The Christmas season, upcoming exams, student job hunting, and lots of visitors have made this a tough time to keep track of things but, before I go on to discuss the reason for the title of this entry, I wanted to make a quick comment on the economic numbers that came out last week. As expected all the economic data points in the same direction as in the past three months. If you are an optimist, you take great comfort in the fact that the data seems to be pointing towards continued growth in most indicators. Industrial production was strong and lending for November was way down from previous months.
If you are a pessimist you worry again that the rapid growth has clearly been fueled by little more than massive credit and investment expansion, and you note that although at RMB 295 billion, net new lending in November is much lower than the 890 billion monthly average for 2009 (and even lower than RMB 477 billion net new lending in November, 2008 – the first time this year any month in 2008 exceeded the same month in 2009), it nonetheless brings the 2009 year to date total to an astonishing RMB 9.2 trillion. The market consensus is that next year’s lending will total RMB 7 trillion, which is being presented as a gentle tightening of credit conditions.
Since 2008’s net new lending was RMB 4.9 trillion, I would suggest that in any other year RMB 7 trillion would have been considered an extraordinary expansion in lending. After a year in which net new lending will probably come close to RMB 10 trillion, we would probably need something much lower even to pretend that loan growth next year will be prudent. Also bear in mind that gossip among bankers suggests that in the rush to grab funding when it was freely available, a significant fraction of 2009 lending is still sitting as unused deposits, to be used next year for current investment projects, so that in terms of real new lending, a part of 2009’s net new loan figures really belong in 2010. This means that it is very possible that if there really are “only” RMB 7 trillion in net new lending next year, real credit expansion next year will be equal to or even greater than this year.
The other thing to bear in mind is that the RMB 7 trillion that the market expects is not carved in stone. As I wrote last year in my “All but the Kitchen Sink” entry, Beijing will do whatever it can to generate whatever growth rate it deems necessary, and Beijing can get any growth rate it chooses to get as long at its borrowing capacity is credible.
Next year we will almost certainly see growth of over 8%, and the total amount of new lending will be determined by whatever credit expansion Beijing requires to get there. This means that the external environment, the increase in trade tensions (the recent “Buy Chinese” provisions announced for government procurement will almost certainly make things worse), and the impact of inventory build-up, among other things, are going to determine what amount of domestic credit expansion we will need. Since no one can accurately predict any of those things, it is pointless to predict loan growth next year. One thing that will almost certainly happen, as my friend Logan Wright told me yesterday, is that banks will rush to lend early in the year, so we should be prepared for shocking new loan numbers in the first quarter which will moderate quickly over the rest of the year.
Pessimists looking at the recent economic data would also note the very high investment rates and worry about the cost to future consumption of misallocated investment. They would hear the continued, and louder, worry about lending at the PBoC and CBRC. On Tuesday for example both the PBoC and the BoC warned again about credit quality and loan growth, covered in front page reports in the People’s Daily. Since a rise in inflation will create a real difficult problem for monetary policy, pessimists will also wonder whether or not it is time to start worrying about inflation (I think it is too early, although my students are telling me that their parents are complaining about rice prices). According to an article in Friday’s Financial Times:
A series of data published on Friday indicated that the rebound remained firmly on track, with industrial production and imports both increasing well in advance of forecasts. One of the main risks to face the economy is a surge in inflation as a result of the massive monetary and fiscal stimulus measures introduced this year.
Consumer prices rose 0.6 per cent last month from a year ago, after falling 0.5 per cent the month before, while prices at the factory gate fell 2.1 per cent last month compared with a 5.8 per cent decline the month before.
Several economists argued that the shift back to inflation was caused specifically by rising food costs, as well as by some rises in energy prices, rather than as a result of the money supply increasing at an annual rate of nearly 30 per cent.
However, the return of even modest inflation will feed into the intense discussion in Beijing about how quickly to ease stimulus measures and whether to abandon a de facto peg against the US dollar and to allow the renminbi to appreciate.
So to summarize, as I have for the last three series on monthly economic data, the numbers will do nothing to resolve the debate within China. Optimists and pessimists both have more grist for their mills.
Turning away from the recent data, I wanted briefly to discuss urban migration in China. For a lot of analysts, it seems that the phrase “urban migration” is the correct response to many of the problems you might identify with China’s growth model. Is there a real estate bubble? No there isn’t because urban migration will create a near infinite future demand for residential and commercial real estate. Does China under consume? Yes but urban migration will raise consumption rates.
This latter claim was highlighted in a Tuesday article in the South China Morning Post, which claims that “President Hu Jintao’s pledge yesterday to spur urbanisation and domestic demand next year has been seen as an attempt to tackle the growing problem of industrial overcapacity.” The article goes on to say:
Announcing the development strategies at the end of the annual three-day central economic work conference, Hu said the government would focus on urging the rural population to work and live in small and medium-sized urban cities while boosting further the spending power of workers and low-income groups.
At the same time, he ordered that new investment in industries with excess capacity be reined in and the problem of underutilised plants be addressed. The moves signalled domestic demand had left much to be desired, as the latest statistics showed 21 out of 24 industries incurred excess capacity in the third quarter, compared with 19 in the first quarter, said Zhang Tao, a researcher at the Chinese Academy of Social Sciences.
“The latest data tells us that overcapacity is not only a problem for several industries but across the industries,” said Zhang, who cited a 2010 economic development blueprint backing Hu’s strategies. “It also shows weak domestic demand.”
There is a surface plausibility to these claims about the benefits of urbanization, but they need to be considered much more carefully than they sometimes are. First, as far as urbanization and consumption go, what China needs, as I argued in last weeks’s posting, is not so much more consumption but rather, as Zhang Tao implicitly points out in the article above, to close the gap between the amount if produces and the amount it consumes.
It is almost certainly true that as migrants move from the rural areas to the cities, their average consumption is likely to rise, but the key here is their net impact, not their total impact. So if rural migrants move to the city and become engaged in expanding infrastructure or manufactured products – after all they need to earn an income before they can start consuming – they are not necessarily resolving the domestic imbalance. They may actually be exacerbating it. If however they migrate to the cities and take jobs in the service sector, then they have a positive net impact.
