Michael Pettis on China: Too Much Credit Not Just a Problem for Shadow Banking System

Investment professionals may not always agree on the relative importance of the big, macro themes driving the global economy, but on one point, at least, you’d be hard-pressed to find much dissent: How successfully the Chinese authorities manage the potentially destabilizing imbalances in their economy over the coming years will have dramatic repercussions far beyond Asia. Recently, the People’s Bank of China (PBOC) has embarked on a strategy to limit so-called shadow lending throughout the Chinese economy by asking commercial lenders to provide capital to the “real” economy and avoid lending for “financial speculation.” As substantial, informal channels for capital were shut down, demand within the formal channels rose sharply, creating a severe liquidity crunch within the Chinese banking system. With commercial lending rates soaring, the PBOC injected massive amounts of liquidity in an effort to regain control of lending markets.

This episode, only one of several recent signs that the Chinese economy is weakening, helped send shares of Chinese stocks into bear-market territory. If our recent poll is any guide, investors expect that further deterioration of the Chinese economy is in the offing.

To help shed some light on recent developments in China, we’ll be asking several in-country experts to share their views. For our first installment, we turned to Michael Pettis, senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. Pettis may be known as a China bear, but he has said that he prefers to be characterized as a “China skeptic.” Last year, he predicted that the growth rate in investment in China would collapse.

CFA Institute: How effective were the PBOC’s recent actions at curtailing so-called “shadow lending” in China?

Michael Pettis: Excess credit expansion in China is not just a problem for the shadow banking system. Economic activity in China is highly dependent on investment growth, and since much of the investment over the last few years has become nonproductive, this means that the only way to keep the economy growing quickly is if debt grows even more quickly. The PBOC’s actions last week may or may not constrain shadow lending — it is too early to say — but the more general point is that any serious measures to limit the growth in debt will also sharply reduce GDP growth.

CFA Institute: How extensive are bad debts in China, and is the liquidity crunch at least in part a reflection of a bad debt situation there?

Michael Pettis: We don’t have good numbers, but it is hard to believe that after several years of ferocious credit expansion at artificially low interest rates there isn’t a significant amount of bad debt in the system. The need to keep rolling over debt, much of which simply cannot be repaid otherwise, is part of the reason for the liquidity strains last week.

CFA Institute: Are China’s banking problems resolved?

Michael Pettis: No. You can only resolve a bad debt problem by assigning the cost to some sector of the economy. In the past it was the household sector that implicitly paid to clean up the debt, but if we expect rapid growth in household consumption to lead the economy going forward, and this is what rebalancing means in the Chinese context, we cannot also expect the household sector to clean up the bad debt in the same way it has done so over the past decade.

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