There have been many cases in which foreigners were able, perhaps because they tend to be more objective, to identify risks earlier than locals. Despite the claims of the traditional China bulls, there is a great deal of worry among China economists living and working in China about the sustainability of the current growth model, and top officials too have made it obvious that they see the need for reform as urgent.
The Chinese growth model, as I have pointed out many times before, is not radically new. It is based primarily on the growth model developed by Japan in the 20th Century. It involves policies that can be traced at least as far back as the “American System” of the early 19th Century, and it has been implemented in various forms by many different countries around the world during the past 100 or even 200 years. There is, in other words, actually quite a lot that we know and understand about the model, even if many of us seem to have forgotten much of it – including its typical weaknesses, one of the most obvious of which is the tendency for over-investment in the late stages of the miracle-growth period leading to an unsustainable increase in debt.
More importantly, the claim that “foreign” skepticism lacks credibility precisely because it is foreign has very little historical support. There have been many cases in which foreigners were able, perhaps because they tend to be more objective, to identify risks earlier than locals. The real estate boom in the US before the 2007-08 crisis, for example, was widely discussed by worried European economists for years, and Paul Krugman, a foreigner, was famously skeptical about the Japanese and Asia miracles at a time when most analysts, local or foreign, regarded such skepticism as evidence of either ignorance or ulterior motives (his work was based at least in part on earlier work by Alwyn Young, another foreigner).
Dismissing the credibility of skepticism about the Chinese miracle because it is foreign, in other words, has little in the history of economic analysis to support it. But the real reason why it is completely nonsensical is that it is simply not true. Among China economists living and working in China there is a great deal of worry about the sustainability of the growth model, and this has been the case for many years – so much so that former Premier Wen groused publicly about these issues long before most foreign analysts had doubts about the sustainability of the growth model, and he did so based on Chinese analysis, not foreign. Just as clearly, Premier Li has made it obvious that he sees the need for reform as urgent, and it is hard to believe that he would consider this to be such an urgent need if Chinese economists as a group were as oblivious to the risks and as optimistic as the traditional China bulls claim they are.
In fact I think until the recent shift in sentiment abroad, there was even more skepticism about the long-term functioning of the growth model within China than abroad, and one has only to read magazines like Caixin, and even the occasional article in the People’s Daily, to see how vigorous the debate is. It is true that sentiment abroad has shifted remarkably in the last year or two, but this reflects, in my opinion, the fact that foreign observers are not as close to events on the ground as are locals. Until about 2009-10, it was widely believed abroad that China’s growth model was functioning well – brilliantly, in fact – and that China would continue to grow at 9-10% a year for the next decade or longer.
Within China, however, most economists that I speak to were far more pessimistic. I remember meetings as far back as 2008, for example involving senior US or European government officials looking to be debriefed on the Chinese economy, in which the foreign (and some Chinese) analysts present spoke jauntily about the great success of China’s growth policies and the brilliant future ahead, while many of the Chinese economists present were much more cautious and even gloomy as they discussed the sheer intractability of China’s economic distortions. In those days, I would argue, skepticism was disproportionately to be found among Chinese economists, and not foreign economists.
The Real Difference In Opinion
This is a good thing, of course. If Chinese economists were nearly as oblivious to China’s problems as the China bulls claim they are, we would have reason to be truly worried about the country’s prospects. In the last two years as the bull argument has been pummeled into reality by the surge in debt, the persistent failure of consumption growth to close the gap with GDP growth, and the sharp slowdown in overall growth, the mood abroad has turned increasingly bearish, to the point that many people are speaking about a China collapse and the horrible implications this will have for the rest of the world.
It is important to note however that nothing has really changed substantially in the past few years. The problems China is facing today should have all been expected, but we shouldn’t be so quick either to expect an imminent collapse in the Chinese economy or, even as China continues to slow sharply, an awful impact on the rest of the world.
The former bulls are using this shift in global sentiment to shift the goalposts somewhat. They now claim that the fundamental disagreement between China bulls and China skeptics is that the skeptics have been predicting an imminent collapse in the Chinese economy for several years – which of course has not happened – and that they are demanding that Beijing take policy steps which will force an adjustment in the Chinese economy such that consumption will immediately surge and investment immediately drop to “acceptable” levels.
But the serious debate has not been about whether or not China’s collapse is imminent. The disagreement was whether or not investment misallocation and the repression of household income growth were fundamental to the Chinese growth model. The bulls argued that they were not, and that while poor investment decisions and low consumption growth could indeed exist, these could be addressed administratively within the model and did not require radical reforms that would essentially result in an abandoning of the growth model.
