Michael Pettis Cautions China's Hidden Debt Must Still Be Repaid

Tyler Durden's picture

Debt always matters because it must always be paid for by someone - even if the borrower defaults, of course, the debt is simply “paid” by the lender. As China Financial Markets' Michael Pettis notes, this is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future. The author of "Avoiding The Fall", explains that if the debt cannot be fully serviced by the increase in productivity created by the investment that the debt funded, unless it is funded by liquidating state sector assets it must cause a reduction in demand elsewhere, most probably in household consumption. Therefore, in spite of all the hope among global stock-buying hope-mongers, this reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.


Via Michael Pettis of China Financial Markets,

Five or six years ago, a few skeptics first started pointing out that the credit dynamics underlying Chinese growth was creating an unsustainable increase in debt. This, they warned, would ultimately undermine the banking system and cause growth to collapse if it were not addressed in time.

There were three standard rejoinders to the warnings.

First, analysts argued that investment was not being misallocated, and because credit growth poured mostly into investment, it did not therefore follow, as the skeptics argued, that debt was rising faster than debt servicing capacity. Although I think few analysts still support this argument, there remain some analysts who do not think China has an overinvestment problem. For example my Carnegie colleague Yukon Huang, who has argued, for example in one of the FT blogs that China is actually underinvested:

The perception that China has invested too much is also misleading. Actually, China’s capital stock relative to GDP is lower than other comparable east Asian countries. Moreover, much of the surge in investment over the past decade is due to housing construction, where the country is still making up for the shortfalls from the Mao era.

Because I have addressed this issue many times before in my newsletters, especially the common and distressingly ahistorical fallacy that one can determine whether a very poor country like China is over- or under-invested by comparing its capital stock per capita to more advanced countries with much higher levels of social capital and the consequent ability to absorb investment efficiently, I will not do so again. Needless to say, I think that the evidence of investment misallocation has continued to rise, and in the past two years the number of analysts that are not worried about a systematic tendency for debt to rise faster than debt-servicing capacity has dropped significantly. I have no doubt that their refusal to accept the consensus on the subject is useful in that it helps sharpen the debate, but this is a losing battle and, like the capital stock argument, distressingly ahistorical.

The second rejoinder, which has also largely faded away as an argument over the past few years, is that debt in China doesn’t matter. Sometimes, these analysts argue, it doesn’t matter because it is funded domestically. Sometimes it doesn’t matter because the banks are implicitly guaranteed by the central government. Sometimes it doesn’t matter because China was able to resolve its last debt crisis, 10-15 years ago, in an environment of rapid growth and at no cost, and so of course it can do so again.

Again I have addressed all of these arguments as to why debt doesn’t matter in China many times before and it is pretty easy to show that all of these claims are fairly nonsensical, and this is especially obvious from the very wide range of historical precedents. Debt always matters. Either it must be repaid out of the proceeds of the investment that was funded by the debt, or – if the debt funded consumption or was misallocated into insufficiently productive investments – it must be repaid by transfers from some other sector of the economy, and these transfers reduce growth by reducing real demand.

The third rejoinder should have been, in principle, the easiest to refute, and for a while it looked like it had been refuted to everyone’s satisfaction, but in the past year I have seen a revival. China doesn’t have to worry about rising bad debts in its banking sector, according to this argument, because the PBoC’s extensive reserves will make it easy to recapitalize the banks.

Ray Chan, of the South China Morning Post, for example, had an interesting article last Saturday that made this point. He starts off the article by warning that the rapid growth in credit in China has uneasy parallels with rapid credit growth in the US before the 2007 crisis:

Parallels between the United States and China have started to look more ominous after several years of rampant credit growth and the emergence of an increasingly uncontrollable and unsustainable shadow banking system. China’s massive foreign reserves could, however, be the last tool in the bag for its bank-centric financial system if no timely regulations are implemented.


