The impact of reform on growth

I got a lot of feedback from my January 5 blog entry because of my argument that the implementation of the reforms proposed in the Third Plenum all but guarantees that growth rates in China will slow down. For that reason I thought it might make sense for me to explain a little more carefully why I think this must happen, mind and why I think that we can almost judge how successfully the reforms are implemented by how quickly growth slows.

The first point to recognize is that when a country’s growth has been driven by wasteful investment, shop GDP growth will exceed real economic wealth creation, productivity will be overstated, and debt will rise faster than debt servicing capacity. Why? Because in China we record growth in terms of the cost of inputs, not in terms of the value of the outputs, and so if the cost of inputs exceeds the value of outputs, we will overstate the real value of economic activity.

Now of course this happens elsewhere too, but there is an automatic mechanism for writing down this excess. This mechanism is usually the recognition of bad debt. Companies that invest poorly go bankrupt, and the value of their loans is written off. This writing off of bad loans shows up as a correction to the overstatement of growth and productivity.

In a system in which bad debt isn’t written down, the losses are simply hidden and rolled over. Of course after many years they are effectively written down, but this happens indirectly. In order to service the loans there is an explicit or hidden transfer from some other part of the economy to cover the full extent of the losses, so that future growth is reduced by the amount of the transfer.

Over long periods of time, in other words, real economic value and recorded economic value is the same, but over shorter periods of time they can differ enormously. If a country fails to record bad debt, its growth today will be overstated by that amount, but its future growth over the longer term will be understated by the same amount.

I think most of us agree that a significant share of the loans in the Chinese banking system would be considered, from an economic point of view, as bad loans. They were made to support investments the true economic value of whose outputs are less than the cost of the inputs. Because many of these loans are implicitly guaranteed, it may make prefect legal sense for the banks to treat these as performing, but this does not change the fact that the loans are uneconomic.

I would argue that China’s GDP is overstated by the value of these hidden losses, and over time these losses will be worked out. As long as bad loans (as I am defining them here) are increasing, it is pretty safe to assume that the gap between China’s real economic output and its recorded output is also increasing. This has been the problem with China’s growth of the last several years.

Beijing’s response is the economic reforms proposed during the Third Plenum, aimed at unlocking greater productivity potential in the Chinese economy and returning the country to a sustainable growth path. They will do this by improving the capital allocation process, so that capital will be diverted from SOEs, real estate developers, local governments and other inefficient users of capital, to SMEs, the agricultural sector, and more efficient users of capital. They will also eliminate constraints that prevent more productive use of resources, including weak legal enforcement of business claims, better protection of managerial and technological innovation, educational improvements, and so on.

The implementation of these reforms is not certain. There is likely to be tremendous political opposition for all the reasons I have discussed in the past three newsletters. But, even assuming they are forcefully implemented, the higher productivity resulting from the reforms will not lead to higher reported GDP growth. This is one of the great recent myths that, to me, make no sense at all. The higher productivity will not even allow China’s economy to continue growing at current rates. On the contrary, successful implementation of the reforms will cause GDP growth rates to drop sharply.

There are at least four reasons to expect healthier but slower GDP growth over the rest of this decade if the reforms are implemented.

1.  Leverage boosts growth and deleverage reduces it. By now nearly everyone understands that China is over-reliant on credit to generate growth. Much new borrowing is needed simply to prevent borrowers from defaulting on existing loans, so that new lending can be divided into two buckets.

One bucket consists of loans made to roll over the debt of borrowers who do not generate sufficient cashflow from the investments that their original loans funded. The loans in this bucket, of course, do not create additional economic activity, but as debt rises, financial distress costs rise with them (most financial distress costs, as is well understood in corporate finance theory, are a consequence of the way rising debt changes the incentive structures of the various stakeholders and so distorts their behavior in non-economic ways). Of course any disruption in lending would cause a surge in defaults.

The second bucket consists of loans that fund new expenditures. These expenditures, of course, generate economic activity, but if they fund consumption, or if they fund investments the value of whose output is less than the cost of the inputs, they incur additional losses that must ultimately be rolled over by loans that belong in the first bucket. Any reduction in loan growth, in other words, is positive in the long term for Chinese wealth creation, but in the short term will either force the recognition of earlier losses or will reduce economic activity.

Beijing has attempted since 2009-10 to rein in credit growth, but each time credit growth has decelerated, GDP growth rates – as we would expect – dropped so sharply that Beijing was quickly forced to relent. Because growth is more dependent than ever on credit, as Beijing finally acts to rein in credit growth decisively, GDP growth will drop sharply.

2.  Hidden transfers will be reduced. As I have discussed many times the investment-led model encourages investment by transfers – hidden or explicit – from the household sector to subsidize investment. In the Japanese version of this model, which very broadly is the version China and the Asian Tigers pursued, the main form of these transfers is the undervalued currency, low wage growth (relative to productivity growth) and, most of all, financial repression.