In that case it is not urban migration per se that matters but rather the strucutre of Chinese economic growth. If it continues to be capital intensive, and to favor manufacturers and real estate developers at the expense of service industries, then urban migration is not really part of the rebalancing solution. We would still be stuck with the same old problem – a growth model that favors overinvestment at the expense of household income, and that leads inexorably, in my opinion, to the very imbalances that China is trying to resolve.
After all, during the past decade there has been substantial urban migration in China, and yet the imbalance became worse, not better. Why? Because for whatever structural reason, urban migration has favored faster growth in the production of tradable goods than in their consumption. Until this structural reason (or reasons) changes, urban migration won’t resolve the problem – unless of course in some way greater urban migration itself forces the structural change.
The other claim, that urban migration prevents the possibility of the existence of a real estate bubble, is more pervasive and, to my mind, even harder to justify. First, I should point out that although I believe we are in bubble territory in both the stock and real estate markets, and clearly policymakers are increasingly concerned that we may be, I am less concerned than others about the economic impact of the bursting of the bubble. I am much more worried about overinvestment in infrastructure and manufacturing.
Last week (sorry, but I lost the article) I read that the head of one of Beijing’s and China’s largest real estate developers (Vance, I think I remember) publicly warned that we are in the midst of a property bubble, making it the second time in the past month that the CEO of one of China’s biggest real estate developers has made the claim. He may be right, and of course the muted warnings by the PBoC that we are in the midst of a stock market bubble may also be correct, but to me the wealth effect of collapses in the two markets are not large enough really to matter. The wealth effect isn’t likely to be big enough to affect consumption. Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.
The main way a fall in real estate prices would hurt China, in my opinion, is if it causes a sharp drop in real estate development and, with it, a sharp drop in employment and the business activities of industries that feed the real estate sector. I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so. This is not an economy where price signals always decide business strategy.
But to get back to urbanization and real estate overcapacity, the logic is that because we can expect 200 million, 300 million, 400 million or whatever number of people moving to cities in the next several years (any number is plausible as long as it is large), then by simple math it becomes obvious that there cannot be overcapacity in real estate. We need new buildings to accommodate all those new people.
But this argument, or some form of it, has been used to justify nearly every period of overbuilding in modern history. After all there was huge urban migration in the US in the 1920s, which was used to justify soaring real estate prices in the major American cities, but after 1929-31 real estate prices nonetheless crashed and apartments and offices when begging for tenants – even though urban migration continued for decades. Another example: I grew up in Malaga, in southern Spain, which has been since the late 1990s and until last year experiencing an out-of-control boom in real estate development and land prices. For years I had been telling my friends there in real estate (and nearly all my friends were in real estate – itself a very worrying sign) that prices were not sustainable.
But whenever I said this, they would immediately pull out the charts showing the inexorable rise in the number of aging Europeans, point out that all these old people wanted to retire in sunny communities along the Mediterranean, and that all the beaches in southern Europe simply could not accommodate a fraction of the expected retires. Conclusion? As long as the sun continues to favor southern Spain, real estate prices could not ever stop going up. The inexorable pace of migration justified rising prices.
Needless to say the sun is still shining over sunny Malaga, but real estate prices have nonetheless dropped sharply and sales of BMWs and Mercedes (the favorite cars, it seems, for successful real estate agents) have collapsed. The old people are still retiring, but new apartments are proving impossible to sell.
Massive expected migration, in other words, is not only perfectly compatible with overbuilding and real estate collapses, it may even be a prerequisite. Bubbles need a plausible-sounding story that allows people to throw caution to the winds, and near-infinite inward migration is one such story.
The problem of course is that even if the migration projections are true, they are long-term projections and they cannot possibly tell us much about either how many people are coming in next year and how much money they will have to spend. Worse, the migration itself is highly pro-cyclical – overbuilding to satisfy future migration encourages current migration, and more generally more people come when there are more jobs, and fewer when there are less. The migration pattern can become very irregular and, more importantly, it tends to exacerbate current trends. For the financial historians reading this, it is the pro-cyclicality of the process that is the grimmest warning signal.
I am not suggesting, of course, that expected urban migration is not important and will not radically change a number of Chinese parameters. But I will insist that urban migration is not at all incompatible with continued overinvestment, underconsumption, and overbuilding. In fact these things have gone hand in hand many times before.
[...] the whole story here: Michael Pettis aggregated by [...]
professor,
please help me understand this. the chinese economy is roughly $3 trillion. in 2008-2010 the banks will pump another $3 trillion of credit to generate 25% growth or some $750bn. and what about the cost of capital? it will be around $500bn of additional interest payments for the period. this is a total waste of money and resources in an economy already running at below 70% capacity utilization.
is it possible to have a happy ending to this story? in my view, within 5 years, there will be massive bad loans at banks that dwarf chinese GDP.
Sir:
The piece in its entirety is quite illuminating, but one comment literally leapt from the page as I read it:
“This is not an economy where price signals always decide business strategy.”
The Chinese trade surplus was reported down again in November. Imports are rising (thanks to lending and stimulus) and exports have not rebounded as some had been predicting. At what level of surplus does the Chinese leadership press the panic button and crack down on large import purchases of commodities?
While migrants may move to Chinese cities, without a residency permit they will not be able to afford the housing that is being built. That is always the story in a real estate bubble; there is a disconnect between housing that people can afford to live in and housing that is profitable to speculate on. Too little of one and too much of the other.
This bit from the WSJ regarding the recent “Buy Chinese” provisions announced for government procurement:
“Chinese industry insiders and companies defended Beijing’s request that state agencies buy products containing domestic intellectual property — but even these intended beneficiaries expressed confusion about how new government procurement regulations would affect them.”
“Chinese executives and academics on Friday defended the government’s effort to foster “indigenous innovation,” saying state backing is needed to erase advantages enjoyed by bigger, more established foreign rivals. As it is, they say, Chinese procurement officials often favor foreign brands because they don’t trust the quality of local products.”
Michael: I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so. This is not an economy where price signals always decide business strategy.
