Michael Pettis, Professor of Finance at Peking University, says that Covid-19 has accelerated a row of problems in the world economy. Hopes of a rapid recovery, led by China, will most likely be disappointed, he warns.
Few western experts know China better than Michael Pettis. He has been living in Beijing for 18 years, teaching finance at the Guanghua School of Management at Peking University, where he specializes in Chinese financial markets.
In an in-depth conversation with The Market, Pettis talks about the current state of the economy in China and warns that expectations of a rapid recovery will be disappointed. China currently only has unhealthy sources of growth at its disposal, he says.
In terms of the relationship between the world's two super powers, he remains pessimistic. «The relationship between Washington and Beijing is only going to get worse», Pettis warns.
Professor Pettis, what do you currently see in terms of the return of economic activity in China?
Beijing is gradually opening. Everyone is out, even though Covid-19 is not over. The thing is that I don’t see many people out shopping. Shops have been open in Beijing for about four weeks, and at least once or twice a week I go out to the main shopping areas, just to get a sense of what people are doing. They are going to cafés, and there is a little bit of travel. But I don’t see much buying of things like clothing, furniture or jewelry. This I think is going to be an ugly consequence of this pandemic: All over the world people react by increasing their savings rate.
What does that mean for the economic recovery in China?
A lot of people say Covid-19 has changed the world. I don’t agree with that. I think what it has done is it has accelerated a lot of things that were going on anyway. In the case of China, the elephant in the room is the level of total debt. In my view, the real underlying growth rate of China – by that I mean the growth rate that is not artificially inflated by debt-financed overinvestment – has for years been much lower than the officially stated rate. While official growth was around 6%, I’d say the real economic growth rate was less than 3%. The way they got to the official numbers was through the big increase in debt.
So basically each additional unit of GDP in China required an ever increasing level of debt?
Yes. Last year, according to the official numbers – which I think understate the problem significantly –, the total debt-to-GDP ratio went up from 239 to 245%. Now when I try to figure out what is going to happen this year, I’d say the debt to GDP ratio will grow by at least another 12 percentage points, twice as fast as last year. That’s just not sustainable.
What’s your estimate of the growth the Chinese economy will achieve this year?
In terms of the official headline number, we don’t know yet, because that number is set by the political leadership. In December, the growth target for 2020 was provisionally set at around 6%. But that target is not officially set until the meeting of the National People’s Congress. This was supposed to take place in early March, but it was postponed and will now take place on May 22. We’ll see what the political leadership will tell us. There are some people saying there won’t even be a target for this year, but I think there will. My assumption is they will set a target of around 3%.
Is that achievable given the effects of Covid-19?
In theory, yes, but the question always is the composition of this growth. You see, there are basically three healthy sources of economic growth in China: Household consumption, exports, and private sector investment. But we know consumption is going to be way down this year, for two reasons: One, household income will be way down, because many people have lost their jobs, and second, it looks like people are responding to the shock by increasing their savings rate. Consumption was down significantly in the first quarter. It will recover somewhat, but it will be down for the year.
Do you have any good estimates of how many workers lost their jobs and how high unemployment in China currently is?
No, there is simply no hard data available. The Chief Strategist of one of the larger investment banks here in China recently estimated that there currently might be 20 million newly unemployed. A few days later, his estimates were taken off and he was demoted. That gives you an idea of the challenge: We don’t know, and if you come up with an estimate that the political leadership does not like, you get into trouble. A problem is the way unemployment in China is measured. It only encompasses urban residents with a residency permit, a so-called hukou. So the official statistics just ignore 300 million migrant workers – and they are the ones that got really badly hurt by the economic slowdown. So while the official unemployment rate is around 6%, we know that doesn’t represent the real numbers. It’s probably anywhere between 10 to 20%, but we simply don’t know.
What about the other two healthy sources of growth, exports and private sector investment?
Chinese exports will be down this year, as they suffer from the global slowdown. Which leaves investment by private companies. But most of that serves either as consumption or exports, at least the good stuff. So private corporations are not going to invest much. All in all, the good type of growth is probably going to be negative this year. Consumption will be down, exports will be down, private sector investment will be down.
Which only leaves the unhealthy sources of growth?
