Depression, PMI and China

The second Great Depression wends its way forward in December ... and lands in China.



Well, China isn't quite in Great Depression mode yet, but manufacturing activity - which forms the core of the Chinese economy and accounts for 43% of all activity - is already very close to a technical recession, and phew, it wasn't very long ago that the Chinese economy was registering double digit growth. So the turnaround is gigantic. The "close to technical recession in manufacturing industry" call comes from the people over at CLSA Asia-Pacific Markets, who compile the China purchasing managers index, and they base their judgment on the fact that their Chinese manufacturing index has now been registering contraction for five consecutive months.

Now for those of you who are new to the world of Purchasing Manager's Indexes (PMIs), welcome. Basically these indexes are very useful, since they give you a "just in time" point of reference to tell you what is actually happening. These are composite indexes - measuring things like current output, new orders (both domestic and export), employment and input prices. They are not perfect, but they are reasonably accurate - the fit which you can get between composite PMIs (manufacturing and services combined) and GDP is often attractively good. And in a country like China where the main data we get is year-on-year (which in a critical moment of rapid change like this one is virtually useless) it is very hard to see what is happening.

The Shanghai-based Industrial Bank estimates, for example, that GDP growth in China will be 5.6% in Q4 2008. But what does that data point - if accurate - tell us? That the economy is slowing fast - well, we already knew that. But just how fast? Well, GDP was 9% in Q3 - down from 10.1% in Q2. So the deceleration is very rapid, but did the Chinese economy actually manage to contract in Q4? I doubt it, but it may do in Q1 2009, although the only way we would really know would be if the National Statistics Office published quarter-on-quarter seasonally adjusted numbers, which as far as I can see they don't. Indeed only a small group of highly developed economies actually take the trouble to do this, and you don't even find all EU member countries doing it yet, although Eurostat (thank god for Eurostat) does require such data from members (but those of you who ever get round to checking will see there are still blanks for some countries in the Eurostat quarterly releases).

Hence you can see why, in the case of somewhere like China, the PMIs are very, very useful, for those of us who would like to try and follow what is happening as it actually happens.

As for the PMI itself, China’s composite manufacturing index contracted for the fifth consecutive month in December as recessions in the U.S., Europe and Japan bit deep into demand for exports - indeed China's exports fell year on year for the first time in seven years in November. The CLSA China Purchasing Managers’ Index registered a seasonally adjusted 41.2, compared with a record low of 40.9 in November. On such indexes any reading below 50 reflects a contraction.

Despite the apparent small improvement in December, the current output index actually fell sharply, and was down to a record low of 38.6 from 39.2 in November, so production was falling, and the index was basically nudged up slightly by other factors, such as the measure of new orders which rebounded to 37 from 36.1, driven by a rise in export orders to 33.6 from a horrific 28.2 in November. However, according to the report, Chinese manufacturers reduced the size of their workforces at a series record in December, and the employment index has now contracted for five consecutive months, to hit 45.2 in December.

So where exactly are we? Well, we aren't (quite) in the Second Great Depression yet, but the situation is deteriorating, and rapidly. Manufacturing output is now contracting at quite a sharp pace, while it was rising in the first half of the year at something like a 15% year on year rate. In a useful summary of the Chinese situation back in November, Nouriel Roubini defined a hard landing in China - which he felt was coming - as follows:

There is thus now a growing risk of a hard landing in China. Let us be clear what we mean by hard landing. In a country with the potential growth of China, a hard landing would occur if the growth rate of the economy were to slow down to 5-6% as China needs a growth rate of 9-10% to absorb about 24 million folks joining the labor force every year; it needs a growth rate of 9-10% to move every year about 12-14 million poor rural farmers to the modern industrial/manufacturing urban sector.

This is more or less the consensus view of what we used to think a hard landing would mean in China, but I think the latest data already take us beyond that. I think there is now a real risk of a technical recession in the more or less classic sense of two consecutive quarters of negative growth (let's say that the risk is 50-50 at this point), and of serious economic and financial dislocation following in the train of this (btw, just how quickly can you burn your way through $1.7 trillion in reserves? It will be an interesting experiment, I think).

