Thursday, July 4, 2013

Roach v. Pettis (on China)

Stephen Roach recently penned an article entitled "Get Ready for the Next China" outlining the transformation that China is undergoing from an economy led by investment led growth to consumer growth:
The message from this new approach to Chinese macroeconomic stabilization policy is clear: Gone are the days of open-ended hyper growth. Significantly, this message has been reinforced by an important political overlay. Xi’s rather cryptic emphasis on a “mass line” education campaign aimed at addressing problems arising from the “four winds” of formalism, bureaucracy, hedonism and extravagance underscores a new sense of political discipline directed at the Chinese Communist Party. The CCP is being urged to realign itself with the core interests of citizens and their need for fair and stable economic underpinnings.

This new mindset works only if China changes its growth model. A services-led growth dynamic, one of the pillars for a consumer-led Chinese economy, is consistent with a marked downshift in trend GDP growth. That’s because services generate about 30 percent more jobs per unit of Chinese output than do manufacturing and construction – allowing China to hit its all-important labor absorption and social stability goals with economic growth in the 7 to 8 percent range rather than 10 percent as before. Similarly, a more disciplined and market-based allocation of credit tempers the excesses of uneconomic investments, necessary if China is to begin absorbing its surplus saving to spur consumer demand.
He went on to say that this transformation presents a great opportunity for American business:
China’s consumer-led growth presents the United States with an important opportunity. With the American consumer on ice for more than five years – underscored by average annualized growth of just 0.9 percent in inflation-adjusted consumption expenditures since the first quarter of 2008 – the US is in desperate need of a new source of economic growth. China is America’s third largest and most rapidly growing export market. Washington negotiators should push hard on market access, ensuring that US companies and their workers have the opportunity to capitalize on China’s transformation.

Second, and related to the first point, is a potential bonanza in Chinese services. At 43 percent of its GDP, China has the smallest services sector of any major economy in the world. Under reasonable assumptions, the scale of Chinese services could increase by around $12 trillion by 2025. Increasingly tradable in a connected world, the coming explosion in Chinese services could translate into a windfall, up to $6 trillion, for foreign services companies from retail trade and transportation to hotels and finance. For the United States, with the world’s largest and most dynamic services sector, this could be an extraordinary opportunity. US negotiators should push especially hard for access to Chinese services markets.

How do you get from A to B?
In recent years, Stephen Roach has changed from the global bear to the cheerleader for China. In his article, he glosses over the little detail of how China can effect this transformation without a significant slowdown.

Michael Pettis has a different take. He wrote a Foreign Policy article about the credit crunch related convulsions within the context of the transformation from an investment-led to a consumer-led economy and also urged caution by the West in their approach to China:
Last week is a reminder that Beijing is playing a difficult game. The rest of the world should try to understand the stakes, and accommodate China's transition to a more sustainable growth model. As policymakers in China continue to try to restructure the economy away from reliance on massive, debt-fueling investment projects that create little value for the economy, the United States, Europe, and Japan must implement policies that reduce trade pressures. Any additional adverse trade conditions will further jeopardize the stability of China's economy, especially as lower trade surpluses and decreased foreign investment slow money creation by China's central bank. A trade war would clearly be devastating for Beijing's attempt to rebalance its economy and have potentially critical implications for global markets.
Here is his key conclusion [emphasis added]:
Regardless of what happens next, the consensus expectations that China's economy will grow at roughly 7 percent over the next few years can be safely ignored. Growth driven by consumption, instead of trade and investment, is alone sufficient to grow China's GDP by 3 to 4 percent annually. But it is not clear that consumption can be sustained if investment growth levels are sharply reduced. If Beijing can successfully manage the employment consequences of decreased investment growth, perhaps it can keep consumption growing at current levels. But that's a tricky proposition.
In other words, Pettis estimates that the consumer-led Chinese economy can only grow at 3-4%. If the Chinese economy changes the tone of its growth from investment and infrastructure to consumer led growth, the consensus of growth in the 7% range is unrealistic.

In addition, what happens to all the leverage in the system? Who eats the non-performing loan (NPL) losses from all of the infrastructure spending by the SOEs and local governments? In past eras, the Chinese government had taken the brunt of the NPL losses through classic financial repression - through artificially low interest rates that repressed the household sector and blew an property asset bubble.

Now that the Plan is to grow the consumer sector, the old trick of household sector financial repression won't work. In a separate interview with Ron Rimkus of the CFA Institute, Pettis stated:
You can only resolve a bad debt problem by assigning the cost to some sector of the economy. In the past it was the household sector that implicitly paid to clean up the debt, but if we expect rapid growth in household consumption to lead the economy going forward, and this is what rebalancing means in the Chinese context, we cannot also expect the household sector to clean up the bad debt in the same way it has done so over the past decade.
So who pays? In the worst case, it could lead to a disorderly unwinding of the excess leverage in China which, given how the global financial system is inter-connected, spark a global financial crisis.

