Reclassifying Investment

October 10, 2012Chinaby Michael Pettis

Is There Any Credibility Left In China’s Bull Case?: Michael Pettis
Is There Any Credibility Left In China’s Bull Case?: Michael Pettis

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The Economist has always tended to be very much in the bullish camp on Chinese economic prospects. In last week’s issue, for example, they have a new article on China – positing whether China is more Keynesian or more Hayekian (I think it is neither). The magazine is, I think, increasingly recognizing how deep China’s adjustment problem is, but I think they are still a little too sympathetic to residual bullish arguments:

Moreover, investment that adds little to a society’s stock of productive assets is not necessarily malinvestment. Michael Buchanan and Yin Zhang of Goldman Sachs say that some Chinese investment is best seen as “quasi-consumption”. In this category they place things like earthquake-proof schools and more comfortable metro lines. Instead of adding to the economy’s productive capacity, these assets provide a flow of services (such as reassurance to parents and relaxed travel) directly to consumers. In this respect they are more akin to consumer durables, like washing machines or cars, than to iron-ore mines or steel plants.

As a rough gauge of the size of quasi-consumption, the Goldman economists add up China’s investment in house building and “social infrastructure”, such as utilities, transport, water conservation, education and health care. Reclassifying this spending as consumption would increase China’s household consumption to 53 percent of GDP last year, compared with only 35 percent in the official statistics.

Hayek thought that badly conceived investment would only result in a worse bust later. This belief is shared by many bearish commentators on China’s economy. But China’s high investment is backed by even higher saving. As a consequence, China does not need its investment to generate high returns in order to pay back external creditors. China has, in effect, already set aside the resources that will be lost if its investments turn sour.

To take the first two paragraphs, the debate about what should or should not be qualified as consumption gets a little wobbly at times and almost always misses the point. I haven’t read the Goldman Sachs piece, and I know Michael Buchanan to be a very smart guy (and a former colleague at Bear Stearns), but there are at least three problems with the argument as it is presented above.

First, it is a little hard to see the point of reclassifying investment outlays as consumption simply because they ultimately serve households, unless it is merely to try to make consumption number numbers look better than they are. Ultimately the point of all investment is to increase household consumption, and yet there is nonetheless a distinction between consumption and investment that is useful and valid in understanding the mechanics of growth.

Adjusting China’s numbers may make consumption seem higher, but in that case we should adjust every country’s in the same way and we would see the same result: China would still have the most unbalanced economy in the world, and it would still urgently need to raise household consumption. After all in the late 1980s we could have done the same thing in Japan to “prove” that the Japanese economy was not unbalanced (lots of comfortable trains, remember?), and yet it still would not have prevented Japan from undergoing the difficult rebalancing process.

Second, the impact on growth, which is the whole point of the exercise, will be unchanged by how we classify the spending. As China reduces investment, consumption must grow to replace it. Are we suggesting that it will be easier for China to increase the investment that it wants to reclassify as consumption? Fine, maybe it will be, but how we will pay for this increased investment? This is the key point, and it doesn’t matter whether you classify the spending as investment, consumption, or indeed anything else.

If this increased spending is paid by direct and hidden taxes on the household sector, as most spending and investment in China are, it simply makes it all the more difficult for household consumption to increase. Transfers from households to fund government spending are at the heart of the Chinese growth imbalances, and reclassifying those transfers does nothing to help the problem. Only reversing them will solve the problem. If it is paid for by liquidating assets in the state sector, then it also really doesn’t matter how this spending is classified. As long as it results in a transfer of wealth from the state sector to the household sector, China will rebalance.

And third, there can be a huge difference between the value of inputs – which is how all this is measured – and the actual economic value of what is created, and this gets us right back to the problem of overinvestment. If a local government spends $2 billion on the subway system, but creates only $1 billion of value (increased economic activity over the life of the subway), reported “reclassified” consumption might rise by the former number, but real “reclassified” consumption only goes up by the latter. In that case the value of the new consumption number is overstated in the same way that investment has been overstated.

The article does point out that not all past investment in infrastructure is wasted, but of course this is a trivial point and no one doubts it. The relevant point is very different. As long as debt in the aggregate rises faster than debt servicing capacity in the aggregate, it cannot be sustained, and one way or the other the difference must be covered by transfers from either the household sector, in which case the imbalances are getting worse, or by the state sector, in which case we are rebalancing but must go right back to the original political problem – which in China is referred to as the problem of “vested interests”.

Throwing Away Your Savings

The biggest problem I have with The Economist article is actually not with the first two paragraphs in the section that I cite but rather in the last. To repeat:

But China’s high investment is backed by even higher saving. As a consequence, China does not need its investment to generate high returns in order to pay back external creditors. China has, in effect, already set aside the resources that will be lost if its investments turn sour.

