In his last email of the Year Michael Pettis takes stock of the current state of China's rebalancing. It's an 18 page PDF, with no online link.
Taking Stock of China's Transition by Michael Pettis
Special points to highlight in this issue:
- While policymakers almost certainly understand that the interest rate cuts announced by the PBoC two weeks ago will slow the pace of rebalancing, the asymmetry of the change in rates was designed to minimize the adverse impact on rebalancing, and indicate just how complex China's adjustment is likely to be.
- Next year will be a very important year for China because possible strains in the banking system and the intensity with which the reformers present their case will give us a better sense both of how much debt capacity the country retains and of how well positioned Xi Jinping and his allies are to implement the needed reforms.
- The completion of [prior] reforms [under Deng Xiaoping] left China ready for an investment-driven growth model that delivered astonishing increases in wealth. It also delivered unprecedented imbalances. China's leaders under Xi Jinping will once again have to liberalize the economy and dramatically change the institutional structure of power in spite, once again, of elite opposition.
I should start by saying that I was a little disappointed, but not terribly surprised, by the PBoC's announcement two weeks ago that it would cut interest rates. The fact that rates were cut, even though many reformers within the administration were very much opposed, exemplifies the challenges that Beijing will face in 2015.
As China's economy continues to slow, a lot of sectors, especially among the more heavily indebted, are suffering losses and running into cashflow problems. There have been calls by the tradable goods sector to depreciate the currency and even more urgent calls by the capital-intensive sector to cut interest rates. At the same time, however, there is also recognition that either move would slow the pace of rebalancing and increase the risk that China run into debt capacity constraints.
We are going to see this argument replayed many times in 2015.
All the various measures of inflation have dropped this year, with Monday's data showing that the producer-price index dropped 2.7% in November, completing nearly three years of monthly declines. Consumer prices rose 1.4%, even lower than the 1.6% increase in October. As a result, real lending rates are strongly positive and real deposits rates are also probably positive.
I don't expect either a sustained housing rebound or stable growth at current levels. The interest rate burden on Chinese businesses and state-related entities has certainly been much higher in 2014 than it was for most of this century.
While the benchmark deposit rate was officially lowered from 3.00% to 2.75%, the upper limit that banks can pay for deposits remained unchanged at 3.30%. It may seem strange to have both a benchmark rate and a "floating range" that establishes a cap, instead of just setting a cap, as was the case until very recently. The official reason for separating the two is that the "floating range" represents a partial liberalization of deposit rates. By widening the floating range, we are told, the PBoC is gradually eliminating the deposit cap until eventually banks will be able to set any rate they want.
Discriminatory pricing Because banks were always allowed to set deposit rates below, but never above, the benchmark rate, so that it was effectively the cap until recently, the logic seems a little faulty, and it is hard see why this represents the gradual liberalization of deposit rates. But there could nonetheless be a real impact on deposit rates that depends on a kind of "benchmark illusion".
At first, the new deposit rate rules set last week seem to have had the expected effect. Within two weeks, however, three of the big four banks raised rates back to the upper limit, suggesting that the competition for deposits may be pretty fierce.
Reducing Consumption Will Not Increase Prices
It is widely accepted in most economies that lowering interest rates is an appropriate response to fending off deflationary pressures, which are a huge potential problem for a country whose local governments and major institutions are as heavily indebted as those of China, but as I have argued many time before, the mechanism that converts monetary easing into inflation in countries like the US works very differently in China.
In fact lower interest rates are likely to be disinflationary in China, not inflationary, and for the same reasons I have been arguing for the last two years that a depreciating yen would be disinflationary for Japan. In either case they reduce consumption demand relative to production.
Normally, lower interest rates are likely to increase consumption in two ways. They lower mortgage and consumer financing costs for households, who represent a substantial portion of total borrowing, allowing them greater spending power. They also tend to be associated with rising stock and real estate markets, which, by making households feel wealthier, encourages higher consumption. If together these two effects increase demand faster than lower rates increase production (as businesses take advantage of cheaper financing to expand production facilities), there is likely to be upward pressure on prices. Depreciation can also be inflationary, but in a different way. It causes the price of imported goods to rise and these can feed into local inflation.
