By Michael Pettis. Cross posted from Michael Pettis’ China Financial Markets
Early this month Martin Wolf had another of his very interesting articles, this time on China, which I think suggests some of the concerns we must have about the upcoming adjustment. Wolf argues that it may be useful to think about Japan as a model for understanding the adjustment process in China since the Japanese model shows how risky it is to shift to a slow-growth model. I of course agree.
Over the next decade, China’s growth will slow, probably sharply. That is not the view of malevolent outsiders. It is the view of the Chinese government. The question is whether it will do so smoothly or abruptly. On the answer depends not only China’s own future, but also that of much of the world.
As an aside it is funny to me (and probably no surprise to any Chinese or foreign economist who writes about China) that Wolf had to stress that it is not just “malevolent outsiders” who predict slower Chinese growth. You would think that identifying risks in the Chinese growth model and suggesting ways to minimize or hedge them would be considered a service to China.
But for some reason in China there is a very vocal minority that considers any skepticism about the sustainability of the Chinese growth model to be either an insult to the Chinese people or a malevolent foreign conspiracy. The extent of this rather surprising rage may suggest a level of fragility in China’s social fabric and its self-confidence that could make any slowdown more difficult to manage, but this is a digression. My point in bringing up Wolf’s article is not to play amateur national psychologist but rather to suggest something about the process of shifting to a new growth model. Wolf says:
As the experience of Japan has shown, managing a shift from a high-investment, high-growth economy to a lower-investment, lower-growth economy is very tricky. I can envisage at least three risks. First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.
Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.
Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.
The government’s plan is, of course, to make the transition to a better balanced and slower-growing economy smoothly. This is far from impossible. The government has all the levers it needs. Moreover, the economy continues to have much potential. But managing a decline in the growth rate without an investment collapse and financial disruption is far trickier than any general equilibrium model suggests.
In his article Wolf implicitly refers to a process on which he doesn’t actually dwell much, but which I think is very important. A lot of economies, and especially developing economies with distorted balance sheets and one or two major drivers of growth, can have embedded in their economic institutions self-reinforcing mechanisms that can be very powerful.
I discuss this a great deal in my book, The Volatility Machine. As a consequence of these self-reinforcing mechanisms, I argue, movements in any direction can be sharply magnified, so that positive shocks will often result in much faster growth than anyone expected. But this comes at a cost. The reversal of these shocks often can result in much slower growth than anyone expected, or even in a wholly unexpected collapse into crisis.
Wolf mentions in his second point the relationship between slower growth and rising bad debt, for example, and he is absolutely correct, but I would add that rising bad debt itself puts pressure on the financial system in a way that creates at least two additional problems. First, it makes banks reluctant to increase credit further. Second, the rising bad debt increases the hidden transfer from the household sector needed to resolve the debt, which then puts downward pressure on household consumption.
This of course is self-reinforcing. Why? Because slowing growth caused an increase in bad debts, but an increase in bad debts will cause further slowing in growth.
We speak of the case in which positive shocks are self-reinforcing, as a virtuous circle, and the case in which negative shocks are self-reinforcing as a vicious circle, but the important point is that these processes are part of the same system and are very common. It is usually a pretty safe bet, for example, that when an economy is surging forward at astonishing growth rates – rates which far exceeded anyone’s prior expectations – it has powerful positive feedback loops embedded within its economic institutions.
In my book I focus mostly on balance sheet feedback loops, but they also exist just as powerfully in the underlying economy. Urbanization, for example, can create very strong feedback loops. How does it work? In the early stages of growth, productive jobs are created in the urban areas, for example as factories are built, and workers very quickly leave the countryside to take these jobs. They are also willing to move quickly around the country, so that migration is very sensitive to the perception of demand.
As workers move to the cities, their need for housing and services immediately rises, and their expenditures create additional jobs. What’s more, their remittances create capital accumulation and higher expenditures in their home areas that cause rural growth to increase by more than it otherwise would have. In the end the original investment in the factory is quickly multiplied throughout the economy, so that growth creates urbanization and urbanization creates more growth in a virtuous circle.
This process is reinforced by the impact of the original investment on the financial sector. As workers get jobs, part of their income is consumed, creating more demand and more jobs, and part of it is saved, which allows banks to direct the additional savings into higher investment. Since the growth impact of this process in the early stages of industrialization can be very high, this creates stronger growth expectations, which then justify even higher investment in capacity and infrastructure.
It is probably not a coincidence that in such developing countries that are growing quickly we almost always see credit growth far surpass anything we might have expected. The impact of financial deepening can be extremely strong in a country that starts out with a very weak and underdeveloped financial system, and as growth exceeds expectations year after year, perhaps not surprisingly, credit standards are weakened and money pours into projects that might have otherwise been considered risky
But what happens when these productive jobs dry up and the economy starts to slow, especially if it slows after credit has been too liberally extended? For one thing, either very quickly the workers go home, or they remain in the cities as unemployed workers without savings or social safety nets. In the former case the goods and services they demanded also disappear quickly and unemployment rises by even more than the direct impact of the reduction in jobs. If they remain in the city they create a drag on social expenditure (and perhaps a rise in crime) that transfers spending from more productive to less productive sectors.
