After dropping as low as 1679 on Tuesday the Chinese stock markets managed nonetheless managed to put in a decent week, with the SSE Composite closing the week at 1748, up 1.1% for the week, helped by Tuesday’s Obama-inspired global rally. A lot of people have asked me what I think the bottom of the market is likely to be, and though I have a very low level of confidence in my ability to predict these things, I think that even with a sharp expected drop in corporate profitability we are already at reasonable valuations.
I would guess that we are probably within 20% of the bottom, which would suggest, if I am right, that the SSE Composite is unlikely to go much below 1500. This would take the index close to its 2006 lows although, for what it’s worth, we did test 1000 in 2005. In relative terms it should be remembered that China has seen official annual GDP growth rates of over 10% during this period.
We will probably see the markets surge Monday because of recently released news (which I will discuss further below) about the State Council’s approval tonight of a RMB 4 trillion package of fiscal expenditures through the end of 2010. This is great news, but I don’t think the surge will last very long because there are many questions about the fiscal package and I don’t think there is a lot of fundamental good news out there. The biggest problem I think is the size of the global adjustment within which China must participate. This leads to two points I want to make in this entry.
1. The size of the US adjustment in Chinese terms.
The first is just to an attempt to get our arms around the magnitude of the global adjustment within which China must participate. Last week I met with a Japanese economist working for a major US fund manager who showed me a very interesting presentation he had prepared. He asked that his name not be mentioned, so over the next few weeks I will be plagiarizing his material without crediting him.
One of his graphs shows the US household savings rate from the 1950s to the present. From his graph it seems that until the early 1990s the US household savings rate tended to hover somewhere between 6% and 10% of GD, except for a brief period in the mid-1970s when it exceeded that level. Since then, as is well known, the US savings rate has declined, to around 2-3% of GDP.
As I see it the most recent globalization cycle began in the late 1980s and early 1990s. My model posits globalization cycles as being caused by rapid liquidity expansion, for which there have historically been many different reasons (including gold discoveries, the invention and expansion of joint stock banks, the recycling of trade deficits or surpluses, even in one case war reparations payments, etc.). The latest liquidity cycle was probably caused by the recycling of the large and growing US trade deficit, which can be seen as a machine that has converted US consumption into Asian savings – at first primarily Japanese and later primarily by Chinese. The decline in US savings beginning in the early 1990s is simply the flip side of the accumulation of Asian savings, and the numbers fit my model well.
Whatever the reason for the decline in US savings, I think most of us agree that it was related to the long rally in stock and real estate markets in the US, which were seen to obviate the need for households to save out of income (I would argue that the liquidity creation fueled the accompanying stock and real estate market rallies – long bull markets have always been a feature of globalization cycles). The banking system played a key role in the process by intermediating the capital inflows into the US (the obverse of the trade deficit) and converting them into consumption via an expansion in mortgage, credit card and consumer loans.
This process has probably stopped. Banks are no longer willing to make consumer loans, and with stock and real estate markets down so dramatically, the US household savings rate will almost certainly rise.
By how much? With households seeing their home and equity savings decline so dramatically I think one can easily argue that we will probably go above or at least to the higher end of the “normal” range of 6-10% of GDP, but even if we assume that households will only go back to the middle of the range, that still implies an annual adjustment of at least 5% of US GDP (around.$700 billion)
If global demand isn’t to collapse, someone else has to increase consumption by that amount. But who? The US government will probably increase its net spending, although it has already significantly increased its gross debt by recapitalizing the banks, and it will almost certainly see tax revenues fall. Corporations are more likely to be cutting spending than increasing it, so the combination of the two is not likely to be significant.
Can the rest of the world step up and replace US consumption? I am not an expert on global economies, but I think it is pretty safe to say that European, Japanese, and Latin American households and businesses are unlikely to be in a hurry to increase spending. In fact they are all likely to reduce consumption, although perhaps not as dramatically as the US. Given high debt levels in all those areas, there are also some constraints on fiscal expansion.
