(This interview with Michael Pettis, professor at Peking University’s Guanghua School of Management, a specialist in Chinese financial markets, was published in DNA edition dated January 10, 2011.)
China’s headline inflation numbers have had global financial markets bracing for tightening measures in what they consider ‘the engine of global economic growth’. But Michael Pettis, professor at Peking University’s Guanghua School of Management, a specialist in Chinese financial markets and a senior associate at the Carnegie Endowment for International Peace, reasons that, in fact, the bigger risk in China in 2011 is that it lacks adequate growth drivers – beyond investment-led growth. And that investment-driven growth is feeding surpluses into a world that is, in fact, experiencing anaemic demand, while also feeding malinvestment in China. To that extent, China isn’t the “locomotive of global economic growth,” and a ‘new normal’ in GDP growth rates, which is well below trendline, would be good for China and for the world, Pettis argues in an interview to DNA Money’s Venky Vembu. Excerpts:
Let’s talk of China in 2011: is inflation or the lack of growth drivers the bigger risk in China?
I would say it’s the lack of growth drivers – or rather that the main growth driver is still going to be growth in investment. I know that there’s a great deal of worry about inflation and if inflation continues rising, it creates real serious problems. But I also believe that in a financially repressed system like China, where interest rates are kept very low, there’s a very weird inflation dynamic. Inflation becomes sort of self-dissipating: as inflation rises and interest rates fail to follow, the real rate declines and the deposit rate is pretty much negative. That has two effects: on the consumption side, it further reduces household income share of GDP because, with such high savings, the return on your savings should be an important part of your total income. But with the return actually negative, it puts significant downward pressure on your total income. I would argue that low household consumption in China is a function of low household income as a share of GDP. Anything that reduces that household income share puts downward pressure on consumption.
On the other hand, rising inflation that’s not matched with rising interest rates means the cost of borrowing goes down: it’s probably also negative. In that case, borrowers – mostly investors, real estate developers and manufacturers – have a huge incentive to borrow and invest even if the investment is not economically viable. If I’m giving you free money, you will make stupid investments. We’re seeing that. And to the extent that a significant portion of that ends up increasing capacity, that increases the amount of stuff produced in China.
So, you have a situation where rising inflation that isn’t met with rising interest rates puts downward pressure on consumption and upward pressure on production, which then itself puts downward pressure on prices. That’s why countries with severely repressed financial systems like China, Japan and so on have been able to see very rapid monetary expansion without very high inflation levels. It’s an inbuilt inflation stabilisation mechanism.
In the absence of adequate growth drivers, have Chinese policymakers reconciled themselves to a ‘new normal’ in terms of lower GDP growth rates
The new normal, I suspect, will continue to evolve this year and early next year. The growth rates that people are talking about will decline.
About a year and a half ago, when I suggested that growth rates should be around 5 to 7 per cent, it was considered pretty shocking. Now, it’s no longer considered shocking, and the consensus will move there.
There are three drivers of growth in China: household consumption, which for reasons that I’ve explained, will be hard to grow even though in Beijing there is a widely developed consensus that they must get consumption to grow. The problem is that there isn’t a widely developed consensus that they must pay the cost of getting consumption to grow. So, I’m not terribly confident that household consumption rates will grow.
The second growth generator in China is trade surplus. But trade surpluses need matching trade deficits elsewhere; the two big deficit entities are the US and peripheral Europe. Trade deficits in peripheral Europe are going to collapse, and the US is politically unwilling to see its trade deficit surge. So it’s hard to see where the growth in trade surpluses will come from.
The third driver is investment, but there is a growing consensus that China has relied too much on investment and that capital is being wasted.
What implications will a slowdown in the Chinese economy, which is considered a pillar of the global economic growth, have for global financial markets and commodities? Will it contribute to remedying global imbalances?
My guess is that if you see a significant slowdown of Chinese economic growth, that will hurt the non-food commodities market a great deal. A lot of the commodities’ prices are held up by Chinese stockpiling and Chinese investment-led growth. I don’t think it will have such a negative effect on food commodity prices. It depends on how the rebalancing takes place in China. If there is a genuine rebalancing, GDP growth can slow significantly but household income growth will slow much less, and that household income growth drives consumption growth and that in turn drives demand for food.
When people say that China is the locomotive of global growth, they’re making a big mistake. Arithmetically it is the largest component of global growth, but that doesn’t make it the locomotive. This is a world of anaemic demand growth, and what it is looking for is demand. In that sense, it is deficit countries that are engines of growth; surplus countries are not engines of growth unless the surplus is contracting very rapidly. If there is a slowdown in China’s growth caused by a real rebalancing within China, I would argue that the trade surplus should contract. That would actually be positive for the world. So, a slowdown in China is not necessarily negative to global growth.