With the memory of the collapse of Lehman Brothers in 2008 still fresh, investors are fretting over the growth of thinly regulated shadow banking activity. Trusts, entrusted loans and bank acceptance bills shot up sharply to a record 294 billion yuan (HK$370 billion) last month. According to Moody’s Analytics, China’s core shadow banking products, which are often opaque and subject to little or no regulation, almost doubled to 20.5 trillion yuan last year from 11.7 trillion yuan in 2010. The US firm excludes entrusted loans and trust loans as they own underlying assets.

Debt and reserves

The article does a good job of listing many of the problems that have emerged in the past few years, but then quotes a number of analysts who argue that China’s problems is very different from that of the US and it is unlikely to suffer the same kind of crisis. The article continues:

China’s credit situation is somewhat different, though, as it has a high saving rate and massive foreign reserves. Mervyn Davies, a former head of Standard Chartered and British government minister, said: “China is very rich in reserves … At the end of the day, the [Chinese] banks do need recapitalising, which is not a huge challenge to them because the government can recapitalise the banks.”

I agree that China is in a very different position than the US, but this isn’t necessarily a good thing. The main relevant difference is that because all the banks are perceived to be guaranteed by the central government, and Chinese households have a limited number of ways to save outside the banking system, it is unlikely that China will experience a system-wide bank run as long as the credibility of the guarantee survives, and runs on individual banks can be resolved by regulatory fiat (banks that receive deposits will be forced to lend to banks that lose deposits). We are not likely to see a Lehman-style crisis.

We are also not likely to see, however, the advantages of a Lehman-style crisis, and these are a relatively quick adjustment in the process of investment misallocation. I have always said that the resolution of the Chinese banking problems is far more likely to resemble that of Japan than the US, and instead of three of four chaotic years as the system adjusts quickly, and at times violently, we are more likely to see a decade or more of a slow grinding-away of the debt excesses. The net economic cost is likely to be higher in a Japanese-style rebalancing, but American-style rebalancing is risky except in countries with very flexible institutions – financial as well as political.

But I do disagree very strongly with Mervyn Davies’ claim that because the PBoC is “very rich in reserves” it will not be much of a challenge to recapitalize the banks. China’s reserves only matter to its credit position if China faced a problem of external debt.

It doesn’t, and so the amount of reserves are almost wholly irrelevant, because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.

A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.

This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets than the interest rate it pays on much of its liabilities.

In fact there have been rumors for years that the PBoC would be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.

This is the point. Any government that is able to borrow money can borrow money to recapitalize its banks, whether or not it has large amounts of foreign currency reserves. The amount of central bank reserves that China or any other country has is wholly irrelevant, except perhaps to the extent that without those reserves the central government would lack the credibility to borrow domestically, which hardly seems to be a concern in China’s case.

Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%.

Does hidden debt matter?

Before finishing on this topic, I want to address another related fallacy that pops up a surprisingly large number of times when I discuss the net liabilities of the central bank. I am often told that because these liabilities are hidden in the central bank books, and so no one really knows how much debt the PBoC adds to the central government’s debt burden, they really shouldn’t matter in our calculations. The central bank will presumably never default because its obligations are guaranteed by the central government, and the its net liability position is hidden, so why bother even consider the PBoC’s balance sheet when assessing China’s debt position?

Even those who do not understand why this reasoning is incorrect should know that it must obviously be incorrect. If it weren’t, any country could solve all of its debt problems merely by borrowing in a non-transparent way through the central bank. As the Greeks and the Italians most recently showed us, non-transparent borrowing may cause us to recognize a problems later than we otherwise would have, but it cannot solve the problem.

The reason is because in any case debt must either be serviced or the borrower must default. If the assets which were funded by the debt do not create enough wealth with which to service the debt, and if the borrower does not default, then by definition there must have been a transfer from some other entity to cover the difference between the debt servicing cost and the returns on the asset.

Typically this other entity, in China and elsewhere, has been the household sector, and in the case of China the transfer occurred primarily in the hidden form of severely repressed interest rates. Whether the transfer is from the household sector, however, of from other sector, this is where the problem of debt lies for China.

