What does a “good” Chinese adjustment look like?

I have always thought that the soft landing/hard landing debate wholly misses the point when it comes to China’s economic prospects. It confuses the kinds of market-based adjustments we are likely to see in the US or Europe with the much more controlled process we see in China. Instead of a hard landing or a soft landing, the Chinese economy faces two very different options, and these will be largely determined by the policies Beijing chooses over the next two years.

Beijing can manage a rapidly declining pace of credit creation, which must inevitably result in much slower although healthier GDP growth. Or Beijing can allow enough credit growth to prevent a further slowdown but, once the perpetual rolling-over of bad loans absorbs most of the country’s loan creation capacity, it will lose control of growth altogether and growth will collapse.

The choice, in other words, is not between hard landing and soft landing. China will either choose a “long landing”, in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing – a few years of continued growth of 6-7% – followed by a collapse in growth and soaring unemployment.

A “soft landing” would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing”. It is not an alternative.

Surprisingly enough until the announcement last month that Zhou Yonkang was under investigation, Premier Li has been pretty insistent that China will make its 7.5% growth targets, even as many analysts have lowered their expectations (Moody’s and the IMF are now saying that 6.5% is a possibility), and it is clear that President Xi is taking far more responsibility for and control of the economy than any recent president. My guess is that as the problems of the real estate sector kick in, with lower prices causing a drop in real estate development, which matters for employment, we are likely to see additional stimulus spending aimed at managing the threat of unemployment and, perhaps more importantly, at managing the possibility of rising anger among provincial elites as the glorious prospect of easy money continues to retreat.

This, to me, is the explanation for the rather surprising insistence by Premier Li in June that 7.5% GDP growth was a hard target. GDP targets are part of domestic signaling about the expected pain of adjustment. I suspect that lower growth targets are likely to generate greater opposition.

Certainly it does seem that growth has temporarily bottomed out. According to this June’s Financial Times “Expenditure by local and central governments in China jumped nearly 25 per cent from the same month a year earlier, a sharp acceleration from the 9.6 per cent growth registered in the first four months of the year, according to figures released by the finance ministry,” and HSBC’s Flash PMI index suggests for the first time in six months that there has been an expansion in manufacturing, although the flash index is, of course, preliminary and may be revised.

Can Beijing rein in credit?

There should be nothing surprising about the improvement in some of the numbers. The “soft landing” that we are seeing is a consequence of credit growth. It means that it is proving politically hard to implement reforms as quickly as some in the administration would like, and it also means that we are getting closer to debt capacity constraints. We would be better off with the long landing scenario, in which GDP growth rates drop sharply but manageably by 1-2 percentage points every year.

I have written many times before that what will largely determine the path China follows is the political struggle the Xi administration will have in imposing the needed reforms on an elite that will strongly resist these reforms – mainly of course because these reforms must necessarily come at their expense. As an aside my friend, Ken Miller, with whom I was having a very different discussion last week, just sent me one of his favorite John Galbraith quotes (from The Age of Uncertainty) that seemed apropos.

People of privilege will always risk their complete destruction rather than surrender any material part of their advantage. Intellectual myopia, often called stupidity, is no doubt a reason. But the privileged also feel that their privileges, however egregious they may seem to others, are a solemn, basic, God-given right. The sensitivity of the poor to injustice is a trivial thing compared with that of the rich.

Although I don’t think China’s economy is adjusting quickly enough, especially credit growth, I remain cautiously optimistic that Beijing knows what it must do and will be able to pull it off. In an older issue of my blog, I tried to place the last 3-4 decades of Chinese growth in a historical context that recognizes four different stages of this growth process. By doing so I try to show how China’s own recent history can help us understand how to consider the policies President Xi must implement.

The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.

This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. In this issue of the newsletter I want to write out a little more explicitly what such an orderly adjustment might look like.

Will financial repression abate?

The key economic policy for China over the past two decades has been financial repression. There have been three components to financial repressive policies. First, by constraining the growth of household income and subsidizing production, China forced up its savings rates to astonishingly high levels. Second, by limiting the ways in which Chinese households could save, mostly in the form of bank deposits, Beijing was able to control the direction in which these savings flowed. Finally, Beijing controlled the lending and deposit rates and set them far below any “natural” level.

Very low interest rates had several important impacts. First, because they represented a transfer from net savers to net borrowers, they helped to exacerbate the split between the growth in household income (households are net savers) and the growth in GDP (which is generated by net borrowers), and so led directly to the extraordinary imbalance in the Chinese economy in which consumption, as a share of GDP, has declined to perhaps the lowest level ever recorded in history.

Second, by making credit extremely cheap for approved borrowers, it created among them an almost infinite demand for credit. Financial repression helped foster tremendous growth in economic activity as privileged borrowers took advantage to borrow and invest in almost any project for which they could get approval.

Third, when China desperately needed investment early in its growth period, this growth in economic activity represented real growth in wealth. But low interest rates, along with the moral hazard created by implicit guarantee of nearly all approved lending, led almost inevitably to a collapse in investment discipline. Financial repression has been the main explanation for the enormous misallocation of capital spending we have seen in China during the past decade.

This is why understanding financial repression is so important to understanding the way in which China will adjust. There are two ways to think about the “cost” of financial repression to net savers. The least sophisticated but easiest to explain is simply to look at the real return on loans and deposits. In this case you would subtract the appropriate deflator from the lending or deposit rate.

In the US we usually use CPI inflation as the deflator, but for many reasons this won’t do in China. Consumption is a much lower share of GDP in China than in the US or anywhere else, so that it is less “representative” of economic activity, and there is anyway a great deal of dispute about the rate at which the consumption basket is actually deflating (Chinese households seem to think it seriously understates inflation). I prefer to use the GDP deflator, which until about 3-4 years ago was in the 8-10% region and currently runs around 1-2% or even less, depending on the period you are looking at.

Using the GDP deflator suggests that the real rate for savers has been very negative for most of this century until the past three years – with savers implicitly losing perhaps as much as 5-8% of their real savings every year. It also suggests that the real rate for borrowers has also been negative, perhaps by 1-3% for most of this century. Clearly these interest rates are too low, especially for a very volatile, poor, and rapidly growing economy.

The more appropriate measure of financial repression is not the deflator, whichever one we choose to use, but rather very roughly the gap between the nominal lending rate and the nominal GDP growth rate, the latter of which broadly represents the return on investment within the economy. Until a few years ago nominal GDP grew at around 18-21% while the lending rate was around 7%.

This is a huge gap. In this case the “cost” of financial repression to households was the gap between nominal GDP growth and nominal lending rates, plus an additional 1-1.5% to account for the larger than normal gap between the lending rate and the deposit rate. This is because in China the gap between lending and deposit rates during this century has been much higher than in other developing countries, probably as part of the process of recapitalizing the banks after the last banking crisis at the turn of the century.

If you multiply the sum of these two gaps by the total amount of household and farm deposits (very roughly around 80-100% of GDP a few years ago, when I last checked), you get an estimate of the total transfer from the household sector to banks and borrowers. Because I think China’s nominal GDP growth has been overstated by a substantial amount because of its systematic failure to write down bad loans, I usually have subtracted 2-4 percentage points from the nominal GDP growth rate before I did my very rough calculation. This was how I got my 5-8% of GDP estimate for the amount of the annual transfer from households to borrowers. This of course is a huge transfer, and can easily explain most of the decline in the household share of GDP over this period.

It is worth noting by the way that a recent widely-discussed study by Harry Wu of the Conference Board claims the China’s average GDP growth from 1978 to the present was not 9.8% but rather 7.2%. The main reason for the revision, according to Wu, is that the GDP deflator had been significantly underestimated which, if even partially true, means real interest rates were even lower (more negative) than I have assumed.

There is some controversy about whether it is true that the nominal lending rate should be broadly equal to the nominal GDP growth rate. In fact most studies of developed countries suggest that over the medium and long term this is indeed the case. UBS tried to show that this was not applicable to China and did a study several years ago showing that among developing countries this relationship didn’t hold. Their studies suggested that among developing countries nominal lending rates had on average been around two-thirds on nominal GDP growth rates (although China, at around one-third, was still well below anyone else’s at the time).

I had a real problem with their sample of countries however. Their sample included a lot of small OPEC countries, who necessarily had high growth and low interest rates when oil prices were high, as well as a lot of Asian countries that followed the Japanese development model and themselves practiced financial repression, which of course made them pretty useless as points of comparison. Neither group of countries, in other words, could help us determine what a “normal” interest rate is compared to nominal GDP.

But regardless of the debate, the point to remember is that when the nominal lending rate is much below the nominal GDP growth rate, two very important things happen. First, it helps eliminate capital allocation discipline. If GDP is growing nominally at 20%, for example, and you can borrow at 7% (which was the case in China for much of this century), you should rationally borrow as much as you can and invest it into anything that moves, no matter how poorly thought out the investment. Imagine a totally ineffective investor, or one whose incentives do not include earning a reasonable return on capital, who manages to earn on his investment only half of nominal GDP. This would be a pretty poor use of capital.

Adjusting the repression gap

But with nominal GDP is growing at 20%, this extremely incapable investor still makes a substantial profit by borrowing at 7% and earning 10%, even though his investment creates no value for the economy. His “profit”, in this case, is simply transferred from the pockets of saving households.

Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.

This was why financial repression, although useful in the early stages of China’s growth period because it turbocharged investment, ultimately became one of the county’s biggest problems once investment no longer needed turbocharging. For many years nominal GDP growth in China was 18-21% and the official lending rate was around 7%. This, combined with widespread moral hazard, had inevitably to result in both tremendous misuse of capital and a sharp decline in the consumption share of GDP (as the household income share declined) – both of which of course happened to a remarkable degree in China.

In the last year or so, however, the official lending rate has risen to 7.5% and nominal GDP has dropped to 8-9% (and just under 8% in the first quarter of 2014). This changes everything in China. First, it is now much harder for borrowers to justify investment in non-productive projects because they can no longer count on the huge gap between nominal GDP growth and the lending rate to bail them out of bad investments. Of course this also means a dramatic slowdown in economic activity, but because this slowdown is occurring by the elimination of non-productive investment, the slowdown in Chinese growth actually represents higher wealth creation and greater real productivity growth. China is getting richer faster now than it did before, even though it looks like wealth creation is slowing (the difference is in the slower required accumulation of bad debt).

Second, the huge transfer from net savers to net borrowers has collapsed, so that growth in the future must be far more balanced. Over time this means that households will retain a growing share of China’s total production of goods and services (at the expense of the elite, of course, who benefitted from subsidized borrowing costs) and so not only will they not be hurt by a sharp fall in GDP growth, but their consumption will increasingly drive growth and innovation in China.

Interest rates are still too low, but not by nearly as much as in the past, and over the next two years as nominal GDP growth continues to drop, the financial repression “tax” will be effectively eliminated. When this happens solvent Chinese businesses will be forced to use capital much more productively, and slowly they will learn to do so. In that case the PBoC will be able to liberalize interest rates (although not without tremendous political opposition from those that have depended on having great access to very cheap capital for their wealth) without worrying about either the deposit rate of the lending rate surging.

There is, however, one group of wasteful borrowers for whom higher interest rates will not represent a more careful approach to borrowing and investing and these, of course, are borrowers that are already effectively insolvent or otherwise unable to repay loans coming due. In that case as long as they can borrow they will do so, no matter the interest rate. It is not clear to me how many such borrowers exist, but I’d be surprised if there weren’t an awful lot of them. These borrowers can only really be disciplined by constraining credit growth and eliminating government support, including implicit guarantees, but this might not be happening.

One of the ways Beijing seems to be reducing the pain of more expensive borrowing (relative to nominal GDP growth) is to loosen credit in a targeted way. We have heard talk of targeted bond purchases although it is not yet clear what exactly Beijing plans to do. An article in Caixin suggests that regulators may also be trying to relax the loan to deposit constraint:

The China Banking Regulatory Commission (CBRC) will change the rules for figuring the loan-to-deposit ratio so banks can have more money to lend to businesses, an official with the regulator says. The requirement that the ratio not exceed 75 percent – meaning banks cannot lend more than 75 percent of their deposits out – would remain the same, but the way ratio is calculated would be adjusted, Wang Zhaoxing, deputy chairman of the CBRC, said June 6.

The regulator would consider broadening the scope of deposits to include “relatively stable” funds that are not now used to calculate the ratio, he said. He did not say what the funds could be, and added that a precondition for doing this was keeping the money market stable.

I suspect that over the next few months we are going to get very inconsistent signals about credit control. But as long as the PBoC can continue to withstand pressure to lower interest rates – and it seems that the traditional poor relations between the PBoC and the CBRC have gotten worse in recent months, perhaps in part because the PBoC seems more determined to reduce financial risk and more willing to accept lower growth as the cost – China will move towards a system that uses capital much more efficiently and productively, and much of the tremendous waste that now occurs will gradually disappear. Just as importantly, lower growth will not create social disturbance because Chinese households, especially the poor and middle classes, will keep a larger share of that growth.

So what does “good” rebalancing look like?

It seems pretty clear to me that the great distortions in the Chinese economy that led both to rapid but unhealthy growth and to the consumption imbalance (by forcing down the household income share of GDP) are gradually being squeezed out of the system. One distortion has been the excessively low exchange rate, but after seven years of 30-40% net appreciation against the dollar, the RMB is far less undervalued today than it has been in the past. I still do not agree, however, with analysts who say the currency is actually overvalued and call for a depreciation, nor, more importantly, does the PBoC seem to agree.

Another one of the great distortions that led to China’s current imbalances was the very low growth in wages relative to productivity. This too has improved. The surge in wages in 20010-11, and their continued relatively rapid pace of growth, has reduced this distortion significantly, especially as it is becoming increasingly clear that productivity growth has been overstated in recent years.

Most importantly, with nominal GDP growth rates having dropped from 20% to 8-9% the greatest of all the distortions, the interest rate distortion, has been the one most dramatically to adjust in the past three years. This is why even though many people I respect are still insisting that China has not really rebalanced I am moderately optimistic that in fact China is adjusting as quickly as could be expected. Credit growth remains a serious problem, but the forces that put China in the position of relying on excess credit growth have genuinely abated.

And it is this abatement of the great distortions that have caused growth to slow so rapidly, and although we haven’t seen much evidence of significant rebalancing yet, it should take a few years for the effects fully to be worked out. Chinese growth is less dependent than ever on the hidden transfers from the household sector, and these transfers both encouraged massive waste and created the imbalances that required this massive waste to continue.

China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten the vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one or two years be able even to get credit growth under control, before debt levels make an orderly adjustment impossible.

It won’t be easy, and already there are many worried about the politically destabilizing impact his measures may have. The Financial Times, for example, had the following article:

Mr Xi came of age in that turbulent time and watched as his elite revolutionary family and everything he knew were torn to pieces. Now it seems it is his turn to wreak havoc on the cozy networks of power and wealth that have established themselves in the era of “socialism with Chinese characteristics”. In recent weeks, the president’s signature campaign against official corruption appears to have spilled into something more significant and potentially destabilising for the increasingly autocratic regime.

Clearly there are many risks to Xi’s political campaign, and unfortunately I have no special insight into how these are likely to play out, but if Xi is able to consolidate power enough to impose the reforms proposed during the Third Plenum, Chinese growth rates will continue to decline sharply but in an orderly way. Average growth during the decade of his administration will drop to below 3-4%, but an orderly adjustment means that not only will the hidden transfers from the household sector be eliminated, they will also be reversed.

If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%. Remember that by definition rebalancing means that household income must grow faster than GDP (as happened in Japan during the 1990-2010 period).

This has important implications. First, the idea that slower GDP growth will cause social disturbance or even chaos because of angry, unemployed mobs is not true. If Chinese households can continue to see their income growth maintained at 5% or higher, they will be pretty indifferent to the seeming collapse in GDP growth (as indeed Japanese households were during the 1990-2010 period). Second, because consumption creates a more labor-intensive demand than investment, much lower GDP growth does not necessarily equate to much higher unemployment.

A “good” and orderly adjustment, in other words, might look a little like this:

1.    GDP growth must drop every year for the next five or six years by at least 1 percentage point a year. If it drops faster, the period of low growth will be shorter. If it drops more slowly, the period of low growth will be stretched out. On average, GDP growth during President Xi’s administration will not exceed 3-4%.

2.    But this does not mean that household income growth will drop by nearly that amount. Rebalancing means, remember, that household consumption growth must outpace GDP growth, and the only sustainable way for this to happen is for household income growth also to outpace GDP growth.

If consumption grows by four percentage points more than GDP, Chinese household consumption will be 50-55% of GDP in a decade – still low, but no longer exceptionally low and quite manageable for the Chinese economy. This suggests that if investment growth is zero and the trade surplus does not vary much, 3-4% GDP growth is consistent with 6-7% household income growth. It might be in principle possible to pull this off if Beijing is able to transfer 2-4% of GDP from the state or elite sector to the household sector by reforming the hukou system, land reform, privatizations, and other transfers, but of course we shouldn’t assume that this level of household income growth will be easy to maintain once investment growth, and with it GDP growth, drops sharply.

3.    What about employment? If investment growth falls sharply, especially investment in the real estate sector, it should cause unemployment to surge, which of course puts downward pressure on household income growth as well as on consumption growth, potentially pushing China into a self-reinforcing downward spiral. This, I think, is one of the biggest risks to an orderly adjustment. The good news is that if large initial wealth transfers to households can kick start a rise in consumption, growth driven by household consumption, especially growth in services, tends to be much more labor intensive than the capital-intensive investment growth that too-low interest rates have forced onto China. A transfer of domestic demand from investment to consumption implies, in other words, that employment growth can be maintained at much lower levels of GDP growth.

Alternatively the state sector can mop up unemployed workers by putting them into make-work jobs, even if they are not economically productive – more infrastructure anyone? – but if we do not want this to worsen the imbalances and reverse the adjustment, they key is how these jobs are funded. If the state funds these unproductive workers by borrowing at repressed rates from households, or by otherwise raising direct or hidden household taxes, this way of managing unemployment will indeed serve simply to prevent or even reverse the adjustment process. But if these jobs are funded by the liquidation of state assets, by borrowing at real market rates, or by indirect transfers from the state, they become one of the ways in which wealth is transferred to households, and the Chinese economic can continue to adjust successfully.

4.    What about the debt, which is the other great risk to an orderly and successful Chinese adjustment? There are two things China can do to address its substantial debt problem. First, it can simply transfer debt directly onto the government balance sheet so as to clean up banks, SOEs and local governments, thus preventing financial distress costs from causing Chinese growth to collapse. As long as this government debt is rolled over continuously at non-repressed interest rates, which will be low as nominal GDP growth drops, China can rebalance the economy without a collapse in growth. This, essentially, is what Japan did in the 1990s.

The problem with this solution is that it is politically attractive (no wealth transfers from the elite to ordinary households) but it does not fundamentally address China’s debt problem, but rather simply rolls it forward. In that case the burgeoning government debt will itself prevent China, once the economy is rebalanced, from ever regaining rapid growth. I have previously explained why the debt burden can prevent growth in my discussions of why I do not think Abenomics can succeed, if by success we mean raising inflation and real GDP growth. What’s more, if a relatively poor, volatile economy like that of China cannot bear the debt levels that a country lie Japan can bear, it is not clear that this solution will work even during the rebalancing period.

A real solution to the debt problem, in other words, may involve initially a transfer of debt onto the government balance sheet, but ultimately Beijing must then take real steps to lower debt relative to debt capacity. This may involve using privatization proceeds to pay down debt, higher corporate taxes, and even higher income taxes if other forms of wealth transfer are robust enough to support them, but one way or another total government debt must be reduced, or at least its growth must be contained to les than real GDP growth.

5.    Although it may be hard to see it in the economic ratios, or in any real restraint in credit expansion, in fact Beijing has already taken serious steps towards rebalancing, although it may take a few more years to see this in the consumption share of GDP. The three most important of the transfers that created the imbalance have all reversed. The currency may still be undervalued, but not by nearly the extent it has been in the past, wages have risen quickly in recent years, and, most importantly by far, the financial repression tax has collapsed, and even nearly disappeared, which it will do fully in the next two years as nominal GDP growth continues to fall (as long as the PBoC does not reduce rates by much more than one or two percentage points over the next two years). Even the much-ballyhooed decision to improve the environment represents a partial reversal of one of the sources of the household share imbalance.

All of these mean that the hidden transfers that both generated spectacular growth in economic activity (if not always in economic value creation) and the unprecedented drop in the household income share of GDP no longer exist, or do so to a significantly reduced extent. It will take time for the elimination of these transfers to work themselves fully though the economy, but we are already seeing their very obvious initial impacts in the much lower GDP growth numbers, even as credit creation remains high.

