Michael Pettis on Chinese Liberalization Reforms and Economic Growth

Two posts worth reading by Michael Pettis (here and here; might need subscription). He suggests in the first one that reports that consumption in China is much higher than previously thought are exaggerated (Ken Peng suggested here that consumption levels are 10% higher than what is often assumed, i.e. closer to 45% rather than 35% of GDP). He argues that if China is to continue to grow, even at a slightly reduce pace, then it:

"must find a way to grow without even faster growth in credit, and the best way to do so... is to boost consumption growth by sharply increasing the household income share of GDP and to shift investment from the state sector to far more efficient smaller businesses."

No problem with the first part. Not sure about the second, i.e. the notion that small private businesses are more productive than large public firms. In fact, public investment has been central for Chinese growth all along, and if anything it is the decline in public spending that has hurt the recovery in developed countries.

A note of clarification on why he argues that credit expansion is dangerous in China. He says in his most recent post that:

"A recent China Beige Book survey suggests that a large and rising share of new loans is being extended simply to roll over old loans that cannot be repaid out of operating earnings. China needs credit growth, in other words, just to avoid recognising bad loans, and any attempt to constrain money growth is likely to cause a surge in financial distress."

Fair enough, but as noted before here, these bad loans are in Chinese currency and do NOT represent a real threat to economic growth, since the central bank can always act as a lender of last resort in domestic currency. The solution he proposes makes even less sense, namely: interest rate liberalization, which was in the list of measures proposed by the infamous Washington Consensus (point 4 in Williamson's original decalogue).

The idea is that market determined interest rates would be higher and preclude excessive debt accumulation, I imagine. Also, higher interest rates would reduce investment, particularly in housing, again in my interpretation of what Pettis suggests. Yet, the experience in countries that actually liberalized interest rates, and the whole financial system, was not to reduce debt and tame excessive speculation.

The demand for credit depends on real economic activity and if consumption and investment (in particular public investment that is autonomous) continues to expand it will increase even with higher rates of interest. The effect of interest rate/financial liberalization is to increase the share of the pie that goes to creditors and capital in general, which according to Pettis' correct logic would reduce the redistribution towards wages and slowdown growth.

Mind you, although Pettis seems to think about credit creation in mainstream terms, with credit driving economic activity, he can be read as suggesting that growth is demand-led, which is pretty radical.