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."

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.

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.

 

Import Share of China's Exports

I'm putting together my Course Guide for a subject called Power in East Asia and came across this - OECD/WTO TRADE IN VALUE-ADDED (TIVA) DATABASE: CHINA - in my list of new material.

Basically the data shows that Chinese exports include a large amount of foreign content reflecting the fact that China is often at the end of the value chain.

The main findings are:

The bilateral trade surplus with the US is about 25% lower in 2009 in value-added terms. Interestingly, a significant factor behind this is the relatively higher imports of US value-added.  

China is well connected to other economies as a hub in "factory Asia": gross exports incorporate a large share of foreign value-added and nearly half of all imported intermediates are used as inputs for exports.  

While China is strong in manufacturing industries, the role of services should not be neglected: 30% of Chinese gross exports correspond to value-added from services industries and in sectors such as electronic goods, 30% of the value exported also comes from services. 

If trade is measured on a value-added basis the US trade deficit is smaller because:

As a final assembler, China relies on intermediate goods and services that are for a significant share imported from the US or that incorporate value-added from the US. China has also moved upstream in some value chains and exports intermediate inputs used by third countries that export to the US.

In some industries as much as 40 per cent of exports are accounted for by foreign value-added content.

Many of China's imports are then exported. In several industries the share of imported intermediate inputs that are exported is greater than 50 per cent, with the average of all industries just under 50 per cent.  Over 80 per cent of textiles and apparel intermediate imports are exported and over 70 per cent of electrical equipment intermediate imports are exported.

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. 

China in the US MIrror: Pettis on China, Free Trade, Protection and Development

This from Michael Pettis's February 11th newsletter contains some gems on the history of economic development ...

I agree that protection has been important in the process of economic development as it was in Australia, but it must be protection with a purpose and there must still be domestic competition or other spurs to productivity growth. Subsidies are a recipe for rent-seeking and domestic favourtism. Competition is what matters even if it is protected competition initially.

Industries must have incentives to remain competitive over the medium to long-term, which is why policies of freer trade are beneficial as development progresses.



The pillars of growth

... I have often argued that the Chinese development model is an old one, and can trace its roots at least as far back as the “American System” of the 1820s and 1830s. This “system” was itself based primarily on the works of the brilliant first US Secretary of the Treasury Alexander Hamilton ...

This development model was also implicitly part of the debate in France that led to one of the most important financial innovations of the 19th Century, the creation of the Crédit Mobilier in France in 1852. The debate concerned one of the great economic questions in France, especially after the defeat of Napoleon: why had England, a country that one hundred years earlier had been poorer than France, managed to surpass France and all other countries economically and technologically, even though in the pure sciences and engineering the French were at least the equal to the British and perhaps superior?

One obvious reason had to do with the financing of the commercial application of new technology. The French banking system, dominated by rentiers and the landed aristocracy, seemed to specialize in protecting savers, in part by mobilizing capital and investing in gold or in government obligations. The English banking system did this too, but it also seemed much more willing to finance infrastructure and manufacturing capacity.

In fact more generally I have argued that the main reason “industrial revolutions” have occurred largely in England and the United States is because industrial revolutions are not driven by scientific developments but rather by the commercial application of scientific developments. For this to happen it seems that a robust financing system is key.

...

I will come back to this issue of the financial system, but the point here is that there have been many versions of this development model, and at least two major economic theoreticians – the German Friedrich List in the 19thCentury and the Ukrainian-American Alexander Gershenkron in the 20th – have formally described variations on the investment-driven growth model.

...

Aside from Alexander Hamilton, its intellectual and political godfather, the main proponents of the American System were figures like Henry Clay, Henry and Matthew Cary, John Calhoun, and even Abraham Lincoln himself. Their vision of economic policymaking was looked down upon as naïve and even foolish by most American academic economists – schooled as they were in the laissez faire doctrines then fashionable in England – but I think it is hard for any economic historian not to feel relieved that neither the academics nor the Jeffersonian and Jacksonian factions had the clout to force “good” economic policy onto US development. America got rich in part by doing the wrong things.

