Can China Take Up Consumption Slack From the U.S.?

After dropping as low as 1679 on Tuesday the Chinese stock markets nonetheless managed to put in a decent week, with the SSE Composite closing the week at 1748, up 1.1% for the week, helped by Tuesday’s Obama-inspired global rally.  A lot of people have asked me what I think the bottom of the market is likely to be, and though I have a very low level of confidence in my ability to predict these things, I think that even with a sharp expected drop in corporate profitability we are already at reasonable valuations.  

 

I would guess that we are probably within 20% of the bottom, which would suggest, if I am right, that the SSE Composite is unlikely to go much below 1500.  This would take the index close to its 2006 lows although, for what it’s worth, we did test 1000 in 2005.  In relative terms it should be remembered that China has seen official annual GDP growth rates of over 10% during this period.

 

We will probably see the markets surge Monday because of recently released news (which I will discuss further below) about the State Council’s approval tonight of a RMB 4 trillion package of fiscal expenditures through the end of 2010.  This is great news, but I don’t think the surge will last very long because there are many questions about the fiscal package and I don’t think there is a lot of fundamental good news out there.  The biggest problem I think is the size of the global adjustment within which China must participate.  This leads to two points I want to make in this entry.

 

 

1.       The size of the US adjustment in Chinese terms.

 

The first is just to an attempt to get our arms around the magnitude of the global adjustment within which China must participate.  Last week I met with a Japanese economist working for a major US fund manager who showed me a very interesting presentation he had prepared.  He asked that his name not be mentioned, so over the next few weeks I will be plagiarizing his material without crediting him.

 

One of his graphs shows the US household savings rate from the 1950s to the present.  From his graph it seems that until the early 1990s the US household savings rate tended to hover somewhere between 6% and 10% of GD, except for a brief period in the mid-1970s when it exceeded that level.  Since then, as is well known, the US savings rate has declined, to around 2-3% of GDP. 

 

As I see it the most recent globalization cycle began in the late 1980s and early 1990s.  My model posits globalization cycles as being caused by rapid liquidity expansion, for which there have historically been many different reasons (including gold discoveries, the invention and expansion of joint stock banks, the recycling of trade deficits or surpluses, even in one case war reparations payments, etc.).  The latest liquidity cycle was probably caused by the recycling of the large and growing US trade deficit, which can be seen as a machine that has converted US consumption into Asian savings – at first primarily Japanese and later primarily by Chinese.  The decline in US savings beginning in the early 1990s is simply the flip side of the accumulation of Asian savings, and the numbers fit my model well.

 

Whatever the reason for the decline in US savings, I think most of us agree that it was related to the long rally in stock and real estate markets in the US, which were seen to obviate the need for households to save out of income (I would argue that the liquidity creation fueled the accompanying stock and real estate market rallies – long bull markets have always been a feature of globalization cycles).  The banking system played a key role in the process by intermediating the capital inflows into the US (the obverse of the trade deficit) and converting them into consumption via an expansion in mortgage, credit card and consumer loans.

 

This process has probably stopped.  Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise. 

 

By how much?  With households seeing their home and equity savings decline so dramatically I think one can easily argue that we will probably go above or at least to the higher end of the “normal” range of 6-10% of GDP, but even if we assume that households will only go back to the middle of the range, that still implies an annual adjustment of at least 5% of US GDP (around.$700 billion)

 

If global demand isn’t to collapse, someone else has to increase consumption by that amount.  But who?  The US government will probably increase its net spending, although it has already significantly increased its gross debt by recapitalizing the banks, and it will almost certainly see tax revenues fall.  Corporations are more likely to be cutting spending than increasing it, so the combination of the two is not likely to be significant.

 

Can the rest of the world step up and replace US consumption?  I am not an expert on global economies, but I think it is pretty safe to say that European, Japanese, and Latin American households and businesses are unlikely to be in a hurry to increase spending.  In fact they are all likely to reduce consumption, although perhaps not as dramatically as the US.  Given high debt levels in all those areas, there are also some constraints on fiscal expansion. 

 

That leaves the net exporters, of which China is the most important.  It is the largest saving nation, and the “other” nation along with the US at the center of the global balance-of-payments imbalance, and so much of that adjustment is likely to be forced onto China.  As the country that has benefited most from US over-consumption, in other words, it is likely to be the one that will most have to adjust to a drastic cut in consumption.

