Nobody really knows what is going on in China, according to Michael Pettis. “Those who know aren’t talking,” he said, “and those who don’t are.”
But Pettis is someone who knows a lot. He predicted China’s slowdown and the resulting crash in commodity prices. One of the most respected scholars on China, he is a professor of finance at Guanghua School of Management at Peking University in Beijing.
Pettis spoke on May 1 at the Strategic Investment Conference in San Diego, sponsored by Altegris and John Mauldin.
Faced with an incredibly difficult rebalancing challenge – one which very few developed countries have overcome – Pettis said that the best China can achieve is 3% to 4% GDP growth.
I’ll discuss the three things China is trying to accomplish and the two ways Pettis said it can achieve its goals. I’ll conclude with Pettis’ thoughts about the implications for investors in China’s economy.
China’s three goals
China and its central bank, the People’s Bank of China (PBoC), are trying to accomplish three things, Pettis said:
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Credit growth must slow from its unsustainable pace. Because most of the credit goes into investment, investment as a share of GDP is at its highest level ever and that complicates this goal. Pettis cited Hyman Minsky’s writings on the structure and the role of debt. “Overly indebted countries have never seemed to grow,” Pettis said. The reason, according to Minsky, is that dependence on debt for investment leads to a very volatile economic environment.
Unemployment must be prevented from rising.
The national balance sheet must be repaired.
All measures China is now undertaking, from its anti-corruption campaign to PBoC’s moves that resemble quantitative easing, are aimed at accomplishing a combination of those three things, Pettis said.
“The bad news,” according to Pettis, “is that it’s not going to work.”
China cannot accomplish all three of its goals. It may be able to slow credit growth, he said, but not without an increase in unemployment or damage to its balance sheet.
Two ways to slow credit growth
There are only two ways China can reduce credit without increasing unemployment and still repair its balance sheet, Pettis said:
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It must transform the nature of investment. Debt has been channeled into a variety of projects, Pettis said, many of which are no longer productive (by that, he meant that the net present value of those projects is less that their capital cost). As a result, debt will grow faster than debt-servicing capacity and ultimately cause a default. It’s not that China lacks investment opportunities, Pettis said. Many small- and medium-sized businesses (including some in the agricultural sector) can borrow at 30% interest rates and still make a profit. “But there is no evidence in history of any country has been able to do that [transform the nature of its investment] as quickly as China needs to,” Pettis said.
It must increase its consumption. Very few countries have had investment generate more growth than consumption for only a very short period of time. Since there are three sources of demand – investment, consumption and foreign capital – China must increase consumption. But that has been “brutally difficult,” Pettis said.
If it could solve those two problems, China doesn’t need to reform, Pettis said. “But that is very difficult.”
To accomplish the first goal, China is trying to change its financial system. “China may have three to four more years to get its debt under control,” he said. “If they could do that, it would truly be a miracle.” But that means giving money to a new group of recipients – not the ones who were getting the cheap credit during China’s boom years. Many of them, those he referred to as the “vested interests,” have gotten extremely rich, Pettis said.
Indeed, according to Pettis, China knows what it must do but can’t do it because of opposition from those vested interests. To find better projects, China is trying to centralize its investment process. But Pettis said it is hard to find cases where such efforts have been consistently successful.
Increasing consumption (and hence decreasing savings) is a bigger problem than changing its financial system. Pettis said it is a myth that China’s problems are due to excessive savings by its citizens stemming from their Confucian religious beliefs. “That is total nonsense,” he said. To the contrary, historically the Chinese have been criticized for laziness and overspending, according to Pettis. He said that Singapore in the 1970s raised taxes to incentivize the Chinese to save more.
“No investment-driven growth miracle has not been followed by a debt crisis or a long adjustment period driven by excess debt,” Pettis said. That is because the savings rate tends to be too low during the boom years of growth. Pettis said this was true in the U.S. during its rapid growth in the 1800s. During that time, the U.S. grew on “imported savings” – foreign capital – since the U.S. ran a trade deficit and a current-account surplus. But in the 20th and 21st century, importing foreign capital has been very risky. Pettis said that is because capital has been in the form of debt and not equity-based, as it was in the 19th century.
