My Blog

MON 25 FEB

When will China overtake the US economically? By Michael Pettis

According to Friday’s China Daily (and a host of other newspapers around the world), a just published Gallup survey claims that most Americans think China will be the world’s largest economy within 20 years.  We obviously need to take these opinions with a grain of salt since, according to the same survey, 40% of Americans believe the China is today the world’s top economy, compared to 33% who believe it is the US.  Since the US economy is currently more than four times the size of China’s, it is a little hard to understand why 40% of Americans think China’s is the world’s largest, but there you have it.

 

I suppose it is the combination of China hype and US paranoia that explains these bizarre opinions.  To their credit, it doesn’t seem that informed opinion in China takes the results of this survey very seriously.  The China Daily article pointed out that Chinese experts are a lot less confident about the validity of these predictions than their American counterparts, and I suspect they are right. 

 

Perhaps this Chinese skepticism is because Americans have made similar predictions before, and these predictions turned out to be absurd.  It was well known in the late 1950s that thanks to their superior technology and better economic management the Soviet Union was all but certain to overtake the US economically before the end of the 20th Century.  That didn’t pan out, of course, but without missing a beat Americans then switched their focus to Germany, whose inexorable rise as a quality-oriented export machine in the 1960s and 1970s made it seem that it was just a matter of time before it did the trick (in the 1930s they were also supposed to overtake the US at some not-too-distant time, but that didn’t pan out either).  By the mid 1980s all other contenders were chucked into the waste bin when it seemed breathtakingly obvious that the Japanese juggernaut was the one that would crush everyone before it.  Now, apparently, it is the turn of China.

 

I don’t want to make too much fun of US paranoia.  Americans are intensely competitive and we seem to need a serious challenger to justify ourselves existentially.  Perhaps that is part of our strength.  On the other hand, as I’ve seen printed on numerous t-shirts, “Just because I am paranoid doesn’t mean they aren’t out to get me.”  So is the paranoia justified?

 

I pulled out my trusty calculator to see what it would take for China’s GDP to overtake that of the US by 2028.  If we assume that China grows by 10% a year for the next few decades years, and that the US grows by 2% a year during that same period, the mathematical conclusion is inescapable: the Chinese economy will equal that of the US in twenty years and will be nearly six times as big by the middle of the century. 

 

But how likely is this?  In my opinion it is extremely implausible.  First, US GDP growth is much more likely to average 2.5-30% a year, as it has for much of its recent history.  Second the idea that China can grow at 10% on average for the foreseeable future is, to put it charitably, a little unlikely.

 

Why is it unlikely?  Since it began its reforms in the mid-1970s, China’s economy has in fact grown at roughly 10% a year, and participants in the earlier “Asian miracle” were also able to achieve similar levels of growth for many years, so why is it so hard to think that this growth level cannot continue for China into the indefinite future? 

 

Let us leave aside the statistical observation that it is far more likely for smaller countries to end up in the “tails” of a probability forecast than for a country as large as China – in other words for purely statistical reasons small countries are more likely to be on the very high or very low end of a standard distribution of outcomes than are large countries.  This observation, by the way, dovetails nicely with the actual range of historical growth rates in Asia, where smaller countries have been both the best and the worst performers. There are still at least three other sets of reasons why this 10% forecast is unlikely and why we need to adjust these numbers sharply downwards. 

 

Special circumstance

The first set of reasons involves the special circumstances that have so far underpinned China’s recent growth and its sustainability, the second has to do with demographics, and the third has to do with a few obvious emerging problems facing China’s economy as it continues to grow.  To address the first set of reasons, Chinese growth since the 1970s, as I see it, was powered by three special circumstances, none of which are sustainable over the long or even medium term.  The first special circumstance occurred in the early stages of China’s reform, when Deng Xiaoping began to unshackle the Chinese economy in the late 1970s.  As is widely known, many of his immensely successful government reforms consisted simply of unwinding some of the policies of his predecessors – which were among the most inefficient economic policies ever put into place. 

 

Remember that in the 1930s, China’s per capita income was not much below that of Japan and Taiwan, and I believe it was higher than that of South Korea (although perhaps not of the more highly industrialized North Korea, which anyway put into place some of the same policies that China had before the Deng Xiaoping reforms, and suffered a similar fate).  China’s per capita income at the time was also substantially higher than many of its Asian neighbors who subsequently undertook their own economic reforms, and who still far surpass China in GDP per capita.  Under the economically repressive policies of its early leaders post-1949 China fell way behind its neighbors, and so it is no surprise that simply unwinding some of the policies that so sharply repressed Chinese economic growth would have created a massive growth spurt that would allow it to narrow the tremendous lead its neighbors had enjoyed.  In a similar way I have little doubt that when North Korea finally begins its economic reforms, its growth rate will even surpass that of China as it too is able to take advantage of the reversal of economic repression.