Because these transfers no longer create net value on the investment side (China overinvests in infrastructure and has excess capacity in a broad range of manufacturing sectors), and the extent of the transfers are at the heart of China’s very low consumption level, the proposed reforms will act to reverse the mechanisms that goosed growth by transferring resources from the household sector to subsidize manufacturing, infrastructure building, and real estate development. These mechanisms put downward pressure on household income even as they subsidized manufacturing and investment and led directly both to higher growth rates and to the investment and consumption imbalances from which China suffers and which it plans to reverse.

It should be clear that as Beijing reverses policies that once acted to increase growth, the result must be slower growth. It is hard to estimate the amount by which growth will decline once all the transfers are eliminated, but when one considers that the total amount of transfers to SOE’s during this century may exceed the aggregate profitability of the SOE sector by as much as five to ten times, it is pretty clear that their impact is likely to be substantial.

3.  Excess capacity will be resolved. Beijing recognizes that cheap credit and limited accountability have created excess capacity in industry and real estate. Why build so much excess capacity? Local governments have supported this build-up of capacity to boost growth and, with it, revenues and local employment, and because capital was essentially free (its real cost may have even been negative for much of this century) and because most projects are implicitly or explicitly guaranteed by local and central governments, there seemed to be no cost, and plenty of benefit, simply to pile on capacity.

As Beijing acts to wring out excess capacity, we will inevitably see a reversal of the earlier growth impact. If building capacity generates economic activity (and it must have, or else why do it), closing down excess capacity must become a drag on growth.

4.  Losses will be recognized. As I discuss above, because many years of overinvestment have left a large amount of unrecognized bad debt on bank balance sheets, China’s GDP growth has been overstated by the amount of the unrecognized losses. Over the next decade as Beijing cleans up its financial system, this bad debt will either be explicitly recognized or, more likely, implicitly written off over the remaining life of the loan. Either way, as the losses are recognized, growth over the next several years will automatically be understated by the amount previously overstated.

These reforms, and others – like attempts to protect the environment – will ensure that even as China’s real economic productivity improves, its GDP growth numbers will drop as the reforms are implemented. For now most commentators argue that by increasing productivity, real reform will ensure a soft landing of GDP growth rates of 7-8 percent during the rest of President Xi Jinping’s administration. A growing minority worries, however, that rapidly rising debt will force China into a hard landing.

GDP growth is an inverse proxy for reform

Although rising debt increases the probability of a hard landing, for now I expect neither outcome. More likely, I believe, is a “long landing”, during which growth rates will drop by roughly one to two percentage points every year for the rest of this decade. Implementing reforms will protect China from a hard landing. It will however force much lower, albeit healthier, growth rates.

In order to understand China’s growth prospects I think we must recognize that while a growth model can deliver healthy growth for many years, this growth can itself transform conditions to the point where the model is no longer able to deliver. At that point the economy must adjust to a new, more appropriate growth model.

The Chinese growth model is a version – in probably its most extreme form – of the investment-led growth model described by Alexander Gershenkron fifty years ago. To simplify tremendously, growth in “backward” economies is supported by policies that subsidize investment while suppressing consumption (usually by constraining household income growth). These “backward” economies are ones in which the level of capital stock is much lower than the country’s social and institutional ability to absorb investment efficiently.

Early on, many years of high investment allowed China to catch up. Once it did, however, continuing to invest in the same way and to the same degree was no longer wealth enhancing. At this point the economy needed institutional and social reforms to continue growing. The political logic of the system, however, forced, as it almost always does, continued high investment growth and, with it, increasing investment misallocation.

With this almost by definition debt began to rise faster than debt servicing capacity. This, clearly, was unsustainable, but of course it can go on for many years. It was as long ago as 2007 that former Premier Wen described the Chinese economy as “unsteady, unbalanced, uncoordinated and unsustainable”, but it proved politically very difficult for Beijing to implement the reforms his advisors suggested, and so the distortions associated with the growth model continued.

Debt surged even as the consumption imbalance deteriorated until late 2011. We have only seen in 2012-13 the beginning of any partial rebalancing, although during this time there has been at best only a deceleration in the growth rate of credit.

And yet the minimal amount of rebalancing that has occurred in the past three years has already lopped three percentage points off China’s GDP growth rate, just as we predicted. China still has a long way to go to rebalance its economy. By my calculations consumption growth must outpace GDP growth by 3-4 percentage points every year for at least a decade just to allow China to raise the household consumption share of GDP to a still-low 50 percent.

