Michael Pettis Warns China Bulls "It Is Almost Impossible For Growth To Remain This High"

Tyler Durden's picture

With manufacturing and non-manufacturing PMIs disappointing, and the nation's banking system still stuck in the thralls of a liquidity crisis (each time the PBOC removes the punchbowl), Michael Pettis' warnings are becoming increasingly likely (even though consensus remains that China will save the world somehow - as it transitions 'smoothly' to a consumer-based economy).


Excerpted from Michael Pettis' China Financial Markets blog (author of "Avoiding The Fall"),

What has been surprising to me is that many analysts – some of whom, but not all, recognize how difficult implementation is likely to be – expect that the reforms will unleash such a burst of productivity that growth rates in China will be maintained or even raised from the current GDP growth target of 7.5%.


This, I think, is extremely implausible. Much of what I have written in recent months concerns the difficulty Beijing will face in switching from one growth model, in which rapid growth disproportionately benefits the elite at the expense of ordinary households, to its alternative, in which much slower growth will disproportionately benefit ordinary households at the expense of the elite.


 I am convinced that analysts who predict that we are about to embark on a decade of 7-8 % growth both misunderstand the nature of China’s transformation and ignore the history of previous similar growth miracles.

It is almost impossible – in my opinion – that GDP growth rates over the rest of this decade remain at or close to current levels.


To explain why, I want to list three of the thoughts I came away with from the general reaction to the Plenum.

First, while many analysts hailed the reforms proposed during the Plenum as extraordinarily “bold” and “innovative”, in fact Chinese economists have been debating these very reforms for a long time – even before March 2007, when then-Premier Wen Jiabao famously described China’s economy as “unsteady, unbalanced, uncoordinated and unsustainable.”


To resolve this problem China must implement reforms that increase investment efficiency. This includes diverting resources from the state sector to small and medium businesses. Beijing must also increase the consumption share of demand, which requires above all an increase in the household share of GDP.

Boiled down to their essentials, the economic reforms proposed during the Third Plenum would do just that – by reforming the currency and interest rate regimes, changing the allocation of credit in the financial system, spurring innovation, reforming land ownership and residency requirements, imposing stronger rule of law, and perhaps even partially distributing state assets to households. There is nothing surprising or unexpected about any of these proposals.


The second thought I came away with from the consensus reaction to the Plenum is, as I have said many times before, that historical precedents suggest that the greatest challenge facing Beijing is not in identifying the right set of reforms but rather in implementing them. The reforms are relatively easy to prescribe, but political opposition to the reforms is likely to be very strong.

[Policies]  resulted in at least two decades of solid and healthy growth, the state sector and the economic elite benefitted disproportionately from the combination of rapid growth and implicit transfers from the household sector. In fact the GDP share retained by ordinary Chinese households shrank dramatically over the past three decades, while the share retained by the state grew commensurately, of course, and income inequality widened. This has nearly always been the case in the early stages of the investment-led growth model – the state and the elite benefit disproportionately.

Now that soaring debt is forcing China to abandon the model, the relative distribution of economic benefits must be reversed. Ordinary Chinese households must retain a growing share of future economic growth, while the state and the economic elite must, almost by definition, retain a shrinking share. This is ultimately what it means to rebalance the economy and – as happened in other countries that followed this growth model – this is why the reforms are likely to be politically difficult. After thirty years in which the interests of the elite were positively aligned with the interests of the country, the reforms now imply a negative alignment of their interests.


My third thought, and this is the most important point, is about the pace of post-reform growth. Many economists believe that a successful implementation of reforms must guarantee growth of 7% or more during the rest of this decade, but this probably represents the greatest piece of confusion about China’s adjustment.

There are however at least three very strong reasons, I think, to argue that as the reforms are implemented, growth rates must drop sharply.

1.  Growth rates underpinned by tremendous credit expansion, which acts to increase demand, are unlikely to be maintained in a period of relative deleveraging, during which demand is reduced.

