Friday, September 5, 2014

The Pettis China "long landing" hits an air pocket

Noted China watcher Michael Pettis recently wrote a new blog post entitled "What does a good Chinese adjustment look like?". In it, he details his growth scenarios for China:
The not between a hard landing and a soft landing. China will either choose a "long landing", in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing - a few years of continued growth of 6%-7% - followed by a collapse in growth and soaring unemployment.

A "soft landing" would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A "soft landing" should increase our fear of a subsequent "hard landing". It is not an alternative.
Pettis believes that the "soft landing" is the "this will not end well" scenario for China. The so-called "long landing" is the optimistic scenario in China's four stages of growth:
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.
Pettis remains optimistic that Beijing can pull it off:
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. In this issue of the newsletter I want to write out a little more explicitly what such an orderly adjustment might look like.
The one key ingredient of the "long landing" scenario is achieving the Third Plenum objective of rebalancing from credit-driven infrastructure driven growth to the consumer driven growth. This involves the ending, or at least, the reduction of financial repression, which lowered the cost of capital for SOEs at the expense of the household sector as regulated banking interest rates were driven to below zero in real terms by the central government.
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.
As financial repression gets reduced, China enters a virtuous growth cycle:
Over time this means that households will retain a growing share of China’s total production of goods and services (at the expense of the elite, of course, who benefitted from subsidized borrowing costs) and so not only will they not be hurt by a sharp fall in GDP growth, but their consumption will increasingly drive growth and innovation in China.
Pettis ended his post with a hopeful prescription and outcome for the Chinese growth path and social stability (emphasis added):
If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%. Remember that by definition rebalancing means that household income must grow faster than GDP (as happened in Japan during the 1990-2010 period).

This has important implications. First, the idea that slower GDP growth will cause social disturbance or even chaos because of angry, unemployed mobs is not true. If Chinese households can continue to see their income growth maintained at 5% or higher, they will be pretty indifferent to the seeming collapse in GDP growth (as indeed Japanese households were during the 1990-2010 period). Second, because consumption creates a more labor-intensive demand than investment, much lower GDP growth does not necessarily equate to much higher unemployment.
In other words, the economy does not necessarily have to grow at a breakneck pace in order to maintain social cohesion for Chinese society. As long as the average household sees a decent increase in its standard of living, Beijing can keep a lid on social tension and maintain the Mandate of Heaven.

Watch out for the reverse wealth effect
I had long been a disciple of Michael Pettis and I was optimistic that "long landing" scenario could be achieved. That was until I saw David Keohane of FT Alphaville highlight a note from JCapital indicating how consumer spending was intricately tied into the health of the property market:
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.
Here is the problem:
Now, the decline in spending we are seeing in each of the cities we survey is going hand in hand with the reduction in investment in new property. Absent a miraculous new source of fast wealth, there is no reason why consumption should not return to the pre-boom level, where it was in about 2006. The land-driven bonanza is over.
Keohane added:
That’s the tricky thing. Consumption is really rather tightly and obviously linked to property investment (and inequality) so forcing a new middle class into existence isn’t going to be easy if/when this round of investment-led money dies off and the property market corrects.
What we have seen is a wealth effect in action as property prices in China have boomed. Analysis from George Magnus shows that while investments in a number of Tier 1 cities look fine, Tier 2 and 3 cities are showing signs of oversupply.

China: Investment and growth by city

Already, the cracks are showing. The latest figures from JP Morgan show that house price declines are spreading to 91% of the cities. In particular, prices in Tier 3 cities are cratering.

What we are seeing, in effect, is the reversal of the wealth effect in China. Because regulated bank interest rates were negative in real terms, savings went either into wealth management products or real estate - and there was leverage in much of those real estate holdings.

When consumer spending is "tightly and obviously linked to property investment", how does rebalancing occur? How can China, as David Keohane puts it, "force a new middle class into existence"?

These conditions call for a serious re-evaluation of China`s growth path. The Pettis "long landing" scenario just hit a major air pocket and its likelihood is quickly diminishing.


Anonymous said...

So what do YOU think? That China will have a tough time or get through it.

WimpyInvestor said...

I know you don't comment on individual stocks, but could you make an exception (just this one time).

I would love to hear your thoughts on the Chinese economy by reviewing the Alibaba IPO video (available through Retail Roadshow website).

I have a hard time reconciling the soft landing or hard landing bearish China scenarios after hearing all the growth prospects oming from all aspects of the Chinese economy (e.g., wholesale trade, retail commerce, logistics buildout, service sector, small merchants, electronic payments, mobile advertising, location based services, etc, etc).

Alibaba Group in China is equivalent to combining US market players like Ebay, Amazon, TripAdvisor, Groupon,, Paypal, Square, Yelp, Visa, UPS / FedEx, etc, and all the metrics are growing strongly, so how can China "collapse" anytime soon?

Cam Hui, CFA said...

To the extent that Alibaba is a consumer oriented company, it should be better insulated from any collapse in China.

As for the other question from Anonymous, I will leave you a quote from the latest Howard Marks commentary on risk:

The future should be not be viewed as a 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.

My post just indicated a shift in the probability distribution.