I’ll be watching a number of
things in 2013 in order to get a better sense of what the future will
bring. On January 22 Princeton University Press will be publishing my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead,
and in the last chapter of the book I argue that the great trade,
capital flow and debt imbalances the were built up over the preceding
two decades must reverse themselves. Imbalances can continue for many
years, I argue, but at some point they become unsustainable and the
world must adjust by reversing those imbalances.
One
way or the other, in other words, the world will rebalance. But there
are worse ways and better ways it can do so. Large trade surpluses can
decline, for example, because exports fall, or they can decline because
imports rise. Large trade deficits can contract under conditions of high
unemployment, but they can also contract under conditions of low
unemployment. Low savings rates can rise with declining household income
or with rising household income. Repressed consumption rates can
reverse through collapsing growth or through surging consumption.
Excessive debt can be resolved by default or by growth.
Any
policy that does not clearly result in a reversal of the deep debt,
trade and capital imbalances of the past decade is a policy that cannot
be sustained. The goal of policymakers must be to work out what
rebalancing requires and then to design and implement the least painful
way of getting there. International cooperation, of course, will reduce
the pain.
My
guess is that we have ended the first stage of the global crisis, and
most of the deepest problems have been identified. In 2013 we will begin
to see how policymakers respond and what the future outlook is likely
to be. Here is what I will be watching this year in order to figure out
where we are likely to end up (and I have a related article, for those who might care, in last week’s Financial Times).
1. Watch how quickly growth adjusts.
The speed with which China’s GDP growth slows in 2013 will tell us a
lot about how determined Beijing is to rebalance the economy in such a
way that growth is driven more by higher household income and
consumption and less by investment funded by rising government and
government-related debt. It will also tell us how successful Beijing’s
new leadership will be in consolidating power and forcing the kinds of
economic and financial reforms on which most economists now agree, but
which are likely to be politically difficult.
China
is ending the year on what many are interpreting as a strong note.
Manufacturing seems to be growing at its fastest pace in a while. Here
is the relevant article in an article from the People’s Daily:
December’s
HSBC China final manufacturing PMI rose to a 19-month high of 51.5,
thanks to stronger new business in-take and expansion of production,
according to figures released by HSBC Monday. The statistics suggest
that China’s economy remains on track for recovery as it enters 2013,
said the HSBC report. Despite persistent external headwinds, as
indicated by still contracting new export orders, the financial
organization expects China’s GDP to rebound to 8.6 percent in 2013,
underpinned by China’s continued policy support.
China’s
economy has ended the year on a strong note after a gauge of its
manufacturing sector rose to a 19-month high. The HSBC purchasing
managers’ index for December climbed to 51.5 from 50.5 a month earlier,
according to figures published on Monday. In rising further above the
midpoint of 50, the reading signalled an accelerated pace of expansion.
Although China is still set for sub-8 per cent growth in 2012, its weakest in more than a decade, momentum picked up noticeably in
the fourth quarter after the government increased its spending on
infrastructure. “Such momentum is likely to be sustained in the coming
months when infrastructure construction runs [at] full speed and
property market conditions stabilise,” said Qu Hongbin, HSBC chief
economist for China.
As
most of us expected, the end of the year saw a reversal of the attempts
earlier in 2012 to slow investment growth, and as a result GDP growth
and manufacturing activity have picked up, but so has debt. Beijing
probably needed to do this for good political reasons – I suspect that
there are many who would have strongly opposed a very weak ending for
the Hu-Wen period of government – but the longer they keep this up, the
worse the overall adjustment will be, and it will be politics that
determines how quickly they can return to a real rebalancing of the
economy.
As an aside, one of my former students, now an investment banker working on the domestic IPO market, came to visit me today and warned me that there is a huge backlog of companies trying to get approval to sell shares. One of the requirements is that they must have two consecutive years of rising net earnings. Many of these firms expected to come to market in 2012 and were able to manage the needed two years of rising net earnings to 2011, but now that they have been pushed back, at least to 2013, they are struggling to show that net earnings in 2012 also went up. For that reason his firm is especially wary of sneaky attempts to boost reported earnings. There are hundreds of companies waiting for approval.
At
any rate it is second half GDP growth that interests me more. If
Beijing has really gotten its arms around the rebalancing problem and is
serious about adjusting quickly, I expect reported growth to drop
sharply, perhaps to close to 6%. If not, I expect reported growth to
remain well above 7% in the second half of 2013. This would worry me.
2. Watch how quickly new debt emerges. Debt
problems are going to continue to emerge in 2013, but as long as each
new manifestation of excessively rising debt is treated as a specific
and localized problem that can be resolved with specific polices,
overall balance sheets will continue to get worse. We need to watch what
Beijing does to rein in the growth in debt, and of course this is
closely related to overall GDP growth. As long as GDP is growing at
levels above 6% or 7%, it is almost a certainty that debt is rising too
fast. If GDP growth levels come in much below 6 or 7%, there is a chance
that debt growth is not excessive.
