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The Re-balancing of China’s Economy. An Expert Perspective.

Posted in China Business, Recommended Reading

I am always getting asked deep questions regarding China’s economy and I almost always demur because I am not an economist.

But is China experiencing a bubble, people always want to know? Based on my experience of having been intimately involved (from the legal side) with two bubbles (the dot.com and the real estate bubble), my feeling is yes. I get that feeling because whenever anyone mentions there might be a real estate bubble in China, non-economists get angry and insist things are different this time or that You Ain’t Seen Nothing Yet?

This all feels a lot like irrational exuberance to me, but what do I know? Read or listen to those who really know economics, I tell people.

But where are those people? 

There really are incredibly few real economists/finance people with China expertise writing/speaking in English to a general audience. Michael Pettis is one of them.  He is someone who clearly does know whereof he speaks. Do I agree with him? That’s irrelevant. What matters is that he applies legitimate economic/financial tools to analyzing China and for that alone, you should be reading his blog, China Financial Markets

I mention all of this today because Pettis just came out with a great post analyzing how China can and likely will go about re-balancing its economy to increase consumer spending. Pettis sets out the following four options and analyzes each of them politically, economically, and, most interestingly, as to who will be the winners and the losers: 

  1. Raising the value of the Renminbi
  2. Raising interest rates
  3. Raising wages
  4. Transferring state assets

This is an important and very thoughtful post and I highly recommend it.

  • http://www.twitter.com/darnoc darnoc

    For an alternative view, I highly recommend this excellent Sinica Podcast….China Bears & China’s Economy: http://bit.ly/arTNPD

  • http://www.iqidu.com Mao Ruiqi

    OMG, how can there not be a Beijing bubble, if a city of 17MM only has sufficient water for 6MM?
    And, why don’t the pundits take into consideration China’s potential IOU for taking care of its cancer patients? Either the government will subscribe to euthanasia or raise taxes to cover the ever increasing numbers of patients.

  • lucane

    I am a huge fan of both Michael Pettis’ and your blogs.
    Many thanks to both of you two for what you do for all of us.

  • Twofish

    I really disagree with Michael Pettis on a great many things, one thing that he misses in his argue are the two primary ways that the Chinese government has in the past cooled the economy.
    1) increase deposit reserve rates – Interest rates have very little impact on the Chinese economy, and the key way that the government controls the flow of money in China is to increase the required reserves that the banks are required to hold. The reason that reserve rates are so effective is that it’s hard for a bank to cheat on this.
    2) administrative directives – These include things that increasing down payment rates, or just ordering banks not to lend. The problem with administrative directives is that once you get some orders to do something, you will get a lot of cheating around the orders, but you can take that into account.
    Also I strongly disagree that transferring state assets to households are going to increase consumption. The problem is that the prices of said assets are priced with the assumption that most of those assets are non-tradable. If the government starts selling large blocks of SOE shares in Shanghai, the market will drop or even crash if those blocks are large enough.
    Finally, I have a lot of confidence in the Chinese economy, because this time it *ISN’T* different. China has had real estate booms and crashes before, and it happens almost like clockwork. Every five years or so there is a real estate crash followed by a bubble followed by a crash. There’s no reason I can see that this real estate crash is going to cause more problems than the five or six that China has already had in the last thirty years.

  • Twofish

    One other thing. China is going to raise the RMB sharply over the next year. Obama and Geithner wouldn’t be screaming at China to raise the RMB as much as they have if China hasn’t already agreed to do it.
    The other thing that governments can do to increase demand is to do Keynesian stimulus. Build massive railways that put money into people’s pockets so they start spending. The thing about China is that the recession is over in China and so over the next few months, the challenge will be to cool an overheated economy.
    Also, I think that privatization of major SOE’s is a dreadful idea. I’ve never seen a privatization in which the wealth ended up in the hands of “ordinary people.” If you do massive privatization what will happen in China is what happened in Russia in which you end up with a few people ending up massively wealthy, and everyone else with worthless pieces left behind.
    One reason that China got out of the recession quickly is that the Chinese government can order SOE’s to not fire people, or to start spending more money or start spending less money. If you privatize things, you lose this level on the macro-economy, which I don’t think is a good thing. The idea that the government can and should control the macro-economy through SOE’s goes against free-market orthodoxy, but as long as it works, I don’t really care about that.

  • Patrick H.

    I agree with you. Pettis is one of the few people speaking on China’s economy who is actually qualified to do so. Nonetheless, I do find his assessments far too gloomy, but it does seem all of the real economists who look at China tend to be gloomy as well. I think this is because if you look at China’s economic fundamentals, things are really quite bad, but the fundamentals ignore from where China is coming and ignore its resolve to get somewhere else as quickly as possible. What does everyone else think about this?