It is widely acknowledged that perhaps the most important reason to change the Chinese growth model is its excessive reliance on debt to generate growth. Debt has soared in recent years, to the point where many economists simply look at credit growth in the current quarter in order to determine what GDP growth over the next few quarters are likely to be.

But as China deleverages, growth in demand must drop sharply. After all if economic growth over the past several years has been goosed by rapid credit expansion, deleveraging must have the opposite effect. It is strange that economists who acknowledge that the current growth model is overly dependent on debt have failed to understand that its reversal will have the opposite impact. If it did not, it is hard to explain why anyone would consider debt to be a problem in the first place.

2.  The failure by Chinese banks to recognize misallocated investment must overstate past GDP growth, in the same way that this overstatement must be reversed in the future, either because the bad debt is explicitly recognized, or because it is implicitly written down over the debt repayment period.

If China currently has wasted significant amounts of investment spending, it is clear that much of the accompanying bad debt has not been written down correctly. Bad loans are almost non-existent in the banking system – that is they have not been recognized in the form of reserves or write-downs – and there have been no significant bankruptcies.

There may be good reasons for this. If a loan has been made to fund a project whose economic value is less than the economic cost of the investment, economists should treat it as a bad loan whose negative present value must be written down. However if the lending bank believes that the government implicitly or explicitly backs the loan, the bank does not need to write it down.

But while the bad loan might not represent a loss to the bank, it does represent a loss to the country, and the amount of that loss should be deducted before the country’s GDP is calculated. If Chinese banks have not correctly written down the bad debt, however, past GDP growth must be overstated by an amount equal to all the bad loans that have not been written down – a fairly large number that may amount to as much as 20-30% of GDP.

But the failure to recognize the loss does not mean that the loss does not exist. The losses implicit in the bad loans must (and will) be written down over the future, either explicitly, in which case they will result in a direct deduction to GDP growth, or implicitly, in which case they will require implicit and hidden transfers from one part of the economy or another (usually the household sector) to cover the gap between the “real” cost of capital and the nominal (subsidized) cost of capital. This transfer must reduce future growth.

The point here is that if credit is a problem in China – something no one doubts – it must be a problem because of wasted investment that has yet to be recognized, otherwise it would have resulted in negative GDP growth today. Failure to recognize the investment losses will, of course, artificially boost GDP growth today, but it must also artificially reduce GDP growth tomorrow as the recognition of those losses is simply postponed, not eliminated. The failure of many economists to recognize that wasted investment has a cost – even as they recognize that investment has been wasted – has caused them both to misunderstand the relationship between wealth creation and GDP and to understate the future impact of this overstated GDP.

Debt matters, and the only time it can be safely ignored is when debt levels are so low, and the borrower is so credible, that it creates no financial distress costs and has a negligible impact on demand. Neither condition applies in China, and so any prediction that ignores debt is likely to be hopelessly muddled. In fact I would like to propose a simple rule. Any model that predicts China’s future GDP growth must include, if it is to be valid, a variable that reflects estimates of the amount of hidden losses buried in the banks’ balance sheets. If it does not, it cannot possibly be a valid model to describe China’s economy, and its predictions are useless.

3.  The same mechanisms that forced up China’s growth rates created China’s imbalances, and reversing the latter means also reversing the former.

China’s astonishing growth during the past three decades is partly the result of a system that subsidized growth with hidden transfers from the household sector. These transfers are at the root of the current imbalances, and once reversed, so that China can rebalance its economy towards healthier and more sustainable sources of demand, the very processes that turbocharged growth will no longer do so.

If growth has been healthy and sustainable, in other words, there would be no need for Beijing to change its growth model – in fact it would be foolish to do so. If growth has not been healthy and sustainable, this is almost certainly because it has been artificially propped up, and if the reforms are aimed at unwinding the mechanisms that artificially propped up growth, then subsequent growth rates must be substantially lower.

Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth.

