«Growth in China is so dependent on even more rapid growth in debt», says Michael Pettis.
Professor Pettis, what has been the most profound change in China during the last year?
Perception. Some of the bullish people even last year were saying that the economic adjustment and rebalancing towards more consumption and lower investment will occur with growth rates of about 7% – no way could growth ever drop below 7%. I said the upper limit of growth under President Xi will be 3 to 4%. Now the bulls suggest 5 to 6%. It is really interesting how people had a completely different view of the adjustment not so long ago. They all reduced their expectations.
Did they reduce their expectations because of the recent weak economic data?
They realized the adjustments will be difficult. Growth in China is so dependent on even more rapid growth in debt. The debt numbers have just gotten worse and worse, so everybody knows this can’t be kept up for more than three or four years at the maximum.
Does it matter whether the economy grows at 4 or 5 or 6%?
No. What matters is debt. If you allow debt to continue to rise, eventually there will be a crisis and everybody wants to avoid a crisis. What matters is not GDP growth but household income growth. If ordinary households continue to be happy, who cares what the GDP numbers are? The problem is that for 30 years, while GDP was growing at around 11%, household income was growing around 7 or 8%, which was very good. But there was rising income inequality within that, so if you look at the ordinary Chinese households, their income has been growing probably at 5 or 6%.
What does this mean?
That means the elite’s income has been growing at an extraordinary pace. Economic adjustment and rebalancing means a reversal of all that: household income must grow faster than GDP, and the elite’s share must grow slower than GDP. If GDP grows at 3 or 4%, China is going to switch from a system where the elite benefitted disproportionately from 11% growth to a system where they will pay a disproportionate share of the cost of much lower growth. Of course, they are going to resist tremendously.
Economic adjustment in developing countries has always been difficult.
Yes, mainly because the elites resisted it. They benefited from the old model, and will not benefit that much from the new model. For five years now, when looking at the debate in China, the phrase «vested interests» has been mentioned, and «vested interest» has a very clear meaning in China. It means we know what to do, but we can’t do it for political reasons. That is the problem.
What other problems are there?
The government is trying to curb credit growth. If you look at the composition of loans, there is already a huge amount of loans that will probably never be repaid. They can default or they can be rolled over. Nobody wants big defaults, so they keep rolling them over and over. If credit growth is kept constant, the amount that is simply used to roll over bad loans is growing – that means the amount that is left for new loans is contracting. The banks have real difficulties making new loans, and when they do make new loans, they are not making them to small, efficient private companies, but to well-connected large companies. Because the amount of money available is contracting, small companies are going to the shadow banking system. But the shadow banking system loans are very expensive and many businesses can’t afford this. Things have become tight and difficult.
This means even less growth.
We have seen this movie many times before, leading to crises. Loan growth accelerates before the problems occur, and it accelerates because the system becomes more and more dependent on rapid credit growth in order to keep it moving. Ultimately, when the high credit growth stops – in Spain in 2008, in the US in 2007 –, the economy falls. We are just replaying that story in China.
There is also the issue of declining investment efficiency.
If counted correctly it is probably negative.
Where will the growth in the Chinese economy come from?
From consumption and making good investments. Good investments are possible, money is being invested in privately owned small and medium-sized enterprises. They are very efficient in China. The agricultural sector is also promising. But it is a political problem. The source of the growth of the leading manufacturers and state owned enterprises has been cheap capital. We need to take the money away from them and give it to the more efficient small companies. But that is politically very hard to do.
How do you make consumption grow?
The problem in China is not that Chinese save too much as individuals, they save too much as a country. Household income is low – only 50% of GDP, which is the lowest of any economy in the world. For more consumption the household share must increase. But this means the elite’s share is reduced. Economically it is very easy to tell China what to do. The Third Plenum reforms are all correct. But they all do the same thing: Be it the hukou system or land reform, interest rates or currency liberalization – all these things shift money from the elite to the household sector or small businesses. That is the right thing to do, but again, politically difficult. The elite will resist.
Recently there have been some minor defaults. Will a crisis be triggered by the banking system?
