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. Pettis is out with his latest missive on Chinese reform and growth. Below is a brief excerpt from Pettis which explains why Chinese growth must slow over the next decade, if reforms are implemented.
Also see Pettis – Chinese Bank Problems Echo Those of Japan (not US)
1. Leverage boosts growth and deleverage reduces it. By now nearly everyone understands that China is over-reliant on credit to generate growth. Much new borrowing is needed simply to prevent borrowers from defaulting on existing loans, so that new lending can be divided into two buckets.
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One bucket consists of loans made to roll over the debt of borrowers who do not generate sufficient cashflow from the investments that their original loans funded. The loans in this bucket, of course, do not create additional economic activity, but as debt rises, financial distress costs rise with them (most financial distress costs, as is well understood in corporate finance theory, are a consequence of the way rising debt changes the incentive structures of the various stakeholders and so distorts their behavior in non-economic ways). Of course any disruption in lending would cause a surge in defaults.
The second bucket consists of loans that fund new expenditures. These expenditures, of course, generate economic activity, but if they fund consumption, or if they fund investments the value of whose output is less than the cost of the inputs, they incur additional losses that must ultimately be rolled over by loans that belong in the first bucket. Any reduction in loan growth, in other words, is positive in the long term for Chinese wealth creation, but in the short term will either force the recognition of earlier losses or will reduce economic activity.
Beijing has attempted since 2009-10 to rein in credit growth, but each time credit growth has decelerated, GDP growth rates – as we would expect – dropped so sharply that Beijing was quickly forced to relent. Because growth is more dependent than ever on credit, as Beijing finally acts to rein in credit growth decisively, GDP growth will drop sharply.
2. Hidden transfers will be reduced. As I have discussed many times the investment-led model encourages investment by transfers – hidden or explicit – from the household sector to subsidize investment. In the Japanese version of this model, which very broadly is the version China and the Asian Tigers pursued, the main form of these transfers is the undervalued currency, low wage growth (relative to productivity growth) and, most of all, financial repression.
Because these transfers no longer create net value on the investment side (China overinvests in infrastructure and has excess capacity in a broad range of manufacturing sectors), and the extent of the transfers are at the heart of China’s very low consumption level, the proposed reforms will act to reverse the mechanisms that goosed growth by transferring resources from the household sector to subsidize manufacturing, infrastructure building, and real estate development.
These mechanisms put downward pressure on household income even as they subsidized manufacturing and investment and led directly both to higher growth rates and to the investment and consumption imbalances from which China suffers and which it plans to reverse.
It should be clear that as Beijing reverses policies that once acted to increase growth, the result must be slower growth. It is hard to estimate the amount by which growth will decline once all the transfers are eliminated, but when one considers that the total amount of transfers to SOE’s during this century may exceed the aggregate profitability of the SOE sector by as much as five to ten times, it is pretty clear that their impact is likely to be substantial.
3. Excess capacity will be resolved. Beijing recognizes that cheap credit and limited accountability have created excess capacity in industry and real estate. Why build so much excess capacity? Local governments have supported this build-up of capacity to boost growth and, with it, revenues and local employment, and because capital was essentially free (its real cost may have even been negative for much of this century) and because most projects are implicitly or explicitly guaranteed by local and central governments, there seemed to be no cost, and plenty of benefit, simply to pile on capacity.
As Beijing acts to wring out excess capacity, we will inevitably see a reversal of the earlier growth impact. If building capacity generates economic activity (and it must have, or else why do it), closing down excess capacity must become a drag on growth.
4. Losses will be recognized. As I discuss above, because many years of overinvestment have left a large amount of unrecognized bad debt on bank balance sheets, China’s GDP growth has been overstated by the amount of the unrecognized losses. Over the next decade as Beijing cleans up its financial system, this bad debt will either be explicitly recognized or, more likely, implicitly written off over the remaining life of the loan. Either way, as the losses are recognized, growth over the next several years will automatically be understated by the amount previously overstated.
These reforms, and others – like attempts to protect the environment – will ensure that even as China’s real economic productivity improves, its GDP growth numbers will drop as the reforms are implemented. For now most commentators argue that by increasing productivity, real reform will ensure a soft landing of GDP growth rates of 7-8 percent during the rest of President Xi Jinping’s administration. A growing minority worries, however, that rapidly rising debt will force China into a hard landing.