Tuesday, September 9, 2014

Michael Pettis on the risks of the "long landing" scenario

I received an email from Michael Pettis on my recent post (see The Pettis China "long landing" scenario hits an air pocket). To recap my previous post, I outlined Pettis' views of China's growth path outlined in his most recent blog post:
The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.
He continued with an optimistic "long landing" scenario (emphasis added):
This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. 
To achieve the Third Plenum objectives of re-balancing the source of economic growth to the consumer, or household, sector, financial repression needs to be eliminated, or at least drastically reduced.
Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.
By re-balancing growth from credit-led infrastructure growth, which has mainly benefited SOEs, to the household and consumer sector, Beijing addresses the problem of mis-allocation of capital. It all made sense...then I came upon this analysis from Anne Stevenson of YCapital (via FT Alphaville):
Consumer spending is second only to unemployment as the most atrociously tracked statistic in the economy, and the NBS numbers offer little insight. We have, however, been choosing two smaller cities per month as focuses of research, conducting interviews with vendors across commercial categories and triangulating the interview data with what we can see from the statistics. In each case, cities that have seen a decline in property sales almost immediately see a decline in spending in the industries we survey, with the sharpest downturns generally in property-related categories such as furniture and building materials. Next-weakest are usually consumer electronics and white goods, then food, while there is often growth left in clothing and personal care. The near identity between property and the consumer economy indicates that a slump in property must lead to a spike in investment in order to buoy the preferred areas.

The consumer segment, to the extent that it can be independently tracked, provides a clear trace for how capital moves through the economy at large and spills out in the form of commissions and kickbacks on contracts, higher compensation locally, and better liquidity for the housing market, leading individuals to spend.
In other words, property prices are intricately linked to consumer spending. If real estate prices tank, as they seem to be doing in the non-Tier 1 cities, so will consumer spending. In that case, how can re-balancing occur?

Pettis' comments
After I published my blog post, I received the following email comment from Pettis, which I reproduce in its entirety with permission:
Cam, thanks for your excellent analysis and kind words. I think you have hit precisely upon the main vulnerability in my "best-case scenario" argument, and because I am a big fan of Anne Stevenson's work (JCapital), I read her reports with the same trepidation you do.

My "best-case" rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public forum, that this is not my expected "most likely outcome".

In fact I don't really yet have a "most likely outcome" because I think the final result is likely to be highly path dependent, and it is too early in the reform process and, more importantly, in the process of political centralization, to make anything but a rough guess. My "best-case" scenario is just one of the plausible ways in which rebalancing can take place, and, obviously enough, it is the one with the highest average growth rate I am able to work out arithmetically, given the logic of rebalancing and the constraints China faces.

I stress "plausible" because I can also propose "better" outcomes, but these would require policies that although not impossible are, I think, pretty unlikely. For example if Beijing were able to implement policies that transferred every year the equivalent of roughly 2% of GDP directly or indirectly from the state sector to median households, my simple arithmetic allows me to show GDP growth rates of perhaps 6% or even higher.
At any rate whether or not my claim that the upper limit of average growth during 2013-23 is 3-4% is credible depends on at least four factors:

1. China must not run up against debt capacity limits. My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3-4 years at most, after which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my "orderly long landing" scenario is less likely.

2. Beijing has largely squeezed out the main mechanisms for both rapid growth and the "unbalancing" process (financial repression, currency undervaluation and low wage growth), but tight rebalancing timetables still require direct or indirect state transfers to the household sector, as proposed during the Third Plenum (hukou reform, financial sector governance reform, interest rate and currency liberalization, land reform, privatization, environmental protection, etc.). These will be politically tough to implement, as you know.

3. Even if the above happen, the uncertainty, especially political uncertainty, can cause nervous households to restrain spending, so that even 5-7% growth in household income might not translate into similar consumption growth, which would reduce potential GDP growth.

4. Finally, and this the point you make about Anne's work, if declining home prices cause a negative wealth effect, (and indeed if consumption growth is positively correlated with investment growth, as Murtaza Syed at the IMF found, especially in the poorer western provinces), it will be hard to maintain current levels of consumption growth as investment growth and housing prices decline.

The wealth effect argument may seem obvious by the way, but it might not be complete. Remember that declining home prices have a negative wealth effect on those who are long real estate, especially speculatively long, and the impact is likely to be immediate, but as these people are likely to be relatively wealthy, the impact on consumption might be limited. For Chinese who are effectively "short" real estate (young people, poor people, renters, migrant workers), declining home prices will have a positive wealth effect which, because they are poor, may affect consumption more, but may take longer because declining prices might not be immediately as credible to non-owners as to owners. I wouldn't suggest that the wealth effect impact of a real estate slump could be positive, but it might not be as negative as it was in Japan or the US.

This is a long way of saying that while Anne's research is first rate, mainly, I think, because she identifies and untangles chains of risk rather than build the data-intensive and largely misapplied math models that much of the sell-side prefers, I think the jury is still out. On the whole I still think the long-landing scenario is more likely than a collapse because Beijing does have levers and a stable, if inefficient, banking system, but my 3-4% number is for me a likely upper limit, not the expected growth rate. At any rate we shouldn't doubt that rebalancing is always the hard part, and because it was too long postponed, any distribution of predictions should come with very fat left-side tails.

Sorry for such a long comment, but because you seem to explain even my own arguments better than I can, I thought I would exploit your blog and get your reaction.

Michael Pettis

A lot of moving parts
I have had the greatest of respect for Pettis and I have been following him for many years. Because of his work, I have adopted his "long landing" scenario as my base case outlook for China. However, I did find a number of his comments to be interesting.

First, while he remains optimistic, the projected "best-case" rebalancing scenario of "average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption" is not his "most likely outcome".

As well, but he stated that he really does not "have a most likely outcome because (he) thinks the final result is likely to be highly path dependent". (Maybe he has been listening to Janet Yellen too much)

Notwithstanding the issues raised by Anne Stevenson, Pettis outlined a number of positive effects from a falling real estate prices, namely that the consumers who were priced out of the market will benefit, even though the effect will be longer term.

There are a lot of moving parts here. On one hand, Beijing appears to know what steps to take in order to rebalance growth. They appear to be taking the right steps in order to achieve their longer term objectives. On the other hand, near-term speed bumps, such as the buildup of credit, falling real estate prices, etc., serve to heighten the risk that the growth path slips over the precipice.

Under these circumstances, I believe that the most appropriate viewpoint comes from the most recent Howard Marks memo on risk:
The future should be viewed not as fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
The "long landing" scenario remains in play, but its probability has retreated a bit in view of the most recent developments.


Anonymous said...

It is almost certain that high real-estate prices dirve down consumption, if a large percent of the public is renting.

In the US, I guess percentage of home ownership is high, so falling house prices impact perception of wealth.

But if a large percentage of the public is renting, then falling prices would translate to lower rents, which would translate to higher consumption.

Anonymous said...

And what is the outcome if there is a regional war (intentional or unintentional)?