I recently listened to a presentation by Michael Pettis where he expressed his views and outlook for the Chinese economy over the next few years. Pettis made several interesting points that, if correct, would have large implications for Australia.

The Chinese growth model is not a new model (think mercantilist) and as it currently exists it is not sustainable. Capital has not been allocated correctly (i.e. according to market forces) and as a result there is massive malinvestment in things like infrastructure, state-owned and export-focused industries. A huge amount of wealth has been channelled into these areas at the expense of the Chinese consumer through direct state investment or, worse still, camouflaged subsides to state-owned enterprises (SOE’s).

This was fine 20 years ago – China lacked infrastructure and it was easy for the government to find things to invest in. Roads and railways actually represented economically viable investments that had previously been neglected. A problem arises when these ‘easy’ investment opportunities no longer exist (China today) in that any further investment into this kind of infrastructure provides very little net return to the Chinese economy – and because price signals and market forces have been so distorted or suppressed, the capital allocation problem becomes increasingly difficult and capital is increasingly likely to be squandered on wasteful projects.

Amplifying this issue is the old concentrated benefits and dispersed costs problem that we have discussed before and exists in any modern democracy let alone ‘managed’ economy. That is, incentives faced by bureaucrats and politicians necessitate that they will misallocate investment decisions on a massive scale because there are short-term gains for people in power (GDP growth, higher local employment, kickbacks) while the costs are paid for by a large, disorganised group of people in the long-term. This is particularly bad in China because the banking system is centralised and loans for local officials are artificially cheap and will often never be repaid. Pettis notes that “…probably beginning in the late 1990’s we [China] began misallocating capital; we began investing in a way that subtracts growth rather than adds to it but we don’t recognise that it subtracts growth for many many years”.

He goes to pains to stress that infrastructure is not a nominal issue but a relative issue – infrastructure is there to boost labour productivity and for China’s level of development (wage levels, productivity), it makes no sense for them to have the same level of infrastructure as, say, Japan, who's labour productivity and wages are ten times greater. The Chinese government has ignored this and as a result has massively misallocated resources in infrastructure investment; capital that could have been better used elsewhere.

Pettis also notes that while SOE’s may be profitable on paper, when you include all of their subsidies then almost all the so-called profit is accounted for by implicit debt guarantees, monopoly or direct subsidies from the state. Give that SOE’s account for about 50% of all loans in China, this is a big deal – if they are not in fact profitable then they are failing the most fundamental of market tests – they are not providing a net social gain. Pettis estimates that SOE’s are in fact making a loss somewhere between 6-8 times their stated profitability – a huge number that does not show up on their books because of these massive, hidden subsidies (much like how a lot of China's debt is hidden). Needless to say, capital is being misallocated on a grand scale.

Australian Implications

Pettis provides some ways out for China that they will have to take if they want to rebalance – both of which involve boosting household consumption, which has been suppressed by the Chinese government through control of the exchange rate (good for GDP and exporters; bad for household wealth), wages (again, if you keep wage growth below productivity growth then it is a subsidy for business and boosts GDP figures at the expense of households) and direct transfers (subsidies).

The first is for China to restructure towards a removal of subsidies to exporters, infrastructure, SOE’s etc., all of which presently comes at the expense of households. This will be a boon for the Chinese people as their purchasing power (real wealth) will increase substantially over time. This does not have to come at the expense of savings – I should note that trying to boost consumption at the expense of savings is a difficult if not impossible task (and downright foolish from an economic growth/wealth accumulation perspective) – it will instead have to come at the expense of state infrastructure spending, SOE’s, removal of growth obstacles and so forth. This is the ‘unproductive’ sector in China at the moment which, due to the way GDP is measured, most people think is the ‘productive’ sector (as it drives GDP ‘growth’).

In this scenario, consumption growth can increase as a % of GDP only when the growth in GDP falls as a result of a restructuring away from centrally planned big GDP boosters such as infrastructure, SOE and other subsidies (along with more rapid reversals of the current household to state transfers, i.e. privatisations). This economic empowerment of the Chinese people would be a good thing for China and the world (excl. Australia, Brazil, and Canada – commodity exporters).

The second scenario is if China tries to manufacture a shift towards consumption with more centrally-planned policies aimed at destroying savings while maintaining infrastructure, SOE and other subsidies and thus GDP growth: the Keynesian way. This method of trying to artificially boost consumption as a share of GDP is doomed to fail and is more likely to end in a hard landing for China as it has for every other mercantile-growth-theory economy in history. But, it can probably keep the “China miracle” (or rather, GDP growth) going for longer.

To conclude, China has a debt problem. China has a banking problem. China has an inflation problem. China has serious structural problems (misallocated investment). Whatever happens in China, all roads would appear to lead to bust for commodity exporting countries like Australia (assuming the European banking crisis doesn’t bring Australia down by restricting funding to our over-leveraged banking sector first). The difference between the two above scenarios, for Australia, is in the extent and in the timing.

Disclaimer: my summary is no doubt lacking, so please listen to the actual presentation – it is well worth the 40 odd minutes of your time.