As Chinese Communist Party’s Third Plenum communiqué is receiving widespread criticism for lacking focus and detail, noted economist Michael Pettis says China’s adjustment phase could be worse than most pessimists have imagined. And it has to do more with politics than econmics. Michael Pettis is a professor of finance at Peking University’s Guanghua School of Management. He has authored three books, The Volatility MachineAvoiding the Fall and The Great Rebalancing.

Michael Pettis

Michael Pettis says Chinese growth model exhausted

Pettis says China has to regain control over credit by minimizing investment misallocation. Since China’s miraculous economic reforms began in 1980s, the state and elite have benefited disproportionately. Now, the country’s adjustment phase must let households and small businesses benefit disproportionately at the expenses of the elite if it wants its economy to survive. That’s why Michael Pettis says it’s a political problem rather than an economic one.

Political turmoil over the past two years including the conviction of Bo Xilai and arrest of several powerful political and business leaders indicate that China’s political elite have lost their remarkable cohesion. Michael Pettis says that was inevitable after about three decades of spectacular growth and advancement. China’s growth model is now exhausted. That this has resulted in internal imbalances is obvious, given its growth model. Beijing very well knows that it urgently needs new policies to absorb the consequences of soaring debt and rebalance the economy.

History repeats itself?

Economists believe that most countries will experience 2-3 decades of miraculous growth in the future. And these growth miracles precede an adjustment phase which is really painful. Japan experienced this in the 1980s, Brazil in the 1950s to 1970s, the Soviet Union between the 1940s and the 1960s, Germany in the 1930s and the U.S. in the 1920s. In each case, the growth seemed unstoppable. But that spectacular growth led to severe imbalances. Some countries resolved it successfully, while others failed. Nobody imagined in 1960s that Soviet Union would collapse three decades later. Or, in 1980s, nobody thought Japan would face two decades of stagnation. No American in 1929 and no Brazilian in the 1980s though that their countries would face negative growth for more than a decade.

For the U.S., South Korea and Brazil, the adjustment was brutal, and was resolved with the help of a robust democracy. But the Soviet Union was unsuccessful, and finally collapsed. Meanwhile, Japan’s adjustment has caused stagnation, deflation and massive debt.

In China’s case, growth driven by heavy investments burdened the country with massive debt, and now the country will find it difficult to bring debt levels under control. Michael Pettis says China’s adjustment period will see political difficulties, disputes and even a radical political transformation. That’s because a large percentage of China’s GDP is still retained by the state and the elite.

Michael Pettis on rebalancing Chinese economy

Michael Pettis says China can rebalance its economy by providing a disproportionate share of Chinese wealth to small businesses and households. And the country has to do it while the economic growth continues to slow down. That will involve a drastic reduction (or even decline) in the rate at which the wealth and assets of the elite and the state are growing. That won’t be easy. Michael Pettis says every country with investment-fueled growth had to do this. And it has always proved politically challenging.

For China, it will be even more challenging. Michael Pettis says the recent political turmoil wasn’t an accident. It’s the consequence of instability caused by rapid growth, and the beginning of a brutal adjustment phase. He says successful adjustments have occurred only in two types of countries. One, those that have a strong political system like democracy, and two, those where decision-making is highly centralized. China’s decision-making was centralized during the Deng Xiaoping regime. It’s highly dispersed today.

Michael Pettis says, to reform successfully, China will have to democratize its political system. That will require the Communist Party to loosen its control. It has no choice. The other option is China moving backward to highly centralized decision-making and a tighter grip. If China fails to sail through the adjustment process, it won’t be good for the world economy.