Michael Pettis: The Future of China

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Is China destined to emerge as the dominant superpower that will drive the 21st century to new heights of prosperity? Or instead, might it collapse spectacularly under the weight of its own overinvestment, dragging the global economy down with it in history's largest 'hard landing'?

Few people can see the big picture in China more clearly than Michael Pettis, Beijing-based economic theorist and Professor of Finance at Peking University. Michael sees China's future prosperity tied to its ability to successfully address:

  • Overinvestment - Its political and economic systems are now dependent on elevated levels of investment spending. Moreover, a decreasing amount of those investment dollars are able to generate net-positive financial or social returns.
  • Currency undervaluation - Money printing and excessive foreign reserves are creating imbalances that will be very hard for the central authorities to unwind without painful repercussions.
  • Low wages (and wage growth) - Chinese household income has not grown as fast as GDP, creating big wealth disparities in favor of the elite.
  • Over-indebtedness & low interest rates - Much of China's new borrowing is used to pay interest on current debt. Any material rise in interest rates is sure to create a cascade of insolvencies.
  • Asset bubbles - Much of Chinese wealth is tied up in assets that are exhibiting dangerous levels of price inflation, real estate being a prime example. (Property prices in Beijing and Shanghai are higher than Manhattan, which is astounding considering the much lower average Chinese income)

Pettis, to put it mildly, is skeptical that China will be able to resolve these issues gracefully. In fact, he feels we've seen this movie before with predictable outcome. Just perhaps not on so grand a scale:

In order to understand the story of China, it is important to start with the recognition that contrary to much of what we have been hearing in the last few years, there is nothing particularly unique or extraordinary about what is happening within the economy. Certainly China has grown at a tremendous rate in the last 30 years, but lots of countries have had investment-growth miracles. Maybe not as long as China and maybe not as profound as China’s investment, but there is quite a lot that we can learn about what is happening in China from looking at previous experiences.

It turns out that the Chinese growth story is one we have seen many times before, and it typically starts out very well. The story begins with the period in which the country, in this case China, has come to be systematically invested. Twenty years ago, thirty years ago, China had no roads, no airports, no manufacturing capacity. Its economy had been pretty much decimated between the period of the anti-Japanese war and then the first two or three decades of Communist leadership. So what China really needed was a significant increase in investment to raise its productivity level, and in fact, that is what happened. We saw investments grow very rapidly during this period. And with all of that increased investment, investment in manufacturing capacity and investment in infrastructure, etc., with all of that investment, we saw very strong, very robust growth take place in the Chinese economy.

But the problem that this model has always faced is that after many years of investment, two things happen: First, the political and economic system gets built around this constantly increasing level of investments, and second, we move from a period in which it is fairly easy to identify economically viable projects – basically, China did not have anything and could use a little bit of everything – to a period in which investment levels are still high. China has the highest investment rate ever recorded, and the highest growth rate of investment probably ever recorded, that we start to run out of economically viable projects. But because the system was so geared towards continuous increases in investment, we keep on investing, and when that happens, investments become allocated into projects that do not generate sufficient real returns on a social basis.

And so, since these investments are funded by debt, one of the consequences is that automatically you find debt growing faster than debt servicing capacity, which, of course, is unsustainable. This, by the way, has happened to every single country that has followed this growth model, so it should not be such a shock to us, but it is happening to China, too. The problem is, we have been doing this for so long, I think in retrospect we will probably look back and see China as the most extravagant period of overinvestment ever seen, exceeding even Japan in the 1980s – that is, if the result has been that that debt models in China are extremely high.

So all of this talk about rebalancing the Chinese economy is basically a recognition of this fact. We can no longer count on investment to drive growth, because investment is being mis-allocated, but unfortunately, the economy is so dependent on investment that if you bring investment levels down – which you have to do if you want to address the debt problem – then you also bring growth down very significantly. We just started to see that process. Investment has not come down, it has not even slowed that dramatically; it has slowed a little bit. Growth rates dropped from roughly 10%, which is where they were before 2008, 2009, to around 7% today, and I suspect they are going to drop an awful lot more before this process stops.

Click the play button below to listen to Chris' interview with Michael Pettis (39m:29s):

This is a companion discussion topic for the original entry at https://peakprosperity.com/michael-pettis-the-future-of-china/

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so, everything, everywhere, is a complete and total mess. Dah!!!
All of this running smack dab into a work force that will be more and more manned by Robots and an energy problem. 

Dr.Pettis, thank you so much as I have seen as many of your seminars as is humanly possible, have read all of your opinions at your blog and have read your book "The Great Rebalancing". It was my pleasure Sir to have heard you here today. Thank you.

Incidentally, I could have mimed every word and had most every question asked by Chris pegged and I feel good about that. Moving forward folks, always forward.

