China’s biggest problem today is debt.
That was the message of Michael Pettis, professor of International Finance at Guanghua School of Management, Peking University in Beijing. He spoke this morning at the CFA Institute’s 69th Annual Conference in Montreal. (Follow our live tweets from the conference here.)
Pettis notes there are three main stages to China’s reform period. First came liberalizing policies, which, despite fierce opposition from some Communist Party elites, were pushed through and quickly bore fruit. Growth went from negative in the year prior to the launch of reforms to explosively positive immediately after.
But removing constraints on economic activity—the form those reforms largely took—can only generate so much improvement. To augment growth further, authorities undertook a massive wave of investment. This second stage reached its peak of usefulness in about the late 1990s, says Pettis. He refers to this as the point of saturation: when additional investment is no longer productive. Think of turning a moderately busy eight-lane highway into a 16-lane highway. It costs a lot to make that happen, but the payoff is essentially nil.
China now sits in stage three of its makeover, which is characterized primarily by debt rising faster than debt-servicing capacity. Pettis says there’s recognition in China that “the model is no longer working.” But the best solution—a new wave of liberalizing reforms—will be met by the same obstacles the first wave faced: pushback from powerful elites with a vested financial and political interest in the status quo.
A key question is which sector of China’s society will bear the brunt of the country’s debt. Pettis says it can’t be households, much less small- and medium-sized business, which are so crucial to China’s economic fortunes. “That leaves government,” he says, and that’s why it’ll be so hard to pull off.
China needs a massive transfer of wealth from the government to the household sector via the liquidation of state assets, argues Pettis. That liquidation would strip some provincial and municipal elites of power, so expect them to fight tooth and nail to prevent this from happening.
Pettis says if you start seeing clear evidence of state asset liquidation and wealth transfer to households, you’ll know China has begun to tackle its most significant problems. In the interim, don’t be surprised if the country’s growth numbers dip to half of what they are currently.
We should expect China’s average growth rate from 2012 through 2022 not to exceed 3% or 4%, says Pettis. “[Growth rates] are going to come down; the only question is, Do they come down disruptively or do they come down smoothly?”