Seeing The Bigger Picture

Originally published in the September 2011 issue

Markets have been crazy this month, but rather than try to wade through all the news, much of which doesn’t seem to have much informational content, I thought I would duck out altogether and instead make a list of things I expect will happen over the next several years. We are so caught up in noise and market volatility – as the market swings first in one direction and then, as regulators react, in the other direction – that it is easy to lose sight of the bigger picture.

My basic sense is that we are at the end of one of the six or so major globalization cycles that have occurred in the past two centuries. If I am right, this means that there still is a pretty significant set of major adjustments globally that have to take place before we will have reversed the most important of the many global debt and payments imbalances that have been created during the last two decades. These will be driven overall by a contraction in global liquidity, a sharply rising risk premium, substantial deleveraging, and a sharp contraction in international trade and capital imbalances. To summarize, my predictions are:

• BRICs and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.

• Over the next two years Chinese household consumption will continue declining as a share of GDP.

• Chinese debt levels will continue to rise quickly over the rest of this year and next.

• Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.

• Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

• If the People’s Bank of China (PBoC) resists interest rate cuts as inflation declines, China may even begin slowing in 2012.

• Much slower growth in China will not lead to social unrest if China meaningfully rebalances.

• Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.

• European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.

• Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.

• Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

• Trade protection sentiment in the US will rise inexorably as unemployment stays high for a few more years.

There is nothing really new in these predictions. These are more or less the same predictions – based largely on historical precedent and the logic of the global balance of payments mechanisms – that I have been making for the past five or six years (or the past 11 years on the breakup of the euro), but I thought it would be helpful to list them.

Note that although at first glance some of these predictions seem unrelated to others, in fact they all flow from the same basic balance of payments and balance sheet frameworks. To explain each in greater detail:

• There has been no decoupling of developing economies, or more narrowly the BRICs, from the developed world. All that has happened is that the transmission from one to the other has been delayed.

Since most global consumption comes fromthe US, Europe and Japan, the collapse in their demand will ultimately be very painful for the BRICs and the rest of the developing world. The latter have postponed the impact of contracting consumption by increasing domestic investment, in some cases very sharply, but the purpose of higher current investment is to serve higher future consumption. In many countries, most notably China, the higher investment will itself limit future consumption growth, and so with weak consumption growth in the developed world, and no relief from the developing world, today’s higher investment will actually exacerbate the impact of the current contraction in consumption.

This delayed transmission, by the way, is not new. It also happened in the mid-1970s with the petrodollar recycling. Economic contraction in the US and Europe in the early and mid-1970s did not lead immediately to economic contraction in what were then known as the ‘least developed countries’ or LDCs, largely because the massive recycling of petrodollar surpluses into the developing world fueled an investment boom (and also fueled talk about how for the first time in history the LDCs were immune from rich-country recessions). When the investment boom ran out in 1980-81, driven by the debt fatigue that seems to end all major investment booms, LDCs suffered the ‘lost decade’ of the 1980s, especially those which suffered least in the 1970s by running up the most debt.

No BRIC decoupling
This time around a huge recycling of liquidity, combined with out-of-control Chinese fiscal expansion (through the banking system), has caused a surge in asset and commodity prices that will have temporarily masked the impact of global demand contraction for BRICs. But it won’t last. By the middle of this decade the whole concept of BRIC decoupling will seem faintly ridiculous.

• By 2013 Chinese household consumption will still not have exceeded the 35% of Chinese GDP reached in 2009. In fact it will probably be lower.

For much of the past decade there has been a growing recognition that Chinese growth has been seriously unbalanced, as Premier Wen put it, and that at the heart of the imbalance has been the very low consumption share of GDP. In 2005, when consumption hit the then-astonishing level of 40% of GDP, there was a widespread conviction in policy-making circles that this was an unacceptably low level and that it left Chinese growth much too dependent on the trade surplus and on increases in domestic investment. At the time the former seemed a more dangerous risk than the latter – although even then massive overinvestment was China’s true vulnerability – but I think by now there is a rapidly developing consensus that investment, and the unsustainable concomitant increase in debt, is China’s biggest problem.

That is why Premier Wen listed the need to raise the consumption share of GDP second in his speech last March before the unveiling of the new Five-Year Plan. This time, the message seems to be, they are serious about doing it.

But I remain very, very sceptical. Low consumption levels are not an accidental coincidence. They are fundamental to the growth model, and the suppression of consumption is a consequence of the very policies – low wage growth relative to productivity growth, an undervalued currency and, above all, artificially low interest rates – that have generated the furious GDP growth. You cannot change the former without giving up the latter. Until Beijing acknowledges that it must dramatically transform the growth model, which it doesn’t yet seemed to have acknowledged, consumption will continue to be suppressed.

