I had coffee with Philip Johnson, former Silicon Valley Bank executive who is now a Beijing-based financial adviser to start-up companies in China. On his visit to the US, one of the most frequent questions people asked him is “How is China affected by the global financial crisis?“ I’ve had similar questions myself: How badly will China be affected? Does the US need China more, or does China need the US more?
When I was in Hong Kong, I asked some of these questions of my Hong Kong based uncle who is in the apparel manufacturing business. He responded that China would be deeply affected by the crisis, maybe even more than Western countries. He then provided a simple, easy to understand framework that I then double-checked against the writings of Michael Pettis, Nouriel Roubini, Brad Setser, and other economists on the Web. Based on this research, I’ve sadly concluded that my uncle is right. Instead of coming to the rescue of the global economy, China will suffer more deeply from the crisis than the US or Europe.
Uncle’s simple but powerful framework: China is supported by a three-legged stool, but two legs are now broken
China’s economic growth is supported by three primary legs:
- export-led growth
- real property growth
- government spending
The first leg is clearly broken. US and European consumers can no longer consume at the debt-supported levels they have at the past. The second leg is also broken, in part because of the first. Rising unemployment, declining Chinese consumer confidence, and significant price declines in real property have slowed sales. So what is left is government spending. Government plays a more significant role in the Chinese economy than Western economies, but can increased government spending make up for the other legs of the stool?
The consensus among economists is “no.” And even more worrying, is the belief that Chinese government policy response could make the global financial crisis worse.
Roubini: The Rising Risk of a Hard Landing for China
Nouriel Roubini, the NYU economics professor that predicted many elements of this global meltdown, writes (at RGEMonitor, reprinted with commentary at JapanFocus) that there is strong evidence that China is facing a hard landing. Roubini points out that a hard landing actually still means a 5-6% growth rate. 9-10% growth is needed to absorb 24 mm new entrants into the labor market, including 12-14 mm poor rural farmers. A 5-6% growth rate means a significant risk to social stability and continued political control, so its clear that Chinese leaders are in a tough place. John Pomfret concurs.
Unfortunately, according to Roubini, China is still an export-led economy without the ability to crank up domestic consumption to absorb its domestic production capability. Roubini:
Note that China is an economy is structurally dependent on exports: net exports (or the trade balance surplus) are close to 12% of GDP (up from 2% earlier in the decade) and exports represent about 40% of GDP. Real investment in China is about 45% of GDP and, leaving aside the part of this investment that is housing and infrastructure spending, about half of this capex spending goes towards the production of new capital goods that produces more exportable goods. So, with the sum of exports and investment representing about 80% of GDP, most of Chinese aggregate demand depends on its ability to sustain an export based economic growth.
Because China’s GDP growth is dependent on exports, when exports go away, there is no domestic consumption to keep fueling growth. Which means that factories need to get shut down and people laid off.
Financial Times: China needs a true change of course
The Financial Times, on 11/10, published an editorial that applauded China for cutting interest rates and announcing the large RMB4 trillion stimulus package. But at the same time, the paper criticized Chinese policy makers for doing too little, too late:
China’s growth to date has been phenomenal, but it was based on exports and investment, at the expense of consumption. China almost aimed to be a supersized South Korea: in 2005, capital investment made up more than half of China’s gross domestic product. The capital-intensity of its growth also meant profits grew strongly as a share of GDP. But employment growth has slowed since the 1980s, so workers have gained small benefit.
Undervalued RMB and a lack of domestic safety net have caused Chinese households and companies to save. This “Supersized Korea” inadvertently created a “savings glut” which poured Asian savings into Western countries, flooding the markets with cheap capital.
Setser: Unhelpful – China never did what it needed to do.
According to Brad Setser, Chinese policy makers knew that China’s “Supersized Korea” strategy needed to change and that the strategy was not sustainable on a global level:
…it also turned out that China never really carried through on its 2004 and 2005 and 2006 and even 2007 rhetoric that it planned to rebalance its economy.
Back in 2004 China’s leaders generally got the benefit of the doubt…most observers expected that China’s leaders would be able to deliver when they announced their plan to shift the basis of China’s growth away from exports and investment. Chinese policy makers generally had a pretty good track record of doing what they said they would do.
