n my Thoughts from the Frontline debut this past March (“China’s Minsky Moment?”), I highlighted the massive bubble in Chinese private-sector debt and explored the near-term prospects for either (1) a reform-induced slowdown or (2) a crisis-induced recession. Unfortunately, it was not an easy or straightforward analysis, considering the glaring inconsistencies between “official” state-compiled data and more concrete measures of all real economic activity, which is why I suggested that China is simultaneously the most important and most misunderstood economic force in the world today.
With the stakes now higher than ever, I returned to Asia’s “miracle” last week (“Looking at the Middle Kingdom with Fresh Eyes”) and probed deeper into the shadows (including China’s shadow banks) with the help of my new friend Leland Miller and a few illuminating excerpts from his Q1 2014 China Beige Book (the largest and most comprehensive survey series ever conducted on a closed or semi-closed economy).
Pulling back the Bamboo Curtain, Leland’s data revealed aspects of the Chinese economy that John and I could have only guessed at before, giving us a rare opportunity to explore regional contrasts in Chinese economic activity, to survey the modest (but still insufficient) rebalancing among sectors, and to identify a series of pressure points within the credit markets that suggest last summer’s interbank volatility may return in 2014.
Unfortunately, Leland’s key insights confirmed our fears that China’s consumption-repressing, debt-fueled, investment-led growth model is slowing down and starting to sputter… but not collapsing (at least not yet).
What happens next – with huge implications for global markets – depends largely on the economic wisdom and political resolve of China’s central planners, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while also rebalancing the national economy toward a consumption-driven growth model.
Finessing the challenges will require not just one but a series of miracles.
Like Every Other Investment-Driven Growth “Miracle”
After 34 years of booming economic growth averaging over 9% per year (the longest sustained period of rapid economic growth in human history), China’s credit-fueled, investment-driven growth model is exhausted and increasingly unstable. As you can see in the chart below, the Middle Kingdom’s credit boom is well past the point of diminishing marginal returns; and no one can deny that the misallocation is widespread, with capacity utilization now below 60%. (I should also note that Societe Generale’s Wei Yao has consistently published some of the best research on China in recent quarters; personally, I won’t be surprised to see her vault to rock-star status as the People’s Republic decelerates.)
Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.
Moreover, state-perpetuated distortions in the cost and availability of financing are (1) funneling huge amounts of capital toward increasingly unproductive, state-directed investments, and (2) pushing household and private business borrowers into the shadows, where the burden of substantially higher interest rates drags on household consumption.
Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.
It doesn’t require much imagination to connect the dots. Structural distortions in Chinese financial markets are a major cause of debt-fueled overinvestment; and without sweeping structural reforms (along with a major crackdown on corruption at all levels of government), captive capital will continue to flow toward unproductive investments, capacity utilization will continue to fall, and China’s investment boom will continue its march toward a mega Minsky moment.
This kind of structural distortion is a classic symptom of an overextended investment boom and a warning sign that rebalancing – whether it’s induced by voluntary reforms or an involuntary debt crisis – will not be easy. The critical adjustments – gradual deleveraging and structural rebalancing – will require a greater slowdown in economic growth and a sharper fall in still-bubbly asset prices than China’s policymakers are letting on.
“This is not an easy task,” The Daily Telegraph’s Ambrose Evans Pritchard says, in a truly brilliant article published this week, “not least because land sales and taxes make up 39% of state revenue in China, and the property sector employs 20% of workers one way or another. It is clearly a bubble of epic proportions and already losing air. Mao Daqing from Vanke – China’s top developer – says total land value in Beijing has been bid up to such extremes that is on paper worth 61.6pc of America’s GDP. The figure was 63.3pc for Tokyo at the peak of the bubble in 1990.” Yikes.
As Peking University professor Michael Pettis explains in his 2013 book, Avoiding the Fall: China’s Economic Restructuring, “Every country that has followed a consumption-repressing, investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led to either a debt crisis or a lost decade of very low growth.”
China’s “miracle” is no different from any other investment-driven growth binge where high levels of leverage (directly or indirectly paid for by the household sector), combined with high levels of fixed investment, eventually result in excessive and unsustainable debt loads. Pettis elaborates:
While these policies can generate tremendous growth early on, they also lead inexorably to deep imbalances. As demonstrated by the history of every investment-driven growth miracle, including that of Brazil, high levels of state-directed subsidized investment run an increasing risk of being misallocated, and the longer this goes on the more wealth is likely to be destroyed even as the economy posts high GDP growth rates. Eventually the imbalances this misallocation created have to be resolved and the wealth destruction has to be recognized. What’s more, with such heavy distortions imposed and maintained by the central government, there is no easy way for the economy to adjust on its own…. [Furthermore], Beijing [will] not be able to raise the consumption share of GDP without abandoning the investment-driven growth model altogether.
