Unimpressed with China’s High Reserve and GDP Growth Numbers 17 comments
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My blog has been blocked in China. Given all the internet blocking that has happened in the past few months I guess this is not much of a surprise, and I was sort of waiting for it to happen, even while I was hoping that it wouldn’t.
I think after a few months – probably once the 60th anniversary of the founding of the People’s Republic on October 1, 1949, is truly behind us – they will begin unblocking sites and my students once again will be able to read my blog without having to jump through all the proxy hoops. On a related note I was pretty pleased when Doug Paal, one of my Carnegie Endowment associates, told me Wednesday that certain local policy analysts with whom he had recently met told him that they had been reading my blog and found it useful, but unless they are allowed to use proxies in government offices I guess whatever use I may have provided will be dramatically reduced.
Because I picked up a flu a couple of days ago (no, not swine flu), and so have been working much shorter hours, I haven’t really been able to comment on all the economic news that has come out recently. Since if I am feeling better I plan to go to Wuhan tomorrow and Shanghai Saturday to see some of my Beijing bands perform a couple of big shows, I figured I would make a few comments before going home to recuperate.
The first comment is about reserves. Chinese central bank reserves surged in the second quarter of the this year, with evidence suggesting that we are once again seeing a flood of hot money pouring into the country. According to an article in today’s South China Morning Post:
Mainland foreign reserves surged to a record US$2.13 trillion at the end of last month, underscoring concerns that speculative capital is flooding into the nation to bet on rising asset prices and a quick economic recovery.
Reserves rose US$178 billion in the second quarter, the biggest quarterly increase on record and up from the US$1.95 trillion yuan at the end of March, the People’s Bank of China said Wednesday.
Most of the increase was driven by the usual suspects – the very large trade surplus and smaller but still high net FDI inflows, plus of course returns on the existing portfolio – but the important point I think is that the unexplained portion of the increase in reserves, which serves as a proxy for hot money, has turned from negative in the first quarter to very positive in the second. I will do my calculations later, but for now it seems pretty clear that hot money is returning to China.
This is not a surprise. With optimism returning to China, and with stronger real estate and stock markets, investors are bringing money back into the country. Hot money, of course, is intensely pro-cyclical, and its effect will be to intensify growth in the short term, even as it increases volatility and makes monetary policy more difficult. Remember that the PBoC must recycle the net surplus on the current account and the capital account, and with the very high current account surplus, China would be creating a huge amount of domestic money just from that source. The fact that it is also running a large capital account surplus makes the PBoC’s monetary management that much more difficult. Worst of all is that as long as this fiscal-stimulus-induced boom continues, hot money inflows will heat things up even more, but once the government is forced to scale down the stimulus, the resulting slowdown in the Chinese economy will likely be seriously exacerbated by hot money outflows. The PBoC has a lot of difficult work to do.
One thing that many observers noticed is that the huge jump in reserves means that China must continue buying US Treasury bonds, and of course this still seems to promote very muddled thinking among the cognoscenti. For example today’s Bloomberg had an article which argues that:
China’s foreign-exchange reserves are surging again, helping the Obama administration sell unprecedented amounts of debt as it seeks to drag the world’s biggest economy out of a recession.
…President Barack Obama’s administration is seeking to sell a record amount of debt to pay for measures to revive the U.S. economy. New York-based Goldman Sachs Group Inc. estimates that government borrowing may total $3.25 trillion in the year ending Sept. 30, almost four times the $892 billion in 2008, to finance the budget deficit.
“China’s reserves will allow the U.S. to run a higher fiscal deficit than other nations,” said Bilal Hafeez, the London-based global head of currency strategy at Deutsche Bank AG, the world’s biggest foreign-exchange trader.
No, no, no. The fact that China’s reserves have surged will in no way make it easier for the US to fund its fiscal deficit even though, as I have argued for a very long time, China has no choice but to invest these additional reserves in US Treasury bonds.
Why? Because besides valuation changes and interest income there are two reasons for the increase in the reserves – the very high trade surplus and net capital inflows into China. Take the second reason first. If money flows into China for investment purposes, it must flow out of somewhere else, and that somewhere else for the most part means the global pool of dollar savings which would anyway have been available to fund the US fiscal deficit directly or indirectly.
