Michael Pettis Warns China Bulls: "Bad Debt Cannot Simply Be 'Socialized'"

Tyler Durden's picture

Excerpted from Michael Pettis latest letter to investors,

Clearly in the past two or three years there has been a huge shift in market perceptions of Chinese debt. Everyone recognizes that debt has become a serious problem.

But there are two very different ways to recognize this. Some believe that the Chinese financial system, and perhaps the shadow banking system more specifically, took a number of wrong steps, compounded by the lack of discipline among local governments, and created a debt problem. By that logic, Beijing can take administrative steps to address credit creation and to bring debt under control. It is especially important, according to this view, to analyze the source of risky credit creation and to suppress it, which is perhaps why so much attention of late has been placed on the shadow banking system and on ways in which Beijing can “resolve” the existing stock of bad debt.

My view is different. Burgeoning debt was not an unlucky accident. It is fundamental to the way the growth model works, and we have arrived at the stage, probably described most imaginatively by Hyman Minsky in his work on balance sheets, in which the system requires an acceleration in credit growth simply to maintain existing levels of economic activity.

China’s debt problems, in other words, cannot be resolved administratively, by fixing the shadow banking system, by imposing discipline on borrowers, or indeed by eliminating financial repression (much of which, by the way, has already been squeezed out of the system by lower nominal GDP growth). Without a massive transfer of wealth from the state sector to the household sector it will be impossible, I would argue, for GDP growth rates of anything above 3-4% – and perhaps even less – to occur without a further unsustainable increase in debt, whether that increase occurs inside or outside the formal banking system and whether or not discipline has been imposed on borrowers.


Last month I spoke with a very prominent European economist and he assured me that although he now agrees (he used strongly to deny it) that China has debt “problem”, he believes it can easily be resolved by “socializing” the debt, by which he means transferring it onto the government balance sheet.


I disagree completely, and not just because transferring bad debt from local governments to the central government, while undoubtedly reducing the probability of a legal default, does not in the slightest way address the cost of resolving the bad debt. The “successful” previous bailouts were not successful in any way if you place their “success” in the context of the rebalancing process, and this is obvious if you work through the full consequences on the structure of Chinese demand.


Because economists for many years have been trained to ignore balance sheets and, more generally, the way debt drives economic activity, the quality of analysis, especially the analysis of economic turning points during which the amount and structure of debt can create significant constraints on the way rebalancing can occur, has devolved, to be replaced mostly by vaguely empirical and very mathematically confused constructions.


I have described many times before why excess credit creation is at the heart of much of China’s GDP growth, and why this means that China must choose between a sharp slowdown in GDP growth as credit is constrained, or a continued unsustainable increase in debt.

No other options are available. But even this point is about new credit creation does not address the existing stock of bad debt, which is what I want to discuss in this blog entry. If you assume that for many years China has been misallocating investment (by which I simply mean that the resulting increase in productivity generated by the investment was less than the correctly calculated debt-servicing cost), it should be obvious that because there have been almost no defaults or other forms of debt write-down, the implicit losses have simply been rolled over, most likely in the balance sheets of the Chinese banks. This has several implications:

1. GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%. Why? Because in an economy in which losses were not simply accumulated and rolled over, the amount of the write-down (which would have occurred, either as a default, or as an equivalent transfer from a more profitable part of operations to subsidize the loss) would have shown up as lower GDP.


2. In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.


3. Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down. Over long periods of time every economy recognizes investment losses, but depending on how these losses are treated, the recognition can take place either in the period in which the losses occur or over the loan amortization period.


4. There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.If the gap is covered by financial repression, for example, (i.e. the authorities force down the borrowing cost to less than the increase in productivity generated by the project, so that the borrow shows a profit), the cost of amortizing the loss is passed onto the net lenders (usually, but not always, the household sector, who are net lenders to the banking system) in the form of a lower return on their savings. This lower return reduces their total income and, in so doing, reduces their consumption, which effectively reduces future GDP growth by reducing demand.


5. GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained. When the system is still accumulating and rolling over losses, in other words, GDP growth is systematically biased upwards. When it stops, GDP growth will be systematically biased downwards.


6. This bias can be considerable. Let us assume, for example, that the real growth in an economy causes it to double its wealth every 10 years. Real GDP would, in that case, increase every year on average by nearly 7.2%. Let us also assume that during the first ten years, GDP growth was overstated by a failure to recognize investment losses, so that reported GDP growth was actually 10%. Finally we will assume that after ten years, this over-reporting stopped, and the excess GDP was amortized during the next ten years so that at the end of twenty years GDP was once more correctly stated. The numbers how that at the end of ten years, reported GDP would be overstated by 22.9% – that is, instead of doubling, reported GDP would be 159% higher. During the next ten years, as real GDP continued to grow by 7.2%, reported GDP would grow on average by just over 4.4% as the earlier losses that had not been recognized were amortized.


