China: Squeezing Out the Exporters

I am working on a fairly long entry that I will post this weekend about why a trade rebalancing and a consumption/savings rebalancing will take place in both China and the US whether or not we want it.

So much for the future. The current bad news is described in an alarming article in Wednesday’s Wall Street Journal which shows that trade tensions are continuing to rise.

European Union trade officials approved pre-emptive penalties on imports of steel pipe from China, a precedent-setting move that suggests the trading bloc is growing more protectionist in the face of the economic downturn.

Tuesday’s vote by trade officials from the EU’s 27 member states is significant, say trade experts, because they accepted an argument from steel producers – including the world’s largest by volume, ArcelorMittal – that punitive tariffs are needed to protect them from the threat of underpriced imports from China. Previously, complainants have had to prove the imports had already hurt their businesses. Trade lawyers say they expect a host of industries to ask the EU for protective tariffs in August.

I have been hearing rumblings for a while about tougher stances being taken in Europe and the US in response to the perception that China is exacerbating the global contraction in demand by increasing subsidized resources available to manufacturers, most importantly by channeling a huge increase in lending at interest rates subsidized by Chinese household consumers and socializing the risk. These new protectionist moves seems to be an expression of just this. The article goes on to say:

Basing a claim on the threat of injury “is a perfectly legal strategy, but it has simply not, until now, been used as a matter of EU policy,” says Nikolay Mizulin, a Brussels-based trade lawyer with Hogan & Hartson LLP. This case “is a sign of growing protectionism and could open the floodgates to many more industries who believe they deserve protection.”

Mr. Mizulin and other trade lawyers say they expect many industries to seek protective tariffs next month.

As I have been arguing for over a year, as unemployment around the world rises and as the necessary contraction in US net demand picks up pace, there was inevitably going to be a conflict with China as Chinese policymakers responded to the collapse in trade in the only way they could, by substantially stepping up investment. The result is that China’s trade surplus has contracted very slowly – much more slowly than the contraction in the US trade deficit – and the result was a huge squeeze on the tradable goods sectors around the world.

The fact that policymakers in Europe, China, Japan and the US seem to have no clue as to how difficult the transition for each of the other countries is likely to be, and so are doing not nearly enough to coordinate their response (in fact lecturing and finger waggling seem to the favorite forms of policy coordination), makes trade conflict almost a dead certainty. I don’t think there are necessarily any bad guys here – each country is desperately doing what it can to get itself out of this mess – but there is a lot of failed opportunity and I am pretty sure that the trade environment will continue to decline.

The problem is illustrated in two interesting recent pieces. My friend Dan Rosen, of the Rhodium Group, has a very illuminating July 17 report that shows the composition of Chinese growth in the past decade. He shows that for the past five years net exports accounted for about 10% to 15% of Chinese GDP growth, before collapsing n to minus 41% in 2009 YTD.

Until recently investment’s share of GDP growth peaked at around 65% in 2003 – a very high share by any standard – and going back the full thirty years of China’s reform period achieved an astonishing historical high of 81% in 1985. From 2005 to 2008 the investment share of GDP growth averaged around 40% – still high – and then in the first half of this year accounted for a mind-boggling 88% of this years GDP growth.

This year’s growth, in other words, is almost wholly a function of the massive increase in investment, and this increase in investment started out largely in the form of reopening production facilities and producing more “stuff”, without any significant rise in consumption. As we know, when production increases faster than consumption, either the trade surplus or inventories must rise.

On that note Xinhua published the following article on Monday:

The per capita consumption spending volume of Chinese urban residents stood at 5,979 yuan (875 U.S. dollars) in the first half of this year, up 8.9 percent year on year, the National Bureau of Statistics (NBS) announced Monday. Deducting price factors, the growth reached 10.3 percent.

The per capita disposable income of Chinese city dwellers rose 9.8 percent year on year to 8,856 yuan in the first six months. Deducting price factors, the increase reached 11.2 percent, said the NBS.

Consumption has been rising at around 9% a year for the past several years. Notice that if GDP growth slows to under 9%, the savings rate in China will decline.

The second interesting piece is put out by the Economic Policy Institute, a group I believe not noted for its commitment to free trade. It shows China’s share of the US trade deficit excluding oil. According to their numbers:

Year	2000	2001	2001	2003	2004	2005	2006	2007	2008	2009
Share of deficit	26%	27%	28%	31%	35%	40%	45%	54%	69%	83%

Perhaps as a consequence of a fiscal stimulus aimed at boosting investment and production, China’s share of the US trade deficit has grown significantly. Since the US trade deficit is shrinking quickly, this means that other exporters are getting killed. As I have argued for a while, this is not sustainable and will almost certainly cause trade tensions to erupt.

