I can only submit a very short entry this time to discuss the raft of numbers that came out this morning.  Regular readers will suspect that once again I am going to suggest that the numbers gave grist for everyone’s mill – optimists will see their hopes confirmed and pessimists will see their worries confirmed.

Yes, but this time around I think the pessimists clearly have the edge.  On one hand optimists who are confident that the massive fiscal and credit stimulus was the appropriate response to the global crisis will note that growth in the fourth quarter was more than robust.  According to an article in today’s Bloomberg:

China’s growth accelerated to the fastest pace since 2007 in the fourth quarter, capping Premier Wen Jiabao’s success in shielding the nation from the global recession and adding pressure to rein in a surge in credit.  Gross domestic product rose 10.7 percent from a year before, more than the median forecast of 10.5 percent in a Bloomberg News survey, a statistics bureau report showed in Beijing today.

Days before the data were released rumors had been circulating that GDP growth would be high.  The People’s Daily today had, for example, a very different interpretation of what expectations were than did Bloomberg:

China easily beat its 2009 growth target after a blistering fourth quarter performance that set the stage for further monetary tightening measures to come out in the upcoming days.

…Gross domestic product surged 10.7 percent between October and December, compared with a year earlier, a tad below market forecasts of 10.9 percent, but up sharply from a revised 9.1 percent in the third quarter.

On the other hand pessimists, of course, were very unhappy with the quality of growth.  Here is what Bloomberg went on to say:

Sales quickened in December on a year-earlier basis, climbing 17.5 percent, while industrial production increased at a slower pace of 18.5 percent, today’s report showed. Urban fixed-asset investment jumped 30.5 percent in 2009, the statistics bureau said.

The surge in industrial production and fixed-asset investment highlights the fact that this growth is still wholly investment-driven, and no one has a clue as to what will happen when the government pulls back, perhaps because of concerns about rising debt.  Worse, the inflation number came in higher than expected.  Yesterday morning, while I was in Hong Kong, I was told by a very credible source that December CPI was going to come in at 1.9%, relative to expectations of 1.4% to 1.5%.  People’s Daily again:

The statistics bureau, which released the GDP figures, also reported that consumer prices rose 1.9 percent in the year to December, a marked acceleration from November’s reading of 0.6 percent.  Alarmed by a new burst of credit at the start of January, the central bank last week increased the proportion of deposits that banks must hold in reserve, rather than lending out, and followed through this week by recommending some of them to sharply curtail lending for the rest of the month.

The central bank has also been raising yields on its 3-month, 6-month, and 1-year-long bills over the past few weeks and on Thursday nudged up the yield on three-month bills for the second time this year.

Given the worrying stories about RMB 1 trillion credit growth in the first three weeks of January, and rumors (subsequently denied) that the CBRC told banks to stop lending for the rest of January, the jump in inflation will give the PBoC the ammunition it needs to press its case on monetary tightening.  It has had a tough time making its case in the past, but inflation is something that worries everyone.

I guess I have been a little more aggressive than others in suggesting that we would see a move on the currency and interest rate tightening in the first quarter.  Most analysts still believe that these will be second quarter events, but are increasingly warning that they could happen in the first quarter.  Let’s see what happens in January, although as usual January and February numbers are always distorted by the Spring Festival celebration, which date varies from year to year according to the lunar calendar (it will be February 14 this year).

As an aside, and as an indication as to how tough the fight over trade is going to get, one of my students sent me the following note yesterday.  It is about a recent Stephen Roach article in which he criticized analysts in the US who argue that the undervalued RMB has had an adverse impact on US employment (sorry but I lost the article):

Xinhua News Agency announced another notice in its internal network saying its “leading organization” instructed it to publish an important article and required all media to adopt the article in full. The article quotes Stephen Roach, head of Morgan Stanley Asia, as saying the US’s blaming China for the imbalance problem is hypocritical. The implication derived from this notice is that China won’t appreciate RMB in the near future.

Hardliners on each side are preparing for a fight.  The key is to insist that the other side is wholly to blame.

I just got back to Beijing three days ago and am still seriously jet-lagged, but I wanted to post a piece today anyway.  Last night I celebrated the new year at D22, where a group of very cool musicians (including the amazing Snapline, for one of their very few shows this year and perhaps one of their last ever) serenaded the passing of 2009.  What a great show.

I suppose it is traditional to dedicate the new-year piece to evaluating the “year that was”, or to make predictions for the coming year, but my only concession to this tradition will be to make the very (I think) obvious prediction that trade tensions are going to rise dramatically in 2010, and even more so in 2011 as interventions initiated in 2009 and 2010 come to fruition.  I am no expert on the subject of criminal law or the environment, and so have little to add beyond all that has already been said, but the huge amount of angry criticism China has received on the very visible subjects of the Copenhagen meeting and the execution of a British subject caught smuggling drugs will make it easier for tariffs and restrictions aimed at China to generate popular approval in Europe, North America and the developing world, especially since protectionists can easily add a “moral dimension” to their arguments.

I am not sure Chinese policymakers fully understand how vulnerable China is to trade war.  This is perhaps because the “success” of the stimulus package has convinced them that they are less vulnerable to external demand than they originally thought.  But this would be a serious misreading.  The stimulus package has postponed the effect of declining net foreign demand on Chinese unemployment, but has actually increased its vulnerability by increasing the future gap between what China produces and what it consumes.  China needs foreign demand to keep absorbing its excess capacity for several more years while it engineers the difficult transition to domestic consumption-led growth, but I don’t see either China taking the necessary steps to force the transition or foreigners looking very eager to help China through the process.

As if to confirm my pessimistic trade expectations, the US on Tuesday announced that it would impose tariffs on Chinese steel grating.  According to press reports this is a pretty tiny market, so it won’t seem to matter too much to the overall economy, but even though US trade measures against China have generally been so far much milder than Asian or European measures, US measures have far more symbolic meaning and will affect behavior elsewhere.  Here is what the South China Morning Post had to say about it:

The US Commerce Department said overnight on Tuesday it has set preliminary anti-dumping duties of up to 145.18 per cent on steel grating imported from mainland to offset unfairly low prices.

The United States imported about US$91 million worth of the product from mainland last year. Steel grating is used in industrial floors, docks, ramps, drainage covers, staircases and other applications. The trade case is one of about a dozen brought by US companies this year against goods made in mainland, saying they have benefited from government subsidies or are being sold in the United States at less than fair value.

Worse yet, the very influential Paul Krugman has been focusing more than ever on China’s role in the imbalances, and he is clearly arguing that Chinese trade interference (via industrial policies and the currency regime) must be met with US protection.  His most recent piece in the New York Times makes the case that the supposed costs of protection are fictional.

China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.

Krugman has an enormous amount of influence in the US and Europe, so his arguments should be worrying a lot of people.  Even more worrying to me however was an alarming article in yesterday’s Xinhua which discusses the incredibly difficult year SME’s faced in 2009.

China’s small and medium-sized enterprises (SMEs) are facing an alarming credit and economic crisis that, by one estimate, has driven at least 20 percent of them to the wall since the global financial crisis began.  Officially the numbers are relatively low, and Minister of Industry and Information Technology (MIIT) Li Yizhong said in March that 7.5 percent of SMEs went bankrupt as a result of the global economic downturn in 2008.

However, a report by the Chinese Academy of Social Sciences (CASS) said 20 percent of SMEs had crashed and another 20 percent went to the brink of bankruptcy during the climax of the global financial crisis from October 2008 to March this year.  “According to my research, to date, most of the 20 percent on the brink of failure have been revived thanks to the recovering economy,” said Chen Naixing, an economist and director of the SME research Center at the CASS, on Wednesday.

Chen, also deputy executive director of the China (Hainan) Reform and Development Research Institute, said most SMEs, especially small businesses, were financially overstretched by falling orders at home and abroad.  The impact of the economic downturn on SMEs has been compounded as they were squeezed out of the massive credit flow unleashed by China’s banks.

There has been a lot of discussion within China about the impact the fiscal stimulus has had on accelerating a process that by some accounts began in the mid-1990s, and by others in the early 2000s, in which the entrepreneurial private sector in China has been squeezed out in favor of the SOE sector.  This seems to have found confirmation in the PBoC numbers, according to the article:

The crisis seems to fly in the face of the government’s “relatively loose” monetary policy introduced to battle the economic downturn.  However, the explosion in bank credit has been weighted toward large, state-owned companies, and the small firms’ share has been shrinking, despite their vulnerability in the economic crisis.

According to the People’s Bank of China, the central bank, new loans to SMEs totaled 3.08 trillion yuan (451 billion U.S. dollars) in the first nine months, accounting for 45 percent of the 6.83 trillion yuan corporate loans.

