My Blog

October 4, 2008

Earlier this week I was talking to my grad student Shang Ning about the awful markets around the world, and he suggested that maybe it was a good thing that Chinese stock markets were closed this week for National Day since this would act as an extended circuit breaker that might protect them from collapsing in sympathy with the rest of the world.  We agreed, however, that whether or not next week would open with a big downward break would depend crucially on whether the rescue bill was passed by the US Congress and, if so, would cause markets around the world to soar.

Well, the bill was passed Friday, but markets continued to fall.  Hong Kong’s Hang Seng Index lost 2.9% yesterday capping the fifth consecutive losing week with a loss of 5.4%.  Unless the government announces some extraordinary measure over the weekend to boost stock prices I expect that next week is going to start out badly.

It would be only reasonable if it did.  On Friday the US government reported that the US economy had lost 159,000 jobs in September, making it the ninth consecutive month that the US job market has contracted, and suggesting that it is going to be harder and harder for the US to avoid a slowdown in consumption.  China has bet its economic future very heavily on sustained US consumption driving its economy forward, and faltering US demand – coupled, as it is almost sure to be, with faltering European demand – cannot help but slow China’s export growth.

This is, in my opinion, one of the two most likely channels by which global financial difficulties will become Chinese financial difficulties (the other is if perceptions of rising risk cause liquidity outflows from the banks).  If exports slow, and domestic consumption is unable to accelerate sufficiently to replace it – and in fact I expect domestic private demand to slow – there is a good chance that domestic investment will also slow, after a lag that sees rising inventories.  In that case three of the four pistons in China’s economic engine will falter. 

This is dangerous for the financial system, of course, because any economic slowdown will finally put the Chinese financial system to its first real test since the massive expansion of the past four years, and I am not sure it will pass the test very easily.  The current issue of Caijing actually has an interesting article on the subject, indicating that quite a lot of people are becoming increasingly worried about that particular risk.  The article says:

It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects.  All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.

First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area.  Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.  

Second, the loan growth rate is falling.  Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source.  With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit.  In the second half of 2008, the People’s Bank of China loosened its credit control by five percent.  But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.

Third, the loan-deposit interest rate gap may further shrink.  On inflation concerns, a loosening of monetary policy will likely be handled in an asymmetric style.  That is, loan rates will be cut while deposit rates remain unchanged, which is what the central bank did September 15. 

Fourth, loans to the real estate sector and local governments will become more risky.  Personal mortgages and property developer loans currently account for more than 20 percent of the lending at major banks.  If house prices continue falling, however, NPLs in real estate may soar.   

Fifth, administrative measures may bring side-effects.  Loosening credit controls and the “double cut” decision to trim loan interest rates while lowering the required reserve ratio for banks are steps aimed at encouraging banks to lend.  If the government sets loan targets for commercial banks through administrative measures, banks will lower their standards for qualified borrowers, which could lead to even more NPLs.

I have often argued that the financial system (including off-balance sheet transactions, unrecorded municipal and provincial activity, and the informal banking system) has been growing much more quickly and in a much more chaotic way than most analysts realize, and its vulnerability to a slowdown may be significantly greater than we think.  If three of the four pistons in China’s economic engine are faltering, fiscal expansion is left as the main driver of the economy, and although I have little doubt that we will see fiscal expansion, its impact is likely to be slow, the adjustment forced into the banks difficult, and it will only lead to greater imbalances in the economy. 

On that note Standard Chartered’s Stephen Green, who regularly puts out some of the best and most interesting economic analyses of China, has a new piece out today called “The world just changed, China hasn’t.”  In it he says:

We hate to be killjoys, but we have some bad news for anyone claiming that China’s transition to a new growth model – one with more consumption, less investment, more domestic demand, and less exports – is already underway. We would love to believe it too, but it just ain’t so. Worse, the US financial crisis and the coming global economic slowdown will show China’s present model to be even less sustainable than was thought before. But they also present Beijing with an opportunity to unleash new growth drivers. The world just changed, and now is the time for Beijing to change too.

