Pettis: China will slow in the second half (or else)

In his latest newsletter, Michael Pettis notes that a raft of Chinese leaders are making the right noises about reform of the economy but several large barriers remain:

The 2013 NPC and CPPCC Annual Sessions have ended with the formal selection of China’s new leaders. Not surprisingly there were few surprises. My quick take is that the leadership is saying all the right things, but they have been saying these things for quite a while – nearly two years in the case of Li Keqiang, the new premier.

The constraints they face, however, have neither changed nor been addressed. First, any real rebalancing means much slower growth than Beijing seems willing to tolerate. Second, the groups (“vested interests) that have benefited from the old growth model remain very powerful and very reluctant to allow any erosion of the benefits they have accrued.

Two weeks ago, in his last formal State of the Union speech as China’s premier, Wen Jiabao announced that the 2013 growth target for China’s economy was 7.5 percent.

We may have gotten a taste of what this means when we consider what happened in 2012. Last year China’s official growth rate was 7.8%, above the 7.5% target but the lowest number in many years and far lower than the more than 10% growth rates China had generated for the past two decades. Much lower growth in 2012 suggested that rebalancing the Chinese economy, a goal that has been actively proclaimed since at least 2005 but which had never happened until 2012, was proving to be more difficult than expected.

But even with the lower growth numbers throughout the year economists were puzzled by evidence that the economy was in fact growing more slowly than the official numbers suggested. Energy consumption in China, for example, usually grows more quickly than GDP, but surprisingly, in 2012 energy usage grew by only 5.5%, well below the official growth rate of 7.8%. Other indicators also indicated that growth may have been lower than the official numbers suggested.

While some of the sell-side economists still insist that China’s growth remained high and healthy enough, in fact among independent economists who specialize in the Chinese economy, both among Chinese and foreign economists there has been growing skepticism. A consensus is developing that China grew by less that 7.8% in 2012. For example Stephen Green at Standard Chartered, one of my favorites of the sell-side economists, refigured his numbers and guesses that instead of 9.3% for 2011 and 7.8% for 2012 (the official numbers), actual growth might have been 7.2% for 2011 and 5.5% for 2012. Other economists are suggesting even lower numbers, closer to zero.

In a system in which almost all the growth is driven by increases in investment, and in which an increasing share of investment is being wasted on factories, bridges, real estate, airports, and other projects that have little or no economic value, rising debt can be a very worrying problem since the ability to service that debt is rising much more slowly than the debt. This is why Beijing has been so eager to slow the growth in debt.

But as they did so in the first half of 2011, growth seems to have dropped very sharply. By the middle of 2012 it seemed that growth had slowed so quickly, even if it did not fully show up in the official numbers, that Beijing may have gotten nervous and begun to allow credit to grow rapidly once again.

The result was a surge of growth in the second half of the year, a surge that has continued into 2013. But this growth came at a huge cost. Total debt in the system, especially in the unregulated parts of the financial system, has grown at a record-breaking pace.

…This is what Premier Wen is referring to, I think, when he warns that achieving 7.5% growth in 2013 is not going to be easy. Last year was tough, and may have actually been worse than the numbers suggests, but more importantly any growth there was seems to have been driven by near exponential increases in debt in the second half of the year. If Beijing wants growth without soaring debt, what exactly are they going to do?

…I have said often enough that we will be able to judge how resolute Beijing is and how capable of overcoming vested interests by how quickly credit growth is constrained and, with it, GPD growth. I expect to see high GDP growth (close to 8%) in the first half of the year but, if Beijing is able to move quickly, I expect growth to slow significantly in the second half.

If GDP growth does not slow, I will be worried about how long it takes the new leadership to get their arms around the problem that they clearly recognize (although perhaps still underestimate).