Will China’s New “Supply-Side” Reforms Help China? by Michael Pettis, China Financial Markets
It wasn’t enough that we started 2016 with one of the worst weeks in the recent history of Chinese and global markets, but the panic continued into the following weeks and wreaked a great deal of damage to confidence. A lot of the reflexive China bulls are cautioning against misinterpreting the implications of the stock market collapse, and of course they are right, but the fact that the plunging Chinese markets can easily be misinterpreted should not in any way suggest that things are fine. Two weeks ago in the FT Alphaville blog (which is the best place to read regularly about China’s vulnerabilities, in my opinion, especially in their relentless focus on the changes in the various components of the balance of payments) Peter Doyle discussed one of the standard set of responses that we’ve seen repeated regularly since 2011 and 2012. The bull refrain has been, in his words: “things really aren’t that bad or surprising, and there’s considerable willpower and ammunition left in Beijing should it be necessary.”
“This makes good copy,” Doyle suggests, and adds, more diplomatically than I might have, “but is not persuasive”. It certainly isn’t, and he discusses some of the reasons why. On the same day George Magnus published an OpEd in the Financial Times that makes a point that too many people, as he points out, are still overlooking.
China’s chief vulnerability, and the main factor driving the tendency towards the increasingly fragile balance sheets that underlie the series of interrelated financial-market disruptions that began seriously in June 2013, is the inexorable rise in debt, and any analyst that fails to come to grips with the problem of excess credit is simply wasting his time. In the article Magnus writes:
Important economic reforms to the real economy and state monopolies have stalled, or succumbed to inertia and pushback. Policies designed to develop new sectors have not been matched by those needed to tackle problems in larger ones, such as poor productivity, chronic overcapacity and now a fourth consecutive year of producer price deflation. Tellingly, China’s most serious problem — the relentless accumulation of debt — received passive attention at most.
[drizzle]I will return to his point about stalled reforms, but Magnus is right about the debt. China’s most serious problem is “the relentless accumulation of debt”, and economic conditions will continue to deteriorate until Beijing directly addresses the debt. In fact it doesn’t really matter if China is able to report growth rates for another year or two of 7%, or 6%, or even 8%. If the only way it can do so is by allowing debt to grow two or three times as fast, there will have been no improvement at all, the economy will not have adjusted, and China’s longer-term outlook will be worse than ever.
It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted. The astonishing ability of the China bulls, both foreign and Chinese, to celebrate every unexpected decline in growth and every new surge in debt as if they somehow justified nearly a decade’s worth of denials of the urgency of China’s rebalancing has done so much damage to China that the sooner Beijing’s leaders finally turn against the bulls, as I believe they might finally have done, the better for the Chinese people and the Chinese economy.
Beggaring thy neighbors
Before I explain why I think Beijing has decided that it has been misled in recent years, I should point out that what worried me most about the events of the past weeks was not the stock markets themselves, nor even the change in how investors and businesses inside and outside China perceive Beijing’s ability to manage the economy and the markets (I have already said many times that just as most people systematically over-rated the quality of Chinese policymaking in the past, they are likely now to be overly harsh in accusing Beijing of mismanagement). I am far more worried about how other countries might misinterpret the rapid decline in the RMB, accompanied by what seems like another surge in capital outflows.
Contrary to some of the muttering out there, I don’t think Beijing is planning competitive devaluations in order to strengthen the tradable goods sector, in the hopes that surging exports will revive growth. Certainly if the PBoC ever were to stop intervening, and to let the RMB depreciate to some imagined fundamental “equilibrium”, we would quickly see that there is no such equilibrium level. In a speculative market, the market does not tend towards some stable value, with self-dissipating movement in any one direction reducing pressure for further movement in that direction. Price movements instead are self-reinforcing, and can quickly overshoot fundamentals.
Beijing is more likely to believe that the economic slowdown was caused by been weakness in domestic real estate and infrastructure construction, and not because exports are weak, and the latest trade data confirms the relatively strong export performance. Although manufacturing overcapacity is certainly a problem, much of it is in areas in which global demand has simply collapsed, and isn’t coming back, and so a cheaper currency would have little impact beyond temporarily reducing excess inventory, which is not enough of a benefit to justify the many costs of a weaker currency. Production facilities would still have to be closed down.
