China must slow growth to tackle 'unsustainable' debt
China’s new government must push through reforms to slow the country’s economic growth within the next two to three years or its rapidly rising debt levels will get out of control, a leading financial academic has told RBS.
Michael Pettis said that the authorities faced their first real economic challenge in rebalancing their economy.
He warned that something had to be done fast to deal with the country’s rapidly rising increase in debt-funded investment.
The Peking University professor – who specialises in Chinese financial markets – said that resulting debt levels were growing at an “unsustainable” pace in China, meaning that debt was growing much faster than the country’s capacity to service it.
“When the European and US economies started to slow down in 2007, the Chinese responded with a massive surge in investment,” he said.
“They already had the highest investment rate in the world and they raised it significantly. But the consequence was a truly unsustainable increase in debt. In January and February this year, China saw its largest ever increase.”
He added: “Although the country has faced financial crises before, it previously resolved them by investing heavily. But this time that won’t work because investment is the cause of the problem.”
Pettis was speaking after taking part in a panel session on Asia at the RBS Macro Conference in London.
He said debt had risen particularly quickly in China over the past four years, mainly in areas outside the regulatory framework.
For example, when the People’s Bank of China (PBOC) focused mainly on RMB loans, the bulk of growth occurred in off-balance sheet financing such as letters of credit and bankers’ acceptances.
But when those measures were included in 2009 in a new initiative, called ‘Total Social Financing’, much of the growth in debt shifted to what are called ‘wealth management products’ and the informal banking system.
Pettis said: “Chinese banks are very good at expanding outside the remit of the People’s Bank of China.”
The former Wall Street trader predicted that China would see growth rates of about 7.5 per cent in the first half of this year. That growth should slow significantly in the second half, but only if the government can consolidate power quickly and force through reforms.
He said: “The Chinese authorities now have to pull off a difficult balancing act. They need to get the debt down and interest rates up. If they raise interest rates too quickly without sorting out the debt problems, however, growth will slow sharply and we would see financial distress spread rapidly. But if they take too long, debt will continue to surge.”
“The faster they rebalance the economy, the more pain they will feel straight away, but long-term they will see greater growth.”
He added: “The good news is that Beijing’s economic policy makers are well aware of this problem and are trying to deal it. As a result, I think we will see a slow-down in the economy which will last over the next two-to-three years.”
Pettis, who is also a senior associate at the Carnegie Endowment for International Peace, pointed out that similar problems had affected other economic growth stories.
He said: “In the 50s and 60s it was widely believed that the Soviet Union’s economy would overtake America’s. In the 1980s only a fool didn’t think that Japan was going to have the world’s biggest economy by the end of last century. In both cases their investment-driven growth miracles suddenly and unexpectedly stalled.
“Neither of those things happened for the same reason – the very rapid growth involved was generated by the debt-funded investment.
“In the early stages it’s easy to identify where this investment should go – it’s needed everywhere as you build more roads, airports, bridges and other infrastructure. You then reach a point where it is no longer essential but it continues and you start to get misallocated investment. That’s when the problems begin.”
Pettis said that the government’s drive to rebalance the economy is also creating inflationary pressures and will affect global commodity prices.
He said: “Every time the authorities lower interest rates, production increases but consumption lowers because the main way Chinese people save is through bank deposits. Lowering interest rates therefore reduces the amount of money they have at their disposal and they spend less. This by its very nature is deflationary.”
This has had a big impact on global commodity prices, which were much lower at the start of the decade than they are today almost entirely because of China, according to Pettis.
“China’s GDP is officially 12 per cent of the world’s economy,” he said, “but it accounts for more than 30 per cent of just about every commodity because of its huge programme building bridges, subways, train routes and other infrastructure. It uses 60 per cent of the world’s iron ore for example and 30 per cent of its copper, so its actions have a huge impact on the rest of the world.
“But rebalancing the economy involves bringing this investment right down, and this will lead to higher prices.”
He added: “Countries like Mexico and Brazil, which rely on low level manufacturing and buying cheap commodities, could see their economies significantly damaged by this. But the likes of Peru which has a big manufacturing industry will fare much better.”
“There’s a well-known economic phrase that when the US sneezes everyone catches cold. When it comes to commodities, that’s true of China.”
The statements and opinions expressed in this article are solely the views of Michael Pettis speaking at an RBS Macro Conference in London on March 14, 2013 and do not necessarily represent the views of the Royal Bank of Scotland.
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