What Rebalancing of Chinese and American Consumption?

Later today I am leaving to New York and DC for a week, so this may be my last post for several days since my schedule will be pretty hectic. Of course most of my trip will involve meetings with bankers, investors and some government officials, but the timing of my visit was based on the three-week tour of a group of my favorite Beijing musicians. For those who live in the northeast and are interested, check out the tour schedule and by all means come and see the shows. The work of these artists is, in my opinion, among the most interesting in the music world and will give a very different idea of what Beijing’s hippest youth are thinking about than most people assume. I will be attending most of the performances until November 11, when I return to Beijing.

But on to grayer topics. When the US economic data for the third quarter of 2009 came out last Thursday judging by the market reaction it seemed much more mixed to me than it apparently did to others, especially as far as it relates to China. It is true that after four quarters of negative growth, with GDP contracting 3.8% in the year to July, we finally got positive GDP growth of an annualized 3.5%. This was above expectations, and given China’s reliance on US overconsumption, the increase certainly seemed to be good news.

Even better, much of that growth was powered by a 3.4% increase in personal consumption, which was itself powered by the rather astonishing 22% increase in durable goods consumption – or perhaps not so astonishing if we chalk it up, as most experts do, to the “cash for clunkers” program. Americans, it seems, bought a lot of cars in the third quarter of 2009.

As I (and many others) see it, however, this surge in auto sales in the US isn’t likely to represent new and sustainable purchases, and so undermines any optimism generated by the growth in consumption. The surge in car sales may simply be Americans taking advantage of temporary government subsidies, and to that extent represent not new purchases but rather an anticipation of future purchases. If that is the case, whatever we get this year in new car sales will result in a reduction next year.

Why am I so negative about the good consumption numbers coming out of the US? Because the rise in personal consumption was accompanied by a 3.4% decline in household disposable income. If US household income declines, and this is likely to continue as unemployment rises even further, it is hard to imagine that US households are really going to splurge on new consumption. Consumption and household income must move in the same direction over any reasonable time period to be sustainable.

As if on cue, this was at least partly confirmed by the subsequent release of September numbers. As Friday’s Financial Times put it:

US consumer spending stalled in September after climbing in each of the prior four months, dampening spirits, as the effects of government stimulus programmes started to wane. Personal consumption expenditures fell by 0.5 per cent, or $47.2bn, last month, commerce department figures showed on Friday. The data were in line with the predictions of Wall Street economists, who expected that the expiration of the popular “cash for clunkers” car rebate scheme would hit spending.

In September, spending on durable goods, which includes cars, fell by 7.2 per cent after jumping by 6.7 per cent the previous month. Incomes were flat in September, slipping by just 0.1 per cent, after ticking up by 0.1 per cent in August. Companies are continuing to freeze pay or cut salaries as they wait to see the shape of the economic recovery.

So in spite of temporarily good consumption numbers, there probably has been no sustainable increase in US consumption, just in government financed spending. Both China and the US are dealing with their imbalances either by slowing down the rebalancing or by exacerbating the very things that caused the imbalances in the first place. Slowing down the adjustment makes good political and social sense, of course, but it shouldn’t blind us to the fact that US households cannot continue leveraging up to absorb the excess production that Chinese companies are leveraging up to produce. We will rebalance, one way or the other.

By the way, and speaking of not rebalancing, net new lending in October might be up. According to an article in Bloomberg:

China’s four biggest banks granted 136 billion yuan in new loans in October, higher than the previous month, Caijing magazine reported, citing industry data. Bank of China Ltd.’s new loans in October were 44 billion yuan, the most among all the banks, Caijing said. China Construction Bank Corp. lent 36 billion yuan, Industrial & Commercial Bank of China Ltd. granted loans of 33 billion yuan and Agricultural Bank of China lent 23 billion yuan, the magazine said on its Web site.

Resolving the imbalances

The same day the economic numbers were released Tom Holland had an interesting piece in the South China Morning Post on two “new” proposals for solving the Asian side of the destabilizing imbalances at the heart of the global economy – one from the International Monetary Fund and one from Barclays Capital. The first:

As the IMF points out in its regional economic outlook published yesterday, household savings have actually declined across much of Asia over the past 10 years. Even in China, the personal savings rate has remained more or less constant, which means it cannot be ordinary individuals who are responsible for the explosion in the region’s excess savings.

What’s actually happened…is that saving by Asian companies has ballooned since the crisis of the 1990s. Thanks to energy and land subsidies, cheap credit, low wage costs and lax environmental standards, Asian companies have made bumper profits in recent years. And because of weak corporate governance, they have been able to retain a large portion of those earnings rather than paying them out to shareholders as dividends, feeding the savings glut.

The answer, according to the IMF, is to strengthen corporate financing options, so companies no longer need to hang on to earnings, while beefing up corporate governance standards to ensure a better dividend payout. The IMF estimates that raising emerging Asia’s financial market development and corporate governance standards to rich-world levels would lower the region’s corporate savings by 7 per cent of gross domestic product, wiping out the savings glut and going a long way towards rebalancing the world economy.

