Is China destined to emerge as the dominant superpower that will drive the 21st century to new heights of prosperity? Or instead, might it collapse spectacularly under the weight of its own overinvestment, dragging the global economy down with it in history's largest 'hard landing'?
Few people can see the big picture in China more clearly than Michael Pettis, Beijing-based economic theorist and Professor of Finance at Peking University. Michael sees China's future prosperity tied to its ability to successfully address:
- Overinvestment – Its political and economic systems are now dependent on elevated levels of investment spending. Moreover, a decreasing amount of those investment dollars are able to generate net-positive financial or social returns.
- Currency undervaluation – Money printing and excessive foreign reserves are creating imbalances that will be very hard for the central authorities to unwind without painful repercussions.
- Low wages (and wage growth) – Chinese household income has not grown as fast as GDP, creating big wealth disparities in favor of the elite.
- Over-indebtedness & low interest rates – Much of China's new borrowing is used to pay interest on current debt. Any material rise in interest rates is sure to create a cascade of insolvencies.
- Asset bubbles – Much of Chinese wealth is tied up in assets that are exhibiting dangerous levels of price inflation, real estate being a prime example. (Property prices in Beijing and Shanghai are higher than Manhattan, which is astounding considering the much lower average Chinese income)
Pettis, to put it mildly, is skeptical that China will be able to resolve these issues gracefully. In fact, he feels we've seen this movie before with predictable outcome. Just perhaps not on so grand a scale:
In order to understand the story of China, it is important to start with the recognition that contrary to much of what we have been hearing in the last few years, there is nothing particularly unique or extraordinary about what is happening within the economy. Certainly China has grown at a tremendous rate in the last 30 years, but lots of countries have had investment-growth miracles. Maybe not as long as China and maybe not as profound as China’s investment, but there is quite a lot that we can learn about what is happening in China from looking at previous experiences.
It turns out that the Chinese growth story is one we have seen many times before, and it typically starts out very well. The story begins with the period in which the country, in this case China, has come to be systematically invested. Twenty years ago, thirty years ago, China had no roads, no airports, no manufacturing capacity. Its economy had been pretty much decimated between the period of the anti-Japanese war and then the first two or three decades of Communist leadership. So what China really needed was a significant increase in investment to raise its productivity level, and in fact, that is what happened. We saw investments grow very rapidly during this period. And with all of that increased investment, investment in manufacturing capacity and investment in infrastructure, etc., with all of that investment, we saw very strong, very robust growth take place in the Chinese economy.
But the problem that this model has always faced is that after many years of investment, two things happen: First, the political and economic system gets built around this constantly increasing level of investments, and second, we move from a period in which it is fairly easy to identify economically viable projects – basically, China did not have anything and could use a little bit of everything – to a period in which investment levels are still high. China has the highest investment rate ever recorded, and the highest growth rate of investment probably ever recorded, that we start to run out of economically viable projects. But because the system was so geared towards continuous increases in investment, we keep on investing, and when that happens, investments become allocated into projects that do not generate sufficient real returns on a social basis.
And so, since these investments are funded by debt, one of the consequences is that automatically you find debt growing faster than debt servicing capacity, which, of course, is unsustainable. This, by the way, has happened to every single country that has followed this growth model, so it should not be such a shock to us, but it is happening to China, too. The problem is, we have been doing this for so long, I think in retrospect we will probably look back and see China as the most extravagant period of overinvestment ever seen, exceeding even Japan in the 1980s – that is, if the result has been that that debt models in China are extremely high.
So all of this talk about rebalancing the Chinese economy is basically a recognition of this fact. We can no longer count on investment to drive growth, because investment is being mis-allocated, but unfortunately, the economy is so dependent on investment that if you bring investment levels down – which you have to do if you want to address the debt problem – then you also bring growth down very significantly. We just started to see that process. Investment has not come down, it has not even slowed that dramatically; it has slowed a little bit. Growth rates dropped from roughly 10%, which is where they were before 2008, 2009, to around 7% today, and I suspect they are going to drop an awful lot more before this process stops.
Click the play button below to listen to Chris' interview with Michael Pettis (39m:29s):
by yogiismyhero