MNI INTERVIEW: Pettis Says Pay Less Attention to China GDP

--Urges Caution on Opening Capital Account

     BEIJING (MNI) - Investors should pay less attention to Chinese GDP growth

data as it may not reflect actual economic conditions in the country, China

expert Michael Pettis told MNI in an exclusive interview.

     Pettis also argued that China needs to be very cautious before making any

decision to open up its capital account.

     Pettis, a well-respected economic theorist and financial strategist, is now

a professor of finance at Guanghua School of Management at Peking University in

Beijing. He was one of the first analysts to warn of the need for China to

change its growth strategy, the topic of his well-regarded book "The Great

Rebalancing," published in 2013. His China Financial Market Blog is also widely

read.

     China's National Bureau of Statistics announced last week that Chinese GDP

grew 6.8% year-over-year in the third quarter, slightly lower than the growth

rate of 6.9% in the first two quarters of the year, but strong enough to

increase many investors' confidence in the outlook for the Chinese economy.

     However, Pettis argued that short-term fluctuations in the GDP figures

likely don't reflect actual growth. 

     In China, GDP is an input into the economic system, not an output, he

noted, and so doesn't provide the necessary information on the state of the

underlying economy.

     "Consider the example of building two bridges: one is a bridge to nowhere

and the other is a useful bridge. They both enter into the GDP data in exactly

the same way," Pettis said. "The way we get the reported data to conform to the

true economic value of the bridges in a market economy is to write down the

first bridge, as it creates no economic value, and then when we record the

associated loss in the GDP calculation, it reduces reported GDP."

     "This mechanism is what ensures that reported GDP growth broadly matches

the underlying performance of the economy. But if this mechanism is eliminated,

as it seems to be in China, then they no longer match," Pettis said.

     The implication is that there will be a gap between the nominal GDP figure

and the actual GDP number, the size of which depends on the extent of

inefficient investments, he continued.

     That Liaoning Province admitted it had inflated its GDP figures from 2011

to 2014 and was forced to cut its estimate of 2015 GDP from CNY2.87 trillion to

CNY2.20 trillion, suggests how large this gap can become.

     In addition, GDP growth in China, to a large extent, is a function of

credit growth, because governments have strong incentives to meet the GDP growth

target set by central government each year. For this year, the growth target is

6.5%.

     "There is a natural underlying growth of GDP, which is whatever the economy

is able to create productively, and then there is the GDP growth target," Pettis

said. "If the target is higher than the underlying growth of GDP, the way to

bridge the gap is to allow debt to grow enough to increase economic activity by

whatever amount is needed."

     "When you set a GDP growth target, in other words, you are implicitly

setting a credit growth target. You either have to hit both or neither," Pettis

said.

     This argument can be used to understand the economic impact of the

government's ongoing deleveraging campaign, which some analysts argue will put

downward pressure on GDP growth as the two pillars of recent China growth --

real estate investment and government infrastructure spending -- will both be

contained. And there seems to be some evidence of this in recent economic data.

     Real estate investment grew 8.1% year-on-year from January to September,

while property sales, recognized as a leading indicator for real estate

investments, fell 1.5% y/y in September, the first negative growth rate since

April 2015.

     Infrastructure investment grew 19.8% in the January-September period,

relatively unchanged from January-August growth, but it has been trending

downward since the 27.3% growth during the January-February period.

     "It is not possible to constrain overall credit growth without constraining

GDP growth." Pettis said. "If you give up the GDP growth target, you can rein in

credit growth. If you don't, you can't."

     "In the past five years, there has been a lot of talk about reining in

credit growth, but [the government] has never been able to do so. And I don't

think that's an accident," Pettis continued. "It remains to be seen whether

things will change."

     NOT THE RIGHT TIME TO OPEN CAPITAL ACCOUNT

     Recently, the prospect that China could soon open up its capital account

has become a heated topic, and some officials have said a window of opportunity

now exists to accomplish the goal. People's Bank of China Governor Zhou

Xiaochuan said as much in an interview with Caijing magazine on Oct. 1,

stressing that if reform is not carried out now, the costs of doing so in the

future would be even higher and the process more difficult.

     However, Pettis suggested that China needs to remain cautious about finally

opening up the capital account, as the costs of doing so could be overly

burdensome.

     "There are liberalizing reforms that make long-term sense, but which under

certain conditions shouldn't be implemented," Pettis said. "To liberalize the

capital account might be good in the long run for China, but it might not be the

right time to do it because this is a time when you want to reduce the risk of a

financial crisis."

     "Financial crises are always the consequences of asset-liability

mismatches. But because its banking system is largely closed and Chinese

regulators highly credible, they can restructure liabilities at will, making

China unlikely to have a crisis," Pettis said. "However, as you eliminate

capital controls, you open up the system and increase the amount of capital

inflows and outflows for the country."

     Pettis said he was worried that capital inflows would not be in the form of

long-term equity investments, but would be more speculative in nature. "The

problem of these kinds of inflows is that when China is doing well, you'll see

an increase in inflows that will strengthen domestic markets, but the moment

China is doing badly, these inflows will quickly convert into outflows, which

will weaken the domestic market at the worst possible time," he said.

     Pettis is not sure if there is a right time for China to open up its

capital account completely, and wonders whether it is ever the right thing for a

developing country to do.

     "As long as China does not have a resilient enough financial system and the

investor structure remains speculative, China shouldn't open its capital

account," Pettis said. "And nobody knows when China will satisfy both

conditions."

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

--MNI Beijing Bureau; +86 (10) 8532-5998; email: vince.morkri@marketnews.com

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