...

It was of course the post-War Japanese development model, itself based on Japan’s experience of economic development during and after the Meiji restoration, that became the standard for policymakers throughout East Asia and China. I think of China’s growth model as merely a more muscular version of the Japanese or East Asian growth model, which is itself partly based on the American experience.
There were three key elements of the American System. Historian Michael Lind, in one of his economic histories of the United States, described them as:

· infant industry tariffs
· internal improvements, and
· a sound system of national finance

These three elements are at the heart, explicitly or implicitly, of every variation of the investment-led development model adopted by number of countries in the last century – including Germany in the 1930s, the USSR in the early Cold War period, Brazil during the Brazilian miracle, South Korea after the Korean War, Japan before 1990, and China today ...


Infant industry tariffs
The “infant industry” argument is fairly well known. I believe Alexander Hamilton was the first person to use the phrase, and the reasoning behind his thinking was straightforward. American manufacturing could not compete with the far superior British, and according to the then- (and now) fashionable economic theories based on Adam Smith and David Ricardo, the implications for trade policy were obvious. Americans should specialize in areas where they were economically superior to the British – agriculture, for the most part – and economic policy should consist of converting US agriculture to the production of cash crops – tobacco, rice, sugar, wheat and, most importantly, cotton – maximizing that production and exchanging them for cheaper and superior British manufactured items.

In this way, as Ricardo brilliantly proved, and assuming a static distribution of comparative advantages, with each country specializing in its comparative advantage, global production would be maximized and through trade both the British and the Americans would be better off. While most academic US economists and the commodity-producing South embraced free trade, Alexander Hamilton and his followers, mainly in the northeast, did not (in fact differing views over free trade as well as over slavery and state rights were at the heart of the North-South conflict that led eventually to the Civil War).

Hamilton was convinced that it was important for the US to develop its own manufacturing base because, as he explained in his Congressional report in 1791, he believed that productivity growth was likely to be much higher in manufacturing than in agriculture or mineral extraction. Contrary to David Ricardo, in other words, Hamilton believed that comparative advantage was not static and could be forced to change in ways that benefitted less productive countries. What is more, he thought manufacturing could employ a greater variety of people and was not subject to seasonal fluctuations or fluctuations in access to minerals.

Given much higher British efficiency and productivity, which translated into much lower prices even with higher transportation costs, how could Americans compete? They could do it the same way the British did to compete with the superior Dutch a century earlier. The US had to impose tariffs and other measures to raise the cost of foreign manufacturers sufficiently to allow their American counterparts to undersell them in the US market. In addition Americans had to acquire as much British technological expertise and capacity as possible (which usually happened, I should add, in the form of intellectual property theft).

This the US did, and in fact I believe every country that has managed the transition from underdeveloped to developed country status (with, perhaps, the exception of one or two trading entrepôts like Singapore and Hong Kong, although even this is debatable), including Germany, Japan, and Korea, has done it behind high explicit or implicit trade tariffs and stolen intellectual property. The idea that countries get rich under conditions of free trade has very little historical support, and it is far more likely that rich countries discover the benefits of free trade only after they get rich, while poor countries that embrace free trade too eagerly (think of Colombia and Chile in the late 19th century, who were stellar students of economic orthodoxy) almost never get rich unless, like Haiti in the 18th Century or Kuwait today, they are massive exporters of a very valuable commodity (sugar, in the case of Haiti, which was the richest country in the world per capita during a good part of the late 18th Century).

