The Myth of China’s Blithe Consensus

This will be an unusual entry in that rather than focus on economic analysis I want to address one of the too-widely-repeated myths common outside China which, I think, may distort some of our understanding of China’s growth trajectory. One of the more absurd claims often made by foreign observers with little knowledge of China is that only “foreign pundits” (why must they always be “pundits”?) are worried by China’s debt levels, the undervaluation of the currency, the financial system, or the development model. Chinese scholars, according to this line, are actually very bullish about everything happening in China and agree very broadly on the measures that have been taken, and so the opinions of foreign worriers should be heavily discounted because clearly they cannot know more than the locals.

This is wrong on two counts. First, there is very little historical evidence that foreign observers tend systematically to be less-often right than local observers. In fact many of the great economic problems in recent years, including Japan’s bubble economy in the 1980s, Argentina’s external debt trap in the late 1990s, Iceland recently, and the Chinese banks at the end of the last decade, (not to mention Keynes’ criticisms of US policies in the 1930s) were first brought to serious attention by foreigners, whose warnings were often enough stubbornly rejected by local observers as being overly pessimistic and caused by the typical foreign misunderstanding of “our culture”.

Second, it is simply not true that Chinese scholars are largely cheerleaders for China’s development policies, and certainly not to the extent that foreign observers tend to be. In fact the discussion within China is far more sophisticated, and fierce, than anything outside the country, although the ferocity of the debate is often disguised by a certain shyness on the part of most of the mainstream Chinese press.

I mention all this because People’s Daily had a very interesting article on the subject several days ago in response to a conference held at my school, Peking University:

China’s unusually high lending growth last year has sparked differences among the country’s top economists as the central bank seems to be taking new measures to contract credit and control inflation. While many economists believe that control of credit is a must to prevent serious inflation and ensure stable growth, some hold that too drastic a contraction could lead to stagflation.

“Currently the government shouldn’t steer off the easy monetary policy track to avoid possible stagflation, which is symbolized by not only inflation but high unemployment,” said Li Yining, professor and dean emeritus of Guanghua School of Management of Peking University.

China may get stuck in stagflation even with a mild GDP growth like 6 percent year-on-year, given the huge unemployment pressure caused by its large population, said Li, one of the most influential economists in China. He made the remarks on the 11th annual China economic forum held by the school. He warned that too early an exit strategy could affect employment and increase the possibility of stagflation at a time when the country’s economic recovery is still not solid enough.

China initiated a massive 4-trillion yuan ($586 billion) stimulus package in late 2008 to overcome the fallout of the global financial crisis. Its new lending was expected to amount to 9.5 trillion yuan in 2009, almost double the previous year. The ample liquidity, while helping the country meet its GDP growth target of about 8 percent in 2009, has triggered concern that the menace of serious inflation may loom large this year.

Zhang Weiying, economics professor and dean of the Guanghua school, warned that excessive credit expansion and low interest rates are the root of all financial crises in history and cause high inflation and massive toxic assets. ”We need to notice that this round of credit surge (in China), boosted by the 4-trillion-yuan stimulus plan, comes on the back of continually strong economic growth for many years,” said Zhang. That means the scale of credit last year was exceptionally large.

By coincidence, the day before, another Peking University economist, Huang Yiping, published a piece in the East Asia Forum making his not-so-rosy predictions for 2010. They were:

  1. The renminbi will probably begin to appreciate against the dollar.
  2. Job market pressures may rise again even as the economy recovers.
  3. Housing prices will probably begin to weaken.
  4. Structural imbalances are likely to worsen.
  5. The government will likely introduce another stimulus package

His comments on his fourth prediction are worth repeating:

Almost all policymakers, from the Premier down, are talking about adjustment of economic structure in order to improve quality of growth. This is very positive. But the measures being considered, such as better credit allocation, remain administrative in nature. In fact the government has been doing the same for at least seven years. But the imbalance problems continued to worsen. I don’t see any difference this time round.

…The root cause of the structural imbalance is distorted incentive structures, especially depressed factor costs. Until more decisive steps are taken to liberalise factor markets, adjusting economic structure could remain on the top of policy agenda every year for a very long time.

So were his comments on his fifth prediction:

Although most analysts expect China’s GDP growth to be at 9-10 per cent in 2010, it is unclear whether strong growth can sustain itself without the helping hand of the government. The ideal scenario is that when the RMB 4 trillion spending runs out, either exports or consumption or private investment or a combination of these would be strong enough to carry forward the growth.

But it is not clear that this will happen in the near term. Exports should recover but they are unlikely to return to the levels achieved before the crisis. The growth potential of the global economy has shifted lower and rising saving ratios further limits potential for China’s export growth. Consumption has been resilient, partly as a result of the stimulus measures. Without strong income growth, the consumption momentum could weaken. Private investment remains weak outside the housing sector.

Along similar lines, yesterday John Garnaut published a piece on his correspondence with one of my favorite Chinese economists, Yu Yonding, from which it is worth quoting a longish selection:

Yu, the recently retired director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, did not explicitly say I was barking mad. But his email continued: “When a country has an investment rate over 50 per cent [of] GDP and rising, you say this country is not suffering from overcapacity! … are you serious? ”To judge whether there is overcapacity you cannot just do a head account. With a 1.3 billion population and human greed, China’s needs are unlimited, you can say that China will never suffer from overcapacity!”