Credit creation remains the great risk to the economy. It is still growing much too quickly. I think there are few people in Beijing who do not understand the risk, so my guess is that political constraints are the main reason that credit has not been more sharply reduced. I believe that the president cannot allow too sharp a contraction in credit growth until he feels fully secure politically, and for me the pace at which credit is brought under control is, to a large extent, an indication of the pace of the process of power consolidation.

The best-case scenario

Although I am still cautiously optimistic that Beijing will pull off an orderly rebalancing, I want to stress that the scenario described above is not my predicted scenario. It is, instead, an examination of the best case of an orderly transition towards a more balanced economy.

As regular readers know I am not very comfortable making predictions, preferring instead to try to understand the structure of an economic system and work out logically the various ways in which that system can evolve. The description above is one of the ways in which it can evolve, and because I think this is probably the best-case scenario, I thought it might prove useful as a way of framing thinking about the adjustment process for China.

One caveat: This is not necessarily the best-case assumption. I can make certain assumptions, which I haven’t made because I believe them to be implausible, although not impossible, that lead to a better outcome. If the global economy were to recover much more quickly than most of us expect, and, much more importantly, if Beijing were to initiate a far more aggressive program of privatization and wealth transfer than I think politically possible, perhaps transferring in the first few years the equivalent of as much as 2-5% of GDP, the surge in household income could unleash much stronger consumption growth than we have seen in the past. This could cause GDP growth over the Xi administration period to be higher than my 3-4% best-case scenario.

The amount of the direct or indirect wealth transfer from the state sector to ordinary households is, I think, the most important variable in understanding China’s adjustment. The pace of growth will be driven largely by the pace of household income growth, which will itself be driven largely by the pace of direct or indirect wealth transfers to ordinary Chinese households. If we could guess this right, much else would almost automatically follow.

 

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125 Comments

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  1. great article! 2 questions. 1, Governor Zhou Xiaochuan promised to finished the marketization of interest rate next year. How do you think it will impact the adjustment process of China? 2, I think the different kind of investments really matters. If the government is committed to investing on healthcare and education, do you think it can be regarded as a transfer of wealth to households? Thanks a lot!

    • Thanks, Peter:
      1. The lending rate hasn’t gone up much but over the past 3-4 years nominal GDP growth dropped from around 20% to around 9%, and the GDP deflator dropped from 8-10% (more, according to Harry Wu) to around 1-2%. I would argue that financial repression, consequently, has nearly been eliminated. Another one or two more years in which nominal GDP continues to drop by 1-2 percentage points a year (which I fully expect), and lending rates should be more or less in line with “reality” (deposits rates however will still be 1-2 percentage points too low). In that case the PBoC can liberalize interest rates, as they have promised, without causing lending rates to skyrocket. The impact is already being felt. The days when preferred borrowers had infinite demand for credit are already past because they are no longer able to profit no matter how foolish the investment, although of course insolvent borrowers are not sensitive at all to interest rate rates and I expect them to continue demanding rollover credit until they are finally forced to stop. This is the main reason, in my opinion, that growth has slowed — it is no longer propped up by out-of-control investment.
      2. Investing in healthcare and education certainly increases household “assets”, but whether their wealth increases depends on how the spending is funded. If it is funded by the liquidation of state assets, households will benefit. The key is always how expenditures are funded.

      • Thanks Michael! I totally agree with the first one. For the second, you mentioned liquidation of state-owned asset. As I mentioned in another comment, it might be unacceptable for the government now. They might try to integrate and encourage private investment into these SOEs instead of selling them. Maybe a large state-owned investment firm like Temasek is their ideal model. I am not sure whether a large “Temasek” will work for China.

  2. [email protected]

    Your writing is a model of clarity. It leaves me mulling the political dimension, namely the resistance of elites to reforms that would undermine them.

    I wonder if the anti-corruption campaigns have been targeted at the elites who could have been the most effective at that resistance (rather than at the most corrupt).

    I wonder whether the last two stages, which have strengthened these elites, now have China in a political trap. I just don’t see many examples in history of such massive changes which benefited the many at the expense of the few – when the many (in this case the workers and consumers of China) did not have access to the levers of power and the few were well entrenched. Do you have such examples at hand?

    There was an interesting incident not long ago when there was an extravagant military demonstration in front of a visiting American and the host (Li?) was taken by surprise. The implication was the military had decided on its own to try a bit of shock and awe with the American.

    • That is the question, isn’t it? Lots of us will tell you the answer, but don’t trust us. There are probably no more than 50-100 people in China who can really tell you what is happening politically, and of course they won’t tell you, or at least they haven’t told me.

  3. Just to round out the picture; as Prof. Pettis knows as well as anyone, China also has an increasingly deteriorating environment – air, land, food and water; increasing water scarcity; increasing number of cars on the road with rising oil imports; prices of coal, oil, gas and water have to rise; increasingly deteriorating health care and delivery system; rising cancer, aids, diabetes, heart disease etc; inadequate soc. security; ghost towns; increasingly negative demographic trends; increasing military and domestic control spending; rising ICOR; over supply and insolvent industries; less favorable international environment; elites and their billions fleeing West; weak property rights; corrupt legal system; stagnant educational system; information and political repression; pervasive corruption (still),cynicism and mistrust.
    Finally, I would add the threat of a negative Black Swan event. For example, the day of the Fukushima nuclear accident ALL of the salt from ALL of the stores in Qingdao disappeared (I was living there at the time). Then ALL of the soy sause. People believed salt would protect them from nuclear fallout. This kind of reaction could occur from political, military, financial, environmental or terrorist risk with unforseen consequences.
    None of the above problems have been sufficiently addressed with 10% real growth; now this same 2 dozen or so families who have been in power since the Truman Administration are going to succeed with 2-3% growth? Unfortunately, I cannot share Prof. Pettis’ cautious optimism. I wish I could.

    • I don’t even want to go there, Dan. I am concentrating on the medium-term adjustment process, and this has always been the hardest part of every growth miracle. You are discussing longer-term problems, of which I suspect that water and demographics are likely to be the most difficult to deal with, but how China addresses them depends crucially on how President Xi and Premier Li manage the adjustment. Modern China does have a pretty good track record of dealing aggressively with its problems, so if we can get through the adjustment process in reasonably good shape I think we can be cautiously optimistic, but this is pure speculation on my part because the future is so profoundly path-dependent on how China adjusts during Xi’s administration.

  4. ^^Michael Pettis WROTE: “..I had a real problem with their sample of countries however. Their sample included a lot of small OPEC countries, who necessarily had high growth and low interest rates when oil prices were high, as well as a lot of Asian countries that followed the Japanese development model and themselves practiced financial repression, which of course made them pretty useless as points of comparison. Neither group of countries, in other words, could help us determine what a “normal” interest rate is compared to nominal GDP….”
    ———

    India is a large developing country that, (a) is not an oil-exporting country, and, (b) does not follow the Japanese-model. Let us compare the data for China, India & US from 2000 to 2013 (period of interest):

    1) Lending rate: http://alturl.com/jugz6
    2) Real interest-rate: http://alturl.com/h9p9a
    3) Consumer Inflation (CPI): http://alturl.com/tdmhr
    4) Overall GDP Deflator: http://alturl.com/pjsj7
    5) Real GDP growth: http://alturl.com/8jw8w
    6) Nominal GDP growth: This is simply (5)+(4)

    We can tabulate the (approximate) AVERAGE of the above parameters over the 2000-13 period for all three countries as follows:

    ….PARAMETER………………..China……..India………US
    1) Lending rate…………………..6%……….11%………6.0%
    2) Real interest-rate……………2%…………5%………3.0%
    3) Consumer Inflation…………3%…………8%………2.5%
    4) Overall GDP Deflator………5%…………6%………2.0%
    5) Real GDP growth…………..10%…………7%………2.5%
    6) Nominal GDP growth…….15%………13%……….4.5%

    From the data it looks like Michael is CORRECT:
    (A) The average nominal lending rate in the US was 6%, which was about the same (or slightly higher, if you like) than the nominal GDP growth of 4.5% during the 2000-2013 period. In the US, the difference was only about 1.5 percentage points.
    (B) The average nominal lending rate in India was 11%, which was about the same (or slightly lower, if you like) as the nominal GDP growth of 13% over the same period. In India, the difference was only about 2 percentage points.
    (C) China is way off the charts, with the average nominal lending rate at 6%, when its nominal GDP growth was a massive 15% during that same period. In China, the difference was a MASSIVE 9 percentage points.

    Another interesting point of note in the data is that for the US & India, the CPI was slightly HIGHER than the overall GDP-deflator, whereas for China it is exactly the other war around, with the CPI being LOWER than the GDP-deflator. What do you make of this curious point, Michael? Is this just a random occurrence, or do you feel this has some underlying meaning in China?

    • Thanks for going through the numbers, Vinezi, but I would suggest that you smooth data out over several years for greater accuracy. At any point in time if nominal lending rates and nominal GDP growth rates are equivalent it is likely to be coincidence, but over longer periods of time I would suggest that they track each other fairly well except when there are specific factors that disrupt the relationship (financial repression tends to hold rates down, while very low government credibility forces them up). As you note, when there is a large disparity between the two then almost by definition there must be a transfer of wealth between net lenders (usually households) and net borrowers, and I think in unbalanced economies (much of the world, unfortunately) this matters.

    • As for China’s GDP deflator being so much higher than CPI inflation, part of it may have to do with inaccuracies in the data, but I would guess a substantial portion of the difference can be explained by the fact that financial repression tends to repress CPI inflation by suppressing consumption growth and goosing production growth, which is why, I think, we see what should otherwise be strange — in financially repressed economies CPI inflation is always much lower than we would have expected given how rapidly the monetary aggregates grow. I discuss this in my December 20, 2013 blog entry as well as in my book on China.

      • Michael Pettis wrote: “…..but I would guess a substantial portion of the difference can be explained by the fact that financial repression tends to repress CPI inflation by suppressing consumption growth and goosing production growth.”
        ——-

        I think you are correct. Here is the proof from Korea:
        http://alturl.com/ex5o4

        A) Before the 1997 crisis, Korea was an investment-driven economy with financial repression. As the graph shows, before 1997, the CPI was LOWER than the GDP-deflator.
        B) After the 1997 crisis, probably seeing the light, Korea reduced or stopped financial repression and turned into a more balanced economy. As the graph shows, after 1997, the CPI has been HIGHER than the GDP-deflator.

        One the other hand, here are the data for Malaysia, which indulged in financial-repression before 1997 and REFUSED to change even after the crisis, and so continues to indulge in financial-repression even today:
        http://alturl.com/cxtt3

        As seen in that graph, the CPI has been LOWER than the GDP-deflator for Malaysia without change either before or after1997.

        I am sure other readers will look up the data for their own countries of interest to see how this interesting principle plays out for other countries.

  5. Prof. Pettis,

    When I look at China, I just see volatility suppression everywhere. You’re saying that China can get growth rates to 3-4% and they should be okay, but I’m not so sure. China’s on the verge of a horrible demographic shift, which is one of the worst in the world. I’d also imagine that there’d be costs of the kind of autocratic system China’s turning to. With a rising middle class, is it really possible for China to maintain the kind of political system that it has?

    It’s very common to see autocratic/authoritarian governments seem perfectly stable for a long time and then just explode. We’re starting to see social unrest in places like Hong Kong and Xinjiang while China’s need for natural resources. Doesn’t China run a real risk of something crazy happening?

    Anyways, my main question has to do with what economic and financial risks does some sort of a geopolitical or political crisis create. If China does fragment (I’m starting to think fragmentation is likely), how would such an event impact the Chinese rebalancing?
    By fragment, I mean the possibility of places like Tibet, Xinjiang, Inner Mongolia, parts of Manchuria, and maybe even Hong Kong flying off. Although those areas account for about 40-50% of China’s land mass, they hold <7-8% of the population–probably less than that.

    • I cannot really discuss those issues, Suvy, but I do think it makes sense to think about China as a more or less optimal currency zone. In the latest issue of my newsletter I try to explain why the global crisis hit Europe so much harder than it did the US, even though it would have seemed that the US entered the crisis in much worse shape (more debt, a huge trade deficit, lower savings, bubblier stock and real estate markets, etc.). I argue that because the US is more optimally a currency zone, and because financial distress costs are not linear, the US automatically had a smoother adjustment. It gets pretty technical and I cannot summarize the (16-page) argument here, but I think the non-linearity of financial distress costs have huge implications for China. The closer China is the the US in terms of currency-zone optimality, the less painful the adjustment will be, which means among other things that the fewer provincial impediments there are to capital and labor mobility, and the easier it is to transfer costs from richer to poorer provinces, the better for China.

    • The probability of any of those regions achieving independence is negligible. In Inner Mongolian, the Mongolian minority currently comprises less than 15% of the population. One of the reasons that there has been a reemergence of separatism in Xinjiang — this goes back to the early 20th century — is because of the influx of Han Chinese into the area, which further dilutes the indigenous Uyghur population making it less likely that fragmentation would occur at the same time that violent incidents may rise (Uyghurs now make up under half of Xinjiang’s population). It is tempting to draw comparisons between Russia, or even the former Soviet Union, and China in terms of splittism or collapse, but ultimately I think such analogies and anticipations are unfounded.

  6. ^Michael Pettis WROTE: “..2. But this does not mean that household income growth will drop by nearly that amount. Rebalancing means, remember, that household consumption growth must outpace GDP growth, and the only sustainable way for this to happen is for household income growth also to outpace GDP growth.”
    ————–

    Good article, Michael. Seems logical on the whole, but I had a few doubts about the sentence above.

    Yes, I agree that the ‘only sustainable way’ for household consumption growth to outpace GDP growth is for household income growth to also outpace GDP growth. This is certainly a necessary condition, but is it SUFFICIENT?

    We note that: household income (policy affects this) = household consumption (needs to be affected for rebalancing) + household savings.

    The rebalancing policy-strategies you have often mentioned are all about increasing household INCOME share of GDP; but surely, increasing household income share of GDP is but a means to an end and not an end in itself. To actually rebalance, we need to increase household CONSUMPTION share of GDP.

    So what if your policy-reforms do cause household INCOME growth to outpace GDP growth, BUT instead of the household CONSUMPTION share of GDP rising, the household SAVINGS share of GDP rises?

    Here is why I ask this: As you have mentioned yourself, a lot of households have invested large portions of their multi-generational savings into housing. They have done so, according to your own previous articles, because (a) they are absolutely convinced that house-prices will never go down (safety, culture, herd-mentality) and (b) because property-sector has offered higher returns than available elsewhere (bank deposits, stocks). Given this situation, it is not a stretch to imagine that if housing prices go down, entire such households will be emotionally devastated and psychologically destroyed. The resulting FEAR for the future that will surely follow may cause them to INCREASE their savings rate (i.e. they will save even more of their income than ever before) by cutting back on consumption even further.

    As a result, then, it is possible that household consumption growth will NOT outpace GDP even though household income growth may well outpace GDP growth.

    If this happens, your rebalancing policies would be like what Greenspan called “pushing on a string”. Given that your policies also call for slowing investment, any such rise in the household savings rate could only be accommodated through either (1) a rise in the export-surplus (leading to trade wars), or, (2) a rise in unemployment (leading to a depression).

    Have I made a mistake in my thought process somewhere? Please advise.

    • You are absolutely right. If an increase in the household share is matched by an increase in the propensity to save, either because of rising uncertainty or because of the wealth effect, consumption won’t rise. Falling housing prices, however, have two separate wealth effects. Those who own speculative property will feel poorer, but those who are short real estate (young people, poor people) will feel richer.

  7. ^Michael Pettis WROTE: “….A transfer of domestic demand from investment to consumption implies, in other words, that employment growth can be maintained at much lower levels of GDP growth…. ….mop up unemployed workers…..”
    ————–

    Is there any reason why we should be fretting at all about “employment growth”?

    For the last 30 years, as the workforce rapidly increased in size, China was desperate to keep employment GROWTH high, so that lots of new jobs could be created for all the new entrants that flooded into the labor market during that period.

    But that phase of China’s demographics is now over. China’s workforce today has started to shrink, with more old people exiting (retiring) than young people entering. So what is the point in increasing the total number of jobs available, if the total number of workers wanting jobs is falling?

    Yes, it is true that even though the workforce as a whole is now shrinking, some of the existing workers may want to move from the agricultural/rural sector to the industrial/urban sector. But the urban workforce bore the brunt of the One-child Policy and that is where the workforce is shrinking the fastest. In other words, even without creating any more jobs overall, China should be able to avoid an high unemployment rate simply due to its demographic curve having tipped over the peak.

    Have I made a mistake in my logic somewhere, Michael?

    • >> So what is the point in increasing the total number of jobs available, if the total number of workers wanting jobs is falling?

      Mostly because the retirement funds are effectively insolvent and technically in default. Without a growing influx of new workers, the pensioners probably have to face a bail-in, losing all their retirement plans. With employment growing though, the contribution of new workers can bail the pensioners out, until it can’t…

    • It depends on how many workers are employed in the real estate sector or in sectors dependent on wasteful investment.

  8. I take the uptick in monopoly investigations as a byproduct of reform. As Chinese companies start to see investment-based avenues for profit squeeze shut, they have to look to consumption for profit. And those pesky foreign companies with their ‘monopolies’ are standing in the way of increasing market share.

    It may not be ideal, but it likely shows some of the political fallout from radically changing the economic landscape.

    • I have had similar thoughts about the investigations, but I see a connection to rebalancing. That is, suppose you run an SOE and the gov’t comes and says “we have to rebalance and that means we need to increase consumption”. You might well respond that the same net effect can be had by simply cutting the market share of foreign firms. After all, the only consumption that matters is that consumption that goes to local firms; money that goes to imports is subtracted from GDP. And the easiest way to reduce the market share of foreign firms is to simply drive them out of the market. If that doesn’t work, reducing their slice of pie is the next best bet.

  9. ^Michael Pettis wrote: “…….at managing the possibility of rising anger among provincial elites as the glorious prospect of easy money continues to retreat…….”
    ———-

    I agree with the statement, and I believe it to be factually correct. However, it does appear to lack a certain “special spice” that we have come to expect from Socialism With Chinese Characteristics as implemented by the Party of Public Assets in China. Without prejudice to the original statement, therefore, I would like to spice it up as follows:

    “…..at managing the possibility of rising REVOLUTIONARY anger amongst the HEROIC provincial elites as the GLORIOUS prospect of easy money continues its REACTIONARY retreat…..”

    What do the regular readers on this forum think? Does the modified sentence have that certain je ne sais quoi that we have come to expect from China?

  10. Michael, I know that the Chinese term for “Communist Party” is actually “Party of Public Assets”.

    I have seen you repeatedly say that in order to rebalance, the Chinese Government must, inter alia:
    (1) Sell-off state assets and transfer the resulting wealth to households, and,
    (2) Transfer all the bad debts from the economy onto its own balance sheet.

    If the Chinese government does do what you suggest, do you think it would be appropriate for the Party to rename itself as the “Party of Public Liabilities”?

  11. Just to round out the picture: China also has an increasingly deteriorating environment – air, land, food and water; water scarcity; an increasing number of cars with rising oil imports; prices of oil, gas, water have to rise; increasingly deteriorating and overwhelmed health care and delivery system; rising cancer, aids, diabetes rates; inadequate soc. Security; ghost towns; increasingly negative demographic changes; increasing military and domestic control spending with rising regional tensions; rising ICOR; massive oversupply and insolvent industries; a less favorable external environment; i.e. slower Japanese, US and European growth; elites and their billions fleeing West; weak property rights; corrupt legal system; stagnant education system; information and political repression; pervasive corruption, cynicism and mistrust. Did I miss anything?
    None of the above have been adequately addressed with 10% real growth; now these same 2 dozen or so families, who have been in power since the Truman administration, will begin to solve all of the above with 2-3% growth? Unfortunately, I do not share Prof. Pettis’ cautious optimism. I wish I could.

  12. Thanks, very interesting.

    I like your use of the word “tax” to describe the transfer from savers to borrowers, and make two points:
    1) This is a more progressive tax than the VAT and income tax/national insurance schemes we use in Europe.
    2) Although interest rates in the USA and Europe have been repressed since the nineties, our transfer from savers to borrowers is still accelerating. We are somewhat behind the Chinese curve!

    • ^^Newell WROTE: “I like your use of the word “tax” to describe the transfer from savers to borrowers, and make two points: 1) This is a more progressive tax than the VAT and income tax/national insurance schemes we use in Europe….”
      ————-

      I think you may have misunderstood what Michael was trying to say. A “progressive” tax is one which, effectively, transfers income from the top to the bottom. Whether repressed interest rates that punish savers and reward borrowers are “progressive” or not DEPENDS on WHO are the net-savers and WHO are the net-borrowers.

      Do you disagree? Let me know your thoughts.