But four years after China indicated that it wanted to rebalance its economy, its economy looks more unbalanced than ever – its current account surplus is far far larger than in 2004, and investment accounts for a higher share of GDP than in 2004…
The underlying problem we are faced with is a global shortfall in demand. Because China did not allow its currency to appreciate when times were good, and did not stimulate domestic consumption, China can only help soak up their own production overcapacity through government spending.
Michael Pettis – China Financial Markets
11/20 – Rising unemployment increases the pressure for misguided trade policies
11/16 – Would a trade war help solve the problem of excess capacity?
11/13 – Can Smoot-Hawley return in a wholly different guise
Michael Pettis, professor at Peking University’s Guanghua School of Management, has been the premier blogger on China’s economy and financial markets. Earlier this year we followed his writings on RMB appreciation and the need for a one-time maxi-revaluation of the RMB. Obviously, things have changed.
He has written on a few themes recently, influenced in part on his reading up on the Great Depression. Here are some of the key insights:
1. Unemployment is putting a lot of pressure on Chinese policy makers–potentially to do counterproductive things like export subsidies or even RMB depreciation.
The employment outlook is looking worse and worse. According to a Financial Times report, the official urban unemployment rate is only 4% but this excludes all rural migrants to the cities. According to Pettis, most people believe official urban employment rate significantly understates real urban unemployment, and the real level could be as high as 10-11%.
The key to social stability is adequate employment growth. That growth either has to be fueled by maintaining exports, or increasing domestic consumption. But there are important reasons why domestic consumption won’t increase. For one, the lack of safety nets in health and elder care cause Chinese households to save in order to self-insure their risks for illness or health care emergencies.
The “super-sized Korea” response would be to stimulate exports, depreciate the RMB, and try to get the export machine humming again. But China is simply too big to play this game. According to Pettis:
Export subsidies, depreciating RMB – all of this might seem to make sense if you look at China as divorced from the global balance of payments system. These measures to boost exports are, after all, pretty standard ways of increasing production.
But if you think of China’s role within the global balance of payments, it seems to me that this is little more that a form of Smoot-Hawley-with-Chinese-characteristics. Global demand is slowing, just as it did in the 1930s, and China as the leading source of global overcapacity is trying to address its global demand problem by shifting the burden abroad.
But it seems quite plausible that Chinese policymakers will do everything necessary to reduce unemployment, reduce social unrest, and maintain political legitimacy. And shifting the problems abroad might work for a while until and unless Western countries respond with trade barriers and protectionism.
2. The exporting countries that have more productive capacity than domestic consumption (the “current account surplus” countries like China) will bear the most pain in the recession.
Most people are comparing the United States of today to the United States of the 1930s. But Pettis argues that this is not the right analogy. The correct analogy is between the US of the 1930s and China of today. In both cases, each country was the source of massive productive overcapacity, and export-led growth. In both cases, domestic consumption was not sufficient to soak up domestic production. And in the case of Smoot-Hawley, US policy makers responded with protectionism because European demand for US goods crashed by 70% in 3 years. And ultimately, the US bore the brunt of the pain.
Today it is China who is exporting overcapacity and it is the US who is consuming too much, fed by Chinese financing. With the collapse of bank intermediation US households and businesses are cutting consumption and raising savings. This is a necessary adjustment. Calling on the US government to engage in massive fiscal expansion to replace lost private demand is crazy. It means that we should continue the current game that has led us into so much trouble, but instead of having US over-consumption and rising debt at the private level we must have it at the public level.
If Keynes were around today he would probably make the same point he did over 60 years ago. Demand must be created by the current account surplus countries, which have, to date, relied on net exports to protect themselves from the consequence of their overcapacity. They must force demand up quickly in order to close the gap, and since expecting private consumption to rise quickly enough is unrealistic, it has to be public consumption – a large fiscal deficit.
Just as the US stupidly tried to increase its ability to dump capacity abroad by creating import restrictions (which has the effect of further expanding domestic production), China seems to be hoping for the same thing by increasing export rebates and slowing the currency appreciation (there is even increasing talk of depreciation).
The responsibility is for the Chinese government to close the gap in Chinese production and Chinese consumption, and that means public spending since private consumption is not going to rise fast enough. Lets hope that Smoot-Hawley with Chinese characteristics does not come to pass.
