Changing the Rules of the Game: China Does Need to Consume More
Recap of a conversation with expert commentator Michael Pettis
FutureofUSChinaTrade.com spoke with Michael Pettis, finance professor at Peking University’s Guanghua School of Management, about his vision of the future of trade between the U.S. and China. He argued that China needs to switch its growth model – from one dependent on investment and trade surplus to one driven by domestic consumption. Yet that transition will be a difficult one and there isn’t yet consensus in Beijing that now is the time. “It’s very difficult to change the rules of the game when you’re winning,” Michael said.
FutureofUSChinaTrade.com: Tell us a bit about your background and your experience in China.
Michael Pettis: I moved to China in early 2001; I spent a week here on holiday and was so blown away by the place that I decided to quit my job on Wall Street and move out here and teach finance for two years. Two years has become nine years, and nine I hope will become twenty.
I was particularly intrigued because China was changing so quickly, so dramatically and it was such a big event. You’re lucky to get one time in your lifetime to see a transformation like that on such a global scale. It seemed to me a very exciting thing to be part of.
I’ve been very lucky because I’ve taught at the top two universities, first at Tsinghua University for four years now at Peking University. These are really the elite schools and the students that I’ve been able to work with are being groomed for positions in leadership in government and business. I’ve been lucky enough to teach some of the young men and women who I think are going to be leading this transition in the next twenty or thirty years.
FutureofUSChinaTrade.com: In the first scenario Bob Mittelstaedt imagines a future where trade is really unfettered and the United States and China compete purely on their comparative advantages. And then Clyde Prestowitz imagines a future where America takes a competitiveness stance and works to reverse the erosion of its economic power and China focuses more on growth led by domestic demand. Then finally in the third scenario Art Blakemore envisions a convergence of growth rates: the U.S. continues to grow on trend and China moves through the catch-up phase and becomes a developed economy. What are thoughts on those scenarios, and what is your own vision of the future of U.S./China trade?
Michael Pettis: I think it’s going to be mixed – that’s sort of a cliché – there are a lot of things on which the two countries are going to want to and will have to work together but there are other areas where there will be tension and conflict. But there is a tendency abroad – and it’s starting to affect people in China – of overestimating the trajectory of Chinese growth. China has some really big problems – probably the worst imbalances that we’ve ever seen in economic history, certainly in modern economic history.
These are imbalances similar to those Japan faced in the 1980s, but in a much more exaggerated way. Basically China has got itself caught up in a growth model that relies desperately on two sources of growth:
- Increased investment. China entered the global financial crisis with the highest investment rate in recorded history and probably already a significant misallocation of that investment and responded to the crisis with a massive increase in that investment to levels that are unprecedented and almost certain to result in significant destruction of value. But China is completely addicted to this investment-based growth.
- The trade surplus. China has a very high trade surplus and is hoping to grow its trade surplus even further. I have an article coming out in the Financial Times in which I argue that the dynamics between the three major trade-surplus countries (Germany, Japan, and China) and the two major trade-deficit entities (trade-deficit Europe and the U.S.) are extremely ugly and we’re almost hurtling toward a trade conflict in the next year or so. How that happens and how China resolves it is going to be very important for longer-term Chinese development.
So China needs to switch its growth model, but it needs to do so very slowly. It waited way too long before switching. A number of people in Beijing have been arguing as far back as 2003 that it was time to switch the growth model, but of course it’s very difficult to change the rules of the game when you’re winning – so nothing happened. Now it is more urgent that ever and I think there is widespread consensus that we need to change the growth model.
The problem is that it’s politically very difficult to do so. And even if they develop the consensus and decide to start taking the necessary steps today – and I think it’s unlikely they’ll take the necessary steps before 2012 – it’s going to take at least 8-10 years of adjusting the model. In the meantime, they’re still heavily reliant on exporting the excess of what they produce. That means the rest of the world needs to accommodate that 8-10 year adjustment. Yet I would argue that the appetite for the U.S. to do that has diminished considerably, and that the U.S. is probably looking for a 3, 4, 5-year adjustment period.
And then in trade-deficit Europe it has nothing to do with appetite, but they are going through a financial crisis which I would argue has only just begun and is going to mean a collapse in their trade deficit – if you can’t finance a trade deficit, you can’t run a trade deficit. So I’m not sure the world is going to give enough time for the Chinese to make that adjustment.
FutureofUSChinaTrade.com: So if the trade-deficit Europe and the U.S. won’t tolerate an 8-10 year adjustment, then what happens?
