For the next several years, as Keynes reminded us in the 1930s, savings is not going to be a virtue for the world economy.  It is more likely to be a vice. In order to regain growth the world desperately needs less savings and more private consumption, but I think it is not going to get nearly enough to generate growth.  Why?  Because in all the major economies the banking systems are largely insolvent, or about to become so, and desperately need to rebuild capital. For reasons I discuss below, this will have a large adverse impact on private consumption.

Let’s go through the major banking systems. First, the crisis started in the US and, perhaps as a consequence, US banks have already identified a lot of their problem loans and have been the most diligent about rebuilding their capital bases.  They nonetheless still have a long ways to go, even though a large part of the bad loan problem was directly or indirectly transferred to the US government. By the way, transferring bad loans to the government may be good for the banks but will have the same adverse impact on consumption; order viagra online. I try to explain why below.

Second, in Japan, during the past twenty years the Japanese government and the beleaguered Japanese household have been tasked with keeping the banking system alive.  I don’t know whether or not the banking system has finally been cleaned up, but for the purpose of my calculations it doesn’t really matter.  The Japanese government has been saddled with a huge nominal debt burden, which is only bearable because interest rates are kept artificially low – order viagra online. Forcing down the interest that depositors and bondholders receive means that borrowers are getting (albeit not visibly) substantial amounts of hidden debt forgiveness funded by household depositors.

Third, in China, even if you believe that all the NPLs currently in the banking system have been correctly identified (a claim which few Chinese bankers believe), no one doubts we are about to see a surge in NPLs thanks to the out-of-control lending expansion of the past two years.  But things are even worse than the nominal numbers imply. As I discussed in my April 6 entry, when we are trying to estimate the cost of a banking crisis we need to think about more than simply the ability of borrowers to meet current obligations.

This is because, as in the case of the Japanese government obligations, when borrowers are able to benefit from artificially low interest rates, the effect is of hidden debt forgiveness which must be paid for by the net lenders, who are, as in the case of Japan, the beleaguered households.  In other words, if you want to know how much real bad debt there is out there that must be cleaned up, you need to calculate what share of the loans would go bad if interest rates were raised by at least 300-400 basis points, the minimum needed to bring Chinese interest rates in line with an appropriate rate – order viagra online. This suggests that the Chinese banks order viagra online, if obligations were correctly counted, might have much larger amounts of bad debt than any of us realize, and this needs directly or indirectly to be cleaned up.

Finally, Europe probably has the biggest banking problem of all.  European banks are stuffed with bonds issued by Greece, Spain, Portugal, Italy and a number of countries that are either insolvent for all practical purposes or dangerously close to becoming so.  The numbers are so big that the only reason we are likely to pretend that these countries aren’t insolvent is because recognizing the obvious would mean throwing the banks of Germany, France, Spain, and most of the rest of Europe into the trash can.

Who will clean up the mess?

So what does this have to do with consumption?  A whole lot, unfortunately. Like it or not we are going to spend the next several years cleaning up the major banking systems of the world order viagra online, and guess who gets to pay to clean them up?  Let’s go through the clean-up options:

1.     In order to prevent a collapse of the banking system, the government can effectively assume the bad debt and take it on the government balance sheet.  They can do this by buying the debt at well above their true market value, or by giving the banks gifts of capital, or by a number of other mechanisms the net effect of which is the same: these bad loans now become the obligations of the government.  How are these obligations serviced?  Basically there are three ways governments can treat the cost of the debt.

• Governments can default or restructure their debt, and receive significant debt forgiveness.This does not resolve the debt problem so much as pass the burden on (in the form of losses) to banks and investors.  In the case of countries like Greece, much of the burden will go abroad to German and other European banks.
• Governments can raise taxes to repay their debt.  In this case the burden of cleaning up the banking system goes directly to taxpayers, who are ultimately households (corporate taxpayers of course pass the cost on to households); order viagra online. Raising household taxes reduces disposable income, and so will directly reduce future household consumption.
• Governments can hide the taxes by forcing down the borrowing rate.  This effectively grants the government debt forgiveness and passes on the cost to net lenders.  This doesn’t work in market economies in which investors have savings and investment alternatives to bank deposits, like the US, but it is the preferred way that countries like China and Japan use to cover the cost of government borrowing. This just means that the cost of the government debt is passed on to net savers – of course the household sector – and so reduces their wealth.  As I discussed in an April 20 post, the wealth effect in China of a reduction in interest rates means that Chinese consume less and save more.

