I got back three days ago from my trip to the US and am still sludging through my jet-lag, but there are two quick takeaways from the trip I should mention.  First, my Washington meetings convinced me (no big surprise here) that, just as it is doing in Europe, the issue of trade is getting more political attention than ever, and the adverse employment impact of the US trade deficit is an issue that will not easily subside.  I did not leave Washington feeling that my worries about a rise in trade tensions were in any way exaggerated.

Second, I met with at least 30 different institutional investors, and perhaps the fact that my trip coincided with the twelve labors of Greece, or however many they have, worry over China and the state of the world economy was deeper than on my previous trips.  For reasons I have often discussed on this blog, I have never been a believer in the survivability of the euro, and many of the people I met on this trip had heard me over the past decade express my doubts, so meetings that were ostensibly on China often became meetings on whether Greece, Italy, Portugal, Ireland or Spain will be forced to exit.  Everyone wanted to know if turbulence in Europe would hurt China (I think it definitely would, especially if it came when there were worries about the Chinese financial system).

In the meetings where we discussed the euro I nearly always made reference to a thesis argued in Barry Eichengreen’s magisterial Golden Fetters (one of my favorite books) that the political enfranchisement after WW1 of very large segments of the population in Western democracies – most crucially the working classes, who historically bore most of the pain of adjustment – meant that the traditional adjustment mechanisms under the gold standard, which were deflation and rising unemployment, would prevent democracies ever from returning to the gold standard.  Politics would make it impossible (and probably a good thing, too).

The pain of adjusting

This has an important implication for the discussion on the euro.  Unfortunately the euro today imposes a kind of gold standard on European countries – it forces them to adjust to excessively high domestic prices, large trade deficits, and/or large fiscal deficits in the same way they would have had to adjust under the gold standard, and I don’t think that is politically likely to be acceptable.  The countries that need depreciation to regain competitiveness or monetization of the debt to regain control of the deficit will have to choose between adjusting via deflation and high unemployment or exiting the euro.  Politics makes the latter more likely.

There is one other way out, perhaps.  Martin Wolf discussed it last week in an important Financial Times article called “Europe needs German consumers”.  Wolf argued that trade imbalance within Europe helped to create the subsequent and damning financial imbalances, and that without resolving the trade imbalance it is pretty pointless to talk about fiscal belt-tightening and lower wages as the means by which the problems of outer Europe will be resolved.

So long as the European Central Bank tolerates weak demand in the eurozone as a whole and core countries, above all Germany, continue to run vast trade surpluses, it will be nigh on impossible for weaker members to escape from their insolvency traps. Theirs is not a problem that can be resolved by fiscal austerity alone. They need a huge improvement in external demand for their output.

This, of course, is the intra-European version of the global imbalance debate.  It is simply another way of saying that policies in major trading nations that constrain consumption and subsidize production – in effect trading off lower household income for higher domestic employment – must have the reverse impact on trading partners who implicitly made the opposite trade-off, giving up employment in exchange for higher consumption.  As long as those trading partners were able to use the recycling of surpluses to leverage up domestic demand, and so boost domestic employment through debt-fueled growth, the adverse employment effect was hidden.

Once the leverage process started to unwind, however, the deficit countries would inevitably see a surge in domestic unemployment.  The best way to deal with the problem is to have both sides unwind the mechanisms that created the mirror trade-offs.  Germany must put into place policies that trade higher consumption for lower employment, and use debt to force employment up, so that deficit Europe can gain employment, albeit at the expense of a lower share of consumption.

Germany might not like reversing this trade-off, which was the source of much of its recent growth (almost 70% of its growth since 1997), but in the longer term it will be much cheaper than bailing out the European countries, or allowing them to exit the euro messily and anyway force the reversal of the trade-off on Germany.  You can’t run large trade surpluses if your trade partners are no longer able or willing to run the corresponding trade deficits.

Global rebalancing

This, by the way, seems to me to be the classic Keynes argument (although not, perhaps, the “Keynesian” argument): In a world characterized by contracting global demand and large trade imbalances, it is the obligation of the large surplus nations (and in the 1930s of course he meant the US) to stimulate domestic demand.  Asking the trade deficit countries to leverage up to stimulate demand is counterproductive and would ultimately just postpone the necessary adjustment.  Asking them to adjust via unemployment, on the other hand, makes everyone worse off.  In other words it is far better for Germany to move aggressively to boost domestic demand than to ask Spain to cut workers’ wages.

In that context I have to say I am very heartened by all this talk in China of pressures to raise the minimum wages in a number of Chinese provinces.  This is exactly the kind of thing China (and Germany) should have been doing all along.  The South China Morning Post, for example, had an article claiming that factory bosses in the Pearl River Delta now fear a shortage of employees.  This month Jiangsu, the third largest exporting province, imposed its first increase in minimum wages (minimum wages are set by local governments in consultation with the central government, and were frozen in late 2008).  Shanghai, the second biggest exporter, has also announced increases.  More is expected, with Beijing, Zhejiang and Guangdong all in line to announce something soon.

Many analysts expressed some worry that rising wages can set off an inflationary spiral in China.  Although I think there is certainly a risk of rising inflation (the relative low CPI number for January, 1.5%, down from December’s 1.9%, was offset by the 4.3% PPI) I am not sure an increase in wages will have such a big impact on inflation because Chinese manufacturing tends to be heavily capital intensive and worker productivity has anyway risen faster than wages in the past ten years (in fact this “suppression” of wage growth relative to worker-productivity growth is part of the mechanism that forces high savings rates and low consumption in China).

In spite of nagging worries about inflation, most observers, as far as I can see, welcomed the possibility of higher wages.  I think they are right.  The whole concept of rebalancing the economy is completely meaningless unless it means raising household income as a share of GDP.  Chinese wage earners have struggled with a number of factors that have made it difficult to raise their wages in line with the increase in national income (GDP), and since the level of household consumption is a function of the level of household income, this has forced a rising gap between the two and has forcibly resulted in a higher savings rate.

Transferring income

But in that sense I think many observers, who argued that raising wages was the best way to rebalance the economy because it is the most direct way to get income into the hands of workers, are missing the point.  As I see it there are four main ways to raise household income, and while each of these can have the same aggregate impact, they differ on how the costs and benefits of that impact are distributed.

¨ Raising wages in the coastal areas will shift income from coastal manufacturers and SOEs to coastal workers.  It may partially undermine the competitiveness of coastal exporters and will probably increase migration to the coastal areas.

¨ Raising interest rates will shift income from bank loan recipients – mainly real estate developers, large manufacturers, and above all the SOEs – to depositors around the country.  By raising the cost of capital it will penalize speculators and the most capital-intensive industries – almost certainly a good thing economically but politically tough to do.

¨ Appreciating the RMB will shift income away from exporters, by reducing their subsidy, in favor of all other companies and households by reducing the cost of imports.  I am not sure how the cost of imports is distributed across income classes, but I suspect that the urban poor will benefit the most and the rural poor second, since a rising RMB may put downward pressure on agricultural prices.  Of course it will reduce China’s export competitiveness.

¨ Improving the health, education and social safety net – probably the weakest of the four mechanisms but the one that seems to get the most attention – transfers income from whoever is forced to fund it (not households through taxes, I hope) to whoever the recipients are.  I suspect that the main beneficiaries are likely to be the urban middle classes and the poor.

The key to which policy is “best” depends on how policymakers want to distribute the costs and benefits.  Of course the relative political strengths of the various sectors who may be forced to bear the cost will have an important impact on which policy is chosen, but there is no getting around the fact that any policy that increases the income of the household sector will have an adverse impact in the short term on unemployment.  Over the long term, however, as it rebalances Chinese growth towards domestic consumption, its impact on employment should be better.

But this trade-off is inevitable, and there is no point in trying to deny it.  Like Germany, China has chosen policies over the past decade that traded off lower household income for higher domestic employment.  Because this necessarily resulted in trade surpluses that the deficit countries are no longer willing or able to tolerate now that their unemployment levels are so high, China, like Germany, must either work towards a reasonably smooth rebalancing or it will be forced into a messy and disruptive rebalancing.  If it is to work towards a global recovery and a domestic rebalancing, like Germany today China must put into place policies that trade higher consumption for lower employment, while using debt to keep unemployment from rising too quickly.

The pace of adjustment

How messy and disruptive could the forced rebalancing be?  That depends on the adjustment taking place in the US.  On the one hand consumption numbers in the US were better than expected for January, but consumer sentiment was not.  Here is the Financial Times article:

US retail sales rose unexpectedly fast in January, the government said on Friday, but hopes that consumers will emerge as a driving force in the economic recovery remained muted after a separate survey showed an unexpected drop in consumer sentiment.

…With unemployment at 9.7 per cent and the housing market still in the doldrums, American consumers have not returned to spending as aggressively as they had in the wake of previous recessions. The rebound in growth in the last quarter of 2009 was instead led by higher business spending and a sharp drawdown in inventories.

But Americans are shopping again: modestly but at a growing rate. In January, retail sales rose by 0.5 per cent, which was an improvement over the 0.1 per cent drop recorded in December and the 0.3 per cent gain expected by most economists.

However other indicators were not so good:

Meanwhile, consumer sentiment unexpectedly dipped from a two-year high of 74.4 in January to 73.7 in February, following big gains over the previous two months, according to the Reuters/University of Michigan monthly survey.

Although the recent drop in equity prices was judged to have contributed to the drop in the public mood, consumer sentiment related to current conditions actually increased, while it was expectations for the future that accounted for most of the unexpected decline. At the same time, long-term inflation expectations edged downwards, from 2.9 per cent in January to 2.8 per cent this month.

The big question facing the US economy is whether consumers will use any cash they accumulate as growth returns to boost personal savings. Alternatively, they could spend it on new goods and services, but with consumer credit still extremely tight, many economists believe that Americans will choose the first option and keep hold of their cash.

Meanwhile the key measure of the pacing of the global adjustment, the US trade balance, has shown some pretty rapid change.  According to an articlein the New York Times:

After years of being told by Asians and Europeans that it had to find a way to reduce its trade deficit, the United States did find a way in 2009. A global recession did the trick, producing the largest decline ever in the deficit.

The recession caused American imports to fall by 26 percent, by far the largest annual drop in imports of goods since the government began keeping trade statistics in 1948. There have been only a few years with any declines at all, with the largest before 2009 being a fall of nearly 7 percent in 1982, another recession year.

Exports also fell, but not by as much, as can be seen in the accompanying charts. The result was a trade deficit in goods of $501 billion, or 3.5 percent of the country’s gross domestic product. That was down from $816 billion, or 5.7 percent of gross domestic product.

Any way you slice that, it was the largest improvement in the trade deficit on record. In terms of G.D.P., the biggest improvement before 2009 was in 1988, when the deficit declined by almost 1 percent. …Even so, the deficit, as a percentage of G.D.P., is larger than it ever was before 1999.

What happens to the US trade deficit, whether caused by changes in consumer confidence or by rising trade tensions, is key.

The fireworks are going off like crazy all through Beijing.  Happy Spring Festival and enjoy the year of the Tiger.

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.

How fast does consumption need to grow in China in order for a meaningful rebalancing to take place?  Probably a lot more than you think.  This is arithmetically the case because China is starting from such a low base.

