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Chris Martenson: Welcome to this Peak Prosperity Podcast. I am your host, Chris Martenson. This rise of China as an economic powerhouse and a massive consumer of resources, such as oil and copper, over the last decade has been extraordinary. If you want to know where the global economy is located, you need to keep China front and center in your view

The story of China is so big, and the methods for measuring it so new and subject to the usual conflicts of interests between and among the reporting parties, that really our best hope of understanding what is going on and where things are headed is to take a macro view and look at how things are balanced or not across the entire economy.

Fortunately, today we are joined by China expert Michael Pettis, who has the best grasp of the macro storyline for China that I know of. Michael is a Beijing-based economic theorist and financial strategist and is currently a professor of finance at Peking University in Beijing. Michael and I met this past April when we both presented at the Wine Country Conference in Sonoma, California. There I found his insights and forecasts in China the most astute I have ever heard. I am very pleased that he is joining us today to discuss China’s present and future. Michael, thank you so much for joining us today.

Michael Pettis: Thank you.

Chris Martenson: You recently wrote a Financial Times piece that China’s main task is to re-balance its economy and that this rebalancing will pretty much guarantee that its rate of economic growth is going to slow down. What is this rebalancing? Why must it happen, and why will it assure a slower rate of growth?

Michael Pettis: In order to understand the story of China, it is important to start with the recognition that contrary to much of what we have been hearing in the last few years, there is nothing particularly unique or extraordinary about what is happening within the economy. Certainly China has grown at a tremendous rate in the last 30 years, but lots of countries have had investment-growth miracles. Maybe not as long as China and maybe not as profound as China’s investment, but there is quite a lot that we can learn about what is happening in China from looking at previous experiences.

It turns out that the Chinese growth story is one we have seen many times before, and it typically starts out very well. The story begins with the period in which the country, in this case China, has tended to be systematically invested. Twenty years ago, thirty years ago, China had no roads, no airports, no manufacturing capacity. Its economy had been pretty much decimated between the period of the anti-Japanese war and then the first two or three decades of Communist leadership. So what China really needed was a significant increase in investment to raise its productivity level, and in fact, that is what happened. We saw investments grow very rapidly during this period. And with all of that increased investment, investments in manufacturing capacity and investment in infrastructure, etc., with all of that investment, we saw very strong, very robust growth take place in the Chinese economy.

But the problem that this model has always faced is that after many years of investment, two things happen: First, the political and economic system gets built around this constantly increasing level of investments, and second, we move from a period in which it is fairly easy to identify economically viable projects – basically, China did not have anything and could use a little bit of everything – to a period in which investment levels are still high. China has the highest investment rate ever recorded, and the highest growth rate of investment probably ever recorded, that we start to run out of economically viable projects. But because the system was so geared towards continuous increases in investment, we keep on investing, and when that happens, investments are misallocated into projects that do not generate sufficient real returns on a social basis.

And so, since these investments are funded by debt, one of the consequences is that automatically you find debt growing faster than debt servicing capacity, which, of course, is unsustainable. This, by the way, has happened to every single country that has followed this growth model, so it should not be such a shock to us, but it is happening to China, too. The problem is, we have been doing this for so long, I think in retrospect we will probably look back and see China as the most extravagant period of overinvestment ever seen, exceeding even Japan in the 1980s – that is, the result has been that debt models in China are extremely high.

So all of this talk about rebalancing the Chinese economy is basically a recognition of this fact. We can no longer count on investment to drive growth, because investment is being misallocated, but unfortunately, the economy is so dependent on investment that if you bring investment levels down – which you have to do if you want to address the debt problem – then you also bring growth down very significantly. We just started to see that process. Investment has not come down, it has not even slowed that dramatically; it has slowed a little bit. Growth rates dropped from roughly 10%, which is where they were before 2008, 2009, to around 7% today, and I suspect they are going to drop an awful lot more before this process stops.

Chris Martenson: The normal sector that would then be expected to pickup and fill in for the investment portion would be household consumption. Where is household consumption in China today?

Michael Pettis: Household consumption in China is probably the lowest ever recorded in times of peace, which is another way of saying that China’s savings rate is the highest ever recorded. Now, we normally think of savings as a good thing, but savings is just postponed consumption, and the purpose of economic growth is to generate increases in consumption. So the problem that we have in China is that consumption is so low and savings so high that it is very hard for growth and consumption to generate a great deal of GDP growth. So we want growth and consumption to replace growth and investment as the generator of growth, but that is going to be very hard to do.