As urbanization reverses, or even as it simply slows, it becomes self-reinforcing in the wrong direction. These kinds of feedback loops exist in every economy, but for a variety of reasons they seem much stronger in developing countries with weak institutional structures, in countries that are undergoing rapid social and economic change, and in countries with rigid and unsophisticated financial systems.
This feedback process may explain one of the puzzles typical of developing countries, and especially developing countries undergoing an investment boom. The historical precedents suggest that in the early stages of a growth miracle we are always surprised by the extent of growth – growth far exceeds even our wildest expectations.
Once the economy begins to slow, however, we have also been – in every case that I can identify – shocked by how vicious the slowdown turned out to be. This would not be a surprise if indeed these economies are caught up in very powerful feedback loops. On the contrary, this would be normal.
What does all of this have to do with Martin Wolf’s article? Wolf suggest plausible reasons for expecting a slowdown in Chinese growth, but his idea of a slowdown is relatively moderate and would, in fact, be considered rapid growth in most economies. But if part of the explanation for China’s spectacular – and spectacularly unexpected – growth of the past three decades has to do with the positive feedback loops that are so typical of developing countries with fragile and unsophisticated financial systems, then a moderate slowdown in growth may be an impossible target to achieve. Once growth starts to slow, the self-reinforcing impact on urbanization, on credit growth, on financial distress, and on expectations may force growth rates to drop far more sharply than any “plausible” analysis would suggest.
Back to Europe
Speaking about feedback loops, Europe continues to bounce violently up and down in the markets. In my January newsletter I expressed my surprise that the market was acting as if it thought the bulk of Europe’s problems was behind us, but since then the market has changed its beliefs. The events in Cyprus have reminded us of just how volatile the situation is and just how pro-cyclical it can be.
As I see it however events in Europe are still unfolding just as they are supposed to. Last week I saw a worrying article in the Financial Times.
Spain’s economic crisis and the near-collapse of its banking sector last year have conspired to choke off the flow of bank loans – threatening to dry out the vast and versatile pool that dominates Spain’s private sector.
In the five years since the crisis started, no fewer than 450,000 small and medium-sized enterprises have gone under, says Jesús Terciado, the president of Cepyme, the Spanish SME association. “But it is not just about staying in business – it’s also about growth. There is no way you can grow your business at the moment,” he says.
I have previously discussed the financial distress process – which affects companies as well as countries – as consisting of a highly pro-cyclical change in the behavior of major stakeholders in response to deteriorating credibility, which itself causes credibility to deteriorate further. In other words the more we worry about the government’s ability to repay debt, the more we behave in ways that have the effect of further reducing the government’s ability to repay the debt. We do this by acting in ways that automatically increase the amount of the debt, make the balance sheet more fragile, or reduce debt-servicing capacity.
One of the key modifications in the way stakeholders respond to a crisis is in the behavior of small and medium enterprises. Business owners respond to deteriorating economic conditions by disinvesting and firing workers, while lenders respond to worsening credit risks by tightening credit conditions. Both responses only worsen the underlying debt problem, and cause the economy constantly to underperform expectations, until at some point conditions spiral out of control.
No matter what Madrid does, in other words, the debt crisis will ensure that the Spanish economy continues to deteriorate as stakeholders respond to the deterioration. Without a major positive shock that can permanently reverse the underlying process of financial distress, Spain cannot help but continue its slow slide into crisis, and should any other country leave the euro, the pressures on Spain will automatically intensify as the burden of adjustment is forced onto a smaller group of countries.
Meanwhile in what also shouldn’t be a surprise, Spain’s savings rate continues to drop. Here is an article in El País:
Spain’s household savings rate declined to a new record low last year as rampant unemployment and the loss of spending power due to inflation and wage cuts forced families to dip into their piggy banks to make ends meet. According to figures released Tuesday by the National Statistics Institute (INE), households set aside 8.2 percent of their disposal income last year, the lowest rate since the INE began compiling the series in 2000. The figure was down 2.8 points from a year earlier.
The INE said disposable income in the fourth quarter declined 4.2 percent from the same period a year earlier, a fall of 7.835 billion euros to 176.766 billion. Wages in the period declined 8.5 percent, with was barely offset by slight increases in income from other sources such as interest rates and deposits.
Why are Spanish savings declining?
The article explains the falling savings rate as reflecting rising unemployment (fired workers, after all, still have to consume), but it is perhaps easier to understand the process, and how difficult it is to unwind, by working through the balance of payments. If Germany is still exporting savings (i.e. running a current account surplus), the rest of the world has no choice but to import savings, and because of monetary constraints the rest of the world in this case is peripheral Europe.