…However, in 2008, SMEs accounted for 51.9 percent of corporate loans, said governor of the central bank Zhou Xiaochuan in March.  However, capital-deprived SMEs, mainly small businesses, contributed 60 percent of GDP, 50 percent of tax revenues and 80 percent of jobs in urban areas, according to the NPC report.

“Less than 20 percent of small businesses have access to bank loans,” said Yin Zhongqing, deputy director of the Financial and Economic Affairs Committee of the NPC. “This is unreasonable given their contribution to the economy and their pressing need for funding.”

Unless you manage an SOE, it is getting tougher than ever to do business, it seems.  Separately, two days ago Premier Wen warned again about the “bumpy road” ahead for China, and yesterday Governor Zhou (of the PBoC), rather than celebrate the end of the crisis, worried publicly that “2010 is a crucial year in strengthening the stabilization and recovery of the economy and defeating the international financial crisis.”  Here is what Bloomberg says about the latter:

Chinese central bank Governor Zhou Xiaochuan said that 2010 will be a crucial year for strengthening the recovery in the world’s third-biggest economy and “defeating” the financial crisis.  Zhou’s New Year message, posted on the central bank’s Web site today, reiterated that a “moderately loose” monetary policy will continue.

Here is what Xinhua says about the former:

Premier Wen Jiabao Sunday urged the Chinese people remain aware of possible hardships and crises in the upcoming year and to work hard for a more promising future.

Wen told Xinhua in an exclusive interview that the way ahead for the Chinese people would be “a bumpy road,” but the nation had made transparent achievements in tackling the global economic downturn.   ”The Chinese people have gone through so many disasters. And one eminent tradition of our nationality is to be independent and indomitable without fear,” he said.

Meanwhile the People’s Daily reported yesterday that Fan Gang, member of the central bank’s monetary policy committee, said that the rising inflow of speculative capital, or “hot money”, into China could lead to “asset bubbles”, a topic that seems to generate discussion every day in the financial press here. In the same edition the People’s Daily also warns about a related risk, inflation:

China’s CPI growth rate may widen to 1.5 percent in December, after the CPI picked up its upward trend in November, said some experts.  Ha Jiming, chief economist of the China International Capital Corporation Limited, predicted that December CPI may grow 1.6 percent year on year, spurred by hiking food prices. Qi Jingmei, a senior economist with the State Information Centre, earlier noted that the CPI growth rate would be higher than 1 percent.

“Judging from price rally in November, CPI may increase more than expected,” said Jiang Chao, an analyst with Shanghai-based Guotai Junan Securities Co. (GTJA). He predicted that due to holiday factors, food prices will continue to rise in January. Meanwhile, non-food prices will also add pressure to consumer prices.

So far in this entry I haven’t provided a lot of good news.  It would be totally curmudgeonly to begin the year on a pessimistic note, and I won’t, but before moving on to two more hopeful pieces, I do want to mention an article in yesterday’s South China Morning Post by my friend Jack Rodman, in which among other things, he warns that the true exposure the banking system has to real estate may be underreported, and may be as high as 40% if correctly recorded.  He says:

Most of this lending is policy-directed with an implicit government guarantee. Despite thousands of closed factories in South China resulting from the global financial crisis, and hundreds of empty office buildings, retail centres and hotels that are not meeting their debt service payments, banks are still not foreclosing on these properties nor calling the loans due.

The banks prefer to rollover or extend the loans to avoid having to report an increase in non-performing loans. It is not uncommon for Chinese banks to extend a loan for as much as one year without interest payments if the lender “believes” the ultimate recovery value of the assets will be greater than the outstanding principal and interest. However, it is nearly impossible for a bank to value an empty office building, in a market with a reported vacancy rate nearing 40 per cent (30 to 40 million square feet) and declining rents.

Bank exposure to the real estate sector has been at the root of previous financial crises worldwide including the savings and loan crisis in the United States, Japan’s bubble economy, the Asian financial crisis, and now Dubai World. All these crises share in common aggressive and exuberant real estate lending, an abundance of liquidity and the false belief that real estate can only rise in value.  If total exposure to real estate secured loans was transparent within the Chinese banking sector, it would approach 40 per cent of total lending – the same level of total loan exposure reached in Japan in 1989, when it was believed Japan would dominate the economic landscape for decades.

So much for year-end pessimism.  The first piece of good news is that a recent revision shows that China’s economy, and more importantly its service sector, was larger than originally thought, even though the service sector is still much too small to support healthy Chinese growth.  According to an article in last week’s Financial Times:

China on Friday revised up its 2008 growth rate to 9.6 per cent, taking it well above the originally reported 9.0 per cent after calculating that the service sector had been more productive than previously thought.  The upward revision underscored that China was well on track to surpass Japan as the world’s second-largest economy in 2010, if not sooner, and has burnt through less energy to deliver each additional ounce of growth.

…The hidden strength found in China’s services sector was a modicum of good news for policymakers in China and abroad, who have said that promoting the development of the country’s non-tradeable sector is a key ingredient in rebalancing the global economy.

But it was still far from mission accomplished on that front.  China’s services sector accounted for 41.8 per cent of gross domestic product last year, up from the previously reported 40.1 per cent. In developed economies, services often contribute more than 70 per cent of GDP.

Needless to say it is very important that China’s service sector grows elative to the economy.  In a sense one can argue that Chinese overcapacity in the tradable goods sector comes with serious undercapacity in the non-tradable sector, and the rebalancing process involves a shift from the former to the latter.  Easier said, than done, of course, since a shift would require a real restructuring of both the banking system and the whole governance framework, but it will happen one way or the other..

The second last thing I want to mention is a lot more macro.  Last week on the day after Christmas (I wonder if many people read it), Robert Schiller published in the New York Times a very interesting piece on what he calls “trills” – bonds whose coupon would be determined by current GDP growth.  Here is how he describes them:

Each trill would represent one-trillionth of the country’s G.D.P. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal G.D.P.

If substantial markets could be established for them, trills would be a major new source of government funding. Trills would be issued with the full faith and credit of the respective governments. That means investors could trust that governments would pay out shares of G.D.P. as promised, or buy back the trills at market prices.

In my book, The Volatility Machine, I discuss the same things, arguing that developing countries typically put on what I called “inverted” debt structures, which automatically exacerbate volatility.  The worst sources of this kind of inversion are either external debt, short-term domestic debt, or contingent liabilities arising out of the banking system.  All of these forms of debt perform better than expected during good times and much worse than expected during bad times, and so they are an important part of the reason why developing countries, especially highly indebted ones, seem to veer so easily from boom to bust.

One of the things developing countries need to do to help break this cycle is to restructure their balance sheets in order to reduce embedded pro-cyclical structures and so reduce volatility.  The best way would be somehow for countries to sell “equity”, the closest thing to which has been long-term, fixed-rate local currency debt.  Schiller’s “trills” are an even better example.  The main point is that these kinds of capital structures force the users of capital to pay more when times are good and less when times are bad.  This provides an important cushion for when times are bad, and the very existence of this cushion not only will reduce the tendency for capital to flee a country just when it needs inflows most, but it should reduce the overall cost of capital by reducing financial distress costs.

I think “trills” are a great idea, and I remember writing a piece many years ago for the Financial Times (“A stake in Argentina’s future”, July 2, 2003) in which I praised the attempts – however minimal – to embed such a structure in bonds issued by Argentina as part of its 2003 debt restructuring.  The Argentine structure was a tiny first step (it only involved a minimal amount of GDP warrants), but if a major developed country were to issue these “trills” and make them respectable, this would be very positive for developing countries who, like China, are much too volatile, tend to fly back and forth between periods of intense growth and intense despair, and have very few options for building hedges into their national balance sheet.  Schiller mentions other economists who have made similar proposals:

Proposals for securities like trills have been aired many times over the years. I argued for them in “Macro Markets,” my 1993 book. The Nobel laureate Robert Merton has had similar proposals. Other ideas for G.D.P.-linked securities have been advanced by John Williamson at the Peterson Institute, by a group at the United Nations Development Program, by Kristin Forbes of the Council of Economic Advisers under George W. Bush, and by Eduardo Borensztein of the Inter-American Development Bank and Paulo Mauro of the International Monetary Fund.

For what it is worth I enthusiastically add my vote.  For all of the associated problems (most importantly, bad data) “trills” are a great idea and would, if actively used, provide a huge boon for investors and, more importantly, risky developing countries.

I finally got back to Beijing Friday, and have spent the past five days getting over jet lag and struggling to climb up the seemingly bottomless pit of unanswered emails.  For those many people who have asked me about the East coast tour of the Beijing musicians, I have to say it was really good – and much better than we hoped and expected.  The performances were packed, with sold-out performances at the Glasslands in Williamsburg, one of NY’s hippest clubs, and in DC’s Velvet Lounge.  In NY several well-known local musicians and artists came backstage to meet the Beijing musicians, and in DC our musicians were given a tour of Dischord’s offices by Ian MacKaye, the legendary founder of Fugazi, who came for the show.  For those who are interested, we are trying to collect the many reviews and comments on the Maybe Mars website, although there is still another week of performances.  The next US tour will be for Austin’s “South by Southwest” festival in March, and we are in the process of looking for sponsors who will help us fund the tour by the six bands and performers who have already been invited to perform there (unfortunately you play SxSW for prestige, not money)..

