Is China Trying to Use Asset Inflation to Stimulate Consumption

Michael Pettis put up a long and useful post on the options open to China given a decline in US consumption and therefore its trade deficit, both of which he deems to be inevitable.

Pettis argues that all things being equal, growth in China would probably be lower than most assume, 5%-6%. Note that while that sound awfully good compared to the US, China needs a growth rate of 8% to absorb new workers, so anything below 8% would seem like a recession. Here is a key section:

Since the balance of payments must balance, if US GDP growth exceeds US consumption growth, China’s consumption growth must exceed China’s GDP growth, and Chinese savings must decline. Chinese savings can decline because consumption rises, or they can decline because GDP declines, but they must decline.

That implies that Chinese GDP growth, rather than be constrained on the bottom by consumption growth (i.e. GDP must grow faster than consumption), will now be constrained on the top by consumption growth. China’s growth in GDP, in other words, will be less than its growth in consumption unless there is a surge in investment. There has, of course, been a fiscally induced surge in investment, but with rising debt and collapsing corporate profitability, I think this can at best continue for a year or two, and probably much less.

So what does that mean for future Chinese growth? When China was growing at 11-13% a year, Chinese consumption was growing by 9% a year. The rapid reversal in the earlier decline in US savings might cause Chinese GDP growth to grow by at least 1-2% below consumption. So if we assume that Chinese consumption continues growing at 9%, this initially suggests GDP growth rates of 7-8%.

But hold on. If GDP growth rates of 11-13% translate into 9% consumption growth rates, is it reasonable to assume that GDP growth rates of 7-8% will still result in 9% growth rates in consumption? I doubt it. My guess is that the growth in Chinese consumption will also slow. This suggests that while the US is adjusting, China’s annual growth rate must be significantly below 7-8%, perhaps 5-6%, or even lower. The key is the rate of Chinese and US fiscal expansion, in the former case to permit the rise in Chinese savings rates not to constrain domestic growth, and in the latter case to slow down the contraction of the US trade deficit.

Pettis, however, thinks China will attempt to stoke rising asset prices to make consumers feel wealthier and therefore spend at higher rates than they might otherwise:

But this is just a guess, and the example of Japan after the 1987 crash and the subsequent reversal in US dis-savings suggests that while a credit bubble can keep the game going in China for a few years longer, ultimately the surprise may be on the downside. On that subject let me note something that an unnamed official confessed about the impact of the US crisis on his country’s economy:

We intended first to boost the stock and property markets. Supported by this safety net – rising markets – export-oriented industries were supposed to reshape themselves so they could adapt to a domestic-led economy. This step was supposed to bring about an enormous growth of assets over every economic sector. The wealth effect would in turn touch off personal consumption and residential investment, followed by an increase in investment in plant and equipment. In the end, loosened monetary policy would boost real economic growth.

It sounds plausible and like it might work. Except that it didn’t. The unnamed official was not an anonymous friend of mine at the PBoC. According to Tomohiko Taniguchi, in Japan’s Banks and the “Bubble economy” of the Late 1980s, the speaker was an official at the Bank of Japan and he made the comments in 1988, during a period when Japan was routinely referred to as a “creditor superpower” (and a country, by the way, with enormous foreign currency reserves, and whose currency would within one or two decades, everyone knew, become the world’s reserve currency).

After the 1987 Crash in the US, many expected the Japanese markets also to crash. But they didn’t. After faltering briefly, the Ministry of Finance ordered the Big Four brokerages to support the market, and support it they did. Within a few months the Nikkei was testing new highs, leading a Ministry of Finance official to boast that manipulating the stock market was easier than controlling foreign exchange. Check Edward Chancellor’s Devil Take the Hindmost for an illuminating take on the Japanese bubble economy of the 1980s.

The comparisons with China are, and of course are meant to be, a little worrying. This is not to say that China must repeat Japan’s spectacular 1990 crash and subsequent lost decade (or two). It is simply to point out that none of what we are seeing in China is particularly new and far from being a source of great strength, the intense manipulation of monetary and fiscal policies and the financial markets can actually make the necessary adjustment for China much more difficult. Just as Japan failed to come to terms with the sudden collapse of the US trade deficit and tried to export and monetize its way out, China may be doing something very similar.

This theory seems plausible. However, it is important to note that China also is well aware of what happened to Japan post the Louvre accord (1985) which forced down the value of the yen (it fell over 50% against the dollar). China appears to be trying to keep its surplus from falling as rapidly as Japan’s did (Pettis notes that it is in fact still rising, which means China is gaining at the expense of other exporters, but it is also due to a fall in imports, which muddies the picture). That of course risks protectionist backlash.

Despite knowing the outcome of Japan’s successful but hugely costly effort to stoke consumption, China may believe it can devise a version 2.0 of their approach that has a happier ending. Stay tuned.

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  1. mxq

    China's got a long way to go on the domestic consumption front. For one, according to the World Bank estimates the Chinese government’s policy response will account for about 6 percentage points of China’s 7.2% forecast growth (setser pointed this out). Setser claims this is a good thing, but it has onerous implications that Pettis points out…eventually the Chinese consumer is going to have to supplement at least some of that growth.

    Despite the housing and auto sales stats that are heavily goosed by gov't incentives, the chinese consumer is in, what seems to be, a state of shell-shock and it is getting worse.

    According to a China central bank quarterly survey (released last week):

    "urban residents in China are more inclined to save than spend as the urge to consume dropped to a record low…Only 15.1 percent of respondents said they now preferred to spend, a 14.6 percent drop on a quarter ago, the People's Bank of China said today…The indicator on how residents' felt about their income was 8.6 percent below zero, a record low (emphsis mine). It was a sharp decrease from 28.6 percent in the first quarter….More than 60 percent of respondents said they found the current property prices were beyond their reach and the number of those willing to buy real estate is down 0.9 percentage points on a quarter ago to 15.8 percent."

  2. Marcf

    Let me complete the sentence: Loose monetary policy results in real economic growth for a while and provided you don't abuse it. If you do, the same dynamic loop kicks in reverse. We are just as stupid though, this crisis is due to monetary asset inflation (stocks 2000, houses 2007). Sure there was real growth, but what does it tell you when a young couple cannot buy a house?

    What really saddens me is that this statement comes from a highly placed official that obviously believes what he says. It shows a basic lack of understanding of monetary impact on the long term. But we are no different. We are all stupid. More of the same here

  3. z... ! ...z

    Pettis underestimates the problem.

    Demand among the largest consumers of Chinese GDP are utterly frozen by two factors: (1) A lack of *available* USD denominated credit; and (2) The inability of Chinese manufacturing productivity to keep pace with RMB appreciation.

    On the first point money supply may be unprecedented, but velocity and dispersion is insufficient. Credit worthiness problems are everywhere.

    On the second point, what I'll term as the total costs of ownership of Chinese goods and services have risen disproportionate with their value. Too much subsidy, inefficiency and risk.

    The shortest path to offset these problems is for China to extend significant credit, though the most effective path is to allow recession to do it cold but effective thing.

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