But rather than just embrace protection I would add that there is one very important caveat. Many countries have protected their infant industries, and often for many decades, and yet very few have made the transition to developed country status. Understanding why protection “works” in some cases and not in others might have very important implications for China. I won’t pretend to have answered this question fully but I suspect the difference between the countries that saw such rapid productivity growth behind infant industry protection that they were eventually able to compete on their own, and those that didn’t, may have had to do with the structure of domestic competition.
Specifically, it is not enough to protect industry from foreign competition. There must be a spur to domestic innovation, and this spur is probably competition that leads to advances in productivity and management organization. I would argue, for example, that countries that protected domestic industry but allowed their domestic markets to be captured and dominated by national champions were never likely to develop in the way the United States did in the 19th Century.
I would also argue that companies that receive substantial subsidies from the state also fail to develop in the necessary way because rather than force management to improve economic efficiency as a way of overcoming their domestic rivals, these countries encourage managers to compete by trying to gain greater access to those subsidies. Why innovate when it is far more profitable to demand greater subsidies, especially when subsidized companies can easily put innovative companies out of business? Last April, for example, I wrote about plans by Wuhan Iron & Steel, China’s fourth-largest steel producer, to invest $4.7 billion in the pork production industry.

The company’s management argued that they could compete with traditional agro-businesses not because steel makers were somehow more efficient than farmers, but rather because their size and clout made it easier for them to get cheap capital and to get government approvals. They were able to invest in an industry they knew little about, in other words, because they knew they could extract economic rent. This clearly is not a good use of protection.

The lessons for China, if I am right, are that China should forego the idea of nurturing national champions and should instead encourage brutal domestic competition. Beijing should also eliminate subsidies to production, the most important being cheap and unlimited credit, because senior managers of Chinese companies rationally spend more time on increasing access to these subsidies than on innovation, a subject on which, in spite of the almost absurd hype of recent years, China fares very, very poorly.

There is nothing wrong with protecting domestic industry, but the point is to create an incentive structure that forces increasing efficiency behind barriers of protection. The difficulty, of course, is that trade barriers and other forms of subsidy and protection can become highly addictive, and the beneficiaries, especially if they are national champions, can become politically very powerful. In that case they are likely to work actively both to maintain protection and to limit efficiency-enhancing domestic competition. It was Friedrich Engels, not often seen as a champion of capitalist competition, writing to Edward Bernstein in 1881, who said that “the worst of protection is that when you once have got it you cannot easily get rid of it.”


Internal improvements
The second element of the American System was internal improvement, which today we would probably call infrastructure spending. Proponents of the American System demanded that the national and state governments design, finance and construct canals, bridges, ports, railroads, toll roads, and a wide variety of communication and transportation facilities that would allow businesses to operate more efficiently and profitably. In some cases these projects were paid for directly (tolls, for example) and in other cases they were paid for tax revenues generated by higher levels of economic activity.

It is easy to make a case for state involvement in infrastructure investment. The costs of infrastructure can be very high, while even if the benefits are much higher they are likely to be diffused throughout the economy, making it hard for any individual company to justify absorbing the costs of investment. In this case the state should fund infrastructure investment and pay for it through the higher taxes generated by greater economic activity.

For me the interesting question, especially in the Chinese context, is not whether the state should build infrastructure but rather how much it should build. In fact this is one of the greatest sources of confusion in the whole China debate. Most China bulls implicitly assume that infrastructure spending is always good and the optimal amount of infrastructure is more or less the same for every country, which is what allows them to compare China’s per capita capital stock with that of the US and Japan and conclude that China still has a huge amount of investing to do because its capital stock per capita is so much lower.

But this is completely wrong, and even nonsensical. Infrastructure investment is like any other investment in that it is only economically justified if the total economic value created by the investment exceeds the total economic cost associated with that investment. If a country spends more on infrastructure than the resulting increase in productivity, more infrastructure makes it poorer, not richer.

In China we have problems with both sides of the equation. First, we don’t know what the true economic cost of investment in China might be. In order to calculate the true cost we need to add not just the direct costs but also all the implicit and explicit subsidies, most of which are hidden or hard to calculate.

The most important of these subsidies tends to be the interest rate subsidy, and this can be substantial. If interest rates in China are set artificially low by 5 percentage points, for example, which is a reasonable estimate, an investment of $100 million receives an additional subsidy of $5 million for every year that the loan funding the investment is outstanding – and loans are almost never repaid in China. Over ten to twenty years of outstanding debt this can add 30-40% to the initial cost of the investment. This means that the recognized cost of an infrastructure project is much lower than the true economic cost, with the difference being buried in explicit and implicit subsidies.

