Pettis: Nine Things to Watch in 2013; Unwarranted Outbreak of Optimism in China and Europe; The Great Rebalancing
Michael Pettis at China Financial Markets believes optimism regarding China and Europe is unwarranted.
Via email, he states the case while giving nine key things to watch in 2013.
The subtitles below are mine, the rest from Pettis.
Too Early to be Enthusiastic About China
I wanted to send out this newsletter last week, but the air in Beijing has been so foul that it has been hard to generate the necessary enthusiasm to write it. Over the weekend I was finally able to finish it, perhaps because I have finally gotten used to breathing solid chunks of grit.
Away from the horrible air pollution the year seems to have begun with an optimism that I think is going to prove hard to justify.
Many countries before China have managed one or more decades of miraculous growth, and in every case, perhaps not surprisingly, they developed significant domestic imbalances that were only subsequently resolved during difficult adjustment periods.
Very few, however, have managed the subsequent adjustment process in such a way that their early economic promises were fulfilled. Beijing must now manage China's own adjustment, and this adjustment must come soon if we are not to run into a serious debt problem. How Beijing does so is key to China's longer-term economic success, and it is much too early in the process to get overly enthusiastic. Certainly last year gives a taste of what we might expect.
The next year or two are also going to be very important in determining the success of the great European experiment and, even more, the viability of the euro as it currently exists. At this point, unless the peripheral countries unite in their demands and force changes in growth policies, the future of the euro lies largely in German hands. If Germany decides to save the euro by expanding its economy sufficiently to allow the peripheral European countries to grow while cutting their debt levels, the euro can be saved. If not, I don't really see how peripheral Europe can manage many more years of grinding away at debt through high unemployment (which anyway doesn't seem to improve debt ratios).
Burst of Optimism for Europe
We ended 2012 in a burst of optimism for Europe, with everyone cheering Mario Draghi for having "saved" the euro, but I am deeply skeptical. As far as I can tell nothing substantial has changed, and if countries like Spain are a little more able today to roll over their debts than they had been during the summer, so what?
If Europe were merely suffering from a liquidity problem (or a problem of "confidence", as politicians and bankers always like to say before the big debt crisis), then the ECB's willingness to fund all this debt would be a step in the right direction. But if the problem is too much debt, too high unemployment, and misaligned currencies, then rolling over the debt means that the ultimate resolution will be more painful simply because there will ultimately be more debt to write down.
It is interesting that policymakers are so pleased by an end (temporarily, I assume) to the financing crisis. One of the regular features of sovereign debt crises, and one amply revealed in Beth Simmons book on the 1930s crisis in Europe, Who Adjusts?, is that one of the complicating factors in a crisis is the tendency of policymakers (along with workers, creditors, small businesses, and middle class savers) to change their behavior in response to a crisis by taking steps that protect them from the consequences of the crisis but that also make the crisis worse. Policymakers do this by shortening their time horizons and managing from crisis to crisis, rather than by sorting out the underlying problems. The fact that Spanish policymakers are so relieved by their ability to access near-term financing may be a case in point. It is easy to see why the worry so much about getting through the next bond auction, but at the end of the day this is not Spain's real problem.
Spain's real problem is unemployment and negative growth.
Under the circumstances there is very little popular appetite left in Spain, I think, for much more pain. When locksmiths in Pamplona got together a few weeks ago and decided that they were not going to help banks bust open locks and repossess homes, even though this must have become a major source of income for them, it suggests that ordinary Spaniards aren't eager to absorb much more damage and that solidarity is spreading. It also suggests that any political party that decides to take drastic action to grow the economy, even (and perhaps especially) at the expense of monetary union and its European partners (i.e. Germany), is likely to get at least some significant fraction of the votes.
One way or the other, the world will rebalance. But there are worse ways and better ways it can do so. Large trade surpluses can decline, for example, because exports fall, or they can decline because imports rise. Large trade deficits can contract under conditions of high unemployment, but they can also contract under conditions of low unemployment. Low savings rates can rise with declining household income or with rising household income. Repressed consumption rates can reverse through collapsing growth or through surging consumption. Excessive debt can be resolved by default or by growth.
