Has the Great Rebalancing already started?
The following was written a month ago for my newsletter but because of the virus problem I had on my site I wasn’t able to post it until today.
China’s official GDP growth rate has fallen sharply – on Friday Beijing announced that GDP growth for the second quarter of 2012 was a lower-than-expected 7.6% year on year, the lowest level since 2009 and well below the 8.1% generated in the first quarter. This implies of course that quarterly growth is substantially below 7.6%. Industrial production was also much lower than expected, at 9.5% year on year. In fact China’s real GDP growth may have been even lower than the official numbers. This is certainly what electricity consumption numbers, which have been flat, imply, and there have been rumors all year of businesses being advised by local governments to exaggerate their revenue growth numbers in order to provide a better picture of the economy.
Some economists are arguing that flat electricity consumption is consistent with 7.6% GDP growth because of pressure on Chinese businesses to improve energy efficiency, but this is a little hard to believe. That “pressure” has been there almost as long as I have been in China (over ten years) and it would be startling if only now did it have an impact, especially with such a huge impact occurring so suddenly. Adding to the slow economic growth, the country may be tipping into deflation. Last Monday the National Bureau of Statistics released the following inflation data:
In June, the consumer price index (CPI) went up by 2.2 percent year-on-year. The prices grew by 2.2 percent in cities areas and 2.0 percent in rural areas. The food prices went up by 3.8 percent, while the non-food prices increased by 1.4 percent. The prices of consumer goods went up by 2.3 percent and the prices of services grew by 1.9 percent. In the first half of this year, the overall consumer prices were up by 3.3 percent over the same period of previous year.
In June, the month-on-month change of consumer prices was down by 0.6 percent, prices in cities and rural went down by 0.6 and 0.5 percent respectively. The food prices dropped by 1.6 percent, the non-food prices kept at the same level (the amount of change was 0). The prices of consumer goods decreased by 0.9 percent, and the prices of services increased by 0.3 percent.
My very smart former PKU student Chen Long, who follows monetary conditions in China as closely as anyone else I know tells me:
The most interesting thing is that even if CPI remains stable month-on-month, it will turn negative year-on-year in January 2013. And if it continues to decline month-on-month at current rates, we could see negative year-on-year CPI as early as August/September.
June CPI increased 2.2% from a year ago, slightly lower than market consensus of 2.3%. June PPI dropped 2.1% on yearly basis, versus the median forecast of a 2.0% decline. On a monthly basis, CPI and PPI were down 0.6% and 0.7% respectively. The consumer price index has posted three consecutive months of negative monthly growth, and it was also the second consecutive month-on-month fall of PPI. Moreover, the year-on-year PPI growth has been negative for four months.
Inflation in China seems to have been licked. This is just what one would have expected in a financially repressed system, in which inflation creates its own correction by increasing the financial repression tax on household savers (thus reducing consumption) and lowering the cost of capital for manufacturing borrowers. Of course this same system means that deflation is unlikely to last very long because, as long as interest rates are not slashed, deflation will cause the real deposit rate and the real borrowing rate to rise. These increase consumption and reduce production, so putting upward pressure on prices.
Unlike some other analysts, in other words, I am not concerned about deflation persisting for long unless the PBoC cuts interest rates much more sharply than any of us expect. I know this may sound strange – most analysts believe that cutting interest rates will actually reignite CPI inflation – but remember that the relationship between inflation and interest rates in China is, as I have discussed many times before, not at all like the relationship between the two in the US. It works in the opposite way because of the very different structure of Chinese debt and consumption.
Overall at any rate things seem to be going so badly in the economy that on Sunday Premier Wen Jiabao warned, yet again, that the economy is under serious pressure, and then did the same on Tuesday. According to an article in Xinhua, Wen on Tuesday reaffirmed Beijing’s commitment to growth:
Premier Wen Jiabao said Tuesday that stabilizing economic growth is the most pressing matter currently facing China. Policies and measures to stabilize economic growth currently include boosting consumption, diversifying exports and promoting investment, Wen said while meeting representatives from research institutes and companies on Monday and Tuesday.
The emphasis on investment to shore up growth comes as the world’s second-largest economy is being challenged with slumping external demand and low consumption at home. Wen said the structure, quality and cost-effectiveness of investment should be given greater importance, adding that investment should be used to improve livelihoods and help the country develop scientifically.
Given the very weak numbers, and Beijing’s reactions, China seems very clearly to be heading towards a hard landing, and many Chinese and foreign experts are urgently warning that Beijing must cut interest rates even more sharply, expand credit, and so save China and the world from disaster. We’ve already had two cuts this year in the lending rate. Here is what Xinhua said a week ago Friday:
The central bank cut interest rates for a second time in a month, fueling concerns that the slowdown in the world’s second-largest economy is worse than predicted. The People’s Bank of China lowered benchmark deposit rates on Thursday by 25 basis points and cut lending rates by 31 basis points, effective from Friday.
