By Michael Pettis
Is China currently rebalancing? The currency has been appreciating, the PBoC has hiked interest rates four times, and wages have been surging. Because of all of this I am often asked if China has finally begun the long-waited rebalancing process and whether we have yet seen an improvement in the underlying economy caused by a rising consumption share.
Those who were hoping the answer was yes will have been disappointed by the release Thursday of the World Bank’s China Quarterly Update – April 2011. Here is their summary:
China’s economic growth has remained resilient as the macro stance moved towards normalization. Both fiscal and monetary policy contributed to the normalization. Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4%, largely on higher food prices.
So what is going on? Isn’t China doing all the right things – raising wages, the exchange rate and interest rates – and, if so, why isn’t the economy rebalancing towards higher levels of household income and consumption?
The key, I think, is in distinguishing between real and nominal changes. On a nominal basis, for example, it is clear that the currency is appreciating, interest rates are rising, and wages are soaring, but it is not the nominal change that matters.
Take the currency. It has appreciated roughly 5% against the dollar since it began “floating” again last June, and on Friday broke RMB 6.5 to the dollar for the first time since the big 1993 devaluation. On an annualized basis that’s around 6% in currency appreciation since June.
But changes in a currency’s real value reflect more than just changes in its nominal value. They also depend crucially on inflation growth differentials and productivity growth differentials. To take the former, if inflation in China is higher than it is in the US, we can say that the RMB is appreciating in real terms even if its nominal exchange value hasn’t changed. Conversely if US inflation is higher than Chinese inflation, then the RMB is depreciating in real terms.
At first glance we might think that since CPI inflation in China has been higher recently than in the US, this would suggest that real RMB appreciation is even higher than nominal appreciation. Last month’s year-on-year CPI inflation in China, after all, came in at 5.3%, well above the 2.7% CPI inflation recorded by the US. A number of officials in Beijing and in the US Treasury Department have suggested that the combination of nominal appreciation and higher inflation in China means that the RMB is appreciating in real terms by a hefty 8-9% annually. If the RMB is undervalued by, say, 25%, three years of this would eliminate the undervaluation.
Figuring out real appreciation
But we need to be careful here – the analysis is wrong in many different ways. In the first place, even if the RMB is undervalued by 25%, and if it is appreciating by 8-9% a year in real terms, we can’t conclude therefore that in three years the RMB will be correctly valued. This would only be true if there were no difference in the productivity growth rates between the two countries. But since Chinese worker productivity is growing faster than American worker productivity, in three years the RMB would still be undervalued by the cumulative difference in productivity growth.
More importantly, in evaluating the real rate of appreciation what matters is not the difference in US and Chinese CPI inflation overall, but rather inflation in the price of inputs to the tradable goods sector. In China almost all the recorded CPI inflation has been in the food sector, not in the tradable goods sector.
It is pretty complicated to compare the appropriate numbers, but I would argue that since there has been relatively low inflation in the price of inputs to both the US and Chinese tradable goods sectors, the relevant inflation differential is quite small. In other words we can probably ignore the impact of inflation on real changes in the currency. So why do I bring it up? Mainly because a lot of commentators have argued that China’s relatively higher CPI inflation means that China’s pace of appreciation is not as low as it seems. It is higher, they say, by at least two or three percentage points. But they are wrong on that point.
The issue of productivity growth differentials, to which I have already alluded, is less ambiguous. Chinese worker productivity has been growing at least two or three percentage points faster than US worker productivity (and probably a lot more depending on how you measure it and what adjustments you make). This means consequently that the RMB should nominally appreciate by at least 2-3% annually just to keep from depreciating in real terms. Real appreciation, in other words, is less than nominal appreciation because of China’s more rapid productivity growth.
When you combine the impact of the inflation growth differential and productivity growth differential, it is not clear that there has been much real appreciation in the RMB against the dollar in the last twelve months. Some analysts actually argue in fact that the RMB has continued depreciating in real terms during this period, but my guess is that while this argument is not implausible, in fact there probably has been some real appreciation of the RMB against the dollar – just not very much.
Of course the dollar is not the only currency in the world that matters. The sharp depreciation of the dollar against the euro and other major currencies in recent months suggests that in trade-weighted terms it is very hard to argue that the RMB has appreciated at all, and probably depreciated, depending on which period you are looking at.
So what does it all mean? Just this: the claim that one of the key components of rebalancing – an appreciating currency – has been occurring may be vastly overstated or even simply wrong. There has been little or no real appreciation of the RMB and there may actually have been some depreciation.
And the net impact is?
But certainly interest rates have risen since October, so at least there has been rebalancing on this front, right? Again, no. On the contrary, although there have been four rate hikes since October, with lending rates having gone up by around 100 basis points, depending on maturity, these have been more than matched by an increase in inflation of at least 200-300 basis points, depending on how you construe the inflation index and on what components you focus.
