Today's interview is brought to you by VanEck, a global leader in asset management since 1955. You'll be hearing more about VanEck's income-focused ETFs later on, but for now, let's get into today's interview. I am very pleased to welcome to Forward Guidance, Michael Pettis, Professor of Finance at Peking University and Senior Fellow at the Carnegie Endowment. Michael is an expert on China, and I want to ask him...
Why has China been growing so strongly over the past 30 years? And why does he think that what is going to come, China's growth is going to slow down dramatically? Michael, it's great to have you here.
Can you start off by describing the Chinese growth model? Sure. The Chinese growth model is not particularly Chinese.
Lots of countries have followed this growth model. You could argue that you can trace its development way back to the 1830s in the US so-called American system. It shares some characteristics with that. But really, the modern version of this model developed with Germany and the Soviet Union in the 1930s. And a number of countries since the Second World War have followed this model.
Japan, for example, Brazil in the 1950s and 60s, and at least two dozen other countries. And what really characterizes this model, you know, some people say that China follows an export-driven model, and that's not really correct. High exports and a high trade surplus, more importantly, are residual effects of this model. But this is really an investment model, an investment-driven model.
And the way the model works is you put into place structures that drive very high levels of investment. Now, in developing countries where savings tend to be quite low because income is low, it's very difficult to have investment-driven models unless either you import a lot of foreign savings. So, for example, that's what the United States did in the 19th century. It imported a lot of savings from England and from the Netherlands to drive up its investment rate, or you have to push up savings domestically. And because there has been a perception ever since the 1970s that relying on foreign savings is very risky, remember that's what happened to Latin America in the 1960s and 70s, leading to the big crisis of the 1980s.
The argument is that you should force up the domestic savings rate. Now, there's really no trick to forcing up the domestic savings rate. Conceptually, it's quite easy to explain how to do that. All GDP is either consumed or not consumed, which means saved. And so the way you force up the domestic savings rate is to take income away from groups that consume, from that sector of the economy that consumes, and pass it on to that sector or those sectors of the economy that don't consume.
So basically, you know, you can divide the economy in many different ways, but you can separate it into rich. people, ordinary people, businesses, and government. And out of those four sectors, the only sector that consumes most of it, most of its income, is ordinary people.
So in a process in where you shift income away from ordinary people towards businesses, towards government, towards the rich, you automatically reduce the consumption share of GDP and force up the saving share. And in the case of China, they did that. In the 1980s, their consumption share was sort of normal for most countries. And over the next 15, 20 years, they drove the consumption share of GDP to the lowest ever seen in history, which also means the saving share was the highest ever seen in history.
Now, is this a good model or a bad model? Well, China entered the reform and opening up period. hugely underinvested.
It had gone through five decades of anti-Japanese war, civil war, and Maoism. And it was among the most underinvested countries, perhaps in history, for its level of development. And so what it really needed was to maximize investment.
It had to invest in infrastructure. It had to invest in property. It had to invest in manufacturing. It had to invest basically in everything.
And so this model, which forced up the savings rate, concentrated the savings within the banking system, and then forced the banks to lend heavily into almost any type of investment you could think of, generated very, very rapid growth. The problem with this model, and every single country that's followed this model has run into this problem. This is not a particularly Chinese problem.
The problem is that a successful development model is one that addresses your particular problems. And to the extent that it's successful, by definition, it resolves those problems. And so, ironically, a successful development model is one that makes itself obsolete. And when that happens, you need to shift the model. And in the case of China and other countries that follow the investment growth model, it becomes obsolete when the amount of investment it can absorb and the amount of investment it has converges.
Once that happens, you can no longer generate rapid growth levels by investing in stuff that's needed for the economy. And then you have to worry more about the distribution of. demand and most demand globally is consumption demand.
Roughly 75% of demand in the global economy is consumption. And it's consumption that drives, that tends to drive business investment because businesses invest in order to satisfy the consumer needs of the population. So the problem in China is that with the household income share of GDP so low, and therefore the consumption share, once they maxed out in the growth rate in investment, once they invested as much as they could productively absorb, the problem is, where do you get demand?
And there's only three sources of demand, investment, the trade surplus or net exports, and domestic consumption. And the problem is that China had way too much reliance on investment and not enough on consumption. So they have to bring up consumption as they bring investment down. And for reasons that I'm sure we'll discuss, that's really hard to do. And one of the consequences was an explosion in the Chinese trade surplus.
Right. So China runs a current account surplus. So they export more than they import.
That can be a very good model. But the problem is that all of this excess savings. China is running out of investment opportunities. Is that what you're saying? That in the 1990s, 2000s, okay, we're going to build subways, office buildings, and it's great.
We're going to get a huge return on that for society, for everyone who builds it, because we need these things. But now you're saying there are enough subways, enough office buildings, and there's just... Is the problem with China too much money, too much savings? Because it seems a little paradoxical.
It seems like a good problem to have. Yeah, it's way too much savings. And it's structurally embedded, right?
It's not because people are thrifty. It's because the household share of income is quite low and there's no social safety net. So it's up to you to save for your retirement and in case you have a medical accident and all these other things.
Now, you said running a trade surplus is a good thing, but I'd want to I'd want to caution you there. Trade surpluses are not good things. Trade surpluses really represent very weak domestic demand.
Exports are a good thing. And the purpose of exports is really to pay for imports. And if you're exporting a lot, but you're not converting that into a lot of imports, all that means is that domestic demand is very weak.
Remember that your trade surplus, technically your current account surplus, but basically your trade surplus is equal to the excess of savings over investment. So the problem China has, it has a really high savings rate. This was good when the investment rate was really high.
But now so much of that investment is nonproductive. They want to bring it down. But as they bring it down, that creates a trade surplus, which creates a whole other set of problems. The rest of the world can't really absorb it.
So they need to bring down investment, which is another way of, I'm sorry, bring down savings, which is another way of saying they need to raise consumption. But that's quite hard to do. The good way to do it is to redistribute income to ordinary people. so that they can consume more. And then this way, the country saves less.
