Speaker 1: Hello, and welcome to another episode of the Odd Lots podcast.
Speaker 1: I'm Joe Wasn't Thal and I'm Tracy halliway, so, Tracy.
Speaker 1: We've been talking about China a fair amount, obviously on
Speaker 1: the podcast. We did that great episode on Evergrand with
Speaker 1: Travis LUNDI. We've been talking about how some of the
Speaker 1: reforms UM fit in with the broader vision with Isabella Vaber,
Speaker 1: some of the uh tech and other industrial policy changes
Speaker 1: with Dan Long. But it still feels like we haven't
Speaker 1: quite like I guess I would say, put all of
Speaker 1: the macro pieces together. No, I don't think we've connected
Speaker 1: the dots between all of those different developments and UM
Speaker 1: and talked about their actual impact on the economy. And
Speaker 1: I mean, I don't know. To me, the big question
Speaker 1: around all of this UM, you know, what's happening in
Speaker 1: the property market right now with Evergrand, and what's been
Speaker 1: happening with the tech crackdowns and various other crackdowns. To me,
Speaker 1: it's just the timing. You know, why decide to do
Speaker 1: all of this right after a global pandemic when you
Speaker 1: could argue that economic recovery might be relatively fragile. And again,
Speaker 1: like we're sort of seeing the impact in the property
Speaker 1: sector now, right, So China introduce this three red lines
Speaker 1: policy last year in order presumably to strengthen its real
Speaker 1: estate market. Um, and fast forward, you know a year later,
Speaker 1: it seems like that's actually caused quite a lot of tensions. Um.
Speaker 1: So yeah, I don't know. To me, it's it's still
Speaker 1: sort of a mystery. Yeah, And there's some interesting things
Speaker 1: so like even take ever Grand for example, And obviously
Speaker 1: there are the sort of like initial effects like okay,
Speaker 1: who is going to be left holding the bag for
Speaker 1: the losses? And I think that's still TVD right, Like
Speaker 1: we don't really know how these sort of like economic
Speaker 1: losses will be distributed among creditors, among regional finance chiefs,
Speaker 1: among people who may have put down a down payment
Speaker 1: for a home and so forth. And then there's sort
Speaker 1: of like limits of like macro impact. And you read
Speaker 1: these stories about commodities piling up in places where the
Speaker 1: home real estate development is slowing and rebar and other
Speaker 1: assets piling up, and so okay, then there's a commodity spillover, etcetera.
Speaker 1: And you know it's interesting you mentioned like why now
Speaker 1: and of course, coming out of the two thousand and
Speaker 1: eight two thousand nine Great Financial Crisis, China was seen
Speaker 1: as like one of the demand engines of the world
Speaker 1: like these, so much of the demand was coming from China.
Speaker 1: Very different dynamic right now from a sort of global
Speaker 1: spillover standpoint where there is a lot of global demand
Speaker 1: for Chinese goods, but not a huge demand impulse it
Speaker 1: would seem coming from China itself. Yeah, so we kind
Speaker 1: of need to have two conversations. So we need to
Speaker 1: talk about what all these recent developments actually mean for
Speaker 1: China's economy domestically, and then of course we have to
Speaker 1: have even bigger conversation about what those changes actually mean
Speaker 1: for China's role in the global economy. Absolutely, and there's
Speaker 1: one of their twists and all this, which is it's
Speaker 1: there's this global energy crisis right now and natural gas
Speaker 1: prices are surging and China is not escaping that. In
Speaker 1: fact that China energy prices are surging in China and
Speaker 1: the sort of curbs and energy consumption, and that don't
Speaker 1: fully understand how that what's going on, or how that
Speaker 1: plays into it. Anyway, we have the perfect guest, I believe,
Speaker 1: to talk about the domestic impacts than the global ramifications.
Speaker 1: He's been on Odd Lots several times. We had to
Speaker 1: get him back. At this moment, we're going to be speaking,
Speaker 1: of course, to Michael Pettis, finance professor Taking University and
Speaker 1: the scholar at the Carnegie Endowment, and of course the
Speaker 1: co author of the book last year, Trade Wars Are
Speaker 1: Class Wars. Professor Pettis, thank you so much for coming
Speaker 1: back on Odd Lots. My pleasure is old. Well, let's
Speaker 1: just start with I guess this sort of like I guess,
Speaker 1: I would say, the first order effects, and we'll probably
Speaker 1: get into second and third and fourth order effects. But
Speaker 1: you know, the big news obviously, Ever, grand we don't
Speaker 1: really know how that story is going to play out,
Speaker 1: kind of like I said at the beginning, they're going
Speaker 1: to you know, we don't know how the economic losses
Speaker 1: from that implosion will be distributed. But what is your
Speaker 1: view sort of a big picture of what that means
Speaker 1: for the Chinese economy, sort of the most straightforward take
Speaker 1: you have, Well, I'd say two things. The first thing
Speaker 1: is that I think the macro view is the is
Speaker 1: the right way to look at it. Ever, Grand d Ever,
Speaker 1: Grand Da in and of itself is uh, you know,
Speaker 1: pretty important, pretty painful, but it's much more important as
Speaker 1: a as a symptom of what we've been seeing. The
Speaker 1: latest round of defaults in China didn't start with ever Grande.
Speaker 1: You could argue that they started in May two thousand
Speaker 1: nineteen with bao Chang Bank, and since then we've had
Speaker 1: a series of very important defaults that have all been
Speaker 1: resolved by the regulators. Um I wouldn't even say ever
Speaker 1: Grande is the most important. I think Hurong is probably
Speaker 1: the most important, and you could also argue that h
Speaker 1: n A and and perhaps uh ping On in the
Speaker 1: future are also more important in terms of size. But
Speaker 1: what really matters about ever grand is not so much
Speaker 1: ever grand but what the property sector represents for China.
