Prasad, Pettis Lock Horns on China Growth

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Prasad, Pettis Lock Horns on
China Growth Prospects
MICHAEL PETTIS, PEKING UNIVERSITY, AND ESWAR PRASAD, CORNELL UNIVERSITY
As China enters the year of the goat, opinions on the state of the economy have seldom
been so divided. Bloomberg Brief asked Michael Pettis and Eswar Prasad to lock horns in
debate. The question: can China maintain GDP growth of about 6 percent to 7 percent for
the next three years or is a further pronounced slowdown assured?
The opening round of arguments appears on pages 1 and 2. Replies from Pettis and Prasad appear on pages 3 and 4.
Michael Pettis is a professor at Peking
University’s Guanghua School of Management
and a senior associate at the Carnegie
Endowment for International Peace. He is the
author of Avoiding the Fall: China’s Economic
Restructuring (ceip.org/JWogj1). Previously, he
taught at Tsinghua University and at Columbia
University’s Graduate School of Business.
Eswar Prasad is the Tolani Senior Professor
of Trade Policy at Cornell University and
the author of The Dollar Trap: How the U.S.
Dollar Tightened Its Grip on Global Finance
(TheDollarTrap.com). He was formerly chief
of the Financial Studies Division in the
International Monetary Fund’s Research
Department and, before that, was the head of
the IMF’s China Division.
MICHAEL PETTIS’S OPENING ARGUMENT:
ESWAR PRASAD’S OPENING ARGUMENT:
Destined to Fall
Hopes for Stability
The fundamental misunderstanding among economists about China’s growth prospects in the last decade, and indeed that of every
country that has experienced a similar growth miracle, has always
hinged on the role of debt. Highly pro-cyclical balance sheets work
both ways, and if they boost growth during the growth acceleration
period, they necessarily constrain it as growth decelerates.
We’ve seen how it works beginning in the early 1990s, when
Beijing put into place a financial system designed both to expand
domestic funding by forcing up the national savings rate and to allocate credit as rapidly as possible into productive investment. The
result was many years in which rapid expansion in the banking
system reinforced and was reinforced by spectacular and highly
unbalanced economic growth.
Nearly 50 years ago, Albert Hirschman told us not to fear imbalances. All rapid growth is unbalanced, he explained, and imbalances always eventually reverse. The difficulty, however, is that vested
interests develop around the institutions on which growth is based
and oppose reform, making it very hard in most cases for the imbalances to adjust before they seriously distort the underlying economy.
This is why most growth miracles ultimately fail.
With investment growing at among the fastest rates in history,
China eventually reached the limit of its productive ability to absorb
continued credit growth at least 10-15 years ago. But when Beijing
tried, in the middle of the last decade, to rebalance the economy,
opposition from vested interests prevented reform, and credit continued pouring into wasteful investment.
During this time, in other words, reported GDP grew faster than
continued on next page
Over the past year, growth has slowed significantly, producer prices
continue to fall and various other indicators of economic activity show
a loss of momentum in the economy. In short, the headline data do
not look good. On the other hand, there has been some progress on
growth rebalancing – the consumption to GDP ratio is up a tad, and
the services sector’s share in the economy has continued to rise.
So what does all this portend for the future of the Chinese economy? Separating the trend from the cycle, especially in real time, is a
challenge in any economy and especially for a developing economy
that is still undergoing massive structural change in many dimensions. As the economy matures and becomes richer both in terms of
absolute size and per capita income, traditional convergence effects
alone would dictate a slowdown in China’s growth.
The concern that you have rightly emphasized, the high level of
debt, is emblematic of the tensions inherent in China’s unbalanced
and unsustainable growth model. The key issue where our analyses seem to differ is whether the required reforms and underlying
growth dynamics will necessarily lead to growth falling significantly
below 7 percent a year in the short term.
On the positive side, there is clearly commitment to deal with problems, including the rapid accumulation of debt. Whether policy makers can do so without severely crimping growth, given the significant
economic and political constraints to reforms, is the key question.
The actions of the People’s Bank of China (PBOC) over the last year
highlight the difficult tension the government faces.
The PBOC has mainly relied on a variety of indirect measures
to support economic activity rather than unleashing a rapid expancontinued on next page
© 2015 Bloomberg LP. All rights reserved.
These commentaries were originally published in Bloomberg Brief: Economics Asia, a daily newsletter, on March 3 and March 17, 2014.
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MICHAEL PETTIS’S OPENING ARGUMENT…
ESWAR PRASAD’S OPENING ARGUMENT…
economic value creation. This was largely due to a significant share
of growth occurring in the form of wasted investment, which was not
sustainable since it meant debt was growing faster than debt-servicing capacity. Only because they failed to understand this, as late
as 2012, most analysts expected GDP growth rates to continue at
9-10 percent for many years.
