Odd Lots - Michael Pettis on What Evergrande Means for China’s Macro Economy

Episode Date: October 11, 2021

The implosion of Evergrande continues. And nobody knows exactly how the losses will be distributed. What will be the impact on creditors or people who have put down payments on homes that haven't been built yet? And what will the ripple effects be on other credits? In addition to the financial fallout, there's also a macro angle. Real estate is extremely important to the Chinese economy for all kinds of reasons. And what happens in China has effects on all of its trading partners. To explain what comes next, we spoke with Peking University Finance Professor and Senior Carnegie Fellow Michael Pettis.See omnystudio.com/listener for privacy information.

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And I'm Tracy Allaway. So Tracy, we've been talking about China, a fair amount, obviously, on the podcast. We did that great episode on Evergrand with Travis Lundy. We've been talking about how some of the reforms fit in with the broader vision with Isabella Weber. some of the tech and other industrial policy changes with Dan Wong. But it still feels like we haven't quite like, I guess I would say, put all the macro pieces together. No, I don't think we've connected the dots between all of those different developments and talked about their actual impact on the economy.

And I mean, I don't know, to me, the big question around all of this, you know, what's happening in the property market right now. with Evergrand and what's been happening with the tech crackdowns and various other crackdowns, to me, it's just the timing. You know, why decide to do all of this right after a global pandemic when you could argue that economic recovery might be relatively fragile? Yeah. And again, like, we're sort of seeing the impact in the property sector now, right? So China introduced this three red lines policy last year in order, presumably, to strengthen its

real estate market. And fast forward, you know, a year later, it seems like that's actually caused quite a lot of tensions. So, yeah, I don't know. To me, it's still sort of a mystery. Yeah. And there's some interesting things. So like even take Evergrand, for example, and obviously there are the sort of like initial effects, like on, okay, who is going to be left holding the bag for the losses? And I think that's still TBD, right? Like, we don't really know how these sort of like economic losses will be distributed among creditors, among regional finance chiefs, among people who may have put down a down payment for a home and so forth. And then there's sort of like limers of like macro impact.

And you read these stories about commodities piling up in places where the home real estate development is slowing and rebar and other assets piling up. And so, okay, then there's a commodity spillover, et cetera. And, you know, it's interesting you mentioned like why now. And of course, coming out of the 2008, 2009, great financial crisis, China was seen as like one of the demand engines of the world. Like so much of the demand was coming from China. Very different dynamic right now from a sort of global spillover standpoint where there is a lot of global demand for Chinese goods. But not a huge demand impulse, it would seem coming from China itself. Yeah. So we kind of need to have two conversations. So we need to talk about what all these recent developments actually mean for China's economy domestically. And then, of course, we have to have even bigger conversation about what those changes actually mean for China's role in the global economy. Absolutely. And there's one other twists in all this, which is there's this global energy

crisis right now in natural gas. Prices are surging. And China is not escaping. that, in fact, energy prices are surging in China and the sort of curbs on energy consumption, and they don't fully understand what's going on or how that plays into it. Anyway, we have the perfect guest, I believe, to talk about the domestic impacts, and then the global ramifications. He's been on the odd lot several times. We had to get him back for this moment. We're going to be speaking, of course, to Michael Pettis, finance professor at Peking University,

and the scholar at the Carnegie Endowment, and of course, the co-author of the book, last year, trade wars, our class wars. Professor Pettus, thank you so much for coming back on Oddlott. My pleasure is always. Well, let's just start with, I guess, the sort of like, I guess I would say the first order effects. And we'll probably get into second and third and fourth order effects. But, you know, the big news, obviously Evergrand.

We don't really know how that story is going to play out. Kind of like I said at the beginning, there's going to, you know, we don't know how the economic losses from that implosion will be distributed. But what is your view sort of a big picture of what that means for the Chinese economy, sort of the most straightforward take you have? Well, I'd say two things. The first thing is that I think the macro view is the right way to look at it. Evergranda, Evergrand in and of itself is, you know, pretty important, pretty painful, but it's much more important as a symptom of what we've been seeing. The latest round of defaults in China didn't start with Ever Grande. You could argue that they started in May

2019 with Bauchang Bank, and since then, we've had a series of very important defaults that have all been resolved by the regulators. I wouldn't even say Evergrande is the most important. I think Huarong is probably the most important. And you could also argue that HNA and perhaps Ping'an in the future are also more important in terms of size. But what really matters about Evergrand is not so much Evergrand, but what the property sector represents for China. I'm sure you know all the figures.

