The US Government Frozen in the Headlights

Often enough I find that when people want to “prove” to me that China will continues growing well this year they simply quote government statements saying that China will grow by at least 8% in 2009. There is a touching faith, especially sometimes in China, in the strong connection between expert projections and the final reality, but as someone who actually keeps copies of “the year ahead” January editions of The Economist by my bedside to ward of insomnia (I am currently re-reading the January 2006 edition, which is a lot of fun), needless to say like most of us who have a Wall Street background I think expert projections are little better than garbage. It is not just that experts get it wrong an awful lot (and they do), but rather that most economic projections ignore the highly pro-cyclical or counter-cyclical (usually pro) processes imbedded in balance sheets, and these usually force wide variations from expectations.

For two years I have been arguing that a US slowdown would cause a very rapid slowdown in China, but I hated projecting GDP growth because I think China’s financial system has hidden but highly pro-cyclical structures that make it likely to overshoot dramatically one way or the other (as it certainly did in the good years). All I was very confident about saying was that reality would be much worse than whatever the current expert projections were. In spite of my pessimism, nonetheless, had someone told me in late 2007 that 2008 fourth quarter GDP growth might approach zero, I would have rejected this projection as implausible.

Well, now we know that it may very well have been true. Year on year growth was 6.8%, and we aren’t given the numbers that allow us to back out the quarter on quarter growth, but most of the estimates I have seen range from negative 1% to positive 3%.

So what will happen in 2009? Of course I don’t know. The “everything but the kitchen sink” strategy that I wrote about a few weeks ago, in which an increasingly worried government throws more and more fuel into the recovery program, suggests to me that there are two possible outcomes. On the one hand the government might fail to do much – or better yet they may decide to use the crisis to force a transition that benefits China in the medium term – in which case GDP growth will slow significantly, and fall well below the roughly 7% consensus that now seems to dominate.

On the other hand the government may throw so much fuel into the fire that they actually are able to get the 7% growth that many expect, but this is an extremely risky strategy. If the world recovers by the end of this year and the global economy races off again, it will look to have been a brilliant strategy, and Chinese policymakers will be feted around the world for saving China from the crisis. But if the world recovery takes a few more years to materialize, which I think it will, China will be worse off next year than this year. Government debt levels – especially contingent debt such as non-performing loans in the banking system and hidden provincial and municipal debt – will be much higher and provide much less room for expansion, and credibility levels will be much lower.

In my opinion, for what it is worth, it probably makes sense for the Chinese government just to assume the next several months are going to be disastrous, and rather than try to hold things off, which will only make it worse in the longer run because it will distort the adjustment process, they should try to accelerate the contraction of those industries that are destined to contract anyway with the collapse in global demand, and work on providing aid for workers who are going to pay the cost. I admit I may not be the brightest guy in the world in making political judgments, but it seems to me that a disastrous six months – which can and anyway will be blamed fully on the US and other foreigners – followed by two or three years of good news trickling in would be much better for political credibility than two or three years in which expectations are constantly disappointed.

So what has suddenly inspired me to start making pronouncements on political strategy? Partly the fact that I spent the past three days in Washington DC, and so breathed deeply of the rarified political air, but mostly because of recent hints that the Chinese government may “revise” its growth target of 8% for 2009. According to an article in yesterday’s Bloomberg:

China may review its 8 percent economic-growth target for this year as the global financial crisis deepens, Deputy Commerce Minister Zhong Shan said. The legislature will discuss the goal at its annual meeting next month, Zhong said in Hong Kong today, adding that the government remains “confident that it can achieve that goal.”

I confess I am a little confused as to why they would want to review the goal if they are so confident that they will achieve it, but the article goes on:

The government’s 8 percent target is aimed at generating jobs and avoiding instability in the world’s most populous nation, China Banking Regulatory Commission Chairman Liu Mingkang said in Beijing on Dec. 13. “If China’s GDP growth slips to 6 percent or 7 percent any time, it will affect the employment rate and also social stability,” Liu said then. Last month, he said meeting the 8 percent target would be “exceptionally arduous.”

It will be exceptionally arduous – no question. On a separate but related note on Wednesday the Financial Times published a piece I wrote with the title “This is not the time to attack China,” in which I argue that policymakers in the US and Europe, and even more so in China, do not understand how difficult the crisis will be for China and how little China can do in the short term to help the global adjustment.

But this does not mean that Chinese policymakers are knowingly engaging in predatory trading behaviour. On the contrary, although they seem unable – some might say unwilling – to understand China’s role in the global imbalance (much like the US failed to understand its role in 1930), they would nonetheless like nothing more than to see China increase consumption sharply. To that end they have unveiled a fiscal stimulus package and forced banks to expand lending at a pace so rapid – January’s new loans equalled one-third of all new loans in 2008 – it will almost certainly lead to a sharp rise in non-performing loans.