      A) China
      The net-savers in China are ordinary households (consumers), as household debt levels are very low. The net-borrowers are corporations, businesses, billionaires, fat-cats (producers), as corporate debt levels are very high. Therefore, repressing interest rates in China leads to a transfer from consumers to producers, which, as Michael has always pointed-out, leads to an investment-driven economy. However, note carefully that the transfer in China is a REGRESSIVE one, in which income is taken AWAY from ordinary people/households and given to the Elite (Corporations, SOE, billionaires, people with Guanxi et cetera).

      B) United States
      The net-savers in the US are the richer sections of society. The net-borrowers are ordinary households (consumers), governments (redistributors), as well as companies (producers). Therefore, repressing interest rates in the US leads to a transfer from richer Americans to ordinary household & governments, which, as Michael has often pointed-out, leads to a consumption-driven economy. In contrast to China, however, the transfer in the US would be a largely progressive one, in which income is taken away from richer Americans at the top and GIVEN TO ordinary people/households and the government.
      ~~~

      In addition, I would like to point out that financial-repression via interest rate manipulation is difficult to do in the US because it has truly a free and open capital account. China can get away with financial repression because its people do not have the choice of moving their savings out of China due to the closed (or controlled) nature of China’s the capital account.

  13. Technically the government will not allow direct sale of state-owned asset, due to some ideological reasons, but they can achieve the transfer of ownership in other ways. The current mixed ownership policy is one of them. It remains to see whether these kind of measures can make things better or not.

    • Actually, Peter, some of China’s lager cities, like Shanghai, have already begun or are in the planning stages to sell off some of the local-owned SOEs. A former student of mine who now works for the SASAC-equivalent for one of China’s largest cities told me last year that they are even considering alternatives to direct sales, such as distributing shares directly to local citizens or to entities that provide services to local citizens — all good ideas but not likely to be free from opposition and I suspect the opposition is more pecuniary than ideological.

  14. prof pettis has only look at China as a self-contained Unit, but in this age of globalization, Especially for country like China which depends on export, an external shock can tip the Chinese economy into a crisis faster than most people realize

  15. Best piece of seen on this for a while (ever?). I think they can manage the issues you address, but you make a very clear case for factors which contribute to the pessimist side of argumentation.

    I would like to note that inconsistent signals is also consistent with an approach which accepts constructive contradictory tensions in managing complex issues. This is more naturally acceptable within a Maoist philosophy (this is possibly this only particularly useful thing I ever got from it).

    Also, I am not convinced that the time to target significantly reduced growth is quite there. Rather, I think they will view internal demand as the source of further gains, and there is a lot of room to go for income gains for a great number of Chinese workers. I do not disagree with the logic you present, but I think rigorous testing in macro models would be required – I don’t think off the cuff calculations will be remotely accurate here for a great number of reasons.

    Adoption of Basel standards in evaluating all forms of market and non-market risk could contribute to effective management of risk at the level of banks and credit departments of other organizations. The government may need to take some debt onto its balance sheet, but improved lending standards and internal controls are likely the main pathway to go.

    I prefer minimum wage hikes as a means to rebalance the value of the RMB. Increased purchasing power of Chinese households is largely the same as rebalancing of the RMB for many purposes, and will contribute significantly to managing the social fallout of huge inequalities of recent decades.

    • There are many was wealth can be transferred to households, including by raising wages. The key I think is to look at who gains and who loses under each form of transfer and what the economic and political implications are. I would rather see deposit rates take the brunt of the adjustment as this would make Chinese growth more labor intensive and so would help reduce unemployment pressures.

  16. I am a Chinese working as a China analyst at a think tank. It is becoming more and more apparent to many people, that the ruling Chinese Communist Party (CCP) knows it is on its last straw of survival.

    The party is facing severe and endlessly increasing systematic stress on all fronts:

    1. Increasing external oppositions from all other countries in the world including all of China’s neighbours. They are forming more and more alliances and becoming more outspoken with rising strengths against China, in addition to increasing anti-China sentiment from people in all other countries. Many countries including Canada and Australia and U.S. have just tightened their immigration policy to prevent Chinese from entering their countries. Even on these casual internet message boards, when you look past the paid Chinese propaganda professional commenters, you notice rising general anti-China feelings from all over the world.

    2. Increasing internal severe and massive violent social unrest and anti-CCP mutiny from people of all Chinese living places. To beat down internal dissent in mainland China, the CCP every year is forced to spend even more money than on its massive military budget. All the semi-external places (Hong Kong, Xinjiang, Tibet, Macau) are fighting harder and harder to break free from China. Taiwan is for all practical purposes already a separate democratic country, with its own army specificly trained to fight the PLA, and anti-China sentiment there (especially among younger Taiwanese generation) is at all-time high after seeing how China violently suppress Hong Kong as an example of “reunification”. This whole situation is continuously worsened by the free flow of information, with Chinese people knowing more and more from travelling abroad and learning about truths from jumping beyond the “Great Fire Wall” on the internet.

    3. Its own economy and social system never able to advance to higher level beyond mass skill-less manufacturing, due to complete absence of law and common morals. High technology and innovations and scientific development all require many citizens working together voluntarily contributing long term in a system they trust, with things like rule of law, no censorship on knowledge, no restrictions on speech and expression, copyrights, open minds, patents, common morals when collaborating and trading with each other etc. These qualities are all destroyed in modern China by the CCP. When was the last time you heard an announcement of technology development or innovations or scientific breakthrough coming from a Chinese organization / company / university? You haven’t because there ain’t any. Unlike mass manufacturing factory work, high level human developments cannot be forced by or bought with a dictator’s central planning. The only way contemporary China gets these things is from stealing and spying from all other countries e.g. using Chinese scientists working overseas to steal secrets, installing spywares in foreign executives’ electronic devices when they enter China etc, but these efforts have become more difficult since the whole world has caught on to their act.

    This systematic fatal flaw is why you do not see even one Chinese brand or company that can compete in the international market in any industry of the human race. For example Lenovo, who is already one of the few Chinese brands some people may have heard of, cannot make either the chips that power their computers or the operating system that run them, so it is just one of many plain vanilla boxmakers without any competitive advantage offering only cheap price. Another example Huawei is blacklisted by many countries and international customers because everyone knows Huawei’s products send all communication data back to the CCP. This CCP weakness is also why China cannot produce even one home-grown science Nobel Prize winner in its history, nor one famous business guru, nor one inspiring leader, nor one cultural icon, not even a third rate national soccer team ( Chinese work hard individually but do not work well with each other ). No rule of law in China also means no people or businesses, both Chinese and foreign, ever invest in China long-term or on a large scale because everything frequently change on a whim along with the political climate. No one trusts any contract or agreement in China because they are always broken by the Chinese and there is no legal protection whatsoever, meaning China can never advance to a knowledge economy or service economy. Your business can be seized from you any second by the military police working for someone with “guanxi”. No rule of law also ensures Shanghai fail to become a financial city despite the CCP dumping huge resources into it for 30 years.

    4. China’s mass skill-less manufacturing itself is going away to other countries due to sharply increasing costs and openly hostile and unfair business environment full of frauds and sanctioned protectionism and government robberies. The labor force is endlessly more demanding in wages and benefits expectations and working conditions. It is further worsened by the rise of robotic automatic manufacturing and 3D printing. This situation is a death knock to the “growth-based legitimacy” of the CCP, which is the only thing CCP can rely on for continuing ruling power. For sure Chinese people tolerate or even “like” the CCP when the economy seemingly explodes, but when one day it crashes and the country’s hopeless bad shape hit them in the face the people’s “support” for the CCP will turn on a dime.

    Since six months ago, all the major economic indicators for China have gone on a continuing nosedive – including manufacturing orders, export volume, commercial investments, graduate employment rate, corporate credits, foreign capital inflow, domestic consumptions, real estate prices, consumer spendings, luxury goods demand, HSBC Service PMI, survey of business sentiments etc. Suddenly all the rich Chinese tourists gobbling up luxury goods at different world cities seem to have disappeared altogether. The CCP is on its last resort of printing literally trillions of worthless renminbi to dump into massive failing and zero-ROI “state projects” that only enrich corrupted CCP officials. China’s gigantic multi-year increase of M2 money supply (it is afraid to publish the figures citing “national security”) causes way more long-term harm on itself than short-term help, and when that is over there is nothing else the CCP can do to prop up the failing economy. China currently ranks 82nd on GDP per capita and that is the highest it can go before falling sharply in the coming near future.

    5. Fierce unstoppable purges and mutually-destructive infighting among different factions within the party, who are imprisoning and killing each other every day. This power grab goes on under the laughable thin guise of “anti-corruption drive” when everyone knows all officials in china are corrupted. No work to manage the country or guide the ship is being done while this is going on.

    6. Its many previously-suppressed fatal problems have all grown too big to be contained all catching up to the CCP e.g.

    – severe carcinogenic poisonous pollution everywhere in air and water and soil and their own food etc, with the WHO issuing multiple warnings on Chinese population having the fastest cancer growth rate in the whole world
    – skyrocketing non-performaing loans, local government bad debts, world’s biggest amount of corporate debt leveraged to the hilt, “shadow banking” liabilities , unrepayable dodgy financial products etc, their true scope no one on Earth knows because all data from China are faked
    – biggest housing bubble in human history, in addition to innumerous crumbling “ghost cities” and shoddily-built vanity project “GDP-creating” infrastructure that cannot and will not be used
    – rapidly aging demographics with a 140:100 male:female ratio and world’s lowest reproductive rate (from one child policy, culture of “leftover women”, and many Chinese families killing their own daughters so as to chase boys)
    – world’s no.1 wealth inequality, with a Gini coefficient rivaling 18th century France just before the French revolution
    – complete absence of soft power / cultural influence / social attraction, partly due to CCP censorship. One result of which is minimal and sharply dwindling number of foreign professionals and tourists and students going to China. It also means the CCP only has force as the only tool to use on the international stage
    – all Chinese chasing foreign-brand goods and services while ditching low-quality Chinese-brands, who have a well known history of poisoning their own food and their own baby formula so as to make more money. This dashs CCP’s hope to build indigenous industries and a domestic consumption economy
    – gigantic need for food, energy, clean water and other vital resources bought from many foreign countries because China make few of them but need more and more of them
    – desperate mass exodus at all levels of Chinese society to escape the country using emigration or buying houses / study abroad or marriage to foreigners or plain old human smuggling, resulting in all able Chinese leaving taking huge amounts of talents and money out of the country
    – global trends of wealth polarization and robots replacing humans mean massive unemployment pressure for vast majority of the 1.4 billion population
    – corruptions and fraud throughout the whole rotten core of a system
    – young chinese today are all single child, many of them spoilt princes and princesses only used to coddling and indulgement by their parents and grandparents. They want all the nice things they see on the internet, they refuse to stoically slave away “for the country”, they will only accept nice-paying cushy office jobs so they can spend all day glued to their smartphones and mobile games, otherwise they would rather live at home on the support of their parents
    – the law of large numbers, “middle-income trap”, “Minsky moment”, “Lewis inflection point” all work against the growth-based legitimacy CCP desperately needs for its survival

    Most importantly, the CCP knows that if 1.4 billion Chinese learn about basic human qualities such as morals, truth, justice, human rights, rule of law, fairness, freedom, universal values etc the CCP will be toppled very quickly. Therefore its state-controlled brainwashing education and propaganda machinations ensure a complete lack of morals and regard for laws in all Chinese growing up and beyond. This casues Chinese not follow any rules or integrate into the system because there is neither internal incentive (moral code) or external restrictions (legal guidance). This results in failure in all basic aspects of human interactions with every modern Chinese, whether it is business trading / personal dealings / technology development / creating innovations / human communications / scientific research / artistic expressions / teamwork collaborations / academic exchange etc. Another propaganda brainwashing technique used by the CCP is to make all Chinese people pathologically nationalistic and very emotional on this issue, so the CCP can always create and point to some “foreign enemies” so as to hide all the domestic crises and government robberies going on. This attention-diverting technique is the same trick magicians have used for more than a thousand years to fool their audience.

    An interesting example would be the Chinese reaction to this report – they are expected to dismiss this report as total rubbish, accuse the author “unpatriotic” for saying the truth, shout China will only become richer and stronger than all other countries, yet they will give no counter-arguments and they will make no acknowledgement to the horrible factual conditions and complete lack of basic human qualities listed above in modern China. Ironically, the longer Chinese people deny or refuse to acknowledge the CCP problem, the longer they are only digging themselves into the hole and hurting themselves for any chance of recovery, causing the chinese economy to crash even further. Consider the example of Google, Facebook, Wikipedia, Youtube, Whatsapp, Twitter, Instagram etc – these services are all completely banned in China while at the same time the rest of the planet are on these services every second communicating ideas with each other, making friends, exchanging knowledge, doing business, working together, improving science and technology and arts, and advancing humanity.

    Some people say China economically developed a lot in past 20 years, but the truth is this “development” is actually debt borrowed against the future. After the 1989 Tiananmen Square massacre of their own students, in order to survive and hang on to power, the CCP was forced to pursue short-term explosive economic growth that sacrifice everything else, including a foundation or potential for long-term economic and social development. This “scorched earth” policy is like winning the lottery for corrupted CCP officials who can rob a lot of money from the country in the short-term before escaping to America. The only entity left to suffer is China’s future from this point on, a country that has been turned by the CCP into a place with no law, no morals, no system for future scientific or economic or social development, no spiritual support apart from money, no trust or cooperation among Chinese, no trust or goodwill from foreigners, no other country as friends, all resources sold away cheaply, entire environment and air and water and soil and food fatally polluted, only social recognition is to make a lot of money for “face”, no creativity or personal development for Chinese young people, a populus not allowed to know the truths and not allowed to say the truths.

    The end result is that majority wealth of this “debt borrowed against the future” has gone to the 0.00000001% elite ruling class “princeling” CCP families (about 250 of them) who have already smuggled trillions of dollars abroad along with their U.S. passports and their own children (all Chinese elites and Politburo members hold foreign passports, with U.S. and U.K. being the most sought after choice). For the CCP in 1989, 1.4 billion people is great central-planning asset when the country start from nothing and you order them to do backbreaking mass manufacturing repetitive factory work 20 hours a day without worker protection of any kind. But in the 2014 borderless knowledge economy when that no longer works, 1.4 billion immoral and uncooperative and selfish and undeveloped and angry Chinese contained in a lawless system without any hopes of growth is very, very dangerous liability for the CCP.

    All debts against the future have to be paid back – China is no exception. That moment may arrive a bit later than expected but it surely will come, as it has on 100% of occasions in human history. The reason that moment arrive a bit later than expected is because in normal countries bad conditions correct themselves with short periods of market ups and downs, but in China the CCP suppress all problems and criticisms until inevitable system meltdown. For China the moment has arrived to suffer the consequences for all its own chosen actions in past 30 years. All the festering fundamental systematic problems listed above and much more, are only getting worse and worse everyday until one day when the system can suddenly no longer bear.

    Think USSR in 1989.

    – Li Peng, 2014

    ( Cliff notes summary for the smartphone generation with ADD, ADHD and Asperger’s:

    – The Chinese Communist Party (CCP) signed a deal with the devil to pursue miraculous short-term economic growth
    – Miraculous short-term economic growth has been achieved, now China has hit the wall on its path of no return, many bad conditions have caught up
    – CCP cannot go on externally, it cannot go on internally, economy has no way to go but greatly down, many fatal cancers and huge structural problems from the past now overwhelming the country
    – Something has to break, what happens is anyone’s guess, guaranteed to greatly impact China and the world )

    • I am not as pessimistic as you are, Flappening, but I am glad Chinese think tankers are worried about these things. I teach at PKU that policymakers should always be thinking about the worst outcomes and how to prepare for them. If reality turns out better than expected, we can survive.

      • [email protected]

        Michael I think you could examine this one closer than your answer was. There is something I suspect in this dude? Otherwise it is “Worst Comment imaginable, from within PRC China ~ By a claimed Expert.” Contradicting Michael near 100% called “Flappening September 2, 2014 A Chinese Person working as a China analyst at a think tank. ” ~ Ok then I think an enemy external tank?”
        Rob Carter remarks there is zero here to back this man’s “think tank membership claim” Or that the think tank is not inside Americas worst phony news spinners ~ So if his #4. comments are true I have ween totally wrong as is Michael Pettit and John Mauldin and a devil of a lot of my consulting Investigator Partners when viewing Mr Xi and PRC Progress and the China ability to survive the USA depression that must come soon.

        It is becoming more and more apparent to many people, that the ruling Chinese Communist Party (CCP) knows it is on its last straw of survival. ~ The party is facing severe and endlessly increasing systematic stress on all fronts:-

        1. Increasing external oppositions from all other countries in the world including all of China’s neighbours. They are forming more and more alliances and becoming more outspoken with rising strengths against China, in addition to increasing anti-China sentiment from people in all other countries. Many countries including Canada and Australia and U.S. have just tightened their immigration policy to prevent Chinese from entering their countries. Even on these casual internet message boards, when you look past the paid Chinese propaganda professional commenters, you notice rising general anti-China feelings from all over the world.
        Rob says: USA Leaders still don’t acknowledge their problems are the same but worse. From 1880’s Boar War to late WWII USA has been profiteering from World Wars and even playing both sides sat on the axis wall same way for 50% hard part of WW II until 1941 Japan bombing of Hawaii Pearl Harbour and Honolulu only, for the rest of that 1200 years USA has had only one City & Base badly damaged whereas most of the World lost whol Nations, Cities Built Assets etc. All that time USA never won a war but collected the cash of all. Then we were all depleted and driven into Jungles we have now emerged from and can easily compete and surpass in quality & price exports and home consumption also.

        China emerged after Nixon and Tiananmen effects so they are feeling the emergence of their neighbors a similar way as they emerge also.

        2. Increasing internal severe..[…]..

        3. Its own economy and social system never able to advance to higher level beyond mass skill-less manufacturing, due to complete absence of law and common morals. High technology and innovations and scientific development all require many citizens working together voluntarily contributing long term in a system they trust, with things like rule of law, no censorship on knowledge, no restrictions on speech and expression, copyrights, open minds, patents, common morals when collaborating and trading with each other etc. Rob Carter says these things like Common morals when Chinese people deal with each other in fairness all round and that includes with normal decent traders as I was from abroad Australia in 1967 Singapore & Malaysian Chinese societies, is what endeared me to set up and profit well from bases in those now ASEAN Nations. The are just not Harvard Greed doctrine ‘Dog eat dog’ mentality by natur, by helping me for future continuance of business reasoning and morality they were if anything overly kind and soft on my dealing business. Westerners never are like that they are more likely to bite the hand feeding them, & do to others biblical morality changed to effect of ‘but do it first. And negative greed at that.
        ..[…]..
        4. China’s mass skill-less manufacturing itself is going away to other countries due to sharply increasing costs and openly hostile and unfair business environment full of frauds and sanctioned protectionism and government robberies. The labor force is endlessly more demanding in wages and benefits expectations and working conditions. It is further worsened by the rise of robotic automatic manufacturing and 3D printing. This situation is a death knock to the “growth-based legitimacy” of the CCP, which is the only thing CCP can rely on for continuing ruling power. For sure Chinese people tolerate or even “like” the CCP when the economy seemingly explodes, but when one day it crashes and the country’s hopeless bad shape hit them in the face the people’s “support” for the CCP will turn on a dime.

        Since six months ago, all the major economic indicators for China have gone on a continuing nosedive – including manufacturing orders, export volume, commercial investments, graduate employment rate, corporate credits, foreign capital inflow, domestic consumptions, real estate prices, consumer spendings, luxury goods demand, HSBC Service PMI, survey of business sentiments etc.

        Suddenly all the rich Chinese tourists gobbling up luxury goods at different world cities seem to have disappeared altogether. The CCP is on its last resort of printing literally trillions of worthless renminbi to dump into massive failing and zero-ROI “state projects” that only enrich corrupted CCP officials. China’s gigantic multi-year increase of M2 money supply (it is afraid to publish the figures citing “national security”) causes way more long-term harm on itself than short-term help, and when that is over there is nothing else the CCP can do to prop up the failing economy. China currently ranks 82nd on GDP per capita and that is the highest it can go before falling sharply in the coming near future.