We won’t have a banking crisis in China. The government controls the banking system. And the only way ordinary Chinese can save financially is in the banking system. They can’t take the money out of the country, the stock market is terrible, and the bond market is tiny. What else can they do? Online banking is growing quickly, but it is still small. If it gets big, the regulator will have to stop it. So ordinary Chinese leave their money in the banks. So you can’t have a bank run like on Northern Rock in England. We are not going to have a financial crisis.
Why do many economists expect a financial crisis in China then?
Many people think that you can only have two possibilities: growth forever or a financial crisis. This is not true. Japan did not have a financial crisis, but for 20 years grew at 0,5%. Japan has the same problem that China does, but the China version is probably more extreme. But Japan never had a financial crisis.
What is the difference to Europe and the USA?
The US and Europe had banking crises because the system is very different. Economists have this big debate about what is better. Economically the best thing is to have a crisis and write everything down because then you start growing again. But socially this is very difficult. The Japanese never had a crisis and never wrote the debt down, so they had 20 years of almost zero growth. That is the trade off: a rapid adjustment which is economically much better in the long term but socially very difficult in the short term, or a very slow adjustment, which is socially easier in the short term, but economically much worse in the long term.
The Chinese government will try to avoid social unrest.
All governments do.
What is most important for China in the near future?
What really matters is whether President Xi can consolidate power quickly enough. If he can consolidate power, he can force the adjustments in spite of the opposition of the elites. That is the most important question. The Soviet Union had similar problems and they had to make their adjustments in the Seventies. But the Soviet Union’s power was much more dispersed and the adjustments failed. This is something China absolutely does not want. Their interpretation, which I think is correct, is that they have to consolidate power much more so they can force through the adjustments.
Are there historical precedents?
There are only two types of countries that adjusted successfully: democracies and highly centralized autocracies. Decentralized autocracies almost never adjust successfully. What we need is Xi Jinping to centralize power and that is what he has been doing for the last two years.
How about the corruption cases that are brought to court?
Every three weeks some important official has to go to jail. But this is not because they are corrupt – everybody in leading positions in China is corrupt – but because they are on the wrong side of the fighting groups, they are resisting the changes.
If power is taken away from state owned enterprises, what will happen to the redundant employees? Will they get pensions like in the reform-wave of the Nineties?
The question is not whether they get pensions but how these pensions are paid. In the past the pensions were paid by borrowing at extremely low interest rates. Very low interest rates are a hidden tax on savers in the household sector – basically the households paid for the pensions. But now household consumption needs to grow, so they can’t pay for the pensions. The state has to pay. The state has to liquidate assets, privatize companies, sell land. But once again, the power of the elites must be reduced. Every solution is the same: transfer wealth from the elite to the ordinary Chinese. The problem is the political implementation.
But eventually it has to be done. What can go wrong?
Debt. Once you run into debt capacity constraints there is no more growth. Typically this happens to a country when foreigners stop lending. Then a country adjusts brutally and quickly. If you say this is not a problem for China, because all is funded domestically, you are wrong. The USA in 1929 had no external debt, in fact it was lending to Europe. Japan in 1989 was lending money abroad, but the country entered a crisis anyway.
Because bad debt kept growing?
The problem is not whether you borrow from foreigners or at home. The problem is that if bad debt keeps growing, there is less money left for investments – and that is where growth comes from. If all new money is used to roll over old bankruptcies that haven’t been recognized, growth stops.
How much longer does China have?
If you are very bearish, this is the last year, if you are very bullish, eight to ten years. I think three to four years maximum. But you don’t know when China reaches debt capacity limits. Changes have to be made before that limit is reached in order to avoid a collapse. So China has two or three years to adjust. But before they can adjust, President Xi has to consolidate power.
Otherwise the economy will collapse?
Yes, it will stall in an abrupt and disorderly way. It is very simple and a very common sense story. It is good that many people are now afraid. So it is easier to force the adjustments. The faster debt gets under control, the slower the economy will grow, but this is good. We should be cheering if growth rates go down and be worried if they go up.
What makes you feel positive about the Chinese economy?
The current developments do not have to be a disaster. China does not have to grow at a rate of 7% forever. But the adjustment to lower growth has to be orderly. The adjustment is key to the long term growth – and it looks like the Chinese are going in the right direction. However, that does not mean it is going to be easy, it never is.