But in fact their efforts have only increased total consumption, not net consumption. China’s outdated development model, a banking system that seriously misallocates capital and its weak consumer base make it very difficult for China’s fiscal stimulus to cause a rapid net increase in consumption.

Rather than penalize China for assumed predatory trade practices, I argue in the piece that it would be much better to recognize Chinese constraints and to work out a long-term agreement in which China is guaranteed room to adjust, in exchange for commitments to adjust.

The world, with US president Barack Obama in the lead, has a tremendous opportunity to help China through a difficult transition and, in so doing, create a new sustainable global balance of payments and a favourable institutional framework that will govern trade and capital relations for decades to come. If not, the advantages trade deficit countries receive from pushing the full burden of adjustment on to trade surplus countries will be overwhelmed by a global environment of deep mistrust and hostility.

Will it happen? Perhaps, but I am not terribly optimistic. On the one hand my article got a huge amount of play in China and was widely reproduced (although I wonder if always with the permission of the Financial Times). Two of the Beijing musicians I am close to even told me yesterday that they had seen the article several times, even though like musicians around the world they rarely spend much time on the financial pages of any newspaper.

Since one of my arguments in the piece is that policymakers here have been unable – in fact unwilling may be a more apt word – to recognize China’s role in the crisis or the cost of Chinese adjustment, I am a little surprised that my piece has gotten so much play here, but maybe they just love to read articles that suggest that China is being unfairly attacked. On the other hand maybe there really is a growing recognition that as a fundamental part of the global imbalance, China is going to have to adjust its economic model just as dramatically as the US. Both countries relied heavily on the same source of growth – infinite leverage on the part of consuming US households – and this was clearly unsustainable. But so far I am not sure that this message is likely to be believed in China.

Not only am I pessimistic, then, about Chinese policymakers’ willingness to confront reality, but my trip to Washington also left me very worried about US policymakers. I was lucky enough to meet a wide variety of very smart and influential people in the US-China Economic and Security Review Commission, the US Chamber of Commerce, the Treasury, Commerce and State departments, the Senate Foreign Relations Committee, Congress, and a very interesting breakfast with people at the Carnegie think tank. The impression I got was that there are a lot of smart people very worried about how quickly policymakers are going to react.

I have already suggested that I think it is pointless to hope that Europe – or indeed other Asian countries – refrain from protectionist behavior or provide needed leadership, and my great hope has been that the new US administration surges forward and begins to design not just a short term solution that addresses the current collapse (I know, I know, much easier said than done, but the crisis part will end soon enough nonetheless), but also a longer term plan about what the new institutional framework will look like. But I don’t think this is happening.

Many people I spoke to last week were really bewildered by China’s role, and although many of them were extremely sophisticated in their understanding, they gave me the impression that policymakers are going through an almost existential crisis and have lost all confidence. The world needs US leadership more than ever, and the US is in a very strong position to provide it for at least three reasons. For all the problems of the economic contraction, the US will probably suffer less than other countries, it will emerge more quickly than the rest of the world, and it commands by far the largest amount of the most valuable resource in the world: net demand.

Inevitably someone will misread this and think I am crazy – the US has a great problem and, they will say, I am insane to suggest things are going so well. But note that I am not suggesting that the US is in great shape. I am suggesting that world is in worse shape, and the US has the flexibility and resources to reshape the global balance.

This seems to be something that not many people in Washington believe. The lack of confidence is so deep that several times I heard people refer knowingly to the Chinese fiscal stimulus (yes, that vague, risky, and hard-to-understand stimulus package) as the “gold standard” of economic stimulus packages. Gold standard? Really? The only way this can be true is if every other stimulus package in the world is total garbage. Perhaps it is.

One of my good friends in Washington, who is considering accepting a very senior position in the executive branch (surprisingly enough he might not accept it because of the bitterness of the confirmation process), asked me to point out a single bright spot for the US right now. I told him geopolitics – the chance to engineer a new global framework that will allow the US to regain the centrality that was lost in the past eight years while including Europe, China, Japan and the rest of the world as firmly committed members. He smiled dubiously and asked me to write it up.

However, even if I am right, unless the mood changes dramatically I am not sure that US policy makers are in any position to seize the reins and steer us firmly into a new global institutional framework. Instead I suspect that things will continue drifting downward for the next year or so, until it is that much harder for anyone to work out a reasonable plan that doesn’t involve a great deal of hostility and mistrust. Maybe it is just because I am a little jetlagged, but I am not very optimistic.

This entry is all terribly abstract and doesn’t say much that is real about Chinese financial markets, the misleading title of this blog, does it? Sorry, dear readers, but I promise that my future pieces will be more concrete and not nearly so pontificatory, if that is a word.

On a less bombastic if more narcissistic note, however, I am delighted to mention a very nice article in this week’s BusinessWeek that discusses my musical activities in China. Sorry to toot my own horn like this, but that accompanying photo makes me look a whole lot better than I really do, and so I would like everyone to see it. Gosh. Bombast and vanity. Who would have though three days in Washington could have had such a profound effect on me?

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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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