Brad Setser (further down the same link) has long been more cautious on China, being sceptical about the impact of a dramatic slowdown in exports (and even more importantly in export oriented investment) on an export driven economy, but those of us who have been closely watching other export dependent economies like Germany and Japan over the last decade and a half were surely not quite so sceptical. However even Brad himself is clear that the possibility of an export downturn feeding its way back into the domestic economy - via some sort of negative feedback process - is real enough:

But the real key to forecasting China’s future growth consequently is determining whether domestic consumption and above all investment will continue to grow strongly in the absence of strong export demand. Remember, over the past few years both domestic investment and exports increased rapidly. If they fall together as well, Chinese growth will slow quite significantly. And unfortunately the latest indicators seem to suggest that they are correlated; consequently domestic demand may fall along with exports.

The $1.7 trillion question is, then, just why China is so export dependent? Doubtless there are many factors at work, but one of these is, I am almost sure, China's very special demographics (30 years of one child per familiy policy), and the special problems that these present in the context of building a sustainable national pensions system at the same time as the population pyramid inverts. Obviously the absence of a credible pension system has to be one of the factors influencing the strong desire to save which we are seeing in China. Economics Nobel Franco Modigliani also thought this, and specifically addressed the Chinese saving puzzle

in his last published paper

:

China's per capita income ranks below 100th in the world. Its saving rate, however, has been one of the highest worldwide in recent decades. In this paper, we attempt to explain the seeming paradox within the framework of the Life-Cycle Hypothesis developed by Franco Modigliani. The key LCH variables are income and population growth. Our results based on data we put together from official sources show that income growth has been the dominant factor behind the dramatic increase in China's saving rate, as predicted by the LCH. Demographic structure and inflation also had significant impact on the fluctuations of the saving rate.
The Chinese Saving Puzzle and the Life-Cycle Hypothesis - Franco Modigliani and Shi Larry Cao

By Way Of Brief Conclusion

Well basically, the conclusion here is that there is no conclusion, at this point at least. But I would draw attention to two potential points of interest for all you "economy watchers".

Firstly, a couple of months back my fellow blogger Doug Muir

drew our attention

to a very interesting point being made

by US economic historian Scott Reynolds Nelson

:

As a historian who works on the 19th century, I have been reading my newspaper with a considerable sense of dread. While many commentators on the recent mortgage and banking crisis have drawn parallels to the Great Depression of 1929, that comparison is not particularly apt. Two years ago, I began research on the Panic of 1873, an event of some interest to my colleagues in American business and labor history but probably unknown to everyone else. But as I turn the crank on the microfilm reader, I have been hearing weird echoes of recent events.

At the time of reading this I thought to myself hmmmm! This isn't that simple, but he is on to something. Basically I think no two (or does that make it now three) Great Depressions are ever really exactly alike. I certainly think the resemblence between what is going on now and what happened between 1929 and 1933 is more than passing (especially for the sequencing, of which more in another post), but evidently there are elements of the 1873 one too, and Scott Reynolds puts his finger on some of them, especially in the context of surplus to requirement investment and large capacity overhangs. So my best guess is that what we have is a hybrid, and that what is now happening in China is the best example of the underlying dynamics behind that other great depression that hit our grand- (or great grand) parents and that may well be now about to come back to hit us, boomerang style.

Which brings me to my second point, the Smoot-Hawley Tariff Act, which,

as wikipedia explain

, was signed into law on June 17, 1930, and raised U.S. tariffs on over 20,000 imported goods to record levels. After the act was passed, many other countries retaliated with their own increased tariffs on U.S. goods, and American exports and imports plunged by more than half. Many economists now regard the Smoot-Hawley Act as having been the principal feedback catalyst for the severe reduction in U.S.-European trade, and which took it from the 1929 high down to the depressed levels of 1932 and which thus accompanied the start of the Great Depression. And here, in the spectre of a repeat performance comes just the danger we face in the wake of the dramatic contraction which is now underway in China.

It is my personal guess that the first major issue to face Barack Obama as President of the United States may well be what to do about China, and especially what to do about a China which lets - as I now suspect they may well do - the yuan float, in order to see it

float DOWN

as the economy unwinds. If this does indeed happen then Obama will really have to struggle to hold back the protectionist pressure I think.