One of the big misconceptions about China is the nature of Chinese savings. China has the highest savings rate possibly ever recorded, and people say it is quite easy to solve that problem. When people save too much, all you have to do is convince them to reduce their savings rate and increase their consumption rate, and the problem is solved. But that is a fallacy, and that is based on our mistaken belief that savings are equal, savings are caused by household savings. But no, there are three parts of the economy that save: the household sector, the government sector, and the business sector. And all of them save at quite high rates, which is why overall savings is so high.

So how do you bring consumption up? Well, it turns out the reason consumption in China is so low is not because Chinese do not like to consume. You only need to visit any city in China and you will see that the Chinese are as eager to consume as anybody else. The problem in China, though, is that all of this very rapid growth was generated by these hidden transfers from the household sector to subsidize growth. In other words, wages grew too slowly. Although they have grown quickly, the currency has been undervalued, which is like a tax on consumption. And most importantly, interest rates are set extraordinarily low, which is like a tax on household savings.

All of these things have generated rapid growth, but they did so at the expense of the household sector, so household income grew much more slowly than GDP. So the household share of the economy was contracted to the point where, at roughly 50%, it is probably the lowest ever recorded for any large economy. The exceptions are one or two oil sheikdoms that have their own distortions. So if you want consumption to grow as a generator of growth for the economy, what you are asking for is for household income to grow – to generate or grow – for the economy. In other words, instead of contracting the share of GDP, you want household income to expand as a share of GDP.

And therein lies the big problem. Because if you eliminate all of those transfers, those hidden taxes, then you also eliminate the source of growth. More importantly, for many years, while China was growing quickly and the household was growing a little bit less quickly, the space sector was growing more quickly, and that generated tremendous benefits for the political elite. So rebalancing in China means that the household share has to grow, which is another way of saying that the state share has to contract. Perhaps not surprisingly, that is going to be strongly resisted by many members of the political elite, which is why the problem that China faces today – the rebalancing problem – is primarily a political problem more than it is an economic problem.

Chris Martenson: So it is really a shift of wealth, and therefore power. And if I have this story right, then for the household income to go up, you can do just a couple of things, which are your big levers. One, you can raise the interest rates on the deposits. Of course, that is going to raise the cost of capital; that slows the economy down. Or [two], you can have income go up, which means wages go up, and that is part of the economic miracle story – keeping wages low so that there is a competitive advantage. Is that roughly right?

Michael Pettis: Exactly right. In fact, they are all related. There is a third thing you can do, and that is to raise the value of the currency. Remember that if the currency appreciates, that eliminates this hidden consumption tax and it makes imported goods cheaper, so it makes the real value of household income go up. So you can do all of these things. But if you raise the currency, that helps the household sector but it undermines the export sector. If you raise wages, that helps the household sector but it undermines employers as a group. And most importantly, if you raise interest rates – this is the key distortion – if you raise interest rates, that helps the household sector because they get a much better, a fair return on their existing savings. But of course that is very, very painful for the borrowers.

There is so much debt in China, it is not even clear that a lot of the borrowers can pay the debt at the existing very low interest rates. So if you were to raise interest rates to whatever the right level ought to be, you would probably see a surge in insolvency, so it is a pretty tough problem to resolve.

Chris Martenson: It has echoes elsewhere in the world, where rising interest rates would be very unwelcome in many a sovereign state at this particular point in history. So where are we in the story, then? It sounds a little bit like a potential stalemate, because there are so many competing interests, all of which are very powerful. How is this story beginning to resolve? Or is there any clarity around which of these big levers is going to be the one that is going to be pulled?

Michael Pettis: We are right in the middle of the process. The good news is that the current leadership, perhaps unlike the previous leadership, is pretty determined to get their arms around the problem rather than just simply kick it down the road a bit longer. Now this may be for the right reasons, or it may simply be because debt levels have risen so quickly that they are understandably concerned that if they do not fix things, we run the risk of running into a debt crisis.

Whatever the reason, the new leadership under the Premier Li Keqiang seems pretty determined to try to contain the growth in credit, but it is a not an easy thing, and the jury is out. There has not been a significant slowdown in credit; what has happened is the growth rate of credit has slowed down, and already we have seen that has had a big impact on GDP growth rate. This has to continue, and it is going to be strongly resisted, so it is not very clear to me yet what is likely to happen. But I would say as a rule of thumb, if you see growth rates in China much above 4% or 5%, you can almost be certain that that is continuing to rise at an unsustainable pace. It is going to take much more growth rate before we can be reasonably confident that they have their arms around the debt problem.

