One of the few areas in which the Chinese fiscal stimulus package is unquestionably having a positive effect is on growth forecasts – although mainly because forecasts seem to be coincident indicators more than leading indicators. In the past couple of week Morgan Stanley raised its 2009 forecast for Chinese GDP growth from 5.5% to 7.0%, while Goldman Sachs upgraded growth forecasts from 6.0% to 8.3%. UBS has raised its forecast from 6.5% to between 7% and 7.5%. RBS has jumped from 5% to 7% and Barclays is up from 6.7% to 7.2%. On the other hand Standard Chartered, worried about the sustainability of the “rebound,” has kept its 2009 GDP growth forecast at 6.8%, and the IMF is still at 6.5%
At any rate I’ve never provided my own forecast of Chinese growth partly because I am not smart enough to come up with an economic forecast and partly because it always seemed to me that in the short-term Chinese growth was going to depend very heavily not on economic conditions but rather on the hard-to-predict outcome of the fierce policy debate taking place in China. As I see it, one side of the debate – which seems to include people around the PBoC and the National Bureau of Statistics, along with many of the more prominent of the think-tank policy critics – is arguing that as difficult as it is, the crisis is a good occasion to force China to change its development model and financial system in a direction that will provide China with a healthier basis for stable, long-term growth. They are eager to see policies aimed at switching resources from production to consumption, even at the expense of a short-term increase in unemployment, and they tend to see the recent surge in credit and investment not as solutions to the crisis but rather as policies that will make things worse for China in the medium term.
On the other hand a different group of policymakers and power brokers – who include, I think, the Ministry of Commerce, the important exporter constituencies, and above all the powerful provincial and municipal leaders – are much more concerned with enacting measures that immediately address the expected rise of unemployment in the short term. These measures include pouring money into investment – mainly into infrastructure and the SOEs – and of course the huge increase in bank lending. They often point out that these policies saved China after the 1997-98 crisis, and so can save China again.
As an aside, and without wanting to take the 1930s analogy too far, this debate in China is a little like the split in the 1930s between the internationalists in the US who favored hard money (incorrectly, I think) and a rapid liquidation of overcapacity (painful but probably correct), and who vehemently opposed measures, including tariffs and competitive devaluations, to boost employment via boosting the export of overcapacity, versus the large and powerful constituencies, dominated by local congressmen, miners, farmers and many industrialists, who stressed immediate moves to weaken the currency, boost production, and resolve US unemployment even at the expense of the global system. In part because the 1929 stock market collapse thoroughly discredited bankers and economists, and in part because politicians are always more likely to be influenced by large domestic constituencies than by internationalists, the latter group pretty resoundingly won the debate, at least in the early part of the crisis, and clearly not to the US’s obvious benefit.
Although the debate is much less transparent in China today than it was in the US in the early 1930s, I think the latter group – the domestic constituency and provincial leaders – is once again winning the debate, at least for now. It is probably no surprise to regular readers of my blog that I largely disagree with this camp, and the main reason I didn’t want to forecast very low 2009 GDP growth numbers with much confidence is because I doubt the former group will win the debate. As I see it, the massive expansion in credit and investment we are experiencing is simply more of the same set of policies that, especially over the past five years, have pushed China ever deeper into the Asian development model, and to the extent that they are successful they will keep pushing China, which I think of as exemplifying the Asian development model on steroids, in the same direction. Beijing, in other words, is increasing the dosage of steroids. (I think I am mixing metaphors all over the place.)
The reason I think this is a mistaken strategy is because I would argue that the Asian development strategy is dead, and over the next three to five years it will become increasingly evident that 2008 was the year it died. I may be wrong, of course because it is doubtful but not inconceivable that the great consumption party in the US can resume for a few more years. It would not be the first time that what seemed like an unstoppable correction in the trade imbalances was interrupted. To a certain extent we already saw a dress rehearsal for this event in the 1987 crash, around which time the US trade deficit, which had risen to around 3.5% of GDP the year before (a level which seemed unimaginably high at the time), began its inexorable reversion, to the point where the US achieved a small surplus in the early 1990s.
