By Michael Pettis
Most of this week’s newsletter was about the release last week of China’s fourth quarter GDP growth numbers by the National Bureau of Statistics (NBS). You can find the full NBS report on their website, but here is the key paragraph:
According to preliminary estimation, the gross domestic product (GDP) for the year 2010 was 39,798.3 billion yuan, up by 10.3 percent at comparable prices, or 1.1 percentage points higher than that in the previous year. In terms of growth by quarters, it was up 11.9 percent for the first quarter, 10.3 percent growth for the second quarter, 9.6 percent for the third quarter and 9.8 percent for the last quarter.
This places China’s official GDP for 2010 at a nice, round $6.0 trillion. There is of course a lot more interesting stuff in the NBS report. Those who are worried about excess investment will find it hard to see the data as anything other than worrying. Investment has gone up 23.8% from last year’s already sky-high numbers, and even the best consumption numbers merely reinforce the sense that there has been no rebalancing – three of the four consumption items that registered the most rapid growth were actually investment related.
All this investment-driven growth seems to have come as a surprise to many people and caused the markets in China and around the world to drop. I think the markets are right to be very nervous. The latest growth numbers are likely to cause real concern in policymaking circles and lead Beijing to do something to slow it down. Do what? Raise interest rates, I hope, and that is what I think the markets are most afraid of.
There were also rumors that the PBoC is going to cut the 2011 loan quota by 10% from the 2010 quota. I don’t believe it. Or rather I believe the PBoC will try to constrain monetary and credit growth, because they are genuinely worried about more misallocated investment and the threat to bank balance sheets, but this is really not something that the PBoC can decide. The growth in credit will be whatever it needs to be to achieve the GDP growth rates the State Council has decided upon.
To move on to another subject, one of the most entertaining parts of observing China’s economy is to watch the frantic race between various Wall Street houses (and a few other players) to predict the earliest date by which China’s economy will surpass that of the US to become the world’s largest. This of course is part of the standard Wall Street hype that accompanies any hot market. I think that so far the winner (I forget who) came in with a prediction of 2017.
But last week in a report a new entrant trumped everyone, although maybe by fudging a little. This new entrant claims that China’s GDP is already bigger than that of the US, according to PPP measures.
Perhaps that’s unfair because everyone else is using market exchange rates, and the poorer a country, the higher the PPP adjustment tends to be, but it certainly upped the ante. If any bank researcher wants to beat him, he is going to have to argue that China’s economy surpassed the US before 2010.
Here is what the author of the report, Arvind Subramanian at the Peterson Institute, says on the institute’s website:
Cross-country comparisons of economic size and standards of living of the average citizen rely on two approaches. The first uses market exchange rates to convert the economic value of goods and services produced around the world into a common currency, usually the dollar. According to the IMF’s latest estimates for 2010, the value of total US GDP was $14.6 trillion while that of China was $5.7 trillion.
…My calculations (explained in greater detail below) based on the most recent version, which is due in early February, show that the size of the Chinese economy in 2010 was about $14.8 trillion dollars—surpassing that of the United States.
So there you have it. China’s economy is already bigger than the US economy according to PPP. I am not disputing Subramanian’s numbers, but comparisons between two such disparate economies on a PPP basis of course have no meaningful content at all. The fact that it is much cheaper to get a haircut or massage in China (something the latter of which I am happy to exploit voraciously) tells us very little about the two countries that we wouldn’t have already known.
Still, it’s exciting, and guaranteed to generate headlines. Last year we had one “sorpasso”, that of China overtaking Japan according to market exchange rates, and this year we have another, that of China overtaking the US according to PPP rates.
But excitement aside, this whole exercise is pretty meaningless, and not only for the reason you might think – that economic growth is not a horse race between countries. It is meaningless for a far more fundamental reason, and this is because the comparable official GDP numbers for China (and PPP numbers start with the official numbers and then adjust for local prices) are wrong.
GDP may be higher
I am not just saying this because, according to Wikileaks, Li Keqiang doesn’t take the official GDP numbers too seriously. This was widely reported, but isn’t really news. None of us take the official GDP numbers too seriously, especially since it is almost impossible to produce good data in a large economy that is transforming itself so rapidly. I am saying that the GDP numbers are wrong for a more fundamental reason.
GDP is supposed to measure the total value of goods and services produced in China, but there are several problems with the official numbers. There are problems with all GDP numbers, but the biases, especially in the developed countries, are fairly consistent, which makes cross-country comparisons more or less meaningful. But in China there are additional problems, which make cross-country comparisons very complicated.
First of all we know that a lot of Chinese income – more than in most other major countries – is hidden, for whatever reasons, and this tends to pull down reported GDP numbers. One plausible recent estimate is that roughly 10% of total income is hidden beyond the NBS surveys, and so this suggests that GDP might really be substantially higher.
I wrote about this in my blog in my August 8 entry. I have no idea if this 10% number is correct or not – the NBS insists that their surveys are more accurate – but clearly there is room for a lot of fudging, and the amount of the fudge can be significant.
Second, when you compare the US and China (or any two countries), you have to think carefully about the exchange rate you’re using. The standard method is to use the current market exchange rate, not because it is the conceptually correct exchange rate, but rather because it is broadly meaningful when you think about international trade and, more than anything else, it is objective. At any point in time I can convert any Chinese GDP number into its incredibly precise dollar equivalent.