But the bigger problem is in the value created by the investment. We can think of the value of infrastructure primarily as a function of the value of labor saved. In countries with very low levels of productivity, each hour of labor saved is less valuable than each hour saved in countries with high levels of productivity. For this reason less productive countries should have much lower capital stock per capita than more productive countries.
This should be obvious, but it seems that often it isn’t. When analysts point to high quality infrastructure in China whose quality exceeds comparable infrastructure in rich countries, this is not necessarily a good thing. It might just be an example of the amount of waste you can achieve when spending is heavily subsidized, when there are strong political (or pecuniary) incentives for expanding investment, and when there is limited transparency and accountability.

Other things matter too. If a country has low levels of social capital – if it is hard to set up a business, if less efficient businesses with government connections can successfully compete with more efficient businesses without government connections, if the legal and political structure creates problems in corporate governance (the “agency” problem, especially), if the legal framework is weak, if property rights are not respected, if intellectual property can easily be lost – then much infrastructure spending is likely to be wasted.

In fact it turns that it may be far more efficient to focus on improving, say, the legal framework than to build more airports, even though (and perhaps because) building airports generates more growth (and wealth for the politically connected) today. Weak social capital becomes a constraint on the ability to extract value from infrastructure, and this constraint is very high in poor countries with weak institutional frameworks.


Journey to the West

This issue of how much investment is enough is a very important topic that deserves much more discussion, but I think there is a very good example of why we need to be worried about how useful additional infrastructure investment in China might be. This shows up most clearly in China’s push to create development in the western part of the country.

Often when I question the economic value of China’s push to the western, poorer parts of the country (by the way economic value is not the same as social or political value, the latter of which may nonetheless justify projects that are not economically viable) I am almost always treated with the story of the American West. In the 19th Century, as everyone knows, the US went west, and most economists agree that this made economic sense for the country and was an important part of the process that led it to becoming the wealthiest and most productive country in history.

But we must be very careful about drawing lessons from the American experience. The US is not the only country in history that “went West”. Several other countries did so too, but for some reason we ignore their experiences altogether when we discuss China. Brazil, for example, went west and north in the 1950s and 1960s as it expanded from the rich southern coastal areas into the Amazon and the Caribbean. The Soviet Union did something similar after the Second World War as it went east into Siberia.

Most economists today agree that the Brazilian and Soviet experiences were economically unsuccessful and left those countries burdened with such enormous debts that they were at least partly to blame for Brazil’s debt crisis in the 1980s and the collapse of the Soviet economy in the 1970s. It turns out, in other words, that there are both successful and unsuccessful precedents for China’s going west.

What are the differences and how do they apply to China? Again, I can’t say that I can fully understand or explain them, but one major difference leaps out. In the US it was private individuals, seeking profitable opportunities, that led the move into the American West, and government investment followed. In Brazil and the Soviet Union, however, there was little incentive for private individuals to lead the process. It was the government that led, and private businesses followed only because government spending created great opportunities for profit. Once government spending stopped, so did business.

My very preliminary conclusion is that large-scale government ambitions allied to strong political motivation and funded by cheap and easy access to credit can lead very easily to the wrong kinds of investment programs. The US experiences of government investment in the 19th Century, in other words, may be a very poor precedent for understanding China’s current policy of increasing investment spending, especially in the poor western part of the country.

Brazil and the Soviet Union may be much better precedents. At the very least these gloomier experiences should not be ignored when we think of China’s policies. “Going West” isn’t always a great idea from an economic point of view and has led to at least as many, and probably more, bad outcomes as good outcomes. It is not clear why these lessons cannot possibly be applied to China.


A sound system of national finance

The third pillar of the American System was the creation of an appropriate financial system. But what does that mean? It is hard to describe the American financial system in the 19th Century as stable and well-functioning. In fact the American banking system was chaotic, prone to crises, mismanaged, and often fraudulent, and yet the US grew very rapidly during that time.