I would have liked to know what debt the banks still held on their balance sheet from the crisis in the late 1990's and how their business model with regards to a lack of a scheduled maintenence plan for currently occupied and currently emptied buildings would reflect in the GDP numbers going forward. As a builder and maintenence contractor in my past career I can assure you this will be one helliva drag on the owners of these properties and the Chinese have no clue. Talk about malinvestments adding to the malinvestments. Chanos presented at the wine country, was rightfully amazed at this and so am I.

My grandson pitches tomorrow for the first time, a 5 tool kid who is as amazing a young man as life can provide. He will be on a strict 35 pitch count or his grandpa will rip his grandsons coaches ear off, my son, his dad. I just might umpire the game and kick my grandson out of the game if my son doesn't adhere to my pitch counter clicker. Additionally, Cabrera hits a walk off and will be talked about with the greats, and is the modern day Babe Ruth and is a once in a century ball player that all of baseball should rejoice. WOW!, what he is doing is not suppose to be done. Good night Folks.

BOB

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Dear Chris,
Thanks for the very interesting interview of Michael Pettis.  It challenged some of the things that I believe(d) about Chinese economy, especially regarding China's growth as it relates to commodities and its possibilities for becoming a new trade and reserve currency.  If you or anyone out there cares to answer my questions, I would be grateful.

Most of what I know about China is based on just two books, When China Rules the World by Martin Jacques (first edition - 2009) and Red Alert by Stephen Leeb (2012).  Both books focus on China's incredible economic growth and rapidly expanding demand for everything from base metals to oil to cars and other consumer goods.  If I remember correctly, Jacques' book contains some nice comparisons of China's transition to a market economy of sorts with Russia's transition, and basically says that the Chinese model holds several advantages over the Russian model, including a reliance on manufacturing as opposed to raw material exports, no default on foreign debt in China's case, unlike Russia in 1998, and more gradual privatization as opposed to Russia's rapid and very rough-and-tumble privatization in the early 90's.

I am guessing that a lot of us here at PP are familiar with Leeb's narrative regarding China, namely that the country will still experience a lot of rapid growth, will consume a massive amount of commodities, and is going to need a lot of energy both non-renewable and renewable.  China is building a lot of solar power, and therefore is going to buy a lot of silver.  If I remember correctly, Leeb also claims that China is positioning itself to (partially) back its currency with gold and strengthen its currency to compete as an international trade and reserve currency that will allow China to have a very strong hand in the purchase of imported raw materials.

So, my questions are as follows:

  1.  What indicators might we follow to decide if China is vying to position a strengthened Yuan as a strong and convertible trade currency if not a reserve currency per se?  Some criteria for evaluating Pettis' claims in the above interview that China is quite far from reserve currency status, and Leeb's claims, would be helpful.

  2.  My second question is, how and to what extent should Pettis’ analysis change my belief that China is likely to consume commodities at impressive rates, thereby exerting upward pressure on commodity prices? 

Pettis says that China has experienced outsized growth in the past decade or so, fueled by too much state-sponsored easy credit secured at the expense of low interest payments on high household savings rates as well as low wages and a weak currency that keeps those households from consuming very much.  Later he says that Chinese GDP growth of over 4-5% is unsustainable. 

On one hand, 4-5% growth in a country of 1.36 billion is still likely to entail a lot of need for commodities.  Why should a fall in growth from 7-10% to 4-5% change the basic story, which is the rise of a massive lower middle class (even if it’s only a portion of China’s total population), that will not only consume a lot as households, but will also be vying to start new businesses that will also consume?

On the other hand, prices are set on the margins, and that means that a major fall in China’s growth will reduce the marginal demand for oil, copper, soybeans, etc, which will tend to exert downward pressure on commodity prices.

So, again, what indicators should we watch to judge the extent to which China is indeed in a transition to slower growth, as Pettis claims, and how this is affecting commodity prices?

I did end up re-reading Charles Hughes Smith’s article on commodity prices (part II here) and it re-emphasizes the basic fact that conventional crude oil supplies are already falling, which means that simply remaining at current levels of oil consumption already entail a higher future price of oil, and by extension, other commodities.  The very simple curve of an oil peak and decline already contains so much explanatory power for what has happened since 2006 and it seems worth remembering that even if China grows more slowly than expected.  In fact, it would be interesting to research to what extent China’s slowdown in growth driven primarily by rising energy prices, as opposed to reasons that Pettis talks about, especially the diminishing marginal return of capital expenditure projects. 

And, if Charles Hughes Smith is correct, there will still be a trend towards the financialization of commodities in order to compensate for the low yields and higher risks for traditional financial instruments such as sovereign and corporate bonds.

So, I am still betting that commodities will rise in price, as opposed to fall, all else equal, although it seems safe to assume there will be at least a brief dive in commodity prices this fall if we do indeed see a general market crash.

