European Dependence on Russian Energy

From: New York Times

Classic dilemma for IR and IPE students.

Who has the power in this situation?

In the short-term it seems clear that the Russians have power (no pun intended) given the dependence of many countries on Russian energy supplies. Over the longer-term, however, it seems likely that the switch away from Russian energy supplies could be disastrous for the energy export-dependent Russian economy.

The sanctions on Russia do not involve stopping the import of Russian energy, but other sanctions could lead to retaliation from the Russians in terms of energy exports or imports. Indeed the Russians have banned food imports from major Western countries. This will undoubtedly punish those exporters to Russia, but will also lead to food shortages in Russia itself. According to this report from the NYT, Russian bans on food  imports will advantage Chinese producers.

Political Cartoons and Comics

Recent Charts on Globalisation, Asia and Australia

The following chart shows the extent of the "patchwork" economy in Australia. Despite the clear differences since 1990, according to the ANZ's analysis, the patchwork economy is coming to an end as WA starts to struggle and as activity picks up in NSW. Clearly, however, the other states have some work to do to catch up. (remember that the common starting point is an artificial construction and there would have been significant differences before this time).

Australia's 'real' saving rate perhaps not as high as traditional saving measure suggests if we exclude super and principal mortgage repayments. 

Home Ownership in Australia from Saul Eslake

Thirty Years of the Float 

China's Foreign Exchange Reserves and Debt

One of my former colleagues dismissed Michael Pettis's work on the Chinese economy and international economics as "accounting focused" and therefore as too simplistic to be helpful in understanding the global economy. 

My view is that Pettis's focus on the key relationships between saving, investment and consumption across countries is a vital component of debate on the world economy because it shows the importance of imbalances - particularly between current account surplus and deficit countries - in causing problems in the global economy. 

I have referred to Pettis regularly on this blog and I admire his work because he highlights logical inconsistencies in some popular assumptions about the role of China and the United States and about the world economy generally.

One area that Pettis has highlighted (more than once) is the fallacy that China's reserves could be used domestically to pay off domestic debt. This fallacy has purchase because it sounds right. Why should the Chinese spend so much capital buying US Treasury securities, when they obviously have more important things to spend on within their own borders. This idea is particularly attractive at the moment with a deal not yet being finalised to ensure there isn't a default on US government bonds. This from Pettis's September 20th 2013 Newsletter.

China’s reserves only matter to its credit position if China faced a problem of external debt.

It doesn’t, and so the amount of reserves are almost wholly irrelevant, Because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.

A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.

This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets than the interest rate it pays on much of its liabilities.

In fact there have been rumors for years that the PBoC would technically be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.

This is the point. Any government that is able to borrow money can borrow money to recapitalize its banks, whether or not it has large amounts of foreign currency reserves. The amount of central bank reserves that China or any other country has is wholly irrelevant, except perhaps to the extent that without those reserves the central government would lack the credibility to borrow domestically, which hardly seems to be a concern in China’s case.

Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%. ...    

So who is likely to cover the cost of NPLs in Chinese banks? This isn’t an easy question to answer. If the household sector continues to pay, either in the hidden form of repressed interest rates, or in the more explicit form of taxes, the existence of bad debt in the Chinese banking system must act to repress future household consumption growth. The transfers from the household sector to pay what may turn out to be a huge NPL bill will significantly lower the household income share of GDP, making it very unlikely that the household consumption share of GDP will rise.

If however the state sector covers the difference (perhaps by privatizing state assets and using the proceeds to pay down debt), we are left with the very difficult political problems, which China currently faces, of assigning the costs to different sectors or groups that control the state sector in China. The potentially very large cost of cleaning up NPLs must be assigned to groups that are likely to be both powerful and reluctant to pay the cost.

Debt always matters because it must always be paid for by someone – even if the borrower defaults, of course, the debt is simply “paid” by the lender. This is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future. If the debt cannot be fully serviced by the increase in productivity created by the investment that the debt funded, unless it is funded by liquidating state sector assets it must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.

Here Pettis is dealing with the argument that China's domestic debt problems can be easily solved. Another mistake is that China's foreign exchange reserves are historically unprecedented. This according to Pettis in a post from 2010 is also incorrect.

Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. At the time, total reserves accumulated by the US were more than 5-6% of global GDP. ...

The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves only a little less than the equivalent of 5-6% of global GDP. By the late 1980s, Japan’s accumulation of reserves drew the sort of same breathless description – much of it incorrect, of course – that China’s does today.

...  both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short. During the early years of the Great Depression of the 1930s, US stock markets lost more than 80 per cent of their value, real estate prices collapsed, and the US economy contracted in real terms by an astonishing 30-40 per cent before recovering in the 1940s.