The skeptics argued that these were indeed fundamental to the model, and that worsening imbalances and an unsustainable rise in debt would be the inevitable and automatic outcome of maintaining current policies. For the bulls, although only after it became clear that debt was indeed growing too fast, debt problems are specific and localized problems created by irresponsible behavior on the part of individual actors, and they can be addressed by administrative measures on the part of the regulators. The skeptics, however, disagree. It doesn’t matter how strongly the regulators clamp down on one sector or the other, high growth rates – the skeptics argue – necessarily mean that debt is rising at an unsustainable pace no matter how vigilant the regulators. Our conclusion was that unless the investment-driven growth model were abandoned, it would lead inexorably to a debt crisis.
The heart of the bull argument until one or two years ago was that a radical adjustment was not necessary. The skeptics argued that it was, and, against the fervent advice of the bulls, they warned that the longer it took to implement the necessary adjustments the more difficult it would be. It is precisely the disagreement over whether or not major structural adjustments were even necessary that separated the skeptics from the bulls.
I wish this were just about bragging rights, but it is not. The bulls have been forced to recognize the inevitable consequences of the existing growth model, although some have resisted longer than others, but many of them still don’t get it. They don’t seem to understand that what is needed is not implementation of the “right” administrative strategies to fix the problems of debt, investment and consumption, and they mistakenly believe that China has plenty of time to implement these strategies.
Most dangerously of all, the bulls think that China can fix its problems while growing at 7% or 7.5% – which is better than the 8% they used to think is the minimum acceptable, although worse than the 6% they will undoubtedly cite next year as the minimal acceptable growth rate. But these growth rates, the skeptics argue, are impossible. In order that Beijing get its arms around credit growth and reduce the extent of wasted investment, GDP growth rates – the skeptics argue – must drop considerably, although since rebalancing means that household income must grow faster than GDP, it will not be nearly as painful as the bulls think it will be.
The issue about how much China’s GDP growth must slow in order to accommodate the necessary adjustment is probably the key difference between the bulls and the skeptics. Contrary to the new argument put forward by the old bulls, the problems of debt, investment and consumption in China are not new and unexpected, they are not just the normal growing pains associated with rapid growth in an otherwise healthy developing economy, they are not simply individual problems caused by irresponsible behavior, and they cannot be addressed except with far more radical changes than the bulls acknowledge.
Radical Change Versus Administrative Change
What’s more, and the various skeptics’ analyses have explained why, the changes China needs will necessarily create strong political opposition within the system. Arguments by former bulls that the real debate between the bulls and the skeptics is all just about whether China collapses in the next few months or not, weaken the case for reform and will, I suspect, make it harder for Li and the reformers to force through the necessary changes. These changes – and I don’t know if the bulls understand this or not – must come primarily at the expense of the political and economic elite, and I don’t just mean that there must be less corruption, as New York Time columnist Tom Friedman, another former bull, and among the most excitable of the lot, is now arguing.
Anyone who understands the fundamental problem with the growth model that China has pursued, which has many historical precedents, and why its great success in the 1980s and 1990s could not be sustained once certain parameters were breached, as they inevitably must be, also knows that until those parameters were breached, the interests of the elite and of overall growth for the economy were more or less aligned. Since then, they are in opposite directions. This is why the period of adjustment after rapid growth has always been the most difficult stage for a developing country, and one that very, very few countries have successfully managed, and why it will be particularly difficult for China, and this is why corruption – although perhaps of enormous social and political consequence – is not the fundamental problem.
The debate about China continues to rage, although it has taken a strange twist. No one doubts anymore that China’s imbalances threaten the success of the growth model and some are even insisting – very prematurely, in my opinion – that China has clearly failed and will face a collapse (whatever that means). I think the key division now, however, is over debt and over the recognition of previous losses. The bulls have retreated from many of their more fantastic predictions but they mistakenly think that the problem of debt is localized, and not systemic, and can be administratively resolved by the regulators. They also seem to ignore the possibility that there is an enormous amount of mispriced assets on the balance sheets of the banks and that these losses have to be assigned to some sector of the economy or the other, and that this assignation is at heart a political process.
The skeptics believe that an unsustainable rise in debt is key to continued growth in the economy and do not believe that it can be resolved administratively. High growth means, by definition, that debt is rising unsustainably. The bulls say that growth has bottomed out at 7% or 7.5% and that China can restructure the economy, rebalance towards consumption, and arrest the credit expansion while keeping growth rates above 7% or close to 7%. The skeptics argue that this is impossible, and to the extent that Beijing takes steps to keep growth rates high, it simply increases the risk of a debt crisis and economic collapse.
Last year in one of my posts I argued that although I remained very skeptical about the sustainability of the China growth model I nonetheless believed that China bulls could make a plausible argument but were failing to do so largely because they did not address the three questions that were fundamental to the debate on the sustainability of the Chinese growth model. These questions are:
- How much debt is there whose real cost exceeds the economic value created by the debt, which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?
