Chinese growth in 2011

by Michael Pettis

For the past two months there have been very strong rumors in the markets that next year’s new lending quota was going to be set somewhere between RMB 6.5 trillion and RMB 7.0 trillion.  For comparison’s sake, total new lending last year amounted to RMB 9.6 trillion, and this year the quota was RMB 7.5 trillion.

But to me RMB 6.6-7.0 trillion seemed likely to be low (and ”low” is a relative word here – compared to the years before 2009 these are actually very large numbers).  We have been telling clients for months, for example, that even ignoring the reportedly large amounts of loans shifted off bank balance sheets this year, it was very unlikely that 2010 would end with new lending below the RMB 7.5 trillion quota.  In fact by the end of November we were already over RMB 7.4 trillion, so I suspect we are going to finish the year with total new lending at pretty close to RMB 8 trillion.  Add in the loans taken off bank balance sheets and we have easily blown through the 2010 quota.

Tuesday’s South China Morning Post has an article suggesting that we may have been right:

China will probably target a limit of about 7.5 trillion yuan (US$1.1 trillion) in new loans next year, the same as this year’s target, a leading official newspaper reported on Tuesday, an indication that policy could be slightly looser than expected.  Control of credit issuance is one of the most important monetary policy tools in China and many in the market had assumed that Beijing would lower the new lending objective next year as a way of tamping down on inflationary pressures.

But the report on the front page of the China Securities Journal, citing an unnamed source described as authoritative, suggested otherwise.  “The Chinese economy is very big now and a target of 7.5 trillion yuan in new loans will not trigger all-round inflation,” the newspaper quoted the source as saying.

The quota hasn’t been set, and may even be set at RMB 8 trillion, but even this number is, I suspect, going to be lower than the reality.  It is proving very difficult to keep growth up in China except with massive increases in bank-driven investment, even though this year China got a lot of help from the surge in the trade surplus.  Next year I suspect it will be much more difficult to count on a surging trade surplus to generate domestic growth, and consumption is not going to kick in, so we are pretty much left with growing investment if policymakers want to keep growth rates in the 9-10% range, which they almost certainly do.

Part of this unbalanced investment-driven growth will be supported by hot money inflows, which are already worrying the PBoC.  Here is what an article in Tuesday’s People’s Daily said:

State Administration of Foreign Exchange (SAFE) stressed the need to strengthen supervision of cross-border capital flows on Dec. 13. It also advocates actively responding to and fighting against hot money and other unusual cross-border capital flows as well as guarding economic and financial interests of national security.

To safeguard national economic and financial security, from the beginning in February 2010, China has been cracking down on hot money. SAFE is organizing special actions in some cities that have a large volume of foreign exchange business.

As of the end of October this year, a total of 197 cases of foreign exchange violations have been verified, and the total amount of money involved reached 7.34 billion U.S. dollars.

SAFE recently issued a document on the further regulation of trade, foreign direct investment, return investment, overseas listing and other sources of cross-border funds flows. These guidelines aim to strengthen banks’ short-term external debt management and obligations to examine the authenticity in the foreign exchange business. This will further aid the crackdown on illegal capital inflows and prevent financial risks brought by cross-border “hot money” inflows.

Hot money inflows are at least part of the reason why the PBoC has been so slow to raise interest rates, and this is likely only to get worse over the next few months.

The new normal

On Wednesday an article in the People’s Daily trumpeted a Merrill Lynch report that said 9% growth was the “new normal” for China.

The Chinese economic growth is forecast to slow to 9.1 percent in 2011, from an estimate of 10.3 percent this year, and the 9 percent growth is expected to be a new norm for China in the post-crisis period, Bank of America Merrill Lynch said in a regional economic outlook report released on Tuesday.

After fluctuations since late 2008, China’s gross domestic product (GDP) growth has stabilized at about 9 percent in both year on year and sequential terms, in comparison with the average 11-percent growth in years before the crisis, said the report.

…From 2012 to 2015, the report forecast the Chinese economy is likely to expand by 9 percent, 8.5 percent, 8 percent and 8 percent, respectively. And for the subsequent five years of 2016- 2020, China’s GDP growth might average at 7 percent.

It is interesting that the consensus is starting to shift downwards, and that 9-10% for the rest of the decade is no longer the default expectation, but I am not sure that even the Merrill Lynch numbers are plausible.  I think too many economists are seriously underestimating how difficult the transition to a new growth model is likely to be.

