巴曙松：“刘易斯拐点”是经济转型的契机_经济观察_求是理论网

巴曙松：“刘易斯拐点”是经济转型的契机_经济观察_求是理论网

Some good points raised on potential effects of China's Lewis Turning Point.

On the lack of the political leadership in the advanced countries

Over the last 3 months, I have self studied history of US (mid 18th to current), Britain (Roman occupation to current), Europe (19-20th century), Japan (Meiji to current) to get some implications on what types of opportunities/risks lying ahead of China's rise. I am especially fascinated by one of America's founding fathers "Alexander Hamilton" - ironically, most of Americans I know never heard of him, and those who do despise him; and me, a Chinese, obsessed with this American patriot! I see parallels between Hamilton period's America and current Europe -- a strong federal/national government is badly needed. After its independence, US was just a group of loosely associated former colonies with a weak federal/central government, and Southern states were in better shape financially than their Northern counterparts after the independence war. Initially, southern states refused to bailout northern ones. It was Alexander Hamilton (author of "Federalist Papers" and 1st Treasury Secretary) who launched a series of unification champion with the back of Washington to consolidate federal powers (including unification of national ccy, fiscal union, consolidation of state debts into a national one, a unified standing army)... So who will be Europe's "Alexander Hamilton" this time??? Trichet is reportedly reading Hamilton's bio these days...

It seems to me that there are 2 scenarios for the European crisis: either to form a closer union via fiscal consolidation (introduce EU Treasury and Eurobond) or half a century's political efforts will turn into ruins. Crisis often breeds opportunities and gives rise to great politicians -- a real crisis might eventually force European leaders to form a stronger union (because the alternatives will be calamitous). But, I believe that we need to see some bloods in the mkts (much larger sell-offs) before politicians can get their acts together... While the politicians might be willing to go all-in in supporting Euro and the union, voters (to most of them, WWII memories are too distant to matter and abstract political ideas matter less than immediate tax concerns) might vote otherwise. While democracy might fail to deliver effective solutions to the crisis, strong political leadership (strongman politics) is badly needed in Europe. However, there is a serious lack of strong political leadership in Europe, or other advanced countries at the moment. "Will enough demand create a supply?" - Russell Walter Mead asked...

As Martin Wolf concluded in his latest FT piece:

In neither the US nor the eurozone, does the politician supposedly in charge – Barack Obama, the US president, and Angela Merkel, Germany’s chancellor – appear to be much more than a bystander of unfolding events, as my colleague, Philip Stephens, recently noted. Both are – and, to a degree, operate as – outsiders. Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing. The realisation that neither the US nor the eurozone can create conditions for a speedy restoration of growth – indeed the paralysing disagreements over what those conditions might be – is scary.

Russell Walter Mead expressed the same concern:

The inadequacy of the political and economic leadership in the advanced world is truly staggering. Japan is observing twenty years of failure to repair the damage of its bubble economy by failing to cope with the aftermath of the spring tsunami. The European Union is still struggling to respond to the Greek financial meltdown as its latest (inadequate and poorly conceived) fudge threatens to fall apart. Again. And in the US, collapsing consumer confidence following poor leadership from both the President and the Congress could be the factor that pushes the US into a double dip recession.

Watching so many second class talents struggle against first class problems is a dispiriting exercise, especially when one reflects on the costs of failure.

It is no secret anywhere that our leaders are failing. The Europeans know their political class is floundering; the Japanese have despaired of their politicians for almost a generation; in the US the only people less popular than President Obama are his Democratic allies and Republican adversaries in the US Congress.

It is not just that our leaders are small, however. It is that the problems are big. Europe, the US and Japan are each in different ways facing up to a similar set of problems: the guiding assumptions of economic and social policy in the western world no longer make sense. Demographic changes mean that all welfare states have turned from social insurance programs into Ponzi schemes; economic and technological changes mean that the stable postwar political and economic institutions and practices of the rich world no longer work; cultural changes mean that the citizens of these countries demand more from their leaders — and are less prepared to defer to or to trust them.

