Source: ABC News

TICKY FULLERTON, PRESENTER: There's been many a comment in the last few days about the impact that such a tiny island of Cyprus can have on markets.

Michael Pettis is one global expert who spends much of his time watching market drivers.

A Wall Street veteran, economist, finance professor and entrepreneur, he's now based at the Peking University in China but we caught up with him in Sydney this week.

Michael Pettis, thank you for joining me.

MICHAEL PETTIS, AUTHOR, THE GREAT REBALANCING: Thank you.

TICKY FULLERTON: Let's go to Cyprus first. We have a bailout. How do you see the event in the broader European context because earlier this year there was an enormous amount of market optimism about Europe?

MICHAEL PETTIS: The optimism was totally misplaced. The optimism arose from the fact that the ECB was helping these countries refinance their debt at lower rates and the assumption was that the problem in Europe was really a liquidity problem.

TICKY FULLERTON: So you don't see Mario Draghi as some sort of guru in what he's been able to do?

MICHAEL PETTIS: No, we've seen this before. Every time there's a sovereign debt crisis we first spend a couple of years calling it a liquidity problem until we finally recognise the fact that it's not a liquidity problem, it's a solvency problem and we're still in the stage where we're trying to pretend it's a liquidity problem.

TICKY FULLERTON: Go back to Cyprus in particular, what does it say about the type of economy it is. Here we are fixing up the banking system specifically?

MICHAEL PETTIS: Cyprus is interesting because it's simply an exaggerated version of the problems throughout peripheral Europe. We have bank problems in every one of these countries. I don't think we're necessarily going to see bank runs tomorrow in Spain, Italy and Portugal but as things get worse, as credibility deteriorates, the memory of Cyprus will jump out again and that will cause a real sort of gapping in the attitude towards the banking system. And that worries me a lot.

TICKY FULLERTON: Do you see the social unrest issue, you know, growing bigger and bigger because you look at the Italian elections, you look at the level of say unemployment in Spain, is this something which is really going to have to be tackled head on?

MICHAEL PETTIS: There's really only two things that happen. Either the Germans significantly reflate their economies in order to make up for the austerity in peripheral Europe or unemployment has to stay very high. And the problem there is that the ball then becomes in the court of peripheral Europe.

If they continue acting "responsibly" that means basically they have to absorb very high unemployment very many, many years and I don't think they are going to do that. Alternatively, what they can do is leave the euro and when that happens the unemployment will be shifted from the deficit countries to the surplus countries, to Germany.

This is, for example, what happened in the 1930s with the United States. So I'm pretty pessimistic about the ability of the euro to survive.

TICKY FULLERTON: Let's move to China and your ideas about the inevitability of a global rebalancing. Different views, of course, on China and you're expecting China's growth to average perhaps as low as 3 per cent for the next decade.

MICHAEL PETTIS: Yes, and that may seem surprising but again if you look at the historical precedence there have been many countries that have had investment driven growth miracles. Every single one without exception has ended up in either a debt crisis or in a lost decade or both. And in every single case even the pessimists, even the sceptics underestimated how difficult the rebalancing was going to be.

TICKY FULLERTON: Another one of the challenges that China has that we're hearing more and more about is their environment. To what extent is there a really urgent need to do something about that and how will that impact growth?

MICHAEL PETTIS: I think in the last year for the first time the environment has become such a problem that the leadership is going to move it more towards the front of their policy choices. The problem is that it's very difficult to clean up the environment while at the same time maintaining very high levels of growth because these high levels of growth have been in part subsidised by the fact that you don't need to worry about the environmental consequences. So it's tough.

TICKY FULLERTON: So where do you see rates this year and next year?

MICHAEL PETTIS: It's a very interesting question because I think that's really a political question more than it is an economic question. As long as Beijing is not in complete control of the process and is still trying to consolidate power we're going to see credit grow very quickly and we're going to see GDP grow very quickly. So my guess is in the first half of the year GDP growth rates will probably be pretty close to 8 per cent. The interesting question for me is what happens in the second half of the year because if the new leadership is able to consolidate power quickly, develop a consensus quickly and halt the growth in credit, then growth rates will slow significantly, maybe 6 per cent or less.

I'm not optimistic that that will happen but I think I and certainly many other economists would love to see that. On the other hand if they're not able to consolidate quickly enough we will see second half growth rates also quite high.

TICKY FULLERTON: Well you're down here in Australia. To what extent will China's changing growth profile have an impact on Australia and how should we be responding?

MICHAEL PETTIS: First of all investment growth will slow down significantly and maybe even go negative which means that China, which is a disproportionately large source of demand for hard commodities, 60 per cent of iron ore, 40 per cent of global copper, etc, that demand is going to go down significantly. That will hurt the commodity exporting sector which is unfortunately very important in Australia.

The other important consequence is that as China rebalances almost by definition that means China's export competitiveness will be eroded which is very good for the manufacturing sectors around the world. So in Australia we'll see the commodity sector get badly hurt, the manufacturing sector do relatively well but in the short term the balance will be negative. I think growth rates will slow down significantly here.

TICKY FULLERTON: Michael Pettis it's been great to catch up with you while you're here, thanks for joining us.

MICHAEL PETTIS: Thank you.

Watch the interview at ABC News.