In other words, the world’s second largest economy is approaching its debt limit and the end of the line for investment-led growth… but China’s financial system is structurally designed to prevent capital from flowing freely toward more productive uses. One way or another, the world’s largest contributor to global economic growth must slow down – either because Beijing has the foresight, resolve, and political capital to pursue aggressive economic and financial market reforms or because party elites fail to address the country’s structural imbalances and policy-induced distortions before the credit bubble pops. “Debt,” Pettis explains, “as we will learn over the next few years in China, has always been the Achilles’ heel of the investment-driven growth model…”
Which Way to Sustainable Growth?
Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national economy toward a more sustainable, consumption-driven growth model.
According to Bob Davis and Lingling Wei at the Wall Street Journal, “That would be a departure from China’s old formula of relying on cheap exports abroad and vast investment at home in building roads, railways and even new cities…. Standing in China’s way are many of the biggest beneficiaries of China’s past growth model.”
The transition will not be easy and may require a far greater slowdown than anyone in Beijing publicly admits. While China’s ruling elite don’t appear to be in denial about its debt problem, the distortions caused by widespread corruption, or the urgency to replace its sputtering growth model, the jury is still on whether President Xi Jinping will maintain the political and social capital necessary to follow through on growth-disrupting, job-displacing reforms.
Dr. Pettis suggests China’s central planners must choose among six possible paths, and the results of that choice will shape China’s future economic success or failure as forcefully as Deng Xiaoping’s Open Door policy did in 1978. We should all be praying for President Xi and his economic policy architect Liu He to choose wisely and follow through:
Irrespective of the chosen path toward rebalancing, growth is clearly decelerating across the Middle Kingdom… and even a modest slowdown will shake the world.
Source: Chen Long, “Testing the Reformers Resolve.” GaveKal Research, May 27, 2014
Our newly illuminated view via the China Beige Book leads John and me to believe that a pronounced slowdown (again, induced either by voluntary reforms or by an involuntary debt crisis) is now inevitable… suggesting that the real story surrounding China’s slowdown is really about the rest of the world, from its trading partners to leveraged investors in seemingly unrelated niches of our highly interconnected global financial system.
What Could Possibly Go Wrong?
Our world is far more integrated today in terms of cross-border flows in goods…
… services…
… and financial flows.
Source: James Manyika, Jacques Bughin, Susan Lund, Olivia Nottebohm, David Poulter, Sebastian Jauch, and Sree Ramaswamy, Global Flows in a Digital Age. McKinsey Global Institute, April, 2014.
We rarely know in advance which hedge fund or mega-bank has massive, leveraged exposures to toxic markets or asset classes, but it is absolutely prudent to assume that at least one systemically relevant institution has over-gorged and over-leveraged on positive carry. That’s a fair assumption, since major central banks continue to promote bad behavior with negative real interest rates, large-scale asset purchases, and forward guidance that chaotically distort market signals.
Any kind of deflationary collapse in China could send a shock wave through the world’s hyperconnected and highly leveraged financial system, triggering extensive losses in European and American mega-banks and likely tipping the developed world back into a hard recession precisely when the central banking community lacks effective policy tools to soften the blow. As we all experienced in 2008, such a shock could effectively shut the door on global trade finance, unwind carry trades around the world, and trigger a sharp reversal in cross-border capital flows as international trade grinds to a halt.
That’s a worst-case scenario that could certainly happen, but it’s not the most likely scenario (thank goodness). However, China doesn’t have to experience a deep recession in order to disrupt global growth.
China is the world’s second largest goods importer, buying the equivalent of more than $1.7 trillion in foreign goods each year (compared to US imports of roughly $2.3 trillion). The Middle Kingdom imports extensively from its immediate neighbors in East and Southeast Asia but also does nontrivial business with Australia, Brazil, the United States, and Germany. (Note: The following analysis relies on 2011 trade data, which is the most recent data-set available in MIT’s online Observatory of Economic Complexity).
Reference: FORBES
With the stakes now higher than ever, I returned to Asia’s “miracle” last week (“Looking at the Middle Kingdom with Fresh Eyes”) and probed deeper into the shadows (including China’s shadow banks) with the help of my new friend Leland Miller and a few illuminating excerpts from his Q1 2014 China Beige Book (the largest and most comprehensive survey series ever conducted on a closed or semi-closed economy).