Any policy that does not clearly result in a reversal of the deep debt, trade and capital imbalances of the past decade is a policy that cannot be sustained. The goal of policymakers must be to work out what rebalancing requires and then to design and implement the least painful way of getting there. International cooperation, of course, will reduce the pain.
Nine Things to Watch in 2013
My guess is that we have ended the first stage of the global crisis, and most of the deepest problems have been identified. In 2013 we will begin to see how policymakers respond and what the future outlook is likely to be. Here is what I will be watching this year in order to figure out where we are likely to end up (and I have a related article, for those who might care, in last week's Financial Times - Hello 2013: Chinese banking and economic reform).
1. Watch how quickly growth adjusts. The speed with which China's GDP growth slows in 2013 will tell us a lot about how determined Beijing is to rebalance the economy in such a way that growth is driven more by higher household income and consumption and less by investment funded by rising government and government-related debt. It will also tell us how successful Beijing's new leadership will be in consolidating power and forcing the kinds of economic and financial reforms on which most economists now agree, but which are likely to be politically difficult.
I expect GDP growth in the first half to be fairly high, probably close to 8%, continuing the investment boom that was recently unleashed. I am not fully confident of this number because there seem to be significant strains in the banking system, and without easy credit growth there cannot be much investment growth. Of course part of any credit tightness will be "resolved" by the tried-and-true method of vendor financing, which is already becoming a problem for SOE balance sheets.
As an aside, one of my former students, now an investment banker working on the domestic IPO market, came to visit me today and warned me that there is a huge backlog of companies trying to get approval to sell shares. One of the requirements is that they must have two consecutive years of rising net earnings. Many of these firms expected to come to market in 2012 and were able to manage the needed two years of rising net earnings to 2011, but now that they have been pushed back, at least to 2013, they are struggling to show that net earnings in 2012 also went up. For that reason his firm is especially wary of sneaky attempts to boost reported earnings. There are hundreds of companies waiting for approval.
At any rate it is second half GDP growth that interests me more. If Beijing has really gotten its arms around the rebalancing problem and is serious about adjusting quickly, I expect reported growth to drop sharply, perhaps to close to 6%. If not, I expect reported growth to remain well above 7% in the second half of 2013. This would worry me.
2. Watch how quickly new debt emerges. Debt problems are going to continue to emerge in 2013, but as long as each new manifestation of excessively rising debt is treated as a specific and localized problem that can be resolved with specific polices, overall balance sheets will continue to get worse. We need to watch what Beijing does to rein in the growth in debt, and of course this is closely related to overall GDP growth. As long as GDP is growing at levels above 6% or 7%, it is almost a certainty that debt is rising too fast. If GDP growth levels come in much below 6 or 7%, there is a chance that debt growth is not excessive.
How do we keep track of debt levels? Obviously this is no easy task in China, where both the banks and the informal banking system have done a great job in recent years of hiding loan growth and keeping formal debt levels from looking to risky.
But follow the cash. Large increases in infrastructure investment and in real estate development are almost always funded, directly or indirectly, by increases in debt.
3. Watch for financial scandals. We should also be keeping track of stories about defaults and bank runs. Remember that the Chinese financial system does not really "do" defaults. When borrowers are unable to repay debt out of operating cashflow, the problem is usually "managed" away by forcing losses onto some other entity.
The late stages of a debt bubble are almost always characterized by the sudden emergence of financial fraud, and the huge extent of the frauds lead many to assume that fraud was the source of the credit problems, when in fact widespread financial fraud is more typically a symptom of a financial system that has already gone to excess. This is why I am going to be following financial scandals closely, no matter how arcane or small. The occurrence and pattern of financial scandal will tell us a lot about the likely problem areas in the financial system.
3. Watch bank activities. More generally I am going to watch the relationship between total credit growth and the growth in RMB loans. Much of the off-balance sheet financing in China is designed specifically to skirt regulations, and the relative size of these transactions will tell us about transparency (or lack thereof).
4. Watch inflation. Inflation is actually a positive indicator for China's rebalancing, and also worth watching because I expect (hope) it to rise in 2013, although not by too much. This may sound like a strange thing to say - everyone else thinks of rising inflation as a bad thing - but remember that the more you repress household income growth, the more you divert resources, especially through cheap financing, from consumption into production, and so this tends to be disinflationary.
