China’s economy has squeezed a lot of growth out of liquidity, exports and new infrastructure. It’s time to embrace efficiency.
Andy Xie 25 May 2009
(Caijing Magazine) The world is awash in Keynesian liquidity. Market consensus shifted in early March from depression mode to today’s bull market. The case for a new bull run was built, first of all, on liquidity pumping up asset prices, followed by improvements in corporate and household balance sheets, and finally on rising demand.
This is a Greenspan dynamic that worked for the past 20 years. But it won’t work this time. This flood of liquidity soon will lead to inflation, nipping the nascent asset bubble in the bud.
Liquidity works when a disinflationary force holds down inflation and channels liquidity into asset markets. Rising asset prices lead to debt demand. Higher leverage increases demand. This asset market-led growth model worked in the past because globalization and IT development kept inflation in check. As the upside from both has been absorbed, and no other source of production growth is in sight, liquidity will soon lead to inflation.
Most analysts argue against inflation on grounds that excess capacity due to slumping demand will keep inflation in check. Hence, they say, the liquidity boom won’t be a problem until the global economy has fully recovered. I think this is faulty logic. Financial markets can channel liquidity directly into inflation through commodity speculation.
Despite declining oil demand, for example, prices have nearly doubled from their lows this past spring. This mainly reflects rising financial demand; a rising amount of liquidity has flowed into oil futures, which is being powered by expectations of inflation. As in the 1970s, these expectations alone are capable of turning liquidity into inflation.
Rising labour activism is another source of inflation. Most think labour unions are no longer an important force because their influence has waned over the past three decades. I think labour union power is driven by demand rather than supply. During an economic boom, few are interested in supporting labour unions. But in hard times, workers are more supportive of unions.
Globalization drove the boom during the past quarter-century. The bottom half of income earners in developed countries did not share this income growth; their wages stagnated through the boom. However, they benefited from rising property prices and easy credit conditions. They improved their living standards by borrowing -- running up credit card debt, paying minimum down payments for autos and property, and running up debt against rising property prices.
The pacification of globalization’s losers is coming to an end. Creditors now know the risks and will no longer lend like before. When credit cards stop working, labour unions are likely to come back, demanding wage increases.
Excess capacity won’t hold down inflation for two reasons. First, manufacturing value-added is much lower than it was before relative to raw material costs. Globalization has forced multinationals to shift production to low-cost countries such as China. In the process, manufacturing has decreased in importance. For example, steel prices are moving in tandem with iron ore prices, despite huge processing overcapacity. The reason is that iron ore accounts for more than half the cost of production. Coking coal is another quarter of the cost. Equipment depreciation, labour, and profits account for small shares of product price.
Second, much of the overcapacity needs to be scrapped because demand won’t recover to yesterday’s levels. The bubble exaggerated demand in many industries. Automobile, IT and financial services stand out in this regard. Credit won’t be as cheap in the future. Auto demand will reflect that. The industry may shrink by one-third.
The bankruptcy of Chrysler was the first step. GM may be next. Profitability in the financial sector was exaggerated by more than 100 percent at the bubble’s peak, leading to outrageous capital expenditures for IT. As the financial sector shrinks and profitability normalizes, IT demand will remain at much lower levels, even as global demand recovers. Finally, the financial sector has to shrink enormously, possibly by up to 50 percent. That bubble-inspired demand simply won’t be back.
The macro concept of excess capacity as a check against inflation will not work this time. Pumping in liquidity while relying on this flimsy concept would lead the global economy down a dangerous path. I expected stagflation as an end-game for the Greenspan era in 2006. It seems the world is sliding down this path without any resistance. After two decades of easy living during the Greenspan era, policymakers, markets and workers all want an easy solution -- a euphemism for a free lunch -- as a way out of an economic downturn. A free lunch may seem likely during special periods, defying economic logic. But the longer a free lunch lasts, the more pain will be inflicted during the inevitable adjustment.
Instead of overindulging in Keynesian stimuli, the world -- especially China -- should focus on reform. I have written on the need for China to shift demand from the export sector to households through wealth redistribution. For example, distributing the shares of state-owned enterprises evenly among the Chinese population would spark a decade-long economic boom. But we should also focus on improving efficiency -- a necessary condition for a new high growth cycle in China.
China has experienced high growth for the past three decades. Good policy mix was the catalyst. But that was a necessary, not sufficient, condition. Starting from a low base in the 1980s and ‘90s gave good policy ample room for effectiveness. The low base could be understood in terms of wage levels, urbanization or export penetration.
