Michael Pettis, professor of finance at Peking University, warns of the significant debt overhang that is weighing on China's economy. He thinks a long period of stagnation will be inevitable.
Few western experts know China better than Michael Pettis. He has been living in Beijing for 17 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, he talks about the trade dispute between China and the United States and the increasing difficulty in reaching a deal after several rounds of escalations. «Xi Jinping has underestimated Trump, he read him wrongly», says Pettis.
The trade conflict hits China at a very bad moment, says Pettis: «The Chinese economy is extremely vulnerable.» Xi should urgently continue the reform of the domestic economy. «Everyone here knows there is a serious debt problem in China, a ticking time bomb», he warns. Though Pettis thinks China will be able to avert a financial crisis, he says a long stagnation will be inevitable.
Mr. Pettis, there was a dramatic escalation in the trade dispute in May. What happened?
It depends on who you listen to. The Chinese say the Americans are being bullies. In Washington there is a belief that certain things have been agreed on, and that Beijing was reneging on these things. The problem is that this is a negotiation between Donald Trump and Xi Jinping, except they are not negotiating in person. Which means that the people who are doing the negotiation can’t commit to anything without having it approved. That’s a tough way to run a negotiation.
Both the US and China had seen pretty strong economic growth in the first quarter. Could it be that both sides thought they were in a stronger negotiating position?
I think that happened in the US, but not in China. Remember, in China, the GDP growth numbers tell us nothing about the economy. If Beijing wants 7% growth, they get 7%, if they want 5%, they get 5%. That is not real growth, it’s just economic activity. The real growth in China, if you were to write down all non-productive investment, would be much lower.
You mean lower than the 6,4% that were reported lately?
Yes. I think the real economic growth rate in China is already below 3%. The economy is not doing very well, and the trade war is making it worse. But again, this has no impact on the published GDP numbers, because they are political numbers. The irony is that the worse the trade war gets, the higher the official GDP growth will probably be. In order to show that China is not affected by the trade war, they will show high growth rates. But you must understand that the published GDP growth numbers do not measure the real performance of the system.
How much are the US tariffs really hurting China?
The Chinese economy is extremely vulnerable. As it is right now, it takes a huge amount of debt in order to generate politically acceptable GDP growth. The central government has been trying for years to bring that debt down, but it was not successful. Politics are very important, because at the end of the 19th Party Congress in October 2017 it looked like president Xi had substantially consolidated power. Which was what he needed in order to implement economic reforms. It looked like he started to do that: You saw the growth in debt slowing down dramatically. And then something happened around April 2018, you started to hear rumors, and then in August it became clear that there had been a significant challenge to the President. The rumors are that he was challenged on the basis of his mishandling of the US-China relationship.
You mean he was challenged from within the Party?
There is a lot of opposition at the elite level to the president. He put a third of them in jail during his anticorruption campaign. So the trade war is very important from that point of view. The hope in Beijing was that they could arrive at a reasonably acceptable solution without China having to change too many things. Because the more you weaken the export sector, the more debt creation it’s going to take for Beijing to bridge the gap between the real growth in the economy and the officially reported growth.
So basically, if they lose the momentum in the export sector, they need more debt-financed domestic investment to keep up the growth?
Exactly. And that goes contrary to their need to bring the debt growth down. So the trade war matters a lot. They keep saying it doesn’t matter much, but I’d quote Shakespeare to say «they protest too much, methinks». That gives me a sense that it matters a great deal. It’s very risky for Beijing to escalate the confrontation. Because if Washington doesn’t back down, then China is forced into either a very embarrassing backing down or a very difficult trade environment.
What went wrong in Xi’s handling of the relationship with the US?
They underestimated Trump, they read him wrongly. There are people that have been arguing for years that the Chinese way was to make promises and then not to keep them. I think there was the sense in China that they could keep playing that game. Trump, with all his faults, and there are many, is not part of the normal political process. He focused on negotiating real deliverables. He was not willing to accept promises without strict enforcement. That is something that the Chinese did not expect. The history of China’s relationship with the US and even more with Europe has been lots of agreements and lots of smiles, but at the end of the day compliance was always an issue.
Can there still be a deal that allows both sides to keep face?