Real interest rates, in other words have actually declined sharply. Borrowers can obtain financing at lower real costs than ever, and depositors are suffering a significant and growing real loss on the money they leave in the banks. This just increases the transfer of wealth from net depositors, who are households for the main part, to net borrowers, who are the state and corporate sector.
So not only has there been no rebalancing on the interest-rate front, but in fact the imbalances have been exacerbated. This leaves wage growth, and here the story is also unambiguous, but unambiguous in the other direction.
In the past year wages have been growing very quickly although, because of inflation, real wages have been growing much less quickly than nominal wages (and remember that the sectors seeing the highest wage growth suffer more from food-based inflation because they are poorer). Still, real wages have probably risen faster than productivity, in which case it is pretty clear that over the past year household wages have comprised a growing share of GDP.
I worry about the reasons for rising wages – I suspect that demand for workers is driven primarily by unsustainable and unhealthy increases in the past two years in real estate and infrastructure development, and so is itself unsustainable. But, regardless of the cause, this is unquestionably healthy for China’s rebalancing process. As long as it continues, one of the main causes of China’s economic imbalances – the lagging wage growth relative to productivity growth – has been eliminated and even reversed.
There are some interesting implications of this constellation of adjustment processes that are worth examining. To summarize, there are three important causes of the consumption imbalances that are plaguing long-term growth prospects in the Chinese economy. One of these, the undervalued exchange rate, hasn’t changed much in the past year and so has not contributed to rebalancing. The second, excessively low interest rates, has got significantly worse in the past year and so has exacerbated the imbalances. The third, lagging wage growth, has got much better and so has contributed to Chinese rebalancing.
What is the net effect of the three processed? Unfortunately there is no real way of comparing the impact of each variable, and so there is no real way of judging the net effect. All we can do is look at household consumption and its relationship to GDP growth, and infer the net impact from that.
If the World Bank analysis is correct, and if household consumption growth has been slowing, it suggests that because the imbalances are getting worse, not better, the adverse impact of declining real interest rates may be greater than the positive impact of rising wages. Or it may suggest that there is a lag in the impact and we will just have to wait out the end of 2011 before we can determine what has really happened.
Who pays for the adjustment?
But there is one thing we can say with a little more assurance. If wages are rising and interest rates are declining, then there should be transfers of wealth within the economy. Specifically, wealth is being transferred from corporates to households in the form of higher wages, and is also being transferred from households to corporates in the form of lower interest rates. This means that labor-intensive industries are bearing more than the full cost of the adjustment and capital-intensive industries are bearing a negative cost.
If this is the case, we should expect to see a shift in China from labor-intensive growth to capital-intensive growth as the former get squeezed out and the latter profit. Unfortunately that is exactly what seems to be happening. I am hearing from a lot of my friends and students (i.e. those who are sons and daughters of SME owners) that SMEs, who tend to be labor intensive, are raising wages as fast as they can and are still losing workers to SOEs, who tend to be capital intensive.
This makes a lot of sense to me. If wages are a significant share of your expenses, rising wages will squeeze you much more than if they are a small part of your expenses, especially if other expenses (namely the cost of borrowing) are declining. The fact that China’s economy is becoming even more capital intensive is almost certainly not a good thing. For one thing, it contradicts Ricardian comparative advantage. As an article last week in the Financial Times points out:
While the productivity of the average Chinese factory worker has increased tenfold in the past 20 years, it is still less than a third of the comparable figure in the US – offsetting the fact that Chinese wage costs are typically a tenth of those in America.
If Chinese wages are one-tenth those of the US while Chinese worker productivity is one-third, and if the (correctly priced) cost of capital in China is substantially higher, then clearly if you agree with the arithmetic of comparative advantage (and it is sort of hard not to agree), increasing capital intensivity in China is at best sub-optimal for the global economy.
That doesn’t mean it is necessarily sub-optimal for China (that depends on whether you believe investment is still heavily value-creating rather than neutral or value-destroying), but the more important the capital-intensive sector is to the economy, and the more addicted China becomes to cheap capital that can be flung into wasteful projects, the harder it will be to rebalance the economy. All that increasing wasted investment is likely to be made viable mainly by continued transfers from the household sector, whether in the form of depressed deposit rates or in the form of direct subsidies funded by taxes and “fees”. These transfers will make the rebalancing towards SMEs and household consumption all the more difficult.
China isn’t yet rebalancing. The way that its growth model works suggests that it cannot happen except with a sharp contraction in investment growth, something we are not seeing, and the empirical evidence so far seems to support the theory. It will probably take a couple of years of this kind of unbalanced growth before this point is more widely recognized, but I suspect that another year or two of stagnant consumption as a share of GDP is finally going to convince policymakers. Until then, expect more of the same, and with it rapidly rising debt levels.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me atchinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.