The last element has played the dominant role on the demand side. By convincing manufacturers to relocate while building support infrastructure, China’s exports achieved a nearly 20 percent annual growth rate. The low base effect, however, will no longer apply in the future. In terms of the share of GDP in value-added, China’s exports are now by far the largest in the world among large economies, although some economies have larger export-to-GDP ratios due to cross-border shipping of parts and components.
On the supply side, economies of scale linked to infrastructure network construction gave an enormous boost to productivity. The key was the so-called network effect. Building a highway improves efficiency by decreasing transportation costs along the route. Building a network squares efficiency per unit of investment by lowering the cost of transporting goods from one point throughout an entire area. China built highway, telecom and electricity networks for the first time over the past decade. As networks were completed, productivity improved enormously by lowering production costs. China’s low costs were as much due to low wages as infrastructure development.
In the past, the market was puzzled by what seemed to be a conflict in China marked by strong macroeconomic performance despite poorly performing businesses (such as firms with low profitability and few sustainable assets, such as intellectual property rights). In the 1990s, most investors thought China’s growth would fall apart quickly due to underperforming businesses. That didn’t happen because benefits from infrastructure development spread through the economy by decreasing production costs and boosting export competitiveness. The upside from economic growth went disproportionately into asset inflation and government revenues. Corporate profits and labour income didn’t benefit as much. The productivity gains from infrastructure development were critical to sustaining good macro, despite bad micro.
Productivity gains in the future will be more difficult. China’s infrastructure networks have been formed. Expansion won’t generate the same gains. The reason is that rising economies of scale when new networks are being built eventually turn into diminishing economies of scale. For example, if one builds a highway to alleviate congestion on an existing highway, the economic benefit is proportional to the investment. If one builds a highway next to one that’s not congested, the benefit is probably less than the investment. Only when a highway is built for the first time is the benefit exponential.
Economies of scale are not well understood by economists. Standard economic theory assumes diminishing economies of scale, i.e. more of the same leads to less output. When a company expands, it runs into coordination problems sooner or later. We frequently hear stories of corporate slimming for that reason. At an early growth stage, coordination at the company level is not a problem, while the advantages of shared resources are significant. Hence, a company exhibits increasing economies of scale during its early development and diminishing economies of scale when it matures. As economic theory deals with state of equilibrium in economic activities, it’s correct to assume diminishing economies of scale.
Network economies of scale are similar to those at the company level, but with more intensity. When a network construction project is just beginning, its economic benefit is probably linear or proportionate to the investment scale. When a network is about to be completed, its economic benefit grows exponentially. When a completed network expands, the benefit diminishes relative to investment, i.e. every additional dollar of investment gets less economic benefit.
Has China’s infrastructure investment reached the point of diminishing return? It’s hard to say. But investment’s effectiveness is much less than in the past because networks have been completed. As there will be fewer productivity gains from infrastructure, productivity gains are needed from elsewhere to maintain the same economic growth momentum.
China’s macro policy is now being dominated by the pumping of liquidity into business and government sectors. The argument is that spending more will bring the economy back, regardless of efficiency, and that what’s needed are the same results with less efficient investment. Of course, if there are no negative consequences, printing money would solve any economic problem: If something’s not working, just print more. However, boosting liquidity and printing money lead to inflation. The less efficient the investment, the earlier inflation arrives. As I have elaborated before, inflation could infect the system more easily now that the benefits of globalization and IT have been absorbed.
China has a lot of room to maneuver: The government’s debt level is low, the banking system’s loan deposit ratio is low, and household leverage is low. A high leverage level in the corporate sector is a worry. But the country has excellent spending power overall reflected in a large foreign exchange reserve and persistent trade surplus.
Today’s options reflect past successes in achieving productivity gains and export penetration. Both stories are running into barriers. Hence, China should spend money carefully to nurse existing golden gooses into the future, and not steer money into unproductive, white elephant projects to pump up GDP today. China should spend carefully even though it can spend more, because money won’t come as easily in the future. The days of easy productivity gains and export penetration are over.
This is why China should tighten its monetary policy as soon as possible. Between December 2008 and April 2009, China’s bank lending rose by 20 percent. If the current pace is maintained, the annual loan growth would reach 50 percent. Lending hasn’t risen this rapidly since 1992. The result that year was rampant inflation. If inflation becomes a problem again, tackling it will be more difficult. In the mid-1990s, China tightened policy to contain inflation while exports rose rapidly to maintain economic growth. The same lucky scenario is unlikely to be repeated this time.