I think the real reason for the recent RMB weakness lies elsewhere. Beijing is trying to boost domestic liquidity in the hopes that this will generate stronger domestic demand, but expanding liquidity fuels capital outflows, and these put downward pressure on the currency, while increasing PBoC concerns about the monetary impact of money leaving the economy which, as an article in last week’s FT argues, might be worse than we think. Last week’s People’s Daily reports that prominent Tsinghua professor and former member of China’s Monetary Policy Committee, Li Daokui, claimed at Davos “that at least $3 trillion foreign exchange reserves in China is required to prevent foreign debt default risk”, for reasons that elude me, but if this reflects official views, after dropping $513 billion in 2015, current PBoC reserves of $3.33 trillion might suggest that two or three more months of continued strong outflows might prompt further steps by the PBoC to limit outflows.
The biggest risk created by the weaker RMB, as I see it however, is not a Chinese risk but rather a global one. The rest of the world may view recent Chinese RMB weakness as a signal for a new round of competitive devaluations. I have already said that I expect 2016 to be another bad year for trade, and I am worried that it seems as if every major economy in the world has implicitly decided to use US demand to bail out its own faltering economy. This will very likely derail the US recovery in 2016 or 2017 unless the US, too, decides to step in and intervene in trade. If that happened, of course, the impact on Europe and China would be terrible, but it seems to me a matter purely of logic that if the hard commodity and energy exporters are nearing the limits of their absorption capacity, either the major surplus nations or the US are going to have to absorb a bigger share of the demand deficiency created in Europe, China, and Japan.
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A new beginning, or more of the same?
My description of the kinds of supply-side reforms that Beijing may be contemplating may seem overly abstract, but the purpose of my very long essay is not to propose specific reforms that will help resolve China’s rebalancing. It is to warn against falling into the trap of economic orthodoxy. China’s problem is not that a spate of recent exogenous shocks has perturbed the economy from its path of high growth, and so it does not require efficiency-enhancing improvements to the way it manages the asset side of the economy in order to return to that high growth equilibrium.
China’s problem is a systems problem, and it is the same problem every country that has experienced a similar investment-led growth miracle has experienced. China must switch from the current growth model to a completely different growth model as smoothly as possible, and the more debt it has, and the more distorted the structure of that debt, the more difficult it will be to manage this switch smoothly. This new growth model requires that household income comprises a much greater share of GDP than it currently does, and one way or another this new model will be imposed upon the Chinese economy. The first of the only two important questions is whether the higher household income share of GDP is a consequence of a rise in household income or a drop in GDP.
Because the quality and structure of Chinese debt severely limits the options available to Beijing and significantly increases the risk of a shock causing a disruption or a crisis, one way or another debt will eventually become a lower share of China’s GDP. The second of the only two important questions is about the manner and speed with which debt is reduced. Put differently, the only way to reduce debt is to allocate the cost to some sector of the economy, and broadly speaking these sectors are the household sector, the private sector, the state sector, and the various more specialized subsectors within these three – for example households can consist of rich households versus the rest, the state sector can be divided among the central government and the provincial governments, the private sector can consist of SMEs, large corporations, labor-intensive industries, capital-intensive industries, the export sector, etc.
China can choose to avoid reducing debt for as long as possible, as Japan has done, but the cost is a near permanent state of economic stagnation and the risk is that a poor, volatile economy like that of China is unable to last as long as Japan, in which case it’s debt burden will be reduced in the form of a debt crisis or in the form of monetization by the PBoC, which is simply another way of saying that the cost of the debt will be implicitly allocated to household savers, as was the case in the Chinese debt crisis of the late 1990s.
But this would make rapid growth in consumption impossible. Without the ability to boost GDP with explosive growth in investment, as China did following the debt crisis of the late 1990s, this also means that GDP growth must collapse, and could even become negative.
Alternatively China can choose to reduce debt explicitly by allocating the costs to some sector of the economy. As I have discussed many times, including in my 2013 book, Avoiding the Fall, arithmetically and logically the only appropriate sector is the government sector, and given the need for President Xi to further centralize power if Beijing is to implement reforms successfully, it is obvious that debt costs must be allocated to provincial governments.
Of course this is politically easier said than done, but nonetheless these are the options open to China. It must rebalance and it will. It must reduce its debt burden and it will. It can do what many other countries have done in similar circumstances and waste time and resources by implementing the kinds of reforms beloved of academic economists that do not directly address the rebalancing or the debt directly, and so significantly raise its ultimate adjustment cost while running an increasing risk of crisis. Or it can take steps aggressively to direct the rebalancing and reduce the debt.
China has done the former during the past several years but Beijing’s recent announcements about supply-side reforms suggest that its leaders are frustrated by the ineffectiveness of the proposed reforms and are determined to set out on a very different path. Whether or not this very different path ends up being more of the same we will learn only over the next two or three years.
But whatever happens, this year will clearly be an important one for China, apropos of which, happy Year of the Monkey, which begins in two weeks. They say if you’re very smart you’re likely to do well this year, otherwise it’ll be a very tough year.
