Michael Pettis: Hard Commodity Prices Will Continue to Fall with Decade-Long Slowdown in China
We recently interviewed the esteemed economist and financial strategist Michael Pettis out of Beijing regarding the ongoing debate of whether China will see a massive credit crunch or growth collapse. Given the important implications this process will have on global markets, various sectors, and economies in general, we highly recommend our followers to read his remarks below. Regardless of how this unfolds, the downside risk for hard commodities seems to be the greatest, in his view.
Here are a few excerpts from his interview (click here for audio link) that recently aired to our subscribers.
FSN: Michael, we’re all familiar with the empty buildings and ghost cities in China due to massive over-investment and misallocations of capital. Due to such, people have been predicting for a few years now that China will see some sort of collapse or hard-landing that could cause numerous problems for the markets and global economy. What are your thoughts on this?
Pettis: Well, I've never been very impressed by the hand-landing/soft-landing debate because I think it misunderstands the Chinese economy and the growth model that we're following. What I really expect is a long landing and, typically, countries that have had these kinds of investment growth miracles have always ended up in the later stages with a significant debt problem, almost certainly because in every case…they become addicted to very high investment growth rates and once we reach the point where investment in the aggregate is being misallocated, they continue doing so. So, when that happens, almost by definition, debt is growing faster than debt-servicing capacity and, of course, that's not sustainable.
FSN: What is your expectation then for China over the long-term and, also, do you think a crisis in China can be averted?
Pettis: Mathematically, I can't figure out how China can adjust with growth rates much above 3-4% on average. So, my expectation is that under President Xi, who will lead from 2013 to probably 2023, during that decade the upper limit of growth is likely to be 3 or 4%, but I'm uncomfortable with the hard landing/soft landing debate because I don't think that China has options. It is going to slow down, there's simply no way growth rates can be maintained at this point, but it's unlikely to have a crisis. Countries that have had crises—they adjusted in the form of crises—maybe Brazil after 1982 for example, had crises because you had the so-called sudden stop in lending, but if the investment is financed domestically and the banking system is very heavily controlled by the central authorities, you never really get the sudden stop. So, Japan didn't have a crisis, it just slowed down significantly. And that is what I expect is going to happen in China. For me, the interesting question is really when they get their arms around the debt problem because growth has slowed down, but debt continues to grow too quickly and the worry is that if debt continues to grow up to some point where they reach their debt capacity limits then you'll have a very ugly and rapid adjustment—a brutal adjustment—with growth collapsing. I don't think that's going to happen, but that's always something to worry about.
FSN: So, over the next ten years you expect China’s growth to dramatically slow, but, given the fact that much of their over-investment has been domestically financed, in addition to how their banking system is structured, you feel the odds favor a more slow adjustment versus a sudden collapse. Now, just recently, the World Bank said that China’s economy could overtake the US in size as early as this year. Given your outlook, do you think China is set to become the world’s largest economy?
Pettis: If it does it'll be temporary and then it'll fall back behind again. My skepticism about the [World Bank’s] PPP analysis—the purchasing power parity analysis—is that it really isn't meaningful at all except for economies that are comparable. And, in fact, generally comparing US GDP with China's GDP is not very meaningful because their economies are so different. So, if you were trying to compare the US and Canada, it makes sense because they are structured in very similar ways…but when you do a PPP analysis on China…the implicit assumption there, which is never explicitly stated, is that China's GDP is comparable to US GDP. In other words, the US constructs its GDP in a way that is broadly similar to what is happening in China, but…China's GDP is constructed very differently because of the failure to recognize bad debt. […] So I would argue that if you really want to compare the two you should adjust China's GDP not just for price differentials but also for the different way in which debt is being treated. And if you were to do that my suspicion is that you would probably want to reduce China's GDP numbers by anywhere from 20-30% to account for all this unrecognizable bad debt. So my big problem with the PPP study is that it makes a very powerful hidden assumption, and that assumption is that the two economies are broadly similar in the way they measure economic activity, but…that's wrong—they’re not. They're quite different and that's why the PPP comparison doesn't, to me, make any sense at all.
FSN: So, it’s not likely that China is going to overtake the US as the world’s largest economy and, if it does, it’ll be temporary and also based on a highly flawed comparison of GDP figures, which are largely overstated when not adjusted for bad debts. Going back to China’s adjustment process, where do you think this will have the greatest impact on the market or with certain sectors?
Pettis: In the past, Chinese demand was driven primarily by investment. That's going to be a smaller and smaller part of demand. It's going to be a contracting share of demand and, remember, China's GDP growth is going to slow. So, basically, investment growth is going to collapse, consumption growth won't. It'll continue at current levels. So things that depend on Chinese investment demand will do very very badly. China, as you know, is only about 12% of the world, if you believe current GDP numbers, but it consumes 60% of global iron, 60% of global cement, 40% of global copper, etc. etc. That's really spectacular. I don't even think the US achieved that share of global demand and it's very easy to explain: Chinese growth has all been investment intensive, which demands hard commodities. As that changes, the price of hard commodities will fall. Again, three or four years ago I was saying commodity prices would fall a lot when iron was at $190. I said it would drop by 50% within in five years. Three years later I think it's around $120, but I think I was too conservative. I think it's got at least another 50% to go. In fact, I expect iron ore prices will drop below $50 and we'll see that with other metals too. So, the impact on the rest of the world depends on which side of the trade you are on. If you are a Brazil or a Chile or a Peru or an Australia, you are going to be really badly hurt by the Chinese adjustment. But most countries are importers of hard commodities so they'll actually do quite well out of the collapse—and I don’t think that's too strong of a word: the collapse in the price of hard commodities. Consumption products will continue growing strongly because in an ordinary adjustment, Chinese consumption growth will continue at 5-7%. So companies and countries that produce manufacturing products for consumption will do very well. Companies that produce capital goods or produce products for investment—subway trains and things like that—are not going to do very well. And companies or countries that are very dependent on hard commodity production will do extremely poorly.
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