        5. Fierce unstoppable purges and mutually-destructive infighting among different factions within the party, who are imprisoning and killing each other every day. This power grab goes on under the laughable thin guise of “anti-corruption drive” when everyone knows all officials in china are corrupted. No work to manage the country or guide the ship is being done while this is going on.
        6. Its many previously-suppressed fatal problems have all grown too big to be contained all catching up to the CCP e.g.
        • – severe carcinogenic poisonous pollution everywhere in air and water and soil and their own food etc, with the WHO issuing multiple warnings on Chinese population having the fastest cancer growth rate in the whole world Rob Carter interpolating ~ since he says here in perfect English “in their food” and not “in our food” this adds to my heading negativity evidence he isn’t a chinese Citizen or even living there? Could easily be a deliberate negative disinformation enemy plant or puppet of evil think tanks abroad? If he was in PRC would be dead now?
        ..[…]..
        • – desperate mass exodus at all levels of Chinese society to escape the country using emigration or buying houses / study abroad or marriage to foreigners or plain old human smuggling, resulting in all able Chinese leaving taking huge amounts of talents and money out of the country, Rob Carter says in #3 above he says there are no skills, throughout he suggests the only money is with the CCP member crooks groups, so how can it be running away and them still in PRC? Below that they are single, spoiled brats (means no skill educated to run way)?
        • – global trends of wealth polarization and robots replacing humans mean massive unemployment pressure for vast majority of the 1.4 billion population,
        • – corruptions and fraud throughout the whole rotten core of a system,
        • – young chinese today are all single child, many of them spoilt princes and princesses only used to coddling and indulgement by their parents and grandparents. They want all the nice things they see on the internet, they refuse to stoically slave away “for the country”, they will only accept nice-paying cushy office jobs so they can spend all day glued to their smartphones and mobile games, otherwise they would rather live at home on the support of their parents
        • Reply Michael Pettis September 3, 2014 at 2:25 pm
        I am not as pessimistic as you are, Flappening, but I am glad Chinese think tankers are worried about these things. I teach at PKU that policymakers should always be thinking about the worst outcomes and how to prepare for them. If reality turns out better than expected, we can survive.

        • I am having a little trouble following these very long postings and, while I don’t like to police comments, I would ask that we keep them shorter and more relevant to the actual blog entry. If people have urgent messages about good and evil they want to spread, I suggest they start their own blogs, please.

          • Ok shorter wilco. I was backing you did I read Flappening wrong he appears to attempt to negative your clearly PRC supportive view and I don’t believe he is real.

            I loved and support your view thanks for the clarity I say never read clearer explanations. Thanks

          • I know your model is Brad Setser who had no qualms about deleting gibberish – do it! and kudos to Vinezi Karim who adds value.

          • I see I have quoted Flapping as I do not agree with him and HE DIRECTLY NEGATED MICHAEL PETTITS MORE BELIEVABLE I THINK CORRECT AND EASILY UNDERSTOOD article.

            Yes my English made it look like me supporting “Flappenings” clear anti China and against Michael’s view?
            Sorry

          • Sorry, Rob, I am not necessarily criticizing your response, but because comments cannot be published until I “approve” them, and because I try to do so as quickly as I can, often from my iPhone, if they are very long I only skim them quickly to see if they are irrelevant, impolite, or involve political grandstanding, and if they don’t I automatically approve them. I find the comments section to be very valuable to me, and so I don’t want to discourage comments unless I think they reduce their value to me.

          • Thanks Michael. Understood with due respect.

      • Michael I think you might reconsider this reply with Flappening suggesting you are 100% wrong and me too, with all my consulting friends & Professors ~ I am 70 Australian in Vietnam 25 years. I see this as a hoax of a paid dis-informer

        1. Increasing external oppositions from all other countries in the world including all of China’s neighbours. They are forming more and more alliances and becoming more outspoken with rising strengths against China, in addition to increasing anti-China sentiment from people in all other countries. Many countries including Canada and Australia and U.S. have just tightened their immigration policy to prevent Chinese from entering their countries. Even on these casual internet message boards, when you look past the paid Chinese propaganda professional commenters, you notice rising general anti-China feelings from all over the world.
        Rob says: USA Leaders still don’t acknowledge their problems are the same but worse. From 1880’s Boar War to late WWII USA has been profiteering from World Wars and even playing both sides sat on the axis wall same way for 50% hard part of WW II until 1941 Japan bombing of Hawaii Pearl Harbour and Honolulu only, for the rest of that 1200 years USA has had only one City & Base badly damaged whereas most of the World lost whol Nations, Cities Built Assets etc. All that time USA never won a war but collected the cash of all. Then we were all depleted and driven into Jungles we have now emerged from and can easily compete and surpass in quality & price exports and home consumption also.

        China emerged after Nixon and Tiananmen effects so they are feeling the emergence of their neighbors a similar way as they emerge also.

        2. Increasing internal severe..[…]..

        3. Its own economy and social system never able to advance to higher level beyond mass skill-less manufacturing, due to complete absence of law and common morals. High technology and innovations and scientific development all require many citizens working together voluntarily contributing long term in a system they trust, with things like rule of law, no censorship on knowledge, no restrictions on speech and expression, copyrights, open minds, patents, common morals when collaborating and trading with each other etc. Rob Carter says these things like Common morals when Chinese people deal with each other in fairness all round and that includes with normal decent traders as I was from abroad Australia in 1967 Singapore & Malaysian Chinese societies, is what endeared me to set up and profit well from bases in those now ASEAN Nations. The are just not Harvard Greed doctrine ‘Dog eat dog’ mentality by natur, by helping me for future continuance of business reasoning and morality they were if anything overly kind and soft on my dealing business. Westerners never are like that they are more likely to bite the hand feeding them, & do to others biblical morality changed to effect of ‘but do it first. And negative greed at that.
        ..[…]..
        4. China’s mass skill-less manufacturing itself is going away to other countries due to sharply increasing costs and openly hostile and unfair business environment full of frauds and sanctioned protectionism and government robberies. The labor force is endlessly more demanding in wages and benefits expectations and working conditions. It is further worsened by the rise of robotic automatic manufacturing and 3D printing. This situation is a death knock to the “growth-based legitimacy” of the CCP, which is the only thing CCP can rely on for continuing ruling power. For sure Chinese people tolerate or even “like” the CCP when the economy seemingly explodes, but when one day it crashes and the country’s hopeless bad shape hit them in the face the people’s “support” for the CCP will turn on a dime.

        Since six months ago, all the major economic indicators for China have gone on a continuing nosedive – including manufacturing orders, export volume, commercial investments, graduate employment rate, corporate credits, foreign capital inflow, domestic consumptions, real estate prices, consumer spendings, luxury goods demand, HSBC Service PMI, survey of business sentiments etc.

        Suddenly all the rich Chinese tourists gobbling up luxury goods at different world cities seem to have disappeared altogether. The CCP is on its last resort of printing literally trillions of worthless renminbi to dump into massive failing and zero-ROI “state projects” that only enrich corrupted CCP officials. China’s gigantic multi-year increase of M2 money supply (it is afraid to publish the figures citing “national security”) causes way more long-term harm on itself than short-term help, and when that is over there is nothing else the CCP can do to prop up the failing economy. China currently ranks 82nd on GDP per capita and that is the highest it can go before falling sharply in the coming near future.

        5. Fierce unstoppable purges and mutually-destructive infighting among different factions within the party, who are imprisoning and killing each other every day. This power grab goes on under the laughable thin guise of “anti-corruption drive” when everyone knows all officials in china are corrupted. No work to manage the country or guide the ship is being done while this is going on.
        6. Its many previously-suppressed fatal problems have all grown too big to be contained all catching up to the CCP e.g.
        • – severe carcinogenic poisonous pollution everywhere in air and water and soil and their own food etc, with the WHO issuing multiple warnings on Chinese population having the fastest cancer growth rate in the whole world Rob Carter interpolating ~ since he says here in perfect English “in their food” and not “in our food” this adds to my heading negativity evidence he isn’t a chinese Citizen or even living there? Could easily be a deliberate negative disinformation enemy plant or puppet of evil think tanks abroad? If he was in PRC would be dead now?
        ..[…]..
        • – desperate mass exodus at all levels of Chinese society to escape the country using emigration or buying houses / study abroad or marriage to foreigners or plain old human smuggling, resulting in all able Chinese leaving taking huge amounts of talents and money out of the country, Rob Carter says in #3 above he says there are no skills, throughout he suggests the only money is with the CCP member crooks groups, so how can it be running away and them still in PRC? Below that they are single, spoiled brats (means no skill educated to run way)?
        • – global trends of wealth polarization and robots replacing humans mean massive unemployment pressure for vast majority of the 1.4 billion population,
        • – corruptions and fraud throughout the whole rotten core of a system,
        • – young chinese today are all single child, many of them spoilt princes and princesses only used to coddling and indulgement by their parents and grandparents. They want all the nice things they see on the internet, they refuse to stoically slave away “for the country”, they will only accept nice-paying cushy office jobs so they can spend all day glued to their smartphones and mobile games, otherwise they would rather live at home on the support of their parents

        • 25 years in VN, so you were there before Doi Moi, as what, how,…… a diplomat?

          • Your comment erred badly, in that “Doi Moi” (meaning “Renovation” policy) was 1986 and accompanied by the “Mo Cua” (Meaning ‘Open Door’ Policy) ~ were both 1986 inviting me, so Rob Carter went to Vietnam 1988 with SRV’s Australian Trade or Commercial attache (Mr Pham Ngoc San)’s delegation to Hanoi, Haiphong and Saigon.

  17. ^Michael Pettis WROTE: “There is some controversy about whether it is true that the nominal lending rate should be broadly equal to the nominal GDP growth rate. In fact most studies of developed countries suggest that over the medium and long term this is indeed the case.”
    ———-

    In one of my earlier comments on this page, I provided the comparative data that showed the truth of Michael’s statement that Nominal Interest being much lower than Nominal GDP growth in CHINA had led to massive misallocation of capital.

    For the sake of comparative-interest, let us do the same analysis for Germany, Spain & Greece after the 1999 introduction of the Euro and see what we get. Here are the data:

    1) Deposit rate: http://alturl.com/upxy2
    2) Lending rate: http://alturl.com/fb992
    3) Bank Margin: http://alturl.com/nk3fz
    4) Real interest-rate: http://alturl.com/3sdpu
    5) Consumer Inflation (CPI): http://alturl.com/3bn7o
    6) Overall GDP Deflator: http://alturl.com/bxsie
    7) Real GDP growth: http://alturl.com/bjyve
    8) Nominal GDP growth: This is simply (5)+(4)

    We can tabulate these parameters, either for the whole EURO period *UPTO* the 2008 crisis, or for 2002 alone in cases where that is the last year in recorded in the WB databank:

    ….PARAMETER……………………Spain…….Greece……Germany
    1) Deposit rate…………………….2.5%………2.5%………2.5%
    2) Lending rate…………………….4.5%………7.5%………9.5%
    3) Bank Margin…………………….2.0%………5.0%………7.0%
    4) Real interest-rate……………..0.5%………4.5%………8.0%
    5) Consumer Inflation…………..3.0%………3.0%………1.5%
    6) Overall GDP Deflator………..4.0%………3.0%………1.0%
    7) Real GDP growth………………4.0%………4.0%………2.0%
    8) Nominal GDP growth………..8.0%………7.0%………3.0%

    From the data, we can make the following observations:
    (A) Michael’s rule that Nominal Lending rate should be around Nominal GDP growth was TRUE for Greece, but NOT true for Spain and Germany.
    (B) Spain’s nominal lending rate of 4.5% was VASTLY lower than its Nominal GDP growth of 8.0%. Exactly as predicted by Michael’s theory, we saw wasteful investment in Spain.
    (C) Germany’s nominal lending rate of 9.5% was vastly HIGHER than its Nominal GDP growth of 3.0%. This is very unusual, as such a high interest rate would discourage even productive investments. This may be why Germany’s investment-rate fell during the Euro period and so forced it to run surpluses. What do you think, Michael?
    (D) Deposit rates in Germany were the same as in Spain, so the reason for the VERY HIGH nominal lending rates in Germany had to be because the margins for German Bank were VERY HIGH (7%) compared to Spanish Banks (2%). I am not sure why German Banks need such a HUGE margin. Perhaps they were still writing-off bad debts from the East-German reunification property bubble of the 1990s? Michael?
    (E) Another interesting point of note is that unlike Germany, where the overall GDP deflator is lower than the CPI, in Spain the CPI was lower than its overall GDP deflator. This is similar to what we saw in the Chinese v/s US case in my earlier comment. I don’t know what it really means, if anything, and so comments are welcome.

    • Thanks Karim for sharing these data and comments. From your data and my experience in Spain I can say something about how too low interest rates promote wasteful investments as you say. As you can see, bank lending margin was relatively low in Spain. For banks to increase their income was then “necessary” to increase their assets (the volume of credit) and their revenues increased mainly in the form of comissions associated with credit activity. Privided that real interest rates were negative, they did not have any problem to find customers willing to ask for credit. In fact, if you entered a bank during these years for whatever reason, credit was offered to you and your companion without asking, no matter what kind of client were you. Also, mortgages were used as an instrument to gain clients and any bank acting responsibly would lose many of them. I think this shows, from the side of bankers, how these parameters work to create “perverse” incentives resulting in wasteful capital misalocation.

  18. what are the factors that drive loan creation capacity and debt capacity constraint?

    If, as you suggest, Beijing would be willing to absorb non-performing loans onto the government balance sheet, I don’t see why the credit boom would ever have to stop. Once debt is the government’s liability I would think it could just be inflated away by any number of measure. So out of control inflation the only risk for nationalizing massive amounts of bad private debt ?

    • Debt capacity constraints are a sticky concept to explain, Joshua, and shockingly enough many economists analyzing China are not able to conceptualize debt constraints in a system funded with domestic savings. How many times, for example, have you heard some idiot say that China cannot have a debt crisis because it doesn’t have foreign debt — as if the US in the late 1920s or Japan in the late 1980s were not massive net exporters of capital?

      What is worse, because they do not understand how there can be debt capacity constraints in China (can’t Beijing simply force banks to lend more?) it took a lot of haranguing before they even began to accept that capacity constraints must exist, even though the only alternative can be infinite debt capacity, which is clearly impossible. I still don’t think most economists focusing on China understand how it works.

      The basic argument is that financial systems can be subject to “sudden stops”, which for the most part means either they are dependent on foreign capital which, at some point reverses (eg Latin America in 1981-82, Mexico in 1994, Asian Tigers in 1997, etc) or that they are subject to domestic bank runs (eg the US in 1930-31, Lehman/Bear Stearns/Northern Rock in 2008, etc). Domestic bank runs are now rare because of deposit insurance, and are unlikely to occur in China.

      But of course this doesn’t mean that therefore China has infinite debt capacity. Debt capacity constraints in China are breached when loan growth is not fast enough both to cover the rolling over of unrecognized bad debt (which, when we include interest and further misallocated lending, must grow exponentially) and to generate new economic activity. This, as Hyman Minsky taught us, is why in the late stages of a credit bubble we must see exponential loan growth simply to maintain current levels of economic activity. Credit is growing quickly in China, but it cannot grow exponentially beyond some point, at which new lending can no longer generate GDP growth.

    • Joshua’s comment above is really indicative of what has become the dominant and quasi monopolistic economic doctrine of the last 30 years:

      – At the first slowdown, keep GDP growing by stepping up credit creation so that debt grows faster than GDP, thereby destroying economic value, and

      – Once total-debt-to-GDP has deteriorated dramatically, at the second slowdown, keep GDP growing or prevent it from falling by inflating the debt away, thereby destroying monetary value.

      Whether in Japan from the mid-1980’s, in the US and Europe from the late 1990’s, in China since the late 2000’s (still in the credit expansion phase), you recognize this basic pattern of economic policy.

      Genius, isn’t it? This is no longer an academic issue. It has been experimented in real life for a few decades. Just look at the fantastic results! It should be very clear by now that this brilliant strategy produces poor economic and financial outcomes. Out of many such poor outcomes, one has been that far from being inflated away debt kept going up relative to income as inflation (as in consumer price inflation) remains very low while inflation (as in asset price inflation) has skyrocketed, triggering a reloading of leverage.

      So may be it is time to follow a different strategy. If the sources of the imbalances could be peacefully rectified so as to allow economic activity to generate value (nominal GDP growth at least equal to debt growth) within the context of broadly stable monetary value, would the outcomes be better? More sustainable? For more people?

      Definitely worth trying.

      Thank you to Michael Pettis and a small minority of others for raising the level of the economic debate, which remains remarkably poor and confused 14 years into the crisis (24 years if you are Japanese).

      It is precisely the point that political and economic leaders should not do “whatever” but “the right thing”.

  19. ^^In the comments section, Michael Pettis WROTE: “Thanks for going through the numbers, Vinezi, but I would suggest that you smooth data out over several years for greater accuracy. At any point in time if nominal lending rates and nominal GDP growth rates are equivalent it is likely to be coincidence, but over longer periods of time I would suggest that they track each other fairly well except when there are specific factors that disrupt the relationship (financial repression tends to hold rates down, while very low government credibility forces them up).”
    ———–

    I did as you suggested, Michael. I actually went to the World Bank database and downloaded the actual numbers for all years from 1980-2013. I then plotted ALL the numbers on the SAME graph on my computer and have pasted the graphs online for all your other readers to inspect.

    NOTE to all readers: I have used the term “Michael’s Spread” = (Nominal Lending Rate – Nominal GDP-growth Rate). This implies that if “Michael’s Spread” is NEGATIVE a sustained manner over a long period in a country, then financial repression is taking place in that country.

    A) China:
    http://alturl.com/ufcjn

    B) India:
    http://alturl.com/udnup

    C) United States:
    http://alturl.com/2pt5x

    D) United Kingdom:
    http://alturl.com/dbf8k

    ~~
    I) Comparing “Michael’s Spread” between developing countries (China v/s India):
    http://alturl.com/pby5n

    II) Comparing “Michael’s Spread” between developed Anglo-Saxon countries (US v/s UK):
    http://alturl.com/v6kwn

    OBSERVATION: From 1980-2000, US, UK and India seems to have had a positive “Michael’s Spread”. But then something happened and all three show a tendency toward turning the spread slightly negative after 2002 or so. I wonder why that is? Could it be that this has something to do with the “global savings glut”?

    ~~
    For those readers who might be interested in what happened historically in Japan by way of financial repression using interest rates, here are the same graphs (with the “Michael’s Spread”) for Japan going back to 1961:
    http://alturl.com/e9hjf

    From that graph, it looks like Japan was indulging in severe financial repression using interest rates in the 60s & 70s. They reduced the repression in the 80s, and have since stopped doing it altogether since the 1990s.

  20. Another piece of great article. Thanks. I got a question which may be a bit off topic.

    Would reminbi internationalization help China on its debt problem?

    Seems to me that this internationalization move got a high priority. Is this move regarded as a prerequisitise for most if not all of the rest of the reform?

    • I am not sure what you mean by RMB internationalization helping the debt problem. Although external debt is rising quickly, it is still dwarfed by foreign currency reserves. Because eliminating capital controls for an economy with a very fragile and rigid banking system is extremely risky, I am very skeptical that we will see in the next decade, and probably longer, any real “internationalization” of the RMB, whose current role in trade, by the way, is at the same level as that of Mexico, which is a much, much smaller economy. It is true that the share of the RMB in international trade has grown rapidly, but people who keep telling us this don’t seem to pay much attention to other currencies.

      A friend recently told me that according to BIS data, the use of RMB in international transaction has more than doubled from 0.9 % to 2.2 % between 2010 and 2013. Pretty exciting, right? But we know that a lot of the growth in trade settlement was cosmetic. In order to boost the amount of trade denominated in RMB, a Chinese company that normally sells shoes to Italian clients, say, and gets paid in USD, now sells the shoes to a newly-set-up HK sub for RMB, and the sub then sells the shoes to the Italian clients for dollars. Nothing has really happened except for an inter-compnay transfer, but the trade now shows up as an RMB trade.

      More importantly, over the same period of 2010-2013, use of the Mexican peso also surged, rising from 1.3% to 2.5%. Perhaps Vinezi can check the data, but I think the trade share of a lot of relatively unimportant currencies has risen dramatically since the crisis, probably because the euro share has dropped.

      By the way I don’t think there has ever been a case in modern history in which the currency of one of the 2-3 largest economies (China is #2) or largest traders (I think China is #1) was not a top five currency, let alone a top ten currency. There is so much hype about the growing role of the RMB that every time you look at the real numbers they come as a shock.

      • Thanks a lot, Michael. Your explanation helps to clear my misunderstanding.

        Regarding the growing role of the RMB, the Shanghai-HK Link is praised to be a milestone of RMB internationalisation. I am wondering how much this will boost the trade in RMB eventually and if this is the main reason for this Link.

        • We’ll see Benjamin, but so often a claim made about China turns out not only to be of dubious validity (remember the new canal they were going to build that would make Panama obsolete, or the railroad from the Peruvian Pacific coast to the Brazilian Atlantic coast, which, because my father designed and built much of the “carretera marginal” road that crossed the Andes in Peru, strikes me as a pretty hefty ambition?) but is also hyped up by an overexcited press (every Chinese acquisition abroad is hailed as China buying up the whole world, even though total Chinese investments abroad are dwarfed by those of many, much smaller, economies, and every decision by a tiny country to swap obligations with the PBoC is hailed at one more step in the RMB’s road to domination, even though the swap lines are tough to execute and many of these countries would accept the currency of anyone willing to lend them money) , so it pays to believe it only when you see it.
          The key is whether RMB internationalization is good for the Chinese economy, and I think it isn’t, because it means Beijing loses a great deal of control over domestic monetary policy and will find it much harder to protect and manage the banking system, which is in too much of a mess to risk it. The PBoC isn’t stupid. I don’t think they will allow true internationalization until the banking system is in much better shape, Beijing is willing to reduce its control of domestic monetary policy, and China can be induced to accept the tremendous costs of “exorbitant privilege”, which everybody talks about but which every country angrily rejects as soon as foreign central banks begin acquiring too much of their currency. Remember that for all the huffing and puffing about the advantages that the dollar gives to the US, as soon as anyone starts to scoop up euros, yen, won, reais, or any other currency, their respective finance ministers begin screaming about currency war and demand that it stop.