In that sense China is acting as kind of upside-down bank that takes risk-seeking money and intermediates it into low-risk assets – as an aside almost the opposite of what the US does, and whereas the US profits from this intermediation, China runs a significant negative carry. Of course the fact of intermediating risk money into low-risk assets will have some impact on US Treasury rates, but the impact is minimal (technically risk-free rates will decline a tiny bit and credit spreads will increase by the same amount).
What about the dollars generated from the trade surplus and invested into US Treasury bonds? Won’t that help the US fund its fiscal deficit?
Again the answer is no. The US government is not borrowing for abstract reasons, but rather is borrowing in order to spend locally to generate domestic employment. The amount of borrowing it needs to generate a fixed amount of domestic jobs is correlated with the US trade deficit, because it is through the trade deficit that domestic consumption “leaks out” to create jobs abroad. The higher the trade deficit, in other words, the more the US government needs to borrow to generate a fixed number of American jobs, and so the fact that China is reinvesting the dollars generated by the trade surplus with the US does not make it easier for the US to borrow since it simultaneously requires the US to borrow more.
Remember that China does not fund the US fiscal deficit. It funds the US current account deficit, and it has no choice but to fund it. In fact this is true for every country – foreigners must fund current account deficits, and they do not fund fiscal deficits. To breathe a sigh of relief because a very high Chinese trade surplus means that China will buy a lot of US Treasury bonds is no different from breathing a sigh of relief because the US is running a very large trade deficit. As I have said many times before, if the US wants China to buy $1 trillion of new bonds every year all it has to do is ensure that the US runs a $1 trillion trade deficit with China every year.
My second comment is about the GDP growth numbers, which are both a cause and partial consequence of hot money inflows. As a Bloomberg article today reports:
China’s gross domestic product grew 7.9 percent in the second quarter as the nation became the first of the major economies to rebound from the global recession.
The figure, announced by the statistics bureau in Beijing today, exceeded the 7.8 percent median forecast of 20 economists in a Bloomberg survey and a 6.1 percent gain in the first quarter that was the slowest in almost a decade.
China, the biggest contributor to global growth, overtook Japan as the world’s second-largest stock market by value Wednesday after a 4 trillion yuan ($585 billion) stimulus package spurred record lending and boosted share prices. The first-half expansion laid the foundation for meeting the year’s 8 percent growth target for creating jobs and maintaining social stability, the statistics bureau said today.
“China’s growth is getting back on track after being pulled down by the global export slump,” said David Cohen, an economist with Action Economics in Singapore. “It’s leading the turnaround in the global economy.”
Besides the fact that I don’t see a turnaround in the global economy, and in fact I think China will be among the last countries to escape from the effects of the global crisis, I have a small problem with the earlier claim that China is “the biggest contributor to global growth.” This is true if a country’s contribution was simply the number we get when we algebraically calculate global growth (each country’s GDP growth multiplied by its share of global GDP).
But with the largest trade surplus in the world, and remembering that the trade surplus represents negative net demand, I would argue that if you want to contribute to global growth in a world of excess supply and collapsing demand, you do so by increasing your net demand, or in this case by reducing your negative net demand. One of my friends, a government official from a neighboring Asian country, told me furiously last week that through its aggressive export policies China is simply expropriating growth from other Asian countries. I am not sure if I completely agree with him, but I suspect that he would be even more furious to hear that China was the greatest contributor to global growth.
Was China’s “surprisingly” high GDP growth numbers a big surprise? Not really. I have argued several times since last year that in fact China can achieve very high growth numbers by throwing a huge amount of resources into achieving short-term growth, but the real question is whether these policies are sustainable and whether the kind of growth they achieve is in China’s best interest.
In my opinion, these policies involve such a huge expansion in fiscal debt and especially in new bank lending that they are certainly not sustainable. Even without including the almost certain surge in future NPLs caused by the unprecedented explosion in new lending, China’s debt is much higher than people think and it is growing quickly. There is a limit to how much further the fiscal expansion and the surge in bank lending (which amounts to the same thing) can go on.