Will financial markets read it that way?
The financial markets will be hurt, because I would argue that the source of liquidity for the markets is the Chinese recycling of its trade surplus, which is a mirror of the US trade deficit. Whenever you see very large recyclings, you tend to have very buoyant asset markets. That’s not a coincidence. You can think about the US-China trade relationship as a big machine that converts consumption into Chinese savings. If the trade deficit in the US and the trade surplus of China come down dramatically, there will be a lot less money recycled into the asset market. That’s actually good; my feeling is that risk appetite is too high, and capital is being misallocated.
So do you expect this year to be a bad one for the markets?
Not this year, because I don’t think we’re going to see a significant slowdown until 2012-13. I expect to see more of the same in 2011.
There are reports that the Chinese authorities will not set loan targets this year. China is battling inflation, on the one hand, and struggling to maintain growth, on the other. Could the authorities end up falling between two stools?
I think this is a reflection of confusion as much as anything else. It’s very difficult to figure out what it is because if they raise interest rates significantly, they could significantly increase financial distress. If they don’t raise interest rates, they will continue to get very rapid growth, but they’ll continue to misallocate capital. There is a developing consensus that this investment-led growth in unsustainable. But the difficulty is: how do you change the system without slowing growth significantly? If you don’t want to slow growth significantly, it’s going to be very difficult. My guess is that they want good growth this year.
Most analysts say Beijing should hike rates, but you say that an interest rate hike will worsen inflation in China. Why is that?
To me, Beijing needs to raise interest rates, but for a very different reason: to improve the capital allocation process. But like I said, severely repressed financial systems tend not to suffer inflation, and the reason is that low interest rates are the main mechanism for reducing household income as a share of GDP. As you raise interest rates, you reduce the transfer.
Beijing blames the inflation on hot money inflows. Does the data bear it out?
Inflationary pressures started before the big increases in hot money inflows in September and October 2010. There definitely is a relationship, but I suspect that hot money inflows are responsible rather more for asset inflation rather than consumer price inflation.
How well is the intended structural transition in China towards a consumption economy coming along? If it’s going well, why is there a need to keep investment levels up?
What we’re seeing is a gradual change in the consumption, but I don’t really see in the data a real move away from investment-led growth. Certainly investment levels in 2010 were extremely high – and that’s even with a rapidly rising trade surplus. If the trade surplus doesn’t rise rapidly in 2011, as I suspect they won’t, I would argue that unless you can get consumption to grow quickly – which is very difficult – you’re still very heavily reliant on investment-led growth. But I think there is a shift in the consensus: increasingly there is concern about the level of investment and about the need to bring it down. There just isn’t consensus about the willingness to pay the price of bringing investment levels down.
Your case is that China’s infrastructure rollout is way beyond its current needs. But other economics analysts argue that for its stage of development, China’s infrastructure actually lags its needs.
I’m astonished by that argument. China has – and has had for many years – the world’s highest investment rate. If you compare China with countries like Brazil, Brazil has a per-capita income that is roughly twice China’s, but China’s infrastructure is already better than Brazil’s. So when they say ‘at China’s stage of development’, they’re making a huge mistake comparing China with Japan, saying that since Japan has a better infrastructure, China has a long way to go. That’s nonsense. The value of infrastructure depends on many things, including – importantly – workers’ wages and workers’ productivity. The purpose of infrastructure is to save workers’ time; its value is the monetary value of that time saved. Japanese workers are eight to ten times more productive and expensive than Chinese, and to compare the levels of infrastructure just doesn’t make sense. It’s like saying, “Let’s go to Haiti and build a supersonic flight transportation from one end of the island to the other.” It would certainly shorten travel time, but would it be worth it…
You say the global financial crisis is not yet over and the final outcome hasn’t been pronounced. What is left to play out?
We haven’t really adjusted any of the major imbalances. The US is starting its adjustment process, and is a little bit ahead of the rest of the world, but debt levels and unemployment are still extremely high. It would be foolish to say that Europe is anywhere close to the end of the crisis. And countries like China and others that have relied on very high commodity prices driven by China have been able to avoid the adjustment process because of huge Chinese investment growth, but that’s not sustainable; it’s merely postponed it.
The comparison I make is with the late 1970s: Europe and the US suffered their crisis around 1972-73 and there was a sharp contraction in the economy, but because of the huge recycling of petrodollars, you didn’t really see that in the so-called Least Developed Countries (LDCs), mainly Latin America, because they had massive capital inflows which generated investments and quite rapid growth through the 1970s. It wasn’t until 1979-80, when interest rates started moving up, that the LDC world, specifically Latin America, finally felt the crisis of the mid-1970s. During that time, there was the same kind of talk about developing countries being no longer so dependent on American growth. But what ended up happening is that the adjustment was simply postponed, and it turned out to be a terrible adjustment.
