The 12 “Great Western Myths”of Chinese (Growth) Mythology…as told by. Michael Pettiswith Rebuttal by Pamria, Pacific Asset Management:Shawn A. Mesaros, Managing DirectorWe say…. You wish Chinese growth would stop…..keep wishing…..but it won’thelp the USA to keep wishing when China is already growinginternally….rapidly shifting its own consumption and spending dynamicswithout the benefit of external follow-on demand from the USA orEurope….their business people know the American and European customersaren’t coming back...and now they don’t need them…. Read on!Meet Michael Pettis, Michael Pettis is a Senior Associate at the CarnegieEndowment for International Peace and a finance professor at PekingUniversity’s Guanghua School of Management.Another wonderful guy who is perhaps well connected but living in the era ofRonald Regan. Pettis worked at Bear Stearns, where he was ManagingDirector-Principal heading the Latin American Capital Markets and theLiability Management groups. He has also worked as a partner in amerchant banking boutique that specialized in securitizing Latin Americanassets and at Credit Suisse First Boston, where he headed the emergingmarkets trading team. Besides trading and capital markets, Pettis has beeninvolved in sovereign advisory work, including for the Mexican governmenton the privatization of its banking system, the Republic of Macedonia on therestructuring of its international bank debt, and the South Korean Ministryof FinanceThesis: China = Mexico = Korea = Macedonia?And he wrote some nice articles in which he predicted that China was goingto slow to 2% growth, consumption would effectively collapse sendingcommodity prices down, and etc….We couldn’t disagree more. Sometimes history isn’t a good guide after all….. And while we “strongly” recommended Brazilian US Dollar backed sovereign debt for our accounts some 12 years ago, we were met with the same “Pettis-like Characters” who only remember *HISTORY* and expect it to keep repeating just like they remember it. Those 15% interest bonds that just “had to fail” because Brazil always fails… brilliant opportunity. Few listened then…and wish for the same opportunity now.
China of today is not the China of 20 years ago with an uncontrollableboom-bust cycle of capitalism. Michael Pettis would love a China of1985….small, perhaps unstable….and you could really push those guysaround….but they grew up and became world class athletes since then.For our 12 predictions (Pettis) and rebuttal arguments….read on….1. China will be the last major economy to emerge from the global crisis. My basic argument was that the global crisis was caused by the necessary reversal of the great trade and capital imbalances of the past decade, and a country can only be said to have emerged from the crisis when those underlying imbalances had been resolved.Chinese companies experienced a growth recession which was an externaldemand problem, basically as a result of a depression which was exportedfrom the USA in the form of leverage and is now ongoing in Europe. Thegrowth recession for China continues to be a depression everywhere else inthe world. Fiscal stimulus of epic proportions is required everywhereelse in the world to avoid economic collapse. This is not the case in Chinawhere capitalism is flourishing and in fact, consumer demand is extremelystrong and growing, replacing much of the Western or European demand.Since China’s contribution to the global imbalances has been its excessively highsavings rate, China could not emerge from the crisis until the high savings rate hadbeen reduced to a more reasonable level. Since 2007-08, of course, the opposite hashappened, as Beijing has exacerbated its domestic imbalances in order to keepgrowth rates high. But without infinite debt capacity this cannot go on. I think it ispretty clear that over the next few years China will be forced to address and reversethe high savings rate, and it will only be after this happens that China can be saidto have emerged from the crisis. This may take a decade or more.It remains our most amazing head in the sand moment that the worldbelieves that someone else outproducing someone else and letting thembuy things that they want….is somehow unfair. In fact, China is the mostresponsible of all the G-7 or G-20 Member countries. China both investsat *HOME* and saves its money during boom times. China leads themodern world in many areas of great significance, and it is a fantasy thatsomehow it is mired in crisis. Perhaps the USA and Europe would like toconsider their own unemployment and economic growth position and wecan now compare how these metrics stack up. #winning2. Chinese consumption will continue to stagnate or decline as a share of GDPuntil the growth model is abandoned. By “abandoning” the model I mean thattransfers from the household sector to subsidize rapid growth must be eliminatedand reversed.
