Exclusively from Michael Pettis’s newsletter:
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…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.
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.
…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.
…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.
…There are however at least three very strong reasons, I think, to argue that as the reforms are implemented, growth rates must drop sharply.
- 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
- 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.
- 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.
