The Evidence on Chinese Consumption Growth is Still Far More Bearish than Bullish

My ten-day trip – partly holiday on Phuket and Phi Phi islands (even more beautiful than I had expected) and mostly meetings in Bangkok, Hong Kong and Singapore – finally ended yesterday. Besides three presentations to large investment groups, I met about twenty to thirty institutional investors in small meetings, and those meetings were very instructive. There is a real mix out there it seems to me of tentative optimism about Chinese prospects on the part of the majority of investors and deep pessimism on the part of a minority, which included both Chinese nationals and foreigners.

Perhaps this is because of my own prejudices as a former bond-markets trader, but the pessimistic minority seemed much more experienced and literate to me. They were also generally a lot more senior. That might not mean much but it does suggest to me that there is a risk of bad news in the future causing a stampede of pessimism. Of course the majority is not necessarily wrong (in spite of the claims of contrariarans, who paradoxically enough include nearly everyone, it seems), but the volatility impact of information that confounds their expectations is much greater than that of information that reinforces their expectations.

I may discuss the impressions I got from some of these meetings more later, but I wanted to talk a little about consumption growth in China. My Financial Times OpEd piece published two weeks ago about the consumption constraint on Chinese growth seems to have generated several letters in disagreement. I don’t think most of them made much sense as far as I could understand. One seemed to have an overly optimistic assessment of the Chinese banking system. It seemed to claim that since officially reported NPL ratios today are much lower than unofficial private estimates of ten years ago, the banks are in very strong shape, and so we don’t have to worry about the NPL effect of the recent surge in lending. That seems to me to be a defensible if illogical claim, but pretty implausible.

The letters also generally assumed – and this confusion seems to happen an awful lot – that the accounting identity GDP = C + I + G is something prescriptive, with GDP growth largely independent of consumption growth and sustainable in the medium and long term by forever-increasing amounts of government-financed investment. Apparently the argument that foreigners won’t consume this rising current and future capacity, and that Chinese won’t consume this rising capacity either, which must lead either to forever-rising inventories, to dumping and trade tensions, or to write-offs, none of which is a happy solution, can simply be resolved by repeating GDP = C + I + G several times.

Nonetheless one of the letters in disagreement, by Professor Peter Williamson of Cambridge University made a lot more sense and identified the main weakness of my argument, as I see it. According to Williamson:

Michael Pettis is right to remind us that correcting the fundamental imbalances in the global economy means that China’s export-orientated growth model is no longer tenable (“Get ready for lower Chinese growth”, July 31). But he is unduly pessimistic about the potential of Chinese consumers to generate sustained, double-digit growth in Chinese gross domestic product.

Between now and 2025 some 350m Chinese are set to become new city dwellers. This alone will give a boost to demand equivalent to the size of another Germany. The government’s stimulus package will also initiate more spending by consumers. The £73bn to provide universal cover for basic healthcare in China by 2011, for example, will encourage savers fearing medical bills to spend more freely. Workers made redundant from export-processing jobs, meanwhile, are adapting quickly – finding new work and retraining (4m in Guangdong alone). Their consumption will rebound.

Local consumption is, indeed, the key to China sustaining high growth over the next decade. But that should be cause for optimism rather than despair.

Professor Williamson accepts the argument that China’s medium to long term growth rate will be constrained by the growth rate of domestic consumption, but he disagrees with me in assuming that the rate of growth in Chinese consumption (roughly 8-9% annually over the past several years) will remain the same or even decline in the next few years. He thinks it is likely to grow much faster.

He may be right, and whether or not he is right is I think the key to the validity of my argument as a prediction of the future. But I am not convinced. For reasons I have discussed many times, I don’t think by his first argument, that China’s plan “to provide universal cover for basic healthcare in China by 2011,” will cause a future explosion in consumption – at least not in the time needed to address the adjustment in the global imbalances.

For one, simply because the government has announced the plan to put into place a good healthcare system by 2011 doesn’t mean that this is a done deal. The government also announced several years ago that Chinese growth would become much more environmentally friendly, Chinese income would become more fairly distributed, corruption would be reduced, the banking system would be cleaned up, SMEs were to receive a growing share of loans, and the corporate bond markets would become a major source of funding, and yet anyone living in China might wonder if any progress had been made on any of those things. Putting in a good health care system is very difficult in the best of circumstances, and with almost no accountability in local governments and local hospitals, and with rapidly rising deficits at both the central and provincial levels, I am pretty skeptical about their ability to achieve anything close to their stated ambitions.

But more importantly, even if they do pull it off, and give China Swedish levels of health care within a year or two, we shouldn’t assume that it will immediately affect consumption levels. Anyone living in China knows how skeptical many Chinese are about government promises, and I would guess that it will take many years of testing the system successfully before even a significant fraction of Chinese household feel that it is no longer necessary to save enough to protect themselves from medical emergencies. After all there are not many responsible adults who will throw caution to the winds when it comes to the possibility of an aged parent or, even worse, a son or daughter, needing serious medical treatment, and cash for that treatment. In that case you don’t give up your safety net of hoarded cash until you are thoroughly and totally convinced that you will no longer need it, and that conviction only comes through experience.

