This weeks’ entry is fairly miscellaneous, a consequence both of the amount and variety of news coming out of China and my own hectic schedule, which prevents me from dealing with all of these issues in a more unified way.  Between lots of investor meetings and finishing up a number of writing commitments, I am preparing next week to go to New York and Washington for ten days.

As an aside, the timing of my trip was determined by an East Coast tour, centered on New York, which my music label, Maybe Mars, is arranging for some of the best Beijing musicians, including the surreal folk singer Xiao He, one of the most astonishing and creative musicians I have ever worked with.  For those of my regular readers based in or near New York who may be interested in checking out the Beijing new-music scene, I strongly recommend that you keep an eye out for the shows, beginning November 5 and running through the end of the month.  These guys are really good and I expect a great reaction from the New York music community.

But back to more mundane stuff.  Last week’s excellent economic numbers once again reinforced everyone’s existing prejudices.  I discussed why in a September 11 entry in response to similar numbers last month.   Those who believe that the stimulus package has essentially resolved China’s plight and eliminated its vulnerability to export demand saw the 8.9% year-on-year GDP growth rate (at the lower end of a narrow range of expectations) as proof that Chinese growth has solidly recovered.  Andy Rothman at CLSA in a research report released the following day had this interpretation:

Other than GDP coming in just under 9%, no surprises, and we agree with the NBS spokesman, who this morning said ‘the overall situation of the national economy was good.’  We maintain our forecast of about 8% GDP growth for this year, and 8-9% for 2010 (closer to 9% if you expect a US/EU recovery to generate a bit of a net exports boost for China).

He then went on to say something that puzzled me:

The fact that China’s GDP grew by 7.7% in the first nine months of the year while exports were still extremely weak (the trade surplus was US$ 135.5bn, down by US$ 45.5bn YoY) illustrates that the mainland economy is not export-led.  Net exports delivered a -47% contribution to GDP growth in the first three quarters, while final consumption accounted for 52% of growth and investment 95%.

I think almost by definition if the decline in exports had such a terrible impact on the growth rate, China must be heavily export dependent, and it was only the impact of a massive stimulus that permitted such high growth rates – in fact the IMF actually claims that 60% of Chinese growth in the past decade was explained by exports and investment in the tradable goods sector.  China, it seems to me, is heavily export dependent, and it is only the massive, and temporary, impact of the stimulus that keeps growth up.

Infrastructure spending

Although Rothman is considered to be one of the most bullish analysts on China’s medium-term prospects, he hasn’t come close to expressing the cheerleading sentiments of Fareed Zakaria, who seems to have very little doubt or worry about China’s economic trajectory.  In an article in two weeks ago in Newsweek he wrote:

The great surprise of 2009 has been the resilience of the big emerging markets—India, China, Indonesia—whose economies have stayed vibrant. But one country has not just survived but thrived: China. The Chinese economy will grow at 8.5 percent this year, exports have rebounded to where they were in early 2008, foreign-exchange reserves have hit an all-time high of $2.3 trillion, and Beijing’s stimulus package has launched the next great phase of infrastructure building in the country.

Much of this has been driven by remarkably effective government policies. Charles Kaye, CEO of the global private-equity firm Warburg Pincus, lived in Hong Kong for years. After his last trip to China a few months ago he said to me, “All other governments have responded to this crisis defensively, protecting their weak spots. China has used it to move aggressively forward.” It is fair to say that the winner of the global economic crisis is Beijing.

I am not sure China hasn’t done the same thing – protecting its own weak spots – since both the Chinese stimulus and the US stimulus essentially went to exacerbating the sources of each country’s domestic balance, US excess consumption and Chinese excess investment, but at any rate there is a 500-year or longer tradition in the West that when we write about China we are really using a mythical China to write about our own societies.  I think Zakaria’s article may be an example.  He goes on to say:

And look at the nature of China’s stimulus. Most of U.S. government spending is directed at consumption—in the form of subsidies, wages, health benefits, etc. The bulk of China’s stimulus is going toward investment for future growth: infrastructure and new technologies. Having built 21st-century infrastructure for its first-tier cities in the last decade, Beijing will now build similar facilities for the second tier.

China will spend $200 billion on railways in the next two years, much of it for high-speed rail. The Beijing-Shanghai line will cut travel times between those two cities from 10 hours to four. The United States, by contrast, has designated less than $20 billion, to be spread out over more than a dozen projects, thus guaranteeing their failure. It’s not just rail, of course. China will add 44,000 miles of new roads and 100 new airports in the next decade. And then there is shipping, where China has become the global leader. Two out of the world’s three largest ports are Shanghai and Hong Kong.

Although Zakaria’s main point may be to insist that the US is failing sufficiently to upgrade its infrastructure (a point with which I and many other people would heartily agree), the idea that therefore, and in contrast, China’s infrastructure spending is a good idea may be very mistaken.  I think China probably already has the best infrastructure in the world for its level of development, and it is not clear that spending a fortune upgrading it makes economic sense, unless you assume that every country at any low level of development has a near-infinite capacity to upgrade infrastructure.  In that light, there is an interesting article in today’s South China Morning Post on this very subject.

China’s high-speed rail network will overtake Europe as the world’s biggest by 2012, posing a threat to the country’s troubled airline industry.

The cheaper tickets and often quicker journeys to be offered by high-speed trains are expected to substantially cut the market share of domestic carriers that already face bruising competition from airline rivals.  Although still in its infancy, the mainland’s high-speed rail system will account for most of the world’s fast tracks by 2020 as Beijing accelerates a mammoth transport infrastructure programme.

Faster, faster, faster

It is easy to get excited by this building program, but are those high-speed rails, which may be fast, exciting and fun to ride, economically justified?  Even if they were justified in the US or Europe, where the economic value of every hour saved is many times the value in China, they are probably not justified in China.  After all an American might gladly pay $100 a month to cut his daily commuting time by one hour, but for most households in Beijing or Shanghai this would be the equivalent of paying one-third to one-fifth of their income – probably not worth it.  And note that I am not even mentioning one of the sub-stories in this article – that China’s airline industry may be seriously hurt by the high-speed rails even as China is splurging on a massive airport investment program.

So does it matter if we waste a little money?  Of course it does.  Remember that if the total economic benefits are less than the cost of the investment, we can’t simply assume away the difference.  We need to figure out who will pay, and it shouldn’t come as a huge surprise if Chinese households ultimately pay for this waste, as they always have, through all the “normal” channels – sluggish wage growth, very low returns on their savings, indirect taxes on income and consumption, and so on.  If they do pay, not only will this make it very hard for them to sustain the consumption splurge that we are all demanding of them, but it represents a transfer of resources from those that must pay for the railway to those that most often use it – all Chinese must pay for benefits that accrue mostly to the wealthier segments of China’s wealthiest cities.

This is a large part why many analysts are not impressed by China’s investment-driven growth.  Not only is much of it explicitly aimed at increasing production, much of the rest of it is implicitly likely to reduce consumption.  Those of us with a pessimistic outlook of course read last week’s data release differently than do those who see the numbers as evidence that the stimulus is “working”.  For example in my last two posts I discuss the risks of inventory build-up, and the increasing sense I am getting that a lot of what I expected to show up as inventory build-up may be happening outside corporate balance sheets.  In that light reader Pangea Joel left a comment on my last post that alerted me to this very interesting and very apposite article on Bloomberg:

Private investors in China, the world’s largest metals user, have stockpiled “substantial” quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd.  Pig farmers and other speculators may have amassed more than 50,000 metric tons, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, wrote in an e- mailed report after a visit to China. That’s about half the level of inventories tallied by the Shanghai Futures Exchange, which stood last week at a two-year high of 97,396 tons.

Sucden’s estimate underscores the difficulty analysts face in gauging metals demand in China amid increased speculation by retail investors, whose holdings remain outside the reporting framework undertaken by exchanges. Private investors in China also had as much as 20,000 tons of nickel, Goldwyn wrote.  “People who have nothing at all to do with the copper trade have been buying copper as a store of value, much like they would with gold,” said Jiang Mingjun, an analyst at Shanghai Oriental Futures Co.

…“Private stockpiles, built by many including the much- vaunted, pig-farming speculators, have clearly absorbed substantial quantities of metal,” Sucden’s Goldwyn said. “Much of this metal will remain out of the normal market place.”  Scotia Capital Inc. analyst Liu Na highlighted the role of Chinese pig farmers and other private speculators in the metals markets in an Aug. 17 note that cited reports from state-owned China Central Television. These speculators may become “quick sellers” if sentiment turned, Liu said in that note.

To be sure, Sucden’s Goldwyn wrote that the stockpiles of copper and nickel held by farmers and others in China may “not be ‘dumped’ back in the foreseeable future as some have recently suggested, wherever prices go.” Goldwyn didn’t give a reason.  The metals holdings by pig-farmer investors and other private speculators give “the impression that there is strong demand in China,” said Jiang at Shanghai Oriental. “But it is actually those who take a pessimistic view of the economy and are looking to preserve their wealth who are buying.”

