Since the beginning of the global crisis in 2007-08 I have argued that the crisis was a consequence primarily of global trade imbalances generated by structural features that led to significant saving imbalances in China, the US, and within Europe. I describe this model in more detail in my recent book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy.
If my model for thinking about the global imbalances was an accurate description of the source of the crisis, there would obviously be a number of “predictions” arising from the model. I discussed this in a number of articles and, two years ago, summarised them in the form of 12 “predictions”.
…It is still too early for all of these predictions either to have materialised or to have failed, but I thought it might be useful to review them to see whether or not they have been reasonably accurate in describing unfolding events and, if not, how my model for thinking about global imbalances should be revised. My reason for doing this is not so much to keep score but rather that these predictions were almost necessary or logical outcomes of the savings imbalance model I implicitly use to understand the world, and so to the extent that my model is valid it should show up in the evolution of these predictions.
Obviously a truly clever economist never makes a verifiable prediction, and if he does he should never refer to that prediction subsequently, so it is with a sense of trepidation that I do so, but here goes:
1. BRICs and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.
… We are already beginning to see this, but I would argue that we are only at the beginning of the process. The next three or four years are going to see much greater pain among the emerging markets and probably more than one sovereign default or restructuring.
Given the huge change in sentiment in the last year that has already taken place about prospects for the emerging economies, and the sharp slowdown in growth in China and other developing countries, I am tempted to declare victory and say this prediction was correct, but of course it is much too early to say anything of the sort. If I am right, it must get worse. We have only just started to recognise the impact of slower investment growth.
2. Over the next two years Chinese household consumption will continue declining as a share of GDP.
I expected consumption to continue declining as a share of China’s GDP because the low consumption share was a consequence of the low household income share, which was itself an automatic consequence of China’s growth model. The consumption imbalance, in other words, could not change until the model was basically abandoned, which I did not expect to see until the new administration came in and recognised how the growth model was leading inexorably to a credit problem.
In fact the unsustainability of the surge in debt became apparent much earlier than I expected, and it seems that the consumption imbalances may have stabilised.
…We don’t know how the next banking crisis will be resolved. The old way – forcing the household sector to pay in the form of negative returns on their deposits – is I think still the default thinking among policymakers, but I don’t think it can possibly work again. Not only is the household share of GDP much too low to tolerate the huge transfers needed to resolve the next banking crisis, but with Beijing determined to rebalance the economy away from investment and towards consumption, it should eventually become pretty clear, if it isn’t already, that the next banking crisis will have to be paid for by transfers from the state sector.
This means that the next few years are critical. Nominally the consumption share has stabilised, which, I am glad to say, means my prediction may have been too pessimistic. But we won’t really know until we see if there is indeed a surge in bad loans in the next two to three years and how Beijing responds.
3. Chinese debt levels will continue to rise quickly over the rest of this year and next.
No one doubts anymore that debt is growing much too quickly. But there really should never have been any surprise about China’s unsustainable debt path. I argued that given the systematic tendency to investment allocation that has driven growth for the past several years, an unsustainable increase in credit is a necessary condition for GDP growth levels much above 3-4 per cent, not an accident caused by spates of irresponsible lending, and whether or not you agree with me I think it would be hard to disagree that credit growth has been astonishing.
For my model to be right, either GDP growth must slow significantly in the next year or two, or if it doesn’t, credit will continue to surge dangerously and perhaps reach debt capacity constraints within two or three years. The consensus seems to be that growth won’t slow. Credit Suisse, for example, sort of in the middle of the pack, wrote in its recent research note that “We call for growth to stabilise, without much upside momentum. We revise up our forecasts for 2013 GDP growth to 7.6 per cent from 7.4 per cent and 2014 to 7.7 per cent from 7.6 per cent.” It is only if the growth forecasts by analysts like those at Credit Suisse are right, and, instead of surging, credit growth slows substantially, that this aspect of my interpretation of China’s growth model will have been proven wrong.
4. Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3 per cent well before the end of the decade.
The first part obviously turned out to be dramatically right – in fact growth began to slow sharply in 2012 for reasons I discuss in the next “prediction”. Whether the second part will also be right is exactly where the debate is now, and I stick to my prediction. The key, as I note above, is whether China can engineer GDP growth rates much above 3-4 per cent without even more rapid growth in credit.
5. If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.
This was a pretty good prediction in spite of the fact that only the most ferocious of bears didn’t agree, and to its credit (or, as rumours have it, to the credit of Li Keqiang even before he became premier), the PBoC did not cut interest rates. Growth indeed began slowing sharply in 2012. The same story stands. If the PBoC begins to cut interest rates sharply, growth will pick up but debt will explode.
6. Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.
I argued at the time that as a result of the disproportionate impact of a GDP slowdown on Chinese demand for hard commodities, the price of hard commodities would drop by over 50 per cent in the next five years. So far this seems to be happening, perhaps even faster than I predicted. According to an article three weeks ago in the Wall Street Journal “copper prices have dropped 30 per cent from their 2011 peak, and iron ore is down 32 per cent,” while The Economist shows an interesting graph on iron ore prices in a recent issue.
According to the graph iron ore traded around $190 at the time I made my prediction and has dropped since then to around $120. The only additional comment I would make is that I think the decline in the prices of hard commodities from their peaks will turn out to be much greater than 50 per cent. I wouldn’t be surprised at all if iron traded well below $50, for example, within the next three years.
7. Much slower growth in China will not lead to social unrest if China meaningfully rebalances.
…After many years of annual GDP growth above 10 per cent, it would seem that a sharp drop in GDP growth rates to below 6-7 per cent would clash with the rising expectations of ordinary Chinese. Won’t slower growth lead to social unrest and perhaps political chaos? Not necessarily. My recent Financial Times article concluded by saying:
“For China successfully to rebalance towards a healthier and more sustainable model without unrest, the growth rate that really matters, as a number of prominent Chinese economists have already noted, is that of median household income. Ordinary Chinese, like people everywhere, do not care about their per capita share of GDP. They care about their income.