 

What are the comparable numbers for China?  US GDP ($13.5 trillion) is about 3.4 times the size of China’s ($4.0 trillion).  In that case a 5% adjustment in the US is equal to roughly a 17% adjustment in China.  That means, all other things being equal, Chinese consumption must go up by 17% of GDP just to compensate globally for the decline in the US, and bear in mind that consumption in China is only around 30-35% of GDP.  What is worse, there is reason to believe that Chinese private consumption is likely to slow down in response to rising uncertainties and a slowing economy.  Domestic consumption tends to be positively correlated with exports – a very pro-cyclical type of relationship typical for developing countries with large export components.

 

There are great hopes pinned on fiscal expansion in China, but I have already expressed my doubt about the government’s ability to expand as rapidly as many of us hope (and Stephen Green and Nouriel Roubini have anyway argued that there is less here than meets the eye).  Even if they are able to expand dramatically without crowding out domestic investment, the sheer magnitude of the numbers make it almost impossible that China can successfully bear the burden of the global adjustment.

 

Of course it is not China’s job to replace US demand.  Chinese policy-makers are only interested, in principle, in protecting growth in the Chinese economy.  So why worry about whether China can or cannot replace US demand?  Because with the rest of the world unable to step up, and in many cases even reinforcing the decline, if China cannot do so the whole world must see declining growth and a rise in savings, and since China was the main counterbalance to excess US consumption, it will probably bear much of the brunt. 

 

An excessively high savings country, in other words, cannot benefit from a massive rise in global savings, and just as the astonishing flexibility of the US financial system meant that until recently US consumption had to adjust to absorb excess Asian savings (warning: I am a believer in the Bernanke savings glut hypothesis), the seizing up of its financial system means it no longer can absorb those savings, and so something must break.  Instead of the US adjusting to excess savings, excess savers must adjust to declining US consumption.  The world must balance.

 

I know this quick analysis is going to be accused of excess oversimplification, and I accept the accusation, but the point of this exercise is not to work out the process in full complexity, and certainly not to make policy prescriptions, but rather simply to get an idea of the adjustment that must be made, and if it isn’t China, as one of the two main players in the global imbalance, that will make the adjustment, then we need to figure out who else will.  The biggest potential mistake in my argument, I think, might be my assumption about how much US savings will need to adjust.  Perhaps the adjustment will be much lower.

 

 

2.       What difficulties might China face in trying to reduce the cost of the adjustment?

 

The second point is to discuss some of the policy options that I think China will consider.  The first and most obvious is fiscal expansion, something which I and other China experts have discussed and about which there is very real and very honest disagreement, with very plausible arguments on both sides.  I have already discussed many times why I am skeptical about the ability of fiscal expansion to make up the slack.

 

As I write this Xinhua reports that the State council has approved fiscal spending equal to nearly 15% of GDP.  The very short article says in its entirety:

 

China has decided to adopt active fiscal policy and moderately easy monetary policies to boost fast but steady economic growth by expanding domestic demand, according to an executive meeting of the State Council on Sunday.   It is estimated that investment into infrastructure, social welfare and other key sectors will amount to four trillion yuan by the end of 2010.

 

A Bloomberg article gives a little more color:

 

The spending announced today, of which 100 billion yuan is earmarked for this quarter, will cover low-rent housing, infrastructure in the rural areas, as well as roads, railways and airports, the State Council said. The government will also allow tax deductions for purchases of fixed assets such as machinery to stimulate investment, a move that will reduce companies' costs by an estimated 120 billion yuan.

 

This seems like a very large spending plan (nearly $600 billion, or about 14-15% of GDP over two years), and I think it may be enough to keep Chinese growth close to current levels, but only under the following conditions:

 

¨          It represents net new spending above current levels of expenditure.  I think government expenditures represented around 14% of GDP last year, so if that suggests government spending will increase by around 50%.

¨          These are actual expenditures – for example tax deductions aimed at stimulating investments much actually stimulate investment by as much as the numbers project.  Without looking carefully at the numbers (and possessing an understanding of budget issues much greater than mine), it is hard to say how much of this is real spending and how much “projections”.

¨          The increased spending is not paid for out of an increase in taxes but rather by borrowing.  I think this is likely.

