Monday, September 21, 2015

Michael Pettis notes

I heard Michael Pettis speak last week. Here are my notes:

Key conclusions

·         China - we should applaud a sharper growth slowdown, as this would make non-destructive adjustment more likely

o   Low capital stock/capita relative to DM is not a good argument to justify high investment/GDP

o   Watch for SOE privatization, transfers of wealth to households and centralization of power under President Xi Jinping

o   Low chance of further CNY devaluation


1.       EM countries have had two unique problems

a.       Very low savings rate

b.      Private sector does a very poor job of identifying productive investments

2.       Old solution was to push up savings, keep savings in the banking system, and have gov't direct investments

a.       How do you force up the savings rate?

                                                               i.      S=GDP-C

                                                             ii.      Reduce consumption (C) by reducing household income share of GDP

                                                            iii.      Side note: need to distinguish hhld savings from total savings

                                                           iv.      Hhlds in China spend as much as other countries - Chinese hhld savings aren't abnormally high

                                                             v.      Total savings are high because hhld income share of GDP is low

3.       Brazil's model - raises taxes, use domestic savings to fund investment

4.       East Asia / Japan model - raises implicit not explicit taxes

a.       1st tax - undervalued FX

                                                               i.      Similar to a consumption tax on imports

                                                             ii.      Subsidizes tradable goods sector

                                                            iii.      Reduces growth of hhld income

b.      2nd tax - have wage growth lower than productivity growth

                                                               i.      Lowers ULC

c.       3rd tax - financial repression

                                                               i.      Set bank deposit rates extraordinarily low

                                                             ii.      Huge transfer from net savers to net borrowers (SOEs, local govts, producers of GDP)

5.       Old argument in favor of high investment/GDP: China has very low capital stock per capita and this needs to converge with DM

a.       This is nonsense - the causation is backwards

b.      Countries aren't rich bc of high investment

c.       Countries have high investment bc they're rich

6.       China started misallocating investment in late 1990s

a.       NPV was less than cost of investment

b.      This leads to debt levels rising faster than debt servicing capacity

7.       Now China is trying to increase hhld wealth at expense of gov't

a.       Two ways to do it

                                                               i.      Japanese way: transfer debt from private sector to gov't

                                                             ii.      Hopefully, China transfers assets & wealth from gov't to private sector

b.      Turning point was (ex-)Premier Wen Jiabao's 2007 four "un"s speech: China is unstable, unbalanced, uncoordinated, unsustainable

c.       Rebalancing are rarely successful

                                                               i.      Historically, only successful under democracies (US in 1930s) or highly centralized autocracies (Deng Xiaoping), but countries in the middle of the political spectrum have a lot of trouble

                                                             ii.      Xi Jinping needs to become Deng Xiaoping and centralize power in order to pass reforms

8.       Ideal slowdown would be for growth to decrease by 100-150bps a year until end of decade

a.       Try to control credit growth -> Inv falls, C is maintained -> GDP falls

b.      Japan in 1990-2010: while GDP grew slowly, consumption growth was steady

c.       Problem is that this comes at the cost of vested interests

                                                               i.      Anti-corruption is about destroying vested interests which benefit under current policies

d.      1st group of reforms is to reduce implicit taxes - this has more or less happened

                                                               i.      Wages are growing as quickly as productivity

                                                             ii.      FX is not undervalued as much as before, look at trade weighted CNY not just USDCNY

                                                            iii.      Standard trade theory says deleveraging low growth DM should have surpluses against high growth China

                                                           iv.      Imbalances have peaked and there have been small improvements - consumption share of GDP has risen 2-3% since bottoming in 2011

                                                             v.      Financial repression has been resolved

e.      2nd group of reforms is actual wealth transfer - hasn't happened yet

                                                               i.      Hopefully starts end-2015 or 2016

                                                             ii.      Third plenum reforms are all about transfer wealth to hhld

1.       Hukou residency reforms - this will allow migrants to have educational/social services/welfare, which will make them richer

                                                            iii.      March 2015, Shandong province announced a transfer of SOE shares into their pension fund

1.       Unfortunately, not a very efficient transfer

2.       Depends on credibility of the pension fund, which is low

3.       Downside is that Shandong inhabitants prob don't feel richer and thus spend more

4.       One virtue is that because the gov't controls the pension fund, it doesn't lose control of the SOE

5.       SOE profitability goes to hhld, but not control

9.       China needs to give up on the 7% growth target

a.       Best-case scenario: 2013-2023 avg growth is 3-4%

                                                               i.      The faster they slow, the less likely the chance of a destructive adjustment

                                                             ii.      West needs to stop applauding high growth numbers from China - we should applaud a sharper slowdown

                                                            iii.      You can have any growth you want - e.g. US could easily have 10% growth today through a credit boom but would  lead to very painful adj later

b.      GDP target is for domestic political purposes

                                                               i.      If they relax this, XJP can be confident about reform

                                                             ii.      If privatization speeds up, this is good - watch for developments here

                                                            iii.      Only just started the adj process, iron prices could fall further

                                                           iv.      Need to recognize losses so that they can allocate capital efficiently

c.       Bad case scenario: 7% for 2-3y then debt capacity limits are hit and system collapses

                                                               i.      If gov't backs all debt, then debt won't stop growing

                                                             ii.      Banking crises usually allocate losses to hhld

                                                            iii.      In China, C needs to replace Inv, so hhld can't take losses

d.      More than 50% chance of best-case scenario (non-destructive adj)

10.   Composition of state reserves is secret, may have illiquid assets

a.       However don't worry, China can take many measures

                                                               i.      E.g. stop outflows with capital controls or devalue FX

b.      Gov't monetizes inflows, prints and buys dollars

c.       Now capital acct outflows are larger than current acct inflows

11.   Low chance of further FX devaluation

a.       PBoC is opposed to further FX deval - PBoC not going to quickly liberalize/internationalize the FX

b.      FX deval transfers wealth from hhlds to tradable goods sector - opposite direction of the correct rebalancing

c.       FX deval might increase outflows

d.      FX overshooting occurs when there's lots of external debt - China doesn't have much

e.      China is pouring reserves to prop FX

f.        If outflows continue at high levels, then they need another solution

                                                               i.      Re-peg? Low chance, this would be a huge loss of face

12.   The idea that the offshore CNY rate (CNH) is a pure mkt expectation of where CNY will go is WRONG

a.       SOEs have ways to arb CNH and CNY - the frictional cost is <2%

b.      SOE will no longer misallocate bc IR are high

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