This is really a continuation of the first prediction. It is too early to say, but 2012may be the first year in which consumption growth will outpace GDP growth, butonly if GDP growth turns out to be much lower than expected – say below 7%. Aslong as GDP growth rates exceed 7%, there can be no real rebalancing ofconsumption.Here we go again…. Michael Pettis suggests (as do all Keynesian basedeconomists) that all the Chinese have to do is stop saving, bankrupt thehousehold sector, and *WOW* will that ever help the rest of the world!Hello to cheaper TV’s and toasters since the Chinese will be desperate tosell anything…. And they will what? Borrow money from the IMF (justlike the good old days Michael Pettis?) in which case they RMB can take aserious nosedive? That’s a “rebalancing” that Europe and the USA wouldreally be able to sink their TEETH into wouldn’t it?3. Although there were many factors that explained both rapidly rising GDPand the contracting consumption share, financial repression wouldeventually be recognized to be the key factor. It took many years to make thispoint, but it has become pretty clear to everyone that financial repression is at theheart of China’s problem. This may explain Premier Wen’s recent and rathershocking attack on the banks, although in my opinion it will still be at least anotheryear or two, if ever, before we see any real liberalization of interest rates.Remember that the more debt there is, the harder it is to raise interest rates, andthe longer we take to raise interest rates, the more debt we run up. In the end Isuspect that financial repression will be eliminated not by an increase in nominalrates but rather by a decline in GDP growth (remember that the size of thefinancial repression tax is a function of the difference between nominal GDP growthand the nominal lending rate).#winning…. EXCEPT Michael Pettis…..that in America the governmentspent (indebted) citizens for $5 TRILLION in added liabilities just duringthe last 4 years and Americans now are stuck with the debt…. The USDwill be hugely impaired given the lack of ability to pay that debt off, andfinally…. The Federal Reserve pays Americans ABSOLUTELY NOTHINGfor their SAVINGS so they are almost a guaranteed liquidation unless theywant to “invest” in the stock market with their rent money.4. Investment is being misallocated on a massive scale and this was not dueto any special Chinese characteristic but was rather a fundamentalrequirement of the way the system operated. Although there are still someeconomists who disagree that investment is being massively wasted, I think this isso well understood by now that there is no need to belabor the point. Peoplerespond to incentives, and for the last decade or longer there has been a strongincentive to keep investment levels high regardless of their returns. It would besurprising if this did not result in a lot of wasted spending.Any time you are racing the race car and trying to tune it at the same timethere is going to be slippage. In America, they call it $500.00 toilet seats
and $250 hammers….. or Solidinera, or Enron, or some other fabulousgovernment supported idea…. Like FANNIE MAE. That’s not just wastedspending…its lighting fire to cash and cronyism at its best. At least inChina the CITIZENS get a bridge or a road or a bullet train…. SOMETHINGbesides a bankruptcy. The “relative waste” (because of how the system isstructured) to use Michael Pettis’s words….is a lot smaller over time sinceAmerican POLICY has the government investing in PAPER and in China thegovernment invests in REAL ASSETS and INFRASTRUCTURE5. Debt is rising at an unsustainable pace and debt levels will becomeunsustainable well before the end of the decade. This follows from the abovepoint – if investment is debt funded and if it is being wasted, then by definition debtmust be increasing at an unsustainable pace – i.e. faster than debt-servicingabilities.In the past three years this warning about rising debt has become much morewidely accepted, especially since Victor Shih started counting local governmentdebt in late 2009. There is still some disagreement on the sustainability of debt,with some analysts, like Arthur Kroeber of Dragonomics and the guys at TheEconomist, saying that China doesn’t have a serious debt or over-investmentproblem. I suspect nonetheless that in another year or two no one will doubt thatthe Chinese growth model tends towards unsustainable debt and that we arerapidly reaching the limit.Wow…. Where do we go with this…. Maybe we should talk about the$1.1 TRILLION USD