We’re trying something new here at FT Alphaville, and like all our experiments we have no idea how this one will turn out.
We’ve started a podcast, which you’ll find below alongside a bio of our guest, a guide to the themes we explored, and links to which we refer. There’s also another audio file of outtakes with questions and answers that we couldn’t include in the podcast itself because of time constraints.
We’re still fumbling our way through the technical side of things and ask for your patience (for instance our guest’s voice came through a bit fuzzy — sorry).
But for anything else, please leave us feedback and any suggestions. We’re especially keen to hear which topics you’d like us to cover and which guests you’d be interested in hearing from. We’re open to anything — including changing the name, format, music
, and firing the host with the nasally voice.
If you like this idea, please subscribe in iTunes and help us convince the FT’s higher-ups to let us keep doing it.
Our topic for this edition was the Chinese economy — our discussion turned out to be mostly about the fragility of the Chinese economic model — and our guest was Michael Pettis. Hope you enjoy…
ABOUT MICHAEL PETTIS
Pettis is a finance professor at Peking University and the chief strategist at Shenyin Wanguo Securities, for which he writes a proprietary newsletter. He also blogs at China Financial Markets, owns a nightclub in Beijing and manages a small indie record.
You can read more about his background on Wall Street and in emerging markets in this Bloomberg Businessweek profile (or hear about it in the outtakes below).
PODCAST GUIDE AND EXCERPTS
[0:00 — 1:00] Funky music, introduction
[1:01 — 5:13] Why predicting the time when China surpasses the US as the world’s largest economy is such a silly exercise, and why we shouldn’t put much faith in China’s official GDP numbers.
Pettis blogged about this issue earlier in the year. He argues that China has probably been overstating its GDP for years because it’s failed to account for environmental degradation and misallocated investments. In every other case of countries pursuing an investment-driven growth model similar to China’s — Brazil in the 1960-70s, Japan in the 1970-80s, etc — growth potential was always overstated.
What happens with these models is that you get very rapid growth in the early stages that is sustainable because it’s very easy to identify investment opportunities that are economically viable. But the nature of the system doesn’t allow you to know when investments are no longer economically viable. And as you keep propping up investments, the value you’re creating in many cases is actually negative, although it continues to show up as rapid growth because the way we calculate GDP does’t distinguish between investments that have a positive net present value from those that have a negative net present value.
As for environmental degradation, Pettis says that factory activity that dumps chemicals in the river shows up in GDP growth, but the reduction in the future value of land and water doesn’t. So any attempt to estimate GDP growth is likely to be surrounded by errors, but historically it’s always been the case that growth has been overstated.
[5:14 — 8:49] On the resemblance between the Chinese economy now and the Japanese economy of the late 1980s.
See Pettis’s articles in the WSJ and Foreign Policy last year, and (by happy coincidence) our colleague Martin Wolf’s piece citing Pettis on exactly this issue in Wednesday’s FT. Pettis says that you should view the Japanese growth story differently — we should have been looking at household consumption, which is more telling than looking at investments (which doesn’t distinguish between good and bad investments). As with China now, it was always difficult to get a true measure of Japanese growth.
He points out that the Japanese economy climbed from about 7 per cent of global of GDP in 1970 to about 10 per cent in 1980, and then to 17-18 per cent in the early 1990s. Now? China just overtook Japan at about 9 per cent. Much of the impressive, nominal Japanese GDP growth in those early decades disappeared.
Much of the growth that took place in Japan in the 1980s was driven by misallocated investments, by wasted capital — and had to be paid for in the future in the form of very high levels of debt… Every one of these countries ended up, after a very high level of growth, with unsustainably high debt levels. That’s not a surprise: You can think of the debt as the measure of the difference between reported growth and real growth — and once we go into negative real growth, then almost by definition debt levels are going to have to rise very quickly.
[8:50 — 12:59] On Chinese household consumption, and the right set of strategies to e the economy
The key to getting household consumption up is not to get the Chinese to consume a higher share of their income, which is usually what people mean when they say to build a bigger safety net. The key is to get household income up as a share of GDP…
They’ve got to raise wages faster than productivity growth, they’ve got to raise the value of the currency, and most importantly they’ve got to raise interest rates. Anything that will raise household income as a share of GDP, and that will automatically cause the household consumption share of GDP to rise. …
He then explains that household consumption plummeted in the 2000s from 46 per cent at the start of the decade to probably around 34 per cent now, and adds:
That to me has made it clear that you cannot raise the household share of GDP through administrative measures [like improving the social safety net]. The only way is through reversing the growth model. There is increasing awareness among Beijing policymakers that this is what they’ll have to do — but with that increasing awareness is a great deal of reluctance, because by definition it means growth rates will have to slow down sharply.
[13:00 — 15:00] Why China is more likely to experience years of slow, grinding growth rather than a financial crisis or economic collapse
The banking system is inefficient, but it is very stable. It’s very difficult to move money into and out of the banking system or the country, and as everyone knows the banking system is effectively by the government.
On the one hand you can adjust with a collapse in asset prices, a surge in non-performing loans, a collapse in the banking system, and some people might argue that in the longer-term that is much more efficient — by allowing these assets to be liquidated and allowing their prices to collapse, you reintroduce them into the economy and you begin the process of capital allocation all over again. …
The problem is that this introduces a lot of social instability in the short-term. So countries like China, rather than allow that collapse through liquidation, will slow down the process. The government will absorb the debt and pay for it through transfers from the household sector. In the long term that makes the adjustment much more costly… I would argue that in China, they’d be willing to sacrifice quite a lot of efficiency in exchange for stability.