But what if you believe that the RMB is undervalued by 20% and held there only because of PBoC intervention? Doesn’t that mean that if the PBoC were to stop intervening China’s GDP would automatically be 20% larger relative to the US?
Yes, it should be larger, but not by 20%. The difference should be less than 20%, but how much less depends on how much of China’s GDP growth can be explained by the undervalued currency.
If part of the country’s high growth rate is a consequence of the undervalued exchange rate, and certainly Beijing seems to believe it is, than raising the value of the RMB would automatically cause a slowdown in Chinese growth. That is why analysts should consider the relationship between the two when they make projections, and by the way they are implicitly (if not very accurately) doing so when they calculate PPP numbers.
GDP may also be lower
But there is more. So far nearly all the adjustments and predictions about Chinese growth that we have seen in the press suggest that the “real” size of China’s economy requires upward revisions of official GDP numbers, but that might reflect China hype more than a judicious approach might justify. What if China’s GDP numbers seriously overstate the true value of China’s economy?
There are at least two very good reasons to believe that they might. The first is environmental degradation. To understand why, it is worth remembering that if an individual earns $100, but in so doing destroys $100 worth of his own assets, then a strict accounting would say that he earned nothing.
The same is true with the environment, which has a real economic value that can be adversely affected by certain kinds of economic activity. For example here is an article that came out four months ago on Bloomberg:
China, the world’s worst polluter, needs to spend at least 2 percent of gross domestic product a year — 680 billion yuan at 2009 figures — to clean up 30 years of industrial waste, said He Ping, chairman of the Washington-based International Fund for China’s Environment. Mun Sing Ho, a senior economist at Dale W. Jorgenson Associates and a visiting scholar at Harvard University in Cambridge, Massachusetts, put the range at 2 percent to 4 percent of GDP.
Failure to spend that much — equivalent to the annual GDP of Vietnam — may cost the Chinese economy half as much again in blighted crops, health costs and pollution-related expenses, He said: “The cleanup can’t catch up with the speed of pollution” if spending is less.
This article suggests that a significant portion of Chinese growth came with a destruction of value that should have been deducted from that growth. After all, if you create net $100 of chemicals, but in so doing you pollute a nearby river to the extent that future economic production associated with the river is reduced by $100 (there will be less fishing, perhaps, or less agricultural production, or less usable water, or more health care costs), then the net value you created is 0, not $100, although of course you as the polluter might earn $100 today while the rest of the country loses $100 over the future.
There is no objective way to figure out how much of Chinese GDP growth should be reversed because of environmental degradation (and in this China is simply an extreme case – most countries to a lesser extent have this problem), but there is no question that the number is big, and the result is that we overestimate China’s GDP growth today and will underestimate GDP growth tomorrow. In other words environmental degradation simply causes us to take future growth and count it today.
And it is not just environmental degradation that may require a downward adjustment in GDP. What about misallocated investment? Doesn’t that do the same thing?
Of course it does. If you invest $100 today to create only $80 dollars of value, you will show an increase in today’s GDP that is lower than the reduction in tomorrow’s GDP as you pay the capital cost of the investment. In that case if you really wanted GDP to account for changes in a country’s wealth, your investment should have shown up as an actual reduction in today’s GDP. This means, once again, that you would overstate growth today and understate it tomorrow.
Every country wastes investment, but China does it on a massive scale. I would argue that at least 1-2 percentage points of Chinese growth, perhaps even more, might consist of this kind of misallocated investment-driven growth.
When you add the impact of misallocated investment and environmental degradation, the necessary cumulative adjustment to Chinese GDP might be huge. For example, if the two adjustments combined range from 2 to 4 percentage points annually, over one decade China’s “true” GDP (whatever that means), would be below the official numbers by anywhere from 16-31%. Over twenty years official GDP would be overstated by 31-52%. That means that we are massively overstating GDP today and will experience very low apparent GDP growth for many years in the future as the official number returns to some reasonable approximation of the real number.
These are big adjustments, both above and below the official GDP numbers. This is why I find the whole horserace to predict the earliest date by which China’s economy will overtake the US to be so silly. What we are in effect doing is predicting the date by which an economy that is officially $6 trillion, but in reality anywhere from $3 trillion to $15 trillion in size, will overtake another economy that is roughly around $15 trillion in size.
And this is not the first time we have played this game. Look at Japan. Fifteen to twenty years ago Japan’s GDP was officially 17-18% of the world’s GDP and it was rapidly catching up to the US. Today it is 8%, and there seems to be no chance of it every catching up.
But can this really be true? Or is it possible that Japan’s official GDP growth was vastly inflated by misallocated investment before 1990, and vastly deflated by the repayment of that investment after 1990?
I think it’s the latter. If you look at the growth in Japan’s household consumption, you will find that household consumption grew much more slowly than GDP before 1990, and much more quickly after 1990. Household consumption might be at least as good an indictor of the real growth in wealth as production-side GDP numbers. So might it not be true that Japan’s official GDP was too high before 1990, and it has been slowly adjusting since then? And if this could have happened in Japan, whose investment growth was high but way below China’s, why can’t it happen here?
Under these conditions what’s the point of predicting when China’s economy will officially overtake the US? We simply have no idea, and we cannot draw any conclusions from the numbers. Can the horserace generate headlines? Yes. Can it generate understanding? Not much.
This is an abbreviated version of the newsletter that went out Monday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me at that address.