Speaker 1: I'm sure you know all the figures they've been they've
Speaker 1: been much repeated recently, but to go through them, the
Speaker 1: property sector, including upstream, upstream and downstream businesses, comprises between
Speaker 1: twenty five and thirty percent of China's GDP, probably closer
Speaker 1: to thirty than to five, and that's roughly twice what
Speaker 1: you would expect in other countries. Real estate investment is
Speaker 1: about thirteen percent of China's GDP. So that's about one
Speaker 1: third of total investment in China, and as you know,
Speaker 1: investment in China is extraordinarily high. It's roughly of g
Speaker 1: d P. In other countries, real estate investment is a
Speaker 1: much lower share. I think in the US it's roughly
Speaker 1: five So when you look at the direct impact of
Speaker 1: a slowdown in the property sector, the numbers are pretty scary.
Speaker 1: They're they're quite large. They represent a very significant part
Speaker 1: of the Chinese economy, and they represent perhaps thirty to
Speaker 1: forty pcent of growth and years. But there's another thing
Speaker 1: that matters a great deal, which may even matter more
Speaker 1: will see, and that is when you look at household wealth.
Speaker 1: Holmes homeownership represents roughly eighty percent of household wealth in China,
Speaker 1: and I've been trying to look at other numbers. This
Speaker 1: is more than twice what it represents in most other countries.
Speaker 1: But I was looking at Japan during the during the
Speaker 1: bubble of the of the late nineties, and there it
Speaker 1: represented I believe roughly sixty of household wealth, which at
Speaker 1: the time was considered a really high number. In China,
Speaker 1: of course, it's much higher than that. And the reason
Speaker 1: that matters, of course, is that if you start to
Speaker 1: see a decline in the price of homes um that
Speaker 1: will very significantly impact household wealth, which in turn should
Speaker 1: significantly impact household consumption. Is things. Yeah, I remember one
Speaker 1: of our previous guests, Travis Lundie, also mentioned that Japan
Speaker 1: bubble comparison. But okay, so here's my one big question
Speaker 1: about what's going on with China property and with ever grants.
Speaker 1: So a lot of people are talking about some of
Speaker 1: the current stresses being caused by the three Red Lines
Speaker 1: program that China introduced last year, where it was trying
Speaker 1: to encourage a lot of real estate developers to delever
Speaker 1: their balance sheets and not to cross um certain thresholds
Speaker 1: for borrowing. I guess, on the one hand, it makes
Speaker 1: some sense for China to try to shore up and
Speaker 1: de leverage its real estate sector because, as everyone knows,
Speaker 1: it is quite heavily indebted. It is very very financialized.
Speaker 1: But on the other hand, given real estates importance in
Speaker 1: the economy, which you, of course just described, it seems
Speaker 1: like a risky proposition to start ring fencing it at
Speaker 1: an economically sensitive time. So I guess my question is
Speaker 1: why did the authorities decide to do it. And then secondly,
Speaker 1: what impact do you think that program has had on
Speaker 1: the property sector overall. It's difficult to figure out why
Speaker 1: the timing, but but I'm not even sure that that matters.
Speaker 1: What I would argue is that the three red lines
Speaker 1: which were announced last year are sort of the trigger
Speaker 1: for ever Grands problems, but they're not really the cause
Speaker 1: of the problems. You know, We've discussed this many times
Speaker 1: before over the past several years, and and the problem
Speaker 1: in China was that you have two types of growth
Speaker 1: in China. You have what Beijing has been calling high
Speaker 1: quality growth, which is really consumption exports and business investment
Speaker 1: oriented towards consumption and exports. That's what I would call
Speaker 1: the sustainable growth, the real underlying growth in the economy.
Speaker 1: And then you have what I would call residual growth,
Speaker 1: which is really investment in the property sector and local
Speaker 1: government spending on infrastructure. And the purpose of that residual
Speaker 1: is to bridge the gap between the real underlying growth
Speaker 1: in China and whatever the GDP growth target is, which
Speaker 1: has always been much higher, in my opinion, at least
Speaker 1: twice the real underlying growth. And I would say that
Speaker 1: at this point, even Shi Jin Ping, the President is
Speaker 1: starting to think this way. In a very important essay
Speaker 1: that he published in July on the New Development Model,
Speaker 1: he talked about the difference between genuine growth and fictional growth,
Speaker 1: and he said, not surprisingly, we need more genuine growth
Speaker 1: and less fictional growth. So what's the problem with the
Speaker 1: fictional grow? Well, when you're when you're borrowing money to
Speaker 1: invest in nonproductive investment than by definition, your debt servicing
Speaker 1: needs your debt, your debt is going to rise faster
Speaker 1: than your debt servicing capacity. And this has been the
Speaker 1: problem in China for well over a decade. And so
Speaker 1: as debt rose, in fact, the growth in debt accelerated
Speaker 1: in the growth and GDP decelerated, That created more and
Speaker 1: more of a debt problem for China, and it was
Speaker 1: just a question of time before Beijing decided to step in.
Speaker 1: They postponed it for a very, very long time, because
Speaker 1: the costs of not stepping in are in the future,
Speaker 1: and the costs of stepping in are in the presence.
Speaker 1: So it's always been easy to postpone the problem and
Speaker 1: hope that something develops. But of course the longer you
Speaker 1: postpone it, you know the costs of both rise, but
Speaker 1: the costs of not intervening rise faster than the costs
Speaker 1: of intervening, and at some point um they were going
Speaker 1: to step in and try to constrain the growth in UM,
Speaker 1: in in in local government debt, and in the property sector.