But that's politically very tough to do. The bad way you can reduce savings is with much slower GDP growth. And that's what they're trying to avoid. Chinese leadership, at what point do you think they became aware of this issue, that there was an excess savings and more money than there was productive investment opportunities? I know China really...
turned on the money printer, did a huge stimulus for China as well as the world in 2008, 2009. But then I think gradually, is it accurate to say that the Chinese Communist Party has become aware that real estate speculation may be not so good a thing because they have been cracking down on that sector, right? Well, they became aware of this much earlier, as early as March 2007. Premier, then Premier Wen Jiabao gave a very famous speech called the Four Uns, China's unbalanced and on this and on that and on the other. And basically in that speech, Wen recognized that consumption was too low of a share of GDP.
and promised that it would become one of the top economic priorities of Beijing to raise the consumption share of GDP. Now, that's not an easy thing to do. Japan has been talking about doing this since the Maekawa report in 1986, and they haven't been able to do it. And to show how hard it is, after Wen gave that speech, the consumption share actually continued to decline for four or five years before it finally bottomed out and it's now starting to rise. But what is it now, 16 years later, we're more or less back to where we were in 2007 when WEN recognized how bad the consumption level was.
It's very hard to change the consumption share of GDP. What is the leadership doing now in order to try and increase consumption? And is it the type of problem where if an entity that wanted to solve it? and really focus on solving it. It could solve it.
Well, you're exactly right. It's a political issue. It's always a political issue.
The reason we've always had these problems dating way back to the 1960s and 70s is because of political constraints. In fact, one of my favorite economists, Albert Hirschman, wrote about this way back in the 1970s. It's not a new problem. Here's the way I think about it, Jack.
I mean, I think it really helps to think about it systemically, something that economists don't do enough. And that is when you look at the total income produced by any economy, China or the US or anybody else, that income is divided into different groups. And one of the ways you can divide income, one of the ways you can divide the economy, as I said earlier, is ordinary people who consume most of their income, rich people who consume very little of their income. businesses who consume none of their income, and government, which, you know, if it's a welfare state like in Scandinavia, a lot of their income is consumed. But if it's a country like China, the buy-side economy, almost none of it is consumed.
So if you want consumption to go up, you have to transfer it to ordinary households. You have to transfer income. You have to give them a bigger share. That sounds great. Everyone's happy to get more.
But by definition, a bigger share for me means a smaller share for you. And so the question is, who are you in this case? And it could be the rich, but in China, China has a very unequal distribution of income. But the problem is not that the rich have too much.
The rich have too much relative to ordinary Chinese. But the problem is that households have too little. So So transferring it from the rich, which is politically quite difficult, is not going to solve the problem.
So who else? You can transfer it from businesses, but business is the engine of growth. And if you really penalize businesses, you may undermine long-term growth rates.
In fact, you almost certainly will. So that only leaves government. And in China, you know, there's not just one government. There's the central government in Beijing.
but there are also very powerful provincial and local governments throughout the country. And they own a lot of assets. And for reasons which we can get into later, if you're interested, as you go through all of the various forms of transfers, the only real way to solve the problem in China is transfers from local governments. Now, that's easy to say, but you think the last 30 or 40 years, local governments have benefited from transfers in the opposite. direction, right?
So a lot of Chinese growth has been built around huge spending by local governments, subsidized by transfers into the local governments. And so the political, the business, the financial elites in each region or each province are really built around those transfers in. And now what we're saying is what we must do is reverse the transfers instead of receiving. instead of being on the receiving end of transfers, local governments must now be on the delivering end of much larger transfers.
And I would argue, and this is Hirschman's argument, that that involves a really substantial change in the political, business, and financial institutions. It involves a change in the distribution of power. So it's easy to talk about as if it were just an economic issue.
But ultimately, it's not an economic issue. It's primarily a political issue. Right. And people hear Chinese Communist Party, communist, social equality, Marxism. How is it that you have all of these very wealthy people whose savings are not being put to good use?
And I suppose, can you go back to, was it Deng Xiaoping who said some... some quote about, you know, he kind of changed the game. And is that is the sort of welcoming of entrepreneurialism and individuals becoming wealthy? Is that changing somewhat?
You know, now that you're President Xi kind of, you know, for lack of a better word, kind of put Jack Ma in his place? Maybe, you know, I think, I think all this talk about communism and Marxism, it's the kind of things Americans like to say to scare ourselves. I don't think it's very helpful in understanding China. China is the model that China has followed, has been followed by other countries, including Japan and Brazil in the 50s and 60s. And Brazil was a right wing military dictatorship.
So I wouldn't use those really to describe what's happening. It's really a classic development model. Now, as part of common prosperity, there is talk about transferring money from the rich to the poor.
But what I would argue is that. common prosperity, which is the phrase that we use for those transfers, is really an attempt to solve the American problem in China. So in the United States, we also have a terrible problem of income distribution.
I'm sure I don't need to tell you, but the share retained by the rich, we have to go back to the 1920s or the 1860s to see such a great distortion. So if you want to solve the problem in the U.S. then what we have to do is redistribute wealth. Instead of distributing it from ordinary Americans to the rich, we have to reverse those transfers.
Will that solve the problem in the U.S.? Yes, because households account for about 80% of American GDP. Business is roughly 20%, and government is net zero or slightly negative.
But that's not the case in China. In China, households retain around 60%. And businesses, let's call it 20%.
It's hard to know where you draw the line between business and government, obviously. But roughly 20% in line with other economies. And the government retains 20%. So it seems to me that in the U.S., redistributing wealth, or at least reversing the transfers from ordinary Americans to wealthy Americans, would probably solve the problem of... of distorted income distribution in the US.
But in China, it solves the minor problem. It doesn't really address the main problem. So, you know, there are a lot of political reasons for what's happened to Jack Ma and other very wealthy entrepreneurs.
But I think as Americans, we probably overstate their importance. The real struggle is the struggle between the central government and the local governments and between the, you know, the the better off local governments and the much worse off local governments. So Professor, how do you see this playing out?
If over the past 30 years, China has had enormous economic growth, what do you see going forward and why? In the medium and long term, it's not so hard to make predictions simply because, as I said, at least two dozen countries have followed this model. And very conveniently, they all do the same thing.