Green argues that while the debate over China’s growth model suggests that policy-makers are in principle acknowledging the need for China to shift from an export-led growth model to a domestic-consumption-led one, in practice this hasn’t happened.  What is worse, one consequence of the global slowdown is actually likely to be a concerted effort to reinforce the “old” model in a desperate attempt to protect the economy from the impact of a slowdown in exports.

The problem also has to do with the gulf between aspirations and actual policy choices, which are often driven by short-term concerns.  To reduce the economy’s dependence upon exports, one needs to reduce exports. It sounds simple, but even with 10% real export growth at present, Beijing has apparently decided to throw incentives back to exporters by topping CNY appreciation and increasing tax rebates to textile producers, and even seems poised to increase them for electronics and machine tool exporters too.  To reduce the amount of heavy industry, one needs to raise manufacturers’ cost of electricity, but there is still no effective system to prevent local governments from protecting their local steel, aluminium, and copper plants from higher power tariffs.

To slow down the investment boom, one needs real positive interest rates (banks currently have negative ones), rigorous dividend payments by state firms into the budget (a reform which is still a small-scale experiment), and local officials whose performance is not measured on investment and tax revenues alone.  To discourage people from investing in the domestic market, one needs a fairly priced exchange rate, but since 2005 it has been fixed and under-valued, as it still is despite the 7% gain in the effective exchange rate over the past year.

To really encourage innovation, one does not need quotas for patent applications, but a reliable civil law system which allows companies to protect their own valuable IPR. To allow people to get decent healthcare, one must allow private hospitals to participate in the state’s insurance system and regulate them. To increase the scale of the service sector, one needs to tackle the state-protected oligopolies that currently dominate – think telecommunications, parts of financial services, health and education, as well as the entertainment business. As PBoC governor Zhou Xiaochuan liked to say a couple of years ago, and everyone else asked themselves more recently with the success of Kung Fu Panda, where on earth is China’s creative film industry?

Green is fairly pessimistic, it seems to me, about the likelihood that China will take the necessary policy steps to shift its economy towards a more sustainable model.  That shouldn’t come as a surprise.  It is always difficult to make major necessary adjustments when external conditions are bad, and yet it seems unnecessary to do so when external conditions are good.  I have mentioned before in this blog the difficult experience of the US in the early 19th Century when the US economy shifted from being driven primarily by exports to the UK, Europe and the Caribbean to being driven primarily by the development of its own internal market. 

This shift did not occur in a gradual way and according to the best thought-out plans of businessmen and government leaders.  The change was forced onto the US and happened mainly because beginning in 1797 the Napoleonic wars and an especially vicious spread of smallpox along the coastal cities decimated the US export business, ushering in a very long depression.  It took the ensuing financial crisis and depression to reorient the economy towards its domestic market, and not without a great deal of difficulty

The “silver lining” in the current global slowdown for China may very well be that China is also forced kicking and screaming into doing what it should have done much earlier, although I suspect Green is right that in the early stages it will actually try to strengthen the export and investment orientation of its economy as a way of slowing job loss. This would be a mistake in the long run, but may be a natural reaction for a government that greatly fears the short-term political consequences of rising unemployment.

By the way and on a completely different and unrelated topic, for some reason some outfit called Forexecutor keeps trying to sneak their advertisements onto the Comments section of my blog.  I checked them out to try to get them to stop.  After running thought their site I have to say that in my opinion they are a scam.  If you see their ads anywhere on this blog please know that I do not endorse them at all.  On the contrary, you should beware of using their “products.”