They've been much repeated recently. But to go through them, the property sector, including upstream, upstream and downstream businesses comprises between 25 and 30% of China's GDP, probably closer to 30 than to 25. And that's roughly twice what you would expect in other countries. Real estate investment is about 13% of China's GDP. So that's about one-third of total investment in China. And as you know, investment in China is actually. extraordinarily high. It's roughly 45% of GDP. In other countries, real estate investment is a much lower share. I think in the U.S., it's roughly 5%. So when you look at the direct impact of a

slowdown in the property sector, the numbers are pretty scary. They're quite large. They represent a very significant part of the Chinese economy, and they represent perhaps 30 to 40% of growth in recent years. But there's a number. Another thing that matters a great deal, which may even matter more, we'll see. And that is, when you look at household wealth, homes, home ownership represents roughly 80% of household wealth in China. And I've been trying to look at other numbers. This is more than twice what it represents in most other countries.

But I was looking at Japan during the bubble of the late 1980s. And there it represented, I believe, roughly 65% of household wealth, which at the time was considered a really high number. In China, of course, it's much higher than that. And the reason that matters, of course, is that if you start to see a decline in the price of homes, that will very significantly impact household wealth, which in turn should significantly impact household consumption and savings. Yeah, I remember one of our previous guests, Travis Lundy, also mentioned that Japan bubble comparison. But, okay, so here's my one big question about what's going on with China property and with Evergrands. So a lot of people are talking about some of the current stresses being caused by the Three Red Lines program that China introduced last year, where it was trying to encourage a lot of real estate developers to deliver their balance sheet. and not to cross certain thresholds for borrowing.

I guess on the one hand, it makes some sense for China to try to shore up and de-leverage its real estate sector because, as everyone knows, it is quite heavily indebted. It is very, very financialized. But on the other hand, given real estate's importance in the economy, which you, of course, just described, it seems like a risky proposition to start ring fencing it at an economically sensitive time. So I guess my question is, why did the authorities decide to do it? And then secondly, what impact do you think that program has had on the property sector overall? It's difficult to figure out why the timing, but I'm not even sure that that matters. What I would argue is that

the three red lines, which were announced last year, are sort of the trigger for Evergrand's problems, but they're not really the cause of the problems. You know, we've discussed this many times before over the past several years. And the problem in China was that you have two types of growth in China. You have what Beijing has been calling high-quality growth, which is really consumption exports and business investment oriented towards consumption and exports. That's what I would call the sustainable growth, the real underlying growth in the economy. And then you have what I would call residual growth, which is really investment in the property sector and local government spending on infrastructure.

And the purpose of that residual is to bridge the gap between the real understanding. underlying growth in China and whatever the GDP growth target is, which has always been much higher, in my opinion, at least twice the real underlying growth. And I would say that at this point, even Xi Jinping, the president is starting to think this way in a very important essay that he published in July on the new development model. He talked about the difference between genuine growth and fictional growth. And he said, not surprisingly, we need more genuine growth and less fictional growth. So what's the problem with the fictional growth? Well, when you're borrowing money to invest in non-productive investment,

then by definition, your debt servicing needs, your debt, your debt is going to rise faster than your debt servicing capacity. And this has been the problem in China for well over a decade. And so as debt rose, in fact, the growth in debt accelerated and the growth in GDP decelerated, that created more and more of a debt problem for China. And it was just a question of time before Beijing decided to step in. They postponed it for a very, very long time because the costs of not stepping in are in the future and the costs of stepping in are in the present. So it's always been easy to postpone the problem and hope that's something to be.

