China’s Mismanaged Economy At A Critical Crossroad

>> John: Great, well, really pleased to have Mickey Levy speak to us today, chief economist for Americas and Asia, every part of the world of Beringer capital. So, let's focus on China today that's great. He's had many years of experience as an analyst, I just realized as 15 years as chief economist at Bank of America.

And he's now very active in the shadow of a market committee since 1983, even though it's a little bit older than that, but it's great to have you here.

>> John: Isn't he older than that, and the title of the paper is China's Economic Woes, sources, challenges, and diminished longer-run potential.

Mickey Hoover Institution, go ahead.

>> Mickey D Levy: John, thanks so much, so China's economic miracle is unraveling. So, its economic story has been extraordinary. It moves from an impoverished nation to the world's second largest economy and the driver of global growth and trade. And now its economy faces major challenges.

And so, as I will describe, the themes that stand out, are Chinas earlier embrace of US style free enterprise and capitalism worked economic miracles. So, they had this odd economic model, command and control model, socialism that allowed free enterprise to run parallel. And that is what brought the miracles, President Xi's imposition of China's socialist ideals and now clamping down on free enterprise and personal freedoms is a failing economic strategy.

And it has led to significant misallocations of resources that are creating the economic troubles. And one of the key themes is, it's a great example of how central planning failed once again. And then its longer-run potential depends critically on the economic regime it chooses. So, just in summary, the focus of everybody is they have government-driven excesses in real estate and debt.

And that is what drove the rapid growth, and it's now all unraveling. And the falling real estate values, not only undercut household net worth and consumption, but it also undercuts the government's finances and their whole fiscal policy multiplier and constrains its ability to stimulate the economy. So, when you hear now, this kind of a hesitant approach to how much they can stimulate the economy, it's because their whole system of fiscal policies unraveling, as I will describe.

And I think this is going to take years to unwind, and China's weaknesses are spreading globally, and depressing growth and trade. Now, as I will show, and while it remains the second biggest economy in the world, its fundamentals really point toward diminished growth. So,

>> Speaker 3: It's failed largely because it's not maximizing economic performance, but it's maximizing something else.

I thought she was maximizing political performance and willing to give up on the economy.

>> Mickey D Levy: Okay, when he took over control in 2012, my perception is he thought he could reject free enterprise. Move back to his socialist ideals and maintain stronger and stronger control, while at the same time maintaining economic growth.

And he's come to realize, he was unable to.

>> Speaker 3: But he's willing to give up on it.

>> Mickey D Levy: But now, I'd say at this crossroads right now, well, he's realized the growth isn't there. And he puts higher priorities on maintaining control, at the cost of economic growth and the cost of freedoms to individuals.

 

>> Valerie: I was wondering how much of this though, is something beyond what he's doing, which is first of all, the whole one child policy. The demographic hangover from that, in terms of slower population growth, in fact declining. But second of all, how much of the growth was a natural sort of transition phase to opening up to capitalism basically with Deng Xiaoping.

And that you're having this somewhat of a catch up, but the slowdown is what you often naturally see, it'll catch up at a different level. But I was wondering how much of it is what he's doing versus these other sorts of forces, that we kinda know from growth theory.

 

>> Mickey D Levy: So, the one child policy was all about central control. We could fast forward to the pandemic and the total shutdowns, that was all about central control.

>> Mickey D Levy: Let me move on, and I think I agree with you. It's quite natural for an economy growth to slow down.

What's interesting is China, like Japan in the second half of the 80s, failed to recognize that its potential growth was slowing, and both took steps to try to pump things up.

>> John: I don't think you're disagreeing.

>> Mickey D Levy: China had a catch-up growth to about a third of the US level, and now it's stuck.

And it would be half or two thirds of the US level if they got of the way and had more.

>> Valerie: No, that makes sense, so the,

>> Mickey D Levy: Yeah.

>> Valerie: Okay, so the slowing is natural, but the level at which that path is, is not.

>> Mickey D Levy: That's right, okay, so I just put this in.

A year ago this week, I had an article in the Wall Street Journal basically saying China's about to fall into the middle-income tract. And I've said I've been writing about China evolving from the engine of growth to a major source of weakness. And I thought everything was pretty easy to predict here.

And I'm scratching my head how the specialists, how all the China scholars really missed it. Now, so the boom years, central control allows US style free enterprise, and what that did is they had this expansive labor supply. They introduced and applied innovation, foreign technology, enormous foreign direct investment, that ramps up productivity.

So, the labor supply migrates from the western provinces to the Guangdong province, and they start producing. And the focus is really export related manufacturing, and they use the benefits of that to grow a modern society. So, it becomes this absolute powerhouse in global manufacturing. Over the 14 years, 2000 to 2014, it constituted 30% of global growth and trade share rose from 4 to 14%, we've never seen anything like this.

And of course, it was a major developer, high tech, and so 2012, President Xi comes in and starts emphasizing central control and allocating resources and starting gradually to clamp down on free enterprise and innovators. And this really accelerated 2018 and more recently, and so, once again, potential growth gradually slowed and naturally slowed as labor and capital rose toward capacity, productivity slowed.

And you could look at, if you believe the data, unit labor costs in China relative to other countries, they started to lose some of their competitive advantage. So, the central planners, and this was in each of their five-year plans, but the central planners continued to target real GDP.

So, they came up with these annual targets of real GDP, despite the natural slowdown in the growth of private consumption, private business investment and exports. And they achieved these lofty GDP targets through more and more aggressive government investment in infrastructure and real estate. And so, the way it would work was Beijing leaders would set the targets, 6.5% GDP down through seven, but six and a half, and they would collect tax.

Beijing would collect the taxes and allocate them to the local governments, the local communist party bosses with their targets. And the distribution of tax receipts was insufficient to achieve the output goals. So, you had this construction and real estate boom, but the local governments relied heavily on land sales to developers, and bond issuance to finance the booming real estate.

