Why a public bet against China is starting to look good

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Peking University Economics professor Michael Pettis received considerable media attention recently with a public wager with The Economist, where the professor bet that average Chinese GDP growth this decade will not exceed 3 per cent. Once an outlier opinion, Mr. Pettis' sceptical outlook for China, based on assumptions of reckless credit expansion now morphing into non-performing loans, continues to gain acceptance.

Mr. Pettis' pessimistic outlook arises from his belief that the majority of real estate and infrastructure investment in China is unprofitable. Because of this, he says an increasingly large portion of the billions of dollars in debt incurred to finance this development will not be repaid to creditors, resulting in a sharp increase in non-performing loans.

Patrick Chovanec, another western-born economics professor teaching in China, found evidence supporting Mr. Pettis' thesis in the collapse of Tianyu Construction Co. Ltd.

Before its bankruptcy, Tianyu, a property developer based in Hangzhou, had written six billion yuan in loans to unrelated companies in the region. The company's fall threatened the solvency of banks and financial institutions, forcing the provincial government to step in with financial support.

"The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis," Mr. Chovanec wrote, "in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks"

Mr. Pettis, in his most recent newsletter published in abridged form on his website, pushes back against bullish economists who argue that "China has a different set of economic rules under which it operates." These economists, perhaps best exemplified by Morgan Stanley Strategist Stephen Roach, have argued that western economists do not understand the resilience of the state-driven Chinese economy and the scale of economic forces, particularly urbanization, that will drive future growth.

Mr. Pettis responded by noting that "there's no such thing as a different kind of economics" and argues persuasively that the credit bubble in China is no different than the credit-driven housing bubble that imploded in Spain, although much larger in scale.

The comparisons between China and Spain are alarming in light of a European financial crisis that has left the financial viability of Spanish banks and the sovereign government hanging by a thread, dependent on vast euro zone government support. Before 2007, Mr. Pettis says that demographic factors - the European elderly retiring en masse to a limited amount of beachfront - were expected to drive Spanish housing prices higher indefinitely. He sees a similar type of misguided faith in the China growth story.

Financial and economic leverage plays a central role in Mr. Pettis' projections. He believes that China's growing stockpile of commodities magnifies the economy's leverage to the infrastructure-driven economic experiment.

Mr. Pettis expects that Chinese infrastructure and real estate spending will slow as the financial viability of new projects is questioned and non-performing loans continue to accumulate. Commodity prices, which had been driven higher by mass investments in these sectors, will decline sharply. The end result, in Mr. Pettis' estimation, will be a negative feedback loop where declining investment causes lower growth, which causes lower commodity prices that threaten the financial sustainability of commodity-based investments, resulting in still lower levels of aggregate investment.