The Three Toughest Questions For China Bulls

Tyler Durden's picture

Whether you believe China is an economic miracle - or a government-sponsored fraud; and can ignore the broken growth model or believe that the CCP can bailout the world; Michael Pettis, of China Financial Markets, provides a much-needed dose of reality for bulls and bears when it comes to the future of the global growth engine. After summing up (and laying-waste to) the three mainstays of China bulls' arguments: he asks the three toughest questions any China bull must be able to answer. Analogizing China's position perfectly he cites Mills: "Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works." Simply put, the bull argument cannot ignore the hidden bad debt.


Via Michael Pettis, China Financial Markets: How To Be A China Bull



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.




[The Bulls] are 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.




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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I am more equal than others's picture

Heading to China on Tuesday.  Will be fun to explore this on the ground

Tango in the Blight's picture

I won't be taking any bets that you will make it out alive.

Totentänzerlied's picture

Bring a respirator. No, really. And don't drink the water or eat the fish.

"Only 1% of the country’s 560 million city dwellers breathe air considered safe by the European Union, because all the China's major cities are constantly covered in a "toxic gray shroud"."

helping_friendly_book's picture

Try the Dan Dan street noodle and the spicey wonton!



hannah's picture

i second the dan dan's.....! impossible to find in the ussa

helping_friendly_book's picture

How about a good ole' hot pot?

Have to go to Flushing to find the hot pot!

jonjon831983's picture

negatory - dandan's are more northern Chinese - Shanghaish.  Look for those types of restaurants and they should have it.


Though, perhaps not as good.... but the yumminess may be due to a crapload of MSG crystals.

aint no fortunate son's picture

"3. What mechanism can be implemented to increase the growth rate of household consumption?"

Ooh, ooh, I know - helicopters!

FreedomGuy's picture

Theoretically, consumption can only increase with increased prodution and productivity. Monetary "tricks" attempt to increase consumption without any real productivity growth...or faster than real productivity. Inasmuch as China practices Western monetary policy they will get a similar result. Just like the West, they enjoy the bubble as it inflates and like the West they will try to reinflate it.

Dr. Bonzo's picture

Well, I've been "here" (in China) now for close to 10 years and I can assure you're not going to find whatever it is you're looking for. To any Westerner everything in Asia looks like spectacular growth. If you're trips are to a city you' ll see the Chinese 1%, and their spending habits are stupendous. You'll come back crowing about all the Gucci Vitton Lamborghini touting brats barreling down the splendid new roads. You'll go Wow look at these shiny new airports, and wow look at the doodad buying mobs thronging the streets. And none of that means jackshit. It doesn't tell you about the land stolen from rural peasants and the theft and graft and fraud. You can't measure which apartment block is a shoddily erected wreck waiting to crumble and which officials were bribed to build it. Nothing you see will tell you which money is clean and what's being laundered and what glitzy sportscar was bought from hard earned cash or some sleazy lending deal. So before you go leaping to any broad conclusions on your little trip check your opinions at the door. As for me, i've never seen a country where scamming and The Scam was practiced on such an epic scale. In China, literally everythng from cardboard dumplings to Googleified Ph.Ds and every ripoff and fraud in between. Trust no one and nothing. Stamp Caveat Emptor into your skull right now cause brother, you are gonna need it.

FreedomGuy's picture

Not fully sure what the point of your post is but I give it credibility based on the fact you live there and my observations are similar. I have taken a few trips and I have a son who lives there and is marrying a judge.

It is my theory that a lot of this is a function and legacy of living under Communism. Under communism lieing becomes part of survival. It starts with "We love the dictator!" to "Yup, that concrete has all the required rebar and is not watered down, comrade." These are the essentials of survival. The black market badguys were the goodguys.

It is also why I warn anyone to beware of anything important made in China. It is one thing if it is a shirt that falls apart. It is another when your heparin is bad, dog food contaminated or your kid's toys covered in cheap lead paint.

