The problem in China is as much the amount of debt as the structure – and by structure I don’t mean the distinction between bonds and loans (bonds end up mainly on the banks’ balance sheets anyway) but rather the unstable and self-reinforcing relationship between underlying conditions and debt servicing costs. The fact that much of the debt is being accumulated in an opaque fashion only explains why so many people did not see this coming, but it is not the fundamental problem.What Pettis is saying is that actions have consequences. While economists may pretend that they can make gold out of feces, reality eventually calls at the doorstep for an accounting.
As for the claim that successful fiscal reform can keep the impact limited, I am not sure what this means. Fiscal reform in China can only be successful, in this context, if it eliminates loss-making investment activities, and unfortunately I see it doing nothing of the sort. If the problem is that China is keeping growth high only or mainly by borrowing and misallocating the proceeds, then hidden losses are rising and one way or another the bad debt must be resolved. The only two ways to resolve the bad debt are by defaulting or by forcing someone else to make up the loss, and the former almost certainly won’t happen to any great extent.
That leaves the latter....
The best solution for China, economically, seems to be off limits because it will be politically difficult. In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.
And how much will growth slow? The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years. That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.
And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall. With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today. Chinese investment demand simply cannot hold up much longer. _Michael Pettis
This is from Also Sprach Analyst:
It seems to be widely believed that China has almost unlimited tools and power to gear the economy towards whatever direction they would like to. It is probably true in some respects. For instance, there are rooms to cut interest rates and reserve requirement ratios, and if you believe the official data (which I don’t) that China has very sound fiscal position, they can certainly throw another trillions RMB to invest in more pointless stuff for the sake of generating GDP growth and create jobs.Al Fin economic analysts suggest that the CCP government achieved a superficial success using one growth model. But they are attempting to sustain the same level of success using an altogether different growth model which is unsustainable.
However, we have already heard deposits flight where households are seeking better returns other than deposits, and if China slow down (as it is, and as I expect), it will not be surprising to see capital outflow and trade surplus shrinking. In the likely event of these happening, it will tighten the screw of monetary policy automatically, and cutting reserve requirement ratio, while it looks useful, could be seen as offsetting the tightening effect of capital outflow and other things. Furthermore, if money is flowing out of the banking system (for whatever reasons, like capital outflow), that makes it difficult to cut interest rates. As I mentioned earlier, the view here is that while reserve requirement ratio will be cut, it is important to understand that it may not make monetary condition easier, and that interest rates may not be an available tool at all. And if things get so bad, we could expect a small probability that RMB will have to be depreciated. And with respect to the fiscal side of the story, if my analysis on the debt side of the story is accurate, the Chinese government’s fiscal position might not be as good as it seems, one will have to question 1) whether they have the financial resources to invest in more for the sake of creating GDP growth and 2) whether it still makes sense to invest in a place where over-investment has happened.
The key conjectures (or the only things that you need to know) are:
1. Inflation might actually surprise on the downside. We might even see deflation.
2. Real estate industry will slow down drastically, and drag the whole economy.
3. Home prices and other asset prices will fall, possibly resulting in debt deflation.
4. The government and central bank may have some tools to help the economy, but the tools are not unlimited.
_Also Sprach Analyst
In other words, China's government may be the victim of its own success and a prior fortunate timing in global markets. We are in a very different global market than that which existed from 1985 through 2007. The dragon which the CCP is attempting to tame has grown too large and unwieldy. Fortune cookie says: Expect surprises.