Why is Germany exporting savings? This, as I have pointed out many times, has nothing to do with German thrift. It has to do with wage repression. From 1991 to 2000, according to an interesting recent paper by Thomas Palley, nominal compensation per employee in Germany rose by 3.2% a year on average, whereas it rose a little more quickly in Europe overall (3.5% a year). From 2001 to 2010, while European-wide nominal compensation growth dropped to 2.4% annually, however, it dropped to 1.1% in Germany.
The sharp slowdown in German wage growth was a direct consequence of agreements hammered out between the government, large businesses and labor unions to repress wages in order to make German goods more competitive in international markets. It might seem surprising that slower wage growth would create a surge in savings, but since savings is simply total production less total consumption, and wage repression had a secondary consequence of repressing consumption growth, by definition it puts upward pressure on German savings.
In the 1990s Germans saved less than they invested domestically, so they imported foreign capital and ran current account deficits, but after the wage-repressing agreements, German’s savings rate was forced up to the point where it so far exceeded investment that Germany began exporting capital in 2002. The amount of net exported capital surged to 7.5% of GDP by 2007 – or, to put it another way, German’s current account surplus was 7.5% of GDP. Because the structure of the euro ensured that the corresponding deficits to German’s forced surpluses were likely to be the countries of peripheral Europe, German’s net capital exports had to result in net capital imports for the peripheral Europe.
There is only two ways a country like Spain could increase its net imports of foreign savings. Its investment could rise faster than its savings, or its savings could fall faster than its investment. In either case, as savings exceeded investment, Spain would import the difference, and so run a current account deficit equal to its net capital imports.
Of course with the economy in such terrible shape, there is no chance that investment is rising. In fact it is probably falling. This means that Spanish savings must also fall, and there are practically speaking two ways it can do so. First, the Spanish can go on a credit-fueled consumption boom that drives down the savings rate while keeping unemployment low, as they did before 2008-09. Second unemployment can surge, as it has since then.
Because a return to the consumption binge is pretty unlikely any time soon, is it such a big surprise that we are seeing savings adjust through high unemployment? Without a significant reversal of Germany’s too-high savings rate, Spain really doesn’t have much choice. The only ways Spain can reduce unemployment is either with a surge in domestic investment, or with a reversal of the trade deficit, which probably requires that it leave the euro and devalue. This is mostly just arithmetic.
The exorbitant privilege
For one last quick point I want to return to some of the absurdities of the currency war. During the 1980s Japan was fairly certain that its large current account surpluses had nothing to do with monetary policy and everything to do with management and business techniques.
In the past decade China has also argued the same thing. When trade surpluses are extraordinarily high, it cannot possibly be the consequence of distorted monetary policy, it seems. This makes the recent dispute between Japan and China a little surprising. According to an article in the South China Morning Post:
Many of China’s top economists are livid at what they view as an effective currency devaluation by Japan and are calling on the People’s Bank of China to retaliate by weakening the yuan to defend itself in what they see as a new currency war. These economists, including Tsinghua University professor Li Daokui and ANZ Bank’s Liu Ligang, see Japan’s plan to double its monetary base within two years as “blackmail” and have criticised the Japanese central bank’s decision to open the liquidity floodgates to bump up the economy.
Liu said Japan’s unprecedented easing programme, aimed at ending more than two decades of deflation, was “a monetary blackmail” targeted at other export-driven Asian countries such as China and that the central bank should sell more yuan and buy the US dollar to push down the yuan. He also called on authorities to guard against a fresh wave of hot money into China’s fragile financial markets, warning that Japan’s move would reignite the so-called carry trade, under which investors borrow in low-interest yen and invest in high- interest markets.
It is interesting that while Beijing has complained bitterly about the exorbitant privilege that allows the US to exploit foreign purchase of dollars for reserves, when Tokyo acts to push down the yen, many of the same people in Beijing argue that the Chinese response should be to transfer to the US even more of this exorbitant privilege. It seems that none of the world’s economies really want to take any of the exorbitant privilege for themselves.
And why should they? Buying US dollars in order to push down the value of their currencies – and this is all the US exorbitant privilege consists of – allows other countries to increase domestic employment by turbo-charging exports growth at the expense of domestic consumption (and imports). Although countries that do this usually insist that this higher domestic employment does not come at the expense of US employment, no one is eager to carry the current account deficit that comes with the exorbitant privilege.
My guess is that until the US takes steps to prevent foreign accumulation of US government bonds, or, if other countries want to retain the use of an international traded currency, they agree not to game the reserve system, the US will always be faced with the choice either of absorbing demand deficiency from every part of the world that wants more growth or of engaging in its own version of currency war, QE. The very same people who complain about the currency consequences of QE, in other words, are arguing that while it makes sense for them to expand aggressively, it is morally wrong when other countries do it.
That sounds a lot to me like old-fashioned beggar-thy-neighbor politics. And there is no reason we should expect this to end soon.