  21. ^^Michael Pettis WROTE: “I had a real problem with their sample of countries however. Their sample included…. x …..a lot of Asian countries that followed the Japanese development model and themselves practiced financial repression, which of course made them pretty useless as points of comparison.”
    ———–

    I am sure a lot of readers here would have been left wondering exactly WHICH Asian countries “followed the Japanese-model and practiced financial repression”. Just to make sure that we are not painting with a broad brush, and also to ensure that we do not punish the innocent along with the guilty, I am now going to NAME these countries in a dramatic expose’.

    NOTE: I define the term “Michael’s Spread” = (Nominal Lending Rate – Nominal GDP-growth Rate). This implies that if the “Michael’s Spread” is NEGATIVE in a sustained manner over a long period in a country, then Japanese-style financial repression is taking place in that country. Here are the results for the “usual-suspects” of East-Asia:

    A) East-Asian countries that *DO* practice Japanese-style financial repression:

    1) South Korea: They used to practice severe financial repression UNTIL the 1997 crisis hit them. Since then, probably under US advice, they have tried hard to reduce repression and have now (like Japan) almost stopped doing that.
    http://alturl.com/qpkx9

    2) Malaysia: These guys are incorrigible. They have always practiced financial repression and continue to do so even now. As seen in the graph below, the only times the “Michael’s Spread” turns positive in Malaysia is during crises: 1997, 2001 and now the 2008. And this is only because their Nominal GDP Growth collapses during these crises. Apart from these three exceptions, the “Michael’s Spread” is uniformly negative, implying that sustained financial repression is occurring in Malaysia.
    http://alturl.com/wymwq

    3) Singapore: Same as the Malaysians. Never seem to change. The 1984, 1997, 2001 & 2008 crises are visibly the only times their “Michael’s Spread” is positive due to a temporary collapse in Nominal GDP growth rate. Other than that, it is almost always negative, indicating that Singapore has been practicing Japanese-style financial repression for a long time.
    http://alturl.com/b2ata

    ********

    B) East-Asian countries that *DO NOT* practice Japanese-style financial repression:

    1) Indonesia: On the whole, there does not seem to be any long-term pattern of following the Japanese-model of repressing interest rates.
    http://alturl.com/qtke7

    2) Philippines: Same as the Indonesians. There does not seem to be any long-term pattern of financial repression using interest rates.
    http://alturl.com/up8wu

    3) Thailand: It looks as if Thailand can’t make up its mind, as the “Michael’s Spread” keeps vacillating between positive and negative without being obviously-linked to any external financial crises. But on the whole, it is difficult to find any conscious policy-pattern of repressing interest rates in Thailand.
    http://alturl.com/sqckf

  22. [email protected]

    One correction from Xi logic:- as I see it. This, to me, is the explanation for the rather surprising insistence by Premier Li in June that 7.5% GDP growth was a hard target. GDP targets are part of domestic signaling about the expected pain of adjustment. I suspect that lower growth targets are likely to generate greater opposition. Rob says but he knew his USTERITY AGAINST CORRUPTION EXPENDITURES AND Stimulation at lower profit infrastructure upgrade for longer term GDP slower above the west 3% norm ge=dp growth in his larger population and allowing for the anti corruption/embezzlement temporary GDP reduction. Thus he rationalized 7.5% rather that 10+% (what the crooks wanted to steel slices from) was appropriate.

    Certainly it does seem that growth has temporarily bottomed out. According to this June’s Financial Times, “Expenditure by local and central governments in China jumped nearly 25 per cent from the same month a year earlier, a sharp acceleration from the 9.6 per cent growth registered in the first four months of the year, according to figures released by the finance ministry,” and HSBC’s Flash PMI index suggests for the first time in six months that there has been an expansion in manufacturing, although the flash index is, of course, preliminary and may be revised.
    Can Beijing rein in credit?

    There should be nothing surprising about the improvement in some of the numbers. The “soft landing” that we are seeing is a consequence of credit growth. It means that it is proving politically hard to implement reforms as quickly as some in the administration would like, and it also means that we are getting closer to debt capacity constraints. We would be better off with the long landing scenario, in which GDP growth rates drop sharply but manageably by 1-2 percentage points every year. Rob says nope it’s more a case of less activity where GDP gain is sacrificed to Infrastructure asset gains with longer GDP rise benefit to come.

  23. Thanks a lot Michael for sharing your thougths again. This article gives an excellent framework to follow and interpret economic news from China in the following years. It is needed because regular news media do not provide such a framework.

    I wonder what kind of instrument should Beijing use to promote massive asset privatization. My doubts are who or what private organizations/instruments have the means to buy public assets and what kind of public assets should be sold.

    • In that case it might be useful to look at other major privatization programs in controlled economies — for example we saw a lot of these in Latin America in the early 1990s and in Russia in the later 1990s. Unfortunately these often occurred in the form of powerful locals buying privatized companies at suspiciously favorable prices and financed on very generous terms by local banks.
      In one case in which I was involved in advising the government, Mr A received full funding from Bank X to buy Bank Y, and Mr B received full funding from Bank Y to buy Bank X. We warned the government that this was extremely risky for the banking system as a whole because what looked like capital for the individual bank was not capital for the banking system, but we were assured that the problem was understood and not really a problem. It is almost unnecessary to say that four years after the privatization program was completed, the country had a banking crisis.
      This doesn’t mean that all privatizations are fraudulent, but it does suggest that there are many ways to complete them, not all of which are good or fair. However if China’s privatization proceeds are distributed directly to households, or indirectly, preferably in the form of government loan repayments, even unfair privatizations can still help rebalance the economy.

  24. Your remark was …If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%.

    Rob asks:- by “oligopolistic elites” did you mean ‘plutocrats’ or government landlords (Oxford says oligopoly is the Government’ ‘plutocrats the capitalists telling them what to do) as I understand it. Viz. Oxford “A state of limited competition, in which a market is shared by a small number of producers or sellers.” ~ “Others married into the financial wealth of the City of London, allying the status of land with the new plutocratic wealth of finance.” ~ In my book the Oligarchy is the government owners, the plutocrats the non-government owners and the plutocrats I can’t see dictating Mr Xi policies as he is not an oligarchic puppet of the plutocrats? Or am I misinterpreting English here? My question is genuine inquiry as I greatly admire your article & opinion Michael.

  25. In your scenario analysis of what a good adjustment might look like for the Chinese economy, you seem to make the assumption that this would largely be an internal affair and that the relative trade position of China vis a vis the rest of the world will remain the same as today (“if … the trade surplus doesn’t vary much, 3-4% GDP growth is consistent with 6-7% household income growth.”)

    But it now looks like another giant intends to put in place the same investment and export-led economic strategy that China implemented in the second of the four stages of its economic development. This giant is India. The election manifesto of the newly elected Government is pretty clear that this is the strategy they intend to pursue (see attached p. 27-31, the punch line being p. 29 “we will make India a hub for cost-competitive labour-intensive mass manufacturing”: http://bjpelectionmanifesto.com/pdf/manifesto2014.pdf ). India has a 1.25 billion population, half of which is below 25 years old and 2/3 of which lives in rural areas. It is English-speaking. It has good technical education. It is 4.5x cheaper than China based on 2013 GDP per capita. And it is a democracy, however imperfect.

    Of course, there is execution risk and India might fail to deliver. It was already expected to become an emerging heavyweight 10 years ago. But, they also might succeed this time. At least, it is clear from the election manifesto and from the background of the recently appointed Central Bank Governor that the Indian political and economic leaders now in place understand full well how the current international trade and monetary system works and that they intend to exploit it in the interests of India economic development. It is inherent to the system that global capital – including Chinese capital – will be delighted to oblige as large-scale labor arbitrage opportunities are reloaded once more. In that scenario, India will gradually replace China as the main exporting, cheap labor, trade surplus, creditor country in the international trade and monetary system.

    So there is a decent likelihood that China’s chances of orderly economic rebalancing and relative deleveraging will be affected and made more complicated by the emergence of a new, large, cheap (cheaper) labor competitor. In that scenario (which may or may not materialize), China could end up joining Japan, the US and Europe in the “balance sheet recession” camp. That would make it 2/3 of world GDP in balance sheet recession.

    Beyond the implications for China (a vast topic in itself), an even higher stake question is whether the entire system can altogether cope with a disruptive Indian phase coming after a disruptive Chinese phase? (Prior to China, the Japanese phase was not so disruptive for the system as the weight of Japan alone was not big enough, it ended up being mostly disruptive for Japan itself). But if India pulls it off and takes over China, “The Volatility Machine” will be tested to extremes…

    I would very much like to be wrong. But the best way to prove me wrong would be to do something about the inherently unbalanced world trade and monetary system in place since the late 1970’s which has been destroying economic value overall (global debt rising much faster than global production and income) for 35 years even if producing headline GDP growth. Since nobody seems to care in policymaking circles (apart 87 years old Volcker) and everybody in those circles much prefers the credit expansion (in the first economic cycle) and currency debasement (in the second economic cycle) strategy that generates ephemeral financial wealth by allowing carry trade speculation in risk assets, i’m not very optimistic.

    Thank you for your stimulating, balanced and well-written articles.

    • DvD WROTE: “But it now looks like another giant intends to put in place the same investment and export-led economic strategy that China implemented in the second of the four stages of its economic development. This giant is India…..”
      ———–

      If India increases its investment-rate, I would think that is a good thing, as obviously-productive investment opportunities are immediately visible in India. Unlike China, Japan & Germany, which have an infrastructure-surplus, India has a SEVERE infrastructure-deficit. In addition, unlike China, Japan & Germany, which have demand-constrained economies under deflationary pressure (i.e. general over-capacity), India has a supply-constrained economy under inflationary pressure (i.e. general under-capacity)

      However, India will NEVER be an EXPORT-LED economy like China, Germany or Japan, because it INTENDS to run a small current-account DEFICIT (about 2% of GDP on average) as a matter of POLICY over the next 20-30 years. In other words, for the next 20-30 years, India intends to import more from the world than it hopes to export to the world. To put it in economist-speak, India intends be a supplier of aggregate-demand to the rest of the world for at least another generation.

      In addition, and also as a matter of POLICY, it intends to fund that ~2% current-account deficit with equity, such that its debt-claims on foreigners (i.e. its forex reserves) are about the same, on a multi-year average basis, as the debt-claims foreigners have on it (i.e. its net external debt).

      Therefore, governments of all shades may come and go in India, but it never be anything like China. Take a look at the world today:
      A) The net-creditor countries by POLICY: China, Japan, Germany, Netherlands etc.
      B) The net-debtors countries (as a result of (A)): US, UK, Spain, Greece etc.
      C) The net-zero countries (neither net-creditors nor net-debtors) by POLICY: India
      ~~~~

      PS: It is important to note that the “policies” mentioned in the preceding paragraphs are not determined by the government-du-jour (whether left-wing or right-wing), but by the independent Central Bank.

      The Central Bank uses its forex reserves only to reduce short-term volatility in the nominal exchange-rate; it does NOT target any specific exchange-rate (i.e. NO pegs, whether static or moving) in the medium/long term.

      The real exchange-rate over the medium/long term is then determined as that inflation-differential-adjusted exchange-rate, which keeps the CAD at around 2%, while simultaneously making the multi-year-average of the net-debt with the rest of the world equal zero (i.e. effectively funding the CAD via equity).

      Readers here may choose to write all this down in equation form and see whether it conforms to the “Impossible Trinity” constraint of all Central Banks.

      • There is no better declaration of intent than the election manifesto:

        “We will encourage savings as an important driver of investment and growth.” p. 27

        “Foreign direct investment will be allowed in sector wherever needed for job and asset creation, infrastructure and acquisition of niche technology and specialized expertise.” p. 27

        “We should no longer remain a market for the global industry. Rather we should become a Global Manufacturing Hub.” p. 29

        “We will set up World class Investment and Industrial Regions as Global Hubs of Manufacturing.” p. 29

        “A strong manufacturing sector will … lead to import substitution to bring down the import bill. We will make India a hub for cost-competitive, labor-intensive mass manufacturing.” p. 29

        “We believe that Indian entrepreneurs have the capability to take on global markets.” p. 30

        My point here is not at all that this would be bad for India at this stage of its economic development. Since we are on a forum discussing China, my point is simply to say that, if India successfully executes the strategy highlighted in the manifesto, it is not so obvious that net trade – either directly or perhaps more likely indirectly – will remain such a supportive factor in China’s future economic performance. Because their size are about comparable and India is significantly cheaper than China, a rebalancing of India in one direction could complicate China’s attempted rebalancing the other way.

        Unless India let’s the Rupee appreciate sufficiently that their economic strategy doesn’t force even more under-employment and more debt on the West. I really hope that this will indeed be the case. What makes you think so confidently that this is what they intend to do? In any case, the Rupee is quite low at the moment.

  26. I disagree with you, Michael.

    My impression is that you seem to believe that China is at a point now where they need re-structure their economy in that way an advanced economy does.

    Tell me, if China followed your plan, how long would it take for China to surpass America’s economy? If China does one day achieve advanced economy status, what would their GDP be compared to America?

    I’ve read a lot of your articles and I think you are completely wrong.

    If China followed your ideas they would become stuck in the “middle income gap.” They would be Russia, Brazil, Argentina, Eastern Europe status: countries where half the country is living relevantly well and the other half lives in abject poverty.

    Before China can even THINK about re-balancing to a consumption based economy in any real way they need to have a very large part of their population urbanized. And When I say urbanized I don’t mean living in shantytowns. Currently, just over 50% are. If they re-balance too early, the ones already in the cities will benefit, the ones outside will get shut out.

    Why?

    If wages rise, so will prices of products. This hurts the migrant workers. The low cost manufacturing jobs will also disappear faster. China still needs these.

    What is the correct way for China to move forward?

    Build more cities, apartments, roads, and public transportation. Do you realize that over 600 million people still live in the countryside? Move the low paying manufacturing jobs inland. Continue to act as a developing country, because that’s what they are.

    Your suggestions is exactly what NONE of the DEVELOPED countries did.

    P.S. You don’t believe in predictions because you lack confidence in your own analysis. You should be more bold like Gordon Chang.

    • Wow, Max111, I don’t know if Pettis will respond and if he does so it will inevitably be very politely, but I think you are way too far into the deep end here. In the few places where you are coherent you have everything almost exactly backwards. For example which Pettis plan are you saying that China is following? They are not rebalancing their economy because they are following anyone’s plan. The rebalancing process will happen whether or not they plan it. What Pettis has done in the past few years is explain the different ways, good and bad, that the rebalancing will happen, and by now I think pretty much everyone (I mean everyone who understands, of course) agrees that he was right.

      At first I wanted to try to explain to you where you misunderstood, but I can’t even figure out whether you understand enough to misunderstand. A perfect example is this: “Your suggestions is exactly what NONE of the DEVELOPED countries did?” Which suggestions? I suppose you mean that his suggestions were all “not done” by all the SUCCESSFUL developing countries, but I wonder if you can even name one of these countries and tell us when it was that they didn’t do whichever of Pettis’ suggestions you claim they didn’t do?

      And this: “If China followed your ideas they would become stuck in the “middle income gap.” They would be Russia, Brazil, Argentina, Eastern Europe status: countries where half the country is living relevantly well and the other half lives in abject poverty.” Besides wondering what the last part of your sentence (“half…other half…”) even means except literally, which would make it totally wrong, which ideas are the ones that would stick China in the middle income trap? The idea that their economy will slow as it rebalances?

      And this: “If wages rise, so will prices of products. This hurts the migrant workers. The low cost manufacturing jobs will also disappear faster. China still needs these.” Rising wages hurts migrant workers? Have you thought this through at all? Sorry, I don’t mean to be rude.

      • http://ftalphaville.ft.com/2013/09/04/1622742/guest-post-understanding-chinas-unbalanced-growth/

        I would say this guy is closest to being right on China.

        Also check out this video. Very informative. I would say the two guys on the right are more in line what Pettis is advocating.

      • I would say this article is where I’m coming from. I think Yukon Huang is closest to being right on China

        http://ftalphaville.ft.com/2013/09/04/1622742/guest-post-understanding-chinas-unbalanced-growth/

        Also this talk where he debates guys with similar viewpoints to Pettis:

        https://www.youtube.com/watch?v=BHlmj12GTpo

        I think the talk of re-balance in China’s economy is way to early because China is not yet at the point where her economy is developed enough to re-balance and slow down growth. With only 50% urbanization and still a relatively low GDP per capita, re-balancing now would thrust those living in developed areas ahead and keep the ones in the countryside poor.

        America achieved 50% urbanization in 1920(what China is at today) and yet they didn’t slow down growth. In fact it was only the beginning of their growth. America grew a ton after WW2 which resulted in the baby boom. America achieved 70% urbanization in 1970. Their consumption as a share of GDP was 78% in 1970. Today America has over 80% urbanization and their consumption as a share of GDP hovers around 85% percent.

        China has a 50% urbanization rate and their consumption as a share of GDP is around 45-50%. This is pretty normal.

        Bottom line: China is not ready for the re-balancing of their economy. So any talk of China transitioning to a heavy consumption based economy and slowing down growth to 2-3% is completely wrong. There is still a ton of human resource yet to be utilized.

        • ^^Max111 wrote: “China has a 50% urbanization rate and their consumption as a share of GDP is around 45-50%. This is pretty normal…”
          ——–

          “Normal” compared to what? Please explain.

          1) Urbanization: Korea is more, Indonesia is equivalent, Thailand is less–
          http://alturl.com/wzssr

          2) Total Consumption: China (48% of GDP) is FAR lower than the others, who are at about 67% of GDP–
          http://alturl.com/f8ry3

          3) Domestic Savings: China (52% of GDP) is FAR higher than the others, who are at about 33% of GDP–
          http://alturl.com/hbmxu

        • ^^Max111 wrote: “Bottom line: China is not ready for the re-balancing of their economy. So any talk of China transitioning to a heavy consumption based economy and slowing down growth to 2-3% is completely wrong. There is still a ton of human resource yet to be utilized.”
          ——–

          The talk is NOT of China transitioning to a “HEAVY consumption” based economy. The talk is of China RETURNING to a “LOW consumption” based economy (which it was in 2000) from a “ULTRA-low consumption” based economy” (which it is now).

          Before 2000, China was similar to the rest of the low-consuming East-Asian countries. After 2000, China rocketed-off into outer space, and now finds itself circling the moon. All that is being said here is that China needs to come back to earth and re-join the rest of the low-consumption based economies of East-Asia:
          http://alturl.com/rfu33

        • Max111,

          The debate on rebalancing or not is not something the central government can control completely. The law of diminishing returns on debt stimulus effect, the willingness and capacity of other economies to absorb more unbalanced growth, and the closeness of total debt capacity of a nation all work *AGAINST* the previous mechanism of growth.

          M. Pettis is simply laying out either a controlled, orderly long decline that yields a stronger China consumer base; and transition into a “more” balanced economy (and “more” is relative from “unbelievably low consumer-participation one”) .

          Of course, the alternative is always there, keep growing by exponential credit; keep belligerently try to grow export surplus — perhaps declare wars if anyone don’t accept the exports as a condition of peace. And when everything is exhausted, lets have civil war or some other explosive dislocations.

          Those are your choices. Prof. Pettis is kind enough to explain what China is facing. Take the advice or leave it, the forces will unfold one way or another. No one has 100% control.

    • Actually Pettis probably has the best track record making predictions of any economist around, certainly any following China, and his predictions were made completely against consensus, so I don’t think he lacks confidence. He even took on The Economist two years ago very publicly in a bet over a prediction, and so far I think even The Economist thinks he is going to win. Google “Pettis” and “predictions” and you can see some of them.

      I don’t always agree with Pettis, but he probably does know a lot more about the economic history of developing countries than anyone in the world, so you might want to specify where you think that the history of developed countries proves him wrong. Honestly, MaxIII, I think you are in way over your head here. Your PS is the only thing you said that sort of makes sense but just barely. You were only kidding when you said you have read a lot of Pettis’s articles, right?

    • ^^MAX111 Wrote: “……..If China followed your ideas they would become stuck in the “middle income gap.” They would be (like)…….”
      ———

      I presume you meant Middle-Income TRAP (MIT).

