US slowdown and Chinese investment

Michael Pettis

Two related stories in today’s Financial Times point out one of the most worrying economic risks facing the world today. The first is a report by China’s National Bureau of Statistics that fixed asset investment (FAI) in urban areas was up 26.9% (to RMB 8.9 trillion) during the first 10 months of the year compared with the same period last year. This is the highest it has been in over a year. Market expectations were for an already high 26.3%, in line with last month’s figure of 26.4%.

In an entry on my own blog yesterday I pointed out that the slowing down of the growth of industrial production (it was up 17.9%, versus 18.9% in October) was one of the few good numbers that had come out in recent months because rising industrial production is what powers growth in the trade surplus, and China desperately needed to bring the trade surplus down. Although most economists were expecting continued moderation in the industrial production growth rate, I was (surprise!) less optimistic because September’s number had been so high and October’s trade surplus was at a record level, so it seemed to me that the dynamics driving this money-creating machine were stronger than ever.

The very high FAI numbers deepens my concern.  All of this investment is likely to increase production, and if Chinese consumption does not keep pace (and it seems that it cannot), the excess must increase the country’s trade surplus and so its money growth. 

The second article in the Financial Times has the headline “US slowdown threatens Chinese export growth”.  It reports that China’s commerce ministry has warned that a slowdown in the US economy could create a sharp enough drop in China’s exports to create what they called a “turning point” for economic growth. 

According to the article the PBoC estimates that every 1% drop in US GDP growth would be accompanied by a 6% drop in Chinese export growth – scary indeed, given that exports account for one-third of Chinese growth, and are probably the healthiest part of that growth. Of course this might just be the typical Chinese posturing before a series of important meetings (with Secretary Paulson and with President Sarkozy) later this month in which the currency is sure to come up, but perhaps it is also true. 

I think I am less pessimistic than most about a sharp slowdown in the US economy, but I confess to being well out of my depths and I recognize that my expectations come with a very wide standard deviation.   The question is what happens if we have both furious Chinese investment and a stalling US economy.  High levels of Chinese investment will lead to high levels of industrial production. 

My simple calculus says that since this will result in a growing excess of production over consumption, and since the difference must be equal (give or take a few smaller accounts) to the trade surplus, the result must be a rising Chinese trade surplus. But if US GDP (and that of the rest of the world in the aggregate) slows, and global consumption slows with it, how does this work?  One effect might be that Chinese exports simply displace the exports of other low-income (or even some middle- and high-income) countries – China, in effect, exports unemployment to its neighbors.  This would be accomplished by lowering prices, and thus lowering corporate profitability (which might affect the banking system). 

Another possibility is that China counteracts a global slowdown by increasing domestic investment further (I don’t think it is likely to increase consumption).  I guess there are three ways this can happen.  First, corporations can invest more in productive facilities.  Second, the government can invest more in infrastructure, education, health, etc.  And third, corporations can be forced to invest by increasing inventory. 

I think we would all agree that the third possibility would be a disaster.  Rising inventories would simply signal that we are in the early stages of an old-fashioned over-production crisis, like those the US used regularly to experience in the 19th Century.  Unless the global economy quickly turned around and started absorbing those inventories, the process would have to be followed by a sharp drop in investment and employment.  (In that context there is a monograph, written by Richard Chew of Virginia State University, called “Certain Victims of an International Contagion: the Panic of 1797 and the Hard Times of the Late 1790s in Baltimore”, that may give some interesting insights on China’s transition from export-led growth to domestic demand-led growth.) 

The first and second possibilities are better, but not necessarily great.  If corporations invest even more in production facilities, we would effectively be simply doubling the bet, and hoping that global growth emerged quickly enough to absorb the future increase in inventories.  Doubling a bet is only fun if you win the bet the second time around – if not, the outcome is even worse. 

The second possibility, that the government expands investment in infrastructure, is probably the least damaging, but it would involve a significant re-orientation of the economy (good in the long run) and a significant increase in debt.  This last may not seem like a big deal, but I think real government debt levels are much higher in China than people think (at least 60% of GDP if contingent liabilities through the banking system are included), and I would not be totally happy about seeing it rise too quickly.  Still, it is probably the least damaging outcome, at least in the short run. 

So, my prediction?  If the US slows down, expect to see a run-up in Chinese government debt or a rapid ruin-up in Chinese corporate inventory, or both.  I wonder if readers of Brad’s blog have other ideas of how rising Chinese investment and slowing global demand may play out in China. 

Two asides: First, at the end of the comments section of my previous posting (November 13, “China’s CPI numbers look bad”), we started a discussion about whether selling stocks is an effective way for China to sterilize money creation.  I hope the participants don’t drop the thread to pursue the two more recent posts.  I think this could be a really important question and I am curious to see what kind of consensus we reach. 

Second, here in China I am often asked to be a guest on an influential TV program called Dialogue.  Many foreign and Chinese academics who watch or participate in the program complain that the hosts are far too solicitous of the opinions and policies of the government and far too eager to blame foreigners for whatever mess in which China finds itself (the station, after all, is government-owned and controlled).  Yet today, when the other guest and I were asked to discuss inflation in China, after the end of the show the host scolded us for being far too soft on the government.  It seemed that they were expecting, and hoping for, more criticism of the government’s inability to control inflation and economic growth.  I have no idea if this is means anything or if the internal debate is getting fiercer, but both guests (the other person was a senior officer in a government think tank) noticed the comment.