On October 20, Blackrock global chief investment strategist, Richard Turnill, explained What cooling growth in China means for investors.
“We see China’s growth rate slowing only to still-solid and more sustainable levels. The implications for investors? Growth in China should remain supportive of emerging market (EM) assets and risk assets in general.”
Michael Pettis
Michael Pettis at China Financial Markets says “China’s Growth Miracle Has Run Out of Steam”.
Pettis’ viewpoint first appeared on the Financial Times. I asked Pettis permission to reprint and received an OK.
What follows is a guest post by Pettis, until the end where I add a few comments of my own on assessing the risk.
China’s Growth Miracle Has Run Out of Steam by Michael Pettis
China’s 19th Communist party congress ended last month with an indication that Xi Jinping’s new administration plans to rein in debt by abandoning the country’s long-term economic targets and allowing gross domestic product growth to fall.
Typically, analysts assume that changes in reported GDP reflect movements in living standards and productive capacity. In China, however, this is not the case. Local governments are expected to boost spending by whatever amount is needed to meet the country’s targets, whether or not it is productive.
GDP growth is not the same as economic growth. Consider two factories that cost the same to build and operate. If the first factory produces useful goods, and the second produces unwanted ones that pile up as inventory, only the first boosts the underlying economy. Both factories, however, will increase GDP in exactly the same way.
Most economies, however, have two mechanisms that force GDP data to conform to underlying economic performance. First, hard budget constraints, which set spending limits, drive companies that systematically waste investment out of business before they can substantially distort the economy.
Second, there is a market-pricing factor in GDP accounting that when bad debts caused by wasted investment are written down, the value-added component of GDP and the overall level of reported growth are reduced.
In China, however, neither mechanism works. Bad debt is not written down and the government is not subject to hard budget constraints. It is the government sector that is mainly responsible for the investment misallocation that characterises so much recent Chinese growth.
The implications are obvious, even if most economists have been surprisingly reluctant to acknowledge them. Anyone who believes there has been a significant amount of wasted investment in China must accept that reported GDP growth overstates the real increase in wealth by the failure to recognise the associated bad debt. Were it correctly written down, by some estimates GDP growth would fall below 3 per cent.
Historical precedents suggest the potential magnitude of this overstatement. Japan’s economy in the 1980s, for example, had distortions that resemble those of China today. Although not nearly as extreme, Japan too suffered from a very low consumption share of GDP and an overreliance on investment that, by the 1980s, had veered into substantial misallocation.
In the early 1990s, Japan’s reported GDP comprised 17 per cent of the overall global total, and few doubted that its soaring economy would become the world’s largest by the end of the century. Instead, once credit growth stabilised, Japan’s share of global GDP began to plummet, and has since fallen by nearly 60 per cent.
The same happened to the former USSR. It grew so quickly after the second world war that by the late-1960s it comprised 14 per cent of global GDP, similar to China today, and was widely expected to overtake the US. But two decades later, its share of global GDP had fallen by more than 70 per cent.
These cases may appear shocking, but, like China today, 1980s Japan and 1960s Russia lacked the mechanisms to account for wasted investment in reported GDP. At their peaks, growth for each country was seriously overstated by the failure to write down the waste, and understated once debt levels stabilised.
The implications are clear. China’s growth miracle has already run out of steam. It is only by allowing debt to surge that the country is able to meet its GDP targets. This may be why President Xi has been eager to stress more meaningful goals, such as increasing household income. Whatever the reason, analysts should not read GDP growth as an indicator of China’s underlying economic performance. Piling up unsold and unsaleable goods or building empty airports may boost GDP in an economy whose financial system does not recognise bad debt, but it does not measure its performance.
Michael Pettis
Assessing the Risk
Blackrock thinks China will slow to “sustainable” growth and it will not matter.
Heck, at this point, hardly anyone thinks anything will matter.
I doubt Brackrock understands just how low sustainable is. And it’s not just China dependent on a debt boom to keep things barely plodding along.
Republicans have yet to do anything about the deficit, a topic of high concern when Obama was president, but zero concern now that their party is in control.
Trump’s trade policy is a disaster. With the breakdown of NAFTA and Trump’s threats against China, a global trade ward looms.
It doesn’t matter.
In Europe, the Eurozone banks are insolvent, and that doesn’t seem to matter either.
Global bubbles surely don’t matter, because few, especially the central banks, even see them.
Leverage? Forget about it.
There are always problems, but the current set seems bigger than the set in 2007 and the set before that in 2000.
The only explanation I can come up with is “It’s Different This Time”.
The four most dangerous words in finance:
This time is different.$SPX $NDX $BTC
— Todd Harrison (@todd_harrison) November 29, 2017
MIke “Mish” Shedlock
It is impossible, even conceptually, for timing of human effected events considered bad to be predictable. If the onset of a negative event was known, those who stood to be negatively affected by it, would just adjust a day in advance; delaying or avoiding the bad.
No matter how much you bet someone, he wouldn’t play Russian roulette if he could predict with certainty the next chamber was loaded. And similarly, no one would bet him anything to play, if they could predict with certainty the next chamber was not.
All macro economics can even hope to say, is that those who destroy net value, will eventually be replaced by someone who doesn’t. Eventually, socialism will fail, simply due to providing no clue as to the relative costs and benefits of an infinite number of choices to pick from. But the Soviets could have lasted for another century past when they did throw in the cards. Ditto Venezuela. Eventually the central planners of China will follow along. And the ones in the US and Europe. But exactly when, will forever remain anyone’s guess.