Walter Russell Mead on the root of India's corruption problem

India’s problem is that its mores and culture remain feudal and clientelist from top to bottom. There are some pockets of modernity, but they float uneasily in a feudal sea. The enduring power of the Gandhi dynasty is more the symptom of wider problems than the leading cause of India’s governance crisis. And by providing the country with a unifying focus (and by being civilian and committed to civilian rule) the Nehru-Gandhi family has done much to create a modern civilian nationalism in India — an achievement buttressed by their support for economic reform in recent years.

Modern capitalism and feudalism inevitably clash; ultimately successful capitalism demands more transparency and meritocracy than traditional family oriented hierarchical societies can comfortably live with. This is what India is trying to deal with today, and it isn’t easy.

India’s addiction to feudalism is more than a manifestation of “backwardness”. It is also about how resources are parceled out legitimately in a society composed of so many different subgroups divided by language, culture, geography, caste and religion. Networks of clientelism and patronage may be necessary to India’s ability to work at all — but modernizing those networks and limiting their drag on the country’s efficiency is necessary for India to flourish.

Some questions on AI (from an amateur :))

It's not all clear to me whether computers remained as tools (albeit, increasingly better/smarter tools) or they are turning into intelligent machines by beating Kasparov...

We have already invented planes/cars that can out-run us, weapons/machines that can out-power us, telescope/telecom that can out-see/hear us, etc -- yet it's obvious to us that those are merely toys/tools, not intelligent machines. Now that we have computers that can out-calculate us, out-memorize us -- what made us believe that this time is different and we are inventing intelligent machines, not just tools? What if calculation, memorization, and brute-force data-mining are NOT essences of intelligence and consciousness? We need to define what is machine intelligence - even if we succeeded in developing a machine that passes Turing Test and gives answers to any questions in the same manner as human (leaving aside daunting computational complexity challenges, i.e. "P=NP"?), it doesn't mean we have finally created an intelligent machine? There is no life attached to that machine - if I smash it with a chair, it won't run for life. It is a dead machine with dead formulas. It's a smart tool and that's it (not that much different to planes, cars, calculators, etc). We still haven't solved the problem that will enable us to give intuition and imagination to machines? Instead of making machines like humans, humans are evolving into a species that getting increasingly better at challenging our own evolutionary limitations - we are making smarter humans! If machines cannot derive meanings/purposes independent of those of human, they are deemed to remain as merely our tools/toys - not thinking machines with real intelligence?

Paradoxes observed in physics and math (i.e. Heisenberg Uncertainty Principle, Double-slit Experiment, Schrodinger’s Cat Thought Experiment, Godel’s Incompleteness Theroem, etc) showed us that there are fatal limitations in human understanding and so far our world cannot be explained by merely science (empirical observation based inductive methodology) or mathematics (rational, deductive axiomatic methods). Prominent among the tools of epistemology are the axiomatic method (associated with rationalism, deduction, and mathematics), and the scientific method (associated with empiricism, induction, and the physical sciences). The axiomatic method derives theorems from axioms, but which theorems can be derived depends on which axioms are started with (Godel’s Incompleteness). The scientific method infers laws from observations, but future observations can break these laws (creating the problem of induction); plus there are problems with observation/measurement itself in quantum mechanics (a particle’s position and momentum cannot be known simultaneously according to Heisenberg). Such methodological limitations have led some theorists to conclude that all knowledge is relative: to arbitrary axioms or to restricted observations... So far, neither physics nor math succeeded in explaining reality – that’s why we have philosophy to bridge this gap in understanding... Can machines ever learn to grasp philosophy? Theoretically, if we can invent a machine which can think for him/her-self, we are turning ourselves into Gods - because we would have comprehended/proved the meaning of "reality"? Will we be capable of creating intelligent machines without solving those paradoxes in limitation of understanding? If we can't bridge our reality with laws of physics and models of math, how likely is it for us to bridge laws of physics with the reality of beings we created?