Still, we are starting to see a shift in expectations.  Perhaps symbolic of that shift is an article in last week’s New York Times by the always-perceptive David Barboza:

For nearly two years, China’s turbocharged economy has raced ahead with the aid of a huge government stimulus program and aggressive lending by state-run banks.  But a growing number of economists now worry that China — the world’s fastest growing economy and a pillar of strength during the global financial crisis — could be stalled next year by soaring inflation, mounting government debt and asset bubbles.

Two credit ratings agencies, Moody’s and Fitch Ratings, say China is still poised for growth, yet they have also recently warned about hidden risks in its banking system. Fitch even hinted at the possibility of another wave of nonperforming loans tied to the property market.

In the late 1990s and early this decade, the Chinese government was forced to bail out and recapitalize these same state-run banks because a soaring number of bad loans had left them nearly insolvent.

Those banks are much stronger now, after a series of record public stock offerings in recent years that have raised billions of dollars from global investors.  But last week, an analyst at the Royal Bank of Scotland advised clients to hedge against the risk that a flood of cash into China, coupled with soaring inflation, could result in a “day of reckoning.”

I already wrote in early November an entry suggesting that we were starting to see some leading Beijing policymakers and advisors warning about a rapid slowdown in growth – the numbers bandied abut were in the 6-7% range.  This is till very much a minority view, but I have almost no doubt that during 2011 all the growth expectations are going to be revised sharply downward.  By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.

Do I believe these lower numbers?  Not really.  About a year and a half ago I wrote in a Financial Times article that, assuming consumption growth could be maintained at 8-9% a year, Chinese GDP growth would average 5-7% annually over the rest of the decade.

My prediction caused a lot of strong disagreement and accusations of being overly pessimistic, but the truth is I think I was being optimistic.  If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range.  But I do think the consensus next year will migrate down to the 6-7% range, even though next year’s growth should remain high – probably in the 9% range.

Slowing growth?

Will that be a disaster?  Here is where I disagree with Barboza’s article.  He says:

A sharp slowdown in China, which is growing at an annual rate of about 10 percent, would be a serious blow to the global economy since China’s voracious demand for natural resources is helping to prop up growth in Asia and South America, even as the United States and the European Union struggle.

And because China is a major holder of United States Treasury debt and a major destination for American investment in recent years, any slowdown would also hurt American companies.

I am not sure why Chinese holdings of USG bonds suggest that a Chinese slowdown will hurt US companies, but I have already explained why I do not think a sharp slowdown in Chinese growth is necessarily bad for the world.  It will be very bad for commodity exporters – or at least non-food commodity exporters, since I think the demand for food from China will continue strong – but the overall effect on the rest of the world depends on the evolution of China’s trade balance.  A contraction in the surplus creates net demand for the world, and so might even be marginally positive.

This marginally positive outcome won’t be evenly distributed, of course.  Non-food commodity exporters will be badly hurt, while commodity importers and manufacturers will benefit.

I don’t even think such a rapid slowdown in Chinese growth will be bad for China.  Again it depends on how it takes place.  If there is a serious attempt at rebalancing the economy by raising wages, interest rates and the currency, China can manage a much slower GDP growth rate while still maintaining a fairly high growth rate in household income and consumption.  I discussed this in more detail in an entry last moth.

In the spirit of end-of-the-year pieces let me suggest a few things to watch for 2011.  First, although I do not believe inflation is going to be as big a problem as many think (I believe the Chinese financial system has a built-in inflation-stabilization mechanism – see my November 18 entry), if I am wrong and inflation continues to rise, this will create a real problem for monetary policy.

Second, debt levels are worryingly high and are starting to act as a serious constraint on the rebalancing process.  My friend Victor Shih at Northwestern University has done great work in trying to figure out the government balance sheet, and he worries, correctly, in my opinion, that it is becoming increasingly difficult for the PBoC to raise interest rates without creating a great deal of financial distress in government-related entities.  Even the PBoC balance sheet is a real problem.  How can they raise RMB interest rates without running a huge negative carry?

Third, the trade constraints are going to get worse, not better. Ashoka Mody and Franziska Ohnsorge have a very interesting piece on Vox that suggests that we shouldn’t count too heavily on consumption growth in the developed world to boost global demand.  That means we are going to spend the next few years fighting over anemic demand growth, and we will be apportioning that demand via trade disputes.

Fourth, although GDP growth rates next year will be very high to see off the current leadership, I am pretty sure that by the end of the year there will be much more concern about the rebalancing process and what that will mean for growth rates.  In order to get those high growth rates, I don’t think we need to take the 2011 lending quota too seriously.  Whatever it is, it will be breached.

Happy holidays and have a great 2011.