Japan’s subsequent experience was economically less violent in the short term, but even costlier over the long term. During the period following its astonishing accumulation of central bank reserves, its stock market also lost more than 80 per cent of its value, real estate prices collapsed, and economic growth was virtually non-existent for two decades.

The idea that massive levels of reserves are a guarantor of economic stability is, in other words, based on a profound misunderstanding both of history and of the nature of reserves. Reserves of course are not useless as an enhancer of financial stability, but their use is for very specific forms of instability. Having large amounts of reserves relative to external claims protects countries from external debt crises and from currency crises.

Great, but neither Chanos, nor even the most pessimistic Sino-analyst, has ever said that these are the kinds of risks China faces today, any more than they were the risks faced by the US in the late 1920s or Japan in the late 1980s. The risks that China faces today (and the US in the late 1920s and Japan in the late 1980s) is of excessive domestic liquidity having fueled asset and capacity bubbles, the latter requiring the uninterrupted ability of foreign countries to absorb via large and growing trade deficits. These risks include an explosion in domestic government debt directly and contingently through the banking system.

These are, very typically, the kinds of risks that threaten rapidly developing large economies, unlike the external debt and currency risks that typically threaten small economies. And reserves are almost totally useless in protecting these economies from the risks they face (and, no, no, no, reserves cannot be used to recapitalize the banks – only domestic government borrowing or direct or hidden taxes on the household sector can be used to recapitalize the banks).

In fact, it was the very process of generating massive reserves that created the risks which subsequently devastated the US and Japan. Both countries had accumulated reserves over a decade during which they experienced sharply undervalued currencies, rapid urbanization, and rapid growth in worker productivity (sound familiar?). These three factors led to large and rising trade surpluses which, when combined with capital inflows seeking advantage of the rapid economic growth, forced a too-quick expansion of domestic money and credit.

It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.

We must be careful how we read history. The fact that the US and Japan had terrible decades following periods during which they had amassed levels of reserves that China has subsequently matched, and under conditions similar to those of China, does not necessarily mean that China too must have a lost decade or two. ... 

But the history does indicate that facile statements about central bank reserves should, at the very least, be measured against the obvious historical precedents.

In an earlier post Pettis explains in more specific details the process of foreign exchange reserve accumulation. In a 2012 post entitled "What the PBoC Cannot Do with its Reserves", Pettis starts by explaining how the Peoples Bank of China (PBoC - China's Reserve bank) goes about keeping the renminbi (RMB) (the yuan if you prefer - see here for explanation) at a lower level.

As long as China ran the largest current account surplus ever recorded as a share of global GDP, and the US the largest current account deficit ever recorded, and especially since China also ran an additional capital account surplus (i.e. other non-PBoC agents ran a net capital inflow), it was almost impossible for the PBoC to do anything but buy US dollar assets. Given the sheer amounts, a substantial portion of these assets had inevitably to be USG bonds. 

This was not a discretionary lending decision. It is the automatic consequence of China’s currency regime, in which it pegs the RMB to a foreign currency, in this case the dollar. Why? Because when the PBoC decides on the level of the RMB against the dollar, it does not do so by passing a law, and making it a capital crime for anyone to trade at a different price. What it does is far simpler. It offers to buy or sell unlimited amounts of RMB against the dollar at the desired price. 

No one will sell dollars for less than what they can get from the PBoC, nor will anyone buy dollars for more than what they can pay the PBoC, so all transactions get done at that price. That is how the PBoC (or any other central bank that intervenes in the currency market) sets the foreign exchange value of its own currency.

Now the reason the PBoC must buy dollars under the regime is because the rest of China is a net buyer of dollars. Remember China runs a current account surplus, which must be matched by a net capital outflow.

This means that as long as it wants to set the exchange rate, then, it must take the opposite position of the market. Since the rest of the market is a net seller of dollars (China runs a current and capital account surplus), the PBoC has no choice but to be a net buyer of dollars, which of course it must then invest. 

If it stops buying dollars, it must let the market decide by itself on the new equilibrium price of the dollar. In that case the value of the dollar has to plunge in RMB terms (or the RMB soar, which is the same thing) in order for buyers and sellers to match up and for the market to clear. The moment the PBoC stops buying, in other words, the RMB will rise in value – and so it cannot stop buying in anticipation of the RMB rising in value.

 The next issue is how the PBoC funds these purchases of dollars:

It does so primarily by borrowing in the domestic money markets, selling PBoC bills or entering into short term repos (although it also issues some longer-term bonds), or by “creating” money by crediting the accounts of the commercial banks who sell it the dollars. 

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities (I say “roughly” because when you run a mismatched balance sheet, changes in the relative value of assets and liabilities will create losses or profits). 

