How to be a China Bull

I recently “debated” twice with senior Chinese officials on the future prospects for China.  In both cases they made the argument that Chinese growth rates were going to rise in the next few years and that the current deep pessimism is unwarranted. I argued, of course, that growth would slow even more.

Neither of the debates, I thought, was wholly satisfying. It seems to me that while a number of officials – at least among those with limited economic backgrounds – acknowledge that perceptions of China’s economic prospects have changed dramatically in the past few years, they don’t always understand why. There seems to be a worried resistance to the idea that we may have reached a major and difficult transition. The unwillingness to acknowledge the difficulty of the transition, however, can only make the transition all the more difficult.

In both of the “debates”, and in conversations I have had with others, my “opponents” (although that is too strong a word since there were many areas of agreement) largely constrained themselves to three arguments, which are the same three very unsatisfying arguments that we have heard many times before. First, they presented historical data showing rapid Chinese growth rates in the past three decades and proposed past growth rates as evidence of rapid Chinese growth rates in the next two decades. I probably don’t need to explain why this is a very weak argument.

Second, they asserted (many times) that since past predictions of failure have all turned out to be wrong, future predictions must also be wrong. If this were true it would, of course, be irrelevant, in the same way that people who predicted in 2002 that the Spanish real estate market was out of control might have been early but they most certainly weren’t wrong. Rudiger Dornbush once said: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”

But this argument, that past predictions have always been wrong, isn’t true. There have been predictions of failure in the past 20 years that were in fact correct – for example the claim in the late 1990s, made first, I believe by Nick Lardy, that China was going to have a banking crisis. The fact that China didn’t “fail”, however, doesn’t mean that Lardy was wrong. China did in fact have a banking crisis, but the growth impact was more than offset by a surge in lending which simply set the stage for the next banking mess.

It is as if you saw a middle-aged man in terrible physical shape running a marathon, and you predicted that after five or six miles he would be forced to quit. If however he took out a syringe and shot himself up with crystal meth, he would be able to continue running a few more miles, but this doesn’t mean that your analysis and prediction were wrong. It means that in a few more miles he will be worse off than ever (or will have to take an even bigger dose of crystal meth).

And third, they produced a number of what seem to me largely circular arguments – for example the claim that urbanization leads to growth and growth to urbanization, and so the process must continue, or the claim that since productivity has soared, past investments in the aggregate have been justified, even though the data “proving” the increase in productivity implicitly assumes that past investments have been economically justified. Except for reports of capital fleeing China, one could easily get the impression that even senior Chinese non-economists really don’t understand why the likes of Wen Jiabao, Li Keqiang, and now Xi Jinping seem so worried.

Can a prediction be based on a prediction?

For an example of this kind of argument, by another seemingly plugged-in person, see this article in Monday’s South China Morning Post arguing that brighter days are ahead for China’s economy:

I can’t predict when the economy will rebound, but perhaps it is time for analysts to look at the longer term. Where will China stand in 20 years?

First, let’s examine the prediction that its gross domestic product will become the largest in the world within a decade, and its economy will continue to improve over the next two decades. The Economist expects Chinese GDP to surpass America’s by 2018, and even if China’s growth rate were to drop to 5 per cent, this transition would only be delayed until 2021. Therefore, there is little need to worry about current GDP growth falling to 8 per cent. Other forecasts of when the transition will happen include 2016 (the International Monetary Fund) and 2020 (the Chinese Academy of Social Sciences). 

…Second, the renminbi is forecast to become freely convertible within 10 years and possibly will be competing with the US dollar in two decades. In recent discussions, it was thought this first step could be realised in five years. I believe it will probably happen by 2020, or when Chinese GDP becomes the largest in the world. 

..Third, it is said that Hong Kong is likely to exceed New York as a global financial centre within 20 years. As China’s economy continues to grow and develop, the realisation of the first two predictions will provide a great boost for Hong Kong, and it is expected to gradually become the dominant global financial centre. 

…Fourth, some predict that Chinese enterprises will make up more than half of the Fortune Global 500 companies in two decades, and China will be a global manufacturing power. This year, there are 73 Chinese companies (79 if Taiwanese companies are included) on the list, a significant increase from only 11 a decade ago. 

…Fifth, China is expected to make significant progress in the field of science, technology and education, and the University of Hong Kong is likely to be ranked among the top 10 in the world within two decades. According to a study by the science and technology think tank Battelle, China currently accounts for about 15 per cent of the total share of global research and development spending, and it will surpass the US spending within a decade. 

…Thus, there is every reason to be optimistic about China’s economic prospects over the next two decades.