At roughly $1.2 trillion in 2008, total Chinese private consumption is only a little more than that of France (around $1.0 trillion) and still less than that of Germany (about $1.3 trillion, not to mention the UK’s $1.4 trillion and Japan’s $3.2 trillion).  This fact alone should cause us to be extremely skeptical of feverish claims about the role Chinese consumers can play in making up for any contraction in US consumption – which at roughly $9.4 trillion last year is nearly eight times the size of China’s – without even taking into account that Europe and Japan are likely to exacerbate, rather than help absorb, the contraction in US net demand.

Chinese private consumption has dropped dramatically as a share of GDP in the past two decades.  McKinsey put out a much-discussed report on consumption in August, which like many McKinsey reports is thoughtful and thorough, and generally does a good job of summarizing the informed consensus – for example the claim that a major reason for high savings is the lack of a social safety net, for which I think there is much less than meets the eye.

Unfortunately, the report tends explain the sources of low consumption too often by referring to consequences of the underlying dynamics, rather than the underlying dynamics themselves, making its proposed solutions either impractical or irrelevant.  For example, the report complains that “China’s investment- and industry-intensive model crowds out consumption.”

In fact the main reason for overinvestment, and the fact that much of it is misallocated, thus widening the future gap between production and consumption, is probably too-low interest rates and a distorted credit allocation system, so it is not a question of reorienting growth away from a capital-intensive model.  It requires first of all a fundamental reform of interest rate management and banking governance.

One can also easily argue that the fact that “China’s consumers make limited use of credit”, as the report claims, reflects the underlying industrial strategy more than just a technical failure to develop consumer credit.  A burgeoning consumer credit market – big enough to matter – will undermine the growth model by changing the direction of implicit subsidies.  This is a pretty big reform.

But that is an aside.  Like most McKinsey reports it has lots of great data.  For example it shows that the Chinese were not always so reluctant to consume.  According to the McKinsey (and the National Bureau of Statistics) data, in 1990 consumption represented just a little over 50% of GDP.  Around the time of the inflationary crisis of 1993-94 it dropped to around 45% of GDP and stayed at that level until shortly after the 1997-98 Asian crisis, when it began a fairly steep decline, hitting 40% in 2003-04 and around 35% currently.  Crises seem to drive the household consumption rate down, even though bull markets don’t seem to drive it back up.  Is that because crises cause households to worry about risk (although if that were true they wouldn’t go permanently down, would they)?  Or is it because the government responds to crises by increasing the amount of misallocated investment, the consequence of which is to reduce future consumption?  Government consumption, by the way, has stayed pretty steady, at around 15% of GDP, during that period.

Compared to non-Asian countries Chinese consumption rates are astonishingly low.  Consumption for most European countries lies in the 55-65% range.  Consumption for other developing countries can easily fall in the 65-70% range – where much of Latin America falls.  US consumption has been around 70-72% in recent years.

Even by Asian standards Chinese consumption is off the charts.  South Korean and Malaysian consumption is around 50% of GDP (although during and after the Asian crisis Malaysian consumption did drop to around 45% of GDP, before recovering).  Other major Asian economies, like India, Japan, Taiwan and Thailand, show consumption in the 55-60% of GDP range.  Compared to those numbers China’s 35% is astonishing, even if, as some claim it may be somewhat understated (which by the way may be true of other developing countries).

The flip side of the decline in consumption has been the rise in household savings.  After bouncing around erratically between 10% and 20% of disposable income in the 1980s, around 20 years ago Chinese household savings equaled 12-15% of disposable income.  Around 1992 they began rising steadily until 1998, and then stabilized at around 24-25% until very recently, when they rose slightly to about 26% of disposable income.  The report correctly notes that the real increase in national savings in recent years was caused by the sharp increase in corporate savings, although as I have often mentioned before, I think corporate savings are themselves caused by the transfer from household savings via low interest rates.

During that same period China ran small surpluses or deficits on the trade account until 1996, when it booked its last trade deficit, beginning a steady upward march of its trade surplus until 2003, when the trade surplus was around 5% of GDP, after which time it surged to over 10% of GDP in 2007-2008.  Investment, too, rose steadily during this period as a share of GDP.  In 1990 it was around 23% of GDP.  It rose sharply in 1992-94 to around 31% of GDP, stabilized at that level, and then began climbing inexorably around 1997-98 to reach around 40% in 2008.

Rising investment and rising trade surpluses are inextricably linked in China’s case.  Strategies that explicitly or implicitly boosted Asian savings rates and constrained consumption, I have argued many times before, were viable strategies as long as the resulting trade surpluses, which were an almost automatic account of these policies, could be absorbed by trade deficit countries.  Of course the US has played this role for the past thirty years, but there is good reason to believe that it might not be able or willing to do so much longer.

These growth strategies basically forced households to subsidize investment and production, thus generating rapid economic and employment growth at the expense of household income growth, and as I have argued many times before it is the growth in household income that has primarily constrained household consumption growth.

This is borne out by the numbers.  From 1990 to 2002, according to the McKinsey numbers, household income ranged from 64% of GDP to 72% of GDP.  It peaked in 1992 and then began a slow, erratic descent to 66% in 2002, after which time it plunged to 55%.  I suspect that if there were a way to measure changes in wealth – for example the value of the deteriorating social safety nets and the environment, the present value of savings as interest rates are changed for policy reasons, etc.—and household income were adjusted by these changes, the decline would have been greater.

The report goes on to discuss McKinsey’s projections and expectations for consumption growth over the next few years.  I read it with interest but frankly I find these kinds of exercises not terribly useful because of the tremendous difficult in ascertaining the various feedback loops – of which there are many in China – which inevitably force reality far away from expectations.  But I did try to do some quick arithmetic, in order to determine what kinds of numbers we are going to need to get anything resembling a rebalancing.

Rebalancing is the key word here.  Many analysts think that what we need is for consumption in China to grow quickly, and this will resolve China’s (and the world’s) problem with contracting net demand in the US.

Actually, no.  What we need is an expansion in Chinese net demand – rebalancing in other words – so that China can adjust to contracting net demand from the US in a way that doesn’t harm trade partners and competitors and rebounds on itself with escalating trade tensions.  The way to rebalance is not for consumption to grow, but rather for consumption to grow as a share of GDP.  Even if consumption declines, and GDP decline more quickly – a horrible outcome to be sure – rebalancing will occur.  The best way of course is for GDP to grow quickly and for consumption to grow even more quickly.

But this is I think what most people miss.  Just growth in Chinese consumption alone does not help if it grows in line with GDP, and less so if it grows slower than GDP.  In that case the imbalances will get worse, and while the impact on the trade account can be temporarily disguised if investment continues to surge, ultimately it just postpones the needed adjustment (and increases the cost if the investment surge is misallocated).

What kind of consumption growth will we need for the country to rebalance?  The numbers are a little worrying.  If China grows by 8% a year, consumption would have to grow by a little over 11% to raise the consumption share of GDP from 35% to 36% in one year.  It would have to grow by a little over 9 1/2% annually to do it in two years.  Consumption, in other words, must grow substantially faster than GDP for the rebalancing even to begin to take place.  This is arithmetically true because China begins the process with such a low consumption ratio.

Look at it over the longer term.  Just to return consumption to 40% of GDP over the next five years (and even that level is widely considered to be way too low, and probably unprecedented in the world excluding recent Chinese history), 8% average annual growth rates in GDP would require a tad under 11% annual growth in consumption.  Similarly, 7% average annual GDP growth rates would require that consumption grow annually over the next five years by nearly 10%.  To bring Chinese consumption in 20 years up to 50% of GDP, which is the low end for other high saving Asian countries, and far lower than any other large economy in Asia (and remember that large economies are less able to rely on exports to fuel growth than small countries), 7% annual GDP growth would require average annual consumption growth of just under 9% for twenty years.

In other words while GDP growth slows significantly from its 12-13% rate of the past several years, consumption will nonetheless have to surge at rates far in excess of the 8-9% growth rates of recent years in order for even a small, partial rebalancing to take place.  I don’t think I have ever seen a case in which consumption has grown at nearly that rate for any length of time.  I believe if China pulled it off it would be unprecedented.

Of course this will not be easy, and I think too many commentators underestimate the magnitude of the problem.  China’s rebalancing process will even in the most optimistic of cases take many years before it can even reach the lowest consumption levels reached by other Asian countries that pursued investment-driven policies accompanied by too-low interest rates and undervalued currencies.  This will be a long haul, and if I am right – if we need to see a transfer of income back for the state sector to the household sector really to get it going – we should expect much lower GDP growth rates over the next decade than anyone is currently projecting.

Later today I am leaving to New York and DC for a week, so this may be my last post for several days since my schedule will be pretty hectic.  Of course most of my trip will involve meetings with bankers, investors and some government officials, but the timing of my visit was based on the three-week tour of a group of my favorite Beijing musicians.  For those who live in the northeast and are interested, check out the tour schedule and by all means come and see the shows.  The work of these artists is, in my opinion, among the most interesting in the music world and will give a very different idea of what Beijing’s hippest youth are thinking about than most people assume.  I will be attending most of the performances until November 11, when I return to Beijing.

But on to grayer topics.  When the US economic data for the third quarter of 2009 came out last Thursday judging by the market reaction it seemed much more mixed to me than it apparently did to others, especially as far as it relates to China.  It is true that after four quarters of negative growth, with GDP contracting 3.8% in the year to July, we finally got positive GDP growth of an annualized 3.5%.  This was above expectations, and given China’s reliance on US overconsumption, the increase certainly seemed to be good news.

Even better, much of that growth was powered by a 3.4% increase in personal consumption, which was itself powered by the rather astonishing 22% increase in durable goods consumption – or perhaps not so astonishing if we chalk it up, as most experts do, to the “cash for clunkers” program.  Americans, it seems, bought a lot of cars in the third quarter of 2009.

As I (and many others) see it, however, this surge in auto sales in the US isn’t likely to represent new and sustainable purchases, and so undermines any optimism generated by the growth in consumption.  The surge in car sales may simply be Americans taking advantage of temporary government subsidies, and to that extent represent not new purchases but rather an anticipation of future purchases.  If that is the case, whatever we get this year in new car sales will result in a reduction next year.

Why am I so negative about the good consumption numbers coming out of the US?  Because the rise in personal consumption was accompanied by a 3.4% decline in household disposable income.  If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption.  Consumption and household income must move in the same direction over any reasonable time period to be sustainable.

As if on cue, this was at least partly confirmed by the subsequent release of September numbers.  As Friday’s Financial Times put it:

US consumer spending stalled in September after climbing in each of the prior four months, dampening spirits, as the effects of government stimulus programmes started to wane.  Personal consumption expenditures fell by 0.5 per cent, or $47.2bn, last month, commerce department figures showed on Friday. The data were in line with the predictions of Wall Street economists, who expected that the expiration of the popular “cash for clunkers” car rebate scheme would hit spending.

In September, spending on durable goods, which includes cars, fell by 7.2 per cent after jumping by 6.7 per cent the previous month.  Incomes were flat in September, slipping by just 0.1 per cent, after ticking up by 0.1 per cent in August. Companies are continuing to freeze pay or cut salaries as they wait to see the shape of the economic recovery.