Caution at the banks

This is something that we are all going to have to keep an eye on – an awful lot of investment has become inventory accumulation and speculative stock-piling, and this automatically increase volatility since in any downturn de-stocking exacerbates the slowdown.  Meanwhile it is not as if analysts inside China are as bubbly as those outside China.  Last week one of China’s most senior bankers gave pretty strong warnings about the impact of excessive credit expansion.  According to an article in last week’s Financial Times:

China needs an “urgent” tightening of monetary policy to prevent the huge stimulus measures introduced this year from inflating stock and property bubbles, one of the country’s leading bankers has warned.  Qin Xiao – chairman of China Merchants Bank, the country’s sixth-biggest – says in Thursday’s Financial Times that the government should not be afraid of a “moderate slowdown” in the economy.

“Monetary policy must not neglect asset-price movements,” he writes. “Therefore it is urgent that China shifts from a loose monetary policy stance to a neutral one.”  Mr Qin’s unusually frank warning comes ahead of the publication on Thursday of third-quarter gross domestic product figures that are expected to underline the rapid recovery in China’s economy, with analysts forecasting growth of nearly 9 per cent compared to last year.

This was followed by a statement by Liu Mingkang, chairman of the China Banking Regulatory Commission.  Here is Bloomberg’s take on a statement he delivered last week on the CBRC’s website:

China urged its banks to lend “reasonably” this quarter, after a surge in credit increased risks in the nation’s banking system.  The China Banking Regulatory Commission will closely monitor the impact of global capital flows and domestic policy adjustments on liquidity in the banking system, Chairman Liu Mingkang said in a statement on the regulator’s Web site today. The CBRC will ensure that “ample liquidity is always maintained,” he said.

…Commercial lenders’ bad-loan ratio dropped by 0.76 percentage point from end of last year to 1.66 percent as of Sept. 30, as non-performing loans declined by 55.8 billion yuan to 504.5 billion yuan, Liu said today. The decline masks growing risks in banks’ loan books, he said.  “Behind the ‘double-dip’ in non-performing loan data, credit risks under the rapid lending growth are accumulating,” Liu told a CBRC meeting in Beijing. The risks “need high attention and should be effectively dissolved.”

While I am on the subject, on Saturday I was discussing with Logan Wright, who co-teaches the PBoC Shadow Committee seminar I run at Peking University, the loan numbers for September.  Net new lending last month was RMB 517 billion, which when corrected for the RMB 352 billion reduction in discounted bills and a RMB 211 billion increase in short-term loans represented a very strong increase of medium- and long-term lending of RMB 657 billion.

Logan told me that of the new lending number, the Big Four banks and the largest national banks only accounted for around RMB 125 billion (RMB 110 billion and RMB 15 billion respectively).  They also accounted for most of the run-off in discounted bills.

This means that most of the new lending, especially the net increase in risk, took place elsewhere.  Where?  Mostly, it seems, in the smaller city banks and cooperatives.  Since these are the banks most directly under the control of the city and local governments, it seems that these are at the forefront of the fiscal and credit expansion – in line with some of the other stories I have been relaying about the difficulty local governments have been having in financing their share of the fiscal expansion.

College blues

I am just guessing, of course, but I wonder if in the next few years as the growth benefits of the fiscal stimulus package wears out we might not see a rapid consolidation in the banking industry as the healthier (less sickly?) large banks are “encouraged” to absorb the smaller banks, struggling with the legacies of the loan boom.  I think there is already some sense of that process occurring among the leadership, although in general I don’t get the impression that anyone in a senior position has a clear sense of what China’s exit strategy is likely to be.  In fact the impression I get is that leaders are basically responding to day-to-day changes without any clear sense of what is likely to happen next.  That is not necessarily a bad thing, of course, but I suggest that foreign analysts who speak feverishly of a great master plan to protect China from the consequences of the crisis may be a little overexcited.

Thee final points.  First, there was an interesting article last week in Asia Times on rising graduate unemployment which, as regular readers know, was a problem even before the crisis hit and which is becoming more serious:

An explosive report released by the Chinese Academy of Social Sciences (CASS) in September said earnings of graduates were now at par and even lower than those of migrant laborers. The news came as a blow to many high-aspiring parents and youngsters in a country that has for centuries prided itself on cultivating elite Confucian intelligentsia.

Some 6.1 million graduates entered the job market this summer, 540,000 more than last year. In 2008 the employment rate for graduates was less than 70%. This year nearly two million of graduates, many of them postgraduate diploma holders, are expected to be left without job placements.

University education is one of the most widely-accepted, and only, forms of upward social mobility in China, so it is a worrying thing that the benefits of college education are seriously undermined.

Second, currency intervention is back in the news, but this time among Asian countries worried about intra-regional currency fluctuations.  Although the biggest story is the decline in trade deficits and the impact that must have on the aggregate of trade surpluses, an almost-equally important story must be the maneuvering among trade surplus countries to increase or protect their share of the trade deficits.  This maneuvering necessarily includes rival currency-management strategies.  Here is the Financial Times on the subject:

China, Japan and other east Asian countries must have “serious” talks on currency co-operation to prevent a recurrence of violent fluctuations that have raised trade tensions in the region, said the president of the Asian Development Bank on Sunday. Haruhiko Kuroda said currency movements threatened the growth of trade between Asian countries, widely regarded as a key way of reducing the region’s reliance on exports to the US and Europe.

…The yen has strengthened to near-record levels against the US dollar since the beginning of the global financial crisis. Many other Asian currencies initially depreciated against the dollar and yen but later strengthened against the weakening dollar and the renminbi.  Traders say Thailand, Malaysia and Singapore are among east Asian countries that have intervened in currency markets recently to try to slow the appreciation of their currencies.

And third, I spend a lot of time talking to large hedge funds and institutional investors – with at least three or four one-on-one meetings a week – on China and market conditions.  It worries me that recently I have heard investors say many times, generally very sophisticated investors, that we are clearly in a bubble and the best strategy is to ride it out as long as we can.  This has almost become one of the mantras of sophisticated investors – the less sophisticated, I guess, assuming that the crisis is safely behind us.

It worries me because of course we can’t all collectively ride the bubble and bail out before everyone else does.  I wonder if this means that an awful lot of the big funds can be expected to rush to the doors at the same time when things turn bleak.  If so, of course, that means we are likely to see both the upside and the downside market risks increase.  Several of my fund management friends have insisted the problem has to do with the nature of hedge fund compensation.  Most of the hedge funds were hurt pretty badly in the financial crisis, but a very large number of them were very pleasantly surprised by how quickly they’ve been able to make back a substantial share of their losses.

This means that recovering the high-water mark, which many thought would take years, has suddenly become a lot easier, and many expect that if the markets go on as they have been doing for another year or so they’ll be back in business (that is, able to charge performance fees once again).  This may create a natural, albeit dangerous, incentive to take big risks on the likelihood of a rapid recovery.

By coincidence I had two OpEd pieces that came out last week, one in the WSJ and the other in the Financial Times.  The latter came about because about a month ago Martin Wolf asked me to write a piece based on my June 20 entry.  The former came about on the previous Friday when I was thinking about last week’s SED meeting and why I wasn’t expecting much to come from it.  Although they are very different pieces, both of them build on this idea that the inversion of the consumption/GDP growth relationship in the US has important implications for China’s future GDP growth. 

For the WSJ piece I start by pointing out that when the Japanese and German currencies soared in value against the dollar after the Plaza Accords were signed in September 1985, many analysts thought that at long last their trade surpluses with the US would decline.  They were partly right in the sense that the German trade surplus with the US did indeed decline.  But in spite of the fact that the value of the yen doubled, Japan’s trade surplus nonetheless surged. 

I don’t think this should have come as a surprise.  There is a tendency to think that the value of the currency and the level of import and export tariffs are the main policy tools affecting the trade balance, and so absent a change in tariffs, any increase in the value of a country’s currency will automatically lead to a decline in its trade surplus.   

Trade surplus

In fact the trade surplus reflects the gap between what a country produces and what it consumes, and so anything that affects that gap is implicitly a trade policy.  I discussed this in some depth in my June 3rd entry. 

In the case of Japan in the post-Plaza Accords environment, the Ministry of Finance and the Bank of Japan responded to the currency agreement by directing a flood of low-interest credit into the manufacturing sector while informally guaranteeing borrowers, so assuring lenders that profitability was irrelevant in determining the flow of credit.  Sound familiar?  As a consequence Japanese manufacturers increased their production even as the flow of funding into the manufacturing sector and traditional constraints on household consumption forced an increase in the gap between Japanese production and Japanese consumption.  The result: a rising trade surplus.   

By the way I have been reading Akio Mikuni and R. Taggart Murphy’s Japan’s Policy Trap: Dollars, Deflation, and the Crisis of Japanese Finance, an interesting book that covers a lot of this ground.  I recommend it to China watchers, although I am no expert on Japan and I did have a big problem with the often-repeated assertion (and one that often pops up in discussions about China) that because Japanese trade was not denominated in yen the Bank of Japan was forced to accumulate dollars.  In fact it doesn’t matter what currency your trade is denominated in – if you run a net current and capital account surplus, your central bank must accumulate foreign currency.  Had trade been denominated in yen foreign buyers would still have had to convert dollars to yen with the Bank of Japan in order to make their purchases. 

