Sustaining China’s Economic Growth Pt. 26

So it’s the cost of producing goods is tending to go down compared to its trading partners and that means if the exchange, if you get to some exchange rate, that may be an equilibrium today, then you just keep it there, in three years, this differential productivity growth will mean that China will have a growing surplus again.  There are different estimates of how much appreciation you have to have to offset this productivity gain, but the lowest estimates are in the neighborhood of 3%-4%.  So I would say that even though the current account surplus today is relatively small compared to four years ago, that these authorities should still allow the currency to appreciate 3%-4% per year at least, in order to prevent the surplus from ballooning back up again.

Question

You mentioned that under international appreciation policy and wondering what do you think is the income distribution fit of a financial repression and when China’s government is going to reform its financial issue and how to balance the economic growth effect and distribution.

Dr. Lardy

That’s another factor that I did not mention when I talked about the rising savings rate, but probably another factor contributing to the rise in savings rate is the fact that the income distribution has gotten a lot more unequal in the last decade.  We know that people at the top of the income distribution save a much higher share of their income.  Those are the ones that are buying the third, fourth and fifth house because they think it is a good investment.  So you have a very high savings rate and so as the income distribution becomes more unequal, the people at the bottom have income so low, they cannot save anything or very little and people at the top have a lot of discretion and they tend to save a great deal.  One of the factors contributing to these rising savings rate in this period is probably the growing inequality in the distribution of income.  Most governments have found this very difficult to deal with in terms of via taxes or any kinds of redistributing programs.  I am not sure what options they have, but I do think that most important one is to get off the capital-intensive growth path and to concentrate more income in the corporate sector, less income in the household sector, more growth of employment in the modern sector because growth of employment in the modern sector in the last seven or eight years has actually slowed down.  So I think the kinds of policies that I talked about earlier would contribute indirectly to some reduction in the inequality, as well.

HOST

Alright.  Before I conclude the lecture.  Let me say that we will have a reception and those of you who still have questions and would like to talk to Dr. Lardy; the reception will be just here.  Please join me.  Thank you.

Sustaining China’s Economic Growth Pt. 26
economics expert witness

Sustaining China’s Economic Growth Pt. 25

When you take into account that most of the housing being built in urban China today is high-rise buildings, the cost of the land does not represent a very large share of the total price to buyers.   I tried to calculate this using various kinds of data and I’m coming up with numbers like 10% or 15%.  It is significant but not as high as many people seem to think.  I’m not saying that is the final word.  I don’t think land prices are as big a factor in driving up prices as some people have said.

Question

My question has to do with the exchange of the RMB because one of the major factors that you stated was how the Central Bank was involving itself in the foreign exchange market and try to limit appreciation growth.  What do you think is the forecast or what is your opinion about the future of the RMB appreciation?

I would say two things.  First of all, the currency is substantially less undervalued than it was back in 2005 when they began to change policy.  The currency has appreciated by about 30% on the real trade-rated basis since July of 2005, when policy changed.  That’s certainly a factor contributing to the reduction of Chinese external surplus.  However, another factor is the fact that economic growth in Europe is very weak and that is China’s biggest export market and that economic growth in the U.S. is not recovering to our long-term growth potential.  So that China’s export growth has been held down somewhat by the aftermath of the global financial crisis.

So if you have recovered more fully in a year or two and if the United States got back to grow to something closer to its potential rate of growth, I think that probability is that China’s surplus could go back up.  I think that the biggest thing to keep in mind is that and I think that this is a problem in China, I think when people like me talk about an equilibrium exchange rate, a lot of people think, “That’s a number once you get to the equilibrium exchange rate, you are set.”  That’s what a kind of equilibrium applies but China has a very high productivity growth compared to most of its trading partners.

Sustaining China’s Economic Growth Pt. 25

Sustaining China’s Economic Growth Pt. 24

The way I put is, “Yes, the state is not giving up its monopoly control of certain key industries and they are not all in the manufacturing.”  The financial sector, for example, still tends to be very heavily state-dominated.  But if you look at the overall economy, it is being driven more and more private enterprises and this is even true with the export sector.  I think people have not appreciated this.  If you just flashed back 10-12 years, state-owned companies were the dominant exporters.

They were producing something like 60%-70% of all exports.  Then we have the rise of joint ventures and wholly foreign-owned companies that came to be the dominant source of exports in China.   But in the last four or five years, the share of exports being produced by foreign-connected companies has actually declined and the private sector has boomed.  The data now show that if you look at growth of exports, the private sector contributed more to the growth of exports in 2009 and 2010, than either state-owned companies or foreign companies.