Chris Martenson: We saw, I think, some early salvos of this with the overnight lending rates that really spiked. Is that particularly to this story? Was that an attempt to constrain this credit growth by putting out a message, or was there something else going on there which pretends something more frightening, such as liquidity freeze that could have rippled through the banking system?

Michael Pettis: I think it is a little bit of both. On the one hand, the central bank –

under the guidance of the state council because the central bank is not independent – the central bank has wanted to slow down credit creation and is willing to see interest rates go up as part of that process. But I think what happened on July 20 when we had the credit crunch was a big surprise to everybody; I think there was even a little bit of panic in the markets.

And the reason for that – and I think we are going to see more of these kinds of things – is that we have reached the stage where a lot of credit growth consists simply of borrowing to repay existing principal and interest. So if you allow interest rates to go up, that does not necessarily slow down the demand for credit, because the borrowers desperately need the money to repay earlier loans; it is not as if they are borrowing money to invest in productive facilities. So this demand for credit is going to stay very strong, and any attempts to slow it down may end up causing pretty significant disruptions within the money markets. So this is not the first disruption we have seen. It is the first big one that was widely noticed around the world, but we have seen these before and we are likely to see them again. They system is very tightly wound up around the need to create credit, and it is going to be very hard to wean it off of that need.

Chris Martenson: So certainly there is a very large economic risk that can happen if you do run into that credit crunch, and that is something that I think is – also, we could look historically and say these things happen. When you have mal-investment, and you have credit growth that has exceeded the underlying rate of economic growth, and you are just now rolling over new credit to pay off past credit, that is a knife edge and it is fraught with some economic risks, even some fairly significant systemic financial risks as well. But socially and politically, what are the risks that exist if this system does really hit a wall of some kind?

Michael Pettis: It is always tough to predict the downside, because the downside is infinite; you can always mismanage a crisis. But in principle, we do not really need to see a great deal of social dismay if there is a rebalancing of the economy. My own expectations are that over the presidency of Xi Jinping, the ten-year period, it is very hard for me to figure out how just arithmetically the country can rebalance at growth rates that average much above 3-4%, so I consider that to be the upper limit of growth over this decade, more now and less later.

Now, a lot of people will tell you if that happens, we run the risk of significant social disturbance and even political crisis within China, because we keep hearing over and over again that 8% growth is the minimum amount of growth required to keep the population happy. To say “some number” is nonsensical; it is not really clear where it came from, but it is also the irrelevant number. People do not care about GDP per capita; people care about their own income. So instead of focusing on very high levels of GDP growth, what we really need to be concerned about is how you keep household income growth high.

Rebalancing by definition means that household income must grow faster than GDP, so if GDP grows to 3% to 4% as I expect it to or as I think is the upper limit, but household income grows at 6% to 7%, I would argue that not only is China achieving the necessarily rebalancing, but there is no reason why ordinary people, ordinary Chinese households, should be unhappy with growth rates of 6% or 7%. That is pretty close to what they have been experiencing in the last 20 to 30 years, and by any standards, that is a great number.

The trick is, after many years in which household income grew much more slowly than GDP, how do you get household income to grow more quickly than GDP? It can be done. If you look at Japan – which has a similar problem to China in the 1980s, although not as extreme – after 1990, Japan’s GDP grew by roughly 0.5% on average, but household income grew by about 1.5-2%, which, when you throw in deflation and a declining population, suggests that Japanese households did not perform nearly as badly in the last 20 years as you might have thought by looking at the collapse in GDP growth rates.

So there is a way for China to do this, there is a way for China to rebalance without significant pressure on the household sector. But notice that Japan rebalanced at growth rates of nearly zero percent, and my expectation is not zero percent but that the Chinese rebalancing will also come at a much lower growth rates. The key, though, is the politics of it. Instead of transferring resources from the state sector to the household sector as part of the rebalancing, which would have been the most efficient way of doing it, what we saw in Japan was a transfer of debt from the private sector to the state sector, which is a politically very easy way of handling the transition but economically not a very good way of doing it.

So for me, the really big question is, will China be able to rebalance at reasonable growth rates? And more importantly, at reasonable growth rates on household income, first of all? And then secondly, if it does so, is it doing so because it is transferring wealth from the state sector to the private sector, or is it doing so because it is transferring debt from the private sector to the state sector? And like I said, the jury is out; we really do not know. But these are the things that we are going to have to be watching over the next two to three years.

