China Continues Downward Revisions

The Citibank (C) rescue Monday caused markets around the world to surge, but China was buying none of it. Monday the SSE Composite dropped 3.7% and, after a morning rally, it declined a further 0.4% Tuesday to close at 1889. The economic news continues to be bad and it is hard to find any enthusiasm anywhere, at least among the people I normally deal with. Tuesday morning the World Bank revised its prediction for next year’s GDP growth sharply downward to 7.5%. Its previous estimate for 2009, made three months ago, was 9.2%

One of the easiest forecasts I made at the beginning of this year was that we were going to see a long process in which every month or so forecasters would revise their growth forecasts for China downwards. I suggested that this would happen because forecasters base their forecasts on predictions about the performance of the asset side of the economy, and generally ignore balance sheet effects (and, apparently, balance of payments effects).

But in developing countries, with their typically unstable and inverted balance sheets, this is especially misleading. There tends to be a great deal of pro-cyclicality embedded in financial, corporate and government balance sheets, and in the behavior of the financial system more generally, so that growth begets changes in the balance sheets that enhance growth and economic contraction begets balance sheet contractions that exacerbate economic conditions. One consequence is that good periods typically involve continual upward revisions from forecasters as the economy systematically outperforms expectations, and bad times involve consistent downward revisions.

We have not reached the end of this process because I don’t think we have seen the end of the balance sheet effects. The rise in NPLs has only just started and we haven’t yet seen a very strong response on the part of the commercial banks, although perhaps in the informal banking sector the unraveling is well under way (I don’t know, but there is some circumstantial evidence to suggest it). I am not even including the possibility that we may see sharper export contraction in the future as the world of international trade turns uglier.

Next quarter the World Bank will almost certainly revise its forecast even further down. As I said early this year (jumping the cue by assuming standard balance sheet effects), I think it is much safer to assume that next year’s growth is going to come in under 7%, perhaps well under, although please note that this prediction is not based on any terribly sophisticated knowledge of the functioning of the economy. My whole model assumes that balance sheet effects add unpredictability, although the directional impact on growth of that unpredictability is often predictable (although this probably isn’t the most elegant way to phrase it – sorry).

The Chinese leadership is clearly worrying about this. A number of senior leaders have made pilgrimages to various economic centers during the past two weeks to get more of a sense of how quickly conditions are deteriorating. According to an article yesterday’s Xinhua:

The spreading global financial crisis and economic slowdown are having bigger negative impact on Chinese economy, vice premier Zhang Dejiang said on a weekend inspection tour to central province of Hubei. Zhang, who aims to learn about performance of the industrial sector during the trip, urged the local officials to give strong support to key enterprises and sectors and also small and medium-sized enterprises and labor-intensive businesses.

The government has also warned, more than once, that as a consequence of the slowdown they expect an increase in social disturbances (a euphemism for rioting). They are also trying to control the process of layoffs, with some provinces requiring companies to get approval before they fire more than a certain number of workers. This obviously can have negative impacts on the adjustment process for businesses, but I think that one of the ways that China can boost private consumption is by various forms of income redistribution, and raising minimum wages and preventing firings may have some positive impact here.

Meanwhile provincial governments have turned eagerly to the government in order to help fiscal expansion plans. According to an article in the South China Morning Post:

Mainland provinces have drawn up long wish lists for roads and other projects since Beijing unveiled an economic stimulus plan, state TV reported, as local leaders take advantage of a new willingness to spend amid the global crisis. Spending proposals announced over the past week by provinces total 10 trillion yuan (HK$11.3 trillion), China Central Television said on Sunday. But the report gave few details and no indication how much of that might be approved by the central government.

The 21st Century Business Herald said few investments announced by provinces were new. It said most are either under construction, have been under discussion for some time or were planned but not begun due to lack of money. The newspaper said much of the proposed provincial spending is still awaiting national approval.

Tuesday’s Xinhua also had a similar article:

Many officials in the less-developed central interior felt that Beijing had been penny-pinching in financing local projects for most of the year until only recently when the focal task of macro-economic control shifted from curbing inflation to slowdown prevention. “The situation reversed completely in less than two weeks. It used to be projects waiting for capital, now it’s the other way around,” said Qiu Yunyang, chief of the Development and Reform Bureau of Hubei’s Zaoyang City.

To seize the opportunity for a boost of local economy, Qiu and his colleagues have put in extra hours these days to screen out projects that were mostly needed locally and had a better chance of getting a portion of the 100-billion-yuan investment newly endorsed by the State Council, or the Cabinet, for the fourth quarter.

Aside from the inevitable graft and waste that this will entail (it is almost impossible to book rooms in hotels near the main government offices responsible for doling out spending approvals, according to a number of reports, because of the rush of provincial officials eager to get in on the handouts), to the extent that this represents real spending it is likely to be good in the short term. Any real boost in domestic demand will help take the sting off the contraction in US and European demand. I just worry that the combination of a slowdown in growth, with its accompanying rise in unemployment, will make it harder socially for ordinary Chinese to stomach the sight of a new army of petty officials suddenly getting rich. I hope the rush to spend comes with relatively stiff safeguards.

Comments

[Douglas Rob...:]

Michael,

I moved to China in March 2006. During the past two years of research for my book (Foreign Capital Investment Banking for China), I found mostly indirect evidence that "safeguards" are systemic or symbiotic -- more like symbolic -- within this "constitutionalized" quasi-feudalistic system of governance.

Money and rules: neither of which exist here as doctrinal constructs so transposed and codified. Currency is restricted based on fiscal and political selectiveness relative to monetary metrics; rule of law is subjugated to prevailing political doctrine(s).