As long as computers remain logic machines (Godel has proved out the incompleteness of formal logic systems!), it's rather implausible to me that they will become intelligent ones which will require the ability to think outside one particular set of logical equations. From a naturalist point of view, it took 4 billion years' evolution for a simple cell to transform into human-level consciousness. We can say that life is an extremely complicated (potentially non-deterministic) algorithm program that aim to keep the species alive and propagate given certain set of environment, subconsciously or consciously. To create intelligent machines, we need to incorporate at least evolutionary biology (not just rational mathematics) right? Machines need to have sensors via which they can connect to external environment. They need to have a data centre to store all information. Then information is processed via programs that enable them to learn from their experience/mistakes (evolutionary trial-and-error type heurstic approach). Pain, pleasure, love, hate, etc need to be programmed in so that this form of life will learn to protect/propagate itself through time? Very dangerous...

I am still undecided and unconvinced whether machine intelligence/consciousness is achievable - there were much hypes about AI in the 70s/80s, but all we have achieved so far is making better machines instead of making them think like humans. We haven't yet quite grasped/explained our own consciousness - why we are convinced that we can give that to a machine?

I am agnostic (not a believer of any prevailing religion), not an atheist. I do believe in Darwinian evolution as we can see evidences everywhere - but evolution does not necessarily contradict with the idea of creationism and intelligent design. If we are convinced that we will be capable of creating intelligent machines one day, why there couldn't have been any super beings who created us (and everything around us)? If we were to create intelligent machines, it's incomprehensible for us not to incorporate some certain "purpose" "meaning" "goal" of their lives whatever those could be? And by doing so, many atheists just endorsed the very essence of creationism they despise?

A history of human societies for the last 13,000 years...

You ever wonder why some regions/nations dominate the modern world in wealth and power, while others (including most sub-Saharan Africa) remain poor and undeveloped? Why some human societies prospered while many others struggled? I haven't found any convincing arguments in answering above questions until I was introduced to Jared Diamond's book "Guns, Germs, and Steel" about 4 years ago (also made into a documentary series can be views via Youtube). Having some idle time at hand, I re-read some chapters lately in an attempt to write a short piece to summarize, re-elaborate some of Diamond's key arguments to a friend of mine with whom I had a discussion on this very subject.

By studying history of human societies over the last 13,000 years, Diamond argues the gaps in power and technology between nations/regions originate in environmental/geographical differences, which are amplified by various positive feedback loops. In his book, Diamond also explained, succinctly and persuasively, the formation of religion and ideology from a society-evolutionary (social-anthropology) perspective. Additionally, for those practical minds who care more about the ramifications of a theory rather than the theory itself, his book sheds some lights into the understanding of many of our current geo-political tensions/conflicts in the world, including the dire prospects facing the Euro-zone.

To illustrate Diamond's ambitious thesis, let's start by looking at some of the environmental factors that have caused the backwardness of sub-Saharan Africa -

Food production was delayed in sub-Saharan Africa (compared with Eurasia) by Africa's scarcity of domesticable native animal and plant species

Not all mammals can be domesticated - while Eurasia's native cows, sheep, goats, horses, and pigs were among world's few large wild animal species to be domesticated successfully; their African equivalents - such as the African buffalo, zebra, bush pig, rhino, and hippopotamus - have never been domesticated (not even in modern times). Had Africa's rhinos and hippos been domesticated and ridden, they would not only have fed armies but also have provided an unstoppable cavalry to cut through the ranks of European horseman! Rhino-riding Bantu troops could have over-thrown the Roman Empire :)

Also, sub-Saharan Africa has limited variety of wild plants that suitable for plant domestication.

Africa exhibits north-south orientation of axis, unlike east-west characteristic of Eurasia. As one moves along a north-south axis, one traverses zones differing greatly in climate, habitat, rainfall, day length, and diseases of crops and livestock. Hence crops and animals domesticated or acquired in one part of Africa had great difficulty in moving to other parts! For example, equatorial Africa's tsetse flies, carrying trypanosomes to which native African wild mammals are resistant, proved devastating to introduced Eurasian and North African species of livestock. Similarly slow in spreading down Africa's north-south axis was human technology. Pottery, recorded in the Sudan and Sahara around 8000 BC didn't reach the Cape until AD 1.

