Key Trends in the World Economy

Comparison of relative performance of China and the West since the financial crisis began

I greatly admire and avidly read Gavyn Davies blog, but his latest comments on China, unusually, lack precise numbers which therefore creates some ambiguities which can give unnecessary credibility to wrong analysis. Putting in precise numbers should bring clarity.

China's government has spelt out officially its precise growth target. That is to increase GDP by 100% in 2010-2020 – about four times the prospective growth rate of the US in the same period.

Given China’s cumulative growth in 2010-2012 (17.8%) this means China has to hit a 6.9% average growth rate for the rest of the decade to achieve its target. As all this is unambiguously spelt out the relevant yardstick is whether China will achieve this.

It is a wholly spurious method, not used by Gavyn but used by others, to invent some target China never set and then claim there is a ‘crisis’ because China has ‘failed’ to achieve a target it never put forward! There is no indication China is falling below its projected growth target - China’s growth this year will clearly be above the target rate.

If Gavyn, or anyone else, wants to say argue there is a serious crisis in China, they have to claim growth will fall below the average 6.9% rate – some people do of course, so we will examine that below.

As for the efficacy of the 2008 stimulus programme it can be seen in two sets of figures. In the five years between the 1^st quarter of 2008 and the 1st quarter of 2013 China’s GDP grew by 51.8% and the US by 3.5% - the EU and Japan contracted. This is shown in Figure 1.

Figure 1

 

To remove any claim of possible distortion caused by the depth of the US recession in 2007-2009, in the year to the 1^st quarter of 2013 China’s economy grew by 7.7% and the US economy by 1.6% - that is China’s economy grew 6.1% faster than the US economy, or at 480% of the US growth rate. This is shown in Figure 2.

Figure 2

 

The argument that China is suffering from economic ‘crisis’ on anything like the scale of the US, Europe or Japan, for example because of its recent liquidity problems, is rather like the spurious argument that really the flu is the same as polio because they are both illnesses!

As for the suggestion that Michael Pettis has been proved right I am afraid that although he edits his blog very fairly his predictions on China are extremely inaccurate. In 2009 he insisted: ‘'I continue to stand by my comment last year... that the US would be the first major economy out of the crisis and China one of the last.' This statement is entirely inaccurate – as the more than 50% growth in China and less than 4% in the US since the beginning of the financial crisis shows. His new thesis  is that: ‘'I still maintain that average growth in this decade will barely break 3%.' The projection of 3% growth is itself entirely inaccurate but given China’s existing growth this means that for the rest of the decade it would have to grow at 1.6%!!! The reason for such inaccurate predictions is that Michael Pettis makes, as shown in his book The Great Rebalancing, one of the oldest errors in economics – underconsumptionism, that is the confusion of demand (consumption plus investment) with consumption. He himself lists in the opening pages a whole series of underconsumptionist authors.

Coming back to Gavyn’s blog, China’s growth rate continues to be above the target it has set itself of 100% GDP growth in a 10 year period. That will be about 4 times US GDP growth in the same period. China will overtake the US to become the largest economy in the world in approximately 5 years. The rest of the world would be highly delighted to have such a ‘crisis'’.

I actually sort of assume Gavyn doesn’t disagree with those numbers? If I am wrong, and he does then of course it would clarify the debate, if he gave his own. But indicating numbers is the best way to clarify the discussion. My projection is simple – China will hit its 100% GDP growth target over a 10 year period.

Behind China's liquidity crisis

In June, China suffered its worst liquidity crisis in over a decade. Some sections of the U.K. and U.S. media exploded with wild comparisons to the US financial crisis in 2008.

Such comparisons were nonsense, however, based on an elementary economic mistake. The U.S. did not suffer a liquidity crisis in 2008. It faced an insolvency crisis. The former is a shortage of means to meet immediate payments; the latter occurs when banks' liabilities exceed their capital. In 2013, Chinese financial institutions faced liquidity problems, but not a single major institution failed. Numerous U.S. financial institutions collapsed in 2008. Comparing the two events is rather like claiming that the flu and the bubonic plague are equally serious, since both are illnesses!

But not being the bubonic plague doesn't mean that in its own terms flu is not unpleasant, or that it doesn't have side effects that last for some time. Therefore, it is important to analyze the crisis' causes in order to determine whether similar events will recur. While the exact form of crisis was not predictable - it never is - both Chinese economists and the present author predicted why there would be problems for the Chinese economy. Now that June's symptoms have been somewhat ameliorated, whether a similar crisis emerges in the future depends on whether the key mistake that led to the present one is resolved.

The key symptom of June's crisis was a spike in interbank lending rates to a 13 percent peak. Willingness to pay this indicated that financial institutions urgently needed cash. Analyzing the links between the underlying disease and the symptoms shows why.