7. My numbers above assume that the overstatement and understatement are symmetrical. In fact the process is not symmetrical because of the possibility of financial distress costs. The total value of overstated GDP during the period when losses are being rolled over is only equal to the total value of the subsequent amortization of those losses if there are no financial distress costs.


8. But there are in fact likely to be substantial financial distress costs. In corporate finance theory we have a very clear understanding of how high debt levels change incentive structures in such a way so as to reduce overall growth. This means that the longer it takes to amortize the hidden losses, the greater the amount by which the future amortization costs will exceed the current overstatement of GDP. Japan after 1990 might a good example of this process. Its share of global GDP rose from roughly 10% in 1980 to 17% at is peak, only to have declined since then to roughly 9% of global GDP. This is an astonishing relative decline, and it must have been made worse at least in part by the financial distress costs imposed on an economy unwilling to write down debt correctly.


9. Remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.


10. There are three sectors to whom the cost can be assigned: households, businesses, or the government. In China we might usefully think of these as households, small and medium enterprises (SMEs), and the state sector (in principle there is a fourth sector, foreigners, to whom the losses can be assigned, but it is very unlikely that they will bear much of the losses). It is pretty clear that after the banking crisis of the late 1990s, the losses were assigned, largely in the form of financial repression, to the household sector.


11. To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth. Rebalancing means effectively that consumption growth (and household income growth) must exceed GDP growth, which means that even if GDP growth slows to 3-4%, as I expect, household income can continue growing at 5-6%. This explains why, contrary to the consensus, a more slowly growing, rebalancing China will not lead to social unrest.


12. Of course if the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.


13. Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.


14. Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector. This is likely however to be politically difficult. China’s elite generally benefits tremendously from control of state sector assets, and they are likely to resist strongly any attempt to assign to them the losses.

This is how I think we need to think about China’s debt problem. Notice that I am making no predictions. I am only trying to outline as schematically as possible the only ways in which the debt problem can be resolved. There are no other possible ways to address the debt, and so any analysis we do or propose must be consistent with the model described above.

The key point is that we cannot simply put the bad debt behind us once the economy is “reformed” and project growth as if nothing happened. Earlier losses are still unrecognized and hidden in the country’s various balance sheets. These losses will either be explicitly recognized or they will be implicitly amortized. The only interesting question, as I see it, is which sector will effectively be assigned the losses. This is a political question above all, and its answer will tell us a great deal about how the newly-constituted, “reformed” China will grow over the next few decades.

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idea_hamster's picture
"Bad Debt Cannot Simply Be 'Socialized'"

The hell it can't!

Anyone who says otherwise is a "sabateur" and will spend the next 3 years in a pig sty!

Escrava Isaura's picture


The Chinese are counting on US consumers to bail them out… while US economy is only at the beginning of its slump.

Chimerican to the dump!

ArkansasAngie's picture

Insolvency vs. Illquidity.

They never addressed insolvency.  Liquidity doesn't solve insolvency.  

Chinese fire drill?


pods's picture

And here I thought dead pigs floating down a red river which you actually cannot see due to the smog was the biggest problem facing China.

They are going to have to get a bigger fog machine.


Escrava Isaura's picture

Pods... Not if you sail at night... you'll miss the pigs and smog.

Coughing might be an issue.

Zeta Reticuli's picture

I live in China. The smog is just another small trouble. You laugh at it. Besides, the people who live in all those polluted-air cities like Beijing, Shanghai, Shenzhen, and Hong Kong all live longer that the average American.

Insert clever remark about last laugh here.

pods's picture

For your health I hope you are right.


nmewn's picture

You either default on it or pay it off with devalued, hyper-inflated currency which buys less & less than it did the day you borrowed it.

Good luck ;-)

disabledvet's picture

Again "the problem is dirt cheap energy" (free for lack of a better word) inside the USA. "You lever oil to ten trillion, buy Chinese everything and wipe your ass with MBS and all that other shit paper."

Worked great from 1993-2008.

Once you reach peak demand however (2008) there is just no way to relever anymore...thus "commence the cascades of default."

And dollar just crushed the Loonie last week "and people are surprised at gold prices getting annihilated"? Bwhahahahahahahaha. That entire country is levered to the price of gold!