This just seems like a description of a real estate Fantasyland. If demand falls and there proves to be a huge over-supply, the over-building will simply continue so as to paper-over the problem. Until what? There’s no more space to build empty condos? Has there ever been an economy that successfully bailed itself out of a real estate bust by continuing the over-building?
The biggest problem with the argument that urban migration will sop up all these empty condos is the absurd mismatch of prices to income. How is a recent migrant making $3,000/year (?) going to help absorb condos costing more than $300,000? It makes the pricing in south Florida seem reasonable.
Many commentators seem to see China as being able to balance some magically unique mix of command and market economies–as if it’s just a big version of Singapore 25 years later. But there are at least three reasons to doubt this is viable. First, China’s market interventions are often clumsy and justified more by political aims than economic ones. Second, China’s size mean its manipulations bring meaningful consequences for the rest of the world and are likely to spur actions elsewhere that will, in turn, bear consequences for China. And last, China seems to have retained the imperial system: all power derives from Beijing. The municipal governments have to incentive to please their citizens, the only check on them is the central bureaucracy.
Sometimes I wonder if China isn’t headed for a different mix of command and market economies: 1930s America and 1980s Soviet Union.
Dear Prof Pettis:
I am a retired Silicon Valley exec, an active equity trader, and faithful follower of your writings on China. I’d love to hear your insight (preferrably by private email, albeit terse) on China’s long term challenges in industrial competitiveness.
To date, the West (AND the rest of Asia) has been losing its manufacturing base steadily to China’s cheap and enormous talent and labor pool. The flip side seems to be a “ma hu” culture that breeds persistent quality problems in products large and small.
Will there be another Deming that creates a lasting quality manufacturing powerhouse in China as we’ve seen in Japan, thereby validating “jobs never to return to the West”? Or will these quality problems cause a return of jobs back to the West (as we’ve seen in the case of call centers in India)?
Thanks in advance for your insight.
Regards
Richard L
Michael,
It was China Vanke. It appeared here in the WSJ:
http://online.wsj.com/article/SB125989454940376061.html
and I believe Bloomberg news also had a story. Essentially the CEO was saying first tier cities were in a bubble and he worries about second tier cities.
The smokescreen of the world economy is that the biggest business in China isn’t manufacturing, but building capacity and buildings, needed or not. Because the nature of this business in itself it to generate demand for all kinds of products, manufactured and natural, it gives the appearance that all is okay.
When I graduated from college, there was a fledgling building boom beginning in Dallas. As it gathered steam the building continued, despite the fact that the absurption wasn’t there to take in what had already been built. At the end of the boom, the tenants were quite often the S&L’s and others involved in building the projects.
I have seen a bust in a market that never quit growing. I suspect China is headed for an across the board bust that is going to shock others. It isn’t that the property won’t be occupied, but that they will have to either cease or slow down building at some time. Andy Xie claimed in a post back in the summer that the entirety of Chinese housing demand would be built in 5 or 6 years and then the problem would be a lack of people to absorb the population shrinkage due to the one child policy. Of course this problem could be alleviated somewhat by slowing down the pace of construction, but that slowdown in itself would quite likely cause a bust.
Here is a study I found on the net that goes more along what I have thought about China after careful study. For one it dispels the idea that China is rural, but instead says that the definition of urban in China isn’t the definition of urban as in Houston or Brisbane. It also says that 70% of the Chinese economy isn’t manufacturing as the average Joe in the US would believe, but instead capital expansion.
http://www.pivotcapital.com/reports/Chinas_Investment_Boom_the_Great_Leap_into_the_Unknown.pdf
At the most basic levels, economics is about demographics and productivity growth. If China has come close to maxing out the latter, then the former could still provide a boost to growth rates in the medium-term. This is not because population is rising – the UN predicts that the size of the labor force will peak some time in the next 5 years. This will be because of the shift from the farm to the factory or other services sector, where a migrants productivity increases by a factor of 5 or so when they leave the countryside. Or that is the way it used to be, when factories were still adding lots of workers. High levels of capital investment means that the demand for new labor will not be as high, though the output of these workers will be comparatively higher because of the capital-labor ratio. All in all, the urbanization question can be rephrased as whether tens to hundreds of millions of new urban residents will consumer enough to absorb all of China’s excess output. The answer would appear to be no: income levels of new urban residents are too low relative to urban cost of living. This includes consumer goods and housing. The government has tried for a long time to boost affordable housing, and in the abscence of a program of public housing (which is unlikely), these migrants are going to be pushed out to the fringes of the cities, call it gentrification with Chinese characteristics. It will help overall consumption levels that new urban residents will have to spend a larger proportion of their incomes than established residents, but they will continue to be frugal and send money back to the countryside. They will spend for necessities only, in other words. So urbanization requires housing and infrastructure…and we all know that most of China’s big cities were designed for about half of the population that already lives in them, so there is plenty of building to do. But then again, these workers have to work, and they will either be factory workers (where is there more productive capacity needed?) or low-end services workers. Either way, this will not be the demographic trend that solves all of China problems, though it will help. The living standard gap and other structural divisions between urban and rural China are too stark for populations to be easily merged. “Reform” just removed obstacles to markets, it did not build the kind of civil and economic infrastructure necessary to function without mercantilism. Deng was and is highly over-rated.
Michael,
Your hypothesis about real estate (price and volume) growth in anticipation of large future (but highly probable) migration is a bit problematic, imo. It would take much longer to explain this. Basically you argue against the common intuition that when there is enough migration pressure, prices will go (and stay) up, despite increasing construction activity. Which will happen, in the short run, but will tend to reverse if the factors favoring the expectation grow weaker, turn out to be overestimated, or are combined with unobserved factors which will pull relative demand sharply down again.