 

China is still benefiting from unwinding of its failed economic experiment, but clearly as China advances it becomes harder and harder to sustain the growth differential simply by removing the earlier political impediments.  Simply put, once all the worst policies of the 1950s, 1960s and 1970s are eliminated, there will be no more free lunch.

 

The second big cause of recent growth, in my opinion, was the tremendous fiscal expansion China underwent in the 1990s.  It is hard to measure the extent of this expansion because it occurred almost entirely through a rapid expansion of bank lending to unprofitable state-owned enterprises, but it also left the banks saddled with enormous amounts of non-performing loans and it nearly crippled the banking system.  This hidden fiscal expansion still occurs to some extent, but clearly there are very tight limits as to how much more expansion the government can engineer, and of course fiscal expansion is not a free lunch.  It must be paid for in the future.

 

Finally, the third cause of extraordinary growth (and the period of most extraordinary growth) began roughly in 2003 or thereabouts, when China found itself locked into a monetary regime that resulted in out-of-control money expansion.  China is still living with this monetary regime, and while the early stages of this kind of growth are always wonderful – asset price increases, plentiful credit, rapid growth – at some point the consequences, as we are already seeing, lead to significant economic imbalances and the need for adjustment.  We may begin to see already in 2008 the process of this unwinding.  At any rate, this latest phase of Chinese growth is also unsustainable, in my opinion (for reasons I have discussed many times in this blog).

 

The demographic crisis

So assuming that there are no special changes or challenges facing China, and assuming that absent these special circumstances things can continue as they have, what is a reasonable projected growth rate?  I am not smart enough to say, but certainly I think we can say 10% annual growth for the medium- or long term horizon is at best the upper limit, not the expected mean.  Let’s assume that if current circumstances remain in place and if we eliminate the special circumstances that underpinned the impressive growth rates of the last three decades, China can grow at an upper limit of 9-10%.  I think this may be a little generous, but I want to be conservative as I work this number down.

 

That brings us to the second set of reasons why a 10% annual growth rate is unlikely for the future – the demographic challenge.  During the period of Chinese growth since the late 1970s, China benefited from a double advantage.  Not only was its population growing, albeit slowly, but more importantly, its dependency ratio improved dramatically (the dependency ratio is the percentage of non-workers – basically the too-old and the too-young – in the total population). 

 

After the horrors and dislocations of the anti-Japanese war and the subsequent civil war, with the establishment of peace and the New China in 1949, the country not surprisingly enjoyed a baby boom.  One consequence of the baby boom, of course, was deterioration in the dependency ratio, as an explosion of births meant that an increasing fraction of the population was too young to work.  From 1949 to the mid-1970s China saw its dependency ratio rise (deteriorate) quickly.

 

This deterioration in the dependency ratio began to reverse itself in the 1970s as young people born in the 1950s and 1960s became old enough to join the work force, causing a surge in employable workers.  With the implementation at that time of the one-child policy, the improvement in the dependency ratio accelerated sharply as China saw the number of children drop as a share of its population.  The combination of the two factors was impressive.  Thanks to the maturing baby-boomers and one-child policy, from the mid-1970s to the present China enjoyed one of the most dramatic improvements in the dependency ratio that the world has seen. 

 

This had to come to an end, however, because fewer children today also means that in the future there will be fewer workers.  Demographic experts project that China’s dependency ratio will continue improving for another two or three years, but after that it will begin to deteriorate almost as dramatically as it had previously improved (the baby boom moves into retirement but there are too few young adults to replace them).  This deterioration will be exacerbated by the fact that China’s total population is at or near its peak, and will decline slowly over the next few decades.

 

How will this affect Chinese growth?  It is of course hard to say, especially since the scale is unprecedented and we don’t have too many examples of similar circumstances with which to compare China, but economic growth is equal to the growth in the number of workers multiplied by the growth in productivity per worker.  From the mid-1970s to now, my very rough back-of-the-envelope calculations suggest that China’s working population grew on average by about 2% to 2.5% a year.  From 2010 to 2050 my equally rough calculations suggest that the working population will decline by around 1% annually.