¨          There is no large reduction in private consumption, the government borrowing and investment does not crowd out private investment to any material extent, and there is no significant reduction in municipal government spending financed by real estate sales.  Here I am much more skeptical, especially about the last two points.

¨          Disbursements begin rapidly and are not wasted.

¨          At least half of the global adjustment tales place outside China.

 

The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits (I predicted earlier this year that guessing the real size of the government liabilities would be a popular sport next year) as well as on the health and stability of the banking system. 

 

If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs, but there are very big question marks.  Still, I think it is an indication of how worried the government is and how determined they are to address the issue that this plan was approved.  (As a complete aside, I also think it is an implicit acceptance of Bernanke’s savings glut hypothesis.)

 

The discussion of the health and stability of the banking system leads easily into the second much-discussed option – really sort of a variation on the first.  The government can force credit expansion by requiring the banks to lend more.  Although there has been a process over the last decade of freeing the banks and allowing them more discretion in lending as a way of improving China’s dismal capital allocation process, there is no reason why policy-makers cannot reverse course and force banks to lend more.

 

Certainly they are trying.  Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks (interestingly enough they have always denied that they had imposed constraints).  But instead of gleefully exploiting their newfound liberty banks have refused to party, and loan growth has been very low.

 

This is hardly surprising.  In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion.  Most good companies seem reluctant to borrow and anyway banks are reluctant to lend. 

 

So what if policy-makers simply announce minimum loan growth targets for every bank?  That should certainly cause an expansion in banks’ balance sheets.

 

I think, however, that there are two problems with such a policy (although administrative measures of this sort hold a dangerous allure to policy makers).  First, I don’t think it will be effective in net credit creation for the country.  This argument is simply the flip side of my previous arguments as to why I did not believe the loan caps that were in place until this summer actually restricted credit creation.

 

In those days I argued that if monetary conditions are consistent with rapid credit creation, we will see credit creation.  Any attempts to restrict credit creation will simply meet with some or all of the following responses:

 

1.        Banks will innovate around the restrictions.

2.        Credit creation will occur outside the restricted areas.

3.        Banks will lie.

 

In China’s case we have definitely seen innovation (securitizations and transactions that took loans off the balance sheets of banks) and outside growth (rapid increases in dollar loans and policy bank loans and, most importantly, growth in the informal banking sector).  If there is a sharp contraction we will know if there have also been many cases of lying.

 

The same thing can happen in reverse.  If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks.  That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system.

 

The second problem is likely to be the quality of the loans.  It is always possible to find borrowers, even in a sharp economic contraction and an overinvestment crisis.  The problem is that many of these borrowers are not the ones that any prudent bank should be dealing with, and to the extent that the forced loan expansion is successful, it will probably do little more than ease the credit crisis in the immediate near term and make it much worse in the medium term.

 

A variation of this might have happened in Japan in the 1980s.  As Japanese GDP growth slowed from its very high levels in the 1970s (from an average of roughly 10% to an average of roughly 6%), Japanese banks flush with liquidity were eager to extend loans.  Loan growth actually accelerated steadily from around 7% in 1980 to around 14% in 1987, even as GDP growth declined from around 8% in 1980 to around 5% in 1987.  Credit creation vastly exceeded real credit needs during this whole period, with the balance going largely into real estte lending and, later, stock market speculation.

 

We may have already seen this process in China in the last four years and of course I don’t want to suggest that the processes in China and Japan are identical, but I do want to point out that forcing credit expansion beyond the real needs of the economy can create tremendous future problems, and China may have already gone through this very process with a monetary policy that accommodated too-rapid credit growth (much of which may have occurred, of course, outside the banking system).

Comments

[cdh:]

I don't know where all this talk of the US consumer "saving" comes from, it's not saving that's happenning, it's a desperate attempt to keep up with paying bills. It will take most US families for all practicle purposes, "forever", to even begin to be able to save anything. Real average wages haven't increased in 30 years. The question is how long will it take for these average consumers to get significant wage increases? I think that the answer to that question is a very long and painfull time.

2008 Nov 09 04:17 PM

[All Roads L...:]

Michael.

My personal belief is that Chinese consumers are simply a tool that some are using to give people some hope.. and a scapegoat should things go wrong.