What one tends to have in real estate booms is that prices overshoot whatever new equilibrium would be justified once a supply/demand balance has recovered from a short term demand shock (or an anticipated one). The latter balance has many moving parts, one of the reasons why it is so difficult to predict eg house price developments. And since no one knows what those equilibrium levels ought to be once a more steady state has arrived, during the transition there is a strange mixture of retail lending principles ( traditionally collateral value related) meeting retail affordability factors (one of which, interest rates should be considered endogenous for countries applying Taylor type monetary policies), and another, household income related to the business cycle), plus, usually in a boom, growing stocks of real estate for sale in non-retail hands. The non-retail hands are aware that they play a game of musical chairs but often benefit from naive wholesale lending, allowing them to gamble with only limited recourse to themselves (what I described so far looks a bit like the conditions facilitating the S&L crisis (apart from high inflation-cum-interest shocks). Growing difficulty in selling wholesale inventory drags in astute retail buyers with enough mobility to sell, bank valuation models restrict finance available to new buyers, monetary policy may have already started to counteract inflationary prces partly arising from the immigration-led real estate boom. Then the smart developers start bailing oput en masse, leaving a few of their peers behind, as well as an army of distressed home-owners.
Now, the question that you raise is twofold: will increased urbanization boost the consumption share in China and is the real estate boom that has been going on (although with a fair bit of price volatility) benefit from official stimulus for urbanization.
I think that, despite the “return to equilibrium” feature of the real estate boom theory applies to China too, there are a few caveats:
1. official urban migration might facilitate the permanent movement of families (rather than individuals) who need housing and services of a type not yet available for them in the cities. More than likely, the family members will start looking for work in the service sector (but not necessarily officially).
2. wholesale real estate lending in China differs from markets with high levels of transparency, rule of law, etc. To put it euphemistically
3. the transmission mechanisms, financial markets and monetary policy instruments in China are very different from, say the UK or US. To what extend the procyclical tendencies that drive part of the above “boom” mechanism are inherent to it is as yet unclear.
spelling fist — first
One thing that will almost certainly happen, as my friend Logan Wright told me yesterday, is that banks will rush to lend early in the year, so we should be prepared for shocking new loan numbers in the (fist) quarter which will moderate quickly over the rest of the year.
(enjoyable as ever)
Nice point on real estate.
I wonder if there isn’t an interesting demographic point in the urban migration issue, though. At the moment, the most productive rural residents (working adults) are spending much of their time in cities working, and sending money home. The next big move may well be to bring the children (and the old people, but children will be the big consumers) into the cities with their parents in large numbers, end the system of leaving them behind with their grandparents on the farm.
With children in the urban areas, consumption will get a decent boost. Whether it will be enough to keep China growing fast is another question…
This all comes back to the net demand gap. China has filled it with credit, but the outcome following the exogenous shock (the sharp reduction of steady state consumer demand) is not sustainable. Note that the great Paul Samuelson passed away, an intellectual giant whether you agree with his theories and conclusions or not. Learn the correspondence principle (not a perfect theory, but applicable and predictive, especially for trading nations), and 2010 for China looks problematic in that the lending binge has to continue in order to preserve the status quo ante and keep the wheels from falling off the proverbial cart in many industrial sectors. Urbanization won’t make up this gap in time, though in time it will be a nice addition to overall demand and productivity.
Baychev, I think most of us, including the PBoC and the CBRC, expect a sharp rise in NPLs. This will be partially mitigated by an increase in bank capital, both through new equity issues and by the wide spread between the lending and deposit rates, and, if things turn out well, by rapidly growing out of the problem, like they did last time around. The problem with growing out of the banking problem, of course, is that this is a very circular condition.
Rajesh, it is not yet clear to me what portion of imports over the past several months represents commodity imports used for production versus commodity imports used for stockpiling, directly and indirectly. If the latter is a high proportion, we should see a sharp slowdown in commodity imports if there is any slowdown in growth.
Richard, I do not think there is much in the way of industrial competitiveness here largely because interest rates and currency policies have shielded Chinese companies from foreign competition and made them dependent on those subsidies. I suspect a significant portion of China’s much-vaunted manufacturing prowess can be explained by the various subsidies. A gradual removal of these subsidies will almost certainly make these companies much more competitive over the longer term and force them up in terms of value-added. I thin this has been much pointed out and discussed among Chinese academics, and is widely acknowledged, but of course the process of dismantling the subsidies will be painful in the beginning.
Thanks Dean. First Soho and now Vance. This is becoming a pattern. Also thanks Paul, I made the change, but I am afraid the other websites that carry my blog still have “fist”.
Rene, yes, this is a topic that requires a much more detailed discussion and from someone far smarter and more knowledgeable about the sector than me. I guess my point was really to argue that the seemingly-plausible claim – that China’s high expected urban migration makes real estate bubbles and overcapacity impossible – is not borne out by historical precedents. Rapid urban migration (and other kinds of impressive-seeming migration patterns, like that of northern European retirees to sunny Spain) can be very consistent with real estate boom cycles, and in fact may be almost a prerequisite. To take a more vivid example, John Jacob Astor, at the time one of the richest man in the world (he died in the late 1840s, I think), was reported to have said on his deathbed that in retrospect his only major mistake was ever to sell New York real estate.
Over the long term he was obviously right. The huge migration from the very beginning of US history meant that New York prices could only go up over long time horizons, but this didn’t prevent temporary imbalances that caused a brutal series of adjustments in the New York real estate markets. Over shorter time frames there were many times that New York experienced real estate bubbles and crashes, and these usually followed credit cycles, rather than migration cycles. NY real estate has always been a market for the very brave.
This is a long way of saying that it is possible both to believe fervently that China’s urban migration story will be one of the great transformative events of the 21st century, and yet still to worry about a near term collapse in real estate prices. The process of urbanization, in other words, protects us from nothing except falling land prices over very long time horizons, and in the case of my own city this says nothing about the recently renewed debate about moving the capital away from Beijing because of the brutal water shortages this region is facing.
Phil, a couple of months ago I met Ronald McKinnon and he said (semi-seriously) that the best way to boost Chinese consumption was to eliminate the one-child policy. Nothing, he claims, is as expensive as raising kids and nothing will spur consumption more. Sounds right.
Regarding urbanization in China, there was a “debate” (which you probably have read) between Pivot Capital and Standard Charter about the actual urbanization rate (summarized here by ft alphaville: http://ftalphaville.ft.com/blog/2009/10/21/78921/urban-commentary-combat-in-china/ )
Any opinions about this discussion?
