Comparing China with Japan and Other Stories

Is it possible or relevant to compare China with Japan and if so which Japan? Should it be 1970s Japan or late 1980s Japan? While many commentators argue that China is better compared to 1970s Japan, Michael Pettis argues that China resembles 1980s Japan because of the unbalanced nature of its economy.

Japan in the late 1960s and early 1970s may share many developmental characteristics with China today, but the Japanese economy in that earlier period never achieved, as far as I can see, the kinds of imbalances that it did much later in the 1980s, and so it is not really comparable to an extremely unbalanced China today.

These imbalances are well documented. The important characteristics of Japan in the late 1980s would almost certainly include the following:

• Japan in the late 1980s grew at extraordinary rates fueled by a credit-backed investment boom funded at artificially low interest rates.

• Although for many decades much of the investment may have been viable and necessary, by the 1980s investment was increasingly misallocated into expanding unnecessary manufacturing capacity, as well as fueling surges in real estate development and excess spending on infrastructure.

• Artificially low rates, set nominally by the central bank but in reality by the Ministry of Finance, and coming mainly at the expense of household savers also fueled a bubble in local assets.

• An artificially low currency fueled very rapid growth in the tradable goods sector while also constraining household income growth.

• Because the growth model constrained growth in household income and household consumption, it forced up the domestic savings rate to extraordinary levels.

• The combination of low consumption and excessive manufacturing capacity required a high trade surplus in order to balance production with demand.

• And finally, and most worryingly, debt levels across the economy began to soar as debt rose much faster than debt servicing capacity.

All of this is true of China today, and this is why it is much more important to understand how Japan rebalanced after 1990 if you want to understand the challenges and risks facing China today. China is not like Japan in the 1950s, 1960s or 1970s in any meaningful way even if its current development level is much closer to Japan during those decades. Because of the serious imbalances China is much more like Japan in the late 1980s, with the major difference being that Japan never took debt, investment, and consumption imbalances to anywhere near the levels that China has taken them.

Ouch ... How, then, will the imbalances be reversed.

For this reason what we really have to consider when thinking about China is how these imbalances tend to be reversed. Since they were reversed in Japan in the period following 1990, Japan provides at least one possible model for China’s rebalancing process and, perhaps much more importantly, it demonstrates the kinds of pressures that China will face as it is forced into rebalancing. ... 

What about Europe?

Economic growth in Europe over the next ten years ... will not be anything like economic growth in the last ten years adjusted for changes in demographics, taxes, or anything else. We will be dealing with a Europe in which the tremendous debt, currency, and labor cost imbalances of the past decade must be reversed, and since the most likely form of the reversal will entail the breaking up of the euro, any growth predictions that do not at least acknowledge this chaotic rebalancing process are likely to be flimsy at best.

Currently Paddy Power is offering odds for both the end of the Euro and for individual countries leaving the Euro. Interestingly Greece is not included. Too short or what? My prediction is for an exit during the Xmas-New Year period, if if indeed happens. It's possible of course that European policy-makers will do whatever it takes to keep the currency going. (In other words I'm not suggesting you take a bet!)

The problem for the world economy is that the credit-fuelled growth strategy prevalent in most of the world has to at best stabilise or keep reversing.

Likewise with predictions of US consumption growth, which will have to deal with reversals in the savings and consumer credit trends of the past decade, and with sharp change in two decades of housing behavior.

For Australia there is, at best, volatility ahead.

Predictions about the prices of hard commodities, which have to consider a major dislocation in the source of commodity demand since the early part of the last decade, are also likely to be highly unstable.

As Pettis points out economic predictions are very difficult.

If you want to make economic predictions, in other words, whereas a long historical view will be very useful because it allows you to consider the dislocations created by a reversal of unsustainable imbalances, recent economic data are largely useless, as are predictions based on linear adjustments of recent economic data. Instead of projecting from past data you must model the various paths by which rebalancing can occur, and your prediction must be limited to those paths.

Pettis gives relatively short shrift to the view that insights from neuroscience could make a difference in predicting economic events.

This suggests that we don’t really need a radically new understanding of economics. To understand the global rebalancing, or the European debt crisis, or the upcoming Chinese economic adjustment, we need only to read the works of John Maynard Keynes, Hyman Minsky, Charles Kindelberger, Friedrich Hayek, or dozens of other economists of the 19th and 20th centuries. In every case they fully understood how economies can beetle along in one direction and then suddenly, as imbalances become unsustainable, reverse course and follow a dramatically different path.

This is simply a logical outcome of disequilibria, and doesn’t require anything quite so mysterious as brainwave patterns or irrational behavior mechanisms to explain the process. I think it was Herb Stein, President Nixon’s economic advisor, who reminded us that "If something cannot go on forever, it will stop."