3. The only way out is massive fiscal stimulus from the “current account surplus” countries like China
China’s RMB4 trillion stimulus package is a good step in the right direction. And the provinces have put together a wish list of projects totalling RMB 10 trillion or more, according to AP and CCTV (h/t China Digital Times). But its not clear that all of these projects are actually incremental projects and many were already planned. This is headed in the right direction but there seems to be a lot of skepticism that fiscal stimulus in China, where graft and corruption could soak up some of the money, will be successful.
Morgan Stanley: Further Growth Forecast Downgrade amid Deeper Global Recession
Morgan Stanley also indirectly confirms my uncle’s three legged stool framework. According to Morgan Stanley, 45% of China’s exports go to US, Europe, and Japan. And 30% of total fixed-asset investment goes into export-oriented manufacturing. So the first leg is highly dependent on the developed economies. Secondly, consumer confidence in the property sector is damaged, with people holding back. Slow property sales will lead to slow investment. Finally, fiscal stimulus is the third leg.
According the Morgan Stanley, likely policy response will be:
- more base-interest rate cuts
- more bond issuances for infrastructure e.g. railway
- reduced taxes
- boosting property sector
- energy price normalization
- agricultural support to farmers
Biggest downside risk is collapse in real estate investment.
My conclusion
Here’s my conclusions:
- China’s equity markets could fall further. Many listed companies are dependent on real property or export markets.
- China’s property markets could fall further. Not only are private individuals freezing up, but the government is also making significant investments in public housing. That might have some effect on price levels for private housing. To early to buy.
- RMB will neither appreciate or depreciate. It will likely hold the dollar peg at the current level, for quite some time.
- China’s labor markets will get more attractive to employers, but less attractive for employees and job seekers. There will be a large number of unemployed new graduates. There is risk of social unrest.
- Freedom of speech and media will likely be curtailed further in the future as the risk of social unrest increases.
In summary, the world doesn’t look as wonderful as it once did.
Okay, I’ll start it off with something my uncle loves to ask:
What was the argument for Ben Bernake raising interest rates again?
Big Ben saw an inflationary spiral happening, with real property prices and commodity prices going crazy. It made sense to deflate the bubble but the problem is the lack of regulation on the shadow banking system. Probably what should have happened was regulation of the shadow banking system first to bring that into line but perhaps there was too much deregulation faith in the ruling Republicans to allow that to happen without a real crisis. Well, now we have that crisis.
And my uncle would then reply:
Why deflate the bubble? Everyone was happy.
I think your completely wrong.
Here’s an analogy for you. There are 5 on a deserted island. To create a functioning society, each one is assigned tasks. 4 of the 5 people (the asians) work: 1 goes and finds fish, another collects berries and veggies, another hunts and the last one collects firewood and cooks. The 1 person left (the American) – his job is to eat and consume.
If and when this consumer is kicked off the island, the other 4 people can work less and eat more.
In the short term, Chinese unemployment will grow and the exports will stagnate. But in the long term when the USD collapses under inflation after printing trillions of new money, the RMB will naturally appreciate and the Chinese will consume more.
Just look at all of the currencies right now. Everyone is rushing to the dollar right now while the Euro, Pound, ect. ect. are all getting hit hard. Still the Yen and the RMB are keeping pace with the dollar.
Who are you replying to?
No question that China’s long term prospects are good. But there will be a long painful transition period where China’s domestic economy will development in order to absorb China’s productive capacity. Its hard for me to fathom the incredible income inequality and the resultant risks around unstability caused by 1 billion farmers and unhappy urban migrants. All I’m saying is that the US consumer shutting off the overconsumption binge and starting to save will hurt the Chinese economy more than the US economy. Not sure what will happen with the USD, maybe nothing in the short term. In the long term, hyperinflation risks are there but depends on whether policymakers can soak up all the excess money they have pumped into the system. Right now they are priming the pump with money supply because money velocity has dropped and people are hoarding cash. Its a dangerous game but what else are you going to do? Like Pettis said, I think there are big debates going on about whether or not to allow the RMB to appreciate or depreciate. I’d leave it pegged as long as possible and only drop off the peg if there were signs of hyperinflation. But that’s tomorrow’s problem, not today’s.
