My meetings in NY and DC were fairly different from the meetings I had in February. This time around I got the impression that far more people in the US (although still a minority) understand how risky the Chinese recovery has been and how trade tensions are likely to result as a consequence of the stimulus. In fact I have the sinking feeling that over the next two or three years I am going to find myself spending an awful amount of time thinking or writing about trade disputes between China and the rest of the world.Regular readers know that for me the key source of China’s high savings and trade surplus is the large excess of the growth rate in national income over household income, caused in large part, I believe, by policies that systematically transfer income from the household sector to investment, SOEs and large producers. Until these policies are reversed I do not think it is meaningful to talk about China’s rebalancing. Just before President Obama came to China President Hu gave a speech which my friend Dan Rosen in his November 13 Rhodium Group report described as a “stirring speech about a policy big bang to promote consumption-led growth.” Dan is skeptical, and I am adamant – a surge in consumption will not happen except perhaps briefly as a consequence of government subsidies and anticipated consumption.
In Washington I had the chance to meet someone I admire a great deal, Nick Lardy at the Peterson Institute, and although I shouldn’t put words in his mouth so as not to misrepresent him, I am glad to say that he seems to agree with the analysis of Chinese high savings as a consequence of policy-related constraints on household income growth, although he thinks currency undervaluation may have a greater impact on high savings than low interest rates, whereas I think it is the other way around. In fact more generally I think this argument has become increasingly influential, and more and more analysts seem to be taking it up, both inside and outside China.
In that light I read earlier this week a fascinating and perhaps important article by Hung Ho-Fung in the current issue of the New Left Review, in which he argues that China’s development model has left it dangerously vulnerable to changes in US demand, and that these polices include repression especially of rural income. According to Hung:
The PRC’s urban-biased development model, then, is the source of China’s prolonged ‘limitless’ supply of labour, and thus of the wage stagnation that has characterized its economic miracle. This pattern also accounts for China’s rising trade surplus, the source of its growing global financial power. However, the low wages and rural living standards that have resulted from this development strategy have constrained China’s domestic consumer market and deepened its dependence on the global North’s consumption demand, which increasingly relies on massive borrowing from China and other Asian exporters. As those other exporters have been integrated with China’s export engine through the regionalization of industrial production networks, the vulnerabilities of the Chinese economy have turned into weaknesses of the East Asian region as a whole.
Hung goes on to make a point that I wish many more would make. When people like me warn about continuing domestic imbalances within China and the difficulty that China will face in its transition, we are often attacked for “blaming” and criticizing China. Monday I was at a conference consisting of many prominent European and Chinese (and a few American) analysts who were discussing global imbalances. At the end of one panel a member of the audience, who turned out to be from the Ministry of Commerce, demanded the right to make a rebuttal and set off on a fairly strange harangue in which she lambasted, to everyone’s bemusement, any attempt to assign China responsibility for any aspect of the crisis as well as any suggestion that its fiscal stimulus was worsening the underlying imbalances. China has not, apparently, made even minor policy mistakes at all in the past decade and especially in the past year.
The nationalist argument
Although her view of the fiscal stimulus is not a majority view among the kinds of officials I am likely to meet, it seems it may be among the much more powerful domestic constituencies. In fact another Chinese government official at the meeting told me afterwards, and at least partly in response to the outburst, that as difficult as it is to make these criticisms of policy, it is extremely important that foreign analysts keep making them so that Chinese policymakers can be made more aware of the difficult transition China will face.
As an aside, this lopsided debate within China between the domestic constituencies (more stimulus) and the internationalists (more rebalancing) reminds me, as I have often said, of the debate over the passage of Smoot-Hawley, which most Americans with knowledge and experience in international economics and finance, including President Hoover, thought at the time a dreadful mistake. Hoover was unable to stop its passage however because domestic constituencies were so strongly in favor. Their reasoning? In previous episodes of US economic slowdown an increase in tariffs had always been expansionary for the economy, so given how bad conditions were in 1930 how could a sharp rise in tariffs not work?
Because underlying conditions were different. Before WW1 the US almost always ran large trade deficits, and so it could raise tariffs with near impunity and boost domestic production. By the end of the 1920s however the US was running what at the time were enormous trade surpluses (the third largest as a share of global GDP in the past 100 years). Because of its changed position the risk of retaliation meant that the US could no longer thumb its nose at free trade. In a global demand contraction, surplus countries are always the most vulnerable, as the US discovered.