Notice that the reasons for saying that the Chinese economy will be much stronger than many people currently expect consist largely of citing a series of earlier predictions. This doesn’t seem like a very robust argument, and although I have only excerpted the article, I think anyone who reads the full article will agree that I did not leave out anything more substantial.

I don’t mean to pick on the author, a prominent former consultant and currently editor of China’s Economy & Policy, especially since it is a short OpEd piece, in which it is always hard to make substantial arguments, but in fact I hear this kind of reasoning a lot. The “proof”, the argument goes, that China will grow very rapidly in the next decade is that many experts have predicted that China will grow very rapidly in the next decade.

Unfortunately expert predictions of this sort are notoriously unreliable, and we seem to be especially bad at predicting turning points. This makes earlier predictions useless in a debate about whether or not we are at a turning point. I will discuss this more in the next entry on my blog, but for now there has to be a stronger argument for it to be credible.

I am not saying of course that there is no credible argument for the bull case. In order to argue that we will not see a sharp slowdown in Chinese growth, however, I would propose that it is not enough to claim that some expert or the other has predicted that Chinese growth will not slow down. Nor can we argue (which is much the same thing, I suspect) that China has grown rapidly in the past so it must grow rapidly in the future. And finally, and most foolishly, we cannot assert, as I have heard many times, that Beijing leaders cannot tolerate growth below 8%, so of course growth will not drop below 8%.

How to sustain the bull argument

To counter the current level of pessimism with the bull case it seems to me that we must answer specifically three questions. The first question, of course, has to do with debt. How much debt is there in China, in other words, whose debt servicing costs (adjusted upwards to eliminate interest rate and other subsidies) exceed the economic value creation of the projects funded by that debt.

Just as importantly, we need to show which sector of the economy will be forced to pay for the difference. Remember that excess debt doesn’t pay for itself, and if you cannot identify who is paying, then you haven’t resolved the problem. Many people, for example, argue that bad debt isn’t a problem for the same reason that China “grew out” of its debt crisis of the late 1990s. This is idiotic. China did not grow out of the debt. It merely forced the cost of the crisis onto the household sector through repressed interest rates and a wide spread between the deposit and lending rates.

This solved the banking crisis, but at the expense of the household sector and so directly caused China’s already very low household consumption rate to collapse. The important implication is that bad debt this time around cannot be resolved in the same way if we expect consumption to power economic growth, rather than lag it as it did during the period in which the banking crisis was resolved.

And remember that official government debt levels are not what matter. We must include contingent liabilities, we must estimate hidden and informal banking debt, and we must consider the further balance sheet consequences of an economic slowdown.

The first question, on debt, is of course closely related to the second important question, which has to with overinvestment. Are there significant areas in which Beijing can and will invest so that the real increase in economic value creation exceeds the unsubsidized cost of capital?

Even this question is a little more complicated than simply looking for good investment opportunities in China and then assuming that the bulk of future investments will go there. There are of course many areas in which the value of investment is likely to be positive in the very long term, such as primary education and social housing, but it is important to remember that these don’t pay off their investments for at least a generation or so, in which case they do not help address the current imbalances.

On the contrary, they make them worse for many years before they start reducing debt and rebalancing the household sector. The only kind of investment growth that can help China address its debt overhang is investment in projects in which the increase in productivity in the next five to ten years exceeds the unsubsidized cost of the investment.

This is a very simple but powerful condition. Any debt-funded investment that does not satisfy this condition must make the debt problem worse. The bull case must identify trillions of dollars of such potential investment and then show that in spite of constraints that led in the past to uneconomic investment, these “good” investments are likely to be made on a substantial scale.

The third question is about future sources of growth. Since it is now widely accepted that investment growth must slow sharply (unless we can find – and execute in spite of political constraints – many trillions of dollars of these new “good” investments) it is obvious that only a surge in consumption growth can replace investment.

So the question for the bulls is: how specifically will China cause consumption to surge? Since at least 2005 Beijing has tried to force up the growth rate of consumption and it has not been able to do so. More worryingly, there is some evidence that the growth rate of consumption may be dropping.

But – and this is just arithmetic unless we assume explosive growth in the external sector – if investment growth drops, consumption growth must rise by a much larger number (because consumption is much lower than investment) to maintain the same level of growth. If you cannot specify the mechanism that will cause consumption to grow (and please don’t propose an improvement in the social safety net), unless you deny that China must reduce investment growth you have no choice but to accept that GDP growth will slow sharply.

