What If?
- What if such analysis is ass backwards?
- What if urbanization is the result, not the cause of growth?
- What if pressures to maintain the symbolism of growth (as opposed to actual growth) do far more harm than good.
Michael Pettis at China Financial Markets tackles the above questions via email on "The Urbanization Fallacy". What follows is a synopsis from Michael Pettis, written as a guest post.
Begin Pettis
The Urbanization Fallacy
Special Points
- Sentiment among China analysts is changing rapidly, and there is a great deal more pessimism about growth prospects, allied to greater support for the radical reforms the new administration is proposing, but the very late change in analyst sentiment underlines how mistaken most analysis about the Chinese economy has and continues to be. Over the next few years, as a consequence of this failure, analysts will continue to lower their growth forecasts for China dramatically.
- If we were expecting the June 20 liquidity crunch to slow growth in Wealth Management Products (WMP), we may be disappointed. Preliminary numbers suggest that WMP rates have risen dramatically but WMP issuance may be as strong as ever.
- The main impact on WMP issuance may turn out to have been deterioration in asset quality, as higher rates are likely to turn away real business borrowers but will probably have no impact on borrowers who simply need to roll over their existing funding.
- China’s plans to shift 300 million people into cities has become the new default argument for high growth, but it is based on a fallacy. First, urbanization does not create growth. Growth creates urbanization, and so the urbanization process is simply a highly pro-cyclical mechanism that increases high growth and exacerbates slowing growth.
- Second, urbanization is actually a cost, not a source of growth, and this cost is only economically justified if the increase in the overall productivity for newly urbanized workers is greater than the cost of urbanization. If China is growing so quickly that it is desperate for new workers to leave less productive jobs in the countryside and take more productive jobs in the city then urbanization will make China richer.
- Urbanization, in other words, is a consequence of rising wealth and can accommodate it. It is not a cause of rising wealth.
- Use of the “stopped clock” analogy – when those who warned about an unsustainable process turn out to be right, for example, they are only right in the way that a stopped clock is right twice a day – is almost always an indication of economic illiteracy.
This year there has been a huge shift in sentiment about China, with many analysts, especially on the sell side, struggling to remain relevant in the face of their earlier assurances about growth and risk in China. That their attitudes have shifted is probably a good thing, but it is not always clear to me that increased skepticism about China’s growth prospects has occurred because of a deeper understanding of the root cause of the investment/consumption imbalances and the relationship between debt and growth. I worry that many analysts are arguing now that the current disruption in Chinese growth is a temporary effect of unexpected adverse shocks – especially shocks caused by poor lending decisions on the part of individual entities – and so they are underestimating both the urgency of fundamental reform and the extent of the slowdown in economic growth.
For many years, and even as recently as 20011-12, these analysts were fairly confident that China’s growth model was in reasonably good shape and required only minor reforms to keep growth rates high for many more years, but now these same analysts are celebrating the new administration (correctly, in my opinion) for the vigor and determination with which they are forcing through dramatic changes in China’s growth model.
I mention this not to criticize the change in sentiment, but rather to point out that as I see it there have been no substantial changes in China in the past five to seven years that would justify such a dramatic change in sentiment. It should have been obvious, at least back in 2009, when analysts were all falling over themselves to applaud China’s fiscal and credit response to the global crisis, that we were making a bad situation immeasurably worse, and that the reforms, urgent then, would become all the more urgent under the new administration.
If it wasn’t obvious in earlier analyses of China’s economy why we were in trouble back then, I worry that the latest analyses are also failing to understand the underlying problem. While everyone correctly applauds Premier Li’s determination to tackle the underlying problems, it is important that we understand what the underlying problem has always been. For the newly converted, the risk is that they see the recent slowdown as a consequence of unexpected adverse developments, rather than as an expression of the underlying systemic problem with the growth model. This should have been obvious many years ago, and not just a problem this year now that local government financing and shadow banking have hogged the headlines.
China’s problem, in other words, is not that in the past three years a bunch of irresponsible borrowers have emerged to ruin the party, and the solution is not that these irresponsible borrowers must be disciplined. China’s problem is deeper than this. Economic growth is systematically dependent on a thoroughly unsustainable credit expansion. China cannot rebalance the economy and it cannot reduce its growing credit risk until it thoroughly overhauls the growth model and the capital allocation process, and it simply cannot do either at economic growth rates at much above 3-4%.