• In the rest of 2011 and during all of 2012 Chinese debt levels will continue to rise very quickly, in spite of attempts to slow the growth in debt.

The attempts to rein in debt growth will fail because they address specific areas of debt and not the overall tendency of the system to generate debt. So although there may be more pressure to rein inlocal government borrowing, for example, this will probably fail, and if it succeeds it will only be because other entities, most probably locally controlled state-owned enterprise or SOEs, are enlisted to fill in the gap. My guess is that next year the general alarm among investors will have switched from local government debt to SOE debt, not because the former will have become manageable, but rather because the latter will surge, albeit in not-always-transparent ways.

Investment pumps up growth

With consumption growth constrained and the external environment unsound, increasing investment is the only way to keep GDP growth rates high. China funds almost all of its major investments with bank debt, and it long ago ran out of obvious investments that are economically viable – at least investments that are likely to be generated by what is a distorted system with very skewed incentives – so increases in investment must be matched by increases in debt.

To the extent that investments are not economically viable, this means that the value of debt correctly calculated must rise faster than the value of assets. By definition this results in an unsustainable rise in debt.

• By 2013-14 Chinese GDP growth will slow sharply, and by 2015-16 predictions of a sustained period of growth rates at 3% or lower will no longer seem outlandish.

I don’t expect a significant growth slow-down until after the new leadership takes power in late 2012, but my guess (and hope) is that by 2013 the stubborn refusal of consumption to rise as share of GDP, and the continuing surge in debt, will have convinced all but the most recalcitrant that China needs a dramatic change of policy. The longer we wait, the more debt there will be and the more pressure there will be on Beijing to use household wealth transfers to service the debt.

Why do I say we will be talking about 3% growth soon? Two reasons. First, I am impressed by the bleakness of historical precedents. Every single case in history that I have been able to find of countries undergoing a decade or more of “miracle” levels of growth driven by investment (and there are many) has ended with long periods of extremely low or even negative growth – often referred to as ‘lost decades’ – which turned out to be far worse than even the most pessimistic forecasts of the few skeptics that existed during the boom period. I see no reason why China, having pursued the most extreme version of this growth model, would somehow find itself immune from the consequences that have afflicted every other case.

Second, I just use a very simple calculus. Remember that rebalancing is not an option for China. It will happen one way or the other, and the sooner the less disruptive. And for China to rebalance in a meaningful way, consumption growth is going to have to outpace GDP growth by at least 3-4 full percentage points (and even then, at that rate, it will take China over five years to return to the 40% that was not long ago considered astonishingly low).

During the boom of the last decade consumption has grown at a very sharp 7-8% annually. If consumption growth remains at that level, China can slowly rebalance with GDP growth of 4-5%. But historical precedent (along perhaps with common sense) suggests that if GDP growth drops so sharply, from 10-11% to 4-5%, it will be incredibly difficult for household income and household consumption growth to be maintained. In that case a 2-3% drop in household consumption growth may be a fairly conservative estimate, and as the growth rate declines, GDP growth will also decline with it.

• The decline in Chinese growth will fall disproportionately on investment and, because of this, it will severely impact the price of non-food commodities.

In the past, as the consumption share of GDP declined sharply, the investment share rose. By definition as China rebalances, this process must reverse. This must mean that consumption growth will speed up (relatively, at least) and investment growth decline even if overall GDP growth remains unchanged. Of course if GDP growth drops, as it absolutely must, investment growth must drop even more.

Implications of rebalancing
The implications are inescapable, although I think many people, especially in the commodities sector, have missed them. If GDP growth drops by X%, investment growth must drop by substantially more than X%. This is what rebalancing means.

What happens to real interest rates will determine when the process of Chinese adjustment begins. In fact there is a chance that we may see growth in China slow significantly in 2012, perhaps even to 7%, although I suspect that it will probably be in the 8-9% region.

This is a bit of wild speculation on my part, but depending on what the PBoC is allowed to do with interest rates, we may see the beginnings of an adjustment as early as next year. In the past year the PBoC has raised interest rates by roughly 125 basis points. Obviously, as I have argued many times, this has not been nearly enough given the much higher increase in inflation and it is part of the reason why the domestic imbalances have seemed to have gotten worse in the past year, not better.

But I expect that inflation will begin to decline soon, and it may even drop quite sharply. In that case what will the PBoC do to interest rates? If they can refrain from lowering them, the higher interest rates will reduce overinvestment while putting more wealth into the pockets of household deposits. This will both slow growth and speed up rebalancing.

Will it happen? I have no idea. What the PBoC does to interest rates is likely to be the outcome of a struggle in the State Council between policymakers that are worried about growth and those that are worried about imbalances. If the PBoC can hold off the former, and especially if wages continue rising, we might begin to see Chinese rebalancing taking place a little earlier than expected. Of course this must, and will, come with much slower GDP growth.