President Xi Jinxing’s administration fully recognizes the problem
and has vowed to rebalance demand and eliminate China’s debt
addiction before it reaches debt capacity limits. But while they now
understand the problem Beijing faces, the same analysts still do not
understand the implications. If the gap between economic value creation and the cost of investment has not been correctly recognized on
the national balance sheet, GDP growth was and continues to be overstated, and this must show up in the form of unrecognized bad debt.
Beijing knows what to do. As the 2013 Third Plenum reforms are
implemented, China’s economic growth will become healthier, but
reported growth will continue to drop for several important reasons.
For one, once Beijing has stopped the continued accumulation of bad
debt, the gap between value creation and reported growth will largely
disappear. As this happens, however, acceleration in value creation
will not be matched by an equivalent acceleration in reported growth.
Only if the reforms cause an extraordinary surge in real productivity
growth will the convergence imply rising rates of GDP growth.
Another reason for reported growth to continue to drop is the deteriorating viability and creditworthiness of Chinese borrowers. When a
borrower’s ability to repay debt comes into question, uncertainty rises
as to how the associated losses will ultimately be distributed – will the
lender lose, or will the government step in and directly or indirectly
force the losses onto taxpayers, savers, workers, local governments,
businesses or other stakeholders? This uncertainty changes how
stakeholders behave in ways that always reduce economic value.
As debt continues to rise faster than debt-servicing capacity, this
loss in value – which may already be happening and which is referred to in finance theory as financial distress – will rise.
GDP growth in China has not bottomed out and consensus forecasts of 6-7 percent growth over the medium term will be disappointed largely because analysts have failed to incorporate the impact of
debt in their analyses. Beijing has already taken important steps to
address China’s imbalances, but China still has a way to go before
credit growth converges with growth in debt-servicing capacity. Just
as the structure of the balance sheet exacerbated growth during
the acceleration phase, so will it exacerbate the slowdown during
the deceleration phase. This has always been the historical pattern,
and history suggests that as Beijing continues its reforms, reported
GDP growth rates will continue to drop even as the country’s real
economic performance begins to improve.
sion of credit that could add to the existing problems. The irony, of
course, is that this vitiates the objective of financial market reforms
as it involves a state-determined allocation of resources. But at least
the PBOC is trying to limit the damage and not throw in the towel
by rolling back reforms.
The government has not unleashed one weapon that could support
growth in the short term and facilitate longer-term rebalancing – fiscal
policy. China’s government budget deficit and explicit public debt levels remain low by international standards. Rather than accumulating
more implicit debt through an increase in nonperforming assets in
the banking system, it would make more sense for the government
to use fiscal policy directly to support growth and also promote longer-term growth rebalancing by strengthening the social safety net.
For instance, funding a more comprehensive catastrophic health
insurance program might help restrain the savings of elderly households. A better safety net would reduce precautionary savings. Financial market reforms that generate higher returns on savings and
allow for portfolio diversification, both domestically and abroad, may
also reduce savings.
Concerns about China’s high rates of investment in physical capital are warranted. But China still has a much lower capital-output
ratio than do advanced economies such as the U.S. and still has
vast needs for infrastructure in its interior provinces. The question
is whether the allocation of domestic savings into domestic investment is being intermediated in an efficient manner that allocates
capital to its most productive uses.
The level of gross debt in China is very high. The fact that much
of this debt accumulation is financed by China’s domestic savings
suggests not so much a source of financial risk as of major inefficiencies and waste because of a broken system of allocating capital.
The fact that the state owns most of the key creditors and debtors
makes it less likely that a financial shock could set off a cascade
that results in a financial crisis or a collapse in growth.
While the Chinese leadership might know what to do, slowing
momentum on domestic growth and a weak external environment
have eroded political support and tightened economic space for
reforms. Yet my reading is that the government remains committed
to its agenda, although the pace and scope are certainly not at the
level I would wish for.
Thus, I concur with your view that the level of debt and its continued rise pose major challenges for China. But I am more optimistic
that, if the government remains committed to reforms and can implement them at a reasonable pace, China can maintain growth at
around 7 percent per year over the next two to three years. What
happens in the longer term will depend to a great deal on what is
done in the next few years to set the economy on the right course.
continued from previous page
continued from previous page
Michael Pettis’s Main Arguments:
Eswar Prasad’s Main Arguments:
 A significant part of China’s growth has come from
wasteful investment.
 That’s not sustainable as debt has grown faster than
debt servicing capacity.
 Fights over who faces the cost of bad loans will add to
downward pressure.
 Government remains committed to its reform agenda.