First, you have very rapid, healthy growth. In the 1950s and 60s, Brazil was growing so rapidly that it was the first country that I can find to be called an economic miracle. And many other countries have done that. Japan right up until the 1970s and early 80s. Then you have a period of very rapid growth where suddenly debt explodes.
Before that, debt was contained. And it's only after that that debt... explodes.
And that makes sense because if I borrow $100 and invest it productively, GDP should go up by more than $100. So my debt goes up, but GDP goes up by more. So it's not a problem.
And debt rose very quickly in all of these countries, including China in the 1990s. It rose very rapidly, but we never talked about it because the debt ratio remained very low. And then something happened around 2006, 2007 that happened to every country that followed this model.
Suddenly, the debt started growing more quickly and GDP growth started to slow down. So now we started to see a rapid rise in the debt to GDP ratio or whatever your favorite measure of the debt burden is. You start to see it rise around that time.
And that sort of confirms the idea that investment is nonproductive. Because, again, if you borrow $100 and invest it in a project that only generates $60 worth of debt, growth to the economy, then debt goes up by 100, but GDP goes up by 60. So your debt to GDP ratio starts to get worse. That's like I said, happened in every country that followed this model.
The third stage is the adjustment. And there, there's only been two types of adjustment in history. I would call them the American type and then the Japanese type. The American type, which occurred in the 1930s.
We saw, obviously, a terribly difficult adjustment in which GDP contracted by roughly 35% in the first three years of the decade. Household income contracted by only, quote unquote, half of that. It contracted by about 15, 20%.
So you notice that the U.S. rebalanced. It rebalanced in the form of a crisis and a contraction. So that's one way.
countries. That's how Brazil rebalanced in the 1980s, etc. So it's one way you can readjust.
The other way, the Japanese way, is you never have a crisis. What you end up having is a very long period in which GDP growth drops sharply and household income growth drops not as sharply. So in Japan, we went from GDP growth of 4% to 5% before 1990 to roughly half a percent after.
But household income was below GDP growth before 1990 and above GDP growth after 1990. It was roughly 1.5%. So then you never have a crisis. You never have the political and social pain of a crisis. But it seems that you have a much worse economic adjustment over the long term.
And the way I think about that is, you know, the two biggest crises of the last 100 years were probably the U.S. in the 30s in Japan after 1990. And the US share of global GDP dropped by about 20 to 30%. But within a decade, it had grown right back up again and continued growing. Japan in 1991 was about 17% of the world, which is where China is today.
But 20 years later, it was around 7%. And it's never really recovered. So it lost about 60% of its share of global GDP. So if that's what happens, if those are the options, I think China is more likely to follow the Japanese model.
There's a third option. It's never happened in history, but in theory, it could happen. And that is if China could transfer about 1% to 1.5% of GDP every year from local governments to the household sector, consumption could take off.
maybe grow at 6% or 7% and drag GDP growth behind it at around 3.5% to 4%. That would be the really good case scenario. As I said, it's never happened, and it's politically quite hard to pull it off. But at least in theory, that could happen. Right.
So Professor, based on from the early 2000s, China managed to grow 8%, 10%, 14% truly astronomical levels. And since then, 2015, 6%, 6%, 6%. And its economy in 2020 was 2%.
Now, is it aiming for that 5%, 6% GDP target? And yeah, I mean, how do you think that China's GDP will be over the shorter term? And I suppose now we can also incorporate the more cyclical factors, as well as the structural, that China is, correct me if I'm wrong, right now emerging from a recession. So growth, almost by definition, is going to be strong because it's coming from a low base.
Yeah, it's not just the low base. It's a partial revival of consumption. The government has targeted growth this year of 5%.
I think it'll be closer to 6% than to 5%. But I would caution that doesn't mean that it's solved its problem. Remember that in 2020, the first year of COVID, growth was around 3%. And most of that growth was bad growth.
The healthy growth. what they call high quality growth was probably net was certainly negative in 2020 consumption exports and business investment But because of that contraction in consumption, we got a partial recovery in 2021. So you'll remember in 2021, growth was close to 8%. And more importantly, most of that was good growth.
The two years together weren't great, but the first year was terrible and the second year was much better. We saw that again in 2022. Growth was around 3%, of which high quality growth, the real growth in the economy. was probably around 1%, 1.5%. Most of it was the kind of growth they don't want, driven by non-productive investment. But as a result, this year, we're going to see a partial recovery of the contraction in consumption last year.
And so that'll drive up growth, but it's just a one-shot thing. It'll happen this year by probably by the end of the third quarter, beginning of the fourth quarter, it'll wear away. And so next year, we're right back to the same old problem that China's always faced, which is its excess reliance on investment and the underperformance of consumption to drive growth.
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Visit vanek.com to read a prospectus before investing. VanEck ETFs are distributed by VanEck Securities Corporation, a wholly owned subsidiary of Avanik Associates Corporation. Thanks, and let's get back to the interview. And Professor, in America, we saw that people working from home and lockdowns, either enforced by the government or just consumer behavior, they wanted to stay home, drove a domestic consumption boom because everyone was ordering goods on Amazon.
Were you seeing that in China where Chinese nationals residents, they were working from home, locked in, quarantined? Were they ordering stuff on Alibaba or Pinduoduo? Or did you not see that domestic consumption boom that we had in the West? Yeah, that exploded. But, you know, I think there is this perception that China is this sort of high tech advanced economy.
It's not. It's a middle income economy. Most jobs involve, you know, pushing wheelbarrows or delivering food on motorbikes.
It's not high tech stuff. So when the economy closed in... 2020 and again in 2022, most small businesses collapse, you know, service businesses. I work a lot in the music industry.
I started an indie label. And so I know a lot of people in the music industry, and many of them were doing, you know, gig work and all of that collapsed. None of them made any money. So, of course, they weren't able to spend. And that was the problem.
You know, there are three reasons why people don't spend money. One reason is because their income goes down and that's not going to come back until their income goes up. And we saw a reduction in income and a rise in unemployment.
The second reason is the uncertainty. When you become nervous, you react. And this is not true just in China, but in the US, Europe, Japan, everywhere, you react by spending less and saving more in case of trouble.
