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When will China emerge from the global crisis?

By Michael Pettis

This posting is from the January 30 issue of my newsletter, and so ignores recent events in Chongqing, but of course those events make my discussion of the political debate  entry all the more relevant, I think.  Before getting to the policy debate, I want to mention that in late January Caixin, one of my favorite magazines, had an interview with Liu Mingkang, former China Banking Regulation Commission chairman. In it Liu says:

I’ve said in the past that this economic crisis will spread from the United States to Europe and finally land in Asia. Now we can see that it’s already begun influencing Asia.

In 2008 and 2009 I argued that the crisis we were undergoing would affect every major economy in the world, but not necessarily at the same pace. I suggested that the US typically is quick to adjust and, given the pace of deleveraging that was already taking place, I expected that it would be the first major economy out of the crisis, probably in the next two to three years, as private debt levels continue to decline and public debt growth slows.

China had an even bigger adjustment to make, but I worried that there were institutional factors that would slow down the adjustment process, especially with the expected change in leadership this year. Although I did not expect to see a serious contraction in growth until after 2013, I said that China would be the last major economy to emerge from the crisis. Why? Because the huge increase in investment it engineered to postpone the domestic impact of the global crisis exacerbated the imbalances within the economy and increased its already-excessive reliance on debt and investment to generate growth.

In 2009 (and even in 2010) I think some people thought these predictions were eccentric at best. This was mainly because they did not understand the relationship between the global trade imbalances and the crisis, and that the uneven adjustment process could extend over many years.  I used the LDC Debt Crisis of the 1908s as an example of how this can happen.  In the late 1970s, a surge of capital inflow (recycled petrodollars) spurred frenzied investment into LDCs, especially in Latin America, that made it seem that they had managed to avoid altogether the economic crisis suffered by the US and Europe in the mid-1970s. These inflows, however, only left the region with a huge amount of debt and a more difficult adjustment once borrowing capacity ran out in the early 1980s.

I expected something similar to happen again, with the crisis hitting developing countries much later than it hit the US and Europe. According to my view China’s investment surge would allow it to postpone the impact of the contraction in global demand and would also carry with it countries that relied on commodity exports. But ultimately – since the purpose of investment today is to serve higher consumption tomorrow – this would only make the ultimate adjustment all the more difficult when China would have to adjust anyway with higher debt and a less accommodating global environment.

By now I think the prediction that the US will be among the first and China among the last to escape the crisis no longer seems as eccentric. Others are making similar predictions. There is growing awareness that China has not yet addressed the changes forced upon it by the global crisis, and will have to do so soon. It has certainly become easier to see how the crisis has spread, as Liu points out, first from the US and then to Europe and now to Asia.

The debate over reform

In the interview he explains further how this is happening:

First, domestic and external demands have taken a sharp drop, especially in the second half of 2011 and first half of 2012. I think that the pressure to increase domestic demand is picking up. That is because domestic demand is driven by business productivity.

…But the consumption capacity of low-income citizens is limited. Demand on the part of middle- and upper-classes is dropping, especially in middle-class families. Everybody’s attitude is “let’s wait and see.”

Second, there will be even more pressure to change our development path in 2012…We urgently need to transform our business development models. It has become a choice between life and death.

Third, it’s hard to be optimistic about employment and stability. If some businesses evaluate market conditions and choose to close up shop or cut half of production, especially in the first half of 2012, there will be employment problems for migrant workers after Chinese New Year.

Fourth, after ten years in the WTO, China’s reliance on exports is relatively high. China is greatly affected by changes in the global economy. Commodity prices fluctuate rapidly, impacting China’s economy directly. It’s also worth paying attention to capital flow trends. In the third quarter, net inbound capital flow became capital outflow. It’s possible that such an exodus will continue into the first half of 2012.

Liu’s claim, that the need to change the business development model has become a choice between life and death, is pretty dramatic, but I think his point is an important one and is being increasingly heard within China. For example Saturday’s South China Morning Post has an article by Edward Ding An Hua, the chief economist of China Merchants Securities, in which he says:

There are two clearly opposing camps in China’s economic circle regarding the role of government. The first objects to government intervention and stresses the role of free- market mechanisms. The second believes in the unique advantage of a strong government in driving growth.