Away from music, my meetings in NY and DC were fairly different from the meetings I had in February.  This time around I got the impression that far more people in the US (although still a minority) understand how risky the Chinese recovery has been and how trade tensions are likely to result as a consequence of the stimulus.  In fact I have the sinking feeling that over the next two or three years I am going to find myself spending an awful amount of time thinking or writing about trade disputes between China and the rest of the world.

Regular readers know that for me the key source of China’s high savings and trade surplus is the large excess of the growth rate in national income over household income, caused in large part, I believe, by policies that systematically transfer income from the household sector to investment, SOEs and large producers.  Until these policies are reversed I do not think it is meaningful to talk about China’s rebalancing.  Just before President Obama came to China President Hu gave a speech which my friend Dan Rosen in his November 13 Rhodium Group report described as a “stirring speech about a policy big bang to promote consumption-led growth.”  Dan is skeptical, and I am adamant – a surge in consumption will not happen except perhaps briefly as a consequence of government subsidies and anticipated consumption.

In Washington I had the chance to meet someone I admire a great deal, Nick Lardy at the Peterson Institute, and although I shouldn’t put words in his mouth so as not to misrepresent him, I am glad to say that he seems to agree with the analysis of Chinese high savings as a consequence of policy-related constraints on household income growth, although he thinks currency undervaluation may have a greater impact on high savings than low interest rates, whereas I think it is the other way around.  In fact more generally I think this argument has become increasingly influential, and more and more analysts seem to be taking it up, both inside and outside China.

In that light I read earlier this week a fascinating and perhaps important article by Hung Ho-Fung in the current issue of the New Left Review, in which he argues that China’s development model has left it dangerously vulnerable to changes in US demand, and that these polices include repression especially of rural income.  According to Hung:

The PRC’s urban-biased development model, then, is the source of China’s prolonged ‘limitless’ supply of labour, and thus of the wage stagnation that has characterized its economic miracle. This pattern also accounts for China’s rising trade surplus, the source of its growing global financial power. However, the low wages and rural living standards that have resulted from this development strategy have constrained China’s domestic consumer market and deepened its dependence on the global North’s consumption demand, which increasingly relies on massive borrowing from China and other Asian exporters. As those other exporters have been integrated with China’s export engine through the regionalization of industrial production networks, the vulnerabilities of the Chinese economy have turned into weaknesses of the East Asian region as a whole.

Hung goes on to make a point that I wish many more would make.  When people like me warn about continuing domestic imbalances within China and the difficulty that China will face in its transition, we are often attacked for “blaming” and criticizing China.  Monday I was at a conference consisting of many prominent European and Chinese (and a few American) analysts who were discussing global imbalances.  At the end of one panel a member of the audience, who turned out to be from the Ministry of Commerce, demanded the right to make a rebuttal and set off on a fairly strange harangue in which she lambasted, to everyone’s bemusement, any attempt to assign China responsibility for any aspect of the crisis as well as any suggestion that its fiscal stimulus was worsening the underlying imbalances.  China has not, apparently, made even minor policy mistakes at all in the past decade and especially in the past year.

The nationalist argument

Although her view of the fiscal stimulus is not a majority view among the kinds of officials I am likely to meet, it seems it may be among the much more powerful domestic constituencies.  In fact another Chinese government official at the meeting told me afterwards, and at least partly in response to the outburst, that as difficult as it is to make these criticisms of policy, it is extremely important that foreign analysts keep making them so that Chinese policymakers can be made more aware of the difficult transition China will face.

As an aside, this lopsided debate within China between the domestic constituencies (more stimulus) and the internationalists (more rebalancing) reminds me, as I have often said, of the debate over the passage of Smoot-Hawley, which most Americans with knowledge and experience in international economics and finance, including President Hoover, thought at the time a dreadful mistake.  Hoover was unable to stop its passage however because domestic constituencies were so strongly in favor.  Their reasoning?  In previous episodes of US economic slowdown an increase in tariffs had always been expansionary for the economy, so given how bad conditions were in 1930 how could a sharp rise in tariffs not work?

Because underlying conditions were different.  Before WW1 the US almost always ran large trade deficits, and so it could raise tariffs with near impunity and boost domestic production.  By the end of the 1920s however the US was running what at the time were enormous trade surpluses (the third largest as a share of global GDP in the past 100 years[1]).  Because of its changed position the risk of retaliation meant that the US could no longer thumb its nose at free trade.  In a global demand contraction, surplus countries are always the most vulnerable, as the US discovered.

What does this have to do with China?  It seems to me that many policymakers in China note that every time they have faced a slowdown in the past, they were able to emerge via a sharp increase in investment.  Given how sharp the current slowdown has been, why not respond with an equally sharp boost in government financed investment?

Because, as in the US in 1930, conditions that permitted the earlier responses have dramatically changed.  When the US was growing robustly and, more importantly, US consumer credit was surging, an increase in the gap between Chinese consumption and production resulting from a surge in investment, no matter how uneconomic, always helped Chinese growth because the excess could be sold to the US.  Now the US is unable to play that role much longer.  The strategy will no longer work.

But to return to Hung, the point is that Hung makes a very different argument as to why China needs to come to terms with something with which many are unwilling to consider, and an argument that should appeal even to the most nationalistic in China:

Unless there is a fundamental political realignment that shifts the balance of power from the coastal urban elite to forces that represent rural grassroots interests, China is likely to continue leading other Asian exporters in diligently serving—and being held hostage by—the US. The Anglo-Saxon establishment has recently become more respectful towards its Asian partners, inviting China to become a ‘stakeholder’ in a ‘ChiAmerican’ global order, or ‘G2’. What they mean is that China should not rock the boat, but should continue to help maintain American economic dominance (in return, perhaps, for more consideration of Beijing’s concerns over Tibet and Taiwan). This would enable Washington to buy precious time to secure its command over emergent sectors of the world economy through debt-financed government investment in green technology and other innovations, and hence remake its ailing supremacy into a green hegemony. This seems to be exactly what the Obama administration is betting on as its long-term response to the global crisis and declining American power.

If China were to re-orient its developmental model and achieve greater balance between domestic consumption and exports, it could not only free itself from dependence on the collapsing us consumer market and addiction to risky us debt, but also benefit manufacturers in other Asian economies that are equally eager to escape these dangers. More importantly, if other emerging economies were to pursue a similar re-orientation and South–South trade were to deepen, then they could become one another’s consumers, ushering in a new age of autonomous and equitable growth in the global South. Until that happens, however, a recentring of global capitalism from West to East and from North to South in the aftermath of the global crisis remains little more than wishful thinking.

I am not sure I agree with everything Professor Hung says about the various political strategies, but I think he is absolutely correct to see the savings and trade imbalances as arising directly out of domestic policies that constrain household income growth in favor of the state and corporate sector, and I am sure he is even more correct to argue that rather than being the source of its strength, China’s continued vulnerability to US overconsumption is a great source of weakness.

We all love free trade, don’t we?

How great?  I guess we will find out over the next year or so.  President Obama’s meetings in China were, as widely expected, more about developing a relationship between the two leaders than about addressing real issues, and both sides did what they could – subject of course to domestic political pressures – do smooth over trade disputes, but for all their attempts trade disputes will not be smoothed over.

President Obama had to listen to several lectures from the Chinese about the importance of keeping trading markets open and fair (President Hu said that the world “must continue to promote trade and investment liberalisation and facilitation and oppose protectionism in all its manifestations, particularly the unreasonable trade and investment restrictions imposed on developing countries”), which of course struck many observers as hypocritical and almost funny, but I think it is important for foreign observers to recognize that China simply cannot adjust quickly enough to a lesser dependence on trade.  It will be a slow and difficult process, which is why I worry that with high and rising unemployment in the US and a high and rising trade deficit, trade cannot help but become a major political issue.

In that light there was an interesting piece on the Vox website by Richard Baldwin and Daria Taglioni with the rather alarming title “The illusion of improving global imbalances.”  They argue that the sharp “improvement” in global trade imbalances is largely a statistical outcome created by a temporary sharp drop in what they call “postpone-able” consumption items, “such as consumer and investment electronics, transport equipment, and other types of machinery.”  Their conclusion?

Projections of improving imbalances are almost surely wrong. The rapid collapse of trade between the third quarter of 2008 and the first quarter of 2009 improved most balances of trade. It could not have done otherwise; if both imports and exports drop rapidly, the gap between them drops equally rapidly. In the same mechanistic manner, the recovery of trade flows – a recovery that seems to have started this summer – will almost surely return the US, Germany, China and others to their old paths.

