Was China’s High GDP Growth a Big Surprise?

My blog has been blocked in China. Given all the internet blocking that has happened in the past few months I guess this is not much of a surprise, and I was sort of waiting for it to happen, even while I was hoping that it wouldn’t.

I think after a few months – probably once the 60th anniversary of the founding of the People’s Republic on October 1, 1949, is truly behind us – they will begin unblocking sites and my students once again will be able to read my blog without having to jump through all the proxy hoops. On a related note I was pretty pleased when Doug Paal, one of my Carnegie Endowment associates, told me yesterday that certain local policy analysts with whom he had recently met told him that they had been reading my blog and found it useful, but unless they are allowed to use proxies in government offices I guess whatever use I may have provided will be dramatically reduced.

Because I picked up a flu a couple of days ago (no, not swine flu), and so have been working much shorter hours, I haven’t really been able to comment on all the economic news that has come out recently. Since if I am feeling better I plan to go to Wuhan tomorrow and Shanghai Saturday to see some of my Beijing bands perform a couple of big shows, I figured I would make a few comments today before going home to recuperate.

The first comment is about reserves. Chinese central bank reserves surged in the second quarter of the this year, with evidence suggesting that we are once again seeing a flood of hot money pouring into the country. According to an article in today’s South China Morning Post:

Mainland foreign reserves surged to a record US$2.13 trillion at the end of last month, underscoring concerns that speculative capital is flooding into the nation to bet on rising asset prices and a quick economic recovery.

Reserves rose US$178 billion in the second quarter, the biggest quarterly increase on record and up from the US$1.95 trillion yuan at the end of March, the People’s Bank of China said yesterday.

Most of the increase was driven by the usual suspects – the very large trade surplus and smaller but still high net FDI inflows, plus of course returns on the existing portfolio – but the important point I think is that the unexplained portion of the increase in reserves, which serves as a proxy for hot money, has turned from negative in the first quarter to very positive in the second. I will do my calculations later, but for now it seems pretty clear that hot money is returning to China.

This is not a surprise. With optimism returning to China, and with stronger real estate and stock markets, investors are bringing money back into the country. Hot money, of course, is intensely pro-cyclical, and its effect will be to intensify growth in the short term, even as it increases volatility and makes monetary policy more difficult. Remember that the PBoC must recycle the net surplus on the current account and the capital account, and with the very high current account surplus, China would be creating a huge amount of domestic money just from that source. The fact that it is also running a large capital account surplus makes the PBoC’s monetary management that much more difficult. Worst of all is that as long as this fiscal-stimulus-induced boom continues, hot money inflows will heat things up even more, but once the government is forced to scale down the stimulus, the resulting slowdown in the Chinese economy will likely be seriously exacerbated by hot money outflows. The PBoC has a lot of difficult work to do.

One thing that many observers noticed is that the huge jump in reserves means that China must continue buying US Treasury bonds, and of course this still seems to promote very muddled thinking among the cognoscenti. For example today’s Bloomberg had an article which argues that:

China’s foreign-exchange reserves are surging again, helping the Obama administration sell unprecedented amounts of debt as it seeks to drag the world’s biggest economy out of a recession.

…President Barack Obama’s administration is seeking to sell a record amount of debt to pay for measures to revive the U.S. economy. New York-based Goldman Sachs Group Inc. estimates that government borrowing may total $3.25 trillion in the year ending Sept. 30, almost four times the $892 billion in 2008, to finance the budget deficit.

“China’s reserves will allow the U.S. to run a higher fiscal deficit than other nations,” said Bilal Hafeez, the London-based global head of currency strategy at Deutsche Bank AG, the world’s biggest foreign-exchange trader.

No, no, no. The fact that China’s reserves have surged will in no way make it easier for the US to fund its fiscal deficit even though, as I have argued for a very long time, China has no choice but to invest these additional reserves in US Treasury bonds.

Why? Because besides valuation changes and interest income there are two reasons for the increase in the reserves – the very high trade surplus and net capital inflows into China. Take the second reason first. If money flows into China for investment purposes, it must flow out of somewhere else, and that somewhere else for the most part means the global pool of dollar savings which would anyway have been available to fund the US fiscal deficit directly or indirectly.

In that sense China is acting as kind of upside-down bank that takes risk-seeking money and intermediates it into low-risk assets – as an aside almost the opposite of what the US does, and whereas the US profits from this intermediation, China runs a significant negative carry. Of course the fact of intermediating risk money into low-risk assets will have some impact on US Treasury rates, but the impact is minimal (technically risk-free rates will decline a tiny bit and credit spreads will increase by the same amount).