If inflation surfaces while the economy remains sluggish, the government may not be willing to tighten down sufficiently to cool inflation. It may lead to a prolonged period of high inflation rates and sluggish growth. This risk of stagflation is quite significant for China, the United States, and the world. While the initial burst in lending was needed to stabilize the economy, its continuation may carry more negatives than positives. It is not worth risking virulent inflation merely for a gain of one or two more percentage points in this year’s GDP growth rate.
Bank lending should switch from extremely expansionary to neutral for the remainder of the year. Neutral means the bank loan/GDP ratio should remain the same. For example, the current loan stock is 37 trillion yuan, or 1.2 times GDP. If nominal GDP grows by 200 billion yuan per month, or 8 percent for the year, bank lending should grow by 240 billion yuan per month. Lending in April cooled to 640 billion yuan from an average of 1.4 trillion yuan for the previous four months. It is still too high relative to the neutral level. Monetary tightening has a long way to go.
China should focus more on improving supply side efficiency to sustain high growth. The global economy is likely to be much slower over the next decade than in the past. China has to be much more efficient to achieve the same growth rate. But efficiency improvement in the future cannot rely on fixed asset expansion. Small facilities and old equipment are no longer problems. Most of China’s industries seem to have state-of-the-art equipment but suffer from excess capacity.
Efficiency improvement in the future is less an investment issue than systemic or incentive issues. Because fine-tuning rather than brutal force must drive productivity growth, market forces rather than government intervention should drive efficiency.
Many now argue that what’s happened in the United States and in developed economies shows the bad side of the market economy and, hence, China should not continue moving toward the market. This is drawing the wrong conclusion from the current crisis. The market remains the best tool for motivating businesses to deliver the best products at the lowest possible prices. All other systems have failed to deliver prosperity. Markets, however, need regulations to function properly. For example, food safety standards need to be in place for that industry to function properly. The main purpose of regulation should be to encourage more efficient market functioning, not replace the market.
Some economies such as those in the United States and Britain deregulated too much a decade ago, laying the foundation for today’s crisis. China’s economy, however, is excessively regulated and controlled by the government. The lesson from today’s crisis has little bearing on China’s policy forward. China still has a long way to go before its market is “too free.”
Excessive liquidity stimuli today may lead to inflation and economic chaos in the future. It’s time for China to rein in its money supply. The policy focus should shift toward promoting household demand and supply side efficiency. Otherwise, China could suffer from low growth and high inflation for years to come.
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Efficiency’s Urgent Cry for Attention
China’s economy has squeezed a lot of growth out of liquidity, exports and new infrastructure. It’s time to embrace efficiency.
Andy Xie
25 May 2009
(Caijing Magazine) The world is awash in Keynesian liquidity. Market consensus shifted in early March from depression mode to today’s bull market. The case for a new bull run was built, first of all, on liquidity pumping up asset prices, followed by improvements in corporate and household balance sheets, and finally on rising demand.
This is a Greenspan dynamic that worked for the past 20 years. But it won’t work this time. This flood of liquidity soon will lead to inflation, nipping the nascent asset bubble in the bud.
Liquidity works when a disinflationary force holds down inflation and channels liquidity into asset markets. Rising asset prices lead to debt demand. Higher leverage increases demand. This asset market-led growth model worked in the past because globalization and IT development kept inflation in check. As the upside from both has been absorbed, and no other source of production growth is in sight, liquidity will soon lead to inflation.
Most analysts argue against inflation on grounds that excess capacity due to slumping demand will keep inflation in check. Hence, they say, the liquidity boom won’t be a problem until the global economy has fully recovered. I think this is faulty logic. Financial markets can channel liquidity directly into inflation through commodity speculation.
Despite declining oil demand, for example, prices have nearly doubled from their lows this past spring. This mainly reflects rising financial demand; a rising amount of liquidity has flowed into oil futures, which is being powered by expectations of inflation. As in the 1970s, these expectations alone are capable of turning liquidity into inflation.
Rising labour activism is another source of inflation. Most think labour unions are no longer an important force because their influence has waned over the past three decades. I think labour union power is driven by demand rather than supply. During an economic boom, few are interested in supporting labour unions. But in hard times, workers are more supportive of unions.
Globalization drove the boom during the past quarter-century. The bottom half of income earners in developed countries did not share this income growth; their wages stagnated through the boom. However, they benefited from rising property prices and easy credit conditions. They improved their living standards by borrowing -- running up credit card debt, paying minimum down payments for autos and property, and running up debt against rising property prices.
The pacification of globalization’s losers is coming to an end. Creditors now know the risks and will no longer lend like before. When credit cards stop working, labour unions are likely to come back, demanding wage increases.