spending deficit that America has every single year, thefact that since Obama has been elected, that the USA has “racked up” $5TRILLION in freshly accumulated credit card debt from excessive spendingwith effectively ZERO SAVINGS. At least in China there’s TRILLIONS inforeign exchange reserves which China deploys as quickly as it can….to buyREAL ASSETS…. So who’s at the debt limit? Not China…. That’s a certainty.Michael Pettis wishes China would somehow become what it was 20 yearsago with 500% debt to equity and in need of a trusty IMF loan package.That’s not a memory that’s likely to repeat in the next 100 years. Chinamay have to use its FX reserves to loan the IMF some money for sovereignbailouts but the USA/European Team doesn’t seem to like the idea ofallowing for a much larger share of the voting pool….. but they want theirmoney back…. (or they’ll print a ton of it through inflation) …..thusdestroying the value of China’s “savings” in the form of FX reserves. It’s a very difficult position for THEM to bein…. China again in the driver’s seat.6. When specific debt problems are identified, resolute attempts by Beijing toresolve them would be warmly welcomed by analysts but wholly irrelevant –because the problem of debt was systemic, not specific. This follows from theabove. The issue is not that specific borrowers may run into debt problems. It isthat the run-up in debt is systemic and cannot be prevented as long as China
maintains the existing growth model.? If there is rapid GDP growth, say anythingabove 6% or 7%, debt within the system must be rising at an unsustainable pace.We recommend that Michael Pettis again review thatmigrant-farmer-culture-no-more the Chinese are largely becoming themost productive people on the planet and as such, high value jobs andservices will keep GDP going strong for perhaps another two decadesbefore slowing appreciable….with clear bumps along the way..7. Privatization, a topic all but forbidden in polite company, would become avery hot topic of conversation by 2013-14. I have discussed why in several of themore recent blog entries.You just can’t make this stuff up! We are seeing massive privatizationefforts whereby the government will keep partial control of a largebusiness but gradually these assets flow into the hands of Chinese citizens.Every year more and more companies are going PUBLIC and as such, everyyear more and more companies are being sold off, and large ones. Thegovernment smartly recognizes that when they sell these assets, theycollect MORE TAXES and the businesses often perform materially better inprivate hands #winning So what’s this idea that “it’s a dirty word” whenin fact not only is China rapidly pursuing more privatization but greatlybenefitting in the process.8. As some policymakers gradually became aware of the problem with thegrowth model and the risk of crisis, a fundamental political split wouldemerge between those that demanded rapid reform and those that wanted tomaintain control of resources. The problem is that continuing the growth modelwill lead to a debt crisis, but abandoning the model will lead to much slowergrowth, and especially to much slower growth in the accumulation of state sectorassets. This is politically very difficult for many to accept and will lead to morepolitical conflicts over the next few years.Growth model that doesn’t happen anywhere else in the developed world isa growth model that the DEVELOPED WORLD would like to see come to anend. The China model of high infrastructure investment, highereducation, production and savings is a #winning model which marginalizesthe “SOLS” super-over-leveraged-sovereigns and the political disconnectover this is one word: JEALOUSY9. Chinese government debt will continue to balloon through the rest of thisdecade. Privatization is the best way to effect the transfer of wealth from the statesector to the private sector, and would be especially efficient if privatizationproceeds were used to extinguish debt, but for the reasons discussed above it will beextremely difficult to do it. This means that debt build-up and the state absorptionof private sector debt will continue for many years.Because the Chinese are becoming so much better a balanced economy anddue to the savings both at the government level and the consumer level,you have something MORE SUSTAINABLE in terms of growth whichmakes the country more “bust proof” in which case China is EXPECTED to
