It may seem strange to be reading an August article in March, but in fact I often find myself a year or more behind in my reading.  This may seem a little perverse, but it does let me see what the smartest people were thinking at the time while knowing what subsequently happened.  Among other things this makes it clear how often informed consensus gets bogged down in the minutiae of everyday events while trying to understand the bigger picture.

In the case of this particular article, however, what triggered my interest is that it was about Japan’s post-1989 rebalancing, and among other things discusses why, in spite of every attempt, Japan has not been able supposedly to rebalance the economy and achieve any real growth during the two lost decades after 1990.  Private consumption never took off to drive economic growth.

Many of these reasons for low consumption we have heard before, and no doubt will hear again, but I am not sure how meaningful they are.  According to the article, the Japanese don’t take enough holidays, they are aging, exporters squirrel away profits to replace households as a source of savings, small companies are too inefficient, government supports big business, the Japanese don’t like to borrow, house prices are too high, and so on.  Maybe these really are the causes of the failure for the surge in consumption, but many sound like variations on accounting identities, and as such they are as likely to be consequences as causes of low growth.

But what interested me is that in spite of the fact that Japan’s economy didn’t grow, and contrary to the article’s claim, some serious rebalancing actually did take place, at least as I understand it.  Japanese gross national savings declined from around 35% of GDP in 1990 to around 23% last year.  The household savings rate dropped too, from around 10% in the 1990s to around 2%.  Neither declined in a straight line, but decline they undoubtedly did.

Household consumption, according to the article, nonetheless failed to grow meaningfully – in the past two decades it only grew by 1-2% annually – and this is much lower, presumably, than consumption growth in the 1980s.

But it was nonetheless higher than GDP growth, and that is exactly the point: consumption growth may have been low, but it exceeded GDP growth.  Rebalancing in the context of Japan (and China) does not mean that consumption growth must surge.  It just means that consumption must grow faster than the economy so as to become a bigger share of GDP and a bigger driver of total growth.  Put another way, it means that the savings rate must decline.  If this is what actually happened, then in fact Japan did partly rebalance.

But, mysteriously, in spite of the fact that Japan may have experienced real rebalancing and a real growth in the relative share of household consumption, the Japanese economy stagnated during the past two decades.  If you had predicted in 1990 that Japanese household and national savings would have declined so sharply as a share of GDP, and that consumption would have risen, you probably also would have predicted that Japan, after a couple of tough years, would resume rapid growth (or at least growth more in line with other rich economies) as surging private consumption pulled Japanese growth forward and away from its over-reliance on net exports.

But you would have been wrong on two counts.  First, Japan did not grow very quickly at all. It stagnated as consumption growth actually declined.  Second, its reliance on net exports did not decline.  The current account surplus remained high as a share of GDP.

Why didn’t Japan grow more quickly?  One reason may be obvious from the very fact that the current account surplus did not decline.  Although Japan certainly rebalanced by some measures, its current account surplus dropped from its peak of 4.2% of GDP in 1986 to 1.5% at its trough in 1996, only to turn around and surge, eventually to reach 4.8% in 2007, dropping to 3.1% in 2008 on the back of the collapse in international trade (and albeit on a much smaller economy as a share of global GDP than in 1990).

Since the current account surplus is another name for the excess of savings over investment, obviously this means that national investment declined as sharply as did national savings.  The article helpfully provides us with the numbers for both in an accompanying graph, and this confirms that investment indeed dropped, from a peak of around 32-3% in 1990 to around 22% last year.

With investment such an important part of Japanese growth prior to the bursting of the bubble, the fact that it declined so dramatically seems to have had a huge impact on Japan’s subsequent lack of growth.  So although in some important ways Japan “rebalanced”, for two decades it was nonetheless unable to grow even with a still-very-high and rising trade surplus, largely because investment declined sharply.

I am not an expert on Japan by any means, even though in the past two years I have been giving myself a crash course on recent Japanese economic history, but my Asian-development-model story suggests at least one explanation of what happened.  After many years of excess investment driving growth, Japan’s rebalancing process, which occurred after corporate, bank and government debt levels prevented the investment party from continuing, locked the country into many years of slow growth because it had to grind through years of debt-fueled overinvestment.

In fact Japanese investment jumped in the last two years of the 1980s, after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth, from an already-high 28% to nearly 33% three years later.  In other words Tokyo seems to have responded to the collapse in the US by increasing its already-high level of investment to counteract the impact on the trade surplus.  This is what happened in China too, after the 2007-08 banking crisis in the US.  This jump in investment seems to have kept Japanese growth going solidly for another two years after the current account surplus began its steep nine-year decline.

But growth in investment wasn’t maintained.  After 1990, when investment growth could no longer keep up, perhaps because Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.

The government tried to continue subsidizing growth over the subsequent decades by keeping both wage growth and interest rates low, not to mention maintaining the undervalued currency, as we know.  This unfortunately may have slowed the growth of both household income and household consumption, while maintaining the high trade surplus.  This also may explain why the drop in household savings was partly matched by the rise in corporate savings – households continued seeing transfers of income to the corporate sector.

But ultimately in spite of maintaining some of the old trade-related policies that kept manufacturing growth so strong for so long, there was nothing Tokyo could do to combat the effects of the decline in investment.  Had they allowed a more rapid rebalancing via higher wages, interest rates and the currency in the first two or three years, perhaps they would have had a tougher time early in the 1990s, and a lot more liquidations, but ultimately they might have pulled out of the slump a lot sooner because they would have transferred income to households more rapidly (although of course had they done this too aggressively, unemployment would have soared and consumption collapsed).

So where am I going with all this?  I am not completely sure, and no doubt I am oversimplifying the Japanese story.  Certainly I am not smart enough to figure out all the inner workings of Japan’s economy.  Just trying to keep the accounting identities in line and, making sure that everything that is supposed to balance actually does balance, is tough enough.

But this macro approach might have some benefit in that it shows how the overall system can constrain the micro-developments that we all hope for.  At the macro level, in other words, it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector, as they did not in Japan.  Rebalancing must occur, but as an accounting-identify matter it can occur both through good ways (a surge in consumption) and bad ways (a drop in growth).

In Japan it occurred the latter way.  Without a serious attempt to redistribute income more rapidly back to households, Japan rebalanced, but not via a surge in consumption.  Since it could not maintain investment levels, on which the economy was too dependent, and in fact increasingly dependent after 1987, it rebalanced via a sharp slowdown in growth.  Either way achieves rebalancing – which only means that consumption has to grow as a share of GDP – but of course the former is much better than the latter.

Japan’s experience suggests one of the risks China faces.  It is easy to talk about rebalancing as a solution to the underlying problem China faces, but as the Economist article points out, rebalancing can be “tricky,” and it does not lead automatically to growth – that depends to a significant extent on how quickly consumption grows, and can take many years before that happens.

Will China rebalance?  Of course it will.  It is not a question of if but rather of how.  The same was true of Japan.  No economy the size of China’s can be so heavily dependent on exports to absorb its excess production, especially once unemployment in the rich countries reaches significant levels.  And no large economy can keep investment rates so high – and the allocation process so constrained by governance issues – for very long without running into the problem of capital misallocation.  But there are many ways rebalancing can occur.

Chinese household consumption will undoubtedly rise as a share of Chinese GDP over the next decade or two, but the process nonetheless can be disappointing for growth.  It depends on lots of other moving parts, most importantly perhaps the change in investment and the speed with which income is transferred to households.  And the change in investment might depend on debt capacity constraints and the extent of earlier overinvestment.

And shouldn’t they get twitchy?  After all this reduction in Chinese holdings of Treasury bonds comes from the USG’s TIC data, so it must be true that China is dumping dollars, right?

No need to twitch, it means no such thing.  First of all, the data from which this was derived indicates national ownership of USG bonds only to the extent that foreigners are directly registered holders.  It says nothing about what happened to the large amount of bonds held by the PBoC and other Chinese investors indirectly or in street names. Those could have easily gone up by more than the reduction in bonds directly held by Chinese investors in their own name.  If the PBoC had let maturing Treasury bonds get repaid, for example, and reinvested the proceeds into the USG bond market through another account, or in a street name, its total holdings would have actually increased even though its registered holdings would have declined.

More importantly, the TIC numbers completely fail to disclose whether China’s reduced holding of USG bonds was matched by increased holding of other dollar assets, thereby increasing the pool of capital available to fund USG bonds by an amount equal to its reduced Treasury holdings.  If Chinese investors decide to take on more risk, for example, they might sell USG bonds and use the proceeds to buy corporate bonds.  Of course the seller of these corporate bonds will then have cash, which must be put to work, and ultimately this ends up back in the USG bond market.

China did not reduce its dollar holdings

So was China a net seller of dollar assets in December?  Almost certainly not.  Just look at the PBoC balance sheet.  PBoC reserves rose in December by $61.3 billion, of which $39.0 billion was the trade surplus.