Excess capacity won’t hold down inflation for two reasons. First, manufacturing value-added is much lower than it was before relative to raw material costs. Globalization has forced multinationals to shift production to low-cost countries such as China. In the process, manufacturing has decreased in importance. For example, steel prices are moving in tandem with iron ore prices, despite huge processing overcapacity. The reason is that iron ore accounts for more than half the cost of production. Coking coal is another quarter of the cost. Equipment depreciation, labour, and profits account for small shares of product price.
Second, much of the overcapacity needs to be scrapped because demand won’t recover to yesterday’s levels. The bubble exaggerated demand in many industries. Automobile, IT and financial services stand out in this regard. Credit won’t be as cheap in the future. Auto demand will reflect that. The industry may shrink by one-third.
The bankruptcy of Chrysler was the first step. GM may be next. Profitability in the financial sector was exaggerated by more than 100 percent at the bubble’s peak, leading to outrageous capital expenditures for IT. As the financial sector shrinks and profitability normalizes, IT demand will remain at much lower levels, even as global demand recovers. Finally, the financial sector has to shrink enormously, possibly by up to 50 percent. That bubble-inspired demand simply won’t be back.
The macro concept of excess capacity as a check against inflation will not work this time. Pumping in liquidity while relying on this flimsy concept would lead the global economy down a dangerous path. I expected stagflation as an end-game for the Greenspan era in 2006. It seems the world is sliding down this path without any resistance. After two decades of easy living during the Greenspan era, policymakers, markets and workers all want an easy solution -- a euphemism for a free lunch -- as a way out of an economic downturn. A free lunch may seem likely during special periods, defying economic logic. But the longer a free lunch lasts, the more pain will be inflicted during the inevitable adjustment.
Instead of overindulging in Keynesian stimuli, the world -- especially China -- should focus on reform. I have written on the need for China to shift demand from the export sector to households through wealth redistribution. For example, distributing the shares of state-owned enterprises evenly among the Chinese population would spark a decade-long economic boom. But we should also focus on improving efficiency -- a necessary condition for a new high growth cycle in China.
China has experienced high growth for the past three decades. Good policy mix was the catalyst. But that was a necessary, not sufficient, condition. Starting from a low base in the 1980s and ‘90s gave good policy ample room for effectiveness. The low base could be understood in terms of wage levels, urbanization or export penetration.
The last element has played the dominant role on the demand side. By convincing manufacturers to relocate while building support infrastructure, China’s exports achieved a nearly 20 percent annual growth rate. The low base effect, however, will no longer apply in the future. In terms of the share of GDP in value-added, China’s exports are now by far the largest in the world among large economies, although some economies have larger export-to-GDP ratios due to cross-border shipping of parts and components.
On the supply side, economies of scale linked to infrastructure network construction gave an enormous boost to productivity. The key was the so-called network effect. Building a highway improves efficiency by decreasing transportation costs along the route. Building a network squares efficiency per unit of investment by lowering the cost of transporting goods from one point throughout an entire area. China built highway, telecom and electricity networks for the first time over the past decade. As networks were completed, productivity improved enormously by lowering production costs. China’s low costs were as much due to low wages as infrastructure development.
In the past, the market was puzzled by what seemed to be a conflict in China marked by strong macroeconomic performance despite poorly performing businesses (such as firms with low profitability and few sustainable assets, such as intellectual property rights). In the 1990s, most investors thought China’s growth would fall apart quickly due to underperforming businesses. That didn’t happen because benefits from infrastructure development spread through the economy by decreasing production costs and boosting export competitiveness. The upside from economic growth went disproportionately into asset inflation and government revenues. Corporate profits and labour income didn’t benefit as much. The productivity gains from infrastructure development were critical to sustaining good macro, despite bad micro.
Productivity gains in the future will be more difficult. China’s infrastructure networks have been formed. Expansion won’t generate the same gains. The reason is that rising economies of scale when new networks are being built eventually turn into diminishing economies of scale. For example, if one builds a highway to alleviate congestion on an existing highway, the economic benefit is proportional to the investment. If one builds a highway next to one that’s not congested, the benefit is probably less than the investment. Only when a highway is built for the first time is the benefit exponential.
Economies of scale are not well understood by economists. Standard economic theory assumes diminishing economies of scale, i.e. more of the same leads to less output. When a company expands, it runs into coordination problems sooner or later. We frequently hear stories of corporate slimming for that reason. At an early growth stage, coordination at the company level is not a problem, while the advantages of shared resources are significant. Hence, a company exhibits increasing economies of scale during its early development and diminishing economies of scale when it matures. As economic theory deals with state of equilibrium in economic activities, it’s correct to assume diminishing economies of scale.