The proposed reforms will certainly unleash greater productivity, but they will also eliminate the very mechanisms that had previously turbo-charged economic activity and which showed up in the form of higher reported GDP growth rates. They will cause a sharp deceleration in economic activity even though growth will be more productive than in the past. The fact that growth rates have dropped by almost a third even before the reforms were implemented suggests to me just how much further they must drop.


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  1. Hi Michael. When an asset is written down, does that get recorded as a reduction in GDP? When a natural disaster strikes and damages real assets, GDP (perversely) rises due to repair work. Is the destruction of real assets recorded against GDP? How about financial assets?

    Perhaps a generous way to think about China’s strategy of funding investments is that, first there is a option value. A pharmaceutical company might invest in a portfolio of research projects. Most will fail, but overall the portfolio delivers positive returns (one hopes!). Similarly the fact that some investments in China turns out to be a failure should not deter the government from funding investments generally. It is hard to select winners, and so the government has to just encourage all investments broadly, anticipating (hoping!) that overall this strategy leads to long term economic development vs the alternative strategy of relying purely on under developed private markets. (Arguably private investors under invest when capital markets are poorly developed, as seems to be the chase in China). Second, there seems to be a human capital element to the development strategy. The investments in China has had the effect of pulling labour from the less productive sectors of the economy (eg rural areas) to the more productive (urban areas). Even if workers are employed to work on inefficient projects, the learning experience is valuable.

    So it seems possibly premature to assume that the large investment led growth has put China on a suboptimal growth path vs the counter factual of relying purely on the private sector to invest.

    Having said that, I broadly agree that we should expect lower growth as China switches to a different growth model. I just think that it is premature to assume that the investment led growth was a poor growth strategy.

    Just a thought.

    • The problem is not some investments fail, it’s that Chinese government does not allow failures/writing down bad debt/default

      • I would say it is both, meo fio. Bad investments reduce overall wealth, and the failure to write them down correctly causes growth to be overstated.

    • Kien, it seems that every few months someone responds to these discussions about over-investment with the point that sometimes investments actually do make sense. I don’t think anyone doubts it, but the fact that sometimes government investment is productive doesn’t really address the point that China is a very poor country with very low levels of productivity and that it has had the highest investment growth rate in the world for well over a decade and that members of the elite are heavily rewarded for increasing investment whether or not the investment is productive and that most attempts to gauge the productivity of investment, like those studies that show SOE profits are a fraction of the amount they receive as subsidies, show that they are not productive. Pettis has been discussing over-investment for years and said one consequence would be an unsustainable increase in debt, and I don’t think anyone doubts any longer that debt is a huge problem. If you think China is not wasting investment spending, please present a stronger argument than the claim that sometimes investment is good. I don’t think there is anyone who denies this.

    • I am not sure why you think that China’s growth model can only fit into one of two boxes, Kien, that either it has always been a bad growth model or that it has always been a good growth model and continues to be so. My preferred interpretation is a lot more nuanced and also complies with historical precedents. In the early stages of the implementation of the model, in the 1990s, for example, when Chinese investment levels were well below the needs of the economy, the investment-led model generated real and sustainable growth. In that case a political and institutional structure that strongly encouraged investment made sense.

      After many years of piling on investment, however, it shouldn’t be a huge surprise that the value of additional investment declined, and even went negative. This is, after all, what seems to have happened in nearly every previous case in history, and I am not sure why it cannot have happened in the case of China too. As J points out, the key is debt. When debt grows faster than debt-servicing capacity, almost by definition investment has been unproductive, which is why most of the debate has moved on to the issue of debt sustainability.

    • To your point, I think Michael could be clearer about debt write-offs on GDP as an economic variable.

      He is clear enough that real wealth needs to be reconciled with the imaginary wealth. Imaginary wealth is calculated by chaining misstated annual GDP numbers, and at some point, people will realize that their assets (and health) are not worth that much. In a sense, that is all that matters to the Chinese citizens.

      However, exporters to China might care about these fake GDP numbers, as a business consideration. From my understanding of economics, destruction of things do not subtract from GDP. I guess if a building or bridge is blown up, it is rightly not negative to GDP based on the economics definition.

      If an individual writes it off, there is of course secondary wealth effect.

      If a bank has to write it off, would the loss in the bank be a primary or secondary effect to GDP?

      Then again, if the numbers are made up, they can continue to diverge from reality. There is no economic model that suggests made up numbers have to be reconciled. At some point, those that rely on the made up numbers will then choose some other metric.

    • Kien, I understand your optimistic thoughts about overinvestment.

      You wrote “Second, there seems to be a human capital element to the development strategy. The investments in China has had the effect of pulling labour from the less productive sectors of the economy (eg rural areas) to the more productive (urban areas). Even if workers are employed to work on inefficient projects, the learning experience is valuable.”