 

That means that China will face roughly a 35 to 3.5% differential growth rate of workers between the last 30 years and the next 30 years.  There are too many unpredictable factors that can result from this decline in workers, so it is dangerous to imply any precision at all in my predictions, but I would guess that a plausible, unbiased prediction would suggest that in order to account for this dramatic change in the growth rate of the working population, we should reduce the current “equilibrium” growth rate by 3.0-3.5%.

 

That takes us to projected growth rates of around no more than 6-7%, and perhaps less.  This may seem like a very low number (and there are additional reasons to think it should be adjusted downward).  Certainly it is well below what nearly every economist seems to be predicting for China, especially in light of the high and persistent growth rates enjoyed by other Asian countries, but it is not as crazy as it sounds.  It is true that many Asian countries were able to generate growth rates at substantially higher levels for many years, but a significant part of that growth was also generated by improvements in the dependency ratio.  I have seen one World Bank report that argues that as much as 30% of the Asian “miracle” can be explained by this factor alone, and of course Paul Krugman in his notorious Foreign Affairs article (in 1997, I think) argued that much of the rest of Asian “miracle” growth could be explained by other factor labor-growth-related inputs.  As surprising as it may seem at first, it is not out unreasonable at all to assume that a sharp reduction in the growth rate of the working population must also result in a sharp reduction in output growth.

 

By the way demographic changes do not have the same adverse effect on the US because not only is the US population growing steadily during this whole period (from four times as big today, China’s population may be 2.5 to 3 times as big as the US by 2050), but its dependency ratio is more or less stable.  US population is expected to grow at around 1% annually into the middle of the century, and its working population is expected to keep pace – and perhaps even grow a little faster as Americans are increasingly likely to work later years.

 

Emerging problems

These two sets of sets of reasons explain why I think a projected 10% annual growth rate into the medium term is very optimistic, but there is still a third set of reasons to doubt the optimists.  China has many other, almost unimaginably tough problems that need to be addressed in order to maintain high growth rates, and by addressing these problems the “equilibrium” growth rates may, and probably will, decline.  One of the most obvious is that Chinese growth has come at the expense of a very serious degradation of its environment.  Chinese environmental problems are by now so well known that it is unnecessary to argue why this process isn’t sustainable in the long run or even in the medium run, but it is worth wondering what the growth consequences will be when Chinese businesses are no longer able to count on the free depletion of their natural endowment. 

 

What do I mean by this?  If I create $10 of economic value in my factory while destroying $2 of economic value by depleting my natural endowment, my real contribution to the economy should be measured as $8.  However in recent years Chinese businesses have been able to ignore the $2 they have destroyed (polluting rivers, destroying agricultural land, etc.) and have claimed the full $10 as economic value-added.  This can’t go on for ever, and once these businesses are forced to recognize and pay for the $2 of damage, their contribution to economic growth per equivalent unit of activity will decline.  This must show up as slower GDP growth (and I am not including the cost of reversing the previous environmental degradation). 

 

I have no idea what the net effect will be, but I have heard estimates of the annual cost of environmental degradation ranging from 1% to 3% of GDP.  Let’s say that these numbers are exaggerated, and that there are also secondary GDP benefits to environmentalism, perhaps it is still reasonable to shave 0.5% to 1% off GDP growth projections.

 

There is more.  China has a severe water shortage – it is so bad that many water experts refer to a looming water crisis in the next decade.  I am not enough a good enough economist or engineer to figure out the economic impact, but it can’t be controversial to suggest that the need to resolve the water crisis will somehow constrain economic growth.  This constraint may be very significant, especially in the north where the water crisis is most severe.

 

Similarly with other commodities.  For China to catch up to the US in total size by 2050, Chinese per capita income in 2050 must equal or exceed US per capita income today (I explained why in an entry last month).  It is hard to imagine that if 20-25% of the world population move from the poverty of China today to the consumption level of the US today, the demands on the world’s resources won’t be strained somewhat.  This will undoubtedly have a cost to GDP growth.  By the way, one measure of how implausible the idea that China’s GDP will equal that of the US by 2050 is precisely that it would require Chinese per capital income in 2050 to be equal to or more than US per capita income today.  Anyone who has traveled though China will find that a little hard to imagine.