      Here is the evidence of the Middle-Income Trap in Brazil & Mexico, which are the two largest economies of Latin America:
      http://alturl.com/o266p

      Next, let us add China (our test subject), Malaysia (a country often said to have FALLEN into the MIT), Korea (a country known to have ESCAPED the MIT) and Japan (a pre-WWII industrialized economy) to that graph:
      http://alturl.com/5×485

      Well, Max111, what do you think? What are your thoughts on the data in the graph? Where do you think China stands? Would you bracket China along with Mexico, Brazil & Malaysia, in that they do not seem to be able to catch-up with Japan? Or would you bracket it with Korea and expect it to catch-up to Japan?

    • What do you mean “surpass” the American economy? Is economic prowess and capability indicated solely by GDP growth? Is a country’s (and society’s) strength measured by economic numbers? I strongly disagree with anyone who says any of these things.

      For the record, many of the 600 million that you claim live on the countryside really live on the outskirts of the city that are accounted for as the countryside, but they don’t actually live on the countryside. Also, China is very ethnically diverse, so pushing different kinds of people who live on the countryside and to try to urbanize them all at once is a recipe for disaster. What’s gonna end up happening is civil unrest. You can’t take people from different cultures with completely different ways of looking at the world, stick them together, and they expect everything to be all hunky dory–the world doesn’t work that way. If you actually do that, you’re gonna get social unrest.

      Secondly, it’s not realistic to expect every single person in China to live in urban areas. Anyone saying that is absurd. You need at least a few people to live and work in the countryside, particularly considering China’s dependence on raw materials and energy. If you urbanize everyone, that increases the demand for food and energy while you’ve gotta create and maintain quality infrastructure to transfer those food and energy resources. All of those things have costs.

      Thirdly, China has MAJOR demographic issues. The one-child policy has created real distortions in China’s demographics. From 2015-2020, the percentage of non-working adults is expected to increase from 16% to 25%. All of this is happening while there were way more boys born than there were girls. Even in 2013, the amount of boys born was around 18% higher than the amount of girls. What happens when those boys grow into men and many of them have difficulty finding wives to raise families?

      Fourthly, China is surrounded by hostile countries and the comparison to the US has ZERO validity. The US is surrounded on the east and west by two oceans while the countries that border it to the north and south are both US allies. China only has access to one ocean while the other part of its borders include very harsh terrain that includes deserts and mountains. Most of China (outside the Han core) is very sparsely populated where 40-50% of the land mass has around 6-8% of the people (if that). Also note that the Chinese government is very authoritarian and a very repressive regime (much more repressive than Russia, which never gets addressed in the US propaganda machine, also known as the mainstream media). All of China’s bordering countries (except Russia) do not like China and are already forming alliances with one another–including India, Japan, Taiwan, South Korea, Vietnam, and Malaysia. They have or will soon start forming treaties with one another to control supply lines ranging from the Indian Ocean all the way to the South and East China Seas and make it difficult for China to get the natural resources it needs. On top of this, the US will side with the others–not China.

      Also note that the US government structure has been in place for 225 years. It’s an extremely robust system that’s handled the worst of times where power changes hands often and new ideas are tried out regularly. China’s government is very repressive and rules with an iron fist. As someone else mentioned, China’s not only ramping up military expenditure, but most of the military budget is going towards internal security.

      • 26. Suvy in response to Max111:- Strongly disagrees that GDP growth is that critical? Rob Carter is also thus inclined also as I see Krugman misinterpret Keynes who never said “Austerity in some things” could not run simultaneously with “stimulus in others” eg. Lower wars Austerity, & stimulate employment without increased debt creation. Suvy has many valid points here.

    • I would like to disagree with you, Max111, and tell you where and why, but in all honesty it would be difficult for me to do because much of what you say, whether it is characterizing my beliefs, or providing your own version of what China is doing or must do, is either incorrect or incoherent, especially when you cite my “advice”, which has usually not been advice but simply a statement of what must happen (a “prediction”, if you like, although I proposed them not as predictions but only as the ways in which the economy must adjust).
      The most obvious cases of such “predictions”, which were wholly against consensus, are the reversal in the decline of the consumption share of GDP, and the unsustainability of the rise in debt needed to maintain growth above 3-4%. I have never advised China that they should reverse the thirty-year-old consumption trend nor did I advise that they should reduce investment. I simply said, against the views of many of the people you cite, that the consumption trend would be reversed whether or not they chose, and their only decision was to choose the way in which the reversal would occur, and that if GDP growth exceeded 3-4%, Chinese debt would explode.
      Obviously both happened.
      In fact I don’t think any member of the economic policy-making elite in Beijing disagrees, nor anymore do any of the people you cite who disagreed several years ago with me (and, by the way, people like Patrick Chovanec, Victor Shih, Capital Research, Jim Walker, Andy Xie, and many others, were part of the tiny minority who saw these things coming).
      The funny thing is that the growth predictions we made, that were widely believed to be “impossible” just a few years ago, have been substantially breached, and not surprisingly many of the people you cite have adjusted their predictions and have set new GDP growth levels below which Chinese growth cannot possibly fall — 6% seems to be the new “impossible”, but some are still at 7%. It is pretty simple process to wait, just one or two years, no more, to see if they still believe these indeed are the minimum possible GDP growth levels.

  27. Michael Pettis Wrote

    “The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).”

    I found hard to follow your comparison of GDP Growth an return on average capital invested. Clearly, it seems to me that, since investment is necessarily a fraction of GDP and that fraction is the base of which the return of said investment is calculated, then the average return on capital should be greater than the GDP growth by a factor of 1/(investment rate to GDP). So the return on investment must be at least 2 times the GDP growth rate for any investment rate <= 50% of GDP. For example it takes 50% average return on capital for a investment rate of 40% of GDP to achieve GDP grows rate of 20%. A developed economy with 25% investment rate needs 10% to 15% average return to capital to achieve GDP Growth rate of 2.5% to 3.75%.

    Naturally on the above GDP is the potential sort and the return is return on total capital invested per period and not only equity.

    Also your reasons (and loaded terms) given by about the "Unbalanced" and "Transfer of Wealth" from household savers and bankers to borrowers as if entrepreneurs do not deserve no premium whatsoever over savers and intermediaries (there's always a risk, distress – even with moral hazard there's no absolute guarantee – not speaking of strategy capacity, vision etc ) in the context of a non free centrally controlled economy that has long lost the culture of free initiative entrepreneurship, seem a little bit odd to me. Of course I understand that ideally a free market interest rate would be fairer so the terms. Anyway I doubt that a free deposit interest rate would be much higher given Asian cultural huge propensity to save.

    If I misunderstood something , please feel free to expose my error. I would very much like to know.

    Thanks.

    • I don’t think I can explain why you are wrong, Ricardo, and I will let Pettis do that, but I think lending rates have historically tracked nominal GDP growth rates pretty closely in most countries over time, and the idea that the return on capital should actually be nominal GDP times the inverse of the investment rate (I think that is what you are saying, right?) means that the lending rate should be incredibly high.

      When you consider that the investment rate in most developed economies is, I am guessing, between 10% and 30% of GDP (China’s is around 50% and we keep hearing that it is by far the highest in history, which is the reason for my guess), and the nominal GDP growth rates have been roughly 2-5% over the past one or two decades, your theory would require that lending rates be, assuming my 10-30% is correct, anywhere from 7% at the lowest to 50% at the highest, and I can’t think of a single case where that was even close to being true. US lending rates were around that level in the late 1980s, if I remember correctly, but then nominal GDP growth was a lot higher than 2% and the investment share was a lot lower than 30%, so your theory didn’t hold then either. In fact I think nominal GDP growth in the US back then was probably around 6-7%.

      I am sure Karim will be kind enough to check the numbers for us, as I am too old and lazy to do it myself, but I don’t think you will ever find a case where the lending rate was equal to nominal GDP growth times the inverse of the investment rate except in cases of developing countries close to bankruptcy or suffering hyperinflation, in which cases the lending rate would indeed be extremely high.

      • ^^Moonunit WROTE: “I don’t think you will ever find a case where the lending rate was equal to nominal GDP growth times the inverse of the investment rate except in…”
        ———-

        …BRAZIL!

        Decadal-Averages from 2000-2010 are as follows–
        1) Nominal Lending-Rate: 50%
        http://alturl.com/s8v8g
        2) Investment-Rate: 18%
        http://alturl.com/yeor9
        3) Real GDP growth-rate: 4%
        http://alturl.com/do79y
        4) GDP-deflator: 8.5%
        http://alturl.com/wrywg
        5) Nominal GDP growth-rate: 12.5%
        (This is Simply (3)+(4))

        Nominal_GDP_growth X (1/Investment_Rate) = 12.5% X (1/18%)= 69%
        Nominal Lending-Rate from (1): 50%

        They do seem to be at about the same level. This is why I strongly suspect that Ricardo Guimaraes is from Brazil himself.

    • ^Ricardo Guimaraes WROTE: “For example it takes 50% average return on capital for a investment rate of 40% of GDP to achieve GDP grows rate of 20%. A developed economy with 25% investment rate needs 10% to 15% average return to capital to achieve GDP Growth rate of 2.5% to 3.75%.”
      ——————-

      You are making the error of assuming that the WHOLE increase in the GDP accrues to capital as ‘return on capital’. This is not only incorrect, but impossible. The inputs to the economy are capital, labor and governance. Therefore, any increase in the GDP (i.e. growth) has to be shared between these three, as return on capital, increases in wages and increase in tax-revenue collection, respectively.

      I presume, Ricardo Guimaraes, that you are from Brazil?
      http://alturl.com/uqrm3

      If so, please see this:
      http://alturl.com/9x8bf

  28. Mr Moonunit, Is the investment return on fixed capital per period (and not the lending rate) that I argued as equal to potential GDP growth rate times the inverse of the investment rate. In fact an acounting identity.

    The whole point that I’m making is that the (nominal) investment return on fixed capital per period is normally greater than the (nominal) lending rate. There’s no transfer of wealth in it being so. So the fact that data shows the lending rate to be lower than GDP times the inverse of the investment rate just confirm the normalcy of investment return on fixed capital being greater than the lending rate I’m referring about.

    I must be at fault and curiously await to be enlighted by the professor.

  29. As I read through this particular exchange, I first concur with most of the points Prof. Pettis raised on China’s adjustment.
    The point however is elsewhere; and this is why the pertinent analysis of Pettis is supporting my initial worries:
    Only yesterday, and before discovering this blog, I concluded backwards that the single most dire threat to the US economy as a whole is particularly a Chinese continuous rise in interest rates, which following the analysis of the present article, seems to be unavoidable for purely local economic adjustment in China.
    Indeed, where China to raise its prime lending rate any time soon, which most comments here come to agree, this will bring economic catastrophe to the US economy.

  30. Sorry to bother you, Prof. Pettis. I haven’t seen throughout the (exceedingly long) comments that anyone has noticed an apparent typo in your otherwise excellent post. Where you state :
    “This was how I got my 5-8% of GDP estimate for the amount of the annual transfer from households to savers”
    you meant “… from households to borrowers”, I presume.

  31. Une fois de plus սn poste véritablement plaisant

  32. Prof. Pettis and others,

    This is an article by the think-tank Stratfor on China’s demographics and the impacts of China’s structural problems on the Chinese rebalancing. They seem to be having a very similar view to you, Professor. I think you may find it interesting.
    http://www.stratfor.com/analysis/urbanization-and-demographics-could-skew-chinas-economic-rebalancing#axzz3CZVWB8oP

    • Thanks, Suvy, I receive their research and usually read it as it is very thoughtful stuff even when we disagree (as we sometimes do). For a while I think a lot of people rather foolishly believed that China’s plan to force further urbanization would guarantee high growth rates for much longer. But I think most analysts now understand that urbanization is a cost, not a source of growth, and can only be economically justified if it accommodates existing growth. Right now I don’t remember exactly what Stratfor thinks about urbanization, but I am pretty sure they never bought into the idea that urbanization itself creates growth.

  33. Enlightening good stuff Professor. I have summarized comments to decide for sure.
    Rob Carter 2-3 Days later says I find the comments as enlightening as the main story ~ All very good stuff.
    1. Rob Carter warned the Flappening appears or perhaps false Chinese think-tanker in a negative place and just Trolling?
    2. Max111 disagreed all, as a “soft approach would create the same inequality USA is fostering Hence rebellion.
    3. Jack Post attacks Max111 as not understanding economics & we all love Pettis’s astute PRC Knowledge refining.
    4. Moonunit likewise says Max NBG ~ Pettis probably best in World Just Google “Pettis & Predictions” see accuracy.
    5. Rob Carter asks by “oligopolistic elites” you mean ‘plutocrats’ ~ Oxford says ‘oligopoly’ is State’ ‘plutocrats capitalists bullies’.
    6. DvD Argues an idea ‘PRC 3-4% GDP growth = 6-7% family income growth’ possible, but India copying so no chance.
    7. DvD says Raising credit to grow GDP, soon Debt faster than GDP a problem others fix by buggering money more debt problems so inflating to correct becomes a snowball chasing a snowballing tail becomes heap. RGVC 100% my view also.
    8. Ricardo Guimaraes climed Financial repression means growth makes imbalances that are unfair ~ gambler gets richer 13%+ saver gets 3% so poorer. But that’s where his final paragraph contradicts that “Asians propensity to save” I say that is not in 3% cash deposit saving, but rather I say, it is in 20% gambler capital profiting metals and/or commodities..
    9. Moonunit on ” investment rate norms 10% to 30% of GDP (China’s around 50% by far the highest in history) GDP Growing 2-5% wherever. But he doesn’t think a case where the lending rate was ever as high as suggested by Guimaraes says.
    10. Vinezi Karim Evidences, Korea is more, Indonesia the same, Thailand is less ~ China 48% of GDP & lower, others 67% average consumption, ~ Savings china 52% is higher than average 33% for most other Nations.
    11. Benjamin asked rightly ~ if Shanghai/SAR-HK & RMB will become a World Trade Currency ~ Rob says Is now but called Yuan.
    That in turn causes Household income & savings falls.
    12. Max111 in response to Jack Post ~ He referrs to FT Alphaville (#13 below ~ authored by a senior associate at the Carnegie Endowment & a former World Bank country director for China.)Who I see might know as much as, or more than Pettis?
    13. FT Alphaville then ~ It isn’t unbalanced in fact, it is Consumption has declined to 35% share of GDP (lower thzn most developed Nations) Investment is up 45% ~ so We see PRC imbalances decade growth, it’s due to transfer of labor in the far west not coastal growth. Hence unbalanced PRC growth is caused by the urbanization cum industrialization process, not financial repression, causing Household income & savings falls also. The author is a senior associate at the Carnegie Endowment and a former World Bank country director for China.
    14. Max111 Offered ~ His source above is senior associate at the Carnegie Endowment & a former World Bank country director for China.) likely right. Rob agrees, I see might know as much as, or more than Pettis?
    15. Vinezi Karim ~ Graphs Brazil & Mexico Middle Income Traps ~ China subjective ~ Malaysia MIT, Graphs show now? ..Mmmm?
    16. Vinezi Karim in response to Moonunit: Thinking no such case ~ Karim Gave Brazil Nom Lending 50%, Invest rate 18%, GDP +4% DEF.GDP 8.5%, Growth GDP 12.5% Supposedly contradicting Moonunit claim?
    17. Vinezi Karim in response to DvD: ~ Argues good for India they can use it their infrastructure needs that, Not so for PRC, Japan, Germany cases of Demand constraints. ~ No I don’t see this specially PRC with Coal-haul to Power Use etc., roads all wrecked, by huge trucks, infrastructure strife abounds, Japan with Fucking-shimmer, & more strife needing investment labor intensive.
    18. MonitorSK in response to cas90: ~ No 2 schools of thought cross playing ~ a Rise in PRC Interest and/or yuan devaluation making USA Consumerism cheaper for more and thus less USA home goods, more Outsourcing all the negatives. Monitor is only looking zt their Loaning more to USA at higher cost rollover etc? USA Has to end debt growth or die anyhow, I suggest. .
    19. Vinezi Karim in response to Ricardo Guimaraes: ~ As he says some of the GDP Growth goes to Governance meaning corruption of the watchers, In USA labor inequality growing so no GDP Gain to labor, all is to that 1% capital sector (Perhaps they meana $20mn a yeatr wage is also counted as Labor ? I sure don’t. To a great extent GDP Growth in PRC isn’t going to Labor they had their rises for a decade already, Capital & Supervision want more now?
    20. Ricardo Guimaraes ~ Rob Carter has no commented I can’t even read what he means by “In fact an acounting identity” no such thing when I passed Accountancy in the 1960’s? Lots of economic theorists words are no value in practical economics, they are an attempt at new word meaning to convert the “Economic art’ to “Pseudo-science” to become a “Science some day” to justify higher economist wages probably?
    21. dan berg ~ Aee what I mean that greatest Economist Science word “Assume” as in assume a can opener in a desert.
    22. salopes asiatiques comment in response to cas90: is a language I don’t comprehend. Bing says “Once more սn post truly pleasant” Still no meaning to me?
    23. Giancarlo in response to cas90: ~ I noticed an apparent typo ~ from households to savers” you meant “… from households to borrowers”, I presume. Await Author Reply?
    24. Michael Pettis in response to Giancarlo: ~ Author agrees with thanks.
    25. Vinezi Karim again in response to Max111 ~ Talknof China returning to Low consumption based economy…..Ultra based it is now ~ Rob Carter argues Xi stated he would deliberately move to more Infrastructure build on direct hire to lower unemployment as USA should do, Australia “REDS” Scheme did to kill US exchange rate in the 1970’s.
    26. Suvy in response to Max111:- Strongly disagrees that GDP growth is that critical? Rob Carter is also thus inclined also as I see Krugman misinterpret Keynes who never said “Austerity in some things” could not run simultaneously with “stimulus in others” eg. Lower wars Austerity, and stimulate employment without increased debt creation.Suvy has many valid points here.
    27. Suvy in response to cas90:~ an article by the think-tank Stratfor on China’s demographics and the impacts of China’s structural problems on the Chinese rebalancing. They seem to be having a very similar view to you, Professor.

  34. Vinezi Karim Wrote

    “You are making the error of assuming that the WHOLE increase in the GDP accrues to capital as ‘return on capital’. This is not only incorrect, but impossible. The inputs to the economy are capital, labor and governance. Therefore, any increase in the GDP (i.e. growth) has to be shared between these three, as return on capital, increases in wages and increase in tax-revenue collection, respectively.”

    OK, I get it.

    Thanks.

  35. ^^DvD WROTE: “if India successfully executes the strategy highlighted in the manifesto, it is not so obvious that net trade – either directly or perhaps more likely indirectly – will remain such a supportive factor in China’s future economic performance…”

    “…Unless India let’s the Rupee appreciate sufficiently that their economic strategy doesn’t force even more under-employment and more debt on the West.”

    —–
    (1) In India, election manifestos are not worth the paper on which they are printed. It is just election-time hot air by low-quality politicians and should be ignored completely.
    (2) Whether India disrupts China’s rebalancing or not depends on whether India switches from being a net supplier of aggregate demand to the rest of the world (i.e. net importer/ Deficit-country), which it has always been since 1950, to being a net absorber of aggregate demand from the rest of the world (i.e. net exporter/ Surplus-country), which it has never been (except 2004) in its independent history.
    (3) IF circumstances are such that India ever seems to be moving to a structural surplus, the India central bank WILL let the Rupee rise such that India moves back to the targeted structural-deficit of around 2%.
    (4) This has nothing to do with India’s political parties, their worthless manifestos or their silly political posturing, as these things have always been handled by their independent central bank.
    (5) “Forcing under-employment & debt on the West” is mercantilism, which India’s central bank has rejected completely. As long as it is a poor country, it will continue to run a small deficit and sees no virtue in the Japanese-inspired belief that “surpluses are profits and deficits are losses”.

    The Indian central banks’ long-term development strategy for the next generation is to first get-to & then HOLD total-consumption STEADY at about 65% of GDP, with national savings at about 35% and current-account deficit at about 2%, to arrive at investment rate of around 37% on average. This, they hope, should allow a BALANCED growth of about 8% per year in the LONG term and should SLOWLY bring India out of poverty over the next generation.

    So the 2% average current account DEFICIT is baked into the overall plan for the next generation. Therefore, there is almost NO chance that CHINA’s REBALANCING will be disrupted by anything that India does over the next 20-30 years. Any danger to China’s rebalancing will come from the actions of the West and not from anything India does.

    ~~~~~~~~~~~~~~~~

    ^^DvD WROTE: ” Since we are on a forum discussing China…”
    ——-

    Even though it may be CALLED “China Financial Markets”, this is clearly not a blog restricted to discussing China. For example, Spain, Greece, Germany and the Euro are often subjects of discourse on this blog. In addition, global imbalances, international debt and reserve-currencies seem to constant themes on this blog, rather than just internal Chinese imbalances, internal Chinese debt and the future of the RMB.