So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending.  Both China and the US are dealing with their imbalances either by slowing down the rebalancing or by exacerbating the very things that caused the imbalances in the first place.  Slowing down the adjustment makes good political and social sense, of course, but it shouldn’t blind us to the fact that US households cannot continue leveraging up to absorb the excess production that Chinese companies are leveraging up to produce.  We will rebalance, one way or the other.

By the way, and speaking of not rebalancing, net new lending in October might be up.  According to an article in Bloomberg:

China’s four biggest banks granted 136 billion yuan in new loans in October, higher than the previous month, Caijing magazine reported, citing industry data. Bank of China Ltd.’s new loans in October were 44 billion yuan, the most among all the banks, Caijing said. China Construction Bank Corp. lent 36 billion yuan, Industrial & Commercial Bank of China Ltd. granted loans of 33 billion yuan and Agricultural Bank of China lent 23 billion yuan, the magazine said on its Web site.

Resolving the imbalances

The same day the economic numbers were released Tom Holland had an interesting piece in the South China Morning Post on two “new” proposals for solving the Asian side of the destabilizing imbalances at the heart of the global economy – one from the International Monetary Fund and one from Barclays Capital.  The first:

As the IMF points out in its regional economic outlook published yesterday, household savings have actually declined across much of Asia over the past 10 years. Even in China, the personal savings rate has remained more or less constant, which means it cannot be ordinary individuals who are responsible for the explosion in the region’s excess savings.

What’s actually happened…is that saving by Asian companies has ballooned since the crisis of the 1990s. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Asian companies have made bumper profits in recent years.  And because of weak corporate governance, they have been able to retain a large portion of those earnings rather than paying them out to shareholders as dividends, feeding the savings glut.

The answer, according to the IMF, is to strengthen corporate financing options, so companies no longer need to hang on to earnings, while beefing up corporate governance standards to ensure a better dividend payout.  The IMF estimates that raising emerging Asia’s financial market development and corporate governance standards to rich-world levels would lower the region’s corporate savings by 7 per cent of gross domestic product, wiping out the savings glut and going a long way towards rebalancing the world economy.

I think it is widely agreed that there should be a more robust mechanism for forcing SOEs and other large corporations to disgorge their profits and return them to shareholders, including the government, but I wonder if it isn’t a little more complicated than that.  As I see it, SOE profits are not the result of their value creation but are rather more than 100% explained by various subsidies delivered from the household sector.  Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which may be the currency undervaluation, SOE profits in the aggregate would be negative.

In that sense SOE profits are simply part of the transfer from household income to the state sector, and the most efficient way to return the money to households is likely to be to raise deposit and lending rates rather than dividend them back to shareholders.  If the shareholders gain access to those profits via increased dividend payments, as I see it we are still seeing a transfer of income from Chinese households to the state sector.

The state may spend it more wisely than the SOEs (something that I would have to see to believe), but unless that money directly or indirectly was sent back to the household sector, perhaps by paying for health care or lower taxes, it doesn’t really address the fundamental problem.  If it goes into state-favored investment projects, there will have been no rebalancing.  I am convinced that Chinese households need to receive a larger share of national income, or their consumption growth will always lag growth in production and high savings rates will persist.

The second new proposal described by Holland:

The emerging-Asia economics team at Barclays Capital have come up with a different solution to the problem. In a report also published yesterday, they argue that the way to get rid of the region’s excess savings is not for Asian countries to save less but for them to invest more. Barclays’ analysts argue that Asia’s problem is not low consumption. Across much of the region, with the exception of China, household consumption ratios are similar to those in the European Union. Instead, the source of the glut is the low level of investment, which has declined since the Asian crisis.

Given Asia’s heavy need for infrastructure, Barclays recommends that governments should use the region’s excess savings to ramp up investment in order to promote future economic development. That certainly appears to be China’s preferred solution. The problem, however, is ensuring that investment is channelled into productive projects rather than misallocated to building excess capacity.  Barclays’ answer is to finance more projects with private, rather than government, capital. That, however, would need financial reform and stronger governance in order to work.

I can’t speak for the rest of Asia, but I doubt that what China needs is a lot more investment.  We seem to have forgotten all the lessons of the overinvestment crises of the 19th and early 20th centuries (and perhaps Japan in the 1980s) in favor of the mantra that increasing investment is always a good solution to whatever the current problem is.  Although there is no question that much of the world probably invests too little (e.g. the US), the idea that there is infinite scope for additional investment is simply not true, and I worry that so much of China’s investment is already non-viable that increasing it significantly can only make matters worse.  Building yet more stuff, if it does not repay the cost of the investment, means reducing future consumption, and it is consumption growth that powers economies over the long term.

Perhaps I am sounding like a skipping CD, but for rebalancing to occur in China we need households to grab a larger share of income.  Any other solution, I think, misses the point.  China entered the crisis with the highest investment rate in history, and probably also one of the highest rates of misallocation of investment in recent times, and then grew it sharply and quickly.  This probably isn’t the solution to low Chinese consumption.

What the 1930s tell us about the coming protection

Finally, Barry Eichengreen and Douglas Irwin have a July 2009 NBER paper out with the title “The Roots of Protectionism in the Great Depression” which examines the relationship between protectionism and monetary conditions.  According to the very helpful abstract:

Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s’ rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study “suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions.”

This was a fascinating paper that covers a lot of the ground in Eichengreen’s magisterial Golden Fetters.  I think the paper (like the book, incidentally) has a lot to say about the current crisis, and the political implications are, I think, a little worrying.  When they argue that countries that were tied to, or late to abandon, the gold standard were the ones most likely to employ protectionist measures, they could also be arguing that countries whose exchange rates are forced untenably high are also more likely to use protectionist measures to achieve adjustment by other means.

In that sense the refusal of Asian central banks to permit the needed appreciation of their currencies against the dollar may end up having the same impact on the adjustment process of the overvalued currencies.  The 1930s seemed to show, according to the authors, that when their currencies could not adjust, countries became protectionist.  So if the overvalued dollar cannot adjust except against the euro, and if the already overvalued euro has to bear the brunt of any further adjustment, will American and European politicians be forced into the “second-best” option of trade protection?  No prizes for guessing what I think.  By the way the chorus of complaints over the currency regime seems to be getting louder.  After Paul Krugman’s piece in the New York Times last week I saw the Financial Times had a pretty strong piecetoday by Alan Beattie called “Renminbi at heart of trade imbalances.”

By the way, Douglas Paal, Taiya Smith, Michael Swaine and I will be speaking at a Carnegie Endowment event, on President Obama’s trip, to China on Thursday, November 5 from 12:15 to 2 p.m.  I have been told that it will be live-streamed and there will be opportunities for questions.  If anyone is interested he can find it here.

The release of September trade data earlier this week was pretty interesting, although because of two or three extra working days last month, plus the very big holiday at the beginning of October which might have pushed activity into September, some of the comparisons are misleading.  Exports were down 15.2% year-on-year, better than the expected 20-21%.  Imports were down 3.5%, much better than the expected 15%.  Month-on-month figures showed a rise in both imports and exports.

So much ink has been spilled in discussing these numbers that I won’t try to summarize, but it is worth noting that for many analysts the numbers were a very positive surprise.  Typical was this Reuters report reprinted in the New York Times:

China reported surprisingly strong trade figures on Wednesday, providing fresh evidence that the world’s third-largest economy is firmly on the path to recovery and that global demand is improving too.

…Brian Jackson, an economist at Royal Bank of Canada in Hong Kong, said the slower pace of decline was good news for China’s recovery because growth this year has depended too much on the government’s 4 trillion yuan ($585 billion) stimulus package.

But even in this article there were hints that the numbers, especially the import numbers, might not be as positive as expected.

Commodities were a driving force behind the sharp improvement in imports. China bought a record 64.55 million tons of iron ore in September, up 30 percent from August; imports of copper rose 23 percent.

Merrill Lynch’s October 14 research report puts it this way:  “Commodity import growth was stunning.”  Andrew Batson in an article in today’s Wall Street Journal explains why the high commodity share of imports might not be as positive an indicator of surging demand as the headline numbers suggest:

A pickup in China’s metal imports in September is stoking debate about how much of the nation’s commodity intake this year is driven by demand and how much is stockpiling that will soon end.

…The trade figures issued Wednesday showed China’s imports of copper rebounding from July and August slowdowns to post a 87% rise from a year earlier. Iron-ore imports also hit a monthly record, at 64.55 million tons in September, up 65% from a year earlier. The gains in imports defied many forecasts that purchases would slow after China took advantage of low prices early this year to build up stocks of many commodities. The data could be a signal that underlying demand for raw materials is stronger than first thought.

I read the data differently – not so much as evidence that demand is stronger then we thought but rather that real imports are weaker than we thought.  According to the October 14 research report by Mark Williams, of Capital Economics, “We do not expect the trend to last. China’s recovery is being driven by investment, but the recent pace of commodity import growth has been much faster than justified by the rise in current demand.  Inventories of many metals have more than doubled since the start of the year (copper inventories are up 500%).”

I think I agree with Mark.  I already discussed in last week’s entry the recent conversations I have had with chemical and steel analysts and investors who were puzzled by their inability to match China’s imports with any reasonable estimate of the end use of these products.  One place where we might see the discrepancy is in a rise in inventories, but although these have been rising, they haven’t been rising fast enough to account for the differences.

Are investors stockpiling?

It seems that there may be another explanation, and that is stockpiling by private investors.  From what I am being told, it seems that a number of wealthy Chinese investors have been speculating directly in commodities, and so some of this inventory buildup is occurring not at the company level but at the investor level.  The Wall Street Journal article mentions this possibility:

Copper stockpiles also have increased. Royal Bank of Scotland analysts estimate that as much as 900,000 metric tons of unreported copper stocks have built up in China this year. There has been some official purchasing by the State Reserves Bureau, but also a lot of private traders buying imported copper because it could be resold for a higher price domestically.

I have no information about how these positions might be financed, if this is true, but I would worry if they were debt financed, and I would worry even more if corporations were financing them indirectly by lending to principles.  Shang Ning, the very smart secretary of the PBoC Shadow Committee seminar I run at Peking University, has been trying to figure out ways of indirectly measuring this kind of stockpiling, but frankly we don’t as of yet have any very good ideas.

Clearly a lot of policymakers are worried about excess commodity stockpiles.  Earlier this week Bloomberg reported on plans to curb steel production.

China, the world’s largest steel producer, is working on plans to curb excess capacity as the nation faces “severe oversupply,” according to the nation’s third-largest mill.  The government may have detailed plans on how to close obsolete mills, advance mergers and reduce the number of iron ore importers by the end of the year, Deng Qilin, the general manager of Wuhan Iron & Steel Group, said in an interview.

…“The government will impose strict measures to effectively close outdated mills and boost consolidation,” Deng, also the chairman of the China Iron and Steel Association, said while attending the World Steel Association annual meeting in Beijing yesterday. “We bigger players will surely benefit from such a move.”

There is more than just steel.  An article in yesterday’s Xinhua reports the following:

The National Development and Reform Commission (NDRC) will mainly redress production overcapacity in six sectors, said Chen Bin, director of the Department of Industry of the NDRC, Thursday.  The six sectors include steel, cement, plate glass, coal-chemical industry, polycrystalline silicon and windpower equipment.