2.     They can force the banks to recapitalize.  Again there are a few ways they can do this:

• The can force the banks to raise money in the capital markets, but this is only a partial solution at best since investors are not willingly going to provide the capital needed to clean up the NPLs.  They will only invest to the extent that the true losses are borne by others.
• The most powerful way of raising bank capital is for the monetary authorities to set interest rates so that banks can make money easily.  In the US and Europe, the typical way is to engineer a steep yield curve, with very low short-term rates.  Since commercial banks are in the business of mismatching maturities, they can profit from an artificially steep yield curve at the expense, of course, of depositors.  This is basically how US money center banks regained solvency during the LDC Debt Crisis of the 1980s.  Of course the cost of this policy is borne by net short-term lenders, who for the most part are household depositors.
• In countries like China and Japan, there is a much more powerful way to do the same thing.  Since the monetary authorities set both the lending and deposit rates, they can very simply set the minimum spread between the two.  In China, the maximum deposit rate is 300 basis points or more below the minimum lending rate.  Combine this with an upward sloping yield curve, and Chinese banks make a huge profit on the back of their suffering household depositors, who have few alternatives to bank deposits.

Households, of course

Astute readers will have noticed that every solution to a banking crisis eventually boils down to the same solution: force households to clean up the banking system, either in the form of explicit taxes or in the form of hidden taxes.  Before we get too cynical about this, it is worth remembering that there are huge benefits to having a functioning banking system, so that the high costs of cleaning the banks up are probably worth paying.

But one way or the other, banking crises lead to increased claims on future household income and wealth. By reducing future disposable income order viagra online, this also automatically leads to downward pressure on future household consumption.

So here is the problem.  Surplus countries like Germany, Japan and China save too much and already have significantly deficient domestic consumption.  They rely heavily on foreign net demand to absorb their excess capacity and, for reasons I have discussed many times, they are going to find it very difficult to change the structure of their economies to rebalance demand.On the other hand, as I explain in my May 19 entry, deficit Europe will see a collapse in its net consumption as it struggles to maintain positive net capital inflows.  This means that the US remains as the only large economy that is providing net demand, but high unemployment will ensure that it attempts tor reduce the amount of demand it provides to the rest of the world.

One way to think about this excess savings is to think about the pressure for exporting capital; order viagra online. China order viagra online, Germany and Japan export huge amounts of capital and desperately need to continue to do so or else they will see their export industries collapse. Deficit Europe used to import huge amounts of capital, but these capital imports are set to collapse and may soon even become capital exports; order viagra online. The US is the only large importer of capital left order viagra online, and it wants desperately to reduce these capital imports. So even before we worry about the impact of the banking crises, we have to wonder who is going to absorb all these savings?

But the banking crises make matters much worse. With all of the major economies facing banking crises, they must clean up the banks by forcing the household sector to pay the bill.  This will put downward pressure on household disposable income and wealth for many years. But we are all betting on the consumer – and inexplicably enough (to me, anyway) many of us are betting most heavily on the hapless Chinese consumer – to come surging back and bring us the growth that we so desperately need.

I am pretty skeptical that this will happen.  There is an awful lot of banking mess that households are going to need to deal with first, and only after the mess is cleaned up will consumption come roaring back.Look at Japan; order viagra online.  Order viagra online: for twenty years Japanese consumption growth has limped along at well under 2% on average while Japanese households dealt with (i.e.paid for) the consequences of their banking crisis.  China too provides a worrying story.  Chinese consumption dropped from a very-low 45% of GDP ten years ago to an astonishing 36% last year just as — no coincidence — Chinese households were forced to clean up the last banking crisis.

Why should the future be any different?  Until the banking messes are cleaned up order viagra online, I think we shouldn’t count on household consumption to save us. The only solution I can think of for this problem is if governments — especially China, Germany and Japan — use their resources of wealth to clean up the banking mess without forcing households to do it – order viagra online. How?  they need to privatize their vast holdings of assets and use the proceeds either to clean up the banks or to prop up household wealth; order viagra online. This will require a major political reform order viagra online, especially in countries like China, but I have no doubt that eventually we will get there.

