Odd Lots - How Financial Repression in China Helped Cause the Trade War

Episode Date: September 30, 2019

For years, China has experienced blistering growth. Driven by an investment-heavy economic model, this growth has limited household income while subsidizing business. This system worked extraordinarily well for years, but the system has recently been hitting its limits. On this week's Odd Lots, we speak with Michael Pettis, a longtime China expert who serves as a finance professor at Peking University as well as a Senior Associate at the Carnegie Endowment. He explains why China must rebalance its domestic economy, and how its domestic policies helped contribute to today's trade tensions with the U.S.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. So, Joe, you know there's a very, very important date coming up. What is it? I'll give you a hint. It's in October. Oh, right. Of course. major, major deadline for the trade tariffs. It took me a second. I'm sorry.

Yes, those are always happening, but there's a date that's even more important. And it's actually really important for the U.S. China trade war. But it's October 1st, and that is the National Day of the People's Republic of China. And this year, it's even more important than usual because it's the 70th anniversary of the founding of the PRC. Ah, okay, that I didn't realize. Okay, and this tends to be a sort of politically sensitive date for the Chinese authorities. It usually comes with a big military parade and they seed the clouds to a couple days before to make sure that the skies are blue. And it's a big, huge holiday. But it's also a chance for the authorities to sort of evaluate or more likely sort of crow about everything they've done to improve China,

including the economy. I like how you just sort of casually throw in there that they affect the weather for the day. Yeah. It's really interesting. Everyone knows it's going to be good weather on October 1st. That's amazing. So I thought in connection with the October 1st date, we could talk about how far China has or hasn't come when it comes to the goal of rebalancing their economy. Right. And this is something that people have been talking about for a long time because people look at the the Chinese economy. And they see, at least on the service, all kinds of crazy things going on. There's very historically, there's been extreme fluctuations in asset prices, real estate prices, claims of real estate bubbles, an economy extremely geared towards investment and so forth. And so people look at an economy that's grown extraordinarily well, that's brought all kinds

of wealth to people over the last several decades, going from one of the port. countries in the world to, you know, building up this significant middle class, but they still see extraordinary imbalances and skewed forces domestically. That's right. And the big one is, of course, the imbalance between an investment-driven economy on the way to becoming more of a consumption-driven economy. That's the big one. And to talk about this, we really have the perfect person. Our guest for today is Michael Pettis. He's finance professor over at Peking University and also senior fellow at the Carnegie Endowment. He's also a former banker and a trader and has been watching exactly this and writing about it for a very,

very long time. So we're very happy to have Michael on the show today. I can't wait. I've been wanting us to have a podcast with an episode with Michael for a long time. So really looking forward to jumping into this one. Yeah. No pressure. Michael, thank you so much for coming on. So maybe just to begin with, we could talk a little bit about what we mean when we talk about an investment-driven economy versus a consumption-driven economy. What does that actually mean and how does it pertain to the case of China? An investment-driven economy can also be thought of as a savings-driven economy. And China is not the only country that's followed this growth model. At least two dozen countries have since the Second World War. And you could argue that

this model was more or less invented in the 1930s in the Soviet Union. But basically, in a consumption driven economy, the United States in the 19th century, you had very high wage levels, which then grow high levels of investment to serve those consumption needs. And it also goes productivity growth and a bunch of other things. In the savings economy, what you do is you force up the savings rate, which is usually a good thing to do in a developing country because developing countries tend to have insufficient investment and they tend to have insufficient investment because they have insufficient domestic

savings rate in all the savings that are available for domestic investment. And you can get very continued to be underinvested. And that's really the problem in China. In the 1980s of Maoism, these were, and it was hugely underinvestment for its level of development for its investment, productive investment as rapidly as possible savings rate. And here's why I think of a misconception about China. It's right in the world propensity to save. It's got nothing to do with what households want to do.

It's great in the world of GDP. The GDP and their total roughly $50. And so, of course, their consumption is less than that. It's such a high saving. A significant amount of investment that you need to do when you're a system of economy, which China was in the 1980s and 1990s. But at some point, perhaps at the end of the 90s or beginning actively absorbed. In that case, what a two-de-down is going to do.

The point to remember is that you get the household income share to grow. Household income share to grow. You've got to reduce this one for China. So, Michael, you've been writing about this problem or this challenge for China for several years, and I went back. I was over the weekend doing some prep reading your book from 2013. You're like, it's pretty clear that in the coming years, they're reaching the absolute limits. to the existing investment-driven model. They have to make the change now because if they don't make it gradually, it's going to be a painful adjustment eventually.