So, once again, they needed the more and more government investment to achieve those targets as the rest of the economy naturally slowed and potential growth slowed down.

>> John: This is really natural, a well-run economy should come up to the US level, there's no reason they should stop at 20 grand a year.

It's slowing up to the level that other supply side inefficiencies stop them.

>> Mickey D Levy: John, yes, but one thing we wanna think about is Japan post-World War II had two generations of booming growth that raised it. And by the time it got, like 1985, got up to that level, it's GDP per capita was maybe 75% of the USs, whereas China has hit the wall with GDP per capita a third, yes.

 

>> John: Yeah, just that wall could be higher, you're just saying it's natural, but that wall could be-

>> Mickey D Levy: Well, it's natural, what's interesting is we can go back to 2015 when China's GDP, year after year, was 7%. And there were some academic economists who said China's economic model is the model of the future.

 

>> John: We understand levels, and a lot of people think growth, don't understand levels versus growth rates.

>> Speaker 3: Including me okay.

>> Mickey D Levy: But another way to say it is some of the mechanisms that China had relied on were petering out. And so, the transition from the rural to the urban sector, which helped power the expansion of the manufacturing sector, that couldn't go on forever, no matter what kinds of crazy policies they had in place to determine the level.

So, in that sense, there was a natural slowdown conditional on the other bad policies they had in place. Now, China was also seemingly good at allocating resources post well, maybe it looks good when your way, way, way below your production possibility-

>> Steve: Started out with a terrible allocation of resources in many respects, including preventing people from moving from the countryside to the urban areas, which they gradually relaxed, right?

 

>> Speaker 3: The kept parts in place, all along.

>> Mickey D Levy: What's that?

>> Speaker 3: They kept parts of it in place.

>> Mickey D Levy: Yes, and they're still second-class citizens, but it's much more relaxed than it was pre-1973. But at the same time, post financial crisis, their stimulus was largely in the form of building infrastructure, high speed rail lines to the ports, and that actually increased productivity.

But at the same time, the migration of labor supply to the east wages, as they move toward their potential, wages rose, and their unit labor costs started to subside. So, this chart on the right and the Chinese National Bureau of Statistics, when you look at their GDP accounts, they have consumption and then they have gross capital formation.

They do not break out government capital formation, that is investment from business. It just combines it, and you look at that any way you can't break it out, and it persisted well above 40% of GDP as consumption growth slowed, disposable income continued to grow, but at a slower pace, export growth slowed.

And so, this just illustrates how, and there have been various studies that estimate that residential investment was roughly 25% of GDP, which is way more than double what a mature economy should be.

>> John: These numbers have always boggled my mind, do you trust them? So, 40% of GDP for 25 years adds up to, do the math for me, they ought to be just swimming in capital stock at this point.

 

>> Mickey D Levy: But wait, wait, John, that they're swimming in capital stock, but a large portion of it was government investment and financing of real estate and that's where the excesses are now. So, it wasn't just building roads and bridges, it was direct investment in residential investment.

>> John: Ten years of GDP of capital stock in order to be sitting around, a lot of empty apartments in China, but not ten years of GDP worth.

 

>> Mickey D Levy: Okay, so I'm gonna fast forward.

>> John: Why don't you go ahead?

>> Mickey D Levy: No, I'm gonna fast forward, yours is a good point, and I actually have a slide on this and it's observations about China's official data. So, the data are unreliable and distorted and incomplete. And the Bureau of National Statistics blends data that makes them very difficult to analyze.

The gross capital formation is the best example. And then like when youth unemployment goes above 20%, they stop publishing the data. And consumer confidence has fallen so much, they stop publishing the data. And so, forecasters put together their official GDP numbers. And I say, this is a ridiculous exercise.

So, when people ask me, what's your GDP number? I said, it's my guess at what the Bureau of Statistics is gonna print rather than a reflection of economic statistics. It's very difficult, in most advanced economies, particularly the US and Canada, there are very good data that are reliable, not so in China at all.

 

>> Speaker 3: What do you think their purpose is for hiding the data?

>> Mickey D Levy: Well, combining gross capital formation as government investment plus private investment. Keep in mind that includes all the SOEs, the state owned enterprises. It's a socialist system, so it's all one. And in fact, Hoover's, what's it called?

The China Sharp Institute has done some very good research on corporations and how the Beijing leaders think of private corporations as their role is to facilitate the objectives of the political leaders rather than to maximize profits. So, a ton of that is real estate, now okay, so let's just put it this way.

I've tried to dig into China's excesses and debt, so let's go back a second. So, they achieved their real GDP targets through more and more government investment and they've targeted GDP way too high, particularly sine say, 2015. And the local party bosses have the political incentive to hit those targets, and they get permission from Beijing on how many bonds they can issue.

Okay, so there's this gross overinvestment in real estate, so how was it financed? Tremendous amount of land sales, so the local government officials get partial financing from Beijing. And this is a whole different fiscal model than in the United States or other Western countries. So, they get tax receipts from Beijing, and then they have to augment those with land sales and bond issuance.

And I must say, I've tried to do a little sleuthing and track the financial flows, and it just gets murkier and murkier. But basically, now fast forward to today, almost all of China's debt is held by domestic creditors, and part of that is because they've abrogated on debt service to foreign creditors, like for the bankruptcy of Evergrande and the like.

But so, basically the local governments are saddled with a lot of debt now because over the years they've had to augment their revenues by issuing bonds. So, the question is, who bought those bonds? Well, Beijing created this artificial government construct called local government financing vehicles, and there are 2700 of them.

And the local, the LGFVs bought the bonds issued by the local governments. And all this worked out very, very well as long as home price expectations continue to rise, sounds familiar, okay? The citizens who bought apartments, and they saw and heard about tens of millions of empty apartment buildings, just tremendous excesses.