Any China bull that does address these three questions is missing the point. I am of course not suggesting that there is no answer to these questions. I’ve already written extensively on steps China can take – economically efficient but politically difficult – to address both debt and consumption growth. Any bullish forecast, however, that cannot come up with answers to these three questions is as useful as forecasts in 1989 and 1990 that Japan would get over its own domestic imbalances and continue growing by 7% annually for the next two decades – because it had always grown quickly in the past.

As an aside one of the predictions cited in the SCMP article above to “prove” future rapid Chinese growth is that “The Economist expects Chinese GDP to surpass America’s by 2018.” Regular readers know that I have a bet with The Economist on just this subject.

Reclassifying investment

The Economist has always tended to be very much in the bullish camp on Chinese economic prospects. In last week’s issue, for example, they have a new article on China – positing whether China is more Keynesian or more Hayeckian (I think it is neither). The magazine is, I think, increasingly recognizing how deep China’s adjustment problem is, but I think they are still a little too sympathetic to residual bullish arguments:

Moreover, investment that adds little to a society’s stock of productive assets is not necessarily malinvestment. Michael Buchanan and Yin Zhang of Goldman Sachs say that some Chinese investment is best seen as “quasi-consumption”. In this category they place things like earthquake-proof schools and more comfortable metro lines. Instead of adding to the economy’s productive capacity, these assets provide a flow of services (such as reassurance to parents and relaxed travel) directly to consumers. In this respect they are more akin to consumer durables, like washing machines or cars, than to iron-ore mines or steel plants.

As a rough gauge of the size of quasi-consumption, the Goldman economists add up China’s investment in house building and “social infrastructure”, such as utilities, transport, water conservation, education and health care. Reclassifying this spending as consumption would increase China’s household consumption to 53% of GDP last year, compared with only 35% in the official statistics (see right-hand chart).

Hayek thought that badly conceived investment would only result in a worse bust later. This belief is shared by many bearish commentators on China’s economy. But China’s high investment is backed by even higher saving. As a consequence, China does not need its investment to generate high returns in order to pay back external creditors. China has, in effect, already set aside the resources that will be lost if its investments turn sour.

To take the first two paragraphs, the debate about what should or should not be qualified as consumption gets a little wobbly at times and almost always misses the point. I haven’t read the Goldman Sachs piece, and I know Michael Buchanan to be a very smart guy (and a former colleague at Bear Stearns), but there are at least three problems with the argument as it is presented above.

First, it is a little hard to see the point of reclassifying investment outlays as consumption simply because they ultimately serve households, unless it is merely to try to make consumption number numbers look better than they are. Ultimately the point of all investment is to increase household consumption, and yet there is nonetheless a distinction between consumption and investment that is useful and valid in understanding the mechanics of growth.

Adjusting China’s numbers may make consumption seem higher, but in that case we should adjust every country’s in the same way and we would see the same result: China would still have the most unbalanced economy in the world, and it would still urgently need to raise household consumption. After all in the late 1980s we could have done the same thing in Japan to “prove” that the Japanese economy was not unbalanced (lots of comfortable trains, remember?), and yet it still would not have prevented Japan from undergoing the difficult rebalancing process.

Second, the impact on growth, which is the whole point of the exercise, will be unchanged by how we classify the spending. As China reduces investment, consumption must grow to replace it. Are we suggesting that it will be easier for China to increase the investment that it wants to reclassify as consumption? Fine, maybe it will be, but how we will pay for this increased investment? This is the key point, and it doesn’t matter whether you classify the spending as investment, consumption, or indeed anything else.

If this increased spending is paid by direct and hidden taxes on the household sector, as most spending and investment in China are, it simply makes it all the more difficult for household consumption to increase. Transfers from households to fund government spending are at the heart of the Chinese growth imbalances, and reclassifying those transfers does nothing to help the problem. Only reversing them will solve the problem. If it is paid for by liquidating assets in the state sector, then it also really doesn’t matter how this spending is classified. As long as it results in a transfer of wealth from the state sector to the household sector, China will rebalance.

And third, there can be a huge difference between the value of inputs – which is how all this is measured – and the actual economic value of what is created, and this gets us right back to the problem of overinvestment. If a local government spends $2 billion on the subway system, but creates only $1 billion of value (increased economic activity over the life of the subway), reported “reclassified” consumption might rise by the former number, but real “reclassified” consumption only goes up by the latter. In that case the value of the new consumption number is overstated in the same way that investment has been overstated.

The article does point out that not all past investment in infrastructure is wasted, but of course this is a trivial point and no one doubts it. The relevant point is very different. As long as debt in the aggregate rises faster than debt servicing capacity in the aggregate, it cannot be sustained, and one way or the other the difference must be covered by transfers from either the household sector, in which case the imbalances are getting worse, or by the state sector, in which case we are rebalancing but must go right back to the original political problem – which in China is referred to as the problem of “vested interests”.