So what do you expect to see happen in 2011? Do you see the rebalancing gaining pace?
Not yet. I see 2011 as not a whole lot different from 2010: trouble in Europe, the US slowly getting its act together, and China continuing with rapid investment-led growth.
Do you see a heightening of the currency war rhetoric, now that Brazil has joined in as well?
Yes. Chile is putting capital controls in place, and India, Korea, Indonesia… everybody is complaining. Countries that can manipulate their currencies will continue to do so, and countries that cannot will resort to tariffs or import quotas.
Will the Chinese purchases of Eurozone bonds be a game-changer in averting default by some European countries?
If you believe the crisis in Greece, Spain, Italy, Portugal, Ireland and elsewhere is a problem of liquidity, making loans to those countries makes sense: they need to restructure, get their act together and then they’ll be able to re-access the financial markets and repay the loans. If you believe it’s a solvency problem – as I do in many cases – it’s a bad idea to lend them money. You cannot borrow your way out of insolvency. All you can do is postpone the restructuring. To me, what I see in Europe is too similar to what I’ve seen in previous cases, including in Latin America. It’s very hard for me to believe that all of this stuff is going to be repaid. I believe several countries will be forced to take haircuts.
So, although China has the financial muscle, it cannot be the Superman in Europe, given the scale of the problems there?
Absolutely. Spain is going to face a choice of 20 per cent unemployment for several years or a haircut instead. Greece is probably the worst of the problems; Portugal is bad too… I really don’t see any way around it. The debt levels are too high, and the economies are too uncompetitive. They can regain competitiveness if they leave the euro and devalue, but if they do that, their debt levels surge. Before Argentina devalued in 2001, its debt level was less than 60 per cent of GDP; after it devalued, it went to over 100 per cent. That’s the problem.
In that context, independent of what China does, is this a make-or-break year for the euro?
I would say that it’s a make-or-break year for maintaining the euro. I’m not saying the euro will break this year, but if they don’t resolve the underlying problems through fiscal union, which I think is very unlikely, my guess is that the political environment after 2011 will get so bad that there will no longer be the chance of saving the euro. But that doesn’t mean the euro will break in 2011. It means that if they don’t achieve fiscal union in 2011, several countries will be forced to leave the euro in the next few years.
You’re sceptical of greater fiscal union in the eurozone?
Who is going to be the fiscal centre? If it’s Brussels, Germany won’t join. If it’s Berlin, not too many other countries will join.
But wasn’t the euro always a political project – and therefore won’t they engineer a fiscal union of some sorts irrespective of the consequences?
When unemployment was low and asset prices were rising, you could pretty much ignore the politics of the union and even the overall population. But it’s unclear who’s going to pay the adjustment cost: the process of assigning the adjustment cost is heavily politicised: is it the workers who pay or the small businessman or the middle-class? In that environment, it’s much less likely that the European elite can simply force a fiscal union over the heads of the population.
You seem far more optimistic about America’s ability to get its act together. Is that an overly sanguine assessment, given the intensity of political discord in Washington?
No, because in the US the financial system adjusts – even if it’s in a brutal way – via liquidations, bankruptcies and so on. People talk about the political environment being the worst ever. But people who say that have not read anything in American history: the environment is no better or worse than it’s ever been. In fact, there have been times when it was much more partisan and worse. One of the great things about the US system is that the economy adjusts with or without the participation of the federal government.
With the new Republican-strengthened Congress set to take over, have the prospects of trade tariffs heightened? If so, how will it play out in China?
Yes, I think so – because historically it’s very hard to find in the 20th century any political compatibility between high levels of unemployment and high trade deficits. And as economist Paul Krugman has pointed out, even if the US starts growing very quickly, it’s going to be many years before unemployment comes down.
Who loses in the event of a trade war?
Trade-surplus countries like China, Germany and Japan.
In China’s case, when authorities calculate what they will lose from a trade war, do you reckon we’ll see greater renminbi appreciation so as to avert such an outcome?
One of the things that fascinates me is that when you look at these periods of rapid contraction in international trade, surplus countries were always characterised by two things: one, they were the ones that were most badly hurt by the contraction; two, they were the last ones to understand they were the most vulnerable. If you look at the US in 1929, 1930 and 1931, it was a period when American arrogance was simply out of control. They believed that since they were a high savings, surplus country, they were in the catbird seat. The Japanese felt exactly the same way in 1989; anyone stupid enough to have predicted a crisis in Japan would have been laughed out of the room. That’s part of the reason why I’m so pessimistic about the outcome – because there is a big mismatch among the various players as to who can do what, who is vulnerable and who is not…
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