develops. But of course, the longer you postpone it, you know, the costs of both rise, but the costs of not intervening rise faster than the cost of intervening. And at some point, they were going to step in and try to constrain the growth in local government debt and in the property sector. And they focus mostly on the property sector. So if this didn't happen this year, it would have happened next year or could have happened last year. I think the time is less important than the mechanics that required that eventually that would happen. It definitely sounds like Xi Jinping has been reading the Michael Pettus blog, because, of course, you've been talking for years about this idea of GDP in China, I guess,

meaning something different than GDP elsewhere. And so whereas in, say, the U.S. or elsewhere, GDP is like you add up everyone's income in China, they start with the GDP target, it would seem, and then they work towards that and they figure out how, either through high quality growth or sort of like manufactured credit-driven growth. There's a lot of things to unpeal there. And I want to get into the sort of like the prospects for the high-quality growth. But one thing that came up in our episode with Travis Lundy, and you'd mentioned it just now, so I want to hit on it. You know, the importance of real estate sales, or the selling of land specifically for regional government revenue. And you mentioned

regional government debt. And so if the property developers have to pull back and they start buying less land from the regional government, can you talk to us about the knock on effects and the structure of regional government finance in China and what that means if we do get for them, for those regional governments, if we do get this pullback? And is there some other structure of regional finance that may emerge in its wake. That's a very important and very interesting and also very complicated point. What I would argue is that in a way it was the way this thing had to develop. Let me digress a bit and talk a little bit about common prosperity.

As you know, that's the new buzz phrase that everybody uses. Everybody invokes to explain everything. The way common prosperity works is that, that Beijing has decided that in order to resolve the over-dependence on non-productive investment, they have to increase the consumption share of GDP. And we've known this for many years. The first time they said this formally in public was way back in 2007, but they've never been able to do it. The way common prosperity seems to be working is they're saying, the problem is that there is a very uneven distribution of income among Chinese households.

The rich have too large a share, and the ordinary and poor have too low a share. And that's why consumption in China is so weak. So here's what we're going to do. We're going to implement policies that transfer income or transfer wealth from the rich and perhaps from businesses to the extent that businesses have, quote-unquote, excess profits, back to ordinary Chinese. And that will boost consumption in China. Now, that's technically true, but there's two big problems with it.

The first problem is their concept of, this gets a bit technical, but tertiary distribution. In Chinese jargon, there are three forms of distribution. There is primary distribution, which is wages, salaries, income on your savings, etc. Distribution of income to households. So primary is wages and salaries. Secondary or redistribution is fiscal transfers. And then they have this third thing, which most of us would have never considered, which they call tertiary distribution, which consists of donations from the rich to the poor.

So common prosperity relies a little bit on secondary distribution, on fiscal transfers, but it relies primarily on tertiary distribution donations. So why is that? Well, I would argue that this was, in a sense, the problem with the dual circulation program. The dual circulation program, which was introduced last year, argued that China would use its strength in exports and its strength in consumption. and growing consumption to reinforce each other and to drive manufacturing in China into the future. The problem with dual circulation is that China's export strength and its large current account surplus, large trade surplus, is caused mainly, as it is in every country with large surplus, as Japan, Germany, South Korea, etc.

It's caused mainly by the relatively low wage share. relative to productivity. So you're good in exports because your wages are low relative to productivity. But of course, as you know, that's exactly why consumption is so low. So the idea that you could solve both problems was always pretty complicated. If you want to solve, if you want to increase exports, you have to keep wages low relative to productivity. If you want to boost domestic consumption, you have to raise wages relative to productivity. So how do you? you do that? Well, in a sense, common prosperity is an attempt to address that. Because rather than raise wages, which would undermine export competitiveness, you do so by forcing the rich

to redistribute income to the poor in the form of donations. Now, will that work? There are, there are, as I said, two problems with it. The first problem is that donations are a tiny part of the economy. My calculation was that donations represented about three-tenths, I'm sorry, three-hundredths of one percent of GDP. So let's say that China is able to multiply donations by 10, which I think is going to be quite difficult, that's less than one-third of one percent of GDP. And while that helps at the margin, they need to redistribute two to three percentage points of GDP every year to really resolve that problem.