If they are right, and already the US trade deficit has risen sharply from its lows, the fight over trade will heat up even sooner than I expect and it will be a hotter dispute.  To repeat my earlier assertion, high and rising unemployment in the US (and Europe) is not easily consistent in the real world of politics with high and rising trade deficits.

Little in the meetings between Obama and Hu was said about the currency, at least in public, but so much has been said about it in the press and among analysts that there was easily a balance.  For the record, I think the much-commented November 11 statement by the PBoC, in which it omitted a phrase promising to keep the renminbi stable and instead said it would “improve the exchange rate pricing mechanism in a proactive, controlled and gradual manner, with reference to international capital flows and major currency moves,” does not indicate that the decision has been made to appreciate the RMB.  That decision is not the PBoC’s to make.  At any rate other policymakers have been saying very different things.  Commerce Minister Chen Deming said less than two weeks earlier that“the renminbi exchange rate has to remain stable for exporters and Chinese manufacturers to make an easier judgment on future situations ”

Real debate

And on Tuesday the Ministry of Commerce was even more strident.  On Monday that IMF Managing Director Dominique Strauss-Kahn said in a conference in Beijing that “a stronger currency is part of the package of necessary reforms.  Allowing the renminbi and other Asian currencies to rise would help increase the purchasing power of households, raise the labour share of income, and provide the right incentives to reorient investment.”  That same day the MoC struck back.  According to an article in Bloomberg:

China’s Ministry of Commerce said international pressure for appreciation in the yuan was “not fair,” as U.S. President Barack Obama started a four-day visit calling for a more balanced relationship between the two nations.

Seeking a stronger Chinese currency as the dollar weakens “is not conducive to a global economic recovery and is not fair,” ministry spokesman Yao Jian said at a press briefing in Beijing today. “It’s necessary for us to provide a stable and predictable environment in terms of macro-economic and exchange rate policies.”

What all this does indicate, I think, is that there is a very active and maybe even fierce debate within China about the whole rebalancing process, and that at least some policymakers are worried about a trade backlash.  In that case it may make sense to appreciate the RMB a little to appease US and European (not to mention Asian) anger while perhaps reversing the impact of the appreciation by managing other variables – reducing interest rates, increasing energy or other subsidies, etc.  In my opinion we will probably see action on the RMB front in the next quarter or so, but the timing will really depend on two things: increasing international pressure, and a sense domestically that the fiscal stimulus is continuing to work and growth prospects over the short term are stable.  It will also depend on what kind of anticipatory hot money inflows we see over the last quarter of 2009.

One of the centers, I think, of those calling for rebalancing is the National Bureau of Statistics, and Xinhua had an article last week on that topic, in which Yao Jingyuan, chief economist of the National Bureau of Statistics, seems both to be assuring policymakers that the stimulus-induced growth is stable and that it is time to focus more closely on rebalancing.

Yao Jingyuan, chief economist of the National Bureau of Statistics (NBS), told a forum in Beijing that China’s economy was over the worst, saying November 2008 to February 2009 was the toughest period for the economy.  The country’s economy had gained momentum each quarter, which would ensure full-year growth of 8 percent, he said.

…The stimulus packages to prop up growth had set a stage for stronger growth in the future, he said.  However problems remained and the real challenge for the economy was to adjust its economic structure, Yao said.  ”We should not pursue economic expansion in terms of size and speed in the fourth quarter or the next year, but put more efforts on structural adjustments.”

It seems pretty clear to me that Yao is explicitly arguing the case for rebalancing.  When I am abroad it often seems to me that foreign observers have a mistaken view of what is happening in China.  There is too much acceptance at face value that China has managed to escape the crisis fairly well, and that there are no serious concerns within the country.  On the contrary, however, it seems to me that the debate in China is very deep, very worried, and although I think that on balance policy is moving in the wrong direction because the preponderance of power is held by policymakers who simply do not understand China’s place within the global balance, it is focusing on most of the right things.

You might not, however, get a sense of the debate at first from today’s rather reassuring lead story in People’s Daily:

The United States and China, the world’s first and third largest economies, have pledged to rebalance each other’s economy and move in tandem on forward-looking monetary polices for a strong and durable global economic recovery, according to a China-U.S. joint statement released in Beijing on Tuesday.

The statement, issued after talks between Chinese President Hu Jintao and his U.S. counterpart Barack Obama, has climaxed the latter’s first China trip since he took office in January. “China will continue to implement the policies to adjust economic structure, raise household incomes, expand domestic demand to increase contribution of consumption to GDP growth and reform its social security system,” said the statement.

The United States, in return, will take measures to increase national saving as a share of GDP and promote sustainable non-inflationary growth. “To achieve this, the United States is committed to returning the federal budget deficit to a sustainable path and pursuing measures to encourage private saving,” it said.

It sounds good, but is this what the two countries are really doing?

Credit growth predicts financial crises

Before going on to the last topic, I want to make a brief mention of a very interesting article on Bloomberg that suggests the magnitude of recent Chinese commodity stockpiling:

Copper stockpiles held in duty-free warehouses in China, the top user, may be re-exported after surging to as much as 350,000 tons from almost none at the start of the year, according to Xi’an Maike Metal International Group.  “We can hardly find buyers for refined copper,” said Luo Shengzhang, general manager of the copper department at Xi’an Maike. The company ranks among the country’s three biggest importers, according to the executive. “China’s got to export some copper from now and next year,” Luo said in an interview.

I have been warning many of my investor friends that if there is a slowdown in Chinese growth over the next three or four years, not only will commodity prices drop to reflect the normal reduction in demand, but they may drop sharply to reflect the reversal of what I think is very significant stockpiling that has occurred in the past year or two, and which has distorted China’s import numbers.  China has been buying lots of stuff which it hasn’t yet used.  Will inventory and stockpiling draw-downs replace contracting trade as the next big drag on Chinese growth (requiring, by the way, a continued fiscal stimulus to generate employment growth)?  I suspect it will.

Finally, Moritz Schularick and Alan M. Taylor have a new NBER Working Paper, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008.”  The paper discusses the behavior of money, credit, and macroeconomic indicators over the long run based on historical data for 12 developed countries over the years 1870– 2008, and argues based on this data that rapid credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong”.  In their words:

Our key finding is that all forms of the model show that a credit boom over the previous five   years is indicative of a heightened risk of a financial crisis.

…The findings mesh well with our overall understanding of the dramatic changes in money and credit dynamics after the Great Depression.  In the summary data for the pre-WW2 sample, we saw how broad money and credit moved hand in hand, so that a Friedman “money view” of the financial system, focusing on the liability side of banks’ balance sheets, was an adequate simplification.  After WW2 this was no longer the case, and credit was delinked from broad money aggregates, which would beg the question as to which was the more   important aggregate in driving macroeconomic outcomes.  At least with respect to crises, the results of our analysis are clear: credit matters, not money.

What about the so-called “Lawson doctrine” – the counterargument that credit booms are risky depending on whether they are funding investment or increased consumption?  Would this make a difference given that China’s credit expansion is aimed almost exclusively at investment rather than consumption?  Leaving aside the possibility that the riskiness of China’s investment boom may be affected by the extremely high level (historically unprecedented) of investment that China had before the crisis, the authors are not terribly positive:

According to arguments heard from time to time, if credit is funding productive investments” then the chances that something can go wrong are reduced—as compared to credit booms that fuel consumption binges or feed speculative excess by households, firms, and/or banks.10 Our results caution against this rosy view. Over the long run, in our developed country sample, the lags of investment are not statistically significant, suggesting that crises are no less likely when they have been funding investment booms as opposed to other activity.  If this is the case, then the suspicion arises that when banks originate lending, they may be equally incapable of assessing repayment capacity in all cases, with investment loans having no special virtues.

Most historical work on financial credit booms and crises (and I think have read a significant portion of the best stuff) suggests the same thing: the best predictor of either financial crisis, or of the long-drawn out contractions like that faced by the US after 1873, Mexico after 1982, or Japan after 1990, is a rapid expansion in domestic credit.  China has had a ferociously rapid expansion in domestic credit.  Does that mean that China is on the verge of a crisis?  No.  I don’t think China will have a crisis, but I do think that after the fiscal stimulus runs out of steam, probably after another two or three more years, we are going to enter a long and difficult period of much slower and more volatile growth as China is finally forced to make the adjustments it has so desperately tried to avoid.

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[1] In the late 1920s, the US represented over 30% of global GDP and ran a trade surplus equal to around 0.4% of global GDP.  In the mid-1980s Japan represented around 15% of global GDP and ran a trade surplus equal to around 0.5% of global GDP.  Two years ago China represented about 7% of global GDP and ran a trade surplus of about 0.6% of global GDP.  Given what the following decade brought to the US and Japan, it may be worth figuring out how these imbalances get resolved.

