Michael Pettis: Forget the Plenum

Yves here. Pettis highlights the difficulties of restructuring the Chinese economy to feature more small business lending and consumption and calls them “political.” I’m not sure I agree fully. While withdrawing the heroin from current favored sectors is difficult both practically and politically (you will gore a lot of powerful oxen), I believe he misses the issues on the other side of the ledger, that of increasing consumption and smaller commercial lending. Fostering more consumption isn’t just a matter of creating better social safety nets (although that is a critical component); it also depends on having retail infrastructure and larger average home sizes. For instance, one of the not-often-enough recognized constraints to increasing consumption in Japan it its bubble years was the small size of Japanese homes and apartments. They simply could not own all that much stuff.

On the small business side, that too requires the building of infrastructure and skills. I’ve remarked in passing elsewhere that one of the reasons we don’t see more small business lending despite the Fed’s fond hopes that pushing on a string will work is that the overwhelming majority of banks no longer do small business lending. (The bigger issue is lack of loan demand, but we’ll put that aside for now). 30 years ago, every large bank had a year or two-long credit officer training program. They’d then cut their teeth working on large corporate loans and some would eventually wind up doing middle market lending or managing branches, which meant they’d approve small business loans. That type of officer has almost entirely died out. Except at small banks, branches sell products and loans are scored against templates set at high levels in the bank. Character-based lending and the use of knowledge of the local market have gone out the window. But Chinese banks need to build the skills that have been largely thrown out the window in the US, and then train staff and build the needed systems and oversight. That’s infrastructure that takes time and effort to construct.

Cross posted from MacroBusiness

Exclusively from Michael Pettis’ newsletter:

While the whole world speculates ceaselessly on what to expect from the Third Plenum… I am going to avoid the subject almost altogether. I am not doing so because the Plenum doesn’t matter, but rather because to me the only interesting questions are political, and these questions will almost certainly not be addressed publicly. Although we may disagree violently about the specifics, the timing, and the sequencing of reforms, most economists basically understand what China must do. It must regain control of credit by reducing investment misallocation, and as it does so it must increase the role of household consumption and investment in small and medium enterprises in driving demand.

This is above all, however, a political problem, not an economic one. Instead of directing unlimited amounts of very cheap credit and other economic resources to approved borrowers and powerful entities, in other words, we must now direct them to small businesses and ordinary households.

The past two years have seen a surprising amount of turmoil at the highest levels of the Chinese political establishment. The arrest last year and conviction this year of Bo Xilai, scion of one of China’s most powerful political families and a high flyer for whom no office seemed out of reach, was only the most spectacular episode in a series of events that have seen political alliances re-shuffled, powerful business and political leaders arrested, factional disputes magnified, and an explosion of rumors of more to come. After twenty years of what seemed, on the surface at least, remarkable cohesion within China’s political elite, events of the past two years have come as a great surprise to many.

And yet the historical precedents suggest that none of this should have surprised us. After nearly thirty years of spectacular economic growth and impressive social and political advances, China has exhausted the growth model that had once served it so well. It now suffers from many of the internal imbalances that were the near-automatic and easily predictable consequences of the policies associated with the growth model it had pursued, and policymakers in Beijing are very aware of the urgent need to adopt a new set of policies that will allow China both to rebalance the economy so as to protect itself from the consequences of soaring debt and to lay the foundations for another thirty years of solid economic growth and social and political advancement.

China is not the first country to have experienced a long period of miraculous growth. But, as University of Chicago’s Robert implied in his Warholian quip about growth miracles (“in the future every country will grow rapidly for fifteen years”), the most difficult part of growth miracles has not been the growth miracle itself but rather the subsequent adjustment. Consider the most notable examples: the United States in the 1920s, Germany in the 1930s, the Soviet Union from the late 1940s to the early 1960s, Brazil from the late 1950s to the late 1970s, Japan in the 1980s, and many others…they were not always resolved successfully.

In some cases, for example that of the United States and perhaps Brazil and South Korea, the adjustment was brutally difficult but the institutions that evolved during the adjustment period laid the groundwork for many more years of growth and stability (and a shift from military authoritarianism to a robust democracy in the latter two cases). In other cases, for example that of the Soviet Union, the adjustment period was long and protracted, and because during the adjustment period the country was unable to develop the right set of institutional reforms, it eventually collapsed into the kind of chaos from which it is still struggling to emerge. In still other cases, for example Japan, the adjustment seemed to leave the country locked into stagnation.