So that's the first problem with common prosperity. The second problem with common prosperity is that they're trying to solve the American problem in China or the European problem in China. And by that I mean, if you think that there is a bad distortion in the way income is distributed in the U.S., and I think there is, and I'm sure you agree, then the place you resolve that is within the household income share. of GDP, which comprises roughly 80% of the US GDP. So if you can redistribute income from rich to poor, then you are significantly resolving the income distribution problem in the United States. But in China, household income is only 55% of GDP. The real distortion is the very high government share of GDP, which is perhaps 20 to 25 percentage

points in the US and in Europe. It's much closer to zero. It could even be negative. So what I would argue is that common prosperity solves the wrong problem. There is certainly huge income inequality within China, but the real distortion in distribution is the very high share government retains of GDP. So if you want to solve that problem, what you really have to do is transfer income from local governments to the household sector.

Now, you asked about the impact of property on local government revenues, and as you know, it's a really important part of local government revenues between 40 and 60 percent, for, you know, depending on which local government. So perhaps by undermining the property sector, this is also part of this process of reducing the income share local governments retain of GDP. and presumably passing it on to the household sector. So theoretically, it makes sense. But, you know, the obvious concern is that that's a really difficult process to manage

and it has huge political implications. So we'll see how those political implications evolve. You know, the one theme that emerges from this discussion is the idea of adjustment or tradeoff. You know, you try to resolve or adjust the economy now in order to. to avoid bigger problems later on. But of course, that kind of change ends up being probably painful and at the very least uncomfortable. So what can China actually do,

what can the authorities do to try to ease the adjustment process and avoid stirring up a lot of public anger? You mentioned how much household wealth is actually tied to property. And of course, we have seen some protests over losses tied to China Evergrand from individuals. So what can China do to sort of manage that process? You know, Tracy, unfortunately, I think there is no way to manage it well. The options are between bad and worse. You know, this is what I've been arguing for many years.

The longer you postpone it, the more difficulty adjustment is going to be. And the way I think, think about it, sort of helps me think about it, is, you know, you look at the existing growth model and you look at the various alternatives you have to resolving this growth model. So right now, as you know, China has a growth model in which you're able to maintain high GDP growth rates only because of this explosive growth in debt. So what can China do? There are literally five paths it can take. One path is to do nothing and continue with this growth model. If you have infinite debt capacity, then that works. But I think most of us agree that you don't, and in fact, Beijing seems to believe very strongly that you don't. So what else can you do? Well, you can bring down all of this

non-productive investment. You have to if you want to stop the growth in debt. So what happens if you bring down non-productive investment. Well, perhaps you can replace it with another source of demand. So one source of demand could be a productive investment. So switch out, you know, don't build bridges to nowhere and don't build empty apartment buildings and use that money to develop the high-tech sector and productive sectors in the economy. That's much easier said than done. They've been talking about this for years and years. And later on, if you like, we can go into, to why it's going to be very difficult. But at least that's one possible path. Another possible path as you bring a nonproductive investment down is to increase the trade surplus.

But of course, you know, if we were talking about Singapore, that would be viable. But for a big economy like China, that's not viable. The trade surplus would have to grow by two to three percentage points of China's GDP every year for that to be the way out. And, and, and Clearly, the world can't absorb that. A third way is to bring down non-productive investment and to increase consumption, and that requires really significant income transfers primarily from the local government sector. And then finally, the only other path China can take is to bring down non-productive investment and not replace it with other sources of growth, in which case GDP growth drops substantially.

I would argue probably to below 2 to 3%. But that's literally it. There are no other options. And when you think about it that way, it's very hard to figure out what is a good way, what is a good adjustment process. They're all going to be quite difficult. That is very well laid out.

And striking of what you characterize is the sort of, I guess, the true rate of growth when you strip out the non-productive investment spending. You know, obviously, and we've talked about this with Den Wong and some of China's industrial or tech ambitions. And we used to talk about it with Brad Setser a lot before he joined the administration. And so now we can't talk to him anymore. But obviously, like, one, you know, one path is just the economy becomes much more productive.