What about the dollars generated from the trade surplus and invested into US Treasury bonds? Won’t that help the US fund its fiscal deficit?

Again the answer is no. The US government is not borrowing for abstract reasons, but rather is borrowing in order to spend locally to generate domestic employment. The amount of borrowing it needs to generate a fixed amount of domestic jobs is correlated with the US trade deficit, because it is through the trade deficit that domestic consumption “leaks out” to create jobs abroad. The higher the trade deficit, in other words, the more the US government needs to borrow to generate a fixed number of American jobs, and so the fact that China is reinvesting the dollars generated by the trade surplus with the US does not make it easier for the US to borrow since it simultaneously requires the US to borrow more.

Remember that China does not fund the US fiscal deficit. It funds the US current account deficit, and it has no choice but to fund it. In fact this is true for every country – foreigners must fund current account deficits, and they do not fund fiscal deficits. To breathe a sigh of relief because a very high Chinese trade surplus means that China will buy a lot of US Treasury bonds is no different from breathing a sigh of relief because the US is running a very large trade deficit. As I have said many times before, if the US wants China to buy $1 trillion of new bonds every year all it has to do is ensure that the US runs a $1 trillion trade deficit with China every year.

My second comment is about the GDP growth numbers, which are both a cause and partial consequence of hot money inflows. As a Bloomberg article today reports:

China’s gross domestic product grew 7.9 percent in the second quarter as the nation became the first of the major economies to rebound from the global recession.

The figure, announced by the statistics bureau in Beijing today, exceeded the 7.8 percent median forecast of 20 economists in a Bloomberg survey and a 6.1 percent gain in the first quarter that was the slowest in almost a decade.

China, the biggest contributor to global growth, overtook Japan as the world’s second-largest stock market by value yesterday after a 4 trillion yuan ($585 billion) stimulus package spurred record lending and boosted share prices. The first-half expansion laid the foundation for meeting the year’s 8 percent growth target for creating jobs and maintaining social stability, the statistics bureau said today.

“China’s growth is getting back on track after being pulled down by the global export slump,” said David Cohen, an economist with Action Economics in Singapore. “It’s leading the turnaround in the global economy.”

Besides the fact that I don’t see a turnaround in the global economy, and in fact I think China will be among the last countries to escape from the effects of the global crisis, I have a small problem with the earlier claim that China is “the biggest contributor to global growth.” This is true if a country’s contribution was simply the number we get when we algebraically calculate global growth (each country’s GDP growth multiplied by its share of global GDP).

But with the largest trade surplus in the world, and remembering that the trade surplus represents negative net demand, I would argue that if you want to contribute to global growth in a world of excess supply and collapsing demand, you do so by increasing your net demand, or in this case by reducing your negative net demand. One of my friends, a government official from a neighboring Asian country, told me furiously last week that through its aggressive export policies China is simply expropriating growth from other Asian countries. I am not sure if I completely agree with him, but I suspect that he would be even more furious to hear that China was the greatest contributor to global growth.

Was China’s “surprisingly” high GDP growth numbers a big surprise? Not really. I have argued several times since last year that in fact China can achieve very high growth numbers by throwing a huge amount of resources into achieving short-term growth, but the real question is whether these policies are sustainable and whether the kind of growth they achieve is in China’s best interest.

In my opinion, these policies involve such a huge expansion in fiscal debt and especially in new bank lending that they are certainly not sustainable. Even without including the almost certain surge in future NPLs caused by the unprecedented explosion in new lending, China’s debt is much higher than people think and it is growing quickly. There is a limit to how much further the fiscal expansion and the surge in bank lending (which amounts to the same thing) can go on.

Furthermore I think the focus on investment in infrastructure and manufacturing will make much more difficult China’s ultimate transition towards an economy in which surging debt-fueled US household consumption plays a much smaller role. In addition much of this new investment is in projects with very low, or even negative, returns (and I suspect they would almost all be negative if interest rates weren’t kept so low by the PBoC). This is not a way to increase Chinese wealth.

I have discussed this too many times to go into it again, but I am worried that China’s high growth rates today can only last another year or so at best, and will result in a much more difficult transition period. This is a lot like the way Japan’s response to the collapse in US consumption after the 1987 crisis resulted in two spectacular years of credit-fueled growth followed by two very difficult decades of transition. Chinese policymakers are in the very tough position of having to choose between policies that make the transition easier but result in rising unemployment today, and policies that spur employment growth today but may create even greater excess and wasteful capacity. I am glad I don’t have to make those decisions, but I am pretty sure that if I did I would be more worried about the impact of the fiscal stimulus on China’s long-term growth.

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.

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