Furthermore I think the focus on investment in infrastructure and manufacturing will make much more difficult China’s ultimate transition towards an economy in which surging debt-fueled US household consumption plays a much smaller role. In addition much of this new investment is in projects with very low, or even negative, returns (and I suspect they would almost all be negative if interest rates weren’t kept so low by the PBoC). This is not a way to increase Chinese wealth.
I have discussed this too many times to go into it again, but I am worried that China’s high growth rates today can only last another year or so at best, and will result in a much more difficult transition period. This is a lot like the way Japan’s response to the collapse in US consumption after the 1987 crisis resulted in two spectacular years of credit-fueled growth followed by two very difficult decades of transition. Chinese policymakers are in the very tough position of having to choose between policies that make the transition easier but result in rising unemployment today, and policies that spur employment growth today but may create even greater excess and wasteful capacity. I am glad I don’t have to make those decisions, but I am pretty sure that if I did I would be more worried about the impact of the fiscal stimulus on China’s long-term growth.
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Businesses need confidences too. I am not talking about stock or bond holders. I am talking about management of big businesses, small business owners, and entrepreneurs. They are the driver for the economy.
People don't have confidence right now. They are waiting for signs of recovery.
The world economy will only recover when people's confidence recovers. The Chinese recovery will not pull the world out of the recession. However, it will help a few resource rich countries like Australia, Brazil and Russia. And when a dozen or so countries recover (lead by China), that will restore the confidence of ordinary people and investors. Only then, will we see a full-blown recovery.
I just read some anecdotal evidence that the Chinese citizens are continuing their spendthrift ways:
"Even more interesting is this tasty morsel (pun intended) about how the Chinese appear to be cutting back on dining, even as their government-created a stimulus firmly targeted at more internal consumption. It's a strange data point considering car sales in China are through the roof, and Intel cited Chinese consumers buying computers - yet they are pulling back on foodstuffs? Weird."
Do you have any info on the savings rate there? Is it still climbing?
Also, what is your opinion on this stat:
The average disposable income of Chinese urban dwellers is about US$1,350 annually, growing at between 10-20% each year. In rural areas, it is about a third of that figure. It will be a long while before it is possible to reach the US$5,000 figure, the point at which discretionary spending is said to take off."
And can I get your reaction to this statement:
"...most of China's banks are only solvent because of the high savings rates of its citizens. The government simply cannot afford massive withdrawals from the banks to fund a consumption-led growth."
I appreciate the insight; it may be useful at some future point. But for today, the rule is "don't fight the tape."
Without the surge in the Chinese stock market, and of course ADRs and ETFs to trade it, it would be very hard to make any money in the market here. And when all that "hot money" runs the other way (assuming Michael's hypothesis is correct), that's why we have inverse ETFs (e.g. FXP).
Can China's frugal savers help the economy? Thursday, 16 July 2009 11:15 UK
"The idea that poorer families in rural areas like the Yu's can be persuaded to spend more cash to help China survive the global downturn is problematic...
...The fear that one day they too might have to make that kind of difficult choice, is probably what drives most Chinese to save such a high proportion of their disposable income.
An illness can rob you of your ability to earn, and cripple you and your family with medical bills.
If China's leaders want families to spend more, they need to help them to worry less.
Discount schemes on home appliances or cars are persuading some to head for the shops.
Real and substantial changes to the country's welfare system would make much more of a difference but that is much more expensive and much much harder to get right."
news.bbc.co.uk/2/hi/as...
Point 1:
“Take the second reason [net capital inflows into China] first. If money flows into China for investment purposes, it must flow out of somewhere else, and that somewhere else for the most part means the global pool of dollar savings which would anyway have been available to fund the US fiscal deficit directly or indirectly.”
Wrong.
This assumes that for every investor there are basically two choices: (1) Buy US treasuries (2) invest into China.
But this is not true: I can just keep money in the bank. How will it help to finance US fiscal deficit?
Point 2:
“What about the dollars generated from the trade surplus and invested into US Treasury bonds? Won’t that help the US fund its fiscal deficit?Again the answer is no.”
Wrong. Let us assume that people in US reduce consumption of Chinese goods so that there is no trade surplus. This does not mean that US government will not need to borrow. On the contrary – the government will have to borrow more because economy will be in even worse shape. To borrow the government will have to sell treasuries, and without China who is going to buy them?