I actually like most the Chinese people I've gotten to know and I admire their energy but there is a legacy they must work out to gain sustained prosperity and even liberty. Their government is also adopting the worst of Western economics and monetary policy.

onebir's picture

Unfortunately the 'legacy [?] they must work out to gain sustained prosperity' is exactly what's being destroyed in much of the west at the moment.

I do like China & esp most Chinese people, having lived there for a few years. But don't forget the 2008 melamine milk baby death toll. And the high speed railway system:

(I still think it's probably safer than domestic flights though :P )

FreedomGuy's picture

Yes, I was making only a partial list of publicized problems. I have been on the high speed rails several times. I love them but they do not run at full speed. They are having to reconstruct a lot of the railways. Lieing and corruption are built into the culture. it is humorous in a dark way that the most ruthless capitalists who actually do sacrifice safety, quality and even gouge are the former collectivist state citizens. There is some lesson in here that will be ignored by the people pushing the USA exactly i the direction you mention. The same system will produce the same results anywhere in the world.

FreedomGuy's picture

Yes, I was making only a partial list of publicized problems. I have been on the high speed rails several times. I love them but they do not run at full speed. They are having to reconstruct a lot of the railways. Lieing and corruption are built into the culture. it is humorous in a dark way that the most ruthless capitalists who actually do sacrifice safety, quality and even gouge are the former collectivist state citizens. There is some lesson in here that will be ignored by the people pushing the USA exactly i the direction you mention. The same system will produce the same results anywhere in the world.

I am more equal than others's picture

Thanks.  I'll be flying into Guangzhou and be there for 5 days, then onto Chonhqing for 5 more days then I believe the tourist thing kicks in when I go to Beijing for the last 4 days.  Bottled water is all I'll be drinking except when its 'Miller Time.'  A friend used to import french wine into the country but the chinesse have no taste for it and cut it with Coke of all things.  He found counterfiet products all the time.  It was horrible. 

jonjon831983's picture

Ppl should keep in mind:

Say 1 billion people and 1% are super elite rich and are willing to spend = 10,000,000.  Broaden that out to say top 5 or 10% who are rich and well off and that is a staggering number of wealthy people who can spend.


Say the only places foreigners and rich locals would want to shop or flash some bling are limited to a few key centres and you'll see the throngs of people there with similar mentalities, because those are the desired locations.

BiggerInJapan's picture

French/canadian/italian water all the way lol

I sometimes I think even the carlsberg and heineken are fake in China.

good luck eghhehahaha

PUD's picture

China is the real time test tube that will prove the folly of perpetual unlimited exponential growth. Put a billion cars on the road, a billion steak eaters at the table, a billion shoe shoppers filling a billion closets and get back to me as to how long you'll survive breathing the air, drinking the water or eating the food.

The rule of 72's is a bitch

FreedomGuy's picture

I never saw a sunny blue day in any of the half dozen cities I have been in. Always gray like forest fire ash or fog.

fourchan's picture

best post of the year pud.

TheSilverJournal's picture

Keynseianism = the practice of keeping malinvestments from becoming exposed by creating even more malinvestments.

HD's picture

Can't help but like that definition...

q99x2's picture

You could take everything China manufactures out of the US and bury it into dumps and the economy of the US would see a 7 year boom that is except for the greedy rat faced middle men.

Jason T's picture

China was so far behind in the productivity side of things, they are playing catch up... fast.  They still have a ways to go.  All their GDP growth is gains in productivity. 

2011, they spent 46% of GDP on gross fixed capital formation.. US spent 14%, closed a few refineries and what have you.. china built refineries.

China is already starting to whip our asses, 10 more years of this, we'll be the ones with hte cheap cooly labor.

Bodysurf's picture

Nah.  Almost all the so-called fixed capital formation isn't needed.  They're building enormous towers all around me in Shanghai as I type this, even though thousands of them are empty. 

A good example is in the car industry.  They're determined to triple auto production, and will be there in the middle of next year, with dozens of new factories coming online.  But current demand is insufficient to move the cars sitting in showrooms right now.  Traffic in the major cities is awful.  America built its cities around the automobile.  China just paved over dirt tracks.  Driving a car is an enormous hassle.  And they think they're going to be putting tens of millions more onto showroom floors?