But that is a digression, and aside from a few irrelevant disagreements I think the book is quite illuminating.  In China, like in Japan during the 1980s, there are a number of factors besides the value of the currency that affect the country’s trade account, and even if the value of the Chinese yuan rises, it will not automatically lead to a decline in China’s trade surplus commensurate with the contraction in global trade, especially if it is matched by a significant credit expansion to the manufacturing sector. 

Several policies are aimed at boosting production besides the undervalued currency.  As I have discussed before, these include very low lending rates enforced by the People’s Bank of China, energy and commodity subsidies, and probably most importantly, a flood of credit aimed at investment both in infrastructure and in the manufacturing sector.  At the same time very low deposit rates, constraints on consumer financing, and low wages, among other factors, prevent consumption from growing at nearly the pace necessary to absorb everything that China produces.   

As an aside MacQuarie’s Paul Cavey has a very interesting OpEd piece in last week’s Wall Street Journal, based on a longer research piece which I am not able to link.  Among other things he argues that although China has run negative interest rates for much of recent history, until last year there was no credit bubble because credit was rationed – and credit rationing implicitly raises the cost of capital for the system, even if interest rates are nominally low.  Recent conditions, however, are different, and all rationing has disappeared with the explosion in credit of the past eight months.  Cavey concludes: 

It’s not impossible for Beijing to take away the punch bowl of credit. There is plenty of room to defy the skeptics and in the next few months and push through structural reforms. For instance, some of the privileges state-owned enterprises continue to enjoy in terms of the ability to provide domestic services like banking and telecoms could be dismantled, allowing the country’s more productive private sector to thrive in local markets rather than just overseas. But without such changes China will be relying on growth financed by cheap domestic debt. This means China will be decoupling itself from the U.S. consumer, but at the cost of a credit bubble. 

China’s consumption will rise 

So to return to the main story, with the credit expansion and other measures aimed at boosting production, will China’s trade surplus soar?  Probably not.  Every trade surplus requires a trade deficit elsewhere, and as the leading trade deficit country, policies in the US that affect the gap between consumption and production will also determine the size of the US trade deficit.  If the Obama administration is successful in forcing a rise in US savings levels, and even if it is not (since in the short term US households have no choice but to increase their savings rates), US consumption must grow more slowly than US production and the US trade deficit will narrow, except in the very unlikely case that US investment soars – investment would have to grow faster than savings to keep the trade deficit from contracting. 

For China this almost certainly forces the country into either of these two outcomes  

1.  The government continues the current fiscal expansion forever, in which a huge expansion in government-led investment pushes growth forward.   

2.  The consumption rate in China must rise as a share of GDP. 

There are at least three problems with the first option.  First, a significant portion of the fiscal stimulus (and almost certainly a higher share than reported) is directed into manufacturing in the tradable goods sector, which needs anyway to be absorbed by rising consumption, either in China or globally.  Second, given the inefficiency of the current fiscal and credit expansion, and the concomitant rapidly rising direct and contingent government debt, there is a real question as to whether this program can be sustained for more than one or two years.   

And third, and this seems to be the most confusing point for some, the economic purpose of investment is to increase future production, and even if the fiscal stimulus turns out to be hugely efficient (it isn’t), without a surge in future domestic consumption to absorb the additional Chinese capacity we will still be stuck with the need for a massive return to US profligacy, and Chinese funding of that profligacy, to absorb the increased production.  

The first option, in other words, is at best possible for a very short time, and ultimately we are forced into the second option: Chinese consumption must rise as a share of GDP, or to put it another way, Chinese GDP must grow more slowly than consumption.   

So why should the US care what China does to rebalance its trade if changes in US consumption will force a rebalancing anyway?  Isn’t discussion and coordination pretty much unnecessary if a rising savings rate in the US must ultimately force an adjustment on China?   

No.  US and Chinese policies matter because there are many ways that international trade can rebalance.  In the US we will see consumption grow more slowly that production, just as in China we will see consumption growth outpace production growth.   

Both will happen, but in both countries there is a good scenario and a bad scenario.  The good scenario for the US would see some growth in consumption buttressing healthier GDP growth.  But the bad scenario would involve a contraction in GDP driven by even faster contraction in consumption.  For China a good scenario would involve surging consumption driving slightly slower GDP growth, and a bad scenario would consist of slow consumption growth dragging down GDP growth.   

If China continues to pump out capacity and tries to export this excess abroad, and if US household savings rise much more quickly than US fiscal dis-saving (borrowing), we will almost certainly see the bad case scenario occur, at least in China, and especially if it leads to trade friction around the world.  The nightmare scenario is that in the US a still-high trade deficit prevents a slowdown in consumption from nonetheless causing a sharp slowdown in economic growth, which leads to rising unemployment, which causes consumption to slow down even further.  Meanwhile in China rising inventories eventually lead to cutbacks in production, which also lead to rising unemployment. 

As fewer Chinese get jobs, the unemployed consume less, and the employed also try to increase their savings because of rising uncertainty.  Since net Chinese savings must decline if net US savings rise (note I am assuming the rest of the world, including sustained investment levels, is constant, but I suspect the impact of the rest of the world will actually be adverse), the only way for this to happen if the Chinese savings rates rises is either for a burst of inefficient and unsustainable debt-fueled investment by the government, or for GDP growth actually to slow sharply. 

I know all this sounds drastic, but the imbalances have to be worked out one way or the other.  Rising savings in one part of the world, even assuming no changein global investment, requires declining savings somewhere else, and although it may be unrealistic to expect no change in global investment, the plausible prediction is that global investment will actually decline, which increases the pressure.  This is just another way of saying that changes in trade deficits in one part of the world require equal changes in trade surpluses elsewhere.  This is also just the obverse of saying that declining consumption in one part of the world requires rising consumption elsewhere (or sharply rising investment, which since it represents future production only postpones the need for consumption growth) or else global GDP must contract. 

Uncoordinated policies 

What will determine whether or not the two countries follow the good scenario or the bad scenario?  Clearly fiscal and monetary policies in both countries will matter because they will set the speed of the adjustment and they may or may not speed up the adjustment process. 

In the US, fiscal expansion is aimed primarily at slowing the pace of demand contraction.  This may be necessary since I expect US consumption will grow slower than US GDP for many years, but it comes at the expense of a rising fiscal debt.  I am not as worried as many others seem to be about US fiscal indebtedness and I am certainly not worried about the ability of the US to fund its debt, especially since the stock of debt in the US is declining (private debt is dropping faster than public is rising).  As I have argued many times, I also think all the fear-mongering about whether or not China and other foreigners will continue to fund the US fiscal deficit is totally muddled thinking and among the least important things to worry about.  Foreigners will and must fund the US current account deficit, and the bigger the deficit the more they will fund – so really we actually want foreigner to reduce their funding.  

But there are reasonable limits to how much debt we want to see in the US, and we certainly don’t want to see a continuation of the global imbalances in which the debt-fueled consumption binge of US households is simply replaced by the a debt-fueled consumption binge by the US government, especially since as long as the trade deficit is high a large part of the job-creating aspect of US fiscal deficits will leak abroad, requiring even larger US fiscal deficits.  In addition, the US fiscal program should be accompanied by specific measures aimed at increasing US household savings – I am not able here to go into much detail on how to do this (and I am no expert on the subject), but for example perhaps we can eliminate taxes on interest income, raise consumption or gasoline taxes, and so on. 

Of course forcing an increase in US savings means improving the long-term US outlook while hurting short-term prospects for employment.  Rising US savings means declining consumption growth, and remember that US GDP growth will be less than growth in US demand for the next few years as US debt levels decline.   

I think China will face an even more drastic version of this trade-off, and this is because, as I have been arguing for two years, contractions in global demand force the most difficult adjustments not on the “sinful” low-savings trade-deficit countries but rather on the “virtuous” high-savings trade-surplus countries.  China needs to cut capacity drastically and put into place the factors that will lead to a rise in net consumption, but most of these policies will actually hurt employment in the short term.  I have already discussed what these policies are likely to be in my June 3rd entry, and almost all of them will almost by definition force a contraction in the tradable goods sector. 

China’s problems will be made much worse if it is forced to cut capacity very quickly, which will happen if trade disputes get worse.  Already disputes with Asian neighbors are pretty nasty, and they are likely to get worse with the US and Europe.  There has been a lot of discussion recently about China turning to other developing countries as sources of net demand to replace the US, but this is unlikely.  Aside from the fact that no one is large enough, none has the ability to run persistent trade deficits.  China can fund these deficits for a while, but it will learn, as many have before it, that funding persistent current account deficits for developing countries eventually leads to defaults on the debt. 

So after all the premable on what do I think the SED discussions should focus?  Since this entry is long enough already I will postpone that part of my discussion for a couple of days. 

Some of the blog readers have noticed some weird goings-on with recent entries.  From time to time an entry will pop up that seems totally inappropriate to current events.   

Sorry.  This is because the old host of my blog, when it was on a different site, is closing down, and I have been going through the time-consuming and boring task of trying to take as many entries as I can from the old site and posting them in the archives on this site.  The repetitive nature of this process leads me sometimes to forget to post the original date of the entry, in which case it shows up as the current entry until I see the mistake and change it. 

