cheap capital, land, and subsidies. As investment surged, China’s physical capital converged with its social capital (i.e. its infrastructure more or less converged to its ability to exploit this infrastructure productively), after which additional physical capital was no longer capable, or much less so, of creating real wealth.
Instead, continued rapid increases in investment directed by the controlling elites (especially at the local and municipal levels) created the illusion of rapid growth. Because this growth was backed by even faster growth in debt, however, it was ultimately unsustainable. This period began around the beginning of the last decade, I would argue, and it is the period in which we currently find ourselves.
- The Second Liberalizing Period, could begin in 2014?
What China needs now is another set of liberalizing reforms that cause a surge in social capital such that Chinese individuals and businesses have incentives to change their behavior in ways that generate greater productive activity from the same set of assets. These must include changing the legal structure, predictably enforcing business law, changing the way capital is priced and allocated, and other factors that determined the incentives, so that Chinese are more heavily rewarded for activity that increases productivity and penalized, or at least less heavily rewarded, for rent seeking.
Since the financial crisis, Warren Buffett's Berkshire Hathaway has had significant exposure to financial stocks in its portfolio. Q1 2021 hedge fund letters, conferences and more At the end of March this year, Bank of America accounted for nearly 15% of the conglomerate's vast equity portfolio. Until very recently, Wells Fargo was also a prominent Read More
But because this means almost by definition undermining the very policies that allow elite rent capturing (preferential access to cheap credit, most importantly), it was always likely to be strongly resisted until debt levels got high enough to create a sense of urgency. This resistance to reform over the past 7-10 years was the origin of the “vested interests” debate.
Most of the reforms proposed during the Third Plenum and championed by President Xi Jinping and Premier Li Keqiang are liberalizing reforms aimed implicitly and even sometimes very explicitly at increasing social capital. In nearly every case – land reform, hukou reform [note: household registration system or the removal of the distinction between rural and urban citizens and thus the freer movement of labor], environmental repair, interest rate liberalization, governance reform in the process of allocating capital, market pricing and elimination of subsidies, privatization, etc. – these reforms effectively transfer wealth from the state and the elites to the household sector and to small and medium enterprises. By doing so, they eliminate frictions that constrain productive behavior, but of course this comes at the cost of elite rent-seeking behavior.
Drawing on this four-stage development framework, Pettis’ research reveals an insight that many economists and China watchers are simply missing. China’s current overcapacity and over-indebtedness is not just the unfortunate consequence of hurried post-crisis stimulus, but an inherent by-product of its command-and-control growth model.
After decades of marshalling resources, educating its workforce, and building out a modern infrastructure, China has amassed the building blocks for economic development. China’s central planners successfully overcame the country’s capacity constraints during the so-called Gershenkron Period, but the problem today is overcapacity and widespread misallocation. More investment in bloated “old economy” sectors like low-value-added manufacturing or construction may support employment and keep the economy growing at or above its headline growth target for a while longer; but as John and I explored in our last China letter (Can Central Planners Revive China’s Economic Miracle?) – the investment boom cannot go on forever.
It’s time for central planners to take another step back in order for China to take a giant step forward.
Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national accounts toward a more sustainable consumption and service-heavy mix.
As John and I have argued for several months, these kinds of liberalizing reforms will not be easy and may require a far greater slowdown than anyone in Beijing publicly admits – but they are China’s only hope of avoiding either a hard landing or a long, frustrating period of depressed growth. Debt has a cost, and that cost must be paid in one form or another.
Although Xi and China’s State Council members seem to understand this dynamic, they are not following through with timely reforms. After a period of weakness in the first half of the year, the State Council announced what could be best described as a mini-stimulus in early April, which in the following months has turned into a full-blown stimulus package.
Rather than encouraging the national economy to rebalance toward domestic consumption or allowing previously misallocated capital to seek out more productive uses in “new economy” sectors like services and technology, China’s State Council is responding to slowing economic growth with more of the same: (1) government spending on railway expansion and shantytown renovations(which may or may not be productive) to replace decelerating private sector demand, (2) “targeted” interest rate cuts to encourage additional credit growth (which will almost certainly be unproductive), (3) last-minute bailouts to prevent corporate defaults (which they told the world to expect a lot more of in 2014), and (4) tax breaks for small and medium-sized enterprises (which remain seriously disadvantaged relative to larger public or state-owned firms).
Since the State Council’s announcement in early April and Premier Li Keqiang’s subsequent guarantee that 2014 economic growth would top 7.5%, the so-called “mini-stimulus” has led to another surge in lending activity,China
slightly better real GDP growth (7.5% YOY in Q2 compared to 7.4% YOY in Q1 – according to the highly questionable National Bureau of Statistics),
and the strongest manufacturing PMI print in eight months (51.7 in July, compared to 51.0 in June, 50.8 in May, and 50.4 in April).
And, of course, Chinese stocks are SURGING on improving “old economy” indicators like industrial activity.