And you get much more high quality growth than China becomes a bigger leader in, you know, wide body airplanes and microchips. pharmaceuticals and all kinds of things like that. And theoretically, that helps balance the economy towards something more productive. That's a long-term project, though. So even if that's the type of thing that it's like, okay, that's the path, you know, obviously that can't happen overnight or even next year or maybe even over the next 10 years. How much, though, do you sense or do you believe that Beijing is sort of like betting on that path, that ultimately that it can sort of do some sort of substitution from the more speculative

growth to the more high-quality growth in some reasonable timeframe? It depends on, you know, which part of Beijing you're talking about. I think the local government politicos, the foreign affairs people, the military people, the non-economists think that that's the obvious way out. I think, you know, when you speak to people at the central bank or at the various regulators or many of the economists that are policymaking advisors, I think there's much less optimism that that's the way out. But I would say two things, Joe. The first is that this is a really tough thing to do.

We don't really know why it is that some countries are very good at, you know, the very advanced, commercially sustainable advanced technology. But I would argue that success in the past doesn't necessarily equate the success in the future, because when you have highly centralized governments and a very clear target, a very clear goal, the highly centralized governments are probably better than decentralized bottoms up type of societies in achieving those goals. When you are hugely underinvested and you know you need to build lots of bridges and subways and trains and airports, et cetera, that's fine. A certain type of centralized approach may be very efficient. But when you take that next step of sustainable, commercially sustainable advanced technology,

it seems like you need much more of a bottoms up approach. So maybe it'll work, maybe it'll not work. We don't really know. But the other issue I would argue that we always forget is that there is a cost to following a growth model where you have an artificial, boosted GDP. And I recently used the word that Galbraith came up with modifications, the word bezel, to represent the huge gap between wealth, real wealth, and perceived wealth. And, you know, this gap is enormous in China, but just think in terms of real estate. The total value of real estate in China is worth twice what it is in the U.S., more than twice, what it is in the U.S., and more than three times what it is in Europe.

So that means there is a perception of enormous amounts of wealth that are probably not real. The real value, if you assume the U.S. is correctly valued, which is a pretty heroic assumption, then the real value of Chinese real estate should probably be between two-thirds and one times U.S. real estate. So there's this huge amount of perceived wealth that doesn't really exist. And what we've seen in the past is that during the adjustment period, that wealth gets amortized. And those losses have to be distributed within the economy. And that causes a couple of things. First of all, it becomes a negative.

It becomes a drag on GDP growth, whereas before it boosted GDP growth. And secondly, and perhaps more importantly, is that when we're all feeling richer, we tend to spend more, and animal spirits tend to be brighter, brisker. But as we start getting poor, as all of that bezel or false wealth gets amortized, that changes the behavior of the economy, typically in adverse ways, which is why I would argue that every country that's experienced an investment-driven growth bubble has always had a surprisingly difficult adjustment. Now, that doesn't mean that has to happen in the case of China, but unless we can figure out why that won't happen in the case of China, then I think the safest assumption is

to assume that it will happen. So there's another thing that's complicating what, you know, you just described as an already painful adjustment process, but that has to be the energy crisis that China is currently experiencing. You know, there have been. electricity shortages, restrictions on power consumption, and of course, a similar thing is going on in Europe. So China isn't necessarily alone in facing these pressures. But again, it seems to be coming at a pretty inconvenient time when the economy is already dealing with things like Evergrand and the slowdown in real estate.

So I guess my question is, how do you see the energy crisis impacting the adjustment the adjustment process that you described, and how big a deal is it for China's overall economy? Well, it certainly doesn't help, and I think it was probably, you know, in retrospect, we probably should have seen it coming, based, you know, basically on high school economics. One of the things that happened in China is that as the input prices in the energy sector soared, coal and oil, et cetera, the output prices didn't because they're heavily restricted, heavily constrained by local governments. So you're only able to raise electricity prices a little bit, often by no more than 10%. So the power companies were in this very difficult position

in which their inputs, the price of their inputs were soaring and the price of their output was pretty stable. And so they began taking very, very large losses. somehow that has to be addressed. In one way is heavily to subsidize those losses. And another way is through rationing. You'll remember from, again, from high school economics, that if you don't allow prices to ration supply and demand, then supply and demands gets, you know, gets matched either in the form of shortages or in the form of excesses. And in this case, because there was no adjustment on the demand side, prices didn't go up, but a huge adjustment on the supply side where prices went up a lot, then inevitably we had to deal with it in the form of rations,

of rationing of scarcity. So the question then becomes, what does China do next? And my way is, I'm not very good at predicting. So what I try to figure out is what are the ways it can react. One way is to allow electricity prices to rise substantially. That will have a significant impact, obviously, on manufacturing productivity and on consumption, too. Another way is for the government to subsidize the losses borne by the power companies, which of course means debt continues to grow. And then the third way is to force the power companies to eat the losses, which is really very similar to the government doing it.