I am still planning to post the longish piece I wrote, on my view of what the SED discussions should have been about.  However since I am beginning tomorrow an eight-day trip organized by two different banks to meet with and speak to their clients (full disclosure: since one of the meetings is in Bangkok I am sneaking out to Phuket for a couple of days to get in some beach time), I thought I would save that post for during my trip and talk about a few other interesting things. 

First off, a lot of investors and government officals have recently been trudging to Beijing in spite of the heat and mugginess and seem to be eager to discuss the outlook for China.  Perhaps because the press, and more importantly a lot of Chinese academics and think tank types, are beginning to worry much more in public about the medium term outlook, the conversations seem to be a lot more worried than they have in the past.  On my upcoming trip I hope to get some more idea of what big investors are thinking, and if I am allowed to repeat their views, I will. 

Next, I see that recent US GDP numbers are getting a mixed reception.  Second quarter GDP contracted by an annualized 1.0%.  That isn’t a good thing, of course, but it is much better than the 6.4% contraction in the first quarter, and also better than the 1.5% contraction that the market was expecting.  According to an article in today’s Financial Times: 

While the contraction was much smaller than in the previous three quarters and slightly better than economists had expected, the data showed that the government stimulus and a slowdown in imports had cushioned the drop.  

Of course most analysts continue to be worried about, and debate, whether the US is better off slowing the stimulus, and so reducing debt while speeding up the needed adjustments at the cost of higher unemployment, or continuing pushing forward – a debate very similar to that taking place in China.  Given my focus on China my main concern – no big surprise – was US consumption, which declined by more than GDP, which I expect to be a regular feature of the next few years. 

Consumer spending, which represents about two-thirds of GDP and has traditionally been the engine of US growth, fell a much worse-than-expected 1.2 per cent as Americans continued to cut back in the face of rising unemployment and the falling value of their homes and investments. 

In Japan, a country that I am spending more and more time learning about because of some worrying parallels between their 1980s and China’s current condition, the numbers continue to be very poor.  Again the Financial Times today tells the story: 

Wages in Japan suffered their sharpest drop in nearly two decades in June, fuelling concerns that the economy would remain under pressure from depressed consumer spending.  Monthly wages, including overtime and bonuses dropped 7.1 per cent from a year earlier for the 13th decline in a row to Y430,620, according to the Labour Ministry.  It was the steepest drop in wages since the government began compiling data in 1990. 

Wages in China, on the other hand, seem to moving in a very different direction – no surprise, I think, given the extent of the stimulus package.  Here is what Xinhua said on Wednesday: 

Average wage per capita for Chinese urban employees grew 12.9 percent year on year to 14,638 yuan (about 2,149.78 U.S. dollars) in the first half of this year, said the National Bureau of Statistics Wednesday.  The growth rate was 5.1 percentage points lower than that in the same period last year, the bureau said.  

Even acknowledging all the distortions, and recognizing that this year’s growth rate in wages was much lower than last year’s (will this put pressure on consumption growth?), this still seems like a very healthy growth rate.  Funnily enough however the numbers were questioned in, of all places, today’s People’s Daily.  In their article they had this to say: 

Banter and sarcasm erupted in the wake of a National Bureau of Statistics (NBS) report Wednesday saying the average pre-tax wage per capita for urban employees grew 12.9 percent, year-on-year, to 14,638 yuan (2,142.43 U.S. dollars) in the first half of this year.

The seemingly inspiring and encouraging news did not draw much applause, but a hail of criticism from the public, with many being skeptical of the figures’ credibility. The term: “I’ve been given a raise,” referring to the furor over the NBS’s statistics, has become increasingly popular among China’s mass of Internet users.

On the popular online forum tianya.cn, a commentary read, “The statistics released by the NBS are miraculous, as the increase managed to surpass the GDP growth of 7.9 percent registered in the second quarter against a backdrop of the global financial crisis.”  However, the poster noted, most people’s pockets remain shallow.

…A poll on tom.com showed as many as 88 percent of 2,816 respondents believed it is reasonable to doubt the income rise announced by the NBS. 

I was impressed by the fact that the article just reported the skepticism and didn’t make much more than a very half-hearted attempt to explain why the public is wrong to be skeptical.  As an aside, in recent weeks it seems to me that there has been an increasingly heated, but not always on-the-record, debate about the conflicts and contradictions implied by official Chinese growth numbers and other indirect measures of growth – with Marc Faber last week giving an especially blunt assessment.  I have been hearing from a lot of Chinese and foreign colleagues about challenges to the data, and although I am not smart enough to contribute much to this debate, I expect it to become more public – already there have been several articles in the Chinese press referring obliquely to disagreements about the data and defending the quality of the NBS statistics.  Perhaps the People’s Daily is now leading the charge for prosecution? 

Speaking of prosecution in the Chinese press, Caijing continues to feature a series of excellent articles questioning the impact of the stimulus package.  I won’t summarize them all, but I found this article in this week’s issue, by Chen Changhua, interesting: 

Through bank lending and money supply, liquidity has been ample in the market. However, nominal GDP growth lagged far behind the growth in lending and money supply, which could raise suspicion that a large portion of the funding has entered asset markets. 

In the next one or two years, the global economy won’t be able to recover and, due to overcapacity, consumer price index (CPI) will not be able to rise sharply. Even if the central bank wants to tighten money supply then, various aspects of society won’t support it. It’s no longer a question of whether the central bank should rein in its loose monetary policy, but whether or not it will actually do it. 

China’s fiscal and monetary policies in the past few years have placed growth before anything else. It is unlikely that the Chinese government will raise interest rates when economic recovery has not yet been secured.  

Chen’s basic argument is that policymakers should be encouraging private enterprises to compete with SOE’s because when the “bubble implosion” occurs (he doesn’t seem to think that the “if” is worth pondering), China will be better served by the productivity-enhancing private sector: 

How quickly a country can recover from an economic slump is determined by the productivity of the country. Japan has not been able to recover from the 1990 slump mainly because there are not enough competitive new-generation enterprises to replace old enterprises.    

If it is difficult to avert a new round of asset bubbles, then opening domestic markets to private enterprises is a good option.  In the past few years, state-owned enterprises have become larger and stronger while playing the role of the offense while private enterprises have been on defense. Maybe it’s just a hope of mine that private enterprises will muster their forces soon as well. 

One of the big worries about the stimulus, of course, is that it is forcing a further concentration of credit and economic activity into the SOEs, who are among the least productive players in the Chinese economy – even when you don’t question whether or not their profits are real or simply a function of highly subsidized interest rates.   

Meanwhile the debate about the duration of the fiscal stimulus rages on.  On the one hand Andy Xie, former chief Asian economist for Morgan Stanley, and someone well plugged into Chinese policymaking circles, said in an interview with Bloomberg: 

“The government is worried that this bubble is becoming too big so they’re going to cut credit growth by probably half in the second half,” said Xie, now an independent economist, in a Bloomberg Television interview in Hong Kong today. “I think the property and stock markets will come under pressure probably around October time.”  

China’s banking regulator said yesterday it plans to tighten rules on work capital loans, seeking to prevent misuse of funds. New loans in July may be less than 500 billion yuan, the Shanghai Securities News reported on its front page, without saying where it got its information.  

It’s “undeniable” that a portion of this year’s new lending entered the nation’s stock and property markets, Cheng Siwei, former vice chairman of the standing committee of the National People’s Congress, China’s parliament, said in June.  

On the other hand Vice Premier Li Keqiang (a graduate of Peking University, I am proud to say) wrote recently in Qiushi, according to an article in today’s Bloomberg: 

China will maintain its “proactive” fiscal and “moderately loose” monetary policies to help the economy recover from a slump, according to Vice Premier Li Keqiang.  The foundations of the recovery aren’t yet solid enough, as evidenced by the continued slide in exports, lower corporate earnings, falling prices and industry overcapacity, Li wrote in the Aug. 1 issue of Qiushi, a twice-monthly Communist Party magazine.  

The outlook for the global economy is still uncertain and recovery is being hampered by rising trade and investment protectionism around the world, Li wrote. There’s been no “fundamental change” to the dollar’s dominant position in the international financial system, though the trend of diversifying away from the greenback will continue, he added.  

Finally, and on a separate point, like me Nouriel Roubini has been wondering about the impact of recent Chinese commodity stockpiling.  According to an article in Reuters today he gave a speech in which he discussed the impact of future commodity prices.  Among other things he said: 

“In the short term there has been a massive stockpiling of commodities by China,” he said. “My concern is that China might have accumulated an inventory of commodities that is probably excessive to the growth of their own economy.” 

I agree.  I am pretty sure that a lot of recent purchases represent many quarters and even years of future demand, and so they are distorting the trade numbers by implying the country is importing more than current demand implies.  By the way for those interested in my argument as to why China should not be stockpiling commodities quite so quickly, here is today’s version of my bi-weekly column for the South China Morning Post.

My blog has been blocked in China.  Given all the internet blocking that has happened in the past few months I guess this is not much of a surprise, and I was sort of waiting for it to happen, even while I was hoping that it wouldn’t.

