Via email here is another update from Michael Pettis at China Financial Markets. What follows is from Michael Pettis.
Special Points
- Europe is attempting to resolve domestic imbalances by forcing them onto their trade partners. This will end badly, especially for Germany.
- China’s new lending, exports, investment, housing starts and GDP growth all continued to slow in May. Many of the numbers came in well below market expectations.
- This is par for the course. Although we may from time to time get a “pop” in quarterly growth, the overall trend will be for growth expectations to follow actual growth numbers down for many years. China cannot get credit growth under control at anywhere near current GDP growth rates.
- Even though credit growth slowed more than expected, it is still extraordinarily high, especially for the amount of growth it is generating. Total social financing grew in May by 2.3% of GDP while GDP itself grew by around 0.6%.
- The IMF claims that China’s real fiscal deficit is around 10% of GDP. This limits Beijing ability to expand fiscally.
- Although overall unemployment seems stable, unemployment among university graduates continues to be very high. It is early to say but this might have social implications at some point.
Adjustment Derailed
Away from Europe the US continues slowly to adjust but I worry that this adjustment will be derailed by a weaker external sector. Meanwhile Japan is still struggling with its debt burden and seems to have no real way of resolving it except by forcing down the currency and interest rates, both of which mean that household sector is expected to reduce consumption to support the debt burden without, it seems, any corresponding increase in investment.
In China the good news is that the rebalancing process seems to have become more determined than ever before in the past, although as of yet there has been minimal rebalancing at the expense of a significant reduction in growth rates. This I expect will continue to be the case, but European trade policies are going to put additional pressure on China’s adjustment.
How Much Slower?
The big worry I have had over the past year is that as China moves to rebalance its economy away from its over-reliance on its investment, with the accompanying investment misallocation, the economy will slow much more quickly than even the reformers expected, so scaring Beijing into backtracking. So far, I am glad to say, this doesn’t seem to have happened.
We keep getting surprised on the downside by the growth numbers, but to anyone who understands the way China’s growth model works and who knows the historical precedents, this should in no way surprise. I don’t think China is yet heading towards an economic crash, but I do think that even current growth rates are too high, and sell-side researchers and the various official entities in China and abroad will continue, as they have in the past, to revise their growth numbers downward almost on a quarterly basis.
And because growth will consistently underperform expectations, many members of the Chinese policymaking elite, and their effective allies among the shrinking but still large contingent of China-bulls, will increasingly argue that the economic rebalancing is being mismanaged, thereby putting pressure on Beijing to go into reverse. This is the real risk. There is no way that China can rebalance its economy even at growth rates of 6-7%, and attempts to keep growth above that level will simply mean that it will take much longer for China to fix the underlying problems in the economy, that the costs will be much greater, and that the risk of a disorderly crisis will increase.
Can China Spend Its Way to Growth?
Real debt servicing costs are growing much faster than the debt servicing capacity. Clearly this cannot be sustained. There are still bulls out there who insist that China is out of the woods and making a strong recovery, for example former Deputy Governor of the Reserve Bank of Australia, Stephen Grenville, who argues in his article (strangely titled “China doomsayers run out of arguments”).
Of course more stimulus will indeed cause GDP growth to pick up, as Grenville notes, but it will do so by exacerbating the gap between the growth in debt and the growth inn debt-servicing capacity. Because too much debt and a huge amount of overvalued assets is precisely the problem facing China, it is hard to believe that spending more borrowed money on increasing already excessive capacity can possibly be a useful resolution of slower Chinese growth.
The slew of economic data released last week will have been much discussed and analyzed in the media so I won’t add much more than I already have. Yes, Chinese growth is slowing, but by now this cannot have been a surprise to any but the most determined of bulls.
Inflation and Unemployment
To me far more interesting than these numbers is what has been happening on the inflation front. Consumer price inflation continues to decline, to the extent that you can trust the numbers, but what is really impressive is the producer price index.
The data showed China's producer price index, which measures wholesale inflation, fell 2.9 percent year on year in May, marking the 15th straight month of decline and the steepest drop in seven months.
Part of the decline in PPI is a result of declining commodity prices, of course, which is good overall for Chinese businesses except to the extent that they have stockpiled commodities (although I suspect that direct and indirect stockpiles are pretty high), but this implies that debt servicing costs as a share of total expense must be rising rapidly. China is reducing its heavy financial repression tax on households and subsidies to borrowers, in other words, not by raising interest rates but rather by a sharp decline in nominal GDP growth rates. This, of course, is exactly what should have been expected, and it certainly is the way Japan resolved its own financial repression after 1990.
I am not sure where this leaves us for the rest of the year. Premier Li said on television on Saturday that China’s economy and employment were stable, and that growth was within a “relatively high and reasonable range”, and so it sounds like he is perfectly willing to let growth continue to slow in order to force the economy into a healthier state. I wonder, however, just how much more Beijing can tolerate before we start seeing political friction and rising unemployment.
Last week People’s Daily had an article on unemployment for college graduates that is pretty worrying:
Never before has the nation had so many graduates competing for jobs, particularly when so few are available. As of April 19, less than 30 percent of graduating seniors in Beijing had signed contracts with employers. Shanghai faces a similar situation.
University education used to be the one certain source of upward social mobility in China, but for many students a college education actually now puts you behind in earning power compared to high school graduates who went straight into the work force. I am not sure what social impact this will have, but historically a country with a large and growing population of unemployed college graduates must worry about the political consequences.
Speculation
The explosive growth in Chinese exports at the beginning of this year had very little to do with strong external demand and nearly everything to do with speculative inflows. With borrowing costs in US dollars in the Hong Kong markets roughly two hundred basis points lower than domestic RMB interest rates, large Chinese companies with subsidiaries in Hong Kong were borrowing money in HK and bringing that money illegally into the mainland by over-invoicing exports.
This allowed them to pick up the 200 bp “arbitrage” plus any appreciation in the currency. This, plus the “arbitraging” of credit (borrowing cheaply from banks and lending to businesses that do not have access to credit) is becoming an increasingly important part of the profitability of large businesses, it seems, and that is always a bad sign when “financial engineering” becomes a profit source for businesses. The PBoC has cracked down on this kind of activity, but it should remind us just how porous China’s capital controls really are. Huge amounts of money have been able to enter and leave the country.
In the mean time let’s see how many more months of declining growth numbers Beijing can tolerate before we see steps to accelerate growth. Complaints by disappointed bulls notwithstanding, the longer Beijing waits, the better for China in the medium term.
END PETTIS
Thanks Michael.
If you have not yet read his book, "Great Rebalancing", I suggest it's well worth a look. Here is my review: "Great Rebalancing" Book Review: Two Thumbs Up; Investment Ideas for Unconventional Times.
Source: Global Economic Analysis