Speaker 1: And they focus mostly on the property sector. UM So
Speaker 1: if this didn't happen this year, it would have happened
Speaker 1: next year, or could have happened last year. I think
Speaker 1: the timing is less important then the mechanics that that
Speaker 1: that required that eventually that would happen. It definitely sounds
Speaker 1: like she J and Pag has been reading the Michael
Speaker 1: Petter's blog, because of course you've been talking for years
Speaker 1: about this idea of g d P in China, I guess,
Speaker 1: meaning something different than GDP elsewhere. And so where is
Speaker 1: in say the US or elsewhere GDP is like you
Speaker 1: add up everyone's income. In China, they start with the
Speaker 1: GDP target, it would seem, and then they work towards
Speaker 1: them and they figure out how either through high quality
Speaker 1: growth or sort of like manufactured credit driven growth. There's
Speaker 1: a lot of things to unpeel there, and I want
Speaker 1: to get into the sort of life the prospects for
Speaker 1: the high quality growth. But one thing that came up
Speaker 1: in our episode with Travis Lundy and you mentioned it
Speaker 1: just now, I want to hit on it. Um. You know,
Speaker 1: the importance of real estate sales or the selling of
Speaker 1: land specifically for regional government revenue. And you mentioned regional
Speaker 1: government debt. And so if the property developers have to
Speaker 1: pull back and they start buying less land from the
Speaker 1: regional government, can you talk to us about the knock
Speaker 1: on effects and the structure of regional government finance in
Speaker 1: China and what that means if we do get for them,
Speaker 1: for those regional governments, if we do get this pull back,
Speaker 1: and is there some other structure of regional finance that
Speaker 1: may emerge in its wake. That's a very important and
Speaker 1: very interesting and also very complicated U point. What I
Speaker 1: would argue is that in a way, it was the
Speaker 1: way this thing had to develop. Let me let me
Speaker 1: digress a bit and talk a little bit about common
Speaker 1: prosperity is you know, that's the new buzz phrase, um
Speaker 1: that everybody uses, everybody invokes to explain everything. The way
Speaker 1: common prosperity works is that Beijing has decided that in
Speaker 1: order to resolve the over the over dependence on nonproductive investment.
Speaker 1: They have to increase the consumption share of GDP, and
Speaker 1: we've known this for many years. The first time they
Speaker 1: said this formally in public was way back in two
Speaker 1: thousand seven, but they've never been able to do it
Speaker 1: the way Common Prosperity seems to be working. As they're saying,
Speaker 1: the problem is that there is a very uneven distribution
Speaker 1: of income among Chinese households. The rich have too large
Speaker 1: a share, and the ordinary and poor have too low
Speaker 1: a share, and that's why consumption in China is so weak.
Speaker 1: So here is what we're going to do. We're going
Speaker 1: to implement policies that transfer income or transfer wealth from
Speaker 1: the rich and perhaps from businesses to the extent that
Speaker 1: businesses have quote unquote excess profits back to ordinary Chinese
Speaker 1: and that will boost consumption in China. Now that's technically true,
Speaker 1: but there's two big problems with it. The first problem
Speaker 1: is their concept of this gets a bit technical, but
Speaker 1: tertiary distribution in Chinese jargon, there are three forms of distribution.
Speaker 1: There is primary distribution, which is wages, salaries, income on
Speaker 1: your on your savings, et cetera. Distribution of income to households.
Speaker 1: So primary is wages and salaries. Secondary or redistribution are
Speaker 1: is fiscal transfers. And then they have this third thing
Speaker 1: which most of us would have never considered, which they
Speaker 1: call tertiary distribution, which consists of donations from the rich
Speaker 1: to the poor. So common prosperity relies a little bit
Speaker 1: on secondary distribution on fiscal transfers, but it relies primarily
Speaker 1: on tertiary distribution donations. So why is that well, I
Speaker 1: would argue that this was in a in a sense,
Speaker 1: the problem with the dual Circulation program. The dual Circulation program,
Speaker 1: which was introduced last year, argued that that China would
Speaker 1: use its strength in exports and its strength and consumption
Speaker 1: and growing consumption to reinforce each other and to drive
Speaker 1: manufacturing in China into the future. The problem with dual
Speaker 1: circulation is that China's exports strength and its large current
Speaker 1: account surplus. Large trade surplus is caused mainly, as it
Speaker 1: is in every country with large surpluses Japan, Germany, South Korea, etcetera.
Speaker 1: It's caused mainly by the relatively low wage share UH
Speaker 1: relative to productivity. So you're good in exports because your
Speaker 1: wages are low relative to productivity. But of course, as
Speaker 1: you know, that's exactly why consumption is so low. So
Speaker 1: the idea that you could solve both problems was always
Speaker 1: pretty complicated. If you want to solve if you want
Speaker 1: to increase exports, you have to keep wages low relative
Speaker 1: to productivity. If you want to boost domestic consumption, you
Speaker 1: have to raise wages relative to productivity. So how do
Speaker 1: you do that? Well, in a sense, Common Prosperity is
Speaker 1: an attempt to address that, because rather than way raise wages,
Speaker 1: which would undermine export competitiveness, you do so by forcing
Speaker 1: the rich to redistribute income to the poor in the
Speaker 1: form of donations. Now will that work there? There, As
Speaker 1: I said, two problems with it. The first problem is
Speaker 1: that donations are a tiny part of the economy. My
Speaker 1: calculation was that donations represented about three tenths I'm sorry,
Speaker 1: three hundreds of one percent of GDP. So let's say
Speaker 1: that China is able to multiply donations by ten, which
Speaker 1: I think is going to be quite difficult. That's less
Speaker 1: than one third of one percent of g d P.
Speaker 1: And while that helps at the margin, they need to
Speaker 1: redistribute two to three percentage points of of of g
Speaker 1: d P every year to really resolve that problem. So
Speaker 1: that's the first problem with Common Prosperity. The second problem
Speaker 1: with Common Prosperity is that they're trying to solve the
Speaker 1: American problem in China or the European problem in China.
Speaker 1: And by that I mean, if you think that there
Speaker 1: is a bad distortion in the way income is distributed
Speaker 1: in the US, and I think there is an I'm
Speaker 1: sure you agree, then the place you resolve that is
Speaker 1: within the household income share of GDP, which comprises roughly
Speaker 1: of the U S g d P. So if you
Speaker 1: can redistribute income from rich to poor, then you are
Speaker 1: significantly resolving the income distribution problem in the United States.