The period during and after the 1987 crash more or less marked the end of that stage of the Japanese miracle, although by then Japan was so caught up in the monetary expansion that had begun with the automatic monetizing of its massive trade surplus with the US in the early 1980s, that an internal bubble kept the local party going for another 2-3 years before it, too, finally ended, and ended disastrously – although many people, especially here in China believe, mistakenly in my opinion, that the bubble was set off by the Plaza Accord.
But the Asian development model didn’t really die then (although the temporary shift in US consumption may have created the serious dislocations that helped lead to the 1997 crisis). At the time the US was itself caught up in great productivity and liquidity growth cycles that kept the model alive by causing a surge in US growth and, later, an even more rapid surge in US consumption.
The rise of US savings
What does the structure of US growth have to do with the Asian development model? As I see it the Asian development model involves polices that aim directly or indirectly at boosting savings and channeling huge amounts of subsidized resources (usually subsidized by savers, and so constraining consumption) into investment and manufacturing capacity. Some people call this mercantilism, and in many ways it does correspond to certain classic mercantilist policies, but I am wary of defining it this way because “mercantilism” is such a loaded word.
At any rate because the combination of consumer constraint and producer subsidy meant that growth in production was likely seriously to outstrip growth in consumption, the Asian development model necessarily involved generating large and consistent trade surpluses – either Asian countries exported the difference between consumption and production or they would have been forced to run up ever increasing inventory. Of course for small countries, running trade surpluses didn’t matter too much – and it made sense to have a strong external outlook because domestic markets weren’t big enough to create the necessary efficiencies and economies of scale to justify the huge investment, and their individual trade surpluses were easily buried within overall global trade.
In other words for small countries the need to export is not likely to be a constraint since they can always generate trade surpluses without creating significant global trade distortions. But when large countries, or a large grouping of countries, have policies aimed at generating trade surpluses they run into a very strict constraint – that some country or group of countries must be capable and willing to run large corresponding trade deficits. Without this willingness to run trade deficits, the Asian development model must inevitably run into brutal 19th-Century-style cycles of rapid production growth leading to overinvestment crises.
This is the main vulnerability of the Asian development model – its dependence on an importer of last resort. We don’t often think of this as a weakness because for so long the US was seen as the automatic importer of last resort, so much so that we didn’t even consider it a constraint. But we may have gotten lazy in our thinking. Many people who should know better simply write off US consuming habits as something endemic to American culture, and we just assume it as a universal constant, but in fact US consumption levels, like those of every other country, respond to changes in conditions, and these are about to change.
There are at least two reasons for the change. The first has to do with specific policy initiatives, and the second with changes in underlying economic conditions, especially household balance sheets. To address the first, I will refer to President Obama’s economic speech last week when he said: “We must lay a new foundation for growth and prosperity — a foundation that will move us from an era of borrow and spend to one where we save and invest, where we consume less at home and send more exports abroad.”
A New York Times editorial draws from Obama’s speech at least one important implication for the future growth of China and Asia:
In a series of comments in recent weeks, Mr. Obama has begun to sketch a vision of where he would like to drive the economy once this crisis is past. His goals include diminishing the consumerism that has long been the main source of growth in the United States, and encouraging more savings and investment. He would redistribute wealth toward the middle class and make the rest of the world less dependent on the American market for its prosperity. And he would seek a consensus recognizing that an activist government is an acceptable and necessary partner for a stable, market-based economy.
…Embedded in that approach is a far-reaching implication: that the rest of the world should no longer count on the United States to snap up imported goods or run up large trade deficits. It is by no means clear that Mr. Obama has the policy tools needed to bring about that kind of change; we are, after all, fundamentally a consumer society. His advisers point to his support for innovative ways of increasing personal savings.
We should never underestimate the immense flexibility of the US and its ability to restructure itself at a pace far faster than most other countries can manage (anyone who grew up in the dismal 1970s will remember the dramatic – and seemingly improbable – US economic transformation of the 1980s), and if the Obama administration is serious about creating conditions for an increase in US savings, it probably wouldn’t be a good idea to bet heavily against success..