Remember that China has a large current account surplus which necessarily must be recycled abroad, and the US has a large current account deficit which necessarily must be funded abroad. It would be astonishing if, under these circumstances, total Chinese holdings of USD assets declined, and of course it is impossible that they declined faster than the willingness of other foreigners to replace them.

Of course if the US current account deficit declines, net new foreign purchases must by definition decline too.  If the US wants its current account deficit to decline so that the USG can reduce the fiscal spending needed to generate any fixed number of jobs, this cannot possibly happen without a concomitant decline in net foreign, including Chinese, purchases of dollar assets.  But it need not result in any difficulty in funding the new, lower amount of debt issuance.  Depending on why it happens, reduced purchases by foreigners should probably be seen as a good thing for the US Treasury market, not a bad thing.

Confused?  How can a reduction in foreign purchases help the USG fund its massive fiscal deficit?  Because the purpose of the fiscal deficit is to create jobs in the US by boosting US spending.  Since some of the jobs that higher USG spending creates will accrete outside the US, via demand that “leaks” abroad through the deficit and creates employment for foreign manufacturers, a smaller trade deficit can itself be expansionary for the economy.  That means the USG will need to borrow less to create the same number of jobs. Fear of Chinese “dumping” of US treasury bonds, even if it were possible, should be a non-issue, but since it plays easily into various geopolitical conspiracies, we seem to love to worry about it needlessly.

Among other strange comments the TIC data generated last week were those by the Financial Times, arguing that “if the latest numbers mark the beginnings of a diversification by China away from US Treasuries and other dollar assets, a widely speculated rise in the value of the renminbi against the dollar is on the cards.”  Aside from the fact that it marks the beginnings of no such thing, it still wouldn’t be an indication of any future RMB strategy.  A rise in the value of the RMB may very well be in the cards, but this has absolutely nothing to do with what Beijing did with its USG bond holdings in December.

Why?  Because if China had intervened less in December, the RMB would have already shot up – in December, not at some time in the near future.  Of course if the PBoC believes that a rise in the RMB will cause the dollar to fall against the euro, it might have swapped out of dollars into euros as a clever trade based on its inside knowledge of the RMB strategy, but since the opposite is almost certain to be the case, it is hard to believe that any PBoC net sales of Treasury bonds would indicate its plan to raise the value of the RMB.

The TIC data in December tells us almost nothing about what will happen to the RMB.  To see why, it makes sense to discuss a little how and why the PBoC has accumulated dollars, and what those dollars mean for China and the central bank.  Here, the first thing to recognize is that the PBoC does not “decide”, as a banker, to lend money to the US.  It basically has very little choice.

Beijing is not Washington’s banker

If China runs a current account surplus, it must accumulate net foreign claims by exactly that amount, and the entity against which it accumulates those claims (adjusting for actions by other players within the balance of payments) ultimately must run the corresponding current account deficit.  And as long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets.  Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds.

This was not a discretionary lending decision.  It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar.  Why?  Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price.  What it does is far simpler.  It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price.

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price.  That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market.  Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest.

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar.  In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear.  The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value, as the FT article suggested.

Of course the PBoC must fund the purchase of these dollars.  It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars.

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets).   Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits).

Here is where things get interesting.  China’s reserves are often thought of as if they were a treasure trove available for spending.  They are not.  They are simply the asset side of the mismatched balance sheet.  If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100.  To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes.  Reserves are effectively borrowed money.

Can PBoC reserves protect China?

So the PBoC cannot give away the reserves without causing an increase in its net indebtedness.  This is why I have often said, to the confusion of some of my readers, that Beijing cannot just recapitalize the banks with reserves.  A substantial amount of NPLs will one way or another increase government debt.  The only way Beijing can recapitalize the banks is by borrowing, or by raising direct (or hidden) taxes.  Having the PBoC recapitalize the banks is just another way for the government to borrow, and since almost everyone would agree that losses in the banking system should be paid directly out of fiscal revenues, and not indirectly by the central bank, it would be a very inefficient way of doing so.

So what are reserves good for?  As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China.  They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption.  They can only be used to purchase or pay for things from outside China.  This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically.  It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment.

Here is where a great deal of confusion arises.  The US crisis of 2007-08 notwithstanding, we seem implicitly to believe that a financial crisis is always caused by an inability to repay foreign debt and investment, in which case having huge amounts of reserves certainly should protect a country from financial crises.

But this is only partly true.  Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).  As I pointed out two weeks ago, there are many cases of countries with huge amounts of reserves that nonetheless suffered from all kinds of financial crises.  It is just that they never suffered from external debt crises.

When it comes to domestic debt crises, large levels of reserves actually can make things worse.  Why?  Because financial crises are always caused by mismatched and highly inverted balance sheets, and the central bank’s accumulation of reserves is exactly that kind of balance sheet.

Of course when the rest of the country has an equally mismatched balance sheet in the other direction – like when South Korean companies in 1997 had huge amounts of won assets financed by dollar debt – the central bank mismatch enhances financial stability.  It acts against the mismatch carried by the rest of the economy, and the net impact is that the economy is less vulnerable to financial crisis.  In that sense reserves are a kind of insurance to protect against excessive foreign borrowing.  Because South Korea, unlike China today, had too few central bank reserves against the rest of the country’s too-large dollar obligations, its overall balance sheet was mismatched and it was susceptible to a collapse of the won.

But China has very little external debt – certainly very small compared to its reserves – and so this clearly isn’t an issue for China.  But then could the huge mismatch on the PBoC’s balance sheet create the opposite risk for China?

Balance sheet mismatches

Yes and no.  And this is where another great misperception occurs.  Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves.  After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency.  Unfortunately this kind of confused thinking is nonetheless the source of some strange claims.  One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings.  Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt:

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama’s advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China’s holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms.  It may now be seen why President Obama’s advisers have a vested interest in not examining the factual situation of China’s trade. They are seeking a large debt relief package.

Sigh.  The arithmetic is apparently not as simple as it seems.  When one of my central-bank seminar undergraduates showed me this article in December, he was chortling with glee at its bad economics and suggested I used the article to teach the freshman class – the assumption being that no PKU finance student above the level of freshman could have ever made this kind of conceptual mistake.  Perhaps not, but certainly anyone writing about currency policy should have at least done the math first.

Although this article is more confused than most about the impact of an appreciation on central bank reserves, it is worth explaining why it is wrong so as to address the less excitingly conspiratorial mistakes made by the merely confused.  First, can an appreciation of the RMB reduce the cost to the US government of its debt obligations?  Of course not.

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets.  Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt.  After all, if a revaluation of the RMB causes the euro to drop against the dollar (a highly plausible outcome), could it possibly be true that the USG would reduce its payments on $100 of obligations owed to Chinese investors while increasing its payments on $100 of obligations owed to European investors?  Exactly how would this work?

Are there no winners and losers?

It wouldn’t.  The claim is nonsensical and violates simple arithmetic.  But if the RMB is revalued are there no losses and gains anywhere?  Yes, of course there are, but the distribution of these gains and losses is completely different from what this article claims, and depends wholly on the structure of various balance sheets.  In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains.

First of all, will China as an economic entity lose?  Leaving aside the vigorous discussion about whether an RMB revaluation will increase or reduce China’s long term growth prospects (I think it will), the net balance-sheet impact of a revaluation depends on whether China is net long or net short dollars.  There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio.  The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB.

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB.  This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one.  It does not “realize” the loss, however, until it revalues the RMB to its “correct” value.

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation.  It occurred the very day the trade took place.  When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB.  This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB.

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter).  Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that.  The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take.

So a revaluation of the RMB will not cause any real loss to any Chinese entity today.  The loss already occurred but hasn’t been realized.

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms.  Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China?

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations.  And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms.

This means that China takes no loss.  It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it.  So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists).

Wealth is transferred within China

But that doesn’t mean nothing at all happened.  Although the Chinese overall balance sheet is probably a little better off with the revaluation, within China there are a whole set of winners and losers. Which is which depends on the structure of individual balance sheets.  Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins.

Who loses?  Of course the PBoC is a big loser.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose.  They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

Chinese companies with more assets abroad then foreign debt might also lose.  Who wins?  Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life.  The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team.  Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB.

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country.  Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption.  This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China.  But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them?  Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts.

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP.  This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss.  (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be).   In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

I apologize for such a long post, but I promised several people that I would try to address some of these issues, and it is hard to do so briefly.  In short, what the PBoC does to the value of the RMB and how it invests its reserves matter a lot to China and the world, but not always in the way China and the world think.  To get it right, we need to keep in mind the functioning of the balance of payments, the PBoC and other balance sheets, and the way the two are interrelated.