Explain to us the sort of specific mechanism by which the investment-driven growth model has to come to an end. Why it can't last forever, why it must run into a wall. And then since then, like in recent years and before the trade war, so before we get to like the sort of immediate stuff, how has China done? with its domestic rebalancing in your view? You invested in building a factory or building a road and building a bridge. That increases the value of the economy by $110.

Right. So you're fine. Your debt's going actually going down. That's healthy growth. But when you reach the point at which you can no longer absorb all of this investment productively, so again, you borrow $100, you build something, but this something only creates $20 worth of value for the economy. Now you have $100 of additional debt, but only $20 of additional debt servicing capacity.

So now your debt burden is growing. And that's, you know, you can argue this has been the case. Well, that's been the case. And that's a developing country. What do we think about China's debt burden at the moment? Because we've had China bears warning about it for, I mean, over a decade at this point. And yet, even though we see these concerns and we see the authority. you know, occasionally try to reduce credit in the wider economy. They tend to give up

after a couple years. And if the economy starts to slow, they just ramp up lending again. So is this something that can keep going for a while longer? Can for another two or three years. Now, there have been two types of China. I would say a lot of them have looked at the debt continues growing China will have a debt crisis. I don't think that's what the history tells us. That crisis is one of the ways you resolve it. debt problem. But another way you resolve it or fail to resolve it is through a really long, slow adjustment. So after 1990, never had a debt crisis. I think that's the more likely outcome in China, because the debt crisis is really a balance you problem. And in China,

as long as the system is closed and the regulators very powerful, they can always restructure liabilities, in which case you'll never have a debt crisis. But that doesn't mean you won't have a debt problem. The debt itself becomes a constraint on future. They continue growing, growing even more quickly. Now, we don't know where the limit to debt capacity is, but we certainly don't want to find out. And I think in Beijing, there's a growing sense that wherever that limit is, we're getting awfully close. In the last two years, a much more serious attitude towards trying to reign in debt. It's done so. That continues to grow much more faster than any measure of debt service and capacity.

investment-led growth model has been built on several foundations which keep household spending, household consumption, household income unnaturally low. Interest rates are set artificially low punishing or hurting savers. Savers don't have very good investment opportunities. Worker rights aren't particularly strong. There are other things built into the system that essentially create a lot of household precarity and drive the savings rate up. Has China done anything structural in the last few years to make a meaningful change towards this domestic rebalancing in your view? You know, the consumption share of GDP pretty significantly in the last four or five years, but there are two things that account for the first thing is just that GDP has dropped.

The growth in GDP has dropped significantly, so the consumption share just as a matter of arithmetic. gets larger and larger. The second thing is, you know, the consumption share of GDP for any country, not just for China. One way is to increase household increase the household income share of GDP. Now,

four or five years ago, China had very little household debt. And since then, it's really exploded. But that's not sustainable, because if you're trying to solve for additional debt isn't the way of reaching a limit there. Ultimately, they have to transfer wealth from local governments and local

elites to the household sector. And there's, you know, a dozen different ways you can do it, and they'll have to do them all. But the problem is a political problem, and that is the local governments and the local... Well, I wanted to press you on this issue, and you mentioned this already, but one thing you often hear is that the Chinese are culturally prone to excess savings, possibly because of recent history, where there was a lot of turmoil in the country, possibly because of a lack of social safety net in China. So are there political solutions to this problem? And what could those realistically actually be? ADP. One of the ways of doing so, of course, is strengthening the social safety net, although it depends on how you pay for it.

So if you strengthen the social safety net and pay for it by borrowing at negative real, And what you're doing is you are, you know, with one hand, you're giving them additional income in the form of a social return on their savings. It's from the household. You have a classic case. It's unlikely because it's political. As you know, in China, you have what's called the hookah system, which means that as a Chinese, you're only allowed to live and work in the area for which you have a permit called the hooko. So when you think about all these migrant workers in, say, in Beijing, most of them here are technically illegal. Now, they're allowed to work here, but the problem is they have a limited ability to access city services, schooling, medical treatment.

If they ever get into a country, imagine that you eliminate the hookah overnight city services. Also, immediately, the city would be poorer for mechanism. And it's something the Chinese have been talking about for many years. It's just too politically difficult to pull it off. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories.

