Thursday, August 19, 2010

Pettis, China and the nature of structural imbalances

I have a lot of time for the views of Professor Michael Pettis. However, I am struggling a little with some elements of his analysis: it may be simply a lack of understanding on my part; it may be that we have different perspectives on time horizons; or perhaps a combination. Since I think that the issues are important, I decided to set down my confusions.

Let me start by outlining Professor Pettis's arguments as I understand them. I accept that I may be guilty of gross simplification; readers please correct me.

China has been following an Asian development model. This involves a focus on export led growth combined with a strong focus on capital investment. Consumption is squeezed to fund capital investment. The outcome in the Chinese case has been rapid growth combined with large export surpluses.

All this sounds pretty good, but there are problems. With time, structural imbalances emerge in the economy. Both capital investment and export activities are effectively subsidised from other parts of the economy. With time, these subsidies become more difficult to maintain: real returns on capital investment fall and may in fact become negative; investment and exports become so large relative to the rest of the economy that simple maths make it increasingly difficult to maintain the process; exports themselves become a problem.

By definition, trade surpluses in one country have to be matched by deficits elsewhere. When a country is small, this is not a problem. However, when the volume of exports and the consequent surplus becomes large relative to the size of world trade, surpluses are harder to maintain. In the Chinese case, the very large Chinese surpluses are especially matched with US trade deficits. The Chinese surpluses on the current account then flow into the US on the capital side; China effectively funds US consumption.

The logical answer to the growing structural imbalances is an expansion in Chinese consumption, thus increasing the size of the consumption share of the economy and of imports. The Chinese surplus declines, as do deficits in other countries. However, the sheer size of the structural imbalances makes this difficult to achieve. It is easier in political terms to continue with current policies even though this creates a growing risk of disaster.

Other factors are involved as well. One is the high Chinese savings rate, itself a mirror image of the investment process.

Accepting that my analysis of Professor Pettis' views may be simplistic , the confusion that I have links to the nature of the adjustment process. It is not clear to me that a simple expansion in consumption is the answer.

There are, I think, two very different sets of issues involved. One is the the nature of the structural imbalances that have emerged in the Chinese economy, the second the trade adjustment process. Let's leave aside the structural imbalances in the Chinese economy, focusing instead just on the trade adjustment process.

On the capital side, and as happened with the UK in the nineteenth century when it had a major funds surplus, I would expect long term Chinese overseas investment to rise. This means that an increased proportion of Chinese funds would be invested in specific off-shore activities rather than US denominated securities. This investment will lead to increased economic activity in other countries that will, of itself, affect trade flows. Those countries will buy more international goods and services as a consequence.

On the current side, and again as happened with the UK in the nineteenth century, rising Chinese living standards will lead to increased consumption. However, there is a scale and timing issue here. The sheer scale of the economic transformation including urbanisation taking place in China dwarfs anything seen before. I haven't attempted to run any rough numbers, but if you add an extra 400 million urban dwellers to a regular % increase in Chinese consumption associated with rising living standards, then you get some very large numbers indeed in the medium term.

This process may not shift the ratio between consumption and investment as usually measured as much as might be expected simply because so much capital investment is required. However, it will certainly lead to shifts in the trade balances. My feeling is that current Chinese surpluses may be more ephemeral than people currently realise.

None of this says that the short to medium term impact of structural imbalances in the Chinese economy is not important. I just think, and I am sure that Professor would agree, that we need to look at all the factors involved.