Pettis: 11 Reasons China Can’t Escape from Its Debt Overhang

Yves here. A certain amount of complacency has set in about China’s unsustainable economic model, simply because the Middle Kingdom has managed to stay a day of reckoning. I remember similar doubt fatigue setting in during the blowoff phase of the dot-com bubble. Even with more worrying sightings, such as distress in wealth management products (the riskiest part of China’s shadow banking system), many of the bearish sorts believe that China has enough control over its economy that it will engineer a soft landing. Yet it’s hard to ignore stories like these:

My last trip to Shanghai and surrounding cities and my earlier trip in November was eye opening. A couple of years before I was in Shenzhen China vising a PC Board manufacturer to discuss $160,000 in premium freight and scheduling charges which were partially our fault. In the end I recouped half which I thought was fair and made some good contacts

On the way in and out of Shenzhen, we passed an enormous outdoor mall of acres of store fronts unoccupied. Fast forward to 2013/14 and I found the same around Shanghai in Ningbo, Shuzhou, Wuzhen, Wuxi, Nanjing, Haimen, Hangzhou, etc. I am sure you have read about China building infrastructure to keep labor busy. They built ghost towns/malls and housing which the people can not afford. China built for GDP.

Michael Pettis has pointed out more than once that China resolved its last bank crisis of 2002-2003 by having households bear the cost, which led China’s consumption share of GDP to fall. That moves it further away from adjusting from being an export-driven economy to one where internal demand plays a much bigger role. Even though China’s export share has indeed fallen, what has taken its place is not consumer demand but an unheard-of level of investment, much of it in unproductive residential real estate.

Pettis works though some of the implications of China’s high (for an emerging economy) debt levels and how they might be resolved.

Cross posted from MacroBusiness

Exclusively from Michael Pettis’ newsletter:

1. GDP growth has been implicitly increased by the amount of losses that should have been, but were not, written down. This means that China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%.

2. In that case all GDP-related data is biased in a predictable way. Productivity numbers, for example, are biased upwards, and real worker’s productivity is lower than the numbers posted officially.

3. Losses that are rolled over do not disappear. They are implicitly amortized over the period of the loan, which, assuming that loans are rolled over indefinitely, means that every year a declining portion of that loan is effectively written down.

4. There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.

5. GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained.

6. My numbers above assume that the overstatement and understatement are symmetrical. In fact the process is not symmetrical because of the possibility of financial distress costs. The total value of overstated GDP during the period when losses are being rolled over is only equal to the total value of the subsequent amortization of those losses if there are no financial distress costs.

7. …We must also remember that the only way debt can be resolved is by assigning the losses, either during the period in which the losses occurred or during the subsequent amortization period. There is no other way to “resolve” bad debt – the loss must be assigned, today or tomorrow, to some sector of the economy. “Socializing” the debt, or transferring the debt from one entity to another, does not change this.

8. There are three sectors to whom the cost can be assigned: households, businesses, or the government.

9. …To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth.

10. …Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.

11. Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector.

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  1. beene

    I would suggest that the only problem with china’s economy is finding a method of creating a middle class. As it already controls currency creation much differently than the usa which lets the banking system control money creations which causes a debt burden in the usa.

    1. 12312399

      China does (or rather did) have a middle class…..they’re called American big box shoppers.

      unfortunately all those profits have been sucked up by the Chinese 0.5% and plowed into Hermes bags, Porsches and Vancouver real estate.

    2. Susan the other

      If China is really a communist economy, only dabbling in capitalism, then the people of the republic own everything anyway. If China is one big bankrupt corporation then just restructure the debt by trading it in for equity. Give away all those apartments to the zillions of Chinese still needing a better place to live. No paperwork necessary.

      1. rjs

        that’s the plan:
        China’s Ambitious Plan to Move 100 Million People From Farms to Cities: This week, Chinese authorities published the results of a long-delayed blueprint for how it will grow its cities—and its economy—by 2020. The plan is sweeping, ambitious, and dense, and it gives us a glimpse of China’s future. The crux of the plan? Move 100 million people—mainly, rural farmers—into cities by 2020. To accommodate them, China will start a massive push to develop better public infrastructure, from hospitals to schools to railways. According to the study’s authors, the whole idea is to bolster the flagging economy with an influx of new workers, new housing, new infrastructure, and new factories.