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

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

The pain of adjusting

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

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

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

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

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

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

Global rebalancing

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

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

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

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

Transferring income

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

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

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

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

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

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

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

The pace of adjustment

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

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

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

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

However other indicators were not so good:

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

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

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

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

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

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

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

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

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

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

As many of my readers know (although I have not made any reference to it on my blog) hedge fund manager Jim Chanos recently made some headline-inducing claims about China.  Chanos, a successful hedge fund manager who has made his reputation – and fortune – by identifying and shorting seriously overvalued assets, most famously Enron, seems to have read the PivotCapital piece that got a lot of attention last year, and partly as a consequence he claimed that China is undergoing a speculative bubble that makes it the equivalent of “Dubai times 1,000 – or worse”.

His claim was met with incredulity by New York Times columnist Thomas Friedman.  Freidman is best known for his writings on globalization, and although I have no doubt that he is a very smart man when it comes to getting politics right, especially in the Middle East, which I believe is his area of specialty, I also have no doubt that he does not understand China much and understands almost nothing about central bank reserves and the functioning of the global balance of payment.  I have read many of his articles, and so far I am pretty sure that these aren’t his strong points.

In response to Chanos’ claim Friedman made a number of very questionable statements about China.  These are matters of dispute and although I think they are completely wrong, they are at least defensible.  For example he says its true that there may have been risks of bubbles.  ”In the last few days, though, China’s central bank has started edging up interest rates and raising the proportion of deposits that banks must set aside as reserves — precisely to head off inflation and take some air out of any asset bubbles.” 

Really?  I think you have to be a tad credulous to believe that the RMB 7.5 trillion lending target for 2010 and the slightly higher interest rates represents taking air out of the asset bubble.  I would argue that they simply mean that the astonishing rate at which they were pumping air into the bubble has moderated slightly, to merely excessive.

He also says:

Now take all this infrastructure and mix it together with 27 million students in technical colleges and universities — the most in the world. With just the normal distribution of brains, that’s going to bring a lot of brainpower to the market, or, as Bill Gates once said to me: “In China, when you’re one-in-a-million, there are 1,300 other people just like you.”

Aside from perhaps his overestimating the quality of the education system, this is very bad statistics, and perhaps shows how easily we can get intellectually overwhelmed by large numbers.  If China indeed has the same distribution of geniuses, or talent, as other countries, the fact that it has so many people won’t make it richer (and what about India?).  After all if you cut China into four countries, each country will have only one-fourth the number of geniuses.  Does that really mean that the four countries together are stupider?  If we combine the US, Canada and Mexico into one country, its a pretty safe bet that the total number of geniuses will be more than any of the three countries currently possess, but will average intelligence rise?  Can we really make the three countries richer that way (of course there may be good economic arguments for suggesting that unifying North American into a single country will make it richer, but the larger number of geniuses is not one of these arguments).

Ok, we can argue about these things, and we can agree to disagree, but where he completely blew it was, I suspect, on the one topic are where he was absolutely certain he could not be wrong.

Too bad, because he was.  Friedman proposed, yet again, a common misconception over the meaning of China’s huge accumulation of foreign reserves.  He argued that thanks in part to the size of the reserves it would be impossible to make money by shorting China. “First,” he warned, “a simple rule of investing that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”

Really? Friedman proposed the rule sarcastically – as both untestable and too obvious to need testing.  It is so obvious that no country has ever had such high levels of reserves, so you can’t really test the hypothesis, but it’s also pretty obvious that a country with $2 trillion in reserves is in great shape.  Anyone who wanted to short it must be pretty stupid, right?

But it turns out that reality is not as obvious as he imagines. Let us leave aside that the PBoC’s reported reserves are a lot more than $2 trillion, and that if correctly accounted they would be pretty close to $3 trillion.  China’s foreign reserves are certainly huge. They add up to an amount equal to about 5-6 % of global gross domestic product.

But they are not unprecedented. Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP.  My back-of-the-envelope calculations suggest that this was probably the greatest hoard of central bank reserves ever accumulated as a share of global GDP, but please check before you accept this claim.

The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP.   By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves.  Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability.  Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s.  The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits.  These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies.  And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two.  Chanos is not being crazy when he worries, but it is still an open question as to whether or not he will turn out to be right.

But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents. Chanos might still lose this debate, but Friedman has already proven himself to be hopelessly wrong.

This is wrong on two counts.  First, there is very little historical evidence that foreign observers tend systematically to be less-often right than local observers.  In fact many of the great economic problems in recent years, including Japan’s bubble economy in the 1980s, Argentina’s external debt trap in the late 1990s, Iceland recently, and the Chinese banks at the end of the last decade, (not to mention Keynes’ criticisms of US policies in the 1930s) were first brought to serious attention by foreigners, whose warnings were often enough stubbornly rejected by local observers as being overly pessimistic and caused by the typical foreign misunderstanding of “our culture”.

Second, it is simply not true that Chinese scholars are largely cheerleaders for China’s development policies, and certainly not to the extent that foreign observers tend to be.  In fact the discussion within China is far more sophisticated, and fierce, than anything outside the country, although the ferocity of the debate is often disguised by a certain shyness on the part of most of the mainstream Chinese press.

I mention all this because People’s Daily had a very interesting article on the subject several days ago in response to a conference held at my school, Peking University:

China’s unusually high lending growth last year has sparked differences among the country’s top economists as the central bank seems to be taking new measures to contract credit and control inflation.  While many economists believe that control of credit is a must to prevent serious inflation and ensure stable growth, some hold that too drastic a contraction could lead to stagflation.

“Currently the government shouldn’t steer off the easy monetary policy track to avoid possible stagflation, which is symbolized by not only inflation but high unemployment,” said Li Yining, professor and dean emeritus of Guanghua School of Management of Peking University.

China may get stuck in stagflation even with a mild GDP growth like 6 percent year-on-year, given the huge unemployment pressure caused by its large population, said Li, one of the most influential economists in China.  He made the remarks on the 11th annual China economic forum held by the school.  He warned that too early an exit strategy could affect employment and increase the possibility of stagflation at a time when the country’s economic recovery is still not solid enough.

China initiated a massive 4-trillion yuan ($586 billion) stimulus package in late 2008 to overcome the fallout of the global financial crisis. Its new lending was expected to amount to 9.5 trillion yuan in 2009, almost double the previous year. The ample liquidity, while helping the country meet its GDP growth target of about 8 percent in 2009, has triggered concern that the menace of serious inflation may loom large this year.

Zhang Weiying, economics professor and dean of the Guanghua school, warned that excessive credit expansion and low interest rates are the root of all financial crises in history and cause high inflation and massive toxic assets.  ”We need to notice that this round of credit surge (in China), boosted by the 4-trillion-yuan stimulus plan, comes on the back of continually strong economic growth for many years,” said Zhang. That means the scale of credit last year was exceptionally large.

By coincidence, the day before, another Peking University economist, Huang Yiping, published a piece in the East Asia Forum making his not-so-rosy predictions for 2010.  They were:

1: The renminbi will probably begin to appreciate against the dollar.

2: Job market pressures may rise again even as the economy recovers.

3: Housing prices will probably begin to weaken.

4: Structural imbalances are likely to worsen.

5: The government will likely introduce another stimulus package

His comments on his fourth prediction are worth repeating:

Almost all policymakers, from the Premier down, are talking about adjustment of economic structure in order to improve quality of growth. This is very positive. But the measures being considered, such as better credit allocation, remain administrative in nature. In fact the government has been doing the same for at least seven years. But the imbalance problems continued to worsen. I don’t see any difference this time round.

…The root cause of the structural imbalance is distorted incentive structures, especially depressed factor costs. Until more decisive steps are taken to liberalise factor markets, adjusting economic structure could remain on the top of policy agenda every year for a very long time.

So were his comments on his fifth prediction:

Although most analysts expect China’s GDP growth to be at 9-10 per cent in 2010, it is unclear whether strong growth can sustain itself without the helping hand of the government. The ideal scenario is that when the RMB 4 trillion spending runs out, either exports or consumption or private investment or a combination of these would be strong enough to carry forward the growth.

But it is not clear that this will happen in the near term. Exports should recover but they are unlikely to return to the levels achieved before the crisis. The growth potential of the global economy has shifted lower and rising saving ratios further limits potential for China’s export growth. Consumption has been resilient, partly as a result of the stimulus measures. Without strong income growth, the consumption momentum could weaken. Private investment remains weak outside the housing sector.

Along similar lines, yesterday John Garnaut published a piece on his correspondence with one of my favorite Chinese economists, Yu Yonding, from which it is worth quoting a longish selection:

Yu, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, did not explicitly say I was barking mad. But his email continued: “When a country has an investment rate over 50 per cent [of] GDP and rising, you say this country is not suffering from overcapacity! … are you serious? ”To judge whether there is overcapacity you cannot just do a head account. With a 1.3 billion population and human greed, China’s needs are unlimited, you can say that China will never suffer from overcapacity!”

