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Thursday, August 16, 2012 10:01 AM


Pettis on Debt, Currency Wars, Commodity Prices and Capital Flight; China FDI Contracts 8.7% YoY, 8th Drop in 9 Months


The much-denied hard landing in China is now underway with weakening data everywhere one looks. Today there is More Bad News For China as FDI Falls.

Foreign direct investment in China fell to the lowest level in two years in July, fueling concern that waning confidence in the nation’s growth prospects may restrain any economic rebound.

Investment declined 8.7 percent from a year earlier to $7.58 billion, the eighth drop in nine months and the smallest inflow since July 2010. The Ministry of Commerce released the data at a briefing in Beijing today.

Chinese financial institutions sold a net 3.8 billion yuan ($600 million) of foreign currency last month, indicating capital is flowing out as property curbs and weakness in exports slow growth and the yuan weakens.

China’s slowdown may extend into a seventh quarter after export growth collapsed in July and industrial production and lending missed economists’ forecasts. The nation reported a $71.4 billion capital account deficit in April-through-June, the biggest quarterly shortfall in data going back to 1998.

Caterpillar Inc. (CAT), the world’s largest maker of construction and mining machinery, shut its main excavator factory in China for much of July and had employees on shortened work weeks, Mike DeWalt, director of investor relations at the Peoria, Illinois, company, said in an Aug. 8 conference presentation, according to a transcript.

“The current sales level in China is quite depressed,” DeWalt said. “We’ve cut production there.”
Pettis on Debt, Currency Wars, Commodity Prices and Capital Flight in China

Via email, Michael Pettis at China Financial Markets has a few comments on debt, commodity prices, and capital flight in China.
Any sustained increase in the growth rate of Chinese consumption – if indeed this occurs, which in my opinion is very doubtful – will not only have to compensate for a reduction in the growth rate of Chinese investment, but might also have to compensate for a reduction in China’s current account surplus.  What is more, the crisis in Europe will only make the global trade environment tenser and nastier. 

Notice already what is happening in commodity-exporting countries like Indonesia.  According to an article in Thursday’s Wall Street Journal: Indonesia's Trade Gap Signals Tougher Times

Indonesia’s trade deficit hit an all-time high in June as exports from Southeast Asia’s largest economy fell sharply, a sign that weaker demand from China and the West is affecting some of the few countries still growing at a considerable clip.

A third straight month of trade deficits in one of the world’s biggest commodity producers bodes ill for Indonesia, which had become a darling of foreign investors looking for fresh opportunities, but has struggled to contain the damage from a sharp fall in its currency in recent months that has rattled investors.


Countries whose growth depends either on growth in Chinese investment or growth in European demand are going to see significant deterioration in their trade accounts.  This will almost certainly lead to even more trade intervention, currency wars, and all the other beggar-thy-neighbor polices typical of a global demand contraction. I think we should expect to see a lot more articles like this.

In addition China itself is seeing noticeable capital outflows as business owners and other wealthy people begin disinvesting and withdrawing deposits.  Capital flight from China began surging in early 2010, and it seems to be getting worse, with some monthly withdrawal estimates as high as $40-50 billion, and this can’t help but put increasing pressure on China’s ability to finance the infrastructure, manufacturing and real estate bubbles that have driven the economy. 

Over the long term, and in the name of rebalancing, this is probably a good thing for China.  The sooner liquidity-driven overinvestment stops, the less debt will pile up and the less painful the deleveraging process will be.  But in the short term it will aggravate the slowing down of the economy.

Rebalancing Effect on Commodities

If we assume that China will have no problem sailing through its economic rebalancing, the European crisis, and everything else, then clearly we don’t need to worry about anything.  But if China’s rebalancing is accompanied by a sharp slowdown in economic growth, or if it occurs during a worsening of the European crisis – both very likely scenarios – then we need to think about what the debt burden will be under those conditions.

So, for example, will commodity prices drop?  I think they will, perhaps by as much as 50% over the next three years, and to the extent that there is still a lot of outstanding debt in China collateralized by copper and other metals (and there is), our debt count should include estimates for uncollateralized debt in the event of a sharp fall in metal prices .  Will slower growth increase bankruptcies, or put further pressure on the loan guarantee companies?  They almost certainly will, so we will need again to increase our estimates for non-performing loans. 

Liquidity Pressures

Will capital outflows increase if growth slows sharply?  Probably, and of course this puts additional pressure on liquidity and the banking system, and with refinancing becoming harder, otherwise-solvent borrowers will become insolvent.  Will rebalancing require higher real interest rates, a currency revaluation, or higher wages?  Since rebalancing cannot occur without an increase in the household income share of GDP, and since these are the biggest implicit “taxes” on household income, there must be a net increase in the combination of these three variables, in which case the impact on net indebtedness can be quite significant depending on which of these variables move most.  Since I think rising real interest rates are a key component of rebalancing, clearly I would want to estimate the debt impact of a rise in real rates.

Just remember the finger wagging and the self-satisfied lectures on banking and debt given by senior Spanish government officials and bankers to US and European bankers as late as 2009.  No one thought Spain had a problem until debt suddenly emerged from every nook and cranny as a response to the adverse shock Spain was undergoing.  Some analysts will complain that it is very difficult to figure out all the contingencies in any country, so acknowledging the possibility adds nothing to the quality of our analysis.  But they are dead wrong.  An experienced balance sheet analysts can easily tell when overall a country’s balance sheet is more inverted or less inverted, and in the former case he must always assume that the potential for a debt crisis is much greater than the raw debt numbers suggest.

When the cost of capital is artificially repressed, economic entities tend to overuse capital as an input.  Perhaps that has not happened in China in the past decade, but if it hasn’t, China would represent a truly unique case in history.

Recognition of Losses

We need to be worried about debt, in Europe and the US of course, but we need also to be worried about debt in China.  The deleveraging process in any country always results in much slower growth than during the period in which debt was rising quickly, and what matters is overall deleveraging, not just government debt.  At some point we will see deleveraging in China, and this must affect growth.  Misallocated investment funded by debt means that losses have occurred and one way or another they will eventually be recognized.  The recognition of the losses can be postponed for a time, by the simple expedient of not recognizing non-performing loans, but at some point, and usually at the worst possible time, they will be recognized.
What to Expect in Deflation

Pettis did not use the word "deflation' in his email, but deleveraging, rebalancing, trade intervention, currency wars, falling commodity prices, and beggar-thy-neighbor polices "typical of a global demand contraction" are certainly synonymous with the word.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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