Increasing in food production (and hence, self-reinforcingly the increase in population) is a key prerequisite for societies to transfer from bands (dozens in population) to tribes (hundreds) to chiefdoms (thousands), and to states/empires (over 50k).

Food production, and competition and diffusion between societies, led as ultimate causes, via chains of causation that differed in detail but that all involved large dense populations and sedentary living, to the proximate agents of conquest: germs, writing, technology, and centralized political organization. Sub-Saharan Africa human societies seemed to have remained in the form of bands, tribes for too long due to environmental factors as argued by Jared Diamond....

Nearly all humans lived in bands until at least 40,000 years ago, and most still did as recently as 11,000 years ago. Band organization is often described as "egalitarian": there is no formalized social stratification into upper and lower classes, no formalized or hereditary leadership, and no formalized monopolies of information and decision making. And band-members are all closely related genetically!! Our closest animal relatives, the gorillas and chimpanzees and bonobos, also live in bands - so band is the political, economic, and social organization that we inherited from our millions of years of evolutionary history.

Like bands, tribes lack a bureaucracy, police force, and taxes; and economic specialization is slight. Tribes also share with bands an "egalitarian" social system, without ranked lineages or classes. And members within a tribe are genetically related as well.

Interesting to note that during the Bands and Tribes periods, people kill strangers!! Because all band/tribes members are somehow related by blood and they all know each other, when they were encountered with a stranger the default solution is to kill the stranger!! It was only with the rise of chiefdoms around 7500yrs ago, people had to learn, for the first time in history, how to encounter strangers regularly without attempting to kill them! (that's why I am highly skeptical towards all these egalitarian talks, and have little faith in anarchy or to a less extend libertarianism until we are evolved into more "conscious" beings :)).

A chiefdom's large population in a small area required plenty of food, which is obtained by food production in most cases instead of hunting-gathering activities. Precursor of taxes made its first appearance in chiefdoms (in the form of "tributes"). Chiefdoms, unlike bands and tribes, functioned unabashedly as kleptocracies, transferring net wealth from commoners to upper classes. At the same time, they do good by providing services impossible to contract for on an individual basis. These noble and selfish functions are inextricably linked, although some governments emphasize much of one function than to of the other.

More interestingly, ideology and RELIGION only appeared in chiefdom - they were used as means for kleptocrats to gain public support. Bands/tribes already had supernatural beliefs, but they didn't serve to justify central authority, justify transfer of wealth, or maintain peace between unrelated individuals. When supernatural beliefs gained those functions and became institutionalized, they were thereby transformed into what we term a religion. Besides justifying the transfer of wealth to kleptocrats, institutionalized region brings two other important benefits to centralized societies. First, shared ideology or religion helps solve the problem of how unrelated individuals are to live together without killing each other - by providing them with a bond not based on kinship. Second, it gives people motive, other than genetic self-interest, for sacrificing their lives on behalf of others. At the cost of a few society members who die in battle as soldiers, the whole society becomes much more effective at conquering other societies or resisting attacks.