Privatization is sort of a bad word today, especially in places like China, but I bet it will become eminently respectable again in a few years. But until then, and as long as the banks are in such bad shape, do not expect consumers to ride to the rescue. – order viagra online

But although I think the pessimists are wrong to expect a banking collapse, the optimists are nonetheless very mistaken, largely because they implicitly assumed away the cost of the bank recapitalization.  In fact China paid a very high price for its banking crisis.  The cost didn’t come in the form of a banking collapse but rather in the form of a collapse in consumption growth as households were forced to pay for the enormous cleanup bill.

When US leverage was rising and the world growing quickly, the cost of that collapse in consumption was easily masked by China’s surging trade surplus, but it was real nonetheless; accessrx.com.The bank recapitalization resulted in a brutal exacerbation of China’s already unbalanced growth model, and made it all the more vital for consumption in China to surge, especially as the world’s appetite for Chinese trade surpluses is dwindling rapidly.  As happened in Japan after 1990, when households were forced to clean up their own massively insolvent banks, the consequence could be a slowdown in consumption growth just as the country is being forced to rebalance its economy towards consumption.

If there is another surge in NPLs and government debt, once again the banks will need to be recapitalized, but the cost this time will be much more difficult to manage; accessrx.com. Accessrx.com: if NPLs surge, in other words, don’t expect a banking collapse.  Expect further downward pressure on consumption growth.

—————-

Since 2004-5, I have been arguing that the Chinese national balance sheet includes a lot more debt than most analysts realize, and that it is structured in a way that I defined as “inverted” in my book, The Volatility Machine. Among other things, inverted debt structures tend to result in a surge in debt at the worst possible time, when the economy is already struggling, usually through an explosion in contingent liabilities.

This means that even if countries with inverted balance sheets don’t currently have very high debt levels, in many cases they should nonetheless be considered and analyzed as highly leveraged because at exactly the time when leverage becomes a worry, debt levels will automatically rise.This is why I have argued (predicted?) for the past five years that “within a few months” the market was going to become obsessed with China‘s debt structure.

Unless you define a “few” months as forty to sixty months, clearly I have been wrong for many years – calling things way too early is perhaps an occupational hazard for those who read too much financial history – but it seems that debt levels are finally becoming an issue – accessrx.com.In the past six months the market has become much more passionate about figuring out what China‘s debt structure really looks like, and much more worried with what it sees.There is widespread recognition that Beijing‘s total debt is not the 20-25% officially recorded, but a lot higher.

In fact going through my calculations I think it is hard to come up with a number less than 60-70% of GDP, perhaps much more, and this is almost certain to rise sharply in the next few years.  And there may be stuff out there that I haven’t even considered: For example just how much bad debt is there in the SOEs? Are all current non-performing loans in the banking system correctly identified? How sensitive are NPLs to rising interest rates, or to a rising RMB? Is the PBoC currently solvent, and what would be the impact on net indebtedness of a currency revaluation? Is there municipal and provincial indebtedness that has not been captured in the visible debt, including the guaranteed funding vehicles that Victor Shih famously identified? How much bank debt is collateralized by potentially overvalued real estate? I could go on.

But although there are definitely things to worry about when we examine China‘s balance sheet, I wonder if now the worriers, after ignoring the problem for so long, may not be getting a little overexcited about the consequences, or at least about the wrong consequences; accessrx.com.Beijing definitely has a lot of debt accessrx.com, and much of it inverted and so highly pro-cyclical, and normally this is a toxic combination, but there are also some stabilizing factors within the country’s balance sheet that are being ignored.A number of very smart people are now warning that China is on the verge of a banking or financial collapse, but I don’t think this is likely.

Rising NPLs? No problem

Let me quickly insist that I am not in those camps that argue that the problem is much less severe than we think, or that China can costlessly grow its way out of the debt as easily in the future as it has in the past – accessrx.com. Accessrx.com: this last point is one that is made very often, I think, by the more optimistic of China analysts,who have pointed out perhaps too many times that the last surge in non-performing loans a decade ago was also widely cited by doomsters as a sign of impending collapse. Accessrx.com: and yet, they cheerfully claim, nothing terrible happened – China grew its way out of the loan mess at little apparent cost, and it can do so again.