That leaves the net exporters, of which China is the most important. It is the largest saving nation, and the “other” nation along with the US at the center of the global balance-of-payments imbalance, and so much of that adjustment is likely to be forced onto China. As the country that has benefited most from US over-consumption, in other words, it is likely to be the one that will most have to adjust to a drastic cut in consumption.
What are the comparable numbers for China? US GDP ($13.5 trillion) is about 3.4 times the size of China’s ($4.0 trillion). In that case a 5% adjustment in the US is equal to roughly a 17% adjustment in China. That means, all other things being equal, Chinese consumption must go up by 17% of GDP just to compensate globally for the decline in the US, and bear in mind that consumption in China is only around 30-35% of GDP. What is worse, there is reason to believe that Chinese private consumption is likely to slow down in response to rising uncertainties and a slowing economy. Domestic consumption tends to be positively correlated with exports – a very pro-cyclical type of relationship typical for developing countries with large export components.
There are great hopes pinned on fiscal expansion in China, but I have already expressed my doubt about the government’s ability to expand as rapidly as many of us hope (and Stephen Green and Nouriel Roubini have anyway argued that there is less here than meets the eye). Even if they are able to expand dramatically without crowding out domestic investment, the sheer magnitude of the numbers make it almost impossible that China can successfully bear the burden of the global adjustment.
Of course it is not China’s job to replace US demand. Chinese policy-makers are only interested, in principle, in protecting growth in the Chinese economy. So why worry about whether China can or cannot replace US demand? Because with the rest of the world unable to step up, and in many cases even reinforcing the decline, if China cannot do so the whole world must see declining growth and a rise in savings, and since China was the main counterbalance to excess US consumption, it will probably bear much of the brunt.
An excessively high savings country, in other words, cannot benefit from a massive rise in global savings, and just as the astonishing flexibility of the US financial system meant that until recently US consumption had to adjust to absorb excess Asian savings (warning: I am a believer in the Bernanke savings glut hypothesis), the seizing up of its financial system means it no longer can absorb those savings, and so something must break. Instead of the US adjusting to excess savings, excess savers must adjust to declining US consumption. The world must balance.
I know this quick analysis is going to be accused of excess oversimplification, and I accept the accusation, but the point of this exercise is not to work out the process in full complexity, and certainly not to make policy prescriptions, but rather simply to get an idea of the adjustment that must be made, and if it isn’t China, as one of the two main players in the global imbalance, that will make the adjustment, then we need to figure out who else will. The biggest potential mistake in my argument, I think, might be my assumption about how much US savings will need to adjust. Perhaps the adjustment will be much lower.
2. What difficulties might China face in trying to reduce the cost of the adjustment?
The second point is to discuss some of the policy options that I think China will consider. The first and most obvious is fiscal expansion, something which I and other China experts have discussed and about which there is very real and very honest disagreement, with very plausible arguments on both sides. I have already discussed many times why I am skeptical about the ability of fiscal expansion to make up the slack.
As I write this Xinhua reports that the State council has approved fiscal spending equal to nearly 15% of GDP. The very short article says in its entirety:
China has decided to adopt active fiscal policy and moderately easy monetary policies to boost fast but steady economic growth by expanding domestic demand, according to an executive meeting of the State Council on Sunday. It is estimated that investment into infrastructure, social welfare and other key sectors will amount to four trillion yuan by the end of 2010.
A Bloomberg article gives a little more color:
The spending announced today, of which 100 billion yuan is earmarked for this quarter, will cover low-rent housing, infrastructure in the rural areas, as well as roads, railways and airports, the State Council said. The government will also allow tax deductions for purchases of fixed assets such as machinery to stimulate investment, a move that will reduce companies’ costs by an estimated 120 billion yuan.
This seems like a very large spending plan (nearly $600 billion, or about 14-15% of GDP over two years), and I think it may be enough to keep Chinese growth close to current levels, but only under the following conditions:
- It represents net new spending above current levels of expenditure. I think government expenditures represented around 14% of GDP last year, so if that suggests government spending will increase by around 50%.