This doesn’t make sense to me at all and illustrates, I think, some of the confusion about what savings mean. The passage seems to assume that the main economic problem facing a developing country is paying back external creditors.

But this isn’t the case. External debt is generally is a problem for smaller countries, but as the Reinhart and Rogoff book, This Time is Different, makes clear (and this is something that most financial historians already knew), most economic or financial crises are domestic, not external. It is true that many of the crises in the 1980s and 1990s were external debt crises, and this has coloured our view of what a financial crisis must be, but this shouldn’t lead us to think that countries only have crises if their savings are insufficient to cover investment (I.e. they are running a current account deficit).

After all the US had no problem paying back external debt in the 1930s and Japan had no problem paying external debt in the 1990s. In both cases domestic savings far exceeded domestic investment – or, to put in the same terms as The Economist, their high investment was backed up by even higher savings – and yet both suffered tremendous slowdowns in economic growth and the US had a financial crisis.

Likewise China of course will also have no problem paying back its external debt, but losses do not occur when you borrow in foreign currency to fund investments. They occur when you invest in projects that are not economically viable, no matter how they are funded.

What is more important, it is not meaningful to say that China’s high investment is “backed” by higher savings. The Chinese growth model forces up savings, by constraining consumption growth, in order to fund investment (a higher savings rate is the same thing as a lower consumption rate) just as Alexander Gershenkron prescribed in the 1950s and 1960s. But once investment is misallocated (or “malinvested”, as The Economist prefers) higher savings is not a solution to the problem but rather a manifestation of the problem itself. If you do not believe this, then Japan’s Lost Decade(s) is very hard to explain.

Perhaps the easiest way to prove this is with a simple thought experiment. Let us assume that Beijing decides immediately to tax half of the Chinese household income and to use the money to build a bunch of useless bridges. Would this be good for China? Certainly not, and the impact would be more debt and slower future growth as the cost of the excess debt was absorbed. What happens to the investment rate? It goes up, of course, along with GDP.

But what happens to the savings rate? It also goes up. Why? Because if you cut the disposable income of Chinese households in half, presumably you would cut consumption by nearly that amount. Since savings is simply GDP minus consumption, savings will soar.

Notice that the condition – that savings exceed investment – will still be met, and by definition as long as China runs a current account surplus savings must exceed investment. And yet it doesn’t help. Wasting money is always value destroying, and the fact that it is funded by domestic savings – as in Japan in the 1980s, the USSR in the 1950s and 1960s, and Brazil before 1975 – or foreign savings – as Latin America after 1975 and much of Asian in the 1990s – makes little difference except in the resolution.

Related Story: Fixing China’s Economic Imbalances: Michael Pettis

Related Story: China’s Economic Puzzle: Why The Bears & Bulls Just Can’t Agree

Externally funded misallocated investment is subject to “sudden stops”. Domestically funded misallocated investment may or may not be, depending on the structure of the domestic financial system

The Bull Argument Cannot Ignore Hidden Bad Debt

So to say that China has already set aside the resources to pay for the losses is, I think, meaningless, especially if it implies that somehow the impact of this wasted investment is in the past and not in the future. China has no more set aside the cost of the losses than Brazil had done so at the end of the 1970s, prior to its own lost decade. The losses are simply buried in the debt.

But an unrecognized past loss must be recognized at some point in the future, no matter how it is funded. On this point I think neither Hayek nor Keynes would disagree. In the end, the strongest indication about whether or not the current Chinese growth model is no longer providing sustainable growth is whether debt is rising faster than debt servicing capacity. This is where the debate must focus.

Or to cite John Mills in his 1868 paper On credit cycles and the origin of commercial panics:

Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

If capital has been destroyed in the past, and that destruction is currently unrecognized, it must be recognized in the future, like it or not. This recognition can occur in the form of what Mills called a panic, and we would call a financial crisis, but given the stickiness of deposits in the Chinese banking system I don’t think this is likely to be the case in China. It can also occur in the form of many years of much slower growth in GDP, as those losses are ground away through excess debt repayment. But it will occur.

So if anyone wants to continue to be very bullish about Chinese growth prospects over the next decade, it seems to me that he must address and answer these three questions:

1.       How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?

2.       What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?

3.       What mechanism can be implemented to increase the growth rate of household consumption?

By Michael Pettis

Michael Pettis is a senior associate at the Carnegie Asia Programme and professor of finance with Peking University’s Guanghua School of Management. He previously taught at Tsinghua University and Columbia University, and worked on Wall Street in trading, capital markets and corporate finance.

How to be a China bull is republished with permission from China Financial Markets.

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