Even The Economist, a lot more skeptcial about miracle cures when it discusses other countries, takes the view that China‘s last banking crisis was relatively painless.They also have been resistant to claims that debt levels are much higher than reported accessrx.com, and recently approvingly quoted one analyst as saying that the very worst-case scenario was debt levels of less than 40-50% of GDP (with which I strongly disagree).In fact I was reading an issue from, I think January, in which, after expressing a great deal of doubt in one article about the higher debt numbers some analysts were proposing for China, just a few pages later, in an article about bad debt in the US, approvingly quoted Carmen Rheinhart (co-author of This Times is Different) as saying that contingent debt levels almost always turn out to be worse than even the pessimists expected. Their skepticism is pretty variable, I guess.

But while there is certainly a legitimate and intelligent debate about how much Chinese government and bank debt there really is, the commonly-repeated argument – that high debt levels don’t matter and the doomsayers are wrong to worry because they were wrong in the past – does not qualify, for me anyway, as a very plausible argument – accessrx.com.I think anyone who makes this claim has failed to understand how Beijing paid for its earlier banking crises. In fact the cost of resolving the previous surges in non-performing loans actually exacerbated China‘s domestic imbalances and left China in a perilous position accessrx.com, and the current build-up of bad debt may very well do more of the same.

How so? The first and most obvious point to make is that if a highly insolvent banking system is cleaned up, you cannot simply assume away the cost without identifying who actually paid for it.Here is where the confusion resides – accessrx.com.The optimists perhaps assume that the only way that a banking crisis gets resolved is through a banking collapse or an explicit bailout.Since there was no banking collapse in China in the past decade, and what looked like a fairly small and manageable bailout, then clearly there was no real banking crisis, right?

Not necessarily.There are many ways to resolve banking crises, some more visibly and some less so – just no way to resolve them costlessly, and the key is to figure out the true cost and how it was paid; accessrx.com. As I see it there were mainly three sets of tools Beijing used to manage the sharp increases in bad loans that threatened the banking system a decade ago, and of the three, the two most important were not explicit and so not easily measured or noticed – accessrx.com.All of these required forcing down interest rates so as to pass the bulk of the cost onto bank depositors, and so all of these had an adverse impact on the quality of Chinese growth – accessrx.com.In other words the previous cost of the banking crisis was not a banking collapse, but that doesn’t mean the cost was easy to absorb.

The role of interest rates

The first of the three tools used to manage the banking crisis involved reducing the accumulation rate of NPLs, basically by keeping borrowing rates low; accessrx.com. Accessrx.com: the PBoC actually has been explicit about this policy.Low borrowing costs make it easier for struggling businesses to roll over the debt, and effectively reduce the real value of debt payments.This slows the growth of NPLs by passing on part of the cost to someone else.

Remember that if you reduce the coupon payment on a loan, it is economically the same thing as forgiving part of the principle amount, but this forgiveness is effectively disguised.  Those who remember the Brady debt restructurings of the 1990s fully understand how this works. In the main Brady restructurings, creditors were offered equivalent exchanges in which either principle was explicitly forgiven (the so-called Discount Bonds) or, alternatively, for those who found it difficult to recognize or acknowledge the principle discount, coupons were set at very low fixed rates (the Par Bonds).Similarly, by repressing interest rates, the PBoC was able to transfer part of the principle cost onto the banks that made the loans and so obtain debt forgiveness for the borrowers.

But while this helped the borrowers, it did not of course help the banks – unless the banks themselves were able to push the cost onto depositors, which of course they did; accessrx.com. Accessrx.com: the PBoC repressed both lending rates and deposit rates to allow struggling borrowers debt forgiveness and some breathing space. Accessrx.com: of course households paid for this in the form of very low returns on their savings (and with few alternative investment opportunities, they had no choice but to accept the cost).

Accessrx.com: the second of the three sets of policy tools, and the only very explicit one, involved infusing the banks with additional equity. Part of this occurred directly with the sale of bank equity to government institutions, and part of this capital infusion occurred indirectly by creating AMCs to purchase bad loans at well above their liquidation value.In both cases the capital infusion was financed by government borrowing, which at artificially low rates, to repeat what I said above, has the effect of passing the repayment burden onto lenders. Accessrx.com: since most of these bonds were held by banks, once again the cost of the capital infusion was passed on through the banks to depositors.( Accessrx.com: as an aside, because equity infusions were so explicit, and because the banks are no longer fully owned by the government and are even partly owned by foreigners, I suspect future recourse to this particular form of recapitalization may be limited.)