Does this mean China is behaving in a predatory way? I don’t think so. I have warned for a long time that it would be very difficult for China to make the necessary transition to a consumption-led economy quickly enough to accommodate the global adjustment taking place. Unless it is willing to see its economy collapse, there is simply no way China can reduce its negative net demand quickly enough to match the contraction in US demand and so avoid squeezing the hell out of the global tradable goods sectors. That is why policy coordination is so important, especially between China and the USD, and of course that is why I continue to be a pessimist. I do not think this policy coordination is taking place. I will write about this more later this week.

To continue the discussion of last week, we are getting more conflicting signals about policy confidence. On the one hand Bank of China seems to love this party. According to an article in today’s Bloomberg:

Bank of China Ltd., which doled out the most loans among Chinese banks in the first half, plans to keep expanding credit unless the government clamps down on the nation’s record lending boom.

The nation’s third-largest bank will maintain its original target of generating about 10 percent of China’s new loans in 2009,

Beijing-based spokesman Wang Zhaowen said by telephone yesterday. Bank of China may “fine tune” its strategy in line with any government policy changes, he said.

…Bank of China will continue to lend to 10 key industries with government policy support, including steel, shipbuilding and automobile, Wang said. About 30 percent of its loans went to those industries in the first half.

On the other hand two of the other members of the Big Four seem a lot more cautious. Today’s South China Morning Post has this article:

Mainland’s two biggest state-owned commercial banks have put a lid on their lending targets for the year, according to domestic media reports, in a move that will significantly slow overall credit growth in the second half. Industrial and Commercial Bank of China (ICBC) is aiming to issue full-year new loans of 1 trillion yuan (HK$1.3 trillion), while China Construction Bank (CCB) has set a goal of 900 billion yuan, Caijing magazine reported.

The two banks, mainland’s largest by market value, granted new loans of 825.5 billion yuan and 709 billion yuan, respectively, in the first half. If they stick to their reported targets, this would imply that ICBC would have already issued 83 per cent of its full-year lending total, while CCB would have already issued 79 per cent.

It is surprising to me that these members of the Big Four are responding so differently, at least in public. I wonder if the management of the different banks belong to different factions and so interpret the fiscal stimulus package differently. Perhaps my friend Victor Shih, who understand these things better than I do and who sometimes reads my blog might comment?

Finally the Financial Times on Monday continued the thread discussed in my Saturday post with an article called “China warns banks over asset bubbles.”

Chinese regulators on Monday ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming. The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier.

…Beijing’s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation. regulators are now concerned that too much money is being lent by the state-controlled banks and the country’s tentative economic rebound could come at the cost of a stable financial system.

In statements published last week, Wu Xiaoling, who recently retired as deputy governor of the central bank, warned new lending this year would probably reach as high as Rmb12,000bn, a staggering increase of 40 per cent of the entire stock of outstanding loans in just one year.

…Ms Wu hinted Beijing may soon raise the amount of money banks must hold on deposit with the central bank, marking a change of policy from last year when it aggressively slashed the reserve requirement ratio and interest rates.

The central bank has also ordered 10 banks, including Bank of China, to buy Rmb100bn worth of central bank notes with a maturity of one year and a return of just 1.5 per cent, according to Chinese media reports. This move is interpreted as a warning to banks that have been the most active lenders that they should now start to rein in their excessive behaviour.

Comments

[James Lewis:]

Hello Micheal,

Liquidity in the system has got out of control here in China. Property (both new and second hand) is being hoarded and there seems to be increases in price almost weekly. Also the IPO market as of late has been unbelievably over subscribed. Reminds me of Nasdaq days.

This latest move seems like a government induced policy initiative.
Reduce lending at banks where the lending is going into asset appreciation. But keep the window open to keep credit flowing to government projects or areas of the economy they want to stimulate.It also removes 'inflation/appreciation expectations of assets'. from investors, As can be seen by market falling.

The Bank Of China is China's government policy bank, so by keeping loans flowing here. The government can easily implement financing any of their projects. But at the same time cut back of speculative loans (which have probably emanated from ICBC, BBC the most)

During US-China dialogue. China said that it would expand fiscally until America stopped its fiscal plans. This to me seemed to be a direct nodd that they would continue stimulating the economy.

Probably quite a smart move - maybe they have learnt from Japan in 1987-1989. Question is, is there so much liquidity in the system that they will not be able to slow down the moving avalanche.