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So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. So let's fast forward to the present day because obviously, And this is something you've talked about in your writing is that, you know, the growth model can continue, even with all the dead, even with all the domestic imbalances, so long as there's a significant amount of foreign demand for Chinese goods. And as long as someone is out there buying and for a long time, really for the whole world, but for China, in particular, the U.S. has been a major contributor of demand for goods of all sorts. And we see that now running into an obvious problem, which is President Trump and the trade war and this sort of general feeling maybe in the U.S. that the current system has gone on too far. And we don't want to be the demand creator of last resort for the Chinese economy. How is that contributing to what we're seeing domestically? I mean, we know the data for China has not been particularly good. Some talk recently about giving up on the 6% GDP growth.

growth goal. Talk to us about how, you know, there's all these challenges and how the additional challenge of the U.S. no longer wanting to play its, the role it has been for the last few decades, how that is affecting things. Everything that China produces, everything that any country has to be absorbed in one of three ways. It's either consumed domestically or it's invested domestically or it's consumed or invested abroad, which is through the through the trade surplus. So the total GDP that's produced in China goes into one of those three things. Now, the consumption shares, we discuss, is very, very low.

So much of it goes into investment. Investment we want to bring down as quickly as possible because primarily in stuff that's not productive. So that just represents a growth in the debt. But here's the problem. if the U.S. were to put in constraints that forced the Chinese trade surplus to contract, then China either has to accept lower growth, everything that it's producing, so it has to make up for that growth in some other way,

by increasing investment even further, which means increasing the debt burden even more quickly. That's why the trade conflict is so. It sort of mediates the investment, down investment, and that's the big problem. Now, the overall trade problem, you know, China's not even the worst offender in this case. The problem there is really on the capital side. Now, this gets a little bit technical, but what ends up happening, if you, in your opinion, they don't have high savings rates because there are countries that value, you aren't particularly more thrifty than other Europeans.

GDP is low, and the share by the government or by the wealthy is quite high. So those are high-saving entities, part of the economy. economy, being low-consuming part of the economy, savings exceeds your investments. Then you have to export the excess sector or trade surplus. So countries with exiting somewhere, trade theory tells us that they export them to developing countries that need the same. Most of it goes as a result because the U.S. that's exported to the U.S. on the corresponding current account or trade deficit. Now, it's a little pedantic, but the point of all of that is to suggest that the reason the U.S. runs a trade deficit is because it runs a capital account surplus over which it has no control.

If that's the case, then putting tariffs on Chinese goods will impact at all. It will reduce the U.S. deficit with China, but if Chinese savings continue to pour into the U.S. the U.S. China will continue to run a surplus and the U.S. will continue to run a deficit, just not with each other. The only impact is to shift trade around. They don't really affect the overall surplus of China or the overall deficit of the United States. And you can see that in the data. The U.S. deficit with China has gone down. The U.S. deficit with the rest of the world has gone up by even more, exactly as you would expect. So just to be clear, is the suggestion here that the trade war between the U.S. and China is basically sort of an excess money problem, and the U.S. is maybe indirectly trying to shrink these capital inflows by targeting Chinese goods, because that's one way that it could possibly alter those inflows.

Yes, it's just the wrong. Like China has such a high savings, right? It's not an accident. and subsidized manufacturing, then, of course, that means that ultimately the part of production retained by the household sector goes lower and lower. So you can take the case of Germany in 2003, 2004, the Hartz reforms. Basically, the Hart's reforms represented a transfer of income from German workers to German businesses. The household share went down, profits stored. That's why Germany was so competitive in the...

international markets because basically workers subsidize their exports. It's the same thing in China. And that's really what the U.S. has to address, not through tariffs. So if you're President Trump, or sorry, if you were advising President Trump, you'd say, don't, you know, forget about all the tariffs and soybeans and all these things, pressure Xi Jinping to get rid of the Hukho system, transfer the domestic. wealth of the country to the workers, eliminate this excess savings that causes all the excess money to come to the U.S. and actually put money in the hands of people who might, over time, buy stuff from the U.S.

Right, right. No, I know, just exaggerating. But that's sort of like the contours here, which is that. Exactly. And I have to admit, just, I know, like, you have a book coming out next year with Matt Klein, who he's at Barron's. And I remember reading this, I think a year ago he had a really good column, sort of making this point, which is that the real way for the U.S. to make progress on the trade war would be for essentially the U.S. to pressure that domestic realignment that you've been talking about so that more of the money in China is in the hands of consumers as opposed to people with a lot of extra cash to put somewhere. Exactly, right.