One of the most obvious places in which to see this is in excess capacity in a wide range of businesses. It is clear that Beijing recognizes the problem of excess capacity. Here is Xinhua on the subject:

Tackling excess capacity will be one of the top tasks on China’s economic agenda in 2014, as the issue becomes a major challenge to maintaining the pace and quality of economic growth. “The Chinese economy still faces downward pressure next year,” the Central Economic Work Conference pointed out on Friday, citing the capacity issue weighing down some sectors as one of the major challenges facing the world’s second-largest economy.

It should be obvious that building excess manufacturing capacity, like building up inventory, is a way of propping up growth numbers today at the expense of tomorrow’s growth numbers. Closing down excess manufacturing capacity must be negative for growth in the same way that building it was positive.

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth.


GDP growth rates of 7% or more, on the other hand, will suggest that credit is still rising too quickly and that China has otherwise been unable to implement the reforms, in which case China is likely to reach debt capacity constraints more quickly. Growth of 7% for the next few years, in other words, is almost prima facie evidence that China is not adjusting.

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Richard III's picture

To Mr. Pettis I aver: a command economy may surprise you.

Harbanger's picture

Forget Mr. Pettis.  Confucius say, Nations with a surplus in trade end up owning all the Gold.

Son of Loki's picture

If they keep flooding their economy with trillions, the 'growth' [and inflation] will continue.

disabledvet's picture

Japan had surpluses "until just recently"...where's all that gold? "China is a lot bigger" i'll grant that. rolling that debt over comes at a price however. Policy makers take note...

artless's picture

Oh, Oh, Oh, I just had to get in on this one and not only because I've down voted (and was probably a tad rude to) disabledvet in the past.

China? Really? While I admire the smarts for holding metal they are a command economy and anyone with half a brain can see that not only are many of their numbers massaged so much as to make ours (US gov) seem honest, but they have embarked on the very same Keynesian stimulus nonsense that everyone else has except-and this is a very big except- the have done it to the tune of a several MORE trillions of dollars. That's not gonna work out all that well.

Here's China in a nutshell. They cannot feed their poulation without MASSIVE importation. Thta's also getting worse as they fuck up their ecology (they have already fished out their seas hence why they are trolling West Africa) flooded farmland, etc AND have a ever growing demand/need for food. That demo along with they have to keep all the otherwise umemployable doing SOMETHING, and they over sized population of males v females and well, THAT"S not gonna work out well either.

China HAS TO purchase a shit ton of their energy from foreign sources. That will only grow as they need more of everything as opposed to The US which CHOOSES to do so and if forced to could withdraw from the world market oil/natgas or at least ONLY use Canada which is like asking your brother for help.

The Japan/ China comparison is why disabledvet has it right. Japan was supposed to take over the world. They had trade surplus, were buying places like Rockafeller Center, land in the US, etc. But like every other dumb fuck Keynesian neo-fascist nation state they blew it and have been in the dessert for what, twenty years now? While they have their challenges I think China's demo problems are far worse.

The US holds the cards. We have suandered our hand for decades, and entirely so in the last 30 or so years but without the US (the customer, the cionsumer) the China miracle comes to a screechiung halt. Not just because we buy all the shit but because we still invent pretty much everything worth damn-japan/China/etc just use our tech in many cases. Obviuosly that analyzation is not oin sprecific small advances but over time with the larger developments. Until these places invents things like TV, video, etc they will always be the vultures of R&D.

Then there is the history part. China was about as low as a nation could be during the Carter years. When all you have left is to go up, it makes growth a much easier thing. Of course China grew from 1980-now. But growth-regardless of our stupid obsession wirh it and our belief that it can be infinite AND ongoing AND exponentially ever increasing regardless that arithmetic says othersie-ha a way of coming to a halt without huge socio-economic upheavals. The kind which command economies rarely allow and certainly do not foster.

But to stress one point really hard. The China thing is a largely a huge fucking mirage. Kinda like our current "properity" but only worse.They gonna crash and it ain't gonna be pretty.

And just to clarify I'm not endorsing Team Amerika or chearleading USA! USA!. Our government sucks balls and is the scourge of humanity. As another ZHer wrote "we are the one inch dick in the eunuch colony"

FieldingMellish's picture

Yes indeed. Real growth may slow but nominal can be kept near double digits for a long time, even if a loaf of bread costs $10 but to pull this off, they would have needed to make sure that the finances of the government were backstopped by something like.... gold. But that's not likely to happen... right?