Speaker 1: But in China, household income is only fifty of g
Speaker 1: d P. The real distortion is the very high government
Speaker 1: share of g d P, which is perhaps twenty percentage
Speaker 1: points in the US and in Europe as much closer
Speaker 1: to zero, could even be negative. So what I would
Speaker 1: argue is that Common Prosperity solves the wrong problem. There
Speaker 1: is certainly huge income inequality within China, but the real
Speaker 1: distortion and distribution is the very high share government retains
Speaker 1: of g d P. So if you want to solve
Speaker 1: that problem, what you really have to do is transfer
Speaker 1: income from local governments to the household sector. Now, you
Speaker 1: asked about the impact of property on local government revenues,
Speaker 1: and as you know, it's a really important part of
Speaker 1: local government revenues between forty and six for you know,
Speaker 1: depending on which local government. So perhaps by by undermining
Speaker 1: the property sector, this is also part of this process
Speaker 1: of reducing the the income share local governments retain of
Speaker 1: g d P and and presumably passing it onto the
Speaker 1: household sector. So theoretically it makes sense, but you know,
Speaker 1: the obvious the obvious concern is that that's a really
Speaker 1: difficult process to manage and that has huge political implications.
Speaker 1: So we'll see how those political implications evolved. You know.
Speaker 1: The one theme that emerges from this discussion is the
Speaker 1: idea of adjustment or trade off. You know, you try
Speaker 1: to resolve or adjust the economy now in order to
Speaker 1: avoid bigger problems later on. But of course that kind
Speaker 1: of change ends up being um probably painful and at
Speaker 1: the very least uncomfortable. So what can China actually do?
Speaker 1: What can the authorities do to try to ease the
Speaker 1: adjustment process and avoid stirring up you know, a lot
Speaker 1: of public anger. You mentioned how much household wealth is
Speaker 1: actually tied to property, and of course we have seen
Speaker 1: some protests over losses tied to China ever grand from individuals.
Speaker 1: So what can China do to sort of manage process?
Speaker 1: You know, Tracy the Unfortunately, I think there is there
Speaker 1: is no way to manage it. Well. The options are
Speaker 1: between bad and and and worse. You know, this is
Speaker 1: what I've been arguing for many years. The longer you
Speaker 1: postpone it, the more difficulty adjustment is going to be.
Speaker 1: And the way I think about it sort of helps
Speaker 1: me think about it is, you know, you look at
Speaker 1: the existing growth model, and you look at the various
Speaker 1: alternatives you have to resolving this growth model. So right now,
Speaker 1: as you know, China has a growth model in which
Speaker 1: you're able to maintain high GDP growth rates only because
Speaker 1: of this explosive growth in debt. So what can China do?
Speaker 1: There are literally five paths it can take. One path
Speaker 1: is to do nothing and continue with this growth model.
Speaker 1: If you have infinite debt capacity, then that works. But
Speaker 1: I think most of us agree that you don't, and
Speaker 1: in fact, Beijing, uh seems to believe very strongly that
Speaker 1: you don't. So what else can you do? Well, you
Speaker 1: can bring down all of this nonproductive investment. You have
Speaker 1: to if you want to stop the growth in debt.
Speaker 1: So what happens if you bring down nonproductive investment, Well,
Speaker 1: perhaps you can replace it with another source of demands.
Speaker 1: So one source of demand could be productive investment. So
Speaker 1: switch out of you know, don't build bridges to nowhere
Speaker 1: and don't build empty apartment buildings and use that money
Speaker 1: to develop the high tech sector and productive sectors in
Speaker 1: the economy. That's much easier said than then. They've been
Speaker 1: talking about this for years and years, and later on,
Speaker 1: if you like, we can go into why. It's going
Speaker 1: to be very difficult, but at least that's one possible path.
Speaker 1: Another possible path as you bring a nonproductive investment down
Speaker 1: is to increase the trade surplus. But of course, you know,
Speaker 1: if we were talking about Singapore, that would be viable,
Speaker 1: but for a big economy like China, that's not viable.
Speaker 1: The trade surplus would have to grow by two to
Speaker 1: three percentage points of China's GDP every year for that
Speaker 1: to be the way out, and clearly the world can't
Speaker 1: absorb that. A third way is to bring down nonproductive
Speaker 1: investment and to increase consumption, and that requires really significant
Speaker 1: income transfers, primarily from the local government sector. And then finally,
Speaker 1: the only other path China can take is to bring
Speaker 1: down nonproductive investment and not replace it with other sources
Speaker 1: of growth, in which case GDP growth drops substantially. I
Speaker 1: would argue probably to below two to three. But that's
Speaker 1: literally it. There are no other options. And when you
Speaker 1: think about it that way, it's very hard to figure
Speaker 1: out what is a good way, what is a good
Speaker 1: ustment process. They're all going to be quite difficult. That
Speaker 1: that's very well laid out and striking of what you
Speaker 1: characterize the sort of I guess the true rate of
Speaker 1: growth when you stirp about the non nonproductive investment spending.
Speaker 1: You know, obviously, and we've talked about this with Dan
Speaker 1: Wong and some of China's industrial or tech ambitions, and
Speaker 1: we used to talk about it with the brad sets
Speaker 1: Are a lot before he joined the administration, and so
Speaker 1: now we can't talk to him anymore. But obviously, like one,
Speaker 1: you know, one path is just the economy becomes much
Speaker 1: more productive and you get much more high quality growth
Speaker 1: than China becomes a bigger leader in you know, wide
Speaker 1: body airplanes and micro chips and pharmaceuticals and all kinds
Speaker 1: of things like that, and theoretically that helps balance the
Speaker 1: economy towards something more productive. That's a long term project, though,
Speaker 1: So even if that's the type of thing that it's like, Okay,
Speaker 1: that's the path, and obviously that can't happen overnight or
Speaker 1: even next year or maybe even over the next uh
Speaker 1: ten years. How much, though, do you sense or do
Speaker 1: you believe that Beijing is sort of like betting on
Speaker 1: that path that ultimately that it can sort of do
Speaker 1: some sort of substitution from the more speculative growth to
Speaker 1: the more high quality growth in some reasonable time framet.