Here is where things get interesting. China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet. If the PBoC wanted to “spend” $100, say for example to recapitalize a bank, it could do so, but this would automatically create a $100 dollar hole in its balance sheet. – it would still owe the RMB that it borrowed originally to purchase the $100. To put it another way, the reserves are not a savings account, free for the PBoC to spend as it likes. Reserves are effectively borrowed money. ... 

So what are reserves good for? As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China. This means that reserves ensure that China can import foreign commodities and other goods as long as it can pay for them domestically. It also means that the PBoC can ensure the availability of dollars to repay foreign debt and foreign investment. ... 

Reserves are useless in preventing domestic debt crises (not totally, because they affect the credibility of the currency, but the RMB today doesn’t seem to suffer from a lack of credibility).

Pettis then goes on to explain why a revaluation of the renminbi against the dollar does not cause the simple scenario of huge losses for China and huge gains for the United States that most commentators allude to when they discuss the so-called economic balance of terror between the United States and China. There are still winners and losers, but the equations are more complex than most assume.

Many people in China and abroad have argued that China cannot afford to raise the value of the RMB against the dollar because it would mean that China will take huge losses because of its massive reserves. After all, if the RMB rises by 10% against the dollar, the value of its reserves will have necessarily declined by $250 billion in RMB terms.   

This is almost completely wrong – China will not take losses anywhere close to that amount and may probably even take a gain if it revalues the currency. One foreign economist even published a rather loony piece three months ago, which excoriated the Obama administration’s “bogus” trade argument for revaluation as done purely for nefarious and no doubt imperialistic reasons – and to strengthen the conspiratorial air it somehow ignored the fact that nearly every country in Europe and Asia has made the same argument.

The argument is that the US wants China to revalue the RMB not because of trade rebalancing (wrong, and this makes a common but still annoying mistake about the relationship between the currency and the trade balance) but rather because of a secret American scheme to reduce the amount that the US government has to pay China on its PBoC holdings. Appreciation of the RMB, according to this theory, represents a transfer of wealth from China to the US because it effectively reduces cost to the US of servicing the debt

An appreciation of the RMB cannot reduce the cost of the US government's debt obligations because:

The US government transacts almost exclusively in dollars, raises dollars in the form of taxes and borrowing, and owns dollar assets. Since it will pay exactly the same number of dollars to Chinese investors after the change in the RMB value as it did before the change, simple arithmetic should indicate that there will be no impact at all on the cost to the US of repaying the debt. But this doesn't mean there aren't winners and losers including within China. Working them out requires an analysis of the "various balance sheets". 

So who are the winners and losers?

In a nutshell, anyone who is net long dollars against RMB loses, and anyone who is net short dollars against RMB gains. For China, the equation is the same. Those who are short US dollars will gain. 

There is no precise way of answering this question, because every single economic entity in China implicitly has some complex exposure to the dollar (by which I mean foreign currencies generally) through current and future transactions, but generally speaking China is likely to gain from a revaluation because after the revaluation it will be exchanging the stuff it makes for stuff it buys from abroad at a better ratio. The value of what it sells abroad will rise relative to the value of what it buys from abroad, and if we could correctly capitalize those values on the balance sheet, it would probably show that the Chinese balance sheet would improve with a revaluation of the RMB. 

Some people might make a more sophisticated argument that since China is a net creditor – i.e. it is net long dollars – it will lose by a revaluation of the RMB. This argument also turns out to be wrong, but for more complex reasons, and to explain why I have to put on my former-trader’s hat and explain the difference between a real loss and a realized loss.

 This is where it gets even more complicated.

If you believe that the RMB is undervalued then you must accept that China takes a “real” loss every single time it exchanges a locally produced good or asset for a foreign one. It does not “realize” the loss, however, until it revalues the RMB to its “correct” value. 

In other words, the PBoC, as the representative of China’s net creditor status, will immediately realize a loss when the RMB revalues, but this loss did not occur because of the revaluation. It occurred the very day the trade took place. When a Chinese producer sold goods to the US and took payment in US dollars, there was an unrealized economic loss equal to the undervaluation of the RMB. This unrealized loss was passed onto the PBoC when it bought the dollars from the exporter and paid RMB. 

This loss, however, will not actually show up until the RMB is revalued, which forces the real loss to be realized (i.e. recognized as an accounting matter). Postponing the revaluation, then, is not the way to avoid the loss – it is too late for that. The only way to avoid future additional loss is to stop making the exchange, which means, ironically, that the longer the PBoC postpones the revaluation of the RMB, the greater the real loss it will take. 

So a revaluation of the RMB will not cause any real loss to any Chinese entity today. The loss already occurred but hasn’t been realized. 

But wait, if the RMB is revalued by 10%, the value of the PBoC’s assets will immediately decline by $250 billion in RMB terms. Since the Chinese measure their wealth in RMB, isn’t this a real additional loss for China? 