There were two interesting and related articles Wednesday, both suggesting that the CBRC continues to be worried about the lending boom and is making what attempt it can to slow the growth of future problems.  The first article, from Bloomberg, was about the CBRC’s plan to tighten rules for personal loans:

China’s banking regulator said it plans to tighten rules on personal loans, seeking to prevent the misuse of funds and curb “irregularities,” especially in lending for auto and real-estate purchases.  The regulations, now being circulated in draft form, are aimed at ensuring loans enter the real economy rather than for speculative purposes, according to a China Banking Regulatory Commission statement posted on its Web site today.

This story has already drawn so much cynical comment from Chinese and foreign observers that I won’t say much more about it.  The second article has Liu Mingkang, head of the China Banking Regulatory Commission, worrying about “blind” expansion among the smaller city banks.  In my last entry I discussed the fact that the bulk of new lending seems to be occurring at the level of city banks and cooperatives, perhaps because they are more easily controlled by cash-strapped local governments, and this may have the result of increasing distress among these banks in the event of an economic downturn.

Perhaps policymakers agree.  According to Xinhua:

Chinese city commercial banks should avoid aiming to expand in terms of size and speed, and ranking among peers, Liu Mingkang, chairman of the China Banking Regulatory Commission, said in a statement posted on the commission’s website Wednesday.   The foundation of the country’s economic recovery was not yet solid, and city banks should pursue prudent growth and pay more attention to and prepare for economic changes, he said.

China’s 136 city commercial banks achieved an average capital adequacy ratio of 13 percent by the end of 2008. Non-performing loans ratios stood at 2.3 percent and the provision coverage ratio was 114 percent.  By the end of June, total assets of city commercial lenders hit5 trillion yuan (732 billion U.S. dollars), up 37.9 percent from a year ago.

Neither of these concerns is especially new, but I have to add that it is becoming harder to go more than a day or two without seeing yet another announcement by the authorities warning about the consequences of the mad dash in credit expansion.  I am not an insider, of course, but it seems to me that we have been getting a rising crescendo of rumors about conflicts and disagreements within policy-making circles about the ultimate consequences of the fiscal and credit stimulus, and it is pretty clear that a lot of people in senior positions are very worried.

Part of the worry, of course, is about rising protectionism.  Today Vice Premier Wang Qishan, who by the way has not turned out to be nearly as visibly active in economic affairs over the past two years as I expected, met in Hangzhou with U.S. Trade Representative Ron Kirk, Commerce Secretary Gary Locke, and Secretary of Agriculture Tom Vilsack.  According to an article in Bloomberg:

The governments of China and the U.S. must “stand firmly together against trade protectionism,” Chinese Vice Premier Wang Qishan said today at a meeting with U.S. officials in eastern China’s Hangzhou city.  His comment underscores an effort to resolve disputes between the two economies, which have $409 billion of trade between them.

Ron Kirk’s more neutral response was that trade frictions are a “normal part of a growing, mature relationship” that should not derail broader bilateral ties.  I don’t want to read too much meaning into these comments, but they do seem to symbolize the growing distance between the perceived interests of the two countries.

Matters weren’t helped by reports of a largely symbolic upcoming launch, by China, of an investigation into whether US carmakers are being unfairly subsidized by the government.  I say this is largely symbolic because I think most US cars sold in China are made here in China.  The Financial Times article on the subject referred to the investigation as Beijing’s “turning the tables” on Washington.  It may well be, but I would imagine that if each country started investigating export subsidies in the other country China would have a hard time winning the argument, and as the trade surplus country most reliant on export markets to absorb its exess capacity, it would be the more vulnerable to trade disputes.  This is not a good argument in which to engage.

Diversifying investment

Meanwhile, and perhaps as a reaction to the sense that too much of the burden of growth is being borne by the government, directly or though the banks, it seems that policymakers want to diversify the funding source.  Wednesday’s People’s Daily has this to say:

China will take more measures to encourage private investment in the next stage of its 4-trillion-yuan ($585 billion) stimulus package, an official with the National Development and Reform Commission (NDRC) said Tuesday.  The NDRC, the country’s top economic planner, will allocate 3 billion yuan of government investment for small and medium-sized enterprises (SMEs) to promote their innovation capability, energy saving and emission reduction, and production condition improvement, said the official.

The government will roll out policies to shore up private investment in expanding market threshold and improving administrative service, according to the official.  The official added that the stimulus investment will support more livelihood projects, and promote innovation and environment protection though he did not elaborate on any specific investment plans.  The NDRC will also strengthen supervision over investment programs to avoid fund abuse and overcapacity, according to the official.

If they are able to decentralize investment decision-making I think that will mostly be positive, since the more we push decision-making down into the hands of people closer to the ground the more informed and intelligent the decisions are likely to be.  I am not convinced however that this is going to happen very quickly.  Previous attempts to diversify decision-making – for example the much-vaunted governance reform of the banks – ended up creating more heat than light.  It is not easy to give up control.

There was another interesting bit in Xinhua Wednesday, this time about industrial profits.

Industrial enterprises in China’s 22 regions reported a combined profit of 1.55 trillion yuan (227.5 billion U.S. dollars) in first nine months, down 9.1 percent year on year, the National Bureau of Statistics (NBS) said Wednesday.  NBS statistics showed the decline was 4 percentage points less than that of January-August period.

Altogether 35 of the 39 major industrial sectors realized profit growth or smaller profit declines compared with the first eight months, said the NBS.  Core business revenues of those companies reached 28.8 trillion yuan in the first nine months, up 3.4 percent from a year earlier. The growth rate was 1.5 percentage points higher than that of the first eight months.  The accounts receivable of enterprises in the 22 regions stood at about 3.56 trillion yuan at the end of September, up 10.6 percent year on year.

A number of my economist friends are very puzzled that furious economic growth seems to come hand-in-hand with declining profitability.  I am not sure I fully understand why this might be happening, but I will add that to me profitability is not a very useful measure of economic value-added in China since, as I see it, there are huge subsidies provided to manufacturers in China in the form especially of low interest rates – as well, of course, as other things such has controlled prices for land, energy and other commodities.  In that case changes in profitability are at least as likely to reflect changes in the nature of the subsidies as they are to reflect changes in underlying economic conditions.

To return to a subject carried in my last two posts, the People’s Daily also had an interesting comment (titled “Metal stockpile sell-off unlikely”) on commodity stockpiling, probably in response to the increasing discussions on that topic.

Chinese investors holding metal inventories are unlikely to sell them quickly because of adequate levels of cash on hand, a senior executive at Sucden Financial Ltd said yesterday. The downside risk to metals prices is limited due to high liquidity, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, said in an interview at a Hong Kong conference. Copper prices may rise to record levels sometime next year, said Goldwyn.

Inventories of copper at warehouses monitored by the Shanghai Futures Exchange are more than five times the level at the beginning of the year after 4 trillion yuan in stimulus spending and State stockpiling boosted imports to a record. Prices in London have more than doubled this year on record Chinese imports.  “The view is that China has seen high imports and that these inventory levels were maybe getting excessive and maybe forming a downward pressure on imports and demand,” Martin Squires, executive director at JPMorgan Securities Ltd in London, said.

Consumer stockpiles of copper, excluding government inventories, could be as much as 600,000 to 700,000 metric tons, said Squires.  Inventories of copper at Shanghai warehouses stood at 95,976 tons last week, up from 17,822 tons at the start of the year. China’s copper imports more than doubled in the first nine months to 2.6 million metric tons, according to customs data.

Private Chinese investors may have stockpiled more than 50,000 tons of copper and as much as 20,000 tons of nickel, Goldwyn said on Sept 17. Chinese smelters may have between 200,000 and 300,000 tons of lead stockpiled, he said then.  Gauging metals demand in China is notoriously difficult amid increased speculation by retail investors. A possible overhang in supply amid high imports and production threatens to damp demand, Chen Hongzhou, vice-manager of the marketing department at Chinalco Luoyang Copper Co, said.

University rankings

Finally, and this is on a completely different subject, although one that interests me a great deal and might interest readers looking for some color on China, People’s Daily Tuesday hailed the creation of “China’s Ivy League”.

China’s Ministry of Education voiced on Monday its support for the formation of C9, an academic conference comprising nine domestic prestigious universities and referred to as China’s Ivy League by some experts.

Xu Mei, the ministry’s spokeswoman, said the establishment of the conference is a “helpful attempt that is conducive to the country’s construction of high-quality colleges, cultivation of top-notch innovative talents and enhanced cooperation and exchanges between Chinese universities and their foreign counterparts.”

On October 12, nine institutions of higher learning including the elite Peking University and Tsinghua Univerisity signed cooperative agreements that featured flexible student exchange programs, deepened cooperation on the training of postgraduates, and establishment of a credit system that allows students to win credits through attending classes in member universities of C9.