- These are actual expenditures – for example tax deductions aimed at stimulating investments much actually stimulate investment by as much as the numbers project. Without looking carefully at the numbers (and possessing an understanding of budget issues much greater than mine), it is hard to say how much of this is real spending and how much “projections”.
- The increased spending is not paid for out of an increase in taxes but rather by borrowing. I think this is likely.
- There is no large reduction in private consumption, the government borrowing and investment does not crowd out private investment to any material extent, and there is no significant reduction in municipal government spending financed by real estate sales. Here I am much more skeptical, especially about the last two points.
- Disbursements begin rapidly and are not wasted.
- At least half of the global adjustment tales place outside China.
The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits (I predicted earlier this year that guessing the real size of the government liabilities would be a popular sport next year) as well as on the health and stability of the banking system.
If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs, but there are very big question marks. Still, I think it is an indication of how worried the government is and how determined they are to address the issue that this plan was approved. (As a complete aside, I also think it is an implicit acceptance of Bernanke’s savings glut hypothesis.)
The discussion of the health and stability of the banking system leads easily into the second much-discussed option – really sort of a variation on the first. The government can force credit expansion by requiring the banks to lend more. Although there has been a process over the last decade of freeing the banks and allowing them more discretion in lending as a way of improving China’s dismal capital allocation process, there is no reason why policy-makers cannot reverse course and force banks to lend more.
Certainly they are trying. Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks (interestingly enough they have always denied that they had imposed constraints). But instead of gleefully exploiting their newfound liberty banks have refused to party, and loan growth has been very low.
This is hardly surprising. In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion. Most good companies seem reluctant to borrow and anyway banks are reluctant to lend.
So what if policy-makers simply announce minimum loan growth targets for every bank? That should certainly cause an expansion in banks’ balance sheets.
I think, however, that there are two problems with such a policy (although administrative measures of this sort hold a dangerous allure to policy makers). First, I don’t think it will be effective in net credit creation for the country. This argument is simply the flip side of my previous arguments as to why I did not believe the loan caps that were in place until this summer actually restricted credit creation.
In those days I argued that if monetary conditions are consistent with rapid credit creation, we will see credit creation. Any attempts to restrict credit creation will simply meet with some or all of the following responses:
1. Banks will innovate around the restrictions.
2. Credit creation will occur outside the restricted areas.
3. Banks will lie.
In China’s case we have definitely seen innovation (securitizations and transactions that took loans off the balance sheets of banks) and outside growth (rapid increases in dollar loans and policy bank loans and, most importantly, growth in the informal banking sector). If there is a sharp contraction we will know if there have also been many cases of lying.
The same thing can happen in reverse. If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks. That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system.
The second problem is likely to be the quality of the loans. It is always possible to find borrowers, even in a sharp economic contraction and an overinvestment crisis. The problem is that many of these borrowers are not the ones that any prudent bank should be dealing with, and to the extent that the forced loan expansion is successful, it will probably do little more than ease the credit crisis in the immediate near term and make it much worse in the medium term.
A variation of this might have happened in Japan in the 1980s. As Japanese GDP growth slowed from its very high levels in the 1970s (from an average of roughly 10% to an average of roughly 6%), Japanese banks flush with liquidity were eager to extend loans. Loan growth actually accelerated steadily from around 7% in 1980 to around 14% in 1987, even as GDP growth declined from around 8% in 1980 to around 5% in 1987. Credit creation vastly exceeded real credit needs during this whole period, with the balance going largely into real estte lending and, later, stock market speculation.
We may have already seen this process in China in the last four years and of course I don’t want to suggest that the processes in China and Japan are identical, but I do want to point out that forcing credit expansion beyond the real needs of the economy can create tremendous future problems, and China may have already gone through this very process with a monetary policy that accommodated too-rapid credit growth (much of which may have occurred, of course, outside the banking system).