Early this month Martin Wolf had another of his very interesting articles, this time on China, which I think suggests some of the concerns we must have about the upcoming adjustment. Wolf argues that it may be useful to think about Japan as a model for understanding the adjustment process in China since the Japanese model shows how risky it is to shift to a slow-growth model. I of course agree.
"As the experience of Japan has shown, managing a shift from a high-investment, high-growth economy to a lower-investment, lower-growth economy is very tricky. I can envisage at least three risks. First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.
"Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding ‘shadow banking’ sector.
"Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment."
In his article Wolf implicitly refers to a process on which he doesn’t actually dwell much, but which I think is very important. A lot of economies, and especially developing economies with distorted balance sheets and one or two major drivers of growth, can have embedded in their economic institutions self-reinforcing mechanisms that can be very powerful.
I discuss this a great deal in my book, The Volatility Machine. As a consequence of these self-reinforcing mechanisms, I argue, movements in any direction can be sharply magnified, so that positive shocks will often result in much faster growth than anyone expected. But this comes at a cost. The reversal of these shocks often can result in much slower growth than anyone expected, or even in a wholly unexpected collapse into crisis.
Wolf mentions in his second point the relationship between slower growth and rising bad debt, for example, and he is absolutely correct, but I would add that rising bad debt itself puts pressure on the financial system in a way that creates at least two additional problems. First, it makes banks reluctant to increase credit further. Second, the rising bad debt increases the hidden transfer from the household sector needed to resolve the debt, which then puts downward pressure on household consumption.
This of course is self-reinforcing. Why? Because slowing growth caused an increase in bad debts, but an increase in bad debts will cause further slowing in growth.
We speak of the case in which positive shocks are self-reinforcing, as a virtuous circle, and the case in which negative shocks are self-reinforcing as a vicious circle, but the important point is that these processes are part of the same system and are very common.
It is usually a pretty safe bet, for example, that when an economy is surging forward at astonishing growth rates – rates which far exceeded anyone’s prior expectations – it has powerful positive feedback loops embedded within its economic institutions.
In my book I focus mostly on balance sheet feedback loops, but they also exist just as powerfully in the underlying economy. Urbanisation, for example, can create very strong feedback loops.
How does it work? In the early stages of growth, productive jobs are created in the urban areas, for example as factories are built, and workers very quickly leave the countryside to take these jobs. They are also willing to move quickly around the country, so that migration is very sensitive to the perception of demand.
As workers move to the cities, their need for housing and services immediately rises, and their expenditures create additional jobs. What’s more, their remittances create capital accumulation and higher expenditures in their home areas that cause rural growth to increase by more than it otherwise would have. In the end the original investment in the factory is quickly multiplied throughout the economy, so that growth creates urbanisation and urbanisation creates more growth in a virtuous circle.
This process is reinforced by the impact of the original investment on the financial sector. As workers get jobs, part of their income is consumed, creating more demand and more jobs, and part of it is saved, which allows banks to direct the additional savings into higher investment. Since the growth impact of this process in the early stages of industrialisation can be very high, this creates stronger growth expectations, which then justify even higher investment in capacity and infrastructure.
It is probably not a coincidence that in such developing countries that are growing quickly we almost always see credit growth far surpass anything we might have expected. The impact of financial deepening can be extremely strong in a country that starts out with a very weak and underdeveloped financial system, and as growth exceeds expectations year after year, perhaps not surprisingly, credit standards are weakened and money pours into projects that might have otherwise been considered risky.
But what happens when these productive jobs dry up and the economy starts to slow, especially if it slows after credit has been too liberally extended? For one thing, either very quickly the workers go home, or they remain in the cities as unemployed workers without savings or social safety nets. In the former case the goods and services they demanded also disappear quickly and unemployment rises by even more than the direct impact of the reduction in jobs. If they remain in the city they create a drag on social expenditure (and perhaps a rise in crime) that transfers spending from more productive to less productive sectors.
As urbanisation reverses, or even as it simply slows, it becomes self-reinforcing in the wrong direction. These kinds of feedback loops exist in every economy, but for a variety of reasons they seem much stronger in developing countries with weak institutional structures, in countries that are undergoing rapid social and economic change, and in countries with rigid and unsophisticated financial systems.
This feedback process may explain one of the puzzles typical of developing countries, and especially developing countries undergoing an investment boom. The historical precedents suggest that in the early stages of a growth miracle we are always surprised by the extent of growth – growth far exceeds even our wildest expectations.
Once the economy begins to slow, however, we have also been – in every case that I can identify – shocked by how vicious the slowdown turned out to be. This would not be a surprise if indeed these economies are caught up in very powerful feedback loops. On the contrary, this would be normal.
What does all of this have to do with Martin Wolf’s article? Wolf suggests plausible reasons for expecting a slowdown in Chinese growth, but his idea of a slowdown is relatively moderate and would, in fact, be considered rapid growth in most economies. But if part of the explanation for China’s spectacular – and spectacularly unexpected – growth of the past three decades has to do with the positive feedback loops that are so typical of developing countries with fragile and unsophisticated financial systems, then a moderate slowdown in growth may be an impossible target to achieve.
Once growth starts to slow, the self-reinforcing impact on urbanisation, on credit growth, on financial distress, and on expectations may force growth rates to drop far more sharply than any ‘plausible’ analysis would suggest.
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, where a longer version of this article first appeared.