No, because remember that the only thing you can do with reserves is pay for foreign imports or repay foreign obligations. And just as the value of the reserves drops 10% in RMB terms, so does the value of all those foreign payments – by definition they must go down by exactly the same amount in RMB terms. 

This means that China takes no loss. It can buy and pay for just as much “stuff” after the revaluation, and with less implied PBoC borrowing, as it could before the revaluation – and the real value of money is what you can buy with it. So the real value of the reserves hasn’t changed at all – just the accounting value in RMB, but this simply recognizes losses that were already taken long ago when the trade was first made, and should be a largely irrelevant number (except perhaps for conspiracy theorists). 

But there are important impacts within China. Who wins and who loses depends "on the structure of individual balance sheets."

Basically everyone who is net long dollars against the RMB loses in an appreciation, and everyone who is net short dollars against the RMB wins. 

Who loses? Of course the PBoC is a big loser. ...

Exporters and their employees, too, are naturally long dollars and so they would lose. ...

Chinese companies with more assets abroad then foreign debt might also lose. 

Who wins? Nearly everyone else in China, since everyone in the country is short dollars to the extent that there are imported goods in his life. The local tea seller is short dollars if his tea is delivered to him in gas-guzzling trucks, as is the family planning to visit Egypt next year, as is the local provider of French perfumes, as is a teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team. Every household and nearly every business in China is, in one way or another, an importer (and this is true in every country), so unless they own a lot of assets abroad they are effectively short dollars and will benefit from an appreciation in the RMB. 

Revaluing the RMB, in other words, is important and significant because it represents a shift of wealth largely from the PBoC, exporters, and Chinese residents who have stashed away a lot of wealth in a foreign bank, in favor of the rest of the country. Since much of this shift of wealth benefits households at the expense of the state and manufacturers, one of the automatic consequence of a revaluation will be an increase in household wealth and, with it, household consumption. This is why revaluation is part of the rebalancing strategy – it shifts income to households and so increases household consumption.

So a revaluation has important balance sheet impacts on entities within China, and to a much lesser extent, on some entities outside China. But the fact that the PBoC loses big time does actually matter and although Pettis doesn't mention it, it would actually lead to the same sort of structural changes in the Australian economy that many people in Australia are worried about right now - namely a decline in manufacturing and (traded) services competitiveness. Pettis's point probably is that the rise in household wealth would help to balance the economy away from the investment and export dominated growth model.

But since it merely represents a distribution of wealth within China should we care about the PBoC losses or can we ignore them? 

Unfortunately we cannot ignore them and might have to worry about the PBoC losses because, once again, of balance sheet impacts. 

The PBoC runs a mismatched balance sheet, and as a consequence every 10% revaluation in the RMB will cause the PBoC’s net indebtedness to rise by about 7-8% of GDP. This ultimately becomes an increase in total government debt, and of course the more dollars the PBoC accumulates, the greater this loss. (Some readers will note that if government debt levels are already too high, an increase in government debt will sharply increase future government claims on household income, thus reducing the future rebalancing impact of a revaluation, and they are right, which indicates how complex and difficult rebalancing might be). In that sense it is not whether or not China as a whole loses or gains from a revaluation that can be measured by looking at the reserves, and I would argue that it gains, but how the losses are distributed and what further balance sheet impacts that might have.

Simple right? If you're confused, you're not alone. It is easy to see why so many writers assume simple effects and consequences of actions because the real world complexity of a change in the value of the RMB is much harder to explain. Much easier just to say China loses from a revaluation of the yuan against the dollar!

Still I wouldn't want to betting on the certainty of anything in this field. As Keynes once said: "Markets can remain irrational a lot longer than you and I can remain solvent."

New Readings on Globalisation, Asia and Australia (1003GIR, 2016GIR, 3012GIR, 6005GIR, 7007GIR)

Bad news for coal
http://www.nytimes.com/2013/09/14/business/energy-environment/us-coal-companies-scale-back-export-goals.html?emc=edit_tnt_20130914&tntemail0=y

Good news for coal
http://www.theguardian.com/environment/2013/sep/17/australia-battle-power-coal

The top 0.1% in the US
http://krugman.blogs.nytimes.com/2013/09/12/good-times-at-the-top/?emc=edit_tnt_20130915&tntemail0=y

American companies back on top
http://www.economist.com/news/briefing/21586558-american-private-enterprise-dominates-corporate-premier-league-again-thanks-waning?fsrc=nlw|hig|9-19-2013|6644475|36817576

Re-emphasising the national interest
http://www.lowyinterpreter.org/post/2013/09/17/Balancing-the-national-interest%28s%29.aspx

The decline of America's middle class and rising inequality
http://www.nytimes.com/2013/09/19/business/americas-sinking-middle-class.html?emc=edit_tnt_20130922&tntemail0=y