If China is truly rebalancing, at least part of this is going to show up in upward inflationary pressure, although it is likely to be the "right" kind of inflation - i.e. it will hurt the rich more than the poor because it will be based on non-food rather than food items. Perhaps this inflation is already starting to happen, although not in the way I would like it to happen. There has been an uptick in inflation but it seems to have been caused by the impact of cold weather on food prices, rather than because consumption of manufactured goods is rising faster than production.
5. Watch the prices of hard commodities. Of course I will be watching copper prices and prices of other hard commodities. I expect that hard commodity prices will fall sharply over the next two to three years, but to the extent that prices rise in the short term, as they have in the past three months, it is likely to reflect additional investment growth in China.
As a quick measure this means that declining copper prices can be seen as a measure of the extent of Chinese rebalancing. The longer it takes for copper prices to drop, the slower is the Chinese adjustment likely to be.
6. Watch the trade numbers. China's trade surplus for November came in much higher than expected, although there are so many discrepancies in the numbers that not all of us are confident about how to interpret the numbers. It seems like growth in both imports and exports may have been exaggerated, as local authorities may be round-tripping both exports and imports in order to make their numbers look good.
In addition, as I have argued many times, China's exports are likely to be misleadingly low and its imports misleadingly high (and so its real trade surplus higher than the official trade surplus) to the extent that there is significant commodity stockpiling and hidden capital flight. Of course destocking and capital inflows will have the opposite effect.
7. Watch the Spanish bond market. Obviously I, like everyone else, will be watching the Spanish bond markets.
I do not think anything important has changed as far as the European crisis is concerned. The fact that there is a additional liquidity for bond purchases does not mean, as I see it, that Spanish competitiveness has been resolved and it does not mean that the economy can grow out of its debt burden. It simply means that there is temporarily a little less pressure to resolve the underlying problems. I would guess that by the second quarter of 2013, and likely earlier, markets will once again have gotten much worse.
8. Watch Target 2. On a related topic, I will continue to watch Target 2 closely as an indicator of strains within the European banking system. This too ended 2013 on a positive note.
For the same reason that I am not optimistic about the Spanish bond market I am also not optimistic that Target 2 will continue to reverse. If it does, of course, that will be a great sigh, but if it doesn't, and if in fact the imbalances continue to grow, that will put additional stress on Germany's ability to maintain the euro system.
9. Watch Japan. Remember that Japanese attempts to get their arms around their huge debt burden will almost certainly affect China and the rest of the global economy. If Japan tries to increase domestic savings to fund the debt, for example by limiting wage increases, or by taxing consumption, both of which they have proposed, these measures may well cause domestic investment to fall. Whether or not they do, if domestic savings rise faster than domestic investment, which is the only way to increase the domestic savings pool available to fund Japanese debt, then by definition the current account surplus must rise.
I am not smart enough to tell you what Japan will do, but I do know that almost anything it does must affect the relationship between its savings and its investment, and hence Japan's current account surplus, which I suspect everyone hopes will rise. Of course everyone else wants the same thing too - rising exports relative to imports - which is clearly impossible, but Japan needs it more urgently than most of the rest of us. This is going to increase strains on the global trading system.
Pettis used point number three twice, I am not sure if on purpose. Both threes are financial. In general, and as is typically the case, I side with Pettis' point of view.
One of the more interesting things on his watch list was "3. Watch For Financial Scandals".
I have been following scandals in Spain that may bring down the Spanish government. Media attention in English has been scant. Here are a pair of significant articles:
In Greece, Law-and-Order Problem Escalates; Bomb Explodes at Athens Mall; AK-47 Shots Hit Ruling Party Headquarters prompting me to say "Worst Not Over"
Complacency reins in European bond markets, even though Spanish and Greek unemployment is over 26% and youth unemployment is over 56% in both countries and both countries have recent fraud investigations at the highest levels.
How much longer this can go on before the powder keg blows remains a mystery.
The Great Rebalancing
Michael Pettis has just released his book "The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead"
I will get a copy soon. Note that Pettis is one of the speakers at my economic conference in April. Please click on the image below for details.