So there's not really a good way. If energy prices come down substantially, then that problem resolves itself. But if it doesn't, I think the most likely thing China will do is to continue effectively to subsidize energy prices to the manufacturing sector and to households. But remember that subsidies aren't free. Subsidies are just transfers. And the way that typically has worked in the past is that these transfers, to the manufacturing sector, which is what it means when you subsidize electricity prices, are indirectly borne by the household sector. So that hurts the rebalancing process, right? When you subsidize the manufacturing sector at the expense of the household sector,

necessarily exports will become more competitive, but domestic consumption will be weaker. So China once again has to face that tradeoff. The idea that, that you can do things that are good for both exports and domestic consumption is simply wrong. You can't. You have to choose one or the other. And we know that they believe they have to choose consumption, but it's very hard to hurt the export sector. So, you know, obviously energy is a good chance to pivot to sort of a more global conversation. But there's one other dynamic I'm sort of curious your take on. And actually, I don't know if you have a take on it even, but I am curious. So with a lot of these energy and power issues that we've seen, there's an element, it seems, of this sort of global transition to more sustainable forms of energy and maybe certain types of cleaner energy haven't come online as fast as other types of dirtier energy have come offline, leaving us in a position where certain types of transition fuels like natural gas end up becoming very scarce.

And obviously, you know, we know in Europe, they seem to take climate issues pretty seriously. And sometimes, like at Davos, we get the impression that China takes climate issues very seriously and wants to come off coal as a source. But I, you know, as an outsider, I never have a great sense of how much of that is a very serious priority climate in Beijing versus how much is it makes for good headlines at global events. What is your sense of the degree? to which leadership in Beijing really takes that issue seriously of changing the energy mix to something that is perceived as being cleaner and more sustainable? I think Beijing is very serious about sustainable growth and about its impact on the environment. But, you know, again, I'm fairly pessimistic there in the sense that I believe, and not just in China and the U.S. and in Europe and everywhere else. it's easier to be environmentally conscious when you're satisfied with growth. But when growth slows, it becomes much easier to push green concerns into the background.

So I would argue that that's really what's going to drive environmental concerns in China and in the U.S. and in the rest of the world. In a good economy, it will resolve them or we'll attempt to resolve them. in a bad economy, it will focus more on generating growth. Well, why don't we widen the discussion even more now and get even more macro and talk a little bit about China's role in the international economy or the global economy. So maybe just to begin with, I know you've done a ton of research into this topic and, you know, have even written an entire book on this, but how would you characterize China's role in recent

years and where do you see it heading, given the emphasis on adjustment that we've been talking about? Well, the way any country interacts with the rest of the world, and this is true of China, is obviously by definition through the balance of payments. So what really matters is the extent to which China is able to reduce the gap between savings and investment. If savings exceed investment, China will be a net exporter of capital and will run a trade surplus. And, you know, what we've seen in the past year or two with the pandemic is that while the pandemic was primarily, in my opinion, a demand-side problem, there were definitely supply-side interruptions too, but it was mostly a demand-side problem.

And the U.S. and Europe and a number of other large economies treated it as a demand-side problem, In China, the response to COVID-19 was mostly in the form of supply-side policies. So additional subsidies for manufacturing, more credit for manufacturing, which is a form of subsidy, et cetera, et cetera. Now, when that happens, you would expect that there's only two ways that the Chinese economy can absorb the resulting imbalance. One way is through increased domestic investment, which really meant residual investment. and therefore non-productive investment.

