UN/BALANCED Episode 4: China's Two Sessions, Who Should Run Economic Policy, and the "Negative Convexity" of China's Local Debts

UN/BALANCED Episode 4: China's Two Sessions, Who Should Run Economic Policy, and the "Negative Convexity" of China's Local Debts

Matt and Michael discuss the state of Chinese political economy in the aftermath of Covid Zero.

Welcome back! This month’s episode covers everything from the potential growth impact of the end of “Covid Zero” to the inter-provincial politics of China’s domestic migration restrictions. Free listeners get the first 15 minutes, while paid subscribers get access to the full conversation. A lightly-edited transcript is below the fold.

Section Outline

0:33 China’s 2023 GDP growth target and the post-”Covid Zero” outlook

18:01 What should we think about the personnel shifts at the top of China’s economic policymaking apparatus?

23:50 Regional variations within China, the “negative convexity” of local debts, and implications for the hukou system

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Matthew Klein: Hello and welcome back to UN/BALANCED, a listener-supported podcast about the global economy and financial system. I’m Matt Klein.

Michael Pettis: And I’m Michael Pettis. Today we’re going to discuss the news out of what in China is referred to as the Lianghui or “The Two Sessions”. These are the annual sessions of the National People’s Congress, which is the legislative body in China, and then the Chinese People’s Political Consultative Conference, which is sort of an advisory group. These meetings are very important for setting the economic and other goals for the year. And we’re going talk a little bit about what has come out of it and what it may mean for the Chinese economy.

Matthew Klein: So maybe you could give us just a little more background for those of our listeners who, unlike you, have not been living in China for the past two decades and are less familiar with these terms. Can you give us a little more sense about what previous iterations of these two sessions have signaled for the years ahead? What have been the biggest changes that have come out recently that give us some guidance for 2023?

Michael Pettis: Well, the sessions cover a lot of topics. But for those of us who are interested in China from an economic and financial point of view, the most important things that come out every year in these meetings is that we get the expected budget for the year. That tells us something about the amount of debt that’s going to be raised—and more importantly in recent years, the amount of transfers from Beijing to local governments to make up for their shortfall in income.

The other really big news—the one that we all wait for—is when they formally announce the GDP growth targets for the year. Now, we typically have very good rumors during the December work conference about what they’re going to choose for the GDP growth target, and those are usually confirmed, not always, but usually confirmed in the two sessions meetings in March.

By now I suspect that most of our listeners know that Li Keqiang, the outgoing premier, on the very first day of the two sessions in his speech announced that the GDP growth target for this year would be 5%. Now, many of us knew that this was likely to be the growth target because these were the rumors beginning in December.

But in recent weeks there was an awful lot of press citing analysts at various investment banks who thought the target may be much higher: 5.5% to 6%. Each province in China and most major cities also have growth targets for the year, and those were all released earlier in the year. If you look at the growth targets for the provinces on a weighted average basis, they are collectively projecting growth of around 5.8%, 5.9%. So that’s the context within which to understand this 5% growth target.

Matthew Klein: The thing that’s striking to me about this 5% is on the one hand you could say, “oh, that’s slow compared to the longer-term history of Chinese economic growth,” where you had many years of 10% or almost 10% yearly GDP growth. You could also say, given the fact that the economy basically didn’t grow at all in 2020 or in 2022, that if you had some sort of reasonable trend baseline of what would’ve happened had there been no pandemic since 2019, you would need a tremendous amount of growth in 2023 just to catch up to that trend.

One would think that with the relaxation of pandemic-related controls that you’d get a lot of that naturally, with all the pent-up demand and savings and so forth that have been accumulated over the past couple of years. You could say that 5% or even 6% you could imagine being on the low side.

I’m curious how you think about that and what that might mean in terms of the target. Or maybe this is like a U.S. corporation where they give soft guidance on purpose?

Michael Pettis: Well, it may help to look back at some of the growth rates. Before 2016, we regularly had the kind of growth rates you were talking about: 6%, 9%, as high as 13% in some of the years. But from—I’m just looking at my data here—in 2016, we had 6.9%, 2017: 6.9%, 2018: 6.7% 2019: 6.0%. That, of course, was the last year before Covid, and during the three Covid years, we’ve had an average growth rate of around 3.6%, but that was very unevenly distributed. In 2020, growth was 2.2%. Then in 2021, growth was 8.1%; a huge recovery. And then in 2022, growth was 3.0%.

But what I always warn my clients and people that I advise is that what’s important in China is not so much the growth rate, but the quality of growth.

So to go back over those numbers again, in 2020, China grew by 2.2%, but what Beijing refers to as “high-quality growth”—that is, unlevered growth, which is mostly driven by consumption, exports, and business investment for the most part—that was actually negative in 2020. More than 100% of the growth was generated by the kind of things China says it wants to avoid, which is investment in the property sector and investment in infrastructure.

They want avoid it because they are way overbuilt on both so a lot of that stuff is non-productive. One of the ways you would expect to see that, if that were the case, is that debt levels would jump especially high during those years in which high-quality growth is low or negative, and low-quality growth more than nearly all of the total. And in fact, the debt to GDP ratio in 2020 rose by—I don’t have the numbers in front of me—I want to say 24-25 percentage points.