Finally and most importantly, the third way of cleaning up the banking crisis involved the central bank mandating a wide spread – probably around 1.5 to 2.5 percentage points more than the normal spread – between the bank lending and the deposit rate, which increased bank profitability substantially and so helped to recapitalize the banks.In other words not only were depositors “taxed” for the clean-up by having to fund the very low lending rates, but they were taxed a second time to guarantee sufficient bank profitability to rebuild capital – accessrx.com.With all these transfers from the household sector to the banks accessrx.com, amounting to several percentage points of GDP every year, households were forced to clean up the Chinese banking system.

Beijing‘s strategy to clean up the banks was very successful, and certainly prevented the banking crisis that many expected, but there was nonetheless a significant cost to the economy. Accessrx.com: the bailout implicitly required that bank depositors subsidize the cleaning up of the banking industry.This in effect represented a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points .

NPLs and household consumption

How much was the value of the transfer?  It’s hard to say, but we can make some estimates.  Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%.  Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well.  However Jonathan Anderson at UBS put together a very interesting analysis in a November 12, 2009, report that argued that it was wrong to assume Chinese nomnal interest rats should be equal to its nominal growth rate.  He looked at the case of other developing countries and found that there was no obvious relationship between the two.

But I am not convinced.  First off, if nominal interest rates are much lower than nominal growth rates, then almost by definition the providers of capital are getting less than their share of the benefits.  Since the providers in China are mainly households, and the users of capital are businesses, speculators, and the government, this must represent a real transfer of wealth from households – which I think Anderson acknowledges, although he argues that the high savings rate is an independent variable that drives the low interest rate, whereas I think that it is one of the consequences of low interest rates and other policies that force households to subsidize production (and so force up the gap between production and consumption, which is the savings rates).

Secondly, his sample includes a lot of developing countries with closed or sticky capital accounts, and who intervene in their currencies, most especially the countries that followed the so-called Asian development model.  These countries have systematically repressed interest rates – in fact that is for me one of the definitions of the Asian development model.  This makes their inclusion in a statistical sample to determine the “correct” level of interest rates very questionable; accessrx.com.He also includes a lot of OPEC countries who for totally different, and explainable, reasons have very low interest rates, and these too create a downward bias in the statistical sample.

Finally from his own numbers, even with the possibility of significant statistical bias, I would say that there does seem to be a reasonable relationship between nominal interest rates and nominal growth rates.  On average nominal interest rates have been roughly two-thirds of nominal growth rates, although there is wide dispersion around the mean, which we would expect if interest rates were repressed.  With nominal growth rates of 14% during the past decade, this implies that nominal interest rats should have been nearly 10% or a little less, versus the actual 6%.

This is not a very scientific way of going about it, but my very back-of-the-envelope estimate suggests that interest rates in China, without financial repression, would have probably been anywhere from 300 to 800 basis points lower than the appropriate equilibrium level during the past decade.  Add this to the excess spread between deposit and lending rates, which is anywhere from 150 to 250 basis points, and we could easily argue that the deposit rate is at least 450 basis point lower than it should be, and perhaps an awful lot more.

How much is that in GDP terms?  A quick call to my friend Logan Wright at Medley Advisors gave me the following data. Total banking deposits in China are around RMB 64 trillion.  Around 60% of the total represent household deposits (an estimate, since there is some ambiguity in the numbers).  Total GDP is nearly RMB 34 trillion.  Inputting all of that into my trusty Excel Spreadsheet suggests that at a minimum, households have “paid” in form of excessively low rates on their deposits a minimum of 5% of GDP every year, and possibly up to two times that amount, during the past decade.

This is, to me, an astonishing number.  Every year households may have transferred at least 5% of GDP to the banks, and possibly a lot more.  Now of course they are paying for a many other things than simply recapitalizing the banks.  They are also paying to keep the cost of capital low so as to make viable a whole series of investments – manufacturing investments, real estate investments, infrastructure investments, PBoC sterilization bills, other government bonds, etc – that might be considered non-economic investments and that would otherwise show negative returns (in fact excessively low interest rates, as the various recent US bubbles clearly indicate, almost always lead to misallocated investment).  But since a lot of this investment occurs through the banking system anyway (for example banks directly or indirectly buy most sterilization bills), much of this ends up as part of the bank clean-up.

