Michael Pettis besides being a professor at Peking University’s Guanghua School of Management is also the man behind mpettis.com (guess that is not much of a surprise) which is one of the most well informed blogs on China’s economy and financial markets.  Given the uncertainties surrounding the global economy and their affect on China’s economy we figured there was no one better to discuss these matters with then Mr. Pettis himself.  Thankfully, he was kind enough to answer our questions in the interview below:  

TCP: There has been a wide amount of speculation about how the Chinese economy will fare during this current global slowdown. What statistics, policies or sectors are you watching most closely to get feel for where the Chinese economy is headed?

MP: I think we need to watch industrial production and inventory levels to get a sense of strength or weakness in the economy and of course we need to watch the banking sector very closely.  First, that means getting a sense of non-performing loans, and second, getting a feel for whether credit is expanding or contracting.  This is made very difficult because unfortunately the informal banking sector, about which we have little information, is very large.

TCP: You mentioned the informal banking sector, what are the best estimates of how big a role it plays in China’s banking sector and what do you make of  the Chinese government recent attempts to regulate and bring the informal banking networks out of the shadows (reuters article). 

MP: I think it is good to regularize the operations of the informal banks because as long as they are outside the system they undermine the PBoC’s monetary policy and of course transparency is worse then ever.  I am just not sure that it will be very easy to bring these banks into the fold.

TCP: The Shanghai and Shenzhen indexes, despite a small reprieve the last few weeks have been battered over the last year. You've suggested in some of your writing that it is unlikely that government policy will be able to help move the markets higher.  In your analysis, what are the greatest problems that the stock markets in China face and what prospects are there for recovery?

MP: The biggest problem is that it is still wholly a speculative market and there is little reason to expect this to change in the medium term.  A well-functioning market that allocates capital efficiently requires a mix of investment strategies that includes not just speculation but also fundamental investing and relative value investing.  The two latter strategies, however, require much better national and company information, a more stable regulatory framework, clear corporate governance rules and less government intervention, in order to develop.  I don't see this happening yet.

But this is a medium- and long-term problem.  In the short term I am not sure what it will take to get the markets to recover.  Confidence is low and probably dropping, the economy is clearly slowing, and we

may start to see hot money outflows.  None of this makes a recovery in the market easier

TCP: In a recent article for the RGEmonitor you talk about trade imbalances between the US and China.  Do you think the current stimulus plan put forward by the Chinese government is likely to only increase these imbalances by increasing capacity?

MP: The current fiscal expansion plan is more likely to increase demand in the short term than to increase capacity, so I think it is definitely a step in the right direction.  The real questions have to do with whether it is a big enough step, how quickly it can be implemented, and whether the financing of the deficit will have adverse balance sheet impacts..

TCP: What policies (by the Chinese government) do you think would be most effective in dealing with these imbalances and have a positive effective on the Chinese economy?

MP:  Anything that boosts domestic consumption, especially if it boosts household consumption.

TCP: Also many people have suggested that China’s exports only account for 10-15% of the economy and a slowdown is unlikely to affect China’s overall economy, is this wrong and what are people missing?

They are missing two things.  First, a lot of investment is export-related, and second, the important thing is the size of the global demand/supply imbalance.  As the world demand adjusts, China will also be forced to adjust, and given the self-reinforcing relationship between exports and imports, each country’s adjustment puts more downward pressure on other countries.  It is worth remembering that total US exports in the 1920s averaged less than 6% of US GDP, and the current account surplus averaged just over 1% of GDP – in both cases far lower than China – but the collapse of international trade after 1930 caused a massive adjustment in the US which made the contraction much worse than it might have been..

TCP:  Over the last few days the RMB has seen a pretty dramatic decline against the dollar, if it continues in this direction what effects is this likely to have the Chinese economy?

MP:  I don’t think it will decline much more – at least I hope it doesn’t – but if it continues it is likely to set off very difficult times for international trade.  Protectionism will almost certainly surge.