The great coffee swindle
http://www.smh.com.au/business/the-economy/the-great-coffee-ripoff--is-no-myth-20130923-2u9bn.html

Courting ASEAN
http://thediplomat.com/asean-beat/2013/09/23/the-courtship-of-asean-2/

Electricity prices around the world
http://reneweconomy.com.au/2013/graph-of-the-day-average-electricity-prices-around-the-world-24207

Factcheck on Greens claims about foreign investment in land
http://www.abc.net.au/news/2013-09-23/greens-foreign-ownership-claim-overstated/4965854

Attitudes to foreign investment
http://essentialvision.com.au/foreign-investment

The eradication of poverty
http://www.nytimes.com/2013/09/25/opinion/the-end-of-poverty-soon.html?nl=opinion&emc=edit_ty_20130925

Australian trade choices
http://theconversation.com/australias-free-trade-choice-is-between-regional-relations-or-the-bigger-picture-18594

The need for a greater diplomatic presence in Asia
http://www.theage.com.au/comment/timid-diplomacy-leaves-us-in-a-sea-of-disputes-20130924-2uc1r.html

Surge in mobile broadband in developing world
http://bits.blogs.nytimes.com/2013/09/26/developing-countries-surge-in-mobile-broadband-u-n-finds/?nl=todaysheadlines&emc=edit_ae_20130926&_r=0 

Graphic on Japan's growing public debt
http://www.economist.com/blogs/graphicdetail/2013/10/daily-chart-4

The short-lived US pivot to Asia?
http://thediplomat.com/2013/10/08/the-pivot-under-pressure/

China's new charm offensive
http://thediplomat.com/china-power/with-obama-mia-china-touts-multipolar-world/

Japan most powerful East Asian military? 
http://breakingdefense.com/2013/09/26/chinas-dangerous-weakness-part-1-beijings-aggressive-idea-of-self-defense/

World GDP forecasts Cool graphic
 http://www.economist.com/node/21587451?fsrc=scn/tw/dc/

Japan's clumsy perception management
http://thediplomat.com/2013/10/10/japans-clumsy-perception-management/?all=true 

Interactive guide to China's maritime disputes
http://www.cfr.org/asia-and-pacific/chinas-maritime-disputes/p31345#!/

How Significant is the State Owned Sector in China?

I was giving a lecture recently and I was discussing the important role of Chinese state-owned enterprises in the Chinese economy. The problem was I didn't really know exactly how significant they actually were.

Here are some figures ...

Clearly the role of SOEs has declined in recent years. A successful rebalancing of the Chinese economy to increase the wage share of the economy (and the consumption share) should help to foster the growth of the non-SOE component of the economy as small businesses attempt to take advantage of increased spending.

Although the Chinese government clearly expresses its desire to rebalance the economy, this will be easier said than done.

What continues to amaze me is the faith that many economic liberals have in the ability of Chinese bureaucrats to control the Chinese economy as it becomes more complex.
 

Role of SOEs in the Chinese Economy

Source: World Bank 2030 Report p. 111.

 

ROE is return on equity

World Bank 2012
http://www.worldbank.org/content/dam/Worldbank/document/China-2030-complete.pdf

Most is direct quotation

SOE percentage of industrial output 27 per cent – projected to fall to 10 per cent in 2030

2010

Percentage of total number of enterprises 4.5 per cent

Percentage of total industrial assets 42.4 per cent

Percentage of employment 19.4 per cent

Percentage of exports 15 per cent

Non-state sector 70 per cent of GDP

Significant enterprise sector reforms have underpinned China’s successful past growth performance. In particular, bold reforms under the 9th Five Year Plan (5YP) 1995–2000 led to a greatly expanded role of the private and other non-state sector. Indeed, the state sector’s share in the total number of industrial enterprises (with annual sales over 5mn RMB) fell from 39.2 percent in 1998 to 4.5 percent in 2010. During this same period, SOEs’ share in total industrial assets fell from 68.8 percent to 42.4 percent, while their share in employment was slashed from 60.5 percent to 19.4 percent (Figure 4). Their share in China’s exports fell from 57 percent in 1997 to 15 percent in 2010. As a result, the non-state sector has become not only the main generator of output (an estimated 70 percent of GDP) and employment, and strongest growth engine, but also the most active sector for innovation.

According to Jia (2009), 65 percent of China’s patents and 75 percent of technological innovations came from the non-state sector. The 9th 5YP’s guiding principle of “grasping the big, letting go of the small” left China with a distinctive industrial structure. Most small and medium-sized firms became privately owned. Facing much domestic and external competition in an increasingly integrated domestic market, they became very dynamic and productive and now dominate many sectors.

In parallel, the “commanding heights” of the economy (most notably the 120 or so large central enterprises in sectors like electricity, petroleum, aviation, banking and telecoms) were kept largely state-owned.

