Michael Pettis is Professor of Finance, Guanghua School of Management, Peking University, author of The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy, Avoiding the Fall: China’s Economic Restructuring and The Volatility Machine: Emerging Economics and the Threat of Financial Collapse. Michael Pettis is out with his latest missive on China’s debt problems. Below is a small excerpt from Michael Pettis.
If you assume that for many years China has been misallocating investment (by which I simply mean that the resulting increase in productivity generated by the investment was less than the correctly calculated debt-servicing cost), it should be obvious that because there have been almost no defaults or other forms of debt write-down, the implicit losses have simply been rolled over, most likely in the balance sheets of the Chinese banks. This has several implications:
Michael Pettis on China’s GDP
GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%. Why? Because in an economy in which losses were not simply accumulated and rolled over, the amount of the write-down (which would have occurred, either as a default, or as an equivalent transfer from a more profitable part of operations to subsidize the loss) would have shown up as lower GDP.
There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.
This bias can be considerable. Let us assume, for example, that the real growth in an economy causes it to double its wealth every 10 years. Real GDP would, in that case, increase every year on average by nearly 7.2%. Let us also assume that during the first ten years, GDP growth was overstated by a failure to recognize investment losses, so that reported GDP growth was actually 10%. Finally we will assume that after ten years, this over-reporting stopped, and the excess GDP was amortized during the next ten years so that at the end of twenty years GDP was once more correctly stated.
The numbers how that at the end of ten years, reported GDP would be overstated by 22.9% – that is, instead of doubling, reported would be 159% higher. During the next ten years, as real GDP continued to grow by 7.2%, reported GDP would grow on average by just over 4.4% as the earlier losses that had not been recognized were amortized.
Michael Pettis on Chinese shadow banks
To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth.
Of course if the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.
The key point is that we cannot simply put the bad debt behind us once the economy is “reformed” and project growth as if nothing happened. Earlier losses are still unrecognized and hidden in the country’s various balance sheets. These losses will either be explicitly recognized or they will be implicitly amortized. The only interesting question, as I see it, is which sector will effectively be assigned the losses. This is a political question above all, and its answer will tell us a great deal about how the newly-constituted, “reformed” China will grow over the next few decades.