 

But wait, since constraints on the world’s resources are a global problem, and not a Chinese problem, won’t that also constrain US growth?  Almost certainly yes, but it seems pretty safe to say that the world’s wealthier, more flexible economies generally suffer less from high commodity prices and commodity shortages than the poorer countries, so the cost will be borne disproportionately by China and other poor countries.

 

I am ignoring in my calculations the possibility of serious social or political disruptions because these possibilities don’t necessarily change the expected outcome – they simply reduce the certainty we associate with those expectations.  The most obvious uncertainty is political.  Given the rapid social change China is undergoing (probably unprecedented in history in its magnitude) and the rigidity of its political structure, it is very hard to make a meaningful prediction about how the political system will react to the tremendous pressure China faces.  Still, it is at least as plausible to argue that there will be occasions of difficult change and adjustment, and that these periods may have adverse economic impacts, as it is to argue that the process will be smooth and uneventful.  This means that whatever the expected outcome, we would have to assign a much wider standard deviation than we might have for predictions about other countries.

 

I could go on, but I will make one final point.  It is fairly well accepted among economists that rapid growth is easier for countries that are further behind technologically than the leaders, but as these countries advance the speed of the catch-up declines.  This will probably happen to China too.

 

When will China overtake the US?

So where does that leave us?  It is hard to say.  These projections are necessarily imprecise and the mathematician in me insists that false precision is a great as sin as bad math, so I don’t want to refine the numbers too much.  In the end I have no idea what a reasonable projected growth rate for China is for the next few decades, but I am very certain that 10% is implausible – almost impossible.  I would suggest that anywhere between 5-7% is far more likely, and even lower numbers are not implausible.  As you can see if you have been following the math, I am actually marking down my projection by a lot less than my arguments above would indicate because, like anyone else, it is not easy for me to want to vary too widely from the consensus.  You can just write it off to my cowardice and inability to trust my own arguments. 

 

At any rate if I reprogram these new set of numbers into my calculator, I show the following:

 

1.        If we assume that the US grows at 2% a year forever, and that China grows at either 5% or 7% forever, in the first case China will be two-thirds the size of the US by the year 2050 and in the second it will be one-and-a-half times the size of the US by 2050.

 

2.        If we assume the US grows by 2.5% forever, in the first case China will be little more than half the size of the US by 2050 and in the second case it will be 40% bigger.

 

3.        If we assume the US grows by 3% forever, in the first case China will be little less than half the size of the US by 2050 and in the second case it will be 10% bigger.

 

4.        Even in the most favorable relative case for China, China will be less than half the size of the US in 20 years.  My guess is that this calculation distorts the likely outcome a little because whatever the average growth rate for China over the next forty years, it is likely to be higher in the first twenty than in the second (for many of the same reasons I downgraded the forecast).  Still, it is in my opinion extremely unlikely that China will overtake the US in size within 20 years.

 

The world seems fervently to believe that China’s rise as the world’s largest economy is more or less a done deal even though it is hard to get the numbers necessary for such an outcome to work.  China is clearly a large and growing economy, and there is little doubt in my mind that it will soon be the world’s second most important economy.  There is even a possibility that it will be the world’s largest economy within our lifetimes, but that possibility is no certainty and, in my opinion, is not even highly likely.  Perhaps paranoia just sells better.

 

TUE 26 FEB

RMB appreciation slows, but so what? By Michael Pettis

According to today’s Bloomberg:

 

The yuan fell by the most in almost two weeks versus the dollar on speculation the central bank wants to slow the appreciation to limit the impact on exporters.  The currency dropped for a third day as the People's Bank of China may seek to deter speculators from betting on one-way moves after the yuan had its biggest advance last week of 2008. Forward contracts yesterday showed traders were the most bullish on the outlook for gains in the currency since a link to the dollar was scrapped in July 2005.

 

I am not sure if the PBoC is trying primarily to help exporters or to scare off speculators, but if the latter, as I suspect, it suggests that hot money inflows are a problem, although regular readers probably already knew that I would say that.  As an aside, the Ministry of Commerce announced yesterday that January FDI was $11.2 billion, more than twice what it was in January 2007 ($5.3 billion).  They didn’t explain why the big jump occurred, especially surprising since the increased corporate income tax on foreign investors which took effect this year should have caused FDI to be accelerated last year, but I wonder if part of the reason for the surge is that even “real” investors want to take advantage of the expected RMB appreciation.  It is worth watching FDI numbers over the next few months to see if they remain high – this really doesn’t make the PBoC’s job much easier.

