Credit Writedowns

One of the reasons that it is been so hard for a lot of analysts, even trained economists, to understand the imbalances that were at the root of the current crisis is that we too easily confuse national savings with household savings. By coincidence there was recently a very interesting debate on the subject involving several economists, and it is pretty clear from the debate that even accounting identities can lead to confusion.

We speak of the case in which positive shocks are self-reinforcing, as a virtuous circle, and the case in which negative shocks are self-reinforcing as a vicious circle, but the important point is that these processes are part of the same system and are very common. It is usually a pretty safe bet, for example, that when an economy is surging forward at astonishing growth rates – rates which far exceeded anyone’s prior expectations – it has powerful positive feedback loops embedded within its economic institutions.

In my book I focus mostly on balance sheet feedback loops, but they also exist just as powerfully in the underlying economy.

I have been arguing for several years that once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4% annually. This is what it will take for household consumption to rise to roughly 50% of GDP in a decade if consumption growth can be maintained at its historic rates of around 8%.

But I always warn that this is likely to be an upper limit, not a lower limit, to growth The key is whether or not it is possible to maintain current levels of consumption growth once investment growth is sharply reduced. A recent paper by the IMF on the topic is very interesting and not encouraging.

My quick take is that the leadership is saying all the right things, but they have been saying these things for quite a while – nearly two years in the case of Li Keqiang, the new premier. The constraints they face, however, have neither changed nor been addressed.

This post is extracted from my newsletter sent out four weeks ago, at a time when the mood in Europe was much better than now and when there was even a sense that the crisis was in the process of being resolved. I mention this to remind readers of how quickly sentiment can change.

The lessons for China, if I am right, are that China should forego the idea of nurturing national champions and should instead encourage brutal domestic competition. Beijing should also eliminate subsidies to production, the most important being cheap and unlimited credit, because senior managers of Chinese companies rationally spend more time on increasing access to these subsidies than on innovation, a subject on which, in spite of the almost absurd hype of recent years, China fares very, very poorly.

There is nothing wrong with protecting domestic industry, but the point is to create an incentive structure that forces increasing efficiency behind barriers of protection. The difficulty, of course, is that trade barriers and other forms of subsidy and protection can become highly addictive, and the beneficiaries, especially if they are national champions, can become politically very powerful.

I’ll be watching a number of things in 2013 in order to get a better sense of what the future will bring. On January 22 Princeton University Press will be publishing my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead, and in the last chapter of the book I argue that the great trade, capital flow and debt imbalances the were built up over the preceding two decades must reverse themselves. Imbalances can continue for many years, I argue, but at some point they become unsustainable and the world must adjust by reversing those imbalances.

In China, I have argued many times, high growth is no longer compatible with a strengthening balance sheet. If China is growing at a rate that approaches or exceeds five or six percent, it is probably a safe bet that debt is rising faster than debt servicing capacity.

By Michael Pettis The big news in the past two weeks has been the slew of economic data suggesting that China has firmly turned the corner on its economic closedown. Growth is up, investment is up, and inflation is down. Here, for example, is the New York Times, a newspaper whose website is no longer available in China without a [...]

By Michael Pettis In the past two weeks we have been treated with a mostly positive but nonetheless mixed bag of economic data from China. There has been good news, bad news, good news with worrying underlying trends, and bad news with silver linings. Analysts have announced that things are getting worse and that things are getting better. There was, [...]

By Michael Pettis Chiwoong Lee at Goldman Sachs has a new report out (“China vs. 1970s Japan”, September 25, 2012) in which he predicts that China’s long-term growth rate will drop to 7.5-8.5%. I disagree very strongly with his forecast, of course, and expect China’s growth rate over the next decade to average less than half that number, but the [...]

By Michael Pettis I recently “debated” twice with senior Chinese officials on the future prospects for China. In both cases they made the argument that Chinese growth rates were going to rise in the next few years and that the current deep pessimism is unwarranted. I argued, of course, that growth would slow even more. Neither of the debates, I [...]