The email noted that, on my logic, no developing country could ever suffer from overcapacity until it became rich and that the world should never have suffered a Great Depression in 1929.

Since that salutary critique, Yu has elaborated further on his views.

He believes China is trapped in a cycle where constantly rising growth in investment is constantly increasing China’s supply, but consumption has conspicuously failed to grow fast enough to absorb it. And so China is forced to increase investment in order to provide enough demand to absorb the previous round of increased supply, thus creating ever-widening cycles of oversupply.

In this manner, the investment share of gross domestic product has increased from a quarter of GDP in 2001 to at least half.  “There is sort of a chase – demand chasing supply and then more demand is needed to chase more supply,” he says. “This is of course an unsustainable process.”

From 2005 China’s overcapacity problem had been “concealed” by ever-increasing net exports – but that strategy was interrupted by the financial crisis. Then came last year’s globally unprecedented stimulus-investment binge, which might not have been so worrying if it were delivering things that people needed.  But the Government’s hand in resource allocation has grown heavier since the crisis without reforms to make officials more responsible for what they spend.

“As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources,” as Yu previously said, in his Richard Snape lecture for the Productivity Commission in November.

So there are now airports without towns, highways and high-speed railways running parallel, and towns where peasants are building houses for no reason other than to tear them down again because they know that will earn them more compensation when the local government inevitably appropriates their land.

Meanwhile a few weeks after Zhang Bin, a CASS economist, called for a 10% one-off revaluation (I discussed this two weeks ago on my blog), Zhang Shugang, another CASS researcher, argued that “China’s exchange rate is distorted, and China has been undervaluing the yuan to keep export prices low and to gain competitiveness.”  According to an article in today’s South China Morning Post:

Mainland must let the yuan rise because its undervaluation is fuelling domestic economic imbalances, such as a stunted services sector, a mainland researcher said on Tuesday.

…While Zhang’s views in no way represent Beijing’s official stance, they do reflect a simmering debate among government-linked researchers about whether and how mainland should let the yuan rise again after effectively re-pegging it to the US dollar since the middle of 2008.

The article goes on to describe the range of opinions in the debate.

Premier Wen Jiabao said in late December that Beijing would not give into foreign demands to let the yuan rise because these were little more than attempts to stifle the country’s growth.

[But] Shi Jianhuai, a professor at Peking University, also added his voice to the camp calling for a stronger yuan, saying in an interview with local media on Tuesday that yuan appreciation would force mainland exporters to move up the value chain.

“If we were short-sighted and cared about nothing but growth this year, we would continue the dollar peg and distort the economy,” Shi told the 21st Century Business Herald. But if we cast our sights a little bit further and are willing to accept some short-term pain, we should see through quick market reform of the exchange rate, letting the yuan rise and float freely.”

…But powerful interests and officials are arrayed against proponents of yuan appreciation. Chinese Commerce Minister Chen Deming last week restated the government’s official view that a stable yuan had benefited the global economy and that any exchange rare reform would be gradual.

As the South China Morning Post article indicates, it is not just among think tanks and academics that a debate is taking place.  One of my former students who now trades interest rates for a major bank in Shanghai sent me a report yesterday in which analysts sought to interpret what was rumored to be a fairly substantial argument in the State Council about increasing the lending quota for 2010, which as originally set at RMB 7 trillion.  In the end, after furious debate, the quota was increased by a mere RMB 0.5 trillion.  My former student’s conclusion (and that of most market participants): the huge fight over such a small increase shows just how divided policymakers are.

Meanwhile yesterday on Caing, in an article titled “Cloudy with a Chance of Torrential Credit”, the author discusses an “unusual” emergency meeting at the PBoC to discuss and react to a panic-inducing burst of new lending in the first two weeks of January (apparently 15% or more of the year’s quota was disbursed in the first two weeks of the year).

Sources close to the central bank say that the State Council’s dissatisfaction with loan growth mainly stems from its large size, uneven pace and irrational structure. “The State Council is looking at credit numbers daily,” the source said.

The point of all this is to suggest the richness and even ferocity of the internal debate taking place within China.  There is a tendency I think, especially among the foreign cheerleading fraternity, to ascribe a unanimity of opinion within China and to see this both as a good thing and as a confirmation of the views of the cheerleaders.

I would argue that this is wrong on all three counts.  First, there is most certainly no consensus.  The debate in China is as fierce and as well-informed as it is anywhere in the world.  Second, unanimity, or even strong consensus, would not be a good thing for China.  Given how complex matters are, any strong consensus would simply represent a failure to debate the issues, and a corresponding increase in the probability of making horrible policy mistakes.  In fact if there is a rapidly growing consensus about anything it is that policymakers seriously flubbed the chance to force through adjustment measures, such as a revaluation of the RMB, earlier when conditions were much more propitious and when the cost of adjusting would have been much lower.  Third, cheerleading tends to occur far more enthusiastically among foreigners than within China.  That is clearly a good thing.

At any rate as the debate rages on, this weekend I will go to DC and NY for a week of meetings, so I’ll probably not be posting anything for a while.

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.

Unfortunately it will mean that my blog postings (in the future, and clearly not this one) will become shorter and perhaps more reacting to market events, but of course it also means that it will be much easier for me to travel to meet clients and friends in Asia, Europe, North America and elsewhere for more focused (and perhaps more open) discussions of China and the international economy.

For now I suspect everyone will want to discuss currencies.  One of the more interesting pieces of news for me was yesterday’s Financial Times story on President Sarkozy’s finding “unacceptable” the disordered currency markets (“disorder” means a rising euro).  According to the article:

Nicolas Sarkozy on Thursday stepped up his attack on global exchange rate imbalances saying “monetary disorder” had become “unacceptable”.  The French president said he would make exchange rate policy an important theme of France’s presidency of the G8 and G20 forums of advanced and developing economies in 2011.

“There cannot be financial, economic and social order until we put an end to currency disorder,” he said at a conference in Paris.  Mr Sarkozy has long railed against Chinese “monetary dumping” and the dominance of the dollar, but has sharpened his criticism in recent days reflecting concern in Paris that a balanced economic recovery in the eurozone could be choked off by an overvalued currency.

With a large trade deficit and with exports that are more price-sensitive than Germany’s, France feels more susceptible to exchange-rate movements than its neighbour across the Rhine.  “We can’t increase the competitiveness of our businesses in Europe and have the dollar lose 50 per cent of its value against the euro,” Mr Sarkozy said. “When we produce in the eurozone and sell in the dollar zone, are we supposed to just give up selling?”

So we are sort of stuck, aren’t we?  The dollar is overvalued, and it must rebalance downwards in order to force up US savings rates relative to US GDP, but since it cannot decline against Asian currencies, whose central banks intervene heavily, it must decline against the floating currencies like the euro.

But the euro is probably already overvalued against the dollar, so European manufacturers will be forced to accept the brunt of the adjustment.  This will be painful for everyone in Europe, but I suspect it will be most painful for Germany, a country that is more dependent on manufacturing than the rest of the region and so who will suffer more if there is a sharp drop in demand for European manufactured goods. The fact that President Sarkozy is nonetheless making the most noise about the euro indicates that this is going to become a very popular political topic and has great demagogic appeal.

Later in the article Sarkozy was quoted as saying “You know how close I feel to the US. But this is not possible. The world has become multipolar. We must have a multi-monetary system.”  As a half-French half-American I have to say I suspect that it is not likely to be easy to convince too many Americans of the truth of the first part of his statement.  I think however, that although the US and the world (except perhaps export-dependent Asian countries) would be better off with a multi-monetary system, Sarkozy may be confusing issues.

The dominance of the dollar in reserve accumulation has little to do with a lack of an alternative currency and a lot to do with the inability of any country but the US to absorb the trade deficits created by export-dependent development strategies.  Trade-surplus countries buy dollars because when they buy euros, they cause angry reactions from European businessmen and politicians who are uncomfortable with the impact of a rising euro on domestic manufacturing and employment.  In fact, the rise of the euro against the dollar is precisely what Sarkozy claims to oppose in the first part of his statement and to support in the second part.  If Asian central banks rely less on the dollar and more on the euro for their reserve accumulation, guess what will happen. Yes, the euro will rise against the dollar.

Japan is worried too

It always surprises me how readily people believe that the status of the dollar as a reserve currency has to do with same nefarious conspiracy.  As long as the US is willing and able to run large trade deficits, the dollar will be the overwhelming currency of choice for reserve accumulation.  Once the US ability or willingness stops, which I suspect is likely to be the case over the next few years, central banks will stop accumulating dollars.  Like it did during the period of large US deficits in the 1960s and the 1980s, the talk about dollar hegemony will once again fade away as US trade deficits decline.