Comments (14) for "US slowdown = Chinese slowdown"

Prof. Pettis: Regarding the American bailout, it seems unlikely that it will help at all. Consumer lending never stopped in America. People who are employed and can put money down on loans can easily get money. The only lending that stopped was the reckless kind. I don't see how the bailout will bring back reckless lending (or that bringing back bad lending is really a good idea anyway). The money markets also seem unlikely to be affected by the bailout. The central bank is much better for affecting short term lending. It really seems like the bailout created a place for politically well connected banks to dump their bad assets. I think that the outlook for export driven economies remains unchanged by the bailout. In the United States, the data coming in for 3Q (particularly PCE) looks like we will see negative GDP growth for the first time this year, no matter how hard the government tries to fudge it with imputations and hedonics. For China, I think that this means continued pressure on the export sector and the political pressures that come with it. By matt - 10/3/2008 9:22 PM

Michael, As an American who tries to follow events here in the West I would say that most smart traders are in cash and most prescient observers are expecting a trapdoor in the market and a moderate recession is best hope. I would think China will now be in a position to more ubiquitously become a power within the Asian sphere by being the stabilizing financial force. Most of your commentary reminds me of the prescient fellows in the States that in 2004 through 2006 really started raising the alarm bells. One of , paradoxically from the Western view I suppose, the strengths that China finds itself with at this moment is the ability to act by diktats. Would think this would allow China to have a 'have it all' strategy that will be criticized but will move the ball down the street.... In agreeance with your views on optionality the direction will be about stability in unstable times. 1. Gradual RMB appreciation. Inflows and outlows will either result in flat if there are enough inflows and appreciating if there are outflows (or outside an acceptable threshold). Depreciation can't fly. Certainly trade sanctions would result. 2. Monetary easing. Expansion of liquidity in the system to inflate China' way out of problems. Maintain 10% growth. 3. Creation of Sovereigh Debt to mop up excess liquidity... the most overpriced asset on the face of the planet earth is the US sovereign debt. How can China not create the same mistakes of all growing great powers and try to have it all? Boom and bust but still more boom left because in part they haven't ehausted all avenues in 'pushing prosperity.' We are starting to run out of bullets in the West and look like we are going to be taking a breather for a while. I think Western panics are always based on too much debt that contracts, China can create a lot more debt before that happens I would think. Best Regards, JE By John Egan - 10/4/2008 1:39 AM

I agree that China's transition from an export led to domestic consumption focused economy won't be easy and won't happen overnight. People here will spend less and save more if the Chinese economy begins to slow down. A slowdown to 4-6% growth in China will likely feel like a recession to most Chinese as most of that growth would comprise fixed asset investment which doesn't benefit the average Chinese in the short term. I would be interested to hear if you are speaking at any events open to the public here in Beijing. On another note, I wonder if F-U and Fck (the same person I suspect) consider themselves to be one of the smart people contributing to this blog. ;-) By David Oliver - 10/4/2008 10:28 AM

Someone has already suggested that the poor guy who writes all those excited comments needs to get a real life, or at least one or two friends who he can talk to on ocassion. He must be very lonely. I am afraid this blog is his whole life, and he resents that the blog doesn't love him back. At any rate, I guess the professor's students are not quite so ignorant, and unlike Fck they have probably read more than the books that the rest of us all read in highschool. By Max - 10/4/2008 2:04 PM

I think Stephen Green is slow on current events. There should be a bettern income distribution system and broad and viable social security net first to achieve all his suggestions. Privatization is not the medicine for everything. The only point I agree is the civic law system, which is vital to China now. For short term financial matters, there is nothing else to say in addition to what we have already expressed before. By fatbrick - 10/5/2008 2:40 AM

Maxists believe that " political systems-policies choices are rooted and influenced by the economic structures and economic interests groups( classes)". We should not overlook the political-economic complex underpinning China's export-FAI driven growth model, there are strong political interests in sustaining the model unless a big economic crisis destroyed it. There are many in the market calling for and wishing a massive fiscal package-tax cut, social spending could help boost the domestic consumer demand and cushion/rebalance the economy. However, this might be naive, government bureacratic nature is expanding fiscal power, more money, more investment projects, more rent-seeking power. This is in bureacratic bloods, Assuming monolithic government driven by best economics is illusory. By isaac - 10/5/2008 9:14 AM

