Michael Pettis says that China could be grossly overstating its levels of economic growth and wealth creation by failing to employ mark-to-market accounting conventions which accurately reflect the long-term outcome of poor investment decisions.
In an article written for the Carnegie Endowment for International Peace, Pettis, a professor of finance at Peking University’s Guanghua School of Management, points out that China’s reported GDP and wealth will be overstated to the extent that unproductive investments made by local governments and state-owned enterprises are not marked-to-market by accountants, in order to better reflect their actual value.
Pettis points out that while GDP reflects the total value of certain productive activities within an economy, it doesn’t necessarily serve as an accurate measure of its wealth or debt-servicing capacity, given variations in accounting conventions used to determine the value of inventory and investments over the long-term.
The same amount of investment in two different bridges will generate the same increase in economic activity and boost reported GDP in the same way during the current period, irrespective of whether one turns out to be productive over the long-term while the other remains idle and in a state of disuse.
The full, long-term economic impact of the two investments may differ completely, however, and this real change in GDP can only be reflected by some form of mark-to-market accounting.
Under mark-to-market accounting an unproductive investment of $100, for example, will see its value as an asset on a company balance sheet written down to zero, as well as a counterbalancing $100 debit to the income statement, which diminishes the GDP of the business sector by reducing its value-added component by a commensurate sum.
“This is how the GDP calculations adjust in a market economy to recognise bad investment decisions,” writes Pettis. “They are written down and the loss is recognised in the income statement.
“This is the mechanism by which the GDP calculation is forced to reconcile the accounting records with the real value creation in the economy.”
Conversely, if an economy does not employ mark-to-market conventions, its nominal GDP will be higher than underlying real wealth by the amount of wasted investment which remains unacknowledged, and isn’t written down by accounts.
This insight has profound implications for interpreting China’s GDP data, if observers are correct in thinking that local governments and SOE’s have made widespread unsound investments that have not yet been properly acknowledged.
It means firstly that China’s GDP as well as wealth is being overstated each year by the net amount of misallocated investment that accountants have failed to accurately write down.
It also means that when China eventually recognises these bad debts and writes them down, households, businesses and government bodies will be poorer than the amount of wasted investment that wasn’t previously recognised.
According to Pettis, this means that the “process of deleveraging, which includes writing down bad debt, consists of nothing more than assigning debt-servicing costs to one economic sector or another.”
It also means that Chinese savings are being overstated by the amount of bad investment or debt that hasn’t been written down, given that GDP equals consumption plus savings.
For this reason Pettis concludes that China’s “stellar growth story” has long ago come to an end, given that the government meets GDP targets via credit expansion, yet reported GDP figures fail to properly reflect the level of real wealth creation in the absence of mark-to-market accounting.
“Growth in the Chinese economy has collapsed, but growth in economic activity has not collapsed,” writes Pettis.
“The growth in economic activity has instead been propped up by the acceleration in credit growth and by the failure to write down investments that have created economic activity without having created economic value.
“In that case, high GDP growth levels simply disguise the seeming collapse of underlying economic growth in a way that has happened many times before – always in the late stages of similar apparent investment-driven growth miracles.”
While official GDP reported by China’s National Bureau of Statistics came in ahead of consensus expectations at 38.1 trillion yuan, for year-on-year growth of 6.9%, pet tis believes analysts are wrong to hail it as an unequivocally positive sign.
“In China…when reported growth comes in above consensus expectations, it does not imply a stronger economy.
“The higher demand that drove growth is unlikely to have been a consequence of underlying health…rather it is far more likely to have been created by a temporary increase in economic activity in response to government decisions to maintain high levels of GDP growth.”
Given China’s dependence upon credit-fuelled investment to shore up growth, higher GDP may also be significant of increasingly rapid debt growth, which would haas negative long-term implications for the economy.
“It simply means a higher level of unrecorded losses must be written down in the future,” writes Pettis.
“There is no way to get around the logic of debt: either the the debt proceeds went to fund a productive investment, in which case debt-servicing costs are fully covered by the additional productivity generated by that investment, or they were not.”