I think we will get a deal. But the uncertainty is much higher than it was a a few weeks ago. The reason I say we’ll get a deal is because both sides need one. Xi needs a deal if he wants to return to the real problem China has, which is the domestic economy. And Trump needs a deal, because he needs to have something to deliver to his base. The problem is that whatever the deal will be, Trump has to be able to spin it as «Everything has changed». He needs a tough deal. But Xi has to be able to spin it as «Nothing has changed». You need a deal that can be spun in both directions.
You mentioned that Xi had consolidated his power and was able to start reforms. Is he really a reformer?
China really does not have a choice. You can’t allow your debt to grow at two to three times your debt servicing capacity year after year, when already your debt is probably well over 300% of GDP and you’re a developing country. Most people realize that this is a ticking time bomb. Beijing has got to address the debt issue. I think there is this recognition that they’ve got to stop the debt from growing and they understood that it’s impossible to do that without seeing a significant drop in GDP growth.
How should the debt problem be addressed?
The typical economist would tell you that you have to implement productivity enhancing reforms and grow your way out of the debt. But let’s face it: No country in history with too much debt has ever been able to just grow out of it. They reduce their debt either by defaulting, by inflating it away, by squeezing the workers or expropriating the rich. In the case of China, the source of the huge growth in debt has been massive amounts of misallocated investment in non-productive infrastructure and unnecessary manufacturing capacity. So as a first step, you have to stop the non-productive investment. But if you do that, you reduce growth. And if you don’t want growth to drop too much, you need another source of demand.
For an economy the size of China, the obvious choice is household consumption. Household income and consumption in China today are at below 50% of GDP. That is the lowest level ever recorded in history. So to me it’s clear that China’s economic growth now must come from the consumption sector. They need to replace non-productive investment with consumption.
How can that be achieved?
There are only two ways to grow consumption: One is to boost household debt, which is what they did in the last four years. Household debt in China has exploded. But of course that doesn’t solve the debt problem, it just moves it to the household side. The other way to boost household consumption is to boost household income. After 30 years in which the household share contracted, we now need the household share to expand. That means the group that benefited most in the last 30 years, the group that enjoyed an expanding share of a rapidly growing economy, must now retain a contracting share of a much more slowly growing economy.
Who is that group?
The local elites and the local governments, which are controlled by the local elites. So the solution is very simple: You have to transfer wealth from local governments and elites to ordinary households. They’ve known that solution since 2007, and if you look at the 2013 Third Plenum reforms, they were all about that transfer of wealth. It’s just politically incredibly difficult to do that.
To put it simply, you’re saying the central government is battling against the vested interests in the provinces?
Yes. It’s interesting to know that the term «vested interest» only emerged in China in early 2008, after premier Wen Jiabao promised to begin rebalancing the economy. That’s not a coincidence. If you’re going to impose those reforms, you have to significantly weaken the vested interests and strengthen the central government. Which is what Xi Jinping has spent the first five years of his presidency doing.
So let’s say the domestic debt level in China today amounts to 300% of GDP. How can that be wound down?
First, we need to understand that there are two types of debt: Good debt is when you borrow money to build something that creates enough economic value to repay the debt. And then there is the other debt, the bad one, that is used to build something that does not create economic value. The way to deal with that is you have to get rid of the debt and assign the cost to somebody. How can you do that? Well, you can default and restructure, which means the creditors bear the cost. That’s difficult in China, because the creditors are the banks and the banks are guaranteed by the government. Another way is you can assign the costs to the household sector, which tends to be politically weak.
How is that done?
By imposing negative real interest rates on household savings. That’s what happened in China in the last decades. The problem today is the issue we just talked about: If the government wants the households to boost their spending, they can’t squeeze them to bear the costs of all the unproductive debt in the economy. So who else? Ideally, you would like to get the foreigners to bear the cost of bad debt, but in China the foreigners are not the lenders. So there is only the government left. And by that, I don’t mean the central government, but local governments. The most effective way for China to reduce the debt level is to force local governments to pay for the debt in their region.
How can they do that?
Local governments own a lot of assets, such as real estate and state-owned enterprises. They should sell those assets and use the proceeds to pay down the debt. There have been many proposals, but it's just not happening. The power of the local elites depends to a large extent on the local government’s control of these assets. It’s incredibly difficult for the central government to take on the local elites.
