Yves here. I particularly like this post because Michael Pettis takes some boundary conditions about China and works through their implications. One quibble I have is that he talks of “debt capacity limits.” That depends who the issuer is. The national government could in theory “print,” it has no need to issue debt to fund its activities. But the constraint on that sort of approach is inflation, and China is trying to cool off inflation without crimping growth too much. So China is pretty much in the conundrum Pettis describes, but for slightly more complicated reasons.
Cross posted from MacroBusiness
An exclusive excerpt from Michael Pettis’ most recent newsletter:
Last week’s news was dominated by the sudden but not wholly unexpected removal of Bo Xilai as mayor of Chongqing.
After the initial shock wore off, much of the speculation within China has moved on to what his ousting says about the evolution of power and, for economists, how it will affect the reform and rebalancing of the Chinese economy. More importantly, it seems to me that too many analysts over emphasize the intentions of the Chinese leadership when projecting China’s future. If Beijing announces that it plans to accomplish a specific goal – e.g. raise the consumption share of GDP, or double the length of railroad track – analysts quickly incorporate that goal into their projections even when it isn’t at all clear how Beijing will do it.
This failure to focus on constraints rather than intentions is why I think most analysts have gotten China wrong in the past five years. By misunderstanding how China’s growth model works, and how the functioning of the model forces certain kinds of behavior and prevents others, they have been much less skeptical about Beijing’s ability to execute its intentions than they should have been.
This is an issue not just for China, by the way, but for any country. Knowing the constraints imposed by the functioning of the balance of payments, I am wholly unimpressed by what many senior German and European leaders say they expect to happen in Europe. The fact is that if we hope to see net repayments by peripheral Europe to Germany, we will also have to see a reversal in their respective current account positions, and so far this seems unlikely. Without the latter, however, the former is impossible, no matter how determined Madrid, Rome, Berlin and Paris might be to reduce debt in an orderly way.
So no matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are internally consistent and if they do not violate external constraints. Any decision made by Beijing that is not consistent with the economic options available is not worth taking seriously as a prediction of the future.
To try to work out what these options might be I will begin with two key assumptions.
Low GDP share of consumption
The first is that the fundamental imbalance in China is the very low GDP share of consumption. This reflects a growth model that systematically forces up the savings rate largely by repressing consumption, which it does by effectively transferring wealth from the household sector (in the form, of very low interest rates, an undervalued currency, and relatively slow wage growth) in order to subsidize and generate rapid GDP growth.
Chinese growth is driven largely by the need to keep investment levels extraordinarily high. What’s more, the very high growth rate in investment, combined with significant pricing distortions, has resulted in massive over investment and an unsustainable increase in debt. China cannot slow the growth in debt and resolve its internal economic problems without raising the consumption share of GDP.
China will rebalance
Secondly, China must and will rebalance in the coming years – its imbalances, cannot get much greater and we will soon see a reversal. There are two reasons for saying this, neither of which has to do with the claims being made by Beijing that they are indeed determined to rebalance the economy.
The first reason is the debt dynamics. Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.
At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.
The second reason for assuming that China will rebalance is because of external constraints. Globally, savings and investment must balance. This means that for any set of countries whose savings exceed investment, like China, there must be countries whose investment exceeds savings, like the US. To put it another way, the world can function with a group of under consuming countries only if they are balanced by a group of over consuming countries.
For the past decade the under consuming countries of central Europe and Asia, of which China was by far the most important, were balanced by over consuming countries in peripheral Europe and North America. But conditions are changing. The overconsuming countries are being forced to reduce or are working towards reducing their overconsumption.
To the extent they succeed, by definition unless there is a surge in global investment – underconsuming countries must increase their total consumption rates, or else the world economy cannot balance savings and investment. As the biggest source of global underconsumption by far, it is very hard to imagine a world that adjusts without a significant adjustment in China.
How can China rebalance?