But
follow the cash. Large increases in infrastructure investment and in
real estate development are almost always funded, directly or
indirectly, by increases in debt. Many of the banks seem to be facing
tight liquidity conditions, so we should also be watching payables and
receivables on the SOE balance sheets. We should also be watching
off-balance-sheet activity by the banks.
South China Morning Post columnist Shirley Yam, who, I am glad to say, recently returned from a one-year leave of absence, wrote one of her typically intelligent articles earlier this month explaining how a RMB 3.5 billion default by Metallurgical Corporation of China was resolved. It is worth reading to get a sense of how low non-performing loan numbers in the Chinese banking system are nonetheless compatible with a surge in bad investments funded by debt.
This
is why those economists who understand the structure of Chinese growth
and who worry about the consequences of rising debt notice even
relatively small defaults. When a default actually takes place, it
usually means that the relevant principals have exhausted all other
means of hiding the debt and were forced into recognizing the losses.
For example, on Saturday the South China Morning Post published this article:
A
former employee of Shanghai Pudong Development Bank is alleged to have
acted as a loan shark and run illegal businesses to the tune of 6.4
billion yuan (HK$7.9 billion). It is the latest scandal to reflect the
severity of the mainland’s shadow banking problem and banks’ lax
management of their branches. Ma Yijiang, formerly deputy head of a
branch in Zhengzhou, Henan province, allegedly used the money from
cash-rich depositors for loan sharking schemes. The bank said in a
statement it was assisting the authorities in their investigations.
Last
month, the failure of a wealth management product (WMP) issued by
Huaxia Bank’s Jiading branch in Shanghai, which resulted in depositors
losing several hundred million yuan, set off alarms in the country’s
banking sector, and analysts warned similar scandals would surface in
the coming months.
A
Zhengzhou court heard Ma’s case earlier this week. The Shanghai bank
said he resigned in October 2011. The 21st Century Business Herald, an
influential business newspaper, said Ma enticed depositors to hand their
money to him by offering lofty interest rates between 2009 and 2011.
He
lent the money, reported to to amount to 6.4 billion yuan, to other
businesses, such as property developers, charging super-high interest,
the newspaper said. “It again proved a lack of proper supervision of
banking outlets around the country,” said an official with the Shanghai
branch of the China Banking Regulatory Commission. “There are increasing
risks that the defaults in the shadow banking system would lead to a
credit crisis.”
Old news, you might say, and no
big deal, but remember that these kinds of problems when they arise tend
immediately to be suppressed, and only become public when there is no
way to prevent information from leaking out. The fact that we are being
regaled almost weekly with stories of banking fraud and scandals
suggests just how unsteady credit in China has been. Remember what
Irving Fisher told us in The Debt-Deflation Theory of Great Depressions:
The
public psychology of going into debt for gain passes through several
more or less distinct phases: (a) the lure of big prospective dividends
or gains in income in the remote future; (b) the hope of selling at a
profit, and realizing a capital gain in the immediate future; (c) the
vogue of reckless promotions, taking advantage of the habituation of the
public to great expectations; (d) the development of downright fraud,
imposing on a public which had grown credulous and gullible.
When
it is too late the dupes discover scandals like the Hatry, Krueger, and
Insull scandals. At least one book has been written to prove that
crises are due to frauds of clever promoters. But probably these frauds
could never have become so great without the original starters of real
opportunities to invest lucratively. There is probably always a very
real basis for the “new era” psychology before it runs away with its
victims. This was certainly the case before 1929.
4. Watch bank activities. More generally I am going to watch the relationship between total credit growth and the growth in RMB loans. Much of the off-balance sheet financing in China is designed specifically to skirt regulations, and the relative size of these transactions will tell us about transparency (or lack thereof). A typical example of this might be this Bloomberg article from last Wednesday:
China’s bank loans as
a share of funding in the economy may have fallen to a record low,
highlighting the growth of alternative financing channels that have
prompted warnings of rising credit risks. New yuan loans probably
dropped 14 percent last month from a year earlier, according to the
median projection in a Bloomberg News survey of 37 analysts ahead of
data due by Jan. 15. That would give bank lending a 55 percent share of
aggregate financing for 2012, based on UBS AG estimates, the least in figures dating to 2002.
The
decline underscores the waning ability of official loan data to capture
the scale of debt in the world’s second-largest economy as borrowers
and investors turn to less-regulated, higher-return shadow-banking
products. The People’s Bank of China is
putting greater emphasis on aggregate financing and the International
Monetary Fund says the growth of nonbank credit poses “new challenges to
financial stability.”