Even here, much progress was made. Many SOEs were corporatized, radically restructured (including labor shedding), and expected to operate at a profit. In some sectors, intra-SOE competition was promoted and the scope for private participation was expanded. Later, the 2003 establishment of the State-owned Assets Supervision and Administration Commission (SASAC) to exercise authority over large centrally run firms laid a foundation for future improvements in governance and investment planning.

As a result, the profitability of China’s SOEs increased. Their reported average return on equity (ROE) jumped from only 2.2 percent in 1996 to 15.7 percent in 2007, before sliding back somewhat to 10.9 percent in 2009 (Figure 5).

However, the average profitability of SOEs remains well below that of non-state (including private) firms.

Role of SOEs in the Chinese Economy

Chinese industry appears significantly less concentrated than Japan and Korea in earlier periods. However, competition remains curtailed in one key dimension—between state-owned and non-state parts of certain sectors—especially in “strategic” industries and utilities. Large SOEs dominate certain activities not because they are competitive enough to keep the dominance, but because the market competition is restricted and they are granted oligopolistic status by the authorities. The weak and unfair competition resulting from such “administrative monopoly” has been deemed “the current problem facing private enterprise in China” (Naughton, 2011) and “the major source of monopolies in China’s economy”

The strong direct ties between the government and incumbent SOEs, especially large SOEs, limit the entry and access to resources of private firms, hampering the efficient use and allocation of resources and stifling entrepreneurship and innovation.

The most problematic form of government intervention in competition and administrative monopoly in China is official lists which grant SOEs an exclusive or privileged role in certain sectors. Two lists stand out. First, in 2006, China identified 7 “strategic” sectors in which the state would keep “absolute control”—defense, electric generation and distribution, petroleum and petrochemicals, telecoms, coal, civil aviation and waterway transport. In such sectors, while a handful of state firms might compete with one another, they are protected from new entry. Second, in designated “basic or pillar” industries—including machinery, automobiles, information technology, construction, steel, base metals, and chemicals—the state would retain “somewhat strong influence”. In such sectors, private participants could face a range of entry barriers or other constraints. Also, the clear signaling of the expected leading role of state enterprises could lead private firms to conclude that they would not be allowed to grow “too big”, acting as a powerful disincentive to expansion if not entry.



Gao Xu (2010) State-Owned Enterprises in China: How Big are They? http://blogs.worldbank.org/eastasiapacific/state-owned-enterprises-in-china-how-big-are-they

Figures for 2008

Percentage of industry and service sector assets 30 per cent

Percentage of industrial sector assets 50 per cent

Percentage of total enterprises 3.1 per cent

All have declined significantly over past decade or so.

The Second National Economic Census conducted in 2008 reveals that of all the 208 trillion RMB total assets of the secondary and tertiary sectors (industrial and service sectors), 63 trillion – or 30 percent of total – was held by SOEs. (SOEs here correspond to state sole funded corporations and enterprises with the state as the biggest shareholder.) Meanwhile, in terms of enterprise number, there were 154,000 SOEs at the end of 2008, only accounting for 3.1 percent of the total enterprise number. Hence, the big picture is clear: SOEs control a substantial part of total enterprise assets in China despite the fact that their total number is marginal. As a corollary of this observation it follows that the average size of SOEs is much bigger than that of non-SOEs. This is indeed the case. In terms of average assets, SOEs are equal to 13.4 times of non-SOEs.



















It is worthwhile to note that the decline in the share of SOEs is much bigger than that in the share of SOE assets. Since 1999, the share of SOEs has declined from 37 percent to less than 5 percent in terms of numbers, and from 68 percent to 44 percent in terms of assets. This is to a large extent a result of the SOE reform – specifically the “grasping the big, letting go of the small” strategy – carried out in the past decade. Since the reform started in late 1990s, most small SOEs have been privatized or filed bankruptcy to lessen the burden of the government, while larger ones have been subsidized (directly or implicitly) and/or merged to hopefully create stronger firms controlling the commanding high of the national economy. This reform strategy is a big success in terms of creating large SOEs. As what is shown in figure 2 by the dark blue line, the average asset size of industrial SOEs increased from 134 million RMB in 1999 to 923 million in 2008, expanding by 589 percent in 9 years. Meanwhile, the average assets of non-SOEs only moderately increased from 36 million to 60 million, up by a dwarfed 67 percent.

