Michael Pettis On China: No Large GDP Growth without Excess Credit Creation

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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. This morning, Michael Pettis sent his latest missive on Chinese debt and GDP to subscribers, and below we excerpt a small portion (with permission) on that topic.

Also read Michael Pettis On The Dilemmas Of Chinese Devaluation and China Re-balancing: Michael Pettis On The Six Different Paths

Michael Pettis on China’s GDP growth rate

Unfortunately it is not clear to me that GDP growth rates much above some minimum level (I would suggest 3-4% at most), can occur without excess credit creation, which I define to mean that the growth in credit exceeds the concomitant growth in debt servicing capacity. In that case reported GDP growth will exceed “real” GDP growth by the amount of bad debt that the banking system fails to write down correctly.

Notice that I define “real” GDP growth here not as the real amount of economic activity (as measured, for example, by electricity use, freight, and other factors sometimes referred to by analysts as the “Li Keqiang index”) but rather as the amount of growth China would report if bad debt were written down as it occurred. There is a vigorous debate about whether China’s reported growth in economic activity (reported GDP) is overstated, but in the rest of this newsletter I am ignoring the possibility that it might be.

Because reported GDP growth can be any number determined by Beijing, subject to the debt constraints described above, it is useless for analysts to try to predict, based purely on economic conditions, whether or when China will have a hard landing. Until China reaches its debt capacity constraints, growth will only slow when Beijing feels sufficiently confident of itself politically to rein in credit growth and so allow GDP growth rates to drop sharply.

The longer it takes to slow GDP growth, however, the sharper the subsequent deceleration in growth.

Michael Pettis on China’s credit growth

The limit of Beijing’s ability to determine GDP growth rates is set by its debt capacity limits. There are too many relevant variables to permit any credible prediction of how long China can continue to allow credit to grow at current rates, but my instinct is that Beijing has at most 3 to 4 years to get credit growth under control. Some analysts believe that China has much less time and others believe there is much more time, but there is no way a prior i to determine who is right. This is probably the most important “uncertainty” about China’s adjustment process.

By definition the longer GDP growth is boosted by excess credit growth, and the slower the pace at which credit growth is re-channeled from current inefficient borrowers to SMEs, the agricultural sector, and other more efficient borrowers, the more reported GDP will overstate real GDP.

This GDP overstatement will automatically be written down over future years. For this reason even if the Third Plenum reforms are successful and are quickly and efficiently implemented, so that Chinese growth becomes much healthier, reported GDP growth rates must nonetheless fall substantially. The longer it takes for GDP growth rates to fall, the more they will fall.

Because short-term costs are inversely proportional to the long-term benefits, however, and because recent history suggests that Beijing is still unlikely to choose long-term benefits if short-term costs are high, there is a chance that China’s adjustment period may stretch out beyond President Xi’s expected decade in power.

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