Speaker 1: It depends on you know, which part of Beijing you're
Speaker 1: talking about. I think the local government politico's, the foreign
Speaker 1: affairs people, the military people, the non the non economists
Speaker 1: think that that's the obvious way out. I think, you know,
Speaker 1: when you speak to people at the Central Bank, or
Speaker 1: or at the various regulators, or many of the economists
Speaker 1: that are a policy making advisors, I think there's much
Speaker 1: less optimism that that that that's the way out. But
Speaker 1: I would say I would say two things, you know.
Speaker 1: The first is that this is a really tough thing
Speaker 1: to do. We don't really know why. It is that
Speaker 1: some countries are very good at, you know, the very
Speaker 1: advanced commercially sustainable advanced technology. But I would argue that
Speaker 1: success in the past doesn't necessarily equate the success in
Speaker 1: the future, because when you have highly centralized governments and
Speaker 1: a very clear target, a very clear goal, the highly
Speaker 1: centralized governments are probably better than decentralized, bottoms up type
Speaker 1: of societies and achieving those goals when you are hugely
Speaker 1: under invested in you know, you need to build lots
Speaker 1: of bridges and subways and and and and trains and airports, etcetera.
Speaker 1: That's fine. A certain type of centralized approach may be
Speaker 1: very efficient, but when you take that next step of
Speaker 1: sustainable commercially sustainable advanced technology, it seems like you need
Speaker 1: much more of a bottoms up approach. So maybe it'll work,
Speaker 1: maybe it will not work. We don't really know. But
Speaker 1: the other issue I would argue that we always forget
Speaker 1: is that there is a cost to following a growth
Speaker 1: model where you have an artificially boosted g d P,
Speaker 1: and I recently used the word that Gal Brave came
Speaker 1: up with with with modifications, the word bezel to represent
Speaker 1: the huge gap between wealth, real wealth and perceived wealth.
Speaker 1: And you know this gap is enormous in China. But
Speaker 1: just think in terms of real estate. The total value
Speaker 1: of real estate in China is worth twice what it
Speaker 1: is in the US, more than twice what it is
Speaker 1: in the US, and more than three times what it
Speaker 1: is in Europe. So that means there is a perception
Speaker 1: of enormous amounts of wealth that that are probably not real.
Speaker 1: The real value if you assume the US is correctly valued,
Speaker 1: which is a pretty heroic assumption, then the real value
Speaker 1: of China his real estate should probably be between two
Speaker 1: thirds and and and one times US real estate. So
Speaker 1: there's this huge amount of perceived wealth that doesn't really exist.
Speaker 1: And what we've seen in the past is that during
Speaker 1: the adjustment period that wealth gets amortized and those losses
Speaker 1: have to be distributed within the economy, and that causes
Speaker 1: a couple of things. First of all, it's slow, it
Speaker 1: it becomes a negative, it becomes a drag on GDP growth.
Speaker 1: Whereas before it boosted GDP growth. And secondly, and perhaps
Speaker 1: more importantly, is that when we're all feeling richer, we
Speaker 1: tend to spend more and animal spirits tend to be brighter, brisker.
Speaker 1: But as we start getting poor, as all of that
Speaker 1: bezel or false wealth gets amortized, that changes the behavior
Speaker 1: of the economy, typically in adverse ways, which is why
Speaker 1: I would argue that every country that's experienced an investment
Speaker 1: driven growth bubble has always had a surprisingly difficult adjustment.
Speaker 1: Now that doesn't mean that has to happen in the
Speaker 1: case of China, but unless we can figure out why
Speaker 1: that won't happen in the case of China, then I
Speaker 1: think the safest assumption is to assume that it will happen.
Speaker 1: So there's another thing that's complicating, Um what you know
Speaker 1: you just described as an already painful adjustment process, But
Speaker 1: that has to be the energy crisis that China is
Speaker 1: currently experiencing. Um you know, there have been electricity shortages,
Speaker 1: restrictions on power consumption, and of course a similar thing
Speaker 1: is going on in Europe. So China isn't necessarily alone
Speaker 1: in facing these pressures. But again, it seems to be
Speaker 1: coming at a pretty inconvenient time when the economy is
Speaker 1: already dealing with things like everground and the slowdown in
Speaker 1: real estate. So I guess my question is, how do
Speaker 1: you see the energy crisis um impacting the adjustment process
Speaker 1: that you described and how big a deal is it
Speaker 1: for China's overall economy. Well, it certainly doesn't help, and
Speaker 1: I think it was probably, you know, in retrospect, we
Speaker 1: probably should have seen it coming, based you know, basically
Speaker 1: on the high school economics. One of the things that
Speaker 1: happened in China is that as the input prices in
Speaker 1: the energy sectors sword coal and oil, et cetera, the
Speaker 1: output prices didn't because they're heavily restricted, heavily constrained by
Speaker 1: local governments. So you're only able to raise electricity prices
Speaker 1: a little bit, often by no more than ten So
Speaker 1: the power companies were in this very difficult position in
Speaker 1: which their inputs, the price of their inputs were soaring
Speaker 1: and the price of their output was pretty stable, and
Speaker 1: so they began to making very very large losses. And
Speaker 1: somehow that has to be that has to be addressed.
Speaker 1: In one way is heavily to subsidize those losses and
Speaker 1: another way is through rationing. You you'll remember from again
Speaker 1: from high school economics, that if you don't allow prices
Speaker 1: to rations supply and demand, then supply and demands gets
Speaker 1: you know, gets matched, either in the form of shortages
Speaker 1: or in the form of excesses. And in this case,
Speaker 1: because there was no adjustment on the demand side, prices
Speaker 1: didn't go up, but a huge adjustment on the supply
Speaker 1: side where prices went up a lot, then inevitably we
Speaker 1: had to deal with it in the form of rations,
Speaker 1: of rationing, of of of a scarcity. So the question
Speaker 1: then becomes what does China do next? And my way
Speaker 1: is I'm not very good at predicting, so what I
Speaker 1: try to figure out is what are the ways it
Speaker 1: can react. One way is to allow electricity prices to
Speaker 1: rise substantially. That will have a significant impact obviously on
Speaker 1: on manufacturing productivity and on consumption to Another way is
Speaker 1: for the government to subsidize the loss is borne by
Speaker 1: the power companies, which of course means debt continues to grow.
