Chinese Bulls Vs Bears
There are two main schools of thought amongst global economists on how the Chinese economic growth story will unfold over the next decade. One is that the current high growth rate is sustainable and will remain, and the other is that the economy will suffer from a debt crisis, go into recession then bounce along at growth rates more like 2-3% for the remainder of the decade. In this article we hear from two of the most prominent advocates of both the bull and bear perspectives.
The Bulls Case
Prominent China bull Stephen Roach refers to the bears as “the 3 to 4 per cent crowd”. The former Morgan Stanley Asia chairman says “their record is extremely poor in predicting the inevitable crash or hard landing in China”. As far as he is concerned, there won’t be one.
Roach, now a senior lecturer at Yale, is not saying China doesn’t have any problems. He recognises debt levels are too high, consumption as a share of GDP is too low and reforms to steer the economy away from a dependence on investment spending have happened too slowly.
However, he says China’s economic model is on the cusp of a major tweak that will keep it growing at between 7 and 8 per cent for the next decade. If this is the case the Chinese economy will be larger than US economy by 2019 (see below).
“China operates strategically,” he says. “This really separates China from more reactive economies and policymakers in the West and elsewhere in the developed world.
“Over the last 20 years, they have been very effective in walking that line with a high domestic savings rate, a low deficit to GDP ratio and monetary policy still affording them ample ammunition to reduce interest rates should they need to. They have plenty of tools they can rely on to cushion the downside.” The graph below shows a comparison of gross domestic savings as a percentage of GDP, it clearly shows China’s vastly higher savings rates.
Those tools include some important changes to unleash the Chinese consumer, such as reforming the household registration system so migrant workers can move around more freely and receive better social service benefits. Roach also argues China needs to support the services sector, ensuring there is a well-funded social safety net and liberalise the setting of interest rates so deposit rates aren’t kept artificially low. He says these reforms will push household consumption from its current 35 per cent of GDP (compared to 71 per cent in the US) to 40 per cent over the next three to five years and more than 45 per cent within the next 10 years. However the figures below would tend to contradict him, showing consumption accounting for a falling share of GDP growth.
The biggest issue Roach has with the China bears is that their argument is based on a view the country has spent too much money building infrastructure. He says that is simply not true. While spending on factories, real estate and infrastructure as a share of GDP is too high – accounting for 53.9 per cent in the first half of this year – Roach says it’s more important to look at the physical capital stock in place, compared to the number of workers in the economy.
“Ultimately what drives economic growth over the long haul is the stock of productive capital per worker and the latest estimates that I’ve seen, it looks like China’s capital to labour ratio is about 13 to 14 per cent of the levels in the US and Japan.”
Roach is a big believer in China’s urbanisation story. One of his favourite statistics is that in 1981, China’s urban population was just 20 per cent. Today it is around 52.6 per cent and by 2030, it is expected to reach 70 per cent. To accommodate that flow of people, China needs to build 100 new cities with a population of more than a million. As long as that is accompanied by strong growth of the services sector to provide enough jobs for the city dwellers and a better social safety net, that will not only keep investment spending relatively high but also boost incomes and consumption.
Roach admits he is not as “unabashedly enthusiastic and bullish” on China today because it faces more complex challenges. However, he is confident the right reforms will be introduced to keep China growing strongly and allow him to lock horns with the sceptics for decades to come.
“They’ve been screaming that the sky is falling in on China for the last 20 years and every few years the screaming gets a little louder.” While sometimes they have legitimate worries, he says they’ve always been proved wrong.
ANZ Chief Mike Smith’s View
“Although there is a rebalancing taking place in China, we need to remember that the world’s second largest economy is still growing at around 7 to 7.5 per cent per annum,” Mr Smith said.
“This is like adding an economy about the size of Switzerland each year. Essentially what we are seeing is growth in China stabilizing to a more sustainable level. This is good news for Australia and good news for the many businesses now directly connected to Asia’s growth.”
The Bears Case
The way Michael Pettis tells it, the outcome is inevitable. The renowned “China bear” says the country is heading for a debt crisis that will see economic growth average less than 4 per cent a year, perhaps for the next decade. From his office at Peking University in the Chinese capital, the former Wall Street bond trader is all conviction. “It’s totally predictable,” he says. “Every case of an investment-driven growth miracle in history has ended up in a debt crisis.” The increasing levels of Chinese debt are shown below.
Such firm beliefs have made the Spanish born American a leading proponent of a view that China will not muddle its way through the current problems. The key issue for Pettis is that China has overspent on building infrastructure – think empty roads and bridges to nowhere.
“In China we are building everything,” he says. “Yes, China is underinvested [in infrastructure] compared to the US, which is the most advanced economy in the world. But it actually has a much higher capital stock per capita than Mexico, Brazil or Russia which are much richer countries.”
This leads us to Pettis’s key economic theory. “I would argue the difference between a rich country and a poor country is its ability to absorb capital,” he says.
Pettis believes China exhausted this ability to efficiently absorb capital in the late 1990s and therefore much of what it has built since has generated diminishing returns and a mounting pile of debt. Put simply, the country has run out of worthy things to build and borrowed too much in the process.
Pettis is not alone in such views, but his argument is taken more seriously because he has not suddenly discovered China and nor is he observing it from afar.
In 2001, he quit his job as head of Latin American capital markets at Bear Stearns and moved to Beijing. The plan was to stay two years, but like many he became fascinated with China. These days Pettis is a professor of finance at Peking University and a Senior Associate at the Carnegie Endowment for International Peace. These two positions and Pettis’s past as a specialist in emerging market bonds has given him a unique perspective on China’s rapid accumulation of debt, which is estimated to have leapt from 140 per cent of GDP five years ago to more than 200 per cent .
“Everyone now agrees that debt is a problem,” says Pettis. This run-up in debt has built China’s gold plated infrastructure and also kept growth above 7 per cent. But it’s not sustainable, which is why Beijing is trying to rebalance the economy away from infrastructure towards household consumption.
“If China does not rebalance, then you run into a debt crisis. If it does then by definition GDP must grow more slowly,” he said. “Over the adjustment period, which probably began last year, average growth rates are unlikely to exceed 3 to 4 per cent.” If this is the case then the US economy will stay larger than the Chinese well into the future.
Another pet theory Pettis has is that rapid growth is the easy part. He says there have been 43 cases of “miracle growth” – above 7 per cent for a decade – since the Second World War. But only South Korea, Taiwan and maybe Chile have made the transition from rich to poor. “Growing rapidly is not the hard part, the hard part has always been the transition,” he says. “Miracle growth periods have happened quite a lot and they generate expectations that in every single case have proven to be much too high.”
Pettis also argues household consumption can’t fill the gap that will be left by the likely drop in fixed asset investment and therefore growth has to decline rapidly. “Consumption was very low in the 1980s at around 50 per cent of GDP, which was at the low end of low consuming countries,” he says. It dropped to “crisis” levels of 46 per cent of GDP by 2000, he says, and then in the decade since has collapsed to just 35 per cent. “Those who say consumption has grown quickly are 100 per cent right but they are 100 per cent irrelevant. They don’t understand the problem,” he says.
In conclusion, whether or not you think China will continue its economic growth miracle largely depends on your view on whether the Chinese government can effectively shift the economy from growth based on infrastructure investment funded by debt, to consumer consumption which is required to repay the accumulated debt. At this point early indicators are not looking good. Either way there seems to be no middle ground amongst most market observers, it’s either boom of bust for the world’s second largest economy.