Never boring here in China..

Jul 29 12:26 PM

[whidbey:]

You say: "..it would be very difficult for China to make the necessary transition to a consumption-led economy quickly enough to accommodate the global adjustment taking place."

Everything I see from Hong Kong says your are correct about the sole alternative China has for growth of any kind. Moreover, the political stability of the Chinese State turns on not just more consumption, but a redistribution of the largess to the low income groups of which there are a surfeit.

Can China make the transition in time to avoid political problems? I think it unlikely that they have the time to make substantial changes. I am constantly shocked that China sees little advantage to attempting a clean-up of its air and water as employment measure that might prime the economic pump and decrease the population pressure on basic resources. As it is the Chinese are as blind as is the US an EU about attempting to recreate the past. It Won't work and it may even be painfully destabilizing to the regimes, all of them. We are moving to a decade of pain.

Jul 29 01:52 PM

[Susan Weerts:]

ICBC and CCB are considered more risky and have rather loose lending standards among the Big 4s. Bank of China, even though sometimes called the dinosaur, is the flagship for the Chinese monetary policy. The signals indicted that China will continue its monetary expansion policy to simulate its economics. However, it will do so more selectively in the future. It tries to reign in the runaway lending practices and also leave a door open in case of needing further monetary expansion. This might be the reason why “these members of the Big Four are responding so differently, at least in public”.

In addition, China will start to sell government bonds to mop up the excess liquidity. Not sure bond-selling is this month. China tries to emulate the Fed practices to be creative in order to avoid an interest hike, which could stymie the fragile recovery.

Jul 29 09:57 PM

[Billy Gee:]

Michael, I enjoy reading your articles but I must ask again why can't China's reserve of U.S. dollars be used to purchase U.S. goods and services? The high velocity of money will be stimulus for the world economy and U.S. employment and not "sterilized" for investment purposes by the Chinese government.

Jul 30 12:15 PM

[Duude:]

I have to say that I believe your statement that it would be 'difficult' for China to make a transition to a consumption-led economy is more than an understatement.
While China's economy is seen now as capitalist, the government still has a large block of government-run companies that are inefficient socialist landmarks from China's past. The government wants to close these relics down in favor of private run business but can't because of the civil unrest that would result with the great loss of jobs. Additionally, they still have over 400 million unemployed largely living in rural China. China has quality universities but only 3% of the population can attend due to lack of space. The government doesn't offer any real safety net support like social security for the masses, so saving will always be a way of life for most families. The younger generations take care of their parents. Add all that together with the fact that they've had a decades long government birth policy of one child per couple and a societal practice to abort the girls and you have a demographic nightmare. China may never be a consumer-led economy.

Jul 30 12:59 PM

[Tesa:]

I agree with the author. Pushing unsustainable growth into markets that can not absorb it will eventually fail if it hasn't already whether its intentional or due to lack of choice

The heavy stimulus for a country like china that was way too hot with unsustainable growth just a year ago is going to make it harder for them to revamp their markets when they actually will need it also.

One thing that is helping them is their low population growth so their unemployment rates will be more bounded that in other countries with higher population growth in the same boat.

Jul 30 02:08 PM

[Michael Clark:]

Protectionism and economic contraction go together. Contraction is retraction, pulling back to the local. One's vision contracts. Nationalism replaces globalism. Dangerous? Yes. But inevitable.

As the crash is inherent in debt expansion, protectionism is inherent in debt contraction. During debt expansion, the future appears bright and full of opportunity: individuals expand, and their vision expands. During the debt contraction, the future turns black, with limited opportunity; individuals get small; they cling to their money, seeing no hope to expand their wealth through investment...so they save.

Market experts keeping analyzing the collapse throught he rational filter they believe rules the world. The rational filter rules the world during the expansion; bur a kind of irrationality rules the world during the contraction (that is, emotion takes the place of mentality, fear takes the place of hope).

Jul 30 09:59 PM

[China Interest:]

Here is how I see it using the game of chess for illustration purposes. Lets say the USA and China are the two players in this geopolitical chess game. Up to more recent times, China appeared to have the definite upperhand. They had taken several chess pieces and frankly were feeling rather good but then all of a sudden the game took a profound flip on a brilliant (or perhaps even dumb luck) tactic move by the USA. China was backed into a check position that if the USA were to keep their chess play in action might just become a chessmate. How might you ask this?