Expectations fell, and this dried up the demand for real estate, such that the land developers stopped buying land to develop, which drained critical revenues from the local governments. And so, what you have is, so as expectations fell, then things started coming apart. It seems it just reveals how fragile the state of debt and debt service is.

Now you can ask the question, okay, so these LGFVs that bought all the bonds, well, how were they financed, and where did they get their capital from? Some of the capital came from Beijing, the base capital, okay? But their leverage came from shadow banks and wealth managers. So, back in the old days, the big SOE banks controlled the vast majority of assets.

And even when nominal GDP was 14% year over year, they were offering 1% yield on deposits, basically stealing money from people who saved. And then to try to stem capital outflows and the like, they started to allow shadow banks and private wealth managers to manage a portion of the wealth of people who had saved.

And keep in mind, as China grew very rapidly, China's a complex society, but their rates of personal saving were very high. Okay, so the shadow banks and wealth managers would say, okay, I can get you 5% yield rather than one by investing in these LGFVs and the like.

But the bottom line is very interesting here, because what it implies is we've seen data, Ken Rogoff and a colleague wrote a paper saying that up to 75% of household net worth in China is in real estate. What digging through the data suggests is a lot of households have more, they have exposure to real estate that they didn't know they had.

No, I don't think that's true. I think because the rates offered on any deposits in the banking system were so low, the only way to accumulate wealth as perceived by most households was to buy an apartment or to acquire one as quickly as you possibly could. In fact, part of the reason for the real estate collapse is that she became very concerned about excessive debt.

And so he mandated that you couldn't have more than one apartment, that there was to be no apartments bought for speculative purposes as he kept saying, housing is for living in. They've lifted that now because it's quite clear that without the speculative demand for housing, the market's begun to collapse and it's collapsed for some of the reasons you say Covid created so much uncertainty.

People decided they'd rather have the money in the bank than punt on real estate. That didn't look to be the good investment that it had been before.

>> John: But didn't okay, so, but didn't the government go back and forth on allowing people to own a second apartment? And then they'd go back and forth, they just started to realize there were excesses.

 

>> Mickey D Levy: Well, I mean, it's recently that they've tried to encourage them back to speculate if you want them to acquire more apartments. Because they'd rather see the wealth propping up Evergrande and country gardens and trying to keep them out of trouble. It's not as if they haven't dealt with all this debt before, I mean, if you go back to when they introduced the asset management corporations took all the bad debt off the banks in two waves in the late 90s and early 2000.

And because there was rapid growth, they managed to hold those bad loans in abeyance until they became a very small part of the overall financial system. And that allowed them to grow their way out of the trouble, as you suggest, now that they're stuck with all these debts at the local government level.

I think you actually give too much credit to the central government, I think a lot of this was a response of the local. Targets haven't really been in force for ten years, they're indicative. They're not absolute, but you still get promoted based on the old four classics, jobs, growth, exports, profits, and you return money to the center.

I remember 96, when I was the country director for China at the bank, and the head of the Bureau of Statistics congratulated all the provinces on having grown faster than the country.

>> Mickey D Levy: Every single one. And the reason for it, of course, is that you got promoted based on your growth performance.

Now, I think the central statistical office is a pretty good office. If you look at some of the work of Carson Holtz, for example, at Hong Kong University of Science and Technology, he's looked for bias and patterns and he's concluded pretty much that it's a fairly honest statistical base.

I wouldn't bet a penny on the absolutes, I think the trends are more or less reliable, that the growth that you're observing over time is probably not too far away from what it's actually been. But the surveys, they didn't have enough money in the 90s and 2000s to do enough surveys countrywide to actually get a decent basis to say, here are the actual figures that we can reliably report as the overall situation.

Anyway, I'll shut up, I'm sorry I hopped in, but I mean, it's something I've spent the last 40 years on. So, every now and again I feel I should.

>> John: No, I sincerely appreciate your comments, but things started to look, the one way I mildly disagree with you is they did set targets every year.

And I know if you look at the international community that focuses on China, and the commentators, they would always focus on, will they hit their six percent target, will they hit their five and a half percent target? And as I mentioned earlier, I think there's, the local party bosses had a great incentive to achieve the targets they were given by Beijing.

 

>> Mickey D Levy: Do better than that.

>> John: Yeah, do better than that.

>> Mickey D Levy: I'm one of these international competitors that look at the growth rate. The one I remember was when Lo Ji Wei was still the finance minister, and she had said that we had an 8% growth rate approximately this year.

And Lowe was asked at some open session with the media and said, what will the growth rate be? And he said, probably around seven, seven and a half. Anyway, shortly thereafter, President Xi said we'll grow at 8% this year. And actually, you could absolutely say for certain that the statistical department will demonstrate at the end that there's been 8% growth.

There's certain things that, yeah, Xi's word is law.

>> John: But isn't that inconsistent with what you just said that the Bureau of Statistics was so reliable, it was reliable to the party bosses.

>> Speaker 3: So, why don't you continue?

>> John: So, when real estate started falling as expectations shifted and land sales started to subside, which was a drain on important revenues to the local governments.

Beijing would actually tell these LGFVs, buy land to make things look good okay? And they did but there wasn't further development. And so, development was what generated a lot of jobs and economic activity. So, now you have this fragile state of debt service, and I mean, I guess you could say unanticipated credit risks and, the bankruptcies of Evergrande and others are just the tip of the iceberg because once again it brings, the reliance on land sales has just revealed that the whole fiscal policy structure is missing a big element now.

And this is really having a big impact, or constraint on how much they can stimulate. And of course, stimulus, unlike talk about in the US, it is a critical part of achieving their GDP. If you were to take out government investment now, GDP growth would be much, much lower.