Negative US consumption growth?
More importantly, during the past decade while the US was growing rapidly, the US trade deficit surged from just over 1% of GDP to over 7% of GDP. When consumption exceeds GDP growth, which must happen when the trade deficit is growing, it necessarily implies a build-up of debt, and sure enough, debt levels in the US surged while savings collapsed to zero and the trade deficit grew rapidly.
Those days are almost certainly over. Even without Obama’s desire to create conditions for an increase in US saving rates, US households have to increase their savings and rebuild their balance sheet, which means that we have several years ahead of us of deleveraging and increased savings. It also means we have several years ahead of US consumption growing more slowly than US GDP. I don’t think anyone is expecting much net growth in US GDP for the next three or four years, and so it is not at all implausible that we will see negative growth in US consumption and, as a consequence, a collapse in the US trade deficit, which may even turn into a trade surplus. The pace of this transition will largely depend on US fiscal policies aimed at slowing, but not eliminating, the contraction in demand.
If the US is no longer the importer of last resort, and if no one else can replace the US in that role in the medium term (I stress medium term because in the long term the demographic changes in Europe and Japan – and China for that matter – may well result in rising trade deficits in those countries), then any development model that necessarily results in production growth exceeding consumption growth – high savings development models, in other words – will run into the trade deficit constraint. They must run surpluses to grow, but if no one else runs sufficiently large deficits, they simply cannot run those surpluses.
This is what I mean about the “death” of the Asian development model. The not-so-hidden but also not-always-explicit assumption behind Chinese growth – with China, as I wrote earlier, representing the Asian development model on steroids – is that large and growing US trade deficits were vital to its success. But if the US is now entering a period of contracting deficits, the model is dead.
This is why I am worried about recent fiscal and credit policies. It is not just that these policies are slowing down the rate at which China will adapt to the new world of lower US trade deficits. More importantly perhaps is that the only obvious replacement for US demand – domestic Chinese demand – will itself be sharply constrained by current policies, especially credit policies.
Why? Among other things because if the explosion in new lending (loans are up 15% in the first quarter of this year) leads, as it almost certainly will, to a subsequent explosion in non-performing loans, in the next few years just as China is expanding its production and struggling with US reluctance to absorb its rising excess capacity, the resolution of the NPLs will itself constrain Chinese consumption. Resolving future NPLs, in other words, will reduce future domestic consumption growth in China, just as the current resolution in the US of bad loans and shattered household balance sheets must come with reduced US consumption growth.
This is because if China’s banks see an explosion in non-performing loans it will have to pay for that increase in the coming years in one or both of two ways. The central government can recapitalize the banks by giving them money, which they have raised by borrowing or increasing taxes, or the regulators can keep deposit rates very low as a way of subsidizing bank profitability so that they earn their way out of the NPL losses. They did both after the last banking crisis, and will probably do both again. There is a third thing they can do, appropriate the money from SOEs, but I suspect that there won’t be nearly enough to resolve the NPLs – the World Bank estimates that the last banking crisis cost China 55% of GDP.
Both strategies will represent, ultimately, a large transfer of income from households to banks, and in either case it will also represent a continued drag on consumption growth in the medium term. If the government borrows to bail out the banks, it will divert resources from the real economy and so slow income growth. If it raises taxes, it will reduce disposable income and so reduce household consumption growth. If it keeps interest rates low it will again reduce disposable income (interest income is an important source of income) and so slow consumption growth (in China lower interest rates tend to increase the savings rate).
Since it is unlikely that the US will be in a position in the near future to return to the halcyon days of large trade deficits, and since no other economy can replace the US in the role, turgid consumption growth in China will translate directly into turgid GDP growth for many years. Rising non-performing loans are not a small threat to China’s long-term growth. If the Asian development model is dead, China will need domestic consumption growth more than ever, and this is cannot be the best time for China to try to revive the production-enhancing model in a way that may limit future domestic consumption growth.
By the way in their next meeting the Guanghua Students Monetary Policy Committee will debate whether or not the PBoC should cap loan growth. I will report the arguments and conclusions of these remarkably sophisticated students.