What does this have to do with China? It seems to me that many policymakers in China note that every time they have faced a slowdown in the past, they were able to emerge via a sharp increase in investment. Given how sharp the current slowdown has been, why not respond with an equally sharp boost in government financed investment?
Because, as in the US in 1930, conditions that permitted the earlier responses have dramatically changed. When the US was growing robustly and, more importantly, US consumer credit was surging, an increase in the gap between Chinese consumption and production resulting from a surge in investment, no matter how uneconomic, always helped Chinese growth because the excess could be sold to the US. Now the US is unable to play that role much longer. The strategy will no longer work.
But to return to Hung, the point is that Hung makes a very different argument as to why China needs to come to terms with something with which many are unwilling to consider, and an argument that should appeal even to the most nationalistic in China:
Unless there is a fundamental political realignment that shifts the balance of power from the coastal urban elite to forces that represent rural grassroots interests, China is likely to continue leading other Asian exporters in diligently serving—and being held hostage by—the US. The Anglo-Saxon establishment has recently become more respectful towards its Asian partners, inviting China to become a ‘stakeholder’ in a ‘ChiAmerican’ global order, or ‘G2’. What they mean is that China should not rock the boat, but should continue to help maintain American economic dominance (in return, perhaps, for more consideration of Beijing’s concerns over Tibet and Taiwan). This would enable Washington to buy precious time to secure its command over emergent sectors of the world economy through debt-financed government investment in green technology and other innovations, and hence remake its ailing supremacy into a green hegemony. This seems to be exactly what the Obama administration is betting on as its long-term response to the global crisis and declining American power.
If China were to re-orient its developmental model and achieve greater balance between domestic consumption and exports, it could not only free itself from dependence on the collapsing us consumer market and addiction to risky us debt, but also benefit manufacturers in other Asian economies that are equally eager to escape these dangers. More importantly, if other emerging economies were to pursue a similar re-orientation and South–South trade were to deepen, then they could become one another’s consumers, ushering in a new age of autonomous and equitable growth in the global South. Until that happens, however, a recentring of global capitalism from West to East and from North to South in the aftermath of the global crisis remains little more than wishful thinking.
I am not sure I agree with everything Professor Hung says about the various political strategies, but I think he is absolutely correct to see the savings and trade imbalances as arising directly out of domestic policies that constrain household income growth in favor of the state and corporate sector, and I am sure he is even more correct to argue that rather than being the source of its strength, China’s continued vulnerability to US overconsumption is a great source of weakness.
We all love free trade, don’t we?
How great? I guess we will find out over the next year or so. President Obama’s meetings in China were, as widely expected, more about developing a relationship between the two leaders than about addressing real issues, and both sides did what they could – subject of course to domestic political pressures – do smooth over trade disputes, but for all their attempts trade disputes will not be smoothed over.
President Obama had to listen to several lectures from the Chinese about the importance of keeping trading markets open and fair (President Hu said that the world “must continue to promote trade and investment liberalisation and facilitation and oppose protectionism in all its manifestations, particularly the unreasonable trade and investment restrictions imposed on developing countries”), which of course struck many observers as hypocritical and almost funny, but I think it is important for foreign observers to recognize that China simply cannot adjust quickly enough to a lesser dependence on trade. It will be a slow and difficult process, which is why I worry that with high and rising unemployment in the US and a high and rising trade deficit, trade cannot help but become a major political issue.
In that light there was an interesting piece on the Vox website by Richard Baldwin and Daria Taglioni with the rather alarming title “The illusion of improving global imbalances.” They argue that the sharp “improvement” in global trade imbalances is largely a statistical outcome created by a temporary sharp drop in what they cal “postpone-able” consumption items, “such as consumer and investment electronics, transport equipment, and other types of machinery.” Their conclusion?
Projections of improving imbalances are almost surely wrong. The rapid collapse of trade between the third quarter of 2008 and the first quarter of 2009 improved most balances of trade. It could not have done otherwise; if both imports and exports drop rapidly, the gap between them drops equally rapidly. In the same mechanistic manner, the recovery of trade flows – a recovery that seems to have started this summer – will almost surely return the US, Germany, China and others to their old paths.