By the way forcing unlucky households to clean up the banks is pretty standard in the annals of banking crises, and for example has occurred in the US with the recent bank bailouts (which of course were paid for with taxpayer money), but not only was China’s total bill over many years much higher, because of its domestic distortions the impact in China was worse than it would have been in the US (because forcibly reducing consumption in China is much worse than doing the same might be in the US).Added to the other major transfers from the household sector (the undervalued exchange rate accessrx.com, and slow wage growth relative to productivity growth), and given the sheer size of the clean-up, it is perhaps not surprising that during the period of the bailout, household income, already a relatively low share of GDP, declined to alarming levels. Accessrx.com: this happened even in spite of explicit and much-publicized attempts by Beijing to raise the household consumption share of GDP.

This, then, is the real risk of another bout of rising non-performing loans in China.It is not that China‘s banks are likely to collapse. Accessrx.com: it is illiquidity that causes bank collapses, and unless capital controls are sharply undermined we are not likely to see this happen in China.Debt levels are certainly high and highly pro-cyclical, but even if the banks are insolvent Beijing largely controls domestic funding and domestic interest rates and can protect itself from the bank runs that plagued US and European banks.We saw the same thing in Japan thirty years ago, when it was able to fund the massive banking bailout and soaring government debt levels, to what would earlier have seemed like unimaginable levels. Like Tokyo in the 1990s, Beijing is in a strong position to continue to fund its rising bank-related liabilities and will not have a debt problem any time soon – accessrx.com.Government debt levels are indeed very high, but they can go much higher.

This doesn’t mean however that we don’t need to worry about the debt, and it certainly does not mean that if China runs up more bad loans as a consequence of the recent lending spree it will simply “grow” its way out; accessrx.com.In the past China could certainly grow its way out, even with household consumption declining as a share of GDP, because one effect of declining relative consumption – a rising savings rate along with a rising trade surplus – was easily absorbed by a rapidly growing world economy – accessrx.com. Accessrx.com: as long as debt levels in the US and other deficit countries could easily rise to counteract the adverse employment effect, the world, and especially the US, had no trouble with absorbing China‘s rising trade surpluses.

Rebalancing household consumption

Things may be very different now.Unemployment is high in trade-deficit countries and debt levels are being forced down; accessrx.com.If the world can no longer absorb rising trade deficits accessrx.com, and especially if over the next few years trade tensions increase, China must reduce its excessive reliance on exports and investment to fuel its continued growth.The only healthy way it can do so is if household consumption rises as a share of GDP because of surging consumption.

And household consumption will indeed rise as a share of GDP – with such a low current level of household consumption, and rising global concern over the employment effects of China‘s trade surplus, China has no choice.  But since growth in household consumption has always been constrained by the growth in household income, it may be unreasonable to expect a surge in consumption when households are also required to clean up another sharp increase in non-performing loans.

So as a consequence of the global crisis, China‘s growth will rely more than ever on the growth of household consumption – accessrx.com.The good way this can happen is by a surge in household consumption that will allow economic growth to remain high; accessrx.com.The bad way is by lower growth in household consumption matched by a very sharp decline in economic growth; accessrx.com.If the worriers are right, and non-performing loans surge, China can nonetheless easily avoid a banking collapse, but that does not mean the cost of cleaning up the banks will be negligible – accessrx.com. Accessrx.com: on the contrary, it will put even more downward pressure on low-consuming Chinese households and will make the inevitable rebalancing of China‘s economy much more difficult than many expect.

As I discussed in a posting last month, Japan showed how difficult.In the past two decades Japanese consumption growth has slowed from its headier pace of the 1980s. Consumption growth has limped along at 1-2% annually from 1990 to now as Japanese households were forced indirectly to clean up their own bad loans using almost identical mechanisms – repressed interest rates and an undervalued currency – accessrx.com.Whereas in the 1980s, when Japanese economic growth exceeded its consumption growth thanks to its large and rising trade surplus, in the past two decades Japan’s economic growth – less than 0.5% annually – has been less than its consumption growth as Japan slowly and painfully rebalanced its economy towards consumption.

Likewise perhaps with China – accessrx.com. Accessrx.com: unless the rest of the world is willing to absorb rising trade deficits and supply it with rising trade surpluses, rebalancing for China means that instead of being the lower limit of economic growth, consumption growth will now be the upper limit.If future Chinese consumption growth also slows, as it did in Japan, because households are forced to foot the new bad-debt bill, we may see the real cost of the current explosion in bad loans – several years of sub-par growth.