• Growth rates of 3% will not necessarily lead to social and political instability. Most analysts argue that China needs annual growth rates of at least 8% to maintain current levels of unemployment. Anything substantially lower will cause unemployment to surge, they argue, and this would lead to social chaos and political instability.

I disagree. The employment effect of lower growth depends crucially on the kind of growth we get. The problem is that China’s current growth model encourages a heavily capital-intensive type of growth – wholly inappropriate, in my opinion, for such a poor country.

Boosting consumption
But since rebalancing in China requires less emphasis on heavy investment and more on consumption, and since rebalancing also means a sharp reduction in free credit provided to SOEs and local governments and cheaper and more available credit for efficient but marginal SMEs, a rebalancing China would presumably see much more rapid growth in the service sector and in the SME sector, both of which are relatively labour intensive. Much lower growth, in that case, could easily come with minimal changes in overall employment.

That is why Japan is a useful reminder of what can happen. After 1990 GDP growth collapsed from two decades of around 9% on average to two decades of less than 1% on average, but there was no social discontent, and unemployment didn’t surge. Some analysts credited Japanese lifetime employment or invoked the natural docility of Japanese people (a bizarre argument at best) to explain the lack of social upheaval, but for me it was because Japan genuinely rebalanced in the past two decades.

Before 1990 GDP growth sharply outpaced consumption growth, whereas after 1990 their positions were reversed – consumption growth sharply outpaced GDP growth. In that time the Japanese savings rate declined sharply, the household income share of GDP rose sharply, and Japan became less dominated by the industrial giants that were almost synonymous with Japan of the 1980s.

So as I see it the Japanese didn’t react to Japan’s ‘collapse’ with outrage or horror largely because Japan didn’t really collapse in any meaningful sense. Japanese standards of living on average continued to rise after 1990, and on a real per capita basis probably only a little slower than they had before 1990. It was the state sector that bore most of the brunt of the slower growth, and this shows up as the explosion in government debt. Households were fine because although the GDP pie was growing at a much slower rate after 1990 than before, their share of the pie was growing after 1990, whereas it shrank before 1990.

I think the same might happen, or at least could happen, in China. It depends in part on how resistant the elites are to the process of rebalancing, which almost by definition means eliminating the distortions that had benefited them for so long. As Jeffrey Friede points out in his brilliant ‘Debt, Development and Democracy’ (1992), the elites that benefit from economic distortions are traditionally the ones most likely to prevent necessary adjustments, and if they actually run the whole show, adjustment can be incredibly painful and disruptive.

Rebalancing puts focus on politics
If I am right, and China begins to rebalance (and it has no choice but to rebalance unless it has infinite borrowing capacity and the world has infinite appetite for Chinese surpluses), then the debate must shift from economics to politics. We need to understand how and under what conditions China’s elite will permit an elimination of the distortions that benefited them. For example, under what conditions will the export sector and its defenders allow the RMB to rise, or will SOEs and provincial governments tolerate an increase in interest rates, and so on?

• Because of its rapidly rising debt burden, the only way for China to manage a smooth social transition will be through wealth transfers from the state sector to the household sector. In the past, Chinese households received a diminishing share of a rapidly growing pie. In the future they must receive a growing share. This will probably be accomplished through formal or informal privatization.

The right way to engineer the transition to a system in which household wealth isn’t used to subsidize growth is to raise wages, raise the value of the currency, eliminate SOE monopoly pricing, and raise interest rates. The problem is that all of these have to adjust so far that to do so quickly would lead to massive financial distress. It would also lead to rising unemployment and, with it, declining consumption, so that the rebalancing would occur through low consumption growth and perhaps negative GDP growth. No one wants this outcome.

Doing so slowly, however, so as not to cause financial distress and a surge in unemployment, will result in worsening imbalances over the medium term. It will also lead to a continued building up of debt – and I think we only have four or five more years of this kind of debt build-up before we hit the debt crisis that every other investment-driven growth miracle country has faced.

An alternative solution
So what can Beijing do? They’re damned if they go slowly and they’re damned if they go quickly. There is however an alternative solution that is relatively easy (easy economically, not politically). It is to increase household wealth through a one-off transfer from the state sector. The state can privatize assets and use the proceeds either to increase household wealth directly (gifts of shares, improvement in the social safety net, etc.) or indirectly (clean up the banking system and pay down debt).

Right now it is hard to find anybody who really thinks Beijing will engage in a massive privatization program, but this is the only logical alternative I can come up with, and it is the least painful. So my guess is that in two or three years privatization will become a very popular topic of policy discussion.