The issue of the unsustainable debt level in China has been talked about for years.
Yes, that’s true. Ten years ago, it was still controversial. Two years ago it stopped being controversial. Everyone here knows that there is a serious debt problem.
And yet, nothing bad has happened so far. Why can’t the investment-led growth model continue for quite a while longer?
If you do the math, it’s hard to imagine it continuing for another two to four years. It’s a mistake to say nothing bad has happened. Something terrible has happened: The real growth rate of the economy has slowed significantly. It takes more and more of this fake growth, this building of useless things, to keep the official GDP growth high. What the economy is really doing, the amount of wealth that it’s generating, is much lower than the reported GDP growth number. If you look at the private sector in China, you see that it’s contracting already. That is very worrying.
I often hear the argument that China is a command economy. They can handle the debt issue. They will not suffer a financial meltdown like the West did in 2008.
I agree on one thing: They most probably won’t have a financial crisis, because the banks are controlled by the state. What I think is much more likely is that growth rates will just keep dropping and we’ll have one or two decades of stagnation. That’s inevitable. If you look at the arithmetic of growth, it is very clear that Chinese GDP growth is significantly overstated, and that overstatement has to be amortized over time.
How healthy is the banking system?
It’s bankrupt. It’s insolvent, but it’s guaranteed by the state. When I first came to China 17 years ago, there were a lot of bank runs here. But by 2007, that stopped, because the credibility of the banking system rose tremendously. There was the belief that the government would guarantee the deposits. Now that guarantee is explicit. So as long as people trust the government guarantee, there won’t be bank runs. Which is why I don’t think we’ll have a banking crisis.
What about the command economy argument?
Remember, the same argument was made about the USSR in the 1960s, when it was growing so quickly. The renowned economist Paul Samuelson predicted that by 1984, the USSR would overtake the US as the world’s largest economy. It didn’t quite turn out that way. The argument again was made with Japan in the 1980s. Japan is not by definition a command economy, but its growth model was highly centralized, run by Ministry of Trade and the Ministry of Finance. Japan forced up the domestic savings rate and poured the savings into government-directed investment. Everyone back then said that Japan would soon be the world’s largest economy. But within two decades, Japan’s share of world GDP had contracted from 17% to 7%. That’s a huge contraction, similar to what the USSR suffered between the 1960s and 1980s. Being a command economy does not save you from adjustments. It might be able to avert a painful crisis, but that comes at the cost of a long, grinding downward movement.
Another argument that is often heard: China can use its huge currency reserves to prevent a hard slowdown of the economy.
Huge reserves only help you if you have a lot of external debt. China doesn’t have that, its problem is domestic debt. Large currency reserves are not a sign of strength, they are a sign of significant domestic distortions. The reason a country builds up large reserves is typically if it has insufficient domestic demand. Look at history: The three greatest collections of currency reserves in the last 100 years were the US in 1929, China today, and Japan at the end of the 1980s. In the case of the US, those reserves did not prevent the Great Depression. In Japan, they did not prevent two decades of stagnation.
China owns more than 1,2 trillion $ worth of US Treasuries. Can they use them as a weapon in any way in the trade conflict?
No. Some people say they could sell the Treasuries and hurt the US. That’s nonsense. It won’t create disruption in the markets, because the Fed and other investors can just buy them. You have to remember China didn’t buy these Treasuries as a favor, they weren’t helping the US by making a loan. They bought them because they were running current account surpluses and needed to keep the currency from appreciating too much. Let’s assume they sold them all. What would they do with the money? If they brought it back into China, the Yuan would appreciate. Beijing wouldn’t want that. What else could they do? Neither the Europeans nor the Japanese would want them to buy Euros and Yen. In theory, they could lend to developing countries, but the Chinese have a really bad experience lending to developing countries. Venezuela hast just cost them 23 bn $, that was a huge shock to Beijing.
On an international level, Beijing pushes its Belt and Road Initiative. In economic terms, is that initiative a good thing for China?
The key question with investment is always: Is the investment productive? Can you get your money back through the economic value this investment creates? A Chinese friend told me recently that through the BRI Beijing is throwing away investment abroad instead of throwing it away at home. So if you don’t get the money back, what’s the difference between building an airport in China that nobody needs, or losing it in Venezuela?