In addition, Kyle Bass sounded a warning on China (via Zero Hedge) [emphasis added]:
The speed and depth of the Chinese policy response will help determine the severity and duration of this crisis. If the Chinese address the issue quickly and move decisively to rein in credit expansion and accept a period of much lower growth, they may be able to use the government and People’s Bank of China’s balance sheet to cushion the adjustment in the economy. If, however, they continue on the current path and allow this deterioration to reach its natural and logical limit, we will likely see a full scale recession as well as a collapse in asset and real estate prices sometime next year.
Even Stephen Roach sounded an implicit warning of potentially higher interest rates as China transforms itself:
But there is another twist. As China shifts to consumer-led growth, it will start to draw down its surplus saving and current-account surplus. That could lead to a reduction in its vast $3.4 trillion foreign exchange reserves, thereby dampening China’s demand for dollar-based assets. Who will fund a seemingly chronic US saving shortfall – and on what terms – if America’s largest foreign creditor ceases doing so?
China's transformation from investment led growth to consumer led growth is a story of short-term pain for long-term gain. The only questions are:
  1. When? And
  2. How much pain?

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Unknown said...

Great article, your effort to summerize and present your comparison in a deeply invoking manner. I am an avid reader of your blog,with your efforts being noted and much appreciated.

I am not a macro expert, and I guess that after the recent woes in China; the next global bear catalyst would probably be from there. I will be following the situation closely from now on.

Anonymous said...

Hi, there is one more thing to that. Household consupmtion grew by nominal 12 percent per annum between 2000 and 2011 (OECD data). I have found no dircet price index for hh consumption, but IMF publishes a GDP deflator which grew 4.4 percent in the same period. Using it as a proxy, and adjusting to a 0.5 pct population growth, it gives you a 6.7 pct annual real per capita consumption growth. This is not muted by any standards, and the claim that China underconsumes does simply not hold. China underconsumes compared to how much it invests, but it has grown its household consumption at a heartbeating rate. Reforming China to ba consumption driven economy does not mean that hh cons will accelerate. It will most likely slow down, if the funding markets are not supporting the economy as they have so far.

C Young said...

Those who like Roach suggest that China can rebalance from investment to consumption without a major recession in-between are surely living in cloud cuckoo land. Can we really imagine a scenario in which the current “economic miracle” narrative dissolves, large numbers of workers in the sectors leading investment e.g. construction, steel and mining are laid off, and the reaction of the general population to this situation is to go on a giant spending spree? As a point of comparison the UK has been trying to effect a rebalancing between two sectors (Finance and Manufacturing) in which it has an established presence for 5 years without success. Do we really think that China can change economic models entirely, change its culture, see a rebalancing of power between social classes and lose just 2-3% of GDP a year ? What happened in Ireland and Spain after their investment blow-outs? Was it “Our prosperity is an illusion, our economic model has no future, let’s go shopping?” I don’t think so.

Anonymous said...

Time for a China trade war!

Tom said...

I think Bass is very sensible for the short run, but nobody quoted here makes much sense for the long run. China will continue to be export-driven but is transitioning from getting most growth from gobbling up developed market share to mutually driven growth through trade among emerging markets. There is great potential in the latter but it is very much easier said than done. Expect a bumpier road ahead.

China's investment is oversized partly because power is concentrated, partly because Chinese culture and zeitgeist favor savings, partly because of heavy investment in export oriented capital equipment. Keep in mind that investment as proportion of GDP is usually measured from spend-side GDP in which exports value added is downplayed because consumer imports are netted from it in the net exports line.

The supposed transition to consumer driven growth is an illusion. Consumption is growing very rapidly but naturally favors imports. Even as domestic production of consumer products for the domestic market booms, materials will have to be imported. China must export to import and it is folly to suggest China should de-emphasize its most competitive sectors. China of course needs to stop subsidies but those are after all a minor bit of the Chinese export juggernaut story. It's a story of concentration of capital, infrastructure and labor. It's a world changer. I frankly suspect westerners predict its pending failure more out of wistful jealousy than sound analysis.

As for changing to service-driven growth, this is a misunderstanding of how economic structure changes in the transition to a developed economy. Service prices take growing shares of GDP because their prices inflate much faster than material goods. Real growth of services in the US since the 30s has been generally on par with real growth of goods production. Real services growth has been mostly in health care and education. Most other services are part of a chain of production and delivery of material goods. Growth still mostly depends on producing more and better material goods, even in DMs.

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