Professor Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. From 2002 to 2004, he taught at Tsinghua University's School of Economics and Management and, and from 1992 to 2001, at Columbia University's Graduate School of Business. 

His predictions are summarized as follows in Next Big Future, a science and technology website, at  http://nextbigfuture.com/2011/08/professor-michael-pettis-makes.html

* BRICS and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the gloMichabal crisis.

* Over the next two years Chinese household consumption will continue declining as a share of GDP.

* Chinese debt levels will continue to rise quickly over the rest of this year and next.

* Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.

* Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.

* If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.

* Much slower growth in China will not lead to social unrest if China meaningfully rebalances.

* Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.

* European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.

* Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.

* Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.

* Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.

I will confine my comments to China. With great respect to the learned Professor, I have the followig observations:

(a) It is true that China is set to slow down. But this is out of choice to change to a more balanced, sustainable, and hopefully more equitable economic model. As I write, the economy is still growing at around 9% p.a. Inflation is likely to peak and property prices are being reined in. But this is very different from an involuntary slide into a 3% growth territory. The reason is in (b).

(b) China currently needs more than 10 million new jobs a year to absorb the still large excess labour pool pouring into the cities from the countryside. Until the whole economy is totally transformed, this level of job creation can only be sustained with a growth rate in excess of 7% p.a. A 3% annual growth is more charcteristic of more mature and advanced economies. It is unlikely that China would have achieved sufficient ''meaningful rebalances'' by the end of this decade to live with a 3% growth scenario without major social instability.

(c) Should any slide in growth happens to be problematic, China is well placed to mobilize her $3.2 trillion reserve to pump-prime investments and job creation. Indeed, what China needs is not under-investment but possibly over-investment as China is creating 221 new cities and growing 320 more urbanites by 2025, according to the McKinsey Global Institute, Preparing for China's Urban Billion, February 2009. Download MGI Preparing for China's Urban Billion

(d) The suggestion that "Over the next two years Chinese household consumption will continue declining as a share of GDP" is perplexing to say the least. China is slated to increase consumption as % of GDP by an average of 1% p.a. over the next decade or so, according to Stephen Roach, Chairman of Morgan Stanley Asia and author of "The Next Asia", John Wiley and Sons, Inc., 2009.

(e) According to McKinsey Quarterly, China's "global affluent' with annual household income over RMB 200,000 ($80,000, adjusted for purchasing power parity) reached 1.6 m in 2008. Even with the global economic slowdown, China's wealthy households are likely to grow 16 % p.a. for the next 5-7 years.

(f) According to World Luxury Association's 2010-2011 annual report, China now accounts for 27 % of the global luxury market, ahead of US at 14 % and right behind Japan at 29 %. The report says China will be the world's largest luxury market in 2012.

(g) More anecdotal evidence is coming to the fore. Yum! Brands opened 500 new restaurants in China in 2010 including one new KFC every single day.

(h) According to Standard Chartered Bank's Chief Economist,"America's drowning, Europe's imploding, Asia's cooling" (August 2011). In a fully globalized world, ''de-coupling" is the wrong word. But clearly there is significant divergence in the growth rates between the BRICS countries and the West.

(i) Notwithstanding increasing adminstrative and policy restricitons, local authority debt remains a problem, but much of the local investment is in physical infrastructure. Interest burden and cash flows may seem threatening but do not appear to be a strangling albatross. Much of the burden can be relieved through land sales at rising prices as urbanization develops and in the last resort, the $3.2 trillion reserve is an insurance policy. However, the situation remains highly problematic and is drawing much closer attention of Beijing's leadership. This tallies with an official assessment "Local gov't debts differ from those in other countries, default unlikely: official" posted on the official website of the Communist Party of China on 30 August, 2011. Click here

(j) With rising uncertainbties around the globe, it will not be easy for China to navigate through the turbulent waters in the coming decade, particularly in the wake of a new leadership transition. So China is likely to keep a tight grip over the exchange rate of the RMB and over domestic interest rates, as both are powerful policy tools beyond the realm of economics and finance.

(k) As the country moves into a new economic model over the next decade, China will continue to lure foreign investment, expertise and technologies to help China to upgrade her industrial and economic structure. There is likely to be more M & As both inside and outside China. But a number of strategic areas will remain out of bounds. Morever, China is wary of too much "privatization" too soon, as evidenced by China's rejection of Coca-Cola's $2.4 billion bid for Huiyuan (a leading juice maker) in March 2009. Moreover, China is to set up a review board to screen foreign direct investments, in much the same way as CFIUS in the United States. Click here

In advancing his predictions, Professor Pettis draws on his Paper 'The Contentious Debate Over China's Economic Transition' published by the Carnegie Endowment for International Peace, 25 March 2011. Click here

The following arguments stand out –

(i) China's household income share of national GDP is not commensurate with workers productivity rises. It is suppressed by continuing predominance of investment, an artifically low RMB exchange rate, and low deposit interest rates.  This would not help lift consumption to meaningful levels, administrative measudres to boost consumption notwithstanding.

(ii) The capacity of Western countries to absorb China's excess capital will decline over time. To balance the economy, China will have no choice but to cut down investments leading to much slower growth.

(iii) China's service sector is still too under-developed to take up the slack.

(iv) There is a great deal of misallocation of capital especially at the local level. Many investments are extremely inefficient and wasteful. This represents massive wealth destruction.

While I agree that the good Professor has made a number of very valid points, they need to be looked at in the followg context –

(i) Even though workers and household income are not commensurate with productivity or investment growth, wage increases at all levels and rising household incomes across the country are real. According to the study "The Value of China's Emerging Middle Class" in the McKinsey Quarterly (2006 Special Edition), 77.3 % households were below the lower middle class income bracket of RMB 25,001 to 40,000. By 2015, this huge group will drastically shrink to only 9.7%. Instead, 79.2% of households will be in the lower and upper middle classes income range of  RMB 40,001 to 100,000. The “mass affluent” with annual household income of RMB100,001 to 200,000 ($80,000 adjusted for purchasing power parity) will jump from 9.8% of total in 2005 to 36.4% by 2025.

Download McKinsey Quarterly – The Value of China's Emerging Middle Class

(ii) Unless the West completely changes their debt-driven consumtpion economic model, China's surplus capital is more likely than not to be welcomed, especially in supporting US treasuries.

(iii) China's service sector is still below 50% of the economy. But it is growing steadily. In the new Five Year Plan (2011-15), service sector value-added output is to be boosted to 47 % of GDP, up 4 percentage points over the period.

(iv) It is very true that China's capital allocation efficiency leaves a lot to be desired. But this may hide at least part of the picture. In a June 2010 study on China, the Federal Reserve Bank of Minneapolis found that starting from a low base and thanks to a vibrant private sector, total factor productivity growth in China remained fairly high in the past decade while the rate of return in both the state-owned and the private sectors has increased substantially. Click here

Best regards,

Andrew

http://www.andrewleunginternationalconsultants.com