“The most striking real economic fact of the past several months is not continued U.S. economic weakness, but that China’s economy has slowed much more quickly than anyone had forecast,” Australia’s central bank Governor Glenn Stevens said this week.
Not quite “anyone”. Quite a few people who read this blog, some of them quite prominent, have been forecasting very grim numbers for China all year, and much of our discussion in the comments section has revolved around how bad the slowdown would be – above 7%, some of us said, or much lower, others have argued. I still say that we haven’t seen the end of downward revisions. By the way, I was just told by a friend two minutes ago that Goldman Sachs has just reduced their projection of 2009 Chinese GDP growth to 6%. I don’t have the citation so it might not be true, but it wouldn’t be surprising to me, and eventually lots of other banks will do the same.
As I have argued for a long time, if you think about China as being one of the two main players, along with the US, deeply linked within the overall global balance of payments, it cannot possibly come as a surprise that the US adjustment was going to require a Chinese adjustment which, given the relative size of the two economies, almost inevitably meant that China was going to get hit harder than the US. Here is a quote from as far back as September, 2005, in an interview with Hamish McDonald of the Sydney Morning Herald, in response to widespread belief at the time that the US was the most vulnerable to a breakdown in the balance of payments relationship:
“My money says the US could survive a disruption in the dependency relationship much more easily than could China,” says Michael Pettis, professor of finance in Peking University’s management school.
I know this sounds like I am tooting my own horn, and I don’t mean to, but the belief that China was protected from a possible crisis affecting the US trade deficit always struck me as weird. Perhaps American paranoia requires a sense of helplessness in the face of a powerful threat, and clearly the rest of the world takes its intellectual clue (and often cluelessness) from the US, but it couldn’t have been such a surprise that a sharp US slowdown would create trouble in a country so reliant on US consumption for its employment growth. Things have always been this way – why should they have suddenly changed?
Because last night I was invited to be a guest on the CCTV current events show, Dialogue, I tried to get my arms around an easier way of thinking about the adjustment so that I could explain it on TV. Let us assume that the US trade deficit will decline by 50%, from 6% of GDP to 3% of GDP – there are some who have argued that it will go to zero next year and others who have even argued that the US will soon be forced to run a small surplus, but I will assume nothing quite so dramatic. I will also ignore any contraction in net demand from Europe and elsewhere.
Since the Chinese trade surplus is equal to up to 2/3s of the US trade deficit, this suggests that within the overall global balance China should, ideally, absorb about 2/3s of this contraction, roughly equal to 2% of US GDP. This is also equal to about 7% of Chinese GDP, which means that either
a) Chinese consumption is going to have to expand by 7% of GDP faster than production,
b) Chinese production is going to have to contract by 7% of GDP more than any contraction in demand, or
c) both will have to happen so that the sum is equal to 7% of GDP.
Clearly the first cannot happen very quickly. The second would mean economic chaos for China, so that leaves the third. In the best of cases China would be given enough time to get as close as possible to the first of the three adjustments, but without a very strong international framework and coordinated action the most likely outcome is for at least some contraction in production.
The problem with all my scenarios is that the numbers are so big it is not easy to make the case for a smooth adjustment, except under the assumption that the rest of the world will do everything it can, including suffer rising unemployment, to pull China out of the crisis. That is unlikely.
That brings us to the terrible trade numbers. Last night, as I was on my way to CCTV to do the show, I got a call from Shang Ning, my Peking University student, about the data release. He told me exports were down 2.2% – terrible news given that economists were confidently predicting a 15% increase as recently as a week ago, but no longer unexpected. By the way Tom Holland in the South China Morning Post claims that in RMB terms, the more relevant measure if you want to judge the pain, exports were actually down 10.1%.
Shang Ning also told me on his phone call that imports were down 17.9%. I immediately called my friend Logan Wright from Stone & McCarthy and asked him about the import numbers. According to Logan, only a part of that decline can be accounted for by lower commodity prices. There was a real contraction in import volume.
This is frankly much more worrying to me than the decline in exports because it suggests that demand in China is contracting quickly. I have no idea what the retail sales numbers are going to say, but last month I complained that it seemed inconsistent to me that imports were contracting while retail sales were implying a healthy expansion of consumer demand. Unless the marginal propensity to import is collapsing, I think I trust the import numbers more. Demand in China is looking very bad.
Finally, and most shockingly, Shang Ning told me on the phone call that the trade surplus was $40.1 billion. At first I thought he was saying $30 billion, and I was surprised that it was so high – it would have been the second-highest monthly trade surplus ever recorded. When I finally understood him to say $40 billion, I couldn’t believe it. That is the main reason I immediately called Logan, to see if my student had made a mistake just before I was going to go on TV to debate the economic outlook.
He hadn’t made a mistake. In October China’s trade surplus was $35.2 billion, the highest every reached by any country at any time in history. In November that record was smashed. In the last three months China’s trade surplus has been $96 billion, nearly equal to the $100 billion from the first six months of 2008.