The privates, they are not the biggest yet, they are still only about 30% and the joint venture foreign companies are about 45%, but the JVs and the foreign companies are coming down and the private companies are coming up, so that the delta, the increase in exports in 9 and 10 came predominantly from private companies.  So there are certainly some areas in which the state has tried to expand its influence, but there are some of these areas where they have either not tried or they have tried and failed.

HOST

I would take three more questions.  Raise your hands.

Question

In China, some land policies are usually criticized because of many Chinese people believe that high residential housing price is because of high land price.  So for example, no net loss for cultivated land, we have a red light for reserve of 1.8 billion cultivated land.  Some Chinese people think that this policy is stupid.  So what’s your opinion to this?

Dr. Lardy

Well, I think the land factor in housing prices has been exaggerated.  As I mentioned before, certainly, local governments have made lots of money selling land, but only a part of these is going to residential housing.  A lot of these are going for commercial and office space and manufacturing and so forth.

Sustaining China’s Economic Growth Pt. 23

Directionally, it is there.  In magnitude, I don’t have a slide powerful enough to explain this big increase.

Question:

You mentioned in your book that instead of scaling back, China’s  private businesses are growing faster in the past few years, where many people have thought that actually the state has been increasing their footprint in the board economy.  Would you say that the investment boom is driven more by private sector or by state or SOEs and whether a private sector-driven investment would be more efficient going forward?

That’s a very good question.   I do take on this argument that the stimulus program China launched in the last quarter of 2008 advantaged the state-owned sector.   That is something that you read about in the financial press meet.  I can show you 50 citations from the economists that assert that banks only lend to state-owned companies.  The reality is much more complicated.

Private companies got a lot of increased access to credit in 2009 and 2010 and again 2011, for which we now have data.  Lending to household businesses grew particularly rapidly, so even a lot of the gutty-type enterprises that are not even enterprises or economics expert witness consultants, they are not organized under the company law, you know they have a handful or dozen employees, the mom and pop shops, they are getting access to credit.

So I think the credit story has been misinterpreted, misrepresented.  I think that the banking sector is lending a lot of money to private firms.  Of course, they don’t lend money to every start-up but if you try to start a firm and walk down and to Citibank, they are not going to make you a loan, so that’s kind of a universal.

The state sector continues to shrink.  In 2009 and 2010, the state sector was the slowest growing sector of the economy, just as it has been every year since 1978.  The facts are roughly that in 1978, when the reform began, when you look at manufacturing, 80% of all manufacturing was done by state companies, but by the time you get to 2008, it is down to 28% and it fell by another 1%-2% percentage points in both in 2009, 2010, and 2011.

Sustaining China’s Economic Growth Pt. 23

Finance and Insurance: Powerful Economic Forces Pt 6

We’ve had episodes in our history when real interest rates have made major moves and these movements are very important for what is happening in our lives.

Most recently, a few years ago, we were living in a regime of negative real interest rates when the Fed was pursuing a very aggressive monetary policy. I suspect that with the subprime crisis, the Fed will be pushing real interest rates down dramatically again and we may be again in a period of negative real interest rates again.

 

After that, I want to talk about the stock market. There’s a lot to talk about. Of course, stocks are shares in companies and they’re traded on stock exchanges and they’re interesting to analyze because there’s sort of an ambiguity about stocks that is not widely perceived by a lot of people. That is, share repurchase can change the units of measurement in a security and companies have to decide how leveraged the stock will be, which changes the stock price. Leverage, meaning how much debt the company takes on. Moreover, companies have to decide how much dividends to pay on the stock. That’s a decision of the management of the company and we have to understand how they make that decision and what does that mean to people who are valuing stocks. It’s a very simple idea. The idea of dividing a company up into shares and selling them off, but in practice, it involves a lot of complexities.

 

We’ll be talking about the Modigliani-Miller Theorem and related issues in this lecture as well as something about the behavior of the stock market and its tendency to go through dramatic movements. For example, like it has done recently if you’ve been following it earlier this year.

 

The next lecture will be about real estate and that brings us into the subprime crisis and connects with interests that are central to my own thinking. The housing market is a huge market. Right now, the total value of single-family homes in the United States is about two trillion dollars and the market has been becoming increasingly speculative. Home prices have gotten unstable. Nationally, home prices in the United States rose 85% between 1997 and 2006 in real terms, in inflation-corrected terms. We’ve seen almost a doubling in the price of the average home in the United States.

Why did that happen? Now, they are falling and in real terms, home prices have fallen almost 10% since the peak in 2006. This is not just a U.S. phenomenon, many countries around the world are experiencing home price booms and the beginning of what might be a home price bust. I want to consider the market for homes and the market for mortgages, which are the instruments that finance homes. To what extent was the housing boom that we saw in recent years, the result of revolution in financial technology? There has been a lot of changes in our mortgage institutions that might be part of the reason for the boom in home prices.