In 2021 we got a partial recovery and the debt/GDP ratio actually dropped by about 4 or 5 percentage points. Most of that 8.1% growth was really high-quality growth driven by something like a 9% increase in consumption. And then last year out of that 3% growth, almost all of it was low-quality growth: consumption grew by about 1%. Not surprisingly, the debt/GDP ratio rose by 11 or 12 percentage points, the second highest ever. So what we’re looking for this year is not a repeat of 2021, but sort of a partial repeat of 2021 where we get both a high growth number, or relatively high growth number, but more importantly, much or most of that growth being what Beijing refers to as “high-quality growth”.

Matthew Klein: Just to add to what you were saying, China’s National Bureau of Statistics, when they track fixed asset investment excluding real estate—which includes infrastructure spending and includes business investment—one of the ways they publish it is they distinguish between private fixed asset investment and state owned or state controlled fixed asset investment. And just to corroborate what you were saying, in 2020, private-sector growth in fixed asset investment was just 1% for all of 2020 compared to 2019. And in 2022 it was 0.9%. That is extremely slow growth, which fits with what you’re saying.

Following up with what you were saying before, why wouldn’t we expect a repeat of 2021, in terms of the magnitudes? Because as you were saying, the overall growth impact of 2022’s Covid restrictions was actually pretty comparable to 2020, both in terms of overall GDP growth and in terms of consumption and private fixed asset investment. Why wouldn’t we expect that kind of a snapback? Do you think there are other constraints that might impair or prevent that kind of recovery this time around?

Michael Pettis: Well, part of it is because in 2020—the bad year—unemployment didn’t really seem to go up that much and there was less downward pressure on wages. There was downward pressure on wages, but less so. Much of the reduction in consumption in 2020 was simply the flip side of an increase in savings. Part of that extra savings was a permanent increase in savings, which is what happens when uncertainty rises: we all spend less and save more. But a lot of it was an increase in unwanted savings, and we saw a big recovery there. Also, don’t forget that in 2020, real estate prices were still going up and the real estate sector hadn’t been badly hit, which is what happened towards the end of 2021. So there were a number of things that suggested that 2021 was going to be a pretty spectacular year in 2020.

In 2022 now you have the real estate sector, which isn’t performing well, and declining real estate prices may have hurt consumption through some kind of wealth effect.

But more importantly, wages were down much more and unemployment may have been up more. Uncertainty is way up.

It’s hard to get the data, but people talk about youth unemployment being around 20%. All of that seems to have combined to make Chinese households much more cautious about spending money. Plus we don’t have the motor that was the real estate sector.

One other point that I should mention—it’s less important, but it’s very visible—is that Chinese exports exploded in 2020, 2021, and 2022. By the end of 2022 they started slowing significantly.

Matthew Klein: That is a really good point that China, especially in 2020, and to a lesser extent, also in 2022 that the Chinese economy was able to rely to a certain extent on foreign demand to supplement or substitute for domestic consumption.

Just to follow up on this, because I would love to know more what your perception is: these points about economic weakness driving the shortfall of consumption 2022 and things like uncertainty in youth unemployment, the property sector and the changes there that you mentioned and the way that flows through to local government financing, which we can talk about later, are obviously very important.

To what extent though, were the Covid controls that are now being lifted also playing a part? As China goes back into full reopening, maybe some of those forces will push in the other direction?

Or do you think there are other deeper issues that are holding back consumer spending in a way that wasn’t necessarily the case a few years ago?

Michael Pettis: I think the uncertainty is very important. I think the lower income is very important. Last year, real per capita consumption was actually down something like 0.2%. I think that’s the first time that’s ever happened since the reform and opening up. There are a lot of things that are included in there.

I think medium term, China’s got a huge problem, but short term, I’m relatively optimistic. I think growth will be closer to 6% than to 5%, but I always warn people that I’m speaking to that there’s a lot of uncertainty around that as of yet, because we’re counting on a very big reversal of last year’s consumption contraction. But it’s too early in the year to really say what happened. The first two months are characterized by Chinese New Year, which has a big distortionary impact on spending. 2023 was the first Chinese New Year that we’ve had without Covid restrictions in three years. So that may have changed people’s behavior in ways that are hard to predict or hard to understand.

The other important thing was that Covid swept through China in December, January, and a good chunk of February. It still had an impact on people’s activity and on people’s spending. So we don’t really know yet. We don’t really have good data on whether or not there’s been a significant rebound in consumption. I would guess we really want to see what happens in March and April.

But if you look at the trade data, they’re really pessimistic. We always get trade for the first two months of the year together because of the impact of Chinese New Year. And for the first two months of the year, exports were down 6.8%. This is like the, I don’t know, the fifth month in a row that it’s been down. That’s very worrying.

But what was much more worrying is that imports were down 10.2%, and so China had the biggest January-February trade surplus in its history. And that’s important because imports are a reflection of domestic consumption.

With imports so weak, that suggests to me that in the first two months of the year, consumption was probably not nearly as strong as we would’ve liked it to be. Now, like I said, the first two months of this year are so weird that you don’t want to draw too many conclusions from it. But it does look so far that it hasn’t started off great. I’m hoping that it gets much better in March and April so that we can count on a reasonably good year.

Matthew Klein: That’s really striking. Imports being down somewhat relative to exports had been the pattern, as you know, for the previous several years. But that was, I think, based on the assumption that China’s Covid restrictions were much harsher than the restrictions in the rest of the world, and therefore that the ability of Chinese producers to produce was going to be always relatively better than the ability of Chinese consumers to consume. Maybe it’s because of the impact of the virus itself, getting so many people sick and dying and so forth in the first few months outweighing whatever benefit there would’ve been initially from the lifting of controls?

Michael Pettis: I also think it’s in the way Beijing has responded.

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