The core problem that led to the liquidity crisis was advocacy that China abandon the policies which for 35 years have made it the world's most rapidly growing economy, in favor of something termed "consumer led growth," a theory that boosting consumer demand will lead companies to a more rapid increase in production of consumer goods and a more rapid rise in living standards. Unfortunately, this theory factually doesn't take into account that investment is the main source of economic growth, and conceptually it doesn't understand what a market economy actually is.

A market economy necessarily can only be "profit led growth." Output does not increase due to "demand," but only because of profit. Failure to understand this pushed the economy towards the liquidity crisis via its key policy proposal that the percentage of consumption in China's GDP be increased, and to pay for these purchases the percentage of wages in GDP should increase.

Increasing the percentage of wages in the GDP necessarily means reducing the percentage of profits. Therefore the theory of "consumer led growth" in reality advocated that a profits squeeze should be applied to companies via wages growing more rapidly than GDP. Regrettably, in the first part of 2013, this policy was pursued, with China's consumption rising significantly more rapidly than its investment, an indication wages were rising more rapidly than GDP. This produced the only possible consequence in a market economy: a chain reaction leading to crisis, which duly broke out in June in credit markets

Wages rising more rapidly than GDP squeezed company profits. By May 2013, the overall profit increase by companies listed on China's A-share market was zero percent - they were falling in inflation-adjusted terms. Consequently, both private and state-owned companies starting reining in investments. In the first five months of 2013, growth in fixed assets investment was 0.2 percent lower than growth in the first four months, and private investment growth was 0.1 percent less than it had been a year before.

This, in turn, led to economic slowdown. GDP growth fell from 7.9 percent in the last quarter of 2012 to 7.7 percent in the first quarter of 2013, placing greater pressure on profits. Profits were then squeezed further by the rise in the RMB exchange rate, which created difficulties for China's exporters.

This inevitably affected credit markets. With profit growth slowing, and in some cases, becoming negative, companies needed credits to plug holes in cash flows. Simultaneously, as companies were using cash to plug payment holes and not to invest, credit became less effective at stimulating growth. Given that profits were squeezed in most sectors, companies diverted what resources they could into markets which were more profitable - most notably, real estate, fuelling price increases in this sector. The pressure on company profitability therefore expressed itself via ballooning demand for credit, ineffectualness of credit in accelerating growth and excess upward pressure on real estate prices.

To attempt to stop ballooning credit, the Central Bank tightened liquidity. But this tackled symptoms, not the disease - rather like treating chicken pox by pressing on the spots. The disease was therefore not cured. Indeed the situation worsened as companies' cash flows were now squeezed from two directions - from the fundamental processes described above and by the Central Bank's liquidity tightening. If this dual pressure had continued, there would have been a financial collapse. Therefore, the Central Bank had to alter course and inject credits.

By supplying liquidity, the Central Bank took pressure off companies from one side, thereby overcoming the immediate crisis. But the underlying cause of the problem will not be overcome until the company profits squeeze is fully reversed.

Finally, while a crisis would have occurred anyway, it was worsened by the incomplete structure of China's banking system. China, like every country, must possess a core of system making banks that are "too big to fail." Such huge banks will never be adequately responsive to small companies' needs, however. In the U.K., which has a private dominated banking system, there are endless complaints by smaller companies about large banks! China has not yet created an adequate system of "small enough to fail" banks, which are responsive to smaller companies, around its large core lenders. Instead, an insufficiently regulated shadow banking system developed.

But the same fundamental factors that made it possible to accurately predict rapid growth of China's economy for 35 years show it is relatively easy for China to overcome these problems, as they are self-inflicted policy problems, not objective constraints.

In 2012, under the influence of the World Bank report on China, similar policies were pursued in the first half of the year. They also led to a growth slowdown. When this policy was reversed in mid-2012, with an investment stimulus, growth accelerated from 7.4 percent to 7.9 percent. In 2013, unfortunately, the wrong policy was pursued for longer and therefore led to June's crisis.

Lin Yifu, former senior vice president of the World Bank, recently stated: "Those who advocate that China's economy should rely on consumption are, in fact, pushing the country into a crisis." Regrettably, June's events confirmed these words.

Large forces in China are working against the errors that led to the June crisis. Companies do not want profits pressured. Slower economic growth will lead to less rapid increase in living standards, creating dissatisfaction among consumers. As June's events in China's financial market were a liquidity crisis, not one of solvency, and China's banks remain highly profitable with assets far outweighing liabilities, no systemic damage has been done to China's banking system. June's events simply demonstrated that even in a country with China's very strong macroeconomic fundamentals, an incoherent theory can wreak havoc. A non-sequitur like "consumer led growth," which necessarily applies a profit squeeze to companies, inevitably leads to economic crisis.

June's credit market explosions were simply the market economy reminding everyone that, within it, there can never be "consumer led growth." Only "profit led growth" is possible.

Hopefully the appropriate lessons have been drawn.

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An earlier version of this article appeared at China.org.cn.