The NDRC also warns of obvious production overcapacity in sectors like electrolytic aluminum, ship manufacturing and soybean oil extraction, said Chen during an on-line interview on www.gov.cn., the website of China’s central government.  He said China would fight serious overcapacity in sectors like steel industry and offer guidance for new-born industries like windpower equipment to avoid low level repetitive construction.

China has achieved preliminary progresses in fighting the global economic downturn, but the foundation for economic recovery is not stable yet and overcapacity might lead to bankruptcy, unemployment and bad bank loans if it was not checked in time, he said.

Industrial policies create overcapacity

I agree with the last paragraph, but otherwise I am pretty skeptical about the fight against overcapacity.  According to my model of China’s overcapacity problem, the source of the imbalance is a set of industrial policies that systematically shift income from households to producers, and as long as these policies continue there is little chance of resolving the problem of excess production.  I have a longish piece coming out next month as a Carnegie Brief on the Carnegie Endowment website, in which I discuss this as part of a discussion about why I expect a rising US savings rate to lead almost inexorably to trade tensions.  Here is the relevant section from the first draft:

Although China is still a very poor country, there is no question that Chinese household income has grown substantially over the past few decades, but it has not grown nearly as quickly as GDP.  While China’s GDP grew at 11-12% over the 2002-2007 period, for example, MIT economist Yasheng Huang estimates that household income grew at a much lower 9%.  If we were able to adjust Huang’s measure to take into account changes in other forms of household wealth – which are described below – growth in household income would have been even lower.  This is why consumption has declined as a share of national income, and why China’s total production has exceeded its total consumption by a large and growing amount.  This is at the root of China’s high savings rate.

Why haven’t Chinese households maintained their share of national income?  Largely because the rise in household income was constrained, especially in the last decade, by industrial polices which were aimed at turbo-charging economic growth.  These policies systematically forced households implicitly and explicitly to subsidize otherwise-unprofitable investment in infrastructure and manufacturing.  Although these policies powered employment and manufacturing growth, they also led to wide and divergent growth rates between production and consumption.  These policies included:

• • An undervalued currency, which reduces real household wages by raising the cost of imports while subsidizing producers in the tradable goods sector.
  • Excessively low interest rates, which force households, who are mostly depositors, to subsidize the borrowing costs of borrowers, who are mostly manufacturers and include very few households, service industry companies or other net consumers.
  • A large spread between the deposit rate and the lending rate, which forces households to pay for the recapitalization of banks suffering from non-performing loans made to large manufacturers and state-owned enterprises.
  • Sluggish wage growth, perhaps caused in part by restrictions on the ability of workers to organize, which directly subsidizes employers at the cost of households.
  • Unraveling social safety nets and weak environmental restrictions, which effectively allow corporations to pass on the social cost to workers and households.
  • Other direct manufacturing subsidies, including controlled land and energy prices, which are also indirectly paid for by households

By transferring wealth from households to boost the profitability of producers, China’s ability to grow consumption in line with growth in the nation’s GDP was severely hampered.  Of course the gap between production and consumption is the savings rate, and as production surged relative to consumption, a necessary corollary was a rising Chinese savings rate.

The basic problem, then, is that there are very powerful policies that force a discrepancy in production and consumption growth, and the only way to eliminate overcapacity is by reversing these policies.  I am not sure that attempting to address overcapacity by administrative means can succeed, and certainly the track record of other efforts over the past year to address the imbalance doesn’t suggest otherwise.

The trade impact

In the steel sector here is one consequence of the continued surge in production, according to an article in this week’s Financial Times:

The unexpectedly swift recovery in China’s steel production has sparked fears that a glut of exports could puncture steel prices as the global industry struggles to emerge from the economic downturn, rival steelmakers have warned.  SK Roongta, chairman of the Steel Authority of India Ltd (Sail), said Chinese over-production was “a point of concern” for the world’s steel producers.

During the past year, producer margins have come under severe strain from falls in prices and high input costs. Global output fell more than 20 per cent in the first half of 2009.  The head of India’s largest state-owned steel group said that Chinese production accelerated 15 per cent in the past quarter, beating forecasts of just reaching double-digit growth.

“We believed that China would grow, but the growth in the past three to four months has certainly been a surprise. I’m not sure this level can be sustained,” he said.  “The magnitude of the growth is a surprise; not the growth per se.”

Meanwhile on Tuesday in the New York Times the always-perceptive David Barboza spells out very explicitly the implications in a much-discussed article titled “In Recession, China Solidifies its Lead in Global Trade”:

With the global recession making consumers and businesses more price-conscious, China is grabbing market share from its export competitors, solidifying a dominance in world trade that many economists say could last long after any economic recovery.

…China is winning a larger piece of a shrinking pie. Although world trade declined this year because of the recession, consumers are demanding lower-priced goods and Beijing, determined to keep its export machine humming, is finding a way to deliver.  The country’s factories are aggressively reducing prices — allowing China to gain ground in old markets and make inroads in new ones.

There are lots of reasons given for why China is able to increase its market share so dramatically, but there is little doubt in my mind that this process will cause rancor and increasing hostility, especially among trade competitors, and the focus will be on policies that continue to subsidize manufacturers.  Barboza goes on to say:

One reason is the ability of Chinese manufacturers to quickly slash prices by reducing wages and other costs in production zones that often rely on migrant workers.  Factory managers here say American buyers are demanding they do just that.

…Because China produces a diversified portfolio of low-priced and essential items, analysts say the country’s exports can hold up relatively well in a recession.  Few other countries can match what has come to be called the “China Price.”

“China has a huge advantage,” says Nicholas R. Lardy, an economist at the Peterson Institute for International Economics in Washington. “They can adjust to market changes very rapidly. They have flexibility in their labor markets. And as consumers trade down the quality ladder, China can benefit.”

The expiration of textile quotas in large parts of the world this year has also allowed China to increase its market penetration.  But equally important are government policies that support this country’s export sector — from Beijing keeping its currency weak against the dollar to its determination to subsidize exporters through tax credits and billions of dollars in low-interest loans from state-run banks.

Although the “wage flexibility” enjoyed by Chinese corporations may seem like a huge advantage, remember my earlier comments about how sluggish household income growth relative to GDP growth is the source of the overcapacity problem (consumption is likely to grow as fast as household income grows).  If I am right, it means that measures that can improve China’s export competitiveness are not good for the rebalancing effort if they exacerbate, rather than reverse, the process of transferring income from households to corporations.  Lower wages, of course, do just that, and so they cannot be a solution to China’s underlying overcapacity problem except to the extent that they allow China to expel trade competitors.  This is not a permanent solution by any means, especially in a world of rising trade tensions.

New loans still soaring

There are two pieces of related recent news.  The first, released on the same date as the trade data, was the PBoC announcement of new loans for the month of September.  According to an article Wednesday in Xinhua:

China’s new yuan-denominated loans in September rose to 516.7 billion yuan (75.68 billion U.S. dollars) from August’s 410.4 billion yuan, the People’s Bank of China, the central bank, said Wednesday.   New yuan-denominated loans in the first nine months stood at 8.67 trillion yuan, 5.19 trillion yuan more than the same period last year.

China’s foreign exchange reserve hit a new high of 2.2726 trillion U.S. dollars at the end of September, according to the central bank.  China’s monthly new loans had slowed from June’s high of 1.53 trillion yuan to 355.9 billion yuan in July as a result of bank contracting credit and the central bank’s open market operations. The figure rose to 410.4 billion yuan in August and then to September’s 516.7 billion yuan.

The broad measure of money supply, M2, which covers cash in circulation and all deposits, was up 29.31 percent from a year earlier to 58.54 trillion yuan at the end of September.   The narrow measure of money supply, M1 (cash in circulation plus current corporate deposits), was up 29.51 percent to 20.17 trillion yuan.

I think most people were surprised by the September net new loan number, expecting something in the RMB 450 billion range (last September total new lending was RMB 378 billion).  Although the current new lending of RMB 517 billion  is much lower than the astonishing RMB 963 billion monthly average this year, when you include the net paydown of bill financing in September of RMB 353 billion, the total new medium and long-term financing in September was actually RMB 870 billion.  This suggests that in fact September lending was equal to this year’s monthly average (especially if you think of the explosion in bill financing early this year as a form of “anticipated” lending).

Regular readers of my blog will know that I have no doubt that this kind of loan expansion can only make the overcapacity problem worse, since either it directly boosts current or future production, or, by leading to a rise in NPLs that will ultimately be paid for by Chinese households, it constrains future consumption growth. Interestingly enough, according to an analysis in Caijing, the share of new loans from the Big 4 was only 21%.  This is down substantially from 40% in August, 47% in July, and a whopping 70% in the first six months of 2009.

What gives?  For one thing, it means that most of the decline in lending from the insane levels of the first half of the year is explained by the decline in lending among the Big 4.   It is not so much that new lending is being pushed downward, since the smaller banks are increasing their lending at roughly the same rate as they have all year.

Chen Shanshan, an analyst at Bocom International Holdings, said large commercial banks scaled their lending after regulators tightened credit controls at the start of the third quarter.  Also, medium-sized banks saw their lending capabilities restrained by the tighter regulatory controls on capital requirements, he said.

“Banks are now actively selling loans,” and mostly selling them packaged as syndicated loans, an executive with a large commercial bank told Caijing.

I am not sure from this whether they are selling down to other banks or to investor groups.  Any color from any of my readers would be much appreciated.  As an aside on the reserve numbers, I haven’t done the numbers yet, and I have not had a chance to discuss this with Medley’s Logan Wright, but my initial back-of-the-envelope calculation suggests that hot money inflows may have moderated but are still positive.

The second piece of related news was the release yesterday by the US Treasury Department of its semi-annual report on exchange rate policies.  “Both the rigidity of the renminbi and the reacceleration of reserve accumulation are serious concerns which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 framework,” the report said. “The Treasury remains of the view that the renminbi is undervalued.”

While the People’s Daily headline today was “U.S. says China not currency manipulator”, and most of the focus of the article was positive (although it did acknowledge that “it also alleged that the Chinese currency renminbi’s exchange rate showed a ‘lack of flexibility’ in recent period”), the Financial Times article was a little more nuanced:

The Obama administration said on Thursday that it had “serious concerns” about the value of the renminbi, but stopped short of accusing China of manipulating its currency in a closely watched report to Congress.

The Treasury toughened its language on China in its semi-annual report on exchange rate policies. While acknowledging that Beijing had been important in steadying the global economy, it said recent moves to accumulate more foreign exchange reserves “risk unwinding some of the progress made in reducing imbalances”.

But the Treasury did not say China was manipulating its currency, in spite of pressure from US labour groups and scores of legislators who argue that the undervalued renminbi makes China’s exports unfairly cheap . Pressure has built this year as manufacturers suffer huge job losses and the US unemployment rate creeps towards 10 per cent .

I am willing to bet that over the next year or two the language gets tougher, not easier.

Finally, I saw the following very interesting article on today’s Bloomberg:

China’s Ministry of Finance is, for the first time, allowing local governments to use the proceeds of land sales to fund stimulus projects, the China Daily reported, citing a ministry circular.  Local governments are required by the end of this month to have provided 1.18 trillion yuan ($173 billion) out of the 4 trillion yuan stimulus plan announced by Premier Wen Jiabao in November, the English-language paper said. Many local governments are finding it difficult to secure funds for projects because of the economic slowdown, the newspaper said.

