Michael PETTIS, Nonresident Senior Fellow, Asia Program, Carnegie Endowment for International Peace; Professor of Finance, Guanghua School of Management, Peking University
The season’s second event hosted one of the most brilliant analysts of China’s economy, and financial markets in particular. Michael Pettis’ presence at The Bridge had been on the agenda for a while, and the audience was enthusiastic to hear his perspectives on the future of Chinese economic reforms after the Nineteenth Party Congress.
Pettis’ goal was to set China’s economy in context, making sense of its past growth model in order to identify future trends. In fact, according to Pettis, the Chinese case is not exceptional, thus we are able to make economic forecasts based on economic history. Pettis identified four separate phases characterizing China’s economic growth up to the present:
Deng Xiaoping’s liberalizing reforms: eliminating constraints
In the 1970s, the Chinese economy was in very serious trouble. Starting from 1978, Deng Xiaoping managed to realize China’s economic liberalization in spite of tremendous institutional constraints and elite opposition to his reforms, proving himself as ‘one of the greatest leaders of the twenty-first century.’ In fact, history has shown that such type of liberalizing reforms only occurs successfully – without causing a significant regime change – in two cases: democracies, and highly centralized autocracies such as China. In Pettis’ view, centralization of power in the 1980s paved the way for China’s growth miracle. Deng’s historic 1992 tour to southern provinces, which relaunched economic reforms after a period of stall, was precisely aimed at tackling resistance to his policies by existing elites.
Gerschenkron’s Model in China: an investment-driven miracle
Pettis argued that eliminating constraints is only the first step to realize liberalizing reforms. The second step, followed by many developing economies around the world, is the so-called investment-driven economic miracle known as the Gerschenkron’s Model, from the name of the economist Alexander Gerschenkron. In sum, developing countries tend to have low savings rates, thus some of them rely on foreign capital to fund their economic growth. However, given the significant risks associated with foreign capital, these countries have the alternative to force up savings rates in order to convert domestic savings into sufficient investments to fuel growth. The way to do this is simply to contract consumption rates by reducing households’ share of GDP, which will obviously limit their ability to spend money in the market.
According to Pettis, the fact that China has arguably the lowest households’ income share of GDP ever recorded, which corresponds to the highest savings rates in the world, cannot be explained by Chinese families’ innate preference for saving money, a popular myth about China; rather, it was caused by a precise government design that ensured indirect and systematic wealth transfers away from households and towards the government and businesses. These transfers were accomplished through a combination of currency manipulation, low wage growth relative to productivity, and negative interest rates. Subsequently, the Chinese government directed this wealth into short-term infrastructure investments. China forced savings into investments at the highest rate ever seen in history, successfully realizing an investment-driven miracle at a time when the country needed it the most.
The core of China’s structural problems: over-investment and unsustainable debt
Pettis continued by referring to the concept of ‘optimal capital level’, which implies that each country has its own level of investment – depending on a set of institutions such as legal, financial, educational, and political – determining the rate at which workers are able to use resources productively. Beyond this limit, injecting capital into the economy ceases to be productive and becomes inefficient, unless further institutional reforms are implemented.
China has passed this critical point: additional investments in unutilised infrastructure facilities, and redundant production capacity in traditional manufacturing sectors, are bringing more costs than value to the economy. Pettis identified this as the core of China’s structural problems: China invests too much, fueling an unsustainable increase in debt. In his view, every country that experienced an investment-driven boom encountered this conundrum, in parallel with the emergence of very powerful constituencies who oppose any change to the existing system. This is where China stands today at the beginning of Xi Jinping’s second mandate.
The trajectory of economic rebalancing
In order to reverse this unsustainable cycle of unproductive investment and debt, China urgently needs to switch off this engine, silencing opposition from powerful elites before it can start implementing an ambitious set of institutional liberalizing reforms. Pettis suggested two necessary steps. First, drastically re-centralizing power, after the wave of political reforms that decentralized economic policy making starting from the late 1990s. An example is the attempt to bring the extremely decentralized banking system back under the central government’s control. Second, addressing the debt problem, in its two interconnected dimensions of flow of debt and stock of debt.
The flow of debt is the mechanism that allows Chinese debt to rise at the fastest rate ever seen in history. The reason behind such rapid increase in debt is that households’ consumption is extremely low, therefore investment is misallocated towards sectors of the economy which are no longer productive: simply put, the government artificially creates demand in order to keep the manufacturing sector producing at current levels, guaranteeing employment. To reduce investment while containing unemployment, consumption must be stimulated, which requires raising households’ share of GDP at the expense of elites and local governments, the main beneficiaries of the current growth model. Unfortunately, after former Premier Wen Jiabao officially acknowledged the serious imbalances of China’s economy, the situation worsened considerably between 2007 and 2012. It is no coincidence that by the end of 2000s Chinese media began discussing the issue of vested interests: these groups became vocal as the government expressed the intention to rebalance the economy by transferring more wealth to households.
Pettis proceeded by discussing the issue of the stock of debt. China’s amount of debt is unsustainable for a developing country because it constraints growth. Pettis suggested that China assigns the cost of debt to the only economic sector which is able to pay for it: the government. Traditionally, households are secretly forced to bear the cost of debt through taxation, as happened during banking crisis in the U.S. and Europe. Indeed, China also forced households to bear the costs of the banking reform in the 2000s: unsurprisingly, consumption dropped from an already low 46 percent of GDP in the year 2000, to 35 percent in 2008. Making Chinese families pay for the debt is clearly unfeasible. Assigning this task to small and medium enterprises is also risky: Pettis noted their political vulnerability, as well as their pivotal role for future economic growth in China.
Only the government has the resources to pay for the debt: according to a recent study by Thomas Piketty et al., cited by Pettis, it has a considerable net position as a percentage of GDP, much higher than most countries: this means it can liquidate assets and use the proceeds to pay down debt and increase households’ share of GDP. Again, this implies wealth transfers from local governments to ordinary Chinese. According to Pettis, the Nineteenth Party Congress has shown political willingness to do so, but given tremendous elite opposition it is hard to predict whether these reforms will be implemented. What is sure, readjustment will come at huge costs if it is to be successful: countries that go through this process normally experience an extremely difficult transition.
In what Pettis described as the ideal rebalancing scenario, China has no choice but to revise its unfeasible GDP growth target and set it at around 2 to 3 percent, while ensuring that households’ incomes grow by 4.5 to 5 percent. In this way, local governments would pay for the debt by liquidating their assets, while growth would decelerate without causing social turmoil. According to Pettis, the government has already been trying to adopt this strategy: whether Xi Jinping has consolidated its power enough to successfully do this will only be seen when such reforms begin.
The Q&A session touched upon many interesting issues. For instance, the lack of hard budgetary constraints, which allows the government to reach virtually any GDP target by way of unprofitable bank loans to corporations and local governments: in Pettis’ view, GDP in China is not so much an ‘output’ but rather an ‘input’, decided by the government and achieved through distortions in production capacity. Another talking point concerned the ways localities can liquidate their assets: while selling real estate could make the banking system collapse, some provinces and municipalities are experimenting different strategies, such as wealth transfers to workers and pension funds. In conclusion, the political momentum seems to be there, but this does not imply that a smooth readjustment is on the horizon.
For further reference, Pettis, Michael. The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy. Princeton University Press, 2014.
Report written by Rebecca Arcesati