 

>> Mickey D Levy: So, I have to object to that, I mean, thinking about China in terms of Keynesian stimulus seems to miss the entire point. I mean, Mao didn't sit around in 1973 with 200 bucks per capita income and say, I know how to make this rich, we'll borrow a lot of money and throw it out windows.

It's a 100% supply setting, yes, the government is now spending a lot of money on investment, but if it didn't, that money would belong to somebody else and it spend it on something, be it investment or consumption. When you're talking about growth over long periods of time from, by factors of ten or, are you 20% of the us level or 80% of the us level, that's 100% productivity, that's not fiscal stimulus.

 

>> John: So, I think you articulated kind of what I was trying to say, that when we think of fiscal stimulus in the US, we think in terms. Well, Keynesian would think in terms of increased deficit spending. That's not how it works, there is the whole structure, in order to maintain the level of GDP growth they want, it has involved a tremendous amount of government investment.

 

>> Mickey D Levy: Let's just take that, so if suppose the government had not made that investment, then that money belongs to someone else, and they would have done something with it. So, the idea, yes, the government took a lot of money and built a lot of stuff that counts as GDP.

But in the absence of the government doing that, that money would have gone to somebody else who would have either built or consumed something else.

>> John: Okay, so I agree with you, and let's do some revisionist history, let's say China had not targeted its GDP so high. Let's say it had a reliable estimate on the gradual deceleration of potential growth, then it would not have invested as much.

There would have been more resources for the people, you would not have the excesses, the excesses they have now that stemmed from their central planning.

>> Mickey D Levy: You're telling a story of misallocation.

>> John: That's what it is.

>> Mickey D Levy: But not a story of the level of GDP.

>> John: That's correct.

 

>> Mickey D Levy: John, you have a really simple theory that the fiscal multiplier is always zero. When we're talking about going from 200 bucks per capita to 20,000 bucks per capita. Yeah, the fiscal pump multiplier is not the issue there, productivity is the issue. Yeah, so long run growth, zero.

For issues of long run growth, zero. Well, a lot of this stuff did help productivity. So, building roads and railroads, if they're in the right place, connecting places where people will go, public capital is part of productivity, but that's not stimulating.

>> John: I'd say, I agree with you, and that's why I said they were seemingly good at allocating resources when they were far shy of their potential.

And then they made this classical central planning error. But having said that, China deserves, up until recently, credit for just being an economic juggernaut is amazing.

>> Mickey D Levy: Credit, a lot of it here I'm channeling Frank Dakota's books, a lot of which is getting out of the way. They did not wake up one morning and say that capitalism is the right road, right?

They woke up one morning and said, we can't stop the farmers from trying to sell their stuff anymore. There's gonna be a revolution, and they got out of the way, am I right? Not quite like that, I give Deng Xiaoping a lot more credit than that. He said, all right, they're trying this experiment in some parts of the country, it's illegal, but turn a blind eye to it seems to be working.

After a while, they generated enough surplus by allowing them to sell some of their agricultural product. If you've got these little, tiny firms in the rural areas, town and village enterprises emerging to produce wage growth. And a lot of the private activity started from that. I think, Mickey, that one of the issues now is that he squelched the private sector, which is responsible for 70% or so of the Chinese economy.

These massively inefficient state enterprises that I thought he was gonna reform back in 2013, and suddenly he decided, no, he wouldn't let go of those. Because that's how you control the economy, where the money comes to invest in all these areas that he wants to get to the frontier of, the innovation and financial.

 

>> John: So, you've captured my last two, no, I'm just gonna say you've captured my last two slides.

>> John: Sorry, one more comment, then we continue.

>> Valerie: Picking up on John's point, I mean, perhaps the counterfactual is Taiwan, so we know what their growth was and what was their government spending, right?

I mean, I think that's-

>> John: Singapore.

>> Valerie: But just to keep it completely Chinese, Taiwan grew, well.

>> John: There's a lot of Malays and Indians who take offense to that yeah.

>> Valerie: Yeah, right, so how much government spending was there during the takeoff of Taiwan? Probably a lot less than.

 

>> Mickey D Levy: So, the myth-

>> John: Really a linguistic complaint, your whole analysis is fine, you say stimulus and I get.

>> Mickey D Levy: And by the way, one of the oddities now is President Xi does not belong, he does not believe in income support and welfare payments. Xi says it makes people weak, morally weak.

So, it's really odd that he almost sounds like, it's all old-fashioned stimulus, but it's clearly in real estate. Now, just this chart, the blue line, which is up to about 22% of GDP, that's what they call government debt. Then you have the local government debt, and then that big yellow area is these LGFVs that in official Chinese government data, it is calculated as corporate debt.

They calculate because they're financing vehicles and they're not part of the government. And so, the excesses are not just in real estate, they're in debt.

>> John: You're being very anti Keynesian, Keynes said the secret to success is to dig ditches and fill them up again. China builds apartment blocks and tears them down again, but Keynes ought to be perfectly happy.

And Keynes said, don't worry about the deficits that come from From this, that's just helpful. And you're saying that was a terrible idea, and look at all the debt these deficits cause, I'm just cheering.

>> Mickey D Levy: Are you gonna do the negative? Are you gonna do this?

>> John: Yes, okay, so where are we now?

Residential real estate activity is falling, and home prices are falling. And the only official government survey of 69 municipalities is almost all of them have falling home prices. But if you were to try to get a measure of the magnitude of the home price decline, it's not available.

But they do say most of the declines are in lower tier cities, just excess supply, which is creating very cautious demand. Think about if you had household net worth, such a large portion of it was in real estate. No surprise that the wealth effect is having a big impact on consumer spending and confidence.

And of course, they no longer published the confidence surveys. Gross capital formation, you would think the outlook is limited in two ways. One is the government's financial squeeze that limits the flexibility to investment and spend, call it stimulus if you want. But also, the private sector is getting clamped down on.