Is that a joke? Nobody wants to be carrying any USD anymore… nobody OUTSIDE the US that is… so for you to be saying that, you must actually be in the US. 4 years ago, the USD:RMB exchange rate was 1:8.2 and now it’s 1:6.4 and depreciating all the time. Everyone wants Euros or RMB right now.
I think you analogy is not quite right and missing this important data-point: The first Chinese national is paid $125-million dollars as are the remaining four Chinese nationals. This $500-million sum represents America’s trade deficit with China. When the American is kicked off the island or leaves for home, his $500-million goes along with him and when interest rates rise, the dollar gets stronger and the bond payments of 1% deflate away.
In addition to reducing demand for goods from western countries, Chinese exports have to fight against rising cost in China as well: wages, real estates, raw material in addition to reduced local resources: clean water, coal (mines closing), and rising local consumer consumption of local resources: food, water, energy.
What makes things worse: lack of safety net for people hurt by the downturn.
The problem in China is that the government is too reliant on administrative controls and SOEs, just at a time when the real saviors of the economy would be SMEs. Unfortunately, the state-owned banks were too reliant on lending to RE developers and continue to refuse to lend to SMEs. The SOEs are good for commodity imports and those items which drive really massive production capacity, which is why China has suffered to from too much capacity to date. The excess capacity is a direct result of Chinese banks lending policy, and government policy, which favors manufacturing (with its high capex requirements) while starving the service sector and startups. Right to this day, the party and government lack KPIs to measure the value of service sector businesses. This is a weakness inherited from Marx, who looked at capitalism only in terms of manufacture, and was unable to understand the service sector.
Unfortunately, the Chinese government is too wedded to the idea of big strategic industries, and does not even show any signs of wanting to lend to Chinese SMEs. This means that the SMEs will be capital-starved, just at the moment China needs them most to pull the economy out of this global super-funk. It also means that Chinese manufacturers, for the most part, will be stuck at the low-end of the value chain and will not do so well working up the value-added chain to more specialized manufacture as the Germans have. Chinese manufacturers will survive though because they they can import raw materials at volumes which no one else can compare to, keeping their costs low.
Failure to make this transition will mean that China will not be able to make the leap to developed nation status before its current generation of single children start to make it into their empty-nest retirement years, and also means that China’s most talented will continue to seek to emigrate to the US, Canada and Australia, even those economies will be severely depressed from this current economic shakeout.
It turns out that the greatest enemy of Chinese economic development and failure to make it to developed nation status are not so much western policies and conspiracies, so much as its own government’s reluctance to expand market policy to lending practices for its own SMEs, and let China’s own private sector grow.
It all depends on how you measure the damage. If China can come out of this crisis relatively stronger, with a healthier and more robust economy, I’d say China gains more than the US. It’s time for China to rethink the foundation of its economy, and I don’t regret at all even if all the three legs you mentioned are hampered. They are simple the wrong legs to support a healthy economy.
We are talking about a shrinking global economy in which all economies will shrink. The question of growth does not enter the equation. Instead, it is all about shrinking _less_ and being in a better position for growth afterwards.
The reality of China is still that it is ruled by a party which controls the government and military in order to maintain overall social control and stability. The great question is which is better able to handle the challenge of adjustment to this economic tsunami: a country with a relatively open society like the US, or a society dominated by one party, like China’s?
I honestly can’t say I know which system is better able to cope with this situation. I think there is a theme that the US and China are converging, with the US abandoning its free market religion to embrace state intervention (as the lender, investor, and consumer of last resort) and China continues to move toward market liberalization (e.g. rural land reform, finance). It seems clear to me that as open and democratic as the US is, our government can invoke “war powers” relatively quickly and easily as demonstrated by Paulson’s TARP authorization and the independent Fed. I don’t think everyday Americans really had that much say over it…maybe they were able to get the House Republicans to cause problems for 1 vote but in fact most Americans just weren’t educated enough about the situation to really be able to form an effective movement to advocate for some position or another. No question China’s government has a more difficult road ahead to manage, and its not clear how they would be able to do that without “war powers” (which I suppose they have had and continue to have since 1949).
The trouble with the “war powers” which Paulson has used is that his measures have not proven effective in stemming the problem. In China’s case, the party has absolute power over anything it wants to exercise power over. It is just that since the reforms started in 1978, it has chosen to withdraw from large chunks of society, letting Chinese make their own decisions re employment, education, etc.