 Low debt means Beijing can unleash fiscal policy to
support growth and rebalancing.
 High domestic savings and state ownership limit the
chance of financial crisis.
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Prasad, Pettis Lock Horns on China Growth Prospects (Round 2)
MICHAEL PETTIS, PEKING UNIVERSITY, AND ESWAR PRASAD, CORNELL UNIVERSITY
As China’s National People’s Congress rumbled to a close, Bloomberg Brief asked Michael
Pettis and Eswar Prasad to resume their debate on the state of the Chinese economy. The
question: can China maintain GDP growth of about 6 percent to 7 percent for the next three
years or is a further pronounced slowdown assured? This exchange is the second and final
round of the debate.
MICHAEL PETTIS’S REPLY:
ESWAR PRASAD’S REPLY:
Hard Constraints Limit High Growth
Resource Reallocation May Be the Key
Given our many agreements some readers might conclude that
we differ mainly because you are more optimistic than I am about
Beijing’s commitment to reforms and its ability to implement them.
I would argue that our disagreement is more fundamental.
I do not doubt Beijing’s determination to reform. After living in
China for 13 years, I have seen first-hand how intent policy makers
have been to modernize China. I have long argued the rebalancing
process was going to be difficult, and yet I believe that Xi Jinping’s
administration has done as well as possible.
The problem, as I see it, is a very different one. In my reading of
development history, it hasn’t been the lack of intelligent reforms and
determination that explains why every country that has experienced
many years of investment-driven “miraculous” growth has had a very
difficult adjustment in which GDP growth has dropped significantly.
The problem has been the balance sheet constraints. Because of
these constraints, and the debt dynamics they imply, GDP growth
must drop sharply even as Beijing manages a substantial transfer
of wealth from local governments to ordinary households.
If Beijing can manage it so that the income growth of ordinary
households drops minimally, perhaps to a very healthy 5-7 percent,
GDP growth must be at least 2-3 percentage points lower if China
is going to rebalance its economy meaningfully, which it must. And
Beijing must pull this off while eliminating the balance sheet impact of
many years when the economic value of investment was overstated.
To put it differently, I think you would argue that if China’s growth
drops to 3-4 percent or less, this would indicate that Beijing was insufficiently committed to the necessary reforms or unable to implement them efficiently. I, on the other hand, would argue that President
Xi will have pulled off an extraordinary feat that few leaders have
managed. Much higher growth rates in consumption and GDP for
the rest of this decade, I would argue, are only possible if Beijing
allows debt to grow out of control, in which case the higher growth
rates would almost certainly be followed by a terrible “lost decade,”
or if Beijing is able to transfer the equivalent of 3-4 percent of GDP
from the state to Chinese households every year, which strikes me
as highly implausible.
There is another area that might also represent a fundamental
disagreement between us. In your letter you say: “But China still has
a much lower capital-output ratio than advanced economies such
as the U.S. and still has vast needs for infrastructure in its interior
provinces. The question is whether the allocation of domestic savings into domestic investment is being intermediated in an efficient
continued on next page
© 2015 Bloomberg LP. All rights reserved.
You have set out the dichotomy in our views clearly and sharply.
The central question is the following – can China maintain high
growth in the next few years without a further massive expansion
of credit and while undertaking economic reforms? My view is that
reforms and rebalancing are compatible with maintaining growth at
its present level of around 6-7 percent. Yours, as I understand it, is
that these two sets of goals cannot be achieved simultaneously. Of
course, we agree that high growth built on a shaky foundation of
rapid credit expansion without reforms and rebalancing would be
undesirable and risky.
At heart, my argument is simple. There is substantial misallocation
of resources in China, so economic and financial sector reforms that
result in improved resource allocation can help China maintain growth
in the government’s target range while promoting rebalancing. How is
this possible? There are a number of inter-related strands underlying
my argument, with the proviso that I fully recognize each of these represents a difficult but not insurmountable challenge. I will sketch these
points here, leaving a detailed numerical analysis for another time.
First, labor reallocation. A large pool of unutilized or underutilized
labor, especially in rural areas, remains to be tapped and drawn into
productive employment. This is one objective of the government’s
urbanization program, although there may be better ways – involving less disruption and fewer congestion costs – of moving labor
from unproductive sectors to more productive ones. This reallocation effect by itself can give a short-term boost to both GDP growth
and productivity growth.
Second, an increase in private consumption growth can become
a more important driver of GDP growth. This will require economic
changes that generate more employment and diminish households’
precautionary savings motives. In my research, I have found that a
weak financial system (lack of diversification opportunities, inability
to borrow against future income) and precautionary savings driven
by an inadequate safety net have contributed to rising household
saving rates. The ownership structures of many firms and their financing sources also create incentives for higher corporate savings
(retained earnings) that are plowed back into investment, some of
marginal value at best.