As Beijing slowly unlocks from its 60^th anniversary celebrations – the streets are still relatively empty but more and more people are going out, although my local Starbucks still hasn’t reopened, forcing me to go elsewhere for my hardcore caffeine fix – a lot is still going on in the rest of the world. Both the US and the IMF have come out with releases that help us to pick through the problems that China and the world are facing.

Before discussing these releases, let me make a quick digression to an event that a lot of people have been asking me about. Two weeks ago China Construction Bank announced that it would rollover 24.7 billion yuan in bonds that it had “purchased” from its AMC, Cinda, for another 10 years. Bank of China and ICBC, which sit on 473 billion yuan worth of AMC bonds, will probably do the same when their AMC bonds come due.

What does this all mean? Remember that as part of the recapitalization of the banks after the NPL fiasco of 10-15 years ago, the AMCs (asset management companies) were created to purchase and liquidate the bad debt. There is a big argument as to whether or not they took out all the garbage loans, but at any rate they bought a lot of bad debt and, since they had no assets of their own, paid for them with issues of medium term bonds, which they exchanged in two tranches. One tranche was for 100% of the face value of one portion of the bad loans they took on, and the other was for 50% of face of the rest of the bad loans they acquired.

The problem of course is that these bad loans were worth a lot less than either 100% of face or even 50% of face. In fact they have been liquidated at a rate of about 20% of face. This leaves the AMCs bankrupt and unable to repay the bonds, so when they came due the bonds were simply rolled over. There is a sort of comfort letter from the Ministry of Finance (its exact value is in dispute), so the banks have been able to get away with treating the bonds as money good. The point of all this is to remind us that all the .losses for the earlier spate of bad loans, even assuming that all the bad loans were identified and cleaned up (which I doubt) have not been resolved.

Someone (the banks? The Ministry of Finance?) will eventually have to pay up. If the process is allowed to drag on for many years, I suspect that the banks will pay out of retained earnings, but since retained earnings at the banks consist primarily of the very wide spread between the lending rates and the interest rates that banks are allowed to pay depositors, ultimately this means that households will be forced to recapitalize the banks. If there is a short term problem, however, perhaps leading to a crisis of confidence in the banks, I suspect that the MoF (unless debt at the sovereign level in the mean time becomes a problem) will explicitly guarantee the bonds or take them directly on the government balance sheet.

US unemployment picture is ugly

To return to the rest of the world, unemployment in the US is not getting better. Yesterday the Labor Department released figures that showed the US unemployment rate climbing to a fresh 26-year high of 9.8% in September. According to an article in the Financial Times:

Official figures on Friday showed that non-farm payrolls dropped by 263,000, making it the 21st consecutive month that the US economy has shed jobs. The data were worse than even the most grim expectations, as economists predicted a 175,000 drop in payrolls, and followed a decline of a revised 201,000 jobs in August when the unemployment rate was 9.7 per cent.

Although I think most economists are expecting that US economic growth in the third quarter was a fairly healthy 3%, as far as China is concerned it is not the future growth in the US economy that matters so much as future growth in US consumption. A jobless recovery in the US, if that is what we get, probably means that dragging household consumption will not be the engine of US growth, and even less will it be the engine of Asian growth, which it was for so many years. Any Asian and Chinese recovery predicated on a revival of out-of-control US consumption is likely to be disappointed.

On Thursday the IMF released its World Economic Outlook, which was mildly positive on the global economy, arguing that “the recovery has started, financial markets are healing, and in most countries growth will be positive for the rest of the year as well as in 2010,” although in line with the US employment report it worried that “the pace of recovery is expected to be slow and, for quite some time, insufficient to decrease unemployment” (later in the report they say “the current rebound will be sluggish, credit constrained, and, for quite some time, jobless”). The report also argued that because most of the “recovery” has been based on public spending and, I guess especially in Asia, gearing up capacity without much regard for demand, an economic recovery was likely to be slow and risky.

The IMF seems increasingly to be agreeing with the “global imbalances” analysis of the economy, probably to the dismay of China and other surplus countries. Early in the report it says:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand and imports.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. To accommodate the shifts on the demand side, there will need to be changes on the supply side.

Surplus countries must consume more

The interesting thing for me was this focus on surplus countries. Although there does seem to be an economic rebound, the report says, the recovery will be weak unless countries with large trade surpluses step up domestic demand. To keep growth up, surplus countries like China must boost domestic spending, and appreciate their currencies. This pretty tough claim will probably not make Beijing, Berlin or Tokyo very happy, although it does chime with US views on global trade imbalances. In their own words:

To complement efforts to repair the supply side of economies, there must also be adjustments in the pattern of global demand in order to sustain a strong recovery. Specifically, many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand—notably emerging economies in Asia and elsewhere and Germany and Japan.

This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies. In these economies, private consumption and investment are unlikely to pick up the slack that will be left by diminishing fiscal stimulus, given that household incomes and corporate profits will be subdued and balance sheet repair will be under way for some time, implying higher saving rates.

The authors of the report do not seem terribly optimistic about the prospects for a sustainable spurt in surplus-country domestic demand in the near term (“This process of rebalancing global demand will be drawn out.”) but I am not sure, perhaps because the IMF is after all a very politicized institution, that they specify the trade consequences. They acknowledge that there will be a problem with expected increases in savings in one part of the world conflicting with high savings elsewhere, and they don’t seem very optimistic about prospects for a surge in investment, but it seems to me that they shy away from working out how this will happen and how the pain will be distributed (through the trade account, I would argue).

What about overinvestment?

In a section in Chapter 4 of the report entitled “Do Precrisis Conditions Help to Predict Medium-term Output Losses?” there was an interesting discussion about the relationship between output losses associated with a crisis and pre-crisis investment levels. On especially commented on section had this:

The prominent role of investment and capital losses suggests that the level and evolution of precrisis investment would be good predictors of eventual output losses. Indeed, regression results provide strong evidence that economies with high precrisis investment-to-GDP ratios, measured as the average investment-to-GDP ratio during the three years before the crisis, tend to have large output losses.

In contrast, the investment gap, defined as the deviation from its historical average of the investment-to-GDP ratio during the three years before a crisis, is not statisti­cally significant. We return to potential interpretations of these results later in this section, but it is worth mentioning that the precrisis investment share is particularly robust as a leading indica­tor, even after controlling for the level of the current account balance. This suggests that countries that have high investment rates tend to experience larger output declines follow­ing banking crises, irrespective of whether the investment is financed by foreign or domestic savings.

For those of us who worry about China’s having recently increased its already-excessively-high investment rate, this passage was an uncomfortable read. In addition for people like me, who believe strongly that the very process of misallocated investment will act as a damper on future consumption growth (and I think this is becoming much more widely accepted, or at least discussed, in policy circles), the combination of warnings over overinvestment and pleas for more consumption from trade surplus countries is deeply worrying. By the way, for a short and quick view of why I think consumption won’t grow, you can check a recent debate held by the New York Times on the subject of Chinese consumption growth.

So what about all this excess investment? The State Council recently made a lot of noise about its determination to curb excess capacity. Here is the Financial Times version of the story:

China has issued a stark warning about the risk from rising overcapacity in the economy, saying it could hamper recovery and lead to a surge in non-performing bank loans. The State Council, the country’s cabinet, issued a new plan to combat overcapacity in seven industries, barring new aluminium smelters for three years and criticising “blind expansion” in parts of the steel and cement industries.

The cabinet statement, which came late on Tuesday evening in Beijing, follows a crescendo of warnings from senior officials. It also outlined measures to restrict manufacturing of equipment for “green” industries of wind and solar power. China’s economy has rebounded sharply in recent months due to an investment boom – much into infrastructure – fuelled by increased public spending and a surge in lending by the state-owned banks.

But over the past three months many government officials have begun to publicly warn that the credit binge could create overcapacity in heavy industry, which could produce a new round of bad bank loans.

The article in the South China Morning Post adds some color, and a partial explanation of why all these angry statements about preventing excess capacity over the past few years have had so little effect:

In unusually blunt wording, the cabinet also pointed its finger at local authorities. “Some regions have acted illegally. We are once again seeing cases of illegitimate approvals, of construction starting before it has been approved, and of construction starting even as the approval process is underway,” it said.

The cabinet’s strident warning about overcapacity underscored why officials have been circumspect about the economy, repeatedly saying that it has shown signs of recovering from the global financial crisis but is still not on solid ground.

It is hard to give up investing

The truth is everyone in the world is against the creation of “excess” capacity, but as long as Beijing has in place policies that explicitly subsidize investment and production, it will take an awful low more than fulminating against wasteful investment to eliminate it. I would argue that wasteful investment is the automatic consequence of policies that lower the cost of capital to “unreasonable” levels, implicitly socialize risk, and otherwise subsidize producers in the name of boosting employment.

Since Beijing has very explicitly chosen to attack rising unemployment in the short term – probably wisely, although also probably more ferociously than was optimal – there is little they can do to prevent a massive rise in wasteful investment. You cannot take an economy with the highest investment rate in history, and already massive waste, and very quickly force investment rates up even higher, without also increasing waste. The problem with all this wasted investment, of course, is that someone must pay for it, and that “someone” will undoubtedly be Chinese households, who will then almost certainly go on to disappoint us by failing to splurge on consumption.

And are they really serious about tackling excess capacity? Here is what Bloomberg said in an article earlier this week about the shipping industry:

China and South Korea’s support for shipbuilders may add to a glut of capacity, slowing a recovery in freight rates and vessel prices. The world’s two largest shipbuilding nations have taken steps this year to aid shipyards and safeguard jobs as customers delay or scrap orders amid tumbling world trade. That support will likely ensure more vessels enter service, even as lines mothball and scrap existing ships because of a lack of cargo.

“The Chinese and Koreans, in particular, will make sure that these ships come,” Philip Clausius, chief executive officer of lessor First Ship Lease Trust, told a conference in Singapore yesterday. The “daunting number” of ships that “will hit the market over the next three, four, five years will make the recovery a rather slow and painful one.”

China’s bid to become the largest shipbuilding nation by 2015 may also worsen the glut as it competes for market share, said Matthias Umlauf, senior economist at HSH Nordbank AG. The world’s shipyards have dry-bulk ship orders with a combined capacity of 64 percent of the existing fleet, according to data compiled by Bloomberg.

China has “the chance to become the world’s largest shipbuilding nation and they will not let this chance go,” said Umlauf. “They will support their national champions and that will definitely add to the overcapacity situation.”

As I have said many times before, I don’t see how pressures to increase savings in the US and other trade-deficit countries will not conflict with pressures in China, Germany, and other trade-surplus countries to maintain policies that force up savings rates, especially if sustainable global investment rates decline. The only outcome, I think, is increasing trade tensions. In that light, today Bloomberg reported a very worrying escalation of the conflict:

The two largest groups representing U.S. companies in China said the Asian nation has enacted a series of policies discriminating against foreign investors and imports. The U.S. Chamber of Commerce and the U.S.-China Business Council said in testimony today that Chinese contracting rules, technical standards and licensing requirements were protectionist. Chinese officials have made the same charge against the U.S. following President Barack Obama’s imposition of tariffs on Chinese tire imports.