China’s banking system, on the other hand, is far more stable – in fact the favorite cliché of Chinese bankers is that while the system may not be efficient, it is very stable. What makes the Chinese banking system stable, of course, is that it is widely believed that the government stands fully behind the banks. It makes no difference, in other words, how weak the credit allocation decision is, because by controlling credit and the deposit rate, and by limiting alternatives for Chinese savers, the government guarantees both the liquidity and solvency of the banking system. As long as government credibility is intact, the banking system is unlikely to fail.

In that sense you can easily make the case the Chinese banks today are sounder than American banks in the 19th century. This might bode well for the future of the financial system in the short term, but in the long term it is not clear to me that monetary soundness and financial stability are necessarily correlated with more rapid growth.

I say this because I have seen no evidence that countries with sound and conservative financial systems grow faster than countries with looser and riskier financial systems (although they do seem to have fewer financial crises). In fact I have more than once made reference to Belgian bank historian Raymond de Roover’s provocative and profound comment that “perhaps one could say that reckless banking, while causing many losses to creditors, speeded up the economic development of the United States, while sound banking may have retarded the economic development of Canada.” Canada was blessed (or cursed, according to de Roover) in the 19th Century with being part of the Britain, and so inheriting England’s much better managed financial system.

“Reckless” banking is hard to define, and certainly it is easy to make the case the Chinese banking has been reckless, especially in recent years, but it is a very different type of recklessness. Once again I cannot say with complete confidence how China’s version of its development model differs meaningfully with the American System on the subject of banking, but I would suggest there are at least two very important differences.

First, the American financial system then (and now) has been very good at providing money to risky new ventures. It provides capital on the basis not only of asset value but, more importantly, on future growth expectations, and risk-taking has been actively rewarded. In China it isn’t clear that this is the case at all. Chinese banks favor large, well-connected, and often inefficient giants at the expense of risk-takers.

Second, although both systems were prone to bad lending, the American banking system tended to correct very quickly – in the form of a crisis – and bad loans were written down and liquidated almost immediately. This was certainly painful in the sort term – especially if you were a depositor in the affected bank – but by writing down loans and liquidating assets three important objectives were achieved. Financial distress costs were quickly eliminated (writing down debt does that in ways I won’t get into because they are well-known and much discussed in corporate finance theory), capital allocation was driven by profitability, not by implicit guarantees, and assets were returned to economic usefulness quickly.

A classic example of the last of these objectives may be the response to the railway bubble of the 1860s. During and after the 1873 crisis, a number of railroads went bankrupt, including major lines like the Union Pacific and the Northern Pacific, the latter of which even brought down Jay Cooke & Company, the leading financier of the US government during the Civil War. After the crisis some major railway bonds traded as low as 15-20% of their original face value, and so they were purchased and reorganized at huge discounts. The new buyers were consequently able to cut freight and passenger costs dramatically, in some cases by over 50%, while still earning more than enough to cover the costs of buying the railroads, and this led to a collapse in transportation costs in the US.

Liquidation, in other words, provides an important economic value to the economy. It allows assets to be re-priced, which creates a boost to the economy and prevents those assets from acting as a deadweight loss. If the railroads hadn’t been liquidated, in other words, any reduction in costs was likely to be minimal and the railroads would have been far less useful to the development of the US economy.


Comparing development models

 ...

1. Infant industry protection has worked to promote long-term development under certain conditions and has not worked under other conditions. I would argue that the key difference is that in the former case there were powerful forces that drove managerial and technological innovation and rapid growth in efficiency.

In the US case this seems to have been brutal domestic competition. If China wants to benefit from its own protection of infant industry, it is important that there be similar domestic drivers of innovation and efficiency. Note that access to cheap capital cannot be such a driver, even though it is one of the main sources of Chinese competitiveness. Access to cheap capital is just another way to protect infant industries from foreign competition.