      This can be a dangerous and addictive justification for government directed investment and spending. I liken it to the Obama administration’s attempt at picking winners in the alternative energy space. These investments have performed very badly. I’m sure they believe all the investment has taught us valuable lessons about solar and wind energy. The problem this has been going on for decades and the market has determined many of these investments are currently not viable.

      The best course of action would be for the Chinese government to promote market reforms and institutions that support freely directed investment and of course both success and failure. The costs of overinvestment might be excessive relative to any human capital value, It also robs the future of growth and investment.

  2. Good post. Sober. How odd you must feel, Michael, while other mainland based economists tow the party line. Others seem to be in a competition for the best description on how the party will overcome all obstacles. Some explicitly stating the China will jump over the middle income trap. Having just watched several on youtube present at a New York conference, I couldn’t believe my ears. To be honest, at the end I just felt cheated of my time. I know these are intelligent men, but real public discussion and analysis will not help their careers.

    The funny thing is I don’t see much terribly wrong with the direction of government policy. Although I agree with your thoughts on over investment (Japan all over again), there is acknowledgement by the government that it must change. And we know at the best of times, it’s difficult to implement change. If a government struggles to implement change, does that make it a bad government? Certainly not.

    • For me the problem with most other economists who have been following China over the past decade, cjared, is not that they are toeing the party line. I think that many of them have simply been bad economists. They have failed to consider China in the context of other developing countries, they seem to know almost nothing about the many historical precedents, and they have tried to force the Chinese economy to fit into very rigid boxes of economic thinking without recognizing where China may or may not differ. Most of the sell-side research lacks any imagination, and although in the past few years they have all rushed to incorporate the problems of debt and slowing growth, which just one or two years ago they insisted would never be problems, I am still not sure they fully understand why these are problems.

  3. Dear Prof Pettis,

    First of all, I would like to thank you for helping me better understand China’s economic issues.

    I would like to get your views on
    a) the China Credit Trust story
    b) a theory I have heard regarding the opening of the capital account and its linkage to the credit issues China faces

    The bailout of the China Credit Trust appears to go against the stated purposes of the economic reforms. It increases the moral hazard of implicit government guarantees and encourages further credit growth.

    One theory I have heard is that the government is trying to hold out on a credit bust (by bailing out things like China Credit Trust) until it has opened the capital account. This is to allow foreign capital to come in while allowing domestic capital to diversify outward. Therefore, if a bust happens, the pain is more ‘spread out’

    Would you lend any credence to this view?
    (I am not a trained economist, so please correct me if this is not economically sound)


    • @CY

      One thing I would point out is that during the last credit crisis, China was very much opposed to the pricing that foreign banks assigned to distressed assets. From what I understand, this has continued to the present. If the Chinese investors aren’t getting 90 cents on the dollar, for example, then they simply refuse to sell to the foreign banks, even if the foreign banks have assessed the true value as closer to 20 cents on the dollar.

      You are right that opening the capital account would probably solve a lot of problems, but not if the government refuses to sell distressed assets at market determined prices. It seems like there is either an element of greed or arrogance that prevents the assets from being sold at a fair price.

      • @Andao

        Thanks – I was not thinking of foreigners buying distressed debt. More likely they will encourage foreigners to lend to domestic companies (through loans or bonds), which may help ‘roll over’ the debt that is currently non-performing into foreign hands.

        Of course, this happens only if the foreigners are not aware of certain companies with bad credit. Your case happens when the foreign buyers are already aware of the non-performing credit.

        • CY, I found your comment that somehow Chinese banks can pass the hot potato (as we would say in English) to unassuming foreign investors to be a bit wishful thinking. Even if this was deemed to be a viable policy option, the game is over.

          The global market’s awareness of bad debt and overinvestment issues has caused a giant pause on the part of foreign investors. Any investment in China will be getting a lot more scrutiny by potential foreign investors. Transparency and accounting concerns have only amplified the hesitance.

    • The problem with eliminating moral hazard is that once a system has adapted to moral hazard, it is hard to eliminate it without causing bank runs and financial distress, and the longer you wait the more painful it is. The US Congress failed to close down S&Ls in the late 1970s, when they were clearly bankrupt, because they did not want to pay the coast, and hoped instead that the S&Ls would use the deposit guarantee to engage in prudent but profitable behavior. of course that didn’t happen, and when the S&L mess was finally cleaned up in the late 1980s, the costs more than quadrupled, if I remember my numbers correctly. The longer you wait, the more urgent it is, but the more costly it is, and so the more reluctant you are to pay the costs.
      This happens pretty regularly. Think about the 2007-08 global crisis. I think it is pretty clear that things were made much worse by a history of the Fed effectively bailing out the banks every time they took more risk than they could handle, and so, not surprisingly, they took on ever more risk. We are fully into that game in China.