“This is not an economy where price signals always decide business strategy.”
I’ll pick this sentence out as well. Of course the most important piece of this great post. Great as usual.
The phrasing implies that credit is THE key in investment. Everything else including business profitability becomes secondary in a speculative, credit-driven world.
Too bad. Will China have a second chance to replay their current investment schemes. Toward a more consumer-orientated, R&D-focused and quality-driven expansion.
Alas, I do not believe it. What is consumed, burnt and lost in such a massive capital mis-allocation cannot be played back.
Two or three years of capital mis-allocation will take 10 years to be made back. That applies to greying OCDE countries. But that applies to greying China too.
“I think it is too early, although my students are telling me that their parents are complaining about rice prices)”
I imagine that there is no equivalent to shadowstats in China. But my inner gut feeling is that your students’ parents are right about inflation. I’ve no doubt they are smart enough to pick real-time inflation in China in a way most expatiates would not.
I bet that price inflation has started to creep in. Where it matters. The chances that it does not become a major hindrance as early as 2010 are next to nil.
Thanks for the great background. Two questions: first, how have credit and urbanization cycles matched up over time. Do they match up, or is urbanization easier for relatively poorer migrants once the credit cycle bottoms out and prices fall. Second, what do you make of the 2 trillion spendin binge that will take place before yearend. After so much credit expansion, what is left to spend on? Gracias.
Chinese urbanisation (ie slowly relaxing and ultimately abandoning the hukou system to allow permanent migration into the cities) may well be the most difficult manoeuvre for the current political structure except relaxing the Leninist form of political organization in this de facto one-party state. Nevertheless the status quo is not sustainable, cities rely on immigrants and given the low fertility of hukou holders, the demand for immigrants will grow (even if construction were wound down as a result of a real estate collapse).
But the urbanization/consumption nexus is entirely dependent on what if any changes to the Hukou system are made. If the official urban population is allowed to expand rapidly by taking in whole families (and the rurals have larger families) marginal consumption (after a while) may well absorb all of the marginal production, while a supply of domestic workers may well create its own demand. On the other hand if the preferences of the producers (and probably the urban authorities) prevail, the immigrants (basically formalized guest workers with some basic privileges) may well have the effect that average propensity to consume decreases…
I followed this blog and discussions with great interest and in general I am concerned about deadweight loss in China’s markets and how that affects future GDP growth and drivers. Just two aspects about the urbanization debate make me wonder.
From some of the comments I have the feeling urbanization here is, colloquial speaking, equated with the circumstance that “some people move to the city to live”. The way I would, however, understand it is that it also comprises people’s changing lifestyles. That means an admittedly limited number of Chinese households increasingly resemble the kind of lifestyle that can be observed in developed, urban areas. That for instances includes aspects like geographic mobility, the transformation of villages into city’s suburbs as well as improvements in people’s health conditions, formal education, …, and marginal revenue product from “parental” to “offspring generation”.
Then I think that the quote of Vanke’s CEO is not as alarming as some may think it is. The way I understand it is that he admits prices in China’s main cities are currently high, while he warns that this kind of speculation better does not spill over into the second and third tier cities. I believe his quote contains a very important distinction – the difference between property in first and second (and third) tier cities. Also I would add to that the difference in income prospects.
I tend to believe that property prices in first tier cities are again quite high, which per se is not a concern in my eyes. The reason is that a broader understanding of urbanization indicates to me the younger generation from the first tier cities and universities is likely to see some decent income increases relatively fast during their career. This among other demand factors will make the property prices in China’s main cities look more reasonable in the future.
Having said this, I am not so optimistic about income increases for the majority of the younger generation from second tier cities and enrolled in second tier universities. Therefore I strongly agree with Vanke’s CEO that the situation in China would be very concerning GIVEN that the speculation increasingly extends to the second and third tier cities.
Now, of course, it may play out very differently and China’s real estate market indeed has the potential of a formidable bubble, but still I would like to make a final point. In any kind of scenario, it is least likely going to be the migrant workers who will fuel domestic consumption. Neither setting their income into relation with property prices nor counting the numbers of how many move to the city is telling us a lot about bubbles. The key will rather be the income expectations of different kinds of university graduates plus some of the better trained workers, I think.
Another sign of a property bubble?
Swire Pacific plans property float
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6818294/Swire-Pacific-plans-property-float.html
And another take:
http://www.marketwatch.com/story/swire-breaks-with-tradition-in-spin-off-2009-12-13?link=kiosk
The problem of urban migration is very complex in China. Many migrants belong to the temporary and “fluid” workforce.
They work in City A, send money back home, and buy house in City B (the city in their home province).
The spike in real estate prices in big cities is partly due to foreign investors.
When the locals are priced out of owning a property, the bubble will burst. Alternatively, when government makes certain policy changes to protect the locals, the bubble will burst.
I think the real estate in China is not just due to demand and supply, the China government has the ability to sustain or burst the bubble.
Dear Prof. Pettis,
I’m a big fan of your blog. A few comments on your latest entry:
- I think another important reason why migrants will not absorb excess real estate supply is the hukou system, which institutionally marginalizes migrants. My understanding is that China’s real estate market is being driven by speculation at the upper end, which most migrants, normally rural-to-urban factory and service workers, have no means to purchase. Even for more affluent migrants (typically those with a college education), many local governments in more desirable cities (e.g. Beijing, Shanghai) set “threshold criteria” for acquiring a local hukou, such as the purchase of a home of more than 500,000 RMB.
