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

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.

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.

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
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.

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.

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: 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.

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” ;-)