Pettis: 11 reasons China’s debt must be faced


Exclusively from Michael Pettis’ newsletter:

1.   GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%.

2.        In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.

3.        Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down.

4.        There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.

5.        GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained.

6.        My numbers above assume that the overstatement and understatement are symmetrical. In fact the process is not symmetrical because of the possibility of financial distress costs. The total value of overstated GDP during the period when losses are being rolled over is only equal to the total value of the subsequent amortization of those losses if there are no financial distress costs.

7.        …We must also remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.

8.        There are three sectors to whom the cost can be assigned: households, businesses, or the government.

9.    …To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth.

10.    …Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.

11.    Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector.

David Llewellyn-Smith
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    • casewithscience

      I assume your consistent message is sarcastic. The obvious impact of continued stimulus is currency devaluation.

  1. notsofastMEMBER

    “There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time.”

    I thought it was pretty clear. All those hard working diligent savers, who are putting their money in the bank for the future, are going to find that when they go to withdraw that money in many years time will find that it can only purchase a small fraction of what it could have purchased when it was deposited. That is savers putting their money in Chinese Banks are being crushed and will be even more so in the future.

    When this starts to happen I think the CCP will blame the Americans for QE and for thereby failing to repay the American debts to the Chinese people.

    • casewithscience

      Since 2008, Chinese money printing has been in a greater volume than American QE and the Japanese printing put together. If you have a total value rising by 7.5% being represented by “chits” increasing at a volume of 12%, then you inevitably end up with less value per “chit”.

      The moral of the story is that the CNY is “chit”.

    • Charles P

      What do you mean ?

      Even teenagers I met on the Shenzhen metro are aware that they will never get their US treasuries paid in good faith.

      • casewithscience

        Huh – the US has not missed a bond repayment in the 20th and 21st centuries. Other than dumb politics (read Republicans), there is no prospect of missing a bond payment in the near future.

      • notsofastMEMBER

        Good or bad faith we can debate, but the Chinese government will be repaid just the same as every other US Treasury holder.

        No one is forcing the Chinese government to hold US Treasury notes.

      • And what will the treasury bill be worth? I think the Chinese teenagers are right to look on it as “chit” as well.

      • In fact the Australiam money printing does not fall. The $A is “chit” as well….