Michael Pettis: Well, what happens is that China is going to be forced to rebalance one way or the other. The good way would be if we could get consumption to surge and drag GDP growth behind it. For many years China has had the opposite situation as the U.S. – whereas in the U.S. consumption grew faster than GDP and debt levels ran up, in China GDP grew faster than consumption (debt levels also ran up, but it was debt to the producing sector, not to the consumer).
If the U.S. reversed and we see consumption growth lower than GDP growth – unless the rest of the world can replace the U.S., which is very unlikely – then China has no choice but to see a role reversal where rather than GDP being substantially greater than consumption growth it is substantially lower.
But getting consumption to surge will be very difficult. There is a lot of foolish thinking here about how we can accomplish that, and the skeptics like me have for five years been saying that it isn’t going to work. Since then, consumption as a share of GDP has declined to truly alarming levels.
The alternative is the way that the Japanese did it: consumption growth actually slowed down but GDP growth slowed down a lot more. I’m afraid that’s the more likely scenario for China – that we’ll see a significant slowdown in GDP growth as China makes the transition to a more domestic consumption economy.
FutureofUSChinaTrade.com: You talk about the particular steps China would have to take to change that growth model, what are some of those steps?
Michael Pettis: There’s all sorts of nonsense that Chinese consumption is low because the Chinese don’t like to consumer or because they’re Confucians or because there is a gender imbalance. But the fact of the matter is that consumption in China is decently high as a share of household income. The key is household income, which has been declining as a share of GDP. So it’s not surprising that consumption is declining as a share of GDP.
In addition, there is a huge inequality of income. In fact, a recent study put out by Credit Suisse suggests that household income has been understated by something like 10% of GDP and that the distribution of that income is worse than any of us thought. And as you know the rich don’t really consumer – they spend a very small share of their income. So it turns out that these very low consumption numbers that we saw from China may be overestimating consumption as a share of GDP by as much as 10% – it’s even lower than the astonishingly low level we thought.
So if you want to get consumption up you’ve got to raise the household share of national income. There are two ways of doing that: The one-off, relatively easy (though politically difficult) strategy of increasing household wealth through a massive transfer of government assets to the household sector. It can be done indirectly by privatizing the assets then using the proceeds to clean up the banking system or it can be done directly by transferring the assets to the pension funds – there are a number of ways of doing it. But that would give a huge booth in household wealth and a huge boost in consumption. Of course there are big political ramifications for giving up significant levers of control.
The more appropriate and sustainable way to raise the household share of national income is to reverse the mechanisms that have systematically subsidized growth and forced the household sector to pay for those subsidies in the form of various hidden taxes. The three most important of those mechanisms are:
- The undervalued exchange rate that reduces the real value of household income and subsidizes manufacturers in the tradable goods sector.
- Wage growth that has been much slower than productivity growth even with the recent wage hikes; that takes income from the workers and subsidizes employers.
- The most powerful of the mechanisms has been financial repression. The vast bulk of savings is in the form of bank deposits and the vast bulk of corporate financing is in the form of bank loans. Interest rates are kept extremely low; in fact, depositors have been receiving negative real rates for most of the past decade. These low rates are a huge subsidy for capital users – real estate developers, SOEs, local, provincial, and central governments, infrastructure investors, etc. – at the expense of the net savers, which is the household sector. My estimate is that every year between 5 and 10% of GDP is transferred from the household sector in the form of a subsidy to users of capital.
So if you really want to raise household income you’ve got to reverse these three mechanisms, but you can’t do it quickly because especially large Chinese corporations are incredibly efficient, and they’re only able to survive because of these massive subsidies. So if you eliminate those subsidies that would lead to a surge in bankruptcies which would lead to a rise in unemployment which would actually lead to a decline in consumption. So you’ve got to do it very slowly. In theory you raise the value of the currency, you raise wages, and you raise interest rates and in doing so China loses international competitiveness, so it loses foreign clients, but it replaces them one-for-one with domestic household consumption. That’s the theory, but it’s very hard to do. The only think I can say with confidence is that it can’t be done quickly – it’s going to take at least 8-10 years if we’re lucky.
FutureofUSChinaTrade.com: It almost sounds like China’s massive economic development was built on a house of cards that is really unsustainable.
Michael Pettis: Yes, it’s certainly unsustainable, but there are plenty of similar cases. If you look at the first time the word “miracle” was applied to a rapidly developing economy I believe it was Brazil in the 1960s and 70s when it was growing 10 or 11 percent a year. The way the Brazilians achieved it was through very explicit taxes on the household sector, the proceeds of which were used to subsidize a massive infrastructure push. And Brazil bought tremendous growth but the problem was the growth was externally- and investment-driven. And credit-risk was socialized and the cost of capital was very low so they quickly came to the point of misallocation of capital. Brazil went though their adjustment, it was called the lost decade of the 1980s.