Comments

[mike904:]

It's hard to argue the merits of Smoot-Hawley in today's economic environment because the general consensus is "S-H bad, period." Often, economists are university theorists who seem unable to understand that we live in a POLITICAL world.

In the 20's the US funded much of it's overseas trade just as China did from 2000 to 2007. When liquidity dried up, the US attempted to hold onto the value of it's manufacturing by limiting imports. I suspect that unless our country is run by college professors with dictatorial powers this will happen again.

China is doing the same thing now. It's first fixing prices, by limiting farm export licenses. It's "helping" domestic farmers by setting up a crop reserve, which will help increase yuan grain prices and ease the transition of millions of people leaving the cities for their old lives back on the farms. It's using infrastructure projects, including 5 bullet trains, to hire excess workers. Sound familiar?

Rather than judging this to be right or wrong I would judge it to be natural, predictable and inevitable. China's goal, as it has been for 2,000 years is stability. In the US, 90% of economists are in complete agreement as to the solution to this problem, a situation I find terrifying.

As to the conclusion to the effects of Smoot Hawley, I have no clue other than to say Naill Ferguson said it had a minimal effect on the US.

Jan 02 02:59 PM

[Griz:]

Actually, this would be the fourth US depression; see attached link: www.kwaves.com/200210K...

Historically, these economic retrenchments happen once every life-span and the last one was just about 75 years ago...

Jan 02 03:02 PM

[Ricard:]

A great, realistic assessment of China today. I was very skeptical about all the hype that China would come through this US mortgage induced recession unscathed. It should really make one pause that your assessment is that Roubini was not bearish enough.

Your reasoning is certainly sound, and given the demographics you cite, it looks like a consumer-led recovery in China is not in the stars. Equity-wise, do you think this is already baked in to the securities? Many are still down 70-90% from their highs, and the Baltic Dry Index has yet to recover.

Jan 02 03:04 PM

[Alan Young:]

There are helpful insights here. However, other sides to the story are being neglected. The Chinese government has enough in reserves to set up a healthcare/pension system that could mitigate older worker's obsession with savings--and/or, foster a systematic and persistent inflation rate which would make savings unattractive. This is in addition to the already-publicized plan to use the reserve warchest for infrastructure investments; with enough economic activity generated this way, perhaps the dearth of exports and consumer spending is not as serious an issue.

All told, I think it's too early to tell whether China will suffer any real recession, much less depression. At worst, it's still a better bet than any other major country, IMHO.

Jan 02 05:06 PM

[Firat Ünlü:]

Health-care and retirement is one reason for the high savings rate but another one is quite simply down to customs, in order to get married Chinese pay twice money to the girl's parents (engagement and marriage, traditionally marriage meant that the girl left her parent's household so a sum was paid to them as compensation). Furthermore owning a home and perhaps even a car are almost mandatory, it's even in the language.
Also there's the cost of education, typically a fund for financing some time abroad. Eventually the money comes out to the economy.
Don't forget that consumer goods are cheap as anything in China, without the consumerism mentality prevalent in the West, you can get by on very little and still have adequate clothes, appliances, food etc
They don't feel the need to splash out on unnecessary items, ever since I came back from China I've found myself spending far less than before.

Jan 02 06:10 PM

[Lok Sang Ho:]

The fact is that if China's exports fall apart, its imports will also fall apart. This is already proven by recent data. A China that sees exports plummeting is a China that no longer serves as an engine of growth for many other countries. That is something we need to be aware of as Americans put pressures on China to appreciate its currency.

Jan 03 09:12 AM

[prudentinve...:]

China has one theoretical advantage as it enters this crisis, the $1.7 trillion in reserves which you have cited. The question is how will they use it, and in which currency. My understanding is that their reserves are about 85% in USD and 15% in other currencies, probably Yen and Euros.

If they wish to spend much of their reserves domestically to create jobs, they have to sell other currencies and buy Yuan. This will raise the value of the Yuan and hurt exports. Alternatively, they can just "print" Yuan a la Fed, and hold onto their foreign reserves. This makes these reserves useless in mitigating the downturn, and exposes them to erosion of their value as the world's central bankers print paper money.