Well China has amassed in excess of $2 trillion reserves (with say $1.5 trillion in USA denomination) but appear to finally have come to realize (really too late) that this comes at a price. They have only two places to move their queen (in chess). Either they accumulate more US reserves (which will depreciate in value) or they accept a sharp appreciation of the RMB. USA have their chess pieces positioned to unless the scenario dramatically changes (which is unlikely for quite some time) to put the pressure on China by creating money supply by issuing TBs. Thus China is backed into the corner - it either accepts this and continues to amass depreciating USA denominated reserves and matching the money supply increases or lets its currency appreciate. China has already desperately tried to get out of the corner with several moves to no avail. For instance, currency swaps with other countries short on cash; resource aquisitions; and acquiring foreign assets - but this comes of little help. Currency swaps are small denominated amounts because frankly no one wants to have (non-tradeable) RMB; the massive resource accumulation that would be needed doesn't make a whole lot of sense; and China has found out that there is liittle to no welcome mat in the world for Chinese acquisitions of their domestic assets (by State Owned Enterprises).

So, here we are now. China is trying to keep their currency pegged to the US dollar and subsidies their industries (via low interest rates, input costs, etc..) while needing to create money supply and buy US treasury bills (to keep their currency from appreciating). The money suppy creation in China has esculated the asset bubbles (i.e., property and stock market) in the economy to very dangerous levels without creating any sustainable increase in domestic consumption. It is highly unlikely that consumption will rapidly increase under the current scenario because assets such as property are well out of reach to all but the most rich people in China (who by the way already own several properties that sit empty). Therefore, the average urban consumer saves even more in the 1st and 2nd tier cities.

From how I see it then, China is forced to succumb to either appreciating their currency or put their economy in dire consequences under the current projectory. So long as the US consumers are saving and inflation remains relatatively low in the USA (which seems likely given the unemployment figures) China has but only two choices. So far they have chosen jobs now rather than the painful but necessary transition to a sustainable consumer society. This current situation only creates a real risk of collapse in the economy when it all unravels (excess NPLs, bubble deflation, etc..) and it will only get worse the longer it is delayed.

On a final note - in my opinion - while this is problem for China it could be an opportunity for other emerging markets (in particular Mexico). They perhaps will finally have a level playing field to compete for the US market in the near future. If China is forced to appreciate their currency - they might regain a competitive (fair) edge.

The ironic part is that the RMB currency is probably much less misaligned with the US dollar in the current scheme of things (it might even be properly priced now) but because of the massive subsidies that the Chinese firms receive (via loan structure, input costs) will be forced to appreciate.

Jul 30 11:37 PM

[Sober Realist:]

China interest,
Your comment held my interest all the way through.One thing I would add is that I believe China's current political/economic system inhibits it from really developing its internal consumption market to any great degree. Read "U.S.-China Trade: Do's and Don'ts for Congress" by Derek Scissors to get an idea just how regulated and controlled China's market is.

Jul 31 05:39 AM

[China Interest:]

Thanks. Interesting article with several good points made. Although I don't think the soft approach will be adequate. Needs a more direct push to get tangible results. The time for waiting for things to change gradually didn't work.

On Jul 31 05:39 AM Sober Realist wrote:

> China interest,
> Your comment held my interest all the way through.One thing I would
> add is that I believe China's current political/economic system inhibits
> it from really developing its internal consumption market to any
> great degree. Read "U.S.-China Trade: Do's and Don'ts for Congress"
> by Derek Scissors to get an idea just how regulated and controlled
> China's market is.

Aug 01 05:30 AM

[Sober Realist:]

By "direct push", what do you have in mind?


On Aug 01 05:30 AM China Interest wrote:

> Thanks. Interesting article with several good points made. Although
> I don't think the soft approach will be adequate. Needs a more direct
> push to get tangible results. The time for waiting for things to
> change gradually didn't work.
>
> On Jul 31 05:39 AM Sober Realist wrote:

Aug 01 05:03 PM

[China Interest:]

Actually what I mean is that the US will have to keep their check position in play. They should also perhaps re-enforce the position by keeping the pressure on through tactical negotiations and WTO directives. If the check position doesn't ultimately push China to take a more long-term position beneficial to all then the US will be forced to use its checkmate.

Andy Xie in his most recent article touches on this scenario:. english.caijing.com.cn...

Once the bubbles are highly inflated (and if nothing else causes them to burst) - the US at its convenience - could strengthen the dollar using higher interest rates - pulling out money (liquidity) from China and triggering a collapse. This of course would not be what the US would want but if nothing else prevails - then the US would have to do what is in its best interests.

On Aug 01 05:03 PM Sober Realist wrote:

> By "direct push", what do you have in mind?

Aug 05 03:29 AM