John and I believe this kind of stimulus-fueled “improvement” – although it is boosting China’s economy and lifting Chinese markets in the short term – is a very bearish sign that Beijing is afraid of the short-term pain associated with its admittedly urgent reform agenda. This kind of about-face may reveal one of two things: (1) the reformers’ resolve is fading, or (2) the economic reality in China is more unstable than we outsiders realize.
A Few Final Thoughts
[John here] As he did the last time he wrote on China, Worth actually ended up writing enough content for two letters. We’ll see Part Two next week.
As I’ve been saying for some time, we think China looms as the single biggest risk to the world economy, if only because no one yet fully recognizes the substantial and I think principal risk that derives from the innumerable global interconnections – with almost everything of a financial nature – that the world’s second-largest economy has forged over the last two decades. I say that fully cognizant of the risks that both Japan and Europe create for the world, risks Jonathan Tepper and I explored at some length in our book Code Red. Next week Worth and I will pin down realities we all need to recognize regarding the global risks posed by the ongoing political machinations within China. Stay tuned.
Montana, San Antonio, DC, Barefoot, and Boston
That sounds like an ambitious schedule, but it is actually stretched over three months, which is the lightest travel schedule I’ve had in five years. Which of course means it will change. Who knows, I may show up in a city near you. My travel life takes some strange twists. In a few weeks I will go up to Flathead Lake, Montana, to be with my partner Darrell Cain for a very long weekend, trying to actually relax. Last year when I was there I was finishing my book Code Red (ergo massive deadline), so I really had no time just to sit and read and think and meditate. My full intention is for this year to be different.
Tonight finds me in Grand Lake Stream, Maine, at Camp Kotok at Leen’s Lodge (highly recommended), where I’ve spent the first Friday of August for the last eight summers with my youngest son, Trey. This annual ritual has been a special time for me, marking the years as my youngest son has grown into a young man. And the reminder is made physical by the pictures in my phone. There are a few more tattoos and other things that make the old-fogey dad a little uncomfortable, but as we sit and catch fish I remember the 12-year-old kid who caught his first fish. He still has the same joy and facial expressions. Where did my little boy go? It’s hard for me to think back over how fast the time has flown.
Philosophical moment. Most of us of with older children experience the phenomenon of how fast our children grow up. It is both thrilling and uncomfortable. But life around us has otherwise tended to flow on smoothly, for the most part. What if the life we experience also changes rapidly in the future, which I think is the likely probability? Does the difficulty we have dealing with how quickly our children grow and change suggest that we will also find ourselves challenged in dealing with accelerating change in the world around us? Just asking…
I had the privilege here of sitting next to Paul LePage, who is the governor of Maine and running a very competitive and combative race for reelection. His problem is that the local media hates him, although he has won over a significant portion of the population with the substantial successes that he has had in the last four years. He has turned Maine around from being an economic joke and a disaster case into a state that is more than respectable. Maine’s unemployment rate has gone from being among the worst to being among the best. Taxes are significantly down. Growth is up. He’s reduced the welfare rolls from 27% to 19%.
He is an interesting character. I’ve been around politicians for the last 35 years, at all levels. And while I’m not significantly involved in politics today, there was a time when I was really into it. After a while, it dawns on you that there are politicians on both teams who are there for the personal benefits they can grab as opposed to the passion they bring to the table. Sadly, the first group is much larger than the second.
Paul is one of the passionate ones. Actually rather extremely so. Four years ago he was a businessman who got fed up and decided to run for governor, and in a very odd election year won as a Republican in a very deep-blue state. In the world of politics strange things happen.
Paul is rather outspoken, which is what has gotten him in trouble with the media. (Besides the fact that he is a libertarian in a state with a very liberal media.) He tells a story about Barbara Bush, who was with him at a collegiate event last year and asked if she could speak to him in private. Who tells Barbara Bush no? She leaned into his ear and said, “Governor, it is very important to get reelected. Maine needs you. Zip it!” He said “Yes ma’am” and has been a good boy ever since (at least on a relative basis).
Given his views and track record, if LePage were governing a state with a population of 10 million (Maine has 1.3 million), the media would be following him as a potential presidential candidate. As it is, he is off everyone’s radar screen. Unless you are in Maine. As I sat at the table and listened to him rattle off businesslike answers to question after question posed by members of the media (for the purposes of this dinner I got to sit with Bloomberg and a few of the other big dogs – go figure), I saw a man who translated his personal philosophy into practical solutions.
Sometimes his solutions were nuanced, but he decided to simply override his Democratic legislature, which wanted to postpone what he felt was a needed nursing home subsidy until after the election cycle – a delay that would have meant even more much-needed nursing homes in Maine would be closing down. He mandated the expenditure in a somewhat Obama-like fashion (or at least that’s what it sounds like to me, but then I’m just a country boy from Texas).
Governor LePage is an original. I’m not sure how he would play on a national