  • Hans Velis

    Pettis an expert? He doesn’t speak Chinese and has lectured on “Chinese Financial Markets” for just two years, during which period they went into a massive decline. He doesn’t even live in China. He’s erudite and writes well, but at the end of the day is just another American Professor spouting off from his Ivory Tower about a countries economics he doesn’t even live in nor understand the language. If you want “experts” go talk to someone who actually lives in the country and deals with the economy on a daily basis as part of his job. Pettis isn’t that man.

  • http://www.chinalawblog.com Dan

    @Hans Velis
    First off, Pettis does live in China and he has spent considerable time there. Here’s his bio:
    “Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Shenyin Wanguo Securities (HK). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.”
    But even if he isn’t there, that does not disqualify him in the slightest. You say we should be listening to someone who “deals with the economy on a daily basis as part of his job,” but unless that person’s job is economic research, they are going to see just one infinitesimally small portion of the whole.
    For example, even though my firm always has at least one lawyer in China at all times, we see little more of China’s economy than what is relevant to American and a few European companies who do business in or with China. That means there are massive swaths of the country and of the economy with which we never deal and so we cannot speak to the country as a whole.
    The job of the economist is to analyze an economy and I would be more likely to trust an economist analyzing China from Washington DC than I would to trust a businessperson analyzing the economy simply because he or she sits in Beijing.
    I think we just disagree on what it really takes to engage in economic analysis.

  • http://www.thefederalcriminalattorneys.com Joseph Marchelewski

    Actually, I wouldn’t put much stock in what most “economists” have to say. When the last American bubble was building, few, if any, economists were calling it such or telling people that it wasn’t sustainable.

  • Twofish

    The problem with Pettis and some other economists like Minxin Pei and Gordon Chang is that they’ve been rather consistently wrong over the last few years. There’s nothing wrong with being wrong, but one thing that I haven’t seen Pettis do is write a “mea culpa” explaining why he has gotten the Chinese economy massively wrong in the past.
    You can get around this by saying “I’m right but just not yet” but that’s useless. I predict that someday the Chinese economy will collapse and the Communist Party will fall from power. I am confident in that prediction because nothing lasts forever. The problem is that unless you can tell me whether these things are going to happen next year, ten years from now, or a thousand years from now, saying that “someday the Chinese economy will collapse” is a perfectly useless statement.
    No one is an “expert” on the Chinese economy, and everyone will get something wrong some times. What you can do is to make some guesses, see what you get right and what you get wrong, and if you are getting things consistently wrong, then maybe there is something basically wrong with your analysis. Before you try to predict the future, lets try explaining the present.
    Personally, I don’t think that the Chinese economy will have any serious problems for the next five years. The reason I think so is that China right now is where the Soviet Union and Japan were in 1950, and you can get some massive productivity increases just by getting people off the farm. Around 2015-2020, that will start to decrease, but I make no predictions about what happens then, because a lot depends on current decisions, and a lot depends on the unexpected.

  • Twofish

    Dan: The job of the economist is to analyze an economy and I would be more likely to trust an economist analyzing China from Washington DC than I would to trust a businessperson analyzing the economy simply because he or she sits in Beijing.
    I wouldn’t. The problem with being trapped in an office is that you end up saying things that are totally nonsensical to someone else that just takes a walk down the street.
    Economics is not like law, where there is a standard set of rules that are agreed to be the truth. One thing that becomes pretty obvious when you talk to economists is that they disagree about almost everything.

  • Hans Bos

    My problem with economists:
    1. Too much ivory-tower nonsense.
    2. Many are the students of one great economics guru and refuse to accept the teachings of another. They, therefore, are often futilely engaged in an effort to put square pegs in round holes. This makes them very frustrated and determined to prove that they are right, after all, by using smoke and mirrors and statistics (you know: you eat a whole chicken, I eat none, we both had half a chicken).
    3. Too often they will parrot the economic/political views of those who sign their paychecks without any regard to how it affects their reputation.
    4. So few of them shut up and find another job when they have been consistently wrong.
    When you find an economist who is open-minded, humble, provides you with useful information and who gets things right most of the time to boot, get on your knees daily to thank the Universe that he or she crossed your path and treat that person like the gem they are.
    In my next life I want to be a famous economist or meteorologist: Oh. to have the luxury of being wrong so many times and still keep my job and, hopefully, the adoration of the masses.