Finance and Insurance: Powerful Economic Forces Pt 6

Finance and Insurance: Powerful Economic Forces Pt 1

Another book, which I haven’t put on reserve yet but I’m going to, is by Peter Unger who is a philosopher. It’s a remarkable book called Living High and Letting Die that refers to a more broad philosophical issue that we have. It is that most of us are really making money for ourselves, that’s what we do with our lives and whether or not that is moral.

It’s not just rich people who do that, the rest of us do it also, and in Peter Unger’s book on the first page, he has an address and it’s an for UNICEF, which is the United Nations Children’s Fund, and he starts out his book with that address where you could send money right now. I thought it was very impressive that he put that on page one of the book because it puts the reader in a moral dilemma. He points out that it’s estimated that for every $3 you send to UNICEF, you can save a life.

That’s because there are people in this world who are not getting medical care. There are people who are dying of diseases for which there are known cures because they don’t have the best medicine which are often not even expensive but they’re living in such poverty. So, he says that why don’t you stop right now and send $100 to UNICEF. It was very impactful to start a book that way because I doubt that hardly any readers actually write out a check on the spot to UNICEF. But, if you don’t, then you are in some sense responsible for the loss of lives. So, it’s quite striking and it helps you to reflect on what makes us behave the way we do.

By the way, when you go back to your computer, Google UNICEF, and you can give $100 to UNICEF, you can do it within the hour. Maybe I could ask for a show of hands of how many people did that. I expect that not many of you will and I don’t think that proves that you are bad people – this is a very interesting philosophical question – but what it means is that there is a moral dilemma underlying all of our economic lives and I think this moral dilemma is the same as the moral dilemma in finance. It’s just that people in finance are sometimes very successful and they could give a lot more than $100 to UNICEF.

One thing that I wanted to emphasize in this course or try to emphasize is that part of finance is actually philanthropy. The most important, the most successful people in finance, I believe, end up giving the money away and that means you can’t consume a billion dollars. There’s no way that you can do that. You can only drive one car at a time, right? And if you have five cars, well, I mean that’s kind of – all right, you could have five cars and you could drive a different one every day, but it’s starting to seem a little ridiculous, right? At any rate, you’re not using them and they’re going to end up being used by somebody else. So, I think the outcome should be philanthropy and those of you who are successful really ought to give it away.

Finance and Insurance: Powerful Economic Forces Pt 1

Sustaining China’s Economic Growth Pt. 22

If you go back and look at the second diagram, China was at 50% a decade ago, it has just come down.  So I don’t think they should emulate the U.S. I don’t think we want to have credit-driven consumption growth.  We want to have consumption growth that is based on growth of real incomes, but there is a lot of headroom to move up from 33%.

Now on the question about the evidence on savings, there is correlation here certainly.    When the savings rate starts to going down and then becoming negative, the real interest rate started coming down and going negative, the savings rate went up.   Now, other people tell stories that it is rising incomes and people save more when their incomes go up, so that could be a contributing factor.  Other people say that the savings went up because the social safety net was abolished, deluded or dismantled from any workers.

I tend to be a little skeptical of those because the dismantling of the social safety net was back here in the mid-90s when Zhu Rhonji pushed through his reform of state-owned enterprises and 50 million people lost their jobs and if they didn’t lose their jobs, they certainly lost the benefit package that came with employment in the state sector, but this data shows that savings rate was actually falling in that period. So when they abolished those safety nets, the saving rate was falling, so I don’t find the argument that China was driven to high rates of saving by the lack of a social safety net.

The other thing to keep in mind is you actually go back and look at the data for this period, there weren’t that many people who had this gold-plated set of benefits.  It was like 5%-6% of the population had a good health plan, had a good retirement program and so forth.  The vast majority of the population had nothing.  So I think we tend to overstate the number of people benefitting from that program or those programs and that we forget the savings rate was actually falling after those programs where dismantled.

Now, the rising income, I don’t see how rising incomes explains this because incomes are rising back here too and savings rate were going down.  There is some specific evidence of people that have tried to test empirically the negative relationship between the cost of rate and the savings rate and they find some support for it.

Sustaining China’s Economic Growth Pt. 22

Sustaining China’s Economic Growth Pt. 21

I’m thinking of a correction that would last for several years and it will be quite painful because that is the way property corrections play out.  At least, that’s what we have seen.

The second part of your question was how do you keep up growth if investment falls as the share of GDP?  The structure of demand will change.  We will have a much more rapidly growing service sector.  One of the striking things about China is that its service sector in the 80s and the 90s doubled as a share of GDP.  Since 2001 or 2002, there is basically no increase whatsoever.  So services have made no contribution to growth.  Capital has been subsidized, that helps manufacturing; the currency has been undervalued, that helps manufacturing.