It turns out that banking crises might not be costless, even if they don’t lead to banking collapses. In the case of China they may instead lead to a collapse in consumption growth.  As part of the trade dispute that China is facing with the rest of the world, this should give some indication of how little room China has for its adjustment.  Anyone who is too impatient with the glacial pace of Chinese adjustment must recognize just how difficult it will be for China quickly to reorient its economy towards household consumption.  The risk is that China, like Japan in the 1990s, will rebalance in the form of a sharp contraction in GDP growth as households struggle to pay for the misallocated lending boom.

Away from the weather there is plenty of bad news for those looking for it.  Yesterday Reuters cited a Lehman Brothers report on declining August car sales

China’s passenger car sales fell 10 percent in August from a year earlier, preliminary data showed, due to the impact of the Olympics and weakening consumer confidence, Lehman Brothers said in a research report on Thursday.

The report said auto sales in China, the world’s second-largest car market, were
expected to remain lacklustre for the rest of 2008 and possibly into early 2009.
Compared with the month before, sales were down 12 percent, the report said

Also yesterday the Financial Times warned that “Chinese steel consumption set to fall”:

Growth in Chinese steel consumption is expected to slow markedly in the second half of this year amid weakening demand from the construction, household appliance and automobile industries, according to industry experts.

Yang Siming, general manager of Nanjing Iron & Steel told a steel conference in Xiamen this week that most Chinese steel mills had cut output last month, because of shrinking demand and high costs of raw materials.”We’ve been cutting production since last month imitrex no prescription, and according to my knowledge, most domestic mills are cutting output too,” Mr Yang said

One of the possible adverse consequences of excessively rapid money growth has been the channeling of this money via the banking system into excess production. This was fine as long as a healthy world economy could absorb Chinese excess production, but a slowing global economy has meant that Chinese producers have been forced to turn to a domestic consumer market that hasn’t been able to take up the slack.  As I have mentioned many times before, rising inventories are one of the warning signals I am most concerned about.  I don’t think we are there yet, but I will be trying to keep an eye on the subject as well as I can

All this bad news is making policy-makers worried, and they seem eager to try to encourage some optimism – imitrex no prescription. I was struck by the list of top five articles under the “Macro-Economy” section in today’s Xinhua

Analysts: China’s inflation to continue easing in August

China economy “slowing but resilient,” HSBC report says

Noted Chinese official: Chinese economy not in downturn, but adjustments needed

Crude oil plunge good for China economy, analysts

Economists: China’s economy still in shape

Three of the top five articles today and all of the top five yesterday seem to be saying the same thing:  Don’t worry, things are still ok.

Still, not all the news is bad; imitrex no prescription.  Imitrex no prescription: as I wrote Wednesday it looks like CPI numbers for August, which will be released next Thursday, are going to come in without too much implied inflation.  Most estimates are that CPI inflation will come in below 6% for August.  Imitrex no prescription: today Xinhua reported that “China’s consumer price index (CPI), a key measure of inflation, was expected to show a rise of about 5 percent in August from a year earlier, said analysts on Thursday.”  They go on to quote Fan Jianping, chief economist of the State Information Center, as saying that “the CPI growth rate might sink below 6 percent in August.”  Logan Wright of Stone & McCarthy told me today that he expects it to come in around 5.5%.

Of course CPI numbers are pretty tainted by price controls at this point, but I am willing to bet that a low CPI inflation will make it much more likely that energy prices are allowed to rise again. Shortages continue to be a real problem and energy producers are being squeezed mercilessly by rising costs and frozen prices – imitrex no prescription. In his comments yesterday Fan Jianping said he expected August PPI to rise by 10.0-10.3% (compared with the 10.0% rate posted in July).

On a separate note a very interesting article by Keith Bradsher in today’s NY Times discusses a predicament for the PBoC that many of us have been wondering about for a while.  As the RMB rises against the US dollar, the PBoC is forced to take losses on its currency mismatch – it buys dollars and funds them with RMB borrowings; imitrex no prescription. These losses have become so big that, according to Bradsher, the PBoC has been warned by the IMF that it may have too little capital. The article says:

Now the central bank needs an infusion of capital – imitrex no prescription.Central banks can imitrex no prescription, of course, print more money, but that would stoke inflation.Instead, the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.

