Michael Pettis's Avoiding the Fall is a tour de force on the structural imbalances facing China's economy. Pettis offers the most comprehensive and compelling case for the pessimists who see a major slow down (beyond the one that has already occurred) in the offing for China. Already inclined to side with the pessimists, reading Pettis's book has made me even less hopeful of a soft landing as China restructures.
The first two chapters present the external and internal imbalances, respectively, and do so in a manner that is accessible to non-economists. The first chapter helps set up the rest of the volume by demonstrating that China has not rebalanced towards a more consumption-driven economy, even though its trade surplus has decreased relative to the enormous peak of 10 per cent of GDP. Adding a necessary international political economy dimension, Pettis argues that large trade surpluses will be increasingly unacceptable for the trade-deficit countries given the global financial crisis. Thus, the trade-surplus countries will have to bear the brunt of adjustment even if they are very reluctant to do so (here Pettis points out that Japan is as reluctant as China to accept such adjustment). The second chapter provides an incisive account of the rise of China's unsustainable investment-driven growth and draws parallels with earlier developers’ pursuit of similar financial repression policies. The chapter also delineates excellently the three different ways (lagging wage growth, undervalued currency and repressed interest rates) that resources are taken from households to subsidize producers, and the different distribution of costs and benefits across households and producers.
Chapter three provides general structural reasons to suspect that capital is inefficiently allocated, including the low cost of capital among other distorting subsidies, the long-time horizon to realize the cost of investment relative to the realization of the benefits, widespread corruption and the lack of reliable data that would allow value investors to enhance market efficiency. Chapter four explains how China has been able to accumulate large current account surpluses without inflation. As in Japan in the 1990s, in China there has been bifurcation in the credit expansion due to financial repression, so the credit expansion primarily goes to those who benefitted from financial repression in the first place, i.e. the producers. In chapter five, Pettis judiciously uses logical inference, the evidence of misallocation in areas where we can measure it (the state sector) and comparison to other economies at a similar stage of development to present a persuasive if admittedly circumstantial argument for massive misallocation.
Towards the end of chapter five, Pettis outlines six scenarios for rebalancing China's economy from its current unsustainable levels of investment and acknowledges that ultimately it is politics as well as economics that will determine their feasibility. Chapter six delves into the scenarios in greater detail and makes for alarming reading. Gradual readjustment is economically unfeasible because China will probably reach its debt limits before enough rebalancing takes place. The likely result of gradual readjustment – China reaching its debt limit – is the same result China would get from not rebalancing, with the timeline just stretched a bit. Unfortunately, the other rebalancing options are highly politically contentious as all involve the governing elites giving up substantial amounts of wealth and/or power.
Chapter seven is a brilliant challenge to the China bulls to come up with better arguments for why high growth will continue. Pettis calls on them to explain how to service the debt within China, where to invest and how China will make consumption surge. Without dealing with these three questions, the optimists are hard pressed to present a logically coherent and empirically based argument.
Despite its excellence, Pettis's book is not without its flaws. First and foremost, I wish the book were longer so Pettis could present additional data and more detailed historical accounts. As an occasional reader of Pettis's newsletter, I know he has such data.
Connected to this first point is a problem with Pettis's critique of the China bulls. Given the shortness of the book, Pettis had to pick and choose which to address. Unfortunately, he spent more time on some of the more insubstantial ones, such as The Economist. As much as this reviewer enjoys seeing criticism of a magazine that trumpets transparency while not revealing the identity of its journalists, a better use of the book's limited space would have been to engage more fully with sophisticated optimists, such as Stephen Green and Nicholas Lardy.
Pettis needs to address Lardy's argument that consumption has been higher for the past decade than he believes (10 per cent rather than 7 per cent at the extremes), which means that it is not necessary to lower growth to 3–4 per cent in order to rebalance. Pettis in chapter two makes his case for low consumption, but fails to explain why he thinks Lardy's consumption growth rates are incorrect; if they are not, then transitioning to a consumption-oriented economy will not require growth to plummet. Moreover, Pettis should decide what he actually thinks the rate of consumption is. On page 30, he says it is 7–8 per cent and on page 40 he claims 7–9 per cent. Given the amount of data Pettis provides on the plummeting household consumption as a percentage of GDP, I am inclined to agree with him, but a head-to-head comparison of the figures with Lardy would be helpful.
These seemingly small differences in consumption actually may matter. Yukon Huang, Pettis's Carnegie colleague, in a recent piece in The Financial Times describes the consumption growth as having been 8.5 per cent (and agrees with Pettis that it is not going to go up any faster) but he sees 6 per cent future growth. Of course, even at 6 per cent growth, China is heading for trouble given the very high debt accumulated by the state.
While Pettis deserves praise for his wide-ranging historical take on financial repression and economic development, one can quibble with his case selection. His contention that “... the period of growth was interrupted in every case either by a debt crisis and many years of negative growth or by a lost decade of very slow growth and burgeoning death,” is generally true, but does not hold for Taiwan. Thus, it would have been helpful to explore this divergent case. After all, Pettis acknowledges that Korea and Taiwan (and possibly Chile) are the only economies that managed to grow for long enough during the 20th century to join the rich-country club.