In other words, as Keynes was reputed to have said: the unsustainable cannot be sustained.

It would have been much more powerful, I guess, if Stein had expressed this idea in a way somewhat more mathematical and abstruse, but anyway it seems like a pretty good explanation of what has happened in the US and in Europe in the past few years and what will happen in China in the next few. Just because many economists fail to see the point doesn’t require an overhaul of the discipline – perhaps it only requires an overhaul of the way the discipline is taught.

Pettis then goes on to quote a number of news sources outlining some very bad news for Australia.

From Bloomberg

Copper inventories at bonded warehouses in Shanghai probably climbed to a record as import premiums dropped to a four-month low, signaling demand in China may not be improving as much as expected after a summer lull.

Reserves were 650,000 metric tons, according to the median of nine estimates from traders, analysts and warehouse managers, compiled by Bloomberg. Five said that this was a record. The amount compared with an estimate of 550,000 tons by Macquarie Group Ltd. on Aug. 20. Fees paid by importers over the London Metal Exchange cash price are about $40 to $60 a ton on a cost, insurance and freight basis, the lowest since May.

Or this Financial Times article:

The southern Chinese province of Yunnan has launched a subsidy programme for metals producers, in a sign of the pain hitting the Chinese metals sector as demand growth remains low. Slowing economic growth in China, the world’s biggest consumer of commodities, has meant falling profits at Chinese raw materials producers, including copper smelters, steel mills and zinc smelters.

An official at the Yunnan Provincial Industry and Information Technology Commission confirmed that a small “stockpiling” programme, which has not been publicly announced yet, was launched in September and would continue until the end of the year. The programme targets copper, zinc, aluminium and other small metals, the official said.

Under the programme, which covers 300,000 tonnes of metals, producers will be able to draw subsidised loans from banks using their material as collateral. Banks will give the companies loans based on preset “purchase” prices for the commodity, and the Yunnan government will subsidise the process by paying for the interest on the bank loans. The system is designed to help smelters by providing them with more liquidity as financing gets more difficult. “The targets of this stockpiling system are the companies,” the government official explained.

But perhaps the inevitable pain could be delayed by more stimulus.

In Saturday’s South China Morning Post there was another article on roughly the same topic:

A group of state-owned Chinese shipping companies has placed a US$4.5 billion order for 50 supertankers, throwing a financial lifeline to struggling shipbuilders.

The order adds to a flurry of infrastructure investments by state companies in recent weeks - a key element in Beijing's effort to reverse a painful slowdown in economic growth. The government has approved a wave of spending on new steel mills, subway lines and other corporate and public works projects.

…Chinese shipbuilders, the world's biggest by tonnage, have been among the industries hit hardest in the slowdown. Orders have fallen by more than half, and shipyards are cutting jobs.

"Small and medium-size shipbuilding companies are either out of business or near bankruptcy," said Xia Xiaowen, an analyst for the China Shipbuilding Economy Research Centre, a think tank in Beijing. If the reports of new orders are accurate, "it will definitely be good news for those large manufacturers, and they don't need to worry about survival any more", Xia said.

But eventually, Pettis argues, rebalancing will have to occur.

no matter what analysts or policymakers may say, there is absolutely no way to resolve the problem of growing excess inventory except by abandoning the development model. Until China rebalances, in other words, it cannot resolve the problem of excess inventory because excess inventory is one of the inevitable consequences of the process that created the imbalances.

Hold onto your hats.

China's Foreign Reserves: What they Mean and How they Can be Used

China's Foreign Reserves are huge. Indeed they are among the largest foreign reserves in the history of the world.

Historically two other countries held huge foreign exchange reserves - the United States in the 1920s and Japan in the 1980s. Neither of those experiences ended well. 

Many commentators see these huge reserves as a marker of growing Chinese power and consequently, of American weakness given that a good deal of those reserves are invested in US dollar assets. I've also seen it written that China should use these reserves to spend within China instead of buying foreign currencies. The problem with this view is that they can't be used domestically. The best explanation on this topic comes once again from Michael Pettis.

In a 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.

Ironically enough, it replaced the very reasonable trade argument with one that is truly bogus, and indicates how foolish and even hysterical the discussion can become.  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".

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.  It has a hugely mismatched balance sheet in which it is long nearly $3 trillion (if everything were correctly counted), funded by an equivalent amount of RMB obligations.

Exporters and their employees, too, are naturally long dollars and so they would lose. They are long dollars because more of the net value of their current and future production less current and future costs is denominated in dollars (they are “sticky” to dollar prices) – for example labor costs, land, and almost all other inputs except imported components are valued in RMB, whereas most revenues are valued in dollars.

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."