New Readings on Globalisation, Asia and Australia (for 1003GIR, 2016GIR and 6005GIR)

Swan defends economic record and future prospects of the Australian economy
http://www.swanmp.org/index.php?id=533 

Down with the running dogs of capitalism ... or at least liberalism
http://www.nytimes.com/2013/08/20/world/asia/chinas-new-leadership-takes-hard-line-in-secret-memo.html?nl=todaysheadlines&emc=edit_ae_20130819&_r=0

Confucian soft power
http://thediplomat.com/china-power/soft-power-or-ancient-wisdom/

More dire climate warnings
http://www.nytimes.com/2013/08/20/science/earth/extremely-likely-that-human-activity-is-driving-climate-change-panel-finds.html?nl=todaysheadlines&emc=edit_ae_20130819

An era of relative peace
http://www.nytimes.com/2013/08/14/opinion/global/the-great-powers-then-and-now.html?_r=0&pagewanted=all

Where is it made?
http://economix.blogs.nytimes.com/2013/08/19/not-really-made-in-china-or-the-united-states/ 

Chinese economic dependence and lack of global companies
http://www.ft.com/intl/cms/s/0/28d1a4a8-e7ba-11e2-babb-00144feabdc0.html?siteedition=uk#axzz2cfZx0e9S

Britain has at one time invaded most of the world http://www.telegraph.co.uk/history/9653497/British-have-invaded-nine-out-of-ten-countries-so-look-out-Luxembourg.html

China as a global but 'partial power'
http://www.amazon.co.uk/China-Goes-Global-Partial-Power/dp/0199860149/ref=pd_sim_b_4/277-4982565-1908159

The financial underpinnings of economic crisis
http://www.nytimes.com/2013/08/23/opinion/krugman-this-age-of-bubbles.html?nl=todaysheadlines&emc=edit_ae_20130825

The impact of technology on the middle class
http://opinionator.blogs.nytimes.com/2013/08/24/how-technology-wrecks-the-middle-class/?emc=edit_tnt_20130825&tntemail0=y 

Peace through globalisation and capitalism (available through uni)
http://jpr.sagepub.com/content/early/2013/08/22/0022343313497739.full.pdf




















 

New Readings for Globalisation, Australia and Asia (for 2016GIR, 1003GIR and 6005GIR)

The importance of the Trans-Pacific Partnership for Japan and the rest of Asia and for US influence in Asia
http://thediplomat.com/2013/08/06/the-tpp-abenomics-and-americas-asia-pivot/

New ways to measure GDP add billions to the size of the US economy
http://www.economist.com/blogs/graphicdetail/2013/08/daily-chart-2?%3Ffsrc%3Dscn%2F=tw%2Fdc

US Primacy?
http://thediplomat.com/2013/08/09/global-primacy-denied-why-american-primacy-is-not-assured/?all=true

Japan's quadrillion yen debt
http://thediplomat.com/pacific-money/2013/08/10/japans-debt-about-3-times-larger-than-aseans-gdp/

An oldy but goody from Mearsheimer
http://www.thedailybeast.com/newsweek/2008/12/30/pull-those-boots-off-the-ground.html

China's environment - some hope?
http://www.economist.com/news/briefing/21583245-china-worlds-worst-polluter-largest-investor-green-energy-its-rise-will-have

How Japan could have defeated the United States in WWII
http://thediplomat.com/the-naval-diplomat/2013/02/11/five-things-japan-could-have-done-to-beat-america/?all=true

Energy gamechanger
http://www.forbes.com/sites/williampentland/2013/08/14/redox-power-plans-to-roll-out-dishwasher-sized-fuel-cells-that-cost-90-less-than-currently-available-fuel-cells/

A picture paints ...
https://www.facebook.com/photo.php?fbid=10151547529313005&set=a.50018433004.62126.549358004&type=1 









 

New Readings for Power in East Asia 2016GIR

Japanese lessons for China
http://www.macrobusiness.com.au/2013/07/japans-lessons-for-china/

The trans-Atlantic trade deal as a response to the shift of power to the East
http://www.nytimes.com/2013/07/28/opinion/sunday/want-world-domination-size-matters.html?pagewanted=2&tntemail0=y&_r=0&emc=edit_tnt_20130728&pagewanted=all

The US shift to Asia
http://thediplomat.com/2013/07/23/wheels-up-has-obama-really-pivoted-to-asia/

The hard side of soft power
http://thediplomat.com/the-editor/2013/07/24/the-hard-side-of-soft-power/ 

Japan
http://thediplomat.com/the-editor/2013/07/22/abe-the-internationalist/ 

The coming slowdown of the Chinese economy
http://thediplomat.com/2013/07/22/how-much-slowdown-can-beijing-tolerate/

Chinese self containment?
http://thediplomat.com/flashpoints-blog/2013/07/29/chinas-folly-of-self-containment/ 

US containment of China
http://thediplomat.com/flashpoints-blog/2013/07/30/us-is-encircling-china-with-fighter-jets-and-stealth-bombers/

China as a maritime power?
http://thediplomat.com/flashpoints-blog/2013/08/01/alfred-thayer-mahan-with-chinese-characteristics/ 

Should Russia be a focus of this course
http://thediplomat.com/2013/07/25/as-tensions-with-west-rise-moscow-looks-to-asia/

Rsing Chinese military power in perspective
http://thediplomat.com/flashpoints-blog/2013/08/05/keeping-chinas-second-aircraft-carrier-in-perspective/







 

Chinese GDP and Trade: Bad News for Australia?