I think it is widely agreed that there should be a more robust mechanism for forcing SOEs and other large corporations to disgorge their profits and return them to shareholders, including the government, but I wonder if it isn’t a little more complicated than that. As I see it, SOE profits are not the result of their value creation but are rather more than 100% explained by various subsidies delivered from the household sector. Without subsidized and controlled interest rates, even ignoring the other subsidies, the most important of which may be the currency undervaluation, SOE profits in the aggregate would be negative.

In that sense SOE profits are simply part of the transfer from household income to the state sector, and the most efficient way to return the money to households is likely to be to raise deposit and lending rates rather than dividend them back to shareholders. If the shareholders gain access to those profits via increased dividend payments, as I see it we are still seeing a transfer of income from Chinese households to the state sector.

The state may spend it more wisely than the SOEs (something that I would have to see to believe), but unless that money directly or indirectly was sent back to the household sector, perhaps by paying for health care or lower taxes, it doesn’t really address the fundamental problem. If it goes into state-favored investment projects, there will have been no rebalancing. I am convinced that Chinese households need to receive a larger share of national income, or their consumption growth will always lag growth in production and high savings rates will persist.

The second new proposal described by Holland:

The emerging-Asia economics team at Barclays Capital have come up with a different solution to the problem. In a report also published yesterday, they argue that the way to get rid of the region’s excess savings is not for Asian countries to save less but for them to invest more. Barclays’ analysts argue that Asia’s problem is not low consumption. Across much of the region, with the exception of China, household consumption ratios are similar to those in the European Union. Instead, the source of the glut is the low level of investment, which has declined since the Asian crisis.

Given Asia’s heavy need for infrastructure, Barclays recommends that governments should use the region’s excess savings to ramp up investment in order to promote future economic development. That certainly appears to be China’s preferred solution. The problem, however, is ensuring that investment is channelled into productive projects rather than misallocated to building excess capacity. Barclays’ answer is to finance more projects with private, rather than government, capital. That, however, would need financial reform and stronger governance in order to work.

I can’t speak for the rest of Asia, but I doubt that what China needs is a lot more investment. We seem to have forgotten all the lessons of the overinvestment crises of the 19th and early 20th centuries (and perhaps Japan in the 1980s) in favor of the mantra that increasing investment is always a good solution to whatever the current problem is. Although there is no question that much of the world probably invests too little (e.g. the US), the idea that there is infinite scope for additional investment is simply not true, and I worry that so much of China’s investment is already non-viable that increasing it significantly can only make matters worse. Building yet more stuff, if it does not repay the cost of the investment, means reducing future consumption, and it is consumption growth that powers economies over the long term.

Perhaps I am sounding like a skipping CD, but for rebalancing to occur in China we need households to grab a larger share of income. Any other solution, I think, misses the point. China entered the crisis with the highest investment rate in history, and probably also one of the highest rates of misallocation of investment in recent times, and then grew it sharply and quickly. This probably isn’t the solution to low Chinese consumption.

What the 1930s tell us about the coming protection

Finally, Barry Eichengreen and Douglas Irwin have a July 2009 NBER paper out with the title “The Roots of Protectionism in the Great Depression” which examines the relationship between protectionism and monetary conditions. According to the very helpful abstract:

Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s’ rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study “suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions.”

This was a fascinating paper that covers a lot of the ground in Eichengreen’s magisterial Golden Fetters. I think the paper (like the book, incidentally) has a lot to say about the current crisis, and the political implications are, I think, a little worrying. When they argue that countries that were tied to, or late to abandon, the gold standard were the ones most likely to employ protectionist measures, they could also be arguing that countries whose exchange rates are forced untenably high are also more likely to use protectionist measures to achieve adjustment by other means.

In that sense the refusal of Asian central banks to permit the needed appreciation of their currencies against the dollar may end up having the same impact on the adjustment process of the overvalued currencies. The 1930s seemed to show, according to the authors, that when their currencies could not adjust, countries became protectionist. So if the overvalued dollar cannot adjust except against the euro, and if the already overvalued euro has to bear the brunt of any further adjustment, will American and European politicians be forced into the “second-best” option of trade protection? No prizes for guessing what I think. By the way the chorus of complaints over the currency regime seems to be getting louder. After Paul Krugman’s piece in the New York Times last week I saw the Financial Times had a pretty strong piece today by Alan Beattie called “Renminbi at heart of trade imbalances.”

By the way, Douglas Paal, Taiya Smith, Michael Swaine and I will be speaking at a Carnegie Endowment event, on President Obama’s trip, to China on Thursday, November 5 from 12:15 to 2 p.m. I have been told that it will be live-streamed and there will be opportunities for questions. If anyone is interested he can find it here.

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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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