- What projects can we identify that will allow hundreds of billions of dollars, or even trillions of dollars, of investment whose wealth creation in the short and medium term will exceed the real cost of the debt, and what is the mechanism for ensuring that these investments will get made?
- What mechanism can be implemented to increase the growth rate of household consumption?
I think these continue to remain the key questions if the bulls are going to be credible.
No More Stopped Clocks, Please
Before closing allow me – perhaps a little foolishly – to display a little peeve. For many years before 2007-9 a few analysts have warned that rising consumer credit in the US and peripheral Europe was unsustainable. They warned that rising debt to support misallocated investment in China was also unsustainable. They warned that soaring US mortgages backed by little more than the hope that land prices could only rise would lead to a real estate crisis. They warned that commodity-exporting countries that did not hedge their bets would find themselves in serious trouble when commodity prices collapsed.
Of course you could not have had a bubble unless the majority of analysts disagreed with these warnings, and most analysts did indeed disagree. So what happened when the warnings turned out to be right? Obviously enough the mistaken bulls publicly acknowledged that their models were incorrect and promised to hit the economic history books so that they never again would be so foolish.
Just kidding. What actually happened is that the former bulls immediately trotted out the stopped-clock analogy. The reason the worriers turned out to be right, they earnestly explained, is that they are perma-bears, and as everyone knows a stopped clock will always be right twice a day. This doesn’t mean, however, that models used by the worriers were right and the models used by the bulls were wrong, so of course there is no need for the bulls to change their models.
As China’s growth continues to slow and as its debt problems become obvious to even the most bullish, the stopped clock analogy is working overtime. How does it work? First, we must assume that there are only two possible positions one can take on China’s economy. The “bull” position is that China is in very good shape and is more or less doing everything right, even though (the remaining bulls have been adding lately) its economic growth must slow down a little. The “bear” position is that China must collapse within six months.
Second, we then point out that China hasn’t collapsed yet, and so the fundamental analysis was wrong. Of course China is slowing, as even the most fervent bulls acknowledge, and just as the bears said it would, but this, the bulls claim, had to happen eventually and has nothing to do with the analysis.
Of course this is just dumb. There are other far more likely alternatives for China that involve neither perpetual double-digit growth nor collapse. For example, I have been skeptical about the sustainability of the Chinese growth model since at least 2006-7 but I have never argued that China would collapse, let alone collapse within six months. My argument is that China’s growth model, which is not at all unique and for which there are many historical precedents, is usually wealth enhancing in its early stages, and then becomes wealth destroying once capital is systematically misallocated. When that happens, debt rises at an unsustainable pace until we reach debt capacity limits, in which case the country will have a debt crisis. I have usually estimated that it would reach debt capacity limits around 2016-18 but now I think it is likely to happen earlier.
However I never believed China would hit those limits, or have a debt crisis, because I was fairly sure that Beijing would begin adjusting earlier. It is during the adjustment period that I expected growth to drop sharply, to 3-4% as the upper limit.
Regular readers know how often I gripe about the superficiality of those analysts who don’t see why describing a growth model that is generating an unsustainable increase in debt is not the same thing as predicting a collapse in six months. Debt can rise unsustainably for many years before the debt burden itself becomes unsustainable – after all it is not true that those who worried about the rise of consumer credit in the US in the mid 2000s were “wrong” until the stopped clock eventually was right.
This strikes me as an incredibly superficial analysis, explained only by the fact that many of us expect economic analysis merely to predict whether the stock market will rise or fall this week. Those who worried about rising consumer credit in the US were not wrong every single year until 2007-8, when they accidentally became right. They were right every single year, and were proven right in 2007. Those who have been arguing that China is experiencing an unsustainable increase in debt have not been wrong every quarter that China has not collapsed. They are almost certainly right and it is hard even for the most foolish of bulls any longer to deny it.
An analysis that points to an unsustainable trend is always right if the trend turned out indeed to be unsustainable. The fact that it may have taken many years before the limits were reached is not an indication that the model was wrong. It is simply how the economy works.
This is why I get very annoyed with people who were obviously wrong when they dismiss people who were obviously right by referring to the stopped clock that is always right twice a day. Whenever a bull defends himself with the stopped-clock analogy, it suggests to me that he is likely to be an economic illiterate – and completely wrong to boot.
By Michael Pettis
Michael Pettis is a senior associate at the Carnegie Asia Programme and professor of finance with Peking University’s Guanghua School of Management. Pettis previously taught at Tsinghua University and Columbia University, and worked on Wall Street in trading, capital markets and corporate finance.
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