But, you know, when the Chinese sell us something for $100, that's $100 flow from the U.S. to China. Ideally, we want that money to float. It will flow back, but it typically flows back in the form of, so the Chinese will buy U.S. treasury bonds rather than U.S. manufacturing equipment. And that's purely caused because of the way income is distributed in China. The only way the U.S. can really pressure China and Germany and Japan and the rest of them to fix their domestic problems is by somehow refusing to allow that capital to flow into the U.S. Perhaps by taxing it, perhaps by quotas, I don't know. But that's really the kind of pressure that the U.S. should be able to answer. Right. So this is something that keeps coming up.

And just to play devil's advocate for a second, can you walk us through both? the positives and the negatives of having a lot of foreign money basically pour into the U.S. because on the one hand, clearly it affects employment through manufacturing, but on the other hand, it does lower the U.S.'s funding costs and, you know, helps people maybe spend more than they would otherwise. So there seem to be pros and cons. So could you just walk us through them and how you see it net net as a positive or a negative? Yeah, so suppose the repayments and then for whatever reason, they're savings to the U.S. That means in the U.S., well, how do we get the deficit?

Well, if the U.S. were a developing country, then, for example, the way it was in the 19th century, then investment in the U.S., there would be huge investment needs that would be constrained by the lack of domestic savings. In that case, foreign money coming into the U.S. would be a U.S. depended very heavily on British capital for its domestic investment. But the U.S. isn't a developing country anymore. Now we have a different problem. We have too much capital. Interest rates are at historically low levels on their balance sheet, which they're unable to invest,

buybacks and things like that. So if you increase the amount of foreign savings, the increase the amount of capital in the U.S. by $100,000 in 2003-2004, it didn't go up. It actually went down. And I think that reflects the fact that we're no longer living. even negative interest rates. To drive down the American savings rate, either you increase unemployment,

or you increase household debt, or you increase the fiscal deficit. None of those are good things, obviously. So that's why for the U.S., running a current account deficit and a capital account surplus is a real... And so that's why I think it does make sense for the Trump administration,

and Bernie Sanders said the same thing and Elizabeth Warren's deficit. It's just that they're addressing. Yeah, I thought it was pretty striking that during one of the recent Democratic debates, the moderator asked the candidates, who would immediately reverse Trump's tariffs on China and none of them raised their hands. And so even to your point, maybe that's not the right approach. There is this political alignment in the U.S. between Trump and the Democrats where none of them want to go back. to the old relationship with China right away. It's no one thinks it's as simple as just reversing Trumpism and that everything's fine. And I know, again, I know you have an upcoming

book sort of exploring this dimension or the sort of the connection between class warfare and trade warfare, domestic inequality and trade wars, regardless of whether Trump is pursuing the right approach, everything that you've laid out and what all of our political leaders seem to intuit is that there really was something truly broken about the existing or the old relationship. Much higher than much longer than trade theory would permit. You mentioned the book that I think it may. And in the book, what we try to argue is that what looks like a conflict between nations

is really a conflict between economic sectors. The same groups in China and in the U.S. or in Germany and. and in Spain with the imbalances. Who's the biggest culprit when it comes to economic sectors? You mentioned both in the case of the U.S. and China, this idea of corporates having a large size of national wealth. So I'm just wondering, is there one particular entity that you would say is worse than others? Well, you know, I spent most of my career on Wall Street, so I hate to say.

The global banks benefit tremendously from this system, from these international capital flows. businesses that are easily able to move their operations and workers are before we go we have to wrap it up surely i want to just turn to one other thing it's not directly related to this but it touches on all this stuff of course but these days there's a tremendous amount of discussion and political pressure on germany specifically to uh expand uh engage in fiscal expansion that when people look at the imbalances in the world right now obviously the U.S.-China trade relationship is all its issues, but that there's this sort of obvious issue in Europe where the richest country really should be spending a lot more and they have this, you know, obsession with balanced budgets. It doesn't make any sense. And how big of a deal? Like, how big of a problem is German fiscal rectitude right now? And how what could happen if they don't do something to address their own imbalances? It's a huge problem because, you know, the problem that we have global, we have insufficient demand. And one of the reasons we have such weak demand is because thanks to income inequality and also thanks to mercantilism, the consuming part of the world is too small.