Other universities are Zhejiang University, Harbin Institute of Technology, Fudan University, Shanghai Jiao Tong University, Nanjing University, University of Science and Technology of China, and Xi’an Jiaotong University.

For those not familiar with the hierarchy within Chinese university system, there are two schools that are considered without reservation to be at the pinnacle of China’s universities, Peking University (known popularly as Beida) and Tsinghua University.  Both are in Beijing’s northwestern Haidian district (also known as the university district since most of Beijing’s most famous schools are located here) and in fact across the street from each other.  I was lucky enough to teach at both, my first four years at Tsinghua and now, for four years and counting, at Beida, and I have to say that they probably have on average the smartest student bodies in the world.

To get an idea of their dominance, every year the national exams produce two “provincial champions” for each of mainland China’s 31 provinces, municipalities (the four that have provincial status), and autonomous regions – one for each of the two high-school study tracks, hard sciences and humanities.  Of these, on occasion you might get one of the “provincial champions” choosing to go to a school other than Beida or Tsinghua, but most years every single one will choose to attend either of the two premier universities.  Beida tends to get more overall, and Tsinghua tends to get more of the hard science champions, although in recent years the discreet competition between the two has suddenly burst out into the open and the gloves taken off.  They have been much more aggressive about offering scholarship money to the top candidates in an effort to affect their choice (by the way, you cannot apply to more than one school).

Below these two there are a number of highly selective universities that compete for the rest of the students.  I was pretty aware that all the named schools except the last two were part of China’s “Ivy league”, but of course there are other highly selective schools that might have had Ivy pretensions.  In particular I was under the assumption that Sun Yat Sen University, the Foreign Service University in Beijing (although perhaps too specialized), and Nankai University in Tianjing might have qualified as being among the most selective, along with one or two others, like Wuhan and Jilin and maybe even People’s University in Beijing (popularly known as Renda).  For those interested, CASS ranks the top schools, although I am not sure about the criteria.

Beida versus Tsinghua

Because I spent so many years in both I am often asked about the differences between the top two schools, and I have to say that to me the differences are not nearly as great as are popularly supposed.  They both draw from nearly the same pool of students but there have been and still are some small cultural differences that seem to be wearing away over time.  Tsinghua has historically been heavily male while Beida historically had a slightly larger percentage of females, probably reflecting the fact that Tsinghua was for a long time primarily an engineering school (MIT is often invoked as a model) whereas Beida specialized in arts and pure sciences.  Both are moving towards a more balanced student body and academic orientation although Beida is where you still are more likely to find a philosopher or a physicist and Tsinghua an engineer.

I am very involved in helping my students get jobs in the financial services industry and so I know that Beida is by far the favorite school among global investment banks – probably placing more students in these highly-desired jobs than the next two schools combined (Tsinghua and Fudan).  Finance is the top major at each school, or one of the top two, meaning that it has the highest minimum required admission score for students who have taken the all-important gaokou, the university entrance exam that most high-school seniors take.  To give an example of how popular it is, last year 24 “provincial champions” chose to enter the Guanghua School of Management at Beida, the most prestigious of the three faculties in Beida that offer economics/finance majors.  I suspect that the School of Economics and Management at Tsinghua has a similar number, implying that around two-thirds of China’s stop students want to be bankers.

I like to think that Beida’s success in placing students in these jobs is because of my influence, but I suspect that it is more because Beida is in the front line in China in liberalizing and reforming education.  Beida students are far more likely, for example, to be required and able to take courses outside their major than students from other schools, including Tsinghua, and tend to have much more varied resumes.  You are more likely to meet a Beida finance major chattering excitedly about his philosophy or literature class than one from Tsinghua.  They also tend to be more encouraged to have outside activities and internships.  Given the extremely narrow specialization and heavy course burden of Chinese universities I think this is unquestionably a good thing, and creates more well-rounded students with greater leadership potential.

Beida is famous in modern Chinese history as being the cradle of Chinese cultural and political change.  In my first year there I asked one of my students, a sophomore from Shandong province, why he had decided to come to Beida rather than Tsinghua.  He smiled shyly but also a little proudly and said: “Because Beida is the edge of history.”  What a great answer!

But even there I suspect that the differences between the two schools are more apparent than real.  In my experience Tsinghua students are as likely to be politically active (and even fairly radical) as Beida students, and I have political discussions at equally high levels of sophistication at both schools, although perhaps my sample is heavily distorted because at both schools I dealt mostly with economy and finance majors.  Tsinghua’s engineers on average may be less politically sophisticated than Beida’s philosophy or government majors.

There is by the way, and perfectly in line with conventional views about philosophers and engineers, a wide-spread perception that Beida-educated leaders are more imaginative and Tsinghua-educated leaders more effective.  A Tsingua professor even told me two years ago that given the risky changes China is undergoing, the Standing Committee needs more Beida graduates and fewer Tsinghua graduates.

Most of these kids at these two schools, however, are amazingly bright and hard-working, a description I would extend to the students of any of China’s top universities.  With such a huge population all so eager to get into the top schools (and China is so hierarchical that everyone pretty much ranks the schools in exactly the same way – although recently there has been a rankings scandal), you can be sure that students at any of the listed schools are pretty impressive.

This is part of the reason I have stayed so long in China – for me there are few things as much fun as teaching very bright kids.  Unfortunately I think the quality of education is pretty low, and especially inappropriate for the brightest students.  Such bright kids need less rote work and memorization and more opportunities to think outside the box – a practice frowned upon within the educational system.  In that sense I think Beida is a real leader, moving Chinese elite education in a much better direction overall.

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.

“What is the point of putting so much effort and time into getting a university degree if at the end all you get is the salary of a migrant worker?” said Wang Lefu, who studied business management. “One needn’t have bothered with exams and all the bureaucracy.”

…For China the global economic crisis has exacerbated a serious unemployment crisis that has been many years in the making and that few believe will disappear with the first signs of global recovery.  China’s official unemployment rate stands at about 4%. Yet a large group of laborers – the communist state’s 150 million migrant laborers or floating population, as they are sometimes termed here – is not taken into account when unemployment figures are calculated.

When the global financial crisis hit last year – diminishing trade flows and reducing manufacturing orders for China’s factories to a dribble – some 20 million migrants were estimated to have lost their jobs and returned home. The pressure of resolving unemployment tension in the countryside this year has been made even more difficult for Beijing by its difficulties in finding jobs for the country’s surging numbers of university graduates.

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.

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

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

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

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

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

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

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

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

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

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

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

Are investors stockpiling?

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

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

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

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

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

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

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

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

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

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

Industrial policies create overcapacity

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

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

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

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

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

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

The trade impact

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

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

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

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

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

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

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

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

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

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

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

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

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

New loans still soaring

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

3. China’s GDP grows much more slowly.

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

Consumption growth determines trade tensions

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

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

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

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

The Japanese parallel

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

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

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

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

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

Household income growth determines consumption growth

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

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

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

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

Two asides

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

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

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

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

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

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

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

Productivity matters

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

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

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

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

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

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

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

Spending must be justified

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

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

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

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

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

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

William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled “Equilibrium Exchange Rates,” in which they try to “estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances” for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative – I would have thought “equilibrium” would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all “countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.”

Using early June 2009 exchange rates, they find that six countries – most of whom are primarily commodity exporters, not coincidentally – have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:

Country	Billions	Undervaluation
Japan	$4,908	18.1%
China	$4,221	40.3%
Switzerland	$491	19.8%
Sweden	$479	15.3%
Taiwan	$392	29.4%
Argentina	$330	18.4%
Thailand	$273	16.7%
Malaysia	$222	33.2%
Hong Kong	$215	27.9%
Singapore	$182	26.3%
Philippines	$169	18.2%

Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the “correct” exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.

The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.

The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF’s projection of the Chinese surplus seems not to have declined despite the RMB’s real appreciation, although the fall in commodity prices in the past year has presumably worked in China’s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.

Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.

What’s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.

But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly “devaluing” the RMB – i.e. policies that implicitly increased subsidies to production, and/or taxed consumption – so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.

New lending surges

We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of “good news” recently – very popular among the China bulls – were claims that new lending had moderated significantly in the past two months (so don’t worry too much about that credit bubble everyone’s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.

In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:

Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.

Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.

Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

He goes on to say:

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

I usually don’t quote so much from a single source, but I think Andy Xie’s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China’s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation – virtual business.

…Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

Tags: John Williamson, William Cline

Last week I spent in Brazil, where I was honored to meet someone I admire very much, former Brazilian President FH Cardoso, along with a large group of Brazilian investors, politicians, and academics, including several old friends. At some point I will write about some of the things I learned there, but I am still a little too tired and jet-lagged to collect my thoughts. As soon as I returned to Beijing I had to go spend two days in Wuhan, a city I had never visited before but a really interesting place with an absolutely wild cultural scene, not all of whose characteristics are totally legal, and so because of all this travelling it has been eight days since I last posted anything here. My apologies.