I think after a few months – probably once the 60th anniversary of the founding of the People’s Republic on October 1, 1949, is truly behind us – they will begin unblocking sites and my students once again will be able to read my blog without having to jump through all the proxy hoops.  On a related note I was pretty pleased when Doug Paal, one of my Carnegie Endowment associates, told me yesterday that certain local policy analysts with whom he had recently met told him that they had been reading my blog and found it useful, but unless they are allowed to use proxies in government offices I guess whatever use I may have provided will be dramatically reduced.

Because I picked up a flu a couple of days ago (no, not swine flu), and so have been working much shorter hours, I haven’t really been able to comment on all the economic news that has come out recently.  Since if I am feeling better I plan to go to Wuhan tomorrow and Shanghai Saturday to see some of my Beijing bands perform a couple of big shows, I figured I would make a few comments today before going home to recuperate.

The first comment is about reserves.  Chinese central bank reserves surged in the second quarter of the this year, with evidence suggesting that we are once again seeing a flood of hot money pouring into the country.  According to an article in today’s South China Morning Post:

This is not a surprise.  With optimism returning to China, and with stronger real estate and stock markets, investors are bringing money back into the country.  Hot money, of course, is intensely pro-cyclical, and its effect will be to intensify growth in the short term, even as it increases volatility and makes monetary policy more difficult.  Remember that the PBoC must recycle the net surplus on the current account and the capital account, and with the very high current account surplus, China would be creating a huge amount of domestic money just from that source.  The fact that it is also running a large capital account surplus makes the PBoC’s monetary management that much more difficult.  Worst of all is that as long as this fiscal-stimulus-induced boom continues, hot money inflows will heat things up even more, but once the government is forced to scale down the stimulus, the resulting slowdown in the Chinese economy will likely be seriously exacerbated by hot money outflows.  The PBoC has a lot of difficult work to do.

One thing that many observers noticed is that the huge jump in reserves means that China must continue buying US Treasury bonds, and of course this still seems to promote very muddled thinking among the cognoscenti.  For example today’s Bloomberg had an article which argues that:

No, no, no.  The fact that China’s reserves have surged will in no way make it easier for the US to fund its fiscal deficit even though, as I have argued for a very long time, China has no choice but to invest these additional reserves in US Treasury bonds.

Why?  Because besides valuation changes and interest income there are two reasons for the increase in the reserves – the very high trade surplus and net capital inflows into China.  Take the second reason first.  If money flows into China for investment purposes, it must flow out of somewhere else, and that somewhere else for the most part means the global pool of dollar savings which would anyway have been available to fund the US fiscal deficit directly or indirectly.

In that sense China is acting as kind of upside-down bank that takes risk-seeking money and intermediates it into low-risk assets – as an aside almost the opposite of what the US does, and whereas the US profits from this intermediation, China runs a significant negative carry.  Of course the fact of intermediating risk money into low-risk assets will have some impact on US Treasury rates, but the impact is minimal (technically risk-free rates will decline a tiny bit and credit spreads will increase by the same amount).

What about the dollars generated from the trade surplus and invested into US Treasury bonds?  Won’t that help the US fund its fiscal deficit? 

Again the answer is no.  The US government is not borrowing for abstract reasons, but rather is borrowing in order to spend locally to generate domestic employment.  The amount of borrowing it needs to generate a fixed amount of domestic jobs is correlated with the US trade deficit, because it is through the trade deficit that domestic consumption “leaks out” to create jobs abroad.  The higher the trade deficit, in other words, the more the US government needs to borrow to generate a fixed number of American jobs, and so the fact that China is reinvesting the dollars generated by the trade surplus with the US does not make it easier for the US to borrow since it simultaneously requires the US to borrow more.

Remember that China does not fund the US fiscal deficit.  It funds the US current account deficit, and it has no choice but to fund it.  In fact this is true for every country – foreigners must fund current account deficits, and they do not fund fiscal deficits.  To breathe a sigh of relief because a very high Chinese trade surplus means that China will buy a lot of US Treasury bonds is no different from breathing a sigh of relief because the US is running a very large trade deficit.  As I have said many times before, if the US wants China to buy $1 trillion of new bonds every year all it has to do is ensure that the US runs a $1 trillion trade deficit with China every year.

My second comment is about the GDP growth numbers, which are both a cause and partial consequence of hot money inflows.  As a Bloomberg article today reports:

Besides the fact that I don’t see a turnaround in the global economy, and in fact I think China will be among the last countries to escape from the effects of the global crisis, I have a small problem with the earlier claim that China is “the biggest contributor to global growth.”  This is true if a country’s contribution was simply the number we get when we algebraically calculate global growth (each country’s GDP growth multiplied by its share of global GDP).

But with the largest trade surplus in the world, and remembering that the trade surplus represents negative net demand, I would argue that if you want to contribute to global growth in a world of excess supply and collapsing demand, you do so by increasing your net demand, or in this case by reducing your negative net demand.  One of my friends, a government official from a neighboring Asian country, told me furiously last week that through its aggressive export policies China is simply expropriating growth from other Asian countries.  I am not sure if I completely agree with him, but I suspect that he would be even more furious to hear that China was the greatest contributor to global growth.

Was China’s “surprisingly” high GDP growth numbers a big surprise?  Not really.  I have argued several times since last year that in fact China can achieve very high growth numbers by throwing a huge amount of resources into achieving short-term growth, but the real question is whether these policies are sustainable and whether the kind of growth they achieve is in China’s best interest.

In my opinion, these policies involve such a huge expansion in fiscal debt and especially in new bank lending that they are certainly not sustainable.  Even without including the almost certain surge in future NPLs caused by the unprecedented explosion in new lending, China’s debt is much higher than people think and it is growing quickly.  There is a limit to how much further the fiscal expansion and the surge in bank lending (which amounts to the same thing) can go on.

Furthermore I think the focus on investment in infrastructure and manufacturing will make much more difficult China’s ultimate transition towards an economy in which surging debt-fueled US household consumption plays a much smaller role.  In addition much of this new investment is in projects with very low, or even negative, returns (and I suspect they would almost all be negative if interest rates weren’t kept so low by the PBoC).  This is not a way to increase Chinese wealth.

I have discussed this too many times to go into it again, but I am worried that China’s high growth rates today can only last another year or so at best, and will result in a much more difficult transition period.  This is a lot like the way Japan’s response to the collapse in US consumption after the 1987 crisis resulted in two spectacular years of credit-fueled growth followed by two very difficult decades of transition.  Chinese policymakers are in the very tough position of having to choose between policies that make the transition easier but result in rising unemployment today, and policies that spur employment growth today but may create even greater excess and wasteful capacity.  I am glad I don’t have to make those decisions, but I am pretty sure that if I did I would be more worried about the impact of the fiscal stimulus on China’s long-term growth.

I am, still trying to work out the implications for China of a rise in US household savings, but here is how I see it. I welcome comments that may help me refine or refute this argument.

For the sake of simplicity I am going to assume that there are only two countries, the US, which represents all the high-consuming trade deficit countries, and China, which represents all the high savings trade surplus countries. Although of course there are other players, these two represent the lion’s share of their respective blocs, and for the most part the impact of other large countries (Europe, Japan, the UK) simply exacerbate the problems as I see them.

For the past decade until the onset of the 2007-08 crisis, the US has been growing quite rapidly. Powering this growth has been an even more rapid surge in consumption. When US consumption grows faster than GDP, two things must happen.

1. The US savings rate by definition declines

2. If the country is running a trade deficit, and consumption is growing faster than production (assuming that investment isn’t falling, or is at least not falling by more than the difference), then the country must run a growing trade deficit. Another way of thinking about this is that if investment exceeds savings (and with such low savings rates, US investment needs were much higher than US savings), the country must be a net importer of capital. To be a net importer of capital the US must run a trade deficit. These are just different ways of saying the same thing.

In that case the US has been running a growing trade deficit powered by the decline in US savings. But everything must balance. If US consumption growth exceeds US growth in production (I am ignoring changes in investment because they are a relatively small part of this), then in China production must exceed consumption. This is just another way of saying that as the US savings rate declines and powers a surge in the trade deficit, the Chinese savings rate must rise and power an increase in the trade surplus. In fact this is what happened.

Notice I am saying nothing about the direction of causality. It could be US consumers who caused the change, and forced China into reacting. Or it could be China whose polices have forced an increase in the domestic savings rate (actually an increase in production greater than the increase in consumption, which amounts to the same thing), thus forcing the US financial, system to accommodate by making consumer financing easier. Or of course it could be a combination of the two. The point is that the balance of payments must and will balance. Actions in one part of the system will cause equal reactions in another part, and the direction of causality is never obvious (See Note 1).

As a consequence of the global crisis we are now seeing a sharp rise in US household savings rates. This has been partly mitigated by a sharp rise in government dis-saving (borrowing), but nonetheless aggregate US savings rates are rising, and with them US consumption must decline (See Note 2). If US GDP is also declining, the combination of a rising savings rate and a declining GDP must result in sharply declining consumption.