  4. The crux of any argument against what you’re writing here would have to largely ignore the accounting of the situation and have a major “unleash the Chinese consumer” fudge factor in their model. But even the most coherent China bulls seem to end up shifting their argument to refute a Gordon Chang ‘collapse’ of China, rather than what seems far, far more likely: a rough reprise of the 1980’s Japan taking over the world story where the experience afterward for the Japanese themselves doesn’t look nearly as horrible as the lost decade idea would suggest.

    A question though: living in China, it feels like inflation has been vastly understated by the official statistics. Do you have any feel for whether that’s the case?

    • but japan was more politically stable, china is not. The highest level of CCP is divided (xi jingping vs. zhou yongkang)

      • I as an outsider would love to read more about this and the forces behind these two factions (I guess this is not the conflict of two individuals)

    • China is not Japan. China has some very real and very serious problems with domestic security with an unpopular rent seeking elite ruling over a vast and unruly populous. Add to that there’s also pressure coming from the military. The PLA at this point has a very strong element that favors the use of force against it’s neighbors, providing an additional driving force towards Chinese expansionist policies. As Germany showed in 1914, this is not a recipe for peace.

      • I often read the 1914 argument. I dont actually believe it.
        I have recently read a great paper on the Kaiser era public finances and war – I regularly read about the Kaiser Germany and WWI in general.
        One defining momentum was that the ruling elite in Germany did not have a firm grip on the finances – only the democraticly elected Reichstag could introduce direct taxes. The Reichstag was dominated by Social Democrats obviously opposing the Weltpolitik and military buildup.
        Because of this Germany, had the lowest relative military spending among the great powers in relation to GDP (about 1%, versus 3% with Russia and France) by 1914.
        The ruling elite sensed that they cannot win the arms race against the Entente without domestic political concessions, felt unsecure, so they wanted war the sooner the better.

        And I think this is a definitive difference. The Chinese elite can certainly raise the military budget just as the post WWII Soviet Union could, actually they did so, I just read in the morning paper that China, India raised military budget in the past years substantially.

        • But that assumes the Communist Party is a unified entity, and it’s not as the purge of Bo Xilai indicates. Add to that there’s also popular dissatisfaction with the Party in general and the there’s also pressure from the PLA to buy more hardware and allow them to use it. The Party’s position is far less secure than it appears.

          A way Germany deflected domestic political tension was to craft an expansionist foreign policy. China today is doing the same thing with it’s Panthersprung against the Philippines and Japan.

    • I think nearly everyone believes that CPI inflation has been understated, and there have been several studies that seem to confirm it. By the way if indeed it has, then real GDP growth has been overstated.

  5. Prof. Pettis,

    I have a question regarding emerging markets and QE. With the Fed tapering, emerging markets are being put under a lot of pressure. Is there any realistic way for countries like Turkey, Indonesia, Russia, and others to escape very high inflation? Also, how does the tapering of the Fed affect China, Chinese growth, and the upcoming Chinese rebalancing?

    • The biggest problem, I think, is that because of PBoC monetary policy, China, like a lot of other EMs, is forced to import US monetary policy, and because China is much smaller and with a much more rigid financial system, small changes in US monetary policy translate into big changes in Chinese monetary policy, even when China needs the opposite domestic monetary policy. As long as the RMB is pegged, China has no choice but to accept the consequences of any US tightening. This is why I don’t think we will see either a currency depreciation or lower interest rates. Either could easily cause massive net outflows from the system.

      • What is the monetary position of other EM countries with flexible exchange rates like Turkey, India, Indoneisia, and others in similar positions? Some of these countries are trying to establish a stricter monetary policy (like inflation targeting in India) while other countries are in complete political turmoil. What options does a country like Turkey or Indonesia or even Brazil or South Africa have?

  6. Dear Dr. Pettis,

    What would happen if the Chinese print a lot of cash. Let us say that they double their monetary base. Inflation will double, but the value of debts will halve. Will that be a good strategy to reduce bad debt. They can also use this newly printed money and transfer to households. Their currency will depreciate, wealth transferred to households and debt halved. Is that not what QE of US achieved? (except that wealth was transferred to 1%)

    • Inflation (assuming it would double in step with the monetary base) devalues cash relative to other assets so those who are long cash (such as households) lose out relative to those who are short (borrowers). It amounts to a soft default and as you point out reduces debt, but at a cost to households, whether directly or indirectly.
      As for US QE, you could probably argue the effects and merits or demerits all day.

