China Rebalancing

From Michael Pettis

The above chart comes from Michael Pettis, who is probably the smartest China analyst I have encountered. For two years or more, Pettis has been predicting a slowdown in China's GDP growth. His arguments with other China analysts are famous. One of his highly publicized bets is with the Economist, that is predicting that China's GDP will eclipse ours in 2016. At this point, almost all the bettors are siding with Pettis.

In his blog, he says very clearly that he is not making direct predictions. He is saying:

• The Chinese economy must rebalance away from debt-fueled investment and toward internal, consumption driven growth. If not, the country will hit its macro debt limit, where further investments will have a negative return, and the financial system starts to crumble with loans that cannot be rolled over, going bad.
• Consumption is at an "off the historical chart" low of 35% of GDP. Investment is at a similar unprecedented 46% of GDP, possibly as high as 49%. Until recently, conventional wisdom explained the low consumption share by pointing out the high household savings rate. Better analysis now shows that this is due to household income suppression (low wage growth, artificially low savings interest rates, low social insurance and other transfer payments to workers). Household income has grown more slowly than GDP for many years, though this has begun to change. The abnormally high investment share of GDP has been supported by mountains of new debt, much of it taken out by State-Owned Enterprises (SOEs').
• A country with excess savings (low consumption, low HHI growth) invariably will export all, or a significant portion of this surplus, according to a combination and rearrangement of the two basic macro formulas for GDP and National Income (Y):

C + I + G + (X - M) = GDP

C + S + T = Y

GDP = Y

So:

(S - I) +  (T - G) + (M - X) = 0

Excess Savings + Government Surplus +Trade Deficit = 0

So if Government Budget is balanced (T - G) = 0, and there are Excess Savings (S - I) > 0, then there must be not a Trade Deficit, but a Trade Surplus, i.e., (M - X) < 0, or (X - M) > 0. Rebalancing China towards consumption will, over time, greatly reduce the country's export surplus. (For example, if C increases 15%, and I decreases 6%, then, holding Government at balance, (X - M) must drop 9%, or to 0 from its current 9% level.)

• To raise C as a percentage of GDP, and to lower I, requires that C grow faster than GDP for a number of years, and that I grow more slowly. Pettis believes it is reasonable to move China's consumption as a percent of GDP from 35% to 50% over 10 years, and to lower investment from 46% to 40%. Stretch objectives would be 55% for consumption and 40% for investment.
• Pettis believes it is reasonable to think Chinese consumption could continue to grow about 7% a year (its current rate) and that lowering the investment growth rate to just about 1% a year represents the most doable scenario. This means, by simple math, that the country's GDP growth rate over the next 10 years will be in the 3 to 4% range (from the chart above).

If China can manage this, over the political objections of the elite, who will see income transferring to workers and away from owners as a share of ongoing GDP - then the country will be in pretty solid shape at the end of the 10 year horizon. If it does not follow this course and investment stays at the currnt high levels, China will probably hit the Debt Wall, and suffer a financial crisis. If it chooses the rebalancing path, which Pettis feels is what the current leadership intends, then the challenge will be in managing discontent within the owner class.

In any case, growth will be slowing. By the end of 2013, we should have dropped down below the current 7% rate, possibly as low as 5%. 2014 will probably see China drop into the 4s', and by 2015, the 3-4% growth rate is likely.

Big changes are underway - changes that will absorb the energies and attention of the Party leadership. I do not think they will have too much extra time for major foreign adventures in opposition to the US. I am also hopeful they will ultimately join the Trans-Pacific Partnership, which might provide some framework for addressing the various territorial concerns China has with Japan, Korea, Indonesia, and others.

In any case, I do not expect China to be an active adversary of the US over the next 10 years. And they will seem significantly less formidable as their growth rate slows to US levels, or slightly above.