See also the end of this FT Alphaville post.
[15:01 — 18:16] On non-performing loans in the Chinese banking system
Pettis explains that this is a definitional problem. The actual amount of NPLs is probably low, though not as low as the official numbers. But this is because so many of the loan transactions are guaranteed by local governments.
But… he goes on to explain that if you define NPLs to mean loans to projects that can’t repay them without government guarantees, then the number is higher. And if you further define NPLs even more broadly — as loans to projects that couldn’t be serviced by the project if all subsidies were removed (for example if interest rates are raised to more appropriate levels) — then you’d see a huge increase in non-performing loans. How much is very hard to say.
[18:17 — 20:50] On the liquidity squeeze in the Chinese banking system, given tighter reserve requirements, lower corporate deposits and slowing growth in household deposits
It’s mostly smaller banks that are experiencing the liquidity squeeze. Some people think this means that monetary policy is tight, but the issue is actually that both deposits and loans are moving off-balance sheet. If you add them back in, then monetary and credit growth in China continues to be very high.
[Monetary policy] feels tight because there’s been such a massive increase in investment flows to infrastructure and real estate projects. So that in spite of rapid credit growth, that growth has been overwhelmed by demand from infrastructure and real estate developers. That’s something we should worry about, because those are the two main sources of misallocated investment, yet so much of the capital is going there.
[20:51 — 23:14] On whether China has a real estate bubble
Pettis says he doesn’t know, but that you would expect to see asset price bubbles when the cost of capital is too low and there is excessive liquidity. And there certainly appears to be excessive liquidity. If you look elsewhere — Chinese art, jewelry, jade, and collectibles — there also seem to be asset price bubbles.
But there’s a tendency to think that the collapse in real estate and stock prices is what caused the Japanese crisis… But I don’t think that’s the case. The stock market and real estate crises were just symptoms of the underlying problem, which was excess investment in a wide variety of areas. That’s what we’re going to have to grind away.
[23:15 — 26:02] A discussion of the appropriateness of the pace at which China is allowing its currency to appreciate
Pettis argues that the currency is only of the three keys to rebalancing: the other two are that wages have to go up faster than productivity and interest rates have to rise.
But each of these three puts pressure on different constituencies. Appreciating the currency puts the brunt of the adjustment on the export sector; rising interest rates puts the brunt on local and municipal governments; and rising wages puts the brunt on all employers.
Pettis cites Jeffrey Frieden’s book — Debt, Development, and Democracy — on how different interest groups benefit from certain distortions, and how the more they benefit, the more powerful they become, and the more powerful they become, the more they try to resist changes.
[26:03 — 27:29] What investors are saying they most worry about
The number of [China] sceptics is rising very quickly… The most interesting thing is that everyone wanted to talk about debt. Several showed me their own attempts to count debts. There is a sense that debt is the Achilles heel of this growth model…
If you talk to people with a strong background in monetary economics [in China], you can see that the focus and nervousness about debt has increased signficantly. And I think that’s a good thing.
[27:30 — 30:21] Something foreigners misunderstand about the Chinese economy
Pettis says that too many people view China’s large foreign currency reserves as a sign of strength, when in fact they are no such thing. Big reserves protect against external debt crises, but nobody is worried about this in the case of China. Historically, for countries with China’s growth model, it is domestic debt crises that threaten — and big reserves do nothing to help. In fact, they make things worse.
Very high reserves protect you from certain types of financial stability — which nobody, not even the biggest bears, think threatens China — and exacerbate other types of financial stability, particularly domestic banking instability.
Rather than thinking of reserves as a huge source of wealth that can be used to paper over problems, we should think of them as a huge source of debt. Remember that the People’s Bank of China doesn’t own the reserves in the form of capital. It has to borrow domestically to buy those reserves. So the PBOC has a huge mismatched balance sheet: it owns dollars and euro assets, against which it has renminbi liabilities. So as the value of the RMB goes up, or as RMB interest rates go up, the net indebtedness of the PBOC rises quickly.
[30:22 — 31:24] Pettis shares some thoughts on the Beijing music scene, and what it’s like to run a nightclub and record label there
LEFT ON THE CUTTING ROOM FLOOR
We tried to keep the podcast to around 30 minutes, but for those who want to keep wonking out, we’ve put the questions and answers we removed into a separate file. See below for a short guide:
[00:00 — 1:53] Pettis shares a bit about his background
[1:54 — 4:01] He explains the basic steps through which China’s investment model leads to misallocated investments
[4:02 — 5:43] Pettis explains how off-balance sheet lending works in China, including the way companies bypass the banking system to lend directly to each other. See also this FT Alphaville post.
[5:44 — 8:04] Pettis comments on the recent reports that the central government had bailed out local governments by taking on a huge portion of their debt burden. Pettis believes this is more about reclassifying debt, not figuring out who is going to pay for it.
Victor Shih’s book recommendations on the Chinese economy – The Browser
How real is China’s growth? – Free Exchange
China’s property rating downgraded on tightening credit – BBC
Three sobering notes about China – James Fallows
Bank loans in China: tapping the breaks – Economist Intelligence Unit
Richard Koo goes unconventional on China – FT Alphaville
Fate of China property a global concern – FT
As wages rise in China, companies fret – NYT
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