  • Duncan

    First just to back Dan up on his response to Hans Velis, Pettis is one of the main go-to people for foreign policy makers and business people visiting and operating in Beijing (where he is based). He is clearly very highly regarded in these groups, even by people who disagree with him, and I get the impression (though have no proof, obscure as these things are) that he is also read with interest in senior Chinese policy circles. To come up with a narrrative that makes sense and is difficult and however much I may disagree with some of his conclusions, I find his arguments are always interesting and well thought through. He also has much experience in researching past crashes, so knows what he talks of.
    A quick response to Twofish: although RRR hikes and credit quotas are indeed the main tools of monetary policy, the problem with using these methods rather than interest rates is that you ration credit rather than pricing it. As a result you end up with a system whereby capital is inefficiently channelled to those who can game the rationing system (SOEs) rather than use the capital most profitably.

  • Twofish

    Duncan: He is clearly very highly regarded in these groups, even by people who disagree with him, and I get the impression (though have no proof, obscure as these things are) that he is also read with interest in senior Chinese policy circles.
    Senior Chinese policy circles do read him, but (IMHO fortunately) his policy solutions don’t have much impact on decision making, and over the past year, the Chinese government has done basically the complete opposite of what Pettis has suggested that they do, and as far as can be told, it worked.
    Duncan: However much I may disagree with some of his conclusions, I find his arguments are always interesting and well thought through. He also has much experience in researching past crashes, so knows what he talks of.
    The curious thing is that his book the Volatility Machine is an excellent piece of work. The trouble is that after reading his research, I’ve generally ended up disagreeing with his most recent conclusions.
    Duncan: As a result you end up with a system whereby capital is inefficiently channelled to those who can game the rationing system (SOEs) rather than use the capital most profitably.
    That’s not true. All you are doing is to tell the bank that any loan that they make has to be backed by $X in reserves. You aren’t telling the bank who to lend to. The problem with using short term interest rates to manage the economy in China is that most lending is bank driven, there is no real money market, so changing interest rates really doesn’t do anything.
    There are administrative measures in which you *do* tell the bank who to lend do, and this *does* result in some capital inefficiency, but it’s better than the alternative. The problem with just relying on interest rates without any controls that there just as many ways of gaming the system in that sort of system. (Borrow massive amounts of money, lend to subprime borrowers, collect bonus.) Yes, there are some capital inefficiencies associated with SOE’s, but even in the US, deregulation led to inefficiencies that ended up being far, far worse.
    The basic problem is that banks don’t price risk very well because once the bank goes under, it doesn’t matter to the individual lender if they lose $10, $10M, or $10B. If losing $10 is the same as losing $10B, then the logical thing to do is to massively borrow money and roll the dice.
    What you need to make the system work is to make sure that the lender of last resort has some control over the banking decisions, and that’s the role of the government that is going to have to bailout the banks if things go wrong.
    Finally, sometimes you *want* the system to be inefficient. Lifeboats are extremely inefficient, until you need them, and one problem with the mantra of efficiency, is that it encourages you to highly leverage and have no reserves, which means that you are dead when things fall apart.
    There’s also the employment problem. One problem with the US economy right now is that it’s too efficient. You can get all of the output you want without hiring more people, and that’s causing problems.

  • Twofish

    Also, you get a better sense of what goes on by reading multiple conflicting experts, and then trying to integrate it with your own experience.
    The big counterargument to the efficiency argument is to point to the crazy housing boom (both in the US or in China) and ask if that is the most efficient use of capital. When interest rates are low, you end up with crazy housing booms, and the way you can cool that without removing money to useful things is to pass regulations limiting lending.

  • Chalmers Wood

    Hey Twofish, Re: “…and the way you can cool that without removing money to useful things is to pass regulations limiting lending”: Who is more efficient at regulating, China, or America, remembering that it was students at Princeton that first put their fingers on Enron with a paper titled “Sell” ;-)

  • Joseph alexander

    I have some data that I’d like to share with you guys. I’m a student at Columbia. I don’t think you need an economist to see a problem.
    China: yearly residential housing construction (Gross)
    2000 – 496,680,000 Square Meters
    2009 – 1,410,626,000 Square Meters
    China: average residential purchase prices
    2000 – $27/SF
    2009 – $62/SF
    (US 2010 – $59/SF)
    China: GDP spent on housing.
    2000 – 14% of GDP is spent on housing
    2010 – 26% of GDP is spent on housing
    (US 2006 – 6% of GDP is spent on housing)
    Average cost of a Chinese home – $58,521
    Average income in China – $3,735
    Using the current Chinese housing price to income ratio we find that the average American family should own a $721,163 home. At the top of the market the average American home was $206,000 – in august 2010 it was $148,000.
    If the average Chinese homeowner had a fully amortizing loan with a 6% interest rate it would take 72 years to pay down the balance using current US loan underwriting standards. (assuming a 70% LTV and a 1/3 maximum gross salary contribution)
    What do you guys see in these numbers – what’s your opinion?
    Sources:
    National Bureau of Statistics
    World Data Bank
    Google Wiki