A super weak dollar is changing the terms of trade globally in a dramatic and primae facie manner. "Now shut up and kill Muslims" seems to be (have been? We have Ukraine now) the..."rhetorical device."

Something isn't going according to plan with interest rates this low though.

And I would argue "that is a good thing." That's not what the war on "terror" was about.

Escrava Isaura's picture

Disable... Plan? There are NO plans.

So, give them Bread & Circus.

AUD's picture

With a name like Michael Pettis, Michael Pettis would have more credibility if he applied that theory to the debt of his own country of origin, rather than constantly claiming that China has a bad debt problem.

He probably pimps US Treasuries.

Escrava Isaura's picture

AUD.... Michael is from Spain.

US is the boss of the world. How dear you.........

malek's picture

Yes, his complete ignorance of the biggest elephant in the room is astounding, if not laughable.

Wild Theories's picture

Agree on the existence of bigger elephants on the planet.

Though in his defence, he is a China economist, so critiquing the rest of the world technically isn't his job.

Escrava Isaura's picture


I realized, especially by living in Washington, DC, PhD’s do not want to hear reality. They are as blind as Catholics would be about their religion. It's a cult/cast system.

DoChenRollingBearing's picture



Michael Pettis is extremely respected among China watchers.  Just sayin'.

Escrava Isaura's picture

And great writer.

By the way Malek, agree with you.

Wild Theories's picture


Even if you may not agree with his every points, his opinions are still a worthy read and well worth considering.

IronShield's picture

Quick,  someone flag down the dim sum cart; need me some more steamed buns with the mystery filling. 

The Most Interesting Frog in the World's picture

So let me summarize for good ole USSA:

Four possible groups could have taken the losses: GS and fellow bankers, government, the taxpayers (approximately 45% of adult US population), foreigners (BTW in Cyprus foreigners did take the hit)

1) GS and bankers were bailed out by the government,

2) which produces nothing so gets bailed out by foreigners lending money

3) Foreigners get paid by taxpayers

4) taxpayers left holding the bag

Not exactly a surprise ending...

Captain Willard's picture

The Central government will be forced to nationalize the Provincial bad debt. Of course, the Cadres responsible for the mistakes will be purged. The Central Commitee will assert more control over the local Parties.

This will be the first response, along with letting the currency depreciate. It probably won't work, but it will buy them some time. Bring your popcorn - it is likely to be a long movie, not a short crisis.

Professorlocknload's picture

The Cadres responsible have already purged themselves and purchased US Real Estate.

Escrava Isaura's picture

US real estate as investments? Let me think: "What could possible go wrong."

Professorlocknload's picture

Guess we might want to ask the Japanese how their investment in Pebble Beach worked out.

But a Half Mil buys a green card and a place to live, until the other millions are laundered. Beats the gulag back home.

caustixoid's picture

"excess credit creation is at the heart of much of China’s GDP growth, and why this means that China must choose between a sharp slowdown in GDP growth as credit is constrained, or a continued unsustainable increase in debt.China must choose between a sharp slowdown in GDP growth as credit is constrained, or a continued unsustainable increase in debt".

So basically China must either suddenly choose pain or choose to do tomorrow what it has done the last 5000 days in a row... hmm, I wonder what they'll do... hmm....

Escrava Isaura's picture


Google"The End of Chimerica" by Niall Ferguson, and you'll find these answers.

Professorlocknload's picture

What politician, anywhere, ever, doesn't take credit for the good and push the bad onto the next watch?

Wild Theories's picture

Pettis is always a worthy read, he's one of the few sane economists who still think bad debt is bad.

Too bad every other economist (working) in the west is on the 'debt is good, good debt is good, bad debt is doubleplus good' train.

Escrava Isaura's picture

Wild Theories

How would they have jobs, if not for debts? That's the beauty, got it? Production are for peons.

shadescale's picture

Well, the Chinese have to buy something with the USD before it collapses....

Ban KKiller's picture

Accountants, banksters and the debtors all walked into a bar...

illuminato's picture

bas debt is always socialised isnt? 

dag's picture

Great article.  

Schmuck Raker's picture

Professor Pettis is the "Bomb".

BTW, most of what he says is only nominally JUST applicable to China.

laomei's picture

I guessed it was a pettis article, and sure enough it was.  he's more or less a gordon chang with better credentials, but his thinking is still hilariously wrong.  He's been wrong about pretty much everything and suffers from the economist syndrome of assuming everything works the way he was taught it works and stays at a constant.  While he is residing in a world of variables and an economic/political structure that runs contrary to everything he was taught.  The vast vast vast majority of the bad loans (there are far more good ones) are effectively the government borrowing money from itself and can again, be effectively written off without consequence.