 

There are some rumors that the PBoC may generally slow the rate of appreciation this year because of concerns about the impact on the economy, but I don’t think this is very likely.  I think it largely represents attempts to talk down the market, although if there is a sharp slowdown in the next few months at least some of the blame will go to the PBoC’s more rapid appreciation of the RMB.  Nonetheless most analysts are raising their expectations about where the RMB will end this year.

 

One last piece of news, today the PBoC announced that the Corporate Goods Price Index (formerly known as the Wholesale Price Index) rose 1.1% month-on-month in January and rose 8.4% year on year.  Not surprisingly these numbers were viewed with dismay since they suggest continued inflationary pressure.  Every bank out there has been recently revising their 2008 inflation expectations upward – I expect these upward revisions will continue.  

 

WED 27 FEB

Will inflation affect China and the US differently? By Michael Pettis

Andy Xie has an interesting Op-Ed in today’s South China Morning Post in which he argues that the US, with Europe not far behind, is entering into a period of low growth and rising inflation.

 

It feels like the 1970s: economies weakening, inflation accelerating, the US dollar tumbling and oil prices surging. Most prominent economists abhor the comparison. The arguments against it are that, first, oil is a smaller part of the economy today and, second, that central banks have learned not to accommodate inflation. I hope so, but I am not convinced. Central banks are putting growth above inflation in their policy priorities. They hope they will have the time to deal with inflation when economies recover. Down this slippery path, central banks may get trapped; economies may take time to recover, which forces them to tolerate inflation for longer and longer. The end could be similar to that in the 1970s, when only a severe recession could cure inflation. Even though central banks know more now than three decades ago, they may still be heading down the same path.

 

As I’ve said many times before I am not as pessimistic as many about the depth and duration of a US slowdown for mainly two reasons:  First, I think the flexibility of the US financial system has weakened the transmission mechanism from financial crisis to economic contraction (they are not necessarily linked except though a change in the financing of investment and consumption).  Second, high commodity prices and high trade surpluses in Asia means that we are still in a cycle in which trade deficits (the US and, increasingly, Europe) are being recycled.  This is likely to keep risk appetite high, and once the markets bottom out, perhaps in the next two or three months, investment flows into risky assets will re-ignite.

 

Nonetheless I do agree with Xie that we are increasingly likely to see a combination of stalling growth and rising inflation.  What he says next is intriguing:

 

China is in a tight spot. The US is in a much better position to tolerate inflation. Foreigners hold over US$14 trillion of America's financial assets, about 100 per cent of its gross domestic product. Inflating away paper assets is a net positive for the US economy. Moreover, America's low-income group is more indebted, and inflating away debt benefits most Americans. China is a net creditor, as reflected in its US$1.5 trillion foreign exchange reserves. Low-income earners in China are net savers. Inflation decreases the purchasing power of low-income earners and decreases the value of their savings.

 

Inflation may be politically popular in the US but is certainly destabilizing in China.  China and the US both face inflation this year, but they will take different approaches to deal with it. China will maintain a tight monetary policy to contain inflation, while the US will loosen monetary policy to stimulate demand. The yuan is obviously an appreciating asset in such a macro scenario. To stop the currency from overshooting, China has to tightly control capital inflows.

 

I hadn’t really thought of the differing impacts of inflation on the various major economies, and I need a little more time to think about this, but if Xie is right, and certainly his argument seems plausible, we may see very different policies implemented in different economies to deal with rising inflation.  These different approaches to dealing with inflation may create more strains in the world economy.  I suspect that in the short term China may be hurt more by rising inflation, but if this forces it to deal strongly with inflation while the US dithers, in the medium term the Chinese economy may emerge in healthier shape – as long as the fight against inflation does not undermine the banking system.  

 

Of course my model of the Chinese economy implies that the only way China can deal seriously with inflation is by adjusting the currency regime.  I had a conversation earlier today with an economist at a major Australian bank (I haven’t asked his permission to identify him, so I won’t), but he believes, as I do, that the key issue is to adjust the currency very rapidly (via a large, one-off revaluation), although he thinks it may be several months before the authorities have the courage and incentive to do so.  In his opinion, it will take significantly higher inflation to force anxiety levels to the point where the authorities will finally agree to a one-off revaluation, but he does think it is inevitable. 

 

We both think that this will happen late this year or perhaps early next year.  His conversations with various Chinese analysts led him to expect inflation in February and March to be much higher than consensus forecasts (which already have risen dramatically recently).  He has also heard that pork production is not as high as it will need to be to bring pork prices down.  If I remember correctly I think he even implied 10% for February would not be a surprise.