Sarkozy’s comments were reinforced, in a way, by comments the same day from Naoto Kan, Japan’s finance minister.  Here is what the South China Morning Post said in an article today.

Japan’s new finance minister backed off his call for a weaker yen following an apparent rebuke from the prime minister yesterday, saying currency levels should be determined by markets.

Still, Naoto Kan said the government should pay heed to the views of the country’s business community, signalling that he was sticking to the view of favouring a weaker yen to boost the competitiveness of Japanese exports.  ”Currencies undoubtedly should be determined by markets,” Kan said. “But I also believe that generally speaking, it’s the finance minister’s job to act against currency moves when needed.”

…He jolted markets in his first press briefing as finance minister on Thursday, saying he hoped the yen would weaken further and that he would work with the Bank of Japan to achieve an appropriate exchange rate level.

For those who remember the 1980s, when many policymakers in Japan insisted that Japan’s trade surplus had nothing to do with the value of the currency, and everything to do with domestic competitive advantages in manufacturing, it is a little weird seeing them now worry so much about the impact of a rising yen on their manufacturing sector and on the process of economic recovery.  Currencies do matter, I guess.

Currency talk is likely to be the flavor of this year.  The currency issue simply will not go away, and the fighting over it is likely to get worse, not better.  On that topic, a research fellow at the Institute of World Economics and Politics at CASS had an interesting proposal earlier this week.  According to an article in Bloomberg:

China should consider a one-time appreciation in the yuan of 10 percent against the dollar to reduce inflows of speculative capital into China, a researcher at the Chinese Academy of Social Sciences said.  The revaluation could be followed by a cap of 3 percent in annual moves up or down for the currency against the greenback, Zhang Bin, a research fellow at the Institute of World Economics and Politics at CASS, which advises the cabinet, said in an interview from Beijing today. He said he couldn’t predict whether his proposal, outlined in an essay, would be adopted by the government.

China may see “huge” inflows of so-called hot money as foreign investors step up bets on yuan gains, Zhang Xiaoqiang, deputy head of the National Development and Reform Commission, said in a statement yesterday. The government has rebuffed calls from U.S. and European officials to allow the market to set the exchange rate and has pegged the yuan at about 6.83 per dollar since July 2008 to help exporters weather a global recession.

“It’s a good strategy to protect China from the impact of short-term capital inflows,” said Zhang. “Now is a very good time. Foreign pressure will intensify this year and China should take an active strategy.”

…A 10 percent revaluation would have limited impact on exports and slow growth in overseas sales by 3.3 percent, said Zhang. Exports dropped 1.2 percent in November from a year earlier, following a 13.8 percent decline the previous month. China’s customs bureau is scheduled to report trade figures for December sometime between Jan. 12 and 14.

Zhang, who has been interviewed by Xinhua news agency on global economics previously, said the revaluation should be adopted soon.  “The earlier, the better,” said Zhang. “We shouldn’t wait until after foreign capital flows into China and expectations on yuan gains increase.”

Does the value of the RMB matter for trade?

What would the impact on trade be?  Strangely enough many of the opponents of RMB revaluation insist that it would have no impact on trade balances.  A new “International Finance Discussion Paper” (Board of Governors of the Federal Reserve System) by Shaghil Ahmed sees it differently (“Are Chinese Exports Sensitive to Changes in the Exchange Rate?”)

The main results of the paper can be summarized as follows: First, including the latest period of greater real exchange rate variability reinforces the conclusions of some earlier studies, such as Marquez and Schindler (2007), which found that Chinese exports respond quite strongly to movements in the real exchange rate, and go against studies which fond little effect of exchange rate changes or effects that go in the opposite direction to conventional wisdom.

Second, considering the components of the real exchange rate, consistent with the theoretical model, when the source of Chinese real exchange rate appreciation is movements of the RMB against other emerging Asian countries, this does not have a significant effect on Chinese processing exports, but it does have a significant negative effect on Chinese non-processing exports.  On the other hand, when the source of the renminbi appreciation is movements against the currencies of non-emerging Asian Chinese trading partners, generally both types of exports go down.  Moreover, even though processed exports remain very important for China, increases in non-processed exports have recently accounted for more of the overall increase in exports.  Finally, model simulations indicate that the path of total Chinese real exports would have been quite a bit lower if the renminbi had appreciated more in recent years.

Overall, the results suggest that greater exchange rate flexibility could have significant impact on China’s trade balance by restraining growth of exports, particularly non-processed exports.

…The implications of the results for global imbalances depend on what is exactly meant by global imbalances, which is not always clear-cut.  If China’s large current account surplus or its bilateral current account surplus with the United States by itself contributes to global imbalances, along with the U.S. bilateral current account deficit with China, then our results suggest that greater degree of appreciation of the Chinese currency would substantially help mitigate global imbalances.  If, however, the big part of global imbalances is the U.S. overall current account deficit and the current account surplus of the emerging market world taken together, then it is less clear that greater appreciation of the Chinese currency would make a significant dent to global imbalances. For example, following an adjustment of the Chinese real exchange rate one scenario could well be that the fall in exports by China is largely matched by a rise in exports by other emerging market economies, including in emerging Asia, leaving aggregate current account balances of the United States and of emerging market economies more broadly unchanged.

But the results do seem to imply that greater flexibility of the exchange rate would help China toward its stated desired goal of shifting the sources of growth more toward domestic demand with less dependence on external demand.

Regular readers of my blog might remember that from late 2006 until the beginning of 2008 I had argued that the best way for China to address the domestic (and of course external) problems caused by the undervalued exchange rate would be for a 15-20% one-off revaluation.  This would both force through a rebalancing and help revive consumption growth, all the while protecting the country from the problem of hot money inflows, which had become terrible by that time.

After the onset of the crisis I backed away from such a large revaluation (not because it wouldn’t be a good idea in the long run, but rather because it would be too painful in short run) while still arguing that a one-off 10% revaluation still made sense.  Needless to say I enthusiastically agree with Zhang Bin although, like him, I am doubtful that policymakers will be willing to absorb the short term cost in exchange for domestic economic benefits that probably won’t accrue until well after 2012, when the current leadership will have retired.

Hot money

My guess is that we will see a much smaller appreciation, perhaps 2-3% during the first quarter.  Apparently I am not the only one who believes that appreciation pressures are mounting.  That terrible bugbear, which made China’s too-little-too-late appreciation strategy from 2005 to 2008 so difficult for the PBoC, hot money inflows, seems to be rapidly becoming a problem again.  Earlier this week a senior policy advisor sounded, and not for the first time, the warning.  According to an article in Bloomberg:

China may see “huge” speculative inflows as overseas investors step up bets on yuan gains, making it difficult to manage liquidity, said Zhang Xiaoqiang, deputy head of the nation’s top planning agency.  Loose monetary polices in developed countries, a weakening U.S. dollar and China’s economic recovery will put renewed pressure on the yuan to appreciate, Zhang, from the National Development and Reform Commission, said in a statement on its Web site today. The country is becoming more reliant on foreign economies, he said.

Already some of my students whose parents own their own businesses have been telling me that Chinese speculative money held abroad is flowing back into the country.  One of my students from rich coastal city Wenzhou, the most free-wheeling and business-savvy city in China, and perhaps the world, just rolled his eyes when I asked him if his family and friends were tying to bring money into the country.  “Of course,” he said.  I didn’t get the impression that he thought mine was an especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China have been pounding the table (in the discreet way preferred of policymakers here) about the risks of monetary expansion.  As everyone now knows, the PBoC yesterday sold three-month bills at a higher interest rate for the first time in 19 weeks.  Long Chen, one of the students in my PBoC Shadow Committee seminar, reported to the class via email as soon as it happened: “Hey guys, the primary yield of 3M PBOC bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant sign that the PBoC no longer wants to wait and is starting to tighten conditions, although I can only add that conditions are so alarmingly loose that it would take an awful lot of tightening to get back just to “loose”, and it would be hard to do this without seriously undermining current growth and employment in the short term.  My guess is that this may be a beginning, but it will be a very slow and tentative beginning.  The PBoC has already been lambasted (unfairly, in my opinion) for jumping the gun in 2007 and 2008 and they have little political capital against which they can afford another “mistake”.

In fact much of their action tends to be signaling – what in the US we would call “jawboning”.  Four days ago, for example, Governor Zhou made another attempt to warn about risks to the banking system in an interview with China Finance very similar to a speech he gave late December.  According to an article in Bloomberg:

Chinese central bank Governor Zhou Xiaochuan reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks’ loan quality.

The People’s Bank of China will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated yesterday on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could “pose a risk to the quality of banks’ loans,” Zhou said.