Freddie's picture

Confucius say - F U Bernake!

lewy14's picture

Is Pettis forgetting the "consumer credit" ace in the hole?

If the only entity in China which as so far not levered up does in fact get levered up, won't that juice things for another round or two?

Worked for America. (And by "worked" I mean "fucked over", but whatever).

If the CCP says borrow, you borrow. Command economy + leveraged consumerism -> mother of all blob-ups.

Musashi Miyamoto's picture

Where is china's growth? It is not Industrial Capacity driven by western consumerism for we will soon be consuming far less. Is it not an emerging middle class? I dare not say without further incite. I can only point to the enormous credit expansion in that "communist" country. It is easy to pretend, bullshitting the world when you blow trillions of hot air. The ultimate truth cannot be held in the bay for much longer. It will break free and will bring with it the forces of karma and of the human motivation of an oppressed masses. Let the chips fall where they may. Social upheaval is only inevitable.


rsnoble's picture

Secondly has growth even been 7%

And can growth be graphed alongside environmently and human rights destruction?  Surely that chart is about topped out.

jcaz's picture

....Only if population has doubled every 10 yrs....

Seer's picture

7% growth, hm... a DOUBLING of the economy in only TEN YEARS!

These kind of numbers are fine with small entitties (though it's unlikely they can keep this pace up for a decade), but when we're talking about the 2nd largest economy on the planet...

Doubling energy imports will rapidly drain their reserve "wealth." (add in that their exports are likely to fall significantly, especially as a percentage applied to their overall growth)

q99x2's picture

China is going downhill fast and they will hang bankers.


Harbanger's picture

China's central bank is run by.......?

Playtime's Over's picture

What a wonderful time to be alive.  Race to the bottom.  

Seer's picture

Normalization.  The "up-swing" was only an illusion.

Wilcox1's picture

So are the hidden transfers from the household sector and the race to the bottom one and the same?  An amortization of the Chinese populaces' hind-ends to this unsustainable economic model?

starman's picture

1.3 Billion credit cards with 17-24% interest rate! A Bernankie wet dream!

dunce's picture

Stien's simple dictum "that which can not go on forever, won't" will be proven once again. They are not stupid, they know that, so why the lemming behavior? Are they locked into a Malthusian destiny?

hardcleareye's picture

A repost of a comment I read on Pettis' blog

"The only way for China to readjust is for the elite to lose power. But this will mean chaos, because the economic system (e.g. see corporate debt) is not capable of functioning without the elite.

....There is only one way, which is an overshoot into chaos."


Dubaibanker's picture

China GDP 1983 - USD 301bn, Annual Growth 10.9%, GDP growth in value USD 32.80bn

China GDP 1993 - USD 613bn, Annual Growth 13.50% , GDP growth in value USD 82.7bn

China GDP 2003 - USD 1,640bn, Annual Growth of 10.0%, GDP growth in value USD 164bn

China GDP 2013 - USD 8,230bn, Growth of 7.50% estimated, GDP growth in value USD 617.25bn

I urge Mr Pettis and some other nay sayers including the best western financial media to TRY to focus on the actual value of growth in GDP instead of focusing on the issue of % growth. 7% or 20% does not matter. What matters is the base and the actual value of GDP growth.



China is adding the size of Switzerland OR Saudi Arabia worth GDP every year in 2013, so you may ignore it at your own peril. Or it is adding the COMBINED GDP of Denmark and Malaysia to itself every year. Ask yourself, does percentage growth even matter?

You may also look at its currency which is now 20% higher than it was 5 years ago. Every other currency in the world is between 20% to 50% weaker over the same period and yet can only create 2% GDP growth with 3% inflation. Hee haw to those who believe that this is GDP real growth!

China does not need 7% or 8% growth rates. All it needs is 5% or 4% growth to create USD 500bn of new GDP every year from a higher base and maintain social stability through per capita growth.