Throwing away your savings

The biggest problem I have with The Economist article is actually not with the first two paragraphs in the section that I cite but rather in the last. To repeat:

But China’s high investment is backed by even higher saving. As a consequence, China does not need its investment to generate high returns in order to pay back external creditors. China has, in effect, already set aside the resources that will be lost if its investments turn sour.

This doesn’t make sense to me at all and illustrates, I think, some of the confusion about what savings mean. The passage seems to assume that the main economic problem facing a developing country is paying back external creditors.

But this isn’t the case. External debt is generally is a problem for smaller countries, but as the Reinhart and Rogoff book, This Time is Different, makes clear (and this is something that most financial historians already knew), most economic or financial crises are domestic, not external. It is true that many of the crises in the 1980s and 1990s were external debt crises, and this has colored our view of what a financial crisis must be, but this shouldn’t lead us to think that countries only have crises if their savings are insufficient to cover investment (I.e. they are running a current account deficit).

After all the US had no problem paying back external debt in the 1930s and Japan had no problem paying external debt in the 1990s. In both cases domestic savings far exceeded domestic investment – or, to put in the same terms as The Economist, their high investment was backed up by even higher savings – and yet both suffered tremendous slowdowns in economic growth and the US had a financial crisis.

Likewise China of course will also have no problem paying back its external debt, but losses do not occur when you borrow in foreign currency to fund investments. They occur when you invest in projects that are not economically viable, no matter how they are funded.

What is more important, it is not meaningful to say that China’s high investment is “backed” by higher savings. The Chinese growth model forces up savings, by constraining consumption growth, in order to fund investment (a higher savings rate is the same thing as a lower consumption rate) just as Alexander Gershenkron prescribed in the 1950s and 1960s. But once investment is misallocated (or “malinvested”, as The Economist prefers) higher savings is not a solution to the problem but rather a manifestation of the problem itself. If you do not believe this, then Japan’s Lost Decade(s) is very hard to explain.

Perhaps the easiest way to prove this is with a simple thought experiment.  Let us assume that Beijing decides immediately to tax half of Chinese household income and to use the money to build a bunch of useless bridges. Would this be good for China? Certainly not, and the impact would be more debt and slower future growth as the cost of the excess debt was absorbed. What happens to the investment rate? It goes up, of course, along with GDP.

But what happens to the savings rate? It also goes up. Why? Because if you cut the disposable income of Chinese households in half, presumably you would cut consumption by nearly that amount. Since savings is simply GDP minus consumption, savings will soar.

Notice that the condition – that savings exceed investment – will still be met, and by definition as long as China runs a current account surplus savings must exceed investment. And yet it doesn’t help. Wasting money is always value destroying, and the fact that it is funded by domestic savings – as in Japan in the 1980s, the USSR in the 1950s and 1960s, and Brazil before 1975 – or foreign savings – as Latin America after 1975 and much of Asian in the 1990s – makes little difference except in the resolution.

Externally funded misallocated investment is subject to “sudden stops”. Domestically funded misallocated investment may or may not be, depending on the structure of the domestic financial system

The bull argument cannot ignore hidden bad debt

So to say that China has already set aside the resources to pay for the losses is, I think, meaningless, especially if it implies that somehow the impact of this wasted investment is in the past and not in the future. China has no more set aside the cost of the losses than Brazil had done so at the end of the 1970s, prior to its own lost decade. The losses are simply buried in the debt.

But an unrecognized past loss must be recognized at some point in the future, no matter how it is funded. On this point I think neither Hayek nor Keynes would disagree. In the end, the strongest indication about whether or not the current Chinese growth model is no longer providing sustainable growth is whether debt is rising faster than debt servicing capacity. This is where the debate must focus. Or to cite John Mills in his 1868 paper “On credit cycles and the origin of commercial panics”

Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.

If capital has been destroyed in the past, and that destruction is currently unrecognized, it must be recognized in the future, like it or not. This recognition can occur in the form of what Mills called a panic, and we would call a financial crisis, but given the stickiness of deposits in the Chinese banking system I don’t think this is likely to be the case in China. It can also occur in the form of many years of much slower growth in GDP, as those losses are ground away through excess debt repayment. But it will occur.

So if anyone wants to continue to be very bullish about Chinese growth prospects over the next decade, it seems to me that he must address and answer these three questions:

  1. How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
  2. What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
  3. What mechanism can be implemented to increase the growth rate of household consumption?

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About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

Visit: China Financial Markets

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