Pettis: Taking stock of China’s transition

Below is an excerpt from Michale Pettis’ latest newsletter, which takes stock of China’s economic rebalancing:

I was a little disappointed, but not terribly surprised, by the PBoC’s announcement two weeks ago that it would cut interest rates. The fact that rates were cut… exemplifies the challenges that Beijing will face in 2015. As China’s economy continues to slow, a lot of sectors, especially among the more heavily indebted, are suffering losses and running into cashflow problems…

I don’t expect either a sustained housing rebound or stable growth at current levels…

In fact lower interest rates are likely to be disinflationary in China, not inflationary… [T]hey reduce consumption demand relative to production.

… [I]n cases where consumption is a relatively small part of total demand… lower interest rates actually reduce consumption by reducing household income (lowering the return on savings), and increase production by lowering financing costs for producers… In cases like China and Japan, the net effect is more likely to increase total production of goods and services by more than it increases total consumption, so that the pressure on prices is disinflationary…

I expect that throughout 2015 we are going to see policy changes that sometimes speed up and other times slow down the pace of rebalancing…

Why is it so hard to implement policies that rebalance an unbalanced economy? Part of the reason of course may simply be that policymakers rely on faulty economic analysis… Even today, while most economists have finally come around to acknowledging that China has a debt problem, it is rare to see in any of their medium-term economic growth projections assumptions that explicitly incorporate debt and the deleveraging process into their models… This makes their models almost useless.

…the fact that Chinese growth regularly surprised on the upside during the phase of rapid growth should imply that it will also surprise on the downside as the economy slows…

Rebalancing creates political resistance because successful growth strategies nearly always create powerful elites that benefit disproportionately from the growth strategies…

Rebalancing the Chinese economy ultimately requires that Beijing choose an optimal balance among three difficult options – rapid credit expansion, higher unemployment, and wealth transfers from the state sector to Chinese households. As long as banks are able to continue funding enough new investment, Beijing can prevent unemployment levels from rising in the short-term by forcing up investment. But because banks cannot redirect lending quickly enough away from non-productive borrowers to productive borrowers, higher investment leads directly to higher debt levels.

If rapidly rising debt causes China to reach its debt capacity limits, it can no longer trade off more investment for less unemployment, in which case any shortfall in consumption must lead to unemployment…

Over the next decade or two China’s imbalances will have been reversed, and the household income share of GDP will be much higher than it is today. But there are many ways this can happen. If Beijing can overcome political opposition to wealth transfers it is possible to maintain high consumption growth rates even as investment growth flattens or turns negative. In that case… Chinese household income and consumption might grow at a vibrant 5-6 percent annually while average GDP growth drops to 3-4 percent…

If on the other hand opposition to reform forces Beijing to rely too long on credit growth, the risk is that China runs into debt capacity constraints, after which GDP growth would plunge, perhaps even becoming negative…

So far President Xi has followed the script for a successful transition fairly closely… But the real test will be his ability implement the reforms that explicitly undermine the power of local governments, SOEs and powerful families, after many years in which they befitted disproportionately from China’s growth.

Leith van Onselen

Comments

  1. Rebalancing creates political resistance because successful growth strategies nearly always create powerful elites that benefit disproportionately from the growth strategies

    That sounds right.

  2. China faces a similar problem to Australia in that the decline in a major capital investment boom will lead to increasing un/underemployment which will hurt demand.

    Either all of the population suffers a bit, or a proportion suffers dramatically as in the US where construction and retail workers were the main losers and there was no “share the work” program.

    When 5 to 10% of the home owners lose their houses as a result of unemployment it also brings on a real estate crash, if one wasn’t already in full swing through gross oversupply during a credit boom.

    Their ability to export their way out of it must be considered doubtful given the pressures on other exporters and manufacturing countries that would cause and the risk of consequent currency wars.

  3. Pettis may turn out to be correct regarding wealth transfer, but will households spend the income growth? I fear China will follow Japan into the same trap. The ingredients are similar.

    Time will tell.