Household income growth has been modest.  Savings rate has gone up and demand for services hasn’t been there.  All that can change and I think, I’m not advocating that investment go back to 25%, all I’m saying is that I don’t it can stay above for a very many more years, particularly when so much is going into the  residential property sector.

 

Questions 

I often heard that you said that Chinese are savers because they are saving for retirement or because of health care.  Is there actual research based on that?  I mean, is that an assumption based on actual research by economics expert witnesses?  I guess related to that, is it advisable for Chinese consumers to consume at a rate that was equal to, let’s say, America at its pre-Great Recession days?

Let me take the second part of question first, which is the easiest.  That was, should we be advocating that China start emulating the United States.  I think that I should have made it clearer that we are polar opposites.   In the U.S., the consumption share of GDP at the peak was about 70%, the highest in any country in the world.  I think we slipped down now to something in the high 60s but we are still very, very elevated.  China is clearly the lowest in the world.  The last year for which we have data, the consumption share of GDP was 33% of the GDP.  I’m not advocating that China aim for 70%, but they should be moving up towards 40% and eventually towards 50%.  India is at 55%.  Most emerging market economies are in the low 50s.

Sustaining China’s Economic Growth Pt. 21

Sustaining China’s Economic Growth Pt. 20

So if they start doing everything perfectly and very soon, certainly, I think they can get to capital account convertibility within five or six years, but going from there to having the RMB used as a major reserve currency, I think is another giant step and I don’t think they can do it in a decade.  I think it is very unlikely.

Question

I know that you have recently had a conversation with Michael Pettis, who has been predicting a very sharp deceleration of growth in China for several now and is sticking to that prediction.  I’m wondering what you think of that prediction.  Tied to that question, if you knock out the sources of hyper growth, investment and increase in current account surpluses and are left with a bigger role for consumption, how do you keep what you refer to as a moderately high growth rate going?

Dr. Lardy

I think Michael Pettis and I have a similar outlook on China.  He is more bearish and I think he is talking about a very substantial slowdown.  As I said, I don’t like to talk about a crash of property.  I think of it as a long term adjustment to the lower rate of investment in residential property.  I don’t think it is going to collapse overnight, but I could be wrong.  It may or may not collapse overnight.

A slowdown in residential property investment will have a very substantial effect on economic growth.  The headwinds from Europe and the United States, where we are having slow recovery and Europe is back in recession, you are right, exports are not going to be the engine of growth.  It has not been the engine of growth in China for the past couple of years.  It is likely this year that the external sector will subtract from growth.  Housing does seem to be correcting. We have a big decline in price.

Not a big decline but a beginning of a decline in a lot of cities.  Some slowdown in transactions although our March data showed a big jump up again.  So I’m betting that there will be more of a prolonged slowdown, which in some ways is worse because if you have a sharp correction, a crash, usually the corollary areas you bounce back fairly quickly. You get rid of the distortion, you bounce back and get back to where you were.

Sustaining China’s Economic Growth Pt. 20 

Sustaining China’s Economic Growth Pt. 17

The Ministry of Commerce which represents the exports industries has done well.  The Ministry of Finance has also done very well because a lot of these bank profits are paid back to the Ministry of Finance in the form of taxes and dividends to the Ministry of Finance and the agencies that it controls.

The losers, I’ve indicated first-time homebuyers are faced with high prices; savers are taking in the ear, so to speak.  The people’s bank is a loser because it has been mandated to try to achieve two goals that are inherently in conflict and it makes that extremely difficult.  When you come right down to it, sometimes I say to my political science friends, “You know this isn’t surprising that this would happen in China.  Households are not well-represented in the Chinese political system.”

These guys over here have lots of influence in the party.   That’s my view on why interest rate liberalization has not started sooner.  This vested interest in the left hand column that benefited mightily from financial repression has opposed it consistently throughout this period.

So looking ahead, I still tend to be an optimist because I think nothing focuses the minds of the top party people more quickly and more importantly than the prospect of a significant slowdown in economic growth.  In particular, a slowdown that might last not just for months and quarters, but actually for years because if the property slows down, it will slow down gradually or it could last a long time, and have widespread repercussions.

Nothing focuses their mind more than the threat of a sustained slowdown.  So I think when the new leadership comes in, Xi Jinping and Li Keqiang, they may have somewhat a different view and they may be able to mobilize more reformers and overcome the vested interest that opposed reform and implement reforms of the type that I’ve talked about this evening which I think have to start in the financial sector with financial sector reform.

There are some other things that need to be done.  They still need a somewhat flexible exchange rate.  That would rebalance the economy and keep the current account low.  They also need to reform certain factor prices: electricity, fuels and so forth are still underpriced in China.  That benefits the manufacturing sector because 75% of all electricity in China goes straight into the manufacturing sector.

Sustaining China’s Economic Growth Pt. 17