Exclusively from Michael Pettis’ newsletter.
…the economic reforms proposed during the Third Plenum [are] aimed at unlocking greater productivity potential in the Chinese economy and returning the country to a sustainable growth path. They will do this by improving the capital allocation process, so that capital will be diverted from SOEs, real estate developers, local governments and other inefficient users of capital, to SMEs, the agricultural sector, and more efficient users of capital. …There are at least four reasons to expect healthier but slower GDP growth over the rest of this decade if the reforms are implemented.
1. Leverage boosts growth and deleverage reduces it. By now nearly everyone understands that China is over-reliant on credit to generate growth. Much new borrowing is needed simply to prevent borrowers from defaulting on existing loans, so that new lending can be divided into two buckets. One bucket consists of loans made to roll over the debt of borrowers who do not generate sufficient cashflow from the investments that their original loans funded. The loans in this bucket, of course, do not create additional economic activity, but as debt rises, financial distress costs rise with them (most financial distress costs, as is well understood in corporate finance theory, are a consequence of the way rising debt changes the incentive structures of the various stakeholders and so distorts their behavior in non-economic ways). Of course any disruption in lending would cause a surge in defaults.
The second bucket consists of loans that fund new expenditures. These expenditures, of course, generate economic activity, but if they fund consumption, or if they fund investments the value of whose output is less than the cost of the inputs, they incur additional losses that must ultimately be rolled over by loans that belong in the first bucket. Any reduction in loan growth, in other words, is positive in the long term for Chinese wealth creation, but in the short term will either force the recognition of earlier losses or will reduce economic activity.
2. Hidden transfers will be reduced. As I have discussed many times the investment-led model encourages investment by transfers – hidden or explicit – from the household sector to subsidize investment. In the Japanese version of this model, which very broadly is the version China and the Asian Tigers pursued, the main form of these transfers is the undervalued currency, low wage growth (relative to productivity growth) and, most of all, financial repression. Because these transfers no longer create net value on the investment side (China overinvests in infrastructure and has excess capacity in a broad range of manufacturing sectors), and the extent of the transfers are at the heart of China’s very low consumption level, the proposed reforms will act to reverse the mechanisms that goosed growth by transferring resources from the household sector to subsidize manufacturing, infrastructure building, and real estate development.
3. Excess capacity will be resolved. Beijing recognizes that cheap credit and limited accountability have created excess capacity in industry and real estate. Why build so much excess capacity? Local governments have supported this build-up of capacity to boost growth and, with it, revenues and local employment, and because capital was essentially free (its real cost may have even been negative for much of this century) and because most projects are implicitly or explicitly guaranteed by local and central governments, there seemed to be no cost, and plenty of benefit, simply to pile on capacity. As Beijing acts to wring out excess capacity, we will inevitably see a reversal of the earlier growth impact.
4. Losses will be recognized. As I discuss above, because many years of overinvestment have left a large amount of unrecognized bad debt on bank balance sheets, China’s GDP growth has been overstated by the amount of the unrecognized losses. Over the next decade as Beijing cleans up its financial system, this bad debt will either be explicitly recognized or, more likely, implicitly written off over the remaining life of the loan. Either way, as the losses are recognized, growth over the next several years will automatically be understated by the amount previously overstated.