    • I am not sure that doubling the money base (which money base?) would cause inflation to double or debts to halve. The arithmetic doesn’t work that way. The key point to remember is just that when money growth exceeds the underlying needs of the economy (which is tough enough to figure out anyway), there is effectively a transfer of wealth from those who are long monetary assets to those who are short. At its simplest this can be described as a wealth transfer from households to net borrowers. Because rebalancing in China requires the opposite transfer, monetizing debt will make the imbalances in China much worse and will reward the most foolish borrowers (again).

  7. Excellent analysis!

  8. Professor,

    What do you make of claims that China’s currency is overvalued, and set for a devaluation? Alphaville has reported a couple of times on this idea; here is one from today:

    Why is this wrong? They say “Of this about half is in the trade-weighted exchange rate, the other half being excessive wage-cost inflation.”

  9. Excellent piece. I just wonder what the political implications will be. The discontent with the almighty CPC is certain to rise and given its fear for the people, we (or at least the chinese) are likely to have to live through some rather unpleasant times during the next two decades.

  10. Hi Michael,

    A wonderful article, could not agree more.

    If we choose any segment, Metals for example, and look at the balance sheet of large corporations, we would notice the ratios have been going awry over several quarters for the last two-three years. These corporations, with such dismal financial ratios cannot continue to create excess capacities any more, or at least the financial norms would make them clean up their balance sheets sooner than later. To give an example, Chalco, the Chinese Aluminum major, after some quarters of loss, just cleaned up the balance sheet by transferring its loss making and inventory carrying downstream business, The Flat Rolled Products unit, to its parent, thus getting rid of the inventory it was carrying freeing cash in the process. Such measures would also mean that Chinese Financial markets would not tolerate extreme excesses any more.

    China now holds 45% of the world’s Aluminum capacity and 50% of the Steel. The frenetic pace at which it had being growing far outpaces the consumption growth in both these sectors. With financial markets slowly tightening credit conditions it is only to be expected that it would create a cascade of balance sheet repair, which will make impact growth.

  11. notify me on new reports

  12. You write that Beijing has attempted to rein in credit growth since 2009-10.

    My understanding is that Beijing actually encouraged credit expansion in 2009. With tremendous success, it has to be said, since bank credit expanded by +31% in 2009 and again by +21% in 2010, according to the National Bureau of Statistics of China. So, credit had a great leap forward – litterally – in these two years, jumping by a cumulative +59%.

    That was the great stimulus that pulled the world out of recession in 2009 … at the cost of setting China on the path to joining the US, most of Europe, Australia and Japan in the club of excess debt countries. You would have thought that the idea in 2008 was to make that club of excess debt countries smaller, not bigger, but that’s a different discussion.

    It must have been only from 2011, when they realized the cashflows produced by these debt-funded investments were lower than anticipated and barely adequate, that authorities started to try to rein in credit growth.

    Monetary authorities, virtually everywhere and at all times seem to be a little naive: first, they ligthen up a small credit expansion fire (by setting interest rates too low for too long) as a way to warm up the economy. Then, when they realize it has turned into a wild forest fire of credit addiction, they come up with a glass of water to try and extinguish it. Obviously, they are reluctant to come up with truck loads of cold water, as this would weaken the economy. From that moment, they are left with no attractive options. The economy eventually gets weaker anyway as debt service crowds out other spending.

    Same causes, same consequences as several Western countries in the previous cycle.

    • Pettis usually says Beijing has tried regularly to rein in credit growth since 2009-10, but every time they do, GDP growth slows so sharply that they pull back and reignite it.

    • Yes, J is right. I would argue that they have tried many times, and failed, to rein in credit growth. By the way I strongly disagree that the Chinese action in 2009 was “the great stimulus that pulled the world out of recession in 2009.” It pulled China out of a deep depression by replacing collapsing foreign demand with soaring local investment, but it’s impact on the rest of the world was much more complex.

      • Ok, so it pulled China out of recession but, to be clear, they were trying to stimulate back in 2009, not to rein in credit (trying to rein in credit with negative real interest rates is a bit counter-intuitive). In any case, credit surged spectacularly, let´s say as if it had been encouraged. We can’t prove the intention but we can observe the result.

        • We can say that likely they intended to rein in credit growth but weren’t and wouldn’t have been successful in the manner that they would have wanted it to be, by keeping their population happy with sufficient economic growth… The party is in a corner and doing some good old typical self-beating up. If they can come out of the next 5 years healthy it will be amazing.

          Thank you Mr. Pettis, I appreciate reading an article with more depth than the usual economic article.

  13. just leaving a comment so I can sign up for new posts….

