Is There Any Credibility Left In China’s Bull Case?: Michael Pettis

October 10, 2012Chinaby Michael Pettis

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Is There Any Credibility Left In China’s Bull Case?: Michael Pettis

In order to argue that we will not see a sharp slowdown in Chinese growth, it is not enough to claim that some expert or institution has predicted that Chinese growth will not slowdown. Neither can we hold on to the argument that China has enough savings in its coffers to bail itself out of a crisis. Nor can we assert that Beijing leaders cannot tolerate growth below 8 percent, so of course growth will not drop below 8 percent. As greater evidence for the bear camp surfaces, China bulls need stronger justifications for their positions or risk losing credibility.

I recently “debated” twice with senior Chinese officials on the future prospects for China.  In both cases they made the argument that Chinese growth rates were going to rise in the next few years and that the current deep pessimism is unwarranted. I argued, of course, that growth would slow even more.

Neither of the debates, I thought, was wholly satisfying. It seems to me that while a number of officials – at least among those with limited economic backgrounds – acknowledge that perceptions of China’s economic prospects have changed dramatically in the past few years, they don’t always understand why. There seems to be a worried resistance to the idea that we may have reached a major and difficult transition. The unwillingness to acknowledge the difficulty of the transition, however, can only make the transition all the more difficult.

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In both of the “debates”, and in conversations I have had with others, my “opponents” (although that is too strong a word since there were many areas of agreement) largely constrained themselves to three arguments, which are the same three very unsatisfying arguments that we have heard many times before. First, they presented historical data showing rapid Chinese growth rates in the past three decades and proposed past growth rates as evidence of rapid Chinese growth rates in the next two decades. I probably don’t need to explain why this is a very weak argument.

Second, they asserted (many times) that since past predictions of failure have all turned out to be wrong, future predictions must also be wrong. If this were true it would, of course, be irrelevant, in the same way that people who predicted in 2002 that the Spanish real estate market was out of control might have been early but they most certainly weren’t wrong. Rudiger Dornbush once said: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”

But this argument, that past predictions have always been wrong, isn’t true. There have been predictions of failure in the past 20 years that were in fact correct – for example the claim in the late 1990s, made first, I believe by Nick Lardy, that China was going to have a banking crisis. The fact that China didn’t “fail”, however, doesn’t mean that Lardy was wrong. China did in fact have a banking crisis, but the growth impact was more than offset by a surge in lending which simply set the stage for the next banking mess.

It is as if you saw a middle-aged man in terrible physical shape running a marathon, and you predicted that after five or six miles he would be forced to quit. If however he took out a syringe and shot himself up with crystal meth, he would be able to continue running a few more miles, but this doesn’t mean that your analysis and prediction were wrong. It means that in a few more miles he will be worse off than ever (or will have to take an even bigger dose of crystal meth).

And third, they produced a number of what seem to me largely circular arguments – for example the claim that urbanization leads to growth and growth to urbanization, and so the process must continue, or the claim that since productivity has soared, past investments in the aggregate have been justified, even though the data “proving” the increase in productivity implicitly assumes that past investments have been economically justified. Except for reports of capital fleeing China, one could easily get the impression that even senior Chinese non-economists really don’t understand why the likes of Wen Jiabao, Li Keqiang, and now Xi Jinping seem so worried.

Can A Prediction Be Based On A Prediction?

For an example of this kind of argument, by another seemingly plugged-in person, see this article in Monday’s South China Morning Post arguing that brighter days are ahead for China’s economy:

I can’t predict when the economy will rebound, but perhaps it is time for analysts to look at the longer term. Where will China stand in 20 years?

First, let’s examine the prediction that its gross domestic product will become the largest in the world within a decade, and its economy will continue to improve over the next two decades. The Economist expects Chinese GDP to surpass America’s by 2018, and even if China’s growth rate were to drop to 5 per cent, this transition would only be delayed until 2021. Therefore, there is little need to worry about current GDP growth falling to 8 per cent. Other forecasts of when the transition will happen include 2016 (the International Monetary Fund) and 2020 (the Chinese Academy of Social Sciences).

…Second, the renminbi is forecast to become freely convertible within 10 years and possibly will be competing with the US dollar in two decades. In recent discussions, it was thought this first step could be realised in five years. I believe it will probably happen by 2020, or when Chinese GDP becomes the largest in the world.

..Third, it is said that Hong Kong is likely to exceed New York as a global financial centre within 20 years. As China’s economy continues to grow and develop, the realisation of the first two predictions will provide a great boost for Hong Kong, and it is expected to gradually become the dominant global financial centre.

…Fourth, some predict that Chinese enterprises will make up more than half of the Fortune Global 500 companies in two decades, and China will be a global manufacturing power. This year, there are 73 Chinese companies (79 if Taiwanese companies are included) on the list, a significant increase from only 11 a decade ago.

…Fifth, China is expected to make significant progress in the field of science, technology and education, and the University of Hong Kong is likely to be ranked among the top 10 in the world within two decades. According to a study by the science and technology think tank Battelle, China currently accounts for about 15 per cent of the total share of global research and development spending, and it will surpass the US spending within a decade.