If the central bank (or the commercial banks or any other borrower whose obligations are covered by the central government) is unable to service its debt – and remember that the “economic” debt servicing cost is not the coupon, which is repressed by policymakers, but consists of whatever the “natural” interest rate would have been – the difference will be paid for by someone else, and the economy will suffer slower growth because of the reduction in demand caused by the transfer payment.

So who is likely to cover the cost of NPLs in Chinese banks? This isn’t an easy question to answer. If the household sector continues to pay, either in the hidden form of repressed interest rates, or in the more explicit form of taxes, the existence of bad debt in the Chinese banking system must act to repress future household consumption growth. The transfers from the household sector to pay what may turn out to be a huge NPL bill will significantly lower the household income share of GDP, making it very unlikely that the household consumption share of GDP will rise.

If however the state sector covers the difference (perhaps by privatizing state assets and using the proceeds to pay down debt), we are left with the very difficult political problems, which China currently faces, of assigning the costs to different sectors or groups that control the state sector in China. The potentially very large cost of cleaning up NPLs must be assigned to groups that are likely to be both powerful and reluctant to pay the cost.

Debt always matters because it must always be paid for by someone –even if the borrower defaults, of course, the debt is simply “paid” by the lender. This is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future. If the debt cannot be fully serviced by the increase in productivity created by the investment that the debt funded, unless it is funded by liquidating state sector assets it must cause a reduction in demand elsewhere, most probably in household consumption. This reduction in demand implies slower growth in the future and, of course, a more difficult rebalancing process.

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NoDebt's picture

"Sometimes it doesn’t matter because the banks are implicitly guaranteed by the central government."

Welcome to the party, pal.  Gotcha!  You're more American than you know.  Many countries, one boat.

willwork4food's picture

Debt always matters because it must always be paid for by someone

I am concerned about global warming...and I vote.


markmotive's picture

Great article.

More: Michael Pettis with Chris Martenson on the future of China


Truthseeker2's picture

DEBT BOMB READY TO EXPLODE ---> link explains how and when



DoChenRollingBearing's picture

@ NoDebt

I wonder if AnAnonymous will make an appearance...

NoDebt's picture

One never knows.  It would be cool if he did.

Interesting to watch people come and go as the theme changes over time.  Less interesting that I don't.  

There are some websites I've been on for so long they just show my registration as "2000" because their databases can't display a date for somebody who joined prior to the turn of the millenium (not the case for me here on ZH, but certainly elsewhere).  Someday I'm going to have to have my kids take over my web accounts, if they show any interest in the subject matter.  But not today.



NoDebt's picture

Kito's cool.  I have been personally assured of that.  He's just on sabatical at the current time.

Schmuck Raker's picture

"Kito's cool.  I have been personally assured of that." Uh.....ok....whatever.

My thought was... he HATES Pettis, more than aNoN hates the US.

DoChenRollingBearing's picture

Pettis is right about China, they have so many problems. Here, he does not even address all the non-financial ones (bad demographics, terrible environmental problems).  

If we fail, it will NOT be because the Chinese beat us, we will have beaten ourselves.

fockewulf190's picture

One thing the Chinese are doing right though is that they are stacking phyzz like crazy. China has had a long and horrid history of mass cullings happening within it's population...be it because of natural or man-made disasters. Regardless, they have always taken the pain, plowed through the wreckage, and continued on.

At least they now have a whole bunch of goast cities they can fill up in a time of crisis with those who continue to voice support for the party. Remember, when it comes down to it, the Chinese government OWNS everything within China, regardless of what might be written on paper, and the Chinese military has never been stronger than it is right now. They can reset the system anytime they want, and no inside, or outside force is capable of stopping them.

Vampyroteuthis infernalis's picture

As valuable as phyzz may be, it will not help a dysfunctional society become functional. Communism does not work. Not today, not tomorrow, NOT EVER!

Oldwood's picture

We have heard it all before.Too much debt that can never be repaid means its all coming down...but it doesn't. These massive debts just create a giant sucking of the wealth from the producers until there is nothing left for the producers to sustain themselves. Then and only then, the parasite dies.