  14. Hi Professor Pettis,

    I previously tried to post this, but somehow it didn’t get through. What I said was that you are my economic rock star. I have read Great Rebalancing and Avoiding the Fall, and the logic backed up by data and historical examples is extremely convincing. You have cleared up so many things for me and many fallacies put forth by other economists/commentators. I think Japan’s lost decade analogy to China today is very instructive. It struck me during reading your books and articles that perhaps the Plaza Accord negotiated in the 80s, which depreciated the value of the Dollar and thus the Yen rose relative to the Dollar, may have accelerated and possibly exacerbated the inflation of the asset bubble in Japan and thus bring about the lost decade and rebalancing sooner than it might otherwise have occurred. I am not saying the Plaza Accord caused the rebalancing crisis, because we know bad debt had already built up in the system and it was just a matter of time until it could no longer be serviced, but perhaps it accelerated this trend and maybe even exacerbated the lost decade. What do you think?

    Also, once Japan was forced into this rebalancing beginning in the early 90s, the US economy began turning a corner and performing better, until from about 1995-2000, we were jamming. I don’t have any data to back this up, but I don’t think this was a coincidence, as our exports became more competitive and trade and capital flows were healthier for us, allowing us to become more productive and grow faster, etc., etc. in a virtuous cycle. Does this seem right to you? if so, it would seem China’s rebalancing, orderly or disorderly, can only bode well for the US economy, despite what most pundits claim. Do you agree? Thank you.

    • I have argued broadly for five or six years that China’s rebalancing, when it happened, would be bad for hard commodity producers, neutral for food producers, and positive for foreign manufactures. I think we have already seen evidence of all three.

  15. When the same happened to Japan that is now happening to China, it gave birth to the expression “balance sheet recession” by Richard Koo. Maintaining 7.5% growth rate would indeed be quite a feat…

    • It would be impossible without piling up more debt. I think this holds a lesson in the dangers of government meddling in the economy. By preventing a downturn, China is setting itself up for either an even bigger fall or more prolonged period of stagnation should they choose to go the bailout route like Japan and the US. The political desire for short term high speed growth is far too powerful for a government to ignore, despite the increasingly huge long term costs involved.

  16. Michael,

    As usual, I appreciate your insightful analysis and presentation.

    With the recent dynamics in EM shares, I wonder how much the China impact (assuming negative) has been priced in the stock prices.

    PS: I have purchased all your three books so far, enjoyed the reading! Any other recommendation on books worthwhile to read on similar topics, from your fellow economicist?



  17. China’s government might have not allow failures or financial issues publicized for people not to be distracted with the issue but instead maintains their focus in working hard. It might be a deceiving act but it produces an advantage as well.

  18. Well written and explained. I would say the China “Miracle” is a classic Boom-Bust economy underpinned by labor-arbitrage from developed countries, mercantilist-subsidies(i.e exchange-rates management), excess-credit with artificially low interest-rates(financial repression). Boom-period started with WTO and when China were given the MFN-status in 2001. And should have ended 2008. Instead politicians did what the always do. More of the same. Not to pay their dues for letting the economy run amok. What is wrong with “natural” interest-rates? Why over-stimulate missallocations of capital? People with economic knowledge really know when to hold their horses. The problem is, even in the west, that politics has become economics and when politicians
    personally profits from developments they can never stop. Also known as corporativism and of course plain corruption. Evidence is clear around the world. Also criminal behavior and organized crime are booming in every economic/financial boom!

    • “People with economic knowledge really know when to hold their horses.”

      I see economists and experts are always debating.

      • Vincent;
        Well what you say is true but people generally have different views mostly because of ideological reasons and of course vested interests. What they often debate is about cause and effects regarding certain policies but on the aggregate side history always gives them reasons to “hold their horses”. It is easy to spot boom and bust-scenarios when studying capital-flows and credit-expansions. And when capital flows freely under extremely low interest-rates (during a long period and under an international carry-trade invironment) the outcome is always the same. Fast outflows(profit-taking!) and credit-crunches showing off the naked malinvestments from the boom. Every economist with 101 his/her economic history 101 must know this. But it is always “politics”, not real economics that stands in the way of taking measures in a pro-active way. China i.e was prohibited to take certain actions using capital-controls etc according to WTO-agreements. But they were by no means obstructed to use interest, bankcredits, credit-regulations, currency-managing, local investments-plans/budgets etc to i.e regulate the pace of investments. China leadership did try to cool-down investment/credit-inflation but always to late.

        • I watch CNBC and Bloomberg TV. In 2010, some experts said the economy started to recover while others said the economy did not hit the bottom yet. I think economy is much complicated. Gordon Chang predicted that China’s economy would collapse very soon over ten years ago.