Your implied call for accountability is based on a common sense mandate for maintaining social harmony -- as to who can stomach what and how much around here, right?

How ironic... Common Sense.

During September, while reducing my 630 page text to the publisher's requested 200 page limit, I found myself frequently reflecting upon undergraduate and juris doctorate studies of the Federalist Papers. I am considering whether we here are now there...

Hu et al may usher in an era establishing rule of law via codification of Federalist precepts as conditions precedent for provinical allocations of (or block) funding.

How? Just as we did at varying times of our American story... with money.

Why should there be details about how much stimulus as well as where and when and to whom? Let those provincial "little emperors" feel the heat of local discontent -- just enough so they are pliable when it comes to rule of law stricture being mandated from upon a mantle of entitlement theory.

Central planners are neither constitutionally constrained to act here based on provincial rights nor politically franchised to finance a subordinated guanxi-system of micro-development programs. Tax rebates and credits directed to natural and corporate citizenry are perhaps more efficient if not directly effective measures for stimulus.

The "Feds" do it to the states. In tern, the states do it to the counties and municipalities. Why get creative?

Central government planners have an opportunity here. Hopefully, this opening window in China's evolution will not be screened for only fiscal accountability and inspector general audits.

Does power of the purse support such a lofty pursuit? To wit: advance openness and reform for all Chinese people as well as us, those foreign guests who have vested hopes for a world-integrated partner that shares similar values -- as well as a liberated currency defended by fixed principles of law.

Given your vantage point, I am curious...

dr

2008 Nov 26 10:44 AM

[M.R. Henderson:]

With the ferocious, wealth-hungry, driven, overly abundant, creative population in china, especially in its government, there can be NO "stiff safeguards", as any rule is outmaneuvered in the provinces, and as far as Beijing dispatching accountants to "account" for the money spent, the creative accounting that goes might get a few of these Beijinger's richer, but construction is one of the more corrupt enterprises - even in the "West". So there will be many petty officials grown fatter and not much trickle through for the 1/4 that Beijing is willing to pay for this stimulus. KTV venues and their associated brothels will see a boost for sure - along with riots. There will be some more jobs, but enough? And really, it IS jobs that are of paramount importance to stability, because without jobs, domestic stability for a land with more men than women will require a war. So how do we create jobs with no fiscal chain of command, no laws, and many hungry very clever people???

Because no one in China has the guanxi to sit down with every regional money baron to convince them it is in their interest to spend in a time of deflation, if a stimulus is to accomplish its goal in China, the clever politician (or businessman) would find a way to sidestep this issue entirely.

One cannot issue checks to 1.3 billion people (or half that number). One cannot implement healthcare overnight to a people accustomed to being lied to all their lives. No one will start spending because the government tells them to.

One idea that occurs to me is to have a second round of export rebates that are not export rebates at all, but rather domestic resale rebates, making all these factories' items ridiculously cheap for six months if sold to the internal provinces; could this help spur the entrepreneurial chinese spirit to do the rest? There would be a bit of round-tripping, but with all the new apartments recently bought, there might be a few people willing to leave their old apartments and actually move into the nice ones, outfitting them, getting a taste of consumption while openning up housing to the lower classes...

mr. D.R., i had (and many, i'm sure have) the same idea with the federalist papers comparisons. China does need Beijing to consolidate power, but neither with fancy words nor with money. It's too risky to let the increasing incidence of pubic unrest grow because it had been growing at an increasing pace, and i believed the government stopped publishing statistics on public incidents, around when you arrived. You might look into the role the military played in america's state/federal struggles: which is the only way Beijing can arrest anyone these days - by sending their own people on a plane and having them return that same day. The roads and facades are built to american specifications, but just inside those starbucks doors, the entire system of thought and communication is very different from anything an english knows. Spend some time in a handful of 4rth tier cities drinking - the government's national pasttime - posing as an investor. Invite the local bank of china manager out to dinner - not telling him youre writing a book -,and bring a translator you trust (preferably a pretty young woman). see where the money goes. Or if you want to talk to retired government officials who know what is what, try the same at Chengdu's KTV's. If you want active local officials at their best, the province rated most corrupt in 2006 was Qinghai province. try just asking at the government office about the 2% investment rebate you get for starting a business: they will laugh and say the emperor is far away - or tell you a story. They nearly doubled the population of their capital city - on paper - to get more aid from Beijing, and they even put away all their audi cars and suv's, ferrying hu jin tao himself in a broken down mini tourist bus, when the leader of China came to visit in 2005. Pre-federal america has some stories like this, and all humanity shares the tendencies that in China are just more developed. While the Mao Dynasty china currently abides has made some strides, this may or may not be its greatest test yet.

China needs stability, and soon the solution may no longer be an academic exercise.

In the next six months we should know.

2008 Nov 26 06:04 PM

[Douglas Rob...:]

Hi MRH,

I think I understand your theme...

With the election of Obama, I am reminded of President Kennedy's use of the Amry to force racial segregation at University of Alabama -- see movie, Forrest Gump.

The direction I was seeking from Michael was along the lines of entitlement theory, whereby the central government would impose legal requirements for funding of provincial programs.

It is my estimation that the standing committee can guide the Hu Administration toward legitimizing an independent judiciary at the provincial level via block funding of stimulus programs via central government agency oversight.

See Marbury vs. Madison, which is how the US Supreme Court commenced ensuring its validity as a one of the three branches of government based on a system of checks and balances.

The standing committee here may accomplish the same...

dr

2008 Nov 28 08:26 AM

[Douglas Rob...:]

Oops... racial desegregation... typo... sorry

2008 Nov 28 08:27 AM