If they are right, and already the US trade deficit has risen sharply from its lows, the fight over trade will heat up even sooner than I expect and it will be a hotter dispute. To repeat my earlier assertion, high and rising unemployment in the US (and Europe) is not easily consistent in the real world of politics with high and rising trade deficits.
Little in the meetings between Obama and Hu was said about the currency, at least in public, but so much has been said about it in the press and among analysts that there was easily a balance. For the record, I think the much-commented November 11 statement by the PBoC, in which it omitted a phrase promising to keep the renminbi stable and instead said it would “improve the exchange rate pricing mechanism in a proactive, controlled and gradual manner, with reference to international capital flows and major currency moves,” does not indicate that the decision has been made to appreciate the RMB. That decision is not the PBoC’s to make. At any rate other policymakers have been saying very different things. Commerce Minister Chen Deming said less than two weeks earlier that“the renminbi exchange rate has to remain stable for exporters and Chinese manufacturers to make an easier judgment on future situations ”
And on Tuesday the Ministry of Commerce was even more strident. On Monday that IMF Managing Director Dominique Strauss-Kahn said in a conference in Beijing that “a stronger currency is part of the package of necessary reforms. Allowing the renminbi and other Asian currencies to rise would help increase the purchasing power of households, raise the labour share of income, and provide the right incentives to reorient investment.” That same day the MoC struck back. According to an article in Bloomberg:
China’s Ministry of Commerce said international pressure for appreciation in the yuan was “not fair,” as U.S. President Barack Obama started a four-day visit calling for a more balanced relationship between the two nations.
Seeking a stronger Chinese currency as the dollar weakens “is not conducive to a global economic recovery and is not fair,” ministry spokesman Yao Jian said at a press briefing in Beijing today. “It’s necessary for us to provide a stable and predictable environment in terms of macro-economic and exchange rate policies.”
What all this does indicate, I think, is that there is a very active and maybe even fierce debate within China about the whole rebalancing process, and that at least some policymakers are worried about a trade backlash. In that case it may make sense to appreciate the RMB a little to appease US and European (not to mention Asian) anger while perhaps reversing the impact of the appreciation by managing other variables – reducing interest rates, increasing energy or other subsidies, etc. In my opinion we will probably see action on the RMB front in the next quarter or so, but the timing will really depend on two things: increasing international pressure, and a sense domestically that the fiscal stimulus is continuing to work and growth prospects over the short term are stable. It will also depend on what kind of anticipatory hot money inflows we see over the last quarter of 2009.
One of the centers, I think, of those calling for rebalancing is the National Bureau of Statistics, and Xinhua had an article last week on that topic, in which Yao Jingyuan, chief economist of the National Bureau of Statistics, seems both to be assuring policymakers that the stimulus-induced growth is stable and that it is time to focus more closely on rebalancing.
Yao Jingyuan, chief economist of the National Bureau of Statistics (NBS), told a forum in Beijing that China’s economy was over the worst, saying November 2008 to February 2009 was the toughest period for the economy. The country’s economy had gained momentum each quarter, which would ensure full-year growth of 8 percent, he said.
…The stimulus packages to prop up growth had set a stage for stronger growth in the future, he said. However problems remained and the real challenge for the economy was to adjust its economic structure, Yao said. ”We should not pursue economic expansion in terms of size and speed in the fourth quarter or the next year, but put more efforts on structural adjustments.”
It seems pretty clear to me that Yao is explicitly arguing the case for rebalancing. When I am abroad it often seems to me that foreign observers have a mistaken view of what is happening in China. There is too much acceptance at face value that China has managed to escape the crisis fairly well, and that there are no serious concerns within the country. On the contrary, however, it seems to me that the debate in China is very deep, very worried, and although I think that on balance policy is moving in the wrong direction because the preponderance of power is held by policymakers who simply do not understand China’s place within the global balance, it is focusing on most of the right things.
You might not, however, get a sense of the debate at first from today’s rather reassuring lead story in People’s Daily:
The United States and China, the world’s first and third largest economies, have pledged to rebalance each other’s economy and move in tandem on forward-looking monetary polices for a strong and durable global economic recovery, according to a China-U.S. joint statement released in Beijing on Tuesday.
The statement, issued after talks between Chinese President Hu Jintao and his U.S. counterpart Barack Obama, has climaxed the latter’s first China trip since he took office in January. “China will continue to implement the policies to adjust economic structure, raise household incomes, expand domestic demand to increase contribution of consumption to GDP growth and reform its social security system,” said the statement.