Chris Martenson: That is a fascinating parallel, and I am wondering if it goes further, because Japan had its own mal-investments. You are noting this investment-led growth model, and of course, one of the big places was in real estate in Japan. And having listened to Jim Chanos at that same conference that we were at, and him talking about where real estate investment has gone in China – and obviously, there have been a lot of stories and a lot of press written around that, if the household sector has a lot of their wealth tied up in Chinese real estate. And that is in bubble territory or mal-investment, over investment, even if their income and wages is rising and/or interest payments, other forms of cash-based income, are rising. If they follow the Japanese model and we look at their overall wealth and there is a correction in the property bubble, that will be a countervailing force to this rise in potential consumption from the household sector.

In your mind, what is the risk in the Chinese real estate sector to this story, and what should we be watching out for there, if anything?

Michael Pettis: I think there is a significant risk. I think it is very hard to believe that real estate prices can continue rising. Beijing is a more expensive city than New York, which, when you consider the differences in income, really does not make sense. Shanghai is more expensive than New York, but the good news is that most of the real estate seems to be owned by the fairly wealthy, so if there is a collapse in real estate prices, that hurts the rich more than it hurts the poor and the middle class.

And from an economic point of view, that is very important, because the rich consume a very small share of their income, and the reduction in their income should not result in a significant reduction in their consumption. After all, if you go from being worth $500 million to being worth only $200 hundred million, it is not as if you are going to significantly reduce your consumption levels. So that is not going to be a big problem.

For me, real estate gets all the attention, because it is very photogenic and it is very easy to understand. But the problem in Japan in the 1980s, and even more so the problem in China today, is not the real estate model; it is the infrastructure model. China has built out an astonishing amount of infrastructure, and many people think that that is a very good thing; it is great to have a lot of infrastructure. Well, it is great to have the right amount of infrastructure, but in the case of China, the quality of the infrastructure far exceeds the productive value of that infrastructure.

For example, one of the longest and the most beautiful bridges in the world was just built in Qingdao, and I want to go and visit it. It opened quite recently, but I am told that there is almost no traffic on that bridge. That to me is a much bigger waste of money and a much bigger cost that the Chinese have to bear in the future than empty apartment buildings. But when interest rates are much too low – we saw this in the United States – you have a tendency to get asset bubbles of all types.

And we have seen that here; we have seen too much money going into real estate, too much money going into infrastructure, and too much money going into manufacturing capacity, when we can produce tons of stuff the world does not need. And that is really the problem that we have here in China. We spent enormous amounts of money building stuff who’s economic value simply does not justify the cost. And we have not recognized that loss yet. It is all buried in the debt, in the banking system. But by hook or by crook, we are going to recognize that loss over the next ten to twenty years, and we are going to recognize it in the form of much lower GDP growth.

Chris Martenson: This is absolutely fascinating. I am wondering if this begins to shed light on something that has been a bit of a mystery to me, and that is the Shanghai Stock exchange. Looking at it here, it is down roughly a third over the past two years, and yet China has had the most robust growth on the global landscape over that time frame. The Shanghai stock exchange seems to be very out of step with its global counterparts, many of which are hitting new highs even as growth loops along out there in the world.

Is this story that you have been telling about this investment lead growth finally running into marginal projects? Is that what is being reflected in the stock exchange, or is that connecting too many dots and we cannot really go there to understand what is happening?

Michael Pettis: It is a bit of a puzzle with money poured into everything. Premium teas are at all-time highs, Chinese calligraphy is at all-time highs, jade is more expensive than gold – the highest quality jade. The prices of everything has gone up, which is what you would expect when there is very rapid money growth at incredibly low interest rates. Interest rates may have been negative for most of the past decade in real terms, and one of the places money normally shows up is in the booming stock market.

I think my own personal opinion is that the stock markets in the United States may be reflecting cheap money more than they are reflecting fundamental value. And we would have expected that in China, but not that much money has gone into the stock markets. And the reason for that may have been that we sort of had our stock market bubble in the run-up to the Olympics, prices went to extraordinary levels. And it was one of those classic stock-market bubble stories, which – like, everybody in China was playing the stock markets, with all the classic stories you hear associated with that – cab drivers, etc.

But when the market started coming down, it created enormous consternation among Chinese investors, because there really was a sense that this was not supposed to happen, that stock prices should not be coming down, that China is growing quickly, this should go up ever onward – and of course, that turned out to be wrong. And it seemed like the bursting of the bubble in late 2008 and 2009 was so painful that households had really resisted coming back into the stock market.

So its the only part of the economy that does not indicate liquidity – every other part of the economy is showing way too much liquidity – will that turn around? Probably not, just because the concerns about the Chinese slow-down are so great now, particularly within China, that we are actually much more concerned about money leaving the country than about money inflating the stock market bubble. But you never know; this could continue for another year or so before it corrects, and during that time we may see money start finding its way into the stock markets. But Chinese households were really badly burnt by the last bubble, so they are probably going to be reluctant from going in for quite a while.