  2. rjs

    just to clarify something Pettis misconstrues…components of China’s GDP may not be paid for in use but they are real…GDP is just the total goods and services produced within the country, and though it’s conventionally denominated in dollars or yuan it’s really a measure of units of production over a given time period…an apartment building, whether its occupied or not or whether the developer may end up bankrupt or not, is still added to GDP just as would be an occupied building that’s making a profit for the developer…

    1. run75441


      This comment:

      “My last trip to Shanghai and surrounding cities and my earlier trip in November was eye opening. A couple of years before I was in Shenzhen China vising a PC Board manufacturer to discuss $160,000 in premium freight and scheduling charges which were partially our fault. In the end I recouped half which I thought was fair and made some good contacts.”

      I either posted it on NC or AB in answer to Edward Lambert.

      is mine. There is no developer involved in this unless you wish to consider the Chinese government to be the developer? This is all about keeping Labor busy digging up bottle of money buried previously by other Labor. As one Chinese Engineer said to me, “it is all about GDP and there is no interest in helping the poor. I looked at here and said; “so you understand this?”

      There is more to this besides apartments and malls. Consider factories.

    2. run75441


      Imagine building two complete factories at $1 billion a piece. The first being for casting and forging and the second being for machining. Each having several hundred thousand square feet. I was not able to take pictures of one forge in the facility as its design was proprietary. It had the ability to forge bearing castings > 2 meters. This particular forging facility will be used to manufacture all of the forgings for Asian bearing requirements as machined by 8 major bearing manufacturers.

      The machining facility does the bases for CNC equipment. It had the capability to machine parts on a bed 6 feet wide. The workers were standing on the bed as they machined a particular steel table top for us. They waited for our arrival to do so.

      Both of these plants were built with gov and private enterprise money. Both are no where near a capacity of 80% and are closer to 10% utilization. I can not imagine this being accomplished in the US as Repubs would have a fit. The bigger picture is this was built to keep people busy. It may be a boon to China and then again it may fail. t was also built with the idea Labor will continue to be cheap. Both of these plants were not built in Shanghai; but, they were built 100-200 miles out. We took the fast trains traveling at either 200 kmph or 300 kmph .

      These plants are basically empty and not utilized to the fullest extent. They are waiting for business to come to them. It will be a long time before they are at 89% capacity if they ever are and if business moves to a LCC. I think China is hanging ten off the edge of the board riding the surf. There is literally $billions riding on this gamble.

      In the mean time, I have some great sourcing alternatives and yes I am a god right now, Not the God; but, a god who could save a company money by the handful. These last 4 months have laid groundwork for me I did not have to offer before if it all remains stable. For a while, China will continue to fund this the same as apartments and empty malls until it proves a bad investment. Then it will go the way of other building sites we saw that never materialized completely.

    3. Stephen Upton

      Isn’t Pettis’ (rather obvious) point that the GDP of a country that invests $100 to create $0 in value is higher than that of a country that doesn’t, and yet wealth and debt repayment capacity are the same? I am pretty sure that is what he means by “overstated”, and not that China is secretly pretending to build empty apartments but really is not.

  3. Jim Haygood

    ‘China’s GDP today, compared to countries in which it is more difficult simply to roll over losses indefinitely, is overstated, and I suspect that it may be overstated by as much as 20-30%.’

    Rolling over losses indefinitely … where have we seen that movie before?

    Oh yeah … now it’s all coming back … JAPAN, post-1989. Year after year, Japanese banks just kept rolling over loans that were effectively secured by real estate … which spent three decades dropping 80% from its 1989 Bubble peak.

    And Japan went from a 1980s miracle economy to the dormant, deflation-plagued laggard of the G7 that couldn’t do anything right.

    If this happens to China, the BRICS are gonna need a total rethink. Not to mention the world’s largest debtor, Usgov.

