My Blog

January 21, 2008

MON 21 JAN

Chinese pro-cyclicality makes predictions so difficult By Michael Pettis

About 15 minutes ago, as I was riding in a taxi back to my office with one of my students, Gao Ming, he told me about a recent Jim Rogers interview in the local media.  Apparently during the interview Rogers said that a sharp US slowdown would have a significant adverse impact on the Chinese economy and, according to Gao Ming, his comments elicited a great deal of alarmed discussion in other media and on internet bulletin boards.

 

I don’t know if one caused the other, but when I got back to my office I saw that the Shanghai A-share index was down 5.14% for the day, with financial stocks being particularly hard hit.  On the China Daily website (they are already calling today “Black Monday”) they explain the decline as being caused by “growing fears over the fallout from a slump in the US economy.”  A recent Bloomberg survey has economists guessing that growth slowed in the fourth quarter of 2007 to a still-sizzling 11.3% (from 11.5% during the second quarter) and the estimates for GDP growth in 2008 are 10.5%, versus the 11.5% expected for 2007.  This would be its first deceleration in seven years.  By the way we should get the actual numbers for Q4 growth and December CPI on Friday.

 

One of the big problems with growth predictions for China relative to other countries is that these predictions should come with a much wider range of expected outcomes.  China, in other words, is likely to perform much better than expected or much worse than expected because, even more than many other developing countries, it has a number of highly pro-cyclical mechanisms built into its economy that act automatically to exacerbate good and bad conditions.

 

The most obvious is the monetary system into which China has locked itself.  If US and other foreign demand for Chinese goods remains robust, the Chinese economy will benefit doubly, first from the economic benefits of strong foreign demand for Chinese products, and then again because the resulting high trade surplus will force the PBoC to expand domestic money as it monetizes the current account inflow.  This double benefit will keep the country solidly in overheating territory.  Of course a sharp fall in exports would have the opposite effect.

 

There is also another very important pro-cyclical mechanism imbedded in the banking system.  Chinese banks still have large amounts of non-performing loans, and there is a great deal of concern – very legitimate in my opinion – that the huge surge in lending in the past three years may end up forcing a significant rise in non-performing loans should the economy suddenly slow (bad loans, as old-fashioned bankers always like to say, are made in good times, and times have been as good as they can possible get).  If this were to happen, it would probably put pressure on banks to cut back lending and otherwise hoard liquidity.  In a financial system like China’s – bank dominated and with few other moving parts – anything that affects bank lending systematically will have a disproportionate impact on the underlying economy, both on its way up and on its way down.

 

There are other pro-cyclical mechanisms, common in many economies but sometimes exacerbated in China.  Company profits recently have been bloated by financial speculation.  Chinese growth is highly dependent on the real estate and development sectors, which are highly sensitive to the banking environment.  Spending on budgets tends to be heavily front-loaded, with political concerns often dominating official expenditure and credit extension (which can create extended time lags between the need for action and the action itself).  Credit extended to support inventory buildup is likely to be easy in the early stages of a slowdown.  And so on.

 

The problem will be compounded because Chinese fiscal and monetary measures have been largely administrative and often a little heavy handed, so they tend to leave the country a bit like the man in the old-fashioned shower who alternatively scalds and freezes himself as he jerks the spigot back and forth.  Because of distortions in the economy and, perhaps more important, serious differences between the more open coastal provinces and the rest of the country (which seems to cause government measures to operate in different ways through different transmission mechanisms and with different time lags), it may be very hard to coordinate a economy-wide fiscal or monetary response.  Parts of China are very open and market responsive and parts of China continue to be highly bureaucratic and government controlled.

 

The thing to watch, I suspect, is inventory levels.  At the first sign of a slowdown in demand they should begin to surge as China still experiences the impact of previous overinvestment, but at some point of course rising inventories will cause sharp cuts in production.

 

The government does have certain countercyclical measures it can use to offset the pro-cyclical mechanisms imbedded in the economy, but these may be limited, in part because of the difficulty of coordination among different sectors and regions of the economy, but also for other less obvious reasons.  For example, the government’s fiscal position seems to be in pretty good shape (debt is around 30% of GDP, and most of it is very well-structured – medium- to long-term fixed rate RMB bonds), so there seems to be plenty of room for fiscal expansion. 

 

However I have already mentioned (in a posting a few months ago) an interesting book put out around March 2007 by the ADB which argued that in developing countries the biggest cause of destabilizing government debt levels has not been accumulated excess fiscal spending but rather the sudden emergence of contingent liabilities during a crisis period.  The most common form of these suddenly-emerging contingent liabilities has either been external debt during a currency crisis, or a sudden explosion of non-performing loans in the banking system during an economic contraction (or of course a combination of the two). The former risk in China is nearly zero (or actually even negative, since China is net long dollars), but the latter risk is not at all implausible.  If a slowdown were sharp enough it is very possible that non-performing loans in the system would rise so quickly so as to create an issue over sovereign credit and so limit the government’s ability to respond too quickly with fiscal stimulus.

 

China could also reverse its recent attempts to contract domestic policy and try to expand the money base.  It could lower both interest rates and minimum reserve requirements, and retire central bank bills.  How successful these measures will be depend on at least two things.  First, increasing liquidity in the system, and especially in the banking system, can cause an increase in investment and consumption if demand is there, but in an economic contraction it might not be.  Second, if an economic contraction does not come with a sharp decline in inflation (which I don’t think is likely in China), monetary expansion might not be possible without creating the even more serious risk of accelerating inflation.

 

My point is not that a certain slowdown in the US will cause a sharp contraction in China.  I am not totally convinced of the sharp US slowdown, although I tend to agree with Jim Rogers, or at least Gao Ming’s description of Jim Rogers’ position, that “decoupling” is more of a comforting myth than a reality.

 

Rather my point is that China has gotten locked into a number of highly pro-cyclical systems that exacerbate external conditions.  This is why Chinese economic growth in recent years has consistently surprised on the upside, in spite of multiple government attempts to slow it down.  The same mechanism can cause equally large surprises on the downside.  It was during my many years of investment banking in Brazil that I learned to adopt the Brazilian horror of virtuous cycles because of the ease with which they can collapse into vicious cycles.  China, like Brazil in other ways, has found itself recently wrapped into in a delightful virtuous cycle (money growth feeds export growth, which feeds money growth), but the only guarantee this kind of system brings is a guarantee of extreme volatility – both up and down.

 

By the way, some people might argue that with its huge reserves China has plenty of spending power to get out of an economic contraction.  Not true.  Reserves cannot be spent domestically since they would first have to be converted into RMB, which means getting the PBoC to sell itself dollars – a meaningless transaction.  If the PBoC reserves were used to subsidize the purchase of foreign goods or commodities, which might be expansionary in some cases, the losses would show up as a net increase in PBoC debt – which is just another way of saying any government spending, whether caused by direct government expenditure or by raiding the PBoC, is fiscal in nature and will cause government debt levels to rise if they are not funded by an increase in taxes.

 

On a separate note, FDI into China in 2007 was $74.7 billion, up 18.5% from last year’s $63 billion.  Consumer sales were up a very healthy 17.0% for 2007 (versus 13.6% for 2006), although there is some worry that rather than represent a permanent increase in consumer spending the increase was at least partly caused by inflation worries.  As it stands domestic consumption makes up about 36% of GDP.