Exactly, and that is public sector investment and real estate development. It’s very simple: Because consumption, exports and private sector investment will be negative, public sector investment will just have to expand in China. There is no other way to keep growth levels in positive territory.
Will we see another big round of infrastructure investment?
The government will certainly try to pull that lever again. If you look at the individual provinces, they are all announcing that future projects are being pulled forward. Construction projects that they were planning to do in the next two to three years will be started immediately. It’ll be interesting to hear the targets for infrastructure investment they will communicate on May 22. But make no mistake: The government can’t do this anywhere near the extent they did in 2009 and 2010, in the aftermath of the financial crisis.
So financial market participants expecting a big stimulus from China which in turn helps to drag the world economy forward will be disappointed?
Yes, I think so. First of all, the idea that China’s fiscal stimulus of 2009 helped the entire world economy get back on its feet is nonsense. This was primarily a domestic decision back then: From the point of view of the political leadership, either public investment or unemployment had to go up. And of course they chose investments, building airports, roads, bridges and high speed train lines all over the country. It was really a way of avoiding domestic unemployment. But however you look at it, they can’t do that again.
For one, China is already overinvested, with the resulting debt level. Look at it his way: If there really were many sensible infrastructure projects out there, that would genuinely increase the welfare of the Chinese people, why did it take Covid-19 to get Beijing to promote them? You know the answer to that. There aren’t any. Plus, China does not have full control over their domestic money supply. After the global financial crisis, from 2008 to 2011, foreign capital continued to pour into China; official reserves during that period grew by 16% per year. But now their reserves are flat. This is the classic dilemma of the impossible trinity: You can’t have an open capital account, a pegged currency as well as full, independent control over your domestic money supply at the same time.
But China does not have an open capital account.
True, it has capital controls, but its capital account is very porous. Capital that wants to get out, finds a way to get out. You might want to call this a dirty open capital account. Also, China has not officially pegged its currency, but it operates with a dirty peg. And with that, the People’s Bank of China has some control over the domestic money supply, but not full control. Stated simply: If their reserves don’t grow, there are constraints on their ability to grow their domestic money supply. And that is happening today. They are encouraging by all possible means to get foreigners to bring money into China, but their reserves are not growing. And there’s the catch: In this environment, even if the central government wanted to introduce a major fiscal stimulus and allow debt to grow by a lot, it’s not that easy to do so. Because they can’t grow their domestic money supply.
So far, the People’s Bank of China has acted with remarkable restraint, especially compared to the monetary policy of the Fed, the ECB or the Bank of Japan. What’s behind that?
This is part of the catch with the impossible trinity they’re in. The PBoC has to act with restraint. Remember, they need foreign investment money to flow into China. One way to do that is to keep interest rates high relative to the Dollar and the Euro. And the other way is to limit the volatility of the currency. If you want to attract foreigners, you have to offer them a higher yield, and you have to alleviate their worry of a currency devaluation. So while the Fed reduced interest rates by 150 basis points, the PBoC only reduced theirs by about 20 basis points.
Just to get this clear: The government and the PBoC would want to be much more expansive, both on fiscal and monetary policy, but they can’t because that would trigger a capital flight out of China?
There are two parts to this question. For one, yes, they need to manage their reserves very wisely, because that’s what will determine their ability to expand the domestic money supply. At the same time, there still are people within the PBoC and the government who are genuinely worried about the level of debt. They don’t want to create another debt-financed investment binge. Rumors say that Vice Premier Liu He is really worried about the level of debt in the country.
And I guess that’s one of the reasons why they are reluctant to use the other unhealthy source of economic growth, the real estate market?
Yes. That’s not a healthy source of growth, because nearly 25% of urban apartments already are empty. What we really need in China is very cheap urban housing. But that’s not what developers are building, because that segment is not terribly profitable. The thing is this: If you want more real estate development, you do that by allowing housing prices to go up. So that people keep buying apartments not to live in, but for speculative purposes. But the government keeps saying apartments are for living, not for speculation. They are truly worried about speculative purchasing in real estate.
But given the lack of healthy sources of growth, Beijing will have no other choice but to let the real estate market run wild again?
We’ll see. They are in the same position as they are with regards to public infrastructure spending. Those are the two levers of growth, and both have been used to such excess in the past that political leaders are reluctant to use them again now. But what can they do? It’s either that or nothing.
Are there no ways to stimulate private consumption?