High stakes in Eurozone
• European politics will become much more difficult and disruptive. The historical precedents are clear. During a debt crisis the political system becomes fragmented and contentious. If the major parties don’t become radicalized, smaller radical parties will take away their votes.

Remember that the process of adjustment is a political one. We all know someone has to pay for the massive adjustment countries like Spain must make. The only interesting question is about who will be forced to take the brunt of the payment – workers in the form of unemployment, the middle classes in the form of confiscated savings, small businesses in the form of taxes, large businesses in the form of taxes and nationalization, foreigners, or creditors.

Deciding who pays is a political process, and because the stakes are so high it will be a very bitter process. This means, among other things, that politics will degenerate quickly, and of course if Europe doesn’t arrive at fiscal union in the next year or two, it probably never will. This conclusion is also the reason for my next prediction.

• Spain will leave the euro and will be forced to restructure its debt within three or four years. So will Greece, Portugal, Ireland and possibly even Italy and Belgium.

Once the market determines that debt levels are too high, then debt levels become too high, and without a deus ex machina the results are predictable. All the major economic agents begin to behave in ways that worsen the debt crisis until finally the country slides into default. Businesses will disinvest, creditors will demand shorter and riskier maturities, workers will strike, politicians will shorten their time horizons, and banks won’t lend. In that case, with incentives lined up so that all the major economic agents worsen the debt problem, debt must rise faster than both GDP and the country’s debt-servicing ability. The worse the debt level gets, the faster debt rises relative to GDP. What’s more, the only strategies by which Spain can regain competitiveness are either to deflate and force down wages, which will hurt workers and small businesses, or to leave the euro and devalue. Given the large share of vote workers have, the former strategy will not last long. But of course once Spain leaves the euro and devalues, its external debt will soar. Debt restructuring and forgiveness is almost inevitable.

• Unless Germany moves quickly to reverse its current account surplus – which is very unlikely – the European crisis will force a sharp balance-of-trade adjustment onto Germany, which will cause its economy to slow sharply and even to contract. By 2015-16 German economic performance will be much worse than that of France and the UK.

If Germany does not take radical steps to push its current account surplus into deficit, the brunt of the European adjustment will fall on the deficit countries with a sharp decrease in domestic demand. This is what the world means when it insists that these countries “tighten their belts”.

If the deficit countries of Europe do not intervene in trade, they will bear the full employment impact of that drop in demand – i.e. unemployment will continue to rise. If they do intervene, they will force the brunt of the adjustment onto Germany and Germany will suffer the employment consequences.

For one or two years the deficit countries will try to bear the full brunt of the adjustment while Germany scolds and cajoles from the side. Eventually they will be unable politically to accept the necessary high unemployment and they will intervene in trade – almost certainly by abandoning the euro and devaluing. In that case they automatically push the brunt of the adjustment onto the surplus countries, i.e. Germany, and German unemployment will rise. I don’t know how soon this will happen, but remember that in global demand contractions it is the surplus countries who always suffer the most. I don’t see why this time will be any different.

About a week after I set down these ‘predictions’, and two days after I finished this point, the Financial Times reported (in late August) that German growth has already hit a wall. Expect to see a lot more articles like this over the next few years.

Intervention on trade
• As the US fights over the fiscal deficit and whether or not it is the right way to expand domestic demand, more and more politicians will focus on the expansionary impact of trade protection. There will be an increasing tendency to intervene in trade – in fact I think of quantitative easing as a policy aimed at trade and currency imbalances as much as one aimed at domestic monetary management.

As unemployment persists, and as the political pressure to address unemployment rises, the US will, like Britain in 1930-31, lose its ideological commitment to free trade and become increasingly protectionist. Also like Britain in 1930-31, once it does so the US economy will begin growing more rapidly – thus putting the burden of adjustment on China, Germany (which will already be suffering from the European adjustment) and Japan.

Trade policy in the next few years will be about deciding who will bear the brunt of the global contraction in demand growth. The surplus countries, because they are so reliant on surpluses, will be very reluctant to eliminate their trade intervention policies. Because they are making the same mistake the US made in the late 1920s and Japan in the late 1980s – thinking they are in a strong enough position to dictate terms – they will refuse to take the necessary steps to adjust. But in fact in this fight over global demand it is the deficit countries that have all the best cards. They control demand, which is the world’s scarcest and most valuable commodity. Once they begin intervening in trade and regaining the full use of their domestic demand, they will push the adjustment onto the surplus countries. Unemployment in deficit countries will drop, while it will rise in surplus countries.

Michael Pettis is a professor of finance at the Guanghua School of Peking University, a senior associate at the Carnegie Endowment and the Chief Strategist for Chinese investment bank Guosen Securities.