Over the past 13,000 years the predominant trend in human society has been the replacement of smaller, less complex units by larger, more complex ones. Obviously, that is no more than an average long-term trends, with innumerable shifts in either direction: 1000 amalgamations for 999 reversals. We know from history books that USSR, Roman, Mongol empires dis-integrated; but the long term trend has still been toward large, complex societies, culminating in states. Obviously, part of reason for states' triumphs over simpler entities when the two collide is that states usually enjoy an advantage of weaponry and other technology, and a large numerical advantage in population. A centralized decision maker has the advantage at concentrating troops and resources; and the official religions and patriotic fervor of many states make their troops willing to fight suicidally (such sentiments are unthinkable in bands and tribes). So the question here is, how did small, non-centralized, kin-based societies evolve into large centralized ones in which most members are not closely related to each other? The French philosopher Jean Jacques Rousseau speculated that states are formed by a social contract - a rational decision reached when people calculated their self-interest and came to the agreement that they would be better off in a state than in simpler societies, hence voluntarily did away with their simpler societies. But observation and historical records have failed to uncover a single case of a state's being formed in that ethereal atmosphere of dispassionate farsightedness. Smaller units do NOT voluntarily abandon their sovereignty and merge into larger units. They do so only by conquest, or under external duress. Historical examples illustrated that wars, or threats of war, have played a key role in most amalgamations of societies.

...

There are many more enrapturing thoughts from the book, but I will leave those to you to discover :)

Latest Fitch report on Chinese banking system shows China's broad money supply has not slowed much

Latest Fitch report on the Chinese banking system confirmed my worry that China's broad money supply has been vastly underestimated due to the surge in shadow banking activities. This helped to explain why China's economic activities haven't cooled down as much as the official M2/loan numbers would have suggested... Implications? Authorities might have to stay tighter for longer to rein in the credit growth (inflation will be more sticky)...

According to Fitch, broad credit has not slowed as much this year as suggested by both the bank lending and social financing data. According to the PBOC, new renminbi bank lending declined by 9.7%YoY from Rmb4.62tn in 1H10 to Rmb4.17tn in 1H11, while total social financing declined by 4.7%YoY from Rmb8.14tn in 1H10 to Rmb7.76tn in 1H11 (see Figure 1). In an attempt to measure better broader credit growth, Fitch has come up with its own so-called “adjusted total social financing (TSF)” index. This indicates four main areas that Fitch argues are not properly counted in the official social financing data; namely letters of credit, credit from domestic trust companies, credit extended by other non-bank financial institutions and credit extended from Hong Kong banks.

Quoting from Chris Wood's latest G&F:

Despite the ongoing credit tightening in China, as reflected in daily loan-deposit ratio targets on individual banks, Fitch estimates that, based on its adjusted TSF, total financing is expected to exceed Rmb18tn in 2011, or 38% of GDP. True, this rate of growth is down from the average of 42% of GDP in 2009 and 2010. But it is still well above the pre-2008 average growth in broader credit of 22% of GDP. It is also important to highlight that Fitch estimates that more than 55% of the new financing is expected to come from areas outside bank lending, since the formal banking system is clearly experiencing much tighter conditions as reflected in those daily loan-deposit ratio targets.

Thus, Fitch estimates that the ratio of total stock of credit to GDP is on course to reach 185% of GDP by the end of this year, up from just 124% of GDP at the end of 2007. This sort of rapid ramp up in credit to GDP (up 61ppts) is often a prelude to an over investment-led banking crisis, as Fitch also highlights by quoting relative historical comparisons, be it Japan between 1985-1990 (credit/GDP up 45ppts), Korea from 1994-1999 (up 47ppts) or America and Britain from 2002-2007 (up 41ppts and 50ppts respectively).

Informal Banking and Shadow Banking in China

Informal banking and shadow banking (in the context of China) are 2 related, but different, concepts -

Informal banking refers to underground, back-ally, black-mkt type unlicensed banking activities that involving taking in deposits and giving loans. Whereas shadow banking is defined as depositing/lending activities not being captured on banks' balance sheet, hence off-balance-sheet banking. Some of these shadow banking activities can be are licensed and formal - just that they are not shown banks' balance sheets, such as trust products, entrusted loans, letter of credit (used as loans), and wealth management products, etc. Some informal banking activities are captured by M2 - for example, if a loan shark (informal banker) loans a small real estate developer 1mio, this 1mio will be transferred out of loan shark's bank account and deposited to that real estate developer's bank account which will be counted as M2. Or should this real estate developer spend this 1mio in paying workers' salary and buying construction material/equipments, this 1mio will turn up on those recipents' bank accounts as deposits which will be counted as M2 (informal banking activity didn't change M2 - simply moved deposits from one account to the other).