And that's probably not going to change for many more years. We'll need many years of stability before people relax again and start spending their income. And then the third reason you stop spending is because you're locked up at home. You know, it's very hard to spend money. That's going to come back.
That's what we will expect to come back this year, that component of savings. But total savings. is still going to be down from before the, I'm sorry, up from before the pandemic, or I should say total consumption will be down from before the pandemic, because many of the reasons for the reduction in consumption haven't really been resolved, right?
So if the main reason you didn't go out and get a haircut is that you were not allowed to leave your home, once you're allowed to leave your home, you're going to rush out and get a haircut. That'll boost consumption. But that's a one-shot thing.
You're not going to, you know, you're not going to permanently increase your level of haircuts. Reading news about China, particularly on websites and newspapers that are affiliated with the states or sort of saying the message that the government is going with, are talking so much about consumption. Oh, there's a consumption boom coming.
Oh my God, over the Chinese New Year, all of these people flew all over the country. Isn't this amazing? To what degree do you think that will occur. Can the Chinese government sort of... influence consumers just to buy more?
I mean, if you see an ad of Chinese officials saying you should go and travel and visit your aunt in Guangzhou, are people going to do it? How do you think the success of that? Yeah, they call it consumption upgrading. They're also telling shops to stay open later at night. They're having consumption festivals, etc.
But think about your own consumption patterns. At the end of the day, what you probably do, what most people do, is you have an income. Out of that income, you know you have to save a certain amount for retirement, for emergency medical, for whatever. And then you spend the rest. And so if I come to you and tell you, you know, guess what?
All the shops are going to stay open two hours later. Go out and spend more. Well, you're not going to spend more.
You still have the same budget constraint. You may go shopping later than you normally do. So you'll spend more at night and less during the day.
but you're not going to spend more because your constraint is your budget, your income. So there's really only two ways to increase the consumption share of GDP. One is to increase the household income share, reduce business profits, reduce government revenues, and give more to ordinary people.
And the other way is to increase debt. So tell the banks to lend more money to consumers. And there's always people who want to borrow in any country.
It's just a question of what will the banks lend to them? Tell the banks you got to lend to them. But the problem with the latter way is that that's already happened. Chinese household debt levels are very high relative to income. They're higher than in the US.
How is it possible that Chinese household debt is so high at the same time that Chinese household savings is so high? If you're saving all this money, you can... pay off debt?
Why are you taking on the debt? Well, the mistake is to think that savings are what households do. Savings are what households and businesses and governments do. So in the US, what we've seen, for example, is with the rise of income inequality, household income has gone down and the savings of the rich has gone up and the savings of the rich has been recycled by lending to households.
So household debt goes up. In China, what happens is if you lower household income, then savings go up, not because households save more, but because households consume less. And so businesses get more, get a higher share, governments get a higher share, which they save. So what really matters in China is the distribution of income.
But if you look at household debt compared to household income, in China, it's actually higher than in the U.S. If you look at household debt relative to GDP in China, it's lower than the U.S. And that's just a mathematical way of saying that the household income share of GDP in China is much lower than the household income share of GDP in the U.S. You know, Jack, let me continue that, because I think that's very counterintuitive.
A lot of people don't understand it. When you think about Chinese businesses are so competitive and. you know, globally. And we think, oh, well, that probably has to do with, you know, this tremendous manufacturing efficiency and hard work and thriftiness and all that stuff. No, it's got nothing to do with that.
Countries that are more competitive, China, Japan, Germany, the Netherlands, South Korea, it's all the same, are more competitive, mainly because households retain a lower share of what they produce. So basically, they're more competitive because they're subsidized. And subsidies have to be paid for.
And if there's only three sectors in the economy, government, households, and businesses, subsidies to businesses and the government must be paid for from the household sector. So you have this mechanism that transfers income from ordinary people to businesses and governments. And that makes businesses more competitive because they're more subsidized.
but that reduces domestic demand. So that's the real problem. If you want to reverse that, I can tell you exactly what to do. It's nothing very complicated.
You have to reverse the direction of those transfers. You have to give households more. But remember, if the reason Chinese manufacturers are so competitive is because of all of these direct and hidden subsidies, take them away and reverse them, and they suddenly become very uncompetitive. And that's a very a painful process through which to go.
That's probably why Japan, for example, has been talking about raising consumption for 30, 40 years, and they haven't been able to do that, because implicitly it means undermining your manufacturing competitiveness. Right. And Professor, how does the Chinese financial system work with the banking sector?
Because, you know, in America, banks privately owned, they make loans. If there's an issue, sometimes the government gets involved. There are government agencies, Federal Reserve, Federal Home Loan Bank, Fannie Mae, that assist in various ways that are actually, you know, quite, you know, they play a very active role. So that kind of countervaries the sort of private markets narrative, but they are privately owned.
In China, how many of the banks are state-owned? And when you say all of this debt is funding these investments, whether it's productive or unproductive or lending to the consumers, how many of that is via the banks versus capital markets? I know in America, Apple, the computer company, is going to borrow money.
It's likely not going to do it from a bank. It's going to issue a bond. And I know the capital markets in America are more than in Europe.
Europe has it, but it's not as much. How much of China is banks versus capital markets, state-owned bank versus private bank? And then how does the central bank, the People's Bank of China, PBOC, how does that play in all that?
Well, there are two really fundamental differences between the financial system in China and the U.S. The most obvious, but the less important, is that China is much more of a banking system than it is of a market system. So in the U.S., last time I looked, things may have changed. But banks represented roughly 30% of financing, bonds 30%, and equity around 40%, something like that.
In China, banks represent something like 90% of the financing. It's a heavily banked system. Germany's like that.
Japan's like that. There are many countries like that. But the real difference, I would argue, is that it's not a market banking system. It's an administered banking system, by which I mean. And, you know, Japan in the 1980s, we called it window guidance.
So in the U.S., if the Fed wants banks to expand their lending, it typically does so by engineering a reduction in interest rates. And that causes more demand for loans and banks expand their lending. In China or in Japan in the 1980s, that's not how it worked. Literally, the regulators would call the banks and say, expand your lending.
to the automobile sector by 10%, expand your lending to the household sector by 5%, expand your lending to steel companies by whatever. Interest rates didn't matter. The purpose of interest rates is the amount of transfer between net lenders, which are household depositors, and net borrowers.
