Anyone who’s heavily invested in China has been on the lookout for signs of a hard landing for at least a couple years now, so it’s not surprising that a reduction in the minimum reserves that Chinese banks have to hold (from 20% to 19.5%) has gotten a lot of attention. But Michael Pettis, finance professor at Guanghua School of Management at Peking University in Beijing, points to 2012 comment from central bank governor Zhou Xiaochuan that the reserve requirement ratio (RRR) is a ‘foreign exchange sterilization tool,’ related to capital flows instead of monetary policy.
“Predicting what will happen in China over the next few months means predicting the outcomes of the resulting political and institutional conflicts,” Pettis writes in a recent newsletter. “I am not going to pretend any particular insight into the thinking and the struggles at the top of China’s leadership pyramid, and I advise my readers to be skeptical of anyone else’s claims to insight.”
Instead of following the political blow-by-blow, which he clearly doesn’t think would be fruitful anyways, Michael Pettis says that investors should focus on medium and long-term forecasts that can be made on a economic, instead of a purely political, basis. For that to happen, he expects the debate over Chinese economic growth to shift in two important ways.
Debt management is China’s key policy challenge, says Pettis
The first big change Pettis expects is that more people will realize that debt management is the most important challenge facing China. That’s not to say that no one realized China had a credit problem, but the usual approach was to imagine that falling GDP growth was the central issue, and if China could manage to bring growth down from double digits (really not that long ago) to a more sustainable 3% – 4%, it could take care of debt along the way.
Pettis sees things the other way around. Unsustainable levels of debt growth spurred the Chinese economy for years, and now he says that the Chinese government needs to focus on reining in credit and worry less about the GDP numbers every quarter.
“I am glad to see more noises suggesting that GDP growth is likely to be deemphasized and I hope to see a greater turning away between now and this summer from high GDP growth targets,” he writes.
But Chinese shadow banking is not
While the management of debt may be the central issue facing the Chinese economy, the location of that debt is not, argues Pettis. He says that there has been an undue emphasis on shadow banking by analysts and the media trying to figure out which parts of the Chinese economy are riskiest. It’s not that Pettis disagrees that there is a lot of debt outside the official banking sector, but he doesn’t think this fact is particularly important if you’re trying to understand where China is headed. Again, the central point is that the buildup of debt was necessary for China’s dramatic economic expansion, and bringing it back down is the key policy challenge. Pettis argues that where the debt has been allowed to accumulate in the meantime is a political question that tells you something about the government’s past preferences, but not what it will do next.
China not likely to devalue the renminbi, says Pettis
For now, Pettis expects China to continue with its current monetary policy, allowing mild strengthening of the renminbi, partially because of the harm that could be caused by deflation. Even though the EU is starting qualitative easing and Japan is continuing it, Pettis doesn’t expect China to follow suit because it could force the US to respond.
“Should the US take countermeasures to bring down its deficit, the consequences for the world, and more so for developing countries, could be very painful,” writes Pettis.
He also points out that what China really needs to do is boost domestic consumption by increasing household incomes relative to GDP, and depreciating the currency won’t make that happen. Pettis says that anyone who disagrees can look to Japan, where are 40% devaluation of the currency over three years hasn’t improved domestic consumption, so there’s no reason to expect a far more mild policy in China to do the trick.
Finally, Pettis warns that China has to be careful not to add to the already significant capital outflows by stoking speculative outflows as well. With $3.8 trillion in reserves, China won’t have any trouble funding those outflows for the time being, but that’s not a good reason for complacence.
“We are far from any questioning of China’s creditworthiness, but it is worth reminding ourselves that we are always far from that point until we are suddenly too close,” he writes.