Pettis: Debt will keep slowing China

Exclusively from Michael Pettis’ newsletter:

There is an implicit divide among economists covering China, for example, about how debt affects growth expectations. For the sake of convenience, I will refer to economists who systematically ignore or deemphasize balance sheet constraints in their China growth forecasts as the “bulls”, and those who always emphasize these constraints as the “bears”.

This pairing is not random. The former traditionally have based their forecasts on an equilibrium level of growth usually close to then-current growth rates, which they may have adjusted for expected declines in productivity growth. Because they did not recognize the systemic role of debt, their growth forecasts were always very high and they usually assumed long-term GDP growth rates that were only a little lower than the growth rates at the time of their forecasts – from 9-10% four and five years ago to 6-7% today.

…The latter group, on the other hand, insisted that China’s GDP growth was systemically over-reliant on excess credit creation. Growth could not possibly exceed some much lower number, in other words, without an unsustainable increase in debt. Because they assumed that the debt burden would rise inexorably until it forced widespread recognition of the need to rebalance growth, they also all predicted sharp declines in growth once China began to rebalance its economy. Traditionally, not surprisingly, the media classified them as the bears.

This classification very mistakenly implied that what separated the bulls and the bears was primarily their relative evaluation of the quality of Beijing’s policymaking abilities, or their “faith” in the entrepreneurial abilities of the Chinese people, and this is certainly how most of the bulls saw it. But what really separated them were their two radically different approaches to balance sheets. The bulls did not consider debt to be a systemic problem in China, or that liabilities can sharply constrain growth, and they believed that under the right conditions and with the right policies China’s GDP could grow at some rate quickly without an even faster rise in debt.

The bears were convinced of the opposite. No mattered what one thought of Chinese policymakers or entrepreneurial skills, the bears argued, China’s growth miracle would eventually face the same systemic constraints shared by every growth miracle in modern history. Even if the right reforms were implemented, until debt was written down significantly the GDP growth rate consistent with no increase in the debt burden (i.e. debt did not grow faster than debt-servicing capacity) is much lower than current growth rates – some even believe it is negative (I think the sustainable growth rate is no higher than 3-4%).

Beginning in 2010-11 debt perceptions began to change even among the least sophisticated of the bulls, and they have sharply reduced their long-term growth projections from around 9-10% to about 6-8% today, but there continues to be a major difference in how they think debt will affect future growth. The bulls still seem for the most part to think of China’s debt surge as an unexpected random shock, dating from 2009, that has forced them to reduce their equilibrium levels of growth, and they do not see continued deceleration in GDP growth as an inevitable consequence of China’s current balance sheet vulnerabilities.

…For the bears, however, lower growth is a certainty, and not an indication of failed reforms. The implementation of the reforms matters, but it matters in the long term mainly because if successful, they will change the country’s reliance on debt, and some of the reforms may even address the debt burden directly.

Put differently, if Beijing is able to engineer sufficient growth deceleration before it reaches its debt capacity constraints, there will not be a collapse. Growth in that case will slow in a non-disruptive way, probably to average 3-4% during Presidents Xi’s administration.

…There are only two conditions under which I expect growth under President XI could come in higher than my 3-4% best-case scenario, and both of them are debt-related. First, if Beijing implements reforms that directly transfer significantly greater amounts of wealth from the state sector to the household sector than I expect, China will benefit from a major source of demand that is not balance-sheet constrained. The amount of the transfers needed, however, make this condition politically implausible, although not impossible. Second, if China’s debt capacity is much greater than I think it is, China will be able to maintain higher levels of growth than I expect in 2013-23, but the ultimate adjustment period will be much longer and much more painful overall.

Houses and Holes


  1. China’s gini coefficient indicates that they have already reached the socially acceptable limits of debt growth.