It's a very, very different banking system. It's administered. The regulators decide what the banks are going to do, basically.
In the aggregate, individual banks can move around a bit. But if the regulators want automobile loans to go up by 10%, automobile loans will go up by 10%. And roughly how many of the Chinese banks are state-owned enterprises? It's not such an important distinction, and it's always hard to tell.
So, for example, the big four banks are partially privatized, and yet their chairman are determined by Beijing, right? So Beijing actually... decides who the leaders are, and they're shuffled between the Ministry of Finance, the central bank, and the big four banks. Then you have a smaller group of commercial banks that are largely privately owned. And then below that, you have a lot of much smaller banks, some privately owned, some owned by cooperatives, some owned by local governments.
But it doesn't make sense to think of a distinction. The banking system is heavily regulated and heavily controlled. So I think most of us don't really think about the difference between privately owned banks and state owned banks. There are differences, but they're not major differences.
Right. And so the government, you said Beijing controls so much of the lending. Oh, lend this much to steel, this much to real estate.
When people talk about the crackdown on real estate, how much of it was Beijing telling banks to curb lending? And then was that one of the three so-called red lines? Well, the three red lines all had to do with restrictions on lending.
The real estate market both soared and collapsed largely because of regulatory reasons. So, you know, for a long time, real estate prices only went up and local governments became more and more dependent on real estate in order to fund all of their spending. And so this mentality developed that China could never allow real estate prices to come down because that would significantly undermine the ability of local governments to fund these huge amounts of spending. And when everyone believes that, if you're a bank, you should lend as much as possible to the real estate sector because prices are never going to go down and the prices never go down.
You can never lose money. Even if the person you lend it to goes bankrupt, you seize his land, liquidate it, and you're fully repaid. So it becomes this heavily self-referential.
It's a self-fulfilling prophecy. Yeah. Yeah, exactly.
But once the central bank or not so much the central bank, but the regulators made clear that they thought real estate prices have gotten out of hand. And as a share of GDP, Chinese residential real estate is almost certainly the highest in the world. Once they decided that and said you can no longer borrow, that sort of caused the whole thing to collapse because the real estate sector was so heavily leveraged. The profit model of the real estate sector. was borrow as much as you can.
Don't worry about the risk because it's very easy to refinance. And in the worst case scenario, you can sell the land at a higher price than you bought it for, so you're fine. The moment you stop that game, the whole thing started to come down. And that's created real problems with the ability of local governments to finance themselves and people who own apartments are worried about prices going down, et cetera.
So now there's an attempt to stabilize the real estate market. But even if they're able to stabilize it, and I'm not sure they can, that means stabilizing it at prices, which would still be the highest in the world relative to GDP. And I don't think, I mean, the historical evidence suggests that when prices are so out of whack, one way or the other, they're going to come down.
You can't stabilize them. And how severe of an impact do you think the implosion, detonation of the Chinese real estate- bubble, if we can call it that, will have on the Chinese economy. When the US real estate bubble popped in 2006, 2007, 2008, it had disastrous consequences.
Yeah. The real estate sector is always a very large part of the economy. And the problem with the real estate bubbles is when they deflate, it's always really painful.
In the case of China, it's more extreme because in the US, maybe the real, it depends how you count it, the real estate sector might have been 10 to 15%. Yeah. percent of GDP.
In China, it was double that. In the U.S., residential property may be, I don't know, 120 percent of GDP. In China, it sort of peaked out at 350 percent. The real estate component of the typical portfolio of savings in most of the world is around 25, 30 percent.
In China, it was up to 60, maybe even 70 percent. The whole Chinese economy was far more leveraged to real estate than even other economies. And every economy is heavily leveraged to the real estate sector, but in China, much more so. So, you know, that's one of the reasons why many people think if you want to understand what is likely to happen to China, you should probably look at Japan post-1990, 1991 as a possible model. When people hear this, you know, when I was growing up.
This is my first thing I heard that, oh, the U.S. has so much debt because it owes so much to China, which is accurate on a government level because U.S. runs a trade deficit. China has recycled a lot of those into U.S. Treasury. So China, the Chinese and Chinese government owns a lot of U.S. government debt. But on the private sector level, corporate borrowing and household borrowing, the debt in China is quite large.
Is that fair to say? Yeah, the thing in China is that it's, you know, the. distinction between private debt and public debt is much less important than it is in the U.S. because moral hazard underpins the banking system. So basically, I think of everything as directly or indirectly government debt, particularly since most of it goes through the banking system. And if you default on your loans to the banks, then the banks default and the banks have to be bailed out by the government.
So effectively, they're a contingent liability of the government. It's mostly. One way or another, it's mostly government debt. But the debt levels are very, very high. You know, that's part of the problem.
We saw this in the 1920s. We've seen this before. When you have these huge trade unbalances, they're bad for both sides. The huge U.S. deficit has to be met with rising debt because the U.S. deficit basically is a reduction of domestic demand. Part of domestic demand goes abroad.
And in order to prevent the economy from slowing, either the fiscal government has to borrow or households have to borrow. And so it's between the Fed and Washington as to who's going to borrow. But somehow or the other, you need rising debt to keep growth from slowing.
In China, you have, in many ways, a problem that's opposite, but also very similar. And that is with domestic demand so weak, the only way China can resolve its domestic production is through a growing trade surplus. And if China was Singapore, it could get away with it. But large economies can't do that or with growing investment. And because more and more of this investment is nonproductive, that means China has to resolve its domestic demand deficiency with rising debt.
So it's not an accident that you see debt levels on both sides of the imbalances rise very quickly. That's always what we've seen. What we're seeing today is no different. Right. You cover that in your book, Trade Wars Are Class Wars.
I think, you know, folks viewing this in America might be familiar with. the sense that US reliance on importing goods from China led to lower employment in the manufacturing sector and jobs got shipped over fees. In China, what are the class implications of China joining the WTO and this huge boom in global trade that began in the late 1990s, early 1990s? Well, the basic argument that Matthew Klein and I make in Trade Wars and our class wars.
