- One of the most important challenges for investors is to assess China’s long-term prospects. A recent analysis by a prominent China watcher, Professor Michael Pettis of Peking University, reshapes the debate about whether the economy is headed for a “soft landing” or “hard landing” and offers several insights.1
- Pettis contends the choice policymakers confront is deciding between a “long landing” strategy, in which China’s growth is allowed to slow over several years to 3%-4% without unemployment surging, versus targeting higher growth of 6%-7% that is unsustainable and likely followed by a collapse.
- Pettis claims Chinese policymakers understand this dilemma, but it is too early to tell which direction they will take. Conventional wisdom holds that slower growth could be socially disruptive, but Pettis contends that eliminating artificially low interest rates will transfer income from inefficient companies back to households, thereby supporting higher consumption.
- My reaction is that the scenario Pettis outlines is plausible in theory, but it is highly questionable whether overall growth could fall to 3%-4% without unemployment surging and China’s policymakers responding. Even if his favorable outcome unfolds, the global economy and world equity markets would feel the fallout of markedly weaker Chinese growth.
Reframing the Debate about China’s Growth Prospects
Most analyses of China characterize the debate about its growth prospects in terms of whether economic growth will slow moderately to 6%-7% (the “soft landing” scenario) or more substantially to 3%-4% (the “hard landing” scenario). The prevailing view is that the former outcome is the most likely over the next few years as policymakers seek to buttress the economy. However, a vocal minority foresees the bursting of a property bubble that will result in financial disruption and much weaker growth.
Michael Pettis, a former Wall Street investment professional turned professor at Peking University, contends this is a false dichotomy. In his view, the Chinese economy has only been able to maintain 7%+ growth due to rapid credit expansion, and he believes the economy is now running up against constraints on how much debt is sustainable.
“Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing.” It is not an alternative.”
For the time being, Chinese policymakers are clinging to the official 7.5% target growth rate and are likely to deploy added stimulus should the property sector weaken further. However, Pettis is hopeful the government will eventually adopt a “long landing” strategy in which China’s growth rate is allowed to transition over time to 3%-4%, while household income grows at a faster pace of 5%-7%. If this transition can be achieved, it would imply that income is transferred away from inefficient companies back to Chinese households, thereby lessening the risks of rising unemployment and social disruption.
Implications of Ending Financial Repression
For this transition to occur, the Chinese government will have to embark on reforms to end so-called “financial repression.” This term refers to policies in which rates that depositors receive on their bank accounts are set well below market clearing levels, which enables banks to provide cheap loans to Chinese businesses, many of which are state-owned.
Pettis notes that financial repression was vital to mobilize savings in the early stages of China’s transition from a poor, agrarian based economy to a more industrial economy. Over time, however, the artificially low interest rate policies contributed to a loss of investment discipline, as inefficient firms were able to obtain cheap financing, which in turn contributed to an enormous misallocation of capital over the past decade. Pettis estimates that over the latter period as much as 5%-8% of GDP was transferred from households to borrowers, which explains why the growth in household income lagged the growth in GDP. (Note: Estimates by the IMF are within a comparable range.)
Pettis sees the low interest rate policies coming to an end, as President Xi appears committed to the process of financial reform. The official lending rate has risen to 7.5% while nominal GDP growth has slowed to 8%-9%. As a result, it is more difficult for borrowers to justify investments in non-productive projects. Also, as the resource transfer from savers to borrowers shrinks, economic growth is likely to transition from being investment-led to consumer-led. At the same time, Pettis acknowledges there are borrowers that are effectively insolvent and which may still receive ongoing support from the Chinese government.
One challenge President Xi faces is vested interests in the Communist Party that are opposed to economic reform. Pettis acknowledges this, but also notes that President Xi is China’s strongest leader since Deng Xiaoping, who pioneered the country’s transition to a more market-oriented economy. He observes:
“China is still vulnerable to a debt crisis, but if President Xi can continue to restrain and frighten vested interests that will inevitably oppose the necessary Chinese economic adjustment, he may in the next one to two years be able to get credit growth under control, before debt levels make an orderly adjustment impossible.”
My Take: Insightful but Unlikely
Pettis’s analysis is both insightful and worth considering, because it challenges conventional thinking about China. His main insight is that by eliminating distortions in capital markets, policymakers can achieve the objective of rebalancing the Chinese economy away from reliance on investments in favor of consumption, and he makes a strong case that the costs of financial repression outweigh the benefits.
That said, I find his favorable outcome, in which growth slows to 3% without unemployment rising, to be very difficult to pull off in practice. It assumes that China’s policymakers have the wherewithal to engineer a controlled slowdown, even though this is rarely the case. Consider some of the dynamics involved; when businesses are forced to cut back on spending due to lack of available credit, some will respond by shredding labor and others may become effectively insolvent, which would create strains for financial institutions. Pettis acknowledges these possibilities, but does not offer a compelling rebuttal. His scenario envisions a wealth transfer to households boosting consumption, especially of services, which tend to be more labor intensive, and he observes the government could mop up unemployed workers by putting them into make-work-jobs. At the same time, he acknowledges this response would not fundamentally address China’s debt problem, but simply roll it forward.
One issue Pettis does not discuss is the impact that substantially lower Chinese growth would have on the global economy and financial markets. Currently, world markets are priced for only a marginal slowdown in China’s economy. Therefore, if China’s growth were to be cut in half in the next few years, world equity markets would likely feel the fallout at some point, with emerging economies that have close trading ties with China taking the biggest hit.
1See Michael Pettis’ blog, China Financial Markets, “What does a “good” Chinese adjustment look like?” September 2014.