Michael Pettis's Contributions

Three weeks ago the Wall Street Journal published my OpEd piece about concern that China may try to make the rebalancing process less painful by allowing the RMB to depreciate. In the piece I argue that this isn’t as obvious as you might think.

We need to be worried about debt, in Europe and the US of course, but we need also to be worried about debt in China. The deleveraging process in any country always results in much slower growth than during the period in which debt was rising quickly, and what matters is overall deleveraging, not just government debt.

China’s official GDP growth rate has fallen sharply – on Friday Beijing announced that GDP growth for the second quarter of 2012 was a lower-than-expected 7.6% year on year, the lowest level since 2009 and well below the 8.1% generated in the first quarter. This implies of course that quarterly growth is substantially below 7.6%.

To start off, in mid-June, just a couple of days before the Spanish treasury raised $2.2 billion in an auction – one in which the cost of borrowing surged, with 10-year bonds breaking 7% – France’s new president complained about the unfairness of the financial markets.

Premier Wen’s recent attack on the Chinese banking system last month has highlighted what was already a very interesting debate on Chinese banks and the Chinese financial system. There is a growing sense that the Chinese banking system is deeply flawed and needs to be reformed.

Perceptions have certainly changed a lot in the last few months. As recently as three years ago there were so few analysts who were skeptical about the sustainability of Chinese growth that we rarely disagreed among ourselves.

The process through which monetary expansions lead to economic globalization has remained consistent over the last two centuries. Typically, every few decades, a large shift in income, money supply, saving patterns, or the structure of financial markets results in a major liquidity expansion in the rich-country financial centers.

For several years I have been saying that Spain would leave the euro and restructure its external debt. I should say that I specify Spain because it is the country in which I was born and grew up, and so it is also the country I know best. When I say Spain, however, I really mean all the peripheral European countries that, like Spain, are uncompetitive, have high debt levels, and suffer from low savings rates that had been forced down in the past decade to dangerous levels.

As more and more analysts are beginning to understand the constraints of the Chinese growth model I think it might be useful to list some of these predictions to get a sense of what might be still to come.

No matter how sincere its intentions, what Beijing says it will do over the next few years is meaningful only if its policies are both internally consistent and do not violate external constraints.

In this issue of the newsletter I want to sketch out a scenario in which rather than analyze policy announcements or make predictions I try to lay out what are the various possible paths open to China. The scenario concerns trade. China’s current account surplus has declined sharply from its peak of roughly 10% of GDP in the 2007-2008 period to probably just under 4% of GDP last year.

Contrary to some recent research reports cited in the press I do not think we have seen any substantial rebalancing of the economy towards consumption in 2011. This is largely an argument being made by economists who did not see why Chinese consumption repression was all along at the heart of the growth model.

In 2008 and 2009 I argued that the crisis we were undergoing would affect every major economy in the world, but not necessarily at the same pace. I suggested that the US typically is quick to adjust and, given the pace of deleveraging that was already taking place, I expected that it would be the first major economy out of the crisis, probably in the next two to three years, as private debt levels continue to decline and public debt growth slows.

Europe’s underlying problem is not budget deficits or even unsustainable debt. These are mainly symptoms. The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%.

For years I have been arguing that the Achilles heel of the Chinese growth model is the unsustainable rise in debt that comes as a necessary consequence of capital misallocation fueled by bank lending.

In China economists are watching the spectacle in Europe, China’s largest export market, with rising dread. Might European deterioration affect Chinese growth? October and November tend to be very important months for Chinese exports, and so the prospect of a miserable Christmas in Europe is weighing heavily on Chinese exporters.

I have already discussed last month why I think the desperate attempts by Europe to get China and other Asian and BRIC countries to bail out the weak sovereign borrowers is absurd, but the topic has become so important in the past two weeks, at least judging by the number of calls I have received from journalists, that I thought I would reproduce a discussion I recently had in a forum among a number of China specialists (the forum is Rick Baum’s estimable ChinaPol).

Last week’s Senate bill on Chinese currency intervention predictably enough brought out all the same old arguments about international trade, and just as predictably has hardened the opposing positions in the debate.

There have been many "economic miracles" throughout history, which, ironically enough, have all been based on a similar investment growth strategy. This model, first invented by the French in the early 1800s, always proceeds along the same lines and, as explained, is no different for China currently.

My friend Mark Williams sent me last week a reference to a very interesting paper written by Malhar Nabar, an economist at the IMF. The paper is called “Targets, Interest Rates, and Household Saving in Urban China” and in it Nabar tries to measure the impact of changes in the real deposit rate on changes in Chinese consumptions levels.