In
2002, if I remember correctly, bank lending represented 93% of
aggregate financing as defined by the PBoC as total social financing.
5. Watch inflation.
Inflation is actually a positive indicator for China’s rebalancing, and
also worth watching because I expect (hope) it to rise in 2013,
although not by too much. This may sound like a strange thing to say –
everyone else thinks of rising inflation as a bad thing – but remember
that the more you repress household income growth, the more you divert
resources, especially through cheap financing, from consumption into
production, and so this tends to be disinflationary.
If
China is truly rebalancing, at least part of this is going to show up
in upward inflationary pressure, although it is likely to be the “right”
kind of inflation – i.e. it will hurt the rich more than the poor
because it will be based on non-food rather than food items. Perhaps
this inflation is already starting to happen, although not in the way I
would like it to happen. There has been an uptick in inflation but it
seems to have been caused by the impact of cold weather on food prices,
rather than because consumption of manufactured goods is rising faster
than production. According to an article in Friday’s South China Morning Post:
China’s
inflation spiked to a six-month high in December after a freezing
winter pushed up vegetable prices, possibly complicating efforts to
sustain a shaky economic recovery. Consumer prices rose 2.5 per cent
over a year earlier, up from November’s 2 per cent and the fastest rise
since June, the National Bureau of Statistics reported.
That
was driven by a 14.8 per cent jump in vegetable prices after the
coldest winter in seven years led to smaller harvests. The statistics
bureau said vegetable prices in some areas rose as much as 40.8 per
cent. Higher inflation could hamper the government’s ability to support
China’s recovery with interest rate cuts or other moves for fear of
igniting a politically dangerous price spiral. Consumer prices are
especially sensitive in a society where the poorest families spend up to
half their monthly incomes on food.
6. Watch the prices of hard commodities. Of
course I will be watching copper prices and prices of other hard
commodities. I expect that hard commodity prices will fall sharply over
the next two to three years, but to the extent that prices rise in the
short term, as they have in the past three months, it is likely to
reflect additional investment growth in China.
There has, I should add, been a lot of talk recently about the price impact of copper ETFs. Here is a relevant article from the Financial Times:
A group of copper users has rounded on the Securities and Exchange Commission for its “arbitrary and capricious” decision to approve the first US investment product that
would hold physical copper. The move is likely to pave the way for a
formal appeal, potentially further delaying the launch of the product by JPMorgan, which was first publicly proposed in October 2010.
The
users, including fabricators who account for about half of US copper
demand as well as London-based trading house Red Kite, said the SEC had
insufficient evidence for its conclusion that the launch of the product
would not affect supply of the metal.
In a letter
sent to the SEC by their lawyer, the copper users reiterated their view
that the launch of the exchange-traded fund would “obviously drive up
the price of copper available for immediate delivery and create
shortages of such supply”. The SEC’s conclusion to the contrary was “not
based on substantial evidence and is therefore arbitrary and
capricious”, they alleged.
7. Watch the trade numbers. China’s trade surplus for November came in much higher than expected, although there are so many discrepancies in the numbers that not all of us are confident about how to interpret the numbers. It seems like growth in both imports and exports may have been exaggerated, as local authorities may be round-tripping both exports and imports in order to make their numbers look good.
In
addition, as I have argued many times, China’s exports are likely to be
misleadingly low and its imports misleadingly high (and so its real
trade surplus higher than the official trade surplus) to the extent that
there is significant commodity stockpiling and hidden capital flight.
Of course destocking and capital inflows will have the opposite effect.
If, however, the trade surplus rises, then clearly savings are contracting more slowly than investment. This means that consumption isn’t growing fast enough to compensate for the reduction in investment growth. It is easy to bring investment rates down (ignoring the political opposition to doing so). It has proven very difficult to bring the savings rate down because this can only happen by diverting resources away from wealthy and powerful groups and families in favor of ordinary households. The evolution of the trade surplus will tell us something about how successful China has been in bringing down the savings rate.
8. Watch the Spanish bond market. Obviously I, like everyone else, will be watching the Spanish bond markets. They ended the year relatively well. Here is the relevant article in El País:
Taking
advantage of improved market conditions, the Spanish Treasury
comfortably exceeded its maximum issue target at its first bond auction
of the year. The debt management arm of the Economy Ministry sold 5.817
billion euros in two-, five- and 13-year bonds, compared with its goal
of five billion euros as the rates offered fell in line with an easing
of yields in the secondary market.
It
sold 3.397 billion euros of a new two-year benchmark issue carrying a
coupon of 2.75 percent. The marginal yield emerged at 2.587 percent,
down from 3.280 percent at an auction for paper of a similar maturity
held in October of last year. Bids for the issue amounted to 7.016
billion euros.