So, if you think about what President Xi has done particularly in the last three years in clamping down on the big cap, social media firms, those are kind of antithetical to the socialist ideal because they create platforms for people to communicate, among other things. You would think that growth capital formation is weak, so that's the domestic economy.

And now exports are declining, and the exports are declining around the world, not just because of Europe's and recessionary type conditions. US goods consumption is a little weaker and emerging economies are really getting hit, so their demand for goods from China is weak. But also the western economies and Japan, they're moving much more quickly than I had earlier anticipated in reducing their exposures to China.

And so, then their imports, China's imports are also declining, reflecting a combination of weak domestic demand and production. So, I speak fairly frequently to BOJ executives, and they say Japan's exports to China, it's a combination of consumer goods and durable goods used in production. And then I would also note, and there's no data on this at all, but in China, jobs in the export related manufacturing sector, the high paying jobs, and they're really getting hit now.

And we don't have any data on that, but I've heard that wage and salaries are falling. Okay, we've gone over that, sure.

>> Mickey D Levy: So, I wanna add a couple of things to the discussion here and then offer just maybe a conjecture for the group as a whole. If you go back to the first half of 2020, there was a sense of euphoria in China about its economic performance relative to the rest of the world, and that was shared by many external observers.

And so, just one marker of this is what happened to the stock market in China, the domestic stock market? So, stock markets crashed around the world in the first half of 2020, in China, they rose sharply. And so, if I remember right, the domestic securities in China, equity securities rose by about 75%, relative to the S&P 500 over the first half of 2020.

And the exchange rate didn't change much during that period. So, that's true both on an exchange rate adjusted basis or not. And if you put yourself back in that period, there were people inside China that were touting the China model, the virtues of central planning. That was a widely shared view, maybe that's why we took up some of their same COVID control policies, I don't know, that was the situation just three years ago.

Here's the conjecture that in centrally planned economies with tight control, with aggressive propaganda, and tight control of information flows, which is my characterization of China, you can have massive swings in expectations about economic outlooks once things kind of change. So, you go back to the first half of 2020, it was massively positive sentiment in China.

It's now massively negative, that's, I think inside China and outside China. It'd be nice to try to document that in various ways. Cuz I think the real estate phenomenon that you've emphasized rightly was just one manifestation of that, maybe the most important one. But I don't think it's just limited to real estate, it's people's investments in their own human capital.

I'd like to see what happened in the stock market since then, I don't really know.

>> John: Okay, so I'm completely in agreement with you. But would add that I think the Chinese stock market is rigged to the extent that the government will come in and prop it up when it falls.

 

>> Mickey D Levy: They did very little of that in the first half of 2020, I've looked at that. These numbers I gave you come from a paper that I'm in the process of writing. And it's not in circulation yet, because I have no explanation for why the market appreciated that much.

You can get some rough numbers on the interventions in the first half of 2020. They were very modest compared to what they'd done in previous episodes, and those interventions are by the PBOC.

>> John: Direct interventions by the PBOC and other central bank and regulatory institutions in China, as opposed to just general public fiscal stimulus, which they did do a lot of.

And this is another reason why this is relevant to this discussion is there's a lot of retail ownership of the Chinese stock market by individual investors. So, it is to some extent a barometer of what average investors are thinking. So, I just throw this, behind all of what we're showing us are these massive swings and expectations about the economic outlook for China.

 

>> Mickey D Levy: Agree, but wouldn't it take a clearing out of the excesses in real estate to stabilize.

>> John: Several things happened, you stressed the recognition of the excess, the overbuilding in the real estate sector. But there was also eventually a recognition that the COVID policy itself adopted by China had been deeply harmful to the economy, rather than save them from some kind of catastrophe, which I think was the early interpretation.

So, there were other things that were coming together at the same time. Much of the rest of the world has pulled back from China, as you've emphasized. So, several things came together and contributed to and were amplified by this massive shift in sentiment.

>> Mickey D Levy: So, let me add something that, and even before the pandemic, it's interesting that auto sales in China peaked around late 2017, even though people were becoming wealthier and wealthier and they had income.

And that peak occurred prior to Trump's trade wars and the like. So, it looked like the consumption started to slow down and people maybe started to express some uneasiness before the pandemic.

>> John: It would be nice to quantify these in various ways, if you can, including analyst reports from outside China who are making their assessments of the growth outlook in China.

 

>> Mickey D Levy: Eve is Mister volatility, so I think you're right in this case, and many of us. Is it fair to call China a centrally planned economy? It does not look to me like the soviet one, if you're running state factory number two, you are not told, produce 10,000 nuts and bolts and send these to Bob and those to Valerie.

You pay wages to your labor, you buy your inputs, you sell your outputs. Yeah, it's state controlled, there's a lot of interference. Isn't it more crony capitalist or fascist economy?

>> John: It's not like the Soviet economy, and it still has some. If you go underneath the radar screen below those big social media firms that are getting clamped down on, there's a whole section of small and middle market firms that are basically allowed to still be entrepreneurial.

 

>> Mickey D Levy: They pay wages, they've even state-owned companies, right? They're not fulfilling the plan, they are trying to make money, granted, at distorted prices, and distorted orders and so forth.

>> John: They're allowed to make money although part of the China's socialist ideal is becoming wealthy is considered a no, no.

And so, you have to do things under seen.

>> Mickey D Levy: It's not a planned economy in the sense that we thought of, we need another word.

>> John: Okay, so maybe the best way I could summarize is I remember, and I don't know when it was like 2007, I was in China, and somebody set up a dinner for me with the person who was second in charge of SAFE.

That's the State Administration for Foreign Exchange, back then managed $3.5 trillion. And he had spent a few years at the IMF and was a smart guy, and we had this private dinner, and he insisted on drinking a lot. So, we drank a lot, and we are nearly done with our second bottle of wine, and we were friendly, and I said, I have a question for you.