The charts below are from ANZ Research. There is good chart coverage of the latest stats on the Chinese economy. Here are a few that I think show some problems ahead for the Australian economy.

The first show the slowing of growth in the Chinese economy. Michael Pettis argues that the rebalancing of the Chinese economy will probably mean that growth will slow to between 3-4 per cent.  While some have argued that there is a social stability rate of growth above 6 per cent, if the consumption increases (due to rising wages and transfers) while investment declines it is likely that this slowing rate of overall growth will not necessarily be bad for Chinese workers.

Contrary to some perceptions that China is an export-led economy, it is actually an investment-led economy. This means that if investment declines, in the short-term at least, growth will slow, because consumption will not be able to take up the slack in the short-term. The rebalancing of the economy away from increasingly unproductive investment to consumption is unlikely to be quick or smooth. As the chart below shows, consumption actually declined in recent times.

As investment slows and consumption increases in China, Australia may eventually be able to take advantage of China's growing middle class, but it won't see levels of demand to match recent years' demand for resources.

 

The US-China Economic Relationship in Pictures

This from the US-China Business Council ... Well worth a read to break down a few myths about US-China relations.

Firstly, US exports to China have grown  at a far greater rate than US exports to the rest of the world.

 The next biggest growth market is Brazil, which has grown at 180% compared to 542%.

Not surprisingly Canada is a far more important export market for the US, followed by Mexico. See geography does still matter, despite the guff written about the "end of geography" in the 1980s. 

To prove its point about the continuing domination of the US economy, the authors use the USD exchange rate measure of economic weight. As I argue in How Big, How Rich and How Developed? The State of Play in the World Economy:

How we measure economies matters. To get a clearer picture of the world economy we need to look not only at size, but wealth, development and distribution. But even when measuring the size and wealth of economies, the method of measurement we choose will have a big impact on the outcome. ...

There are two ways to measure the size of economies. Firstly, we can convert the value of a country's gross domestic product (GDP) into US dollars and compare it to the GDP of other countries whose currencies have been converted into US Dollars also.  ... When exchange rates do vary considerably over time, such as the dollar–yen exchange rate after the 1970s, this method may cause distorted measures of size. ...

Such discrepancies have led to the increased use of an alternative method of measuring the size of economies based on the concept of purchasing power parity (PPP). Statisticians measure purchasing power within individual economies and then make comparisons on that basis. PPP measures GDP adjusted to reflect different costs of living and production within different economies. As most travellers know, goods and services and production costs are considerably lower in some countries than they are in others.

One should be very cautious about this projection, which seems to animate Australian policy-makers as well. It could turn out to be true, but before 2020 China is likely to suffer a big slowdown in growth, which might make these "middle class" growth projections come unstuck.

This is the one that would surprise most people. Although value-added measured via purchasing power parity would show a significantly different result I would think. Other analysts argue that the Chinese manufacturing sector surpassed the US manufacturing sector in terms of value-added late last decade. Remember too that value-added is just one way to measure the size of the sector (although it is perhaps the most important measure). China does a good deal of assembling still, but as wages increase these assembling operations will increasingly shift to elsewhere in Asia and perhaps Latin America.

Given the still very large US manufacturing sector it is not surprising that US companies' manufacturing assets are located mainly in the US itself.

 

Chinese foreign direct investment (non-bond investment) in the US has grown rapidly in recent years, but to put the level of Chinese FDI in the US into context, it is roughly the same as Chinese FDI in Australia.

As The Heritage Foundation reports: "The leading recipients of Chinese non-bond investment since 2005 have been Australia and the U.S. Other major recipients are Canada, Brazil, Britain, and Indonesia. In 2012 alone, Canada topped the list, thanks to the Chinese CNOOC's $15.1 billion acquisition of Nexen, the largest outbound investment to date. The U.S. was second: After a weak 2011, Chinese investment here shattered the old annual record with over $14 billion spent (including a $4.2 billion acquisition late in the year). North America drew a full 40 percent of Chinese non-bond investment in 2012."




Perhaps the most controversial and widely misunderstood aspect of the US-China economic relationship is the issue of Chinese purchases of US Treasury securities, with many commentators arguing that it represents a Chinese advantage over the US.  As Hillary Clinton said: "How do you deal toughly with your banker?"  Fortunately for the US, this 'problem' is overblown. Indeed, reduced Chinese purchases of US Treasury securities would be good, rather than bad, for the US. As the graphic makes clear most Treasuries are held by Americans anyway. For an explanation of China's Reserves see here and here.