Local governments have been borrowing from the state banks to fund development which increases land value which is from which they derive their main income... as there is no property tax and other taxes go to the central government directly.  The state banks are backed by the government. ?Worst case scenario, there are writedowns and individual investors get their money back with reduced interest for the bonds the bank passed along.  More likely, the banks will end up eating some of the losses, which does not matter because they are incredibly profitable as it is.  It's not so doom and gloom as pettis and his ilk demand to exist.

demoses's picture

This would be like Germany in 1943 blaming the USA for putting the Japanese in the Internment Camps while at the same time having a much crueler version themselves. Oh the irony...

hedgiex's picture

All that the Professor said are the forecasts thrown out of his model for a largely free market capitalist state. This is China still embedded in state capitalism where monetary policy is not independent but directed from atop of a planned economy.

China has the reserves to arrest critical problems in its economy. It does not play the short game of economic growth and has to worry about markets dictating its directions.

The crucible lies in China's middle class (that really matters) in being convinced that they will take the bumps and shall galvanize the populace to sacrifice. They have a dream much despised or underestimated by economists playing with Western Models and that dream is to focus on being an economic power.

(keep hoping that there is 100 m middle class morons who have rural farmer mentality that are daily briain washed by their equally moronic leadership).

Those shorts taken years ago are licking their wounds and yet the drum beats go on. Not saying that there are no serious economic challenges particularly when this already the World second largest economy adapting at iis own pace to free market practices.

China at worse if all of the Professor's prognosis comes to past may even be the last major economy standing. You want to understimate the power of a creditor nation in today's global economy ?

Escrava Isaura's picture


Well said, in my opinion, hed.

State capitalism is the accurate description, instead socialism. China is not socialist. Cuba and the Amish in Pennsylvania, are.

“…brain washed by their equally moronic leadership.”

Therein lies the problem, everywhere.

AdvancingTime's picture

Much of the recent growth in China after 2008 came from a massive 6.6 trillion dollar stimulus program that expanded credit and poured massive amounts of money into the system. This money encouraged expansion and construction with little regard as to real demand or need. Like a plane on autopilot China continued in the direction it had been on.

Now China finds itself in a credit trap. For years the people of China have had the habit of saving much of what they earn but the low interest rates paid at banks has not rewarded savers. With few investment options much of this money has drifted towards housing and driven housing prices sky high. The economic efficiency of credit is beginning to collapse in China and the unwinding of China’s giant credit spree could be very painful. More in the article below.



AdvancingTime's picture

A great deal of any economic system has to do with the concept of debt. It is important to remember not all debt is created equal. A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects. Joining the idea of a mirage and contagion with the reality of collapsing debt forms an interesting subject.

It is important to remember all debts and obligations do not come due at the same time. Also, it must be noted when a bill is not paid or defaults it often starts a long and drawn out legal battle, this collection process that may extend years without harsh consequences. This my friends is the reality of modern life in America and much of the world. More on this subject in the article below.



andrewp111's picture

China could paper over the losses by simply printing enough Yuan to cover them. This would pay for the losses through inflation. But which sectors bear the brunt of inflationary losses? That is not entirely clear. The household sector pays unless their wages are rising faster than inflation. The Corporate sector pays if wages are rising faster than inflation. The State sector pays if the cost of the things it buys (military hardware) rises in price faster than general inflation. Or if China allows free export of Yuan, that will involve foreigners in the action. They could also impose the costs on foreigners by conquering territory and grabbing valuable resources.

Global Observer's picture

The problem is not about generating money, that any Cantral Bank can do. Problem is getting it into the hands of people with debts, without someone else going into debt. Conventional banking has no answer for that. But there are other options as I pointed out in my post below yours.

Global Observer's picture

I have described many times before why excess credit creation is at the heart of much of China’s GDP growth, and why this means that China must choose between a sharp slowdown in GDP growth as credit is constrained, or a continued unsustainable increase in debt.

No other options are available.

Actually there are, but none within the conventional banking system. Chinese government can issue sovereign credit notes for a limited period of time, that can be used to pay off bank debts. These can be distributed to all the citizens equally. Those without any bank debt can sell them to those with bank debts at par. This can be a dangerous precedent in a democratic set up, since governments can increase entitlements endlessly through sovereign credit until the sovereign credit notes lose value completely, but no problem in a single party system like China's. They need to issue the sovereign credit notes only to the extent necessary and by setting an expiration date on them can ensure they don't create a parallel money system.