And I knew it was a rude question, I said, how do your leaders define communism? And he raised his glass and he said, any way they want.

>> Mickey D Levy: You listening?

>> John: So yeah, it's not a Soviet planned economy, it is not.

>> Mickey D Levy: Okay, so they call themselves a planned economy, that helps.

 

>> John: No, but they're central planners, and now what they've done is they have backed away from an annual GDP target. They've backed away from that. Steve, am I right on that, I think they've backed away from it.

>> Mickey D Levy: Global implications.

>> John: Global implications, okay, so China had been the driver of global growth.

Now, it's hitting global growth, every big Asian nation has declining exports now and that's the biggest trading block in the world. Japan, South Korea, Taiwan, Hong Kong, Singapore, Australia, India, declining exports. Many emerging economies that rely heavily on exports to China are being harmed, particularly those that export a lot of industrial commodities and materials.

So, partly if you look at MSCI index of global industrial commodities which includes copper, nickel, iron ore, zinc, nickel, they're all low now and drifting down. And these hits select emerging economies and so they're getting hit pretty hard. And then among advanced economies, Australia is getting hit, and then Germany stands out like a sore thumb.

Okay, so Germany, before the pandemic, it had more exports to China than it did the UK. So, Germany had assumed kind of this economic model where it relied on energy from Russia and exports to China. And by the way, Germany's industrial production peaked with the peak in China's auto sales in 2017, 18.

And so, one of the implications here is Germany had been the engine of growth for the EU and now it no longer is. And Germany doesn't have an economic, the leaders there understand their dilemma, but they really don't have any strategy, okay, and so it's really affecting the world.

So, you would think the renminbi would be getting clobbered. It has fallen pretty decidedly, but it's managed pretty closely by the PBoC. And then there's this issue, China is not only the largest creditor to With about a 31% global share, but it's Belt and Road Initiative. You have a lot of partners that are really reeling now, the IMF is urging China to forgive some of the debt, China doesn't really like that idea.

And so, everything adds to the current situation negatively for China.

>> Steve: We might note that last week was the 10th anniversary of the BRI, Belt and Road Initiative, and it was the third forum, was held in Beijing, and it was a proclamation of triumph all around. And for China, it's been a political triumph, economically, it's a bit harder to assess, but there's an awful lot of failures along with one or two victories.

 

>> John: Nikki, do you have any idea how much the PBOC is intervening to prop up the renminbi? And if so, how are they selling treasury bonds to do this and how much is that affecting treasury rates here?

>> Nick: Okay, so that's a tricky one, the tick data suggests that China's holdings of US treasuries are coming down a bit.

So, it looks like they're not reinvesting maturing treasuries. Don't know the answer to your question about the PBoC's direct involvement.

>> Valerie: Is that one of the reasons that the ten-year treasury rate is going up?

>> Nick: I think it's a partial, but kind of a small reason. So, my thought is, yeah, the ten-year treasuries were normalizing and the new normal is kinda like the pre-financial crisis normal, and in between was abnormal.

And while there is growing concern about deficits, and one of the points I would emphasize here, which is another economic issue is this is the first economic expansion the US has had where tax receipts are falling because of all of the government's credits for this and that, and this and that.

 

>> John: Randy has a question of external, Randy, go ahead.

>> Randy: Yes, thank you, it's really an observation just about the foreign exchange. As you know, I work in the foreign exchange market, and we're convinced that they are intervening through the state banks as well, and that they are also intervening in a way where they can disguise it in their forward book so that it doesn't show up in their reserves.

And they're really doing a lot of things, manipulating the fixing and this so-called countercyclical factor. But the point is, it is as Nikki was saying, it's much trickier to determine what they're doing, but they really are intervening through other counterparties.

>> Nick: Randy, thank you, my assessment with how the sentiment about China has just fallen apart, they would be better off with a much weaker currency, and you would think the Chinese leaders would use the currency as a policy tool, but they haven't.

So, I've talked about the losers, but let's talk about the potential winners around the world from this, because I think the realization is China's not going to return to its previous strong growth, whatever the GDP numbers printed. And so, there are some interesting observations. But first, this shows on the right-hand side, the finance ministry in the Netherlands puts out an aggregate on global trade volumes.

And you can see it plummeted during the pandemic, went up to new highs, and now it's decidedly receding. And what I try to do when new data come out, for example, on China's imports and export, they try to reconcile them with the trade data from their big trading partners.

And so, it looks like trade volumes are falling, and they will continue to fall for a bit. The right-hand side, this just shows goods exports, not goods and services. The US is the biggest exporter of services in the world, so goods exports. And then this is euro area, goods exports outside of the euro area.

And so, you see the US is relatively well situated or positioned for China remaining soft. Now, messy slide on the right, because it's World Bank data, it's not seasonally adjusted and it's monthly, so I apologize. Okay, but looking at the left-hand side, Mexico has become the US's largest trading partner beginning in 2023.

Right behind that is Canada, and China's playing a lesser role as a total trade partner. And then the right-hand side, once again, I apologize for the choppiness, but you see, US imports from China have soared. Now these are monthly, not seasonal adjusted, not annualized. So, it's $55 billion, and so, US now imports more from Mexico than any other country.

Canada's next, and you see the green line and it's very choppy, but it looks like the run rate for imports from China has subsided quite a bit, I mean, quite a bit. And once again, we do not have good data on how the reducing supply chains is affecting things, but I'm sensing more and more anecdotal evidence.

But let me toss out a caveat to this right-hand chart and that is some of the surge in US imports from Mexico have Chinese content in them. And there have been a few Chinese firms that have moved their operations to Mexico. Now, if you think about that, that generates more jobs and disposable income in Mexico.

The profits from that activity are repatriated to China, but China loses out on employment and disposable income.

>> John: Now, so let's ask two questions now, first is, okay, so how long is it gonna take for China, these excesses, to unwind? And then the next question is gonna be about potential growth in China.