The author is 100% right.  Capital formation needs to have a rate of return.  Using debt, it has to be a function of your borrowing rate; with just equity, you need to have an opportunity cost measuring stick to use instead.  And either way, the Chinese are throwing money away. 


Peter Pan's picture

Capital has clearly been destroyed by creating excess capacity which is exacerbated by imbalances between nations and resource constraints. China shot for the stars and will be brought to its knees before resuming its upward and more considered ascent.

The West however needs to understand that it does not need growth. What is needs is for wasteful expenditures to be replaced by productivity enhancing expenditures. This will generate much needed future savings which will enable more to be done with less.

For example, the reduction of war spending (defence spending is not an appropriate term) and the reduction of America's waist line will bring greater savings and opportunities than any level of QE or ZIRP. We need to stop including war expenditures and gambling expenditures in GDP.

So we need to remember that the China equation cannot be looked at in the absence of the western world.

nmewn's picture

And third, they produced a number of what seem to me largely circular arguments...

Chinese citizen citizensim is eternal. 

akak's picture

Trulywise, the consumptionalistic, hypocritizenistic blobbing-up nature of Chinese Citizenism is eternal.

"American' resource consumptionism?  Make me laugh!

While it does exist, it can hardly hold a candle to the explosive nature of the resource consumption trend of China over the last ten years.

But when self-indictment is impossible for those involved (i.e., certain dishwasher trolls), denial rules the roost and blame-placing must desperately be shifted onto others, so ....

Totentänzerlied's picture



TheFourthStooge-ing's picture

Confusious say:

"Sure, when you have a long history (compary to your own history of course) of stealing other people so you can stash your own people (turning them de facto into non US citizens by the way, so Chinese citizenism will keep working), well, you might grow oblivious to the contextual framework to deal with predictable issues that mature in the future, trying to avoid self indiction at all costs round the clock, 24 out of 24, 7 out of 7, 365 out of 365, so maybe we should eat the grasshoppers. That is if the ants embrace US citizenism."

nmewn's picture

It was an incredible thing to observe.

At first, I thought he had to be an MDB-ChiCom clone variant. But as time went on, I realized he was actually serious. Golden hordes, Tibetan monk beating, Vietnam invading and "native resource depleting" in the Gulf of Mexico be

But at least they are a heavilly regulated society and very respectful of "green concerns" and ALL individual rights so no planetary harm can come from any of their ambitions ;-)

Apostate2's picture

My first take was that he/she/it was an American eco-fascist Van Jones acolyte. My second, an LSE student. My third, a Belleville hairdresser who snorted too much hairspray. I've run out of takes for Mr Wu. Now window cleaning is not the worst one can do when the laundry folds.

Yen Cross's picture

IQ infinity, "between akak and nmwen" , I would highly urge any smart Z/Hers to listen "well"!

Apostate2's picture

I'd say more like a slinky, like their historical world-view.


dbTX's picture

Rule number 1; what goes up must come down.

Tango in the Blight's picture

Trust us, we will soon make contact with an alien race which will bailout the world.

-- signed Ben S. Bernanke & Paul R. Krugman

Miss Expectations's picture


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

This is so analogous to the phone call my friend received. 



"Who is this?"

"I'm the husband of the woman your husband is having an affair with.  It's been going on for a year and a half.  I just found out and I thought you should know."

Let me tell you, this call caused complete panic.  But, it wasn't the phone call that destroyed the marriage, it merely revealed the extent to which it had been previously destroyed by betrayal into hopelessly "unproductive works."

So, you can have  lots of denials and circular arguments, but actually the suspicious wife might just be correct.

EDIT:  Wait, there's more.  A few weeks later she found out that her husband had HELOCed the house, there was NO equity left after 15 years of paying the mortgage (he'd forged her name on the paperwork.)  A few months after that she found out she had herpes...she found out because she needed to go to the hospital to be catheterized and had to wear a bag strapped to her leg for a week. 