Informal banking sector is free-market's answer to China's highly centralized near-rationing credit system. Credits, via banks, are channeled into SOEs and municipal governments at depressed official rates (if there is abundant supply, i.e. in 2009, these cheap money will reach SMEs via formal banking as well) ; while the leftovers then get to be allocated to SMEs at rates largely decided by the supply&demand of credit, via informal channels. However, I dont think informal banking sector can create money supply as demonstrated by the example I gave above (only banking sector can due to the very nature of fractional reserve banking system - please do correct me if you think I am being wrong here!) - they just channeled some liquidity out of formal sector, into informal sector to generate higher rates.

Shadow banking sector ('s recent rampant expansion) is the bank sector's answer for the government clampdown on banking lending, as well as financial sector's response to the "invisible-hand" of market force. Chinese govt had given banks loan quotas, imposed higher loan-to-deposit ratio, hiked reserve ratio continuously. As a result, banks innovated their way out of these restrictions - moving loans off their balance-sheets. How? they repackage their loans into trust products and sold to households as wealth management products. Trust loan portion of wealth management products totaled CNY3.7 tril for the 1st half of 2011 according to Caing Magazine (issuance of wealth management products aggregated at CNY8.25 tril through 1st half of 2011). To further move assets off balance-sheet, banks issued Letters of Credit (many were created based on fake trade transactions) and so-called entrusted loans (neither accounted in loan-to-deposit calculation). To match the expansion of banks' shadow assets (loans), shadow deposits also surged in the form of various wealth management products that absorbed a great deal of deposits which are not counted in M2. Why not counted in M2? Because China's M2 doesn't include same-industry deposits and government deposits - many of these wealth management products are sitting with securities/trust companies or other banks as deposits, or ended up at government deposit account with banks (they might be backed by government loans/securities). That's why M2 vastly underestimated deposits growth in China...

Over the last 2-3years, banks have blossomed in major Chinese cities with smaller regional banks aggressively expanding their branches all over the country. With more and more banks competing for the business, there is an ever more fierce fight in bringing in deposits given the caps on loan-to-deposit ratio imposed by CBRC. As a result, banks have started a battle in bidding deposits - numerous tricks have been deployed to do so. As official deposit rate is set by PBoC, banks are attracting deposits by giving out "red-package" (equivalent of 60bps to 1pct) to the depositors (corruption is rampant). On top of this, banks started to introduce numerous types of wealth management products (some linked to wine, some linked to modern art!!) with much higher yields than official deposit rate to attract depositors. Maturities of these products are getting shorter and shorter. Why this will help banks to boost their deposits? Households will usually transfer their deposits to this bank in order to subscribe those products, and these deposits are usually left with this bank untouched a few days before the subscription and a few days after the redemption - hence banks get a boost of deposits on these days (usually "arranged" to be month-end, quarter-end, or half-yr end). These products are extremely popular with households - why earning negative interest rates while you can get higher returns elsewhere? So by moving into shadow banking, both banks and households are happy! It's the state that is screwed - sooner or later, govt has to come in to bail out.... Well, actually, it's the households who will bear the burden in the end via more financial repression, or taxes, or inflation...

There are increasing signs of credit distress in China:

Many local govt funding vehicles on in trouble as their income < interests payments to banks
Some, albeit a small number of, SME bankruptcies in the coastal region have led to stress in the informal/black markets there
Informal banking rates are at unprecedented levels
Maturities of wealth management products are getting shorter and shorter
7D repo, and SHIBOR rates have been volatile

So, overall broad money supply is not nearly as tight as M2 growth numbers have suggested due to rapid expansion of shadow banking in China. But why we are seeing increasing signs of credit tightness/distress? Where did all the money go? I guess the culprit lies in China's credit distribution system - price of credits are distorted due to heavy-handed govt intervention. Many govt advisers (such as 祝宝良)are calling for liberalization of China's interest rate mechanism.

