In his most recent book “The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy” (Princeton University Press, 2013), Michael Pettis, 55, adverted about the Chinese investment orgy of historical unprecedented dimensions, its massive but unsustainable investment growth, based on an artificial lowering of the cost of capital and the bigger and bigger role of the banking shadow system with Chinese colours. The turmoil we are witnessing now in China, with rumors about a huge credit crisis, is probably the “new normal,” the most critical moment after the consolidation of Deng Xiaoping reforms in the 1990s. The critical challenge for China is to “manage” the de-leveraging of that unprecedented bubble, «but it is not just a question of de-levering the bubble, but also of writing down the value of assets that are not generating returns.»
Meanwhile People’s Bank of China (PBOC) had announced that it had injected liquidity into troubled financial institutions in an effort to increase their liquidity and stabilise interbank lending rates. The central bank of the second world economy posted it would make similar moves in the future, if necessary.
Professor Pettis is today one of the most important analysts from “inside” China. A former Wall Street veteran he is based nowadays in Beijing where he is professor at the Guanghua School of Management. He is also Chief Strategist at Guosen Securities (HK), a Shenzhen-based investment bank. Born in Spain from a French mother and an American father he is an American citizen and received a Masters of International Affairs in 1981 and a Masters of Business Administration in 1984, both from Columbia University.
# The new “normal”: As Beijing continues to take steps to constrain excessive credit growth, we will see these kinds of strains re-emerge from time to time within the banking system.
# PBOC dilemma: If they do it [control of the financial bubble] quickly they risk destabilizing the financial system and if they do it slowly it is almost certain that they will accumulate even more bad debt and so the total cost will be greater.
# Bernanke’s spillover: Loose monetary conditions in the US result in very loose monetary conditions in China and tightening in the US will result in more rapid tightening in China.
# Ironic trade-off: A rapid re-balancing would probably result in a surge in China’s trade surplus, which would be very difficult for Europe. A slow re-balancing would probably result in a contraction in China’s trade surplus, which will help Europe.
INTERVIEW by Jorge Nascimento Rodrigues, ©JNR 2013
What’s happening in China in the financial system? There is the risk of a large credit crunch as some analysts have warned, which has generated panic in the West?
It seems that for much of 2013 and 2012 mainland corporations with offshore affiliates had been borrowing money abroad and bringing it into the country disguised as export revenues in order to re-lend the proceeds in renminbi. This enabled them to earn the significantly positive carry, although at the expense of the People’s Bank of China, which had to borrow domestically in order to purchase the dollar net inflows, and so run the corresponding negative carry as the central bank invested the dollars in low-earning US Treasury bonds. The “carry trade” also forced the central bank to expand the domestic money supply as it purchased the inflows, and this expansion accommodated China’s credit expansion. In May, however, the authorities began clamping down on fake export invoices. As reported, export revenues consequently declined, the net inflows automatically dried up, undermining the liquidity expansion that had accommodated rapid credit growth. But it proved very difficult to slow the growth in credit commensurately, and the combination of rapidly rising credit and slower growth in the money supply created enormous liquidity strains within the banking system. This is probably what led to last week’s liquidity panic and this week’s market convulsions. As Beijing continues to take steps to constrain excessive credit growth, we will see these kinds of strains re-emerge from time to time within the banking system.
Temporary incidents in some banks as the BoC and ICBC occurred over the weekend and this week were signs of something bigger or just tech glitches?
I was able to take money out of my ICBC account on Sunday with no problem. I think this was just an unlucky coincidence.
PBOC aims to control the huge financial bubble that is powered by a hyper-leveraged shadow system feed by the official banking sector. Is this really possible?
It is possible, but it will be very difficult. If they do it quickly they risk destabilizing the financial system and if they do it slowly it is almost certain that they will accumulate even more bad debt and so the total cost will be greater.
Monday crash at CSI 300 Index and Shanghai Composite indexes, already with significant annual losses, is the result of a disproportionate reaction of investors or a good reflection of the seriousness of the situation?
The mainland stock markets are wholly speculative and tell you almost nothing about the underlying economy. They are driven more by government signaling and liquidity.
The communication of the QE exit strategy by Bem Bernanke, US Fed’s chairman, will expand Chinese financial problems?
Yes. China’s currency regime means that while Chinese exports can remain competitive for much longer than otherwise, China must also import and leverage up US monetary policy. This means that loose monetary conditions in the US result in very loose monetary conditions in China and tightening in the US will result in more rapid tightening in China. Economists have warned for many years that pegging the currency for trade reasons would undermine China’s ability to manage its domestic monetary policy, but the export sector was very powerful and resisted any change in the status quo. Unfortunately one of the consequences has been an investment bubble perhaps unprecedented in history, a little like what happened to Japan in the 1980s, but even bigger.
Do you think the critical challenge for China is to “manage” the de-leveraging of that unprecedented bubble?
Yes, but it is not just a question of de-levering the bubble, but also of writing down the value of assets that are not generating returns.
China risks the fate of Japan’s end of the 1980s? If so, with what political consequences?
I don’t think it will be as bad as Japan, but I do think that we will see a decade or more of much slower growth, perhaps averaging 3-4%. If the transition is managed well we will see few adverse political consequences because by definition household income must rise quicker than GDP if China is to re-balance. If China grows at 3-4%, for example, and household income grows at 5-6%, China will re-balance and households will still be happy. This, by the way, is what happened in Japan — household income grew faster than GDP.
What is your forecast for GDP growth in 2013 and 2014?
I think the official growth numbers in 2013 will come in at around 7.4% and perhaps 7% in 2014, but real growth will probably be lower.
The slowdown of the Chinese economy below 8% will aggravate the global economic situation?
I think capital goods and hard commodity exporters will be hurt over the medium term, and in Europe this mainly means Germany as a capital goods exporter. The rest of Europe should benefit from lower prices of hard commodities. The key is how quickly China re-balances.
How will Europe be affected?
A rapid re-balancing would probably result in a surge in China’s trade surplus, which would be very difficult for Europe. A slow re-balancing would probably result in a contraction in China’s trade surplus, which will help Europe.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Guosen Securities (HK), a Shenzhen-based investment bank. Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt. Pettis has been a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. Pettis was born in Málaga, Spain to a French mother and an American father. He spent his childhood in Peru, Pakistan, Tunisia and Haiti, before returning to Spain for High School. Pettis received a Masters of International Affairs in 1981 and a Masters of Business Administration in 1984, both from Columbia University. He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University. His new book, “The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy,” was published in January 2013. He is also co-author of the recently published “After the Fall, The Future of Global Cooperation: Geneva Reports on the World Economy.” He was founder and co-owner of the iconic punk-rock nightclub D22 in Beijing, which closed in January 2012.
He can be followed at his blog http://www.mpettis.com.