 

 

On a very different note, Martin Wolf has an article in today’s Financial Times which includes a graph prepared by the World Bank that lists the fiscal costs, in GDP terms, of various bank bailouts since the Spanish banking crisis of 1977 (which cost around 17% of Spain’s GDP).  The worst two were the Argentine crisis of 1980-82 and the 1997 Indonesian crisis, which the World Bank estimates to have cost around 55% of GDP.  In comparison the1980’s S&L crisis in the US (the least “expensive” of the lot) cost just under 4% of GDP, and the Mexican crisis of 1994 weighed in at around 19% of GDP (I am reading these numbers off a bar chart, so I may be off by a point or so).

 

The World Bank estimates that the Chinese banking crisis of the 1990s cost the country around 46-47% of GDP.  That is a big number.  One of the wilder things I often hear from analysts who argue against any slowdown of the Chinese economy or of a crisis in the banking sector is that naysayers have been warning about crises in China for nearly three decades and yet have always been wrong.  Why should we believe that this time they will be right?

 

There are many reasons why this argument is nonsense, but the most obvious is that the naysayers were not wrong.  China has indeed suffered from at least two, possible three, crises during the reform period (as is natural – a fast-changing fast-growing economy nearly always has a rough path to follow).  Just because a non-marketized economy with a rudimentary financial system experiences financial or economic crisis differently than countries with very different financial systems doesn’t mean that things in China have progressed smoothly – although I guess if Wall Street bankers don’t lose their jobs it hardly seems like a real crisis, does it?  

 

I haven’t been able to get the figures for the 1985-87 inflation period, whose most obvious manifestation may have been a political showdown in 1989 but which also has an economic counterpart, but the World Bank estimates of the fiscal cost of the Chinese banking crisis in the 1990s suggests that it was pretty ugly – indeed it was the third most expensive crisis among the 15 listed..  Among other things the World Bank figures show why we need to be skeptical about reports that China’s total government indebtedness is less than 20% of GDP.  Much of its debt still exists in the form of unrecorded contingent liabilities.

 

Finally, one last think that struck me while I was reading a Bloomberg article about China Railway Construction Corp’s upcoming RMB 22.3 billion IPO.  There are rumors that it has already drawn RMB 3 trillion in bids (oversubscribed 135 times).  I have already written why this process is fraught with risk for eager investors, but I was struck by the following comment:

 

“Investors are moving their money to the primary market to hedge against the decline on the secondary market, as the returns are quite secure,'' said Wu Kan, who manages the equivalent of $41 million at Dazhong Insurance Co. in Shanghai. ``The first-day gain of China Railway Construction won't be amazing, but at least investors won't be running the risk of losing money.”

 

I know from personal experience how easy it is to be misquoted or to have one’s quotes taken out of context, so I really hope that Mr. Wu didn’t mean what he sounds like he said, but if so, it is very scary when a professional money manager believes that bidding in these IPOs does not involve the risk of losing money.  Just because IPOs shot up in the past is no guarantee that they will shoot up in the future, and the size of the first-day IPO surge has declined dramatically in the last few months.  What is more, because of the subscription mechanics even a small decline will be very costly to the poor retail investor, who because of the expected oversubscription needs to leverage up the amount of risk he wants to take by an astronomical amount.  If the deal is successful the investor on average may profit on 1/135th of the money he puts up, but if it is unsuccessful, he may find himself with a large part of his order, or perhaps even all of it, filled.  That is not a reassuring thought.

 

THU 28 FEB

More warnings on inflation vigilance in China By Michael Pettis

The State Information Center, a think tank affiliated with the National Development and Reform Commission, the country's top planning agency, has weighed into the policy debate by recommending that the government maintain its tightening monetary policy.  It said that the government might consider relaxing the measures over the short term because of last month’s horrific weather crisis, whose economic impact nonetheless is likely to be “limited and temporary”, but that ultimately policymakers should continue with prudent fiscal policy and tight monetary policy.  In the same report they predicted that CPI inflation for the first quarter would be 6.9%

 

I have already pointed out many times that I don’t believe monetary policy can be tight until the currency regime is fixed and capital inflows sharply reduced, which is not what the authorities are contemplating.  I also think 6.9% for the quarter is overly optimistic, although perhaps announcing this estimate as their expectation may just be part of the campaign against rising inflationary expectations (although if this is the case it does nothing to help their credibility). 