I am also skeptical about his other claim for a surge in consumption based on a flexible work force quickly replacing export jobs with other jobs. Unemployment seems to be rising (of course the official urban employment data is nearly worthless, but the anecdotal evidence isn’t good), and the main reason it hasn’t surged is probably because of the massive stimulus package, so once again we circle back to the argument about the sustainability of the stimulus package. In that light let me just highlight a passage from the’s Dragonbeat by my friend Arthur Kroeber, a very smart China watcher with whom I used to disagree in the past a lot more than I do currently (perhaps a little to my chagrin, because given how much he knows about China, debates and disagreements with Arthur were always very educational for me):

China’s ability to maintain economic growth of around 8 per cent despite the global shock took many by surprise. But this ability has nothing to do with systemic advantages, a distinct “China model” of growth, or skill in macroeconomic management.

Still less has it anything to do with the reasons cited by the People’s Daily editorial [Note: this is in reference to an especially silly editorial you can find here]. China’s present economic vitality results from a Great Wall all right – a Great Wall of borrowed cash. There is nothing remarkable or spiritual about an economy growing at 8 per cent when credit is allowed to expand by 34 per cent.

The fact becomes even less remarkable when we recognise that nominal GDP (the appropriate comparator for nominal credit growth) grew just 3.8 per cent in the first half. In other words, 10 dollars of new loans were required to generate just one dollar of economic growth.

In fact China’s first-half growth shows one thing and one thing only: the existence of a powerful state with the ability to commandeer its citizens’ wealth and plough it into more buildings, bridges and roads, with no regard for the return those investments will bring.

Not to be outdone, Shen Minggao, Caijing’s chief economist, also worries about the Chinese adjustment in an article in this week’s Caijing. In particular he is concerned that Chinese consumption needs to accomplish the very difficult task of increasing at a rate commensurate with the increase in US savings:

During the S&ED the United States highlighted signs of healthy economic adjustments. For example, the savings rate for U.S. residents climbed to over 7 percent in June and will likely reach 10 percent in the future. The United States has done better than China in terms of these adjustments. China has to change its current exports-driven growth mode because a U.S. recovery does not necessarily boost consumption, given the soaring saving rates.

…The wealth decrease for American households did not shake the foundations of consumption. Though the recession led to negative consumption growth, the largest year-on-year decline was only 4.4 percent, recorded in the last quarter of 2008. It was far less than the 8.9 percent drop during the late 1970s oil crisis.

However, it is uncertain whether deleverage of household balance sheets and rising savings rates are a one-time thing or a permanent change. As U.S. financial regulators tighten systemic risk supervision and easy lending becomes no longer available, American consumers have to rely on savings rather than borrowing to spend.

…In contrast, China’s high saving rates and constant inflows of foreign funding compel the Chinese government to make a hard choice: continue investing in infrastructure or buy Treasury bonds? China will have to suffer additional risks if the dollar depreciates but to continue investing in infrastructure will bring about low efficiency caused by overinvesting.

If China wants to avoid such a dilemma, it must boost domestic consumption. Chinese consumers must lower their savings rates. Meanwhile, the percentage of residents’ incomes in the gross national product should be increased greatly. Second, China needs to push for the appreciation of the yuan. Chinese firms have to rely more on domestic markets than overseas markets. Finally, China needs to turn potential consumption into real consumption during its industrialization and urbanization. Only in this way can China become a new engine for global economic growth and gain a bargaining advantage in future U.S.-China negotiations, which is commensurate with China’s economic size.

In another article another writer in the same magazine warns of growing overcapacity in steel:

The government will freeze approvals of new steel projects for the next three years in a bid to curb overcapacity, Ministry of Industry and Information Technology chief Li Yizhong told a news conference August 13. Li said oversupply is a serious problem, with annual production capacity of 660 million tons far exceeding estimated demand of 470 million tons. China will produce a record 580 million tons of prime steel in 2009, far above the government’s target of 460 million tons, according to China Iron and Steel Association data.

So it mostly boils down to what policymakers can do to boost consumption growth – net consumption growth – in the short and medium term, and the sustainability of the fiscal stimulus to get the economy over the hump, and there is a whole lot of skepticism on my part, and on the part of many of my favorite China-based observers, that this is not going to be easy.

Of course Williamson may be right that there is a possibility of a surge in Chinese consumption, and if he is right my entire argument about a sharp slowdown in Chinese growth over the next decade will thankfully get thrown out the window. That is the main point – my whole argument rests, I think, on whether or not consumption growth can be positively and, more importantly, sustainably affected by the current fiscal stimulus. It is hard enough to present one’s full case in a letter to the editor, so I may be slighting the full extent of Williamson’s argument, but for now I think the evidence is still far more bearish than bullish on Chinese consumption growth.

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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.

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