See GMO's Edward Chancellor on China's bad debt concerns.

Political Contexts of Resource Constraints

In his quarterly letter, Jeremy Grantham argued that the world is experiencing a permanent shift in the value of commodities as we are using up natural resources at an alarming rate. I have learned to take arguments of "this time is different" with some degree of skepticism. It is risky to predict long-run trends in commodity prices as technology in particular always turns out unexpectedly - but most forecasters conclude from current trends that prices will stay high or rise higher because supplies will not match increases in demand. Between 1900 and 2000, global population went from 1.5bn people to 6bn people - over that time frame, commodity prices fell -70% in real terms!

To expand this topic, let's assume Jeremy Grantham's predictions on commodities were to be realized - what kind of political world we are heading into? In other words, given limited resources, how to impose resource constraints in the context of politics and the role of the states? Chandran Nair's book painted a not-so-rosy picture of Western capitalism. Nair believes that capitalism that has served the West and parts of the world very well over the last 60-70 years has exhausted itself now due to constraints of resources. While denying his analysis as a rant against capitalism, Nair attempts to advocate for the true pricing of resources and therefore its more equity use via 3 major adjustments:

1st, we need to accept resource limitations and constraints
2nd, resources need to be re-priced to reflect their true total cost
3rd, shared resources need to be at the centre of policy making, not at the periphery as they currently are - the economy needs to be subservient to maintaining the vitality of the resource base (not the other way round)

"Extreme capitalism", as paraphrased by Nair, was borne out of circumstances of abundance and of entitlement - it all looked possible in the West as it had access to vast resources via its colonies and the only challenge was how to export it. As a result, much of Western concepts of productivity were built on under-pricing resources (such as Adam Smith), simply because there was so much and so few people to use it. Faced by an ideological bias against any ideas for a strong government intervening in the individuals' right to consume, Nair advocates for a stronger state as he believes that a strong government can, and should, stand up and prevent the inevitable collapse of shared resources.

Nair asserts that a form of capitalism can exist which brings forward the idea of a strong state (something essential for implementing and enforcing the self-imposed constraints Consumptionomics advocates), while also enabling a sufficiently free market that can equally encourage innovation and risk taking. In a world that has seen in the last century two ideologies oscillating (see Commanding Heights Battle of Ideas) - one disastrously advocating the role of the state alone, and another promoting free markets driven by individual self interests - Nair's suggestion that a balanced relationship needed to adapt to the realities of the 21st century.

Balassa-Samuelson Effect on China

Balassa-Samuelson Effect:

As productivity growth would not be as rapid in the non tradable sector of the economy, wage costs and prices of non tradable goods would necessarily rise more than in the US. So even when the prices of tradable goods would evolve the same in the developing economy than in the US, the higher speed of price increase in the prices of non tradable goods in the developing economy would cause an inflation differential between this economy and the US. This phenomenon is described in the economic literatures as a version of the “Balassa-Samuelson effect”.

According to this paper, Balassa-Samuelson effect implies that:

Deterioration of their terms of foreign trade is another reason for having an inflation differential in rapid growing economies which have to import food and raw materials because they lack the necessary natural resources to produce them. The significant rise of oil and other primary commodities in the 70s meant a sharp deterioration of its terms of trade that explained part of the inflation differential as imported inflation in spite of the appreciation of the Yen. The same phenomenon has been happening in China in the last years as a consequence of the rapid upward trend in primary commodity prices that are the bulk of Chinese imports. This was clearly a good part of the explanation for the higher inflation differential in Japan during the 70s and explains also a good part of the higher inflation differential in China since 2004.

To curb high inflation, rapid movement toward greater exchange rate flexibility is required - appreciation of CNY will lead to deflation of the tradables, hence reducing the differential inflation between non-tradables and tradables associated with the Balassa Samuelson effect that would otherwise happen through higher inflation of the non tradables. However, significant and persistent deflation of the exportable goods will inevitably lead to much lower rate of GDP growth (demonstrated via the studies of Japan's growth/real-exchange-rate data). So, to preserve high rate of GDP growth (that is to avoid the deflation of the exportables), China must accept higher overall rate of inflation. Monetary policy instruments such as capital controls, sterilization, reserve ratio hikes will not succeed in preventing inflation originated from the Balassa Samuelson effect, unless monetary policy succeeds in reducing GDP growth significantly.

