore, the massive imbalances that have recently plagued the European banking system have shrunk, if only slightly.
As recently as the summer of 2012, investors and those with savings accounts in crisis-stricken countries were moving their money out as quickly as they could. Billions of euros were withdrawn from accounts in Greece and Spain and banks in stable countries such as Germany put a cap on the amount of money they were willing to lend business partners in countries hit hardest by the euro crisis.
But since last autumn, this trend has come to a stop. Indeed, the most recent numbers indicate that a slight reversal is underway, with ECB statistics showing that deposits in Spanish and Greek banks have recently ticked upwards. Furthermore, Germany’s central bank, the Bundesbank, reported this week that imbalances in Europe’s so-called Target2 settlement system, in which euro-zone central banks and the ECB transfer money across the common currency union, have declined. As the euro crisis progressed, the system had become massively imbalanced, which could result in massive losses for countries such as Germany should Greece, for example, be forced to exit the euro zone.
For the same reason that I am not optimistic about the Spanish bond market I am also not optimistic that Target 2 will continue to reverse. If it does, of course, that will be a great sigh, but if it doesn’t, and if in fact the imbalances continue to grow, that will put additional stress on Germany’s ability to maintain the euro system.
10. Watch Japan. Remember that Japanese attempts to get their arms around their huge debt burden will almost certainly affect China and the rest of the global economy. If Japan tries to increase domestic savings to fund the debt, for example by limiting wage increases, or by taxing consumption, both of which they have proposed, these measures may well cause domestic investment to fall. Whether or not they do, if domestic savings rise faster than domestic investment, which is the only way to increase the domestic savings pool available to fund Japanese debt, then by definition the current account surplus must rise.
I am not smart enough to tell you what Japan will do, but I do know that almost anything it does must affect the relationship between its savings and its investment, and hence Japan’s current account surplus, which I suspect everyone hopes will rise. Of course everyone else wants the same thing too – rising exports relative to imports – which is clearly impossible, but Japan needs it more urgently than most of the rest of us. This is going to increase strains on the global trading system.
This is an abbreviated version of the newsletter that went out four weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.