It
issued a further 1.949 billion euros in bonds maturing in 2018 as the
cut-off rate declined to 4.033 percent from 4.769 percent in a tender
held in November. Demand came to 5.050 billion euros. In the third leg
of the auction, the Treasury sold 470 million euros in paper maturing in
2026 at a marginal rate of 5.569 percent, down from 6.218 percent in
July.
Analysts
said the outcome of the auction reflected a reduced aversion to risk as
investors seek higher yields. “Today’s [Thursday] auction reflects
there’s no imminent concern Spain might go down the same road as
Portugal, Ireland and Greece,” Fadi Zaher, the head of fixed-income
sales and trading for Barclays Wealth and Investment Management in
London, told Bloomberg.
More important to me is what is related in another article from the same newspaper:
Spain’s
household savings rate fell to its lowest level on record in the third
quarter of last year as high unemployment and wage deflation in the
latest recession obliged them to devote more of their disposable income
to consumption, according to figures released Wednesday by the National
Statistics Institute (INE).
…The
main reason for the drop in the third quarter was falling income. The
INE said net disposable income in the period declined 1.6 percent from a
year earlier to 164.675 billion euros. This in turn was the result of a
5.4-percent contraction in salaries and a fall in other sources of net
income such as interest on bank deposits and share dividends of 4.4
percent.
9. Watch Target 2.
On a related topic, I will continue to watch Target 2 closely as an
indicator of strains within the European banking system. This too ended
2013 on a positive note. Here is an article from Spiegel:
There
is cause for hope in Southern Europe. New numbers indicate that trust
is returning to banks located in countries that have been hit hardest by
the euro crisis. But even as discrepencies in the Continent’s Target2
payment system shrink, danger still lurks.
The
turning point came almost exactly four months ago. On Sept. 6, 2012, 22
men gathered on the 36th floor of the European Central Bank building in
Frankfurt to reach a momentous decision on the Continent’s common
currency. The euro, said ECB President Mario Draghi at the press
conference following the meeting, is “irreversible.” To save it, he
added, his bank would undertake unlimited purchases of sovereign bonds
should it become necessary.
Since
then, an amazing thing has happened. Although the ECB has yet to embark
on any such bond shopping sprees, countries such as Italy and Spain, at
risk of being engulfed by the crisis, no longer have to pay the
horrendous interest rates they did in the middle of 2012. Furthermore,
the massive imbalances that have recently plagued the European banking
system have shrunk, if only slightly.
As
recently as the summer of 2012, investors and those with savings
accounts in crisis-stricken countries were moving their money out as
quickly as they could. Billions of euros were withdrawn from accounts in
Greece and Spain and banks in stable countries such as Germany put a
cap on the amount of money they were willing to lend business partners
in countries hit hardest by the euro crisis.
But
since last autumn, this trend has come to a stop. Indeed, the most
recent numbers indicate that a slight reversal is underway, with ECB
statistics showing that deposits in Spanish and Greek banks have
recently ticked upwards. Furthermore, Germany’s central bank, the
Bundesbank, reported this week that imbalances in Europe’s so-called
Target2 settlement system, in which euro-zone central banks and the ECB
transfer money across the common currency union, have declined. As the
euro crisis progressed, the system had become massively imbalanced,
which could result in massive losses for countries such as Germany
should Greece, for example, be forced to exit the euro zone.
For the same reason that I am not
optimistic about the Spanish bond market I am also not optimistic that
Target 2 will continue to reverse. If it does, of course, that will be a
great sigh, but if it doesn’t, and if in fact the imbalances continue
to grow, that will put additional stress on Germany’s ability to
maintain the euro system.
10. Watch Japan.
Remember that Japanese attempts to get their arms around their huge
debt burden will almost certainly affect China and the rest of the
global economy. If Japan tries to increase domestic savings to fund the
debt, for example by limiting wage increases, or by taxing consumption,
both of which they have proposed, these measures may well cause domestic
investment to fall. Whether or not they do, if domestic savings rise
faster than domestic investment, which is the only way to increase the
domestic savings pool available to fund Japanese debt, then by
definition the current account surplus must rise.
I
am not smart enough to tell you what Japan will do, but I do know that
almost anything it does must affect the relationship between its savings
and its investment, and hence Japan’s current account surplus, which I
suspect everyone hopes will rise. Of course everyone else wants the same
thing too – rising exports relative to imports – which is clearly
impossible, but Japan needs it more urgently than most of the rest of
us. This is going to increase strains on the global trading system.
This is an abbreviated version of the newsletter that went out four weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
Article Source: http://www.mpettis.com