So, on the unwind, the two benchmarks we could think about, maybe you could add, you could help me out on this. Japan in the 1990s, and the US following the early 2000s suggests a very long adjustment period. So, if you remember, the US had this debt financed housing bubble in the early 2000s, where John emphasized kinda too long interest rates facilitated the mounting complex derivatives.

So, when we think about that, and housing in the US peaked and expectations shifted in spring of 2006. It took a financial crisis and then a very, very slow recovery after that because household balance sheets and the banking system got clobbered. So, it really was a long adjustment process.

Okay, Japan's asset price bubble of the late 80s, also fueled by low interest rates when Japan refused to acknowledge that its potential growth had slowed, that led to a 70% collapse in both the Nikkei and real estate values. They had what they would now call a lost decade of on and off deflation and recession, mild deflation.

But it took a long, long time and the Nikkei is still well below its 1989 peak. Okay, both of us, we blew up key parts of the financial system in both of those cases, Japanese banks, the US financial system. If China does this without, I don't really understand what financial structure is, but if the financial institutions are the same, and it just winds up on the government budget somehow, you don't necessarily have the same wrong unwind.

Why in Japan was zombie loans not so much as thought the government, that seems different somehow than all in banks that can't make loans anymore.

>> Nick: I completely agree with you. So, we don't know what China's gonna do, but here's what, you're exactly right. The US, when things were coming apart at the seams, forced Sifi banks to take capital through the TARP program.

And then after that, as the economy began to recover slowly, the fed dictated the dividends they could pay, and so banks were forced to raise further capital as the economy improved. Japan refused to acknowledge that it had a problem until 1997. They had all these zombie banks that were making bad loans.

We actually have data on bank lending during that period and it was just falling. And then in 1997, the Japanese government recapitalized the bank and insurance companies and only then did things start to improve until they lay it on their next VAT tax.

>> John: And it could be worse because if their method of investment is it goes through governments rather than through financial systems, redirecting investment to profitable private things away from building a private sector.

 

>> Nick: Okay, but China could be much better off because give them credit for acknowledging that they really have a problem. Now, China going right at this stage right now, has much higher debt than Japan did in 1990. And the Japanese debt to GDP didn't jump until they recapitalized.

So, let's think about China's unwind strategy. You would think they're gonna address their weaknesses and try to unwind the excesses. And they could do so in various ways, they could do selective bailouts and forgiveness. They're acknowledging the problem and they could absorb the higher deficits. They could be forced to raise taxes, which clobbers disposable income.

And the other thing they're doing now is they're subsidizing winners, and the best example of that is EV's. They've become the biggest producer and exporter of EV's in the world. So, they're still-

>> Mickey D Levy: We don't know yet that's the winner.

>> Nick: We don't-

>> Nick: That was gonna be one of my remarks.

 

>> John: Because when you central plan, you don't know-

>> Mickey D Levy: There's a great, I forget, Valerie will remember the great study recently came out of China's subsidies of things turning out that they're subsidizing the low productivity industry.

>> Valerie: I don't recall.

>> Mickey D Levy: I thought you might have written the paper or Steve wrote the paper.

So, we have to presume-

>> Steve: But they do have a history of decapitating some of the more successful firms, so that's not exactly subsidizing for winners.

>> Nick: And we have to presume that Chinese government bureaucrats are no different than US government bureaucrats. They can't pick winners and losers, what?

 

>> Mickey D Levy: It couldn't be that bad.

>> Nick: What do you think would be the result of the kind of intersection between the changing demographics, and the workforce getting older, and their reliance on real estate as an investment vehicle. So, as they get older and they try to retire or know they have medical issues, what's gonna happen?

Is that gonna extend this recovery period, or is there gonna be a precipitous collapse at some point when we have too many people trying to retire to sell houses that no one's buying?

>> John: At minimum, it extends the excesses in real estate, at minimum. So, we hear anecdotal evidence of certain local governments saying, yes, we'll give you a job if you buy a house.

 

>> Mickey D Levy: This is issue, you have an aging, declining population, and you're counting on house prices to subsidize your retirement, you're in trouble. But they still have a lot of people who can move from country to city, right?

>> John: Yeah.

>> Mickey D Levy: So, there is still a reason for demand for housing in cities, even though the numbers-

>> Speaker 3: Women retire at 50 and men retire at 60, and life expectancy for women in the 80s and that's high 70s for men.

They should let them work a bit longer, but they all want to retire when they hit the retirement age. But that's just as the US Social Security system required people to work past 65, they're gonna have to start working past 60.

>> Nick: But do they have much of a pension?

 

>> Speaker 3: They don't have a pension system.

>> Randy: No pension at all, what's the trouble?

>> Mickey D Levy: I mean, if they've got any wealth, they've got no kids anymore either, they only have one and the kids are not there to take care of them. I mean, this is part of the, Mickey said this earlier, but consumption's not gonna bail them out, which is what we've been talking about for more than a decade, rebalance, rebalance.

Got to be more consumption expenditure, but you don't consume if you see, a, we can't pay if we get sick and b, we've got no money to take care of us when we retire, and our kids won't.

>> Nick: Well, in fact, their government pension is still fairly modest and that's why the rate of personal saving is pretty high.

 

>> John: Okay, now, so I think the excesses, we just really don't know, but my hunch is it's gonna take a while, years rather than months. Okay, so now there's this issue to conclude, what is China's long run growth outlook? And just taking a simple neoclassical growth model, the fundamental factors, labor, capital and total factor productivity.

So, the labor force and population are declining, and we're at the peak, it's already declining. Here are some anomalies right now, you have youth unemployment is over 20% and it's odd, but-

>> Mickey D Levy: It's also labor force quality, I'm gonna channel Rick Hanushek here, I gather Chinese schools are actually terrible and so people-

 

>> Speaker 3: Not on the East Coast, the Western.

