The great trade, capital flow and debt imbalances that were built up over the preceding two decades must reverse themselves. Imbalances can continue for many years but at some point they become unsustainable and the world must adjust by reversing those imbalances.
But whether they reverse in more orderly or less orderly ways will depend on policy decisions. It is likely to be political considerations that determine how quickly the rebalancing processes take place and whether they do so in ways that set the stages for future growth or future stagnation.
My guess is that we have ended the first stage of the global crisis, and most of the deepest problems have been identified. In 2013 we will begin to see how policymakers respond and what the future outlook is likely to be. Here is what I will be watching this year in order to figure out where we are likely to end up.
1. Watch how quickly growth adjusts
The speed with which China’s GDP growth slows in 2013 will tell us a lot about how determined Beijing is to rebalance the economy in such a way that growth is driven more by higher household income and consumption and less by investment funded by rising government and government-related debt.
I expect GDP growth in the first half to be fairly high, probably close to 8 per cent, continuing the investment boom that was recently unleashed. I am not fully confident of this number because there seem to be significant strains in the banking system, and without easy credit growth there cannot be much investment growth.
At any rate it is second half GDP growth that interests me more. If Beijing has really gotten its arms around the rebalancing problem and is serious about adjusting quickly, I expect reported growth to drop sharply, perhaps close to 6 per cent. If not, I expect reported growth to remain well above 7 per cent in the second half of 2013. This would worry me.
2. Watch how quickly new debt emerges
As long as GDP is growing at levels above 6 per cent or 7 per cent, it is almost a certainty that debt is rising too fast. If GDP growth levels come in much below 6 or 7 per cent, there is a chance that debt growth is not excessive.
How do we keep track of debt levels? Obviously this is no easy task in China. But follow the cash. Large increases in infrastructure investment and in real estate development are almost always funded, directly or indirectly, by increases in debt. Many of the banks seem to be facing tight liquidity conditions, so we should also be watching payables and receivables on the state-owned enterprise balance sheets. We should also be watching off-balance-sheet activity by the banks.
3. Watch for financial scandals
We should also be keeping track of stories about defaults and bank runs. Remember that the Chinese financial system does not really "do” defaults. When borrowers are unable to repay debt out of operating cashflow, the problem is usually "managed” away by forcing losses onto some other entity.
This is why those economists who understand the structure of Chinese growth and who worry about the consequences of rising debt notice even relatively small defaults. When a default actually takes place, it usually means that the relevant principals have exhausted all other means of hiding the debt and were forced into recognising the losses.
4. Watch bank activities
More generally I am going to watch the relationship between total credit growth and the growth in renminbi loans. Much of the off-balance sheet financing in China is designed specifically to skirt regulations, and the relative size of these transactions will tell us about transparency (or lack thereof). A typical example of this might be this Bloomberg article from last Wednesday:
"New yuan loans probably dropped 14 per cent last month from a year earlier, according to the median projection in a Bloomberg News survey of 37 analysts ahead of data due by Jan. 15. That would give bank lending a 55 per cent share of aggregate financing for 2012, based on UBS AG estimates, the least in figures dating to 2002."
In 2002, if I remember correctly, bank lending represented 93 per cent of aggregate financing as defined by the People’s Bank of China as total social financing.
5. Watch inflation
If China is truly rebalancing, at least part of this is going to show up in upward inflationary pressure, although it is likely to be the "right” kind of inflation – i.e. it will hurt the rich more than the poor because it will be based on non-food rather than food items. Perhaps this inflation is already starting to happen, although not in the way I would like it to happen. There has been an uptick in inflation but it seems to have been caused by the impact of cold weather on food prices, rather than because consumption of manufactured goods is rising faster than production.
6. Watch the prices of hard commodities
Of course I will be watching copper prices and prices of other hard commodities. I expect that hard commodity prices will fall sharply over the next two to three years, but to the extent that prices rise in the short term, as they have in the past three months, it is likely to reflect additional investment growth in China.
7. Watch the trade numbers
China’s trade surplus for November came in much higher than expected, although there are so many discrepancies in the numbers that not all of us are confident about how to interpret the numbers.
Yet in spite of this confusion the direction of the trade numbers, especially the trade surplus, tells us something important about the rebalancing process. Remember that the current account surplus is simply equal to the excess of savings over investment. China must bring both its savings rate and its investment rate down sharply. If it can bring savings down faster than investment, China is probably rebalancing in the right way, and this should show up as strong growth and a declining trade surplus.
8. Watch the Spanish bond market
I do not think anything important has changed as far as the European crisis is concerned. The fact that there is an additional liquidity for bond purchases does not mean, as I see it, that Spanish competitiveness has been resolved and it does not mean that the economy can grow out of its debt burden. It simply means that there is temporarily a little less pressure to resolve the underlying problems. I would guess that by the second quarter of 2013, and likely earlier, markets will once again have gotten much worse.
More important to me is that Spain’s household savings rate fell to its lowest level on record in the third quarter of last year. If Spain is going to repay its debt it probably will need to be a net exporter of savings, which means that savings have to exceed investment. If savings decline, the only way for this condition to be met is for investment to decline much more quickly. This, of course, isn’t good for growth.
9. Watch Target2
Germany’s central bank, the Bundesbank, reported this week that imbalances in Europe’s so-called Target2 settlement system, in which eurozone central banks and the European Central Bank transfer money across the common currency union, have declined. As the euro crisis progressed, the system had become massively imbalanced, which could result in massive losses for countries such as Germany should Greece, for example, be forced to exit the eurozone.
For the same reason that I am not optimistic about the Spanish bond market I am also not optimistic that Target2 will continue to reverse. If it does, of course, that will be a great sigh, but if it doesn’t, and if in fact the imbalances continue to grow, that will put additional stress on Germany’s ability to maintain the euro system.
10. Watch Japan
Remember that Japanese attempts to get their arms around their huge debt burden will almost certainly affect China and the rest of the global economy.
I am not smart enough to tell you what Japan will do, but I do know that almost anything it does must affect the relationship between its savings and its investment, and hence Japan’s current account surplus, which I suspect everyone hopes will rise. Of course everyone else wants the same thing too – rising exports relative to imports – which is clearly impossible, but Japan needs it more urgently than most of the rest of us. This is going to increase strains on the global trading system.
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.