Yes, sentiment is changing and growth expectations are dropping, but analysts continue to misunderstand the nature of the problems and so continue to get it wrong – although at least they are now moving in the right direction.
Has bad credit been constrained?
I have no doubt that higher rates will eventually cause a reduction in demand for WMP funding, but as long as there continues to be an implicit guarantee from the issuing banks, which are in turn implicitly guaranteed by the central government, I see no reason why wealthy depositors will shun WMP. On the contrary, higher rates with no change in risk should actually increase the supply of WMP funding, just as it seems to have done in the past two weeks.
Trouble with Ponzi Schemes
It will take one or more major WMP defaults in which depositors lose money before the supply of WMP funds dries up, but of course the risk there is that if we do see defaults the result could be a destabilizing run on WMP. This is the trouble with Ponzi schemes once they become too big – you’re damned if you stop them and damned if you let them continue.
What worries me about the higher WMP rates is that they can have an adverse sorting impact on the asset side. Higher rates of course might dissuade borrowers who are using the money for productive purposes – as the higher borrowing cost approaches or exceeds the expected return on investment – but higher rates will have almost zero impact on borrowers who need new financing just to roll over old financing. They will continue to borrow at any rate as long as they can. One consequence may be that even as (or if) WMP growth slows, the quality of the assets funded will deteriorate, so that the overall risk for the banking system continues to grow as fast as it did before rates rose.
Controlling debt
Meanwhile in all the excitement over WMP and SHIBOR we risk losing sight of the fact that, contrary to what a lot of analysts are suggesting, the problem in China is not that there are specific areas of risky lending that need to be controlled. The real problem is that increased economic activity is inextricably tied to unsustainable increases in debt, and this is a system-wide problem. It will prove impossible both to control increasing financial risk and to keep growth even at current levels. Any attempt to crack down on one form of bad lending will only cause another form of bad lending to surge, and if Beijing really wants to control the worsening financial risk it will have to tolerate growth rates of 3-4% or less.
Tey point is that the economy is addicted to unsustainable increases in debt, and while Beijing can flail away at individual problems areas, it cannot resolve the underlying debt problem without a sharp slowdown in growth.
Most analysts have lowered their forecasts substantially in the past two years, and especially in the past month, but they are still deluding themselves about longer-term growth prospects.
I just don’t see how we can grow at 7-8% without running the risk of a serious debt crisis before the end of the period. As it is we are having a hard enough time understanding what current growth rates really are. Power consumption, for example, simply doesn’t suggest that growth rates have been able to hold up.
Last year’s GDP growth clocked in at 7.9%, although a lot of analysts believe it may have been closer to 5.5%, and if power consumption year to date is already much lower than it was last year, unless there has been a major – and hard to detect – improvement in energy efficiency it is hard for me to imagine why growth this year and next year should even match last year.
Ignoring Overinvestment
Analysts have (finally) started to understand the weaknesses of China’s growth model and they recognize that it is imperative that investment and credit stop growing, but in their analysis, they wholly ignore the previous overinvestment and the associated costs. In other words they assume that if China stops overinvesting now, they can predict future growth rates while wholly ignoring the costs already incurred of many years of overinvestment.
But this is a mistake. It is not just that China has to stop investing in non-productive projects, and so growth must slow. China must also write down many previous years of investing in non-productive projects, and so growth must slow even more as these asset are written down in the form of continued transfers from the productive sectors of the economy to cover the gap between economic returns and debt servicing costs.
It is as if analysts believe that once China stops wasting money on uneconomic projects, it can move forward as if nothing has happened. But many years of wasted investment must have a cost, or else why bother stopping? This was the same mistake made about Japan’s growth in the early 1990s. Analysts, it seems to me, are assuming that China can start with a clean state and grow at a slower but healthier rate once it corrects its mistakes. All that piled up debt is simply ignored.
Is urbanization the answer?
Growth rates over the next decade cannot exceed 3-4%. There are a lot more growth forecast downgrades to follow. There is still a lot of resistance to this idea.
Like so many of the earlier bull arguments, however, this new belief that urbanization is the answer to China’s growth slowdown is based on at least one fallacy. The first and obvious reason is that urbanization is not an act of God, and therefore indifferent to earthly conditions. Urbanization itself responds to growth. Countries do not grow because they urbanize, in other words, they urbanize because they are growing and there are more good, productive jobs in the cities than in the countryside. In that sense urbanization is not a growth machine. It is simply a pro-cyclical process that accommodates growth when growth is rising and reduces it when it falls.
