Welcome back!
Michael and I were not expecting to discuss China again quite so soon, but the surprising and persistent weakness of the consumption, production, trade, and investment data are all so striking that we felt compelled to dig in.
We cover what Michael has been seeing on the ground, how the government might respond, the constraints facing the central government, why Richard Koo is right (or wrong) about what China can learn from Japan, why Chinese policymakers are like Herbert Hoover, what America’s recovery from Covid might teach China, the plight of China’s young graduates, and what has happened to architecture majors—among other things.
The edited transcript is below the fold. Remember, subscribers cover our cost of production. Paying listeners get to listen to the full recording and read the full transcript.
Related links:
China's Missing Post-Pandemic Rebound—The Overshoot
Why US debt will continue to rise—Michael Pettis
New Top Document Promoting China's Private Economy—Pekingnology
Richard Koo on China's Risk of 'Japanification'—Odd Lots
The old approach to US-China relations no longer works—Stephen Roach
China Used to Be an Architect’s Dream. Now, It’s Becoming a Nightmare.—Sixth Tone
Matt 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 what's been happening in the Chinese economy since the end of “Covid Zero,” which was at the end of last year. Many of us, including me, were expecting a strong recovery, particularly on the consumption side. But so far that hasn’t happened. And month after month, we’ve been hit with fairly disappointing economic numbers.
Matt Klein: So just to get started, maybe we can talk about what people had been thinking, and why you and others were relatively optimistic at the end of last year and the beginning of this year, which was when the government announced the end of the restrictions associated with suppressing the pandemic.
Michael Pettis: During the Covid period, not just in China, but in most countries, you saw a contraction in consumption. That’s particularly important in China because consumption is already very low and consumption drives business investment. What we’d seen during the three years of Covid was a year of significant contraction in consumption that was then followed by a reasonable recovery. In 2020, Chinese GDP grew something like 3%. But consumption, along with business investment and exports, actually contracted. So more than 100% of the growth was driven by the kinds of things that China is trying to back away from: investment in the property sector and investment in infrastructure. And one of the ways we see that is that China’s debt/GDP burden worsened significantly in 2020—it went up by 25 percentage points.
In 2021, however, we had a very different year. GDP growth was around 8%, but that was driven largely by a major recovery in consumption. It was not a full recovery, it was a partial recovery, but still, consumption grew by about 9%. Business investment was strong. Exports were strong. So you had pretty high quality growth. One of the things that I’ve mentioned many times before is that when the quality of growth is high, you don’t see a significant increase in the debt burden. And in fact, the debt to GDP ratio went down for the first in a very, very long time.
Last year, we had another bad year. You had the terrible lockdowns, most notoriously in Shanghai, but in a lot of other places too. And once again, growth was fairly slow. The high-quality growth, which again is consumption, business investment, and exports, did quite poorly. Much of the growth was the kind of growth that, again, China doesn’t want. And once again, we saw a surge in the debt/GDP ratio, something like 12 or 13 percentage points.
So many of us were expecting, not a repeat of 2021, but a partial repeat, where some of that contraction in consumption—which was a forced contraction when you’re locked at home and you simply can’t go out and consume to the same extent you used to—that some of that was going to recover this year. We’d see consumption grow reasonably quickly, not enough to make up for last year, but partially to make up for last year. And as a result, business investment would do reasonably well. So we would be able to achieve the 5% growth target quite easily. And more importantly, It's not just 5% growth or 6% growth. It would be a high-quality growth.
But month after month, we’ve been very disappointed. We saw a partial recovery in February and in the beginning of March. And after that, it pretty much fizzled out. We’ve had very slow growth. And we’re seeing that in all of all of the relevant numbers. The consumption numbers are very weak. The retail sale numbers—the monthly proxy we have for consumption, because we only get consumption every three months—have been very, very weak.
While the rest of the world is still dealing with inflation, China is dealing with deflation. We had a little bit of inflation in January but every month since then we’ve had deflation. Chinese exports are down a bit, but Chinese imports are down a lot. That’s another indicator of domestic consumption.
All of this information is telling us the same thing: consumption simply isn’t reviving.
That creates a lot of questions about what happens in the second half of the year. There are many, many people in Beijing who think that we still need to wait a little bit longer and that consumption will revive. Perhaps it will, perhaps it won’t. We don’t really know. It’s very hard to predict these things. If it does revive, we’ll probably get a partial revival in business investment. But if we don’t, we won’t. And I think most economists agree that exports are not going to grow this year because the global economy isn’t doing very well. The property sector has been badly hurt and is not going to recover.
When you go through all of the possible sources of growth, there’s really only one left: renewed spending on infrastructure, which is something Beijing doesn’t want to do because China already has way too much infrastructure. And this is the big source of debt. But that’s the big question that we’re all asking ourselves: Will we see a partial revival in infrastructure spending? If that happens, that’s bad for China in the long term, but at least it delivers growth in the short term. And for political reasons and employment reasons, Beijing is very concerned about seeing an increase in economic activity over the rest of this year.
Matt Klein: I definitely want to follow up on a few of those points. But before doing that, I want to highlight that this is a surprise, because a lot of the indicators one might look at—not necessarily economic indicators, but just indicators of what life is like as a person living in China today—show that there has been a tremendous normalization. Since the end of last year in terms of the experiences that normal people actually have. So I think that’s part of the reason why it’s surprising that consumption hasn’t revived. Maybe you can give us a sense of what that contrast is like and why, given this, it is so surprising that we’ve seen such a weak recovery.
Michael Pettis: In many ways life seems to have gone back to normal. If you travel around Beijing, it’s full of people. There are terrible traffic jams. The subways are full, the city is full of tourists. But it’s a little bit distorted, because when you look at the various components of consumption, catering and travel have come back very strongly—that’s the number one area of growth among all the various types of consumption.