…What is strange, however, is that the two don’t actually fiercely disagree but, rather, appear to be in remarkable accord over long-term economic issues. Both adopt the same language; such as “adjust the structure” and “change the economic growth model”.

However, regrettably, the Chinese language is a concise but not precise language that often omits the subject in a sentence. In this way, a key subject can be omitted or “harmonised”. The free-market camp unilaterally interprets the subject as the market mechanism, while the strong-government camp quietly furthers their viewpoint of strengthening the role of government in the economy.

Reforming corporate governance

It is important to note, as Ding points out, that it is not just Liu who is thinking along these lines. There were for example two other interesting articles last week in Caixinwhich I think are useful in understanding China. The first article, by Wang Lan, addresses the problem of SOEs in China.

Before discussing the article, I should note that last week’s issue of The Economisthas a special section on state capitalism. This includes a debate on state capitalism. There was nothing especially new in the debate, and I suspect that a relatively uncontroversial claim might be that state-directed investment can be a very useful way to overcome failures of the domestic financial markets to allocate capital to projects that, especially when you include externalities, have positive returns for the economy. This was Alexander Gerschenkron’s argument back in the 1940s and 1950s.

At some point however it becomes very to identify such projects, but given pricing distortions and political imperatives it is also hard to pull back, in which case we typically see wasted investment and misallocated capital. This is when the process becomes value destroying rather than value enhancing, and it can occur over many years before it is finally reined in, typically by the unsustainable debt levels that accompany state-directed wasted investment.

Wang’s article addresses one consequence of state investment in his Caixin article. He says:

In recent years, the enormous profits of state-owned enterprises (SOEs), once widely considered a good thing, have come under public scrutiny. The core of the problem is monopoly. SOE bigwigs are rapidly expanding their monopolies, relying on growing scale and rising prices to extract huge profits. But these companies bring little technical or organizational innovation to the table.

The vitality of the Chinese economy is being stifled by SOEs, especially central-level, or top, SOEs, and this is borne out by research. In October 2011, the State-Owned Assets Supervision and Administration Commission of the State Council (SASAC) released a breakdown of state-owned assets and earnings information for 102 for-profit SOEs. This showed that in 2010, the capital of 102 central-level SOEs was equivalent to 61.4 percent of GDP, and their earnings equaled 42.2 percent of GDP… The second national economic census taken in 2008 reported profits of nearly 900 billion yuan by finance industry central-level SOEs. Banks accounted for 64 percent of that profit.

These gargantuan SOEs have not only failed to lead us toward a new stage of development, but they have actually inhibited the vitality of the Chinese economy by distorting resource allocation.

Wang recommends that Beijing begin a privatization process to wean SOEs from their addiction to excessively cheap capital, monopoly power, and distorted governance. This, he says, will force the SOEs to address and resolve their role in wasting capital, stifling innovation, and concentrating wealth. It will also allow China to grow in a much healthier and balanced way.

I have always thought that the least painful way for China to rebalance its economy requires that it radically redistribute income and wealth away from the state sector and to the household sector. There are many ways this can happen, some better and some worse, but privatizing SOEs and using the proceeds to clean up the banks (whose NPLs are a future claim on households), to shore up the social safety net, and to permit SME’s more scope in which to compete is, in my opinion, the most efficient ways to do so. It would also weaken sectors that are able to restrain change in the economy.

Returning to the system

Of course for that very reason there are likely to political impediments to such a solution, and for many years we were told that privatization was pretty much out of the question in China. I disagree, and have argued often that within two or three years the constraints imposed by the current growth model will ensure that policymakers and their advisors in Beijing will be discussing privatization much more actively.

In that light it is interesting to see that in the past year or two the topic has come up more and more regularly in domestic debates. Wang Lan’s article seems to be part of this debate. This discussion actually ties into the second Caixin article, by Tsinghua University sociology professor Guo Yuhua. Guo starts by referring to a deep malaise in the country:

What is the most common feeling in China today? I think many people would say disappointment. This feeling comes from the insufficient improvement in their lives that people are achieving amid rapid economic growth. It also comes from the contrast between the degree to which individual social status is rising and the idea of the “rise of a great and powerful nation.”