And there's a bunch of arguments, but I would say the two most counterintuitive things that we point out, first off, is that when people say that the U.S. runs a deficit because Americans save very little, they don't understand the balance of payments. Countries that have totally open capital accounts cannot control the relationship between investment and savings. And so we invert that.
We say because the U.S. has a big deficit, the U.S. has a big deficit because the rest of the world needs some place to dump all of their savings. So the U.S. must run a deficit and that forces down American savings. So we have we we say the causality of the argument most people make is completely backwards. It's not that the U.S. has a trade deficit because Americans save very little. Americans have to save very little because the U.S. is running.
a big trade deficit driven by the excess savings of the rest of the world. So that's one argument we make. The other argument we make, more to your point, is that trade imbalances, trade conflicts, we think of them as conflicts between surplus countries and deficit countries, between the US and Europe.
I'm sorry, between the US and China. And what we try to show in the book, and I think, you know, when you think about the balance of payments arithmetic, balance of payments logic, it's very clear. It's that it's not that one country benefits and the other country suffers. What ends up happening is that certain groups, and they tend to be the same groups, in both countries benefit and other groups suffer.
So what we argue is that China's trade surplus benefits the government and the elites, particularly the owners of movable capital. because it's built on the backs of very low wages for Chinese workers. And we argue the U.S. deficits, which benefit Wall Street, which benefit, weirdly enough, the foreign affairs establishment, and again, owners of movable capital, is built on the backs of small businesses, producers, and farmers in the U.S. So that's why we say the trade wars are not really national wars, they're class wars. Certain sectors of the economy in both countries primarily workers, the middle class, small businesses, suffer because of these imbalances.
And then certain sectors, the elites in both countries, benefit because of these imbalances. And I think that's probably the strongest message we try to get through in that book. Right.
So as you say, the US has an open capital account and anyone can move money easily in and out of the US treasuries. China, which I think has a closed capital account, what is that? mean?
Is it a lot harder to get money in and out of China? Why does the government have that policy? To what aim are the sort of capital controls in China?
It's much harder to get money moving in and out of China. And the reason is because the Chinese aren't befuddled by the sort of bizarre faith Americans have that in order to maximize growth, you have to allow... basically Wall Street to have maximum freedom. There's no argument in favor, there's really no legitimate argument in favor of removing capital controls. You know, back at Bretton Woods, Bretton Woods was a negotiation between Keynes representing England.
and Harry Dexter White representing the United States. And clearly they differed on many things. But one of the things they both agreed was that there was no justification for the free flow of capital.
A small amount of capital flows is a good thing if it flows from less productive countries to more productive countries. In other words, from rich countries to developing countries. But they argued that most capital flows were really speculative, were not driven by productivity, were driven by other reasons. Immediately, the economy had to adjust to these capital flows. So I would argue that countries like the United States, England, Canada, Australia, they're sort of embedded with this ideology of free capital flows, which is quite new.
As recently as 1983, the US had capital controls. But then we decided in our wisdom or in our stupidity, that what you really needed was to liberate capital flows as much as possible. and maximize the influence and power of international banks.
And once that happened, the rest of the world, because they became more competitive by repressing savings, that pushed up their savings rate, which they couldn't invest at home. So when you run a surplus, you need to acquire assets abroad. And what's the best place to acquire assets? Well, for legal reasons, for flexibility, for financial reasons, it's the so-called anglophone economies, the US, the UK, Canada, and Australia.
So it's not a surprise that 60, 70, 80% of all of the excess savings in the world goes to those four countries, even though they don't need the capital. And of course, that also means that 60 to 80% of all of the trade deficits in the world belong to those four countries. That's not a coincidence. It's a necessary component.
If the U.S. is running a capital deficit, if it's importing money from abroad, which understands what that means. Many people say the U.S. is exporting dollar bills and getting goods. That's total bullshit.
What the U.S. is exporting is claim on American assets, real estate, stocks, bonds, farmland, equity, in exchange for goods. And that's what creates that imbalance. Foreigners buy American assets because if you have excess money, whether you're an oligarch or a drug dealer or a central bank or a middle class saver, the best place to put your excess money is in the U.S.
But by doing that, you force the U.S. to run deficits, which undermines U.S. workers, U.S. businesses, U.S. middle classes. You know, I think that's the really important. point to understand.
These trade imbalances are bad for both sides of the equation, but they're very hard to get out of. Right. And so China may be running out of profitable, productive investment opportunities domestically, but there are a lot of investment opportunities abroad, not just in the United States. So China has done something called the Belt and Road Initiative. Oh, let's lend to emerging markets.
nations to build railroads, build ports. How successful have these programs been? And yeah, are they a viable path forward for sort of marshalling the surplus excess savings that we've been talking about?
Well, initially, you're exactly right. That was one of the big purposes of BRI is we have all these excess savings. We've got to invest it.
Let's invest it in developing countries. But understand that only a very tiny share goes to developing countries. Most of it goes to advanced countries.
It's much safer to put it there. Now, China made, you know, a lot of people talk about debt trap diplomacy and all this other, you know, paranoid stuff. That's not what really happened.
China did the same thing the US did in the 1920s when it first started to go out and lend heavily to Latin America, what the Soviet Union did in the 1950s, what Japan did in the 1980s. is because it didn't really understand lending to developing countries. It thought it was very easy, and loans to developing countries expanded very rapidly.
Now, before I moved to China, I worked on Wall Street. I used to trade and run capital markets specializing in Latin America. So I know Latin America reasonably well. And it was very clear that Chinese loans were expanding most quickly to countries like Ecuador, Venezuela, Argentina, which were countries that nobody wanted to lend to.
for pretty good reason. They were very risky countries. But like the U.S. in the 1920s, like the Soviets in the 1950s, the Japanese in the 1980s, they thought it was quite easy and they were quite successful at it. But in every case, you learn at some point that it's not that easy.