But in cases where consumption is a relatively small part of total demand, in which household savings are high and tend to occur in the form of bank deposits, and especially if most new credit is allocated to producers rather than consumers, lower interest rates actually reduce consumption by reducing household income (lowering the return on savings), and increase production by lowering financing costs for producers. The same can happen with currency depreciation, which reduces disposable household income by raising import prices while subsidizing the tradable goods sector. In cases like China and Japan, the net effect is more likely to increase total production of goods and services by more than it increases total consumption, so that the pressure on prices is disinflationary, not inflationary.
For years we have seen massive monetary expansion in China accompanied by low consumer price inflation, and most of that inflation was anyway driven by higher food prices, which were caused not by loose money but rather by agricultural shortages. For the past three years we have also seen the yen depreciate by nearly 40%, and yet not only has there been no corresponding increase in Japanese inflation, but we are constantly surprised by much weaker-than-expected consumption. Disinflation and even deflation, in other words, is going to be very hard to fight.
Why is it so hard to implement policies that rebalance an unbalanced economy? Part of the reason of course may simply be that policymakers rely on faulty economic analysis, and it is clear that even as late as 2010-11 most China specialists did not understand the systematic nature of China's unbalanced growth and the dangers of its over-reliance on investment. Even today, while most economists have finally come around to acknowledging that China has a debt problem, it is rare to see in any of their medium-term economic growth projections assumptions that explicitly incorporate debt and the deleveraging process into their models.
This makes their models almost useless. Nearly all the historical precedents suggest that highly indebted economies grow well below potential because of the impact of financial distress, while logic suggests that if growth was boosted by credit expansion, credit contraction must have the opposite effect. Economists even seem to have misinterpreted the pro-cyclical nature of rapid credit expansion. Rapid credit expansion is highly self-reinforcing because it both creates and responds to rising growth expectations.
For this very reason, the fact that Chinese growth regularly surprised on the upside during the phase of rapid growth should imply that it will also surprise on the downside as the economy slows. And yet most analysts have interpreted the former as implying that policymakers in China were especially capable, and so they assumed that the same high-quality economic management would ensure that the subsequent slowdown would be much less than expected. This isn't the first time, of course, that the balance-sheet dynamics during a growth miracle have created unrealistic evaluations about the quality of policymaking.
Pettis provides a great deal of information I skip in these excerpts about the transition of China's growth, and expectations about that growth.
The four stages he sees are as follows.
Stage 1: The first period of liberalizing reforms under Deng Xiaoping
Stage 2: The investment growth period
Stage 3: The overinvestment period where "miracle" GDP growth was accompanied by a far greater expansion of debt to the point of saturation and malinvestment
Stage 4: The second period of liberalizing reforms under Xi Jinping
We are currently in state four. Pettis Continues ...
Under its new president, Xi Jinping, China must implement a second round of liberalizing reforms that in many ways will replicate Deng Xiaoping's reforms. There is one major difference however between Deng's reforms and the reforms Xi must implement. Although both sets of reforms should lead to an immediate improvement in real productivity growth, it is very unlikely that China's adjustment under Xi will result in spectacularly high GDP growth rates the way Deng's reforms almost immediately did. The reason has to do with debt.
When Deng began his reforms Chinese debt levels were low. As he eliminated the institutional constraints and distorted incentives that prevented Chinese from behaving productively, the resulting increased productivity showed up immediately as higher growth. But high debt levels change the impact of more productive behavior in at least three important ways. First, by distorting the distribution of earnings, high levels of debt almost always impede growth. This process, called "financial distress" in finance theory (and for some reason still barely understood by economists), ensures that until debt is written down, reforms aimed at unleashing productivity will result in far less wealth-creation than expected. It is not an accident that highly indebted economies always grow much more slowly than projected, even after implementing productivity-enhancing reforms - Argentina during Domingo Cavallo's second term and Spain under Mariano Rajoy are examples that immediately come to mind - although in every case the failure of the reforms to speed up growth is inevitably blamed on insufficient reform.
