by Michael Pettis, China Financial Markets
Although still vague on the specifics, China’s Third Plenum last November partially clarified the nature of the reforms that Beijing is proposing for China over the coming year. Of course very little was said in any of the related releases about the difficulties, of which the most important are likely to be political, in implementing these reforms, nor did we hear – not unsurprisingly, I think – much about what specific steps Beijing will take to address these difficulties. What has been surprising to me is that many analysts – some of whom, but not all, recognize how difficult implementation is likely to be – expect that the reforms will unleash such a burst of productivity that growth rates in China will be maintained or even raised from the current GDP growth target of 7.5%.
This, I think, is extremely implausible. Much of what I have written in recent months concerns the difficulty Beijing will face in switching from one growth model, in which rapid growth disproportionately benefits the elite at the expense of ordinary households, to its alternative, in which much slower growth will disproportionately benefit ordinary households at the expense of the elite. This remains, in my opinion, a key consideration in evaluating prospects over the next few years, but however successfully the reforms are executed, I am convinced that analysts who predict that we are about to embark on a decade of 7-8 % growth both misunderstand the nature of China’s transformation and ignore the history of previous similar growth miracles.
It is almost impossible – in my opinion – that GDP growth rates over the rest of this decade remain at or close to current levels. I suspect that when growth rates drop, as they must, those who claimed that current growth rates would be maintained will argue that the reason their prediction was wrong was Beijing’s failure to implement the reforms correctly. While this may help save face, it is, in my opinion, profoundly incorrect. On the contrary, I would argue that if China’s GDP continues to grow annually at above 7% in 2014 and 2015, this will be precisely because Beijing did not implement the reforms. Successful execution of the reforms, in other words, is exactly why growth rates will fall sharply.
To explain why, I want to list three of the thoughts I came away with from the general reaction to the Plenum. First, while many analysts hailed the reforms proposed during the Plenum as extraordinarily “bold” and “innovative”, in fact Chinese economists have been debating these very reforms for a long time – even before March 2007, when then-Premier Wen Jiabao famously described China’s economy as “unsteady, unbalanced, uncoordinated and unsustainable.”
Most economists now recognize that in recent years too much of China’s massive investment spending has been wasted on projects with negative real returns – as happened in the late stages for every country that followed a similar growth model. Debt, consequently, is high and is growing much faster than China’s debt-servicing capacity. This is clearly unsustainable. Once China reaches debt capacity constraints, like nearly all of its predecessors did after many years of high growth, the country runs the risk of a sudden and disorderly disruption in growth.
To resolve this problem China must implement reforms that increase investment efficiency. This includes diverting resources from the state sector to small and medium businesses. Beijing must also increase the consumption share of demand, which requires above all an increase in the household share of GDP.
Boiled down to their essentials, the economic reforms proposed during the Third Plenum would do just that – by reforming the currency and interest rate regimes, changing the allocation of credit in the financial system, spurring innovation, reforming land ownership and residency requirements, imposing stronger rule of law, and perhaps even partially distributing state assets to households. There is nothing surprising or unexpected about any of these proposals.
The second thought I came away with from the consensus reaction to the Plenum is, as I have said many times before, that historical precedents suggest that the greatest challenge facing Beijing is not in identifying the right set of reforms but rather in implementing them. The reforms are relatively easy to prescribe, but political opposition to the reforms is likely to be very strong. To see why, we must understand how the alignment between the interests of the economic elite and the needs of the economy will change.
In the early 1980s, after many decades of war and economic mismanagement, China’s capital stock was far below its institutional and social ability to absorb investment productively. China urgently needed much higher levels of investment. Following the experiences of a number of “growth miracle” countries – and employing policies proposed by economist Alexander Gerschenkron fifty years ago – China put into place policies that did just that.
These policies, among the most important of which was the repression of interest rates, all worked in the same way. They diverted resources from the household sector, whose wealth nonetheless grew rapidly as rural migrants flocked to new jobs in the cities, into investment in infrastructure and manufacturing capacity, much of which was directed or controlled by the state and the economic elite.
While this resulted in at least two decades of solid and healthy growth, the state sector and the economic elite benefitted disproportionately from the combination of rapid growth and implicit transfers from the household sector. In fact the GDP share retained by ordinary Chinese households shrank dramatically over the past three decades, while the share retained by the state grew commensurately, of course, and income inequality widened. This has nearly always been the case in the early stages of the investment-led growth model – the state and the elite benefit disproportionately.