I don't think that China has ever had a export-driven growth model. The main drivers for economic growth has always been domestic capital spending, and I've always disagreed with people who have argued that the Chinese economy has been "imbalanced" because of high investment levels. Keynesian stimulus in the from of high investment levels are useful to the Chinese economy since it is highly underdeveloped, and the switch from investment to consumption wouldn't (and in my mind shouldn't) happen for another decade. Also NPL's will be a problem but what prevents a problem from turning into a crisis are cash reserves, and China's reserves seem to me enough to at slow the situation down so that it can be dealt with. The equation US slowdown=Chinese slowdown historically hasn't held, since the China credit cycle has been off sync with the US credit cycle. I'd expect that whatever downturn there is in the US economy can be dealt with by fiscal and monetary stimulus. (The fact that the Chinese credit cycle has never been synced up with the US one is why a pegged currency was never a good idea.) By Twofish - 10/5/2008 11:37 PM

Pettis: What is worse, one consequence of the global slowdown is actually likely to be a concerted effort to reinforce the “old” model in a desperate attempt to protect the economy from the impact of a slowdown in exports. One consequence of the global slowdown and the massive financial meltdown is that people who argued for a "new model" have had their political stock shredded. We are, over the next few months, about to find out how well the "old model" works, and my belief (which again may be totally wrong) is that the "old model" will actually work better than the "new model" that has been suggested. I don't think that good-old fashion Keynesian stimulus to boost investment to make up for lost exports is a bad thing or is particular desperate. The thing about the "old model" is that it involves putting a lot of liquidity into the banks in order to deal with the NPL's that will definitely come once you have the a shock to the system. The logic behind the "new model" was that you could increase consumption and decrease savings between the risk management tools had gotten sophisticated enough so that you didn't have to worry about having a capital cushion. Well, that isn't the situation, and right now, it's far from clear that the "new US model" was actually better at pricing and managing risk than the "old Chinese model." Again, events may prove me wrong, but I think that China is going to undergo a lot less pain than the United States will. One thing that is definitely the situation is that the "new model of US banking" is dead, and one thing that the US is going to have to look at over the next few years is to figure out exactly what the "new economic model" for the United States is. How well or badly China fairs is going to under into this discussion. By Twofish - 10/5/2008 11:51 PM

2fish, of course that China took the export-driven growth model. What do you expect? There is almost no natural resources for China to sell. The productivity level and education level are still low compared to West. The only viable option is to promote the low end manufacturing (sometimes even polluted) to increase employment and personal income. So if China does not seek oversea markets aggressively, 1) where can we sell the products 2) where can we get the capital to produce in the first place? Needless to say, this is the unavoidable stage in economic development path. I do not see any country in the world skipping this stage. Because of China's huge population size, this process is painfully long and difficult for us. China's position is still relatively strong today because 1) the firewall between the outside financial markets and domestic credit markets is still there and has some impacts; 2) People benefit from the previous few years despite the increasing inequality, thus the spending power should make some difference compared to the previous recession China has experienced in 80 and 90s. 3) Government still has bullets to make fiscal spending, since Beijing has not shot many of them. There are many challenges. I remembered that Beijing tried to stimulate domestic consumption in 90s once, under Zhu Rongji's watch. It includes attempts of privatization of healthcare and education sectors. That cerntainly did not go well. One lesson is that the social safety net was actually destroyed at that time. With spiking tuition and hospital bill, Beijing's effort on forcing consumption made people more reluctant to spend. Until WTO was there and the world market was open for China, the economy finally found its path. Now the difficult time comes again. The world shrinking demand has the similar effects on China's economic outlook as the 90's recession. The only difference is that we are more productive and own more wealth than 10 years ago. But the preference of saving is still there. Education and healthcare are still expensive. There is still few alternative way to invest money. Rebuilding the social safety net is the only way out. Without the net, people will overwhelmingly continure preferring saving over consumption. Thus, only investment spending won't help us a lot more. By fatbrick - 10/6/2008 1:48 AM