- One of the interesting aspects of China’s growth model is the degree of consistency since 1949 (and even possibly during the KMT period, too). The capital intensive, urban bias model (the “Stalinist model”) was the primary industrialization model under Mao. Notably after the universal implementation of the commune system in the mid-1950s and the Great Leap Forward that followed, China’s growth model has operated under an extreme form of urban bias. Industrial development and capital were narrowly invested in urban areas, while state procurement boards effectively taxed the rural population through artificially depressed prices for agriculture output and charged inflated prices for industrial products, subsidizing urban industrialization and effectively transferring wealth from rural households to the state enterprise sector (sound familiar?). The primary instrument used to carry out this policy was the hukou system, which heavily restricted a rural worker’s ability to migrant from a rural to urban region and find work (e.g. through assignment of food rations and public and welfare service provisions). An interesting theme in Yasheng Huang’s most recent book (2008) is that it was the 1980s, when the CCP largely de facto relaxed and even temporarily abandoned these policies that were the most “capitalistic” period. The flourishing of township and village enterprises (TVEs) during this period was a direct outcome of a policy shift away from the decades-old focus on urban industrialization. The pendulum swung back beginning in the 1990s, starting with tax reform in 1994 and later a re-focus on the state sector under Zhu Rongji’s direction. I think it’s important to tie the current issues around overcapacity to these larger, historical patterns.
I think that the CEOs of the big property companies have savvy political instincts (they have to in order to be what they are). This makes their comments about bubbles seem to be a populist ploy that will win them the good graces of regulators or their political patrons. Migrants are not going to buy housing unless it matches their savings and income levels. If a migrant earns 2000 RMB per month, spends 500, their disposable income is 18000 RMB per year. If they want to buy a 50 sqm flat at say, 4000 RMB per sqm, not an unreasonable amount in a second tier city these days, the down payment alone is equivalent to 11 years of disposable income. Migrants will be renters, and they will spend on non-durable consumer items. This will amount to large numbers, but will have a far different composition than the current spending of legitimately middle income urban dwellers. It is always amusing to hear people blame high real estate prices on foreigners given the low-single-digit percentage that their purchases contribute to the overall market. And by the way, most of the “foreigners” are Chinese with a foreign passport, or buying property through relatives. So the “foreign speculation” argument is a ruse. Foreigners would speculate rampantly if they could, but real laowais are heavily restricted in China’s domestic property market.
NB I fixed your math, Mark (MP)
Mr Pettis
Haven’t had much time to do more than a scan of your post – sorry. Frankly, what’s really amazing isn’t the bubble(s) but rather the fact that deflation attempts have gone no where for so long. Found it really disturbing a couple of years ago when given a “tour” of several developments that not merely were there empty residence developments (completed) but empty commercial buildings and that was in “first-line” cities like beijing . The real question is why investors continue to pour money into these investments if the returns are minimal or the currency risk unpredictable – still think a one-way bet is “ahem” really casino finance.
What really worries me is what kind of exit strategy do the investors really have?
As for migration – one of the factors cited by a major developer in China as an explanation for the rocket propulsion growth figures is the rapid urbanisation – could migration in a sense be replacement for a slower rate of urbanisation?
Hope everypne will have a decent break from all the weighty issues – Merry X’mas!
Interesting paper on China’s currency and savings rate:
http://www.voxeu.org/index.php?q=node/4397
Viktor, I posted the pivotcapital study near the top of this thread. M. Pettis, though I don’t always agree with you, I check your blog most days to see what is new. I do agree with the one premises that China is going to have a hard time with consumption in the US lagging and most likely protectionism growing in Europe. My post above, I mention that the big business in China is expansion and not manufacturing. I live in the DFW area and I was just out of college when the commercial property sector here was literally doubled in 8 years. The entire economy was geared to the over expansion. They built 200,000 housing units in 2 years (1983/1984) and destroyed the market. DFW real estate has been fairly flat over the past 25 years despite the local population going from about 4 million to around 6.2 million.
The pivot capital link above covers a lot of items, like the level of industrialization of China. The insinuation is it is overindustrialized and also that it is more urban than outsiders are being told. I see on the net all the time video of modern and empty cities that kind of remind me of North Dallas 25 years ago. If the building jobs cease, the ripple effect will be huge. I have read enough to realize that the Great Depression was pretty much caused because the US was on its on hell bound expansion trip when the world ran out of credit. This is the real issue and it can’t be covered up by continued building. Japan already proved that won’t work.
Niall Ferguson has a new working paper on his concept of ‘Chimerica.’
http://hbswk.hbs.edu/item/6094.html
Right now, real estate in Shanghai goes for more than $3,500 sq.m. The interest on servicing 12sq.m. of living space is above the median income in China as a whole. Probably with an interest only home loan, the average citizen in Shanghai, cannot afford more than 24sq.m as well (if someone has income data, please share). My analysis also assomes the homebuyer lives on photosynthesis.
In fact, rents are 1/10 of the interest on a high end home in the city. Once the credit expansion stops and there is no more free money flowing in, this market will pop and the bubble will vaporize, nothing will be left from the Chinese economy.
Of course China’s economy cannot outgrow this problem: incomes have to shoot up in the stratosphere and surpass even US income levels to support those property prices. You see that possible in an economy where more than 30% of the urban population is employed by the construction industry?
Suggesting that migration can mitigate the problem is simply utopia: those people are at the bottom of the food chain.
OFF TOPIC, but my thoughts drifted this way after reading:
Mr Pettis,
If US defaults on its debt to China, what do you think the likely reaction from China will be?
Viktor, yes I have followed the debate. The key thing I think that is missed is that discussions about the relationship between very long-term trends and short-term balance sheet effects do not address the possibility of sharp, even pro-cyclical variations in the long-term trends. This is what I worry about, and although I don’t doubt China is experiencing a long term urbanization process, this on no way satisfies me that it cannot therefore have a short-term overbuilding problem.
DdP, I think China will have a “second chance”, in fact many second chances, but as you point out, what is currently wasted is gone. Misallocated investment represents a double process, in which total growth is reduced and future growth is moved forward to create growth today. Fort me this implies that we should expect a sharp slowdown in growth as the impact of current capital misallocation is ground out of the economy. To a certain extent this is how I would describe Japan’s lost decade(s).
Mark, I am not sure the process is so directed. Credit cycles affect business growth cycles, which affect migration cycles. When Shanghai is building lots of buildings because of ample credit, whether or not these buildings are occupied won’t matter to the migrant workers streaming into Shanghai to get the construction jobs.
Thanks for your comments, ADL. I still think we need to be careful of conflating long term demographic trends with short term balance sheet effects. The process of university graduates acquiring housing (by the way and as an aside, unemployment among new graduates is extremely high and becoming a serious problem) will take many years especially since most of the expansion in university enrollment has occurred so recently (from about 1 million graduates a year at the beginning of the decade to 6 million currently).
