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Michael Pettis: Chinese Growth Will Almost Certainly Drop Below 7%

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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.

Below are some nuggets from Michael Pettis’ private newsletter. As per Pettis’ request we can only quote a few hundred words; check out two interesting points he makes about China.

I think it is safe to say that nominal GDP growth rates will continue to decline, in spite of mistaken but widespread expectations that the reforms will keep growth rates high. This is partly because inflation seems to be stable. The latest CPI numbers suggest that inflation is low and is likely to stay low. Here, for example, is Monday’s Xinhua China Ltd (OTCMKTS:XHUA):

China’s CPI main gauge of inflation

China’s consumer price index (CPI), a main gauge of inflation, grew 3 percent year on year in November, down from the 3.2 percent recorded in October, the National Bureau of Statistics (NBS) said on Monday. Inflation rose 3 percent in cities, and 3.1 percent in rural areas. Food prices rose 5.9 percent over a year ago, while prices of non-food products edged up 1.6 percent, according to the NBS.

On a month-to-month basis, November CPI contracted 0.1 percent from the previous month. Food prices dropped 0.2 percent from October. Prices of non-food products remained flat against the previous month. In the first 11 months of 2013, China’s CPI rose 2.6 percent year on year, well below the government’s full-year target of 3.5 percent.

In addition to stable inflation real GDP growth rates have also been declining, although the market consensus is that we have bottomed out in terms of GDP growth at around 7.5%. This consensus will almost certainly prove wrong, and if we don’t see growth dip below 7% in 2014 we will almost certainly see it drop substantially in 2015 and later as surging debt forces China to adjust.

The combination of low inflation and declining GDP growth means that the financial repression “tax” – the spread between the lending rate and the nominal GDP growth rate – is declining, and as it declines the upward pressure on interest rates will decline with it. Once nominal GDP growth is in the 8-9% region, which I expect to happen soon enough, the PBoC will probably be in a position to eliminate, or at least de-emphasize, the deposit cap without a surge in interest rates that could destabilize the banking system.

On interest rates Michael Pettis comments:

We are not there yet, but we are getting awfully close. As long as the PBoC can resist pressure to lower interest rates, we will back our way into the position that the PBoC has long wanted, but which powerful players in the market, most of whom benefit from the huge financial repression tax, have prevented them from doing.

We can effectively think of the difference between where interests ought to be and where they actually are – the amount of “financial repression”, in other words – very broadly as the gap between the nominal GDP growth rate and the nominal risk-free lending rate. When the nominal lending rate is much below the nominal GDP growth rate, as has been the case for most of the past thirty years, there are two important consequences.

First, and most obviously, the benefits of investment are not shared equitably or efficiently between net savers and net borrowers, but rather are disproportionately retained by net borrowers at the expense of net savers. This represents a hidden transfer of wealth from savers to borrowers, which I have calculated as being in the order of 5-8% of GDP every year for most of this century until 2011-12. This transfer, of course, is at the heart of the current consumption imbalance in China.

The second consequence is a huge incentive for borrowers who have preferential access to credit to borrow as much as they can, and to become fairly cavalier about how they disburse the proceeds. From 2000-01 to 2010-11, nominal GDP growth rates exceeded 18%, while the lending rate was roughly 7%, which suggests that even the most wasteful investment on average is likely to earn more than enough to repay the debt that funded it, in which case it cannot be a surprise that so much Chinese investment has turned out to be wealth destroying.

Of course the near-infinite demand from preferred borrowers for sharply underpriced credit has left very little credit available for non-preferred borrowers, which include nearly the entire universe of small and medium businesses, who are widely acknowledged to be the most efficient and productive part of the Chinese economy.

Michael Pettis on China’s economic imbalances and China’s soaring debt

Low interest rates, in other words, are at the heart both of China’s economic imbalances and China’s soaring debt, and the amount by which interest rates are too low is broadly equal to the gap between the nominal GDP growth rate and the nominal lending rate. But, as I suggested last September in an OpEd piece for the Financial Times, there has been good news on that front:

The hidden subsidy has declined dramatically since 2011. In the five years from 2006 to 2011, nominal GDP growth averaged about 18 per cent or more, while the official lending rate averaged around 7 per cent. In the past two years the nominal GDP growth rate has fallen to below 10 per cent while the lending rate rose to 7.5 per cent, bringing the gap down by an impressive three-quarters.

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