China’s policy makers are seeking to contain risks from an unprecedented credit boom, in which banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11 months of 2009. Liu Mingkang, chairman of the China Banking Regulatory Commission, said yesterday that lenders have “more than” enough capital, while also cautioning that asset bubbles may emerge in the world’s third-biggest economy.

It is hard to be both soothing and at the same time to raise the alarm.

To move away from currencies and monetary policy, I saw an interesting article about the US in Xinhua.

A recent New York Times/CBS News poll has found that more than half of Americans said they are spending less money in stores and online.  A New York Times report available on its website Saturday quotes the poll as saying that nearly half of Americans said they were spending less time buying nonessentials.

“Some are working longer hours, but a larger proportion are spending additional time with family and friends, gardening, cooking, reading, watching television and engaging in other hobbies,” says the report.  The report also quotes the U.S. Department of Labor’s time-use survey as showing that compared with 2005, Americans spent less time in 2008 buying goods and services and more time cooking or taking part in “organizational, civic and religious activities.”

Net demand from abroad

This is almost certainly good news for the US in the medium term, but if true, needless to say, it seriously undermines hopes that US net demand will revive enough to justify the overcapacity issues exacerbated by China’s fiscal and credit expansion.  There has been some hope that boosting trade with developing countries, and especially with developing Asia, will result in a new source of net demand.  James Kynge said something like this in the Financial Times earlier this week:

Popular narratives sometimes overshoot. One of the latest to outlast its veracity is the conventional wisdom that China’s export engines have been spiked by subsiding consumer demand in the US. This, so the argument goes, leaves Beijing with no option but to spur domestic demand to compensate for lost export revenues.

This became an über-narrative last year. Its snowballing popular appeal was powered by two unassailable charms: it made sense and seemed largely true – but not any longer. Its potency appears set to wane in coming months not so much because of a challenge to its central plot, but by other things happening off stage.

The telling off-stage action is the recent upsurge in trade with south-east Asia and the “newly-rising economies” of Brazil, Africa and India. Although Chinese trade with these places has historically been limited, it has grown so fast in the past five years that a robust performance in 2010 may be enough to offset any moderate weakness in China’s trade with the US.

A friend wrote to me to ask what I thought of this possibility, citing Kynge’s article, and my response (with some editing) was:

The idea that net demand from developing countries can replace net demand form the US is alarmingly widespread, both in China and abroad, and mainly indicates to me a lack of familiarity with the history of developing countries.  The developing world excluding China is roughly the same size as the US, so if you want them to replace the US you need the developing world to run trade deficits of roughly equal to 7% of their GDPs.

Leave aside the huge problem that most developing countries also want trade surpluses and have a stubbornly tough time understanding why they should run deficits in order to help Chinese employment, the historical evidence suggests that just a few years of trade deficits of 2% of GDP will lead to external debt crisis.  For example it took the Asian Tigers just a few years of deficits after 1993-94 to run into the Asian crisis.  Do Malaysia, Indonesia, Vietnam and so on really want to go through that again?  Developing country demand cannot replace the US.  Even Europe cannot replace the US.  This is an unrealistic hope.

No, I think the rapid growth of US consumption relative to (very healthy) US GDP over the past 30 years or longer may have been a special historical circumstance whose life, if not over, is coming to a close.  Except for small countries whose trade surplus can easily be accommodated, I think the days of rapid growth driven by trade-surplus policies may be over.

This is getting to be another of my very long pieces (as my friend Kaiser Kuo reminded me last night at my club), so I will stop, but not before referring to one last interesting article about another controversy in Chinese academic circles.  China is trying very hard to boost the quality of its scientific and technological research, which is, with a few exceptions, of very low quality.  I am skeptical about how successful they will be, in part because the educational system here, as a history teacher in the top high school in Shanxi province once told me, is a machine for stamping out critical and creative thinking, and in part because the process is not being driven by scientists but by bureaucrats.  Here is what the South China Morning Post says:

The exposure of two researchers who published fake data in an international journal is the subject of heated debate in mainland scientific circles, with opinion divided on whether the blame should rest on unscrupulous individual behaviour or deep flaws in the academic system.

Zhong Hua and Liu Tao from Jinggangshan University in Jiangxi published faked datasets in specialist journal Acta Crystallographica Section E in 2007. The fraud would have gone undetected without new computer analysis, the journal said on its website.

Leading British medical journal The Lancet urged China to tighten measures against scientific fraud, otherwise it would not become the research superpower President Hu Jintao has pledged by 2020.

These kinds of problems are so commonplace that normally I wouldn’t bring it up except for two reasons.  The first is that it is a measure of how complex the problem is that there is even a debate about this episode.  Normally, faking research brings universal condemnation, but the researchers have earned some sympathy because they are desperately responding to a very difficult system.  The second reason I cite this article, which follows the first, is because of a very perceptive quote from Professor Jiang Gaoming of the Institute of Botany under the Chinese Academy of Sciences:

“All living creatures have an instinct to survive. When a bad system determines the survival of researchers, they have to do all kinds of corrupt and unethical things to live. The outcome is inevitable,” Jiang wrote.

This is something I often tell my students, especially about the banking system.  It is not because they are especially stupid or dishonest that bankers have made bad loans, but rather because they are responding intelligently to bad incentives.  Any system with distorted incentives creates distorted results.

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.

This has some relevance to China’s long-term economic and social prospects, and is a topic that I have discussed a lot with my students.  In fact it is almost a subtext in Frederic Wakeman´s book.  To put it simply, one of the great strengths of the US is its ability to change quickly and dramatically, even though this ability necessarily comes with a sometimes brutal insensitivity to the short-term social costs of the change.  As Manzi puts it,

An economy built upon constant and relatively free innovation is inherently difficult to sustain in a democracy. This is not so much a matter of anti-market ideology as of the painful realities of economic change. Innovation forces change, and the pain involved tends to be felt immediately while the benefits are usually diffuse and harder to perceive in the short term.

It is therefore natural for people to organize to prevent the spread of significant innovation. The original Luddites were cotton weavers who, in the throes of Britain’s Industrial Revolution, responded to their displacement by automated weaving technology directly: They smashed looms. In America, people in similar situations rarely assault property en masse, but they do form political coalitions to pass laws that restrict innovation. It is understandable that the enormous waves of innovation always sweeping over a dynamic free-market economy will arouse great unease and opposition. But for that economy to prosper, the unease and opposition must be overcome.

A big question for me is how China decides in the future to face the continuing trade-off between social stability and rapid change.  In the past it is pretty clear that China has experienced wrenching social change.  This change began from a widespread recognition during the 1970s that the Chinese model simply was not working, and that without a dramatic transformation, China was likely to collapse.  It took the brilliance of Deng Xiaoping to understand how to steer China forward without risking an even worse crisis, and the economic rewards for this transformation have been dramatic, even as the social cost of such rapid change has put increasing pressure on the political and social systems of the country.  How is China likely to face the continuing trade-off in the future?

This is not just an abstract and very macro question.  It addresses much more specific things such as the liquidation process following a financial crisis.  For example, if we were to see a break in the housing bubble, there are broadly speaking two ways to address the problem.  The so-called “Anglo-Saxon” model would involve a rapid liquidation of loans, the seizing and selling of collateral, and bankruptcies.  The advantage of this model is that assets are quickly re-priced and allocated to their most profitable or efficient uses.  

Assets that are non-viable at their original costs, in other words, are marked down and returned to the economy, and very often the new users engage in rapid innovation and the creation of new industries.  One obvious example is the massive railroad bankruptcies that occurred in the US after 1873.  The railroads were liquidated and purchased by new investors at steep discounts, allowing them to cut freight costs sharply, thereby spurring a whole series of new industries, most famously, I think, the mail-order retail business.  More recently the collapse of the broadband suppliers and the subsequent drop in internet costs permitted the existence of Amazon.com, Ebay, Google and a host of other new technology companies.

But there is a cost.  Liquidation can be brutal – businesses close down, land and assets are seized, workers lose jobs, families are forced to leave their homes, and so on.  Americans, for whatever reason, have been more tolerant than many other societies of these kinds of disruptions, perhaps because of a combination of innate optimism and a robust political framework that absorbs some of the costs and anger.  Other societies are less so.

The second way, broadly speaking, that the break in the housing bubble might occur, and without the brutal social adjustments, is what has sometimes been called the “Japanese” model.  Rather than force bankruptcies and rapid liquidation, borrowers would be permitted easily to roll over their loans, financing costs would be kept low (at savers’ expense of course), and excess inventory taken off the market.  The disadvantage of this kind of process is that assets are very slowly reallocated – sometimes after many years – to more efficient uses, and those assets taken off the market become a pure dead-weight to the economy.  In addition the need to keep financing costs low, so as to delay recognition of the losses, hampers future growth by encouraging continued misallocation of capital and slowing the development of domestic consumption by forcing households to bear most of the cost of the adjustment via low interest rates on their savings.  The advantage, of course, is that it much less socially disruptive and painful.