And in China, that happened in 2015 with the huge problem in Venezuela. That caused a real shock in China. And you'll notice that before 2015, lending to developing countries goes up. Since then, it's come down very sharply. China wants to reduce its lending to developing countries because it increasingly recognizes in Sri Lanka, in Zaire, in Pakistan.
that it's very hard to get the money back. So that's not really a useful outlet. It would be good if this excess savings went to developing countries, because it would generate growth there. But the problem is, it's not coming back.
And these loans that China makes to foreign countries, advanced countries, as you say, as well as emerging frontier market countries, how many of them are denominated in yuan versus denominated in dollars? And how relevant is that to the global dollar as the global reserve currency de-dollarization narrative, which I know you have a lot of thoughts about? Well, by definition, China cannot invest its surpluses in Yuan or in renminbi.
You can only invest your surpluses in a foreign country. And so the real question is, will it be dollars? Will it be rupees? Will it be Brazilian or Aish?
Will it be whatever? And the fact is, for all the talk, it has to be dollars. And the way you can tell, Jack, it's very easy.
Look at the surplus countries and look at the deficit countries. By definition, the surplus countries are investing their surpluses in the deficit countries. And what you'll see is that 70 to 80 percent of the deficit countries are the four anglophone economies.
Throw in Europe and it's probably like 80 to 90 percent. So that means by definition, the surplus countries collectively. are investing in the rich countries of the world, the US, Europe, and the Anglophone economies. There's no way of getting around the arithmetic.
So one of the things that happens is that, you know, we all look at the PBOC holding of treasuries, and we see they're coming down slowly, but they're coming down year after year. And everyone says, wow, the Chinese are not investing in the US. Well, that's nonsense, because First of all, much of the increase in reserves are happening outside of the central bank. They're held by the state banks, and much of that is in dollars. And secondly, even as China is selling U.S. treasuries, it's replacing it with U.S. agencies or other U.S. assets.
So if you just look at Chinese holding of treasuries, that's not Chinese holding of dollars. That's just Chinese holding of treasuries. The total dollar amount is going up.
The other thing you have to understand, this gets a little bit complicated, but let's say the Russians decide to hold their large surpluses in renminbi. The way the balance of payments works is if the Russians take $100 worth of surpluses and invest it in renminbi, China can only respond in one of two ways. Either the China surplus must decline by $100. or Chinese acquisition of foreign assets must go up by $100.
And what we're seeing is that Chinese acquisitions of foreign assets are going up by $100. So when people see China investing in, I'm sorry, Russia investing in China, and saying that means the dollar is being used less, not really. What it means is that instead of the Russians investing in dollars, The Chinese are investing in dollars on their behalf.
They're intermediating those flows. And so we see renminbi go up and we get all panicky and crazy. By the way, let me add one other thing, Jack.
Many people think that abandoning the dollar would be terrible for the US and great for China and Iran and Russia. They have it absolutely backwards. If the world gave up use of the dollar and Washington should force the world to give up use of the dollar, the American trade deficit would immediately contract and the surplus of all of those countries would immediately contract.
That would add demand to the U.S. economy and subtract demand from those economies. It would actually benefit the U.S. and hurt those other countries. That's why these countries have been talking about replacing the dollar basically since the 1970s, and they've never been able to do it.
The ones who really should be forcing the world to replace the dollars is us. Americans should demand that foreigners stop acquiring American assets. So is it realistic at all that the Chinese yuan becomes the next global reserve currency and Chinese leadership in Beijing?
Do they have that ambition at all? No, I think what they would like to do is to have more trade denominated in a system in which the U.S. cannot turn it off. But ultimately, what matters to trade is not what currency you denominate the trade in. For example, if you want to sell me, you know, whatever, a pair of shoes, we can do it in dollars.
But if you have a smartphone with the right app and I have a smartphone with the right app, we can do it in Malaysian ringgit. We can do it in euros. We can do it in any currency we both agree on.
It doesn't really matter. What really matters is if I buy the shoes from you, what do you do with the money? And at the end of the day, what you're going to do with the money is you're going to buy U.S. assets.
And that's what's important. Professor, tell us about the Chinese stock market and its relationship with growth and real estate. U.S., many excess savings go into the stock market as well as real estate.
In China, is it accurate to say that, you know, a lot more goes into real estate as well as bank financing of real estate than in equities. And also, can you comment on the fact that over the past, let's say, decade, the China has grown a lot, but the stock market returns are quite meager? Yeah. Well, that's been a big concern for investors for a long time.
There's almost no correlation between the performance of the stock market and the performance of the economy or corporate profits. It's a very speculative market. It goes up and down largely on government signaling changes in underlying liquidity.
So in 2015, when the government made very clear that they wanted the stock market to go up, it went up 150 percent in a year. And then when they made clear that it had gone up too much and they were starting to get nervous, it dropped 60 percent in a couple of months. By the way. Up 150, down 60 means you're right back to where you started from.
So you get these huge swings in the market, largely based on investor interpretation of government signaling. It's not a market driven by fundamentals. Mind you, I would say in the last 10 years, it's hard to argue that the U.S. market is driven by fundamentals either. But at least from time to time, it is.
What's really important in China is the real estate market as an asset market. The stock market is quite small in China relative to the size of the economy. It's not that important. It matters at the margin. Prices go up.
A few people feel richer. Prices go down. A few people feel poorer. But it's not like in the US.
Okay. Thanks for explaining that. Professor, you mentioned the People's Bank of China and adding liquidity, taking liquidity away. I've interviewed folks, experts on liquidity who say global liquidity is actually going to resurge this year because the Bank of Japan is here to save the world.
The People's Bank of China is here to save the world. How important are those flows? When the Federal Reserve does quantitative easing, as it does in March 2020, extend dollar swap lines to so many countries, an immense resurge in global liquidity. My question for you is, number one, can the People's Bank of China...
increase global liquidity? And number two is, are they? Will they this year?
Well, they'll increase domestic liquidity. Already, debt levels are growing. In the first quarter, debt levels grew faster than they ever have before in Chinese history. But there is very little contagion between the Chinese markets and the international markets because of capital controls. So.
When you had the banking crisis in the US and in Europe this year, that had almost no impact on China. But the flip side of that is if you have a banking crisis in China or an expansion of liquidity in China, that will have very limited impact on the rest of the world through financial means. Now, it could have an impact through the real economy.
