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.
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
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.
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.