Guo goes on to argue that a main source of the problem is the limited and declining opportunities arising outside the state system:

The disappointment of being unable to extricate oneself from difficulty is, of course, not restricted to college graduates. In opportunities for education, employment, promotions and overall improvement of their lives, people are discovering that society’s resources and opportunities are increasingly concentrated in the hands of a few. People in the middle and lower strata of society are becoming increasingly marginalized and are finding that improving their lives is getting harder.

The 2004 China Social Mobility Report published by China Academy of Social Sciences said that people whose fathers have power or capital have an easier time becoming party cadres than people in general. Research into the changes in private businesses ownership after 1993 showed that the elite in non-business fields were more likely to own businesses today. Thus, opportunities for common people to start private businesses are fewer and fewer. It is exceedingly difficult for farmers moving to a city to find success. The registered permanent residence system and economic factors conspire to make this move very difficult.

A social trend has been captured by the phrase “returning to the system,” which refers to resorting to traditional means of advancement. The number people signing up for the national civil service examination was 600,000 in 2007, 800,000 in 2008, 1.1 million in 2009, and 1.5 million in 2010, a clearly rising trend. “Returning to the system” has become the main method for members of society to climb the social ladder.

Guo asks for a more robust social system in which the benefits of economic growth are not so heavily skewed towards a political elite and in which members of the various strata below the elite have increased opportunities of participating in the economic process:

Power is becoming too formidable and cruel. It is out of control, and without limits. It has kidnapped society and strangled reform. Facing this, finding a solution is a matter of vital importance. In a situation where special interest groups have choked off the possibility of various types of progress, building a just society and enacting reform is difficult. Moreover, there is not a ready-made civil society waiting to settle into the void.

We need to realize several things. The impetus for reform comes from society, not from authority, and reform within the system is produced under the force of social strength. Fair and just rules are formed by interaction between various forces. Civil society is produced by the participation of citizens. Extrication from stagnation and the restoration of social vitality can only come from the start of civil consciousness and civil action. Only by empowering society and enlightening citizens can the strength to reform be developed.

Reform and rigidity

Large-scale privatization, of course, is not the only, or even the main, “solution” to the problems that Guo identifies, but if done correctly it can be part of the solution by undermining entrenched power and adding flexibility to the country’s governance structure. What is especially interesting, at least to me, is that an increasing number of commentators within China are identifying the social and economic rigidities imposed by the state system as crucially important in constraining China’s future economic and political growth.

This is becoming a pretty contentious debate. Over the past several months, in fact, we have seen a noticeable surge in articles and reports like this one – often by very prominent academics and policy advisors – criticizing the power of special interests in China. Their main concern seems to be over the constraints these special interests impose on further Chinese development, with the entrenched interests that have benefitted over the last decade or two having become so powerful that they are making it increasingly difficult for China to adjust.

A lot of very smart people in China, in other words, seem to be worried that the country’s governance structure and its development model are no longer able to accommodate the needs of the economy and that it is vitally important to confront the entrenched interest that make change difficult. This is sometimes presented in the foreign press as the debate between the “Chongqing” model versus the “Guangdong” model.

I apologize for the rather abstract and dry description in this and the three previous paragraphs of what is actually a gripping and very interesting topic, but for perhaps obvious reasons this is something about which I am reluctant to say too much. Still, anyone trying to predict China’s economic outlook for the next few years should be very aware of this fierce debate.

This is an abbreviated version of the newsletter that went out three weeks ago.  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 want to buy a subscription should write to me, also at that address.

Michael Pettis

About 

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987. Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University. He writes the blog .

2 Comments

  1. GaryJ says:

    How do you define “escape the crisis” – its easy to be always right with such a subjective comment. Why not agree on a visible benchmark like whose overnight cash rate is the first to 5%. Generally considered a neutral rate consistent with trend growth.

    I bet China “escapes the crisis” first…