Speaker 1: And then the third way is to force the power
Speaker 1: companies to eat the losses, which is really very similar
Speaker 1: to the government doing it. So there's not really a
Speaker 1: good way. If energy prices come down substantially, then that
Speaker 1: problem resolves itself. But if it doesn't, I think the
Speaker 1: most likely thing China will do is to continue effectively
Speaker 1: to subsidize energy prices to the manufacturing sector and to
Speaker 1: two households. But remember that subsidies aren't free. Subsidies are
Speaker 1: just transfers, and the way that typically has worked in
Speaker 1: the past is that these transfers to the manufacturing sector,
Speaker 1: which is what it means when you subsidize electricity prices
Speaker 1: are indirectly born by the household sector. So that hurts
Speaker 1: the rebalancing process, right when you subsidize the manufacturing sector
Speaker 1: at the expense of the household sector, necessarily exports will
Speaker 1: become more competitive, but domestic consumption will be weaker, So
Speaker 1: China once again has to face that trade off. The
Speaker 1: idea that you can do things that are good for
Speaker 1: both exports and domestic consumption is simply wrong. You can
Speaker 1: you have to choose one or the other, and we
Speaker 1: know that they believe they have to choose consumption. But
Speaker 1: it's very hard to hurt the exports sector. So you know,
Speaker 1: obviously energy is a good chance to pivot to sort
Speaker 1: of a more global conversation. But there's one other dynamic
Speaker 1: I'm sort of curious your take on, and actually I
Speaker 1: don't know if you have it take on it even
Speaker 1: but I am curious. So with with a lot of
Speaker 1: these energy and power issues that we've seen, there's an element,
Speaker 1: it seems of this sort of mobal transition to more
Speaker 1: sustainable forms of energy, and maybe certain types of cleaner
Speaker 1: energy haven't come online as fast as other types of
Speaker 1: dirtier energy have come offline, leaving us in a position
Speaker 1: where certain types of transition fuels like natural gas end
Speaker 1: up becoming very scarce. And obviously, you know, we know
Speaker 1: in Europe they seem to take climate issues pretty seriously,
Speaker 1: and sometimes like a Davos, we get the impression that
Speaker 1: China takes climate issues very seriously and wants to come
Speaker 1: off coal as a source. But I you know, as
Speaker 1: an outsider, I never have a great sense of how
Speaker 1: much of that is very serious priority climate in Beijing
Speaker 1: versus how much is it makes for good headlines at
Speaker 1: global events. What is your sense of the degree to
Speaker 1: which leadership in Beijing really takes that issue seriously of
Speaker 1: changing the energy mixed to something that is perceived as
Speaker 1: being cleaner and more sustainable. I think Beijing is very
Speaker 1: serious about sustainable growth and about its impact on the environment.
Speaker 1: But you know, again, I'm I'm fairly pessimistic there in
Speaker 1: the sense that I believe, and not just in China
Speaker 1: and the US and in Europe and everywhere else. It's
Speaker 1: easier to be environmentally conscious when you're satisfied with growth.
Speaker 1: But when growth slows, it's it's it becomes much easier
Speaker 1: to push, you know, green concerns into the background. So
Speaker 1: I would argue that that's really what's going to drive
Speaker 1: environmental concerns in China and in the US and in
Speaker 1: the rest of the world. In a good economy, will
Speaker 1: resolve them, or will attempt to resolve them. In a
Speaker 1: bad economy, will focus more on generating growth. Well, why
Speaker 1: don't we widen the discussion even more now and get
Speaker 1: even more macro and talk a little bit about out
Speaker 1: China's role in the international economy or the global economy.
Speaker 1: So maybe just to begin with, I know you've done
Speaker 1: a ton of research into this topic, and you know,
Speaker 1: have even written an entire book on this, But how
Speaker 1: would you characterize China's role in recent years and where
Speaker 1: do you see it heading given the emphasis on adjustment
Speaker 1: that we've been talking about. Well, the way any country
Speaker 1: interacts with the rest of the world, and this is
Speaker 1: true of China, is obviously, by definition, through the balance
Speaker 1: of payments. UM. So what really matters is the extent
Speaker 1: to which China is able to reduce the gap between
Speaker 1: savings and investment. Right if savings exceed investment, China will
Speaker 1: be a net exporter of capital and will run a
Speaker 1: trade surplus. And you know what, what we've seen in
Speaker 1: the past year or two with with the pandemic is
Speaker 1: that while the pandemic was primarily, in my opinion, demand
Speaker 1: side problem, there were definitely supply side interruptions too, but
Speaker 1: it was mostly a demand side problem, and the US,
Speaker 1: in Europe and a number of other large economies treated
Speaker 1: it as a demand side problem. In China, the response
Speaker 1: to COVID nineteen was mostly in the form of supply
Speaker 1: side policies, so additional subsidies for manufacturing, more credit for manufacturing,
Speaker 1: which is a form of subsidy, etcetera, etcetera. Now, when
Speaker 1: that happens, you would expect that there's only two ways
Speaker 1: that the Chinese economy can absorb the resulting imbalance. One
Speaker 1: way is through increased domestic investment, which really meant residual
Speaker 1: investment and therefore nonproductive investment, and the other way is
Speaker 1: through a growing trade surplus. And needless to say, we've
Speaker 1: seen both China's trade surplus in the last year year
Speaker 1: and a half has grown to among the highest month
Speaker 1: lead trade surpluses we've ever seen. And at the same time,
Speaker 1: until very recently, we saw a significant increase in property development,
Speaker 1: which grew i think by seven percent last year while
Speaker 1: GDP only grew by two point three and in public
Speaker 1: sector infrastructure spending. So now the interesting question is what
Speaker 1: is the impact of the of the crisis and the
Speaker 1: property sector. Well, that should drive down property investment. So
Speaker 1: because there is no corresponding reduction in Chinese savings, if
Speaker 1: that's the only thing that happens in China, then almost
Speaker 1: by definition, the Chinese trade surplus should grow, because of course,
Speaker 1: if investment goes down, the gap between savings and investment
Speaker 1: will increase. That I think the Chinese are very worried about,
Speaker 1: and with good reason, because the rest of the world
Speaker 1: is unlikely to be very happy with a significant increase
Speaker 1: in the Chinese trade surplus. So there are only two
Speaker 1: other ways that that that adjustment can take place. One
Speaker 1: is through an increase in unemployment, which reduces the savings rate,
Speaker 1: but of course Beijing doesn't want to see that, So
Speaker 1: the only other resolution to that problem would be an
Speaker 1: increase in quote unquote other investment. And the only other
Speaker 1: investment Beijing could really push is public sector local government
Speaker 1: investment in infrastructure, and already there have been a series
Speaker 1: of announcements saying that that's exactly what they're going to do.
