China’s Domestic Market: Don’t Count Too Heavily on It

There’s still no respite for Chinese stocks. The market bounced around violently today with the SSE Composite making at least eight or nine up or down moves of more than 1%, before closing the day at 1720, down 0.5% for the day. This is the lowest closing in over two years (it closed at 1722 on September 15, 2006). The declines were led by industrial companies this time – not the usual banks and real estate developers – because of Friday’s data release suggesting the development of problems in the industrial sector (which I discussed in a Saturday posting).

Amid attempts at reassuring the public (“China’s economy in good shape despite global financial turmoil”, say the main business-related headlines today on Xinhua and in the People’s Daily), it is clear that policy-makers are feeling anything but reassured. Xinhua reports that “Wen sees worst year for growth”, and even through the soothing noises in the article it is clear that policy makers are in a quandary:

The government should find the right balance between curbing inflation and maintaining a stable economic growth, Premier Wen Jiabao said on Saturday. “We must be aware that this year would be the worst in recent times for our economic development,” Wen said in an article published in the Qiushi journal.

Curbing inflation is still a challenge, even though it fell from a 12-year high of 8.7 percent in February to 4.6 percent in September, he wrote. In his article, Wen said that the global downturn will continue to pressure the Chinese economy, which already faces a number of problems.

Given the situation across the world, “it is very difficult to maintain high growth and a low inflation rate in the long run,” the premier wrote. “The (global economic) situation is worsening,” and the negative impact of the volatile international market on the Chinese economy would become more obvious as the days go by.

The main task of the macro-economic policy is “to successfully maintain a balance between stable and relatively fast economic development and curbing inflation,” Wen said.

In many of my conversations with Chinese and foreign analysts recently there has been a growing consensus – shared by me, by the way – that since inflation is politically easier in the short term than a sharp banking contraction (although likely to be worse in the medium term), there would probably be excess monetary easing to “fix” the banking problem, and that this would lead to inflation down the road, and not just in China.

But nearly every statement I have seen by senior Chinese officials continues to make a big deal about the inflationary threat. I am not sure if this is because the monetarists are desperate to convince an unconvinced majority of policy-makers, or if because there is a real acknowledgement of the dangers of an upsurge in inflation as the world races to create money, but if it is the latter it is undoubtedly a good thing. The temptation towards inflation is one that is likely to be hard to resist, and of course even harder to reverse.

Meanwhile one of the reasons most likely to create a pre-disposition towards inflation is the possibility of rising college unemployment. A recent survey of more than 1,000 Chinese university students graduating this year reported in claimed that:

Only 12.1% had “successfully” found jobs, indicating that the employment situation for educated young people presents an ever-growing challenge. The survey found that by the end of August, nearly 80 percent of newly-graduating job hunters were jobless, while about 10 percent were dissatisfied with the jobs they had found and planned to seek better employment.

I have been writing about rising unemployment among college graduates for more than a year now, and it struck me that even with GDP growth well into double digits there had been a real problem with the economy’s ability to absorb college graduates. With enrollment up and the number of graduates surging (I think it is growing by more than 15% a year), it is hard to see how an economic slowdown will not make this a major problem for the authorities.

One of the most widely agreed-upon “solutions” for dealing with slowing Chinese growth is to switch the country’s focus towards domestic consumption rather than investment and exports. Today, again, the point was made by a number of policy-makers. According to an article in today’s Xinhua:

China’s government should continue efforts to expand domestic consumption amid the global economic uncertainty, said Liu Tienan, Vice Minister of the National Development and Reform Commission, in remarks published on Monday.

The fundamentals of China’s economy were sound, but the country also faced challenges, Liu said during an industry meeting in Beijing at the weekend, according to Monday’s China Securities Journal. China should step up efforts in industrial restructuring, innovation and changing its development mode.

He called for more support for farmers and more public resources allocated to improve social welfare. Su Ning, deputy governor of the People’s Bank of China, the central bank, said at the meeting that there was “still room to tap more domestic consumption” and the central bank would adopt a flexible and prudent monetary policy.

There is almost no question that the transition to domestic consumption is necessary for China’s long-term development, but I am concerned that too many people seem to think that this is a rather easy and straightforward process, and that it can happen quickly enough to bail China out of the global slowdown.

It isn’t and it won’t. The transition will be very difficult and will take several years, perhaps even longer than a decade. There is no relevant precedent I can think of in history in which a large economy has made the transition quickly and in benign conditions. I was in a meeting today with a Japanese economist (who prefers not to be identified because of his affiliation) and we discussed this very issue in the context of Japan. He confirmed that Japan has been in a similar transition basically since the early 1990s and still has a long way to go to complete the transition..

Japan may not be a totally relevant comparison because its transition took place in a period of rapid growth in international trade, thereby putting less pressure on the country to adjust quickly. China’s transition, on the other hand, is likely to take place in a period in which the rest of the world will not be nearly as accommodative. But that just underlines the fact that these transitions are tough. China may be forced to adjust more quickly than Japan only because the rest of the world will see a sharp drop in its ability to absorb Chinese production. This will make the transition more difficult.

The Japanese economist and I discussed China and the Japanese experience in much greater detail, and I hope to present some of his findings later after I have had a chance to look at them further.

One last thing before closing, Shang Ning, one of my students who focuses on monetary issues (he is the Secretary of the Guanghua Students Monetary Committee) sent me an email yesterday. According to him (with slight editing on my part):

There are rumors that the MoF has prepared a report saying municipal governments are under liability management difficulties, and passed the report to the State Council. People are guessing that issuance of provincial government debt may be coming soon.

I asked him to track this for me, and the next day he wrote the following:

Normally in the past the most important resources for regional governments are sales of lands (ranging from 40% to 60% of total regional budget as said) and fees (not taxes). But now land sales have sunk with the decline in real estate. This obviously violated the regional budgets.

I am guessing the regional budgets are thought to be facing pressures both from declining income and expanding expenditures as a part of fiscal expansion. The rumors was first quoted by China Security Journals yesterday, and then spread widely today. It is also said that MoF has established a sub-dept focusing on regional liability management under their department of budget.

This is all very interesting and I will certainly be trying to keep track of it. I think there are at least two important issues here. First, the fact that municipal-level budgets are under such strain suggests that real fiscal expansion is going to be harder than we think since there is likely to be fiscal contraction at the municipal level. Second, and I have discussed this often before, I am willing to be that there is a lot of unrecorded and uncollectible debt at the municipal level that should be aggregated to government debt levels when we try to figure out the government’s debt position. Remember that municipal and provincial debt is implicitly central government debt. If municipals are allowed to borrow I wonder whether they will be able to borrow in their own names or under government guarantee. There are very strong reasons for arguing either way.

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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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