 

Why overly optimistic?  I am already hearing anecdotal evidence and rumors that February CPI inflation will be higher, maybe even substantially higher, than January’s 7.1%.  Let us assume that it comes in at 7.0%.  We would need March to come in at 6.5% to bring inflation for the month to 6.9% (if February is 7.5% or 8.0%, March would have to be 6.1% or 5.6%).  Since even the one-off-food-constraint camp believes that it might not be until summer or early fall that food production gets back on line, I don’t think we can expect March CPI numbers to drop so quickly, although they are priced off a higher base.

 

In addition, a friend sent me this today from MarketWatch:

 

Guangdong, China's richest province, said it plans to raise minimum wages by as much as 18% in some cities starting April 1. The decision followed similar actions in other areas, notably the major cities of Shanghai and Beijing. Tibet, an autonomous region administered by China's central government, raised minimum wages by nearly 50% at the beginning of this year. The wage increases, aimed at relieving food and other price pressures, could instead fuel inflation, analysts said. Higher wages are also likely to raise prices of U.S. imports from China, and possibly reduce China's attraction as the world's manufacturing center…

 

Guangdong will increase the province's minimum wages by an average 13% on April 1, the province's labor bureau said in a news release last week. The southern China province produces about 13% of China's economic output, the most among the country's 32 provinces.  Minimum wages in the capital city Guangzhou will rise to 860 yuan ($120) per month from 780 yuan, an increase of 10%. Wages of other cities in the province will also get a boost, with those in some inland cities up nearly 18%.

 

China's other provinces took similar actions earlier this year. Starting Jan. 1, four provinces hiked their average minimum wages by more than 20%, with the increase in Tibet topping the list, according to data collected by Citigroup. Five other provinces increased average wage caps by more than 10%.  Beijing and Shanghai, China's two biggest cities, last year raised their minimum wages to 730 yuan and 840 yuan respectively, in the face of rising consumer prices.  Average minimum wages in China have risen 15% in 2007, Citigroup said in a report, and 21% in 2008 based on available data.

 

If minimum wages are rising, driven by rising food prices, it seems hard to imagine that these increases won’t be priced into factory production.  Some of these wage increases are after the first quarter, so they will not contribute to inflation until much later, but several cities and provinces seemed to have raised the minimum wage early this year or late last year, and I guess we should start seeing the price effect now and into the near future.

 

In line with the announcement by the State Information Center, Han Yongwen, secretary general of the NDRC, is reported to have said in a conference in Suzhou yesterday that China faces “relatively high” inflationary pressure.  From what I gather other senior officials at the conference made similar noises about the need for vigilance, with one of them, Ma Delun, vice governor of the People's Bank of China, adding that China is “confident” that it will be able to tame inflation.

 

In the past few weeks there have been a whole series of statements on inflation worries and the need to maintain vigilance.  I am not sure how to interpret this.  On the one hand it may be evidence that the monetary alarmists have once again regained the upper hand in the policy debate.  On the other it may be because they are worriedly signaling to the NPC, which will be held next week and which will anoint the new senior leadership, including provincial and municipal leaders who traditionally like to begin their time in office by splurging on new investments, that this is not the time to go wild on new projects.

 

One group of players that might welcome a little inflation is the banking sector.  The good news is that last year’s profits have not been reported yet but are expected to surge.  According to an article in the Financial Times, analysts are expecting pre-tax profits to be up 83% in 2007 over 2006 (the 2007 estimate for pre-tax profits is for RMB 610 billion).  For four of the big five (the exception is ABC), ROA went up from 0.88% to 1.11%, a healthy improvement. 

 

On the other hand there is rising concern about real estate loans and declining real estate prices.  Yesterday the CBRC’s vice-chairman Jiang Dingzhi warned bank executives on the CBRC website of the risks of lending to real-estate developers, highly polluting or energy-intensive firms, and other problem sectors, ordering them to step up controls to prevent a rebound in bad loans.  According to today’s South China Morning Post:

 

More than one quarter of the new loans extended by domestic banks in Shanghai last year went to real estate, and by the end of last year the sector accounted for about 32 per cent of their outstanding loans, the 21st Century Herald reported on Thursday. The National Audit Office issued a separate warning that banks were lending too much to finance road construction - their exposure was 800 billion yuan at the end of 2005.  Bad management of some roads and insufficient toll collections meant many banks were finding it hard to recoup their loans, state media said.