What does this mean for China? Obviously the US trade deficit is contracting quickly. This means that China’s trade surplus must also be contracting quickly.  In fact China’s trade surplus has been growing, and this is where my simplification (the world consists of the US and China) runs into a problem. Although all trade surpluses are contracting, the fact that China’s trade surplus is rising indicates that other surplus countries are bearing more than 100% of their share of the global contraction. I don’t think this is sustainable and ultimately, perhaps even already, China’s trade surplus will decline. By the way the fact that China has been able to force at least part of its own adjustment onto trade competitors will likely lead to increasing anger with China, as it already seems to be doing especially on the part of Asian competitors, and will power a further rise in international trade tensions.

Here is the important point, I think: As long as the US was consuming more than it produced, Chinese GDP growth was constrained on the bottom by the growth in Chinese consumption. In other words, China’s GDP had to grow faster than Chinese consumption (which means of course that the Chinese savings rate was rising). In fact, while GDP was growing somewhere in the region of 11-13% annually, Chinese consumption was growing by around 9% annually. Thanks in large part to US dis-saving, in other words, Chinese GDP growth exceeded Chinese consumption growth by around 2-3% annually.

So what next? Now that the US is raising its saving rate, this means among other things that the growth in US consumption will be lower than the growth in US GDP. If the US GDP grows slowly, consumption will be flat. If it contracts, consumption will contract sharply. In either case the US trade deficit should continue declining except in the very unlikely event that US investment grows by more than the increase in savings.

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

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

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

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

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

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

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

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

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

But one way or the other if the US is raising its savings rate and so forcing more rapid growth in US GDP than in consumption, China is likely to see its consumption growth constrain its GDP growth. This suggests to me that once the effects of the (I think) unsustainable credit bubble being inflated by policymakers here run their course, we are in for a longish period of much slower GDP growth.

Note 1. I know I will be assailed on both sides by people saying that only a fool is unable to see which way causality runs in this case, but let me suggest that if you know beyond any doubt the direction of causality here, then you probably do not understand the problem.

Note 2. Except, of course, in the case in which US GDP is rising much more quickly than the US savings rate, which is a complication I don’t think we need to worry too much about.

Tags: Chancellor

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today’s Financial Times has an article titled “Fears over US sovereign debts unfounded” which, as the title implies, argues that “Fears of a crisis of confidence in the US sovereign debt market – and a subsequent dollar collapse – are unfounded.” On a related note Bloomberg has an article today which notes that “Russian Finance Minister Alexei Kudrin said the dollar is in ‘good shape,’ further affirming that there’s no substitute for the world’s reserve currency.”

It’s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage – it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin’ economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9’s Dialogue, two points were made – that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in “good shape” as the world’s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to “undermine” the reserve status of the dollar – announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on – are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government’s real debt position. “The cost of China’s stimulus program,” he writes, “is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.” He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, “virtually all of which are indirectly backed by local governments.”

He concludes: “As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.” In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week’s Caijing (and what other magazine would have reported this?), with the unsettling subtitle “The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.”

The article notes how unlikely it is that the massive contraction and the difficulties in last year’s property market were not accompanied by high-profile failures among property developers. This is because, they explain, “local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,” and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article’s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn’t imply, of course, that all these deals will go bad. What I am worried about is something a little different – the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don’t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you’ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly “inverted” structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country’s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author’s words, “A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.”

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world’s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a ‘doubling up” of china’s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don’t think this is such a big deal except to the extent that it gives us a “businessman’s” view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday’s People’s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April’s exports and the 23.0% drop in April’s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April’s and May’s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China’s trade surplus is still up more than 13% compared to last year – $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday’s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don’t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today’s People’s Daily has another front page article in which Premier Wen “stressed the importance of promoting domestic consumption”).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday’s Financial Times came up with this story (“China accused of predatory pricing practices”):

India’s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India’s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was “huge and difficult to explain”. Amit Mitra, the FICCI’s secretary-general, said Indian industries were being hurt by “typical Chinese predatory pricing” intended to drive rivals out of business so that Chinese companies could capture the market – and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China’s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

Strangely enough I think I am among the least disappointed people about Premier Wen’s speech this morning during the opening of the National People’s Congress. Like most people I think there was very little of substance in the speech except the usual statements about boosting consumption, maintaining growth, and promoting social welfare – all easier said than done – and I have already argued many times, in a recent blog entry, for example, and in today’s WSJ Op-Ed piece, that China’s development model and financial system make it very difficult for China to boost consumption in the short term except by boosting investment, which is both slow and contrary to China’s role in the global crisis.

The main thing I got from his speech is that while Premier Wem claims that China is ready significantly to expand its stimulus, for now policymakers plan to wait and see what are the effects of the current stimulus spending. This makes sense, I think, because there is a real risk that continued deterioration in the global environment and rising domestic unemployment may panic the government into throwing everything they can into the stimulus mix.

And if they do, what will that accomplish? Global demand is contracting so there is no way to get around the fact that Chinese overcapacity will have to decline, and since it cannot decline sufficiently via a sharp increase in net domestic consumption, it will inevitably decline in the form of reduced production, especially as the threat of protection, which Wen explicitly addressed, rises.

I think to a certain extent this was recognized by the premier. According to Xinhua’s coverage of the speech:

When delivering a government report to the annual session of the Chinese legislature, he said that the global financial crisis continues to spread and get worse. Demand continues to shrink on international markets; the trend toward global deflation is obvious; and trade protectionism is resurging.

“The external economic environment has become more serious, and uncertainties have increased significantly,” he said. “Continuous drop in economic growth rate due to the impact of the global financial crisis has become a major problem affecting the overall situation. This has resulted in excess production capacity in some industries, caused some enterprises to experience operating difficulties and exerted severe pressure on employment,” according to the Premier.

But what if policymakers try to force the problem away? The risk is that they cause a massive increase in investment in the hopes of boosting employment, but if this boost comes as a consequence of building even more capacity, there are, in my opinion, likely to be two very dangerous outcomes. First, they will enter next year with even more excess capacity, and second they will have weakened the banking system further and increased government direct and contingent indebtedness.

If the world recovers quickly, then none of this will matter. But if it doesn’t, China will face 2010 with even more excess capacity and in a much weaker fiscal position to combat the contraction.

There were a few worrying aspects to the speech. Recently there has been an increasing chorus among exporters demanding RMB depreciation, and three days ago Commerce Minister Chen Deming said that February’s trade figures would be much weaker than January’s. According to an article in the South China Morning Post:

Mr Chen did not rule out the possibility that the country would adopt some trade protection measures but said it would resist out-and-out protectionism. “Trade protection does not equal protectionism. Some measures are allowed under the [World Trade Organisation] framework,” he said.

I am not sure I understand how trade protection is different than protectionism, except perhaps in a strictly legalist sense that will hold little water in the global debate. I would propose, if anyone wanted my opinion, that the world’s leading exporter by far of overcapacity – and the only major country that has seen its trade surplus surge during the crisis – does not need to push exports, especially not via any form of protection, legal under WTO rules or not.

More worrying, at least superficially, it seems that it was not just Chen who is making these kinds of noises. The People’s Daily, in reporting today’s speech by Premier Wen, had an article with the kind of headline almost designed to catch my eye: “Wen’s report urges unslackened efforts to promote export.” According to the article:

China “must not slacken efforts” to promote export amid a sharp decline in external demand and growing international trade protectionism, Chinese Premier Wen Jiabao said Thursday, pledging reinforced government support.

…”We will continue to diversify our export markets and compete on quality, enhance traditional export markets, and energetically open up new markets,” said Wen. The government is to take a series of measures to relieve the difficulties of exporters and to ensure steady growth in foreign trade, according to Wen.

The rest of the article was a little less worrying, suggesting mostly anodyne feel-good measures

A central government fund for trade development will be increased, eyeing to cultivate brand-name export products and support small and medium-sized enterprises in expanding their international markets, Wen said. To improve the country’s financial services for importing and exporting, the government will expand the coverage of export credit insurance, and encourage financial institutions to develop export credit, he said.

The government will adjust the prohibited or restricted commodity categories of processing trade, and encourage the relocation of export processing industries from the eastern to the central and western regions, Wen said.

Perhaps all of this is more designed to ward off continued attacks by a frantic export sector than to represent a real attempt to force export growth. Let’s watch the trade figures over the next few months. China has only just begun to feel the impact of sharply declining exports, and is suffering a lot less than most other Asian countries.  This should change soon.

Tags: NPC

With the tense start of China’s parliamentary season this afternoon – and with the National People’s Congress meeting Thursday – there isn’t much incentive to try to figure anything new out in China since we are likely to be given a lot more information and proposals over the next few days. What are the major topics likely to be covered in the meetings? I suspect that this article from yesterday’s South China Morning Post, on the topic of unemployment, gives a pretty strong hint:

If this is not addressed, it will be even more difficult for the government to maintain social stability down the road if unemployment remains high. China’s official urban unemployment rate is expected to be 4.6 per cent this year, which would make it the highest since 1980 when figures first began to be collected.

But, economists, including Zhou Tianyong from the Communist Party’s Central Party School, forecast that the real unemployment rate could reach 14 per cent, counting migrant labourers.

Senior officials estimate that up to 20 million migrant labourers have already lost their jobs because of the global economic crisis. They were mostly laid off by private firms and foreign-funded enterprises, the hardest-hit sectors.