Since I am still a little addled and way behind on work I don’t have much to write today except a series of miscellaneous notes. The first is extremely anecdotal, admittedly, but also worrisome and more than a little humorous. In an entry two weeks ago, as evidence of some of the dangers of the current loan boom, I mentioned an article that my friend Dan Rosen had sent me. It discussed a statement made by Lin Zuoming, the General Manager of AVIC, the largest single borrower in the current lending spree, who said that now that he had raised $35 billion, his biggest single worry was “how to allocate the borrowings to increase returns.” Dan found it a little worrying (as did I) that anyone could engage in such massive borrowing without a clear sense of what he planned to do with the money.

Today Dan sent another article that partially helps clear up the mystery. AVIC has recently decided to place RMB240 million with a private equity fund to invest “in technological renovation and production capacity expansion of the special spherical plain bearings project,” which I think are ball bearings.

I don’t doubt that ball bearings are a profitable business, but it seems to me a bit of a stretch for an aircraft manufacturer (although I suppose airplanes use ball bearings) to make a large investment in a ball-bearing producer. In the 1970s Americans learned the hard way how dangerous it was to allow CEOs free rein to exercise their natural preference for expanding their companies into a wide range of unrelated businesses – all of which was made easy and almost inevitable by access to seemingly “free” capital. We spent a very difficult 1980s watching the famous conglomerates created in the 1960s and 1970s brutally torn apart so as to eliminate their huge inefficiencies.

Give CEOs anywhere unlimited access to very cheap funding, and pressure them to take as much of it as they can, and it would be surprising if they didn’t manage to convince themselves of the viability of quite a few projects that, under different funding circumstances, they would have avoided.  By the way, in this context I should mention a very interesting April 2009 paper, produced for the HKMA by Giovanni Ferri and Li-Gang Liu, which argues that the rapidly rising profitability of SOEs may be a mirage.

We are interested in in investigating whether the profits of SOEs would still be as large as they claim if they were to pay a market interest rate.  Using a representative sample of corporate China, we find the costs of financing for SOEs are significantly lower than for other companies after controlling for some fundamental factors for profitability and individual firm characteristics.  In addition our estimates show that if SOEs were to pay market interest rate, their existing profits would be entirely wiped out.

In my reading it seemed to me that the authors only compared SOE funding costs to that of other Chinese corporates, and did not take into account the possibility (very likely) that overall interest rates are much lower than they would normally be because of regulatory controls.  Had they done so, they might have found that SOEs are actually value destroyers, made profitable only by the fact that the income of savers has been “appropriated” and converted into subsidies via very low interest rates.  Besides what this means for value creation in the economy, this is important because it also affects consumption levels (remember that in China low deposit rates are associated with higher savings) and trade policy.  In another entry I will discuss low financing costs as being as much a trade-related policy as tariffs and currency levels.

At any rate as the AVIC anecdote suggests I suspect that at least part of the current fiscal stimulus in China will end up creating more corporate monsters who will work hard to keep productivity growth in the future low. This is all the more likely since it seems to me that quite a few Chinese policymakers (and much of the general public) are a little too comfortable with the idea of national champions and other forms of corporate gigantism, even though the evidence for their social and economic value is pretty limited.

This of course is not in and of itself an argument against a large stimulus program, since it would be easy to counter that even wasteful spending is acceptable in a crisis (I don’t necessarily agree, but many wise people have said so), but of course I am very worried that China is making it more difficult to deal with its own transition. At any rate I am not sure that wasteful spending to drive this year’s growth rate up from 6% to 8% is such a great idea if it causes future growth rates to drag significantly. This will not be a quick crisis which we can put behind us next year.

I discuss all of this in an article in yesterday’s Financial Times, titled “Asia needs to ditch its growth model,” with which many of whose arguments regular readers will be very familiar. My basic argument, of course, is that policies that constrained domestic consumption growth while boosting production implicitly required someone (the US) to run large trade deficits, and with US savings on the rise, those days are over, at least over the next decade. As if to reinforce those claims, last week there was a very interesting article in the New York Times about US savings, which starts out with “The economic downturn is forcing a return to a culture of thrift that many economists say could last well beyond the inevitable recovery.”

The piece argues that it is unlikely that this time, unlike after previous short-term crises, Americans will return to high levels of consumption once the economy stabilizes. Higher savings rates may persist for long after the economy finally turns around.

To continue on trade-related issues, I thought I would refer to an article in last week’s Financial Times with the ominous title “US lawmakers to revive China tariff bill.” According to the article:

A group of Republican and Democratic lawmakers will on Wednesday revive a bill that threatens to raise tariffs on Chinese goods to punish the country for what they call “currency manipulation”. Highlighting the protectionist sentiment within Congress, the bill would let companies apply for tariffs on imports from countries deemed to be deliberately undervaluing their currencies to be more competitive. China is its main target.

“By illegally subsidising its exports through the undervaluation of its currency by 30 per cent or more, China distorts the gains from trade, creates barriers to free and fair trade, harms US industries and has destroyed millions of US jobs,” those sponsoring the bill said in a statement.

Their move comes as countries across the world consider protectionist trade rules in the face of recession. Measures such as anti-dumping investigations rose 18.8 per cent in the first quarter of this year against the same period in 2008, according to research by Chad Bown at the Brookings Institution, with China’s exporters the target in two thirds of those cases.

As I have said many times before, I am very pessimistic about our ability to prevent a sharp rise in trade friction and an equally sharp contraction in international trade. The OECD website is currently running an article called “World trade set to fall 13 percent, OECD urges governments to avoid protectionism” in which they claim that world trade will drop 13% from 2008 to 2009.  Not surprisingly China is worried, and today’s People’s Daily discusses one of the now-familiar response:

Chinese Premier Wen Jiabao announced Wednesday that China will shortly send another buying mission to the European Union (EU) to increase imports from Europe. The Chinese trade promotion mission sent to the EU immediately after Wen’s European tour in January had produced positive results, Wen told reporters at the end of the 11th summit between China and the European Union (EU).

“China is ready to work with the EU to further promote mutual investments, enhance cooperation in small- and medium-sized enterprises, trade facilitation, science and technology, transportation and post, in an attempt to fight all forms of trade and investment protectionism,” said Wen. He expressed the hope that the EU will loosen control over export restrictions on high-tech products and nurture new growth potential in economic and trade cooperation in order to further promote China-EU trade.

In spite of the good-will generated by these buying missions (and I am not sure how much good will this really creates — my European corporate friends are extremely cynical about these missions), I don’t think there are a lot of warm and fuzzy feelings about trade anywhere in the world just now.  The various claims by interested parties don’t seem to be making the prospects very bright.

To show how confused the debate has become, and how unlikely we are to see a good resolution, I recently participated in a panel with a Chinese economist from a leading local investment bank who gave an impassioned argument against financial protectionism in the US. Among her claims were that China is totally open to foreign investment whereas the US and the West are almost wholly closed to Chinese investment which, she seemed to think, was extremely unfair. This is a claim I have heard so often in China that I am worried that it has become entrenched in local thinking.

The economist argued as evidence of this unfairness that that any foreigner could start a joint venture in China, or engage in any form of FDI, whereas the opposite was almost impossible. But this is mistaken on many counts. First of all, the restrictions on Chinese investments abroad have not been on FDI or other related start-ups and joint ventures. They have occurred when Chinese companies tried to buy large, existing companies that were considered, rightly or wrongly (and more often wrongly, I think), strategic assets.

But, and contrary to what the economist claimed, foreign purchases of equivalent Chinese assets are far more restricted. Almost every large company in China that a foreigner has tried to purchase has been prevented on the grounds of strategic interest, even some amazingly bizarre recent cases, and generally speaking most foreign companies don’t even try to buy large companies in China because everyone expects that transaction automatically to be turned down by the regulators. China, for example, would have never even considered anything similar to the purchase of IBM by Lenovo, and so no foreign company wonders about the possibility.

On the other hand, it is true that foreigners can fairly easily start new companies, enter into joint ventures in China (well, fairly easily – a lot of industries are off limits), and otherwise engage in FDI, but there are likewise almost no restrictions for Chinese investors in the US or elsewhere in the West to do the same. Any Chinese company that wants to start a company in the US from scratch can do so, with very few restrictions that would not apply to US or other foreign investors.

The point is that many Chinese sincerely believe that the restrictions facing their expansion abroad are much more onerous and stringent than the restrictions facing foreigners in China. Foreigners, of course, sincerely believe the opposite. Both sides feel aggrieved. Regardless of who may be right, the fact is that these very sincere beliefs make accommodation difficult.