I have been speaking with friends who are in China's pubic and private sector, some rich.. but primarily middle class, to see what their thoughts are.. and I am farily confident that Nike and GM are not going to like what they hear.

the market is down.. the real estate market is down... global demand for Chinese production is down.. 70,000 factories have closed down.. and people are unsure if this is the beginning, middle, or end... they are even less sure of what can/ will be done to turn this situation around.

Scared from what they know, and possibly scared more by what they don't, they will continue to save money to ensure that they are protected to weather the storm. Perhaps if the US provided real leadership and the world was able to develop a "plan", consumers would feel more confident, but until that day I would expect it to be a cold consumer season....

not saying cabbage will find its way under the bed yet...but not out of the realm of possibilities either

r
allroadsleadtochina.co...

2008 Nov 09 05:12 PM

[Steven Hansen:]

i am sure this post will generate significant comment.

1) the usa savings rate should have been part of this discussion. just because somehow it supported your model is irrelevant. the problem is the way savings are counted specifically in the areas of capital gains and 401k's. with savings interest rates being so low, people just made (saved) money other ways that were not counted in this savings rate number.

seekingalpha.com/artic...

bigpicture.typepad.com...

2) i think china will not be leveraging the stimulus, and will try to go on a public works spending spree. if they try to stimulate using low interest loans, the money will be misused and wasted.

2008 Nov 09 07:31 PM

[NOWHEREMAN:]

Chinese imports will be probably be of the common variety, basic materials for the continued expansion of their infrastructure and the rebuilding of the earthquake ravaged areas. Whether this results in the importation of goods from the West is moot. I would think they would be prone to importing from countries in their immediate vicinity to bolster the Asean zone concept, South Korea especially because of the currency differential and their currently closer ties.

IMO

2008 Nov 10 10:58 AM

[Portable Alpha:]

CDH, here is a note concerning your concerns as to where "all this talk of the US consumer 'saving' comes from"[as you've mentioned]:

Quote -

"US Private Savings Rate Is Rising Sharply

In a note we issued on November 15, 2007 (To Gisele and Jay-Z: US ‘Twin Deficits’ Are Shrinking), we pointed out that the dominant driver of the US C/A deficits has been the US personal savings rate. Until recently, it had been in a secular decline since the mid-1980s. In trying to determine the key drivers of this variable, we found that three factors – (i) US net housing wealth, as a percentage of disposable income, (ii) US net equity wealth, as a percentage of disposable income and (iii) the long bond interest rate – explain 83% of the movements in the US private savings rate. Of these three variables, the most powerful driver is US net housing wealth, which had been in sharp decline for four quarters.

After remaining close to zero from 2005-07, the US private savings rate surged sharply from 0.1% in 1Q08 to 2.7% in 2Q08 – a level last seen six years ago in 2Q02.

This sharp recovery in the US private savings rate was predicted by our three-variable model. In fact, based on what we know about the determinant variables, the US savings rate could rise to 5.7% by end-2009 – a level last seen more than a decade ago, in 1997. "

www.morganstanley.com/...

Which cements Michael's point.

btw, how are you guys holding up on PE business, CDH? :)

2008 Nov 10 11:04 PM

[Uln:]

Dear professor Pettis,

I have seen Nouriel Roubini mentions you (but doesn't link you) in his latest article about crisis, and in particular about the fiscal policy. www.japanfocus.org/pro...

Finance is a bit my weak link in economics so I would like to ask you, how is China's fiscal policy limited by the government liabilities? Doesn't China have a large amount of reserves (as opposed to the US) and therefore it should be easier for China to apply aggresive fiscal policy without fear of deficit?

I suspect the main problem has to do with most of China's reserves being denominated in dollars, and by selling them to spend in RMB they would be pushing the RMB up and harming their own export economy. Is this the reason?

I would really appreciate it if you could give us some explanation on this point. Thanks!

2008 Nov 11 01:12 AM

[M. Pettis:]

Chinayouren, that's part of the answer. China cannot use foreign currency reserves for domestic investment without pushing the RMB through the roof and effectively killing off the export industry. But there is also the fact that reserves aren't unencumbered wealth. They are simply assets against which there are liabiltiies, in the same way that Citibank has a trillion dollars of assets but is not worth a trillion dollars (it also has nearly that much debt).