The United States, in return, will take measures to increase national saving as a share of GDP and promote sustainable non-inflationary growth. “To achieve this, the United States is committed to returning the federal budget deficit to a sustainable path and pursuing measures to encourage private saving,” it said.
It sounds good, but is this what the two countries are really doing?
Credit growth predicts financial crises
Before going on to the last topic, I want to make a brief mention of a very interesting article on Bloomberg that suggests the magnitude of recent Chinese commodity stockpiling:
Copper stockpiles held in duty-free warehouses in China, the top user, may be re-exported after surging to as much as 350,000 tons from almost none at the start of the year, according to Xi’an Maike Metal International Group. “We can hardly find buyers for refined copper,” said Luo Shengzhang, general manager of the copper department at Xi’an Maike. The company ranks among the country’s three biggest importers, according to the executive. “China’s got to export some copper from now and next year,” Luo said in an interview.
I have been warning many of my investor friends that if there is a slowdown in Chinese growth over the next three or four years, not only will commodity prices drop to reflect the normal reduction in demand, but they may drop sharply to reflect the reversal of what I think is very significant stockpiling that has occurred in the past year or two, and which has distorted China’s import numbers. China has been buying lots of stuff which it hasn’t yet used. Will inventory and stockpiling draw-downs replace contracting trade as the next big drag on Chinese growth (requiring, by the way, a continued fiscal stimulus to generate employment growth)? I suspect it will.
Finally, Moritz Schularick and Alan M. Taylor have a new NBER Working Paper, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008.” The paper discusses the behavior of money, credit, and macroeconomic indicators over the long run based on historical data for 12 developed countries over the years 1870– 2008, and argues based on this data that rapid credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong”. In their words:
Our key finding is that all forms of the model show that a credit boom over the previous five years is indicative of a heightened risk of a financial crisis.
…The findings mesh well with our overall understanding of the dramatic changes in money and credit dynamics after the Great Depression. In the summary data for the pre-WW2 sample, we saw how broad money and credit moved hand in hand, so that a Friedman “money view” of the financial system, focusing on the liability side of banks’ balance sheets, was an adequate simplification. After WW2 this was no longer the case, and credit was delinked from broad money aggregates, which would beg the question as to which was the more important aggregate in driving macroeconomic outcomes. At least with respect to crises, the results of our analysis are clear: credit matters, not money.
What about the so-called “Lawson doctrine” – the counterargument that credit booms are risky depending on whether they are funding investment or increased consumption? Would this make a difference given that China’s credit expansion is aimed almost exclusively at investment rather than consumption? Leaving aside the possibility that the riskiness of China’s investment boom may be affected by the extremely high level (historically unprecedented) of investment that China had before the crisis, the authors are not terribly positive:
According to arguments heard from time to time, if credit is funding productive investments” then the chances that something can go wrong are reduced—as compared to credit booms that fuel consumption binges or feed speculative excess by households, firms, and/or banks.10 Our results caution against this rosy view. Over the long run, in our developed country sample, the lags of investment are not statistically significant, suggesting that crises are no less likely when they have been funding investment booms as opposed to other activity. If this is the case, then the suspicion arises that when banks originate lending, they may be equally incapable of assessing repayment capacity in all cases, with investment loans having no special virtues.
Most historical work on financial credit booms and crises (and I think have read a significant portion of the best stuff) suggests the same thing: the best predictor of either financial crisis, or of the long-drawn out contractions like that faced by the US after 1873, Mexico after 1982, or Japan after 1990, is a rapid expansion in domestic credit. China has had a ferociously rapid expansion in domestic credit. Does that mean that China is on the verge of a crisis? No. I don’t think China will have a crisis, but I do think that after the fiscal stimulus runs out of steam, probably after another two or three more years, we are going to enter a long and difficult period of much slower and more volatile growth as China is finally forced to make the adjustments it has so desperately tried to avoid.
 In the late 1920s, the US represented over 30% of global GDP and ran a trade surplus equal to around 0.4% of global GDP. In the mid-1980s Japan represented around 15% of global GDP and ran a trade surplus equal to around 0.5% of global GDP. Two years ago China represented about 7% of global GDP and ran a trade surplus of about 0.6% of global GDP. Given what the following decade brought to the US and Japan, it may be worth figuring out how these imbalances get resolved.