Excessive savings cannot be “fixed” by trying to convince consumers to “buy more neat stuff,” Pettis said. “The problem is structural.”
Despite its structural nature, raising the savings rate is considerably easier than financial system reform, Pettis said. Since GDP consists of savings plus consumption, China needs to lower its consumption rate to increase savings. Most consumption is at the household level. To lower it, China must decrease the household-income share of GDP. “Every country that has had an investment-driven growth miracle has forced down its household-income share of GDP,” Pettis said. Brazil, for example, did it successfully through a high income tax. Its economy kept growing and everyone benefited; although income as a share of GDP decreased, it was offset by GDP growth.
China is following the Asian model pioneered by Japan. For 30 years, Pettis said, Japan grew 10%-11%, but household income grew 7%-8%. As a result, its household share of income was contracting.
Broadly speaking, Pettis said, there are three keys taxes in the Asian model:
An undervalued currency, which is a tax on imports. This reduces the real value of household income and subsidizes the tradable goods sector.
Low wage growth relative to productivity growth. Wages grow more slowly than the value of the goods that workers produce. Labor costs are lowered, so it helps boost GDP.
Most importantly, financial repression. Households have a limited number of ways they can save, mostly through bank deposits. Keeping interest rates very low transfers wealth from savers to borrowers (who are mostly businesses and government). Theoretically, Pettis said the interest rate paid to savers should be equal to nominal GDP growth (in China this has been about 20%). But China’s lending rate is 7%.
China is also using a series of hidden taxes, such as environmental degradation. By dumping waste in unsafe places, it lowers production costs, but raises healthcare costs. That drives down household income but increases GDP.
Indeed, all the three prongs of the Asian model deliver subsidies from households to the government.
There is nothing wrong with imbalances, Pettis said. “Rapid growth is always unbalanced, but it must eventually be reversed.” Countries often put into place intelligent policies, but then fail to change when those policies no longer work, he said. Good policies develop institutional structures that benefit vested interests, he said, who become politically powerful. That has happened in all countries with an investment-driven growth miracle, according to Pettis, and it is happening to China too.
Implications for investors
Rebalancing means that the median Chinese household will get a larger share of a more slowly growing pie, Pettis predicts. The elites will get less than they have in the past. On balance, he said, that will be good for China and the rest of the world.
Some observers think that with a successful rebalancing China can grow at 6%, about half of its past growth rate, Pettis said.
“There is no way China can grow at 6%,” he said. If everything grows right, at best it will grow at 3%-4%. But if household income grows at 5%-7%, it could be “wonderful” for the Chinese and global economies, according to Pettis.
China needs “liberalizing” reforms to reduce the power of vested interests, Pettis said. “That is very tough to implement and very rarely succeeds without political disruption because opposition tends to be very strong.” But he said there have been successes: in highly democratic countries (such as the U.S.) and in highly centralized governments (such as Deng Xiaoping’s rule in China in 1980s).
China needs to centralize power because democracy is unlikely, Pettis said. Its anti-corruption campaign is about the centralizing of power.
“I am moderately optimistic about its chances for success,” Pettis said. China is “following the script” by centralizing power and transferring resources to productive sectors. Interest rates are high and positive. China’s currency no longer undervalued. Wages are up. Now, Pettis said, China has to do the hard part, which is to transfer wealth to the household sector.
Pettis’ advice to those who attempt to forecast China’s trajectory: “Put a huge margin of error on whatever you believe.”
Pettis said that China’s rebalancing will cause commodity prices to revert to levels held 15 years ago. Food prices, however, will be strong, he said, and China’s manufacturing sector will still do well.
Don’t believe that China is the growth engine of the world, Pettis said. Demand in the U.S., which is the “consumer of last resort,” will continue to fill that role. China’s adjustment will be disruptive for commodity-producing countries, Pettis said, “but it will be great for the rest of the world.”
Read more articles by Robert Huebscher