Speaker 1: So that's really the way I think about it. If
Speaker 1: China matches the reduction in property investment with an increase
Speaker 1: in infrastructure investment, then you really haven't solved the domestic problem,
Speaker 1: the domestic debt problem in China at all, but at
Speaker 1: least there won't be a significant balance of payments impact
Speaker 1: if they don't, if they try to constrain the growth
Speaker 1: in debt, then we should see either an increase in unemployment,
Speaker 1: which I think Beijing will do everything it can to prevent,
Speaker 1: or an increase in the trade surplus, which I think
Speaker 1: will be difficult for the rest of the world to absorb.
Speaker 1: Does that make sense? I try to set it out
Speaker 1: really schematically. Yeah, well, so this is and you know,
Speaker 1: kind of one of the weird things about right now.
Speaker 1: And I mentioned that we're sorry to talk about the
Speaker 1: outset in the post Great Financial Crisis environment. The sort
Speaker 1: of well not the perception of the reality is that
Speaker 1: China was this huge growth engine for the world and
Speaker 1: was driving a major contributor to the surgic commodity prices.
Speaker 1: I think the Bloomberg Commodity Index. It peaked in anyway,
Speaker 1: it's peaked again, the Bloomberg Commodity Index, and every day
Speaker 1: we're just sort of jaws dropped at the surgeon in
Speaker 1: various commodity prices. And I've been kind of surprised, however,
Speaker 1: that it's you know, obviously this time China is not
Speaker 1: playing the same role it has And I started off
Speaker 1: with that point, and it is a Bloomberg article that
Speaker 1: I read about ever Grand and the sort of the
Speaker 1: various construction materials that were just sort of lying dormant
Speaker 1: because it's falling behind on its production of real estate
Speaker 1: and so where it is. Previously, it seemed as though
Speaker 1: China was this sort of a major contributing positive impulse
Speaker 1: of the price of commodities. It feels like if anything
Speaker 1: this time around, that price of the surging price of
Speaker 1: commodities is a burden. Yeah, I would say what really
Speaker 1: matters is investment in the property sector is going down.
Speaker 1: I think I think we're all pretty much convinced that's
Speaker 1: that's happening and going to continue to happen. So what
Speaker 1: really matters is that whether it's balanced by an increase
Speaker 1: in public sector infrastructure spending. If it is, we'll just
Speaker 1: see a shift in commodity demand from one sector to another,
Speaker 1: and China will continue absorbing whatever forty of the global
Speaker 1: production of of of industrial commodities. If they don't, in
Speaker 1: other words, if they really do try to constrain the
Speaker 1: growth in debt, then we will see demand for industrial
Speaker 1: commodities go down. Eventually. That has to happen, Jo, I mean,
Speaker 1: there's no way China can continue absorbing roughly of everything
Speaker 1: that's produced. But is it going to happen now? I
Speaker 1: don't think so, because I think we're going to see
Speaker 1: uh an increase in the infrastructure spending side that will
Speaker 1: match the reduction in the property investment side. So I
Speaker 1: have one sort of big picture question in my mind.
Speaker 1: It actually maybe goes back to the more original part
Speaker 1: of the discussion, where we're talking about different modes of growth.
Speaker 1: It feels to me that over the course of my career,
Speaker 1: having you know, covered global markets in the economy, certain
Speaker 1: crackdowns on speculation in China happen or not that uncommon,
Speaker 1: and so you'll get, you know, for years it's like
Speaker 1: other China is doing this or that to encourage discourage
Speaker 1: the purchase of a third apartment, or they're doing this
Speaker 1: so that to crack down on online trading, and then
Speaker 1: it doesn't seem to go anywhere, and then somehow it
Speaker 1: emerges again. And I don't know if they're toothless or
Speaker 1: if they're not in force or whatever it is, but
Speaker 1: that is just my sort of outside perception. Is that
Speaker 1: is that accurate that this sort of this that China
Speaker 1: has made attempts in the past to sort of correct
Speaker 1: from the sort of poor growth to quality growth via that,
Speaker 1: And if so, would you say it's different this time
Speaker 1: in terms of the seriousness with which Okay, after all
Speaker 1: these years and these imbalances building up, that they're not
Speaker 1: just going to in sort of six months again be
Speaker 1: taking various measures to sort of stoke the property sector
Speaker 1: once again to ensure that household wealth and incomes remain elevated.
Speaker 1: I think they will um and I think because of
Speaker 1: a fundamental incompatibility. So why do you why do you
Speaker 1: have surgeon debt, why do you have speculative activity, etcetera, etcetera.
Speaker 1: One argument is because you've got bad apples and you've
Speaker 1: got to identify them and throw them out of the
Speaker 1: barrel as quickly as possible. That could be true. But
Speaker 1: the other argument is, and and it's the one obviously
Speaker 1: that I'm I'm much more comfortable with, is that there
Speaker 1: are systemic tendencies within the growth model that require all
Speaker 1: of this speculative activity, all of this bad debt, all
Speaker 1: these things that you don't want, And until you eliminate
Speaker 1: the source of that, then you're never really going to
Speaker 1: eliminate the bad actions by the bad actors. And so
Speaker 1: what I would say is that the fundamental incompatibility is
Speaker 1: that if you allow GDP growth to be equal to
Speaker 1: the real, healthy, underlying growth what what she didn't been
Speaker 1: called genuine growth, what they used to call high quality growth,
Speaker 1: then you don't need all of this stuff to happen.