    1. scraping_by

      OH? I thought Japan’s problems were converting its economy from a government-directed mercantile enterprise with a strong egalitarian bent to financial engineering by large corporations when the US economy could no longer support its export sector.

      Seen this way, maybe their zombie economy is just about as good as it can be.

  4. fajensen

    Couldn’t the China Communist Party set up an investment bank, staff it with all the dum-dums, misfits and corrupt apparatchiks they want to get rid off, load up the books with all the bad debt they can find and then, when it blows up, the debt is destroyed, the blame is safely pinned on the proper persons and the CPP is there to pick up the pieces with various social reforms?

    It IS a command economy still after all?

    1. Bam_Man

      I’m absolutely sure that is what they will wind up doing – in spades – at the first sighting of the wicked “deflation monster”.

      1. Lord Koos

        No doubt that is why China has been buying thousands of tons of gold, and encouraging private citizens to own it as well.

    2. scraping_by

      Right. Adoption of business accounting by a government gives misleading answers to pretty much all questions you ask.

      The debt overhang is really a question of use or misuse of national assets. The PRC government has chosen to create the outward evidence of a broad based middle class economy while keeping the vast majority of its population in serfdom. This works in supply side economics, which means it doesn’t work in the real world.

      The archreactionary economist von Mises spoke about creating the demand for a product by creating the product. This is magical thinking, or course, reversing cause and effect. The PRC has been trying this for the last decade and, of a wonder, the magic didn’t happen. The debt is just the mathematical expression of that real world surprise.

      The real story here is about the misallocation of resources. The outcome is a sovereign decision unconnected to any theoretical books balancing. Money is not about money.

  5. Min

    “A certain amount of complacency has set in about China’s unsustainable economic model, simply because the Middle Kingdom has managed to stay a day of reckoning.”

    No comprende, señora.

    What is a day of reckoning for China? What would it look like? Why is it inevitable under current Chinese policy?

    Last I heard China had somewhere around $1,000,000,000,000 in foreign debt, but has something like 3 times that stashed away. What is the problem? Furthermore, China’s exchange rate policy is becoming more flexible. They widened the range last month, right? What is the problem?

    Thanks. :)

    1. jm

      In buying the 3+ trillion dollars in foreign exchange reserves China holds, the government paid out more than 20 trillion yuan. But the 3+ trillion dollars aren’t, and never were, worth anything like 20 trillion yuan in actual buying power. Perhaps 5 trillion yuan? If so, those reserves represent in fact a loss of around 15 trillion yuan. That’s the difference between the value of the things the Chinese people worked hard to make and ship to us, and the value of the things they might someday buy with those dollars if they were ever to send them back to us (directly by buying our exports, or indirectly by buying the exports of another of our trading partners*).

      For a long time, the Chinese government was paying out 8.2 yuan to buy dollars worth about 1.9 yuan at purchasing power parity. That meant that China sustained a loss of 6.3 yuan for every dollar bought. The loss was real, and was a loss incurred the moment they bought the dollars, not, as so many think, one that might be incurred in the future in the event of a change in the yuan/dollar exchange rate. (Think about it — instead of paying out the yuan to buy the dollars exporters got from shipping those goods abroad, the government could have bought the goods and distributed them to the people, making China itself that much wealthier in real terms.)

      The actual effect of the Chinese government’s currency peg has been vendor financing fraud on a Brobingnagian scale.

  6. monday1929

    #9 of course fits the USA to a “T”, “significant hidden losses on banks balance sheets being assigned to the household sector thereby killing income growth and consumption”.

  7. craazyman

    This could be a huge opportunity.

    if China could pay millions of people to repair all the losses on the balance sheets, that could be a new source of growth. It’s like home renovation, but you don’t need raw materials and tools.

    They would have to repair them well, though. No faking it. Once they’re repaired, you’d have to have something else for the people to do or else there would be structural unemployment.

    Then, Maybe you could pay them to live in the ghost cities and pretend they’re middle class professionals acting in a huge movie that will be years in production. don’t laugh. Think about it and it will make your mind wobble in amazement at the strangeness of the way things are.