And pro-cyclicality is a bad thing, not a good thing. It means that increases in growth are enhanced but reductions in growth are exacerbated, so it adds costly volatility to the economy. As the economy slows, in other words, urbanization itself slows, thus subtracting economic activity.
Of course if 300 million people move from the Chinese countryside to the cities, we would need to build lots of new apartment buildings (assuming the existing apartment buildings are already full, which is an heroic assumption in China), roads, hospitals, schools, and so on to accommodate them, but these do not make China any richer. They have to be paid for, and their cost is equal to the cost of capital (resources, machines, steel, copper, etc.) plus the total amount of labor that workers building all these things were doing (and no longer can do) before these things were built. We can assume, if we like, that all of the labor was previously unemployed, in which case the labor cost of urbanizing will be zero, but there will still be a tremendous cost of resources.
Paying for these resources would require transfers from other sectors of the economy, so that the economic activity created by all this building would be exactly equal to the economic activity subtracted from the economy.
The only way China would be “wealthier” is if the value of the new stuff created was greater than the value of the stuff that would have been created but no longer can be.
No more stopped clocks, please
Before closing allow me – perhaps a little foolishly – to display a little peeve. For many years before 2007-9 a few analysts have warned that rising consumer credit in the US and peripheral Europe was unsustainable. They warned that rising debt to support misallocated investment in China was also unsustainable. They warned that soaring US mortgages backed by little more than the hope that land prices could only rise would lead to a real estate crisis. They warned that commodity-exporting countries that did not hedge their bets would find themselves in serious trouble when commodity prices collapsed,
Of course you could not have had a bubble unless the majority of analysts disagreed with these warnings, and most analysts did indeed disagree. So what happened when the warnings turned out to be right? Obviously enough the mistaken bulls publically acknowledged that their models were incorrect and promised to hit the economic history books so that they never again would be so foolish.
Just kidding. What actually happened is that the former bulls immediately trotted out the stopped-clock analogy. The reason the worriers turned out to be right, they earnestly explained, is that they are perma-bears, and as everyone knows a stopped clock will always be right twice a day. This doesn’t mean, however, that models used by the worriers were right and the models used by the bulls were wrong, so of course there is not need for the bulls to change their models.
Regular readers of my newsletter know how often I gripe about the superficiality of those analysts who don't see why describing a growth model that is generating an unsustainable increase in debt is not the same thing as predicting a collapse in six months. Debt can rise unsustainably for many years before the debt burden itself becomes unsustainable – after all it is not true that those who worried about the rise of consumer credit in the US in the mid 2000s were “wrong” until the stopped clock eventually was right.
But this strikes me as an incredibly superficial analysis, explained only by the fact that many of us expect economic analysis merely to predict whether the stock market will rise or fall this week. Those who worried about rising consumer credit in the US were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007. Those who have been arguing that China is experiencing an unsustainable increase in debt have not been wrong every quarter that China has not collapsed. They are almost certainly right and it is hard even for the most foolish of bulls any longer to deny it.
An analysis that points to an unsustainable trend is always right if the trend turned out indeed to be unsustainable. The fact that it may have taken many years before the limits were reached is not an indication that the model was wrong. It is simply how the economy works.
End Pettis
Stopped Clock Syndrome
I have great deal of sympathy regarding Pettis' stopped clock message. I have been in a similar situation regarding equity risk in the US for two years.
Looking even further back, I was a year or two early calling for a housing bust, a credit crunch, and a collapse in treasury yields in the US. The email taunts mounted.
After catching the rebound, I became too cautious, too early, as the stock market marched higher. Taunts come in again now.
Thus, I know far too well what it is like for Pettis to call for 2% growth in China for the rest of the decade (on average), when everyone else thinks 7% is a huge slowdown.
Wrong vs. Early
Right vs. wrong has to do with timeframe and the nature of ones positioning in the interim. But how far can one carry the message?
Are hyperinflationists wrong or early? Here is the answer: A dollar collapse has supposedly been coming every year for over 10 years. With each pullback in the US dollar index, screams get louder and louder, and the comparisons to Zimbabwe more and more absurd.
If by some 1% chance that hyperinflation does occur in the next decade, I will be the first to admit I was dead wrong.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