Totentänzerlied's picture

Do you consider the planet a producer? What about humans?

Oldwood's picture

A producer create things of value others are willing to trade their production for. Parasites only consume without consideration of the host. A parasite can be a government employee who forces a producer to pay his wages regardless of if the producer sees any value. An entitlement consumer is a parasite if they contributed little or nothing to the fund. There are countless examples of parasites and growing. That IS the problem.

firstdivision's picture

Is China the one responsible for taking WTI to pound town tonight whilst doing coke off natty's back?

ZH Snob's picture

the party will really begin once the chinese launch their gold trade centers that are sure to finally supplant the USD as the world's reserve currency.


of course this will be quite an adjustment, but at least we will have plenty of time to reflect as we are eating our daily allotment of beans.

MFLTucson's picture

Let’s see if we share Michael’s concern.  The Chinese have more Gold than any country except Russia.  Not imaginary Gold hidden in Ft Knox but real Bullion.  The Chinese have 3 Trillion in excess reserves.  The US has no Gold and is 17 Trillion in debt and printing money to buy its debt.  Hey Michael, which picture you think has a better future?  Then why waste our time with this bullshit game?  Focus on the real disaster!


This article is a joke!

LongMarch's picture

ok, so the Chinese got into this position by rapid increases in debt demoninated in RMB. Care to explain how they then turn around and back it with gold?

Theosebes Goodfellow's picture

First off, outstanding article and excellent discussion. To answer the question LongMarch, the moment they do back the RNB with gold, (and that day is coming), to a certain extent thay get to set the initial exchange rate, since they've been manipulating that versus the dollar, (and all other currencies), all along. But once they peg the yuan to gold, or more precisely back the yuan in gold, they instantly become the world's reserve currency. In a sense, doing this could and would probably be construed as an act of war by the USA, (unless of course they do it whilst Obama is president since the cat simply lack the cojones to really put up a fight).

Lastly, for the newbies, (and I remember when I was one and didn't know all the acronyms), NPLs are Non-preforming Loans, i.e., defaults.

Oracle 911's picture

China don't have that much loans and not even that much NPL's for giving reason in Chinese dept default.

Reason, Chinese family or individuals buying real estates mostly from savings, so if there will be NPL it is on developers side or on the side of landlords/speculates.


The real reason or many reason behind the Chinese slow down are these main cases:

-drop in demand for Chinese products;

-practically nonexistent Chinese middle class i.e. domestic demand for products.

q99x2's picture

No one is going to repay debt to banks. We are going to outlaw debt in a few years anyhow. 

falak pema's picture

we are going to bail in massively; like in Cyprus.

WHen the banking and fiscal system hits the asymptote. 

Which it will as we are in peak cheap oil and we will be in peak cheap money; the second is inevitable because of the first strangulating productivity and natural economic growth.

And the reserve will burn under BRIC pressure. When? Nobody knows but since Syria, the signs are all out war to save Pax Americana is no longer an option that the US MIC now considers. 

They run the political war machine and Snowden's lullaby is now making them entrench in their home bunkers like scared rabbits under the headlights. Awesome turn around of the psychology of Pax Americana war game worldwide.

If this trend continues, it will inevitably effect the reserve status and then the economic slide becomes a rout and the FED is left holding the rotten bag, so clumsily hidden behind the tinsel curtain of FAMA's "what crisis, no crisis" song. 

luckylongshot's picture

It is simply dishonest to say that debt always matters because it must be repaid by someone. Firstly history shows a repeating cycle of debt bubbles being written off, dating back to the Pharoah that indebted his people  building the great pyramid. Secondly if it is interest free it does not need to be repaid. Thirdly if there is a public banking system, free from the  private banking parasites that infest the westérn worlds financial system, the state can write off the debt without consequence. This is how China operates and unfortunately many western authors make fools of themselves by missing this point. Michael Pettis is yet another of these.