…Thus, there is every reason to be optimistic about China’s economic prospects over the next two decades.

Notice that the reasons for saying that the Chinese economy will be much stronger than many people currently expect consist largely of citing a series of earlier predictions. This doesn’t seem like a very robust argument, and although I have only excerpted the article, I think anyone who reads the full article will agree that I did not leave out anything more substantial.

I don’t mean to pick on the author, a prominent former consultant and currently editor of China’s Economy & Policy, especially since it is a short Op-ed piece, in which it is always hard to make substantial arguments, but in fact I hear this kind of reasoning a lot. The “proof”, the argument goes, that China will grow very rapidly in the next decade is that many experts have predicted that China will grow very rapidly in the next decade.

Unfortunately expert predictions of this sort are notoriously unreliable, and we seem to be especially bad at predicting turning points. This makes earlier predictions useless in a debate about whether or not we are at a turning point.

I am not saying of course that there is no credible argument for the bull case. In order to argue that we will not see a sharp slowdown in Chinese growth, however, I would propose that it is not enough to claim that some expert or the other has predicted that Chinese growth will not slow down. Nor can we argue (which is much the same thing, I suspect) that China has grown rapidly in the past so it must grow rapidly in the future. And finally, and most foolishly, we cannot assert, as I have heard many times, that Beijing leaders cannot tolerate growth below 8 percent, so of course growth will not drop below 8 percent.

How to Sustain the Bull Argument

To counter the current level of pessimism with the bull case it seems to me that we must answer specifically three questions. The first question, of course, has to do with debt. How much debt is there in China, in other words, whose debt servicing costs (adjusted upwards to eliminate interest rate and other subsidies) exceed the economic value creation of the projects funded by that debt.

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Just as importantly, we need to show which sector of the economy will be forced to pay for the difference. Remember that excess debt doesn’t pay for itself, and if you cannot identify who is paying, then you haven’t resolved the problem. Many people, for example, argue that bad debt isn’t a problem for the same reason that China “grew out” of its debt crisis of the late 1990s. This is idiotic. China did not grow out of the debt. It merely forced the cost of the crisis onto the household sector through repressed interest rates and a wide spread between the deposit and lending rates.

This solved the banking crisis, but at the expense of the household sector and so directly caused China’s already very low household consumption rate to collapse. The important implication is that bad debt this time around cannot be resolved in the same way if we expect consumption to power economic growth, rather than lag it as it did during the period in which the banking crisis was resolved.

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And remember that official government debt levels are not what matter. We must include contingent liabilities, we must estimate hidden and informal banking debt, and we must consider the further balance sheet consequences of an economic slowdown.

The first question, on debt, is of course closely related to the second important question, which has to with overinvestment. Are there significant areas in which Beijing can and will invest so that the real increase in economic value creation exceeds the unsubsidized cost of capital?

Even this question is a little more complicated than simply looking for good investment opportunities in China and then assuming that the bulk of future investments will go there. There are of course many areas in which the value of investment is likely to be positive in the very long term, such as primary education and social housing, but it is important to remember that these don’t pay off their investments for at least a generation or so, in which case they do not help address the current imbalances.

On the contrary, they make them worse for many years before they start reducing debt and rebalancing the household sector. The only kind of investment growth that can help China address its debt overhang is investment in projects in which the increase in productivity in the next five to ten years exceeds the unsubsidized cost of the investment.

This is a very simple but powerful condition. Any debt-funded investment that does not satisfy this condition must make the debt problem worse. The bull case must identify trillions of dollars of such potential investment and then show that in spite of constraints that led in the past to uneconomic investment, these “good” investments are likely to be made on a substantial scale.

The third question is about future sources of growth. Since it is now widely accepted that investment growth must slow sharply (unless we can find – and execute in spite of political constraints – many trillions of dollars of these new “good” investments) it is obvious that only a surge in consumption growth can replace investment.

So the question for the bulls is: how specifically will China cause consumption to surge? Since at least 2005 Beijing has tried to force up the growth rate of consumption and it has not been able to do so. More worryingly, there is some evidence that the growth rate of consumption may be dropping.

But – and this is just arithmetic unless we assume explosive growth in the external sector – if investment growth drops, consumption growth must rise by a much larger number (because consumption is much lower than investment) to maintain the same level of growth. If you cannot specify the mechanism that will cause consumption to grow (and please don’t propose an improvement in the social safety net), unless you deny that China must reduce investment growth you have no choice but to accept that GDP growth will slow sharply.

Any China bull that does address these three questions is missing the point. I am of course not suggesting that there is no answer to these questions. I’ve already written extensively on steps China can take – economically efficient but politically difficult – to address both debt and consumption growth. Any bullish forecast, however, that cannot come up with answers to these three questions is as useful as forecasts in 1989 and 1990 that Japan would get over its own domestic imbalances and continue growing by 7 percent annually for the next two decades – because it had always grown quickly in the past.

Click to continue reading… Reclassifying Investment

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