Shannon, roughly every twenty years the press, political pundits, and television comedy shows get themselves into a lather about an upcoming US default. It is a little hard for most economists to take this kind of excitement very seriously, and I don’t, but to answer your question, the US cannot selectively default on debt because of its extreme fungibility and the fact that most of it is or can be held in street names. Either it defaults on everything within a certain class of debt, or it defaults on nothing. If, for example, the US decided to default only on the USG bonds held by me (and if I owned USG bonds, no one would know except my broker, in whose name I would most likely hold them), I am pretty sure for a tiny discount I could convince you or someone else to buy them from me and so collect the full amount.
mannfm11:
Yes, but I think it is of interest to also hear the opinions from the smart people here about Standard Charter’s reply, which pretty much said the Pivot report was completely wrong about the urbanization of China. That is why I posted that link.
Michael:
Thanks for your answer.
[...] a real estate bubble, but he isn’t much concerned. In a post earlier this week, he writes: Last week (sorry, but I lost the article) I read that the head of one of Beijing’s and [...]
The Reisen paper I linked to above and the Ferguson/Schularick paper that Dean Jackson link to come to very different conclusions. Reisen argues that it is not the currency peg that distorts trade balances, but the corporate and SOE savings rate, while Ferguson takes aim squarely at the peg.
This made me notice that those who dismiss the peg’s importance seem to focus only on the level or percentage of currency adjustment and the theoretical ways the economy will compensate for the distortions. But, the way the Chinese government attempts to sterilize the intervention, both in the US and in China would seem to be at least as important as the level of currency valuation change. This is because implicitly or explicitly the sterilization interventions have served to amplify the distortionary effects of the currency manipulation.
Hi Prof. Pettis, a newbie question here.
Why are people talking about urbanization almost as if it goes independent of the economy? I mean, countries like Sierra Leone and Niger would certainly like to use some urbanization. Does that mean they can start a building fancy and not worry about demands?
What I’m trying to get to is that, if we all agree that China has a steep hill to climb regarding import/export imbalances, when the clock is ticking between its massive stimulus and the growing US savings(ie. reducing export for china), where do people suppose the housing demand (which must be accompanied by increasing wealth) come from?
Article from China South Morning Post on the frenzy to spend. The story about the steel factory with undermaintained equipment is very common. “nobody bears the consequences” is clearly rife in government and SOE mindsets. It’s just the government’s money. Anyway, article below….
Waste feared in last-gasp spending
Analysts voice concern as local governments rush to spend two trillion yuan in 10 days
Toh Han Shih
Dec 21, 2009
The mainland’s poorly monitored big building projects lead to waste and corruption on a massive scale, and a stampede by local governments to earmark about two trillion yuan (HK$2.27 trillion) in unspent budget allocations before the fiscal year-end is set to make the problem worse, critics say.
“Infrastructure projects anywhere in the world are ripe opportunities for corruption. Even in developed countries. It happens everywhere,” said Dane Chamorro, the North Asia general manager of Control Risks, an international risk consultancy.
However, corruption tended to be a bigger problem in developing countries such as China because there were fewer checks and balances since no government departments were independent of the Communist Party, he added.
Now, with just 10 days left before the end of the fiscal year, local governments are in a rush to “use it or lose it” and show that they have begun projects worth about two trillion yuan so that they can lay their claims on the funding.
That headlong rush was a recipe for waste in a country where the performance of local governments was gauged on the scale of new assets they had built, not the quality of the assets or the efficiency with which the funds were spent, said Frank Mizuno, a founding partner at business consultancy LMM Consultants.
Aggravating the problem was that Chinese banks were measured on how much they lent to infrastructure projects, not whether they made good loans, he added.
“There’s a big driver in the Chinese economic system. It is asset-based. When you read information on Chinese companies, the first and easiest number to find is usually assets, like gross asset value,” Mizuno said.
By contrast, the profiles of United States or Hong Kong companies will focus on such things as market value, turnover and profits.
“There is no question China needs infrastructure. There is also no question that projects are overdone,” said Mizuno.
“A lot of these showcase projects clearly have problems. The question is, is there something systemic going on?”
A foreign venture capitalist who is a long-time investor in China endorsed these views and said he had seen many examples of wasteful expenditure during his recent travels through the country.
“In the past six months, I have travelled extensively to many rural or peripheral areas in China and saw giant local Communist Party offices and highways to nowhere,” he said.
“Infrastructure investments with no economic outcome are a waste of money and I venture to say the majority of that in China is turning gold into base metal.”
Infrastructure spending in China received a boost with the four trillion yuan stimulus launched by the central government to tackle the global financial crisis late last year, of which 1.5 trillion yuan was earmarked for infrastructure.
Lim Juay Peow, a founding partner of LMM, said he had also seen waste and mismanagement on the mainland, citing the example of a quarry project for which LMM was engaged.
“They told us they didn’t have enough capacity, but when we looked at the quarry, we found that the problem was down to productivity since the equipment was down 30 per cent of the time,” Lim said.
“They were thinking of putting in US$3 million to increase capacity by 30 per cent. Instead, we trained the people to maintain the equipment properly, and they gained 30 per cent without putting in the US$3 million.”
Visits to steel mills offered similar insights, he added.
“They work the machines without maintaining them until they break down. Then it takes a long time to get spare parts, sometimes months. But maintenance is not encouraged.”
Mizuno likened the wastage in projects in China to the US subprime mortgage crisis.
In the case of that crisis, housing loans had been processed, packaged and distributed to investors. Along this chain, various parties took their fees.
“All these parties took their fees, yet the assets were often worth nothing and there was no incentive to make them worth something, because you passed it on,” Mizuno said. “In China, you have a system very much like the US subprime system, where a lot of people have the incentive to spend a lot of money on big projects.
“The consequence is, efficiency gets dissipated. Nobody bears the consequences if the train runs slow or the factory doesn’t work well. Like in the US, there are no consequences for many parties.”
