“What the world desperately needs is demand,” asserted Michael Pettis, professor of finance at the Guanghua School of Management at Peking University, in the closing session at last week’s 65th CFA Institute Annual Conference in Chicago.
With the United States likely to increase its savings rate and the euro in turmoil, who will be buying goods in the global marketplace? China has net negative demand, he noted, and will not be the solution to the world’s demand problem. China’s growth has been fueled by government investment, and even in the best-case scenario, he said, “the growth rate in investment is going to collapse.”
The Growth Miracle Story Is Not New
Extrapolating recent GDP growth rates of the United States versus China quickly leads to projections of when China will be the world’s largest economy, and many say it will be soon. But Pettis warned that the engine of growth in China is a familiar model simply taken to a new extreme. He compared China today to:
- Germany in the 1930s
- The Soviet Union in the early 1960s
- Brazil in the 1960s and 1970s
- Japan in the 1980s
At various points in prior decades there was a strong consensus that the Soviet Union and Japan would overtake the United States economy, yet all purported challengers suffered a debt crisis or a “lost decade” (or two), he noted.
In the typical economic growth cycle, Pettis explained, policymakers start by powering the economy with investment by the state to build manufacturing capacity and infrastructure. However, the gap between what the country has and what it needs closes quickly, and then it is difficult to recognize what isn’t needed. This is where China finds itself today: it has run out of obvious investments and has begun to misallocate capital. There are strong political incentives to continue to invest and increase debt, since the benefits are concentrated and the costs are spread across people and time. Quite simply, countries become “addicted to high growth and low unemployment,” he said. Furthermore, in such an environment, pricing signals like the cost of capital are distorted, so it is difficult to know if investments would produce returns once the subsidies are removed.
Evolution of Debt Concerns in China
Pettis was asked by the audience if his public skepticism about China’s prospects had provoked any negative response from the government in Beijing, and he responded that there is a healthy debate about these topics and, in fact, he is not as pessimistic as many others. Significantly, he noted that both the current and next Chinese premiers are very nervous about the structure of the economy and want to rebalance it, although this will require consensus in the government.
Concerns about growing debt levels were sparked, he said, in 2009 by Victor Shih at Northwestern University, who estimated China’s debt at the local and municipal levels and called them “classic Ponzi schemes.” This led the Chinese government to focus in 2010 on debt at the local level and to consolidate it to the central balance sheet. In 2011, debt grew in the informal banking sector. Now, in 2012, the focus has shifted to debt in state-owned enterprises.
When asked if a debt crisis is looming, Pettis noted that it is difficult to say when China will reach its debt capacity, especially since we don’t know exactly how much debt is in China, but his “intuitive guess” was that this would happen in about four to five years and that a crisis will follow.
The Need to Rebalance GDP: Increase Consumption and Reduce Investment
According to Pettis, in most Asian growth countries consumption is 50–55% of GDP, and it is at 70% in the United States. China’s consumption as a percentage of GDP has been trending downward (see table below).
Consumption as a Percentage of China’s GDP
The level in 2000 was already similar to what is typically found in countries in crisis, and the 2010 level was unprecedented for a large economy. Pettis thinks that China should aim to get to 50% in the next 10 years. This will require household consumption to outpace GDP growth by 4% each year.
As consensus views for China’s annual growth have decreased to 5–7%, there remains pessimism about rebalancing. Pettis observed that the skeptics in previous cases (e.g., Japan, Brazil, as above) were never skeptical enough, and policymakers usually underestimate the difficulty of transition. Still, he said, “countries always rebalance — the good way or the bad way — but they always do.” The “good” way is for consumption to surge on its own. The “bad” way is that a constant consumption level means GDP must decline. He expects this to be the more likely scenario and that a well-executed transition to a balanced economy will mean a sustained 3% growth rate for China.
Why won’t the good way work? Pettis said that you can’t ask the household sector to do two things at the same time: clean up the banking sector and increase consumption. He explained that China didn’t grow quickly despite low consumption but because of it. China has been systematically transferring income from households to investment via:
- an undervalued currency, equivalent to a consumption tax on imports;
- low-wage growth versus productivity, a gap that has widened greatly in the last decade (the difference between these is like a tax on consumers); and
- financial repression (i.e., extremely low interest rates), which taxes savers and subsidizes borrowers.
With household income continuing to rise 7–8% annually, this has been palatable and has not sparked social unrest. Pettis does not expect this to be an issue but notes it will be a challenge for the government to reverse these policies. He does not believe the economic system in China can support a floating currency but thinks China’s focus should instead be on raising interest rates.
As the Chinese saying goes, “A journey of a thousand miles begins with a single step.” There is a path to transition for China, and policymakers may even possess the right road map, but investors would be wise to recognize that it will be a long journey, paved with lower growth and bumps along the way.