Tall tales and Chinese shape-shifters

Part of the reason for the concerns that my blog has been hacked for political reasons may be the widespread belief abroad that no debate is permitted within China about the urgent need for economic reform. In fact this isn’t true. The discussion within China is quite vigorous, and the misperception is probably fuelled by the belief – spread often enough, it seems, by China bulls – that the debate about the weaknesses in the Chinese economy is largely a debate between foreigners and Chinese, with some bulls even arguing that it is a debate between those who wish China ill and those who wish it well. The implication, of course, is that only someone who is incapable of understanding China – ie a foreigner – could possibly believe that China has problems.

But this is just silly. I will ignore the irony involved in a foreigner’s claiming that it is precisely because they are foreign that it is impossible for the foreign sceptics correctly to understand the Chinese economy, Chinese culture, and the thinking of the Chinese people (those inscrutable orientals!). I suspect the reason they find China so different and alien is because they have little experience of other developing countries, and know almost nothing either about developing countries outside East Asia or about economic history.

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 20^th 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”  scepticism 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  sceptical about the Japanese and Asia miracles at a time when most analysts, local or foreign, regarded such  scepticism 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  scepticism 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.

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 sceptics is that the  sceptics 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 sceptics 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 localised problems created by irresponsible behaviour on the part of individual actors, and they can be addressed by administrative measures on the part of the regulators. The sceptics, however, disagree. It doesn’t matter how strongly the regulators clamp down on one sector or the other, high growth rates – the  sceptics 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 was 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 sceptics 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 that the disagreement over whether or not major structural adjustments were even necessary that separated the sceptics from the bulls.

I wish this were just about bragging rights, but it is not. The bulls have been forced to recognise 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 per cent or 7.5 per cent – which is better than the 8 per cent they used to think is the minimum acceptable, although worse than the 6 per cent they will undoubtedly cite next year as the minimal acceptable growth rate. But these growth rates, the sceptics argue, are impossible. In order that Beijing get its arms around credit growth and reduce the extent of wasted investment, GDP growth rates – the  sceptics 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 sceptics. 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 behaviour, 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 sceptics’ 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 sceptics 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 Times 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 localised, 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 sceptics 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 per cent or 7.5 per cent and that China can restructure the economy, rebalance towards consumption, and arrest the credit expansion while keeping growth rates above 7 per cent or close to 7 per cent. The sceptics 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 blog posts I argued that although I remained very sceptical 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.

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.