    1. craazyman

      things are really far stranger than almost anybody can possibly imagine. economics is only a minor and modest colonial outpost of strangeness, when the real empire of strangeness is the stuff every day you just don’t have the finely cultivated perception to allow you to see. You really have no idea. Unless you have a highly refined and trained perceptival and analytical consciousness. That takes quite a lot of open minded reflection, but when you reach the point you can see things as they are Then you just say Whoa! That’s strange.

      You’d need somebody like Cecil B. DeMille to direct the movie. You can call it “Fortune Cookie”. Well, that might not be politically correct. OK, you can call it “Yellow River by I. P. Freely” All right, that’s not funny. It was when I was 9 years old though. Like Spots on the Wall by Hu Flung Du. All right. How about “In Another Country”. That’s more Oscar material but it’s plagiarisim since Ernest Hemingway wrote a short story with that title. It’s a good title. But it would be true — if people decided to pretend they are something they are not in order to be that thing. It would be another country in the movie and in real life at the same time, life imitating performance art imitating life. In fact, that’s how things do work in real life, but more slowly and with much more frictions — that’s an economic term too. This would be friction free evolutionary strategies at work.

  8. Synopticist

    If there are 2 very simple lessons to be drawn from the last ten years for an economy they are…

    1. Don’t allow your financial sector to accrue large amounts of shadow assets which are difficult to understand, let alone numerate. Like the US/UK/European banking systems did.

    2. Don’t build too many houses and shopping malls which no-one will live in or use. Like Spain and Ireland did.

    China has made both of these mistakes to a vast degree. So they’re f*cked, to put it shortly. Their hidden debts are going to ruin them, and millions upon millions of construction companies and workers will be left high and dry when the building orgy stops. That entire sector of the economy will collapse and it’s huuuuuge.
    Even if they use their FX reserves or print money to pay off their debts, they’ll still have all those unemployed builders to deal with. And that problem is totally intractable, because they have no other skills,

    1. mellon

      The US has huge partially completed housing developments too. Or did last time I went cross-country by car, I saw two of them.

  9. allcoppedout

    I love the idea of an inflated Chinese GDP when ours are floating on banking. Pity Craazyman had to come up with the sensible idea of Chinese ghost cities being filled with actors doing Challas. Unemployment in the rest of the world would be eradicated feeding the cast. This economics stuff is really easy. This time we must get the gender of the country club right – it’s le rather than la mirage. Sooner or later some time and motion man would do a study that found no difference between the real professionals and the Challas ones. Some economic entrepreneur would work out farms could be run much cheaper with actors and liberated from growing food.

    1. craazyman

      Yeah I was listening to this radio program last night about people who get knocks on their door and on their porch are a few kids with pitch black eyes who ask to come in. They can’t cross into the house unless you let them. Don’t let them because they’re not real. This happened to me once, although it was in a stream in a woods where I was fishing. This young girl came from down a hill with her friend and asked me if I could drive her home. She and her friend looked like angels in some painting by an Italian renaissance master, surrounded by an aura of vibratory strangeness. She was not a human being, as far as I could tell. I told her we could call her mother to come and get her and I held out my cell phone. I was standing in the middle of a creek up to my hips fishing. A human being would never ask a question like that. She just laughed and it sounded like some sort of musical series of notes, then she walked up the hill and disappeared. Things are strange. It was late afternoon in a gentle and radiant sunlight where a path crossed the stream. If you read about Roman mythology you’ll realize the crossroads have always been a place of visitations. Economics has nothing on stuff like this. It’s just there to toy with for amusement.

  10. mellon

    You guys should do a little reading on Cargo Cults. Economists always like making theories about them. Cargo cultism reminds me a little bit of the fetish/myth of “job creators” which ignore the basic economic fact that jobs are created only when there is a real NEED for people to do work.

  11. NotSoSure

    No crisis will happen, if the Eurozone, Japan, etc can last this long, China can last even longer. Heck, I was wrong to predict an Indonesian crisis when the currency hit 12000 to the USD.

    1. run75441


      That is when you take out an American Express card when you check into your hotel and do not exchange dollars for the local currency. Being there for 2 days really did not require local currency as we were in meetings, eating, or sleeping. Pretty country.

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