Another example is Japan. The Japanese model is basically the model that most of East Asia, including China, has followed; except that China has done so in a pumped-up way. Japan was overly reliant on the export surplus and on investment. It responded to the 1987 crisis in the U.S. with an increase in investment from what was already a very high level and it got tremendous growth – whenever you increase investment, you will get growth today, but if the investment is misallocated you give back more than 100% of that growth in the future. And so Japan had its own lost decade in the 1990s, and you can argue that they still haven’t really emerged from that lost decade.
So the historical precedence for this very rapid growth caused by a massive transfer of income from the household sector to subsidize especially investment is not very good. You can achieve tremendous growth but you have to know when to stop and switch the growth model. So far no one has been able to do that at the right time – everyone has waited too long. And it seems to me clear that China has also waited too long.
FutureofUSChinaTrade.com: If we think about the shortish-term future of China as a lost decade, after that is the future brighter? Can they emerge and continue developing and become, in per capita GDP terms, a developed economy?
Michael Pettis: That’s a political and social question more than an economics question. There are many cases of countries that have had very rapid investment growth that then hit their difficult adjustment period and never got through. Then there are many other cases of countries that did get through – Japan is a rich country; the United States went through it, too.
We’re not really sure why certain countries go through the difficult path and then regain growth and other countries don’t. I suspect it has as much to do with politics and social structures and institutional structures as anything else. My guess is that China is going to continue growing faster than the rest of the world for many more years. Their rough patch may not be Brazil’s or Japan’s lost decades of zero or negative growth; it’ll probably be much lower levels – 3, 4, 5 percent growth. So China is still going to grow faster than the world.
So it’s a rockier story. That doesn’t mean that China is going to fail; every successful country has gone through difficult periods. But to assume that China cannot go through a difficult period is just silly.
FutureofUSChinaTrade.com: Is there a willingness in China to confront these issues?
Michael Pettis: There’s a real debate going on. There are people who are much darker than I am, who have been arguing for much longer that urgent change is needed.
But it’s a little bit like the U.S. in 1930 where the more internationalists, including President Hoover and most leading economists and bankers, understood that the balance of payments constraints on the U.S. made an adjustment very difficult. Then the domestic constituencies didn’t really understand that but they were the bulk of the political power.
China is going through that too; there are constituencies around the central bank, around the banking regulators and the so-called Shanghai faction, certainly in many of the think-tanks and universities, who really understand how difficult the adjustment process is likely to be. There are even some fairly powerful people who understand that. There is some evidence that Premier Wen understands it. But until there is a crisis it is very difficult to develop a consensus among the SOE heads and the provincial and municipal leaders and the people from the Communist Youth League who under Hu Jintao have been very powerful. It is very difficult for them to understand the meaning of the global imbalances and why they’re likely to be so disruptive.
It’s not clear to me that there is a consensus about how urgent the need for change is. Everybody agrees that China needs to adjust and rebalance, but so far it seems to me that the argument is that China should rebalance without giving up growth; they haven’t recognized that rebalancing is going to require a significant retraction of growth – there is simply no way to get one without the other.
FutureofUSChinaTrade.com: Is it fair to say that it is in everyone’s interest that China move successfully through this period of rebalancing?
Michael Pettis: Of course. In the short term there are a lot of good reasons for the U.S. to take a much tougher trade position. The truth is, and most economists don’t often like to say this, is that a rapid contraction in trade can actually be expansionary for deficit countries.
But over the long run most of the really big problems that the world faces are going to require Chinese participation. And that’s without even saying that most of the big problems are basically going to be resolved by the U.S. and China. Whether we’re talking about global warming or nuclear proliferation or global terrorism or the world’s water crisis, it’s going to require Chinese participation.
So from that point of view, what is not good for the world is a hostile and distrustful China. In the 1920s the United States was very reluctant to join multinational, multilateral agreements; it refused to join the League of Nations and the BIS because there was a sense of distrust toward Europe and I think almost everybody would agree today that the refusal of the U.S. to participate in these global organizations probably made things much worse than they needed to have been – probably economically and certainly politically. I would say the same is true today; it’s not really going to help us over the long turn to have a mistrustful China that sees participation in global institutions as an attempt to shackle China.
So from that point of view a very difficult adjustment in China is going to be bad for the world. A minimally difficult adjustment is going to be better for the U.S. and the whole world over the long term. It’s not clear to me that’s what we’re going to do. It is clear to me that’s what we ought to do.
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