Growth of China's broad money supply is higher than what M2 numbers have suggested?

The key questions to ask are - to what extent that recent slowdown in M2 growth (from 30% to 15%) is being offset by the surge in shadow banking activities via numerous launches of wealth management products? If broad money growth didn't come down as much as suggested by M2, does this mean that inflation will be more sticky than commonly believed?...

As we know from fractional reserve banking practice, banks can create money supply (deposits) in fractional banking. And on banks' balance sheet, total assets (approximately reserves + loans + treasury bills) = total liabilities (deposits). So we get approximately Loans = Deposits. By expanding loans or investments, banks in aggregate are able to create deposits (as long as they keep enough currency on hand to redeem whatever amounts the holders of deposits want to convert into currency). M2, by definition is the aggregate of currencies in circulation, plus all deposits (M1 + savings deposits). However, only cash and balances held by NONBANK public are counted in money supply - deposits of govt, depository institutions, foreign banks and official institutions, as well as vault cash in depository institutions are excluded.

In China M2 (approximately) = total deposits - govt deposits - deposits btw financial institutions + currency in circulation + margins for securities investment/trading (2001).

PBoC introduced the calculation of total social financing which includes broad financing vehicles - but this calculation is to aggregate total loans, M2 is to aggregate total deposits.

However, as we know the development of China's shadow banking has been rampant in recent years which has NOT been quite captured through the measurements of M2 - why? For example, there are a lot of wealth management products (理财产品) being sold by banks in recent years. When households bought these types of funds, their deposits turned into liquid assets outside of banking sector balance sheets. These products are mostly backed by govt bonds, financial bills, corporate debts, and commercial papers, etc. So that household deposits have turned into govt deposits, same industry deposits (同业存款) and corporate deposits. But, govt deposits and same industry deposits are not deposits held by nonbank public - hence, they are not counted in M2. Many these shadow banking products should be counted as broad money supply to give a better gauge of monetary conditions in China.

This implies that broad money supply in China might not have come down as much as M2 and official loan growth numbers have suggested. Evidence of tight monetary conditions in China such as skyrocketing informal banking rates might reflect more of investors' increasing aversion to risk, rather than overall monetary tightness???

The implications of these heated shadow banking activities are:

Monetary policies are increasingly ineffective in China

Tightness in M2 might have led to the expansion of shadow banking - broad money supply didn't slowdown as much as suggested by M2.

High inflation, as a monetary phenomena, will linger much longer even with the slowdown in M2 (monetary policy is getting less effective for PBoC).

Banks don't count wealth management products as deposits (not included in calculations of M2) - but, to pump up their deposits numbers, banks were indeed actively engaged in issuing these wealth management products with maturities varying from 1m to 3m (very short maturities). According to some measures, total size of this year's wealth management products (through June) is at CNY 8 trillion - about 25% of GDP (rose doubled from same period last yr). Most of these wealth management products have expiry dates falling just 1-2 days ahead of quarterly end or half-yr end. Why? Because right after the expiration of these products, principal repayments of these products) will fall onto banks' balance sheets as deposits (most people won't immediately withdraw those deposits for other purposes). Under the pressure from loan-to-deposit ratio, banks managed to come up with these types of tricks with quarter-end, half-year being most sensitive periods.

Overall, off-balance-sheet deposits are matched by off-balance-sheet loans in the innovative forms of trust products (信托), letter of credits (票据), and entrusted loans (委托贷款).

There are increasing signs of credit stress in China these days - hardly a day goes by without some headline news on some Local Govt Funding Vehicle distress or informal banking saga.... It seems to me that China has her own "subprime" issues these days.