Yes, one thing they are trying is to get coupons to households, to get them to consume more. You know, in Europe, the US, or Hong Kong, central banks are just giving out money. In China they are not doing that, because my guess is Beijing wants the local governments to pay for it. So the local governments are providing coupons which you have to use within a set time frame. I think that’s a sensible strategy, but so far, the program is very small. Households in China, but also in the US and in Europe need to be incentivized to continue consuming, because ultimately, consumption drives everything. It drives other consumption, it drives imports, it drives private sector investment. Without consumption, there is no growth.
The Yuan has been weakening to the Dollar in the past few days. What’s behind this move?
Don’t forget that the Yuan weakened after some very irresponsible talk in Washington about not repaying the Treasuries that China owns. That’s total nonsense. The whole idea of a selective default of the United States is idiotic and probably impossible to implement. So the move in the Yuan could have been some kind of political signalling. But generally speaking, if you look at the basket of currencies against which the PBoC manages the Yuan, it hasn’t really changed that much.
That kind of rhetoric from the White House shows that the relationship between the US and China is deteriorating even more. How do you see that playing out?
For at least the past two to three years, my message has always been the same: The relationship between Washington and Beijing is only going to get worse. So, as with other developments, Covid-19 has simply sped up a process that was already in place.
Donald Trump has repeatedly said that he wants to force China to fulfill its purchasing promises from the Phase 1 trade deal. Is that even possible?
It’s arithmetically possible, but it will be extremely difficult. With the current weak demand in China, it will be very difficult for China to keep its promise. But because at the same time demand is weak in the US, it is very hard for Washington not to insist. For political reasons, Trump will want to increase pressure on Beijing. One side is going to lose out on this. Will it be China or the US? I would argue that if China is unable to buy what it has promised, that will open up the whole agreement again. So I think once more we’ll move back to rising tariffs. But it’s important to add that this is not just a Trump-Xi or a US-China issue. We are neglecting conflicts of economic imbalances everywhere.
What do you mean by that?
On the surface, the problem is the bilateral trade deficit that the US runs with China. But the real problem remains that countries like China, Germany and a few others simply haven’t done the necessary domestic reforms to rebalance their domestic demand. They still rely on the rest of the world to absorb their domestic production and savings surplus. And the worse the economy gets, the more difficult it gets for the rest of the world to absorb that. Remember, as long as all the excess savings of the world flow to the US, America has no choice but to run a huge current account deficit. There is nothing Trump can do with tariffs about that. And just look at Europe: The problem between Germany and Italy is in essence a balance of payments problem.
From some emerging economies, there is a growing call for debt relief. We know that through the Belt and Road Initiative, China has granted billions of Dollars in credit to emerging economies worldwide. What do you see happening there?
The short answer: We don’t know, as there is a total lack of transparency. We don’t get any details on how much is owed by whom to China. The Financial Times recently published their estimates of China’s exposure to a bunch of countries. And if you look at that table, you see a startling correlation: the more exposure, the worse the country. So it’s hard to believe that this won’t become a big problem, as some of these countries are not going to be able to repay their debt to China. Remember, we saw this two years ago with Venezuela, which was a big shock for China. We are going to see more developing countries running into balance of payment difficulties. Again, this would have happened without Covid-19. But with this pandemic, the next two to three years of problems are going to be concentrated into one year.
2021 will see the 100 year anniversary of the founding of the Communist Party of China. How important will it be for the political leadership to show roaring growth rates again?
Of course we’ll have a base effect, but growth because of a low base is not really growth. The IMF is saying that China will achieve 8 to 9% growth next year. That’s the yo-yo scenario of economics. But I am really skeptical that they will achieve this, given the longer lasting effect of the pandemic. What will drive it to 9% next year? Maybe the US and Europe come roaring back and will import a lot of stuff from China? I’m skeptical about that. What about consumption in China roaring back? Well, that would mean massive redistribution of wealth to households. But that’s really hard to do in China, they were trying to rebalance the economy for 13 years without much success. So if exports don’t come roaring back and domestic consumption won’t come roaring back, then private sector investment won’t come roaring back. So to get 9% growth, what do you do? Build a bridge over every single ditch you can find? Sure, that could bring you 9% growth, but at no economical use and with ever rising levels of debt. There is just no easy way out of this.