So there is insufficient consumption unless it's boosted by debt, which of course is unsustainable and risky. consumption, there is insufficient business investment to serve that consumption. When Germany says that the solution for the world is for everyone to be like us, that's a huge problem because what that means is that everyone should continue competitive. But if we all lower wages to become more competitive, we just get poor. We run into the problem of the 1930s, which then explained it. He said that as you keep pushing down workers' wages, you're not even benefiting the wealthy, because if workers are unable to consume the things, then everyone gets caught in. And that's sort of what Germany forced on to the rest of Europe. It's your fiscal record of choice. Once the world is unable,

and it's huge, it's about 9 or 10% of GDP, then what can Germany do? If it is unable to consume it domestically, helping, producing, it means closing down factories and firing workers, etc., etc. So ultimately, I don't think they'll recognize that they have to engage in domestic spending their force to, I think. So before we go, one of our listeners said that we absolutely have to ask you the following question. So I'm going to try to tie it into some of the topics that we've been discussing. But when you view China's economy, are you confident that the rebalancing is going to

happen and in what time frame do you think it might happen? And also, are you sort of positive about the direction of the overall China economy? And when you do some of the other stuff that you do in Beijing, which is a music label, you're involved in the music scene over there. And I think at one point you ran a club, I'm not sure if it's still open or not. No, it's not, but yes. What does that tell you about the direction of the Chinese economy? Well, the question is, will rebalancing happen is very often? And it will happen once eventually reverse. The question is, how does it reverse? It could reverse in the form of a crisis. So, for example, if you look at the U.S. in the early 1930s, in the 1920s, the U.S. had many of the same problems that China did. And the way it rebalanced in the 1930s is of the decade, GDP contracted by something like 35 percent, household income contracted by roughly half. incredibly painful. Another way of rebalancing is the way the Japanese did. After 1990,

they also have the same imbalances that China does. No one nears severe. They rebalanced in the form of two lost decades of stagnant GDP growth. Those are basically the models that the world gives us. Those are the two ways you rebalance. And my guess is that China will rebalance the Japanese way in a very long, grown-out rebalancing. Now, for China, the sooner, they start that process, the better, which basically means the more rapidly GDP growth gloss. A few months, I've been pretty impressed that they haven't done what they always do when growth slows, and that is to panic and step on the accelerator.

Going pretty sharply for students who are... And he thinks it's possible we may even see months of 5.8% growth this year. That, I think, would be a really good sign, because that means that China is... The problem is that I think they 3% before C will see what happens. And what about the music scene? What does that tell you about the future of China? There's been good one of the most exciting things about being in China. And it's something that I think a lot of people miss because they're looking for the wrong signals.

Urban Young in China. And music is at the center of it, but it's not the only part of it. You see it in movies, you see it in lots of different things. But I don't think that should be a surprise. Chinese incomes have soared in the last 20 to 30 years. And China has gone from a country that has primarily never seen anything take place at this speed going to be. But it's probably a safe bet that it's going to be culturally extremely interesting and something very vibrant. All right, Michael Pettis.

We're going to have to have you come back on just to talk about music for an episode, I think. I'd love to. That was great. Thank you so much, Michael. That was, I learned so much. I really appreciate it. Thanks very much. I hope that was useful. So I love that conversation, and I love that we're having it at a sort of key political date in the Chinese calendar, because I think the policy is so important to all of this, right?

Absolutely. I really like that conversation. And the way Michael explains things is so clear, because a lot of this type of analysis, a lot of which is sort of based on seemingly accounting identities, the sort of axiomatic relations. between savings, investment, and the current account, it can seem like it can be, I always have a slightly hard time keeping these relationships in my head exactly like what moves up and so what therefore then has to go down. And I just think, Michael did such a clear job explaining it and then explaining how these things have real world ramifications. Yeah. And the other thing that seems to be coming through on our episodes recently is the notion that there is, some sort of problem of imbalances with too much money flowing into the U.S. We talked about it with David Beckworth most recently, and Michael brought it up yet again.

And people seem to be moving towards a consensus that there is an issue here. They just disagree on how exactly to fix it. And it's one of those things that to the average person, they would have a really hard time wrapping their head around why that's a problem. So it's like, oh, okay, China is investing all this money, all this exporting, all this capital to the U.S., I think intuitively to a lot of people, like, that's a good thing. Why not have people bring their money here? But then the way Michael explains it, in terms of driving up asset prices, driving up the dollar, etc.,

or causing a loosening of lending standards, and that hurts U.S. savings, you start to actually crystallize what it really means to have capital flow to the U.S. as opposed to demand for our goods. So I just feel like that was so instructive and just seems to explain so much of what's happened in the economy over the last several decades. Yep, for sure. And we'll have to have him back on to talk about his music label and his club as well. All right. Well, let's leave it there for now. This has been another episode of the Odd Lots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwork. And you should definitely follow our guest on Twitter. He's way. underfollowed for how much he knows. Criminally underfollowed.

Michael Pettis. He's at Michael X. Petis. Check him out. And be sure to follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson, as well as the Bloomberg community of podcasts, which is under the handle at Podcasts. Thanks for listening.