Point 3:
“In my opinion, these policies involve such a huge expansion in fiscal debt and especially in new bank lending that they are certainly not sustainable.”
China has much smaller level of debt relative to GDP than US and much higher GDP growth. Consumer lending is still very limited. US enjoyed many years of growth driven by lending, why China cannot do the same? Why credit cannot continue expanding in China for the next 5-10-15 years?
Sober realist, the savings rate is probably declining if fiscal debt were correctly counted. More importantly, the Chinese savings rate has no choice but to decline. As long as the US had very low savings rates that fed into consumption that exceeded production, China could run the opposite position, but with the rise in US savings, unless we see a real surge global investment we are going to see non-US savings decline, either via a decline in the savings rate or a decline in GDP. With Japan and China accounting for most of the increase in savings when US savings declined, I expect they will see most of the decline as US savings rise.
Roma, you would probably have been wiser to say “I disagree” rather than “wrong”. First, you have obviously assumed that once you put money in a bank it disappears from the economy forever. Strangely enough banks actually use deposits to fund investment, which directly or indirectly ends up in USG bonds. As a rule you should assume money invested continues to exist, and figure out the subsequent cashflows. Second, even a very brief familiarity with balance of payments economics would have made you realize that if Americans do not buy Chinese goods, and so China does not run a trade surplus with the US, the whole question of whether China should buy US bonds becomes moot. They cannot. Third, I am a little surprised that you think China has so much lower debt level than the US. Since total government debt in China is considered a state secret I am curious how you got your numbers – what are your sources? Perhaps you think that the official debt numbers in the US are as representative of total US debt as the official debt numbers in the China represent total Chinese government debt? And third, as to why they can’t go on borrowing for 5-10-15 years more, in 1997 Argentine government debt was lower than the US, but strangely enough they only were able to continue borrowing for three more years before defaulting. The amount of debt, the structure of the debt, and the volume of new borrowing would, I suggest, have something to do with all of that. I would suggest that when new banks loans are growing at 25% of GDP every six months, even ignoring the rise in central, provincial and municipal debt, the answer as to why they can’t continue for 3 years, let alone 15 years, should be pretty clear.
---Another article out implies the same thing you do but gives a time line of no more than a year before the SHTF.
See here:
"China Refuses to Adjust Its Economy"
by Derek Scissors, Ph.D.
"China's economic policies have shifted from being unsustainable over the very long term to being unsustainable for any more than one year. The core of this degeneration is the role of investment, but behind that investment, and making it possible, is bank lending..."
"...The PRC's response to the crisis has been to intensify pre-crisis policies. The damage caused by a global demand bubble inflated by overly loose American money is to be healed by Chinese production and asset bubbles inflated by overly loose Chinese money. Restructuring is to be put off to some indefinite future when the external situation is better. Of course, at that time, the economy will appear to be hitting on all cylinders and reform will--again--be dismissed.
Keeping one's eyes pinned to current GDP growth shows an improving Chinese economy. A broader view shows the PRC trying to drag itself and the rest of the world back along the trail that led to the current economic crisis."
On Jul 17 11:23 AM Billy Gee wrote:
> Michael, is there not the other option for the massive surplus of
> U.S. dollars held by China? -- that being the purchase of U.S. goods
> and services.
I do not think I understand the argument that all investment dollars eventually end up in USG bonds.
I think this assumes that banks invest all of their reserves into the bonds, particularly into the long term bonds.
But even if the banks did do that, I do not think that along will be sufficient to buy all of the bonds the government will have to issue.
Looking at this form a different perspective – bond prices depend on supply and demand. If I buy a bond I increase the demand and therefore contribute to the higher bond price, which in turn makes it easier for the government to borrow. The same thing happens when China buys bonds.
Regarding the second point about Chinese surplus:
“if Americans do not buy Chinese goods, and so China does not run a trade surplus with the US, the whole question of whether China should buy US bonds becomes moot. They cannot.”
This is exactly the point I was trying to make – if they do not have surplus they cannot buy US bonds and therefore cannot help to finance US fiscal deficit. The reason I made the point was because in your article you suggested that Chinese surplus will not help to finance US fiscal deficit:
“The fact that China’s reserves have surged will in no way make it easier for the US to fund und its fiscal deficit even though, as I have argued for a very long time, China has no choice but to invest these additional reserves in US Treasury bonds.”
