I just finished Michael Pettis’ new book on China recommended by Tyler. He uses a neat framework to think about China’s growth and how it fits in the global system. I’m probably more optimistic about China’s long-term growth outlook than Michael Pettis, although we might be thinking in a different time horizon.
Things I agree:
1) Continue rising debt to GDP is not sustainable, and at some point debt will be rising faster than debt-servicing capacity.
2) The structure of the economy (implicit government guarantee, distorted price signal, etc.) makes it vulnerable to capital misallocation, and the surge in credit and investment to GDP ratios suggest there are lots of wasteful investments.
3) Economists are bad at predicting turning points and adjusting their expectations during major turns in growth cycle.
Things I don’t necessarily agree:
1) The assumption that China must rebalance toward a greater reliance on consumption. I don’t think consumption is inherently better than investment from a growth prospective (it matters for income distribution and social welfare, but that’s a different question). A debt-fueled consumption boom is probably worse than a debt-fueled investment boom. Michael Pettis noted that wasting money is always value destroying, but consumption is about spending money with no monetary return, while bad investment might still earn some returns. In general the classification between consumption and investment is not well-defined (housing, education, types of investments, etc.).
One could argue that investment is more likely to be debt-financed relative to consumption and hence less sustainable, or that stronger consumption could encourage investments in the service-producing sectors that are likely less capital intensive. Those are valid points for rebalancing but don’t change my view about consumption versus investment. I think investment helps drive long-run productivity growth, while consumption is the ultimate end, and there is a trade-off to be made by each country. I see debt-financed investment and types of investments as the main problems, not investment per se.
A few other issues regarding consumption share: Data are not very good so we probably should assign less weight to the level of consumption to GDP. Singapore also has a very low consumption share but its model seems to be sustainable. Admittedly Singapore is a small economy and China probably won’t get away with the type of current account surplus Singapore has. My point is that for sustainable economic growth, institutions are likely the key, not consumption level.
2) I think China’s growth is more likely to slow sharply at some point as the economy deleverage, but I don’t think a lost decade of very slow growth is a necessary outcome. Reforms are key, and China is slowly moving forward. FX appreciation and strong wage growth have been happening, There are also some limited progress on improving social safety net and hukou reforms, while gradual liberalization of interest rates, further hukou and land reforms, and energy price reforms are also on the agenda. These are all steps that should help redistribute income to the households.
I think the party leaders’ main objective is to stay in power. As long as reforms are consistent with this goal, I think they will continue to pursue them. The progress might be too slow to solve the existing problems, with lots of powerful vested interests trying to stifle reforms. But there are not many emerging economies where the top leaders seem to be serious about reforms.
Assuming China hits the debt limit and growth slows down sharply, my base case is that this will help trigger some serious and difficult reforms, like what happened during Zhu Rongji’s time. The government and state-owned enterprises will likely have to shoulder the bad debts, and they seem to have enough resources to do so (i.e. selling assets).
I’m more worried about political and social instability, a topic Michel Pettis doesn’t focus on in the book. Barring major instability, I’m relatively optimistic about China’s long-term economic outlook.
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