I was told privately by a friend of mine two days ago that the number of migrant laborers who have already lost their jobs is actually closer to 30 million, but nonetheless Mr. Zhou’s comments reinforce some other claims to which I refer in a piece by me in the current Newsweek:

Although official estimates put urban unemployment in China at just over 4 percent of the workforce, most unofficial estimates are much higher—closer to 8 percent—and nearly everyone agrees that the figure is set to rise significantly in the next few months. Some credible estimates suggest that even if China were able to achieve the 7.5 percent growth projected in 2009 by the World Bank, unemployment would nonetheless double before the end of the year.

Clearly unemployment is going to weigh heavily on the minds of policymakers in China, like in the rest of the world, and we will have to wait and see what specific new measures are proposed over the next few days. Meanwhile I did nonetheless want to make a few comments about interesting stuff I’ve seen recently.

The first is a reference to an article in yesterday’s Financial Times, “Asean split on protectionism,” which highlighted the difficulties of getting leaders to agree on free trade even during a conference whose primary goal was to defend free trade:

As south-east Asian leaders gathered on Friday for their annual summit, the region’s united front against protectionism was starting to crack under the pressure of the global economic crisis. The fight against protectionism is top of the agenda at this weekend’s meeting of the 10-country Association of South East Asian Nations, which on Friday signed an agreement cutting tariffs and other barriers with Australia and New Zealand.

However, the leaders appeared far apart in pre-conference comments on the balance to be struck between sustaining open markets and promoting economic activity at home. In the most forthright remarks, Abdullah Badawi, Malaysia’s prime minister, said every country had the right to encourage its citizens to buy local products.

“I think it is a normal reaction under this kind of situation. First of all we have to protect our people; we are doing the same thing. If we do not create projects by Malaysia, for Malaysians, then who will buy our products?” Mr Badawi told the Bangkok Post newspaper.

For some of my readers I may be beating a dead horse, but as usual I will put up my warning that we need to be very aware of the deterioration in global trade relations that is likely to be a consequence of the rising unemployment everywhere in the world. The fact that even in a region heavily dependent on exports it is so easy (and so natural) to make the case for protectionism doesn’t bode well for trade discussions in North and South America, Europe and Australia. The article goes on to say:

Lee Hsien Loong, Singapore’s prime minister, said Asean might miss its target of establishing a regional economic community along the lines of the European Union by 2015 if member states failed to maintain open markets. “In this global environment, if we give the impression that Asean is not fully open for business I think we will be the losers when the new landscape emerges,” Mr Lee told CNBC.

Most of the regional economies have built their prosperity on the back of export growth, and the slowdown in the US, Europe and Japan has hit them hard. “I think we all worry about protectionism, and not just from traditional channels,” said Mari Pangestu, trade minister for Indonesia. In spite of Mrs Pangestu’s reservations, Indonesia is encouraging civil servants to buy Indonesian products, an echo of Barack Obama’s Buy American campaign that angered so many both within and outside Asia.

It may seem like a non sequiter to follow up with a second Financial Times article from yesterday, this one called “Emerging market finance: a gap to fill,” but bear with me:

Two years ago, nearly a trillion dollars flowed into emerging markets as investors in rich countries toured the globe in the hunt for yield. Now there is a melancholy long, withdrawing roar as private capital flees to safer havens.

…Net capital flows to emerging markets will drop to just $165bn (£115bn, €130bn) this year, down from $929bn as recently as 2007, according to estimates by the Institute of International Finance, which represents the world’s leading financial companies. Net lending from commercial banks, the IIF says, is likely to go into reverse. The reasons for this are not altogether straightforward. Some accuse rich governments, particularly the US, of “crowding out” emerging markets, sucking up all the available capital to finance their stimulus packages. But Brad Setser, a former International Monetary Fund and US Treasury official, notes that as the private sector retrenches, the US current account deficit – and hence its need for outside financing – has actually been declining.

More likely, he says, is that emerging markets are being hit by a general decline in demand for riskier assets, as banks and investors haul money back home to shore up balance sheets and reduce borrowings. Similarly, the global shortage of the trade credit that finances cross-border commerce reflects a general desire of banks to reduce leverage, not the rich countries hogging all the available loans.

Why is this relevant to a blog on Chinese financial markets? Because if annual net capital flows to emerging markets drop by the projected $700-800 billion, an inevitable consequence is that foreign currency reserves plus net imports for those emerging market countries will also have to decline by exactly the same amount. In other words while some of this decline will be accommodated by a running down of central bank reserves, we should expect a very large decline in net imports among those developing countries, to add to the decline in net imports from North America, non-German-Europe and other trade-deficit-countries. Needless to say this decline in net imports must have as a necessary corollary an equal decline in net exports in the trade surplus countries.

My final comment – hinted at in the title – is on Paul Krugman’s Op-Ed piece in today’s New York Times. he starts off by discussing the viciousness of the global crisis and then goes on to ask (and answer):

How did this global debt crisis happen? Why is it so widespread? The answer, I’d suggest, can be found in a speech Ben Bernanke, the Federal Reserve chairman, gave four years ago. At the time, Mr. Bernanke was trying to be reassuring. But what he said then nonetheless foreshadowed the bust to come. The speech, titled “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world. The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States — hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.

I have written often about the savings glut hypothesis and my very strong belief that it lies at the heart of the fundamental global imbalance of the past decade, and I think it has extremely important consequences both for our understanding how the crisis will evolve and what are the likely consequences to the major players involved in the imbalance. I am a big admirer of Krugman’s and have been for fifteen years – in the 1990s I used to read everything he wrote, and often within days of his publishing it – so I am delighted that he seems to agree with Bernanke’s thesis, but I should add that I believe the evidence in support is so overwhelming that even if Krugman decided to deride the whole notion, I would remain convinced that the sudden and massive rise in Asian net savings following the 1997 Asian crisis was a prime cause of the corresponding and necessary decline in US savings.

I know I know, this is going to be considered a very controversial statement – and inevitably someone will very stupidly demand to know why I am blaming China when obviously the full blame for the crisis should fall on the US – but there it is. I just don’t see how recent events can be explained without the Asian Crisis of 1997 having played a major role. At least Krugman seems to agree. At any rate he finishes worryingly with:

And the saving glut is still out there. In fact, it’s bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift and the worldwide property boom, which provided an outlet for all those excess savings, has turned into a worldwide bust. One way to look at the international situation right now is that we’re suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off.

Tags: Krugman, NPC

Earlier this week I was talking to my grad student Shang Ning about the awful markets around the world, and he suggested that maybe it was a good thing that Chinese stock markets were closed this week for National Day since this would act as an extended circuit breaker that might protect them from collapsing in sympathy with the rest of the world.  We agreed, however, that whether or not next week would open with a big downward break would depend crucially on whether the rescue bill was passed by the US Congress and, if so, would cause markets around the world to soar.

Well, the bill was passed Friday, but markets continued to fall.  Hong Kong’s Hang Seng Index lost 2.9% yesterday capping the fifth consecutive losing week with a loss of 5.4%.  Unless the government announces some extraordinary measure over the weekend to boost stock prices I expect that next week is going to start out badly.

It would be only reasonable if it did.  On Friday the US government reported that the US economy had lost 159,000 jobs in September, making it the ninth consecutive month that the US job market has contracted, and suggesting that it is going to be harder and harder for the US to avoid a slowdown in consumption.  China has bet its economic future very heavily on sustained US consumption driving its economy forward, and faltering US demand – coupled, as it is almost sure to be, with faltering European demand – cannot help but slow China’s export growth.

This is, in my opinion, one of the two most likely channels by which global financial difficulties will become Chinese financial difficulties (the other is if perceptions of rising risk cause liquidity outflows from the banks).  If exports slow, and domestic consumption is unable to accelerate sufficiently to replace it – and in fact I expect domestic private demand to slow – there is a good chance that domestic investment will also slow, after a lag that sees rising inventories.  In that case three of the four pistons in China’s economic engine will falter. 

This is dangerous for the financial system, of course, because any economic slowdown will finally put the Chinese financial system to its first real test since the massive expansion of the past four years, and I am not sure it will pass the test very easily.  The current issue of Caijing actually has an interesting article on the subject, indicating that quite a lot of people are becoming increasingly worried about that particular risk.  The article says:

It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects.  All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.

First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area.  Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.  

Second, the loan growth rate is falling.  Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source.  With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit.  In the second half of 2008, the People’s Bank of China loosened its credit control by five percent.  But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.

Third, the loan-deposit interest rate gap may further shrink.  On inflation concerns, a loosening of monetary policy will likely be handled in an asymmetric style.  That is, loan rates will be cut while deposit rates remain unchanged, which is what the central bank did September 15. 

Fourth, loans to the real estate sector and local governments will become more risky.  Personal mortgages and property developer loans currently account for more than 20 percent of the lending at major banks.  If house prices continue falling, however, NPLs in real estate may soar.   

Fifth, administrative measures may bring side-effects.  Loosening credit controls and the “double cut” decision to trim loan interest rates while lowering the required reserve ratio for banks are steps aimed at encouraging banks to lend.  If the government sets loan targets for commercial banks through administrative measures, banks will lower their standards for qualified borrowers, which could lead to even more NPLs.