Cheers, Hugh

 

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Michael Pettis said:

So people say it is not actively traded, but it is growing very, very quickly, and the government wants it to grow very quickly, so it must – well, not necessarily. It is very hard to have an internationally traded currency. And by the way, it is not a good thing. Actually, in my latest book, I refer to the so-called “exorbitant privilege” of the dollar as actually an exorbitant burden. Because if your currency is the dominant reserve currency, it means that any time a country wants to turbo-charge growth, it actually accumulates your currency, thus running a current account surplus against the U.S. current account deficit. A reserve currency needs to be able to accept those kinds of pressures, and I do not think China would ever be willing to accept that.

Hmmmm....I don't fully understand this quote, so I will have to think on it some.  But, it still seems to me that when the US buys Saudi or Nigerian oil for US dollars, many of which then get converted into treasury bonds, that we are running a bit of a scam, or at the very least, we are consuming a very valuable and limited resource for an increasingly devaluing dollar.  So, in terms of American consumers and American government today, this exchange seems to be giving us a very special privilege, especially since there is some corelation between OPEC members who attempted to stop trading oil in dollars and intervention, either in the form of military intervention(Iraq) or economic sanctions (Iran).  

But even if one doesn't believe that there was a connection between how oil was traded by those two major oil producers and U.S. foreign policy towards them, it still seems that the US gets a lot of consumption today for future promises in the form of dollars and T-bills.

I think Pettis is saying that being a reserve currency provider has a disadvantage in terms of current and capital accounts, which has the long term trend of weaking one's export industries, so in that sense I agree.  If anyone can shed any more light on Pettis' point, I'd be grateful.

Cheers, Hugh

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Pettis gives a clear explanation of his point on the Economic front (and HughK chimes in with a nice counterpoint).  Also, Hugh brings up the second E(nergy), specifically the oil crunch.  (Thanks to both Pettis and Hugh.)
I've also read at various times about China's problems with the third E(nvironment), in particular the increasing urgency of the need to address air pollution.  I've also read that China has a water problem, which could affect many parts of the economy.

Now what I'd like to see is someone pull these threads together.  I seriously doubt that their effects on the Chinese economy can be treated as though they were independent.  (Example: growth at 4-5%/year entails a commensurate growth in energy consumption.  Can the world energy producers underwrite a doubling of China's consumption in 14-18 years?  And where will a doubling of available water come from?)

Of course, as mentioned above, what happens in China is more than academic for the rest of the world, so I think this integration of aspects is quite important.

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Big fan of the interview.  Great questions and answers.  He sure makes things understandable.  I have a much clearer idea of what that Chinese reserve account really is now - basically, money taken from the Chinese people through inflation, lower than normal interest rates, and higher than normal import prices.  Effectively, its a record of the approximate losses in the standard of living of the individual Chinese due to government action.
It was especially interesting when he talked about how historically this sort of setup routinely ends in an  asset bubble.  It is a good lesson that distortions of economic truth usually end badly.

When things normalize, which they always seem to end up doing at some point, some chunk of that capacity built by China will go idle.  When there is a depression, importing countries have a bad time, but the producing countries really get hosed - during the 1930s it was the US, this time - perhaps China.

And he also explained how such an imbalanced situation can enrich the elites, and how that situation once in place makes it very difficult to implement changes.

Both of our countries have problems, just in different forms.  Our elites are enriched by our debt - and theirs are enriched by artificially low interest rates.

I did find his (likely) unconscious use of the pronoun "we" pretty interesting when he was referring to China.  At this point he identifies himself with China pretty closely.

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http://www.winecountryconference.com/2013-speaker-presentations/
All speakers were just outstanding as well as our community member/leader, Chris.

Bob

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From ASPO-USA's Peak Oil Review for 8/19/13:


The country has had a bout of bad weather this summer with considerable flooding and temperatures in many cities reaching new highs. Beijing has had to step of wheat imports to offset losses caused by the bad weather. The government once again reiterated its intention to deal with pollution seriously by established a centrally administered effort which will document pollution-control goals, establish responsibilities of local governments, and evaluate their progress.
The “crazy-bad” air pollution seen last winter has already caused a drop in foreign visitors including businessmen. It is becoming more difficult to find foreign executives willing to bring their families to live in a near-lethal atmosphere. Given the size of China’s pollution problem, any serious attempts to clean u p the air have got to be a drag on economic growth.

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…Gordon Chang is no slouch either. Everywhere a powder keg, a lit fuse and when she blows is fascinating to me as no one knows. What is incredible is that some really fine minds are betting this market and are long! They must think they are smart enough to get out before everyone heads for the exits. They must. Greed is an amazing aphrodisiac.
http://www.worldaffairsjournal.org/blog/gordon-g-chang/china%E2%80%99s-incredible-shrinking-economy