A study by Tsinghua University estimated 13 per cent of China’s gross domestic product was lost to corruption and fraud, compared with 4 per cent in the US, estimated by the US Association of Certified Fraud Examiners.
“Taking those figures, that is a huge difference,” said Chamorro.
Hi Professor,
I didn’t manage to tell you after attending one of your seminars a while ago – but thank you, your theories and arguments are truly intriguing.
Several points I would like to share regarding this article:
1. On inflation and loan growth.
I disagree with your view that it is too early to think about inflation. Looking at monthly figures you would notice that it is food inflation, rather than non-food inflation, which is pulling CPI up from deflationary territory. In fact, food inflation has already reached high single digit when non-food inflation is still struggling. From the policymakers’ point of view, it is food inflation, rather than the composite CPI, which is more worrying given the detrimental effects this would have on the lower income masses. Continued support of these masses are key to the Communist Party’s continued stronghold of the socio-economy. Therefore, the policymakers have got to be thinking about “tightening” at the moment.
Rmb7tr of new lending sounds like a lot, but key points to bear in mind are: (i) the “unused” credit that you highlight in your piece consisted mainly of short term loans that have already been retired gradually in 2H09; (ii) a lot of these would be recurring loan demands required by existing projects. This suggests that incremental new project starts would be much lower on a year-on-year basis. Supporting evidence would be the clear rising trend in historical credit growth – credit demand is sticky. Therefore, this already represents some “tightening”, though not in the conventional sense.
2. On the property market.
I agree with your view that urban migration fails to justify the bubbling property market, but believe that you have missed the main point: that is, the overbuilding we are currently reading about in the papers and seeing everywhere in Beijing, Shanghai, Chengdu…etcetc, are mostly for the better off. The “property market” in China, even including the “mass market” segment, caters to the top 25% of household income. This means that in comparing urban property prices vs potential immigrants, we are talking about completely different social and income classes. Rural migrants would not be able to afford anything which is currently built by the main developers. This is the reason behind the government’s massive push for social welfare housing investment while introducing more severe governing measures for developers…but when profit margins for social welfare housing are max 8% vs commodity housing at >30%…well, good luck to that!
Stephanie:
On the point about the property market, you might want to read a post by Patrick Chovanec on his blog about the new property turnover tax and in that post, he talks a lot about who is buying residential units. It’s quite enlightening and also to your point.
http://chovanec.wordpress.com/2009/12/18/china-goes-wrong-way-on-property-taxes/#comments
I share the worries about inflation. If China keeps the yuan on a peg, then that means they buy dollars at a fixed RMB rate. That should result in flooding the China market with more rmb. Indeed, money supply has been growing at 25-30% annually. In the long run, how can this not be inflationary? The only way I can think of is either the PBOC must reduce the velocity of money or productivity must grow. Surely, productivity is growing, especially with the urban migration but not at a 25% rate. I imagine also that, while worker productivity increases, per unit wages are falling (this is another way of looking at Professor Pettis’ theme of falling household incomes as a % of GDP).
As for velocity, by monkeying with reserve requirements and jawboning banks to not lend, I suppose there are some blunt velocity instruments that could be used. Or, is it perhaps the black hole called SOEs that suck up liquidity and hold it? But it’s hard for me to imagine that these kind of tactics could work long term.
One thing is certain (everyone, including the CCP would agree) that if inflation in base items like food and energy hit the already meager pocketbooks of the masses, it would create a powder keg for civil unrest.
The order of economic priorities for the CCP are I assume: 1) keep ‘em employed (and off the streets); 2) Keep consumer price/consumer income ratio under control; and 3) try to narrow the income distribution gap. In sum, make today look better than yesterday and tomorrow look better than today.
The question is whether there might come a time when you can’t have both 1 and 2. As to #3, the country is already failing miserably and an interruption in 1 or 2 will further inflame feelings about #3.
As you can tell, I am not a deep thinker on this and I am sure my points are muddled. (I’m keeping my day job!) I’d appreciate any thoughts you all might have.
And, all the worry and problems notwithstanding, everyone have a Merry Christmas!
Prof you said…”roughly every twenty years the press, political pundits, and television comedy shows get themselves into a lather about an upcoming US default. It is a little hard for most economists to take this kind of excitement very seriously, ”
I am so glad to see this answer, it is hard not to be spooked by the various high profile writers and blogs predicting default and the return to Maoist China…interestingly most admit to never having set foot in China, yet they continue to post pictures of ‘empty cities’ etc! Regards.
Hua Qiao says: “The order of economic priorities for the CCP are I assume: 1) keep ‘em employed (and off the streets); 2) Keep consumer price/consumer income ratio under control; and 3) try to narrow the income distribution gap. In sum, make today look better than yesterday and tomorrow look better than today.”
I completely agree with you. The CCP is entirely entrenched in its power grab and does everything to extend it while enriching its members at the top in the process. Focusing on 1) & 2) is all important, 3) is more of a wishful thinking theme. And as Chovanec said it as well: building is the easiest way to add to GDP growth and is very labor intensive, so everyone builds, regardless of economic needs.
[...] year that new credit growth was CNY295 billion in Nov., equal to $43 billion. That was down from 2009’s monthly average of $130bn, but took full-year credit growth to the equivalent of $1.35 trillion, equal to 27% of [...]
[...] year that new credit growth was CNY295 billion in Nov., equal to $43 billion. That was down from 2009's monthly average of $130bn, but took full-year credit growth to the equivalent of $1.35 trillion, equal to 27% of [...]
[...] year that new credit growth was CNY295 billion in Nov., equal to $43 billion. That was down from 2009’s monthly average of $130bn, but took full-year credit growth to the equivalent of $1.35 trillion, equal to 27% of [...]
[...] year that new credit growth was CNY295 billion in Nov., equal to $43 billion. That was down from 2009’s monthly average of $130bn, but took full-year credit growth to the equivalent of $1.35 trillion, equal to 27% of [...]
[...] year that new credit growth was CNY295 billion in Nov., equal to $43 billion. That was down from 2009’s monthly average of $130bn, but took full-year credit growth to the equivalent of $1.35 trillion, equal to 27% of [...]