Pulling back the Bamboo Curtain, Leland’s data revealed aspects of the Chinese economy that John and I could have only guessed at before, giving us a rare opportunity to explore regional contrasts in Chinese economic activity, to survey the modest (but still insufficient) rebalancing among sectors, and to identify a series of pressure points within the credit markets that suggest last summer’s interbank volatility may return in 2014.
Unfortunately, Leland’s key insights confirmed our fears that China’s consumption-repressing, debt-fueled, investment-led growth model is slowing down and starting to sputter… but not collapsing (at least not yet).
What happens next – with huge implications for global markets – depends largely on the economic wisdom and political resolve of China’s central planners, who must find a way to gradually deleverage overextended regional governments and investment-intensive sectors while also rebalancing the national economy toward a consumption-driven growth model.
Finessing the challenges will require not just one but a series of miracles.
Like Every Other Investment-Driven Growth “Miracle”
After 34 years of booming economic growth averaging over 9% per year (the longest sustained period of rapid economic growth in human history), China’s credit-fueled, investment-driven growth model is exhausted and increasingly unstable. As you can see in the chart below, the Middle Kingdom’s credit boom is well past the point of diminishing marginal returns; and no one can deny that the misallocation is widespread, with capacity utilization now below 60%. (I should also note that Societe Generale’s Wei Yao has consistently published some of the best research on China in recent quarters; personally, I won’t be surprised to see her vault to rock-star status as the People’s Republic decelerates.)
Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.
Moreover, state-perpetuated distortions in the cost and availability of financing are (1) funneling huge amounts of capital toward increasingly unproductive, state-directed investments, and (2) pushing household and private business borrowers into the shadows, where the burden of substantially higher interest rates drags on household consumption.
Source: Wei Yao & Claire Huang, “SG Guide to China Reform.” Societe Generale Research, May 14, 2014.
It doesn’t require much imagination to connect the dots. Structural distortions in Chinese financial markets are a major cause of debt-fueled overinvestment; and without sweeping structural reforms (along with a major crackdown on corruption at all levels of government), captive capital will continue to flow toward unproductive investments, capacity utilization will continue to fall, and China’s investment boom will continue its march toward a mega Minsky moment.
This kind of structural distortion is a classic symptom of an overextended investment boom and a warning sign that rebalancing – whether it’s induced by voluntary reforms or an involuntary debt crisis – will not be easy. The critical adjustments – gradual deleveraging and structural rebalancing – will require a greater slowdown in economic growth and a sharper fall in still-bubbly asset prices than China’s policymakers are letting on.
“This is not an easy task,” The Daily Telegraph’s Ambrose Evans Pritchard says, in a truly brilliant article published this week, “not least because land sales and taxes make up 39% of state revenue in China, and the property sector employs 20% of workers one way or another. It is clearly a bubble of epic proportions and already losing air. Mao Daqing from Vanke – China’s top developer – says total land value in Beijing has been bid up to such extremes that is on paper worth 61.6pc of America’s GDP. The figure was 63.3pc for Tokyo at the peak of the bubble in 1990.” Yikes.
As Peking University professor Michael Pettis explains in his 2013 book, Avoiding the Fall: China’s Economic Restructuring, “Every country that has followed a consumption-repressing, investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led to either a debt crisis or a lost decade of very low growth.”
China’s “miracle” is no different from any other investment-driven growth binge where high levels of leverage (directly or indirectly paid for by the household sector), combined with high levels of fixed investment, eventually result in excessive and unsustainable debt loads. Pettis elaborates:
While these policies can generate tremendous growth early on, they also lead inexorably to deep imbalances. As demonstrated by the history of every investment-driven growth miracle, including that of Brazil, high levels of state-directed subsidized investment run an increasing risk of being misallocated, and the longer this goes on the more wealth is likely to be destroyed even as the economy posts high GDP growth rates. Eventually the imbalances this misallocation created have to be resolved and the wealth destruction has to be recognized. What’s more, with such heavy distortions imposed and maintained by the central government, there is no easy way for the economy to adjust on its own…. [Furthermore], Beijing [will] not be able to raise the consumption share of GDP without abandoning the investment-driven growth model altogether.
In other words, the world’s second largest economy is approaching its debt limit and the end of the line for investment-led growth… but China’s financial system is structurally designed to prevent capital from flowing freely toward more productive uses. One way or another, the world’s largest contributor to global economic growth must slow down – either because Beijing has the foresight, resolve, and political capital to pursue aggressive economic and financial market reforms or because party elites fail to address the country’s structural imbalances and policy-induced distortions before the credit bubble pops. “Debt,” Pettis explains, “as we will learn over the next few years in China, has always been the Achilles’ heel of the investment-driven growth model…”
Which Way to Sustainable Growth?