fatbrick: of course that China took the export-driven growth model. What do you expect? Except that Chinese growth has by and large not been export-driven. It's investment-driven. It's only since 2003 that Chinese growth has had a substantial export component and that makes up about 2-3% GDP growth. Chinese growth has taken some elements of export-driven growth model, but it can't copy it completely, China is just too big for that, and global markets are too small. fatbrick: The only viable option is to promote the low end manufacturing (sometimes even polluted) to increase employment and personal income. No. Most of Chinese growth has been achieved by pour lots and lots of concrete. That's not low end manufacturing. The concrete does help low-end manufacturing by creating first rate infrastructure in a third world nation. fatbrick: So if China does not seek oversea markets aggressively, 1) where can we sell the products 2) where can we get the capital to produce in the first place? You sell the products domestically and you get people to afford the products by dropping money from helicopters. Also China is a capital *exporter* not importer. If anything China has too much capital for investment not too little. During the early 1980's things were different but that was 25 years ago. It's the US that is finding itself capital starved, not China. fatbrick: There are many challenges. I remembered that Beijing tried to stimulate domestic consumption in 90s once, under Zhu Rongji's watch. It includes attempts of privatization of healthcare and education sectors. No it didn't but there are other ways of stimulating consumption or increasing investment. Pouring massive amounts of money to build earthquake-proof schools and lots of free clinics for example. fatbrick: But the preference of saving is still there. Education and healthcare are still expensive. So make it cheap. Have the government borrow the money that people are saving and having them pump into into schools and health care. It's a very good investment. fatbrick: Thus, only investment spending won't help us a lot more. If export markets collapse, and there is no consumption, then you boost investment. Whether this is a good idea or not depends on what you invest the money in, and there isn't a lack of places to put investment in China. I'd go first for earthquake proof schools, universal health care, and lots of health and food inspectors. By Twofish - 10/6/2008 2:10 AM

Max: “books that the rest of us all read in highschool” Any five books that you can suggest? which can clarify in an authoritative and well documented way where China will be 5 years from today? Taking into account all major important drivers including natural resources, economics, environmental degradation, social upheaval, energy risks, political stability, military challenges, water resource fragility, among others? Most of these books will be outdated before they are written. But have you read them? Titles, please. By . - 10/6/2008 2:19 AM

No, 2fish. You would want return from your investment in infrastructure. If it is public money, you expect the increased tax revenue from more business activities due to the better roads, more uility supply and more convienent telecommunications. If it is private money, you expect the large amount of toll fees. Bottom line, infrastructure is the means but not the end. Luckily we have a large part of the country that is still in poor conditions, thus another 20-30 years of infrastrucuture spending are not so off the base. The direct GDP impact of export industry might be small. But the related industrial investment and service economy are the larger pie. More importantly, the employment, you will need several service jobs to support one manufacturing position. There is a reason that Beijing listened to the exporters intently. Yes China has worked on moving up in the value chain and made some progress. Again, the sheer size of the population made this transition very difficult. I personly do not see assembling IPod or PCs is very high end job. Here goes my argument about your perceptions about the China economy, export and industrial investment. About capital, I did not talked about 80s. The period I referred to was the end of 90s or maybe the beginning of 21 century. The bank failures and capital outflows were too huge at that time to ignore. China right now seems to have available liquidity on average. This could change over night. I mentioned the reasons why we hold up right now. However the headwind seems to change everyday right now. Also this is not only about the amount of capital available, but also about the capital allocation system. Does capital move to the more effective part of the economy? Based on what I know and this blog, I am not so sure. We have improved a lot, but still not good enough. Zhu did try to effectively privatizing hospitals and schools, not by selling the ownships but by cutting the public funding. By investment spending I mean fixed asset spending. I of course support pumping money in education and healthcare. That is a part of social safety net. Many know this. The question is how. We know the current education system is not competitive, especially the college education. Universal health care is definitely too much. I am not sure the free clinic idea is practical too. Quality and safety regulations should be reinforced, that is for sure. By fatbrick - 10/6/2008 3:16 AM

