More Downward Revisions

The Citibank rescue Monday caused markets around the world to surge, but China was buying none of it. Yesterday the SSE Composite dropped 3.7% and, after a morning rally, it declined a further 0.4% today to close at 1889. The economic news continues to be bad and it is hard to find any enthusiasm anywhere, at least among the people I normally deal with. Tuesday morning the World Bank revised its prediction for next year’s GDP growth sharply downward to 7.5%. Its previous estimate for 2009, made three months ago, was 9.2%

One of the easiest forecasts I made at the beginning of this year was that we were going to see a long process in which every month or so forecasters would revise their growth forecasts for China downwards. I suggested that this would happen because forecasters base their forecasts on predictions about the performance of the asset side of the economy, and generally ignore balance sheet effects (and, apparently, balance of payments effects).

But in developing countries, with their typically unstable and inverted balance sheets, this is especially misleading. There tends to be a great deal of pro-cyclicality embedded in financial, corporate and government balance sheets, and in the behavior of the financial system more generally, so that growth begets changes in the balance sheets that enhance growth and economic contraction begets balance sheet contractions that exacerbate economic conditions. One consequence is that good periods typically involve continual upward revisions from forecasters as the economy systematically outperforms expectations, and bad times involve consistent downward revisions.

We have not reached the end of this process because I don’t think we have seen the end of the balance sheet effects. The rise in NPLs has only just started and we haven’t yet seen a very strong response on the part of the commercial banks, although perhaps in the informal banking sector the unraveling is well under way (I don’t know, but there is some circumstantial evidence to suggest it). I am not even including the possibility that we may see sharper export contraction in the future as the world of international trade turns uglier.

Next quarter the World Bank will almost certainly revise its forecast even further down. As I said early this year (jumping the cue by assuming standard balance sheet effects), I think it is much safer to assume that next year’s growth is going to come in under 7%, perhaps well under, although please note that this prediction is not based on any terribly sophisticated knowledge of the functioning of the economy. My whole model assumes that balance sheet effects add unpredictability, although the directional impact on growth of that unpredictability is often predictable (although this probably isn’t the most elegant way to phrase it – sorry).

The Chinese leadership is clearly worrying about this. A number of senior leaders have made pilgrimages to various economic centers during the past two weeks to get more of a sense of how quickly conditions are deteriorating. According to an article yesterday’s Xinhua:

The spreading global financial crisis and economic slowdown are having bigger negative impact on Chinese economy, vice premier Zhang Dejiang said on a weekend inspection tour to central province of Hubei. Zhang, who aims to learn about performance of the industrial sector during the trip, urged the local officials to give strong support to key enterprises and sectors and also small and medium-sized enterprises and labor-intensive businesses.

The government has also warned, more than once, that as a consequence of the slowdown they expect an increase in social disturbances (a euphemism for rioting). They are also trying to control the process of layoffs, with some provinces requiring companies to get approval before they fire more than a certain number of workers. This obviously can have negative impacts on the adjustment process for businesses, but I think that one of the ways that China can boost private consumption is by various forms of income redistribution, and raising minimum wages and preventing firings may have some positive impact here.

Meanwhile provincial governments have turned eagerly to the government in order to help fiscal expansion plans. According to an article in the South China Morning Post:

Mainland provinces have drawn up long wish lists for roads and other projects since Beijing unveiled an economic stimulus plan, state TV reported, as local leaders take advantage of a new willingness to spend amid the global crisis. Spending proposals announced over the past week by provinces total 10 trillion yuan (HK$11.3 trillion), China Central Television said on Sunday. But the report gave few details and no indication how much of that might be approved by the central government.

The 21st Century Business Herald said few investments announced by provinces were new. It said most are either under construction, have been under discussion for some time or were planned but not begun due to lack of money. The newspaper said much of the proposed provincial spending is still awaiting national approval.

Today’s Xinhua also had a similar article:

Many officials in the less-developed central interior felt that Beijing had been penny-pinching in financing local projects for most of the year until only recently when the focal task of macro-economic control shifted from curbing inflation to slowdown prevention. “The situation reversed completely in less than two weeks. It used to be projects waiting for capital, now it’s the other way around,” said Qiu Yunyang, chief of the Development and Reform Bureau of Hubei’s Zaoyang City.

To seize the opportunity for a boost of local economy, Qiu and his colleagues have put in extra hours these days to screen out projects that were mostly needed locally and had a better chance of getting a portion of the 100-billion-yuan investment newly endorsed by the State Council, or the Cabinet, for the fourth quarter.

Aside from the inevitable graft and waste that this will entail (it is almost impossible to book rooms in hotels near the main government offices responsible for doling out spending approvals, according to a number of reports, because of the rush of provincial officials eager to get in on the handouts), to the extent that this represents real spending it is likely to be good in the short term. Any real boost in domestic demand will help take the sting off the contraction in US and European demand. I just worry that the combination of a slowdown in growth, with its accompanying rise in unemployment, will make it harder socially for ordinary Chinese to stomach the sight of a new army of petty officials suddenly getting rich. I hope the rush to spend comes with relatively stiff safeguards.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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