The headlines in China and around the world have been dominated by the contraction in Chinese exports, and this certainly is a bad number, but it cannot be a surprise and it is not the number on which we really should be focusing. The trade surplus is much more worrying, and soon enough that is what all the headlines will be reporting. Remember that the trade surplus is the measure of Chinese overcapacity that is being exported onto the world economy, but the world economy is looking for ways to increase net consumption, not net production. While demand in the rest of the world is shrinking, China is providing even more overcapacity, which means effectively that not only is China not absorbing its share of the demand/supply adjustment, it is exacerbating the imbalance. Other countries are going to have to withstand a faster decline in production than otherwise.
I know that China is facing a real problem of economic slowdown, one that seriously worries policy-makers. The other guest on the CCTV show last night was the chief economist of a large local securities firm, and he accomplished the not-inconsiderable feat of making me sound like an optimist. But still, it is wholly unrealistic to assume that the rest of the world will accept that they must bear more than 100% of the adjustment in order to pull China out of its trouble.
As a related aside, one of my former Columbia students, currently a government official in Vietnam, just told me an hour ago that Vietnam’s exports are awful. Declining exports are going to be a real problem for a lot of developing countries. With the collapse of the part of the capital markets that financed developing countries, and the resurgence of capital flight, developing-country trade-deficit countries will be forced suddenly to run trade surpluses (via, almost inevitably, a sharp contraction in domestic demand). If that happens, anti-China feelings are inevitably going to rise. If these result in anti-trade acts, China will suffer far more than it would under even the worst of current economic scenarios.
The chief economist who was on the TV show with me last night clearly understood this, as do many others in China (there is a even rumor that one reason the RMB depreciated before the SED meeting last week was that some people in the PBoC wanted to bring the matter to a head), and it is really important that US, Chinese, European and Japanese policymakers fully understand the problem. The major economies must work out a plan in which they provide for a three or four year period during which China can adjust its overcapacity problem, but if China tries to go it alone and allows the trade surplus to remain at anywhere near these levels, it is hard to see how we can avoid trade trouble. To repeat ad nauseum, the Chinese economy absolutely cannot tolerate a world of trade protection.
By the way I talk mostly about the US and China as being fundamental to the current global imbalance, but there is another pair that is also suffering from some of the same problems. Germany is running a huge trade surplus while the rest of Europe is running huge deficits. Already relationships in Europe are fraying. Paul Krugman, in Sweden to collect his Nobel purse, writes about it:
Everyone here seems to be talking about…the German problem. At a time when expansionary policies are desperately needed, the leaders of Europe’s largest economy seem to have their heads in the sand. This is a huge problem: there are large spillovers in fiscal policy among EU nations — that is, a significant fraction of, say, French fiscal expansion ends up promoting employment in Germany or Italy rather than France. So there’s a crying need for a coordinated policy. But the Germans aren’t participating.
The Financial Times explains it a little more colorfully in an article today (“Berlin hits out at ‘crass’ UK strategy”):
Germany’s finance minister has launched a stinging attack on the “crass Keynesianism” pursued by Gordon Brown, the British prime minister, fuelling tensions on the eve of European economic crisis talks in Brussels. Peer Steinbrück accuses Mr Brown in a magazine interview of “tossing around billions” and saddling a whole generation with a bill for paying off British debt.
His comments come as the European Union’s 27 leaders meet in Brussels to debate a proposed €200bn fiscal stimulus package, designed to stop a protracted economic slump. Mr Steinbrück, a Social Democrat in chancellor Angela Merkel’s grand coalition, has previously accused other European leaders of acting like “lemmings”, borrowing billions to fund tax cuts or higher spending. His irritation has been heightened by efforts by Mr Brown to construct a coalition to put pressure on Germany to follow suit.
…Germany has insisted the summit communique, while endorsing a €200bn stimulus package, should include the need to maintain fiscal discipline. A draft statement says the goal of long-term budgetary sustainability “implies a swift return to the reduction of deficits which have been temporarily increased.” Mr Steinbrück, speaking to Newsweek, questions whether Mr Brown’s £12.5bn (€14.2bn) cut in value-added tax will work. “All this will do is raise Britain’s debt to a level that will take a whole generation to work off,” he said.
He added: “The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking.” He said British policy would simply repeat mistakes of previous years in fuelling credit-financed growth.
I don’t want to wade into these very deep waters, but I think Steinbrück is right to warn Britain and France against excessive fiscal spending to get their economies going. Given their trade deficits a lot of their spending is going to be used to pull non-British and non-French workers out of unemployment, as Krugman notes. But on the other hand they are right to insist that German do more to expand fiscally. It is German overcapacity that is now the European problem. Perhaps Germany, like China, should be doing more to rebalance its excess capacity and foist less of it on the rest of Europe – struggling as they are with rising unemployment.
As distressing as it is to say this, I think few things are going to raise more irritation and anger next year than global trade.