>> Mickey D Levy: Yeah.

>> Speaker 3: Yeah, but all the East Coast are the top of the world.

>> Valerie: And they've really done a lot to improve their universities and expand them, I know from the grad student dissertations at UCSD.

>> Speaker 3: But they have a huge expansion of universities in the early 2000s, that was quite dramatic, so they're sort of replacing fewer people with higher quality.

 

>> Valerie: Exactly.

>> Mickey D Levy: Well, what gonna matter in the next 20 years is the quality of the workforce, not just people to run the steel mill number 32. So, labor force and population are declining, and then if you take capital, well, capital includes private investment and government investment. And I anticipate a slow growth trajectory because the government has less financing to continue to invest rapidly.

And meanwhile, the government's clamping down on some of the big companies that their capital spending is very strong, and then it comes to productivity. And so, much of the government investment is in SOEs and clamping down on private innovators. Then also when we talk about productivity, you have to introduce the dramatic declines in foreign direct investments now.

And with those foreign direct investments embodied in them is technological know-how. And so, when President Biden signed that executive order preventing exports and direct investment of certain semiconductor chips, that really hit China. That will hit China very hard because that's their flow of technological know how. So, you could add all this up and say China's potential growth is very weak, very, very weak.

The level of activity is very high, but potential growth could eventually be negative.

>> Speaker 3: But if you come back, it still comes back to whether they're gonna maintain the current misallocation of labor. I mean, they have 65% of the population still rural, and there's a lot of potential there unless they want to keep them in the western provinces.

 

>> Mickey D Levy: And I agree, so the positive on China not only being the second biggest economy is it's still capable, I don't know if that's the right word, capable of sustained high potential growth if it addresses its weaknesses and its current weaknesses, central control and misallocation of resources.

>> John: Let me ask this question in a different way, sometimes if everybody's making $20,000 a year, then we have to find a way of doing something new as a country, finding a new business to be in.

But if the situation is, we've got a coastal range that pretty much looks like Europe, maybe, I don't know, I'm gonna make it up 70, 80% of us GDP per capita. Combined with hinterland, then there still is a lot of growth from making the hinterland look a lot more like the coastal cities without having to import any new ideas or do anything different.

 

>> Speaker 3: Yeah, no, that's the point, I mean, it's only if they wanna keep them out in the west and stop migration into Shanghai.

>> John: Or not take whatever the Shanghai model is and put that in the west somehow, so this gets back to your earlier comment.

>> Nick: Squandered a fortune trying to promote these Shanghai type cities out west, they were building roads to nowhere, go back 25 years.

And, I mean, they might eventually have been handy, but they were premature. Decades, of course, was to let the people go to where the jobs are, not to try and take the jobs in the cities the people, seem to me US is doing a bit of this now, isn't it?

Building chip factories in areas where we think we're a bit depressed, and so we need to put good jobs back into the sort of rust belts in the United States. It doesn't strike me as the smartest policy for us any more than it was for China but migration into the cities, that's the thing, Rick's got it right, but you've got to provide cheaper housing.

This is the sort of paradox of too many houses, too many apartment buildings, but kids that get a good job, they can't afford to rent one, it takes their whole salary to try and rent an apartment in Beijing or Shanghai.

>> Speaker 3: At some point, supply and demand have to come in, right, Nick?

 

>> Nick: It's starting to happen, it is starting to happen that housing prices in some of these bigger cities are falling, but not enough so that with starter salaries that these unemployed youths can start a job and then get a house.

>> John: So, that suggests to me the current adjustment, you can measure it in years rather than months.

And meanwhile, China's most recent quarter of GDP was up 4.9%, which doesn't mean anything, to me at least, and the world has to adjust to this.

>> Nick: Isn't your last tick speculative?

>> John: My last point?

>> Mickey D Levy: John, yes, so, China's GDP per capita is still one third of the US, it has the capability of growing rapidly if it chooses to shift back toward a friendlier pro-growth regime.

But we're certainly not seeing that right now.

>> Speaker 3: But maybe Nick knows, but it's still not obvious why they don't want the rural urban migration, I mean, why they keep the system going-

>> Nick: Pretty obvious back in the day, I mean, the tax base was weak then, it's weak now.

They've been trying to get a property tax in place for years and years and they can't do it, there's no real income tax of any use. The value added tax introduced in 94 transformed the whole fiscal situation but put the taxes back in the hands of the central government.

And they've been pretty generous in terms of transfers, but the local government's partly to promote this growth that Mickey's described, they spent money that they didn't have. And of course, they tapped the banks, whether through it was one of these special purpose vehicles that they introduced or not.

But if you were Shanghai or Beijing, the last thing you wanted was a couple of million people flocking in when you were responsible for their schooling, the kids' education, all the health benefits, unemployment benefits. If they couldn't find a job or they got kicked out of their jobs and housing.

I mean, these people were a tremendous drag on the system. So, when the floating population got up to around 10 million or so, they'd come into the cities, and it's still the case in many cities.

>> Steve: They only have a local hukou, so they don't have any benefits.

They can't send their kids to local schools, they've got to find private schools to put them in. And so, it's a maze, the whole Social Security, well, the welfare system is a complete mess.

>> John: Now, also keep in mind now historically and particularly during the pandemic, export related manufacturing was the primary source of growth.

And it was the revenues and jobs and profits from that that fueled the modernization of society. And I don't expect China's exports are all of a sudden gonna turn up because of what's happening globally, my hunch is wages and jobs are falling in export-related manufacturing. And Steve, I would say, consumer sentiment is very negative in those production facilities where they're seeing fewer and fewer export orders.

So, I think a little rough sledding in here, and in the long run, it's up to them.

>> Steve: Sounds like a good way to conclude.

>> John: He had a question, okay, thank you.