Mentaliusanything's picture

Miss Expectations - The Thai Woman have a cure for this - they get a rusty clever and exercise their rights over the dangling bits. Problem forever over.

Encroaching Darkness's picture

There's no mention here of the trillion-plus reminbi money printing / injection over the last couple of years - this also will prove a short-sighted measure. Printing money to stay in power works - for a little while. Then the rampant inflation and currency devaluation will prove problematic.

Seems rather sad - printing up all that money, and malinvesting it - ghost cities, empty shopping malls and highways. I sure wish some humans, somewhere, understood what they were doing.

nmewn's picture

The ghost of Keynes looms large across the globe this Halloween.

klwilly's picture

good analogy.  sorry for your pain Miss.

disabledvet's picture

i was under the impression that it was the Chinese STATE that was hiding all the bad debts...not Chinese business interests. I could be wrong of course but it seems to me there is a lot to offer the United States should these Chinese Tycoons wish to be provided a safe solid return without fear of a political backlash...ideally here in the United States. I did take note Canada is thinking about torpedoing that huge energy deal the Chinese business interests were talking about. The same cannot be said of the real estate fire sale currently going on in the USA of course. Anywho they are formidable competitors...and of course offer great opportunities. I fail to see how the collapse of Communist Government in Beijing...should it be happening of bad for US business or sales. Obviously they've done a better job of keeping the jobs where there own people are of course...

RockyRacoon's picture

Do not mention "fire" and "real estate" in the same comment.  It will get you disappeared into a black SUV some night.

helping_friendly_book's picture

More China bashing.

I don't know if any of you guys saw the 60th anniversy parade or are hip to the fact the USA owes China 1.5 trillion dollars?

China is not in unsustainable debt. THE USA IS IN UNSUSTANABLE DEBT!

China is not bankrupt fighting wars of aggression in multiple wars. THE USA IS BANKRUPT FIGHTING WARS OF AGGRESSION IN MUTIPLE WARS!

I don't think the author understands that it is the West which is financially and morally bankrupt.

I see China doing well dispite all the articles trying to make comparisons of China to the West.

We are BROKE. They are STRONG!

What the heck does the author know about China's printing policy?

China saves 1/2 of all US dollars brought into China by buying Western debt and spends the other half, internaly, on infrastructure and the military.

The USA is a bunch of broke bitches that can't even agree on a budget and lets a banking cartel print money and buy US Treasury Debt. 70% of ALL U.S. Treasury debt. 

China signed a 50 billion EURO trade agreement with Germany last year so there will be plenty of Western currency flowing into China.

The USA seems to think they are the only country on Earth and the world and the heavens revloves around the USA. Well it doesn't.

The author is full of and doesn't know diddly-squat.

nmewn's picture

"I don't know if any of you guys saw the 60th anniversy parade or are hip to the fact the USA (government) owes China 1.5 trillion dollars?"

lol...they'll just print em up and send them over tomorrow.

Problem? ;-)

helping_friendly_book's picture

Do you think that will solve the ecomonic disparity in the USA?

I don't think 1.5 trillion will break China but, the USA monetary cabal printing up 1.5 trillion dollars to continue their currency debasement might not be to good for us. I don't want to pay $10/gallon of petrol.

RockyRacoon's picture

$10 a gallon for gas?  No problemo.  Gold at $3,500+ /toz means that gas is the same price as today.

Don't have gold?  Oh.  So solly.

lasvegaspersona's picture

$10/gal sounds about right when Bobby Triffin's little 'dilemma' (paradox if you prefer) is finally resolved. China knows what it has in those $1.5 trillion in treasuries...NOTHING!!! they can't spend them, they are not allowed to invest in the USA to any extent....they will just hold them to keep the books in order until they have enough gold...and like most CBs are getting ready for some kind of major monetary policy change which seems to involve gold.

I don't understand how Geithner (and now Romney) think it is ok to taunt the Chinese unless they just figure that soon it won't make a difference so why not rack up a few points here in the US with a little boosterism.