Number two, interestingly enough, is gold jewelry, things like that. You sort of wonder why are people buying so much gold and jewelry. Could it be because they’re very optimistic and everyone's running around getting married and things like that? That seems unlikely. Could it be as a way, not so much of consuming, but as an alternative way of saving? We don’t really know, but we’ve seen this in the past.
Automobile sales are up largely because of a lot of support from the government. But most other goods, durable goods, et cetera, are way down. So on the one hand, China looks like it’s fully recovered from “Zero Covid”, but it’s still not showing up in the in the numbers.
Now, one of the things that’s been interesting to me this year is that a lot of people who weren’t able to come to China in the last 3-4 years have returned to China for visits, and I meet with quite a lot of them: academics, business people, investors, bankers, government people, et cetera, And all of them seem to think that the level of depression, the level of anxiety, the level of nervousness is much higher than they’ve ever seen before in China. It’s hard for me to tell because I’ve been here during this whole period, although it seems to me that anxiety certainly has gone up.
But all of these people who haven’t been here in three or four years, were all really struck by this sense of nervousness, concern, worrying about the future.
And this, of course, is something that that Beijing worries about a lot. If you’re nervous about the future, you’re unlikely to spend. If you don’t spend, we’re not going to get a recovery in the economy. And if we don’t get a recovery in the economy, of course, you’ll continue to be nervous about the future.
Matt Klein: Right. There’s a real reflexivity there. It’s interesting too, because, as you said, the government in Beijing, the authorities, they do want consumer spending to rise. And you see lots of independent academics and analysts talking about this, think tankers, university deans, and people like that. It seems like there’s a consensus intellectually that there has to be more consumer spending. And yet there doesn’t really seem to be much of a policy response. I guess the People’s Bank of China sort of has been asking banks, but not asking very hard, to see if they can charge less mortgage interest on existing mortgages.
But otherwise, it doesn’t seem like there’s been really kind of any major significant initiatives that match the sense of urgency or intellectual consensus that there should be more consumer spending. What’s your sense of what explains this disconnect? On the one hand, people seem to understand what's going on, there’s a belief about what should be done, but then there’s not really actually any follow through, or not much follow through.
Michael Pettis: Well it’s incredibly frustrating. By now, almost everyone agrees that it’s vitally important to increase the consumption share of GDP because that’s what needs to drive growth. The two big sources of growth are consumption and investment, and there’s way too much non-productive investment in China, so you have to bring that down. But if you bring that down, either you bring up consumption or you reduce GDP growth, and of course, they don’t want to reduce GDP growth. So by a process of elimination, you must increase the role of consumption in economic activity.
But there’s only two ways you can increase the consumption share of GDP in any economy: one is you can increase household debt, in other words, get households to borrow more money to consume. China did this in the last 7-8 years, to the point where household debt in China as a share of household income is among the highest in the world. It’s higher than in the U.S. Beijing is very concerned about not encouraging any additional household debt.
So that leaves the only other way, which is to increase the household income share of GDP. In other words, give workers more money, improve, the pension system, reduce fees and payroll taxes. There are lots of different ways of doing it. Even make the subway free, or build cheap housing and give it to the poor, or rent it very cheaply to the poor. There’s lots of ways of doing that.
But when you look at all the talk about boosting consumption—and I tell you, you can pick up the People’s Daily, and every single day there’s another article saying we are going to boost consumption—and then you read through what they’re planning to do and you see that none of them, or very, very few of those proposals actually boost household income. They’re more along the lines of “let’s make the shopping experience happier, let’s have shops stay open later at night.” Or “let’s improve delivery on the internet,” et cetera, et cetera.
But the problem is that when you as a typical household think about spending money, your constraint is your income. Let’s say you have 100 of income and you decide for whatever reason that you’re going to save 15. That means you get to spend 85. And if I can figure out a more enjoyable way for you to spend that 85, you’ll be happier when you spend that 85. But you’re still not going to spend more than 85. That’s the problem. Most of the proposals are really what we would call supply side proposals, they’re not really demand side proposals.
And it’s really intriguing to try to understand why that’s a problem. Part of it is institutional. But I was reading on one of my favorite topics, which is the 1930s, and as I was reading about Herbert Hoover, who was a very smart guy, but during the early days of the depression in 1930-31, he could not bring himself to deliver income to households directly.
He was absolutely convinced that if you gave any money to the households that they would become “morally degenerate”. They would become “lazy”. They would stop working and you would create this big welfare class—even as household income collapsed!
He was more concerned about making them “lazy” than about creating demand, so his policies were all supply side policies: “If only we can give more money to businesses, then they will go out and hire more workers and household income will go up.” The problem is that businesses couldn't sell what they were producing, and so subsidizing them further didn’t really solve the problem. They still weren’t going to hire workers. And it seems like we’ve been caught in that sort of Herbert Hoover trap here in China.
Matt Klein: That’s a great point. I remember a couple of years ago when Xi Jinping introduced, or reintroduced, the concept of “common prosperity”, and then people were very excited about this. There was a lot of potential about what that could mean and how that could fit in potentially with this rebalancing agenda. And then there were these caveats of, “well, obviously, we don’t want to end up—” I think actually, you can correct me if I’m wrong, but I believe that they explicitly made comparisons to Latin America and said, “we don’t want to end up like them.”
I remember being struck by that tension there. You can recognize the macro imbalance, but then you don’t want to address it because there’s a not entirely unreasonable concern about how you might affect micro behavior and incentives. But at the same time, if you let that concern get in the way too much, then you prevent yourself from doing the macro policy that you need.
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