China experts are predicting the country’s growth will slow in the medium- to long-term as the government undertakes the difficult task of rebalancing the economy away from its dependence on investment and exports.
Beijing-based economist Michael Pettis says China’s development model is unsustainable and he predicts that the next generation of Chinese leadership will have to rein-in spiralling debt driven by what he described as a “massive misallocation of investment”.
While less pessimistic than Pettis, Jing Ulrich, JP Morgan’s China chairman of global markets and managing director, told attendees at a recent CFA Institute conference she expected GDP growth would fall to 7 per cent a year down from the double digit levels enjoyed for much of the past decade.
Ulrich said that while China has to “contend with a lot of imbalances in the medium- to long-term”, she predicted that there would not be a hard landing for the Chinese economy.
“China may have to live with lower growth rates over the coming few years. If China can maintain a 7 per cent plus growth rate, despite an adverse economic environment, there’s nothing wrong with that. If our economy grows at a lower rate I would be much happier,” she says.
Pettis, a professor of finance at Peking University Graduate School of Economics, said the investment-driven development model that China has adopted since opening its economy in the early 1980s was the same model that had been tried and failed in various economies since the 1800s.
Citing Brazil in the 1970s and Japan in the early 1980s as the most recent examples of a centrally managed investment and export-driven development model stalling, Pettis says eventually investment is misallocated into economically unviable projects that push up debt levels.
“Every single example of this growth model has generated tremendous and miraculous growth in the early stages and then growth stopped in the middle of huge amounts of debt,” he says.
“I would argue that this problem is intrinsic to the model.”
Pettis doubts that China will face a dramatic slow-down but he predicts GDP growth will need to flat line at more normal 3 per cent in the coming years if the government is going to be successful at rebalancing the Chinese economy.
He says the longer the government waits to address the imbalances, the higher the levels of debt it will face and the more painful and protracted the re-adjustment period will be.
Pettis argues that China’s household sector has been effectively paying for China’s investment binge, through a range of transfers to the state-sector.
This occurs in a number of ways including monopolistic pricing, a devalued currency which erodes purchasing power, and a collapse of wage increases relative to productivity.
But Pettis argues that the most significant transfer has come through what he calls “financial repression” via low interest rates.
Real interest rates have been effectively at zero or negative levels for the past decade, says Pettis.
This has the duel effect of penalising depositors to the benefit of borrowers and also distorting price signals for investors. Chinese savers have very little alternative than to put their money in the bank account at what is effectively a negative real rate of interest.
A very low interest rate simply transfers money from savers to borrowers which are state-owned enterprises, infrastructure investors, real estate developers, local and provincial governments and the central bank, he says.
“This transfer is an enormous boost for growth, if you lower interest rates and make interest rates negative, than clearly people will borrow and invest. But it doesn’t come free. It comes at the expense of the household sector.”
Pettis estimates that every year China transfers between 5 and 7 per cent of GDP from households to borrowers in the form of repressed interest rates.
“In these conditions, it is perhaps not surprising that we got very rapid growth and investment became significantly misallocated and, above all, it is not surprising that consumption has declined dramatically as a share of GDP.
In 2009 domestic consumption as a share of GDP had fallen from 46 per cent at the start of the decade to 35 per cent. Typically, low-consuming Asian countries consume about 50 to 55 per cent of GDP, while in the developed world domestic consumption is usually around 60 to 65 per cent of GDP.
“These low levels of domestic consumption make China overly reliant on investment and exports to drive growth,” says Pettis.
Pettis says the level of debt in China is just beginning to be fully understood, with much of it still hidden in off-balance sheet non-bank lending.
Credit growth is rising at an unsustainable pace despite government efforts to rein-in lending, says Pettis.
“We are seeing very rapid expansion in debt, and any attempt to slow it down is undermined by local government officials and the banks themselves, who are growing rapidly.”
“Because without credit growth, there is no investment growth, and in China without investment growth there is no GDP growth.”
Pettis says that bank lending makes up just 56 per cent of total lending in China in 2010, the lowest levels seen since 2002.
Internal promotion within the Communist Party also depends on local and provincial officials achieving high levels of growth.
This incentivises officials to misallocate investment, concentrating short-term benefits locally but creating long-term unpaid debt throughout the nation’s banking system.
“Misallocated investment in China occurs not because people are stupid but because it is a systemic problem,” he says.
“The system requires you to keep on pumping up investment well past the stage when it is being wasteful or misallocated.”
He said the hard evidence of misallocation of resources could be found when examining the profitability of China’s state-owned sector, which he argues is heavily supported by transfers from the household sector of the economy.
If direct subsidies, monopolistic pricing and a lending advantage from access to cheap capital were taken into account, Pettis says state-owned enterprises were actually losing an amount of money that was up to six to eight times the sector’s stated profitability.
He predicts the Chinese leadership will have to pull a number of economic levers to rebalance their economy including a slow appreciation of the currency and a gradual increase in interest rates.
He also predicts China will go consider an extensive program of privatisations as a way of transferring wealth through the state sector to the private sector and thereby boosting consumption.
“The debate in China is much more ferocious and much more interesting than that going on outside China about the problems with the growth model,” he says.
Pettis points to the comments by the current Premier Wen Jiao Bao, who has raised concerns about imbalances in China’s economy, as evidence of concern from some in leadership circles in Beijing about China’s growth model.
He points to Wen’s slated replacement, Li Keqiang, as being one who is also concerned about the pressing need to rebalance the economy.
“If growth rates slow significantly but China genuinely rebalances we could see income continue to grow at 5 or 6 per cent a year, which is much better for China than 10 to 11 per cent growth rates but continued misallocation of investment and continued imbalances,” he says.
“It is also much better for the world if China rebalances. Instead of being a huge negative draw on world growth, a huge absorber of that most precious commodity, demand, its amount of negative net demand will contract as its current account surplus goes down and that will actually be positive for the world.”