    In light of the above facts, I see no digression in expanding the discourse to other countries, subject to the constraint that any such discussions relate to the overall issue of global balances and international debt.

    • You are right, Vinezi. The name “China Financial markets” is long out of date. I am thinking about changing it to something more appropriate, and eventually will.

  36. ^^DvD wrote: “…..Since we are on a forum discussing China, my point is simply to say that, if India successfully executes the strategy highlighted in the manifesto, it is not so obvious that net trade – either directly or perhaps more likely indirectly – will remain such a supportive factor in China’s future economic performance…..”
    —————–

    Forget about India, it is just a PUNY little economy.
    http://alturl.com/vr2ej

    In a world severely short of aggregate-demand, where everyone wants to run a surplus, it is what the HUGE 15-Trillion$ Euro-economy does in the future that will pose the REAL DANGER:
    http://alturl.com/knmjg

    Can the world handle a 15-Trillion$ Euro-economy that runs a 3% surplus, as the IMF is predicting may happen by 2019? What if China increases its own surplus to help in its rebalancing away from excess-investment? Will the Euro-surplus block the Chinese surplus? Who is going to absorb all these surpluses? Are we heading for trade-wars?
    http://alturl.com/jtzct

    Something for all of us to think about.

  37. ^^DvD Wrote: “Unless India let’s the Rupee appreciate sufficiently that their economic strategy doesn’t force even more under-employment and more debt on the West. I really hope that this will indeed be the case. What makes you think so confidently that this is what they intend to do? In any case, the Rupee is quite low at the moment.”
    ————

    What makes me so confident is because I have PROOF from the past-actions of the Indian Central Bank. Remember that actions speak louder than words. Officially-stated policies are worthless; it is actual actions that reveal to us the real intentions and mind-sets.

    Preamble Note: We observe that the nominal exchange rate is NOT the only mechanism by which a currency rises (strengthens) or falls (weakens). There is also the inflation-differential to account for. By way of hypothetical example:

    (i) Let us that 1 USD = 50 Rupees today. Over the next 20 years, let us say US inflation = 3.5% and India inflation = 7%. Further, let us that 20 years later, we find that 1 USD still = 50 Rupees
    (ii) Superficially, some people might say, the Rupee had NOT strengthened v/s the USD over those 20 years.
    (iii) They would be right, obviously, on a NOMINAL basis. However, they would be wrong on an EFFECTIVE (or real) basis.
    (iv) A simple calculation using the inflation differential (7%-3.5%) shows that the Rupee HAD indeed EFFECTIVELY strengthened by 100% over those 20 years.
    (v) To gauge or track the effective strengthening and weakening of any currency we need to look at its PPP-conversion factor data and not at its nominal exchange-rate.

    CASE STUDY: Keeping this difference between Nominal and Effective in mind, we can see how the Rupee EFFECTIVELY weakened or strengthened v/s the USD as a function of India’s current account deficit by looking at the following two graphs–
    1) PPP-conversion factor
    http://alturl.com/k9tni
    2) Current-Account balance
    http://alturl.com/9ti7y

    OBSERVATIONS:
    (1) The USD is, by definition, exactly equal to 1.0 in the PPP-factor graph.
    (2) We note that as the USSR collapsed and India began it move away from socialist isolation in 1991, it had to slowly devalue its currency to adjust to competition in the free-market global trading system. This is seen as the FALLING PPP-factor curve through the 1990s, implying that India was effectively devaluing its currency slowly during that period (i.e. the Rupee was weakening in effective or real terms).
    (3) As the devaluation turned excessive, however, the current account balance started to move to a structural surplus around 2000-2003, as seen in the current-account balance graph.
    (4) Now carefully notice India’s RESPONSE to this in the PPP-factor graph. India’s Central Bank immediately allowed the rupee to EFFECTIVELY STRENGTHEN continuously from 2001-2010.
    (5) As seen the current account graph, this effective strengthening of the Rupee removed the tendency to run a surplus and RETURNED India to a small structural deficit.
    (6) After 2010, however, India’s deficit CROSSED the red-line (designed upper-limit) of 3%, as seen in the current account graph.
    (7) Now carefully notice India’s RESPONSE to this in the PPP-factor graph. India’s Central Bank immediately allowed the rupee to EFFECTIVELY WEAKEN continuously from 2011-2013.
    (8) As seen the current account graph, this effective weakening of the Rupee removed the tendency to run the excessive (>3%) deficit and RETURNED India to a targeted smaller structural deficit of around 2% by 2013.

    Once you follow the above explanation, you have the PROOF– in terms of the ACTUAL past ACTIONS of the Indian Central Bank– of what I said, viz., that India INTENDS to run a structural deficit of around 2% as a matter of POLICY for the next generation and that India has no intention whatsoever of either (a) running a surplus like China or (b) running excessive deficits like Greece.

    I hope this does not come across as too muddled. Please let me know if you see any flaws.

    • Thanks.

      I look at the same data than you but my interpretation is different.

      Starting in 2001 and up to 2004, under a BJP government, India ran a current account surplus. Indeed, the Rupee appreciated. But FX reserves rose dramatically relative to GDP from 2001 to 2004, strongly suggesting that the Central Bank intervened to avoid the Rupee to appreciate too much. Central Bank FX reserves increased by quite a bit more than Foreign Direct Investment, which is to say that outflows from the official sector more than offset FDI inflows, thereby capping the Rupee appreciation. This strongly suggests that India started to follow the same economic strategy as China in the 2001-2004 period.

      Then came the 2004 election. The UPA won and assumed power, replacing the BJP. It seems indeed that economic policy changed: FX intervention ceased, FX reserves remained flat relative to GDP from 2004 to 2007 and the Rupee appreciated in effective terms, consistent with a small current account deficit which reappeared then.

      Then came the crisis. Initially (end 2007, early 2008), the Rupee appreciated strongly and the Indian Central Bank had to intervened heavily again, as we can see from FX reserves shooting up. From 2010, as you say, the current account deficit increased, leading to a depreciation of the Rupee, which indeed the Central Bank seemed to have tried to contain, judging by the drop in FX reserves.

      Then came the 2014 election and the same BJP party that started implementing the same economic policy than China in 2001-2004 won by a landslide on the basis of an election manifesto saying explicitly that they will revive that exact same strategy. I understand your point about taking election manifesto at face value (not specific to India) but i thought a little credibility might be warranted here coming from the same people who had already implemented this strategy with some results in 2001-2004.

      Note that the relative size of the Indian economy today is similar to the relative size of the Chinese economy in 2001. If indeed the system is at the very beginning of its Indian phase (like it was at the beginning of its Chinese phase in 2001), it is quite normal that it looks like a “puny little economy”. What matters is rather where it can be in a decade or so and what disruptions it could cause to the rest of the world during that period if it delivers on the stipulated economic strategy. It would have been a huge mistake to dismiss China in 2001 with that same argument that it was a small economy in value terms. That’s precisely the point of these countries that are huge population-wise but initially small in economic value terms: their potential to disrupt the system by offering large scale labor arbitrage opportunities to global capital via Foreign Direct Investment is tremendous! Note that in the case of India, this potential applies not only to the “blue-collar” manufacturing sector but also to the “white-collar” services sector, IT in particular. In fact, the IT sector was the main beneficiary of FDI in the 2001-2004 period.

      At the end of the day, I rather hope that your interpretation is correct rather than mine as it will mean that India is playing “fair game”. That would be good because i doubt the system can cope with India turning mercantilist. We will see. In the meantime, we can may be conclude that India is, by its sheer size and low cost position, a potentially important swing factor in an already unbalanced economic world with not enough aggregate demand, with potential implications for China and for the world at large, and that it is worth watching it carefully.

      Thank you for the discussion.

      • ^DvD Wrote: “Starting in 2001 and up to 2004, under a BJP government, India ran a current account surplus. Indeed, the Rupee appreciated. But FX reserves rose dramatically relative to GDP from 2001 to 2004, strongly suggesting that the Central Bank intervened to avoid the Rupee to appreciate too much.”
        ——

        You analysis is 99% sound, except that it is not absolute-FX or even FX/GDP that is relevant, but rather FX/External-Debt:
        http://alturl.com/nbsbt

        After the 1991 move away from Soviet-friendly Socialism, India shifted to a NET-ZERO external-debt target. Therefore, even as India ran a deficit, their Central Bank was accumulating reserves so as to make NET-DEBT with the rest of the world EQUAL ZERO (as seen in the linked graph as the 100% mark). This effort, which began in 1992, was re-doubled after the 1997 South-East Asian crisis, as the crisis re-enforced the ideas about the undesirability of NET-external debt. This was why the reserves kept rising. Once FX was equal to external-debt, since they had no intention of becoming a net-creditor like China, the rupee was allowed to effectively keep rising further to reach the targeted structural current-account deficit. This will keep happening cyclically in the future as the FX/External-Debt ratio keeps oscillating around the 100% mark in the multi-year average in the long term.

        I assure you all this had nothing to do with the government-du-jour. The Indian Central Bank does not manage reserves, effective exchange rates and net external debt under government advice. If fact, it the other way around. It is the government that receives advice on internal macroeconomic management from the independent Central Bank.

        In summary, unless there is a violent ideological coup d’état at the Central Bank, it has no intention of running either a structural-surplus like China or an excessive structural-deficit like Greece:
        http://alturl.com/5wt5c

  38. A great article, and with everything that’s been happening over the past few months in China- quite timely. Michael, would you ever consider writing an article about how China will affect other countries that rely on exports into China such as Australia? 99% of Aussies believe that we are immune to recessions (last recession was 1994) and also that house prices always go up as they more than have tripled in the last 15 years which has created many multi millionaire property enthusiasts. Australian people are still in denial but there has been increasing news over the past 6 months that China’s slowdown is starting to affect us. Unemployment in the mining sector went from 2-3 % to over 10% in 2013, unemployment in 15-24 year olds hitting 14.1% (highest since 2001), general unemployment rising and national income has just recently been shown to be dropping for the last 2 years straight ( last time it did this was the early 1990s where we had our last recession). Iron ore is our biggest export and most of it goes to China, 36% of our total exports go to China and around 75% of our exports go to Asia. I really can’t be very optimistic about the next decade in Australia but would love to hear your thoughts.

    • I agree with you, Aussie 22. In my latest newsletter I attempt to work out what slower Chinese GDP growth (well under 6%, well before the end of the decade) will mean for the world. My main argument is that it will not be nearly as bad for China or the world as many people think, but, unfortunately for countries like Australia, I think it will almost certainly mean a much greater fall in metal prices, especially iron ore, than even the pessimists now expect.
      I have been saying for years that once China began rebalancing, metal prices would have to fall a great deal, and obviously they have already — iron ore from $190 to around $90 today (I think, but haven’t checked the latest prices). I worry, however, that it is far too soon to say that we have bottomed out. I think iron will drop to less than $50 within five years. Other metals will follow, but I think perhaps not nearly as much (I am ignoring gold and silver because I simply can’t begin to understand their demand and supply dynamics).
      The newsletter goes out to paid subscribers, academics and government officials, but sometimes it is later reproduced in part on my blog — for example the current blog entry was extracted from the newsletter which went out three months ago. I might post parts of the current newsletter here at some point, but either way I think your basic argument is right.
      Let me tell you my Australia story. Nowadays I go to Australia at least twice a year and have met a number of people in Canberra who, you should rest assured, are not nearly as blithely optimistic about China as they might have to pretend to be. In fact I have been actively involved in the China-economy debate in Australia for a while and I have to say that the level of sophistication and understanding of the Chinese economy is a lot higher than it is in many other countries.
      The first time I went, however, was about five years ago, to speak at a major conference, and I suspect that my presentation then about the Chinese economy and where it was headed may have been the first time an awful lot of people had heard what was then such a contrarian view. Given how much you Aussies seem to like adventurous guys who take crazy risks, I guess I shouldn’t have been surprised by the number of people who later came to me to congratulate on my speech. They didn’t congratulate me for being smart or convincing, however, but rather for being so brave, which I interpreted to mean that they admired me for having the courage to stand up with conviction and tell a whole bunch of people something that was so obviously bloody wrong and against all common sense. They genuinely admired my sheer foolhardiness. I loved that response.

    • ^^Ozzy22 wrote: “Australian people are still in denial but there has been increasing news over the past 6 months that China’s slowdown is starting to affect us.”
      ———-

      What did we see in the 1990s as a run-up to the South-east Asian Financial Crisis of 1997?
      STEP 1) Wasteful construction & investment boom, with bubbles in asset/house prices
      http://alturl.com/us6in
      STEP 2) High current account deficit financed by International debt
      http://alturl.com/9kydy
      STEP 3) Rising local currencies w.r.t USD
      http://alturl.com/j3cif
      STEP 4) Boom! Major BOP crisis in 1997

      Australia & Canada are major commodity exporters that have been feeding the Chinese investment-boom of the past decade or so. Here is what has been happening in Australia & Canada from 2000 to present:
      STEP 1) Wasteful construction & investment boom, with bubbles in asset/house prices
      http://alturl.com/rcujn
      STEP 2) Rising current-account deficit financed by International debt
      http://alturl.com/kv7ko
      STEP 3) Rising local currencies w.r.t USD
      http://alturl.com/tiqfc

      So what will be STEP 4 for Australia & Canada once China’s investment boom ends? It CANNOT be a BOP crisis, because, unlike the ASEAN countries which had “soft” currencies pegged to the USD, Australia & Canada have free-floating “hard” currencies. So how will the same underlying scenario play out in Australia & Canada now?

      Here are my guesses:
      1) AUD/CAD will fall w.r.t. USD. Exports will fall, but imports will fall faster and so deficit will fall.
      2) Asset prices will also fall (Housing & commodity-stock bubbles in both countries will burst).
      3) Local Banks will do under, creating a MAJOR FINANCIAL CRISIS and need massive bail-outs.
      4) Government Debt/GDP ratio will sky-rocket.
      5) Unemployment will rise rapidly, thereby capping future wage-increases.
      6) Even as wage-increases are capped, consumer inflation will rise (UNLIKE Euro, USD).
      7) As a result of (5) & (6), standards of living in both countries will fall.
      8) Pain. A lot of it. Expect it. Prepare for it.

      What do the other readers on this forum think? Any opposing views?

      PS: Note that during the same period Germany (a) has had no house/asset-price bubble, (b) runs a surplus instead of a deficit, and, (c) has not seen trend-increases in the Euro w.r.t. USD. So clearly Germany & Australia/Canada are polar opposites. AND YET, I suspect Germany is ALSO headed for disaster. I think unemployment & Government-debt are also going to sky-rocket in Germany once China’s investment-boom ends. This is a separate analysis and its details could be pursued some other time, perhaps when Michael writes an article about Germany in the future. At this time, however, it suffices to note that in a period of great global imbalances, it is JUST AS DANGEROUS to be imbalanced to the unsustainable-surplus side, as it is to be imbalanced to the unsustainable-deficit side.

  39. Hi, thanks for your insight. I’m glad that there are people in Canberra who know what’s going on because on TV they do seem to “pretend” to be very optimistic. But obviously they just want to show calmness to the markets. Haha yeah, Australians do like people being brave and I can imagine people saying that type of thing after the conference. There are a couple of Aussie economists who are being realistic but it still amazes me that at dinner parties 95% of Aussies expect property to double again in the next 5-7 years and believe that because we avoided the GFC we are immune to any type of slowdown in spite of recent data.

    Can you give me the link to your paid newsletter?

  40. I had the oppurtunity to take a graduate level course at Peking University this summer, and I may daresay, the Chinese actually know what they’re doing. There’s way too many factors to discuss from one post, but I listened to economists and state officials give lectures on everything from demographics, to technology research, to the price of raw resources.

    People relate to China using western economic theory, when in many ways, it’s not relevant. Is real estate in a bubble? Yes. Everyone there knows it, and everyone from the government to the heads of giant corporations are prepared for it. In fact, at least part of the recent slowdown in GDP was “forced” so that they can have other ways to pump it back up when the crash comes.

    Really, the only thing that could stop China is a large amount of public unrest. They have plenty of great backup plans in the event that anything else happens.

    • ^^Reid Wrote: “People relate to China using western economic theory, when in many ways, it’s not relevant.”
      ——-

      The same “Western economic theory” was ALSO said to have been irrelevant in many ways to:
      a) The USSR in the 50s & 60s, because of all the brilliant people at their Gosplan.
      b) Japan in the 70s & 80s, because of all the brilliant people at their MITI.

      There is a sense of Déjà vu; we have heard this before, we have seen this before:

      “What has been will be again;
      what has been done will be done again;
      there is nothing new under the sun.

      Is there anything of which one can say,
      “Look! This is something new”?
      It was here already, long ago;
      it was here before our time.

      No one remembers the former generations,
      and even those yet to come
      will not be remembered
      by those who follow them.”

      –Ecclesiastes I

    • How does what they know matter? We live in a world where uncertainty dominates and fat-tailed distributions are the norm. What matters is the country or society’s response to uncertainty, not how much the leaders know (it’s akin to the difference between knowledge and wisdom, which are completely unrelated BTW). The most important part are the strength of the institutions. China’s one of the most autocratic/authoritarian governments in the world where everything seems stable on the surface. The environmental degradation has been horrible. Chinese geography and demographics are working against the country.

      It doesn’t matter what the heads of the country know because the problems China is having right now have nothing to do with smart leaders. The problem China has are long term problems coming from taking long term risks for short term gains over the past few decades

      I’m also baffled at why people overlook China’s geography. Half of China isn’t even hospitable for large populations and consists of very harsh terrain. On top of this, China only has access to one coastline where it’s surrounded by countries that’re all hostile to China AND they’re all forming alliances with one another (with the help of the US) to prevent Chinese expansion. The US, on the other hand, is surrounded with two large coastlines that surround some of the world’s most fertile soil (particularly Kansas). China’s surrounded by harsh terrain and hostile countries.

      Keep in mind that in order to make sure China has access to the natural resources it needs, it must keep control of key supply lines and trade routes. Since trade by sea is much easier and cheaper than trade by land, China must control those supply lines. For China to have complete control over those supply lines IMO, means war (or proxy wars) with India, Japan, Vietnam, Taiwan, Malaysia, and Korea with the backing of the US.

      • Rob to Suvy ~ I really I don’t think I have ever read any so wrong about all argued points in a discussion:-
        a) How does what they know matter?….The environmental degradation has been horrible. Chinese geography and demographics are working against the country. Rob view is that EPA Matters only to NGO’s for opulence that donors give them to splurge, from kindness unknowing. Also the Corporate Plutocrats running EPA businesses & supplies. In fact as a God believer I believe God will, if you don’t then Nature has for millions of years fixed whatever damage is done and evolves all to fit the facts of that day.
        b) It doesn’t matter what the heads of the country know because the problems China is having right now have nothing to do with smart leaders. Rob asks then why do we spend so much for Governance if Anarchy can do better? Oxford argues “anarchy is a state of disorder due to absence or non-recognition of authority: eg. A leader must ensure public order in a country threatened with anarchy”
        c) The problem China has are long term problems coming from taking long term risks for short term gains over the past few decades. Micro–v-macro management economics. Rob says did you ever consider what PRC do now is planned to wreck Western Capitalist/Democracies so their reserves can buy you?
        d) I’m also baffled at why people overlook China’s geography. Half of China isn’t even hospitable for large populations and consists of very harsh terrain. Rob says you just destroyed your EPA argued in a) above. Inhospitable meaning natural Jungle and desert not created by man? You would have USA do more of it in one breath and less in next?
        e) On top of this, China only has access to one coastline where it’s surrounded by countries that’re all hostile to China AND they’re all forming alliances with one another (with the help of the US) to prevent Chinese expansion. Read the treaty ending the Sino/French War ~ PRC coast was all Vietnam from Yangtze down and British to HK. France sold the Vietnamese section (with Vietnamese King Tu Duc’s earlier defense treaty permission) to China for 8mn taels of silver and War end. As for the sea access to National import rout channels ~ no one owns it refer UNCLOS & ILICOS and international waters lw Worldwide.
        f) The US, on the other hand, is surrounded with two large coastlines that surround some of the world’s most fertile soil (particularly Kansas). China’s surrounded by harsh terrain and hostile countries. Check out the 13+ “Operation red Hat” and “Operation Chase” WMD’s sunken in decommissioned ships offshore USA coasts so how many years left safe? http://en.wikipedia.org/wiki/Operation_CHASE. Where are the Buffalos and Bison and like flora and fauna USA, are deserts increasing, is garbage disposal, fracking oil and leaking oil & gas improving their perfect examples you offer?
        g) Keep in mind that in order to make sure China has access to the natural resources it needs, it must keep control of key supply lines and trade routes. Since trade by sea is much easier and cheaper than trade by land, Rob has answered that above ILICOS & UNICLOS do that well and PRC isn’t arguing 10 dot now 9 dot line for anything but oil potential and a bargaining point for (BILATERALISM ONLY) China must control those supply lines. For China to have complete control over those supply lines IMO, means war (or proxy wars) with India, Japan, Vietnam, Taiwan, Malaysia, and Korea with the backing of the US. Rob says pure rubbish PRC has same as USA Veto power in UNSC thise others haven’t and can’t act against PRC really as UN can’t bypass vetos to support them.