          • I never watch CNBC! Thanks god. We live in a media-hyped world and there is pseudo-competitions between new “gurus” who happened to be on the right side or successful for a while. Media-corporations loves to sell opinions especially in turbulent times when volatility is high. My advice to You Vincent. Start reading instead of watching. And look at the numbers and follow the money. But the best advice to give is to start reading economic history. It is always about politics and power. Maybe you should start to wonder why Big Media Corp(USA) is silent about why there is no one in jail this time around? After the S&L-crisis more then 1.000 high bankers were sent to jail. Media is bought (advertisement) by vested interest, i.e banking sector. So is congress(lobbying). That is how Obama is getting away(by media) with turning blind to obvious criminality(i.e Libor, MF Global, RMBS, Foreclosures, Robo-signing….. . And the President have personally elected the Attorney General! When law becomes politics. And I am not talking about taking new law-proposals to congress here. Only about living/ruling according to laws and the constitution.

            I am not talking about predictions here either. You have to look at the ground, not in the sky for signs. As we all know China is still a commando-economy. Just as Prof Pettis said, China has to choose between hiding losses or writing them down. The consequenses will be very different. China´s next step will be much more demanding. Going from the “easy” investment-phase to a more “mature” economy. Depending more on consumtion and a fair distribution of wealth. China leadership will probably understand it will be much more difficult to steer the economy than in the first phase. I don´t think a real market-economy is possible with dictatorship(one party). Maybe this time is different :).

          • Thank you, Christer, for the advice. I am engineer and trying to understand economics. I follow several economists’ blogs. This one is my favorite. Micheal’s balancing/re-balancing is a very scientific concept, similar to mass, energy conservation laws in my field.

            As you said, pundits’ opinions are politically biased. Many books, blogs are no exception. And the very biased bloggers usually get large support population such as Krugman. I sometimes have problem to extract the true “economic fact” from such information. A country’s leader such as Obama and Xi may not be much better than I am in this regard.

          • Vincent, I am very glad to hear that You don´t “swallow” everything out there. I agree with you about this blog . Prof Pettis writes very well about difficult things. What I appreciate most is how he, unlike quite a few other phd´s, often gives you a full explanation about complicated processes. Cause and effects but also real alternatives(if there are any!). You can so to speak follow his arguments momentarily, even as an non-economist. I would also say he tries to be very transparent without too much of implied/implicit understandings. This gives you a more positive feedback especially for non economists. Furthermore he follows his own thesis/writings on a continuous basis and with references to earlier posts which is also very positive. Learning about China his way I find really great. He is very very logic in his reasoning and I am very keen on people who are realists and not always go by the stream.

          • Christer, I agree with your thoughts on American media hyping the “guru du jour” and more importantly your view that vested interests (financial sector, etc.) have bought off the democratic machinery in the U.S. by way of advertising (media/press) and lobbying dollars (politicians). Thankfully we can read Matt Taibbi in Rolling Stone. He has a liberal, anti-big business bent, but that is a helpful perspective when standing up to the power of the aforementioned. (Side note: I can’t believe I read Matt Taibbi when he had a web magazine based in Moscow during the 90s where he and his cohorts wrote about the Russian sex scene, Russian Oligarchs and detailed the excesses of modern Russian culture during these post-communism free-wheeling days)

            Back to point, I do disagree with your placing blame at the feet of Obama and his Attorney General Holder. I’m no Obama fan, but it’s just plain silly to think this is an Obama problem. Both parties are to blame. The Republicans are currently not happy about new bank regulation and never will be with any banking reform. The SEC (under both parties) has been embarrassed repeatedly by a lack of teeth in their pursuit of financial crimes. They always seem to convict some small guy or small firm while the big, powerful firms are slapped on their hands with a fine. Christer, it’s okay to dislike Obama, but let’s not be dishonest about who is behind the U.S. financial sector’s undue influence in media and politics.

  19. Hi prof. I was so surprised to see you few weeks ago on cctv news. I really thought the guy who hack your website was from government.
    I have a question on QE. You say that, roll over debt change economic behavior. But QE purpose is to roll over debt. When you look at Japan and Sony and Nintendo. We can see that theese brand who was so strong are now very weak. Do you think it’s also because of the QE, and what do you think of QE in US and LTRO in EU?

  20. Re balancing is a necessity rather than free will for China. The huge market for exports does not exist now. It vanished post 2008 crisis in US. I guess we are about to see role switch between China and US in next decade. China to become consumption driven while US export driven.

    • I agree. What will be interesting to see is how China manage this transformation. Inflation or deflation-hazards? For the moment China-deleveraging is deflationary. Just as the global economy.

  21. Thank you Pettis Sir, as always very simple yet extremely informative article from you

  22. Thanks for sharing this excellent blog with us.This blog is full of information regarding financial help.This blog will be very satisfied for them who are interesting in financial planing.

  23. obviously like your website but you have to test the spelling on several of your posts.
    A number of them are rife with spelling issues and I to find
    it very bothersome to inform the truth nevertheless I’ll definitely come back again.

  24. Hi, i think that i saw you visited my site so i came to “return the favor”.I’m trying to find things to enhance
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