China is reaching the end of its current (post-1979) growth process, argues Michael Pettis, and the direction it takes next will be decided in large part by its approach to the country’s debt over-hang. Dismissing glib talk about a magical ‘socialization’ of the debt-burden, Pettis insists that the problem of assigning losses is irreducible, and the only serious question is where these costs will be concentrated. Irrespective of the specific policy mechanisms selected, there is essentially a three-way-option: someone has to pay, and it will either be the country’s households, its small-and-medium enterprises (SMEs), or its large state-owned enterprises (SOEs).
Of course if the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.
[… ] Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.
[…] Finally Beijing can assign the losses to the state sector, by reforming the houkou [sic] system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector. This is likely however to be politically difficult. China’s elite generally benefits tremendously from control of state sector assets, and they are likely to resist strongly any attempt to assign to them the losses.
According to Pettis’ (non-predictive) analysis, re-igniting Chinese growth in a new phase will be inseparable from an intra-establishment struggle over the responsibility of the SOEs to cover the legacy costs of the country’s economic reformation to date. Status quo resistance to this compelling developmental logic is sure to provide critical context for the actions of China’s new Xi-Li administration, as it consolidated power among unusually challenging circumstances.