Tags: Cardoso, HKMA

Today’s Financial Times and last week’s Economic Observer had articles that display the kinds of confusion that economic crises can create among policymakers. The Financial Times article was actually an opinion piece written by Wang Qishan – a Vice premier in the State Council and presumably one of the top three or four economic policy decision-makers in China.

It starts out, correctly I think, by warning that the global crisis is far from over. “The global financial crisis is still spreading,” Wang warns, “The world economy is going to get worse before it gets better, and the situation remains serious.” Much of the article discusses the same grab-bag of regulatory reform proposals whose purported aim is “to prevent a repetition of this financial crisis,” which include financial regulations to “strengthen, on the basis of sovereign rules, co-operation in regulating international private capital flows, financial institutions and markets, financial products and intermediaries.”

I have already written why I think financial reform aimed at preventing financial crises (as opposed to improving the capital allocation process during “normal” times) is largely a waste of time, and to that end I will remind my readers that Hyman Minsky, whose understanding of financial instability surpasses everyone else’s, argued that: “Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing.” In “A Minsky Meltdown: Lessons for Central Bankers”, a speech delivered on May 1, Janet Yellen, president of the San Francisco Federal Reserve Bank, explains:

As Minsky’s financial instability hypothesis suggests, when optimism is high and ample funds are available for investment, investors tend to migrate from the safe hedge end of the Minsky spectrum to the risky speculative and Ponzi end. Indeed, in the current episode, investors tried to raise returns by increasing leverage and sacrificing liquidity through short-term – sometimes overnight – debt financing.

Avoiding financial crisis, in other words, is a total pipe dream because to the extent that we are successful and enforce conditions of stability we actually increase the probability of future instability.

But that is an aside. Wang goes on in his article to propose action:

It is imperative for countries to co-ordinate macroeconomic policies and for all to adopt stimulus, fiscal and monetary policies. It is vital unequivocally to reject protectionism of all kinds.

Anti-protection sentiments are, of course, all fine and good, but it doesn’t make sense to define protection too narrowly. In contrast to Wang’s sentiments, last week’s Economic Observer had a very different take on protection.

China should give preference to locally-produced goods in government procurement, the Ministry of Finance said at an April 22 meeting focused on the issue. Assistant minister Zhang Tong said at the meeting that most of the public welfare projects benefiting from the government’s four-trillion-yuan stimulus package announced late in 2008 were closely related to government procurement.

Chinese law stipulates that government procurement favor local goods. But the EO has learned that many officials were not satisfied with the amount of local goods that the government had purchased since stimulus funds kicked in last November. Against this backdrop, China’s State Council ordered on April 10 that government at all levels give preference to domestic goods, and new regulations tightening government procurement have been slated for legislation in 2009.

It is hard for anyone, especially the country that does most to export overcapacity, to preach free trade while putting into place such blatantly obvious restrictions on trade. Of course some might argue that this is no different than the “Buy American” provisions discussed last year by the US congress, but I think in fact it is very different, for at least three reasons.

First, the “Buy America” provisions were never enforced and, what’s more, they are in many cases against US law. Of course they may also be against the law in some cases in China, but there is a robust legal mechanism in the US that can be used to prevent the US government from enforcing rules that violate US laws or US trade agreements. Importers, American as well as foreign, can sue the US government with every expectation of winning in court, in a way that no one, especially no foreigner, would even attempt doing in China.

Second, US government procurement is a tiny fraction of total US purchases, even taking into consideration the US fiscal stimulus. In China, almost the entire stimulus package is going to expand investment in SOEs and/or government projects, so the share of government procurement in total GDP is much, much higher in China. That makes it a far more trade-constraining measure in China than it could ever be elsewhere.

Finally, and probably most importantly, China is the country that most desperately needs foreign demand to absorb its excess capacity. In a world of contracting demand, China is the country that is most likely to suffer from protection, for the same reason that it is the country that benefits most from absorbing other country’s badly-needed demand. In that case it is not enough to say that China is just doing what everyone else is doing (and never mind that it is much harder for foreigners to invest in China or sell to China than it is for China to do either abroad), since any dispute that resolves itself in greater trade protection hurts China worse than it hurts the other disputant.

Meanwhile the Economic Observer had also last week a very interesting (and a little troubling) editorial on just this subject. The title says a lot: “A shift is needed, but not overnight”. The article starts:

Chen Deming, head of China’s Ministry of Commerce, recently wrote in the Communist party magazine Qiushi that earnings from Chinese exports could trickle down to compensation, and ultimately end up stimulating domestic consumption. He came down against certain popular opinions in China, including that the country relied too heavily on exports, and stressed that although a withering global market has sapped demand for Chinese goods, it has also presented great opportunities. Chinese enterprises needed to push abroad under such circumstances and promote Chinese exports, he concluded.

Chen’s arguments come at a sensitive time for China’s exports. As the Canton export fair opened this past week, the export industry was not optimistic – official data just released showed another slide in China’s export value in March.

The article goes on to discuss China’s transition from export orientation to domestic market orientation. Although many foreign and Chinese commentators, including me, would argue that almost nothing was done to accommodate this transition – indeed that China in the past decade actually deepened its over-reliance on the export sector – the editorial gives the government good marks in managing the process:

In the past few years, the government has long sought to transform the economy from a export-oriented model to a consumption-oriented one, while the Ministry of Commerce strove to reduce the trade surplus. But the economy’s restructuring could not be completed within one day, and a consumption-oriented economy never meant wholly abandoning foreign trade. Eagerness for an overnight success could only lead to adverse consequences. In this sense Chen’s article reflected a realistic attitude.

We believe this was a positive sign that the Chinese government has a deep understanding of the necessity of economic transformation, and that the consumption-oriented model would remain the core of future policy. At the same time, it also meant China understood it needed to be patient throughout the process.

The editorial concludes basically by saying that although China must continue (!) improving the relative importance of domestic markets, it must “stabilize” exports since “foreign demand must still serve as the engine of the Chinese economy for a period of time.”

I think in one sense Minister Chen is right – foreign demand is still the engine of Chinese growth – which is one of the reasons I am so pessimistic about medium-term growth, but of course I am a tad more skeptical than he is that in the past few years there were active policies (as opposed to formal announcements) aimed at reducing China’s over-reliance on exports. For example two of the most obvious steps – increasing the value of the currency and allowing interest rates to rise to a ‘natural” level – were never really seriously tried, remembering that any increase in the RMB against the dollar, and other currencies, must be set against an even faster relative increase in productivity. This was almost certainly because polices aimed at assisting the transition would necessarily have slowed export growth, and with it economic growth in the short term.

The fact that the editorial and the original article from which it was draw were both published, and seem to be arguing a case, gives some indication, I think, of the ferocity of the debate taking place about the nature of the stimulus package. One side says: Before we can fix the economy we need relief, and that is most likely to happen by reinforcing the existing economic structure. The other side says: The longer we take to postpone the adjustment, the worse.

For the other side of the debate, Hu Shuli in last week’s Caijing insists that “Beneath the surface of China’s ‘warming’ economy are structural impediments to long-term growth that demand attention – now.” She dismisses the recent optimism about China’s “bounce” back with “The ‘warnming’ is more show than substance.” and she goes on to say:

Since we know that credit expansion is not the best economic healer, we should spend the coming days thinking about long-term approaches that will help China survive the crisis and pursue lasting development.

China is being forced to rebalance. It’s clear that, regardless of the angle from which we examine the situation, our economy is being squeezed by internal and external crises. Excessive consumption in the United States is a root cause of the global financial crisis. Instead of complaining about this fact, or even quietly congratulating ourselves, China must consider what to do if the United States learns its lesson and, for example, gradually raises its household savings rate. If external demand for Chinese goods is declining, how can internal demand rise?

At this juncture, structural adjustment should not be empty talk. It must involve a series of basic policies that deepen the nation’s economic reform. Structural adjustments can only follow the market’s lead and, for the most part, involve breaking up monopolies, opening the market wider, relaxing controls, and getting the pricing mechanisms right.

Instead of betting even more heavily on foreign demand to bail China out, in other words, China must urgently move towards policies that force the transition, even if those policies are painful in the short term.

And it is not just Caijing that is voicing criticism about the current stimulus policies. A number of very prominent Chinese economists have been scathing (at least in private, so I cannot reveal their names) about the failure to have taken the appropriate steps when conditions were optimal, and are now insisting that to continue increasing reliance on foreign demand is going to create huge problems for China. Increasingly I am hearing people here say that, although few expect a “collapse”, whatever that means, China is facing its own “lost decade” of sub-par economic growth and a very difficult transition. As regular readers know, I am very inclined to agree.

Next week (Wednesday, I think) I will have a piece in the Wall Street Journal arguing that the surge in lending actually makes China’s transition more difficult in the medium term because it will act to constrain future consumption in China. I think Hu Shuli might agree.

Tags: Chen Deming, Wang Qishan