When I discuss this with my students at Peking University their responses, not surprisingly, vary.  A number of them insist that Chinese have learned long ago to suffer disruption, and they will be forced to continue absorbing the costs of change since there is a widespread consensus among the leadership that China must continue in its forward rush.  Others, the majority, think that although socially the Chinese are used to absorbing the cost of rapid social change, the political system itself is less able to do so.  Most interestingly to me is that whenever we have these discussions it becomes pretty clear to me that for most of my students our discussions are not the first time they have thought of this or related issues.  This is something that many students, at least within the elite schools, have thought about.

This discussion extends into the whole issue of financial reform, and not just for China.  Financial crises are usually the way a distorted system rebalances, and although they are often necessary in the long run, they can obviously be painful in the short.   Needless to say there is nothing like a financial crisis to bring out calls for the reform of the financial system, but I think we should be very cautious about what kinds of reform we ask for.  The recent financial crisis, which seemed most to affect “Anglo-Saxon” financial systems, have brought out, predictably enough, fervent warnings about the riskiness of deregulated and fragmented financial systems, along with a pride of proposals for reform, many of which aim to prod and force financial systems into more rigid and constrained forms.

But we risk, as always, drawing the wrong lessons from the crisis, and confusing the triggers with the underlying causes of the crisis.  Every major financial financial crisis in history was preceded by a massive liquidity build-up. which the financial sector was forced to accommodate, as it always does, by taking on too much risk.  Hyman Minsky, and his disciples like Charles Kindleberg, describe this process vividly, with banks and other entities taking on too much risk as a function of excess liquidity and excessively low costs of capital.  It doesn’t matter if the system is highly fragmented and deregulated or highly regulated and monolithic.  After all a large part of the prestige of the “Anglo-Saxon” model derives from the spectacular collapse of its antithesis, the Japanese model of the 1980s, which seemed — mistakenly again — to prove the superiority of deregulated systems, with their breakneck innovation, over highly regulated and very rigid systems.

So which is it that can best prevent crisis and the associated economic costs — the very open systems or the very rigid systems?  Neither, it turns out.  All of them react more or less the same way to excessive liquidity and too-cheap capital — by taking on too much risk, whether in the form of complex derivatives and securitizations, in the case of the former, or in the form of very old fashioned collateralized loans, in the case of the latter.

So is there no room for financial sector reform?  Of course there is, but the purpose of reform should not be to allow us to turn from the crisis and proclaim “Never again!”  That is silly.  It will happen again and again and again.  Instead, the purpose of regulation should be to ensure that the financial system does a better job of allocating capital during “normal” periods.  A financial system designed to minimize the risks of crisis is probably a waste of time.  It should be designed to create the best mix of risk capital and safety consistent with a rapidly growing economy over the long run.   Periodic financial crises are a necessary evil, and there is little we can do about them except try to create automatic structures (counter-cyclical in national balance sheets, as Mnsky argued) that minimize their transmissions into the real economy.   So in China’s case, contrary to breathless advice by press and experts, the US financial crisis teaches almost nothing about how to manage financial sector risk.  It neither proves nor disproves the usefulness of a highly deregulated and innovative financial system.  China´s financial sector issues are different.   China´s systematic misallocation of capital is its biggest financial problem.  China needs serious governance reform and interest rate liberalization so that capital can flow to the most dynamic parts of the economy and be made available to risk-taking entrepreneurs in a way the fosters productivity growth.  It needs capital to be correctly valued so that it is not wasted on creating overcapacity, asset market bubbles, and trophy projects, all of which detract from future consumption growth.  But no matter how well-designed it is, the regulators should have a plan for the inevitable crisis, because it will come.  The interesting question is not how China can avoid problems, but rather how it should deal with them when they come.

There was something else I thought was interesting in Manzi’s article discussed at the beginning of this entry.  The graph below reproduces data about the recent history of manufacturing in the US.  One of the claims that has been repeated so often that it has become true merely by virtue of repetition is that the US is losing its status as a great manufacturing power.  The US used to make real “stuff”, according to this argument, but now it no longer does so.  What this graph shows is that this claim is at best exaggerated, and almost certainly wrong.

The huge (and hugely disruptive) surge in manufacturing productivity in the last sixty years has dramatically reduced the share of American workers employed in manufacturing, but manufacturing’s share of GDP has barely budged. 

The decline in US manufacturing labor has created a sense of crisis in manufacturing, but it mostly means that labor productivity has risen sharply.  That is unquestionably a good thing.   Unfortunately fears about US manufacturing decline have, unnecessarily I think, complicated discussions about China´s rise in the US, and created more worry then is merited.  China´s growth is not hollowing out US manufacturing.  There are certainly problems with imbalances that need to be addressed, but they need to be addressed rationally with a clear understanding of the difficult issues each country faces within the relationship.

By the way, and on a different subject, for those who are interested in demographics, the US Census Bureau released its latest projections.  According to the release:

China’s population is projected to peak at slightly less than 1.4 billion in 2026, both earlier and at a lower level than previously projected. Meanwhile, India’s population is projected to surpass China’s population in 2025, according to new data being released by the U.S. Census Bureau.  These figures come from the population estimates and projections for 227 countries and areas released today through the Census Bureau’s International Data Base. This release includes revisions for 21 countries, including China.

The latest projections indicate that by 2026, the population of China will begin to decline. Population growth in China, the world’s most populous country, is slowing and currently stands at 0.5 percent annually. China surpassed the 1.2 billion population mark in 1994 and reached 1.3 billion in 2006.  According to the latest revisions, India is projected to become the world’s most populous country in 2025. The population growth rate in India currently is about 1.4 percent, nearly three times that of China. The difference in the growth rate between the two countries is explained by fertility. India’s total fertility rate — the number of births a woman is expected to have in her lifetime — is currently estimated at 2.7 and projected to decline slowly, and that is driving population growth in the country.

The slowdown in China’s population growth is the result of declining fertility. China’s total fertility rate is estimated to have been 2.2 in 1990, 1.8 in 1995 and less than 1.6 since 2000. China’s fertility rate is currently half a birth below that of the United States, which is more than two births per woman. Key evidence for the new fertility estimates comes from analysis of data from China’s recent census and surveys.  One of the consequences to China’s declining fertility rate is that the number of new entrants to China’s labor force may be near its peak. The population ages 20-24 is projected to peak at 124 million in 2010. This peak is earlier than in India, which is projected to reach 116 million in 2024.

Despite a shrinking younger population, China’s labor force may continue to grow for several years since the population ages 20 to 59 (prime working ages) is not expected to peak until 2016 at 831 million, an increase of 24 million from the current estimated level. “These changes in China’s age structure may affect its economic growth and competitiveness in the world market,” said Daniel Goodkind, demographer in the Census Bureau’s Population Division.  Given that China and India together account for 37 percent of the world’s population, their demographic trends have major implications for worldwide population change.  The Census Bureau’s International Data Base includes projections by sex and age to 100-plus for 227 countries and other areas with populations of 5,000 or more and provides information on population size and growth, mortality, fertility and net migration.

So much for 2009.  In two days I return to Beijing in time for the crazy end-of-year festivities at D22.  I wish you all a great 2010.

If you are a pessimist you worry again that the rapid growth has clearly been fueled by little more than massive credit and investment expansion, and you note that although at RMB 295 billion, net new lending in November is much lower than the 890 billion monthly average for 2009 (and even lower than RMB 477 billion net new lending in November, 2008 – the first time this year any month in 2008 exceeded the same month in 2009), it nonetheless brings the 2009 year to date total to an astonishing RMB 9.2 trillion.  The market consensus is that next year’s lending will total RMB 7 trillion, which is being presented as a gentle tightening of credit conditions.

Since 2008’s net new lending was RMB 4.9 trillion, I would suggest that in any other year RMB 7 trillion would have been considered an extraordinary expansion in lending.  After a year in which net new lending will probably come close to RMB 10 trillion, we would probably need something much lower even to pretend that loan growth next year will be prudent.  Also bear in mind that gossip among bankers suggests that in the rush to grab funding when it was freely available, a significant fraction of 2009 lending is still sitting as unused deposits, to be used next year for current investment projects, so that in terms of real new lending, a part of 2009’s net new loan figures really belong in 2010.  This means that it is very possible that if there really are “only” RMB 7 trillion in net new lending next year, real credit expansion next year will be equal to or even greater than this year.

The other thing to bear in mind is that the RMB 7 trillion that the market expects is not carved in stone.  As I wrote last year in my “All but the Kitchen Sink” entry, Beijing will do whatever it can to generate whatever growth rate it deems necessary, and Beijing can get any growth rate it chooses to get as long at its borrowing capacity is credible.