fatbrick: No, 2fish. You would want return from your investment in infrastructure. Not necessarily. You can put government spending in things that provide public goods that are not easily quantifiable like clean air or good health. One problem in the way that resources are allocated in China is that it goes into things that are easily quantifiable, but you might be causing damage in things that are not. Creating a factory that causes large amounts of pollution for example. fatbrick: The direct GDP impact of export industry might be small. But the related industrial investment and service economy are the larger pie. But you can stimulate the investment without exports. In fact if the US goes into recession, you will have to stimulate that investment without exports. fatbrick: The period I referred to was the end of 90s or maybe the beginning of 21 century. The bank failures and capital outflows were too huge at that time to ignore. No. You had bank failures, but the amount of capital outflow was small in comparison with capital generation. The fact that Chinese have been huge savers is what allowed China to avoid the fates of Latin America. With a cash cushion from savings, there was enough liquidity to keep the banking problems from turning into a crisis. fatbrick: Also this is not only about the amount of capital available, but also about the capital allocation system. Does capital move to the more effective part of the economy? I do think that we really have to rethink how we deal with capital. The Chinese economy has been often criticized for being highly inefficient at allocating capital, while the US economy has been praised as being the model of efficiency. The problem is that by being "efficient" the US economy ended up with very high leverage that has caused the major crisis that we have now. My assertion is that the very things that made the Chinese economy seem inefficient will help it through the next year. One way that may be a description of what happened is that by trying to do more with less, the US moved to the point where by moving money around, no real wealth was being generated, and only the illusion of wealth. Again, a lot will depend on what happens. If Chinese banks start failing due to overwhelming NPL's, then I'm just wrong. However, what I think will happen is that the NPL's will be manageable, and that the government will be able to keep demand from collapsing by pumping in money that it saved in the boom times. The thing about the Wall Street crisis is that for the most part it was unforeseen and if the economic theories that have been in vogue over the last ten years were correct, it should not have happened. fatbrick: By investment spending I mean fixed asset spending. That's probably an overly restrictive definition. Health and education spending will probably produce more ROI than pouring concrete. Also if you look at the cost of setting up universal basic healthcare and education, they really aren't that expensive. By Twofish - 10/6/2008 6:39 AM

"Pouring massive amounts of money to build earthquake-proof schools and lots of free clinics" Always a good idea to invest in health and education. But, no degree of massive amounts of investment, in any public works, can compensate for the downside of such extreme overpopulation. It would be best to spend the maximum resources toward reducing the population from 1.3 billion to a more manageable 400 million within a 40 year span of time using benign and innovative methods which would appeal to the populace. There are ways to do this using relatively huge incentives. And the positive payoff for China, and individual citizens, in the near term and long term would be immense, in almost every facet of its society and environment. The so-called one child policy is a failure because it uses coercion and harsh methods instead of incentives. There probably is not one citizen of China who does not secretly wish that China's population was at a much more manageable level. But, just because population control is a taboo subject does not mean that this subject should not be openly discussed now, while it just might not be too late. It is amazing that while so many valid trusted indicators point to unreasonable expectations for any sort of future good quality of life, with 9 billion lost souls living cheek by jowl, still the subject of seriously controlling population remains one of the last taboo topics of discussion. People throw up their hands and declare overpopulation to be an act of god, with no possible chance of remediation. No matter today's report by the World Conservation Union that 1 in 4 of all mammals are being pushed towards extinction. By soak the rich - 10/6/2008 11:43 AM