        I could give examples for a week nd find more to deny your post Suvy. Sorry.

        • Actually, one of my best friends works for the EPA. In much of the US, we’re actually seeing forests being regrown. There’s a lot of wonderful stuff the EPA has done BTW. I’m not a fan of almost all agencies, but the EPA is one of the good ones. Even in places like Brazil, the amount of deforestation has gone down and, in many places, these forests are starting to come back. You’re talking about animals like Bison, but the amount of buffalo and other animals have started to really grow over the past few decades. Actually,
          http://www.epa.gov/agriculture/forestry.html
          http://www.naturalhistorymag.com/picks-from-the-past/101507/the-coming-back-of-the-bison?page=3

          You’re talking about things like fracking for natural gas without realizing what these new things are replacing. Burning oil is far more harmful and oil contains more toxins than natural gas.

          I hope you realize that 60% of the water in China is virtually unusable. China’s wiping out entire mountain ranges. There’s a real problem when you’re unable to use 60% of your water. The amount of cancer that you’re seeing in China is growing at an alarming rate.
          http://www.bbc.com/news/world-asia-china-21545868

          You’re talking about veto power in the UNSC, but who cares? The UN is a corrupt, useless organization that can’t get anything done.

          With regards to why the PBoC is accumulating reserves, it’s not accumulating reserves to “buy you”. They’re accumulating reserves because they have to. China works off a fixed exchange rate, which means they must buy the net inflow of dollars (or dollar backed assets).

          • Rob to Suvy
            There’s a lot of wonderful stuff the EPA has done BTW. I’m not a fan of almost all agencies, but the EPA is one of the good ones. Even in places like Brazil, the amount of deforestation has gone down and, in many places, these forests are starting to come back. You’re talking about animals like Bison, but the amount of buffalo and other animals have started to really grow over the past few decades. Actually,

            Rob answers you say so, but as I said you talk from your heart, low research as you thought Doi Moi SRV Open door was after I entered in 88 but that event was 2 years earlier (Error on your part) so how can I accept you are right that EPA is fixing forests, and that they won’t be simply recut as sold when grown, rather like a slow grain farm grow, cut, grow, cut but here you have them being paid (ODA) from your treasury for their rent free farm forest? Animals likewise and with GMO Tampering you may be lucky if they don’t poison you as they have done to the bees and now Corn? Thanks Monsanto and foreign aid before.

            Rob Reminds you:- You must know there are always more than one side your heart kindness to consider your opposition has a different agenda.

            You’re talking about things like fracking for natural gas without realizing what these new things are replacing. Burning oil is far more harmful and oil contains more toxins than natural gas. Rob reminds “I realize” just fine thanks. Says you, I assure burning coal is worse, and methane is destroying ozone many times faster than CO2 and others and for thousands of years from natural subterranean leaks not man-made, anyhow God fixes or Darwinian evolution does if you don’t believe God or Nature does. Fracking is very dangrous, I read causing earthquakes, climate troubles and all maner of things in USA it was and is allowed because it’s Obama Dem’s way of patching the bankruptcy (Soon bigger depression) until they can cause more than thei current 4 wars and smash more of the World to buy more USA construction, medical and other necessities later. Early on 1st term some even hoped Obiwan could have a 3rd term like FDR for this his New Deal or new whatever he called it. Bringing USA from oil importer to net exporter from tar sands and fracking etc.

            I hope you realize that 60% of the water in China is virtually unusable. Rob asks ‘Says who’ I thought Canada was the one with that trouble and USA heading that way? Same with your cancer problem next discussed I don’t know if it’s worse than your USA cancers or Nuke ones to come, but 7bn is enough dudes to load the World and China can sure do with less than 1.2bn heading for 1.5bn before the aging of 1 child reverses them in a domestic consumption panick that will increase their causing cheaper products and USA competition for greater USA unemployment.

            I really can’t keep countering your kond hearted erring. Good luck to you and yours Mate

      • I don’t know anyone who has been to China, studied them, and overlooks Chinese geography.. especially the Chinese. The western/northern parts of China are poor, but they also account for a huge amount of investment. In addition, the fertility of central China makes up for this and any “resource problem” is one that China is solving with Africa. They are all over the continent investing and buying up farmland/mines.

        Most of the region is certainly not hostile to China, including the majority of Southeast Asia (Malaysia hostile to China?), Russia, North Korea, etc. Regardless, the region is certainly not headed for war in the near future and even if it were, the U.S. is not in a position to be a part of it.

        Sure, being aware by itself solves nothing. But the Chinese are also ready with responses. I’m not going to write about every single issue they face, but they have everything from the aging problem to the middle income trap sorted out.

        As for the poster above.. This is different from Japan/Russia. First off, Japan is certainly not a failure, if that’s what you’re implying. They’re the third largest economy in the world. The only thing stopping them from becoming first was that they have less than half the population of the U.S. and about 1/10th that of China.

        For the former, USSR.. I don’t know anyone who ever thought they had a chance of overtaking the U.S. economically. The only reason they were a threat was because of their military and ideology.

        Regardless, they had a completely different system and strategy than the Chinese. The Russians simply put their reforms through all at once, and never intended on taking them any further, which resulted in social and economic disaster. The Chinese are doing things gradually, and are almost approaching things as an entrepreneur would.. “testing” ideas on a small scale in limited areas before making policies national.

        And they certainly are not “communist” anymore. They’ve been opening up ever since the agricultural reforms in the 1970s, which were followed by private ownership of companies in the 1990s, and very soon, they will be privatizing land and even the largest state owned companies. I wish I had an article or something to cite, but I heard this straight from the mouth of a senior CPC official.

        • Isn’t it a problem when the poorest parts of China with the harshest terrain have the most investment? What about depreciation?

          You don’t believe me about these countries being hostile to China?
          http://www.businessinsider.com/r-hagel-backs-japan-plan-to-bolster-self-defense-2014-04
          http://www.chinatopix.com/articles/2262/20140512/china-led-asia-bank-project-shuns-japan-india.htm

          India and Japan are already building ties while the US is already arming South Korea and Japan with its anti-missile defense systems.
          http://www.haaretz.com/business/1.609859

          Maybe you should look at the territorial disputes between Malaysia and China or the territorial disputes for the entire region.
          http://en.wikipedia.org/wiki/Territorial_disputes_in_the_South_China_Sea

          You know what? I basically spoke about all of these issues here.
          http://suvysthoughts.blogspot.com/2014/07/chinas-geopolitical-trouble.html

          China’s also the largest importer of raw materials. Hell, look at all of the investments they’ve been making into African countries. They’re even bringing in Chinese troops into these war-torn countries to make sure they can control the supply lines necessary. See the links here. They came out only a couple days ago, but this kind of behavior goes back a few years.
          http://www.theaustralian.com.au/business/latest/china-deploys-troops-in-south-sudan-to-defend-oil-fields-workers/story-e6frg90f-1227053636017

          They may not be “Communist”, but it’s still a centrally planned top-down economy. The way the US adjusts is actually a good thing because the adjustments are automatic and immediate. The debts get cleared quickly and the system gets reset. The way China adjusts is much less robust. The adjustments rely on some people at the top making the right decisions, but we don’t really know what the right decisions are before they occur. As I said, we live in a world we don’t understand.

          When you live in a world you don’t understand, the wrong thing is to do is to say we need to understand it so that we can predict it. You can never predict the future and trying to do so in complex systems is futile because small shifts can create large, large deviations. In other words, the system is highly sensitive to small perturbations and the systems are chaotic. So one small error (and there will always be errors) will propagate through the system. What you need is a system that benefits and gains from disorder–not smarter bureaucrats.

          With regards to Japan, Japan’s got major issues, but I never even mentioned that in my comment. All I’m saying with regards to Japan is that Tokyo and Beijing don’t like each other. They’re both fighting for resources in the South China Sea.

        • China has a secret plan that all other countries have overlooked…haven’t heard that argument before.

          Textbooks published in 1980 said the USSR’s GDP would overtake the US’s by 2002: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1517983

          In the 1990s, everyone said the genius bureaucrats at MITI had a plan for everything and Japan would sustain high GDP growth rates for decades. Yeah, that didn’t happen

          Chinese bureaucrats are like bureaucrats everywhere in the world: they are human, and fallible. There’s no secret plan – they’ve followed the East Asian investment-export heavy model that every other Asian country has used. I’m not sure why you have so much blind faith in these people that have a lot less control than they think and probably don’t know much more about these economic concepts than you or I.

      • ^^Suvy wrote: “How does what they know matter? We live in a world where uncertainty dominates…….What matters is the country or society’s response to uncertainty, not how much the leaders know..”
        ———–

        Are you CERTAIN about this? Do you actually KNOW that this is true?

        ~~~~~~~

        ^^Suvy wrote: “….it’s akin to the difference between knowledge and wisdom, which are completely unrelated BTW…”
        ———-

        Knowledge is a first-order phenomenon associated with the conscious mind, whereas Wisdom is a second-order one associated with the sub-conscious. Wisdom is nothing but the subconscious (or “intuitive”) knowledge of the optimal utilization of conscious knowledge. In other words, consciously gathering knowledge is like acquiring a set of tools, whereas wisdom is like the subconscious knowledge of how to use those tools correctly.

        A man with a lot of knowledge and little wisdom is like the man who uses his screw-driver to hammer nails and his hammer to turn screws. A man with a lot of wisdom and little knowledge is like the man who finds himself forced to dig a ditch with his teaspoon because he does not possess a shovel. Knowledge and wisdom are both necessary, but neither one in isolation is sufficient. First, we must possess the tools (i.e. acquire knowledge). Next, we must use the right tool for the right job (i.e. act wisely). In the Indian Upanishadic tradition, this is called the desirable state of Knowledgeable Wisdom.
        http://en.wikipedia.org/wiki/Upanishads

        • “Are you CERTAIN about this? Do you actually KNOW that this is true?”

          Yes, I do. How many moving parts are there in an economy? How complex are economic and geopolitical systems? When you’re dealing with complex systems, small amounts of measurement error can create large deviations (butterfly effects). So unless you can eliminate error completely (and you can’t), prediction is a bad tool to rely on. A better tool to rely on is the response the system has to disorder, volatility, randomness, and uncertainty.

          I agree with you on knowledge vs wisdom BTW.

          • You are right in one thing at last there are many parts in Economic systems worst I suggest is the variance theory micro-fix has with practical macro–long term effec.ts But I hold your Butterfly wind theory as foolish as Economic theorists “Assumptive solutions” Like many can openers in a desert can feed the hungry.

          • My butterfly wind theory isn’t foolish at all. It’s not even a theory really, it’s just a concept. All I’m saying is that errors don’t propagate linearly. The world is a gigantic dynamic, nonlinear system. It makes no sense to think as if we can predict and deal with everything determinisitically.

          • Suvy earlier [My butterfly wind ........ determinisitically.] lets answer researchedly? Suvy extra issue lis ~ ineally or determanistically leave it to others and the factors? Suvy ~ I’m being truly economist minded here to “ASSUME” . Guess you are youngish student. Anyhow the Butterfly is a theory according to Wikipedia. Bot simply a caterpillars mum flapping her wings in UK to make a Hurricane in Brazil. There is an abstract broader meaning of causes and effect. Sensitivity dependency on initial conditions.

            In chaos theory, the butterfly effect is the sensitive dependency on initial conditions in which a small change at one place in a deterministic nonlinear system can result in large differences in a later state. The name of the effect, coined by Edward Lorenz, is derived from the theoretical example of the details of a hurricane (exact time of formation, exact path taken) being influenced by minor perturbations equating to the flapping of the wings of a distant butterfly several weeks earlier. Lorenz discovered the effect when he observed that runs of his weather model with initial condition data that was rounded in a seemingly inconsequential manner would fail to reproduce the results of runs with the unrounded initial condition data. A very small change in initial conditions had created a significantly different outcome.

            Although the butterfly effect may appear to be an unlikely behavior, it is exhibited by very simple systems. For example, a ball placed at the crest of a hill may roll into any surrounding valley depending on, among other things, slight differences in its initial position. Also, the randomness of throwing dice depends on this system’s characteristic to amplify small differences in initial conditions – the throw – into significantly different dice paths and outcome, which makes it virtually impossible to throw dice exactly the same way twice.

            The butterfly effect is a common trope in fiction, especially in scenarios involving time travel. Additionally, works of fiction that involve points at which the storyline diverges during a seemingly minor event, resulting in a significantly different outcome than would have occurred without the divergence, are an example of the butterfly effect.

            On the other hand my can-spanner in the desert is a LOL on your take. “Air-wrecked survivors, 3 hungry, thirsty guys. They find a can of beans. Engineer wants to smash with a rock, the others reject it will spill and waste. Chemist lab-man says lets light a fire under it till it bursts open. Others object again the spillage and the economists says I “ASSUME” you have matches, but the answer is much simpler “FIRST “ASSUME” A CAN OPENER”.

            ………Now to your claim of “cant do it deterministic-ally” that doesn’t always work, True but is as variably affected as the butterfly? Mmmmm both change direction at a whim or wind? Sounds like a POTUS doesn’t it? Anyhow Oxford’s explanation of English makes you philosophical meaning of “deterministic-ally” not within your control th vary any other way, inless to shoot the determiner? Philosophy pronounces “The doctrine that all events, including human action, are ultimately determined by causes external to the will. Some philosophers have taken determinism to imply that individual human beings have no free will and cannot be held morally responsible for their actions.” Leave it to God? Then why are we debating it?

          • Rob,

            My primary training is in mathematics. I’m well aware of Edward Lorenz and how chaos theory first came about. The study of such systems showed up during weather patterns, but the concepts show up everywhere. I’m not an economist. I find most economists virtually useless and the stuff taught in economics classes as complete garbage.

            With regards to determinism, all I’m saying is that epistemology matters. We live in a world where we don’t know what’s going to happen. We live in a world where uncertainty rules the day. Due to the large impacts that small perturbations can have, we live in a world we can’t predict.

            So what I’m saying is that we need to be robust to prediction error. In other words, we shouldn’t rely on trying to predict what’s going to happen. Instead, we need to create systems that actually strengthen from error, not ones that rely on bureaucrats to correctly predict how world events will play out. China doesn’t have that kind of a system.

        • You are absolutely right, Vinezi! Judging by your superhuman efforts on Pettis’s Blog you possess both knowledge and wisdom in spades. Perhaps you should find some kind of way to employ your superb attributes – like becoming President or Governor of the Central Bank of India?

      • ^^Reid wrote: “For the former, USSR.. I don’t know anyone who ever thought they had a chance of overtaking the U.S. economically”
        ——

        http://alturl.com/kqzjr
        http://alturl.com/6a33a

        ~~~~~

        ^^Reid wrote: “First off, Japan is certainly not a failure, if that’s what you’re implying. They’re the third largest economy in the world. The only thing stopping them from becoming first was….”
        ——

        http://alturl.com/se25d
        http://alturl.com/rmg5m
        http://alturl.com/42gfj

        ~~~~~~

        ^^ReiD wrote: “Regardless, [XYZ] had a completely different system and strategy…”
        ——

        Look at what Japan did after 1991 (rebalancing, by ending financial repression & slowing GDP growth):
        http://alturl.com/5k7b5

        Look at what Korea did after 1997 (rebalancing, by ending financial repression & slowing GDP growth):
        http://alturl.com/nuzdb

        That is exactly what China will have to start doing VERY SOON….
        http://alturl.com/infir

        • Here’s a post I did on Japan. You might find it interesting Vinezi. I’d like to get your (and others) thoughts on it.
          http://suvysthoughts.blogspot.com/2014/09/japans-got-issues.html

          Japan’s biggest problem is a problem no one really talks about: Japan imports most of its food and virtually all of its energy. I also think putting up nuclear power plants in Japan is a terrible idea considering that Japan is on one of the world’s most active geological fault lines.

          • Suvy your second point is a few decades to late they did just that and it does answer your first point would you have them eat Fukishima Tainted food Or did you think Hiroshima Nagasaki to acclimatizing food taint for Japanese constitution of body?

          • The problem is that no one knows the consequences yet. That’s the problem with (most) issues of environmental degradation where the cases where the costs and impacts don’t stay localized. We don’t have a robust way to determine the bounds of what we do. This is why environmental damage transfer risks across time to future generations (and why it should be banned).

      • ^^Reid wrote: “…And they certainly are not “communist” anymore. They’ve been opening up ever since the agricultural reforms in the 1970s, which were followed by private ownership of companies in the 1990s, and very soon, they will be privatizing land and even the largest state owned companies. I wish I had an article or something to cite, but I heard this straight from the mouth of a senior CPC official…”
        ——

        From the Communist Manifesto (1848): “The proletariat will use its political supremacy to wrest all capital from the bourgeoisie and so centralize all instruments of production in the hands of the State… The proletariat then makes itself the ruling class, and, as such, SWEEPS AWAY by force the OLD CONDITIONS OF PRODUCTION, and so it will, along with these conditions, have swept away the conditions for the existence of class antagonisms and of classes generally, and will thereby have ABOLISHED ITS OWN SUPREMACY as a class.”
        **

        Zhong Guo Gong Chan Dang.
        Privatizes all Public Assets.
        Publicizes all Private Liabilities.
        Thereby abolishes its own supremacy.

        Ask the mouth of that CPC official:
        Does he want to be a senior member,
        assuming responsibility without power,
        of Zhong Guo Gong Fu Zhi Dang?

    • Policymakers of all nations most likely know or think they know what they are doing (how many times have you met or heard one of them saying “we have no idea how to deal with this”?) – though sometimes the results they achieve suggest otherwise – and it is of course always with the best intentions.

      But really, the only thing policymakers should focus on is try to ensure the best possible outcome within the constraints of keeping things balanced. For, once imbalances have developed and grown, all kind of things can happen and control can quickly become illusory.

      One can only meditate the words of Maurice Allais: “the analysis shows how cautiously one should consider the prosperity of an economy in real terms as long as potential imbalances develop, at first glance small in relative terms, but able to trigger, when they crystallise and compound, deep changes in collective psychology.” – La crise mondiale d’aujourd’hui, 1999 (my translation).

      China has fallen (remarkably easily, it seems) into the highly predictable outcome of the current international trade and monetary system whereby the creditor country, to avoid the economic impact of reduced export growth once trade imbalances have gone too far, uses its accumulated monetary reserves to unleash a domestic credit boom that ends up leaving it under excess debt. See comments from “Bad debt cannot simply be socialized”.

      In that sense, they look like normal, fallible, human policymakers to me.

  41. Mark Garbin, CFA PRM

    Michael, you mentioned that Europe might be an external shock that can tip the Chinese economy into a crisis. Two questions: How might that manifest itself? Are there any other economic or environmental shocks that might have a similar impact?

    • A) Spain, Italy & Greece eliminated their current-account deficits:
      http://alturl.com/wc3dk

      How is it then that Germany & Netherlands have maintained their huge current-account surpluses, as if the Euro crisis never really happened at all?

      B) In the Anglo-Saxon world, the US & UK saw falling house-prices, bank failures, bailouts & recession:
      http://alturl.com/pff2s

      How is it then that Australia still has soaring house-prices, no bank failures, no bailouts and no recession, as if the global crisis never happened at all?
      ——–

      When you have the common answer to both these questions, I think you will see that the original crisis in not yet over. The pain we are seeing in US, UK, Spain, Greece et cetera right now is merely Act-I of the crisis. At some point in the near future, we will see Act-II, in which Germany, Netherlands, Australia, Canada et cetera will be the “second shoe to drop”.

      • “At some point in the near future, we will see Act-II, in which Germany, Netherlands, Australia, Canada et cetera will be the “second shoe to drop”.”

        Yup. I think countries like Australia and Canada will experience stagflation. Hell, I think all commodity exporters could experience something of the sort. The drop in commodity prices (particularly industrial commodities) will reduce the demand for these currencies, which means the currencies will fall. Also note that since these countries export commodities, they’ll experience falling output and falling employment with a falling currency. I think we’re likely to see input price inflation combined with falling output and employment. In other words, I think these countries will experience stagflation or stagflation-like effects. I talk about it in more detail here.
        http://suvysthoughts.blogspot.com/2014/09/economicsfinancial-consequences-of.html

        • As an Australian I glad I will end life here in SRV Aussie might have that problem, USA has but won’t admit it. They use war spending to make numbers look better for sales and consumption and Government spending. But essentially you are right all should see the problem soon unemployment already critical everywhere so falling domestic consumption as low employment income is low disposable consumer buying, as all countries are suffering the same USA over-automation surplus production capacity etc. they can’t rely on export to replace the demand?

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