My Blog

February 8, 2008

FRI 8 FEB

A US slowdown won’t help China By Michael Pettis

I just got to New York yesterday and have been meeting pretty continuously with friends and investors.  Not surprisingly, everyone is very interested in hearing about what is going on in China.  Last time I was here, in July, a lot of people asked me about the “decoupling” thesis, and not everyone was terrible pleased (or in agreement) when I said I thought the idea was mostly nonsense, based partly on mistaken premises and partly on wishful thinking

 

Now, it seems, no one takes the idea of decoupling seriously at all.  Everyone is convinced that a sharp slowdown in the US will be disastrous for the rest of the world.  This is one idea whose death seems to have come quick and hard.  In fact, the most noticeable aspect of my trip here is the sheer gloom and worry about the state of the US and world economy.  It has been a while since I have seen so much pessimism and nervousness. 

 

Actually on this trip I found myself taking the unusual but not disagreeable role of downplaying some of the risks and terrors that lurked out there.  The sub-prime crisis has certainly been tough, but the resilience of the US financial system has really been impressive during the many crises of the past three or four decades, and the transmission mechanism from financial crisis to economic contraction has, in some way, been sharply weakened in the US. 

 

More importantly, in my view, the long, globalization cycle we have been through since the 1990s won’t truly end until we start to see a sharp reduction in the combined US/Europe trade deficits if, as I believe, it has largely been Asian and (more recently) OPEC recycling of their huge current account surpluses that has underpinned the growth in underlying global liquidity.  I am not saying that this can’t happen – it can and some point must – but so far this has not happened at anywhere near enough of a scale to convince me that we’ve reached the end.  The main thing to watch, in my opinion, is inflation.  If there is a slowdown, however mild, that is accompanied by a sharp increase in inflation, this could really spell the beginning of the end.

 

Talk of rising inflation and a slowing economy brings us straight back to the topic of China.  Xinhua yesterday reported that the “U.S. slowdown could be opportunity, not crisis, for China.”  They report that a number of Chinese economists believe that a US slowdown, by reducing the growth rate of exports, could help rebalance Chinese growth, towards a healthier mix of investment, exports and consumption and would help relieve monetary expansion.

 

To their credit few Chinese have taken the decoupling thesis very seriously, but if they expect a US slowdown to help resolve their domestic problems I think they are missing the point.  One economist mentioned in the article, Zheng Jingping, a researcher with the National Statistics Bureau, did get focus on the key issue when he noted that “it was not export growth but the trade surplus that would be the key issue”.  This is exactly right.  If China’s exports decline, and Chinese imports decline also so keeping the trade surplus high, China will get hit by a double whammy.  The reduction in exports will hurt economic growth but the high trade surplus will keep China’s furious money expansion going, so continuing to put upward pressure on investment and industrial production.  The “rebalancing” would consist of an even greater share of investment as part of total GDP growth.  This would be a worst-case outcome.

 

Could exports slow while causing a decline in imports?  Yes, in fact it is highly likely.  Remember that nearly half of Chinese exports are recycled imports, and any slowdown in the very important and lively export sector might indirectly affect Chinese overall consumption by increasing uncertainty.  But even if there is a small decline in the trade surplus, that is not enough.  In order to halt the money-creating monster that China’s currency regime has become, we need the trade surplus (and hot-money inflows) to decline substantially.

 

The problem in China is excessive monetary expansion, caused by the lack of a domestic monetary policy, and until that is resolved it is wishful thinking to talk about a healthy rebalancing.  Rapid money growth will continue to fuel excess investment and industrial production, until it comes to end either after a sharp increase in unsold inventories forces companies to cut investment or after persistent and rising inflation forces the government to clamp down brutally on economic activity.

 

On a slightly different topic, there has been a lot of recent downgrading of expected growth rates for China (so much for decoupling). According to the New York Times in an article about a recent World Bank report:

 

The bank said in a quarterly update that it now expected gross domestic product in China to expand at a 9.6 percent rate in 2008, which would be the slowest growth since 2002.  In its previous report in September, just as the global credit crunch was intensifying, the bank projected 10.8 percent growth for 2008.

 

Revising 2008 growth down from 10.8% in September to 9.6% in January is a big jump, and I expect that number will be sharply revised upward or down again.  One of the things I have tried to point out about China is that there is a lot of pro-cyclicality embedded into its capital structure, which means that external events, whether adverse or positive will have exaggerated impacts on domestic growth.  In spite of a recent report by UBS claiming that the old boom-and-bust of China has given way to smoother change, I continue to think that economic growth is going to be extremely volatile.  

 

This will be reflected in bank stock prices, by the way