And the other way is through a growing trade surplus. And needless to say, we've seen both. China's trade surplus in the last year, year and a half, has grown to among the highest monthly trade surplus as we've ever seen. And at the same time, until very recently, we saw a significant increase in property development, which grew, I think, by 7% last year,

while GDP only grew by 2.3%. and in public sector infrastructure spending. So now the interesting question is, what is the impact of the crisis in the property sector? Well, that should drive down property investment. So because there is no corresponding reduction in Chinese savings, if that's the only thing that happens in China, then almost by definition the Chinese trade surplus should grow. because, of course, if investment goes down, the gap between savings and investment will increase. That, I think, the Chinese are very worried about, and with good reason, because the rest of the world is unlikely to be very happy with a significant increase in the Chinese trade surplus.

So there are only two other ways that that adjustment can take place. One is through an increase in unemployment, which reduces the savings rate. But of course, Beijing doesn't want to see that. So the only other resolution to that problem would be an increase in quote-unquote other investment. And the only other investment Beijing could really push is public sector or local government investment in infrastructure. And already there have been a series of announcements saying that that's exactly what they're going to do. So that's really the way I think about it.

If China matches the reduction in property investment with an increase in infrastructure investment, then you really haven't solved the domestic problem, the domestic debt problem in China at all, but at least there won't be a significant balance of payments impact. If they don't, if they try to constrain the growth in debt, then we should see either an increase in unemployment, which I think Beijing will do everything it can to prevent, or an increase in the trade surplus, which I think will be difficult for the rest of the world to absorb. Does that make sense?

I try to set it out really schematically. Yeah, so this is, and, you know, kind of one of the weird things about right now, and I mentioned that we were sort of talking about the outset. In the post-great financial crisis environment, the sort of, well, not the perception, the reality is that China was this huge growth engine for the world and was driving a major contributor to the, the surge of commodity prices. I think the Bloomberg Commodity Index, it peaked in 2010 or 2011. Anyway, it's peaked again, the Bloomberg Commodity Index, and every day we're just sort of, our jaws drop at the surge in various commodity prices. And I've been kind of surprised, however, that it's, you know, obviously this time China is not playing the same role it has. And I started off with that point. And it was a Bloomberg article that I read about Evergrand and the sort of the various

construction materials that were just sort of lying dormant because it's falling behind on its production of real estate. And so where it's previously, it seemed as though China was this sort of major contributing positive impulse to the price of commodities, it feels like if anything this time around the surging price of commodities is a burden. Yeah, I would say what really matters is investment in the property sector is going down. I think we're all pretty much convinced that's happening and going to continue to happen. So what really matters is whether it's balanced by an increase in public sector infrastructure spending. If it is, we'll just see a shift in commodity demand from one sector to another, and China will continue

absorbing whatever 40 to 60 percent of the global production of industrial commodities. If they don't, in other words, if they really do try to constrain the growth in debt, then we will see demand for industrial commodities go down. Eventually, that has to happen, Joe. I mean, there's no way China can continue absorbing roughly 50% of everything that's produced. But is it going to happen now? I don't think so because I think we're going to see an increase in the infrastructure spending side that will match the reduction in the property investment side. So I have one sort of big picture question on my mind, it actually maybe goes back to the more original part of the discussion, where we talk about different modes of growth. It feels to me that over the course of my career,

having covered global markets in the economy, certain crackdowns on speculation in China are not that uncommon. And so you'll get, you know, for years, it's like, oh, China is doing this so that to encourage, discourage the purchase of a third apartment or they're doing this or that to crack down on online trading. And then it doesn't seem to go anywhere and then somehow it emerges again and I don't know if they're toothless or if they're not enforced or whatever it is. But that is just my sort of outside perception. Is that accurate that this, that China has made attempts in the past to sort of correct from the sort of poor growth to quality growth via that. And if so, would you say it's different this time in terms of the seriousness with which,

okay, after all these years and these imbalances building up, that they're not just going to in sort of six months again be taking various measures to sort of stoke the property sector once again to ensure that household wealth and incomes remain elevated. I think they will, and I think because of a fundamental incompatibility. So why do you have surging debt? Why do you have speculative activity, et cetera, et cetera? One argument is because you've got bad apples and you've got to identify them and throw them out of the barrel as quickly as possible.