I think my first assumption has been controversial in some quarters as recently as three years ago, but it is pretty much accepted among most economists, and it has certainly been a formal part of Beijing’s discourse. Everyone from Premier Wen and Vice Premier Li on down has insisted that the consumption imbalance has reached danger levels, and that China must and will rebalance.
My second assumption is also very plausible. In fact over the long run it is an arithmetical certainty because it can only be violated if China has unlimited borrowing capacity and if the world has unlimited appetite for rising China trade surpluses. Neither is true.
Where some analysts might disagree is in the issue of timing. China bulls continue to argue that there isn’t yet a significant overinvestment problem in China, which implies that debt is not rising at an unsustainable pace, or if it is, that it can continue rising for many more years before the debt burden itself becomes unsustainable.
This also implies that the consumption imbalance is temporary and can resolve itself gradually and over time as the benefits of earlier investment begin to emerge and eventually overwhelm the total costs of those investments. Of course if this is true China does not need a surging current account surplus because if investment isn’t being wasted it can keep investment rising faster than savings for many more years.
The key vulnerability of my argument, then, is whether or not you think investment in the aggregate is being misallocated in China and has been for many years. If you agree, then you must also agree that consumption must become a greater share of GDP over the next five to ten years. What’s more, you should also agree that the only way to increase the consumption share of GDP is to increase the household income(or wealth) share of GDP.
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. The various ways in which this can take place can all be accounted for by one or more of the five following options:
1. Beijing can slowly reverse the transfers, for example by gradually raising real interest rates, the foreign exchange value of the currency, and wages, or by lowering income and consumption taxes.
2. Beijing can quickly reverse the transfers in the same way.
3. Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
4. Beijing can transfer wealth from the state sector to the private sector by absorbing private sector debt.
5. Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Notice that all of these options effectively have China doing the same thing: In each case the state share of GDP is reduced and the household share is increased. There are however very big differences in how the changes are distributed among various parts of the household sector and the state sector.
Notice also that the changing share of GDP tells us little or nothing about the actual GDP growth rate, or about the growth rate either of household wealth or of state wealth. It just tells us something very important about the relative growth rates. For example we can posit a case in which GDP grows by 9% annually while household income grows by 12- 13% annually. In that case the rest of the economy would grow by roughly 5-6% annually ( household income is approximately half of GDP), and the distribution of this growth would be shared between the state sector and the business sector.
How will Beijing choose?
As I see it these are ultimately the only options – or at least the major set of options – Beijing can choose to follow over the next few years if it wants to avoid a debt crisis. Beijing could choose an intermediate path between the first and second options, and raise interest rates sharply over the next two or three years while also raising the value of the RMB by 10-15% in an overnight maxi-revaluation.
In order to protect workers from the resulting surge in unemployment, Beijing can instruct state-owned companies and local governments temporarily to hire a huge number of workers for make-work programs (the fifth option) and initially pay for this by increasing borrowing (the fourth option). At the same time it can begin a massive program of privatization, which should include transferring ownership of land to peasants, and selling off assets and using the proceeds to shore up the social safety net and to pay down debt in the banking system.
This would certainly work economically to rebalance China in a way that guarantees fairly high growth rates over the rest of the decade, but is it politically possible? Here I would defer to Minxin Pei, who might argue that the scale of privatization required is not possible politically. In that case China would end up being forced into rebalancing via the fourth option, with a long-term surge in government debt.
And this is my point. If you believe my assumptions are correct, then you should agree that China has no choice but to follow one or more of these paths. If privatization is not an option, then a collapse in the economy caused by a rapid adjustment in interest rates and the currency (the second option) might be. If that is ruled out, then perhaps the outcome will be a surge in government debt (the fourth option again), and so on.
This what I mean by the economic constraints that limit the choices Beijing can make. It doesn’t matter what anyone thinks or wants Beijing to do, if the plan violates the economic constraints, it cannot be done. To be really complete we should outline the political constraints, the environmental constraints, the demographic constraints, the external trade constraints, and so on, although of course this is way beyond my ability, but each of these exercises allows us to escape from the confusion of stated intentions and to focus on the possible.