The central bank cut interest rates on June 8 for the first time since 2008 to bolster economic growth. “The limits for rates charged on individual property loans will not change and financial institutions must strictly implement differentiated policies on property loans to continue constraints on speculative purchases,” the central bank said.
A leading economist said that cutting rates twice in a month suggests weak growth. “The two cuts in interest rates within a month indicate that the GDP growth rate in the second quarter is indeed weaker than expectations,” said Lu Zhengwei, chief economist at the Industrial Bank, adding he expected that the figure would be 7.6 percent.
The cuts, or at least the first one, seem to have some impact. Although loan growth has been much slower than expected for most of this year, the June loan numbers finally surprised the market on the upside. According, again, to Xinhua:
China’s new yuan-denominated loans surged in June as the government moved to buoy the slowing economy. The June new yuan-denominated loans rose 285.9 billion yuan (about 45 billion U.S. dollars) year-on-year to 919.8 billion yuan, the People’s Bank of China (PBOC), or the central bank, announced Thursday. PBOC data showed that new yuan-denominated loans in June hit a three-month high after reaching 1.01 trillion yuan in March.
Mark Williams, at Capital Economics, added a lot more color:
China’s bank lending last month turned out not to be as weak as we had feared. Net new loans amounted to RMB920bn. This was only slightly above the median forecast of analysts surveyed by Bloomberg (RMB880bn) as well as our own (RMB900bn). But ever since the People’s Bank cut interest rates last week, we had thought that the risks to these forecasts were skewed heavily to the downside, on the belief that weak lending was the most likely trigger for the rate move.
In fact, new lending was significantly higher last month than in May when it reached RMB793bn. That suggests that government attempts to revive bank lending were starting to work, even before last week’s rate move.
The fact that the government has continued to loosen nonetheless is positive for GDP growth in the near-term. A continued pick-up in lending to fuel investment should quieten immediate doubts about the economy in the months before the leadership handover. But it is questionable how much stimulus China really needs at this point and, in particular, the degree to which more investment-led growth should be welcomed.
I think Williams is right, and I agree that those calling for additional interest rate cuts and more rapid investment and credit expansion are wrong. Why? Because what is happening in China may be just what China and the world need. After many failed attempts, over the past six months we may be seeing for the first time the beginning of China’s urgently needed economic rebalancing, in which China reduces its overreliance on investment in favor of consumption.
Regular readers of my newsletter may be surprised to see me say this. For the past four or five years analysts have been earnestly assuring us that the rebalancing process had finally begun, and I had always insisted that it couldn’t have begun yet. Why? Because as I understand it rebalancing is almost arithmetically impossible under conditions of high GDP growth rates and low real interest rates. Once the real numbers came in, it always turned out that in fact imbalances had gotten worse, not better. Typically many of those too-eager analysts have resorted to insisting that the consumption data are wrong, although even if they are right this does not confirm that rebalancing had taken place since errors in reporting consumption have always been there.
But this time seems different. Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.
Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.
How to rebalance
The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates. But these measures will necessarily slow growth.
The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.
And this seems to be happening. Beijing has reduced interest rates twice this year, and reluctant policymakers are under intense pressure to reduce them further. The students in my central bank seminar at PKU tell me that there are new rumors about the way the cuts were implemented. “Usually it is the PBoC that submits a proposal of rates cut to the State Council,” one of them wrote me recently, “but this time (July 5th) it was the State Council who handed down to the PBoC the decision to cut rates, so that the PBoC was not fully aware of the rates cut before July 5th.”
If my student is right (and this class has an impressive track record), this suggests that monetary easing is being driven by political considerations, not economic ones, which of course isn’t at all a surprise. But even with the rate cuts, perhaps demanded by the State Council, with inflation falling much more quickly than interest rates the real return for household depositors has soared in recent months, as has the real cost of borrowing. China, in other words, is finally repairing one of its worst distortions.
But this necessarily comes at a cost. Raising the real borrowing cost cannot help but reduce investment growth and increase cashflow pressure on local governments, and so with the rise in real rates China’s GDP growth rate must fall sharply. China bulls, late to understand the unhealthy implications of the distortions that generated so much growth in the past, have finally recognized how urgent the rebalancing is, but they still fail to understand that this cannot happen at high growth rates. The problem is mainly one of arithmetic. China’s investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of rapid growth.
As China rebalances, in other words, we would expect sharply slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that Beijing is finally resolving its problems. Andy Xie has a typically intelligent article on just this subject in last week’s South China Morning Post. In it he warns:
China has cut interest rates twice in a month, showing the government’s grave concern for the weakening economy. But it is the wrong medicine. Side effects will include worsening inflation, saddling credulous property speculators with debt and weakening the banking system’s ability to handle the looming bad-debt crisis. The renminbi may come under devaluation pressure, too.