“In recent decades real disposable income has grown at well above 7 per cent a year on average. To ensure social stability, it should continue growing at this rate or close to it. But growth in household income and household consumption of about 6-7 per cent implies that, if China is to rebalance meaningfully, GDP must grow by “only” 3-4 per cent. This much lower rate is consistent, among other things, with almost zero investment growth.
“China’s GDP, in other words, does not need to grow at 7 per cent or even 6 per cent a year in order to maintain social stability. This is a myth that should be discarded. What matters for social stability is that ordinary Chinese continue to improve their lives at the rate to which they are accustomed, and that the Chinese economy is restructured in a way that allows it to tackle its credit bubble.
“If household income can grow annually at 6-7 per cent, income will double in 10 to 12 years, in line with the target proposed by Premier Li Keqiang in March during the National People’s Congress. What is more, if China can do this while the economy is weaned off its addiction to credit, it will be an extraordinary achievement, even if it implies, as it must, that GDP grows far more slowly that the growth rates to which we have become accustomed.”
8. Within three years Beijing will be seriously examining large-scale privatisation as part of its adjustment policy.
The only relatively quick way to rebalance the Chinese economy (and they probably don’t have time to do it gradually), which by definition means that households must retain a higher share of GDP and the government a lower share, is to transfer assets from the state sector to the household sector. This will not be easy.
Privatisation is the most efficient way to do it, but there will be tremendous political opposition to doing so. I am pessimistic about the likelihood of a serious privatisation program, but there is no question that it is being increasingly discussed, for example in a recent article in the New York Times by Chinese banker Joe Zhang, in which he says:
“Thus, to avoid long-term stagnation, China will soon have to embark on a second wave of privatisation, as the government is running out of options to fund further growth. Its fiscal deficits have risen quickly, banks are overextended and land sales have become untenable. Moreover, there are growing calls for the government to replenish the inadequate social security fund to meet the needs of an aging population.”
…I expect these discussions to get more heated in the next two years.
9. European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalised or marginalised.
There certainly has been some deterioration in European politics, but I confess I am surprised by how little has happened so far. Still, for the reasons discussed in the 12th prediction, below, I do not expect conditions to improve.
10. Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.
I continue to be quite certain of this but, as I said in my original prediction, we will probably have to wait another two or three years before the debate about leaving the euro becomes central to the political discussion (I think only in Portugal and Greece is this debate taken seriously). As an aside it is worth remembering that every time a weak country leaves the euro, the currency is likely to strengthen and so the overall burden of adjustment will, at the very least, remain the same while being concentrated on a smaller group of countries.
11. Germany will stubbornly refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.
So far, as I expected, we have not seen a serious reflation of German demand that will allow Europe to adjust without either punishingly high unemployment for many years or an attempt to force European imbalances abroad in the form of a huge European trade surplus. I discuss this in much greater detail in a VoxEU interview earlier this year. Without a German reflation, which they are unlikely to do because of their own debt concerns, I don’t really see many other options for Europe.
…For a few more years the deficit countries will try to bear the full brunt of the adjustment while Germany scolds and cajoles from the side. Eventually they will be unable politically to accept the necessary high unemployment and they will intervene in trade – almost certainly by abandoning the euro and devaluing. In that case they automatically push the brunt of the adjustment onto the surplus countries, i.e. Germany, and German unemployment will rise. I don’t know how soon this will happen, but remember that in global demand contractions it is the surplus countries who always suffer the most. I don’t see why this time will be any different.
12. Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.
Trade policy in the next few years will continue to be about deciding who will bear the brunt of the global contraction in demand growth. The surplus countries, because they are so reliant on surpluses, will be very reluctant to eliminate their trade intervention policies, and in fact the current European plan, is to force the cost of the European adjustment onto its trading partners by running a large surplus. In principle this mostly means the US. Because they are making the same mistake the US made in the late 1920s and Japan in the late 1980s – thinking they are in a strong enough position to dictate terms – the surplus countries will refuse to take the necessary steps to adjust.
But in fact in this fight over global demand it is the deficit countries that have all the best cards. They control demand, which is the world’s scarcest and most valuable commodity. Once they begin intervening in trade and regaining the full use of their domestic demand, they will push the adjustment onto the surplus countries. Unemployment in deficit countries will drop, while it will rise in surplus countries.
Finally one additional “prediction” which was not included in the original list but which belongs here, was that the US would be the first major economy to emerge from the crisis of 2007-08 and China probably the last, although Europe might give China a run for its money.
13. The US will be the first major economy to emerge from the global crisis, and China will be the last.
The US, and deficit countries generally (unless they are suffering from serious financial distress), tend to adjust fairly quickly and I expected that this time would be no different. I expected the adjustment to take much longer in China because it was always likely to be politically very difficult and because the system was more rigidly locked into the policies that underlie the imbalances.
Although this was another one of the predictions that seemed to cause a lot of surprise and disbelief when I first proposed it in 2009, and even two years ago, I am pretty sure that by now no one is surprised by the claim that the US is in the process of recovery (although it can still be derailed). Nor are many surprised by the claim that China has only just begun the adjustment process (although there are still China bulls who believe China has already bottomed out).
If US growth has more or less bottomed out, and if savings rate are on a long-term upward path, and if Chinese growth has not yet bottomed out and the savings rate is forced further downward, as I expect, the US will have emerged from the crisis much sooner than China. It doesn’t matter if Chinese growth rates are currently, or ever, higher than that of the US. This should be obvious.
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.