Third, directing more financial resources to parts of the economy
that are better at generating employment, especially the services
sector and small and medium sized enterprises, could add to employment growth. This would have the added benefit of reducing the
capital intensity of growth.
continued on next page
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MICHAEL PETTIS’S REPLY…
ESWAR PRASAD’S REPLY…
manner that allocates capital to its most productive uses.”
I would say that there is a prior question. Are poor countries poor
because their capital-output ratios are low, or are they poor because
they are unable to absorb very high levels of capital productively?
The former model implies that development is largely due to rising
investment, whereas the latter model implies that advanced countries
have different social, legal, financial and economic institutions and
incentives that permit individuals and businesses to exploit capital
more productively, and that development has more to do with acquiring these institutions.
Obviously there is no way to resolve this question here, although
elsewhere I have written about how much investment is optimal according to each of these models. The former model has been used
to justify the ever-increasing amount of investment spending, but I
think the latter informs Beijing policy makers as they focus on reforming the financial system, the legal and regulatory framework,
education, and so on.
This matters not just in the case of comparing capital-output ratios
between China and the advanced economies but also between the
various provinces in China. Two years ago the chief China economist
at Standard Chartered proposed that simply bringing the poorest
provinces in China to the same GDP per capita level of the richest
could guarantee at least five more years of growth above 7 percent.
This may be arithmetically true, but if differences in provincial GDP
per capita were so easily explained, it leaves unexplained why the
IMF found that even though they had lower levels of investment per
capita, the return on investment in these inland provinces was lower
than in the more developed coastal provinces.
These are major issues that cannot be resolved within the limits
of a short exchange of letters, but they point to an important difference between our views. You argue that China can manage to keep
very high growth rates for many more years if Beijing continues to
manage the economy as well as it has in the past. I argue that there
are hard constraints that will make it almost impossible for China’s
GDP growth rates to remain high unless credit grows even faster.
This leaves us with radically different ways of evaluating the success of Beijing’s policies.
Fourth, in the short run, fiscal policy can play a more effective
role at supporting growth, creating fewer risks for the financial sector
and promoting growth rebalancing (for instance, by strengthening
the social safety net). In a nod to this, last week the government set
a modestly higher deficit target for the coming fiscal year, although
I would have liked to see that accompanied by more substantive
changes in the composition of expenditures and the tax structure.
Fifth, the rate of investment growth can be maintained at a high
level if some of it is financed through alternative channels such as
corporate bond markets. Moreover, even if investment growth declines
by 1-2 percentage points, other components can make up for this. I
agree with you that a cross-country comparison of capital-output ratios
by itself is overly simplistic. Improvements in corporate governance,
the financial regulatory framework, and legal reforms that underpin
a market-oriented system are all essential for productive investment.
President Xi has indicated that his government will push forward with
reforms in these dimensions. Of course, one should have no illusion
that they presage sweeping institutional, legal, or political reforms
– Xi has made it abundantly clear that those are not on the cards.
What will it take to generate the shifts in the economy I have laid
out? A broader, more efficient, and better-regulated financial system
is crucial to accomplish the different aspects of rebalancing I have
set out above. A more flexible monetary policy framework that is not
hampered by a tightly managed exchange rate regime and a more
supportive fiscal framework have to be part of the package. Institutional reforms and the freer play of market forces in the enterprise
sector are necessary as well.
These are all major transitions, time is short, political opposition
is strong, and the risks of stumbling are great. But I remain optimistic (or, at least, hopeful). So long as the government keeps moving
in the right direction at a reasonable pace, the reforms and rebalancing can take place without the economy necessarily facing the
sharp growth slowdown you envisage.
To round up this year’s debate on a more harmonious note, we
seem to concur that the Chinese government is committed to reforms. That, at least, is something positive and encouraging that
we can agree upon!
continued from previous page
continued from previous page
Michael Pettis’s Main Arguments:
Eswar Prasad’s Main Arguments:
 Arithmetic of rebalancing means even if household
income growth can be maintained at 5 percent to 7 percent, GDP growth must necessarily be lower.
 China’s limited institutional development makes it
difficult to absorb large volumes of capital productively.
 GDP growth of 3 percent to 4 percent, combined
with progress on rebalancing, would be a significant
achievement.
 Improved resource allocation can maintain growth in the
6 percent to 7 percent range while promoting rebalancing.
 Underutilized rural labor and inefficient allocation of
capital both represent opportunities to use reform to
unlock new sources of growth.
 Progress will be tough, and require new arrangements for monetary and fiscal policy, as well as freer
play of market forces in the enterprise sector.
CURRENCY MOVES & Central Bank Policy
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