Among the various reforms set forth in last November’s Communist Party Third Plenum, ranging from financial liberalization to a crackdown on corruption and pollution, the most challenging is the gradual deleveraging of the Chinese economy while simultaneously rebalancing the national economy toward a more sustainable, consumption-driven growth model.
According to Bob Davis and Lingling Wei at the Wall Street Journal, “That would be a departure from China’s old formula of relying on cheap exports abroad and vast investment at home in building roads, railways and even new cities…. Standing in China’s way are many of the biggest beneficiaries of China’s past growth model.”
The transition will not be easy and may require a far greater slowdown than anyone in Beijing publicly admits. While China’s ruling elite don’t appear to be in denial about its debt problem, the distortions caused by widespread corruption, or the urgency to replace its sputtering growth model, the jury is still on whether President Xi Jinping will maintain the political and social capital necessary to follow through on growth-disrupting, job-displacing reforms.
Dr. Pettis suggests China’s central planners must choose among six possible paths, and the results of that choice will shape China’s future economic success or failure as forcefully as Deng Xiaoping’s Open Door policy did in 1978. We should all be praying for President Xi and his economic policy architect Liu He to choose wisely and follow through:
- Beijing can do nothing, maintaining its high investment growth rate, until it reaches its debt capacity limit, after which a sudden stop in investment will force up the household share of GDP, albeit in an outright recession.
- Beijing can quickly reverse the transfers that created the imbalances by, for example, pushing up wages and raising real interest rates sharply, forcing up the foreign exchange value of the currency by 10 to 20 percent overnight, or by lowering income and consumption taxes.
- Beijing can slowly reverse the transfers in the same way as outlined in path #2.
- Beijing can directly transfer wealth from the state sector to the private sector by privatizing assets and using the proceeds directly or indirectly to boost household wealth.
- Beijing can indirectly transfer wealth from the state sector to the private sector by absorbing private-sector credit (a virtually guaranteed lost decade).
- Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
Irrespective of the chosen path toward rebalancing, growth is clearly decelerating across the Middle Kingdom… and even a modest slowdown will shake the world.
Source: Chen Long, “Testing the Reformers Resolve.” GaveKal Research, May 27, 2014
Our newly illuminated view via the China Beige Book leads John and me to believe that a pronounced slowdown (again, induced either by voluntary reforms or by an involuntary debt crisis) is now inevitable… suggesting that the real story surrounding China’s slowdown is really about the rest of the world, from its trading partners to leveraged investors in seemingly unrelated niches of our highly interconnected global financial system.
What Could Possibly Go Wrong?
Our world is far more integrated today in terms of cross-border flows in goods…
… services…
… and financial flows.
Source: James Manyika, Jacques Bughin, Susan Lund, Olivia Nottebohm, David Poulter, Sebastian Jauch, and Sree Ramaswamy, Global Flows in a Digital Age. McKinsey Global Institute, April, 2014.
We rarely know in advance which hedge fund or mega-bank has massive, leveraged exposures to toxic markets or asset classes, but it is absolutely prudent to assume that at least one systemically relevant institution has over-gorged and over-leveraged on positive carry. That’s a fair assumption, since major central banks continue to promote bad behavior with negative real interest rates, large-scale asset purchases, and forward guidance that chaotically distort market signals.
Any kind of deflationary collapse in China could send a shock wave through the world’s hyperconnected and highly leveraged financial system, triggering extensive losses in European and American mega-banks and likely tipping the developed world back into a hard recession precisely when the central banking community lacks effective policy tools to soften the blow. As we all experienced in 2008, such a shock could effectively shut the door on global trade finance, unwind carry trades around the world, and trigger a sharp reversal in cross-border capital flows as international trade grinds to a halt.
That’s a worst-case scenario that could certainly happen, but it’s not the most likely scenario (thank goodness). However, China doesn’t have to experience a deep recession in order to disrupt global growth.
China is the world’s second largest goods importer, buying the equivalent of more than $1.7 trillion in foreign goods each year (compared to US imports of roughly $2.3 trillion). The Middle Kingdom imports extensively from its immediate neighbors in East and Southeast Asia but also does nontrivial business with Australia, Brazil, the United States, and Germany. (Note: The following analysis relies on 2011 trade data, which is the most recent data-set available in MIT’s online Observatory of Economic Complexity).
Reference: FORBES