Chris Martenson: Fascinating. I am wondering if you can shed some light, then, on another asset class. You mentioned calligraphy is way up; jade is way up, it is more expensive than gold, in some cases, for higher quality jade. I want to talk about gold for a minute because I am absolutely astounded by the import tonnage that has been coming into China as reflected through the Hong Kong exchange that exists there. Are households the drivers of this fascination with gold and all this importing? Is that perhaps – are they viewing it as a better safer asset class than stocks at this point in time and that is a measure of this liquidity as well?

Michael Pettis: I suspect so. With the price of everything soaring – anything that retains value the price has gone up – it is probably not a surprise that a lot of Chinese think the gold might retain value, so they are buying that. So it is very interesting to try to figure out what will happen next.

I am not really a gold expert, but I did notice that in next-door Vietnam, I think it was about two or three years ago when the financial sector first started getting into serious trouble, there was a brief period, a six-month period, in which Vietnam, one of the smallest economies in the world, was actually the world’s number one trader of gold bullion. My reason for thinking that, I suspect, was not very controversial, but as the banking system got into trouble, the Vietnamese fled into gold as a way of protecting their other savings. So could that happen in China. It could.

We might see if there is more weakness in the financial sector, money flowing into gold, but I suspect that there will not be anywhere near the extent that it was in the case of Vietnam simply because as long as the government is credible – and I think the government has tremendous credibility among Chinese people – then the implicit guarantee of the banking system suggests that the Chinese will not be in a panic to take money out of the banks. If they ever are, I suspect a lot of that will go into gold, silver, and anything else that retains value. But I do think that credibility is still quite high, so I do not see any near rush for the doors.

But certainly the Chinese are buying everything, Chinese artists and antique furniture, everything that retains value is being eagerly sought after by middle-class and upper-class Chinese.

Chris Martenson: Interesting. The final question here, then, relates to the value for currency itself. There has been a lot of talk back and forth about the yuan becoming the next player in the world-reserve currency landscape. I know that China has set up bilateral trade agreements so that they can do direct currency transfers with certain trading partners. Obviously China is moving to integrate more with the world currency system. What are the chances of that really happening, and what needs to happen in order for China to actually become a reserve currency?

Michael Pettis: There is so much hype and nonsense about that, it is a little bit hard sometimes to disentangle it all. But it was only 20 years ago when you would have had to have been a complete and total idiot not to know that the Japanese yen was going to become the dominant reserve currency – and of course that never happened. And the renminbi, the yuan in China, is even less likely than the yen, I think, to become the dominant reserve currency or even the major reserve currency.

And the reason is, first of all, there has been tremendous growth in the use of the yuan in international trade, but its growth from a tiny base – remember that China is the second largest economy in the world, and it may very well be the largest; it may have overtaken the U.S. as the largest trading nation in the world. And yet the yuan is not among the top ten most actively traded currencies in the world. Last time I looked at it, it was something like fourteenth, which is tiny, tiny. It is negligible. You will not see any of the top five, six, seven economies of the world whose currencies are not also among at least the top five or the top ten currencies traded. The exception is China, the number two economy with a barely traded currency.

So people say it is not actively traded, but it is growing very, very quickly, and the government wants it to grow very quickly, so it must – well, not necessarily. It is very hard to have an internationally traded currency. And by the way, it is not a good thing. Actually, in my latest book, I refer to the so-called “exorbitant privilege” of the dollar as actually an exorbitant burden. Because if your currency is the dominant reserve currency, it means that any time a country wants to turbo-charge growth, it actually accumulates your currency, thus running a current account surplus against the U.S. current account deficit. A reserve currency needs to be able to accept those kinds of pressures, and I do not think China would ever be willing to accept that.

But more importantly, most monetary economists will tell you that open capital controls – that is, the complete freedom of money moving in and out of China, which is a prerequisite if it is going to be a dominant trading or reserve currency – is a very, very risky factor, particularly for a developing country whose financial system is not very flexible and robust. And China’s financial system is not flexible nor robust, and it may even be insolvent.

So is China eager to allow massive inflows and outflows of capital likely to destabilize the banking system? Probably not; they should not want to do that. So why all of this talk? Part of it is probably because most people simply do not understand what it means, and they think having the dominant reserve currency is like having a very large flag – it is a nice thing and it generates tremendous pride. I think not; I think it is a huge cost. But more importantly, the argument within Beijing is that the central bank and the reformers have been pushing for the internationalization of the renminbi as a back-door strategy to force domestic financial