In both China and the US, I expect a stronger trend to localization of power. As much as they would like to, Beijing and Washington DC only have limited effect in this crisis. Instead, local governments and institutions will step in to fill the gap.
I doubt that the Chinese economy will be more affected that the US. This is a financial crisis, in addition to an economic one, and the US is much more reliant on finance that the Chinese economy. Carl Jung Types (http://carljungtypes.com/) has a great articles on the psychology of the crisis, and possibly the solution ;)
Ummmm… This crisis is much more than a psychological crisis and study in the psychology of crowds and bubbles. It is a banking and financial crisis all rolled into one. As for your statement that the US is more reliant on finance than China, what happens when China accepts US finance for its own exports and economic development? At that point, it becomes much more than a simple US crisis with some international implications, it becomes a full-blown international crisis.
I think this author just makes this stuff up, because even a minimum amount of research shows how full of it this guy really is. As of January 2008, domestic consumption has been the #1 driver of economic growth in China. Direct investment is #2 and exports are #3. However, the author fails to even mention this. In fact, his three-legged stool model, which is the basis for his entire argument, is fundamentally flawed.
Drivers of economic growth in China
Domestic consumption: 39%
Investment: 38%
Exports: 23%
Either this author has no idea what he is talking about, or he is intentionally misleading his readers.
Blake: The author did mention his sources: his HK-based uncle and then he checked against the writings of Michael Pettis, Nouriel Roubini and Brad Setser. Now what are your sources for your Jan. 2008 stats, which you have not mentioned?
Let’s just assume that your statement that domestic consumption takes up 39% of the overall economy is correct. Well, it doesn’t do you a lot of good if people are not spending because they read the papers and watch the news. And I can tell you that the factories in Guangdong and other provinces are laying off workers and shutting down, and that this trend is spreading throughout the rest of the country. If you are interested in following the developments, you can get something from this layoff map (in Chinese) hosted by Netease.
http://go.money.163.com/layoff/index_1.html
I don’t think that I have to tell you that investments have taken a dive too, and this situation has not been helped by the fall of the yuan this week.
Instead of weakening the author’s argument, you have strengthened it because the three legs of the stool, consumption, investment and exports are all hit badly by this recession/depression. The author said that two out of three legs are in bad shape; you have shown that all three are in bad shape. You have made the mistake of thinking that the size of the individual pie slice matters when it is the aggregate of the pie slices which is important.
Peanut Gallery: *winces*
Wasn’t the term peanut gallery originally derisive towards African-Americans?
Anyways, there’s this Economist article on the Chinese economy. I think this is what Blake is referring to, it insisted that the Chinese economy was relatively decoupled and was resistant to a global slowdown. As a percentage of economic growth, exports only accounted for only ~33%, while domestic consumption accounted for the other ~67%.
http://www.economist.com/displayStory.cfm?story_id=10429271
@Blake,
Hey sorry I haven’t responded earlier. Yes I have no idea what I’m talking about. But I’m right and you’re wrong. BTW, I’m not “full if it” LOL.
New York Times article: consumer spending is 35% of total GDP, but that has been declining since the 1980s. Now we need them to reverse the trend. On the other hand, US consume spending powers more than 2/3 of US GDP. So China is much more dependent on other factors.
And yes, capital investment is an important part of the economy. But most private capital investment has been to support a export-led economy.
Since I wrote this post, it seems that people far smarter than I am have come to the conclusion that China is not going to “save the world.” I’m curious if you’ve changed your opinion and can offer some other citations to support your original point that China is really not in trouble in this economic crisis.
Thanks for the comment.
This is indeed a very good article, expressed the concern from not only SMEs, but also the mass public and those who really know what a economy is.
Also, I’d suggest that the title of this article can be slightly changed to ‘GLobal financial crisi will hurt China much more than the US –If Chinese policy makers failed to build up consumption confidence’.
I have read all the previous comments, it seems some people just don’t understand what domestic consumption is based of — money and extra money. So say, i have 800 RMB income pre month, but because i live in a large city, 80% of the income will then be used to pay off bills (food, energy), and only the rest 20% money will be used on shopping stuffs. But due to the issues of our social seurity system, i have to save some money for go to hospital and pay the medical bills; and if i have parents i need to look after and child i need to feed, then those factors will further limited my spending on market than on education, and mostly, the medical bills.
fortunately, there are some rich guys in China too. They have the enormous buying power and can spend 170k RMB in a day without any problem — they are the reason of our good domestic consumption figures. But the problem is they are way too few, so that they can only spend big money on a few big brand, rather than contribute anything real to most of Chinese manufactories.