2. Every country that has become sustainably rich has had significant government investment in infrastructure, but not every country that has had significant government investment in infrastructure has become sustainably rich. On the contrary there are many cases of countries with extraordinarily high levels of infrastructure investment that have grown for a period and then faltered.

I would argue that the difference is almost certainly the extent of capital misallocation. In some countries it has been much easier for policymakers to drive capital expenditures, and in those countries it seems to have been relatively easy to waste investment. If this is the case in China, as I believe it is, the key issue for China is to rein in its spending and develop an alternative and better way to allocate capital.

The point is that there is a natural limit to infrastructure spending, and this limit is often imposed by institutional distortions in the market economy. When this natural limit is reached, more investment in infrastructure can be wealth destroying, not wealth enhancing, in which case it is far better to cut back on investment and to focus on reducing the institutional constraints to more productive use of capital, such as weak corporate governance and a weak legal framework. The pace of infrastructure investment cannot exceed the pace of institutional reform for very long without itself becoming a problem.

3. Any economy looking to achieve sustainable long-term growth must have a “good” financial system that allocates capital efficiently and rewards the correct level of risk-taking. It is hard to determine what the characteristics of a “good” financial system are, but we shouldn’t be too quick to assume that this has to do with stability.

What’s more, while obviously the capital allocation process is vitally important, I would also suggest that the liquidation of bad loans is just as important. Bad loans, as Japan showed us in the past two decades, can become a serious impediment to growth in part because financial distress distorts management incentives in the way widely understood and described in corporate finance theory and in part because they retard the process by which bad investment is absorbed by the economy.

4. One thing I have not discussed above is the role of wages. The American System was developed in opposition to the then-dominant economic theories of Adam Smith and David Ricardo, in part because classic British economic theory seemed to imply that reductions in wages were positive for economic growth by making manufacturing more competitive in the international markets. A main focus of the American System, however, was to explain what policies the United States, with its much higher wages than in Europe at the time, had to engineer to generate rapid growth. Sustaining high wages, in fact, became one of the key aspects of the American System.

The Japanese version of this development model, as well as many of the various versions implemented in other countries throughout the 20th Century, shared its view of wages not with the American System but rather with classic British economic theory. Rather than take steps to force up wages and keep them high – thereby both driving productivity growth and creating a large domestic consumption market for American producers – many of the later versions of the American System sought to repress growth in household income relative to total production as a way of improving international competitiveness. This is perhaps the main reason why the United Sates, unlike many other countries that have implemented similar development strategies in the 20th Century, tended to run large current account deficits for much of the 19th Century.

This different focus on whether high wages are to be encouraged or discouraged is, I believe – although very little discussed in the theoretical literature as far as I know – nonetheless perhaps the most important difference between the American development model and its many descendants in the 20th and 2st centuries. I would even argue, although I cannot prove it, that one consequence of this difference is that growth in demand tends to be more sustainable when it is balanced between growth in both consumption and investment.

In analyzing China’s growth in the past three decades we seem to forget that there have been many growth “miracles” in the past two hundred years. Some have been sustainable and have led to developed country status but many, if not most, were ultimately unsustainable. Nearly all of the various versions have had some similar characteristics – most obviously infant industry protection, state-led investment in infrastructure, and a financial system that disproportionately favored producers at the expense of savers – but the way these characteristics played out were very different, in large part because the institutional structure of the economy and the financial sector created a very different set of incentives.

I would argue that in understanding China’s growth and its sustainability we need to have a clear understanding of why these characteristics worked in some cases and not in others. Most economists who focus on China seem to know little about economic history, and when they do, their knowledge tends to be limited to a very superficial understanding of US economic history. But there are many precedents for what is happening in China and not all suggest that further Chinese growth is inevitable.
On the contrary, the historical precedents should worry us. In most cases they suggest that China has a very difficult adjustment ahead of it and the closest parallels to its decades of miracle growth suggest unfavorable outcomes. Understanding why the growth model has succeeded in some few cases and failed in most will help us enormously in understanding China’s prospects.