Pettis Writes ...
August is supposed to be a slow month, but of course this August has been hectic, and a lot crueler than April ever was. The US downgrade set off a storm of market volatility, along with bizarre concern in the US about whether or not China will stop buying US debt and the economic consequence if it does, and equally bizarre bluster within China about their refraining from buying more debt until the US reforms the economy and brings down debt levels.That is a lengthy clip of ideas, yet hopefully within the spirit of Pettis' guidelines on these emails. His PDF is 14 pages and will appear on his blog shortly.
What both sides seem to have in common is an almost breathtaking ignorance of the global balance of payment mechanisms. China cannot stop buying US debt until it engineers a major adjustment within its economy, which it is reluctant to do. Until it does, any move by the US to cut down its borrowing and spending will trigger a drop in global demand which will cause either US unemployment to rise, if the US ignores trade issues, or will cause Chinese unemployment to rise, if the US moves to counteract Chinese currency intervention.
The Big Picture
Rather than try to wade through all the news this month, 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 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 and unemployment stays high for a few more years.
1. No BRIC Decoupling
Since most global consumption comes from the 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.
2. Near-Term Decline in Chinese Consumption
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.
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.
But I remain very, very skeptical. 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.
3. Chinese Debt Levels will Continue to Rise Very Quickly
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.
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.
4. By 2013-14 Chinese GDP Growth will Slow sharply
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.
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).
5. Non-Food Commodities Disproportionately Affected
The decline in Chinese growth will fall disproportionately on investment and, because of this, it will severely impact the price of non-food commodities. The implications are inescapable, although I think many people, especially in the commodities sector, have missed them.
6. Significant Slowing Could Start in 2012
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.
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.
7. Social Unrest Not a Given
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. 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 labor intensive. Much lower growth, in that case, could easily come with minimal changes in overall employment. Japan is a useful reminder of what can happen.
8. Large-Scale Privatization
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.
9. Disruptive European Politics
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.
10. Spain, other PIIGS Leave Euro
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.
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.
11. Germany Will Not Voluntarily Share Costs
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.
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.
12. Expect US Rising Trade Protection Sentiment
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.
I added the bold headlines in the detailed discussion points above.
Six Key Ideas
- China Will Slow Much More than China Bulls and Commodity Bulls Think
- Non-food Commodities Take Big Hit
- Eurozone Experiment Ends in Breakup
- US Protectionism Takes Hold
- Deficit Countries Control Demand, Thus Have the Best Cards
- Disaster Hits BRICs
Contrarian Thinking
Except perhaps for points three and four (and perhaps for all six points) investors and analysts have taken the opposite view. Most are looking to buy the dip, invest in commodities, invest in commodity producing currencies, and invest in the BRICs.
We did not have commodity producer decoupling in 2008 and there is no reason to expect it as debt-deflation plays out and China abandons its reckless investments in infrastructure.
I suspect China slows sooner than Pettis thinks, but no sooner than the next regime change in China. Markets, however, may react well in advance.
Global Deflationary Outlook
Pettis does not use the word "deflation" in his writeup, but he describes a very deflationary global outlook complete with protectionism, beggar-thy-neighbor policies, currency wars, and falling non-food commodity prices.
Pettis did not discuss energy, but the forces are clear: peak oil. vs. global slowdown. Given peak oil and the possibility of war over it, energy is a wildcard.
What Country Leaves Eurozone First?
The current political path including the dismissal of Eurobonds by Germany and France certainly indicates a breakup of the Eurozone. However, I wonder if Germany abandons the Euro first, rather than one of the PIIGS.
I doubt it matters much, at least from the perspective of Germany. However, should Germany leave the Euro, France would then be in the position Germany is in now, certainly unable to bailout the rest of the Eurozone.
One way or another, the grand experiment will fail. Historically speaking it never had a chance. There has never been a successful currency union in history that did not also include a fiscal union.
The question at hand is how much more will governments force down the throats of taxpayers (hoping to bail out the banks and the bondholders) before this mess cracks in pieces. The more politicians force down taxpayer throats, the bigger the eventual repercussions.
Shrink to Survive
Just as I typed the above thoughts a Bloomberg headline came in on this very subject: Prospect of New Core Euro Gains Traction
The euro area may need to shrink to survive.Don' expect rational thinking from EU leaders. Instead, expect politicians to act in their perceived best interests and secondarily in the perceived bests interests of the banks and bondholders.
As its sovereign-debt crisis nears a third year and rescue efforts fail to stop the rot in financial markets, economists from Pacific Investment Management Co.�s Mohamed El-Erian to Harvard�s Martin Feldstein say ensuring the euro�s existence may require members to leave the 17-nation currency region.
The result would be what El-Erian, Pimco�s Newport Beach, California-based chief executive officer, calls a �smaller, much better integrated, fiscally strong euro zone.� While leaders such as German Chancellor Angela Merkel consistently rule out that option, El-Erian told �Bloomberg Surveillance� with Tom Keene on Aug. 17 that they eventually may embrace it over the fiscal union required to maintain the status quo.
All it takes is for any country to leave, even Greece, before other countries consider the same thing.
There are lots of ideas in this post to consider, and I thank Michael Pettis for sharing his thoughts.
Addendum:
Reader Craig writes: "I was shocked by your commentary on 12. I thought for sure you would come out blasting U.S. trade restrictions as protectionist and leading to economic slowdown in the U.S. Instead, you basically said what Trump has been saying in every interview, and that is that China is playing us for fools and that we need to recapture our manufacturing from them. I thought you were a "free trader" to the max."
Craig, I am indeed a free trade advocate and I certainly do not agree with Donald Trump and other protectionists such as Paul Krugman. I simply failed to point out every nuance in the article I disagree with. It is a mistake to assume I agree with "everything" in an article just because I agree with 90% of it. I made no specific comments on protectionism so there should not have been an implication of agreement.
I do not think the US gains by protectionism. Other countries will do the same and US exports will dive if imports dive as other countries retaliate. There is serious potential for another Smoot-Hawley with equally devastating consequences if Congress goes overboard.
Where I did comment and where I agree with Pettis' contrarian thinking is that the brunt of the adjustment will be felt on trade surplus countries. Mathematically it has to, in any kind of rebalancing. Not every country can run a trade surplus. It is impossible.
Moreover, and as Pettis points out, the imposed austerity measures in Europe will impact Germany's ability to export. The slowdown in China and the US will also impact Germany.
The question is whether or not adjustments come about in a reasonable manner or by trade wars and currency devaluations. No one wins in another Smoot-Hawley setup.
I have pointed out what I believe is the solution on many occasions. Rather than tariffs I have supported a return to the gold standard. I saw no need to bring it up yet again, but perhaps I should have.
Here are the pertinent links once again.
Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold's Honest Discipline Revisited
Michael Pettis Warns of "Virulent Political Turn Against Euro", Adds Clarification to "Gold's Honest Discipline"
To that I would add we desperately need to get rid of fractional reserve lending.
I also want to add a note that peak oil (some say "peak everything") will impact China's ability to have an investment led economy based forever expanding infrastructure. Add peak oil to the list of reasons China will slow, whether they like it or not.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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