Second, high levels of debt require that the Chinese economy deleverage, and except in an economy in which all resources, including labor, are fully and productively utilized, deleveraging always reduces growth. Finally, because the Chinese banking system has not recognized the economic losses its lending has generated, China's GDP has been substantially overstated by the amount of these bad loans. This overstatement will automatically be amortized over the adjustment period, necessarily lowering future reported GDP by the amount past reported GDP had been overstated. Because so much investment in China is non-productive, higher investment causes the country's already excessive debt burden to rise further. But attempts to slow investment would force up unemployment unless consumption growth can pick up the slack. Because China's low consumption share is mainly a consequence of the extraordinarily low share of GDP retained by Chinese households, to increase consumption rapidly, Beijing must force up household income at the expense of state-owned enterprises and local governments.
This is the heart of China's adjustment choices. Rebalancing the Chinese economy ultimately requires that Beijing choose an optimal balance among three difficult options - rapid credit expansion, higher unemployment, and wealth transfers from the state sector to Chinese households. As long as banks are able to continue funding enough new investment, Beijing can prevent unemployment levels from rising in the short-term by forcing up investment. But because banks cannot redirect lending quickly enough away from non-productive borrowers to productive borrowers, higher investment leads directly to higher debt levels.
If rapidly rising debt causes China to reach its debt capacity limits, it can no longer trade off more investment for less unemployment, in which case any shortfall in consumption must lead to unemployment. There is no accurate way of determining how much longer China can maintain current levels of credit growth, but while some optimists suggest it may have around decade, my own view is that it doesn't have much more than 3-4 years, after which credit simply cannot grow fast enough both to roll over unrecognized bad debt and fund new investment.
How will China rebalance? President Xi has only just begun the reform process and his task will not be easy. His first steps in government have been to consolidate power and to weaken and frighten potential opposition. This was always going to be necessary if the reforms were going to be implemented.
So far he seems to have been successful, but we should expect continued political opposition to rebalancing the Chinese economy and continued attempts by Beijing to undermine the power of local governments and state-owned enterprises. It took highly centralized power under Deng Xiaoping to implement the liberalizing reforms of the 1980s, and it will probably take highly centralized power under Xi to implement a new set of liberalizing reforms. Unlike Deng, however, Xi will not be able to point to an almost immediate surge in growth to justify his reforms.
While I am relatively optimistic about the likelihood of Beijing's engineering a successful economic rebalancing, my expectations come with a high variance. So far President Xi has followed the script for a successful transition fairly closely. Both the slowdown in GDP and the deceleration in credit growth since 2012 have come in close to what I would have expected in a successful transition. But the real test will be his ability implement the reforms that explicitly undermine the power of local governments, SOEs and powerful families, after many years in which they befitted disproportionately from China's growth.
It will probably take a year or so before we can say with any confidence that these more difficult reforms are taking place, and this is what we should be watching for. The events of 2014 have been fairly easy to understand, in my opinion, because they fit very clearly into the long-term rebalancing script whose potential paths were listed in my 2013 book, Avoiding the Fall.
I would have liked that, along with wishing my readers happy holidays and all the best for 2015, I could promise you that events in 2015 will be equally easy to interpret, but because many of the most important events will take place within the black box of elite politics, I suspect there will be a lot more confusion and wild guessing than in the past. We are probably going to have to be especially creative in trying to extract information from as we assess the rebalancing process and the administration's ability to do what it needs to do. It will be confusing, but happy New Year anyway.
Michael Pettis is always a great read. Inquiring minds may wish to pick up a copy of his book Avoiding the Fall, China's Economic Restructuring.
For more on strains in China's banking system please consider Chinese Banks Hemorrhaging Deposits, 1st Quarterly Drop Since 1999; Banks Offer iPhones, Even Cars for Large Deposits.