Network economies of scale are similar to those at the company level, but with more intensity. When a network construction project is just beginning, its economic benefit is probably linear or proportionate to the investment scale. When a network is about to be completed, its economic benefit grows exponentially. When a completed network expands, the benefit diminishes relative to investment, i.e. every additional dollar of investment gets less economic benefit.
Has China’s infrastructure investment reached the point of diminishing return? It’s hard to say. But investment’s effectiveness is much less than in the past because networks have been completed. As there will be fewer productivity gains from infrastructure, productivity gains are needed from elsewhere to maintain the same economic growth momentum.
China’s macro policy is now being dominated by the pumping of liquidity into business and government sectors. The argument is that spending more will bring the economy back, regardless of efficiency, and that what’s needed are the same results with less efficient investment. Of course, if there are no negative consequences, printing money would solve any economic problem: If something’s not working, just print more. However, boosting liquidity and printing money lead to inflation. The less efficient the investment, the earlier inflation arrives. As I have elaborated before, inflation could infect the system more easily now that the benefits of globalization and IT have been absorbed.
China has a lot of room to maneuver: The government’s debt level is low, the banking system’s loan deposit ratio is low, and household leverage is low. A high leverage level in the corporate sector is a worry. But the country has excellent spending power overall reflected in a large foreign exchange reserve and persistent trade surplus.
Today’s options reflect past successes in achieving productivity gains and export penetration. Both stories are running into barriers. Hence, China should spend money carefully to nurse existing golden gooses into the future, and not steer money into unproductive, white elephant projects to pump up GDP today. China should spend carefully even though it can spend more, because money won’t come as easily in the future. The days of easy productivity gains and export penetration are over.
This is why China should tighten its monetary policy as soon as possible. Between December 2008 and April 2009, China’s bank lending rose by 20 percent. If the current pace is maintained, the annual loan growth would reach 50 percent. Lending hasn’t risen this rapidly since 1992. The result that year was rampant inflation. If inflation becomes a problem again, tackling it will be more difficult. In the mid-1990s, China tightened policy to contain inflation while exports rose rapidly to maintain economic growth. The same lucky scenario is unlikely to be repeated this time.
If inflation surfaces while the economy remains sluggish, the government may not be willing to tighten down sufficiently to cool inflation. It may lead to a prolonged period of high inflation rates and sluggish growth. This risk of stagflation is quite significant for China, the United States, and the world. While the initial burst in lending was needed to stabilize the economy, its continuation may carry more negatives than positives. It is not worth risking virulent inflation merely for a gain of one or two more percentage points in this year’s GDP growth rate.
Bank lending should switch from extremely expansionary to neutral for the remainder of the year. Neutral means the bank loan/GDP ratio should remain the same. For example, the current loan stock is 37 trillion yuan, or 1.2 times GDP. If nominal GDP grows by 200 billion yuan per month, or 8 percent for the year, bank lending should grow by 240 billion yuan per month. Lending in April cooled to 640 billion yuan from an average of 1.4 trillion yuan for the previous four months. It is still too high relative to the neutral level. Monetary tightening has a long way to go.
China should focus more on improving supply side efficiency to sustain high growth. The global economy is likely to be much slower over the next decade than in the past. China has to be much more efficient to achieve the same growth rate. But efficiency improvement in the future cannot rely on fixed asset expansion. Small facilities and old equipment are no longer problems. Most of China’s industries seem to have state-of-the-art equipment but suffer from excess capacity.
Efficiency improvement in the future is less an investment issue than systemic or incentive issues. Because fine-tuning rather than brutal force must drive productivity growth, market forces rather than government intervention should drive efficiency.
Many now argue that what’s happened in the United States and in developed economies shows the bad side of the market economy and, hence, China should not continue moving toward the market. This is drawing the wrong conclusion from the current crisis. The market remains the best tool for motivating businesses to deliver the best products at the lowest possible prices. All other systems have failed to deliver prosperity. Markets, however, need regulations to function properly. For example, food safety standards need to be in place for that industry to function properly. The main purpose of regulation should be to encourage more efficient market functioning, not replace the market.
Some economies such as those in the United States and Britain deregulated too much a decade ago, laying the foundation for today’s crisis. China’s economy, however, is excessively regulated and controlled by the government. The lesson from today’s crisis has little bearing on China’s policy forward. China still has a long way to go before its market is “too free.”
Excessive liquidity stimuli today may lead to inflation and economic chaos in the future. It’s time for China to rein in its money supply. The policy focus should shift toward promoting household demand and supply side efficiency. Otherwise, China could suffer from low growth and high inflation for years to come.
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