Cutting interest rates is doubling down on a bad hand; the policy of printing money to fuel bubbles was wrong in the first place. To revive the economy, China must cut taxes, slim down the government, retrench state-owned enterprises, strengthen the rule of law, and give businesses incentives to focus on quality, technology and brands.
Except for the “worsening inflation” part, I agree. He goes on to conclude: “Trying to revive the bubble now will only crash the economy.”
The costs of slowing
Needless to say I think Xie is right, and we should not be trying to revive “growth” because that simply means reviving the credit bubble. But won’t slower growth create social dislocation in China and economic dislocation around the world? No, not if it is managed well. Remember that Chinese rebalancing requires that household income grow faster than GDP for many years, and if Chinese growth slows even to 3%, as I expect it will within the next few years, but household income continues growing at 5-6%, this is far from being socially disruptive. Households don’t care what GDP growth is, they care about the growth in their spending power.
The key to how painful this will be domestically is likely to be employment. So far this year rising unemployment doesn’t seem to have been a serious problem, but unemployment is a lagging indicator, and there is some evidence that we are starting to see strains in the job market. According, for example, to an article in last week’s Financial Times,
China’s job market has started to show signs of stress, putting pressure on the government to intensify fiscal spending to prevent the economy from weakening further. Like politicians the world over, Chinese leaders’ biggest single economic worry is whether unemployment is under control, and analysts say the job outlook will help determine whether they launch a big stimulus effort as they did nearly four years ago.
So far the labour market has held up much better than in late 2008 when 20m migrant workers lost their jobs. But cracks are appearing and that experience showed how the situation can change virtually overnight in China. “Depending on how deep the growth slowdown is, unemployment can deteriorate very suddenly,” said Ding Shuang, an economist with Citi.
We will need to watch unemployment numbers closely in the next few months. As for the rest of the world, Chinese rebalancing under conditions of much slower GDP growth shouldn’t elicit panic. What the global economy needs from China is not faster GDP growth, but rather more net demand, i.e. a contracting trade surplus. Chinese rebalancing will eventually provide exactly that, although the trade surplus will probably rise first before it begins to decline. We are already beginning to see that happen. Here is the Financial Timeson the subject:
Chinese export and import growth both slowed in June, showing that the world’s second-largest economy faces strong headwinds. Exports rose 11.3 per cent from a year earlier, down from May’s 15.3 per cent pace. Imports increased 6.3 per cent from a year earlier, half of May’s 12.7 per cent and well below expectations.
With imports so weak, China was able to pull in a trade surplus of $31.7bn, nearly double May’s total and the country’s biggest in more than three years.
Earlier this year there was a debate about whether China’s then-declining trade surplus was likely to rise or to continue falling. At the time I pointed out that as long as the global environment allowed it, we should see China’s trade surplus rise substantially before it began declining.
Why? Because it would prove much easier to reduce Chinese investment than to reduce Chinese savings, and the difference between the two, of course, is simply the trade account (or, more accurately, the current account, of which the trade account is by far the biggest component).
By the way, and as an aside, we need to make two adjustments to the trade surplus in order to understand what is really going on within the balance of payments. First, one of the causes of last month’s weak imports has been a sharp decline in commodity purchases. I have many times argued that commodity stockpiling artificially lowers China’s trade surplus by converting what should be classified as a capital account outflow into a current account inflow. If China is now destocking, then China’s real trade surplus is actually lower than the posted numbers.
Second, we know that wealthy Chinese businessmen have been disinvesting and taking money out of the country at a rising pace since the beginning of 2010. One of the ways they can do so, without running afoul of capital restrictions, is by illegally under- or over-invoicing exports and imports. This should cause exports to seem lower than they actually are and imports to seem higher. The net effect is to reduce the real trade surplus.
Since these two processes, commodity de-stocking and flight capital, work in opposite ways to affect the trade account, it is hard to tell whether China’s real trade surplus is lower or higher than the reported surplus. But once de-stocking stops, we should remember that the trade numbers probably conceal capital outflows.
How does all this affect the world? In the short term rebalancing may increase the amount of global demand absorbed by China, but over the longer term it should reduce it. Rebalancing will inevitably result in falling prices for hard commodities, and so will hurt countries like Australia and Brazil that have gotten fat on Chinese overinvestment. Rising Chinese consumption demand over the long term and lower commodity prices, however, are positive for global growth overall, and especially for net commodity importers. Slower growth in China, it turns out, is not necessarily bad for the world. The key is the evolution of the trade surplus.
This is an abbreviated version of the newsletter that went out last month. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at email@example.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.