The email noted that, on my logic, no developing country could ever suffer from overcapacity until it became rich and that the world should never have suffered a Great Depression in 1929.

Since that salutary critique, Yu has elaborated further on his views.

He believes China is trapped in a cycle where constantly rising growth in investment is constantly increasing China’s supply, but consumption has conspicuously failed to grow fast enough to absorb it. And so China is forced to increase investment in order to provide enough demand to absorb the previous round of increased supply, thus creating ever-widening cycles of oversupply.

In this manner, the investment share of gross domestic product has increased from a quarter of GDP in 2001 to at least half. “There is sort of a chase – demand chasing supply and then more demand is needed to chase more supply,” he says. “This is of course an unsustainable process.”

From 2005 China’s overcapacity problem had been “concealed” by ever-increasing net exports – but that strategy was interrupted by the financial crisis. Then came last year’s globally unprecedented stimulus-investment binge, which might not have been so worrying if it were delivering things that people needed. But the Government’s hand in resource allocation has grown heavier since the crisis without reforms to make officials more responsible for what they spend.

“As a result of the institutional arrangements in China, local governments have an insatiable appetite for grandiose investment projects and sub-optimal allocation of resources,” as Yu previously said, in his Richard Snape lecture for the Productivity Commission in November.

So there are now airports without towns, highways and high-speed railways running parallel, and towns where peasants are building houses for no reason other than to tear them down again because they know that will earn them more compensation when the local government inevitably appropriates their land.

Meanwhile a few weeks after Zhang Bin, a CASS economist, called for a 10% one-off revaluation (I discussed this two weeks ago on my blog), Zhang Shugang, another CASS researcher, argued that “China’s exchange rate is distorted, and China has been undervaluing the yuan to keep export prices low and to gain competitiveness.” According to an article in today’s South China Morning Post:

Mainland must let the yuan rise because its undervaluation is fuelling domestic economic imbalances, such as a stunted services sector, a mainland researcher said on Tuesday.

…While Zhang’s views in no way represent Beijing’s official stance, they do reflect a simmering debate among government-linked researchers about whether and how mainland should let the yuan rise again after effectively re-pegging it to the US dollar since the middle of 2008.

The article goes on to describe the range of opinions in the debate.

Premier Wen Jiabao said in late December that Beijing would not give into foreign demands to let the yuan rise because these were little more than attempts to stifle the country’s growth.

[But] Shi Jianhuai, a professor at Peking University, also added his voice to the camp calling for a stronger yuan, saying in an interview with local media on Tuesday that yuan appreciation would force mainland exporters to move up the value chain.

“If we were short-sighted and cared about nothing but growth this year, we would continue the dollar peg and distort the economy,” Shi told the 21st Century Business Herald. But if we cast our sights a little bit further and are willing to accept some short-term pain, we should see through quick market reform of the exchange rate, letting the yuan rise and float freely.”

…But powerful interests and officials are arrayed against proponents of yuan appreciation. Chinese Commerce Minister Chen Deming last week restated the government’s official view that a stable yuan had benefited the global economy and that any exchange rare reform would be gradual.

As the South China Morning Post article indicates, it is not just among think tanks and academics that a debate is taking place. One of my former students who now trades interest rates for a major bank in Shanghai sent me a report yesterday in which analysts sought to interpret what was rumored to be a fairly substantial argument in the State Council about increasing the lending quota for 2010, which as originally set at RMB 7 trillion. In the end, after furious debate, the quota was increased by a mere RMB 0.5 trillion. My former student’s conclusion (and that of most market participants): the huge fight over such a small increase shows just how divided policymakers are.

Meanwhile yesterday on Caing, in an article titled “Cloudy with a Chance of Torrential Credit”, the author discusses an “unusual” emergency meeting at the PBoC to discuss and react to a panic-inducing burst of new lending in the first two weeks of January (apparently 15% or more of the year’s quota was disbursed in the first two weeks of the year).

Sources close to the central bank say that the State Council’s dissatisfaction with loan growth mainly stems from its large size, uneven pace and irrational structure. “The State Council is looking at credit numbers daily,” the source said.

The point of all this is to suggest the richness and even ferocity of the internal debate taking place within China. There is a tendency I think, especially among the foreign cheerleading fraternity, to ascribe a unanimity of opinion within China and to see this both as a good thing and as a confirmation of the views of the cheerleaders.

I would argue that this is wrong on all three counts. First, there is most certainly no consensus. The debate in China is as fierce and as well-informed as it is anywhere in the world. Second, unanimity, or even strong consensus, would not be a good thing for China. Given how complex matters are, any strong consensus would simply represent a failure to debate the issues, and a corresponding increase in the probability of making horrible policy mistakes. In fact if there is a rapidly growing consensus about anything it is that policymakers seriously flubbed the chance to force through adjustment measures, such as a revaluation of the RMB, earlier when conditions were much more propitious and when the cost of adjusting would have been much lower. Third, cheerleading tends to occur far more enthusiastically among foreigners than within China. That is clearly a good thing.

At any rate as the debate rages on, this weekend I will go to DC and NY for a week of meetings, so I’ll probably not be posting anything for a while.

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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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