Numbers in China sometimes is only a trick, a politic stunt to misleading the mass public. In fact, most people in China still find life is tough, and can’t find the GDP number can actually do anything to them. So what our government needs to do is to ease the pressure of them, the real mass public, and not some rich guys.
The real Chinese mass public can’t afford the property market while they are still finding ways to survive; maybe the CEOs and employees of SOE can but not the ones from SME. But knowing that, Chinese SME has contributed 80% job for Chinese society and 50% tax income for government treasury.
Surely the SOE won’t go bankrupt, surely they won’t cut their employees; because they hold every good business in China, you know, monopoly. In another word, Chinese SOE dont do buiness, they do politics. While for SMEs, they do real business, they face real finance matter and they contribute real things, but they still live a low-life. —as one Chinese economist once said: a small business wont survive more than 3 years if its motto is fair-play.
You make several really interesting points.
1. That SMEs need to be supported in China and become the growth engine for China. These SMEs need to serve domestic demand not just being export-oriented as they have in the past. Paul Denlinger has spoken about the lack of financing for SMEs in China as a big problem, and that big SOEs get all the advantages. But that is not enough to build a robust economy.
2. The issue is consumer confidence, and people are being smart to conserve their cash to handle emergencies, medical costs, retirement, and elder care. It seems that this will not change for quite a while.
By consider all the information i provide about mass public and their life provider, the SMEs, you will then see why the crsis will hurt China alot, and maybe why elliot was keeping talking about increasing domestic consumption, not just a number but the real content of it.
However, there are still billions people in China, a huge consumption market that no one will not agree. So that if our policy makers can address the issues people are concering as above and put some real solution on those, such as to help transforming the export based factories to feed domestic market by supporting fund, as well as to build up markets for people to trade, while put big money on social security system to enchance consumers’ confidence and fund that will help new graduates to create opportunities, then there will be a fat chance for us to escape from the crisis.
sorry for my bad english:)
The greatest asset of this article is the use of your uncle’s wise and practical explanation as the premise, then supported by academic theory of economist. Over the last few months since you wrote this, the effects of a Chinese economic Super-Typhoon has surely reared its ugly head. I have been attempting to explain China’s fragile economy for the last year and a half now and I think your article presents a very logical framework, which will help me to better accomplish this. I have already emailed this link to many friends.
Chris, thanks for the comment and encouragement. Yes it usually feels nice to be right but in this case it is a pretty painful feeling instead as the world slowly grinds to a halt.
everything will be o.k with china
Dear Elliott N
I have read the article and all the comments and I’m really interested by the subject.
I am writing my thesis on the decoupling hypothesis under the financial crisis and I would like to know a little more about the framework your uncle spoke you about.
Would it be possible to explain me more about that and how he came to the framework you are talking about?
Would you also be able to recommend me websites or books where I can find more information about this subject?
Thanks in advance
Kind regards
Marie
gee, in hindsight this guy’s predictions are all wrong :(
As a Chinese girl, I can hardly agree with your opinion.
First, China’s economy doesn’t rely on exporting as much as you thought. About 10 million worker lost their jobs during the financial crisis during 2008 and 2009. But thing about the population in China. That’s just a minority of whole population. Some of products didn’t export to foreign countries. But in the end, those products were consumed by Chinese people with the help of the government.
Second, as my Professor said, the financial crisis in 2008 didn’t occour in China actually. As the financial market in China is not a totally free market, foreign capitals cannot go in or out of the Chinese market freely. So the crisis didn’t have any serious impact on the Chinese financial market and the Chinese financial system ran as usual during the crisis. In fact, there is no financial crisis in China. The Chinese exporting industry was just suffering from the consequense of the financial crisis indirectly.
Third, your opinion is deeply influenced by your uncle living in Hongkong. But the situation in Hongkong is really different from that of China. Hongkong economy is heavily rely on exporting while China’s economy is not. Hongkong is a place where capitals will have the least stricts to enter or exit. So the financial crisis did slow down the growth in Hongkong.