So for example, if you saw a massive expansion in liquidity in China, that would probably not cause consumption to rise. That would probably cause... production to rise because most of the expansion tends to be on the supply side, not on the demand side. So that would cause the Chinese current account surplus to rise. And as the Chinese current account surplus rose, China would have to convert more of that into the acquisition of foreign assets.
So you would see an increase in foreign liquidity through an increase in the current account, but it's not a direct... It's not from financial system to financial system. It's from the Chinese financial system to the current account and from the Chinese current account to the US financial system.
It's much more indirect. Thank you, Professor. I've got two final questions for you.
My first is on the shorter term cyclical, let's say, over the next years. Setting aside the structural worries you have about the Chinese growth and growth model going forward, I think perhaps it's accurate to say now that the US growth is slowing, probably entering recession. Europe growth is not looking great as well.
However, China is emerging from a recession, man-made, whatever. So China is sort of the engine of global growth in 2023. And although you're not optimistic on long-term Chinese growth prospects, you actually are more optimistic, it sounds like, over the next year than the Chinese government is. Because Chinese government is aiming for 5%. You said they could do 6%.
So, I mean, yeah, what do you think the next year will look like economically? The consequences of, if you're right, China is once again sort of leading the torch for the world, as it did in 2009. Well, not... You have to be very careful about that.
First of all, I think China will get, as I said, closer to 6% than to 5%. I don't think that makes me more optimistic than the government. If you look at provincial GDP growth targets, on a weighted average basis, they're around 5.5, 5.6.
So I think many people in China believe it's going to be well above 5%. I think they picked a low target in order to beat it. But I wouldn't call China the growth engine of the world.
I would say that it'll be arithmetically the highest component of GDP growth. But the way China interacts with the world, the way any country interacts with the world is through its balance of payments. So what really matters is what happens to the Chinese balance of payments.
If the Chinese maintain very, very high trade surpluses, then they will actually be sucking growth out of the rest of the world. And if their trade surplus contracts, that will add demand to the rest of the world and add growth to the rest of the world. So what really matters is not how quickly China grows.
What really matters for the world is not how quickly China grows, but the evolution of China's current account surplus. And I think it will probably remain pretty high this year. It's at world record levels, and I don't think it's coming down very rapidly. Right.
And because China is a production rather than consumer led economy, if you have a Chinese boom this year, a relative boom in China, if I gather from what you're saying, that is not going to necessarily cause a boom in demand for U.S. goods. Yeah, we're going to see, I hope, a boom in consumption in China, pretty strong consumption. And that'll be good for the world. But I think it's important to recognize it's not the growth rate in China that matters.
It's the relative growth between production and consumption, which shows up in the trade account. That's what matters to the rest of the world. And even that's very uneven because very rapid Chinese growth with a rapid growth in the trade surplus could be bad for the world. But if it causes commodity prices to surge, then it's good for commodity producers and bad for commodity importers. So it's a very uneven impact on the rest of the world.
If you're Brazil, you would love to see a massive investment-driven growth in China, which China doesn't want to do. That would be bad for China and bad for the world, but great if you're Brazil because it would cause iron ore prices to go up. Right. Okay. That makes sense.
Professor, you're very active on Twitter. People should check you out at MichaelXPettis. That is your handle, as well as your multiple blogs on the Carnegie Endowment, as well as your book, Trade Wars or Class Wars.
Professor, if you could sum up your views of China's longer-term growth prospects and just tie it back. I mean, how high do you think the growth will be? And why is it do you think that China will have very low growth?
And we'll surprise on the downside. I've heard you say China long-term growth, 2%, 3%. So it'd be great to get you on the record for that, as well as I've heard you say in previous interviews that... You're pessimistic on Chinese growth, but history says that even the pessimists are not pessimistic enough. Well, yeah.
You know, I mean, imagine if you had predicted in the year 1990 that for the next 20 years, Japan would grow at 2%. You would have been laughed at, right? 2% is ridiculous. There's no way it could possibly happen. In fact, it turned out to be half a percent.
By the late 1970s, early 80s, people knew there was a... problem in Latin America and in Brazil, etc., not one of them would have predicted how difficult that problem was. Look at American history. In the early 30s, we knew there was a problem, but no one predicted the Great Depression. So we tend to underestimate the...
the boom phase of the investment cycle and underestimate the contractionary phase. So that's why I say we should be prepared for the outcome to be much worse than we think it is. But my reasoning is very simple. China invests right now between 42% to 44% of its GDP.
It's been doing that for more than 20 years. In fact, it reaches as high as 47%. This is an extraordinary number.
The world invests about 25%. 45%. High investing countries invest around 30 to 33 percent, not as long as China has for shorter periods, but that's what they invest.
So if you just do the math, at some point, China has to stop probably 10, 15 years ago. But certainly it can't continue this high level of investment forever. It must bring it down. So if you do the math, you'll see that as the investment share comes down, there's only two ways to balance that.
right? Either consumption growth must pick up speed while investment's coming down, theoretically possible, but it's never happened before, or consumption growth slows a little as investment growth slows a lot, in which case GDP growth slows a lot. That's just arithmetic.
So when people say China's going to grow at 5% for the next 15 years, that assumes that for the next 15 years, they're going to keep investment at this impossibly high level, which is almost impossible to conceive, or somehow they're going to get consumption to grow much faster than it has in recent years, to grow at 6% or 7%. And it's very hard to imagine how they will do that as they're bringing investment down. So I'm saying it's just logical. This is just the way an economic adjustment works.
All the historical precedents show. that the investment miracle has been followed by a much more difficult adjustment than we expected. And the reasoning for that is that as you bring investment growth down, either GDP growth drops, or you must bring consumption growth up.
And those are your only alternatives. Super interesting. Professor Pettis, thank you so much for joining us, sharing your insights on China. And thank you, everyone, for watching.
Thank you very much. Bye-bye. Forward Guidance, the program you just enjoyed, hopefully, can be viewed on YouTube at Blockworks Macro or heard as a podcast on Apple Podcast and Spotify.
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