grow the debt outstanding as a SOVEREIGN entering the global debtmarketplace from a VERY SMALL LEVEL so we expect rapid growth of debtfrom smaller beginning. That’s more a positive than a negative.10. If the transition is not mismanaged, average Chinese GDP growth rateswill drop to 3% for the 2010-20 decade. As my bet with The Economist suggests,this is one prediction that is still an outlier. The Economist(and many others) stillbelieve that Chinese growth will make it the largest economy in the world beforethe end of the decade, but much slower growth is what rebalancing requires and itis hard to make the numbers work at growth levels much above 3%. By the way if Iam wrong and Chinese growth this decade is materially higher than 3%, myprediction is that the “lost decade” of much lower growth stretch out over twodecades.China’s growth may slow down and is of COURSE going to slow downeventually, but what Michael Pettis (again!) fails to consider is that the USAhas been growing at an “average” GDP rate of 3% annually for perhaps 100years, and the idea that a country like China whose population is 300%greater than the USA and coming off of a much smaller initial base of GDPshouldn’t continue to grow until it reaches “per capita productivity parity”in which case the European and Western world should be very, veryafraid…. Imagine if the average Chinese citizen enjoyed “relativeproductivity parity” with the Western World…. Indeed the United Stateswould be a third world country by comparison. Politics will manage thisprocess, but the disadvantage is certainly not with China11. If China rebalances correctly, then much slower GDP growth rates will beaccompanied by only slightly slower growth rates in household income. Inthat case there need be no social instability. The political risk comes frominstability at the top, not at the bottom. Factional disputes, in other words, haven’tended with the Chongqing affair. They will persist.Unlike the United States where (the USA being the world militarysuperpower) their gross spending relative to the number of citizens shouldmake the average US citizen much more afraid of their government. TheUSA owns all of the guns and tanks and fighter jets. In the case of China….Political risks aren’t the issue at all…. The government is MORTALLYFEARFUL of their citizens who now demand a better life, and in the case ofChina, there’s no turning back the tide of prosperity. Expectations arevery high, and they will continue to be met with a government ready,willing,. And able to provide what the citizens need, The citizens still singsongs about Mao Tse Tung and the establishment remembers the CulturalRevolution. The cleansing that took place for better or worse…. Thegovernment will do everything it takes to satisfy the people. Those“mercantilist, over-savings, anti-consumerism” Chinese people….who havebuilt a sustainable model where (unlike the USA) the government is nowmortally afraid of disappointing the people, while the USA and Europe that(Europe burning….literally burning….) people are only just beginning to
blame the government and wholesale REJECTING the notion that it wassome “prior administration” who created the problems of Europe andnext….America. The social instability will in fact not come from withinChina. As we watch from a distance, Greece burning, Spain burning, allacross Europe….burning….and Occupy Wall Street in the USA….burning….we note that it rather appears the social unrest happens OUTSIDE of Chinaand that China may be impacted more by external social imbalances andunrest rather than INTERNAL problems as Michael Pettis again seems tohave it backwards.12. Non-food commodity prices are set to collapse over the next three to fouryears. “Collapse” is not too strong a word. China’s share of global demand for suchcommodities as iron, cement, copper, etc. is completely disproportionate to its sizeand almost wholly a function of its very high growth in investment. As investmentgrowth drops sharply, as it must, global demand for non-food commodities willplummet.We keep repeating that when investing in long term infrastructure so thatthe “other” 900 million Chinese citizens who don’t live in Beijing, Shanghai,Chengdu, Nanjing when you have to work to build out your infrastructurewith REAL ASSETS and then MAINTAIN those assets for 900 million MOREcitizens who need to live at a standard befitting of the new China…. Well…Michael Pettis must understand that this will keep going for many moredecades…. There is no epic-collapse coming in this marketplace when youhave to build infrastructure at a world-class standard for 900 millionpeople. And of course, then it will all have to be rebuilt again some day….#winning