Speaker 1: You don't need the rapid expansion in debt, the rapid
Speaker 1: expansion and the money supply, etcetera, etcetera. But as long
Speaker 1: as you have a GDP growth target that exceeds the
Speaker 1: real underlying growth in the economy, you have no choice.
Speaker 1: You have to The system has to be supported by
Speaker 1: moral hazard, because who in his right mind is going
Speaker 1: to lend into a project which has no chance of
Speaker 1: generating the debt servicing capacity needed to pay off the debt.
Speaker 1: You would only do so if you believe that you're
Speaker 1: guaranteed by either the local government or the central government.
Speaker 1: So without moral hazard, the GDP growth target doesn't work.
Speaker 1: And so as long as you have a GDP growth
Speaker 1: target that that exceeds the real underlying growth rate, you
Speaker 1: need moral hazard in the system. And as long as
Speaker 1: you have widespread moral hazard in the system, that necessarily
Speaker 1: you're going to get all of the speculative and inefficient behavior.
Speaker 1: So you can put as many people as you like
Speaker 1: in jail. But as long as you require a GDP
Speaker 1: growth rate that exceeds the real underlying growth rate, you
Speaker 1: will never get rid of the problem. I think that's
Speaker 1: a great spot to leave it. Michael, thank you so
Speaker 1: much for coming out an odd lot I really like
Speaker 1: the way with every question we ask, you're like, well,
Speaker 1: this could resolve in three or four ways, and there's
Speaker 1: always have clearly laid out, and I think got tied
Speaker 1: up a lot of the themes that we've been discussing
Speaker 1: in other episodes. I appreciate you coming back on Thanks show.
Speaker 1: It's the only way I can think about these things.
Speaker 1: I take care of Michael. Thanks Michael. It is very
Speaker 1: easy for me to imagine, and again I say this
Speaker 1: is an outsider without really much perspective, it's very easy
Speaker 1: for me to imagine in three months or six months
Speaker 1: per year, we're back to like real estate records, you know,
Speaker 1: real estate prices, hitting records and China and stories about
Speaker 1: real estate mania and all of this stuff about oh
Speaker 1: finally they bite, they bit the bullet and they took
Speaker 1: this big adjustment. Is having been another another head fake? Um,
Speaker 1: it's definitely a possibility. I mean you're sort of asking
Speaker 1: the classic is a different this time question? But I
Speaker 1: mean Michael's long running point, the more you put it off,
Speaker 1: the worse it's going to get. Right, And so I
Speaker 1: guess the question becomes is now a politically expedient time
Speaker 1: for China to be making that adjustment process. And I
Speaker 1: guess like I can kind of argue it both ways, right, So, like,
Speaker 1: on the one hand, China the economy is still recovering
Speaker 1: from the global pandemic. But on the other hand, China
Speaker 1: has come out of it relatively resilient compared to other countries.
Speaker 1: It's also still closed off from much of the world.
Speaker 1: You know, travelers can't really go in and out. There
Speaker 1: are some pretty heavy restrictions. Um it has a huge
Speaker 1: export boom at the moment, and so like maybe that
Speaker 1: isolation and that narrative of China successfully controlling COVID, maybe
Speaker 1: that's what makes it a particularly good time to sort
Speaker 1: of tackle some of these issues. And also, you know,
Speaker 1: tag on some sort of populous endeavors like uh, cutting
Speaker 1: education costs or having kids stopped playing so many video games.
Speaker 1: I mean, some of that makes sense. Yeah, I guess
Speaker 1: I go back and forth that you don't after speaking
Speaker 1: with Dan and Isabella, you know, it's like, oh, this
Speaker 1: is real. And then and then when Michael lays out
Speaker 1: it's like there are no good options, right, Like, there's
Speaker 1: not like some magic bullet that's going to create good
Speaker 1: growth to substitute for low quality, speculative growth, and I
Speaker 1: go back and forth. So I don't know. I'm glad
Speaker 1: it's not my job to have to make calls and
Speaker 1: I just get to talk to people. I just go
Speaker 1: back and forth. Oh, I thought you were gonna say.
Speaker 1: I thought you're gonna say, You're glad you're not a
Speaker 1: Chinese policymaker. But um, I guess for many reasons. Yeah, yeah,
Speaker 1: I'm glad I'm not a Chinese That also seems like
Speaker 1: gonna be stressful. All right, We're happy that we neither
Speaker 1: are we, you know, Chinese policymakers, nor do we have
Speaker 1: to make actual calls on China. But I mean I
Speaker 1: do think we are at an interesting juncture. I mean,
Speaker 1: at the risk of saying, you know, something very cliche like,
Speaker 1: it does seem to be an interesting time for the
Speaker 1: China economy and I am very, very interested to see
Speaker 1: where it actually goes. Well, we're going to be certainly
Speaker 1: doing more episodes, I'm sure. Yeah, shall we leave it there,
Speaker 1: Let's leave it there. Okay, this has been another episode
Speaker 1: of the All Thoughts Podcast. I'm Tracy Alloway. You can
Speaker 1: follow me on Twitter at Tracy Holloway, and I'm Joe
Speaker 1: wi isn't all. You can follow me on Twitter at
Speaker 1: The Stalwart. Follow our guest on Twitter, Michael Pettis. He's
Speaker 1: at Michael X Pettis. Follow our producer Laura Carlson. She's
Speaker 1: at Laura M. Carlson. Follow the Bloomberg head of podcast,
Speaker 1: Francisco Levi at Francesca Today, and check out all of
Speaker 1: our podcasts at Bloomberg under the handle at podcasts. Thanks
Speaker 1: for listening.