In other words the PBoC had to borrow RMB to buy the reserves, and some people think the rise in the value of RMB liabilities may have already wiped out the PBoC's capital cushion. Giving the government reserves as a 'gift' is no different than having the MoF borrow the money domestically, with the difference being that it would result in a rise in PBoC domestic liabilities rather than MoF domestic liabilities.

2008 Nov 11 07:12 AM

[Chris B:]

So if China's economy collapses and exports drop, who will be buying the massive US government debt being generated by the bailouts and the continued wars?

If Chinese exports to the US suddenly slow and US debt supply suddenly increases, would that result in higher interest rates, a decline in the value of the dollar, or both?

2008 Nov 11 03:38 PM

[Focus Advisory:]

Exports as a % of Chinese GDP is approximately 10%. The U.S. accounts for 24% of those exports. EM's account for the plurality of Chinese exports.
The Chinese are trying to hold up exporters, but will realize a stronger currency will increase consumption. In so doing, they will also accomplish their goal of moving their exporters up the supply chain as they are forced to become more competetive.
Bottom line: The Yuan will rise and Chinese consumption will rise in kind. Having said that, it will not happen overnight, but will be a strong trend over the next 3-5 years.
Get long the Yaun with CYB. I am long this note for clients and believe it will provide a bond like return over the next 5 years. The underlying currency that you are invested in over the next 3-5 years will be the most important decision an investor makes.
Thank you for the article...good stuff.

2008 Nov 11 04:33 PM

[Consider_this:]

The point is, China has options, USA doesn't.

China can choose to forgo it's export industry and raise it's currency. In doing so, it can either sell some foreign reserves for domestic buildout; or borrow against it's RMB by issuing bonds itself. No doubt painful, it is non-fatal and actually yields positive results.

The choices here may start out bankrupting exporters, but non-export industries will benefit, exporters can convert to domestic purpose and consumer's standard of living will be allowed to raise. This will lead to raising prosperity.

USA's choice boil down to either issuing more debt (in the hopes that someone will buy it), esp as it recklessly bails out everyone; or letting it's currency devalue, which again will mean much higher interest rates on new debts, so that the govt can service it's own finances.

Both choices here lead to lower standard of living and widespread poverty.

The writing is clear on the wall.

2008 Nov 11 04:56 PM

[Michael Zhuang:]

Very insightful article and very easy to follow. If there is any conclusion to draw, it is that the adjustment will be very long since the imbalance has been built up over the last 20 years. The scope of the imbalance is far beyond the US housing market.

2008 Nov 11 05:24 PM

[Even Walser:]

I am so tired of China's GDP being quoted in PPP terms. It is my opinion that too many poor overseas investment decisions have been made because of the BS that is PPP. China's real GDP is only 1.3 Trillion not 4 Trillion or 7 Trillon as many like to quote. PPP does not count when it comes to purchasing globally important goods. PPP really only applies to good produced locally for consumption such as food. That said oil is in dollars, tanks and airplanes are in dollars, minerals are in dollars, fertilizers are in dollars. PPP is BS plain and simply. If you want to take a real look at the size of the adjustment headed China's way rework the numbers with real GDP. A train wreck is coming to China plain and simple.

2008 Nov 11 08:36 PM

[Uln:]

OK, I get it now.
I have taken some time to get back to the basics last night. Even undusted my old Samuelson. Too long time not dealing with economics and some concepts were starting to swim in my head. Thanks for your help!

Anyway, from you posts I understand that we don't have a very clear picture of where The MoF stands today in terms of liabilities. So any prediction of when or how much all this will affect the state budget is little more than a guess. Right?


On Nov 11 07:12 AM M. Pettis wrote:

> Chinayouren, that's part of the answer. China cannot use foreign
> currency reserves for domestic investment without pushing the RMB
> through the roof and effectively killing off the export industry.
> But there is also the fact that reserves aren't unencumbered wealth.
> They are simply assets against which there are liabiltiies, in the
> same way that Citibank has a trillion dollars of assets but is not
> worth a trillion dollars (it also has nearly that much debt).

>
>
> In other words the PBoC had to borrow RMB to buy the reserves, and
> some people think the rise in the value of RMB liabilities may have
> already wiped out the PBoC's capital cushion. Giving the government
> reserves as a 'gift' is no different than having the MoF borrow the
> money domestically, with the difference being that it would result
> in a rise in PBoC domestic liabilities rather than MoF domestic liabilities.

2008 Nov 13 02:51 AM