Michael Pettis is irritated that I have criticised his pessimism on China's growth prospects and accuses me of revising my forecasts without acknowledging any change. But the two linked posts he offers in evidence seem to be standing up pretty well.
The first, posted in early 2012, forecast 7-8% growth for that year. Growth came in at 7.8%. The second post talked of a sustainable growth rate of 7%. That, too, still looks fine to me. As for Pettis' own forecasts, his bet with The Economist that average annual growth for this decade would 'barely break 3%' is looking more outlandish with each passing year.
Let's not, however, have an arm-wrestle about the detailed growth forecasts, when we are unlikely to agree on even the growth figures that should be used. What I am keen to pick up on are some of the serious analytical issues Pettis raises. I'm never too confident about paraphrasing his arguments, but one important issue he seems to focus on is the relationship between growth and credit/debt. Let me give my version of this issue, and see how far apart we are. [fold]
It is hard to establish a consistent relationship between growth and credit even in mature economies, let alone economies which are experiencing rapid transition, including financial deregulation and financial deepening. When the financial sector is deregulated, it will grow substantially faster than GDP. After all, that's what deregulation is about: going from an economy where most investment is self-funded, to an economy where investors can borrow and build up balance sheets with assets on one side and debt on the other. When credit grows much faster than GDP, ipso facto, debt/GDP rises.
During the deregulatory transition there is a good chance that borrowers and lenders will make mistakes. They are inexperienced in this new financial world, as are the institutions that often intermediate their borrowings and the policy-makers who oversee this world. Thus one truism is that financial deregulation is usually accompanied by disruption or even crisis. In Australia, the deregulation and fast credit growth of the 1980s was followed by 'the recession we had to have'. The US had the savings-and-loans crisis in the 1980s. Much of Asia had the 1998 crisis. So we can agree that financial deregulation is a fraught transition, with opportunity for things to go wrong.
How does this apply in China? Has credit grown too fast and as a result is debt now too high? Again, we would agree that the answer to both these questions is 'probably yes'. The specific circumstances in China are worth retelling. When the 2008 global financial crisis arrived, the Chinese authorities administered a massive stimulus, mostly in the form of encouraging credit growth. The rest of us (especially Australia) should be grateful that China did this, because it meant that China not only kept on growing, but accelerated out of the crisis-years with double digit growth. China, almost single-handed, kept the world growing through the global crisis and its aftermath.
But that was then: what about now? This pace of credit growth was clearly unsustainable. It has since slowed sharply, although it is still growing faster than nominal GDP.
Total Social Financing (TSF*) and Private Credit (in %, year on year)
*TSF is the IMF’s favoured broad measure of financing and excludes lending to the government. (Source)
The McKinsey Global Institute’s comprehensive report on global debt (with a full chapter on China) includes a fabulous graph that captures both the level and the recent rate of increase in debt for around 50 countries. It’s too complex to be reproduced here, but take a look at the original on page 3 of this document. In terms of debt/GDP, China is in the middle rank but high for its stage of development — somewhat higher than Thailand and about the same as Malaysia. But it is a clear outlier in terms of rapid rise in debt over 2007-2014.
No disagreement so far: in my posts I have consistently noted the need to restructure the financial excesses over time. Where Pettis and I seem to differ (again, it's hard to be sure) is that he sees it as inevitable that the necessary slower credit growth would produce dramatically slower GDP growth (viz, his 3% forecast). If slow growth is countered by policy stimulus to encourage credit growth, Pettis argues, this makes the debt accumulation problem worse and just puts off the crisis to a later date.
The relationship between credit and GDP is an unsettled issue in economics. Since 2008, many argue that central banks everywhere gave too little attention to the role of credit in the lead-up to the 2008 crisis. But attempts to put a universal number on 'too much debt' backfired badly. We know that shifting purchasing power to people who were previously liquidity-constrained (i.e. they wanted to spend more than they had available) increases their spending, but we don't know whether this spending adds to GDP or bids up asset prices. We don't know what is the effect on those who funded this lending: did they cut back their own expenditure, or did their lending come out of their saving? If the borrowers bought existing assets, what did the sellers of those assets do with the proceeds? As usual, 'it all depends ...'
What evidence is there for China? We know that China grew at double digits in the pre-2008 period without a rapid growth of debt/GDP. Thus the two aren't inexorably linked. Investment must have been largely self-funded, especially by the hugely profitable state-owned enterprises. The big growth in credit was a once-off free-for-all credit binge which ended five years ago, although the hangover is ongoing. Credit is now increasing only modestly faster than GDP, and yet growth continues at close to the official target of 7% (which is also my suggested sustainable pace).
Could growth go lower during the tricky ongoing transition? Of course: year-by-year GDP growth will cycle around the sustainable rate. The exact path will depend, inter alia, on the skill of the policy-makers and on corporate profitability (which determines how much investment is self-funded).
Could there be a sudden sharp crisis? It's possible, but by no means inevitable. In any case, there is a supplementary question here: if it happens, would this pull the ongoing sustainable rate of growth down to 3%, or would there be a 'V'-shaped recovery putting China back on the 7% trajectory? Would China be like Japan after the 1990 asset-bubble burst, or like South Korea after the 1998 crisis and Australia after the 1990 recession?
On this, I count myself among the optimists. The greatest economic narrative of the past half-century has been the GDP convergence of previously poor countries (Japan, South Korea, Taiwan, Hong Kong, and Singapore have completed the journey, but there are a good many others still on their way). China has already demonstrated that it is possible to scale up this model to fit the globe's most populous country. The narrative is unfinished, with many catch-up opportunities remaining and many slip-ups likely. Achieving this potential convergence requires skilled policy-making, but isn't this what China has shown for three decades?
Photo by Zhang Peng/LightRocket via Getty Images