Tuesday, January 21, 2014

Michael Pettis On The Consequences Of China's Rebalancing (Why Deleveraging Will Slow Growth)

Michael Pettis, finance professor at Peking University's Guanghua School of Management and author of "The Great Rebalancing", "Avoiding the Fall: China's Economic Restructuring", and the "China Financial Markets" blog, explained everything you need to know about China's rebalancing at the 2013 Wine Country Conference. He also did a Q&A session with hedge fund manager Jim Chanos, who is short China. Michael Pettis also talked about China at the Instituto Fernando Henrique Cardoso (iFHC) and Columbia University in 2009 (see videos at this post).

In the video below, Michael Pettis explains how China's rebalancing will occur and how it will affect GDP growth as the country shifts away from its levered fixed asset investment, export-driven growth model and towards domestic consumption. Basically, from what I learned from Pettis' lecture, what needs to happen is China's "household income share of GDP" needs to rise. To do this, people's wages need to rise relative to productivity growth, the value of the Chinese yuan needs to rise to make imports cheaper for consumers, interest rates need to rise to increase the real return on savings and the real cost of capital, and privatization needs to occur (also in the form of debt transfers). So that's how you do it. But, unfortunately he thinks China's rebalancing will be a tough adjustment for its economy.

Here are Michael Pettis' own words from the video (emphasis mine):

In China the household share of GDP is the lowest maybe ever recorded. Household income is roughly 50% of GDP. Under those circumstances it's not surprising that household consumption is so low, right? If the income share of GDP is very low, then by definition the consumption share of GDP must be very low. To say it another way, assume we could bring the household savings rate in China to zero, which would be even worse than in the U.S. In that case China would still be the lowest consuming country in the world. So the problem is not the propensity to save of households. The problem is that household income is too low. And if household income is too low, household consumption is too low. And as you know savings is simply GDP minus consumption. That's why the Chinese savings rate is so high. So if you want to raise consumption, that is lower savings, there's really only one way to do it. And that's to increase the household income share of GDP.

So, Beijing knows this. Everyone says now that what we need to do is increase the household income share of GDP. So I'm going to assume that it's possible to do that; it's possible to do that in a non-destructive way. So how do you go about doing it. Well there are only a few ways you can raise the household income share of GDP. One way is do nothing and let debt levels continue to rise until we reach debt capacity limits and then China will rebalance. It will rebalance in a chaotic way, but it will rebalance. After all, the United States in the early 1930s, it rebalanced, but how did it rebalance, investment declined by 98%, GDP declined by 35%, household consumption declined by 10%. So the U.S. rebalanced. So if China does nothing, it will rebalance, but it will rebalance in a very chaotic way. So what can China do not to rebalance in a chaotic way. Well, it can take steps to increase the household income share of GDP. How can it do it? Well, one way is to reverse the mechanisms that caused household income to decline so rapidly. And these mechanisms are very straight forward... China is just the Japanese growth model on steroids. And there were three very important mechanisms that both caused rapid growth and rapid growth in the imbalances. And they are basically an undervalued currency, low wage growth relative to productivity growth, and most importantly and most difficult to explain, is financial repression.

Recent updates from Michael Pettis (emphasis mine):

1) Will the reforms speed growth in China? (China Finanical Markets)

These three conditions, which are the automatic consequences of the reform process – deleveraging, writing down unrecognized investment losses, and reversing policies that goosed growth rates – must lead to much slower growth. In theory these conditions can be counterbalanced by an explosion in productivity unleashed by the reforms. When analysts claim that growth rates will not slow if the reforms are implemented, this must be implicitly what they mean.

2) Analyst forecasts Chinese economic growth will slow to 3 or 4 per cent (ABC via MacroBusiness)

A China expert says expectations of continued 7 per cent or more economic growth are too optimistic.

Michael Pettis, professor of international finance at Peking University, believes growth rates might fall to as low as 3 or 4 per cent, which he says means the reform process is working.

However the forecast will strike fear into the board rooms of Australia's resource companies which have enjoyed years of booming exports to feed China's rapid industrialisation.

Here is more information on China's crazy credit growth. In September 2013, Jim Chanos of Kynikos Associates told CNBC:

So every three to four years at the current rate, China is doubling its debt relative to its GDP. It's already about 200 plus percent right now, so another three or four years we'll be worse than Greece. These are staggering kinds of numbers. And at some point that has to end.

And in June 2013, Charlene Chu, formerly of Fitch Ratings, told Bloomberg TV:

A lot of people are aware that we've had a large expansion of credit in China but they are not aware of the magnitude. By the end of this year, this will be the fifth year running, we'll have increased 14 trillion U.S. dollars in assets. That's equivalent to the entire U.S. commercial banking sector. So China will have replicated the entire U.S. system in five years.

Local government debt has also exploded. According to The Economist:

The audit showed that China’s local governments (and the investment vehicles they sponsor) owed 10.9 trillion yuan ($1.8 trillion) at the end of June. They had also guaranteed several trillion yuan of debt explicitly and another 4.3 trillion implicitly. Adding these three figures together yields a total of 17.9 trillion yuan, or about a third of China’s GDP. But the National Audit Office (NAO) itself was careful not to add these three figures together. The debt guarantees, it pointed out, are only “contingent” liabilities: they will land in officials’ laps only if bad things happen, and bad things do not always happen.

This is why a deleveraging cycle needs to occur in China. And it appears that government reforms will allow some deleveraging to occur in 2014. CLSA's Francis Cheung recently told Bloomberg TV that deleveraging will put pressure on economic growth and Chinese stocks in the near-term:

The two biggest priorities for the government is actually overcapacity and local government debt. To manage these problems is essentially a deleveraging process that's going to pressure growth. I don't think that's factored into the market yet.

Also, at Project Syndicate, George Soros recently wrote, "there are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008." But, if you still want to invest in China, Jim Rogers recently told Reuters TV to "go where the Chinese government is going, that's where the money is." The Shanghai Stock Exchange Composite Index and the Reuters/Jefferies CRB Index (Commodity Index) will be interesting to watch during China's rebalancing.

Related post at News Moving Markets: Exporters Bear The Brunt Of China's Economic Transformation (Reuters TV)

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