China rebalances for a sustainable future

After many false starts, there is now evidence that the long-awaited, and much desired, Chinese rebalancing – where consumption reels in investment as the engine of growth – has finally started.

Unlike some other analysts, I am not concerned about deflation persisting for long unless the People's Banks of China cuts interest rates much more sharply than any of us expect. I know this may sound strange – most analysts believe that cutting interest rates will actually reignite CPI inflation – but remember that the relationship between inflation and interest rates in China is, as I have discussed many times before, not at all like the relationship between the two in the US. It works in the opposite way because of the very different structure of Chinese debt and consumption.

Hard landing?

Overall at any rate things seem to be going so badly in the economy that in July Premier Wen Jiabao warned, yet again, that the economy is under serious pressure, and then did the same two days later. According to an article in Xinhua, Wen then reaffirmed Beijing’s commitment to growth:

"Premier Wen Jiabao said that stabilising economic growth is the most pressing matter currently facing China. Policies and measures to stabilise economic growth currently include boosting consumption, diversifying exports and promoting investment, Wen said while meeting representatives from research institutes and companies," it read.

"The emphasis on investment to shore up growth comes as the world’s second-largest economy is being challenged with slumping external demand and low consumption at home. Wen said the structure, quality and cost-effectiveness of investment should be given greater importance, adding that investment should be used to improve livelihoods and help the country develop scientifically."

Given the very weak CPI and PPI numbers, and Beijing’s reactions, China seems very clearly to be heading towards a hard landing, and many Chinese and foreign experts are urgently warning that Beijing must cut interest rates even more sharply, expand credit, and so save China and the world from disaster. We’ve already had two cuts this year in the lending rate.

The cuts, or at least the first one, seem to have some impact. Although loan growth has been much slower than expected for most of this year, the June loan numbers finally surprised the market on the upside.

Mark Williams, at Capital Economics, added a lot more colour:

"China’s bank lending (in June) turned out not to be as weak as we had feared. Net new loans amounted to RMB920 billion ($138 billion). This was only slightly above the median forecast of analysts surveyed by Bloomberg (RMB880 billion) as well as our own (RMB900 billion). But ever since the People’s Bank cut interest rates last week, we had thought that the risks to these forecasts were skewed heavily to the downside, on the belief that weak lending was the most likely trigger for the rate move."

"In fact, new lending was significantly higher last month than in May when it reached RMB793 billion. That suggests that government attempts to revive bank lending were starting to work, even before July's rates move.

"The fact that the government has continued to loosen nonetheless is positive for GDP growth in the near-term. A continued pick-up in lending to fuel investment should quieten immediate doubts about the economy in the months before the leadership handover. But it is questionable how much stimulus China really needs at this point and, in particular, the degree to which more investment-led growth should be welcomed."

I think Williams is right, and I agree that those calling for additional interest rate cuts and more rapid investment and credit expansion are wrong. Why? Because what is happening in China may be just what China and the world need. After many failed attempts, over the past six months we may be seeing for the first time the beginning of China’s urgently needed economic rebalancing, in which China reduces its over-reliance on investment in favour of consumption.

Regular readers of my newsletter may be surprised to see me say this. For the past four or five years analysts have been earnestly assuring us that the rebalancing process had finally begun, and I had always insisted that it couldn’t have begun yet. Why? Because as I understand it rebalancing is almost arithmetically impossible under conditions of high GDP growth rates and low real interest rates. Once the real numbers came in, it always turned out that in fact imbalances had gotten worse, not better. Typically many of those too-eager analysts have resorted to insisting that the consumption data are wrong, although even if they are right this does not confirm that rebalancing had taken place since errors in reporting consumption have always been there.

But this time seems different. Now for the first time I think maybe the long-awaited Chinese rebalancing may have finally started.

Of course the process will not be easy. Debt levels have risen so quickly that unless many years of overinvestment are quickly reversed China will face debt problems, and maybe even a debt crisis. The sooner China starts the rebalancing process, in other words, the less painful it will be, but one way or the other it is going to be painful and there are many in China who are going to argue that the rebalancing process must be postponed. With China’s consumption share of GDP at barely more than half the global average, and with the highest investment rate in the world, rebalancing will require determined effort.

How to rebalance

The key to raising the consumption share of growth, as I have discussed many times, is to get household income to rise from its unprecedentedly low share of GDP. This requires that among other things China increase wages, revalue the renminbi and, most importantly, reduce the enormous financial repression tax that households implicitly pay to borrowers in the form of artificially low interest rates. But these measures will necessarily slow growth.

The financial repression tax, especially, is both the major cause of China’s economic imbalance and the major source of China’s spectacular growth, even though in recent years much of this growth has been generated by unnecessary and wasted investment. Forcing up the real interest rate is the most important step Beijing can take to redress the domestic imbalances and to reduce wasteful spending.

And this seems to be happening. Beijing has reduced interest rates twice this year, and reluctant policymakers are under intense pressure to reduce them further. The students in my central bank seminar at PKU tell me that there are new rumours about the way the cuts were implemented. "Usually it is the PBoC that submits a proposal of rates cut to the State Council,” one of them wrote me recently, "but this time it was the State Council who handed down to the PBoC the decision to cut rates, so that the PBoC was not fully aware of the rates cut before July 5.”

If my student is right (and this class has an impressive track record), this suggests that monetary easing is being driven by political considerations, not economic ones, which of course isn’t at all a surprise. But even with the rate cuts, perhaps demanded by the State Council, with inflation falling much more quickly than interest rates the real return for household depositors has soared in recent months, as has the real cost of borrowing.

China, in other words, is finally repairing one of its worst distortions.

But this necessarily comes at a cost. Raising the real borrowing cost cannot help but reduce investment growth and increase cashflow pressure on local governments, and so with the rise in real rates China’s GDP growth rate must fall sharply. China bulls, late to understand the unhealthy implications of the distortions that generated so much growth in the past, have finally recognised how urgent the rebalancing is, but they still fail to understand that this cannot happen at high growth rates. The problem is mainly one of arithmetic. China’s investment growth rate must fall for many years before the household income share of GDP is high enough for consumption to replace investment as the engine of rapid growth.

As China rebalances, in other words, we would expect sharply slowing growth and rapidly rising real interest rates, which is exactly what we are seeing. Rather than panicking and demanding that Beijing reverse the process, we should be relieved that Beijing is finally resolving its problems.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.