That could be true. But the other argument is, and it's the one obviously that I'm much more comfortable with, is that there are systemic tendencies within the growth model that really, that require all of this speculative activity, all of this bad debt, all these things that you don't want. And until you eliminate the source of that, then you're never really going to eliminate the bad actions by the bad actors. And so what I would say is that the fundamental incompatibility is that if you allow GDP growth to be equal to the real healthy underlying growth, what what Xi Jinping called genuine growth, what they used to call high quality growth, then you don't

need all of this stuff to happen. You don't need the rapid expansion in debt, the rapid expansion in the money supply, et cetera, et cetera. But as long as you have a GDP growth target that exceeds the real underlying growth in the economy, you have no choice. You have to, the system has to be supported by moral hazard, because who in his right mind is going to lend into a project which has no chance of generating the debt servicing capacity needed to pay off the debt? You would only do so if you believe that you're guaranteed by either the local government or the central government. So without moral hazard, the GDP growth target doesn't work.

And so as long as you have a GDP growth target that exceeds the real underlying growth, rate, you need moral hazard in the system, and as long as you have widespread moral hazard in the system, then necessarily you're going to get all of this speculative and inefficient behavior. So you can put as many people as you like in jail, but as long as you require a GDP growth rate that exceeds the real underlying growth rate, you will never get rid of the problem. I think that's a great spot to leave it. Michael, thank you so much for coming out on odd lots.

I really like the way with every question we ask. You're like, well, this could resolve it three or four ways. And there's always so clearly laid out. And I think got tied up a lot of the themes that we've been discussing in other episodes. So I appreciate you coming back on. Thanks, show. It's the only way I can think about these things. I take care, Michael.

Thanks, Michael. It is very easy for me to imagine. And again, I say this is an outsider without really much perspective. It's very easy for me to imagine. in three months or six months or a year, we're back to like real estate records, you know, real estate prices hitting records in China and stories about real estate mania and all of this stuff about,

oh, finally they bit the bullet and they took this big adjustment as having been another head fake. It's definitely a possibility. I mean, you're sort of asking the classic, is it different this time question? But, I mean, to Michael's long run, running point, the more you put it off, the worse it's going to get, right? And so I guess the question becomes is now a politically expedient time for China to be making that adjustment process.

And I guess, like, I can kind of argue it both ways, right? So, like, on the one hand, China, the economy is still recovering from the global pandemic. But on the other hand, China has come out of it relatively resilient compared to other countries. It's also still closed off from much of the world. You know, travelers can't really go in and out. There are some pretty heavy restrictions. It has a huge export boom at the moment. And so, like, maybe that isolation and that narrative of China successfully controlling COVID,

maybe that's what makes it a particularly good time to sort of tackle some of these issues and also, you know, tag on some sort of populist endeavors like, cutting education costs or having kids stop playing so many video games. I mean, some of that makes sense. Yeah, I guess I go back and forth. You know, after speaking with Dan and Isabella, it's like, oh, this is real. And then when Michael, like, lays out, it's like, there are no good options, right? Like, there is not, like, some magic bullet that's going to create good growth to substitute

for low-quality, speculative growth, then I go back and forth. So I don't know. I'm glad it's not my job to have to make calls and I just get to talk to people. I just go back and forth. Oh, I thought you're going to say you're glad you're not a Chinese policymaker, but I guess for many reasons. I'm glad I'm not a Chinese. That also seems like going to be stressful.

All right. We're happy that we neither are we Chinese policymakers, nor do we have to make actual calls on China. But, I mean, I do think we are at an interesting juncture. I mean, at the risk of saying, you know, something very cliché, like, it does seem to be an interesting time for the China economy. And I am very, very interested to see where it actually goes. Well, we're going to be certainly doing more episodes, I'm sure. Yeah. Shall we leave it there?

Let's leave it there. Okay. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Holloway. And I'm Joe Wisenthall. You can follow me on Twitter at the source. stalwart. Follow our guest on Twitter, Michael Pettis. He's at Michael X. Petis. Follow our producer,

Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.