Later you explain why:
“The US government is not borrowing for abstract reasons, but rather is borrowing in order to spend locally to generate domestic employment. The amount of borrowing it needs to generate a fixed amount of domestic jobs is correlated with the US trade deficit, because it is through the trade deficit that domestic consumption “leaks out” to create jobs abroad.”
I do not think the described correlation between the amount the government needs to borrow and the trade deficit is correct. When consumers stop spending (and this what is happening now) trade deficit goes down, tax receipts go down, and the government has to increase borrowing.
Regarding the Chinese debt level – you are correct, I do not have hard data – just knowledge that I got form reading various articles about China, so I can be wrong about this. However, I believe the following is correct: China does not have subprime loans, zero down payment mortgages, as well as multiple credit cards in every wallet. On top of that Chinese do have very high savings rate.
On Jul 17 03:29 AM Michael Pettis wrote:
> Alan, I am not giving stock advice because that involves timing.
> I expected that after the 1987 crash Japan’s economy would get into
> serious trouble, but it enjoyed another 2 years and more of bubble
> conditions and high growth before the final adjustment took place.
> I think the same may happen in China. And as one of my Columbia
> professors assured me before I became a trader, “never short a bubble.”
>
>
> Roma, you would probably have been wiser to say “I disagree” rather
> than “wrong”. First, you have obviously assumed that once you put
> money in a bank it disappears from the economy forever. Strangely
> enough banks actually use deposits to fund investment, which directly
> or indirectly ends up in USG bonds. As a rule you should assume
> money invested continues to exist, and figure out the subsequent
> cashflows. Second, even a very brief familiarity with balance of
> payments economics would have made you realize that if Americans
> do not buy Chinese goods, and so China does not run a trade surplus
> with the US, the whole question of whether China should buy US bonds
> becomes moot. They cannot. Third, I am a little surprised that
> you think China has so much lower debt level than the US. Since
> total government debt in China is considered a state secret I am
> curious how you got your numbers – what are your sources? Perhaps
> you think that the official debt numbers in the US are as representative
> of total US debt as the official debt numbers in the China represent
> total Chinese government debt? And third, as to why they can’t go
> on borrowing for 5-10-15 years more, in 1997 Argentine government
> debt was lower than the US, but strangely enough they only were able
> to continue borrowing for three more years before defaulting. The
> amount of debt, the structure of the debt, and the volume of new
> borrowing would, I suggest, have something to do with all of that.
> I would suggest that when new banks loans are growing at 25% of GDP
> every six months, even ignoring the rise in central, provincial and
> municipal debt, the answer as to why they can’t continue for 3 years,
> let alone 15 years, should be pretty clear.
Knowing China's communist regine can do anything, it will not surprise me if the China is cooking the books.
You can see the transcript of 7/17 interview on Charlie Rose website.
China should never have pegged the Yuan to the USD, and they should dismantle this ban ASAP and start buying US products immediately. The US is not infinite, the US cannot run a negative trade deficit indefinitely.
This is the reality of global economics, we have reached an inflection point..
On Jul 17 02:02 PM Tony Daltorio wrote:
> Here is another meaningless article on China penned by an American
> academic who has no practical "real world" experience........
Thank you for posting your article. I appreciate your reasoning. The cheerleaders of positive thinking will find any kind of careful reasoning that doesn't include 'see no evil, hear no evil, speak no evil, think no evil' as being flawed (usually because of an academic bias).
Expanding credit levitates the markets, filling the bubble with air and positive thinking and the cheerleading of businesses and analysts. Nearly everything rises. Once the debt-level bubble reaches the maximum extension, it implodes. Then the psychology of the people changes. The future turns black. People see disaster ahead. And they hold on to their money as an emergency life-raft.
Cheerleading doesn't work in the life-raft. No one believes the cheer-leader when everyone is in the life-raft.
During the expansion of credit phase, all that matters is 'the bottom line' because everyone is making a profit. During the contraction phase, all that matters is 'beating Street expectations' since no one is making a profit. It's all just a form of cheerleading.