 

I have heard it said, often enough that I believe it, that a lot of real estate lending is effectively hidden on the banks’ balance sheets and is not classified as such.  Banking exposure to real estate prices is much greater than the already high exposure levels reported.  As I mentioned in an earlier post, the NPL ratio rose slightly during the last quarter of 2007.  It was only a small increase in a year in which the ratio declined overall, but it occurred during a period rapid economic growth, slowing loan growth, and ample liquidity.

 

THU 28 FEB

Revisiting the one-child policy By Michael Pettis

As a finance guy whose area of interest is financial stability and the impact of short-term adjustments on the economy, I usually don’t spend a lot of time thinking about what might happen in the next few decades, but because of the significant and historically unprecedented demographic imbalances we are seeing in the world today, and especially in China, in spite of myself I have found myself paying attention to demography.  In that light a few weeks ago I began hearing rumors that the Chinese government was seriously considering revising the one-child policy.  Yesterday a number of newspapers around the world carried articles on the topic.  This is what The Times of London had to say:

 

China's political leadership is considering ending the country's hated “one-child” policy because it is damaging the economy and creating a demographic timebomb, a senior minister admitted today.

Zhao Baige, Vice Minister of the National Population and Family Planning Commission, revealed that there is concern at the highest levels that the policy is already tearing apart the fabric of society.

 

"This has become a big issue among decision makers," Ms Zhao told reporters at a routine government press conference in Beijing.  "We want incrementally to have this change. I cannot answer at what time or how."

 

…Ms Zhao suggested that long-term planning on how to bring the policy to at least a partial close may already have begun.  "The attitude is to do the studies, to consider it responsibly and to set it up systematically," she said

 

There have been similar reports in the past about a reconsideration of the one-child policy.  So far nothing much has happened and this may be another case of more of the same – it usually takes a crisis to get the leadership to reverse course dramatically.  Still, as things stand today China has a real demographic problem.  

 

Not only is the population aging at an alarming rate – it is among the most rapidly-aging countries in the world, and the only low-income member in the club of rapidly-aging countries – but it has a serious sex imbalance with about 60-70 million more males than females.  Along with the rate of aging the sex imbalance is also supposed to be a consequence of the one-child policy, although sex imbalances in other Asian countries without birth policies suggest that the reason may be more complex.  As for the rate of aging, I don’t have the numbers in front of me but I think I remember that today just under one in ten Chinese is above the age of 65, whereas in twenty years just over one in four will be.  Please don’t quote me on this because I am relying on my terrible memory for the ratios, but certainly China is aging rapidly.

 

That makes the need to address the one-child policy more urgent than ever.  The members of China’s big baby boom of the 1950s and early 1960s are for the most part still working, but in ten to twenty years they will be moving into retirement, and the number of working age people whose efforts will be needed to support them is not growing nearly as quickly.  To solve the problem China needs more young people. 

 

The problem is that while a relaxation of the one-child policy may be very good for China in the long term, and perhaps even necessary if China is not to suffer a terrible old-age crisis in the next few decades, in the short run it may create even more demographic challenges that may make the authorities less willing than ever to move. 

 

For that reason it is worth considering what the impact of a relaxation of the one-child policy might have in the medium term.  In the long term birth rates would probably decline naturally in China as they have everywhere else.  I read one poll that suggested that most urban Chinese said they wanted to have at most two children, and I think in twenty or thirty years Chinese fertility, even without a one-child policy, would be similar to that of many other urban Asian countries. 

 

But in the short to medium term if the one-child policy were to be relaxed there would almost certainly be a baby boom.  That suggests that for the next 20-25 years China’s dependency ratio, which is already expected to deteriorate dramatically after 2010-2011, will probably get a lot worse before it gets better.  A smaller proportion of China’s population, in other words, would need to produce the goods and services – including expanded health care, education facilities, and a social safety net – needed by a rapidly-growing elderly population and a rapidly-growing population of children.

 

As an aside, my friend Dan Rosen and I have in the past discussed the evolution of China’s trade balance and foreign currency reserve position, and Dan has argued, and I agree, that one consequence of China’s aging population may be future pressure on the trade account.  It may not be irrational, in other words, for China to accumulate such a huge stockpile of foreign exchange reserves because for some period in the future China may be forced to pay for demographic adjustments and finance a trade deficit by liquidating foreign holdings. If China were to experience a baby boom in the near term the pressure would be even greater.