Both organizations have previously defended China, calling it a large and growing market for U.S. exports and lobbying to fend off legislation aimed at punishing China for currency policies and government subsidies. The criticisms of the two U.S. groups reflect mounting tensions that economists said could spark a spiral of retaliatory measures between the countries.

“There are growing indications that China’s movement toward a market economy has stalled,” Jeremie Waterman, senior director for China at the U.S. Chamber of Commerce, testified to a hearing at the U.S. Trade Representative’s office today. “The voices of protectionism in both countries are on the rise.”

While the G20 leaders make reassuring noises about international trade, I think the risk of rising trade tensions have not abated at all. As I see it, everything depends on whether or not domestic Chinese polices had any role in creating the global imbalances, and if they did, then we are still in the early stages of a difficult process of assigning the costs of the global adjustment through trade.

Beijing hates when anyone suggests that Chinese policies were partly at fault for the current global imbalances, and doesn’t even like people to use the phrase “global imbalances,” but like it or not, we have to figure out whether in fact Chinese policies mattered. As I see it, China’s consumption rate, the lowest ever recorded, and it’s trade surplus, the largest as a share of global GDP ever recorded, could not help but have been caused by policies – such as an undervalued currency regime, excessively low interest rates, sluggish wage growth, unraveling social safety nets, and manufacturing subsidies – that were almost wholly under domestic control.

According to my understanding of Chinese growth, it was policies that systematically forced households implicitly and explicitly to subsidize often-otherwise-unprofitable investment and manufacturing that led to wide and divergent growth rates between production and consumption, and of course the gap between the two is the savings rate. If that is true, the stimulus package is only likely to exacerbate the domestic imbalance.

This matters because as the US begins the too-slow but irresistible process of raising its savings rate, something else must change too. At the global level savings must of course balance with investment, and with general expectations that investment will at best remain steady and probably actually decline over the next few, a rising US savings rate must result in one or more of three outcomes:

1. Total US savings do not rise – which means US GDP must contract as the savings rate rises

2. The savings rate in the rest of the world declines, or at least grows much more slowly than in the past. Since China is the country with the highest savings rate and the largest trade surplus, this means China’s savings rate will decline, and this is just another way of saying that consumption growth will surge.

3. China’s GDP grows much more slowly.

So we are left with the almost inescapable fact that if the US savings rate increases, either China (and the rest of the world, technically, but in practice mainly China) must see much faster consumption growth or the world must experience a slowdown in GDP growth.

Consumption growth determines trade tensions

How quickly can China raise its consumption growth rate? Optimists, and those who think that Beijing’s policies did not contribute to the global imbalances, believe that the fiscal and credit expansion of the past several months can cause both investment-led growth and a sustainable rise in consumption growth. Pessimists point out that it was exactly these sorts of highly inefficient investment-driven policies that left China with its savings and trade imbalances, so that intensifying them can only exacerbate the imbalances over the medium term.

If the optimists are right, and China sees a long-term and sustainable surge in consumption, most of the brunt of the global adjustment will take place in the US, and China and the rest of the world will return relatively quickly to growth. If the pessimists are right, and of course I am a pessimist, the global economy is likely to suffer a period of struggling growth as tendencies to force up global savings conflict with the tendency of global investment to decline.

In that case the main mechanism for distributing slower growth among the world’s major economies will be through international trade. Differences in the savings and investment rates in each country show up as surpluses and deficits in the trade and capital accounts. With consumption being the most valuable commodity, both trade surplus countries, with their consumption deficits, and trade deficit countries, with their consumption surpluses, will be maneuvering ferociously to access as much global consumption as they can. In that case expect a sharp and continuing rise in trade tensions. The G20’s best intentions won’t matter.

This, by the way, seems to be a repeat of the Japanese story in the 1980s and the 1990s. As regular readers of my blog know, I believe there are lessons for China from what happened to Japan after the US stock market crash in 1987 signaled the need to end Japan’s dependence on a burgeoning US trade deficit to absorb its excess capacity. Japan then, as China now, responded to the collapse in its biggest export market with a credit and fiscal expansion that at first protected Japan from the employment consequences of the contraction in US net consumption, but which ultimately may have exacerbated Japan’s imbalances and made its adjustment all the more difficult.

The Japanese parallel

I’ve been speaking to a lot of investor groups in the past month, and when I discuss the parallels between China today and Japan after the 1987 US stock market crash I am often told that the comparison isn’t useful because of one (or both) of two major differences. The first is that since China’s current consumption level is so much lower than Japan’s in 1987, it is far more reasonable to expect a surge in Chinese consumption to replace the declining US demand for Chinese excess capacity than for a surge in Japanese consumption to have done the same after 1987. Japan might not have been able to pull it off, but, they say, it is much easier for China to do so because it is so much poorer and starting from a much lower base.

The second objection – perhaps not so different from the first – is that since China is so much less developed than Japan was in 1987, an infrastructure investment surge is a lot more sustainable. After all, Japan already had great infrastructure in place at the time, so that much of its new investment after 1987 was inevitably in the form of highly wasteful “bridges to nowhere”. Since China has much lower quality infrastructure stock, they argue, there is much more it can do in the way of sustainable investment.

I am always a bit puzzled by how widely-held these views seem to be, especially in China but also abroad. The idea that being poorer makes policy easier can’t have emerged from looking at the experience of developing countries. I suspect that it arises from assuming that poverty does not represent differences in real factors – worker productivity, education, the institutional and legal framework, etc. – so much as in policy mixes.

It is true that poorer countries are able generally to achieve faster growth rates than richer countries, perhaps because they have only to play catch-up, but there is little evidence from other countries that poverty leads systematically to more profitable investment or to more sustainable consumption growth. I think both objections stem from implicit assumptions that there is some highly attractive upward limit to either consumption or infrastructure investment, and that the further away we are from that limit the stronger the attraction towards it. But if that assumption weren’t mistaken poverty should have ended long ago.

Take consumption. At the very least if consumption growth were an inverse function of wealth, or of existing consumption levels, the US would have the slowest consumption growth rate in the world and certain African or Caribbean nations would have the fastest. This clearly isn’t the case.

Household income growth determines consumption growth

I would argue instead that the growth rate in consumption is partly a function of demographics and income distribution, partly a function of the willingness of banks to increase or reduce consumer credit, and more generally a function of the growth rate of household income. Other things matter too – for example I agree with many of my colleagues in and out of China that a good health insurance system may reduce the need for Chinese households to save since it smoothes out expected health costs – but it seems to me that absolute level of wealth is almost irrelevant in determining potential consumption growth rates. Rich people, after all, seem as determined to increase their consumption as poor people (you can easily see that in the behavior of the hordes of the new wealthy in Beijing and Shanghai), although of course the goods and services they will want to buy will be very different.

In that case what really matters to Chinese consumption growth is the rate at which wages and other forms of household income grow, and the extent of implicit taxes or subsidies that penalize or favor consumption. I exclude possible growth in consumer credit because Chinese banks have never figured out how to do this without a rapid increase in non-performing loans.

Of course it is very important to remember that household income in China is not just wages. Interest on bank saving deposits is also an important source of income, as are various social transfers. There are also a variety of hidden taxes on household income – some obvious and very significant, like the low deposit rates the PBoC demands to subsidize bad lending practices and otherwise non-viable investments, others less so, like an undervalued exchange rate, which effectively creates a consumption “tax” on imported goods.

These are the things that matter. While other factors may affect consumption rates at the margin, I think it is pretty clear that the growth in total household income – wages, interest income, and other social transfers including the various “safety nets” – largely determine the growth rate in consumption in China, Japan, and in almost any country. If this is true, the relative wealth or poverty of a county says little about future consumption growth, and the fact that China is much poorer today than Japan in 1987 in no way should convince us that it will be that much easier to boost Chinese consumption.

Two asides

It is worth making two asides which may seem obvious, but are often lost in discussion. First, in discussing the resolution of global imbalances we need to take gross amounts into consideration. In other words because both the Japanese and the US economies are so much larger than China’s, and their consumption rates higher (more than twice as high, in the case of the US), a 1% slowdown in US consumption is not dissipated by a 1% growth in Chinese consumption, and a 1% increase in Japanese consumption does not have the same effect as a 1% increase in Chinese consumption. In both cases the change in Chinese consumption would have to be much greater.

Second, there is a big difference between consumption growth and growth in the consumption share of GDP, and this difference matters very much to the whole rebalancing debate. If Chinese consumption is growing at the 8-9% rate characteristic of the past several years, it still might not resolve the problem of a decline in US consumption even though by any standard that would represent a rapid rate of growth. If Chinese GDP is growing faster than this, as it has done for the same period, the imbalance is not only not being resolved, it is getting worse.

Chinese consumption, in other words, has to grow faster than Chinese production over the medium term in order replace a decline in net US consumption. High growth rates in China do not resolve the imbalance if production grows faster than consumption.

This is a very long way of saying that in comparing of policy responses the lower level of consumption in China is not at all an important difference between China today and Japan in 1987. Even if it creates more “room” for a rise in Chinese consumption than in Japanese consumption – a claim about which I am very skeptical – it does not make it any easier for Chinese consumption to rise to the challenge in a way that Japan could not. It still means very broadly that over the medium term Chinese household income will have to rise faster than Chinese GDP – something it has not been able to do at all in the last decade – in order for China to absorb the declining net demand from the US for Chinese goods once its government-fueled investment boom peters out.

But what about investment – must the government-fueled investment boom peter out? China has a much weaker and lower quality infrastructure than Japan did in 1987, so it seems a safe bet that China can sustain its investment boom for a lot longer than Japan could, right? This is the second objection to the comparison between China today and Japan in 1987.

Again, I think this is a fallacy. Let’s leave aside the obvious problem that much of China’s infrastructure investment may be wasted on spending that has no social benefit or simply is stolen, not because this is a small problem but rather because most of us would easily understand that a government debt-fueled investment boom to finance the purchase of private homes in Paris or Los Angeles or even large swimming pools and luxurious dining facilities for local municipal officials must still be repaid, and that it will be repaid out of future household income that would be better and more fairly spent on future household consumption.

The problem is that even “good” infrastructure projects, like airports, railroads and highways, also have limits. These projects have to repay their cost, including the appropriate cost of capital, because if they don’t, the payment must anyway be made out of future household income, acting as a drain on future consumption. Some projects can pay for themselves, and some might not pay for themselves directly but can increase economic value so that ultimately, by creating wealth, they effectively pay for themselves out of higher future income. In either case households are left wealthier even after paying for those projects, and so able to consume more.

Productivity matters

But does relative poverty really improve the value of these investments? It might seem obvious that taking a good railroad system in Japan and turning it into a state-of-the-art railroad system increases the value of the railroad less than taking a bad or non-existent railroad system in China and turning it into the same state-of-the-art railroad system. In that case China seems to have more scope for additional investment than Japan does.

But does it? Maybe not. Japanese labor costs a lot more than Chinese labor, and is far more productive, so it is not clear that the improvement in labor efficiency caused by the railroad investment is necessarily more valuable in China than in Japan, even though the absolute change in quality of the railroad service in China is certainly higher than in Japan in my example.

That is I think core of the problem. The scope for nominal improvement in infrastructure is certainly higher in China than in Japan, but nominal improvement doesn’t matter. It is the economic value of that improvement that matters, and the economic value of improving the railroad in China is not necessarily higher than in Japan since, for example, every hour of transportation time saved in Japan may be substantially more valuable than an hour saved in China.