Now that soaring debt is forcing China to abandon the model, the relative distribution of economic benefits must be reversed. Ordinary Chinese households must retain a growing share of future economic growth, while the state and the economic elite must, almost by definition, retain a shrinking share. This is ultimately what it means to rebalance the economy and – as happened in other countries that followed this growth model – this is why the reforms are likely to be politically difficult. After thirty years in which the interests of the elite were positively aligned with the interests of the country, the reforms now imply a negative alignment of their interests.
How much growth can we expect?
My third thought, and this is the most important point, is about the pace of post-reform growth. Many economists believe that a successful implementation of reforms must guarantee growth of 7% or more during the rest of this decade, but this probably represents the greatest piece of confusion about China’s adjustment. Here is my Carnegie Endowment colleague, Yukon Huang, with one of the more optimistic predictions:
Despite the vagueness of the communique, the “decision” provided a comprehensive reform programme that, if acted upon, will absorb the energies of this generation of senior leaders and beyond. Ironically, rigorous implementation of these reforms will alter market incentives so that annual gross domestic product growth in the coming years could rise to 8-plus per cent even as the recent Central Economic Work Conference debated whether to lower the official target to 7 per cent to reinforce that quality now matters more than quantity.
Although not many other analysts are predicting growth rates above 8%, certainly there are widespread expectations that if the reforms are implemented growth will remain above 7%. Arthur Kroeber from Dragonomics in a Foreign Policy article expects that the reform program “is likely to be effective in sustaining the nation’s economic growth” while the Financial Times cites one analyst as suggesting that growth will stay in the 7-8% range:
However, data released on Tuesday confirmed that Chinese growth momentum remains robust, with investment slowing but retail sales picking up. The economy is believed to be growing roughly on par with the 7.8 per cent year-on-year pace it notched up in the third quarter.
This has put Lu Ting, an economist with Bank of America Merrill Lynch, in the camp that believes there need not be a trade-off between growth and reforms. “Reforms can also support growth, especially those reforms that make growth more efficient. So I don’t understand why people think reforms have to be negative for growth,” he said.
There are however at least three very strong reasons, I think, to argue that as the reforms are implemented, growth rates must drop sharply.
1. Growth rates underpinned by tremendous credit expansion, which acts to increase demand, are unlikely to be maintained in a period of relative deleveraging, during which demand is reduced.
It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.
But as China deleverages, growth in demand must drop sharply. After all if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.
2. The failure by Chinese banks to recognize misallocated investment must overstate past GDP growth, in the same way that this overstatement must be reversed in the future, either because the bad debt is explicitly recognized, or because it is implicitly written down over the debt repayment period.
If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs – and there have been no significant bankruptcies.
There may be good reasons for this. If a loan has been made to fund a project whose economic value is less than the economic cost of the investment, economists should treat it as a bad loan whose negative present value must be written down. However if the lending bank believes that the government implicitly or explicitly backs the loan, the bank does not need to write it down.
But while the bad loan might not represent a loss to the bank, it does represent a loss to the country, and the amount of that loss should be deducted before the country’s GDP is calculated. If Chinese banks have not correctly written down the bad debt, however, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down – a fairly large number that may amount to as much as 20-30% of GDP.
But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.
The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.
Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.
3. The same mechanisms that forced up China’s growth rates created China’s imbalances, and reversing the latter means also reversing the former.
China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.
If growth has been healthy and sustainable, in other words, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.
Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.
One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject:
Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.
It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.
These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms. When analysts claim that growth rates will not slow if the reforms are implemented, this must be implicitly what they mean.
But this is unlikely to be the case. For the net impact of the reforms on growth to leave China’s GDP growth unchanged, or even to accelerate, the amount of productivity that must be unleashed by the reforms is implausibly, even extraordinarily, high. What is more, the positive impact on productivity must emerge almost immediately. Longer-term productivity improvements – for example those generated by education, land, and hukou reforms, or reforms to the one-child policy, or a speedier and more efficient urbanization process – do not count.
I am so convinced that the implementing of these reforms must result in slower growth – if only because it is impossible to find a single relevant case in history in which the adjustment following a growth miracle did not include an unexpectedly sharp slowdown in growth – that I would propose that we can judge the forceful implementation of the reforms inversely with GDP growth. If China is able to impose an orderly adjustment quickly, its GDP growth rate will slow substantially for several years.
GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.
— I wish my readers a great 2014. This year promises to be an exciting and unsettling one. Stay tuned. This is an abbreviated version of the newsletter that went out nearly four weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.
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