China’s possible economic futures – New economy drives growth, stagnation or crisis

Three financial scenarios were published in a Financial Times article and reviewed by economist and analyst Michael Pettis.

SCENARIO 1: THE “NEW ECONOMY” WILL DRIVE GROWTH

In the first scenario proposed by the Financial Times—clearly the best-case scenario—the focus is on growth in consumption-related and “new economy” sectors in China. If these sectors continue growing at current rates, according to those who expect this to be the most likely outcome, they can soon replace the old, contracting sectors of the economy as the main source of demand that drives economic activity and keep growth rates high.

Pettis agrees there are certainly good things happening at the micro level in the Chinese economy, we cannot ignore the macro if these create growth constraints.

Nextbigfuture notes that there is the possibility of positive returns from the One Belt One Road investments in other countries.

Where Pettis really disagree is with Dehn’s Financial Times scenario is with characterization of savings. Dehn seems to have confused China’s total savings with the personal savings of Chinese households, a common mistake even among economists, but a mistake nonetheless and especially egregious in the case of China. Dehn seems to think that China saves nearly half its GDP because Chinese workers save nearly half their paycheck, and that because it is relatively easy to induce workers to cut back on their savings, the country can easily rebalance demand toward consumption.

Leaving aside that as uncertainty rises we should expect the household savings rate in China to rise, as it has been doing, and not fall, this characterization of savings fails to understand that changes in household savings preferences almost don’t matter. Contrary to what Dehn claims, it is not at all the case that at roughly 50 percent of GDP, China has the highest savings rate in the world—and the lowest consumption rate, which is the same thing—because when the average Chinese worker receives his RMB 100 paycheck he immediately puts half of it into his bank account. The average worker of course puts in a lot less than that, and more importantly, it isn’t the average worker that drives China’s high savings rate. The reason China has the highest savings rate in the world is because when the average Chinese worker produces RMB 100 of goods and services, he only gets a paycheck of roughly RMB 50, of which roughly RMB 15 is put into his bank account. The rest of the roughly RMB 35 in savings has nothing to do with household saving and instead comes from businesses and government entities.

Chinese households are not able to consume a substantial portion of what they produce, in other words, simply because they are paid too low a share of what they produce. The constraint on consumption growth is not the savings preferences of the Chinese household. It is the very low share of GDP Chinese households retain.

This is why a surging “new economy” cannot generate enough growth over the medium and long term without some mechanism that drives up household income growth, any more than will improvements in supply-side efficiency. GDP growth cannot be maintained while investment growth decelerates unless consumption growth accelerates, and consumption growth cannot accelerate to anywhere near the extent that it must unless the growth in household income accelerates.

Pettis thinks there are only two ways in which current growth rates can be maintained. These are:

1. If Chinese investment is on the whole productive, and the value of assets is growing as fast as the value of debt, then we can assume that current growth rates are not driven mainly by excessive debt and that Chinese growth is sustainable without the need to bring down investment growth. Of course, with debt in 2016 rising by roughly 40–45 percentage points of GDP while nominal GDP grew by less than 8 percent, it isn’t easy to explain how the real value of assets in China grew by roughly 40–45 percentage points of GDP, nor why it is proving so difficult to rein in credit growth without a sharp slowdown in GDP growth.

2. If, however, Beijing does need to bring down investment growth, then if Beijing can engineer a transfer of wealth from local governments of roughly 3–4 percentage points of GDP every year, household income growth will speed up by enough to keep GDP growing at 5 percent or more even as investment growth is allowed to drop sharply. The problem is that Beijing has so far found even much smaller transfers incredibly difficult, and while in theory transfers of that magnitude are not impossible, I think they are extremely implausible for obvious political reasons. This is especially the case when one considers that the larger the transfer program, the greater the “wastage” likely in order to buy off political opposition, which means that for each unit of wealth actually transferred to households, the value of assets liquidated must be higher.

SCENARIO 2: STAGNATION

This is the scenario that Pettis has always argued is the most likely. Under this scenario, growth drops steadily during the economic adjustment period, but in an orderly way for over a decade or more as Beijing slowly gets credit growth under control. This scenario must also involve a wealth transfer process, but at roughly 1–2 percentage points of GDP, it is I think politically manageable.

Several years ago Pettis argued that beginning in 2011–2012, an optimal adjustment scenario might see reported GDP growth drop by roughly 100 bps a year or more to average under President Xi (during the 2013–2023 period) no more than 3–4 percent. Both household income and consumption in this scenario will grow faster than GDP, perhaps by 4.5–5.0 percent, because of wealth transfers of roughly 1–2 percentage points of GDP annually. Although many might find a forecast of 3–4 percent GDP growth shocking, Pettis should add that in fact he is not predicting 3–4 percent average growth. Three to four percent is the highest number that I can logically work out except by making implausible assumptions. The actual average growth could be lower.

SCENARIO 3: ACUTE CRISIS

The authors worry about

the dangerous nexus between shadow lenders and large, systemically important commercial banks. Trusts raise funds for their loans by selling high-yielding wealth management products [WMPs] to investors. For the riskiest trust products, banks typically serve only as sales agents but bear no legal responsibility for product payouts.

Yet investors often ignore these technicalities, assuming that state-owned banks — and by implication, the government — stand behind the products they distribute. Adding to the perception that defaults are impossible is a history of bailouts of WMPs by banks, even where no legal responsibility exists.

Pettis continue to think that a financial crisis in China is unlikely, but as debt levels rise, it takes smaller and smaller shocks to cause balance sheet unraveling, and so a crisis becomes increasingly likely if the debt burden continues to soar. Contrary to widespread beliefs, financial crises are not caused by insolvency. They are caused by systemic asset-liability mismatches acute enough that a collapse in liquidity make impossible to bridge. In the article this is exactly the risk that is highlighted:

Yet wealth management defaults alone would probably be insufficient to spark a crisis. They would have to coincide with a system-wide tightening of liquidity, which would magnify the effect of isolated defaults by making it more difficult for banks to fall back on interbank borrowing.

As long as the regulators are credible, however, what looks like significant asset-liability mismatches within the Chinese financial system are in fact manageable because the regulators can restructure most of the relevant liabilities.

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