In fact I would argue – as have many economists, by the way – that China’s obsession with high-technology or state-of-the art infrastructure is extremely wasteful because the benefits of the most advanced technology only justify the costs if labor productivity and labor costs are very high. This is perhaps another way of saying that China’s highly capital-intensive growth is far from optimal for China, and probably only reflects the fact that capital is so cheap in China, at least for the capital-intensive SOEs that get the bulk of bank financing. This means that achieving Japan-style levels of infrastructure are not necessarily the best way to invest in infrastructure. The optimal infrastructure level in China is lower than the optimal in Japan, so the fact that China starts from a lower base does not automatically mean that it has more scope for profitable investments.

Airports are perhaps a good way of thinking about this. China doesn’t have as many airports as Japan does (adjusting for size and population), so clearly that means that China can engage in an airport-building spree that would be folly in Japan, right? Maybe not. Chinese are far less likely to be able to afford air travel than Japanese, and are less likely to need to ship goods by air than are the Japanese, so China needs efficient air travel much less than does Japan. Simply pointing to the fact that China has fewer airports does not imply that it has more room to build airports. In fact in my opinion it is very likely that we are going see so much money spent on Chinese airports in the next few years that it is almost impossible that we will ever recoup their cost.

As an aside I am often told about, as another example of the kind of investment spending that can pull China out of the crisis, the building of “shadow” cities next to older ones, with much better facilities. Eventually everyone is expected to move out of the old city, with its less than optimal facilities, to the new state-of-the-art version. If enough cities do this, the argument goes, China can achieve huge growth rates.

Of course it can, in the short term. And if the US government were to raze Chicago and immediately rebuild it, I suppose that they could build a far more efficient city and would certainly create a huge short-term boost to the local economy (for one thing they would probably wipe out local unemployment).

Spending must be justified

But is this a good idea? If the US government were to propose doing it I am sure President Obama would meet with a storm of criticism. It would be pointed out that the increase in productivity created by this new, improved Chicago would almost certainly be only a fraction of the cost of rebuilding the city, and the difference would represent a straight increase in net indebtedness.

They would almost certainly be right. But I think this kind of activity is actually even more wasteful in China than in Chicago because much higher productivity levels in the US mean that the resulting – expensively acquired – improvements in efficiency would be more valuable in Chicago than in China. So building ultra-modern facilities may appease the pride of local officials, but it may do so at a cost far greater than its true economic benefit.

What about cases in which there is very rudimentary infrastructure that is being upgraded as part of the 2009 stimulus package? Here too I am not sure that we should be overly sanguine about the surge in infrastructure investment. China already has excellent infrastructure for such a poor country, and well before the stimulus package it was widely accepted that there had already been overbuilding, misallocated capital, and wasted investment in infrastructure. The recent surge in investment might all be for very productive purposes whose resulting increase in production will easily pay off the true, unsubsidized cost, but this is an argument that would need an awful lot of proof before I would believe it.

It is hard to imagine that a system that was already misallocating capital on a huge scale (for example by almost any reasonable standard most SOEs are value destroyers, whose viability is only assured because of input subsidies and highly subsidized borrowing costs) would suddenly, under tremendous pressure to expand investments massively and quickly – and with the understanding that all risks would be socialized – could do so without increasing the number of unprofitable investments. Maybe I will prove to be wrong, but I do think a lot of skepticism is warranted.

By the way my argument is not that “Keynesian” spending is a waste. I think its usefulness depends on existing capacity use, including employment, and can generate more value for the economy than it costs. My argument – a much more limited one – is only that infrastructure spending is not automatically more economically viable in poor countries than in rich countries. The larger possible “nominal” improvement in the quality of infrastructure will only lead to greater economic value if the poorer country is able to capture as much economic benefit from the investment as the richer country.

If labor productivity is much lower, as it is in China, it might not be able to do so. In fact I would go further. State-of-the-art infrastructure in China is almost always harder to justify economically than in Japan.

Perhaps it has been because I have been so busy in meetings and school in the past week but it seems to me that not a whole lot has happened to give us much more sense of what is happening in China since the big release of economic data by the National Bureau of Statistics on Friday 11.  As I wrote then, the data was able to confirm both those who see the stimulus package has having been a big success in protecting China from the ravages of the global economic crisis as well as those who worry that it is actually making the Chinese imbalances worse.  Both are right, in my opinion.

In that light there was an interesting article in the Financial Times suggesting that the CBRC, as it has been all year, almost alone among the official institutions, is still worrying out loud and publicly about the impact of the stimulus package on the banking system:

China’s top banking regulator on Friday warned of growing risks to the country’s financial system as a result of an unprecedented expansion in new loans and urged the country’s lenders to improve their internal management.

The statement by Liu Mingkang, chairman of the China Banking Regulatory Commission, may signal a more assertive stance from the body in the build-up to a top-level Communist party meeting scheduled for November that will set the country’s economic agenda for the coming year.

The FT quotes Mr. Liu as writing that “This year, all kinds of risks have arisen in the banking sector along with the rapid credit expansion. Banking institutions should always stick to the bottom line of compliance management, to lay a solid foundation for risk management.”

Xinhua also carried the story in an article Friday although, perhaps not surprisingly, they seemed to play it a little softer and give it a more postive spin:

China’s banking regulator has reiterated that domestic lenders should seek to enhance their risk management and stick to regulatory requirements to reduce worries over financial risks caused by rapid credit growth this year.  “With bank loans growing rapidly, all kinds of risks are rising in the banking industry”, Liu Mingkang, chairman of the China Banking Regulatory Commission, was quoted as saying by Saturday’s China Daily.

Although Mr. Liu’s statements will not come as a surprise to senior policymakers, i suspect that everyone’s attention was focused on last week’s annual plenum of the Communist Party Central Committee.  Something many people were expecting to happen did not happen, leading to a whole lot of speculation about whether or not this has significant implications for a factional disagreement within the top leadership.   The always insightful Australian journalist John Garnaut had this to say:

Palace intrigue has swept Beijing following the failure of President Hu Jintao’s assumed successor to receive a crucial promotion. Vice-President Xi Jinping was expected to be promoted to Central Military Commission deputy chairman at last week’s annual plenum of the Communist Party Central Committee.

Mr Hu was given the position at the equivalent stage of his career. Mr Xi is still considered the most likely candidate to succeed Mr Hu, but his path now appears to be contingent on a period of bruising deal-making.

I am not smart enough to say whether Xi’s failure to get the promotion was indeed as significant as many of my Chinese and foreign friends seem to think (many also disagree), but it adds to constant rumors about factional differences, disagreements among policymakers, and other noise that is clouding our ability to understand what policymakers may do next.

I have been working on a few pieces about what i am increasingly thinking as a possible global savings clash.  To summarize briefly, we know that savings and investments must balance.  If it does not balance domestically, it balances globally through adjustments in trade and capital accounts, so that countries with excess savings (over investment) export capital to countries with excess investment.  of course to do so they must also run current account surpluses.

This, in a nutshell, is the relationship between China and the US.  In China savings had reached the highest rate, probably ever recorded, while in the US savings declined to extremely low rates.  Both were possible because China ran a large and growing trade surplus with the US.

I have always argued that high Chinese savings were a result of specific industry and trade policies that favored investment and manufacturing and that subsidized them through sluggish wage growth, low deposit rates, and other “taxes” on household income.  Obviously if production grows significantly faster than consumption, the result is a rising savings rate.

That means that for global savings and investment to balance, any change in one of the major net savers or dis-savers will have an effect on others.  As i have written many times before, I expect that one consequence of the crisis will be a deleveraging of US households and an increase in the savings rate.  This can be forestalled for a while by government dis-savings, but i don’t think government borrowing can forever hold back the necessary rise in the US savings rate.

Unless global investment rises significantly, an increase in US savings must come with a decrease in non-US savings, and in practice this means Chinese savings.  If global investment declines, of course, this is even more true.  But I do not believe that it will be easy for the Chinese savings rate to decline, for all the reasons i have mentioned many times before, especially once the impact of the stimulus package wears off.

So how does this clash over global savings get resolved?  Obviously there are lots of ways it can get fixed.  One way, of course, is a completely benign surge in Chinese consumption.  Another way is a slowdown in global growth.  The first is unlikely.  The second almost by definition means a huge increase in trade tensions since it is through the trade account that the global slowdown will be distributed.  Needless to say every country will be eager to pass on the adjustment to other countries, and in this kind of fight I am afraid trade surplus countries are more vulnerable than trade deficit countries.

On a related note, several investors i have met in the past two weeks have been very worried about some seemingly bizarre reports that apparently argue that the dollar is in for a very difficult period over the next few years because of the Chinese adjustment.  As far as I understand it, the claim is being made that the Chinese trade surplus is destined to fall rapidly over the next few years.  So far so good.  I agree.

The report then argues that because of the fall in the Chinese trade surplus, the PBoC and other Chinese institutions will be buying fewer dollar assets.  Again, I agree.  This is simply the statement of an accounting identity.  But here is the bizarre part.  The report then claims that such a massive decline in dollar purchases by Chinese investors is very bearish for the dollar.  If one of the world’s biggest buyers of dollars stops buying, in other words, the dollar must decline.

On the face of it this might seem true, and even obvious, but a very quick glance at the balance of payments suggests that this view seriously confuses the nature of dollar flows.  For many years a lot of commentators argued that the dollar was destined to collapse because of the large US trade deficit, which had the effect of forcing a huge flow of dollars onto foreign investors.  Since the flow of dollars was likely to exceed the appetite for dollars, this would unquestionably put downward pressure on the dollar.

In the standard trade model this would almost certainly be true, but Jim Walker, of Asianomics, manged to undermine the argument with his “51st state” thesis.  He argued that this would only be true if the US ran a current account surplus with non-dollar bloc countries who weren’t forced to recycle their surpluses because of the nature of their currency regimes.  If they didn’t recycle, in other words, the dollar would weaken and the current account surpluses and deficits would disappear.  As long as they were forced to recycle, however, this wouldn’t occur.  If you combine all the dollar bloc countries (China, much of Latin America, etc.) into a “51st state”, Walker concluded, the US in fact ran no current account deficit and so there was no balance of payments pressure on the dollar.

I think Jim walker is right, but I also agree that when a country is running large current account deficits it is natural to worry about a depreciation in its currency as the resulting outflow through the current account leaves investors less willing to continue holding more.  That is why the new argument for dollar appreciation is, in my opinion, a little weird.  It is true that China will soon be buying a lot fewer dollars, but this will happen presumably because a rapidly declining US trade deficit is forcing the decline in the Chinese trade surplus.  That means that although the demand for dollars by foreigners will decline, it will decline at the same time and for the same reason that the supply of dollars also declines.  there isn’t likely to be any imbalance between supply and demand.

I have no idea which way the dollar is going to go over the next few years, but I am pretty sure that if it declines it will not be because the Chinese are buying fewer dollars as they recycle their smaller trade surplus.  That doesn’t make sense to me.

A lot of people, via emails, letters and phone calls, have been asking me how I can be so pessimist about consumption growth in China given the spectacular consumption growth figures coming out of China – 15.4% year to date.  An editor who asked me for a piece, after reading it also wondered if my view – that China’s GDP growth would be constrained by its consumption growth – was such a worrying thing given China’s 15% growth rate of consumption. 