This all goes to show how near impossible it is to get broad macro economic *TIMING* right. We have all heard forever now that China is a debt bubble. We have heard since Greece in 2009 about the Euro sovereign debt issues. We have heard for 3-4 years how subprime auto loans explosion is imminent. We have heard for probably 9 years now about the looming student loan crises. We have all heard until we are sick about global central banks financial engineering, but nothing on the downside has happened in markets due to it. I could go on and on about RE bubbles in Canada, echo bubbles in US RE, etc…. But WHEN? WHEN? WHEN? Next year? 5 years? 10 yrs? No one has a effing CLUE on the timing of this stuff!
It is amazing how long the permabear crowd has been on the wrong side of this market. What 8-9 years now? Permabear arguments are very well worn. We have all heard them a million times ad nauseum the last 9 years. And they all make a ton of sense. But when the F are we ever going to see some downside action??? This watched pot never seems to boil!
Pettis’ explanation of why GDP growth does is not the same as economic growth, is just as relevant for the US as for China. Likely more so, as at least Chinese malinvestment is generally directed towards building something, however pie in the sky. An empty airport at least has some future potential. And at the very least provided apprenticeships for workers that come out at the other end with some useful skills.
While the US version (running around dragging people who could otherwise be doing something productive into courts, _adds_ to GDP…. Ditto for lobbying to ban people from engaging in productive activity and creating, upholding and strengthening regulations barring them from doing the same), for the most part either produces nothing of value at all, or at least as often straight up destroys it.
Look at housing: Chinese malinvestment may produce empty residential towers. But at least those have some value. While the American version, produces housing shortages in the places where there are jobs, homeless people, excessive commutes leading to broken (or never formed) families, and commercial (and residential) space rents that render otherwise productive ventures paying decent wages, prohibitive.
While, no different from in China; Fed printing, government programs like TARP, implicit backstops, Full Faith In… etc., just as effectively as in China prevents malinvestments from clearing, bad debts from being written down, and value destroying activities from being routed around with their purveyors having to find something less destructive to do.
“Republicans have yet to do anything about the deficit, a topic of high concern when Obama was president, but zero concern now that their party is in control.” It’s called gaming the voter. Republicans hounded Clinton over balancing the budget. When Bush Jr. took over, Cheney declared that Reagan proved deficits didn’t matter. Obama bashed Bush’s deficits, then ran even Yuger deficits when his turn came.
RE: “First, hard budget constraints, which set spending limits, drive companies that systematically waste investment out of business before they can substantially distort the economy.”
Isn’t this the definition of a Zombie company? Hasn’t the Federal Reserve disabled this mechanism in the US?
link to theguardian.com I note China’s credit impulse is now the worst in the world at -14%. Looks like Steve Keen is right again.
I’m a fan of Michael Pettis writings about the Chinese economy and have read many of his books. If you want an in-depth look at the issues facing China’s economy, read his book ‘Avoiding the Fall’. It’s a bit dated (2013) but still relevant today and that says a lot about his ability to understand China’s economy.
One area Michael stresses is that China must change its citizens from savers to spenders. To do this the RMB must be allowed to rise in value thus giving the working class purchasing power to buy all the stuff they make. Even if GDP falls, the people of China must become consumers.
If the Chines become big consumers, here is an interesting scenario.
1. RMB rises dramatically in value, over 15%.
2. Chinese goods cost more in the US due to the rise of the RMB.
3. The revised corporate tax changes make it feasible for repatriating or at least stop off shore profiting.
4. As proposed by the Trump administration, excess corporate money starts flowing to workers’ wages.
5. All the stuff the Fed currently measures for inflation suddenly become more expensive and workers now have increased wages.
6. Bada-Bing, Bada-Boom you have inflation, well above 2%
Without infrastructure spending there would not be a “China miracle.” But without knowing where to draw the line there’s a lot of wasted money on projects that never should have been greenlit. Just looking back at post-civil war United States expansion, by subsiding the crooked railroads the infrastructure got built out much faster than would have happened organically, but with a tremendous price due to misallocation. Compare that to the Hill route to the Pacific Northwest and how it took much longer but was far more profitable.
The big problem I see is that government types are impatient and want it all done right now, or at least in an election cycle or two so they can campaign for reelection on their successful projects. And there’s a whole lot of “me too” demands from the electorate who are unwilling to either pay up themselves or relocate to where the infrastructure is to their liking,. For example, rural broadband. The cost of building out fiber to rural homes is getting to the point where it will make sense very soon now, but not soon enough for the more vocal who are demanding government either force ISPs to build and/or demand taxpayer dollars be used, or tax-backed bonds be issued, for their Internet service. No politician will ever suggest they move (and risk losing population in “their” district? No way!), or they accept that the cost of some products and service are just going to be higher in rural areas, so they get onboard. And they get to play Santa Clause too. Who wouldn’t like that?
China’s economy has surely grown over the last decade by any way you measure it. And their citizens are wealthier. It’s impossible to continue to grow as fast as China has for a sustained period of time once your economy reaches a certain size. Economic growth will slow but, outside of war, I don’t see a collapse. Chia
This time is different from the point of view that central banks don’t have any interest rates left to cut and their ability to quantitatively ease is massively diminished
“Global bubbles surely don’t matter, because few, especially the central banks, even see them.”
Central Banksters may or may not see them but they have the two levers, interest rate and money printing, that make them feel like magicians who can do anything. That they have been able to do it for a decade has boosted their confidence. I only hope this time people understand that they have been had and can find the rope and lamp posts for the job that needs to be done.