Next year we will almost certainly see growth of over 8%, and the total amount of new lending will be determined by whatever credit expansion Beijing requires to get there.  This means that the external environment, the increase in trade tensions (the recent “Buy Chinese” provisions announced for government procurement will almost certainly make things worse), and the impact of inventory build-up, among other things, are going to determine what amount of domestic credit expansion we will need.  Since no one can accurately predict any of those things, it is pointless to predict loan growth next year.  One thing that will almost certainly happen, as my friend Logan Wright told me yesterday, is that banks will rush to lend early in the year, so we should be prepared for shocking new loan numbers in the first quarter which will moderate quickly over the rest of the year.

Pessimists looking at the recent economic data would also note the very high investment rates and worry about the cost to future consumption of misallocated investment.  They would hear the continued, and louder, worry about lending at the PBoC and CBRC.  On Tuesday for example both the PBoC and the BoC warned again about credit quality and loan growth, covered in front page reports in the People’s Daily.  Since a rise in inflation will create a real difficult problem for monetary policy, pessimists will also wonder whether or not it is time to start worrying about inflation (I think it is too early, although my students are telling me that their parents are complaining about rice prices).  According to an article in Friday’s Financial Times:

A series of data published on Friday indicated that the rebound remained firmly on track, with industrial production and imports both increasing well in advance of forecasts. One of the main risks to face the economy is a surge in inflation as a result of the massive monetary and fiscal stimulus measures introduced this year.

Consumer prices rose 0.6 per cent last month from a year ago, after falling 0.5 per cent the month before, while prices at the factory gate fell 2.1 per cent last month compared with a 5.8 per cent decline the month before.

Several economists argued that the shift back to inflation was caused specifically by rising food costs, as well as by some rises in energy prices, rather than as a result of the money supply increasing at an annual rate of nearly 30 per cent.

However, the return of even modest inflation will feed into the intense discussion in Beijing about how quickly to ease stimulus measures and whether to abandon a de facto peg against the US dollar and to allow the renminbi to appreciate.

So to summarize, as I have for the last three series on monthly economic data, the numbers will do nothing to resolve the debate within China.  Optimists and pessimists both have more grist for their mills.

Turning away from the recent data, I wanted briefly to discuss urban migration in China.  For a lot of analysts, it seems that the phrase “urban migration” is the correct response to many of the problems you might identify with China’s growth model.  Is there a real estate bubble?  No there isn’t because urban migration will create a near infinite future demand for residential and commercial real estate.  Does China under consume?  Yes but urban migration will raise consumption rates.

This latter claim was highlighted in a Tuesday article in the South China Morning Post, which claims that “President Hu Jintao’s pledge yesterday to spur urbanisation and domestic demand next year has been seen as an attempt to tackle the growing problem of industrial overcapacity.”  The article goes on to say:

Announcing the development strategies at the end of the annual three-day central economic work conference, Hu said the government would focus on urging the rural population to work and live in small and medium-sized urban cities while boosting further the spending power of workers and low-income groups.

At the same time, he ordered that new investment in industries with excess capacity be reined in and the problem of underutilised plants be addressed.  The moves signalled domestic demand had left much to be desired, as the latest statistics showed 21 out of 24 industries incurred excess capacity in the third quarter, compared with 19 in the first quarter, said Zhang Tao, a researcher at the Chinese Academy of Social Sciences.

“The latest data tells us that overcapacity is not only a problem for several industries but across the industries,” said Zhang, who cited a 2010 economic development blueprint backing Hu’s strategies. “It also shows weak domestic demand.”

There is a surface plausibility to these claims about the benefits of urbanization, but they need to be considered much more carefully than they sometimes are.  First, as far as urbanization and consumption go, what China needs, as I argued in last weeks’s posting, is not so much more consumption but rather, as Zhang Tao implicitly points out in the article above, to close the gap between the amount if produces and the amount it consumes.

It is almost certainly true that as migrants move from the rural areas to the cities, their average consumption is likely to rise, but the key here is their net impact, not their total impact.  So if rural migrants move to the city and become engaged in expanding infrastructure or manufactured products – after all they need to earn an income before they can start consuming – they are not necessarily resolving the domestic imbalance.  They may actually be exacerbating it.  If however they migrate to the cities and take jobs in the service sector, then they have a positive net impact.

In that case it is not urban migration per se that matters but rather the strucutre of Chinese economic growth.  If it continues to be capital intensive, and to favor manufacturers and real estate developers at the expense of service industries, then urban migration is not really part of the rebalancing solution.  We would still be stuck with the same old problem – a growth model that favors overinvestment at the expense of household income, and that leads inexorably, in my opinion, to the very imbalances that China is trying to resolve.

After all, during the past decade there has been substantial urban migration in China, and yet the imbalance became worse, not better.  Why?  Because for whatever structural reason, urban migration has favored faster growth in the production of tradable goods than in their consumption.  Until this structural reason (or reasons) changes, urban migration won’t resolve the problem – unless of course in some way greater urban migration itself forces the structural change.

The other claim, that urban migration prevents the possibility of the existence of a real estate bubble, is more pervasive and, to my mind, even harder to justify.  First, I should point out that although I believe we are in bubble territory in both the stock and real estate markets, and clearly policymakers are increasingly concerned that we may be, I am less concerned than others about the economic impact of the bursting of the bubble.  I am much more worried about overinvestment in infrastructure and manufacturing.

Last week (sorry, but I lost the article) I read that the head of one of Beijing’s and China’s largest real estate developers (Vance, I think I remember) publicly warned that we are in the midst of a property bubble, making it the second time in the past month that the CEO of one of China’s biggest real estate developers has made the claim.  He may be right, and of course the muted warnings by the PBoC that we are in the midst of a stock market bubble may also be correct, but to me the wealth effect of collapses in the two markets are not large enough really to matter.  The wealth effect isn’t likely to be big enough to affect consumption.  Not only are these markets relatively small as a share of Chinese savings, but ownership is heavily concentrated among the relatively richer.

The main way a fall in real estate prices would hurt China, in my opinion, is if it causes a sharp drop in real estate development and, with it, a sharp drop in employment and the business activities of industries that feed the real estate sector.  I suspect however that if we were to see a drop in real estate prices, the decline in activity would be much less than expected because banks and the government would continue actively supporting real estate development projects as long as they had the credibility to do so.  This is not an economy where price signals always decide business strategy.

But to get back to urbanization and real estate overcapacity, the logic is that because we can expect 200 million, 300 million, 400 million or whatever number of people moving to cities in the next several years (any number is plausible as long as it is large), then by simple math it becomes obvious that there cannot be overcapacity in real estate.  We need new buildings to accommodate all those new people.

But this argument, or some form of it, has been used to justify nearly every period of overbuilding in modern history.  After all there was huge urban migration in the US in the 1920s, which was used to justify soaring real estate prices in the major American cities, but after 1929-31 real estate prices nonetheless crashed and apartments and offices when begging for tenants – even though urban migration continued for decades.  Another example: I grew up in Malaga, in southern Spain, which has been since the late 1990s and until last year experiencing an out-of-control boom in real estate development and land prices.  For years I had been telling my friends there in real estate (and nearly all my friends were in real estate – itself a very worrying sign) that prices were not sustainable.

But whenever I said this, they would immediately pull out the charts showing the inexorable rise in the number of aging Europeans, point out that all these old people wanted to retire in sunny communities along the Mediterranean, and that all the beaches in southern Europe simply could not accommodate a fraction of the expected retires.  Conclusion?  As long as the sun continues to favor southern Spain, real estate prices could not ever stop going up.  The inexorable pace of migration justified rising prices.

Needless to say the sun is still shining over sunny Malaga, but real estate prices have nonetheless dropped sharply and sales of BMWs and Mercedes (the favorite cars, it seems, for successful real estate agents) have collapsed.  The old people are still retiring, but new apartments are proving impossible to sell.

Massive expected migration, in other words, is not only perfectly compatible with overbuilding and real estate collapses, it may even be a prerequisite.  Bubbles need a plausible-sounding story that allows people to throw caution to the winds, and near-infinite inward migration is one such story.

The problem of course is that even if the migration projections are true, they are long-term projections and they cannot possibly tell us much about either how many people are coming in next year and how much money they will have to spend.  Worse, the migration itself is highly pro-cyclical – overbuilding to satisfy future migration encourages current migration, and more generally more people come when there are more jobs, and fewer when there are less.  The migration pattern can become very irregular and, more importantly, it tends to exacerbate current trends.  For the financial historians reading this, it is the pro-cyclicality of the process that is the grimmest warning signal.

I am not suggesting, of course, that expected urban migration is not important and will not radically change a number of Chinese parameters.  But I will insist that urban migration is not at all incompatible with continued overinvestment, underconsumption, and overbuilding.  In fact these things have gone hand in hand many times before.