The problem is that these are not consumption growth figures.  They are retail sales figures.  Fair enough, you might think, but the retail sales growth rate should still be a reasonable proxy for consumption growth.  It isn’t.  Among lots of other noise retail sales figures include government purchases and shipments to retailers even before these shipments are sold to consumers.  That makes it a very bad proxy for consumption.

Take a look why.  I took the following chart from the September 14 issue of Jim Walker’s excellent Asianomics report.  This shows retail sales for the past decade.  As you can see, first of all for all the excitement there has not been much of a surge in retail sales.  Secondly, retail sales have been supposedly growing between 13% and 24% for the past six years, which even on an inflation-adjusted basis (I assume it is inflation that explains the late 2007 and early 2008 surge) significantly exceeds GDP growth.  But if retail sales were really a decent proxy for consumption growth, it would be hard to tell from this graph that consumption has plunged as a share of GDP.

 

 

But it has.  Consumption has been growing over the past several years by about 8-9% a year, while GDP has been hurtling forward by 10-12% a year and, not surprisingly, this implies arithmetically that consumption is declining as a share of GDP.

This is supposed to be a short entry, but before closing I should discuss the recent 35% tariffs on Chinese tires imposed by the Obama administration, especially since that seems to have been one of the hottest topics of conversation today.  For nearly two years I have been arguing that the global crisis is a two-step crisis in which, as the first step, the low-saving trade-deficit countries would see an interruption in their ability to finance their consumption.  The second step would see the impact of the crisis spread to the high-savings trade-surplus countries, which were ultimately more vulnerable to a contraction in global consumption.

This spreading out would almost automatically involve, as it always has in the past, a sharp contraction in international trade and a rise in trade tensions, as the trade surplus countries responded to the contraction in external net demand by self-defensively trying to improve their ability to export excess capacity (as in Smoot-Hawley in 1930).  But this effort is doomed to failure.  Collapsing trade deficits require collapsing trade surpluses.

For me the tire dispute is par for the course and not a surprise.  US labor unions are angry that China’s cheap exchange rate and its interest rate and other subsidies to manufacturers effectively act as tariffs on imports and subsidies on exports, especially since the stimulus package seems to have added capacity unnecessarily.  China is angry that the US is imposing tariffs on its products, and wants to retaliate.

This is a dialogue of the deaf.  Many in China seem completely incapable of understanding why what it considers as purely “domestic” issues (even the currency is considered a domestic issue) should have anything to do with trade.  Many in the US see China cheating in fact but not in form, and cannot understand how slow and how difficult it will be for China to retool its economy and remove its implicit subsidies and taxes. 

Most of the press focus is on US-China disputes, and the truth is that these matter a lot because this is the most important trade relationship, but trade-surplus countries are in disputes almost everywhere.  This, in my opinion, is only likely to continue.  I suspect that we will make a concerted effort to coordinate the adjustment process only after things have gotten much worse for everybody.

P.S.  The proxy battle rages on.  I can only get through the great firewall occasionally to read or post on my blog.  My favorite proxy will be suddenly disabled, and then somehow a few hours later it begins working again.  Even when it is in theory working, it takes me an hour each time to post entries.  Other friends here complain of the same thing.  Sigh.  The good news, however, is just as I suspected and discussed last week, the reason my blog has been acting weird is not because of a hacker out to disable it.  All Wordpress blogs have been hacked, but fortunately there is an easy (apparently, but I don’t understand it) process to fix the problem, and soon one of my computer-literate friends will do so.

Regular readers of my blog will have noted all sorts of unfortunate goings on here in recent days.  It has become impossible to get into the comments section, or indeed into any other section of my blog except the front page, and so to my great dismay the excellent discussions that have been so useful for me have been temporarily halted.  I am not sure why this is the case, and now that school has started again I hope to get one of my terribly smart Peking University students to find out and fix it.  

 

Actually in recent months a large number of China scholars who I know – and me too – seem to have been targeted by very specific viruses, with emails and attachments cleverly disguised to look like something we would want to read from someone we would trust.  I am not smart enough to know what those viruses do, but I have been warned that they probably allow someone access into my computers.  

 

Perhaps for the same reason my own blog has been hacked in some way, but it seems to me that if anyone really wanted to close me down they would have closed down the blog altogether and not just the comments section, so unless there is a commenter that regularly raises the ire of some censor out there, I suspect the problem has more to do with my blog site than with any malicious intent.  Of course if my blog suddenly begins posting pornographic pictures, spewing venom, or otherwise does some unexpected and obnoxious things, please know that it was probably not me who came up with the idea.

 

I have also had a lot of trouble getting my regular proxies that allow me to jump the great firewall and post onto my blog.  That is why my posting has slowed a bit, but it seems that yesterday and today the anti-proxy regiments have been at least temporarily defeated.

 

That’s good, because of course today the National Bureau of Statistics has released a whole lot of data.  A European TV station asked me to comment on the import of the data, and while I hate to make too much of a few data points, I was able to say rather glibly that the data pretty much confirmed the hopes of the optimists as well as the fears of the pessimists.  

 

I will explain why I think this below, but I should note that most analysts were pleased with the results, and the stock market surged on the news.  The SSE Composite was up 2.2% today.  Surprisingly it was down 0.7% yesterday, suggesting that there was probably no information leakage.  Things seem to be improving on that front.

 

To summarize the data released today, manufacturing output was up by 12.3% year on year, better than last month’s 10.8% and higher than consensus, although I think last August, during the Olympics, a lot of factories were closed so that this number may not be as impressive as it seems.  Steel output was up 29% and auto production was up 90%, which as my friend Mark Williams at Capital Economics points out is not likely to soothe worries about overcapacity creation.

 

Urban fixed-asset investment was up 33.0% for the first eight months of the year, which slightly exceeded already-high estimates of 32.5%.  This suggests that it is still investment that is in the driver’s seat, as far as growth is concerned. 

 

This might not be as obvious as all that.  A lot of people were excited that retail sales climbed 15.4%, slightly higher than consensus and the highest growth rate all year after seasonal factors are stripped out, but remember that retail sales are not a very good proxy for consumption growth.  Also remember that this surge in liquidity can easily cause consumption to rise in a temporary way without indicating anything structural about changing consumption and saving patterns in China.  In 1988-89 consumption in Japan also surged, probably as a consequence of the investment boom, but it was unable to survive, if I remember correctly, the contraction in that boom in the 1990s.

 

The most interesting piece of information is that net new lending for the month was RMB 410 billion, less than half the monthly average this year (RMB 1,105 billion).  This seems small given the huge numbers we’ve seen but, as I pointed out two weeks ago, last August new lending was around RMB 272 billion, and if you strip out the bills coming due the real increase in medium- and long-term lending is closer to RMB 550-600 billion.  More importantly, RMB 410 billion is a lot more than the rumors of RMB 300 billion that had panicked the market last week. 

 

The one piece of news that everyone read as negative was the trade data.  Exports were down 23.4% and imports down 17.0%, both substantially worse than expected, although leaving the trade surplus at a still-hefty $15.7 billion, which is roughly average for the year. 

 

For the optimists, the economic numbers, with the exception of the trade data, were all positive and suggest that China is on track to recovery.  For them, the great risk to China was that the global contraction in demand would result in terrible damage to China’s export industry and, with it, would cause factory closings and soaring unemployment.  Rising unemployment would lead to a collapse in consumption, and of course would not make China’s transition easier

 

The main purpose of the stimulus package, in this view, was to forestall an economic contraction and with it the possibility that the economy would fall into an ugly process in which rising unemployment would cause a contraction in Chinese consumption which, when added to the contraction in foreign demand for Chinese exports, would push the economy into a tailspin.  In that sense the stimulus has proven to be a great success.  Chinese growth has slowed, but by a lot less than expected, and unemployment seems to be manageable.  The August data points pretty solidly to continued growth.

 

And yet, and yet….

 

For pessimists like me the global contraction underscored Chinese vulnerability to out-of-control US consumption, and the need to develop a more balanced approach in which Chinese consumers take a larger share of China’s production.  This vulnerability existed in large part because China was overly reliant on investment for its growth.  China has had probably the highest investment rate ever recorded for a large economy, and for years there has been widespread concern that much of this investment was misallocated. 

 

It is only because the cost of capital is artificially so low (thanks to Chinese households, who are forced to earn a miniscule return on their savings) that many companies are able to show profits at all.  A few months ago I wrote about an HKMA paper that suggested that the implicit interest-rate subsidy to SOEs – not relative to the “right” interest rate in China (whatever that may be but which is certainly many percentage points higher than the official lending rates) but relative to the borrowing cost of large Chinese private corporations – accounted for 100% of SOE profitability.  If China had reasonable interest rates, in other words, (and in fact there were negative real rates for much of the recent past), SOEs would on average be value destroyers.

 

This, by the way, is why China’s supposedly puzzling addiction to capital-intensive growth rather than labor-intensive growth – more befitting to an economy with lots of unskilled labor and very poor technology – is not so puzzling.  If you artificially lower the price of a particular input, it is not surprising that producers will use more of that input than might otherwise be considered optimal.  With capital practically free, capital is everyone’s favorite input in spite of incredibly low labor costs.

 

With the recent surge in government financed investment (and I include most bank lending in this category), it would be surprising to me if much of this year’s new investment were not of even lower quality than the older investment, with very low or even negative expected returns.  If this turns out to be true, it means that the only way these investments could be viable is by effectively continuing to “tax” Chinese households to subsidize state-owned enterprises and large manufacturers.  This tax of course will come mainly in the form of low wage growth and extremely low deposit rates on the savings of Chinese households.

 

This is why we all hope Chinese growth will become more reliant on rising consumption rather than on rising investment, much of which is certain to be unprofitable.  The current path requires a large trade surplus to absorb the difference between what China consumes and what it produces, but it is not clear that foreign consumers will absorb the balance.  China is trying to plug the gap by a surge in government-financed investment, but this is likely only to widen the gap in the future. 

 

So the August data suggests that while China is growing, it is actually more reliant, not less reliant, on investment.  What is worse the very poor import numbers suggest that in spite of high retail growth figures, consumption growth in China is still sluggish.

 

For the pessimists, then, the August numbers confirm that the stimulus package may be boosting production solely because of government-financed investment, and that a serious misallocation problem will result in more future pressure on Chinese households to foot the bill.  The export numbers show that China’s external accounts continue to deteriorate, and it will take more than simply an end to the global crisis to return to the good old days.

 

So who is right, the optimists or the pessimists? 

 

In fact both are right.  If the purpose of the stimulus package was solely to protect China from the immediate employment impact of the global contraction in demand, it has been an almost unqualified success.

 

But if at least part of the goal was to help China shift its unbalanced growth model to one less reliant on foreign, and especially American, consumers, it is not clear that any progress has been made.  In fact to the extent that a significant share of new investment has been wasted, it may actually make future imbalances worse.

 

China’s response to the global crisis needs to be seen as a two-part process.  The first part is to goose economic growth in response to the rapid deterioration in the external environment.  The second part is to rebalance the economy away from its excess reliance on investment and foreign demand.  The August data seem to confirm that China is very successfully managing the first part.  Whether it has made any progress on the second part is still very much open to question.