I have often argued that the financial system (including off-balance sheet transactions, unrecorded municipal and provincial activity, and the informal banking system) has been growing much more quickly and in a much more chaotic way than most analysts realize, and its vulnerability to a slowdown may be significantly greater than we think.  If three of the four pistons in China’s economic engine are faltering, fiscal expansion is left as the main driver of the economy, and although I have little doubt that we will see fiscal expansion, its impact is likely to be slow, the adjustment forced into the banks difficult, and it will only lead to greater imbalances in the economy. 

On that note Standard Chartered’s Stephen Green, who regularly puts out some of the best and most interesting economic analyses of China, has a new piece out today called “The world just changed, China hasn’t.”  In it he says:

We hate to be killjoys, but we have some bad news for anyone claiming that China’s transition to a new growth model – one with more consumption, less investment, more domestic demand, and less exports – is already underway. We would love to believe it too, but it just ain’t so. Worse, the US financial crisis and the coming global economic slowdown will show China’s present model to be even less sustainable than was thought before. But they also present Beijing with an opportunity to unleash new growth drivers. The world just changed, and now is the time for Beijing to change too.

Green argues that while the debate over China’s growth model suggests that policy-makers are in principle acknowledging the need for China to shift from an export-led growth model to a domestic-consumption-led one, in practice this hasn’t happened.  What is worse, one consequence of the global slowdown is actually likely to be a concerted effort to reinforce the “old” model in a desperate attempt to protect the economy from the impact of a slowdown in exports.

The problem also has to do with the gulf between aspirations and actual policy choices, which are often driven by short-term concerns.  To reduce the economy’s dependence upon exports, one needs to reduce exports. It sounds simple, but even with 10% real export growth at present, Beijing has apparently decided to throw incentives back to exporters by topping CNY appreciation and increasing tax rebates to textile producers, and even seems poised to increase them for electronics and machine tool exporters too.  To reduce the amount of heavy industry, one needs to raise manufacturers’ cost of electricity, but there is still no effective system to prevent local governments from protecting their local steel, aluminium, and copper plants from higher power tariffs.

To slow down the investment boom, one needs real positive interest rates (banks currently have negative ones), rigorous dividend payments by state firms into the budget (a reform which is still a small-scale experiment), and local officials whose performance is not measured on investment and tax revenues alone.  To discourage people from investing in the domestic market, one needs a fairly priced exchange rate, but since 2005 it has been fixed and under-valued, as it still is despite the 7% gain in the effective exchange rate over the past year.

To really encourage innovation, one does not need quotas for patent applications, but a reliable civil law system which allows companies to protect their own valuable IPR. To allow people to get decent healthcare, one must allow private hospitals to participate in the state’s insurance system and regulate them. To increase the scale of the service sector, one needs to tackle the state-protected oligopolies that currently dominate – think telecommunications, parts of financial services, health and education, as well as the entertainment business. As PBoC governor Zhou Xiaochuan liked to say a couple of years ago, and everyone else asked themselves more recently with the success of Kung Fu Panda, where on earth is China’s creative film industry?

Green is fairly pessimistic, it seems to me, about the likelihood that China will take the necessary policy steps to shift its economy towards a more sustainable model.  That shouldn’t come as a surprise.  It is always difficult to make major necessary adjustments when external conditions are bad, and yet it seems unnecessary to do so when external conditions are good.  I have mentioned before in this blog the difficult experience of the US in the early 19th Century when the US economy shifted from being driven primarily by exports to the UK, Europe and the Caribbean to being driven primarily by the development of its own internal market. 

This shift did not occur in a gradual way and according to the best thought-out plans of businessmen and government leaders.  The change was forced onto the US and happened mainly because beginning in 1797 the Napoleonic wars and an especially vicious spread of smallpox along the coastal cities decimated the US export business, ushering in a very long depression.  It took the ensuing financial crisis and depression to reorient the economy towards its domestic market, and not without a great deal of difficulty

The “silver lining” in the current global slowdown for China may very well be that China is also forced kicking and screaming into doing what it should have done much earlier, although I suspect Green is right that in the early stages it will actually try to strengthen the export and investment orientation of its economy as a way of slowing job loss. This would be a mistake in the long run, but may be a natural reaction for a government that greatly fears the short-term political consequences of rising unemployment.

By the way and on a completely different and unrelated topic, for some reason some outfit called Forexecutor keeps trying to sneak their advertisements onto the Comments section of my blog.  I checked them out to try to get them to stop.  After running thought their site I have to say that in my opinion they are a scam.  If you see their ads anywhere on this blog please know that I do not endorse them at all.  On the contrary, you should beware of using their “products.”

Much of the focus in China continues to be on the performance of the stock markets.  Yesterday the market bounced around both above and below Friday’s close, before ending the day at 2874, up slightly less than 0.2%.  That was the first positive day for the SSE Composite in nearly two weeks (after last week’s 14% decline), but a quick look at the trading patterns and trading volume didn’t seem to indicate much conviction.

Today, the market dropped sharply again.  It started the day with a little bit of buying – in the first half hour the market traded up nearly 0.7%, but as often happens with any strength, sellers took advantage to unload positions and prices quickly bounced their way down to 2769, down 3.7%, just 30 minutes before the close of day, before staging a late rally to close at 2794, still nearly 2.8% down for the day.

This puts us at 6.9% below the 3000 level which we broke last Wednesday and which, supposedly, was the level below which the government would intervene.  As I have been pointing out during the past two months, this kind of rumored intervention means that when the market finally breaks the expected support level, it is likely to drop pretty quickly – and so far it has. 

There is still a lot of discussion and rumor-mongering about whether or not the government will eventually intervene, with the introduction of index futures and the permitting of margin trading as being the most likely forms of intervention.  My understanding is that Vice Premier Wang Qishan (the new economic “tsar”) and a number of other relevant policy-makers are worried, correctly I think, that China’s history of frenzied intervention has undermined the functioning of the market, and so they are reluctant to continue intervening in response to market behavior, unless of course they get any indication that the drop in the markets might causing social discontent or unrest, especially in the period before the Olympics.  

So we are in a very unstable position.  As of yet not a whole lot has happened to indicate that investors are furious – there have been small demonstrations and nasty comments about the failure of the government to protect investors on various investor-related websites, but not much more – so perhaps the government will hold off doing anything.  I suspect that they are beginning to learn that active intervention brings with it the cost of declining credibility, and this declining credibility undermines their ability to intervene successfully in subsequent periods.  Perhaps they want to keep their powder dry in case they have a bigger market problem in the near future.

But I suspect this situation is unstable because the market is still expecting some new measure to prop it up, and if the government continues to hold off intervening, I don’t see prices continuing at this level.  In fact I would imagine that a lot of investors are eager to get out and just waiting to see if they can get one last chance to recoup some of their losses before doing so.  My guess is that if we don’t get something positive soon, we’ll have another bad week next week, and if it is bad enough it may prompt some action by the government.

Away from the stock market, some more interesting numbers on the economy have come out recently.  Fixed asset investment was up 25.6% year on year for the first five months of the year (it was 25.9% up over the same period last year).  Industrial output was up 16.0% in May, compared to 18.1% last May.  Both numbers may understate the decline in growth relative to earlier periods, especially the latter, because this May the “Golden Week” holiday was cut from five days to two days. 

If we assume a five-day work week, presumably that means the working month was about 15% longer this year than in previous years, but I am not sure that this would be the best way to look at the amount of time worked.  In fact the typical work week seems closer to six or seven days, and certainly in Chinese universities we were supposed to make up for the holiday by holding extra classes before the holiday (which, I always thought, sort of negated the point of the whole thing for my poor students).  I don’t know that the real working hours are for the average Chinese worker and I don’t know if they typically faced pressure anyway to make up for the foregone work during the holidays, but I suspect cutting the holiday from five days to two days might not be as big an adjustment in output as many people think.

It is perhaps an indication of how frothy things are that, although some analysts read these numbers as indicating that Chinese growth is in good shape, many saw the numbers as indications that the Chinese economy is beginning to slow down and may run into trouble if something isn’t done.  As I see it, both numbers suggest that the economy is still roaring along, and it may just be a statistical necessity that they begin to slow.  After all, the larger the Chinese economy becomes, the harder it is to maintain the same levels of growth – this is partly just a question of arithmetic.  This is especially true for export numbers.  Still, rising inflation means that an increasing portion of the nominal growth is not real, so we probably are seeing a slowdown in domestic economic activity, driven primarily by a slowdown in global demand.

Needless to say, any perception of economic slowdown will make it all the more difficult for the authorities to achieve the consensus necessary for them to address the monetary imbalances.  We may be entering into the toughest period of all – in which as the need for monetary tightening, via the currency regime, becomes all the more obvious, the opposition to monetary tightening becomes even stronger because of weakness in the economy.  I guess that means more policy paralysis.

Meanwhile we are being hit with yet another natural disaster.  Heavy rains in the past week are causing enormous floods across 20 provinces south of the Yangtze River.  Once again we are likely to see pressure on the economy, from inflationary pressure to greater investment in reconstruction.  One thing I ma not sure about is what the conditions of China’s food and energy reserves.  My suspicion is that they are quite low – in part because of selling to reduce inflationary pressure.