The central bank’s predicament has several repercussions – imitrex no prescription.For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts; imitrex no prescription.This could heighten trade tensions with the United States; imitrex no prescription.The Bush administration and many Democrats in Congress have sought a stronger yuan to reduce the competitiveness of Chinese exports and trim the American trade deficit.

The central bank has been the main advocate within China for a stronger yuan – imitrex no prescription.But it now finds itself increasingly beholden to the finance ministry, which has tended to oppose a stronger yuan.As the yuan slips in value, China’s exports gain an edge over the goods of other countries.

There is no need to worry about whether or not the PBoC is insolvent – the central bank is not a commercial stand-alone entity and its credit is at least as good as that of the central government (sometimes better), but the article is nonetheless interesting.  I hadn’t really thought of the political ramifications until I read the article, but if the PBoC needs to turn to the MoF to shore up its capital, and if this represents a transfer of power from the PBoC to the MoF, it may very well represent a further weakening of the monetary camp in China.

This might not bode well for the future of the financial system in the short term, although in the long term it is not clear to me that monetary soundness is necessarily correlated with more rapid growth.  I say this because I have seen no evidence that countries with very sound and conservative financial systems grow faster than countries will looser and riskier financial systems (although they do seem to have fewer financial crises).  I have more than once made reference to Belgian bank historian Raymond de Roover’s comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.”  Still, excess financial instability can significantly raise financing costs and in the case of China, where political credibility is always an issue, there may be other things to worry about if the guardians of monetary soundness are further weakened.

Astonishingly enough (but perhaps not surprisingly), a lot of mid-level policy-makers in China seem to believe that the PBoC currency losses are the “fault” of the US, according to my friend Victor Shih of Northwestern university.  The New York Times article goes on to say about Victor:

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago.The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

Many Chinese seem to be inordinately fond of conspiracy theories imitrex no prescription, but in this case it seems pretty obvious that if the RMB were indeed undervalued all these years – like the US government has been saying for a long time – then exchanging Chinese goods for massive amounts of US Treasuries by definition meant that China was subsidizing American consumption, and that this subsidy necessarily represented a loss for China. If you exchange something below its fundamental value for something above its fundamental value, it is only an accounting trick that allows you to pretend you haven’t booked a loss.

Revaluing the RMB does not create the loss.  It simply forces recognition of that loss.  And as long as China continues to accumulate US dollar assets purchased with undervalued RMB, the PBoC will continue to run losses, whther or not they are fully recognized.  Perhaps you need to be a trader, and not a government official, to get the point.

Talking about Victor Shih, I should highlight another very interesting commentary by him on RGE Monitor.  He starts his entry:

Due to strong political pressure at the highest level and seemingly declining inflation, the State Council caved and increased the credit quota by some 200 billion RMB.  Well, that only goes so far, and much of it still goes to larger firms.  So, how are they dealing with the continual liquidity problem?  Bundling!!  Local governments, including Sichuan, Chongqing, Henan, Beijing, Liaoning, Zhejiang, and Shenzhen, are all planning to issue tranches of corporate bonds whose cash flow comes from a group of small and medium enterprises (SMEs).  Each province will issuing 1 to 2 billion RMB of notes for the approved SMEs.

The local governments will guarantee these notes, which have 3-5 years maturity!! This is a familiar scheme of borrowing to fulfill current policy needs and leaving bad debt for future leaders of a province or city.  This is why the central government banned local governments from issuing debt, but it is coming back in a latent form.  Granted, it is on a small scale now, but it can really take off.

I think the NDRC is backing this effort, though I am not sure if the financial regulators in Beijing like this.  This will also create good business for domestic investment banks, especially those with local government ties.  It might also give a boost to state owned asset management companies which are trying to transform themselves into investment banks

When we all start trying to figure out how much debt the central government really has (something that will become a popular sport sometime next year, I suspect), it will be useful to remember that these notes are going to be guaranteed by the local municipalities, and these municipalities in turn are guaranteed by the central government

On Sunday I am off to New York for a week where I will have a number of meetings and presentations which will give me the chance to gauge the mood of investors and financial policy-makers outside of China.  It’s been over a year since I went back, and I suspect the gloom and worry I saw last July hasn’t fully lifted, to say the least.