China’s new leadership has taken shape since November and March. The early signs of their policy direction are incomplete by necessity and programmatic policy statements are not expected until around the time of the Third Plenum of the Central Committee in the autumn.
Michael Pettis of the Carnegie-Tsinghua Center and Peking University joined Carnegie’s Douglas H. Paal to assess the new Chinese leadership and its early steps, looking at the likely paths forward in the economic sphere.
- Growth Drivers: The weaknesses and vulnerabilities of China’s investment-led growth model are now well-recognized and relatively uncontroversial, Pettis said. He explained that China has generated growth by transferring wealth from households to the state sector, through three mechanisms: an undervalued exchange rate, constrained wage growth, and financial repression through artificially low real interest rates.
- Dangerous Imbalances: This has created rapid but imbalanced growth, leading to a problem where investment is no longer allocated efficiently or productively, and debt creation is beginning to outstrip debt servicing capacity, Pettis added. China’s “inverted balance sheet” makes it vulnerable to a debt crisis during an adverse shock, he argued.
- How Long to a Crash? The debt problem is widely recognized by Chinese policymakers and economists, Pettis continued. Observers disagree how long it will take to reach debt servicing limits, but Pettis offered a more pessimistic position that China has at most three to four years to address the situation.
- Consumption Reorienting: While policymakers recognize the necessity of rebalancing the economy, the problem is that bringing down investment will cause economic slowdown unless it is offset by a corresponding increase in consumption. There are five possibilities for the Chinese economy to rebalance to consumption, Pettis said.
- Status Quo: If China continues current levels of infrastructure and real estate investment, he stated, the economy will eventually rebalance through a painful contraction and debt crisis, as the U.S. economy did during the Great Depression.
- Rapid Adjustment: Increasing the share of household income to GDP would lower national savings and raise consumption, Pettis said. This could be done by an immediate appreciation of the yuan, or by hiking interest rates and wages substantially. All these methods will result in economic rebalancing but would also create financial distress.
- Gradual Adjustment: Rebalancing could take place through gradual adjustments to the exchange rate, interest rates, and wages. However, in Pettis’s opinion the timing will be too slow to actually reverse imbalances.
- Privatization: Because forced transfers of wealth from households to the state sector are the root cause of imbalanced growth, the government could rebalance by privatizing state companies and directly or indirectly transferring proceeds back to households, Pettis continued. While this is an efficient solution, political obstacles and vested interests make it unlikely.
- Absorbing Debt: A form of “backdoor privatization” would be moving debt to government balance sheets, like Japan did in the 1990s, achieving rebalancing by tolerating a period of lower growth rates, he said.
What to Expect
- Preferred Policies: Pettis guessed that policymakers will implement gradual adjustments to wages, interest rates, and exchange rates, as well as transferring debt to government balance sheets. Other policies proposed to increase consumption, such as subsidies for cars and consumer goods or building up the social safety net, cannot create real rebalancing because they rely on the same government funding system that forces wealth transfers from households, shrinks household income share, and drives up the national savings rate, he added.
- A Question of Politics: The pain of rebalancing will be borne by the state sector, Pettis said, explaining that ultimately China’s ability to complete this transition is a question of political will. Although Paal mentioned that the incoming Politburo members are mostly not seen as reformers, Pettis described it as encouraging that both President Xi Jinping and Premier Li Keqiang seem concerned about imbalances and debt problems. Assuming that rebalancing is not mismanaged, Pettis predicted average three percent GDP growth during the Xi administration.