So, from the above, their enormous reserves are not very useful in terms of their domestic stimulus spending. Which means that they need to use their reserves for imports.

Importing consumer goods cannot help them. They make most of the world's mass-market consumer goods, and they need the jobs to make them domestically. importing more luxury consumer goods in a time of crisis will not enhance social stability.

Importing machinery and capital equipment from the US, Europe and Japan poses its own set of problems. First is the scale, they don't need, cannot use, and the world cannot supply $1.7 trillion worth of capital equipment and machinery in short order. Additionally, they have been increasingly manufacturing these things domestically. Most of their agreements with major manufacturers of capital equipment have been Joint Ventures in which they make increasing percentages of the equipment domestically, and many include eventual licensing of the designs to produce them entirely domestically.

So, in conclusion, I cannot see how they will utilize their $1.7 trillion in reserves in an effective way to mitigate the current downturn, and while these reserves look great in theory, they seem of little use in getting them out of this slowdown.

Jan 03 10:01 AM

[John Booke:]

What about China's retail sales numbers over the past several years? They are hitting 20% m/m growth month after month - now about $140 billion a month. Are these numbers believable figures and are the calculated like we calculate them in the US? Would you expect these numbers to show a collapse in the near future?

Jan 03 10:20 AM

[NOWHEREMAN:]

China has started stockpiling Base Metals.

I don't believe they are doing so just to have them available. Huge stockpiles expected copper amount 150,000 tons.

Kitco.com

IMHO, this is no fly in the pan coincidence after their stimulus announcement.

Jan 03 02:46 PM

[Moon Kil Woong:]

I think Obama will not fight protectionism too hard. But he can't tighten the reins on China too much. If they stop buying Treasuries or dump them the US is not in a good financial position since that means the US basically has to go on an austerity program to reign in more deficit spending.

Although protectionism probably aided in the effects of the great depression The Hand argues well that protectionism as the root cause of the depression is very over-rated. A tidal shift in thinking (adversity to debt and living beyond your means) occurred. That thinking is happening now too.

I am not sure if fed pumping will actually work right unless done to cause strong inflation. This forces people to keep taking financial risks with their assets so their purchasing power doesn't disappear. However, factories will still keep being conservative thus less goods and more money stagflation rears its ugly head.

As for China's savings rate I think it's caused by 2 very identifiable things. First, the concentration of wealth is worse than the US. So if 99% of the money belongs to 1% of the population then it doesn't really spur spending does it. What are they going to buy, Billion dollar houses? If they did China would have an instant revolution.

Which brings the second point, China is not completely stable. the rule of law arbitrary, there is corruption, and a fear of purges if the public nationalism changes to extreme socialism. I suppose that's why China loves blaming the US, Japan, Taiwan, and anyone else for all their ailments.

If they think they had problems then I hate to see what will happen if the recession lasts for several years there. Perhaps they should think about a concept called rule of law, social equity, and democracy. It is rather pathetic that a a country touting itself as the last bastion of socialism should so enrich themselves at the expense of their population. I personally think it's crooked and despicable.

Their allocation of wealth roughly mirrors a totalitarian tyranny much like the dictatorships in Africa. Which arguably they are. Don't rush to invest in China. The dragon is made out of fool's gold. It looks great when you are getting in but don't try to get out of it. They won't let you if things get bad.

Anyway, sorry for bashing China so much. I am critical of the powers that be there, not of its people. They are the victims.

Jan 04 03:34 AM

[Ricard:]

Constructe:

"Which brings the second point, China is not completely stable. the rule of law arbitrary, there is corruption, and a fear of purges if the public nationalism changes to extreme socialism. I suppose that's why China loves blaming the US, Japan, Taiwan, and anyone else for all their ailments."

Let's play Madlibs:

"Which brings the second point, the US is not completely stable. the rule of law arbitrary, there is corruption, and a fear of purges if the public nationalism changes to extreme socialism. I suppose that's why the US loves blaming Russia, China, Hank Paulson, and anyone else for all their ailments."

Don't get me wrong, I agree with just about everything else you said. But political commentary almost always involves propaganda. I'm sure this Madlib version is blasted all over Russia and China (and maybe even the Treasury department).

Jan 04 08:35 PM